A Vertical Vision

Developer Yaromir Steiner's latest creation is going on display this month with the opening of Zona Rosa, a $100 million mixed-use project in growing suburban Kansas City, Mo. The project features 24 apartments and 45,000 sq. ft. of office space atop 486,000 sq. ft. of shops in a town center project, complete with a public square.

It's the most experimental mixed-use development to date for Steiner & Associates, the Columbus, Ohio-based firm founded in 1993. Steiner decided to add a residential component to his projects a couple of years ago. That's when he witnessed heavy demand for apartments near his 1.5 million sq. ft. Easton Town Center mixed-use development. He had successfully topped Easton's shops with 125,000 sq. ft. of office, so why not do the same with apartments at Zona Rosa?

“I can see where we started, where we are now and where we are going,” says Steiner, who partnered with closely held New York real estate investment firm Mall Properties Inc. to develop Zona Rosa. “It is clearly toward vertically integrating office space and residential units into our projects.” Zona Rosa, located on 93 acres in a growing Kansas City suburb between downtown and the Kansas City International Airport, is a vertical mixed-use town center complete with specialty retailers, including Barnes & Noble, Abercrombie & Fitch and Ann Taylor Loft.

Trend on the Ascent

Steiner isn't alone in the vertical movement. A growing number of developers are stacking offices, housing and hotels on top of shopping centers, aiming to create mixed-use projects where people can shop and be entertained — and even perhaps work — within walking distance of home. The profit motive certainly exists: Successful vertical mixed-use developments can generate stabilized cash-on-cash returns of approximately 12%, according to developers.

To be sure, massive projects such as the $1.7 billion, 2.8 million sq. ft. Time Warner Center in New York, which includes offices, condominiums and a hotel on top of five levels of retail, only reaffirm the vertical mixed-use concept's vitality in urban settings. The scarcity of prime locations — and the high prices for those spots — requires vertical construction, and the population density supports the components.

But now developers are pushing smaller-scale versions of the vertical idea beyond the commercial meccas and out into the suburbs. There, developers are responding to consumer frustration with the byproducts of sprawl and rigid zoning laws: gridlock and bland neighborhoods.

Experts predict that over the next 50 years, vertical mixed-use projects could become the predominant configuration in older, built-out suburban cities with set boundaries. Michael Beyard, senior resident fellow at the Urban Land Institute in Washington, D.C., suggests that developers will redevelop aging strip malls along prime commercial corridors into vertical mixed-use projects, which will translate into reinvestment and expanded tax bases for the communities. “These projects will continue to happen because of today's rapidly growing metro areas,” he says. “The trend is inevitable.”

Indeed, Steiner's planned redevelopment of the enclosed Bayshore Mall in Glendale, Wis., suggests developers and suburban cities already are moving in that direction. Bayshore Mall owner Corrigan Properties in Glendale has partnered with Steiner to renovate the 534,000 sq. ft. mall into a 950,000 sq. ft. town center. There, Steiner anticipates stacking some 100 apartments and 150,000 sq. ft. of offices on top of the retail shops.

“As people adopt these new concepts, they are going to progressively spread to less complex uses … I mean, why not power centers?” Steiner asks. “People are becoming more sensitive to better uses of land.”

Towering Complexity

Yet numerous hurdles threaten to trip up the momentum building for vertical mixed-use development. Not only do these projects require a balance between the distinct demands of different users, but they also must connect to surrounding neighborhoods and attract consumers.

Furthermore, vertical mixed-use endeavors are more complex and take longer to build than single-use buildings, requiring developers with deep pockets. Developers also have to worry about the supply and demand whims of more than one product type.

Add to the mix the fact that vertical mavericks are operating in a marketplace where developers, architects, contractors and financiers have specialized in single-use products since World War II. Meanwhile, cities have spent the last 50 years separating the different uses into homogeneous zoning districts. Thus, a lot of explanation and painstaking analysis must take place before spades turn any dirt.

