PRINT THIS STORY:

CHANGE TEXT SIZE:

MIXED-USE CARRIES RISKS, SOME WARN

BY DONNA MITCHELL

Santana Row suffered two calamities before it even opened: Job losses in Silicon Valley and a devastating fire.

The mixed-use center has become one of the most universally accepted formats, favored by developers, New Urbanists and public officials alike. But players should not allow that popularity to mask some of its formidable financial risks, market watchers caution.

“Developers need to be able to build [mixed-use] facilities with a high degree of confidence about the total cost,” said W. Kindred Powell Jr., a portfolio manager at Enterprise Financial Services, an Atlanta-based investment firm. “And they have to be confident that rents will make decent economic returns on costs.”

No one in the industry denies the allure of mixed-use centers, which can create buzz for their host cities. In 1970 Gerald Hines did just that for Houston, when he developed The Galleria. Combining retail, office, hotel and recreational uses in an urban setting, the Galleria immediately sparked interest in the format — some of it initially skeptical.

“They thought I was crazy,” Hines said. Back then three-level retail development had been done only in Asia, where the density of the population forced developers to build in only one direction: up. Second, the Galleria’s retail portion had only one anchor, Neiman Marcus, he says.

Since then, the industry has embraced the concept, as have communities, for both economic and social reasons. Such centers can reuse vacant space and bring people back into downtown areas to live, work and play. In Long Beach, Calif., for instance, officials hope that CityPlace, which opened in August 2002 with 450,000 square feet of retail gross leasable area, 221 apartments and 80 condominiums, will bring in as much as $1 million a year in sales tax revenue. Developers Diversified Realty, Beachwood, Ohio, spent $100 million to build it.

There are similar expectations for the AOL Time Warner Center in New York City, which contains a mall, condominiums and offices. Slated to open in the fall, the project, developed by a partnership led by The Related Cos., New York City, will revitalize the long-dormant Columbus Circle area, its supporters say.

Mixed-use centers “revive cities and keep them going,” said Emerick Corsi, senior vice president of development at Forest City Commercial Development. The firm is now turning the 4,700-acre site that once accommodated Denver’s Stapleton Airport into a multiple-use project.

But it can put a strain on developers. Federal Realty Trust, which helped spearhead the interest among developers in urban Main Street shopping and living environments through such projects as Pentagon Row, Arlington, Va., and Santana Row, San Jose, Calif., has gotten out of the mixed-use development business altogether. Santana Row’s development costs, originally slated at $500 million, left the company with $660 million in debts. There are considerable challenges to creating mixed-use projects, and developers need to be aware of what they are getting themselves into, players warn. Unexpected costs crop up — from demands imposed by municipalities to the difficulties that arise from combining uses.

“The overriding concern for developers is [that] they do not have any good methodology to create a firm budget [for developing mixed-use centers],” said Powell. “There is open-endedness to the cost.”

The land alone can be a costly start to a project, as Hines discovered, thanks to the Galleria site’s location in Houston’s central business district. He bought 20 acres at $3 per square foot, at a time when land was generally selling at 50 cents per square foot. Ironically, he says it was the cost that prompted him to build a mixed-use center.

“We had to intensify the site,” Hines said. “We had to build more square footage on the site than a one-story mall, and we thought about doing mixed-use.”

Once construction is under way, mixed-use projects present additional, often unforeseen, costs. It is popular today to build residential space over street-level retail, for instance. But the two property types require different framing techniques, which brings potentially expensive complications into the construction process, says Kevin M. Zak, a partner at Cleveland-based architectural firm Dorsky Hodgson & Partners. Most retail buildings carry a depth of 100 feet, Zak says, versus a depth of about 70 to 80 feet for a town house or condo.

“Certain residential units would end up looking over a roof of retail, so you have to decide how to handle that,” Zak said. One solution might be to provide a terrace, but that itself is expensive.

Subcontractors run into problems too, especially when they are unfamiliar with the format. A plumber might be perfectly familiar with installing pipes in an apartment, for instance, but not when it sits on top of a store, according to Powell.

