When Vista, Calif. signed a contract with a local developer for the creation of a mixed-use project on a city-owned parking lot near its downtown in 2005, Vista officials felt like they had hit the jackpot.

The project, blending 40 condominiums with 20,000 square feet of ground-floor retail on the corner of Santa Fe Avenue and Vista Village Drive, seemed like the perfect catalyst for the revitalization of the Santa Fe/Mercantile Corridor, a 2,000-acre stretch of road lined with dusty 50-year-old buildings. The developer, Newport Beach, Calif.-based Pelican Properties, had a proven track record in mixed-use, including Plaza Almeria in nearby Huntington Beach and a development in downtown Tustin. The residents appeared pleased with the project. It seemed nothing could go wrong.

However, in October, after spending two years in the planning process and attending countless meetings with local business leaders and community groups, Pelican Properties decided not to go ahead with the development. The reason? The firm felt the terms of its agreement with the city clashed with the reality of the housing market in the San Diego area, where the median house price had dropped 4.4 percent since May 2006, to $595,070, according to the California Association of Realtors.

“The problem was that the city doubled the land price to $2 million and they wanted the project delivered in 2009,” says Daniel Howse, a Pelican principal. “We told them that we were willing to pay the price, but didn't want to deliver the project until 2010, until the housing market stabilized.”

Vista officials rejected Pelican's offer and plan to solicit new proposals for the site. But with the national real estate market navigating choppy waters, proposed developments like the one in Vista may be jettisoned in communities across the United States. The mixed-use concept isn't going away — it solves too many problems, including easing traffic congestion and getting the most mileage out of pricey land.

But in many cases, mixed-use components will be reevaluated, and deals held up or even scrapped, as developers face greater uncertainty across most real estate sectors.

Set sail

As the residential and office markets began to take off in 2003, projects marrying retail, residential and/or office space grew in popularity. This year, mixed-use became the dominant format in the national retail development pipeline, accounting for 26 percent of all projects, according to brokerage firm Colliers International. That's up from 14 percent last year.

“We love the concept of mixed-use and think it's the way to go,” Howse says. “The commuting costs are just getting greater and greater; plus, people can't drive an hour each way to get to work. We are very solid on mixed-use.”

But a mixed-use project can only work if each of its elements is viable on its own, according to the Urban Land Institute — a challenge in an uncertain real estate market. For now, uncertainty is the watchword.

By now, everybody knows that condos and single-family housing is a problem, either as part of a mixed-use development or on its own. The Pending Home Sales Index fell 21.5 percent to 85.5 in August 2007 from 108.9 during the same month in 2006, with Western and Southern states suffering the brunt of the decline, according to the National Association of Realtors. Condo and co-op sales as of August were down 11.7 percent to 690,000, on a seasonally adjusted basis, from 781,000 in August of last year.

Feeding the real estate industry headwinds, the office, retail and hospitality sectors all trended downward, according to a recent report from Property & Portfolio Research, Inc., a Boston-based real estate research and portfolio strategy firm. Since the beginning of the year, retail vacancies climbed 0.2 percentage points, to 10.2 percent at the beginning of August. And the national office vacancy rate, which posted declines of 20 basis points in 2006, fell only 10 basis points this year, to 14.8 percent. Meanwhile, the national office construction pipeline is forecast to grow by 25 percent in 2007, to 75 million square feet, reports Colliers International.

That's already affecting markets with large construction pipelines, including Baltimore, Orlando and Phoenix.

Even the growing hospitality sector is poised for a slowdown. Last year, demand outpaced the amount of new supply coming on the market. This year, hotel room supply and demand grew at the same rate, 1.3 percent, according to PricewaterhouseCoopers. However, in 2008, supply is projected to grow 2.1 percent, outpacing demand by 0.4 percentage points.

Right now, the effect on mixed-use properties remains minimal, says Ross Moore, senior vice president and director of market and economic research with Colliers. But, he says, “I do think we will see an impact.”

