(FORTUNE Magazine) – Just a few years ago, if you had said that REITs were destined to become a sexy investment, your prediction would have been greeted with laughter. Or maybe a blank stare. To those with longer memories, real estate investment trusts were a sleepy, defensive vehicle with a checkered past; to others they were simply obscure.

Times have changed: The benchmark REIT index has outperformed the S&P 500 in four out of the past five years. No wonder investors have gotten over their pronunciation problems (rhymes with Street) and started pairing this suddenly fashionable acronym with words like craze, run-up, and boom. Along the way, the combined capitalization of the REIT industry has climbed from just $13 billion six years ago to about $116 billion today; REIT mutual funds have proliferated too (see box).

In the process we've come full circle, with REITs now a symbol not of Wall Street esoterica but, to some, of the overheated state of the bull market. Indeed, you could be forgiven for wondering if all the easy money has been made in REITs, and if it's just too late to jump on the bandwagon.

Don't fall into that trap. After all, the sector has gotten hot for a reason. The key is to sidestep the hype (pro and con) and get down to basics, evaluating REITs as you would any other prospective investment.

So to begin, what are REITs, anyway? The simple answer is that they're like mutual funds for real estate: Instead of owning, say, an apartment building, buying into a REIT can make you the owner of a pool of apartment buildings, office complexes, or shopping malls. Thus the fate of your investment isn't tied to a single building. That's true, but remember that many REITs specialize by either geographic region, or type of property, or both. So if a REIT is like a mutual fund, it's like a sector fund: Having your money spread around to every mall in Phoenix won't help if the region's retail market tanks.

Next question: What's made them so popular right now? People in the industry point to better REIT management as well as to consolidation that has primed the growth pump, allowing publicly traded REITs to buy property now in private hands and boost their earnings power. But there's another factor too: As investors leery of the soaring stock market take profits, many are looking at REITs for safety. Yields are high--an average of roughly 6% right now--partly because REITs are required by law to pay out 95% of taxable income as dividends. And that's particularly attractive at a time when ordinary stock dividends are at record lows.

But if, as one industry PR person recently chirped to us, a REIT "is the widows-and-orphans investment of the '90s," then it's an unconventional one. The truth is that the level of risk is escalating in this sector just as it is for blue-chip stocks. For starters, the underlying market, real estate, is a notoriously treacherous one. But even more important, with investors piling into certain popular offerings and REIT managers under pressure to keep growing, it's easier than ever to overpay. So picking the right REIT is an awful lot like picking the right stock: What's important is figuring out who's going to keep performing once the current fad dies off.

There are two ways to go at it, depending on what you're after. If you crave growth, you want a REIT whose acquisitions and rising rents are pushing up its stock price. The alternative: REITs with high but solid yields that, paired with more modest growth, can deliver double-digit total return. With that in mind, we've put together two model portfolios made up of what we think are the best REITs in each category. Of course, some investors may well want to mix in a little of both.

GOING FOR GROWTH

It's nearly impossible to talk about REITs today without mentioning Sam Zell. The legendary Chicago vulture investor's three REITs are all growing fast and changing the face of their respective markets ("Property to the People," October 13). We prefer his Equity Office Properties, partly because rents for commercial space are rising faster than they are for apartments.

Zell's latest deal--the mammoth $4 billion merger with Boston-based Beacon Properties announced last month--will turn Equity Office into a true industry giant, with 235 buildings stretching across 20 states. Even before the merger, it controlled more square footage than any other office REIT, often in central business districts where there's little threat of new building to pressure rents. Lehman Brothers analyst Steve Hash calls it "the highest-quality, nationwide, diversified portfolio in existence." It certainly isn't too dependent on any one region. (That's our concern with another REIT giant, Richard Rainwater's Crescent Real Estate Equities, whose future is heavily tied to a continued boom in Houston; Rainwater may be right, but the downside risk is worrisome.)

EOP is off a bit from its recent highs, providing a good entry point for investors who missed its run this past summer. Even better, Hash points out, is a nifty arbitrage play that can get you in even cheaper: Buy shares of Beacon now, trade them in for Equity Office when the merger goes through, and you earn 2.5% right off the bat. Hash sees little chance of the deal cratering.

Another solid choice: Patriot American Hospitality. You may have stayed in one of the 69 hotels the REIT owns, although you knew it as a Marriott or DoubleTree. Now, with the planned purchase of Wyndham Hotels, Patriot's 30% growth rate should accelerate, helped by tight margin controls and strong demand for hotel rooms. Plus, Patriot is one of only a handful of REITs that enjoy what's called paired-share status, which allows it to both own and manage its hotels, and which carries certain federal tax advantages. Another paired-share REIT, Starwood Lodging, is also a Wall Street favorite, but Patriot is a bit more of a bargain: BT Alex. Brown analyst Kevin Comer says Patriot trades at about 11 times next year's earnings, compared with Starwood's 12.3 multiple.

