Part 2 of 2

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LOS ANGELES- As GlobeSt.com reported in partone of two just two days ago, Saman Shams, a managingdirector in the Los Angeles office of ICO Group, who recently satdown with GlobeSt.com’s Natalie Dolce, said that “there has been asignificant shift in commercial real estate from a financialarbitrage market to skilled operating expertise.” In the secondpart of the two-part series, Shams talks about utilizingrelationships to identify opportunities, protecting the downsiderisk, and multifamily as the “most compelling” product type in thiscycle.

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Dolce: How do you see the economy affecting thecommercial real estate market in the next two to fiveyears?

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Shams: As a nation we are in anawkward and overall depressed balance sheet position. The next fiveyears will be quite tough as a new reset to the new normal for manyAmericans festers through the economy. The residential marketcollapse serves as a framework of how substantial resets in somecommercial real estate assets may be. It’s all about a ‘Tale of TwoCities’. Specifically, I recently heard that in many parts ofCalifornia residential prices on average are as if we went back to1989 and grew prices at 2% per year. That is not the case for primeresidential assets in core markets such as those close to thebeach—however, this shows the discrepancy and how hard the hardesthit areas have been to drive the average down as such. Not only isthe residential market largely a tale of two cities but so iscommercial real estate. You may see a destruction of prices incertain areas in excess of 70% juxtapose that to markets that haveactually seen price appreciation—albeit nominal. I believecommercial real estate will also enter into a relatively high levelof bifurcation—clearly seen in the Public REIT markets, but makingits way into the private market as well. Some borrowers haverepriced assets based on their own interpretation of values—ourinterpretation of values were 60% lower in some cases. That is anextreme example but the glut of true repricing has yet to be feltin tertiary and secondary markets. People are accepting the anemicspreads in commercial real estate right now because there arelittle to no alternative markets to generate higher returns andbecause we are in the middle of a quantitative easing program setby the Fed to keep rates low. The CRE market is spotty in terms ofopportunities and will continue to be that way for a period oftime. This market has investors scratching their heads about whycap rates are in some cases at 2007 levels less the rent prospectsthat we had back then. The problems facing the economy are obviousyet the solution or solutions are highly complicated and cross manyunchartered territories so there will be much debate. Thedeleveraging both at personal and corporate levels will sustain fora number of years. The notion of GDP rates driving the economy toappreciably lower unemployment levels over the next two to threeyears remains highly unlikely. If you can lock in long term debttoday with the ability to hold over a longer period of time andride out the next two to three years with positive leverage andsweep some cash then you may actually hit a high teens leveredreturn without having to bet the farm on assumptions that won’tmaterialize—but your hold period is longer—meaning we are actuallygetting paid to operate again. With that said, there may be a waveof very interesting opportunities that hit market—in an impendingdouble dip in CRE—where investors can generate substantially higherreturns than today’s rates. This scenario of the perfect storm is acombination of willingness for the banks to sell after recoupedprofits, marks set on assets and a continued low interest rateenvironment for two to four years.

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Dolce: How are you finding opportunities in themarket when dollars are chasing many of the samedeals?

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Shams: We are primarily focused onutilizing our relationships to identify opportunities that are notbeing widely marketed. These tend to be either situations we havebeen tracking for a long time or those that we feel will be worthpursuing at a later point in time. While we have extensive reachand relationships within the brokerage community half of our dealsare off-market. We are very much focused on working with existingborrowers to look at a broader recap opportunity that allow them tohave some economics as opposed to none.

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Dolce: Where do you focus your efforts? How muchequity do you expect to deploy over the next twoyears?

