The Housing Downturn + Rising Construction Costs: More Than a Bump in the Road for Mixed-Use?

[ By Lisa Harbatkin ]

Washingtonian, by the Peterson Companies, is a mixed-use project that has been built out.

Rising construction and building materials costs are becoming more worrisome issues for mixed-use developers. Declining job growth could be another factor leading to recent postponements and some outright cancellations of mixed-use developments in California, the Las Vegas area and elsewhere in the country. Still, mixed-use synergies may offer advantages over single-asset development in the face of the residential downturn and arranging financing has not been a hurdle for well-planned, well-located properties.

Development asked a group of mixed-use developers and economists, investment and brokerage specialists about the current concerns and their expectations for the longer term.

Ryan Companies’ Dean Lakes mixed-use development in Shakopee, Minnesota is projected for 2008 completion. It will include residential, hotel, retail and restaurant components. Shown here is a completed medical building.

Is the residential downturn chilling mixed-use development in the current time frame?
JON PETERSON: It’s a combination of the downturn in residential and increased construction costs. Construction costs have increased by as much as 35 percent. What’s happening is that the retail, office and hotel markets are not accepting those costs as something they can absorb in their pro formas. There is some friction between developers and tenants as a result of the increases.

DAN WALSH: Residential has slowed, and it will take a year for the market to adjust. But the residential downturn might actually help a bit by refocusing attention on higher-quality sites. It takes a year for us to get zoning in any case, so we’ll be coming on line with several projects as the market adjusts. Construction materials costs are actually more of a concern.

WHITAKER JOHNSON: Some mixed-use developments have been put on hold, some in California and a few in Las Vegas, but it’s largely because of rising construction costs. With respect to the lending market, there is a larger field of lenders willing to lend on mixed-use projects in comparison to several years ago. Single-asset condominium developments will continue to be problematic.

JOHN McDERMOTT: Profits are the real problem. Even with all the concerns, property appreciation since January 2001 has been far higher than the rise in construction materials costs. Real estate is still more valuable than the materials. But the spike in costs can take away almost all your profit. That’s why developers are all fine-tuning their pro formas.

Dr. Mark Dotzour chief economist Texas A&M University, Real Estate Center College Station, Texas	Whitaker Johnson senior managing director Holliday Fenoglio Fowler Dallas, Texas	John McDermott senior vice president Sperry Van Ness Irvine, California
Trey Morsbach senior managing director Holliday Fenoglio Fowler Dallas, Texas	Jon Peterson senior vice president of commercial development The Peterson Companies Fairfax, Virginia	Dan Walsh vice president of development Ryan Companies Naperville, Illinois

How are these issues affecting you and your market areas? Have you put anything on hold or cancelled anything outright? Changed phasing or configurations?
PETERSON: We’re going forward with our National Harbor, Cross Trail, Moorefield and Waldorf Town Center developments. We are assessing how the phasing will occur, and making some decisions on infrastructure, mainly parking and roads. We’d normally put a higher percentage of infrastructure costs up front, but we’re scaling back on that spending. That means we’ll put in a two-lane road for now, and widen it to four lanes later, or maybe have surface parking now and put in structured parking later. WALSH: We’re watching materials costs closely because they’re putting a lot of pressure on pro formas. But we’re not a commodity developer. Most of our customers are working with us for performance, relationship and expertise.

McDERMOTT: We had two properties in contract in coastal Orange County, one where the client is moving forward with a retail center and will add the residential later. The residential developer in the other opted to forfeit $400,000 in earnest money rather than continue. Most of what’s happened is that high-rise sites approved for Class A office have been converted to residential. That residential is moving forward, but in a market that’s not that good. Builders are making “buyer accommodations.” They’ll throw in the Sub Zero and the flat-screen TV with the condo.

What mix of components and configurations can work in the market today? What about intermediate- and long-term?
WALSH: That depends on the local markets, and on what people want. You have to take the time to put together a combination of land uses providing for future market demands without over-burdening the project with excessive carrying costs. In Chicago, it has to do with amenities, services, recreation and transportation. It’s a matter of convenience and lifestyle. People are finding that the most precious thing in their lives is time -- and do they want to spend it commuting?

