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Shares of Real Estate Investment Trusts have rallied almost 90 percent since the market bottomed in March, but the jury is out on whether this recovery is warranted given the difficulties facing commercial real estate. To gain some clarity on this issue, we talked to Paul Curbo, portfolio manager for AIM Real Estate (IARAX), AIM Select Real Estate Income (ASRAX) and AIM Global Real Estate (AGREX).

What are the catalysts behind the rally in REIT shares?

Part of this recovery is a function of the weakness that afflicted this sector from 2007 through the beginning of this year. Over that period uncertainties about the availability and pricing of credit made it exceedingly difficult for analysts and investors to predict the group’s prospects as well as the fortunes of individual names. Accordingly, improvements in debt markets have played a key role in the rally. As spreads have narrowed on all sorts of asset classes--including commercial mortgages--that’s given analysts greater confidence in their valuation methods.

In addition, REITS have raised significant amounts of capital on both the debt and equity side--close to $17 billion thus far through equity issuance. Now the best REITs have the cash to weather the downturn and take advantage of attractive opportunities.

Of course, any discussion of the rally in REIT shares also should acknowledge the role that signs of economic recovery have played in buoying the broader market.

Is the rally in REIT shares sustainable?

Without question, the problems facing commercial mortgage issues still exist and must be dealt with. Although many publicly traded REITs have taken steps to address their own issues, these maneuverings won’t protect the broader real estate market from the significant number of commercial mortgages that will reach maturity over the next few years. Between 2010 and 2013 well over $1 trillion dollars of commercial and multifamily mortgages come due.

How have you positioned your portfolios to weather these challenges?

AIM Select Real Estate Income, which invests in both debt and equities, holds a portfolio that’s representative of our overall outlook and strategy, so I’ll structure my comments around that offering.

Earlier this year close to 70 percent of the fund’s investable assets were allocated toward common stocks. However, the rally has pushed markets closer to what we regard as fair value; we’ve shifted the portfolio mix to a 50-50 blend between debt and equities, which provides a degree of downside protection in the event of a short-term pullback. We’re not going to venture a prediction as to when and if such a correction will occur, but equities’ recent strength hinges on prospects for economic growth and improved fundamentals in the credit market; any hiccup in either of those areas could precipitate a bit of a selloff.

What qualities do you look for in your portfolio holdings?

Even with the rally and improving sentiment, we continue to favor companies that boast strong balance sheets; financial flexibility affords a degree of protection in a weaker economic and market environment.

Ample cash and access to credit likewise positions a company to take advantage of coming opportunities. The wave of mortgage maturities that I mentioned will bring hardship to the industry, and some weaker names inevitably will come up short in the capital department; companies with superior balance sheets can take advantage of these investment opportunities, whether that involves dealing with financially distressed owners or the banks.

Are you bullish on any particular segments of the REIT market?

Before I respond, I’d like to emphasize that in this environment investors should focus on individual names and the relative strength or weakness of a company’s balance sheet.

We like some regional malls, a segment that benefits from long-term leases. The mix of healthy and distressed landlords in this space offers opportunities for the strongest, publicly traded names.

We also like the health care and apartment segments, two groups that feature defensive names and provide a bit of safety to the portfolio.

What are some of your favorite names in the retail space?

We’re not overly bullish on the retail space. In an environment characterized by reduced consumption, lower retail spending eventually will weigh on the rents that tenants are willing to pay.

But we do like Simon Property Group (NYSE: SPG), a REIT that has $3 billion in cash and another $3 billion remaining on its line of credit--that’s on top of the $700 million in free cash flow that the firm has generated this year.

This financial strength is important for two reasons. For one, it reassures tenants that Simon will be there for the long haul and won’t go through the financial distress that’s afflicting a lot of smaller, private landlords. This stability provides an edge during tenant negotiations. And the company’s sizable war chest should enable it to cherry pick the best investment opportunities down the line. Simon’s biggest competitor, General Growth Properties (OTC: GGWPQ), recently declared bankruptcy; there should be no shortage of attractively priced assets in the retail space.

You mentioned that some apartment and health care REITs offer defensive qualities. Which names did you have in mind?

Mid-America Apartment (NYSE: MAA) is one of our top holdings. This REIT owns a portfolio of Class B apartments that tend to appeal to individuals who are renters by necessity rather than renters by choice. Focusing on this demographic keeps occupancy rates fairly stable and limits the extent of rent correction during a downturn. And the geographic mix of the company’s portfolio has held up better than some rivals.

