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THE MIXED-USE SUPPORT SYSTEM

RETAIL AND OTHER USES HELP OFFSET AILING RESIDENTIAL RETURNS

By Joel Groover

Mixed-use developers have argued for years that their diversified projects would weather a housing crash better than single-use developments. No doubt about it: The market is giving them a chance to prove the theory.

Shots of vacant houses with “for sale” signs out front are a staple on the nightly news, and outrage over the rash of foreclosures is becoming a flash point in Congress. In an October survey, the National Association of Home Builders found the morale of its members to be at an all-time low. No less a public figure than Treasury Secretary Henry M. Paulson Jr. has called the housing slowdown the No. 1 threat to U.S. economic growth.

Given these jitters, some might expect mixed-use developers to be nixing projects in droves. After all, their developments often contain big housing components, from rows of upscale town houses to hundreds of condos atop retail spaces.

So far, observers say, the sector appears to be marching forward. “The mixed-use projects are the ones that
are still happening, because they have the other component pieces on which to rely,” said Gerald S. Divaris, chairman and CEO of Virginia Beach, Va.–based Divaris Real Estate, which specializes in mixed-use projects. “Go try to build a condominium or apartment development today on its own — you’re going to have a lot harder time getting financing than the guy who goes in and says, ‘Listen, I’ve got a mixed-use property with 400,000 or 500,000 square feet of retail space, 200 apartment units, a hotel and some office.”

It is far too early to declare mixed-use to be safe and sound, however, says consultant Jeff Green, head of Jeff Green Partners, Mill Valley, Calif. “I have not seen anybody pulling back,” he said. “But because this all happened so fast — the personal mortgage issues — it may be that developers haven’t yet been able to respond. They could be trying to work through what it all means.” In some cases, a planned project may be too far along to be canceled; in others, the development entity itself may be too large or complex to be able to change course rapidly, Green says. “Imagine how difficult it is for a joint venture to make changes,” he said.

The question is not whether mixed-use will be affected by the downturn, but rather how deep and lasting those effects will be, says Dan Martin, managing director of the Arlington Heights, Ill., office of Sperry Van Ness. “The situation with the housing market and then the increase in the prime rate affects anything that has any kind of a housing or condo component to it,” he said.

One clear consequence of the downturn is the sharply pessimistic turn in the national mood, Martin says. The mixed-use boom started not long after the recession of the early 1990s and has been riding high, along with the housing market itself, ever since. Until now, retail developers who jumped into the mixed-use game have endured just one slowdown: the relatively brief and shallow one that followed the Sept. 11 attacks. “Skies have been blue for a long time now,” said Martin. “Frankly, it seems like nearly every project, no matter how well or poorly done, has been successful primarily because money has been cheap and the demand has been great.”

The phenomenon of eager investors trying to flip condos at a furious pace was one hallmark of this bullish era. Horror stories about investors who took a hit when the market crashed explain why flipping is no longer a major driver of housing growth. “I know people who have bought up to 10 [condos],” Martin said. “When the closing day came, they could not come up with the money and essentially walked away from a $1 million deposit.”

In Chicago and the Midwest, retailers too appear to be more cautious, Martin says. “With the developers I know on large mixed-use projects, the retail deals are coming slower,” he said. “They’re still coming, but everybody is on the fence, wondering what’s going to happen.”

Lenders still like mixed-use, observers say, for the same reason stock investors favor diversified portfolios: distributed risk. Divaris Real Estate’s Town Center of Virginia Beach (Va.), for example, will contain 4.3 million square feet of uses on 17 acres. A single building within the half-finished development contains retail, hotel space, offices, condos, a conference center, restaurants and parking.

Such tightly integrated projects may give investors more confidence, but that does not mean mixed-use is immune to the credit crunch that has made financing harder to get. “The developers are most affected today not necessarily by the interest rate, though that certainly does increase their spread, but more importantly by the lenders’ need for a larger equity contribution,” Martin said. “Whereas, previously, the developer may have been able to get a loan for 10 percent or 15 percent down, now you’re most likely looking at 25 percent or more.”

Would-be buyers of condos or town houses face similar hurdles, especially those applying for jumbo loans in excess of $400,000, says Green. “That whole segment has stalled,” he said. And thus, even in high-growth, urban markets where demand for condos or town houses is strong, mixed-use specialists consider whether home buyers will be able to get loans.

Not surprisingly, some firms are rethinking projects they have in the pipeline. Cleveland-based Forest City Enterprises has 13 mixed-use developments on the drawing board, says Emerick J. Corsi, executive vice president of development in the commercial group. “We’re looking at our mixed-use projects around the country and saying, ‘Where is the housing market?’ When you start getting outside those big, densely populated areas, you really have to sit back and take a close look,” Corsi said.

Taken together, the mixed-use pipeline at the St. Petersburg, Fla.–based Sembler Co. includes about 10,000 residential units, says Jeff Fuqua, Sembler’s president. In overbuilt markets such as Florida, developers clearly must regroup, he says. “Florida’s residential is catastrophic, which is not the case anywhere else in the Southeast,” Fuqua said. “Condos are overbuilt, but also, growth has stopped. The stuff that is built is not being absorbed. We’ve done projects in Florida where we have a residential component but the co-developers doing the residential aren’t building. The retail is built, but the residential is not being built.”

By contrast, strong growth engines like Charlotte, N.C., require less caution, says Corsi. “They have good business, good principles, down there,” he said. “People aren’t buying homes to flip. They’re buying homes to live in.”

