High dividend yields equate to high risk, and Real Estate Investment Trusts (REITs) have some of the highest yields on stock exchanges right now. That means they’re among the riskiest of investments right now, too. To understand why their yields are so high, you first need to understand how REITs work.

REITs make money by borrowing gobs of cash at low interest rates, then using those greenbacks to buy higher-yielding mortgage securities (things like rental properties, derivatives or office space). It’s similar to how banks work. They borrow cash from the Federal Reserve at near-zero percent interest rates, then loan that money out to home buyers and small businesses at rates starting around 3.5 percent.

Banks make stable loans. REITs make riskier bets, and that means they stand to make more money. Once the interest rates start to rise, though (and the Fed has signaled that could start as early as 2014), the profitability of REITs goes down (sometimes dangerously fast).

That’s why investors have been wary of REITs. The historically low interest rates set by the Fed can’t last. REIT investors know that, so they diligently watch interest rates while holding shares in a REIT.

Before investing in REITs, there’s one other factor you need to understand: dividends from REITs are subject to higher taxes than normal dividends. This happens because REITs enjoy special tax benefits. By paying out 90 percent of their income as dividends, the REIT itself doesn’t have to pay taxes.

So long as you understand the unique risks, investing in REITs can be very profitable. Let’s take a quick look at the Top 5 highest dividend-yielding REITs:

1) Invesco Mortgage Capital Inc. (NYSE:IVR). Yield: 21.45%. Residential and commercial mortgage-backed securities.

2) American Capital Agency Corp. (NASDAQ:AGNC). Yield: 18.86%. Residential mortgage pass-through securities.

3) Resource Capital Corp. (NYSE:RSO). Yield: 16.72%. Invests in real estate debt through a series of subsidiaries.

4) CYS Investments Inc. (NYSE:CYS). Yield: 14.84%. Residential mortgage pass-through securities.

5) Chimera Investment Corporation (NYSE:CIM). Yield: 14.10%. Residential and commercial mortgage-backed securities.

Photo by Gerard79.

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