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DERAILED: Mixed-use Financing Charts New Course

AtlanticYards in Brooklyn and the Grand in Los Angeles — two massive proposed mixed-use projects with prominent locations, titanic budgets, legacy developers and the same big-name architect (Frank Gehry) — share a lot of good things in common.

And both added something else to the list of qualities they share. Only this is something neither development team will be boasting about: waffling financial backers.

On January 28, New York City-based Forest City Ratner acknowledged it was concerned about securing financing for the $4 billion Atlantic Yards project in court filings related to its ongoing battle over eminent domain with Brooklyn residents.

Meanwhile, New York City-based Related has postponed the ground-breaking of the $3 billion Grand three times. Initially, the event was supposed to take place last October, but was moved to early 2008, then March and now, an unspecified date this summer. Real estate sources speculate the reason for the delay is Related's inability to line up a construction loan.

Related denies the charge. The ground-breaking date has been moved because Related was working out last-minute design considerations, says Kenneth Himmel, president and CEO of Related Urban. At press time, the Los Angeles Downtown News reported that the company had a breakthrough, securing a partnership with Dubai sovereign fund Istithmar after a previous partner, California Public Employees' Retirement System, pulled out of the project. It hopes to have secured all the necessary approvals by the end of March.

Himmel says Related is in negotiations to secure further debt and equity financing for the property and expects to close a deal by June. However, Himmel acknowledges negotiating with lenders won't be easy.

After causing havoc in the investment sales sector, the credit squeeze has started to constrict development. Mixed-use projects especially have come under fire for several reasons. For one, they typically are more expensive than similarly-sized single-use developments. Futhermore, lenders have to assess and underwrite each use of the project independentally of the others. With underwriting standards becoming more strict across the board, it may be a tall order for lenders to sign off on every use. Lastly, pressures are mounting on different uses to different degrees, meaning the outlook for office, hospitality, retail and for-sale housing sectors are not all the same.

Last year, mixed-use projects were the “it” trend, representing 26 percent of all retail development in the U.S., according to brokerage firm Colliers International, as a growing number of retail developers tried their hand at building them. But, given the current environment, lenders project the number of viable mixed-use developments will fall by half.

“Projects that looked economically viable seven or eight months ago, if they were marginally profitable then, are not going to work now,” says David E. Ross, managing director with Tremont Realty Capital, LLC, a Boston-based real estate investment and advisory firm. “We are a lot more cautious in secondary and tertiary markets; we are more concerned about competition than we were before. At the moment, I think it's easier to finance something that's all retail.”

Changed landscape

The Atlantic Yards call for 336,000 square feet of office space, 247,000 square feet of retail, 6.36 million square feet of residential space and an 850,000-square-foot sports and entertainment arena. Forest City Ratner's financing plan for the development involves the issuance of bonds underwritten by Goldman Sachs. However, Forest City told court officials if it waits any longer for the issuance to take place, there might not be enough bond buyers left in the market.

“There is a serious question as to whether, given the current state of the debt market, the underwriters will be able to proceed with the financing for the arena while the appeal is pending before the Court,” wrote Andrew Silberfein, Forest City Ratner's director of finance. On Feb. 1, the U.S. Court of Appeals ruled in favor of the developer.

The delayed Grand, a proposed 3.6-million-square-foot project, located in the Bunker Hill section of Los Angeles, will boast 400,000 square feet of retail space, a 275-room hotel and 2,600 residential units. It is projected to cost $3 billion.

With mixed-use projects costing anywhere from 20 percent to 50 percent more to build than single-use developments they often need several hundred million dollars in financing, says Michael Hurst, vice president with the structured finance team at Buchanan Street Partners, a Newport Beach, Calif.-based national real estate investment bank. Loans upwards of $200 million require syndication and with no commercial mortgage-backed securities (CMBS) bonds issued in January, that large amount of money is hard to secure.

But the problem goes deeper than that. Now that the word “recession” is being bandied about, lenders are being extraordinarily careful in evaluating profits from future projects. They want to know what the current rents and vacancy rates are in the given market, rather than focusing on future projections. And, when it comes to retail, they are scrutinizing in-line tenants as much as anchors, says Mark Strauss, managing director with Cohen Financial, a Chicago-based national real estate services company that originates both debt and equity transactions. “One of the challenges with mixed-use is where we are in the business cycle compared to a year ago,” adds Hurst. “The recession obviously affects both office and retail.”