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Shams: In general we believe that weare in a period of lower returns and higher volatility. We areaggressively protecting the downside risk and not unrealistic aboutthe current return expectations. We think the multifamilyfundamentals and overall macro picture allow investors to benefitfrom the economic woes at hand—multifamily is less exposed to theanemic job market, allows you to effectively take a short positionin the single family residential market and have REAL rent growthprospects. Attractive agency financing makes that side of theequation look good too. The only part that is challenging ispricing—we are seeing cap rate compression across the board inmultifamily. Don’t expect to make substantial returns on locking inspreads that allow a 100bp positive leverage—the longer hold timesfor multifamily are the only way most of the deals are pencilingout for our return expectations. On some deals, however, we haveactually seen cap rate compression within 6 months of purchase. Onthe office side, we are seeing more value-add opportunitiesprimarily due to the exposure this asset class has to the jobmarket. Simply because prices are below replacement cost doesn’twarrant an investment—rather we seek deep discounts, in some cases1/3, to compensate for the uncertainty of the job market over thenext three to five years so long as you can manage a hold periodthat puts you several years out. There must be an underlying viewthat the asset can be leased up when we return to more favorablejob growth fundamentals. Cap rates on many office deals are notuseful as most leases are above market and rent growth can’t befactored into the equations. This isn’t to say that cap rates areirrelevant all together but rather today’s market demands a closerlook at true value drivers and multiple investment return proxiesas opposed to a blanket cap rate underpinning.

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Dolce: What product type do you find most compellingin this cycle and why?

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Shams: We believe that multifamily hasseveral characteristics that make the asset class relatively immunein this economy. Senior housing and data centers offer a compellingmacro level picture in our view. We continue to believe that infillwill be the first markets to come back and have the least downsiderisk under the current economic set of cards we have in hand. Weare particularly skeptical of baking any rent growths in officeunderwriting so we are seeing that there has to be a verycompelling opportunity to but at a deep discount to replacementcost and true reset of market rates in the underwriting. Whereas insome multifamily deals the rents are actually below market. Again,it’s a combination of macro themes and asset fundamentals.

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Dolce: How are you partnering indeals?

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Shams: We have institutional capitalpartners that range from real estate opportunity funds tointernational pension funds. We are the west coast real estateoperators for many of our partners. Having a private equity,development and operating platform allows us to be very aggressivein the market to find the next opportunity. Between the financialcomplexities inherent in capital stacks, operating issues andlarger economic themes it is important to maintain a platform thatallows you to bring all of the three aforementioned together.

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Dolce: What is the bottom line or your take on themarket?

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Shams: It takes double work and effortto get the same returns or lower than what was previously expected.It can’t be overstated how the level of information available intoday’s market is influencing the efficiency and diminishment ofarbitrage opportunities. In the 1990s you had to fly cross countryto “drive” the asset, now you can do a street view in five secondson Google maps. Does that broaden or diminish the ability to profitopportunistically on deals? You can answer that I’m sure. Theability to scour through information is in many cases as importantto accessing the same information which is readily available toeveryone—ranging from most of sophisticated to unsophisticatedbuyers. How one manages to function in this paradigm shift willlargely dictate an investor group’s success. If you take a look atCRE transaction volume, it is still a tiny fraction of where it wasat the height in 2007. We have a ways to go before there is a clearfunctioning market and in the meantime the values are in some casessecondary to just acquiring good real estate for the longerterm.

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Natalie Dolce

Natalie Dolce, editor-in-chief of GlobeSt.com and GlobeSt. Real Estate Forum, is responsible for working with editorial staff, freelancers and senior management to help plan the overarching vision that encompasses GlobeSt.com, including short-term and long-term goals for the website, how content integrates through the company’s other product lines and the overall quality of content. Previously she served as national executive editor and editor of the West Coast region for GlobeSt.com and Real Estate Forum, and was responsible for coverage of news and information pertaining to that vital real estate region. Prior to moving out to the Southern California office, she was Northeast bureau chief, covering New York City for GlobeSt.com. Her background includes a stint at InStyle Magazine, and as managing editor with New York Press, an alternative weekly New York City paper. In her career, she has also covered a variety of beats for M magazine, Arthur Frommer's Budget Travel, FashionLedge.com, and Co-Ed magazine. Dolce has also freelanced for a number of publications, including MSNBC.com and Museums New York magazine.