“He comes up with his best guess,” Powell said. “When it starts to go wrong, and now [the subcontractor] decides [he] needs a change order, someone needs to pay for that.”

Sometimes municipal powers can complicate matters by requiring developers to include certain components in a project as a condition to grant zoning and permitting approvals, industry insiders say. Some require buildings in an open-air layout within a grid system, with a lot of trees and curbside parking in front of stores, Corsi says.

“You have to make streets now, so everything gets moved up and bigger,” said Corsi.

But developers often need the involvement of municipalities, without which some projects would be out of the question. The city of Rancho Cucamonga, Calif., for example, is kicking in about $53 million of the $300 million-plus cost of building Victoria Gardens, a mixed-use center of 30 square blocks. The project, which Forest City and Lewis Retail Centers are building, will include 1 million square feet of retail, 200,000 square feet of office space and 500 residences.

City officials sold the 155 acres for Victoria Gardens to the developers for $1. If the companies had paid for the actual value of the land, they would have needed to charge sky-high rents to recoup their investments, putting the space beyond the reach of most tenants, says Linda Daniels, director of the city of Rancho Cucamonga’s redevelopment agency.

“When you add the cost of the project, including the infrastructure, and compare that to the rents of what the market can support, the land has to have a zero value to make it work,” Daniels said.

These and other issues oblige the financial community to look very carefully at mixed-use centers, says Dan Smith, senior vice president of North American debt at Stamford, Conn.-based GE Capital Real Estate. For a start, a fundamental vulnerability to mixed-use centers is that, by definition, they are dependent on more than one real estate sector. If there is a slump in any one area — retail, residential or office — they’ll be hit.

When Smith’s unit gets involved with mixed-use properties, it offers highly structured loans. GE Capital wants to know the developer’s business plan, its target tenancy and the property manager’s expertise with the local market to try to determine whether the project will perform well in the long run. Mixed-use centers work better in central business districts, Smith says, despite the challenges of putting residential over retail.

In the end, notes Smith, financial and property-level management are crucial to keeping a mixed-use property profitable. The owner has to be sure that if one property type suffers an economic slump, the other property types perform well enough to compensate.

Perhaps the trouble is mixed-use projects’ relatively short track record in the retail development industry, says Donald C. Wood, president and CEO of Federal Realty Trust, which developed Santana Row. Each project is highly customized, making it hard for developers to duplicate similar techniques in various projects.

“There is an absolute lack of familiarity,” said Wood. “In a lot of ways, you are new at your job.”

Sometimes it isn’t construction complications or municipal meddling that trip up a mixed-use project. The problem can be simple market forces. In the case of Santana Row, the project got started just as the technology market, which buttressed the Silicon Valley economy, crashed. The economy was still booming when Federal Realty bid out costs for the project in the late 1990s, but by the time they got around to leasing the properties in 2000 and 2001, the economy had crashed.

“Time is the enemy of development,” said Wood. “Complicated projects take more time, and more time increases cost and lowers predictability.”

Santana Row opened in November 2002, after surviving a fire that destroyed nearly all the apartment units in one of the project’s buildings. The incident delayed the opening of the building’s retail units until early this year. At press time, Santana Row cost Federal Realty $450 million.

“We will probably never earn a return on our money [that’s] in line with the risk we took,” Wood said.

Santana Row’s second phase, which will probably cost about $27 million to complete, is still ahead. Federal Realty hopes it will generate a cash return of 16 percent, according to a new release the company put out in February.

Going forward, says Wood, Federal Realty will stick to managing the mixed-use projects it has already built. And more developers will find themselves burned by mixed-use projects, predicts Zak.

“A lot of developers who are getting involved with the projects are not experienced,” he said. But he adds that the format itself will survive. In spite of everything, some developers will find ways to make the numbers work, he says. Initial returns on investment might not be as robust as developers want, but the projects will provide some payback in the long run.

“If you create a livable environment all in one area, it takes on a life of its own,” he said. “The investment will hold its own down the road.”

© 2008 ICSC. All rights reserved. | Terms and Conditions | Privacy Policy | Contact ICSC | ICSC Home |