Real Estate Index Funds

What are the major real estate indexes, and what vehicles are available to invest in them?

Unfortunately, there isn't a residential real estate index in which one can invest. This is a real shame, because the ability to buy puts against the value of such an index would be a great way to hedge away some of the risk of a decline in the price of your house, much as you buy property insurance to protect against other sources of risk. But so far, nothing is available.

That leaves commercial real estate. The first problem you run into here is that nobody seems very happy with the available real estate indexes. Let's take a look at the major ones to see what they're talking about. The National Council of Real Estate Investment Fiduciaries (NCREIF) publishes an index that tracks the performance of about 3,000 properties that are directly owned by tax exempt institutions. Values are calculated on an unleveraged basis through regular property appraisals, using a standard methodology. Criticisms of this index include the fact that it underweights certain regions of the country (e.g., the Northeast), and the fact that appraisals are only done annually, and, by definition, tend to be backward looking (due to their reliance on comparable sales data). A similar index -- the Investment Property Data bank -- is produced in the United Kingdom.

The second major index is produced by the National Association of Real Estate Investment Trusts. A REIT represents an alternative structure to direct ownership of equity in a commercial real estate project. In this case, a trust is formed, and trust units (shares) are issued to investors to raise funds. The REIT uses these funds to make equity investments in a number of commercial real estate projects (typically in a single type of project, such as health care, resorts, multifamily housing, shopping centers, office buildings, and the like). The majority of the annual earnings from such investments are paid out to the holders of the REIT shares. A very similar type of company is called a real estate operating company, or REOC. The major difference between it and a REIT is that it is under no legal obligation to pay out a percentage of its annual earnings to investors in its shares.

The NAREIT index measures the performance of the shares issued by NAREIT members. Three criticisms have been leveled at this index. First, it includes many smaller REITS whose shares have low trading volume. This makes it a difficult index for investors to match. Second, it does not include Real Estate Operating Companies, which are very similar to REITs; it does not, therefore, represent the full universe of real estate shares that are available to investors. Finally, there is an ongoing argument as to whether REIT shares should be classified as equities or as real estate. The argument in favor of the former is that movements in the overall equity markets (and especially in small cap indexes) affect REIT returns. The argument in favor of the latter position is that the underlying assets are clearly real estate, with cash flow dynamics that are different from the average non-real estate company.

In response to these criticisms of the NAREIT Index, a number of other indexes have been developed. The Wilshire Real Estate Securities Index includes about 100 large REITs and REOCs. The Dow Jones Real Estate Index has a similar structure. Taking a slightly different approach have been Morgan Stanley, Standard and Poors, and Cohen and Steers, which have stuck with REITS, but focused their respective indexes on a subset of larger players -- 115 of them in the case of Morgan Stanley, 100 in the case of S&P, and only 30 in the case of Cohen and Steers.

As for indexed investment vehicles, there are four major alternatives available today. The first is the Vanguard REIT Index Fund, which tracks the Morgan Stanley Index. The minimum investment for regular accounts is $3,000, and $1,000 for retirement accounts. As is usually the case at Vanguard, expenses are very low, at .33% of assets.

If you want to track the Dow Jones Real Estate Index, iShares has an exchange traded fund that allows you to do so. Its trading symbol is IYR, and it carries an expense ratio of .60%.

IShares also offers an ETF that tracks the Cohen and Steers Index. Its symbol is ICF, and its expense ratio is only .35%.

Finally, the Wells family of funds offers an S&P REIT Index mutual fund (symbol WSPAX), which has a minimum investment of $2,500, and an annual expense ratio of .99%.

Given the differences in expense ratios, and the similarity of the underlying indexes, our recommendations from this group would be the Vanguard fund and the Cohen and Steers ETF.

Finally, real estate index funds are also available outside the United States. For example, investors located in Europe can invest in the Balzac Real Estate Index Fund, which is run by State Street Advisors, and tracks the Salomon Broad Market Euroland Property Index. Vanguard offers a similar fund to Australian investors that tracks the performance of property companies located in that country.