Second-tier markets

Mixed-Use Matures

Developers sharpen their focus to succeed in small markets.

Across North America, commercial real estate professionals are identifying pockets of development opportunity outside the major gateway cities. And, thanks to a renewed interest in urban living, real estate experts are successfully introducing a variety of mixed-use commercial projects into secondary and even tertiary markets.

“City governments in smaller markets will stretch to get these mixed-use projects even more than in primary markets because they’re gung-ho on building up pedestrian activity and 24-hour downtowns,” says Robert Bach, chief economist for Grubb & Ellis. “Mixed-use is an important part of that.”

Car washes are being developed on 1-acre mixed-use infill sites in Sacramento, Calif. Photo credit: Inve$tnet

Pedestrian traffic is precisely the sort of activity Allen C. McDonald, CCIM, a principal with Baker Storey McDonald Properties, is hoping for at 12th South Station, a project breaking ground this summer in Nashville, Tenn.’s artsy 12th South District. Baker Storey McDonald is planning 10,000 square feet of ground-floor retail, 20,000 sf of offices, and on-site parking. The company has letters of intent from local retailers and is marketing the office space in part to the city’s thriving music industry. “It’s an up-and-coming place to live, work, and be entertained,” McDonald says of the 12th South District.

Nashville and other small and midsize cities seek to attract what author Richard Florida terms “the creative class” in his books on the transition from manufacturing to a knowledge-based economy. This class of young, educated workers supports and fosters job growth in software, professional services, and other business lines that aren’t tied to a specific market. Rather than gravitate to a manufacturing center — as automakers did in Detroit, for example — knowledge-based companies collect in cities that offer a high standard of living complete with nightlife, arts venues, and other recreational outlets that help those companies lure and retain employees.

“Grand Rapids, Mich., Memphis, Tenn., and places like that have to work harder to attract those types of people, and mixed-use and infill fit the profile of the type of development those cities want,” Bach says.

From the developer’s perspective, a well-planned mixed-use project may be easier and faster to lease than a single-use asset, particularly in secondary and tertiary markets that lack a primary market’s volume of leasing activity, Bach adds. “It means you can tap into different absorption streams and get your project leased up more quickly.”

Financial Worries

Despite its growing acceptance among city planners, mixed-use infill development remains challenging in smaller markets. This year in particular, one of developers’ greatest challenges may be access to capital, both for construction and long-term financing.

“The secondary and tertiary markets are clearly impacted more by tightening in the capital and credit markets than are major markets,” says Jody Thornton, executive managing director at financial intermediary Holliday Fenoglio Fowler in Dallas.

Financing is troublesome in smaller metropolitan areas because institutional investors generally stick to primary markets in periods of uncertainty, Thornton says. Private investors remain active in smaller markets but usually need a loan to close a deal, making those projects more vulnerable to the credit crunch. “Most private capital needs leverage, so when leverage is hemorrhaging it makes deals in secondary and tertiary markets more difficult,” Thornton says.

The current capital crisis struck in August 2007, when weak sales of commercial mortgage-backed securities spurred lenders to clamp down on new loans. Financing fell through on deals in droves and by the end of September, transaction volume across all property types had plummeted 26 percent, according to Real Capital Analytics.

At one point the credit crunch threatened to derail the Whitaker Hill Neighborhood in Asheville, N.C., according to developer James H. Diaz Jr., CCIM, principal of CoveStar Investment Realty Advisors in Asheville. Tucked into a scenic mountain valley, Asheville has a thriving artist community and is experiencing surging land values due to a proliferation of luxury homes, Diaz says.

CoveStar and its partners plan to convert primarily industrial land in Asheville to a mix of several residential uses along with ground-floor local commercial-service uses in a neighborhood format. In its market analysis, CoveStar identified unmet demand for new, moderately priced housing within the city. Whitaker Hill will combine high-quality architecture with density and smaller square footages to provide homes that meet an affordable price point — despite the market’s high land and construction costs.

However, the project has not been immune to the credit crunch: Last year a local bank that provided land acquisition financing informed Diaz that it didn’t intend to renew its six-month loan as previously agreed, despite an appraisal that showed the acquired property’s value had increased to triple the acquisition price. To make matters worse, some of the project’s institutional investors caught wind of the local bank’s decision and grew hawkish about proceeding with the development phase.

Today Whitaker Hill is back on track with land improvements scheduled to begin later this year, thanks to an increased investment by the project’s chief equity partner. Replacing financing delayed development by nearly a year. “We were collateral damage to the national liquidity crunch, but we’re making the best of it,” Diaz says. “We’ll be able to come out of the ground, as designed, at a time when the market is recovering, and we’ll be leaps and bounds ahead of our competition.”

Paying for the Privilege

Other developers confirm that leverage is more expensive and harder to obtain than it was 18 months ago. Long-term loan amounts have decreased, averaging about 60 percent of projects’ overall value, a dramatic shift from the 70 percent to 75 percent loan-to-value ratios that were typical a year ago.

