Despite the buzz surrounding new and proposed mixed-use projects, the product niche remains a fledgling and untested formula for long-term financial success.

Lenders increasingly are challenged in underwriting mixed-use projects because of ever-higher construction costs, changing market conditions and the built-in unknowns about how mixed uses ultimately will work together.

Mitigating risk, especially considering that construction costs nationwide have increased by 7.6% in the past year alone, according to New York-based Turner Construction Co., is driving investor thinking. “The rule of thumb has changed,” says Aden Kun, vice president of Los Angeles-based Buchanan Street Partners, a real estate investment bank. “Historically you could underwrite to a 5% hard-cost contingency buffer for construction costs, and now you need 10% plus.”

According to Atlanta-based Reed Construction Data, nearly 1,000 mixed-use projects nationwide have been completed or are in the development pipeline in 2007, 10 times the number of mixed-use developments completed in 2003.

To be sure, there are a few glitches on the rosy mixed-use horizon. In May, plans for a $2.5 billion mixed-use project called W Las Vegas were suddenly nixed when minority partner Starwood Hotels & Resorts pulled out of the project. Next door, the highly touted Las Ramblas condo tower — which prominently featured partner George Clooney — was canceled in summer 2006 because of weak presales. While Starwood officials aren't talking publicly, higher construction costs and slow condo presales had cast doubt on the future of the project and forced rumors of Starwood's pullout for months.

Despite the increasing challenges, some lenders aren't so much worried about current costs as they are about the long-term viability of mixed-use projects, given recent financing trends.

“With the excesses and the type of lending that has gone on in the last two years, you can feel pretty good that there have been some bad loans made, given 10-year, interest-only structures and the like,” says David Durning, managing director of originations and agency lending at Newark, N.J.-based Prudential Mortgage Capital Co. “That means you're going to have problems. We're still waiting to see the total fallout from the condo overbuilding.”

Experience counts

When it came to financing a $170 million mixed-use project covering three city blocks now under development in downtown Houston, lenders wanted an established track record. Denver-based Entertainment Development Group had completed the successful Denver Pavilions downtown in 1998. That fact alone helped convince Buchanan Street Partners to sign on as an equity partner in the new Houston project to the tune of $47 million, or nearly 30% of the total project cost.

“A market can shift, but your owner/developer is always going to be there,” says Kristin O. Penahal, senior vice president with Buchanan Street Partners. “We spend a lot of time understanding who our partner is, how they think and how they operate. You can't control everything on one of these projects, but you can control who you partner with.”

When completed in October 2008, Houston Pavilions will include 360,000 sq. ft. of retail space, a 44,000 sq. ft. House of Blues, and 200,000 sq. ft. of speculative office space.

For projects large and small, Durning notes that having the right development partner can yield better financing terms. “The market is very aggressive in financing a track record,” says Durning. “Mixed-use as a phenomenon is something we are very comfortable with, but when you don't have a track record that's when it can be a little more challenging.”

Mark Schurgin, president of Los Angeles-based The Festival Cos., which has developed more than 130 retail properties nationwide over the past 25 years, agrees. “Lenders should shy away from inexperienced sponsors because you don't know what you've forgotten until the building is up and then it's too late,” he maintains. “You need to be with an experienced developer who has the understanding of the combination and synthesis of putting all of the components together.”

Schurgin is teaming up with New York-based Goldman Sachs on a new $800 million retail fund, which kicked off in January. Already it has invested more than $200 million and is looking for mixed-use opportunities large and small. Schurgin is targeting a 20% internal rate of return on deals, and is already talking with Goldman about jump-starting a second fund.

Major mall owners like Simon Property Group and Pennsylvania REIT are also diving headlong into the mixed-use game, bringing more scrutiny from Wall Street analysts. Indianapolis-based Simon, for example, intends to include a mix of property uses in every future development it undertakes.

Chicago-based General Growth Properties is undertaking one of its most intensive redevelopments yet, reshaping the enclosed Cottonwood Mall near Salt Lake City into mixed-use with shops, residences, offices and streetscapes with a community feel for completion by 2010.

Getting comfortable

Billy Procida, a New York developer turned lender and now president of Palisades Financial in Fort Lee, N.J., recently invested $20 million to help acquire the land and start site work for a portion of the $1 billion Centuria Fort Lee project. When completed in 2011, the mixed-use development will feature luxury rental units, 90,000 sq. ft. of office space, 126,000 sq. ft. of retail space, a 19-story hotel and a 65,000 sq. ft. convention center at the foot of the nearby George Washington Bridge outside Manhattan.

One selling point: Procida's office overlooks the project site, but key to the funding was Procida's 16-year relationship with the owner, Town & Country Developers, which Procida has partnered with on $1 billion in condominium developments.

“Like anything else, you can have the greatest piece of property in the world, and in the wrong hands it can turn to scrap,” observes Procida. “We liked the property, we liked the developer and we liked the concept.”

Lenders run through a battery of tests before they become sold on a mixed-use project, but location and demographics are paramount factors in determining a project's viability. With the Houston Pavilions project, significant retail pre-leasing and Houston's relatively healthy 12% office vacancy rate made Buchanan's decision easier.