Quick Answer
- REITs are companies that own income real estate and must pay out at least 90% of taxable income as dividends, which is why the yields are high.
- The catch: those dividends are mostly ordinary income, not qualified, so a REIT fund is tax-inefficient in a taxable account and belongs in an IRA.
- REITs are rate-sensitive by design. They borrow heavily and their dividends compete with bond yields, so VNQ and XLRE fell roughly 25% when rates rose in 2022.
- Modern REIT indexes are dominated by data centers, cell towers, and warehouses, not the malls and offices most people picture.
- VNQ (0.12%, ~160 REITs) is the default; SCHH (0.07%) is cheaper. You may already own about 3% REITs inside a total-market fund.
What a REIT Actually Is
A real estate investment trust is a company that owns, and usually operates, income-producing property: apartment buildings, warehouses, data centers, cell towers, shopping centers, hospitals. You buy a share of the company, not the building. A REIT ETF bundles hundreds of these companies into one fund.
The defining rule is the one that creates the high yield. To qualify as a REIT and avoid corporate income tax, a company must pay out at least 90% of its taxable income to shareholders as dividends every year. That forced payout is why REIT funds yield more than the broad market, often 3% to 4% versus 1.3% for an S&P 500 fund. It is also the root of the tax catch in the next section.
A REIT hands almost all of its profit to you as a dividend instead of reinvesting it. You get income now, but the company keeps less to grow with, which is part of why REIT total returns lean more on the dividend and less on price appreciation than a typical stock fund.
The Tax Catch That Decides Everything
This is the part most REIT articles skip, and it is the most important thing to understand before you buy.
Most stock dividends are qualified, which means they are taxed at the lower long-term capital gains rate of 0%, 15%, or 20%. Most REIT dividends are not. They are taxed as ordinary income at your full marginal rate, which can run as high as 37%. The reason is structural: because a REIT pays no corporate tax itself, its dividends never earned the preferential treatment that regular corporate dividends get.
A 20% qualified business income deduction under Section 199A softens this, effectively shaving the rate on most REIT dividends, but it does not turn them into qualified dividends. The bottom line holds: a REIT ETF is tax-inefficient in a taxable brokerage account.
Because the income is ordinary, a REIT ETF does its best work inside a tax-advantaged account. In a traditional IRA the tax is deferred; in a Roth IRA it disappears entirely. Holding VNQ in a taxable account means paying your full marginal rate on that 3% to 4% yield every year. This is the same logic that governs where JEPI and other high-income funds belong: ordinary income wants a sheltered account.
Why REITs Move With Interest Rates
REITs are one of the most rate-sensitive corners of the stock market, and 2022 made the point in brutal fashion: as the Federal Reserve raised rates at the fastest pace in decades, VNQ and XLRE fell roughly 25%. Two forces drive that sensitivity.
They borrow heavily. Real estate runs on debt. When rates rise, a REIT's financing costs go up and the value of the property it owns goes down, because buyers pay less for a building when mortgages are expensive.
Their dividend competes with bonds. People buy REITs largely for income. When a 10-year Treasury yields 2%, a REIT yielding 4% looks generous. When the Treasury yields 4.5%, that same REIT has to fall in price until its yield rises enough to compete. The dividend that makes REITs attractive is exactly what ties them to interest rates.
What's Actually Inside a REIT ETF
Ask someone to picture real estate and they think malls and office towers. Open VNQ and you find something different. The largest holdings in a modern REIT index are usually data centers, cell towers, and logistics warehouses: companies like American Tower, Prologis, and Equinix. These are the landlords of the digital economy, not the strip-mall economy.
That shift matters. Retail and office REITs, the ones people worry about, are a shrinking slice of the index. The fund is increasingly a bet on the physical infrastructure behind e-commerce, mobile data, and cloud computing. It still owns apartments and shopping centers, but the growth story sits in towers and server farms.
Because cell-tower and data-center REITs behave like technology infrastructure, a REIT fund is less of a pure diversifier than it used to be. It now shares some of the same drivers as the tech sector, which is part of why REITs and stocks have moved together more closely in recent years.
Equity REITs vs Mortgage REITs
One distinction can save you from a painful mistake. The REIT funds in this guide hold equity REITs: companies that own actual buildings and collect rent. There is a separate category called mortgage REITs that owns no property at all. They borrow short-term money, lend it long-term against real estate, and pocket the spread.