“That’s probably the biggest change,” says Art Lomenick, managing director at Trammell Crow Co. in Dallas and president of High Street Residential, a wholly owned subsidiary of Trammell Crow. “Two years ago, lenders were very aggressive, asking for sometimes 20 percent or even as low as 15 percent equity.”

City leaders can help developers clear underwriting hurdles by reducing risks for capital providers, Lomenick says. Providing tax breaks for a project’s tenants, waving city fees, or fast-tracking the approvals process are some of the ways municipalities can reduce mixed-use projects’ costs and investment risk.

Andrew Stuart Cheney, CCIM, an associate with Lee & Associates in Phoenix, says eight years of real estate tax abatements from the City of Tempe, Ariz., are an important component of Hayden Ferry Lakeside, a mixed-use project about five miles from downtown Phoenix. SunCor Development Co. is building the mix of office, retail, hotel, and residential space. “In new developments where demand and lease rates haven’t caught up with construction costs, this is a way to jump-start cool projects,” says Cheney, who is marketing two new phases of the project for the developer.

Hayden Ferry Lakeside in Tempe, Ariz., includes more than 5 million square feet of office, retail, and residential space. Photo credit: A.F. Payne Photographic

On the bright side, mixed-use projects have become an accepted product type and are even a preferred asset for some capital providers, Lomenick says. “Mixed-use is no longer hard to finance if it underwrites economically,” he says.

Compelling Combinations

Even when financing is readily available, introducing a mixed-use project into an existing community brings with it a bevy of challenges. From zoning changes and environmental remediation to reconciling with neighborhood groups over added traffic, parking, and tenants’ hours of operation, infill is a thorny business. Why then are some developers choosing to tackle urban redevelopment rather than more conventional single-use projects in smaller markets?

“Peoples’ lifestyles and how they want to live are changing,” explains Walter S. Clements, CCIM, president of Greenleaf Properties in Overland Park, Kan. Greenleaf Properties is developing the Shoppes at Deer Creek Woods, which combines 275,000 sf of retail space with 185,000 sf of offices, a 129-unit hotel, and both rental and for-sale housing on 56 acres of land in Overland Park.

“We’re becoming less enamored with the car and more concerned about activities,” Clements says. “We want to have a community with security and safety to live in where you don’t have to hop in your car to drive to a coffee shop on Sunday morning, or you may not even have to drive to the golf course.” In other words, there is a growing demand for mixed-use that enables people to work, shop, exercise, and be entertained close to home.

That sort of mixed-use has characterized European communities for centuries but is being rediscovered in the U.S., according to Harold Hunt, a research economist at Texas A&M University’s real estate center. Due to the automobile, U.S. residences in the 20th century clustered in the suburbs, away from the pollution of factories and the congestion of shopping and business districts.

Today, traffic and high gasoline prices are driving more Americans to opt for urban living near their places of employment, which in turn fuels demand for retail and services in urban centers. “Mixed-use obviously makes more sense in densely populated urban areas,” Hunt says. “If you don’t have a car, it’s nice to have everything you need — retail, office, residential space — nearby.”

Beyond providing a product to suit a growing need, mixed-use infill developers gain a diversification of income streams that may sustain the property through difficult economic periods. “When the office market is down and not performing too well, the apartments could still be making a contribution to the property owner,” Hunt says.

National retailer Trader Joe’s was willing to compromise hours of operation and limit truck deliveries to build near a mixed-use project in St. Paul, Minn. Photo credit: Meridian Management

Tenants often gain customer traffic from the close proximity to other property uses, according to Dewey Struble, CCIM, senior adviser at Sperry Van Ness in Reno, Nev. Struble is developing Airport Gateway, a 10.25-acre tract slated for hotel, residential, and retail development just outside Reno/Tahoe International Airport. “When people come to their [office] via the airport, there’s a hotel next to them so they don’t have to rent a car,” Struble says. “They have a place to stay, they have a place to eat, and when they’re done, they can walk to the airport.”

Finally, developers often find they have less competition in secondary and tertiary markets, particularly with tricky infill projects. “Typically you’re not competing with somebody right across the street,” says Sandy G. Shindleman, CCIM, president of Shindico Realty in Winnipeg, Manitoba. Shindleman has orchestrated numerous mixed-use and retail projects, including several shopping centers anchored by Home Depot. “It’s not as competitive once you are in there, and if you have great anchors you have a good chance to succeed.”

No Place for Beginners

Success in mixed-use projects hinges on identifying and meeting site-specific demand, which means local knowledge and expertise are paramount. Even the mixed-use infill projects national developers undertake usually originate with a local expert, Bach says. “A lot of these types of developments get done by local developers: people who see an opportunity that the big developers don’t really see,” he says.

In Nashville, McDonald says he chose the site and mix of uses at 12th South Station based on his years of experience in the local market. “Urban development is expensive and you better be right-on with the real estate,” he says. “We’re going to invest our money where we know it is right.”

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