The logic behind our health care holdings resembles our investment thesis on Simon Property Group in that these names have better-than-average balance sheets and should benefit from acquisition opportunities. But the health care segment is generally less susceptible to the economic downturn.

Take, for example, Ventas (NYSE: VTR), one of our largest positions. The REIT holds a geographically diverse portfolio that comprises over 500 health care facilities in 43 states. The focus of these properties is relatively varied, though it does have a bit of a concentration in senior housing, which isn’t immune to the economic downturn but has held up better than other segments in the marketplace. More important, only 1 percent of its leases expire next year, providing a degree of stability. Its leverage ratio ranges between 35 and 40 percent.

What are some of the aggressive names in your portfolio?

Digital Realty Trust (NYSE: DLR) is one of our more-aggressive holdings, but the company has performed well throughout the downturn and should fare well going forward because it excels in serving an underserved niche.

Digital Realty focuses on properties designed to house server farms, data warehouses and other technologies that are increasingly essential to doing business in today’s world. When companies like Facebook or JP Morgan Chase (NYSE: JPM) need properties to house their data storage equipment, they turn to Digital for a custom-built solution or space in an existing property. We expect that trend to continue, as data management has become central to productivity.

The REIT’s business has remained impressive throughout 2009. Year-to-date the company has raised the rent on expiring leases by an average of 10 to 15 percent. Boasting a solid balance sheet, Digital is in a position to make acquisitions that will yield 10 to 12 percent in the first year. To top it off, the REIT recently increased its dividend by 9 percent.

What moves have you made on the bond side of the portfolio?

Our bond portfolio generally consists of three components: preferred shares, debt issued by REITs and commercial mortgage-backed securities (CMBs). This year we’ve added significantly to the latter category, taking advantage of the uncertainty that reigned at the end of last year and early this year to scoop up quality assets and a discount. One of Invesco’s arms actually purchases and manages real estate, so we felt comfortable with our ability to evaluate the underlying collateral. We also purchased tranches at the top of the capital structure, the most secure from a valuation standpoint. These are the tranches for which the government is providing financing to potential buyers through the Troubled Asset-Backed Securities Loan Facility (TALF) and the Treasury Dept’s Public-Private Investment Program.

As economic conditions have improved and panic has subsided, the spread between yields on AAA-rated CMBs and rates on US Treasuries have narrowed from 1,400 basis points at the height of the credit crisis to around 450 today. Prior to the collapse of Bear Stearns and Lehman Brothers, this spread typically ranged between 35 and 40 basis points, so there’s room for some compression to occur.

Governments have spent trillions of dollars to revive the international financial system, arousing concern that these near-term palliative efforts may have the unintended consequence of enervating the global economy in the long run. Given this uncertainty, investors have taken a renewed interest in gold, propelling the metal’s spot price to new highs. This month we spoke with Rachel Benepe, one of the new co-managers of First Eagle Gold (SGGDX) who took the helm in the wake of the departure of Jean-Marie Eveillard, about the role of gold as a hedge against portfolio risk.

In the wake of the huge run in prices, should investors still buy gold?

Gold is the best insurance against unforeseen events and the ultimate hedge.

We’re in an environment where there’s a broad understanding that gold can operate as insurance; from individual investors to central banks seeking to maintain or add to their gold holdings, the number of participants and the amount of activity in the gold market has exploded.

Generally speaking, it’s a tumultuous time for financial markets; the unprecedented involvement of central banks and governments around the world increases the potential that today’s policy actions will have unintended consequences down the line.

From our standpoint, buying gold as insurance made sense before and makes sense now. Concerns about inflation have raised awareness of gold’s defensive qualities, but the precious metal is the ultimate insurance against any event or risk that’s difficult to hedge.

Is that what’s driving China’s central bank and others to add to their gold hoard?

A lot of investment in gold is driven by a lack of confidence in competing currencies. The value of an ounce of gold is readily identifiable, so it’s viewed as the ultimate substitute currency.

If you’re the Chinese, or anyone else that holds a lot of US dollars, and you’d like to diversify your holdings, your choices are gold or other paper currencies that may run into some of the same issues as the US dollar.