We also like certain regional offerings as growth plays. One is Arden Realty, which holds office buildings around Los Angeles. Southern California real estate looked hopeless a few years ago: it experienced a deeper trough than the rest of the country and has taken much longer to recover. That gives new investors in California companies a taste of the recovery surge that REITs in the Midwest and East Coast have been enjoying. Already, suburban L.A. office rental rates are growing by more than 10%. Franklin Real Estate Securities fund manager Tom Branch says Arden's management has "been through thick and thin, and has been careful not to overpay for their properties." And with Los Angelenos wary of new development, there's little threat of new construction that could undercut Arden's rents. The stock pays a dividend of 5.3%, yet it trades at a slight discount to its peers.

Even beyond L.A., the California real estate market is white-hot, from booming Silicon Valley all the way to the Pacific Northwest, which is also enjoying rising rents and occupancy rates, thanks to strong growth and resistance to new building. No REIT is better positioned to benefit from these trends than Spieker Properties: For starters, its properties saw rent increases averaging 21% so far this year, according to BT Alex. Brown analyst Sam Hillers. Plus, its recent decision to purchase over $700 million worth of office and industrial properties should only speed up its growth.

The densely built New York market may be tough for developers, but it's great for the likes of S.L. Green, an owner of Class B Manhattan office buildings, many of them prime sites in midtown. (Class B is industry argot for buildings that are at least 25 years old and rent for a bit less than the top of the line.) Lehman's Hash says S.L. Green has a history of acquiring underperforming assets, making improvements, and thus gaining higher returns. Bonus: SLG's 5.6% yield.

Our last growth pick is Reckson Associates Realty. This suburban New York REIT owns offices throughout John Cheever country--from Westchester County, N.Y., to southern Connecticut, to suburban New Jersey and Long Island. The locals tend to frown on new construction in Reckson's region, which should help keep earnings growing by over 10% for the next few years. And last December Reckson moved into the hot office market in northern New Jersey.

THE INCOME APPROACH

But what if you want a steady performer that can beat out bonds? After all, 30-year government bonds yield just 6.4% these days, and treasury bills pay much less. Consider our choices: Not only do all these REITs pay at least 6.9% annually, but they should also see reasonable share price appreciation--something you just won't find in a CD or Treasury bill. You can find other REITs that offer higher yields, but we've opted for those that can comfortably pay their dividends while continuing to grow.

That description aptly fits Associated Estates Realty, an apartment REIT based in Cleveland. "This is a sleeper," argues BT Alex. Brown's Catherine Creswell, who notes that Associated's 7.8% yield is 12 percentage points above the typical apartment REIT's. Creswell also sees share price growth that would add up to a total return of just over 20% in the next 12 months.

Next is Boykin Lodging, a hotel REIT. Boykin combines some of the growth potential of Patriot with a safe yield of 6.9%. With little debt, says Ken Heebner, manager of the CGM Realty fund, Boykin can borrow to fund more acquisitions, which should only help its stock price. And with just 15 hotels in its portfolio, any new properties should have a big impact on earnings. "It's my favorite," says Heebner.

Our next two choices are health care REITs, companies that lease and provide financing for nursing homes, assisted-living centers, hospitals, and medical office buildings. Because rent growth in this sector is slower than it is for the lodging or office REITs, these should be thought of primarily as yield plays that are more sensitive to swings in interest rates than our other picks. But even if their shares come under pressure, these two choices offer sizable dividends that should cushion any drops.

LTC Properties, which sports a yield of 7.7%, is a growing player in the assisted-living and skilled-nursing markets. BT Alex. Brown's Hillers says that new acquisitions and investments by LTC are picking up, and that LTC has a history of consistent dividend increases. Our other choice, Health Care REIT, is also on the small side and even less well known, but that's fine with us. Although its profits and balance sheet have been improving all year, Wall Street has barely noticed. We like the yield--currently just under 8%--but Hillers says Health Care REIT could see some nice price appreciation as well. Combine that with the yield, and he sees a 12-month return of 18%.

Our final choice, Lexington Corporate Properties, isn't a household name, but it's worth seeking out. With 45 office, industrial, and retail properties in 23 states, Lexington focuses on high-quality tenants and secure, long-term agreements. That strategy, along with some wise acquisitions, has lifted its stock from around $12 in April to just over $15 now. We also like the shareholder-focused attitude of Lexington management: The pay of Lexington's employees, from secretaries to executives, is closely tied to the stock price. Oh, yeah, and its yield is 7.5%. With that kind of dividend, who needs bonds?

REPORTER ASSOCIATE Jeanne Lee

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