“Real estate has really become a commodity business, and people just want to stamp out repetitive product,” says Kenneth Himmel, CEO of New York-based Related Urban Development, a development partner in Time Warner Center. “There's nothing repetitive about vertical retail and mixed-use. Every project is another exercise in brain damage.”

Temporary hemorrhaging may be worth it to some developers. Components within successful projects typically lease — or sell in the case of condos — at premiums to prices that their single-use counterparts fetch, according to Himmel and other experts. The same is true when those projects are put up for sale; they tend to generate international interest and command lower capitalization rates than single-use buildings.

About 70% of the retailers in Time Warner Center opened for business in mid-February, for example, and already most are performing far beyond their sales projections — some by as much as 70% to 80%, Himmel says. He adds that the condo sales at Time Warner Center — which totaled $750 million as of mid-April — are making history in Manhattan in terms of pricing and the speed at which they're selling.

Federal Retreat

Mixed-use makes absolutely no sense for some developers. Case in point: Washington, D.C.-based Federal Realty Investment Trust originally built its business by buying and redeveloping community shopping centers. But in the late 1990s, the retail real estate investment trust (REIT) launched a strategy to develop vertical mixed-use town centers. Then in 2002, Federal Realty junked the town center idea and announced a succession plan to replace the strategy's architect, then-CEO Steven Guttman.

The reason? Quite simply, the concept required Federal Realty to risk too much time and capital on large ground-up developments when redeveloping community centers required less of each and generated far better returns, says Larry Finger, CFO of Federal Realty. The turning point came in early 2002, as Federal Realty constructed its second major mixed-use development, the lavish $500 million first phase of Santana Row in San Jose, Calif., which included 331,000 sq. ft. of retail and 256 apartments.

The project, undertaken at the height of the dot-com bubble, opened in late 2002 amid one of San Jose's worst apartment markets. Worse, a disastrous fire in August of that year prevented apartment renters and retail tenants from moving in when the center opened.

Even with insurance covering nearly all of the REIT's loss, Federal Realty expects to reach a stabilized cash-on-cash return of only 5% next year on the first phase, says Finger, who joined the REIT in 2002. (Subsequent phases will generate more returns, however, and require less capital.)

“The first time I set eyes on Santana Row, which was before I took the job, I said, ‘It's a great project, but it's a terrible investment,’” recalls Finger. “Time is what creates risk, and you're delivering these projects into a market that you can't possibly foresee.”

Financing Choices

Mixed-use poses particularly vexing challenges for REITs in general. First, publicly traded companies must answer to shareholders, who usually demand that the REIT focus on a single property type. Second, the firms strive to keep their equity/debt ratios more or less in balance, which requires them to dump more cash into a project than private developers.

Private companies that work in the mixed-use arena enjoy financing requirements common in typical single-use projects: about 25% equity to 75% debt. But for the past 50 years, debt lenders and equity providers have typically analyzed and financed single-use developments; the lion's share are unfamiliar with the complexities of vertical mixed-use projects.

Still, some investors are becoming frequent players in the space. Investment management firm MacFarlane Partners in San Francisco last year acquired a $359 million participation in GMAC's $1.22 billion commercial construction loan on Time Warner Center. MacFarlane also has agreed to buy 49.5% of Time Warner Center's retail space, though it won't complete the sale until early next year. The investment firm will only say that the price will range from $425 million to $500 million.

Chuck Berman, managing principal of MacFarlane, maintains that fruitful mixed-use investments hinge on having in-house development experience with multiple property types and an intimate knowledge of the mixed-use developer. “The issue is how much have they [developers] done before and how have they handled problems?” Berman says. “There are developers who are extraordinarily litigious, developers who never write checks and give you the building back, and developers who are with you until the end.”

