Except for a brief period during the first technology bubble when real estate investment trusts were left for dead, real estate never seems to go out of favor. Investors have a perpetual hankering for bricks and mortar.

Even now, when a new group of technology stocks—the so-called FAANGs, or Facebook, Apple, Amazon, Netflix and Google—have captured investors’ imaginations, REITs are holding their own. From 2009 through 2017, the Vanguard REIT ETF (VNQ) delivered a hefty 14.3% annualized return, or a 232% cumulative return, to investors without a negative calendar year. The fund gained 4.91% in 2017.

But there are many real estate exchange-traded funds, and it’s hard to know what you’re getting without doing some due diligence. An asset class that has spanned the eons is now sliced, diced and packaged in many ways for prospective investors. This article will clue you in to what some of the biggest funds offer in terms of property REITs, mortgage REITs and real estate operating companies.

First, some basics. REITs are stocks of companies that hold real estate or real estate-related investments such as mortgages. A company organized as a REIT holds property or mortgages and avoids income tax at the corporate level. In exchange for that benefit, the company must pay out 90% of its net income as a dividend to shareholders. As a result, REIT dividends are taxed as ordinary income at the level of the individual investor, making them better to hold in tax-advantaged accounts.

REITs, REOCs, Mortgages And VNQ’s Problems

Job one for investors in this space is to distinguish between mortgage REITs and property (equity) REITs. The former are firms that borrow money to buy mortgages or mortgage-backed securities. Often, like a bank, a mortgage REIT has borrowed up to 90% of the value of its assets. This business model aims to exploit a steep yield curve by borrowing short-term and holding longer-term mortgages. The largest mortgage REIT is Annaly Capital (NLY). The iShares Mortgage Real Estate Capped ETF (REM), with more than $1 billion in assets, is a popular ETF dedicated to this segment of the REIT market. Annaly is the fund’s largest holding, representing 18% of its assets.

Mortgage REITs tend to have bigger yields than property REITs, but they aren’t what most investors think about when trying to diversify their portfolio with real estate. Because of the short-term nature of their loans, they depend on available credit—and can get crushed when credit markets tighten up. They got hammered, for example, during the credit crisis. As a result, REM has a 10-year annualized return of 2.01% through the end of 2017, and was up 18.54% for 2017. The low long-term return of REM, combined with its high volatility, results in a meager 10-year Sharpe ratio of 0.18. VNQ’s 10-year Sharpe ratio, by contrast, is a little more than double REM’s at 0.41, meaning it has much better returns per unit of volatility.

Investors should carefully scrutinize REIT funds with the highest yields because they often contain a large slug of mortgage REITs. This includes funds such as the Global X SuperDividend REIT ETF (SRET), which consists of 30 of the highest-yielding REITs globally. In fact, nearly half of this fund’s portfolio is mortgage REITs, and investors who purchase it and others like it without doing their homework may be getting a group of highly levered, ultra-interest-rate-sensitive companies.

What most investors are really looking for when they buy a REIT fund is a product that owns property. And that’s a broad category encompassing apartment buildings, office buildings, industrial space, hotels, malls, self-storage space, medical and laboratory space, cinemas, gas stations, single-family homes, farmland and computer equipment warehousing space, among other types.

Instead of having a thin equity layer against a lot of borrowed money like mortgage REITs do, property REITs generally have borrowed 40% to 60% of their asset value. That’s not a small amount, but it’s less than the 90% of a mortgage REIT, and it’s also typically much longer-term debt. Borrowing half the value of occupied properties for, say, seven years is a much less risky proposition than borrowing 90% of the value of a pile of mortgages for six months. If the credit markets dry up, the mortgages have to be sold at any price.

REIT investors are mainly after the current yield that comes from renting existing properties. They also want companies that can generate rent growth from well-located properties and from inflation, as well as management teams with the ability to maintain properties efficiently, develop new properties and occasionally sell existing ones at attractive prices.

The largest ETF dedicated to the property REIT sector is the aforementioned Vanguard REIT Index Fund. At more than $30 billion, it is the behemoth in the category. It tracks the MSCI US REIT Index, a capitalization-weighted index composed of 151 constituents representing 99% of the U.S. equity REIT universe. Its largest holding is the mall landlord Simon Property Group (SPG). Other large constituents are Equinix (EQIX), owner of large data centers; Prologis (PLD), an industrial landlord; Public Storage (PSA), a self-storage company; and AvalonBay Communities (AVB), a residential, multifamily landlord.

The problem with VNQ is that it’s getting too big, and it recently asked shareholders to allow it to track a different index that holds both REITs and real estate operating companies (REOCs). That’s because REIT rules demand that no mutual fund or ETF own more than 10% of a REIT.

Neither VNQ nor Vanguard’s other real estate funds have violated that rule yet, but putting all the firm’s funds together shows that Vanguard owns more than 13% of the roughly $1 trillion property REIT sector.