At the end of the day, you have a choice between two forms of mattress money: a fiat currency or gold bullion in a vault. In this environment, where there’s a lack of trust in what other central banks are doing and concern about the potential consequences of current monetary policies, hard currency is the most attractive option.

Both everyday investors and central banks are worried about fiat currencies. If you look at a basket of currencies going back to 1791 and compare buying that basket of currencies with gold or US dollars, gold maintains its value over that period; since Franklin Delano Roosevelt abolished the gold standard, the dollar has lost 95 percent of its value.

News reports suggest that miners aren’t producing enough gold to meet demand. What role has that played in the upsurge in gold prices?

There is a scarcity factor to gold. Including proven and probable reserves, there’s more gold above ground than below, and mine production has declined.

But there are two factors that drive demand and, ultimately, price.

In a benign environment where people aren’t worried about the financial markets, jewelry is the primary source of demand. But when jewelry demand grew in the 1990s, it didn’t influence prices dramatically.

Investment demand helps to drive the price up because investors are hoarding gold and there’s less float. Today we’re in an environment where central banks aren’t sellers, but an increasing number of investors are purchasing physical gold.

And gold is a scarce asset. Every ounce that’s ever been mined can fit into two Olympic-sized swimming pools. As more people invest in gold and there are fewer gold ounces available on the market, gold prices will go up.

There’s a supply and demand component to gold prices, but most investors focus on the demand side.

Is the rally in gold prices sustainable?

We don’t forecast the price of gold because we view it as a form of insurance: If gold’s doing well, other assets are likely to underperform; if gold isn’t doing well, your equity portfolio is likely doing very well. We usually don’t take a stance on where prices are headed.

That being said, there are a few market trends that investors should keep in mind. First, Barrick Gold Corp (NYSE: ABX) is active in the market because it’s adjusting a very large hedge book. And central banks are reluctant to sell their gold holdings. Without question, gold investments continue to attract a great deal of money.

Should investors hold bullion or buy stock in mining companies?

Because we view gold as a form of insurance, we prefer the safest gold investment--gold that we have in our vault, gold that’s free of mining risk and accounted for.

At the same time, we recognize that gold bullion isn’t always the cheapest way to access this insurance policy; we use a proprietary model that examines a mining company’s proven and probable reserves and the total cost of extracting those ounces from the ground. The model then compares these factors to spot price of gold. If there’s a significant margin of safety between reserves and the spot price of gold, we invest in that company.

Absent those opportunities, we invest in bullion.

Would you recommend that individual investors maintain a mix of bullion investments and gold-related equities holdings?

It makes sense to have a mix of both bullion and gold-related equities; the key is determining the cheapest way to add gold exposure. Outside of owning a gold fund, the easiest way for individual investors to gain exposure to physical gold is SPDR Gold Trust (NYSE: GLD), but it’s unclear if that vehicle is 100 percent physical gold 100 percent of the time.

That being said, mining presents a lot of risks and requires huge amounts of capital, so your safest investment is probably the gold out of the ground. But equities also offer leverage to gold prices, and sometimes a mining stock’s valuation doesn’t reflect the current gold environment.

Are there any miners whose stocks appear attractive from a valuation standpoint?

Because we own gold as insurance, we prefer to own names that currently produce gold. We also look at names that are building out mines and have a production plan in place. A company that makes a great discovery but doesn’t plan to build it out offers little in the way of insurance--in the ground, those ounces are worthless.

We recommend striking a balance between junior, intermediate and senior producers. It’s a rare occasion, indeed, when one of these groups appears more attractive than another; stock-picking acumen and a corresponding sensitivity to individual situations are essential to investing in gold.

Today South African companies appear cheaper relative to spot prices. By and large, these firms operate fixed-cost businesses whose revenues are more leveraged to gold prices than those of producers in other parts of the world.

Of course, that leverage has both an upside and a downside. But those names are still trading at levels that provide a sufficient margin of safety.

How much of their portfolio should investors allocate to gold?

First Eagle’s non-gold funds have always invested at least 5 to 10 percent of its assets in gold; a gold position below 5 percent doesn’t influence the portfolio in a meaningful way, while a position in excess of 10 percent suggests that the manager is making a speculative call on gold.

If gold prices were to go up five times, the rest of your portfolio probably isn’t doing very well; with a 10 percent gold target, your portfolio has at least 50 percent downside protection.

What’s your best piece of advice for investors over the next 12 months?