Real estate can offer investors an important source of diversification. Financial pros often refer to real estate and real estate securities as inflation hedges. That's because during the 1970s—the last period of rapid inflation in the United States—investors flocked to tangible assets, including real estate. Studies have shown that adding real estate investments to a diversified portfolio increases returns and reduces risk, as these investments have little correlation with the S&P 500.   

Investors have a few different options to consider when investing in real estate.

Direct Investment
Most people's homes are indeed their largest investments. We all have to live somewhere, and a happy side effect is that real estate tends to appreciate in value over time. But if you are going to use real estate as a true investment vehicle by buying a second home, a piece of land, or a rental property, it's important to keep the following in mind.

First, despite exceptionally strong performance runs, real estate can and does occasionally decline in value. Second, real estate taxes will constantly eat into returns. Third, real estate owners must worry about physically maintaining their properties or must pay someone else to do it. Likewise, they often must deal with tenants and collect rents. Finally, real estate is rather illiquid and takes time to sell—a potential problem if you need your money back quickly.

Other Ways to Invest in Real Estate
Instead of owning real estate directly, investors can also purchase shares of a real estate investment trust (REIT) or shares of a mutual fund that invests in these securities. REITs own and manage income-producing real estate. They are governed by many regulations: At least 75% of gross income must come from rents, interest from mortgages, or other real estate investments and, most importantly, REITs must distribute at least 90% of their taxable income to shareholders each year as dividends.

REITs specialize by property type. They invest in most major property types with nearly two thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities.

Some benefits of REITs include:

• High Yields. The average long-term (15-year) dividend yield for REITs is well more than the yield of the S&P 500 Index. Also, REIT dividends are secured by stable rents from long-term leases. 

• Capital Gains. In addition to the growing, secure dividend yield, REITs have historically appreciated in value, providing decent capital gains. Recent returns have been exceptional for REITs—which is great if you've held them over the last few years, but it could mean they're due for a cool-down.

• Simple Tax Treatment. Tax issues for REIT investors are fairly straightforward. Each year, REITs send Form 1099-DIV to their shareholders, containing a breakdown of the dividend distributions. As REITs do not pay taxes at the corporate level, investors are taxed at their individual tax rate for the ordinary income portion of the dividend.

• Liquidity of REIT Shares. REIT shares are bought and sold on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.

REITs also have some drawbacks, including:

• Sensitive to Demand for Other High-Yield Assets. Generally, rising interest rates could make Treasury securities more attractive, drawing funds away from REITs and lowering their share prices.

• Property Taxes. REITs must pay property taxes, which can make up as much as 25% of total operating expenses. State and municipal authorities could increase property taxes to make up for budget shortfalls, reducing cash flows to shareholders.

• Tax Rates. One of the downsides to the high yield of REITs is that taxes are due on dividends, and the tax rates are typically higher than the 15% most dividends are currently taxed at. This is because a large chunk of a REIT's dividends (typically about three quarters, though it varies widely by REIT) is considered ordinary income, which is usually taxed at a higher rate.

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