Real estate operators/private equity players are dealing in situations that have value-add issues lease up risk, construction completion, preventing functional obsolescence, working with borrowers to extract maximum value and in some cases helping cure the bankruptcy risk that ails the existing asset. Fund managers and sponsors looking to deploy capital have to largely partner with real estate operators that have a proven track record and are comfortable with “trainweck” situations.

Dolce: Were there any other shifts that you noticed?

Shams: The other significant shift is that we are in a period of lower yields and higher volatility. Given where debt financing rates are currently for performing and generally stable assets, locking in yields (albeit much smaller anticipated returns than previously imagined) on a long term basis provides a roadmap to a unlevered low teens return and levered mid-to-high teens return in a low cap rate environment. Said another way, you can still achieve a 2.0x on your equity multiple but you’ll have to be much more patient to achieve it. I often hear the debate about what happens to cap rates and rents if we see a huge spike in interest rates. The answer is that cap rates will rise much quicker than rent increases in such an environment. Any bets that rent increases in an inflationary environment will cancel out or equal cap rate increases is a dangerous position to underwrite to. If you look back at previous cycles and look at timeframes in which credit tightening and widening occurred we are still in the middle of things. Under certain scenarios we may not see a “normal” credit market for commercial real estate in earnest until 2015—also having to do with how long it takes banks to recoup some profits from position held on the balance sheets. I believe it is imperative to be able to understand the potential outcome of a longer than expected credit calibration when investing in assets that require a three-year to seven-year hold period. Cap rates are also in many cases not a relevant measure of risk-adjusted yield expectations, especially in cases where nearly all the leases and rents are above market. I believe one of the keys in today’s market is to understand the fundamentals of the asset you are purchasing (pay for today’s values not tomorrow’s hope note). There is now very little to no room for any operating errors that previously would have been absorbed without recognition.

Dolce: What do you see as the biggest opportunity in commercial real estate?

Shams: We believe that yields in core/core plus will continue to see shorter term yield compression whereas higher yields are likely in class B / B- opportunities with a value-add or opportunistic approach. I approach our investments by first understanding the macro level themes that pertain to the asset class we are investing and then couple that with the fundamental asset analysis itself. A defined exit is an important characteristic of what makes many of our investments interesting to our partners in addition to our ability to manage the operational turnaround and create value. You have to know and understand what the story is with an asset—really driving towards markets that have a more sustainable growth profile over the long-term. Compare Detroit vs. Washington D.C.

Some opportunities in this market have to simply be rationalized by observing that the investment period’s entirely long term with no assurance. That may mean a seven-year to 10-year hold on an asset that generates attractive risk adjusted market returns with an ability to reach a 2.0x or higher on the equity multiple or those assets that are being repositioned by us for more longer term buyers that may not be able to have the comfort level of playing in the market. In summary I believe the biggest opportunity in commercial real estate is in the value-add and opportunistic competencies. Class B in A locations continues to generate good return profiles for us.

Dolce: Tell us about your background, how it has helped you in your current position, and what your current responsibilities are at ICO Group.

Shams: I spent the majority of my career on Wall-Street deploying capital to willing buyers and bringing them to willing sellers as an investment banker and subsequently entered private equity. I structured transactions in both down and up markets and saw the REIT market transform into an institutional investment platform from a nascent and relatively unknown asset class. I built deep relationships with private equity firms, investment banks and capital sources throughout my career. I currently oversee the private equity group at ICO Group—my mandate is to substantially broaden our real estate holdings over the next several years. Approximately 50% of our deals are off-market deals. The only real case where it makes economic sense for a seller to have an “off-market” transaction is when they are proactively approached with some economic upside or where relationships are involved. A lot of my deals are based on a phone call from someone I’ve known for from my experience and exposure in the market. Probably the most important value you have in your career is transaction experience and deep relationships that are built over years. Off market transactions are largely a function of relationships.

Dolce: What is your competitive advantage in the market or what in other words, what is ICO Group focusing on?

Shams: Local market experience gives you an ability to be that much smarter than your competitor—a bit of extra knowledge can change the odds. Our focus is generally on infill, major gateway cities with access to port hubs where we see growth rather than fringe opportunities that will continue to contract over the short-to-medium term. We believe there are fundamental longer term drivers in place that reduce the availability and desire for single family residential in commuter markets and more towards the 24-hour “markets.” We have been primarily a player in these markets for the last 25 years so today’s market plays to our strength. Additionally, given technology and how quickly information gets disseminated we really focus on bringing about opportunities not widely marketed.

Dolce: Where do you think cap rates will be two, five and seven years from now?

Shams: Cap rates are going to be subject to more downward pressure over the short term—largely because of quantitative easing as opposed to fundamentals behind the real estate. I don’t believe that inflation will be the primary driver of cap rates over the short-to-medium term. However, you still have to make the assumption that cap rates will be much higher over the long term when underwriting your deals. The longer the hold period, the higher we put probabilities about seeing higher cap rates and a reduction to overall exit values. … I generally believe that the required pace and growth rate for GDP to generate job growth is further away than most people think—we are in a structural shift in the economy that may take three-years to five-years to just sort out what sectors will absorb jobs anew. However, I don’t expect the Quantitative Easing by the Fed to be unwound in such a manner to create a demonstrable and immediate increase in cap rates—this would quite frankly tank the commercial real estate markets. You can extrapolate what that means for interest rates and cap rates in the short to medium term. Required mandates in the market to capitalize and in some cases super capitalize banks (regional and national) has really just begun and in the meantime banks have actually recouped some profits to set some new marks on assets—not all of which we entirely agree with as you can imagine.

Dolce: What kind of returns are you striving for and what kind of returns are you achieving?

Shams: Risk-adjusted returns that are in the unlevered low to mid-teens and levered returns of low 20’s. We are looking for two handle [2.0x] on our equity multiple and will typically look at a three-year to seven-year exit. In some cases we will exit sooner.

Check back in the next day or so for part 2 of 2 of the Q&A with Shams, where we discuss how to find opportunities in the market when dollars are chasing many of the same deals, and where he is focusing his efforts to grow the company, and how the economy will affect the CRE market in the next two years, among other things.