Real estate is an important asset class, and the source of enormous wealth.

Unfortunately, its not an easy one for most investors to gain access to. An asset with low correlation to others in your holdings can both reduce risk at the portfolio level and increase returns. Individual real estate properties meet none of the usual tests for market efficiency: Each parcel is unique, transaction costs are very large, sales occur only occasionally, and market knowledge is often local and restricted, making this an insiders market. Most transactions are private, so detailed knowledge of rent rolls, replacement costs, deferred maintenance, and other critical data is not widely known. Liquidity can be non-existent, and the smallest possible purchase unit can be above the means of many investors. By now we should have learned that speculating in houses carries a load of undiversifiable and unrewarded risk. When the housing market crashed it took far too many individual investors with it. Additionally, its a huge time sink to manage individual properties. Even if you dont lose your shirt it may not be worth the effort and aggravation to be a landlord. Real Estate Investment Trusts (REIT) solve those problems. REITs are special investment vehicles that hold real estate and avoid the double taxation problem of corporations as long as they distribute their earnings to investors. REITs offer equity like returns with low correlation to other stocks which make them a potent diversifier for your portfolio with the potential to lower risk in the portfolio while increasing returns. Real estate has always acted differently than the stock market. It goes through its own market cycle, which is characterized by boom and bust periods, most notably commercial real estate in the 80s, and residential in the recent housing bubble. Using a portfolio of REITs, investors can economically and efficiently obtain exposure to real estate in publicly traded, liquid, transparent, daily valued, regulated, audited, securities. REITs come in a wide variety of types. There are REITs that specialize in hospitals and health care, apartment buildings, theaters, office space, shopping malls, or warehouses. Some mutual funds expand the definition to include construction companies and property managers as well as firms that simply own and manage their own real estate. These different definitions and specialty focus can have important impacts on short-term performance. As asset-class investors, however, we dont have to worry about the focus of any individual REIT mutual fund. If we choose to, we can effectively and economically participate in the REIT and realestate markets through index funds or exchange traded funds that invest in REITs. Rather than try to beat the real-estate market, or play the sector game, we should opt for wide diversification and low cost to obtain the lowest risk profile and least tracking error with the asset class. As an example, the Vanguard REIT ETF closely tracks the MSCI REIT index at an expense ratio of only 0.10% or 10 basis points. To further diversify your portfolio, you might well consider similar funds that invest in foreign real estate. While not all foreign countries have the exact REIT structure, they have many securities that participate in their local real estate markets. While any foreign security is subject to currency risk, it also provides a valuable hedge against a falling dollar. For each percent that the US currency falls, a foreign security gains a percent.

Both foreign and domestic real estate are great asset classes with little correlation to the stock markets. That means that they can over time reduce portfolio risk and increase returns in a properly structured portfolio. At the top end it is suggested that it may be a good idea if 20% of your risk assets be divided between domestic and foreign REITS through index funds or ETFs. Another point to note is that, with REITs, taxation effectively occurs at investor level. Dividends and interest received by investors will be taxed in the hands of the investors as a dividend. Similarly, the disposal of a share in a REIT by an investor may result in capital gains tax consequences. On the other hand, REITs are able to claim deductions against their gross income in respect of what are called as qualifying distributions. A qualifying distribution is a dividend paid or payable or interest incurred in respect of a debenture forming part of a property linked unit that is distributed to an investor; provided that 75% of the gross income of the REIT, in the previous tax year, emanated from rental income as defined. Capital gains or losses will also be disregarded for certain types of assets, including immovable property. Essentially, if a company is purely operating as a REIT, minimal if any taxes should be payable, which is a great advantage.