Despite the buzz surrounding new and proposed mixed-use projects, the product niche remains a fledgling and untested formula for long-term financial success.
Lenders increasingly are challenged in underwriting mixed-use projects because of ever-higher construction costs, changing market conditions and the built-in unknowns about how mixed uses ultimately will work together.
Mitigating risk, especially considering that construction costs nationwide have increased by 7.6% in the past year alone, according to New York-based Turner Construction Co., is driving investor thinking. “The rule of thumb has changed,” says Aden Kun, vice president of Los Angeles-based Buchanan Street Partners, a real estate investment bank. “Historically you could underwrite to a 5% hard-cost contingency buffer for construction costs, and now you need 10% plus.”
According to Atlanta-based Reed Construction Data, nearly 1,000 mixed-use projects nationwide have been completed or are in the development pipeline in 2007, 10 times the number of mixed-use developments completed in 2003.
To be sure, there are a few glitches on the rosy mixed-use horizon. In May, plans for a $2.5 billion mixed-use project called W Las Vegas were suddenly nixed when minority partner Starwood Hotels & Resorts pulled out of the project. Next door, the highly touted Las Ramblas condo tower — which prominently featured partner George Clooney — was canceled in summer 2006 because of weak presales. While Starwood officials aren't talking publicly, higher construction costs and slow condo presales had cast doubt on the future of the project and forced rumors of Starwood's pullout for months.
Despite the increasing challenges, some lenders aren't so much worried about current costs as they are about the long-term viability of mixed-use projects, given recent financing trends.
“With the excesses and the type of lending that has gone on in the last two years, you can feel pretty good that there have been some bad loans made, given 10-year, interest-only structures and the like,” says David Durning, managing director of originations and agency lending at Newark, N.J.-based Prudential Mortgage Capital Co. “That means you're going to have problems. We're still waiting to see the total fallout from the condo overbuilding.”
When it came to financing a $170 million mixed-use project covering three city blocks now under development in downtown Houston, lenders wanted an established track record. Denver-based Entertainment Development Group had completed the successful Denver Pavilions downtown in 1998. That fact alone helped convince Buchanan Street Partners to sign on as an equity partner in the new Houston project to the tune of $47 million, or nearly 30% of the total project cost.
“A market can shift, but your owner/developer is always going to be there,” says Kristin O. Penahal, senior vice president with Buchanan Street Partners. “We spend a lot of time understanding who our partner is, how they think and how they operate. You can't control everything on one of these projects, but you can control who you partner with.”
When completed in October 2008, Houston Pavilions will include 360,000 sq. ft. of retail space, a 44,000 sq. ft. House of Blues, and 200,000 sq. ft. of speculative office space.
For projects large and small, Durning notes that having the right development partner can yield better financing terms. “The market is very aggressive in financing a track record,” says Durning. “Mixed-use as a phenomenon is something we are very comfortable with, but when you don't have a track record that's when it can be a little more challenging.”
Mark Schurgin, president of Los Angeles-based The Festival Cos., which has developed more than 130 retail properties nationwide over the past 25 years, agrees. “Lenders should shy away from inexperienced sponsors because you don't know what you've forgotten until the building is up and then it's too late,” he maintains. “You need to be with an experienced developer who has the understanding of the combination and synthesis of putting all of the components together.”
Schurgin is teaming up with New York-based Goldman Sachs on a new $800 million retail fund, which kicked off in January. Already it has invested more than $200 million and is looking for mixed-use opportunities large and small. Schurgin is targeting a 20% internal rate of return on deals, and is already talking with Goldman about jump-starting a second fund.
Major mall owners like Simon Property Group and Pennsylvania REIT are also diving headlong into the mixed-use game, bringing more scrutiny from Wall Street analysts. Indianapolis-based Simon, for example, intends to include a mix of property uses in every future development it undertakes.
Chicago-based General Growth Properties is undertaking one of its most intensive redevelopments yet, reshaping the enclosed Cottonwood Mall near Salt Lake City into mixed-use with shops, residences, offices and streetscapes with a community feel for completion by 2010.
Billy Procida, a New York developer turned lender and now president of Palisades Financial in Fort Lee, N.J., recently invested $20 million to help acquire the land and start site work for a portion of the $1 billion Centuria Fort Lee project. When completed in 2011, the mixed-use development will feature luxury rental units, 90,000 sq. ft. of office space, 126,000 sq. ft. of retail space, a 19-story hotel and a 65,000 sq. ft. convention center at the foot of the nearby George Washington Bridge outside Manhattan.
One selling point: Procida's office overlooks the project site, but key to the funding was Procida's 16-year relationship with the owner, Town & Country Developers, which Procida has partnered with on $1 billion in condominium developments.
“Like anything else, you can have the greatest piece of property in the world, and in the wrong hands it can turn to scrap,” observes Procida. “We liked the property, we liked the developer and we liked the concept.”
Lenders run through a battery of tests before they become sold on a mixed-use project, but location and demographics are paramount factors in determining a project's viability. With the Houston Pavilions project, significant retail pre-leasing and Houston's relatively healthy 12% office vacancy rate made Buchanan's decision easier.
