Source: Scott Hingst.

Real estate investment trusts have been a great source of income for investors over the past several years, as low interest rates have made alternative fixed-income investments less attractive and have also made it cheaper for REITs to borrow money. Yet while both the real estate market generally and REITs in particular have thrived in the low-rate environment, the biggest red flag for REIT investors has to come from the possibility that those low rates are coming to an end. Let's take a closer look at the threat to REITs and whether REIT investors should worry enough to pare down their holdings.

How rates affect various types of REITs
One thing to keep in mind about REITs is that just because a company is organized as a real estate investment trust doesn't mean that it has all that much in common with other REITs. In particular, different categories of REITs have very different exposure to interest rates.

Mortgage REITs are perhaps the most sensitive to the rate environment. With their heavily leveraged business models, mortgage REITs like Annaly Capital (NYSE:NLY) buy mortgage-backed securities, counting on being able to pay less for short-term financing than they receive in interest payments on longer-term investments. The leverage amplifies profits during favorable conditions in the bond market, but it also raises the risk level extensively when those conditions deteriorate. For mortgage REITs, rising rates can be catastrophic if they haven't locked in arrangements with their lenders to limit the increase in their financing costs or made other hedging transactions to offset higher costs.

More broadly, most REITs outside the mortgage-REIT realm hold actual real estate, either in the form of physical properties or through leases with property owners. For instance, Simon Property Group (NYSE:SPG) is a huge player in the retail REIT space, developing and leasing malls and shopping centers to retailers. For them, interest rates are secondary to the conditions in the particular real estate market that matches up with its holdings.

Yet even for typical commercial or residential REITs, interest rates still play a role in valuation. REIT investors expect income to play a major role in their overall return, but they are also drawn to the growth opportunities that bonds and other straight fixed-income investments typically lack. When rates rise, other fixed-income alternatives look more attractive, and REITs often see their share prices sag as new investors demand higher dividend yields in order to compensate for what they see as higher opportunity costs from not investing elsewhere.

Protecting REIT investors from risk
Given the capacity for REITs to suffer from rising interest rates, the natural question is how to protect against it. There are several things REIT investors can do to reduce their rate risk with REITs.

One way to reduce your risk is to focus on companies that have themselves taken on hedges against rising rates. For instance, some mortgage REITs use derivatives like interest rate swaps to offset the negative impact from higher interest rates. Hedging risk comes with cost, though, so REITs that use hedges sometimes have less income to pay to investors through dividends than their unhedged peers.

Timber REITs have been popular in recent years. Source: Sean Mack.

Another strategy involves tailoring your REIT portfolio to particular market conditions. For instance, REITs in the natural resources sector, such as timberland and forest-products companies, tend to see their shares rise and fall with commodity prices, with rates being a secondary consideration. Similarly, health care REITs focus on hospitals, skilled nursing facilities, and other medical real estate, and the demographic demand for those facilities makes health care REITs somewhat less susceptible to rate increases.

Yet perhaps the best way to deal with interest rate risk with REITs is merely to accept it as a cost of having a diversified portfolio. Numerous predictions over the years for what seemed like imminent rate increases have turned out to be dead wrong, and REIT investors who stayed the course have seen rich rewards. That won't necessarily be the case forever, but as part of a smart asset allocation strategy, REITs can serve a valuable role even with the risks involved.

Interest rates are always a red flag for REITs. But by being smart about how you structure your investment portfolio around particular REITs, you can mitigate that risk and get the income and growth potential you want.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.