Part 2: ICO’s Shams Identifies Opportunities

Part 2 of 2

LOS ANGELES- As GlobeSt.com reported in part one of two just two days ago, Saman Shams, a managing director in the Los Angeles office of ICO Group, who recently sat down with GlobeSt.com’s Natalie Dolce, said that “there has been a significant shift in commercial real estate from a financial arbitrage market to skilled operating expertise.” In the second part of the two-part series, Shams talks about utilizing relationships to identify opportunities, protecting the downside risk, and multifamily as the “most compelling” product type in this cycle.

Dolce: How do you see the economy affecting the commercial real estate market in the next two to five years?

Shams: As a nation we are in an awkward and overall depressed balance sheet position. The next five years will be quite tough as a new reset to the new normal for many Americans festers through the economy. The residential market collapse serves as a framework of how substantial resets in some commercial real estate assets may be. It’s all about a ‘Tale of Two Cities’. Specifically, I recently heard that in many parts of California residential prices on average are as if we went back to 1989 and grew prices at 2% per year. That is not the case for prime residential assets in core markets such as those close to the beach—however, this shows the discrepancy and how hard the hardest hit areas have been to drive the average down as such. Not only is the residential market largely a tale of two cities but so is commercial real estate. You may see a destruction of prices in certain areas in excess of 70% juxtapose that to markets that have actually seen price appreciation—albeit nominal. I believe commercial real estate will also enter into a relatively high level of bifurcation—clearly seen in the Public REIT markets, but making its way into the private market as well. Some borrowers have repriced assets based on their own interpretation of values—our interpretation of values were 60% lower in some cases. That is an extreme example but the glut of true repricing has yet to be felt in tertiary and secondary markets. People are accepting the anemic spreads in commercial real estate right now because there are little to no alternative markets to generate higher returns and because we are in the middle of a quantitative easing program set by the Fed to keep rates low. The CRE market is spotty in terms of opportunities and will continue to be that way for a period of time. This market has investors scratching their heads about why cap rates are in some cases at 2007 levels less the rent prospects that we had back then. The problems facing the economy are obvious yet the solution or solutions are highly complicated and cross many unchartered territories so there will be much debate. The deleveraging both at personal and corporate levels will sustain for a number of years. The notion of GDP rates driving the economy to appreciably lower unemployment levels over the next two to three years remains highly unlikely. If you can lock in long term debt today with the ability to hold over a longer period of time and ride out the next two to three years with positive leverage and sweep some cash then you may actually hit a high teens levered return without having to bet the farm on assumptions that won’t materialize—but your hold period is longer—meaning we are actually getting paid to operate again. With that said, there may be a wave of very interesting opportunities that hit market—in an impending double dip in CRE—where investors can generate substantially higher returns than today’s rates. This scenario of the perfect storm is a combination of willingness for the banks to sell after recouped profits, marks set on assets and a continued low interest rate environment for two to four years.

Dolce: How are you finding opportunities in the market when dollars are chasing many of the same deals?  

Shams: We are primarily focused on utilizing our relationships to identify opportunities that are not being widely marketed. These tend to be either situations we have been tracking for a long time or those that we feel will be worth pursuing at a later point in time. While we have extensive reach and relationships within the brokerage community half of our deals are off-market. We are very much focused on working with existing borrowers to look at a broader recap opportunity that allow them to have some economics as opposed to none. 

Dolce: Where do you focus your efforts? How much equity do you expect to deploy over the next two years?

Shams: In general we believe that we are in a period of lower returns and higher volatility. We are aggressively protecting the downside risk and not unrealistic about the current return expectations. We think the multifamily fundamentals and overall macro picture allow investors to benefit from the economic woes at hand—multifamily is less exposed to the anemic job market, allows you to effectively take a short position in the single family residential market and have REAL rent growth prospects. Attractive agency financing makes that side of the equation look good too. The only part that is challenging is pricing—we are seeing cap rate compression across the board in multifamily. Don’t expect to make substantial returns on locking in spreads that allow a 100bp positive leverage—the longer hold times for multifamily are the only way most of the deals are penciling out for our return expectations. On some deals, however, we have actually seen cap rate compression within 6 months of purchase. On the office side, we are seeing more value-add opportunities primarily due to the exposure this asset class has to the job market. Simply because prices are below replacement cost doesn’t warrant an investment—rather we seek deep discounts, in some cases 1/3, to compensate for the uncertainty of the job market over the next three to five years so long as you can manage a hold period that puts you several years out. There must be an underlying view that the asset can be leased up when we return to more favorable job growth fundamentals. Cap rates on many office deals are not useful as most leases are above market and rent growth can’t be factored into the equations. This isn’t to say that cap rates are irrelevant all together but rather today’s market demands a closer look at true value drivers and multiple investment return proxies as opposed to a blanket cap rate underpinning.

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

Shams: We believe that multifamily has several characteristics that make the asset class relatively immune in this economy. Senior housing and data centers offer a compelling macro level picture in our view. We continue to believe that infill will be the first markets to come back and have the least downside risk under the current economic set of cards we have in hand. We are particularly skeptical of baking any rent growths in office underwriting so we are seeing that there has to be a very compelling opportunity to but at a deep discount to replacement cost and true reset of market rates in the underwriting. Whereas in some multifamily deals the rents are actually below market. Again, it’s a combination of macro themes and asset fundamentals.

Dolce: How are you partnering in deals? 

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

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

Shams: It takes double work and effort to get the same returns or lower than what was previously expected. It can’t be overstated how the level of information available in today’s market is influencing the efficiency and diminishment of arbitrage opportunities. In the 1990s you had to fly cross country to “drive” the asset, now you can do a street view in five seconds on Google maps. Does that broaden or diminish the ability to profit opportunistically on deals? You can answer that I’m sure. The ability to scour through information is in many cases as important to accessing the same information which is readily available to everyone—ranging from most of sophisticated to unsophisticated buyers. How one manages to function in this paradigm shift will largely dictate an investor group’s success. If you take a look at CRE transaction volume, it is still a tiny fraction of where it was at the height in 2007. We have a ways to go before there is a clear functioning market and in the meantime the values are in some cases secondary to just acquiring good real estate for the longer term.