NAIOP's Development Magazine - Special Section Article

Anatomy of an Urban In-Fill Development

[ By Paul H. Maenner ]

Developers of the Pinehurst Building in Edina, Minnesota overcame major challenges, including an over-extended contractor, an overly aggressive schedule and a highly-detailed design.
Nationwide, each community has its own higher-end or specialty neighborhood commercial retailing district. In the Minneapolis/St. Paul market, there are three such districts, the most prominent of which is known as the "50th & France" district.

It consists of properties located in southwestern Minneapolis, and northeastern Edina, a first-tier suburb known for its high-quality housing stock, schools and retail composition (home of Southdale Mall, the nation's first enclosed regional mall).

When I was a partner at Pinehurst Properties, Inc., my partner Tom Lohmann had owned a small, 12,000-square-foot commercial building located immediately north of this prime intersection. After watching the occupancy of this building drop from 100 percent to 30 percent over the course of 12 months between January 1996 and January 1997, and after considering one disappointing retail concept after another, we concluded that the time was ripe to pursue a much broader development opportunity.

This is the tale of this pursuit, including some successes and failures, the materialization of both good luck and bad, and the ultimate results and performance of what is now known as the Pinehurst Building.

The Pinehurst Building is situated on a 44,000-square-foot site. It is clad in brick, built to the lot-line and has underground parking that is visible from the sidewalks.
With a small toe-hold in the market, a few pretty architectural renderings and a grand vision of what could be, we embarked on convincing City of Minneapolis officials (where the property is located) that a redevelopment of the property, along with the balance of property comprising the corner of northeastern 50th Street and France Avenue, was an absolute necessity to preserving and enhancing the livelihood of Minneapolis' side of the commercial district.

This ambition dovetailed with the neighborhood's completion of a Master Plan concept that adopted certain features of "New Urbanism" design (embracing pedestrian-friendly design, parking either underground or behind, etc.). The problem with our plan, however, was that it included property we did not own. In addition, the projected cost of the project was far in excess of what a private party could afford to create the asset we envisioned.

Good Luck and Bad Luck

There were several good-luck, bad-luck breaks during the course of the project. The first stroke of luck came in the form of an astute City Council Member who happens to hold an MBA from a top five business school. Having grown up in Chicago, and schooled in the ways of "getting things done" politically, this Council Member assisted us in creating a Tax Increment Financing (TIF) District that allowed us to finance a critical piece of the project through use of the "increment," but more importantly, the TIF District allowed for the City's assistance in acquiring the remaining two properties (one of which was a gasoline station), which we were unable to obtain through private negotiations.

(As an aside, we don't view the use of condemnation lightly: Property Rights are fundamental to our capitalist system and our very own commercial development industry. In the case of both properties, the property owners received approximately 30 percent more for their properties than what the appraisals indicated. In addition, they received relocation benefits and assistance, all of which are afforded by law.)

Having acquired control of the property, we commenced development, in earnest, of our Concept Plan and Leasing Strategy. We felt that we had control of a highly desirable - and rare - corner location that demanded the highest-quality design we could afford. In the Twin Cities, we are fortunate to have a sophisticated architectural community from which to choose talent according to the opportunity at hand. Our firm had worked closely with the Minneapolis firm Bentz/Thompson/Rietow on a prior project in downtown Wayzata, and we believed that their design esthetic and heritage in the community was appropriate for this task. In essence, we believed we had a "jewel" of a location and that the design should reflect the rarity of the opportunity. As my partner and I discussed at length, "You only get one shot at the design - if you screw it up, there's no fixing it."

In addition to giving the architect the neighborhood Master Plan for guidance, we gave their principal designer six key instructions:

The building had to be built to the lot-line along both 50th & France.
It had to be 100 percent clad in brick, so that there would be no "front" or "back" to the building.
It had to consist of two stories, with retail shops on the first floor and offices on the second.
It should have underground parking that must be visible from the sidewalks, so a visual connection could be made to create cumulative awareness that underground parking existed.
It had to embody a "European" flair (one of our more nebulous directions).
Finally, the Building should measure 41,400 square feet (net rentable) and be situated on a 44,000-square-foot site.

Fortunately, the architect nailed the solution, thereby affording us the opportunity to wax eloquently on the virtues of the building to our prospective tenant base.

Lease-Up Anxiety

As sales tasks go, this assignment was unique. As a smaller development firm with limited resources, we were required to achieve at least 60 percent pre-leasing before our construction lender would commit to the deal (not unusual, but who needs pre-leasing when you've got the corner, or so we thought). So we set out to convince both a major retailer and a major office user to anchor the two different components of the project. The challenge was, of course, our inability to specifically communicate the logistics of the deal.

While the pretty pictures and high-design were our calling cards, what all prospective tenants saw was a corner gas station and a fuzzy schedule. National retailers on an expansion campaign are typically looking for opportunities that have a tangible end in sight. When comparative options become complicated, the retailer will typically choose the easier or earliest delivered option. Office tenants, likewise, typically choose not to commit to something speculative or uncertain, especially since most office tenants don't look for space too far in advance of a lease expiration. Requiring a firm commitment from an office tenant, in order for the developer to take the next step, rarely happens for a project as small as ours.

