When Vornado Realty Trust bought the former flagship Filene's Department Store in Boston's Downtown Crossing last year for $100 million, it was no surprise that its plans for the site involved converting it into a mixed-use tower incorporating a hotel, luxury condos, office space and retail. After all, mixed-use has been all the rage among developers for the past few years.

What is surprising is that Vornado's 1.2-million-square-foot One Franklin represents a breakthrough of sorts within the market. Boston, one of the wealthiest and most densely populated cities in the nation has not been a major participant in the trend, up to this point.

The reason is that Boston, perhaps more than any other Northeast market, has been nearly impossible for developers to crack and has become a notoriously challenging market in which to build.

“Historically, it's been very difficult because of the lack of developable land and the long permitting process,” says Robert Shannon, a Massachusetts-based senior investment advisor with brokerage firm Sperry Van Ness. “But now we are seeing a lot of development and redevelopment.”

What Vornado and Federal Realty Investment Trust and other firms have found is that it's possible to circumvent Boston's difficult developing climate by instead opting for redevelopment. Rather than looking for green space — a folly in such a densely packed city — developers are scooping up former industrial sites, office buildings and defunct department stores.

“There is so much money out there, it's been easier to develop new properties rather than trying to compete with institutional buyers to acquire A and B class assets,” says Tom Garesche, senior director of acquisitions with Federal Realty Investment Trust, a Rockville, Md.-based REIT that is currently working on a mixed-use project on the site of the former Assembly Square Mall in nearby Somerville, Mass.

As a result, a new wave of development is gripping Boston. There is 4 million square feet of space scheduled to come on-line in 2007, the biggest year for the city since 1991 when 4.5 million square feet was added, according to data from CoStar Group, Inc. In contrast, in 2006 Beantown saw just 1.8 million square feet of new retail.

But there are few fears that the wave of construction amounts to overbuilding. Although the amount of retail space in the city has increased by 12 percent since 2003, it has failed to keep pace with demand, which has grown 19 percent during the same time frame, according to brokerage firm Marcus & Millichap Real Estate Investment Services.

Additionally, a recent spate of residential projects in South Boston, East Boston, the South End and Fenway-Kenmore Square have helped to fuel new retail development. And, with an estimated 17.6 million visitors annually, who spend $8 billion, Kristen Keefe, retail sector manager with the Boston Redevelopment Authority (BRA) says, “we also have very healthy tourism.”

Moreover, for firms looking to enter the market, building is cheaper than buying. Boston's low cap rates — which averaged 6.6 percent in the first quarter of 2007, according to Real Capital Analytics, compared to the national average of 6.75 percent — and high prices ($190 per square foot vs. $176 per square foot for the United States) made development the most viable option.

That means acquisitions won't be easy to come by. Developers wishing to enter the flushed market will have to explore ground-up development or wait until investors run out of funds.

According to Federal's Garesche, the demand is being driven by foreign investors who will continue to buy, even when interest rates rise.

“I believe that the retail performance will continue at its existing level until a lot of that [foreign] money is either reallocated or spent,”he says.

Mass appeal

The development is luring retailers. In June, Zara, a Spanish fashion apparel chain was the first to sign a lease at One Franklin Street. It will be its second store in Boston (it already has a lease lined up for a storefront downtown on Newbury Street) and its third in Massachusetts. Additionally, last spring Barneys New York opened a 46,000-square-foot store at Simon Property Group's Copley Place mall and upscale shoe retailer Jimmy Choo also stepped in.

Meanwhile, local brokers say that Lowe's is shopping for its first location in the city and Target, with one store at the South Bay Center in Dorchester, is actively out hunting for additional sites. “We just got back from the ICSC Spring Convention and everyone was asking us where they can find space,” Keefe says.

Boston's retail vacancy rate is less than 5 percent and is projected to stay in the low single digits through 2010, Shannon says. And, according to Marcus & Millichap, this year rents are expected to rise 2.6 percent to $20.37 per square foot.

Yet there is still a dearth of retail downtown, especially in some categories. For example, the BRA says there is a need for more grocery stores and big box retail, as well as moderately priced restaurants.

“We are keenly interested in those,” says Keefe, who notes that although Boston's restaurant scene is booming, most of the venues tend to be upscale and tout celebrity chefs.

The question now is whether Boston can sustain its current pace. “ I would say for the next three or four years, we will,” Shannon says. Most brokers agree demand for retail will continue to be strong, although it might trail off from its current level.

Since it's somewhat easier to get approvals for so-called “smart growth” projects than for neighborhood centers or regional malls, the bulk of new construction in the Boston area is lifestyle and mixed-use properties, says Robert F. Sheehan, vice president of research with Burlington, Mass.-based real estate services firm KeyPoint Partners, LLC.

Down the pike

In addition to Vornado Realty's One Franklin Street in Downtown Crossing, Gale International (Vornado's joint venture partner in the project) recently unveiled plans for Seaport Square, a 6.5-million-square-foot mixed-use development on 24 acres in South Boston. Of that total, the waterfront development will include 1.5 million square feet of retail space.

Two additional mixed-use projects on the South Boston waterfront, to be developed by Clarksburg, Md.-based Core Development Group, LLC are currently being reviewed by city planning agencies. They are the 1.1-million-square-foot Waterside Place and the 720,000-square-foot Waterside Crossing.

“Waterside Place will be a little bit like an urban mall,” Keefe says. “It will be easily accessible from the interstate and it will likely be a regional draw, rather than just a local draw.”

Meanwhile, in the Bay Back area, Boston-based partnership CWB Boylston LLC is working on the construction of 800 Boylston Street, a 450,000-square-foot mixed-use project. And, earlier this year local development firm Samuels & Associates formed a joint venture with Lyndhurst, Ohio-based private equity firm Legacy Capital Partners to build a 240,000-square-foot mixed-use project on the South Shore called the Launch at Hingham Shipyard.

The city also recently approved Fan Pier, a 3-million-square-foot mixed-use project in South Boston being built by the Boston-based Fallon Company.

All that adds up to a lot of space hitting the market not just in 2007, but for many years to come.