As it expanded in Chicago during the 1990s, Starbucks stuck to a proven strategy: building outlets where there were plenty of BMWs and young professionals. Its green and white logos spread through the affluent neighborhoods along Lake Michigan and the inner loop. Then, the company followed the new money into gentrifying areas and into the suburban strip malls, where middle-income residents lived.

In 2004, however, Starbucks headed in a new direction. In partnership with basketball legend Earvin “Magic” Johnson, the coffee chain opened a shop at 71st Street and South Stoney Island Ave. in the heart of a predominately African-American south side neighborhood, where many households have annual incomes of less than $20,000.

From the beginning, the new store was successful, generating sales comparable to those in upscale locations. “Some people said that minorities would never pay $3 for a cup of coffee,” says Johnson. “But we knew that it would work because people in the area were already driving a long way to get a great cup of coffee from Starbucks.”

Johnson has helped prove that there is money to be made by retail developers in underserved inner-city markets that have not seen private investment in decades. Since February of 1998, Johnson Development Corp. has co-developed, among other projects, 81 Starbucks, 15 Washington Mutual loan centers, six Magic Johnson Theatres, as well as health clubs, restaurants, offices and apartments — all located in areas with modest household incomes and heavy minority populations. Many of the units rank among the top performers in their fields. “In the past, retailers that came to urban locations had second-rate stores, but people don't want that,” says Johnson. “If you provide a high-quality choice, city customers will support it.”

The proof is in the profits. Canyon-Johnson Urban Fund I, a $300 million private-equity fund backed by Los Angeles-based Canyon Capital Realty Advisors LLC has generated gross annual returns in excess of 28% annually since 2002, according to Bobby Turner, a managing partner of Canyon-Johnson. A second, $600 million Canyon-Johnson fund, which closed in April 2005, aims to produce annual returns of 20%. “We are able to generate higher returns than you will see in other markets because there is very little competition,” says Turner.

Maybe not for long. With Johnson's high-profile success, developers who have stuck to conventional suburban venues and high-income urban areas are now pouring money into projects in neighborhoods like New York's Harlem and Philadelphia's south side. Much of the activity focuses on stable, but underserved neighborhoods with middle-income households. But some projects are in neighborhoods that have not been touched by gentrification, where stores have been boarded up and unemployment is high.

Opening doors

Even though the embrace of urban retail development has been cautious, development in these areas has also been spurred by dwindling opportunities in more traditional places. Promising greenfield sites in suburbia are becoming scarcer and harder to develop. And prices for existing retail properties have become prohibitive.

A suburban open-air shopping center may command a cap rate of 7% or less. A comparable urban facility may have a cap rate of 9%, says G. Lamont Blackstone, principal of DLC Urban Core, a developer in Tarrytown, N.Y., who has completed inner-city projects in New York City and Dallas.

Clearly, the big guns are now aimed at these new underserved venues. Baltimore-based Rouse Co., recently bought by Chicago's General Growth Properties, has revitalized part of downtown Baltimore with Harborplace, a mixed-use retail development described as an urban festival marketplace. And General Growth's Town Center redevelopment in Trotwood, Ohio, is expected to spark new retail life in the depressed Dayton suburb, where the median family income hovers at $35,000.

At the same time, major pension funds and institutional investors are setting their sights on underserved urban neighborhoods, including CalPERS, the giant public employee retirement fund, Florida-based American Ventures and Pennsylvania-based GMAC. The success of Canyon-Johnson Urban Funds is an indicator that urban redevelopment is viable. Canyon-Johnson Urban Fund I took over two years to raise $300 million. Fund II raised $600 million in less than a year.

Retailing powerhouses such as Home Depot and Target have accelerated development in low-income neighborhoods in Chicago, New York, and Washington, D.C. “Target and Home Depot are looking for more urban locations because the evidence suggests that inner cities can support stores,” says General Growth vice president D. Lyneir Richardson.

Overcoming hurdles

To be sure, urban developers face plenty of obstacles. Many lenders remain reluctant to participate in neighborhoods where the right economic profile is not on paper. And retailers still face both the reality and perception of higher crime rates, bigger security budgets and personnel problems, including higher turnover and a shortage of qualified job candidates.

“I have been in business in 70 communities, and we have not had one stabbing or shooting in any of our projects,” says Johnson. “We don't have a problem with graffiti because the people trust and respect us. When you train people in the community for jobs, then people embrace the business and protect it.”

Johnson emphasizes that when people in these communities are involved in the building and operation of the project, it instills a sense of ownership and pride. Retailers get in trouble when they develop a second- or third-rate store, assuming the market will not support their standard setup. “People don't want that,” explains Johnson. “It comes across as disrespectful to the customer by not building the same type of store you'd find in suburban America. When they see it, they won't go in.”

For companies entering into one of Johnson's partnerships, he explains that they don't have to change what they do, but rather just “tweak it a little bit for urban America,” much like anyone would tailor their business model to meet the needs of different demographics.

