The original version of this article did not mention that Prentiss Properties will be acquired by Brandywine Realty Trust. We regret the omission.

As an asset class, real estate investment trusts or REITs have had an incredible run for the past five years. There has been some variation among the different sectors, with REITs that focus on retail and self-storage performing well while office and apartment REITs struggle.

Like those in many other industries, REIT returns have historically experienced boom and bust cycles, with rising interest rates often negatively affecting them. REIT's returns, however, have continued to be strong for the past year and a half despite interest rates' upward climb.

Many believe that its only a matter of time before gravity takes hold and the highest-flying REITs plunge back to earth. Others, however, think recent gains are here to stay and that any retreat will be brief. Count Vornado Realty Trust (NYSE:VNO) CEO Steven Roth among the believers who also see this as the beginning of a long-term bull market. In the most recent issue of NAREIT's Real Estate Portfolio, Roth said, "Income-producing real estate is in a secular bull market -- emphasis on secular." While it can't be said that Roth is unbiased, he does have over 40 years in the business, so his opinion should hold some weight with even the most bearish on real estate.

Where to start digging
Fools know that no matter the sector, it pays to buy out-of-favor companies with sound cash-generating capabilities. This rule of thumb applies whether you're buying Simon Property Group or its tenants Gap (NYSE:GPS) and Federated Department Stores (NYSE:FD).

So in my search for an underappreciated REIT, I decided to focus on office and industrial REITs as well as their apartment counterparts. But since some of these companies also carry relatively rich valuations, there is no guarantee I'll find anything here. I still believe, though, that starting with currently slower-growing and underappreciated REITs is more likely to bear fruit.

This week, then, I'll start with a handful of office REITs and go from there in future weeks.

Looking for a new space
Office REITs have had a rough go of it for the past few years, primarily because the economy's recovery has focused on the consumer. Month after month, employment data shows that most businesses aren't significantly hiring or expanding, which signals tough times for office REITs. And while many office REITs' 2004 annual reports predicted brighter times ahead, they have yet to materialize as 2005 draws to a close.

Below, I've taken a handful of office REITs and stacked them up based on trailing-12-month funds from operations (FFO) per share, price-to-FFO ratio, dividends per share, and dividend yield. (FFO is a measurement of a REIT's operational cash-generation capability, not cash profitability. For our purposes, FFO allows us to get at the price-to-FFO multiple and a broad idea of how the REIT is currently valued.)





Boston Properties (NYSE:BXP)





Equity Office Properties (NYSE:EOP)





Trizec Properties (NYSE:TRZ)





Prentiss Properties (NYSE:PP)





BioMed Realty Trust (NYSE:BMR)





* includes fourth-quarter FFO estimate

This group has delivered some fairly varied results. Equity Office Properties -- the big daddy of REITs -- carries a large 6.4% yield, but its FFO per share has been in decline for the past few years. In addition, its dividend hasn't been funded by FFO over the past 12 months. Equity Office Properties does own many unique properties, but based on the business' health, I don't feel the risk/reward is compelling enough.

Of the remaining businesses, Boston Properties is the most richly valued despite its relatively anemic growth in recent years. However, assuming a market turnaround, the company is quite healthy. That leaves Trizec, Prentiss Properties, and BioMed Realty Trust. The latter intrigues me most because it specializes in leasing lab space to fairly reliable tenants such as biotechs and pharmaceuticals -- and the growth opportunities there. I'm also attracted to Prentiss Properties because its valuation is a bit better than that of BioMed, but unfortunately it is being acquired by Brandywine Realty Trust.

Foolish final thoughts
Taking into account some office REITs' strong recent performance, I am convinced that the market is offering us a few interesting plays. Moving beyond just valuation, it's also important to consider the quality of management, tenants, and underlying properties. That said, a REIT with a 5% to 7% dividend yield only needs to deliver another 5% to 6% in capital gains to be considered in the range of market-beating returns --not too unreasonable.

If you're interested in learning about more compelling REIT ideas, our Income Investor service has recommended six over the past two years. Last month, lead analyst Mathew Emmert recommended another with a dividend yield of more than 7% and a stable tenant base. For a free trial that gives you access to previous picks as well as this month's issue, which will be released next week, click here.

Nathan Parmelee has no financial stake in any of the companies mentioned, but he does have a thing for real estate. Shhh, don't tell his wife. He is faithful to The Motley Fool's strict disclosure policy.