MARK DOTZOUR: Longer-term, a mix of retail, housing, transportation and entertainment opportunities will be a high-growth opportunity. A big growth area will be in providing new housing for baby boomers aged 65 to 85. They’ll trade in the tulip bed for a chance to walk to a restaurant and a movie, and for the convenience of being close to their doctors and medical services. These are people who want to be independent, but at the same time are less confident about their mobility.

PETERSON: There is no perfect mix of uses in mixed-use. A project in the suburbs needs to be thought out and planned very differently from one in a semi-urban setting. Retail tenants might need to adopt different store footprints in mixed-use. Medium to large retailers might have to go to two stories instead of one. Residential parking may become less restrictive and more in line with a shared parking scenario.

TREY MORSBACH: It depends on your market and your project. But qualified developers with well-conceived projects shouldn’t have problems getting loans even with the softening of residential.

Mixed-use demands close attention to timing the phases. Are we just seeing more of the same?
PETERSON: Timing is always the hardest part of mixed-use. You have to match the construction cycles and the different components to the market demand. Certain uses that are on the downturn in a cycle can have a major effect on the project as a whole. You have to make sure you have the ability to deliver the uses as the market is ready to support them.

WALSH: We’re not a residential developer. A lot of our mixed-use is anchored by projects we do for our own account. I don’t need to cancel a job because of a temporary slowdown in residential. I can wait for the residential component to get done later. That goes for all Ryan’s markets. In the Midwest, we’re more oriented to population growth, with retail, entertainment, hospitality and medical offices as drivers. Our Southeast and Southwest markets are more job-driven, with the focus on industrial, office and medical.

McDERMOTT: The reality with mixed-use is that you can always adjust to a changing marketplace as long as the design elements are kept flexible. Maybe I can hold off on the residential tower, or rent it as apartments instead of selling it as condos.

What goes into the planning process and into due diligence for mixed-use in today’s time frame? What about financing?
WALSH: Mixed-use projects are inherently more long-term and more complex. We often work with communities as a partner to adjust the risk profile to a financially workable deal. We try to build in flexibility. We look for flexible zoning. We also try to be very user-driven. So while we’re a company that takes calculated risks, a big part of the risk is knowing who our users are -- retail, office or residential. We are in frequent communication with our residential development partners, so when we come up with an idea, we have reason to believe the market is there.

MORSBACH: Capital has had to learn to adapt to financing mixed-use projects. You have to know how large the hotel will be, the retail footprint, how many square feet for offices, how many residential units. You have to determine all those components, deal with things like parking and ground lease agreements, and create a condominium regime so each piece can be liquidated separately.

JOHNSON: There is a lot of capital that wants to invest in real estate generally and there is plenty of capital for well-conceived, well-sponsored mixed-use development. If you’ve got the right deal, you can get it financed.

DOTZOUR: There is an intermediate trend building that will affect financing in all commercial real estate development, not just mixed-use. Institutional investors perceive that returns are too low on existing buildings. So momentum is building for pension funds, endowment associations, and REITs to get more heavily involved in new commercial real estate development. They seem confident that they can develop new projects and get those higher return rates. One thing holding this wave of new capital back is high construction costs.

What will mixed-use look like over the next few years, as the current concerns ease?
WALSH: It isn’t any one thing. Public-private partnerships will remain an important element. Communities are becoming more sophisticated in understanding the benefits and costs, including the role of transportation in the success of mixed-use developments. Another trend is the need for residential to be linked to commercial to offset the financial impact to schools, libraries and park districts.

DOTZOUR: Municipalities are aggressively seeking retail development in their downtowns. But many just want the retail and not residential. The challenge for mixed-use developers is to overcome the bias cities may have against apartment development and moderate-priced housing. You need that for the retail to work. lders.that national names and big box retailers "may or may not be interested, but often what makes a place interesting are the locals."

Lisa Harbatkin is co-editor of Development.