Balancing Tenants' Needs

Beyond market risks, vertical mixed-use projects pose physical challenges that developers, architects and contractors obviously avoid in single-use projects or expansive horizontal mixed-use endeavors. Chief among the physical challenges within the shopping space is the mix and placement of retail tenants, says Richard Green, vice chairman of U.S. Operations for Westfield Property Corp. In San Francisco, Westfield anchors its 497,300 sq. ft., five-story San Francisco Centre at 865 Market Street with a 300,000 sq. ft. Nordstrom on the top floor to pull shoppers up through the project.

Last November, Westfield, in conjunction with Cleveland-based Forest City Enterprises, embarked on a $410 million mixed-use project next door to San Francisco Centre in the long-shuttered Emporium building. The developers are adding 720,000 sq. ft. of retail and entertainment space in the Emporium, as well as 235,000 sq. ft. of office space on the top three floors of the eight-story project. A 338,000 sq. ft. Bloomingdale's will anchor all five floors of the new development, which will link to San Francisco Centre when it opens in fall 2006.

Like Nordstrom, Westfield is counting on Bloomingdale's to draw shoppers to the upper floors. “The tenants allow you to circulate people, so all levels of these projects will be successful,” Green says. “If you have the wrong tenants in the wrong place, then you're going to struggle.”

A mixed-use project's design also influences a property's performance. In January, furniture store Room & Board vacated 49,000 sq. ft. on floors five through seven of Chicago Place, the 311,000 sq. ft., eight-floor retail center located along the city's Magnificent Mile below a condo tower. Room & Board cited a lack of traffic on the upper floors of the retail portion as one of the reasons it moved to a nearby building, which will give it street-level exposure.

Indeed, Chicago Place's underlying problem stems from the property's small floor plates and inefficient escalator scheme, says Ross Glickman, CEO of Urban Retail Properties Co. in Chicago, which was hired to lease and manage the project last year for New York-based Brookfield Properties. Those deficiencies discourage shoppers from moving through the center, he adds. (Urban Retail relinquished its leasing and management duties at Chicago Place on May 1.)

Glickman has an eye for such detail. In addition to developing the premier vertical mixed-use gem Water Tower Place in Chicago and other acclaimed projects throughout the country, Urban Retail today manages and leases preeminent vertical projects around the country.

In February, the Massachusetts Port Authority selected Urban Retail, along with Boston-based Drew Co., to develop a $500 million, 1.2 million sq. ft. vertical mixed-use project on 11.3 acres on the South Boston waterfront area. Known as Waterside Place, the massive project will feature 600,000 sq. ft. of retail on two floors topped off by two towers — a 21-story hotel and 20-story condominium complex.

The challenge at Waterside Place, which is slated to open in 2007, is similar to any other vertical development, Glickman says. “It's about integrating a central plant that benefits all of the different users while separating users so they don't step on each other's toes,” he says. “It's about making traffic flow conveniently and easily so that office workers, residents or shoppers aren't wandering around in a maze.”

Engineering for the Senses

Small-scale vertical projects in the suburbs possess complications, too, especially when it comes to physically separating users. The Southland Cos. of Pasadena, Calif., recently completed a $14 million retail, office and condominium project in two, three-story buildings in the Los Angeles County suburb of Pamona. Known as the Mission Promenade, the project features first-floor retail and restaurants, second-floor office space and third-floor condominiums.

Among other challenges, developers wanted to mitigate noise filtering to offices from the dwellings. The architects' solution was to separate the second and third floors with a six-inch concrete slab, says Mitchell Sawasy, design principal of Rothenberg Sawasy Architects.

Not only did that eliminate the potential Led Zeppelin fan from dictating an office user's morning music, but it also provided the project with raw concrete floor slabs — a hot item in the market, he says. In addition, it allowed the developer to cut costs by framing the condos in wood — the bottom two floors were framed in steel.

“This type of project was really untried in Pamona, but when we were only 25% to 30% along, all the condo units were reserved,” Sawasy says. “I think people and cities are seeing this as a way to live, work and shop within walking distance. Here in Southern California, believe me, that's a whole new concept.”

Joe Gose is a Kansas City-based writer.

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