More headwinds forecast

In the short term, developers express the most concern with the sagging housing market. For example, in Florida, a region where hundreds of thousands of new units came on-line in just the past few years, condo buyers have been walking away from their contracts, says Scott R. Lynn, director and principal with Metropolitan Capital Advisors, Ltd., a Dallas-based real estate investment banking firm. Now, lenders simply refuse to finance projects with condominiums, notes John C. Gunn, a development executive with Urban Partners LLC, a Los Angeles-based real estate investment, planning, development and management firm.

Urban Partners experienced this dramatic shift first-hand when it failed to find a lender for its 231-unit Aspira tower in Seattle, a project scheduled to break ground later this year. “We had a very tough time financing it as a condo project, but when we switched to a rental format, the capital pool became quite large,” says Gunn.

Aspira happens to be a residential development, but Gunn says he already witnessed how several mixed-use projects in California got killed because of the same problem. Once this year ends, more and more people will start reassessing their development plans, and will switch from residential and office components to hospitality and retail, says Jeff Green, president of Jeff Green Partners, a Mill Valley, Calif.-based shopping center research and consulting firm.

“There will be a huge impact on many mixed-use projects, especially in California, Nevada, Arizona and Florida,” the markets hardest hit by the housing slump, says Green. “I'm surprised I don't see people reacting yet, it's a mistake to wait.”

Urban Partners, however, has already started thinking about a change in strategy. To date, the firm has concentrated on the residential/retail mix and still intends to move ahead with its $200 million Burien Town Square development in Burien, Wash., which will feature 404 condominiums and 51,100 square feet of retail space when it is completed in 2010.

The residential market in the Seattle area is still healthy, Gunn notes, and its commercial sector will outperform the rest of the country in 2008, according to a recent report from the Urban Land Institute and PricewaterhouseCoopers. But Urban Partners plans to put more emphasis on nonresidential components going forward.

“A project we are looking at in Culver City, Calif. will have four different uses,” Gunn says.

The Culver City development, Washington National Station, will contain approximately 180 hotel rooms, 100,000 square feet of office space and 60,000 square feet of retail, in addition to 185 apartments and 50 condo units when it is completed in 2011. Urban Partners plans to begin construction on the project in 2008.

Course corrections

Urban Partners is in a better position than some, with its ground-breaking for Washington National Station still months away. But, if a project has already started construction, shifting uses will require some ingenuity on the part of the developer, according to Lynn.

From an architectural point of view, condominiums can be turned into hotel rooms; however, to be successful, hotels need to be located in a vacation destination or have an established base of business travelers, Lynn notes. Plunking a project down in the middle of a residential area just because you need an alternative use for your condominiums won't work, and the same principle holds true for office buildings.

In some regions of the country, even going from condos to rentals might prove tough. “We have to be careful not to overbuild the rental housing either,” says Lynn.

Plus, many of the mixed-use projects currently in the pipeline are the products of joint venture partnerships between two or more developers, and sorting out those kinds of agreements takes longer than when you are doing a project alone, Green says.

Does that mean developers might be better off scrapping their projects completely? “That depends on how pregnant you are,” says Scott Kaplan, senior managing director of retail services for the Western region with global brokerage firm CB Richard Ellis. If most of your project is already built out, you are better off switching to a new use, even if it's difficult. In many cases, you will manage to at least break even, rather than take an outright loss.

“People are very resourceful when they've put millions of dollars into a project, so they will find a way out,” Kaplan says.

However, some projects will end up scrapped. For the most part, they will include developments in secondary and tertiary markets, where the fundamentals were never strong enough to support the deal in the first place, according to both Kaplan and Lynn. And, going forward, developers are more likely to scale back their mixed-use pipelines until the market corrects itself; which by most estimates won't occur before 2009.

The idea of mixed-use, however, will continue to hold appeal, Lynn notes, because it reflects long-term changes in attitudes toward new development, not just short-term shifts in real estate market statistics.

“I personally think that mixed-use is here to stay,” Lynn explains. “I think people who already got their projects started will do better in the end because the supply of new product won't be what it might have been had there not been this shift in the capital markets this summer.”