As you look through the latest news headlines, you may have noticed seeing more about REITs than usual. On one hand, they've been the target of large acquisitions, including the recent takeover of Equity Office Properties by the Blackstone Group, and Simon Property Group's (NYSE:SPG) buyout offer for Mills (NYSE:MLS). On the other hand, REITs focusing on lower-end mortgages, such as Novastar (NYSE:NFI), are facing a significant reversal of fortune after several years of outstanding performance.

Until recently, however, extremely few investors knew anything about REITs. Excluded from the traditional asset allocation mix of stocks, bonds, and cash, REITs represented an obscure sector where few investors felt comfortable putting their investment capital. After huge double-digit percentage gains over the past several years, however, understanding what REITs are and what role they might play in your portfolio is essential to making the best returns you can earn.

The nuts and bolts of REITs
REIT is an acronym for real estate investment trust. However, don't let the name fool you. Most REITs are organized not as trusts, but as corporations. As such, they have shares of stock just like any other corporation. These corporations tend to have the bulk of their assets either in rental properties or in mortgages. If they meet certain requirements, these corporations can elect to be treated as REITs.

Corporations often choose to become REITs for tax purposes. In general, corporations are subject to corporate income taxes at the entity level. When they pay dividends to shareholders, those dividends are also treated as income on each shareholder's individual income tax return. As a result, corporate investments tend to be subject to double taxation -- a common criticism of the tax laws, and one reason why some stock dividends are taxed at lower rates than other income.

If a corporation qualifies for REIT treatment, however, it is able to avoid being taxed at the corporate level. Instead, the REIT is treated as a pass-through entity, whereby shareholders pay the entire tax liability on their individual tax returns. With corporate tax rates as high as 38%, this can be a substantial incentive for companies that focus on real estate investments.

In order to qualify as a REIT, a company must have at least 75% of its investments in real estate, with 75% of its income coming from rental income or mortgage interest. Most importantly, REITs must pay out at least 90% of their taxable income each year in the form of dividends. This explains why many REITs have such high dividend yields in comparison to ordinary stocks; most corporations retain a larger fraction of their earnings.

REITs are everywhere
REITs have gained in popularity due to a number of factors. During the early part of the decade, when stocks were falling sharply, investors sought alternatives that offered diversification in order to stabilize their dropping portfolio values. Later, when interest rates fell to their lowest levels in 40 years, investors looking for current income had to look beyond traditional fixed-income securities like bonds and bank CDs to generate enough cash to pay for living expenses. When combined with rising real estate markets, the potential for explosive price growth became a reality. One index of REITs is up nearly 25% per year over the past five years.

As REITs have become a more established investment vehicle, financial institutions have offered investors new ways to invest in REITs. Exchange-traded funds like the Vanguard REIT ETF (AMEX:VNQ) and iShares Cohen & Steers (AMEX:ICF) track the performance of a basket of REITs. In addition, the scope of real estate holdings among REITs has expanded greatly in response to investor demand. A new exchange-traded fund, StreetTracks Dow Jones Wilshire International Real Estate (AMEX:RWX), gives investors global exposure to real estate holdings around the world.

Changing allocation models
In response to the emergence of REITs, some financial advisors have recommended changing portfolio allocations to include a percentage for REIT investments. Some allocation models include REITs as a component of the fixed income portion of the portfolio, reducing exposure to other interest-paying securities such as bonds, while other models treat REITs as a completely separate asset class. On the other hand, many advisors argue that most people already have a huge amount of exposure to real estate in the form of their equity in their primary residences, and so there's less need to make additional investments in real estate for diversification purposes.

With their long run of outperformance, it seems inevitable that REITs will eventually suffer a significant correction in price. However, many analysts have been calling for such a correction for the past several years, but prices have continued to climb. With the increasing interest in REITs as a target of mergers and acquisitions activity, it's definitely possible that REITs have further to go before they succumb to pressure among investors to take profits.

Chasing performance is a mistake that many investors make, and the outstanding returns of REITs give those investors another opportunity to repeat past errors. Though REITs may play a useful role in creating a well-balanced portfolio, investors shouldn't expect those 25% annual returns to continue forever. Cautious consideration about adding REIT exposure to your portfolio is the best strategy for now.

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Fool contributor Dan Caplinger will be spending more than enough on his new house, so he's not planning to buy back the REITs he sold in 2005 anytime soon. He doesn't own shares of any of the companies or ETFs mentioned in this article. The Fool's disclosure policy gives you shelter.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.