Lending hands

Johnson relies on salesmanship and his star power to bring lenders into the picture. Seeking financing from reluctant pension funds, he meets with trustees again and again, talking about the hefty potential returns of urban investments — and the chance to develop jobs for neighborhoods that need them.

Many projects still rely on government help, however. And the prospects are not great. The Bush Administration is planning to cut much of the funding for the Department of Housing and Urban Development in the 2006 budget. These cuts include a 50% reduction in the $4.7 billion Community Development Block Grant. It remains to be seen how these budget cuts will impact banks that receive tax credits when they make loans or open branches in low-income areas.

For several years, Washington Mutual has been opening branches in blighted areas of the south side of Chicago, says Greg Kirsch, a principal of Baum Realty Group, a brokerage serving retail tenants. Kirsch says that the banks have been profitable because they are welcomed by residents who are eager to open checking accounts instead of relying on expensive money orders. The banks also stabilize the neighborhoods, encouraging other tenants to test urban locations. “The banks have provided landlords with solid rent payers,” says Kirsch. “And because banks have security guards and cameras, they make the area safer.”

Washington Mutual has also partnered with Magic Johnson to open branches in urban settings across the country. “If I build condos, it doesn't make any sense if people can't get home loans to buy them,” says Johnson. “I explained to Washington Mutual that urban America is an overlooked segment. We have worked together to open 15 banking and loan centers nationwide now, and Washington Mutual is booking many home loans.”

Also active in the urban development market, GMAC Commercial Mortgage is able to make loans at below-market rates because of the federal tax credits. GMAC recently provided a $65 million mortgage to Steadfast Cos., the developer that is renovating the Everett Mall in Everett, Wash. Located in an area of moderate-income and poor households, the mall declined as retailers moved to suburban locations. But since the renovation, the mall is 75% occupied. Steadfast Cos. plans to spruce up the surroundings and hopes to bring in new tenants, including a Borders bookstore and Bed Bath & Beyond. Steadfast Cos. could take on the project because of the subsidized loan, and after the mall has been stabilized, Steadfast Cos. may sell it or refinance with conventional debt.

American Ventures, a real estate financing company in Coral Gables, Fla., is opening a series of mezzanine funds that can enable banks to win tax credits for projects in urban redevelopment zones. In a current deal, the company is providing $2 million for a 90-unit condo called San Lorenzo that will cost a total of $20 million.

Located on Northwest 12th Avenue in Miami's Little Havana, the units will cost residents about $225 per sq. ft. That may sound steep for moderate-income residents, but not compared with the $550 per sq. ft. average across metro Miami's booming condo market. “We believe there is tremendous pent-up demand for our type of product,” says Derek Johnson, portfolio manager of American Ventures' Urban Initiatives Fund. “Our projects are located near hospitals and other employment centers. Right now, there is little affordable housing, and people are traveling an hour or more to work.”

About half of the Canyon-Johnson Urban Fund projects rely on tax credits or other assistance. For example, the City of Cleveland Heights provided loans and grants that helped Canyon-Johnson justify a $14.5 million investment in Severance Town Center, a 650,000 sq. ft. shopping center. But financing is only one part of the equation. For urban redevelopment to be successful, community and political support is essential.

Strategic relationships

Before starting construction, Johnson knows the importance of community buy-in. He canvasses the neighborhood, meeting with pastors, community leaders and even school children. Johnson's aim is to assure residents that the project will have a positive impact.

Indeed, even as developers like Johnson show that inner-city projects can be profitable, redevelopment still often hinges on government support and public-private partnerships. In the Canyon-Johnson Fund deals, Johnson and his partners are careful to work closely with government officials, too. “I know a lot of mayors and governors who are looking to turn their communities around,” says Johnson. And these political figures are key to helping bring in public participation.

Another factor that is attracting more developers to underserved urban markets is a new approach to redevelopment by cities. In the past, government officials insisted on controlling renewal projects. But lately, city governments have aimed to serve as catalysts, starting a project and then turning the work over to private groups. In some cases, cities, including Washington, D.C., and Riverside, Calif., have assembled plots of land, using public money and the powers of eminent domain. Once the parcel is complete, it can be sold to private developers who proceed with the projects.

Rappaport Cos. is currently building a 275,000 sq. ft. shopping center in the Anacostia section of Washington, D.C., an area of moderate-income and poor households. Today, many shoppers drive across the Potomac River to buy groceries in the Maryland suburbs, says Gary D. Rappaport, the lead developer.

The new $48 million center will be anchored by a 126,000 sq. ft. Target, a grocery store and a drugstore. The land was assembled by the National Capital Revitalization Corp., a development group chartered by the federal government.

To complete the parcel, the organization had to buy 19 separate parcels from different owners. “A private developer would never have been able to put together a parcel that was big enough for the project,” explains Rappaport.

Yet, the brightest example of public-private redevelopment is taking place in one of America's most well known lower-income, minority communities — Harlem.

