REITs hold real estate or mortgage pools and pass income on to shareholders.

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The term "REIT" stands for "real estate investment trust." These are corporations that invest primarily in rental real estate, though some entities, called "mortgage REITs," buy pools of mortgages. Individual REITs receive favorable tax treatment, in that unlike most C corporations, they don't have to pay income tax at the corporate level. In exchange, they are required to pass on at least 90 percent of their profits to investors in the form of dividends. The investor then pays personal income tax on REIT dividends. ETFs, or exchange-traded funds, are pools of REITs, sold over the stock exchanges.

Publicly Traded vs. Privately Held REITs

Some REITs are traded over the major stock exchanges, such as AMEX or the New York Stock Exchange. These REITs tend to be liquid -- you can generally buy or sell shares quickly and at a reasonable cost. Other REITs are held privately and sold only through agents or dealers. You may be able to buy them at lower valuations, but it could be difficult or expensive to sell your interest if you want to cash out.

Advantages of REITs

REITs are primarily set up to be income-generating vehicles. The tax code requires them to forward 90 percent of their earnings to their shareholders, or they will have to start paying corporate income taxes. Therefore, REITs tend to provide reliable dividend income while still offering the potential for capital appreciation. REITs are also historically an effective diversifier against stock market risk. Their inclusion in a portfolio can help lower volatility while not hurting returns, according to modern portfolio theory.

Exchange-Traded Funds

An exchange-traded fund, or ETF, is a pool of money that is invested in an index that tracks a particular asset class -- including REITs. Investment companies then package these shares and trade them over the stock market. Investors can buy shares in ETFs through their stockbroker and collect their share of dividend income. ETFs help investors diversify across scores of REITs with a single transaction. ETFs charge a small annual expense ratio, which is generally cheaper than those charged at comparable mutual funds. There is normally a cost for buying or selling ETF shares, however.

Choosing Between a REIT and a REIT ETF

Buying shares in individual REITs may make sense for relatively experienced investors who are comfortable with the risks involved in owning a single company or who want to to focus investment in a single area. ETFs may make sense for those who are not comfortable doing the detailed research it takes to invest in individual stocks or who just want broad exposure to the real estate asset class without having to do the digging.