Changing demographics, punctuated by a sharp rise in the number of empty-nesters and Generation Xers keen on urban living, have led to a growing enthusiasm for projects that combine residential and commercial uses. Smart growth planners point to projects such as 16 Market Square in Denver, South Village in Los Angeles and Colonial TownPark in Orlando, Fla., as models of successful mixed-use development.

For developers, large-scale, mixed-use projects have the potential to yield double-digit returns. Yet, the inherent risks have left many on the sidelines. Why? It can take years before returns ever materialize for multi-phase developments, and unforeseen project costs are common.

Real estate investment trusts (REITs) face an added burden. They must answer to shareholders who value short-term results and expertise in developing specific product types, says analyst Matthew Ostrower of Morgan Stanley. Only a handful of REITs have been willing to take those risks. Consequently, private developers are leading the charge, often partnering with local governments.

One company with vast experience is Denver-based Continuum Partners LLC, which has developed and managed more than 15 million sq. ft. of mixed-use space over the last two decades. One of its marquee projects is the $55 million, 280,000 sq. ft. 16 Market Square in downtown Denver, which includes the area's first Class-A building in more than a decade.

Completed in the spring of 2001, 16 Market Square — which is located within walking distance of Coors Field — consists of ground-floor retail, five floors of office space, two floors of condos, 50 restaurants and several hotels. The development's office and retail space is 100% leased, according to Dan Murphy, a partner at Continuum.

Because of the popularity of the project, the condo units all sold before the building was finished, in effect creating upfront equity that helped with the project's office and retail components. “People said we'd never get more than $250 per sq. ft. for our condos,” says Murphy. However, all of the units were sold before the building was finished, with the last units selling for $350 per sq. ft. And since the building was finished in 2001, resales are at more than $400 per sq. ft.

“We achieved a leveraged return of over 25% at 16 Market Square because we took advantage of the premium we could get for residential, which drove costs down on office and retail,” says Murphy.

A Formula for Success

One way for developers to raise the bar — and the payoff — for mixed-use projects is to collaborate with the government. Local municipalities are learning that where residential and commercial uses exist side by side, property values increase, as does support for much-needed public transportation, according to the Smart Growth Network, which published the 2002 report “Getting to Smart Growth: 100 Policies for Implementation.” The network is a group of nonprofit and government organizations that focus on ways to boost the economy, protect the environment and enhance community vitality.

Los Angeles-based real estate investment firm CIM Group, for example, manages the $180 million CIM California Urban Real Estate Fund, which focuses on California urban infill projects. One of the firm's current projects is South Village, a $247 million public-private partnership development in downtown Los Angeles.

The 7.2 acre multi-block South Village will be completed in four phases. The $48 million first phase is a conversion of the three Gas Company buildings into 251 rental lofts and 22,500 sq. ft. of retail space, scheduled for completion in September. The $60 million second phase will include five levels of loft apartments above a 50,000 sq. ft. supermarket and an additional 10,000 sq. ft. of retail space. The $21 million third phase, scheduled to begin in 2004, will consist of 152 loft apartments and 25,000 sq. ft. of retail space. The $118 million final phase will add 520 for-sale condos and 30,000 sq. ft. of retail space.

“CIM faced significant financial hurdles arising from the high land cost and low rent the market could pay, the high cost of underground parking for the supermarket, and the cost of building housing above a market while preserving its standard dimensions,” explains John Given, senior vice president of development of CIM.

Realizing these hurdles, the Los Angeles Community Redevelopment Agency allotted funding to acquire the site at its $7.3 million market value and lease it back to the CIM Group at a nominal rate. “The agency committed an additional $4.3 million to finance the unique costs of designing a supermarket to support five floors of housing above, without compromising critical supermarket floor plan dimensions,” Given says. And the agency's assistance also “funds the feasibility gap associated with restricting 20% of the units to low and very low income residents,” he adds.

Likewise, one of the earliest examples of a successful public-private collaboration is valued at more than $150 million. Mizner Park in downtown Boca Raton, Fla., occupies the former site of a dying 430,000 sq. ft. regional shopping center designated a blighted area. In 1989, the city created the Boca Raton Community Redevelopment Agency and allotted $50 million to improve infrastructure downtown.

The city teamed up with local real estate firm Crocker & Co., along with New York-based financial services company TIAA-CREF, to build Mizner Park, which features more than 200,000 sq. ft. of retail space, 272 apartments and townhouses, a 180,000 sq. ft. office building, an amphitheater and a museum.

Now, Mizner Park boasts a 94% residential occupancy rate, while the office tower is 96% occupied, according to Jo Ann Root, marketing director for the mixed-use project. Rents for the retail space, which include national retailers such as Enzo Angiolini, Ann Taylor Loft and Banana Republic, have held steady at $50 per sq. ft. for the past several years. Sales for 2002 averaged $545 per sq. ft., a slight drop from 2001's average of $556 per sq. ft., but still nearly twice the national average. Now the center is up for sale by TIAA-CREF and real estate experts predict that the center could sell for more than $150 million.