The uncertainty of our pursuit caused one major retailer and a national securities brokerage firm to shy away from the project. These discussions were classic: 12 months spent on plans, letters of intent and plan revisioning, only to have both walk from the deal. Our patience and pocketbook were both wearing thin, and we seriously considered throwing in the towel, when two strokes of luck came our way in the form of Urban Outfitters, which wished to open an Anthropologie store, and Piper Jaffray, the Minneapolis-based securities brokerage firm that wished to establish a new, high-end money management/financial advisory office to serve the growing affluence of the surrounding demographic.

These two critical tenants, along with a Caribou Coffee Shop, a Birkenstock Footprints store, a local bank and a local dentist helped us to achieve 65 percent pre-leasing at rents and leasehold improvement costs we could justify.

Construction Delays

The good luck soon ran out. We broke ground in February 2000, at what I would describe as the "screaming peak" of the local and national construction cycle. Remember, the Internet bubble had not yet burst (it would a month later) and the market for construction services and materials in the Twin Cities, as elsewhere, was running at a furious pace. Needless to say, our little "jewel box" of a building was an extraordinarily expensive structure to build. Because of this, we boldly - but wrongly - hired a local "up and comer" general contractor to build the building. They had speculated a significant amount of their time assisting us in "value-engineering" the plan, and they ultimately came in with the lowest bid.

We believed that the prominence of the opportunity would give them incentive to focus on the details, but they had ambitiously taken on so much additional work that we ultimately were in competition with their other projects for masons, drywallers, plumbers, steel erectors, concrete plank, you name it. As a result, our schedule dragged and the penalty-clauses-for-delay which we had reluctantly agreed to began looming as more real than not.

Couple an over-extended general contractor and an overly aggressive schedule with a highly detailed and sophisticated design, and you have a genuine recipe for fear, anxiety and sleepless nights. This is where I received a crash course in construction management and learned the art form that is called the "Change Order." Our architect's pretty design was complicated to build and difficult to stage. Our one-acre site, at the absolute corner of 50th & France, in a 100 percent built-up location, created staging and excavation issues that complicated the construction from the outset.

As an example, we had to shore up the home located to our immediate north so that we wouldn't undermine their foundation with our excavation. Other examples included shutting down France Avenue, requiring consent from both Minneapolis and Edina as well as the county, which had the ultimate jurisdiction for this road. In the end, the project was completed in late March 2001, approximately three months behind schedule, which forced a delay in collecting rents and extending the amount of interest-carry we had projected.

Financial Viability

The inordinate number of Change Orders meant that we overshot our construction budget by approximately 12 percent. Our lender soberly adhered to the loan documents and denied us additional funds, which meant that the cumulative cost overruns had to be funded by the partners, thus necessitating the much-dreaded Capital Call Memo. This meant that we had to collectively contribute another $1.3 million in cash to the deal, which also meant that our profitability would be much eroded. At the outset, we had anticipated creating a total profit margin of approximately 16 percent (the difference between appraised value and cost). Based on take-out financing projections for an 8.5 percent mortgage interest rate amortized over 25 years, we believed we could achieve a 35 percent cash-on-cash return, leaving only $611,000 in cash equity in the deal. The cost overruns severely damaged those calculations; we would have to leave over $2.7 million of cash invested.

Despite the cost overruns, delay in schedule and the imposition of rent-delay penalties, we benefited from one last stroke of luck: The Falling Interest Rate Environment. While we had to leave more cash in the deal than expected, we were able to secure from a nationally respected life insurance company a 10-year loan at a 6.49 percent interest rate, amortized over a 30-year period.

Our current day cash-on-cash return is over 16 percent. This clearly is not what we had projected, but given the "thrills and spills" of this deal, as Tom calls them, we feel fortunate that things worked out as they did.

The Pinehurst Building was the 2002 Winner of the Minnesota Chapter of NAIOP's "Awards of Excellence" competition, in the "Office, Multi-Tenant Less Than 100,000 Square Feet" category. In addition, the project won the Minnesota Shopping Center Association's "STARR Award" for 2001 and the Minneapolis-St. Paul Business Journal's "Best In Real Estate" for 2001.

Lessons Learned

Today, the property is 95 percent leased and occupied and is generating a stable and reliable cash flow. It has become a legacy asset for each of the partners. It represents what is truly a "fortress" piece of real estate: a highly functional and attractive asset, located at a prominent corner in an affluent market. It serves its niche extraordinarily well.

Even though we have been involved in the commercial real estate industry for 30 and 20 years, respectively, when it comes to urban infill development, we both learned several very valuable lessons, some practical, some philosophical:

Hire a Good Architect. A good rule-of-thumb would be: the-better-the-location, the-better-the-design. Since we're in the business of building better mousetraps, make sure yours matches the site.
Hire a Large Contractor. The more complicated the design and the location, the more you need a large contractor with urban experience. A strong background in scheduling, staging and subcontractor "clout" are invaluable assets.
Double Your Contingency. I don't need to dwell on this. The more complicated the job, the more likely you will need to tap additional resources.
Risk is real. This may sound trite, but when things go wrong (and they will) and you wake up thinking about the Personal Guaranty you signed, you realize that risk has to be priced accordingly.
Luck. What is sobering about living through a complicated project is the realization that we as developers are not nearly as instrumental in our success as we think. Much of the development process is out of your control. Recognize this, and you can sleep a little easier.

Paul H. Maenner, formerly of Pinehurst Properties, Inc., is a partner in JMW Development, LLC, a Minneapolis-based commercial development firm focused exclusively on traditional retail and urban redevelopment opportunities.

For more information

JMW Development: www.jmwdevelopment.com

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