Real estate investment trusts (REITs) have produced high returns over the last seven years, leading to some false expectations and misunderstandings.

If you’re not really sure what a REIT is, welcome to the club. Fortunately, they aren’t mysteriously complex.

A real estate investment trust is a business created in order to invest in real estate. There are three major types: Some own real estate outright; others own mortgages or securities backed by real estate; still others are a combination of the first two.

REITs usually specialize in one or more types of real estate: apartments, offices, hotels, malls, retail stores, etc. Some are highly leveraged, while others own what they own free and clear of debt.

Stocks of REITs trade like other stocks. While some investors own individual REIT stocks, it’s more common to invest in REIT funds, and they have become increasingly popular in the past few years. As you can easily guess, various REITs have a range of risks and returns.

Here are 10 things I think you should know before you invest in a REIT fund:

1.    REITs have a long history of producing good returns.  From 1975 through 2006 the annualized return of U.S. REITs was 16.7 percent.*

2.    Risks and returns of REITs have been very similar to those of value stocks. From 1975 through 2006, U.S. large-cap value stocks compounded at 15.2 percent, U.S. small-cap value stocks at 20.4 percent.

3.    REITs are not closely correlated with most other major asset classes. This makes them valuable for reducing risk. Again using the 1975-2006 period, a portfolio divided half-and-half with REITs* and the Standard & Poor's 500 Index produced a return of 15.2 percent (vs. 13.5 percent for the S&P 500 Index alone) while reducing risk by 12 percent.

4.    Many people assume that REITs rise and fall like bonds, in response to interest rates. But the evidence for that assumption is not convincing.  In many periods, just the opposite occurs. From 1978 though 1981, interest rates doubled (and long-term U.S. corporate bonds fell 7.7 percent) while REITs gained 160 percent.

5.    REITs may seem relatively low risk because they’re based on real estate. But they can be quite volatile, quickly transforming themselves from heroes to goats, and vice versa.  In five of the past 32 calendar years, REITs were the top performers among the 11 equity classes that we recommend. In another four calendar years, they were the very worst performers.  

6.    By law REITs must pay out most of their taxable income to shareholders, effectively bypassing the corporate tax. This is similar to the tax break given to mutual funds. But there’s an important difference that every REIT investor should understand: While the tax investors pay on corporate dividends is capped at 15 percent, that cap doesn’t apply to dividends from REITs (and from REIT funds). They are taxed as ordinary income.  

7.    Because of their tax treatment, REIT funds are significantly more valuable when they are owned inside a tax-sheltered entity such as an IRA or a 401(k).

8.    As in any other asset class, I expect that index REIT funds are likely to have better performance than the average of all REIT funds.

9.    Some REIT funds are broadly diversified; The Vanguard REIT Index Fund holds more than 100 REITs. Others are more focused (hence more risky); Cohen & Steers Realty Focus I has only 30 holdings.

10.    Portfolio turnover, expenses, tax efficiency, changes in style, changes in management, etc., are just as important in REIT funds as in any other funds.

Like other stock funds, REIT funds come in a wide variety of flavors. If you pay careful attention to the details, you can find one to sweeten your portfolio.

* Results are from the Don Keim REITs Index for 1975-1992 and a Dimensional Fund Advisors Real Estate Securities portfolio for 1993-2006.