Risk And Reward
Investing in retail for the long term can be uncertain, but proliferation of mixed-use presents opportunities.
David St. Pierre

They say in certain parts of the country, “If you don’t like the weather here, wait a minute.” A similar statement might be made of retail development, an industry that has evolved and changed so rapidly and continuously that it resembles the fickle weather in our nation’s heartland.

Only 10 years ago, the notions of lifestyle center and town center were novelties — untested and unproven commodities that had yet to live up to time’s scrutiny. Was outdoor, mixed-use development the next big thing, or merely a passing fancy that would only make true impact in warmer climates?

Through the scope of history, we clearly see now that it was then, and remains today, the wave of retail’s future across the country. We rarely see today a new retail project of any great significance that does not incorporate some elements of lifestyle/town center discipline. It has become conventional wisdom that mixing uses and offering patrons a wide variety of lifestyle options — shopping, dining, entertainment, housing, office, etc. — is the preferred path by which to attract the greatest number of tenants and maximize consumer traffic.

But what about the investment piece? Attracting capital for the development of retail projects has traditionally been a safe bet. Retail projects are, by nature, rather predictable ventures. A retail center is most often pre-leased before a developer seeks to secure financing, making the project far less speculative than, say, a multifamily project, which has no pre-leasing and for which one cannot as easily predict important factors such as future rents and market occupancy when the project’s construction is completed in 18 to 24 months. As a result, retail projects have been very attractive to institutional investors who can easily valuate the retail investment deal, projecting rates of return with some degree of accuracy and assurance.

However, this speaks only to the short term viability of the retail investment. If an equity investor is simply looking to invest in the development of a new retail project, then flip the investment after 2 to 3 years, the rate of return is fairly predictable and traditionally attractive. But should the investor have a long term investment horizon of 10 years or more, new factors weigh in, in many ways flipping the equation when comparing investment “security” between retail and the multifamily investment that was riskier at the outset.

Over a 10-year period, there are clearly risks in owning a multifamily project. But after the project is leased and stabilized, no single tenant can hurt you, which is why so many investors are attracted to multifamily investments. That is very unlike a retail project. In that same 10-year period, a lot might change in retail (as it has in the past 15 years), and perhaps the project that looked like a sure bet 10 years ago does not look nearly as attractive today. In retail, the loss of a large tenant in a given project can hurt you — in fact, it can be devastating.

Which brings us back to change. Retail continues to evolve. The proliferation of technology in the retail experience is likely to change retail even more. People shop differently than they did only a decade ago, so we may be shopping differently still 10 years from now. In fact, some developers who built retail projects only 3 or 4 years ago — even outdoor lifestyle centers — are today lamenting missed opportunities for having not incorporated multiple uses such as office and residential. Four years from now, will we be lamenting additional missed opportunities?

Equity capital providers manage risk and reward for a living. If the equity source is one that prefers longer holding periods to capitalize on recurring income streams and long term value creation, they tend to shy away from an investment that is unpredictable. It is fairly safe to assume that we cannot predict what retail will look like 10 years from now, so investing in retail today for the value it will hold in 10 years can be risky business.

That is what makes mixed-use projects attractive. Mixed-use projects are retail projects at their core, and when you add in the additional uses such as residential, entertainment, restaurant, hotel and office, you begin to diversify the risk profile of the project. Don’t get me wrong, these are not easy projects to develop. There are clear challenges related to mixed-use projects, but once they are built, there are a number of characteristics that make them very attractive.

The synergies of a well designed mixed-use project that combines live, work and play elements create a dynamic environment that enhances the overall project. Retailers benefit from the increased traffic driven from the restaurant clientele, while the restaurants benefit from the traffic from the movie theatre and the daytime traffic from the office tenants. The residential component is strong due to all of the amenities that are made available to the residents.

As a result, had the retail project been developed as a single-asset, separate and distinct from the other assets, the loss of a single large tenant may have had a devastating impact on the project’s returns. This is not to say the loss of a single tenant is not damaging to a mixed-use project, but there are other income drivers that help to minimize its impact.

Mixed Reaction To Mixed-Use

Though few dispute that mixed-use is largely the preferred development style today, institutional investors and other sources of capital approach these investment opportunities as somewhat uncharted waters. For one, they defy definition. Is this a retail project? Is it a multifamily project? Is it an entertainment project? Or office? This aversion to traditional labeling can present challenges for both the investor and the developer looking to secure financing.

Most of the projects we are discussing, though, are retail projects at their core. They may incorporate other uses to maximize traffic flow and tenancy or to satisfy the municipality’s requirement for mixed-use, but they are, in essence, retail projects. Yet, still, there are these other uses, which differ from retail in their speculative nature, presenting unique new challenges in terms of financing.

The strategy that many developers are employing today to address this challenge is likely the tack that increasing numbers will take to address the proliferation of mixed-use centers and mixed-use investment opportunities. Many see a mixed-use center as a mélange of deals in the making, treating the residential component as its own deal, and doing the same with the office component, et. al.

The challenge is that traditional lenders do not as aggressively finance these other uses as they do retail. As soon as you incorporate uses other than retail, the project becomes inherently more speculative at the development stage, and those looking to maximize short term internal rates of return understandably tend to shy away.

A Variety Of Uses, A Variety Of Solutions

The most obvious solution, then, would be to find equity sources that aren’t focused on short term IRR. There are not many out there; however, they do exist — and it is a strategy that is finding increasing favor with developers across the country. It stands to reason that real estate, which is a long term asset, is a sound investment that grows in value over time, yet the vast majority of equity capital providers are loath to commit to longer holding periods. However, patient equity capital is out there for the taking, which seems to fit perfectly with the new face of retail (being mixed-use).

Additionally, developers are increasingly bringing in development partners to handle the various pieces to the puzzle. A multifamily partner may develop the residential component, while a developer with office expertise may take over the office component. By segmenting each portion of a project to each respective expert, a developer maximizes insight and experience…all the while presenting distinct investment opportunities. Each development partner may even seek its own financing for its portion of the project.

Another strategy is the acquire-and-divest approach. Say a developer acquires a parcel of land to develop a large mixed-use project, with plans to incorporate retail, residential, restaurant and office. In such an instance, it may make the most strategic sense to subsequently sell off a portion of the land to a “sub-developer,” who may take over the multifamily portion of the project, for example. The developer would still maintain control over the master plan and retain decision-making rights with respect to design and construction, but will have divested not only the land, but also the development responsibility and its inherent investment risk to a third party.

Moreover, those we traditionally consider retail experts are not necessarily multifamily experts, or experts in developing office, and many would likely admit that.

Stable Conditions

While we, as investors — especially equity providers committed to long term investment — have invested, and will continue to invest, in single-use retail projects, we have become more intrigued by mixed-use retail. Capital providers see more opportunity and more stability. With retail at its core, a mixed-use project’s other uses (residential, office, etc.) help to further diversify the project’s risk profile and inject long term viability and predictability that make the investment more attractive to capital providers looking for patient, longer term holding periods. In other words, regardless of what the future may hold for retail, the combination of the project’s uses creates an asset with long term investment appeal.

David St. Pierre is co-founder and president of Lyndhurst, Ohio-based Legacy Capital Partners, a $44 million private equity investment fund geared toward longer-term equity financing. He can be reached via e-mail at dsp@lcp1.com.