Shifting Strategies

But mixed-use projects are complicated. Despite the potential to achieve double-digit returns, developers new to the arena can be confronted by an array of unforeseen costs that eat away at profits. For example, to meet fire safety requirements, developers must provide multiple lobbies and adequate exits based on the number of building occupants, as well as provide adequate parking for residents, shoppers and office workers.

In addition, these multiple-phase projects can take years to complete as developers attempt to generate enough cash flow to justify moving on to the next phase. For all the patience required, developers would much prefer to see consistent returns well above 10%, says Gregg Logan, managing director of Atlanta-based real estate advisory firm Robert Charles Lesser & Co.

Federal Realty Investment Trust learned the hard way. The Rockville, Md.-based REIT specializes in the redevelopment of shopping centers but has developed mixed-use properties such as Santana Row in San Jose, Calif. When completed, Santana Row will include 680,000 sq. ft. of retail space, 1,200 luxury rental units, a hotel and parks.

But these kinds of mixed-use projects can face high costs and controversy with shareholders. “Santana Row was a huge expenditure for Federal Realty — 20% of their capital was tied up,” says Ostrower of Morgan Stanley. “REITs are broken down into property types and mixed use has too many types, which increases the controversy because shopping center investors don't want their REITs in property types that aren't their core competency.”

Phase I of Santana Row has been completed for seven months and Phase II is under construction. It can take three to five years before it becomes clear if a mixed-use project will be successful and Federal Realty “isn't going to see the profits they wanted” on Santana Row, says Ostrower. “They had been predicting an 8% return but now the number is 5% or lower.”

According to Andrew Blocher, vice president of capital markets and investor relations for Federal Realty, the REIT earned 4% to 5% on $445 million invested in the first phase of Santana Row. “We are expecting to generate a 5% stabilized yield, and the first phase will be stabilized in 2004,” Blocher says.

Blocher acknowledges that while mixed-use may work well for some private companies, “for a public company and for what we want to provide to our shareholders, the returns on mixed-use don't justify the risks.”

While it is still committed to the mixed-use properties in its portfolio, such as Santana Row, Federal Realty in the spring of 2002 decided to alter its business plan. Instead of embarking on huge mixed-use projects from the ground up, Federal Realty will now focus on developing specific portions of a mixed-use project, such as retail space, while other developers and the city collaborate on the remainder of the project. “We won't develop large, mixed-use, complicated projects. But we may buy an incremental space where costs are low and returns are high,” says Blocher.

Under Federal Realty's new strategy, future phases of Santana Row will “be smaller and the risk will be mitigated,” says Blocher. In Phase II, Federal Realty will invest $27 million in retail space that is already 95% pre-leased to Best Buy and The Container Store. The REIT expects to receive a 16% return.

A New Approach

Despite the difficulties REITs face in the mixed-use arena, some have found success by offering one-stop development and management expertise for all phases of mixed-use development. Birmingham, Ala.-based REIT Colonial Properties Trust, for example, is one of the few REITs that can manage all phases of mixed-use development in-house, according to Robert Jackson, executive vice president of Colonial's office division.

“This enables us to reduce coordination time and multiple ownership complexities associated with having other developers helping to execute the master plan,” explains Jackson. In addition, “we are careful to introduce into the marketplace whichever segment is most in demand at the time. That can be critical in an uncertain economy.”

Colonial capitalizes on corporations' desire to create an identity through their real estate choices. “Even in today's weak economy, corporations are looking at ways to use real estate to differentiate who they are as they recruit people,” Jackson explains.

To that end, Colonial purchased 175 acres in Lake Mary, outside of Orlando, Fla., to build Colonial TownPark, which includes 250,000 sq. ft. of retail, 1 million sq. ft. of office space and 500 residences. Tenants include the Bank of New York and Mitsubishi Power Systems.

At TownPark — scheduled for completion in November — Colonial uses technology as a convenience for its tenants. “We think high performance as a landlord is helping everybody connect their business,” says Jackson. Employees can use the TownPark intranet to locate restaurants, which in turn may offer discount coupons on the intranet to build repeat customers. Hospitality events promote networking within the community.

Colonial hopes to increase employee productivity in these high-performance workplaces, which include such amenities as park benches wired for laptops so people can work outside.

In measuring Colonial's success, Jackson believes that in addition to a 5% to 10% rent premium over freestanding developments, “we get a larger market share because we do more deals.” Space is also at a premium: the project is just over 90% occupied, while nearby developments are struggling to reach 70% occupancy.

“We're also signing longer-term leases than the competition, so we've reduced risk, reduced capital investment,” Jackson says. In fact, Colonial has been named as the 2003 National Developer of the Year by the National Association of Industrial and Office Properties.

In addition to simplifying a complex product by using an in-house team, Colonial is exploring other ideas, such as focusing on build-to-suit projects. “We want to focus more on demographics to find out where the real job growth will occur,” Jackson says. “Where job growth and income demographics intersect — that'd be the perfect sweet spot.”

Lisa-Anne Culp is a St. Petersburg, Fla.-based writer.