Indeed, the health of some in-town residential markets shows how the same dynamics that led to the rise of mixed-use in the first place still give this sector an edge, says Stephen S. Fuller, director of George Mason University’s Center for Regional Analysis. However gloomy the national headlines, says Fuller, housing markets in such closer-in Washington communities as Fairfax County, Va., and Montgomery County, Md., have actually improved in recent months. “The days on the market have stopped rising,” Fuller said. “Prices have firmed and gone up.”

These urban areas, where demand for apartments and condos is stronger, are precisely the kind of markets that mixed-use developers tend to prefer, Fuller says. In-town settings offer greater access to jobs, public transportation, convenience-oriented retail, and dining and entertainment venues. They also are cheaper than houses farther out in the metro Washington suburbs and exurbs. “The average price for a single-family, detached house in Loudoun County, Virginia, just out past Dulles Airport, is $900,000,” Fuller said. “You can’t be a starter home at that price.”

Buyers in these upscale suburbs tend to belong to what Fuller calls the trade-up market — wealthy people choosing to move into bigger, more expensive houses. They now have every incentive to stay put. Not only has financing suddenly become elusive and costly, but values have plummeted, which means trade-up buyers may be forced to sacrifice a painful amount of equity in their existing homes before they can move into new ones. These dynamics help explain why residential space in the overbuilt Washington suburbs and exurbs is so stagnant, Fuller says. “There are lots of brand-new houses competing with the resale market [in the suburbs],” he said. “They’re sort of killing each other, fighting over prices. There’s just too many of them.”

For this reason, developers might rethink the ostentatious approach to home building that flourished before the bubble burst, says Fuller. “People building mixed-use might want to focus a little less on luxury,” he said. “Some of these national builders could price luxury items separately and make them optional. Take the marble or granite countertops out, and go back to Corian. Let people decide whether they want all those options. That may take $25,000 or $30,000 off the house price.”

Careful market-by-market reevaluations such as those taking place at Sembler and Forest City are clearly a good idea, Fuller says. After all, the lack of circumspection during the boom is part of the reason today’s housing market is in trouble. “In a cautious market, you have to be more targeted and make sure you provide a product the market needs,” Fuller said. “The term coined for the stock market 10 years ago by Alan Greenspan was ‘irrational exuberance.’ The same term applies to the builders from 2003 to 2005. They just built without ever doing a market study, without ever asking people what they wanted, because [housing] was so easy to sell.”

They don’t have that problem anymore.

CRISIS EXPERT'S DANCE CARD IS FULL IN REAL ESTATE CIRCLES

?Stuart M. Saft speaks to big crowds these days, and his phone rings all day long. That may be good news for this veteran real estate attorney, a partner in the New York City office of LeBoeuf, Lamb, Greene & MacRae, but it is a bad omen for commercial real estate.

Saft is the author of a book titled Commercial Real Estate Workouts, which he wrote during the recession of the 1990s. He is an expert who helps developers and lenders sort through the mess when real estate projects go south. Thanks to the housing crash and credit crunch, demand for his expertise is white-hot once again, he says. “I’m getting calls from across the country,” Saft said. “I chaired a conference a couple of months ago on distressed real estate, and it was standing-room only. This was in south Florida, which is the poster child for the soft real estate market.”

Many of Saft’s tips are relevant to the current downturn. Rather than waiting for lenders to make the first move, for example, a borrower with a mixed-use project unable to cover its expenses should go directly to the lenders as soon as the scope of the problem becomes clear. “This is better, because it shows the lenders that the borrower is on top of what’s going on,” Saft said.

On the other hand, the rise of securitized, packaged loans has created a host of new and difficult questions, many of them critical to the success or failure of the workout. “In the current market downturn, the situation is different than it has been for the last 50 years,” Saft said. In the past a lead lender such as a local savings and loan would make quick decisions about the way a distressed property should be handled. In addition to having clear legal authority to make those decisions, the lender also tended to know a lot about the property itself.
“What we’ve seen happen in the last 15 years with the collateralized mortgage-backed-securities market is that the properties are no longer held the way they once were,” Saft says. “Now the interest in these properties is sliced and diced into little pieces and put into these huge portfolios, these pools of investments. When you have a property with $100 million worth of debt on it and you have six mezzanine lenders involved, the question becomes, ‘Who makes the decision?’ ”

Loan documents for these pooled investments often call for unanimous approval by all lenders before any workout-related decisions can be made. But what if the lenders cannot agree on whether to, say, cut their losses by foreclosing immediately or to let the borrower try a new strategy such as converting condos to rental units?

“You can have the smallest lender have a different agenda than the lenders with the hugest pieces, and everything comes to a grinding halt,” Saft said. “We now have properties with huge amounts of debt on them and multiple lenders who don’t have a relationship to one another. The borrower doesn’t know who to turn to, because the mortgage servicer doesn’t have the authority to do anything.”

This fall Saft witnessed a workout in which a junior mezzanine lender learned to his horror that senior lenders involved in the deal wanted to foreclose. That would have left insufficient equity to cover the junior lender’s investment. “The junior mez lender would have been wiped out,” Saft said. “He had to step in, take over and refinance all the debt on the property in order to get the other lenders out so he could control the situation.”

That workout had a relatively happy, or at least tolerable, ending. Others might not be so lucky, particularly if the downturn continues and the economy plunges into recession, as a growing number of CEOs and economists fear could happen. “Unless things turn around, it is going to be a god-awful mess,” Saft said.

Without a single, acknowledged entity possessing the authority to act, working out such troubled projects will take longer than in the past, Saft says. And when key decisions about a distressed property stall, the consequences for lenders and borrowers alike can be dire. Slashed maintenance staff or dark retail spaces, for instance, can undermine a project’s value. Debt can spiral out of control.

After it all shakes out, Saft may need to update his book.

— JG