“That made us comfortable in the underwriting for this type of unique project in Houston,” says Buchanan Street's Penahal.
Cleveland-based Forest City Enterprises is well known for tackling large mixed-use projects around the country, including Atlantic Yards in Brooklyn and Stapleton in Denver. But when Canadian-based Magna Entertainment Corp. approached the firm with plans to create a joint venture to redevelop the famous Gulfstream Park race track in Hallandale, Fla., Forest City had to dig deeper.
“Clearly we did our due diligence, understanding what was going on with the demographics, with the tourism dollar, where we think the customers are coming from,” says Will Voegele, vice president of development for Forest City. “What gets you over the hurdle is ultimately making a deal for a project in its highest and best use, which also fits within the context of the economics of the deal and translates into economic success.”
Strategic approachLenders agree that financing mixed-use properties is more challenging than single-use buildings, but each project has its own unique characteristics. The focus, they say, is first to underwrite individual properties within larger developments, then look to how they work with the overall project.
“A savvy lender will not only look at whether a robust market exists for each of these elements, but it also will carefully review the mix of the elements and how complementary they are, or aren't, to each other,” says Gregg Winter, president of Winter & Co. in New York, which finances mixed-use developments.
Abe Schear, a partner in the commercial real estate practice of law firm Arnall Golden Gregory, which created the financial and leasing structures for the 138-acre Atlantic Station development in Midtown Atlanta, agrees. “In a mixed-use property, you could be doing the retail right and the office terribly or vice versa, and it's very difficult to get your arms around the entire project to figure out what the future is going to hold for the project,” he says.
Schear is now working with O'Neill Properties Group of King of Prussia, Pa. on the 1.6 million sq. ft. Uptown Worthington project outside Philadelphia. Located on 100 acres, the project includes retail, entertainment and offices, and apartments.
“For larger projects, the lenders do want to see how the parts get along and underwrite on their own feet,” says Kun, “because at the end of the day one plus one doesn't necessarily equal three.”
Unifying all of the moving parts once they are built is one thing, but getting them built and marketed in an orderly, phased strategy is a bit trickier. Atlanta-based Cousins Properties is developing one of Atlanta's largest mixed-used centers, called Terminus, in the heart of the tony Buckhead district. The 10-acre, $660 million project includes two office towers and a 32-story condominium building started in April, along with 125,000 sq. ft. of street-level retail and restaurant space. Future phases include two more 40-story condominium buildings.
“Some of the previous plans for this prominent site only included office buildings, but we felt we could bring our office, residential and retail experience to bear to take advantage of this prime location,” says Matt Gove, vice president of corporate communications for Cousins. “As we bring each new phase of the project on line, they are designed to feed off each other. While this live-work-play concept is new to Buckhead, it is a combination of mixed uses that works, from both a leasing and an investment perspective.”
Ben Johnson is a Dallas-based writer.
Landmark financing deal for Denver projectFor his first major mixed-use financing, mortgage banker Scott Lynn chose a doozy. Lynn's firm, Metropolitan Capital Advisors based in Dallas, recently placed a whopping $182 million construction loan with Hypo Real Estate Capital Corp.
The German lender is funding the ambitions of young developer Zack Davidson, CEO of Everest Development Co., and his latest project, a 1 million sq. ft. mixed-use development in Greenwood Village, Colo., called Denver Landmark.
Set for completion in 2009, the project, located 10 miles outside of Denver, will include 252 condos in two high-rise towers, 175,000 sq. ft. of retail, 10 restaurants, a European spa, a gourmet market and an 1,100-space parking structure. The project features a 30,000 sq. ft. prototype cinema by Landmark Theatres, a company run by Mark Cuban, owner of the Dallas Mavericks and high-tech entrepreneur.
Making Lynn's job easier was the fact that the retail space was already 90% pre-leased. And the condos are 80% presold at prices ranging from $500,000 to $1.5 million for 1,300 to 3,700 sq. ft.
The 38-year-old Davidson was a newcomer to the Denver development scene, but he has completed $700 million worth of condo developments in San Francisco, Houston and Dallas.
After securing a $56 million retail construction loan with a local bank in 2006, the developer's preleasing and presales successes led Lynn to create a new, single offering package that included refinancing of the retail along with construction financing on the two condo towers. Then he went looking for a capital source.
But instead of a frothy bidding war, Lynn found something else. Despite Davidson's track record, local banks shied away because of the condo component after they had bulked up on condo loans over the past few years.
Even after identifying Hypo as the lead candidate, Lynn says the placement took five months to complete. Part of the delay was Hypo's concern over costs. “They were very thorough in their underwriting, both from a market and construction perspective. For these projects, I don't care where you're building them around the country, costs are going up.” Only after he produced final contracts from the general contractor did Hypo put pen to paper.
Lynn learned a lot during the process. “Now I would be hesitant if a developer came to me and asked me to get financing, and then the sales and preleasing would show up later. You have to put your performance where your mouth is and easily demonstrate the success is there.”
— Ben Johnson