In January, a report from Property & Portfolio Research, a Boston-based independent real estate research and portfolio strategy firm, revealed that demand for retail space will drop 60 percent in 2008 compared to 2007; and absorption in the office sector will decline 55 percent, to 42.2 million square feet.

In the hospitality sector, occupancy levels will decline 0.7 percent, resulting in the slowest pace of revenue growth since the terrorist attacks on Sept. 11, according to PKFC, an Atlanta-based consulting firm that serves the hospitality, real estate and tourism industries. And, with condominiums, things have only gotten worse in recent months with sales having fallen 24.5 percent in December 2007 to 580,000 units from 768,000 units in December 2006, according to the National Association of Realtors.

“I can't say that there are not going to be any mixed-use projects with for-sale condominiums built in the near future, but there won't be many,” says Ross. As a result, Ross estimates that over the past seven months, he has seen the number of loan applications for mixed-use properties decline 30 percent.

In these challenging times what does it take for a developer to get a shovel in the ground? Those who have a proven track record in mixed-use development will get first preference, says Kristin O. Panehal, senior vice president with the investment management team at Buchanan Street Partners. That means if retail developers want funding for a mixed-use project, they should partner with a mixed-use builder or hire an experienced mixed-use consultant.

This signals a sea change for retail REITs, which in the past few years had started allocating a significant portion of their budgets to mixed-use projects. They will now have to step away from such properties for a while, according to Himmel.

“Most lenders today are concerned about any ground-up development,” he says. “But, with a mixed-use project, the first thing they ask is ‘Who is the developer?' When things were moving along faster and money was plentiful, the REIT guys didn't have to worry about that. But today, if your primary investment is retail, Wall Street won't get excited about you doing mixed-use.”

Key, too, is having a significant portion of the retail and office components pre-leased and condos presold. For retail, developers need to show leases and letters of intent accounting for at least 50 percent of the project, says Billy Procida, principal with Palisades Financial, a Fort Lee, N.J.-based investment banking and advisory firm. Last year, most lenders asked for pre-leasing levels of just 25 percent. “There are cowboys out there who do things on spec, but that's how people got hurt in the 1980s,” Procida notes.

Meanwhile, those with the conviction to attempt for-sale condominiums will have to work even harder. Himmel notes that to appease potential lenders for Related's 5.5-million-square-foot CityNorth project in Phoenix, the company has built a multi-million sales and marketing center for its residential component that will be open to the public seven days a week. “This is something we usually don't have to do,” he says. “But it's vitally important now.”

The debilitating uncertainty over the performance of various real estate sectors in the next few years means vertical projects will fall out of favor compared with those that can be built in phases, like CityNorth. There, because all the uses are not within a single structure, developers have the flexibility to build the stronger components first and delay the weaker ones until the next up cycle.

“Vertical can be a strain, especially in semi-urban environments without public transport access,” says Hurst. “With separate buildings you can slowly introduce pieces of the development so you are not flooding the market with space.”

And now there is far greater emphasis on a substantial equity contribution from the project's developers. Today, senior lenders won't finance more than 65 percent of debt for a mixed-use property, whereas a year ago, many people were able to receive up to 80 percent, says Ross.

That translates into a greater need for mezzanine loans. But, with those lenders shying away from the market as well, many developers are left to search for joint venture partners to bridge the gap. And while there are plenty of those left in the market, according to Panehal, they are now a lot more conservative about what they consider a viable project.


As a result, the number of new mixed-use properties is expected to decline dramatically over the next year — to approximately 10 percent of all real estate development, says Himmel. He believes that in the current lending climate, companies that own valuable land parcels will prefer to hold on to them, rather than risk scrambling for a loan. “There will be very few people who can actually have these projects started today.”

However, lenders still insist they think mixed-use makes a great deal of sense. When done right, those projects offer some of the best returns in real estate, according to Ross.

He notes that Tremont is currently looking at five mixed-use projects of varying sizes. Make sure that developers invest in mixed-use because it makes sense, not because it's what everybody else is doing.

“We like the concept of mixed-use, but what has happened is that a lot of times developers went with mixed-use projects because they didn't know what else to build,” Ross says. “Today, there have got to be compelling arguments for building both the retail and non-retail components.”

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