If VNQ begins to hold REOCs, its dividend yield will almost certainly decrease. That’s because REOCs are mostly land companies, not unlike home builders. REOCs like Tejon Ranch may own some developed property on which they collect rent, but they also typically own vast swaths of undeveloped land that generates no revenue or income. REOCs potentially produce good returns when development occurs, and some actively managed mutual funds pepper their portfolio with them. But the development typically has no set schedule and can be a difficult process, often making REOCs less attractive for real estate investors in the public markets.

The second-largest REIT ETF, with nearly $5 billion in assets, is the iShares U.S. Real Estate ETF (IYR). This product isn’t a straight property fund, though, because nearly 5% of it is in mortgage REITs. It tracks the Dow Jones U.S. Select Real Estate Index; REOCs and real estate services companies occupy around 7% of the fund’s portfolio. This fund comes with a twist in that its underlying index contains some property REITs not found in other indexes. Specifically, its top holding is cell tower company American Tower instead of Simon Properties, which is more commonly found as the top-holding in a property REIT fund. The third-largest holding is another cell tower landlord, Crown Castle International REIT. Altogether, more than 10% of this fund’s portfolio is in cell tower real estate.

Straightforward Property REIT ETFs

Given the size of the Vanguard ETF and the unusual qualities of the iShares U.S. Real Estate ETF, investors might want to consider other ETFs for basic property exposure. One example is the Schwab U.S. REIT ETF (SCHH), which tracks the Dow Jones U.S. Select REIT Index. This fund clocks in with a 0.07% expense ratio and provides straightforward exposure to property REITs—including the largest ones that are part of the S&P 500 as well as much smaller ones.

The iShares Cohen & Steers REIT ETF (ICF) and its sibling, the iShares Core U.S. REIT ETF (USRT), also provide straightforward property REIT exposure. The former has an expense ratio of 0.34% while the latter has a much lower expense ratio of 0.08%. Over the past decade, the core fund has outperformed as a result of its lower expenses, posting a 6.76% annualized return versus 6.39% for the ICF fund. It’s unclear why the iShares Cohen & Steers fund has a higher expense ratio since it concentrates on larger-cap stocks—or why investors should own it. USRT shareholders get the benefit of exposure to some smaller stocks with a lower expense ratio.

The SPDR Dow Jones REIT ETF (RWR) also tracks the Dow Jones U.S. Select REIT Index. But its 0.25% expense ratio makes it less attractive to investors than the SCHH fund from Schwab, whose ratio is 0.07%.

Another fund within this property-focused grouping, the Real Estate Select Sector SPDR Fund (XLRE), tracks the S&P Real Estate Select Sector index comprising the 33 REIT stocks within the S&P 500. It has a pleasingly low 0.14% expense ratio and, like the iShares U.S. Real Estate ETF, has significant exposure—16% of its portfolio—to the cell tower REITs: American Tower and Crown Castle. Investors in this fund will miss mid-cap and small-cap REIT exposure, but the fund will provide a dose of the REIT sector as represented in the S&P 500.

Diversification And Dividends

This brings us to the big reasons many investors own dedicated REIT funds—diversification and dividends. The diversification argument holds that a dose of REITs beyond what exists in a broadly diversified stock fund may provide diversification, thus boosting a portfolio’s volatility-adjusted returns. It turns out that’s partly correct. A recent study by Jared Kizer and Sean Grover of Buckingham Asset Management shows that REITs provide some diversification, though not in doses exceeding their weightings in broad market indexes, which is around 3%.

But for income-seeking investors, the dividend argument can still be a reason for adding REIT funds to their portfolios. While dividends make property REITs somewhat bond-like and somewhat interest rate sensitive, they are not as sensitive as mortgage REITs, whose entire business model depends on a steep yield curve. Also, property REITs can raise rents in rising interest rate or inflationary environments, allowing them to deliver higher dividends to investors.

But REIT investors should familiarize themselves with one idiosyncrasy of REIT accounting. Namely, there is usually a large and unrealistic depreciation charge running through REIT income statements that deflates net income considerably. That means investors trying to understand whether a REIT or a group of REITs can cover the dividends they’re paying should look at a metric called “funds from operations,” or FFO. It adds back the depreciation charge to net income. It also subtracts the gains earned from property sales, since sales don’t indicate how existing properties are performing. Investors should want to know if funds from operations—i.e., money left after collecting rent and paying expenses—are covering dividends.

There are a lot of real estate ETFs, but investors seeking straightforward commercial property exposure to dividend-paying property REITs can narrow it down to those few funds that deliver just that. Happily, those funds don’t charge expenses that resemble Park Avenue rents.   

John Coumarianos, a former Morningstar analyst, is a financial writer in Laguna Niguel, Calif.