It's no secret that New York City is one of the best office markets in the country.

Shares of real estate investment trusts, or REITs, focused on the prime market have shot up as of late. But given the strong rental growth in the city and the lofty prices at which property deals are trading, the group might actually be undervalued.

Last year, rents rose 5% in Manhattan, with office vacancy dropping 80 basis points, to 9.4%, according to a recent Deutsche Bank report. Vacancy in Midtown -- the most attractive market because of its lack of new supply -- is even lower at 7.8%.

A recent report from CB Richard Ellis says that if office employment growth and new inventory remain steady, vacancy rates in Manhattan will decline below 5% in 2008. By 2009, vacancy could fall below 3%, and asking rents could be up 49% from 2006, CBRE says.

"New York City is among the best markets where REITs can increase their operating margins the greatest because occupancy levels have rebounded to the point where companies can really push their top line," says Robert Promisel, a principal with Adelante Capital Management, which owns several companies with heavy exposure in the city, including SL Green ( SLG), Vornado ( VNO), Boston Properties ( BXP) and Brookfield Properties ( BPO) (which isn't a REIT).

Strong capacity for rent growth and recent pricey office-building sales are two main reasons why Banc of America Securities analysts John Kim and Ross Nussbaum recently upped their price targets on SL Green (to $100) and Boston Properties (to $88). Banc of America provides investment banking services to both companies.

SL Green now trades around $93 and Boston Properties around $89. Both shot up in price after the upgrade and now trade at over 20 times their 2006 estimated funds from operations (a proxy for REIT earnings), higher than historic valuations.

The biggest pure play on the market is SL Green, whose entire office portfolio sits in Manhattan. The company owns 28 office properties totaling 18.2 million square feet, mostly in Midtown. In the fourth quarter, SL Green's new leases averaged 20% more than previously leased space.

Boston Properties owns space in several other markets besides New York, including Washington, D.C., Boston and San Francisco. The company is rumored to be shopping two of its office properties in Manhattan for what could be hefty gains.

By selling such properties in a red-hot investment market, Boston Properties can demonstrate the value inherent to its portfolio, which may prompt the public market to value the stock even higher. One property that is considered very valuable -- but not rumored to be one of the two for sale -- is 399 Park, which the company bought from Citigroup ( C) in 2002 for $600 per square foot. Promisel, of Adelante, says that property could possibly fetch $1,000 per square foot today, which would represent a sub-5% cap rate, or initial rate of return.

Scott Latham, executive director of Cushman & Wakefield, one of the leading sales brokers in New York, says office properties in general have been selling at cap rates close to 5% or lower. The key reason for the compression is that buyers believe rent growth will eventually boost the lower initial yields.

The stock prices of many REITs don't represent the true value of their real estate, Latham says. But this is slowly changing. "You're seeing a run-up in REIT prices as people start to focus on the underlying story," he says.

If Boston Properties actually does sell some of its properties for such low yields, it would help demonstrate why the REIT might be undervalued as a stock. Many REIT investors value the sector based on net asset value, where a market cap rate is applied to a firm's net operating income to determine how much the REIT's assets are really worth.

Even though Boston Properties could sell buildings for sub-5% cap rates, the REIT's portfolio is being valued "well north of 5%" based on the stock price, Promisel says. The higher the cap rate, the lower the price for the real estate. This means that the underlying value of Boston Properties' real estate could be priced higher in the private market than where it's trading in the public market.

Banc of America's price target on SL Green assumes a 5.4% cap rate for its portfolio. For Boston Properties, the cap rate assumed is 5.3%.

Some worry that REITs with heavy New York exposure are now "fully valued." But Promisel isn't concerned.

"To the extent that private market values are durable, REITs are trading at an attractive price relative to those private market yields," Promisel says.

Other wise buy-siders hum a similar tune.

"We like New York City-focused REITs because we view the Midtown Manhattan market very favorably," says Kelly Rush, director and portfolio manager for the Principal Real Estate Fund, which owns SL Green, Boston Properties, and Vornado. "The stocks look expensive today, but we think the multiples will prove justified as these companies will grow into their multiples with above-average earnings growth."