Harlem comeback

The stunning revival of Harlem stands as a symbol of how inner-city redevelopment pays off. In the past decade the neighborhood, a 7.2 square-mile area containing 544,000 people with an annual buying power of $2 billion, has attracted dozens of retail and residential developers, including the Disney Store, Starbucks, Old Navy and a Magic Johnson Theatre.

When a pioneering development team headed by G. Lamont Blackstone of DLC Urban Core set out to build a 50,000 sq. ft. Pathmark in Harlem — the first supermarket to be built in a section of 200,000 people in decades — the grocery chain insisted on off-street parking. Blackstone agreed to build a deck on top of the store, but the additional cost threatened to make the project uneconomical. What finally made the deal work was a $700,000 federal grant and financing from the state.

“Pathmark didn't get as much parking as they would have liked, but they were prepared to live with the arrangement because of the tremendous population density in the area,” says Blackstone, who was involved in the negotiations with the city and Pathmark. The store remains a strong performer for Pathmark and it has proved to be an important catalyst for development in Harlem.

Gentrification

Now that more developers are targeting overlooked inner-city neighborhoods, will it turn out to be too much of a good thing? Will the improved retail facilities bring more renovations and more gentrification — making the community inhospitable to the low-income minority residents that have made it their home?

Developers concede that some gentrification is inevitable, but Johnson argues that his developments benefit a range of people. In addition to retail and office projects, he invests in affordable housing in areas where buildings have been abandoned. “The communities do not complain if you hire local people for the construction and you train people for long-term jobs,” Johnson says.

As values go up, it does become harder for lower-income residents to purchase homes in the area. On the other hand, people who have owned homes for generations in these areas are seeing the value of their assets soar, says Johnson. “We are seeing real estate prices skyrocket in Harlem,” he says.

Magic Johnson concedes that building in blighted areas takes considerable effort. But he argues that the arrival of just a few new stores can help to lift a community. When a Starbucks or TGIFridays appears, the attitude of the residents changes. “We see the whole community become excited,” he says. “The mindset of people changes, and they begin to think that things can be improved.”

Johnson's enthusiasm is far from universal. Many national retailers remain hesitant to venture into new ground. But Johnson says that the reluctance will soon disappear: “As people see how strong the profit margins are in the inner cities, you are going to see a big increase in development.”

Stan Luxenberg is a freelance writer based in New York City.

Some Persistent Funds Focus on Inner Cities

In 1999, Bobby Turner began recruiting institutional investors for a real estate fund with a bold mission: focusing on inner cities with big minority communities. At first, pension funds — and the consultants that advise them — were reluctant to sign on. Afterall, inner cities had been losing retailers and residents for years, and many developers feared to enter areas that were plagued by high unemployment rates. But Turner, who is managing partner of Canyon Capital Realty Advisors of Beverly Hills, Calif., persisted in shaking hands and selling. He was assisted in the uphill struggle by Magic Johnson, the former NBA star and head of Johnson Development Corp. By 2002, the two partners had raised $300 million for Canyon-Johnson Urban Fund I.

The bold venture scored some immediate successes, turning around failing properties, and building gleaming retail and housing projects in communities that welcomed them. Canyon-Johnson faced no shortage of tenants after it invested $10 million into Park Place, a condominium project in Brooklyn, New York. Seeing the fund's growing track record, institutions lined up to join Canyon-Johnson Urban Fund II, which recently raised $600 million in six months. Participants included such blue-chip pensions as funds for New York City employees, Pension Reserve Board of Massachusetts, and City of Los Angeles. “Institutions are beginning to gain confidence that there are excellent investment opportunities in inner cities,” says Turner.

Growing markets

While funds such as Canyon-Johnson represent only a tiny fraction of institutional investments, Turner predicts that the field will grow rapidly. Ethnic minorities now represent 35% of the U.S. population, he says. Thanks to immigration, the population of inner-city neighborhoods is growing at seven times the rate of the nation as a whole. While minorities may have low average incomes, many households include several breadwinners. And because urban populations are dense, they can generate enormous sales figures for retailers. “The typical Home Depot has sales of about $400 per square foot,” says Turner. “But the Home Depot in Queens, New York, reportedly does close to $1,500.”

To find promising locations, the partnership typically looks for sites with more than 250,000 people in a five-mile radius and where minorities account for at least 40% of the population. Canyon-Johnson had one of it biggest successes when it acquired Capital Court in 2001, a mall on North 60th Street in Milwaukee with 23% occupancy. The fund demolished the failing property and built a new center called Midtown Center. Anchored by Wal-Mart, Lowe's, and T.J. Maxx, the mall soon registered 98% occupancy. In 2004, Canyon-Johnson put the revitalized shopping center up for sale. About 20 institutions bid eagerly for the stabilized property. Inland Western Retail Real Estate Trust emerged as the winner, paying $53 million for a healthy cap rate of 7%.

Turner sees no shortage of such opportunities. Because many developers are still reluctant to focus on urban areas, the field remains open for Canyon-Johnson and other pioneers. “We are just getting started,” says Turner. “There is a huge demand in inner cities that is not being met.”
— Stan Luxenberg