Discover the risks and benefits associated with investing in various real estate investment trust index fund options so you can make more-informed buying decisions

A real estate investment trust or REIT is a type of income trust—an investment trust that holds income-producing assets. Their units trade on stock exchanges, but they flow much of their income through to unit holders as “distributions.”

Index funds are mutual funds or exchange-traded funds (ETFs) that invest to equal the performance of a market index. We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio. Below, find more about real estate investment trust index funds and ETFs.

How to Make Money with ETFs Learn everything you need to know in 'The ETF Investor's Handbook' for FREE from The Successful Investor. ETFs Guide for Canadian Investors: Find the best way to invest in ETFs with low fees, low risk & high satisfaction.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

A real estate investment trust index fund can cut your investment risk—but not completely

REITs are usually publicly traded (although they can be private), and investors like REITs because they typically have a high dividend yield, based on the requirement that they flow through at least 90% of their taxable income to unit holders.

Canadian REITs must be a corporation that’s taxable, and follow all the rules of being a corporation. They must invest 75% or more of their total assets in real estate and make at least 75% of their gross income from their properties, including rent, financing and sales. Like most stocks that are publicly traded, they adhere to the rules of exchanges, and require no less than 100 shareholders.

Real estate investment trusts can be lower risk, because they invest in income-producing real estate such as office towers, shopping malls or hotels. Even so, real estate still has risks—its value rises and falls with changes in the economy, interest rates and occupancy levels.

Here are three advantages that index mutual funds can bring to your investment portfolio

Index mutual funds are specialized mutual funds that invest so as to come close to passively equaling the performance of a market index. They typically show better long-run performance than many actively managed mutual funds with long-term track records. That’s partly because index fund fees run around 1.0% of assets per year, compared to 2.5% or more on many broker-sold mutual funds.

Index mutual funds offer three main advantages to investors:

• They can give investors with limited funds a low-cost way to get some stock-market exposure.
• Index funds typically have low management fees.
• They can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance.

Index mutual funds are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

As mentioned, index mutual funds are typically cheaper than mutual funds, due to their lower MERs, even though they may hold more or less the same stocks.

Here are 9 keys investors can use to find the best real estate investment trust index funds to invest in

Keep “investment inputs” in mind when judging a REIT—or an index fund that holds REITs.

In evaluating investments, many investors focus on what we’d call “investment outputs,” such as earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”

Here’s a list of investment inputs that we look at before recommending a REIT – whether individually or in index funds that hold REITs:

1. Do you have any doubts about the integrity of the insiders? If so, stay out.
2. Did the REIT buy its assets in the midst of a recent boom, or has it owned them for some time? Bidding for assets in the midst of a boom tends to be risky, since it can lead to unpleasant investment surprises.
3. How much debt is the REIT carrying? You need to gauge the debt in relation to all assets, including hidden assets and those that appear on the balance sheet. Too much debt can lead to a steeper downturn in distributions when the business hits a snag.
4. Is the REIT dominant or at least prominent in its industry? If the answer is no, risk is higher.
5. How much of its cash flow is it paying out? Paying too much leaves it vulnerable to a cut in distributions. This can have a devastating effect on the unit price.
6. Has its cash flow and profitability shown acceptable performance in relation to the rest of its industry? If it can’t make money when business is good, when can it make money?
7. Are there any special factors worth considering? With REITs, you need to look at the quality of tenants, length of leases and the possibility of improving the use or expanding the occupancy of existing properties.
8. Is the REIT the subject of a lot of favourable broker and media attention? If so, investor expectations may be excessively high, and that leaves the trust vulnerable to a steep downturn on any hint of bad news.
9. Is the current and prospective yield high enough to justify the risk?

Bonus tip: Use our three-part Successful Investor approach for the success of your overall portfolio

• Invest mainly in well-established, mostly dividend-paying companies;
• Spread your money out across most if not all of the five main economic sectors;
• Downplay or avoid stocks in the broker/media limelight.

Do you include REITs in your portfolio, or do you prefer to stay away from real estate as an investment?