By Alyssa Katz
Despite a brief flurry of securitized lending before the mortgage market blew up, mixed-use development was and still is uncharted territory for most lenders. But this development model may be poised for new popularity in the coming decade.
Reasons for the improved outlook include a combination of market demand from affluent workers and residents who embrace the convenience and conviviality of walkable communities, and growing government awareness about the economic and environmental benefits of transit-oriented development.
Locating work, shopping, and housing together near mass transit cuts down on vehicle trips while creating 24/7 districts that generate tax revenue through multiple streams. Minimizing car travel brings commensurate reductions in greenhouse gas emissions. Government policy at all levels, including changes in Federal Housing Administration (FHA) mortgage insurance programs, is increasingly favorable to these kinds of developments.
Developers looking to include commercial space are increasingly considering FHA lending programs, and the Obama Administration wants to encourage even more activity. FHA loans are a crucial source of credit in the new era of lending caution. They also have the distinct advantage of financing construction and permanent phases in one loan. (They also impose costly prevailing wage requirements for construction workers.)
FHA is taking steps to make its programs more useful for mixed use, while remaining focused on its main mission of financing housing. The mainstay Sec. 221(d)(4) program only allows 10% of the net rentable area, and 15% of estimated gross income, to come from nonresidential uses.
To get more commercial space, some developers are turning to Sec. 220, designed for use in HUD-certified urban renewal areas. FHA currently has 39 Sec. 220 projects in its pipeline. Sec. 220 allows nonresidential components of projects to be up to 20% of floor area and generate up to 30% of gross income, and permits waivers to allow even more. To qualify for HUD approval, a project must be located in an area “where concentrated housing, physical development, and public service activities are being or will be carried out in a coordinated manner, pursuant to a locally developed strategy for neighborhood improvement, conservation or preservation.” Certification has become routine.
“We’re working with a lot of developers who had never really used FHA at all,” says a loan officer with a leading FHA multifamily lender. “FHA is one of the only games in town.” He says he’s currently using Sec. 220 on several transactions, including mixed-use projects in Dallas, L.A., and San Diego, after doing his first just a year and a half ago.
In 2008, the agency permitted master lease agreements for the first time—designating a tenant distinct from the borrower/owner—making it feasible to combine FHA loans with new markets tax credits in support of mixed-use projects.
The biggest obstacle to using FHA is that it can be used only for projects that meet its cost limits, which are too low for most major cities. The Senate Committee on Banking, Housing, and Urban Affairs is considering legislation, passed by the House last fall, that would significantly boost per-unit borrowing limits for elevator buildings under 221(d)(4), making the program more feasible for projects in high-cost, high-density urban areas with retail or other uses on the ground floors.
Administratively, the agency is expected to make FHA-financed buildings more retail friendly by guaranteeing that commercial tenants won’t lose their leases if a borrower defaults and liberalizing how it considers commercial rental income in underwriting.
Fannie and Freddie’s Delegated Underwriting and Servicing (DUS) program is more flexible, allowing up to 25% of income to come from sources other than housing, but developers and lenders say the ratio is still too limited to make the product of much use for mixed-use development. In most markets, commercial uses bring in more net revenue per square foot than residential, so to keep the commercial space income ratio below 25%, a building has to be tall—usually tall enough to require an elevator and steel-frame, instead of wood, construction. The relatively high construction costs of such structures makes such plans prohibitive at all but the luxury end of the market.
Under federal conservatorship and suffering severe losses, Fannie and Freddie are in a poor position to build a secondary market for mixed-use commercial lending. In the absence of such a market, FHA is playing an increasingly important role in mixed-use lending despite its restrictions, pushed by developers and lenders eager to tap a new source of combined construction/permanent financing.
FHA can help lead the way, but ultimately the critical factor in making mixed-use financing routine will be strong secondary market support—support the federal government can promote but whose risks it is unlikely to shoulder. Tim Wright, senior managing director of the San Diego office of commercial lending intermediary Holliday Fenoglio Fowler, says he’s confident private-sector mixed-use financing will regain momentum as the credit markets recover, but that lenders will be wiser about what it takes to make a project work. “They’re going to be built in heavily supply-constrained areas, where you don’t have to make an excuse for any of it,” says Wright. “It’s a place where you already have a deep residential and office or retail environment.”
Private Lenders Are Reluctant
Private lenders may still need lots of convincing to do a mixed-use deal.
The surge of mortgage lending during the height of the mortgage securitization boom for mixed-use projects has receded, leaving some mortgage lenders feeling burned by mixed-use projects. Too many were not well designed or conceived, especially urban-style projects built in isolation within car-dependent suburban environments. Many of those are now struggling with empty storefronts and offices and unsold condos. John Fett, a senior loan officer for Irvine-based commercial lender Westcap Corp., counts himself as a skeptic of mixed-use in suburbia, calling such projects “unfinanceable.”
“Putting a second story over office or over retail never works,” Fett asserts. In his experience a resident won’t want to live over a restaurant and its smoky woks, or to be woken up by garbage trucks, while office workers don’t want to fight grocery shoppers for parking spaces. “Unless you segregate the uses carefully,” says Fett, “you’ll have conflicts that are inevitable.”
Tim Wright is all too familiar with collisions between different types of tenants, which is why he and his clients set out to prevent them. The first step, he says, is to make sure mixed-use projects are built in high-density places that can support their diversity.
He hopes that Pacific Station, a $45 million project set to open in the coastal town of Encinitas, will fit the bill. Anchored by Whole Foods, which has signed a 20-year lease agreement, Pacific Station will also be home to 47 rental apartments and 10,000 square feet in offices. A critical ingredient binding them together is a set of agreements that each tenant must sign outlining obligations to the others. Wright says such contracts “govern functionality and preserve value”—by making sure, for example, that luxury condo buyers don’t one day find themselves living above a 7-11 convenience store.
Wright secured a $36.5 million construction loan from a savings and loan, La Jolla Bank, that understood the potential for mixed-use to thrive in Encinitas. Regional lenders like La Jolla are now the leading source of construction loans for such projects. In the absence of a secondary market for commercial mortgages, permanent financing remains hard to come by, leading many developers to negotiate extensions of construction loans as they come due.