Mortgage REITs often advertise eye-catching yields of 10% or more, and those yields come with leverage, interest-rate risk, and a history of deep dividend cuts. They are a different and riskier instrument. The good news: the major broad REIT funds (VNQ, SCHH, XLRE) are equity REIT funds and exclude mortgage REITs by design. If a "REIT" fund is yielding double digits, check whether it is a mortgage REIT product before assuming the income is safe.
The REIT ETFs Compared
| Fund | Expense Ratio | Coverage | Notes |
|---|---|---|---|
| VNQ | 0.12% | ~160 US REITs | The default. Broadest and most liquid US REIT fund. |
| SCHH | 0.07% | US REITs | The cheapest broad US REIT fund. Similar coverage to VNQ. |
| FREL | 0.084% | US REITs | Fidelity's low-cost version. A strong VNQ alternative. |
| XLRE | 0.09% | S&P 500 REITs only | Narrower and more concentrated. Large-cap REITs only. |
| VNQI | 0.12% | International REITs | Real estate outside the US. A complement to VNQ, not a replacement. |
| IYR | 0.40% | US REITs | Older and far pricier. Hard to justify against VNQ or SCHH. |
Expense ratios approximate. All are equity REIT funds and exclude mortgage REITs. Past performance does not guarantee future results.
For a domestic REIT allocation, the decision is mostly cost and platform: SCHH and FREL undercut VNQ on fee, while VNQ wins on size and liquidity. XLRE is the choice only if you specifically want large-cap S&P 500 REITs and nothing smaller.
Do You Actually Need a REIT ETF?
Probably less than the income pitch suggests. A total US market fund like VTI already holds REITs at their market weight, around 3% of the fund. So you very likely own real estate already without a dedicated fund. Buying VNQ is a decision to overweight the sector, not to fill a hole.
The historical argument for that overweight was twofold: REITs paid a high income and moved differently from stocks, adding diversification. The income half still holds. The diversification half has weakened, because REITs have correlated more closely with the broad market as tower and data-center names have grown into the index. A REIT tilt today is best understood as a deliberate bet on real estate income, sized as a satellite, not as a piece every portfolio is missing.
If you do want the exposure, the cleanest version is a low-cost broad fund held inside a tax-advantaged account, for all the reasons above. The sector ETF guide covers how to size any single-sector tilt without wrecking your diversification, and the dividend ETF tax guide goes deeper on why ordinary-income funds belong in sheltered accounts.
Frequently Asked Questions
A REIT ETF holds shares of real estate investment trusts, companies that own income-producing property such as warehouses, data centers, cell towers, apartments, and shopping centers. By law a REIT must pay out at least 90% of its taxable income as dividends, which is why REIT funds carry high yields. A REIT ETF gives you a slice of hundreds of these companies in one fund, so you get real estate income without buying or managing property yourself. VNQ is the most widely held example.
Most REIT dividends are taxed as ordinary income at your full marginal rate, not at the lower qualified-dividend rate that applies to most stock dividends. A REIT pays no corporate tax, so its dividends never qualify for the preferential rate. A 20% qualified business income deduction (Section 199A) softens the blow but does not erase it. This makes a REIT ETF tax-inefficient in a taxable brokerage account and a better fit inside an IRA or Roth IRA. This is general education, not personalized tax advice.
Two reasons hit at once. REITs borrow heavily to buy property, so higher rates raise their financing costs and lower property values. And REITs are bought largely for their dividend, so when bond yields rise, that dividend has to compete with safer Treasury income, pushing REIT prices down until the yield is attractive again. VNQ and XLRE fell roughly 25% in 2022 as the Federal Reserve raised rates aggressively.
Not necessarily. A total US market fund like VTI already holds REITs at roughly 3% of the fund. Adding a dedicated REIT ETF like VNQ is a choice to overweight real estate beyond that. The historical case was diversification and income, but REITs have correlated more closely with the broad market in recent years, which weakens the diversification argument. A REIT tilt is a deliberate bet on real estate, not a missing piece every portfolio needs.
For most investors VNQ (Vanguard Real Estate, 0.12%, around 160 REITs) is the default for its size and breadth. SCHH (Schwab, 0.07%) and FREL (Fidelity, 0.084%) cover similar ground for less. XLRE (0.09%) holds only S&P 500 REITs, so it is narrower. All are equity REIT funds and exclude the riskier mortgage REITs. The pick mostly comes down to cost and which brokerage you use. Past performance does not guarantee future results. Nothing here is personalized investment advice.