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Everywhere, investors are scurrying to try to find higher-yielding investments to pay them the income they need. In the process, though, the huge demand they're creating has pushed prices to the point at which the downside of investing in them outweighs the potential reward.

Real-estate investment trusts have gained hugely in popularity in recent years, as low interest rates and a rebound in some real-estate investments have combined to send their share prices soaring in a huge recovery from the housing bust and financial crisis in 2007 and 2008. Given their sensitivity to prevailing interest rates, though, the risk of loss from investing in REITs now goes up every time rates fall further -- and eventually, the perfect environment for REITs will become a thing of the past.

The REIT stuff?
Real-estate investment trusts have been around for a long time, but they came into vogue during the bear market from 2000 to 2002, during which they offered diversification that helped investors preserve the overall value of their portfolios. Before mainstream investors discovered them, many REITs paid very attractive yields.

The secret to understanding REIT income is knowing that the rules that define what companies can be REITs require them to pay out 90% of their taxable income each year. With the need for at least three-quarters of their assets and income to be tied to real estate, not every company can qualify -- but those that do enjoy the tax benefits of pass-through entities, avoiding corporate-level tax at the cost of having to distribute nearly all of their earnings to shareholders rather than retaining them for business purposes.

Those requirements can lead to impressive payouts, the highest of which tend to come from mortgage REITs. Annaly Capital (NYSE: NLY  ) and ARMOUR Residential (NYSE: ARR  ) aim to earn profits by borrowing money cheaply and using it to buy mortgage-backed securities from agencies like Fannie Mae and Freddie Mac. For them, the low-rate environment has been hugely beneficial, as it keeps their leverage costs low.

But most REITs are more directly tied to real estate investments. Forest-products maker Weyerhaeuser (NYSE: WY  ) made news in 2010 when it converted itself to a REIT, paying a huge one-time special dividend in order to take advantage of favorable tax status for its timberland holdings. Meanwhile, General Growth Properties (NYSE: GGP  ) focuses primarily on regional shopping malls and other retail space, while Apartment Investment & Management (NYSE: AIV  ) does exactly what its name suggests: owns and manages apartment complexes and other multi-family residential properties.

What's wrong with REITs?
As REITs have gained in popularity, Wall Street has responded in its normal way: giving the customers what they want. According to Money, investors put nine times as much money into REIT funds as they did in 2009. That's pushed REIT prices higher, even when their earnings don't necessarily support those moves up. General Growth sports negative funds from operations even after having emerged from bankruptcy in 2010, yet its share price is up more than 25% since late September.

Even worse, so-called non-traded REITs, which don't trade on stock exchanges, have also lured many investors. Estimates put the inflows into non-traded REITs at $9 billion in 2011, which approaches levels last seen at their highs in 2007. These investments offer higher yields than public REITs, but they also carry upfront fees and usually force you to keep your money invested for years at a time.

Be careful
REITs can be strong investments and rightfully deserve to be part of a basic asset allocation strategy. But don't let the hype over REITs convince you that they're the perfect solution to all your income needs. If you're not careful, you could get in over your head at exactly the worst time for these real-estate investments.

If you're looking for powerful income-generating ideas, we've got several we'd like to share. Read the Motley Fool's latest special report on dividends to find 11 rock-solid dividend stocks. It's free but it won't be around forever, so click here and read it today.

Fool contributor Dan Caplinger likes income but not at the wrong price. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital and Weyerhaeuser. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't risky at all.

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