Mixed-use development: Through the lenders' looking glass

Mixed-use developments were the norm in American towns and cities in the early part of this century. Now they are making a comeback, raising issues for lenders. (Photo courtesy of the Metropolitan Council)

At the turn of the century in the United States, mixed-use buildings were commonplace along urban neighborhood commercial corridors and small town main streets.

These were practical structures, places that provided local grocers, hardware store owners and other merchants an opportunity to operate a business and live upstairs in second-floor apartments. These buildings also provided convenient and accessible retail goods and services to neighborhood residents.

Mixed-use neighborhoods built up around factories and manufacturing plants too. In some neighborhoods, companies provided worker housing adjacent to industrial facilities. These areas contained residential, commercial and industrial components allowing people to live, work and shop without the use of an automobile.

Changes in land-use patterns and public preferences in the mid-1900s resulted in cities establishing zoning codes and ordinances that encouraged the separation of residential, commercial and industrial development. Mixed-use buildings lost their popularity and were no longer constructed.

During this time, older mixed-use buildings often fell into disrepair in many urban commercial corridors and neighborhoods.

History tends to repeat itself and, in the last decade, business owners and real estate developers have rediscovered mixed-use buildings.

The resurgence of compact, self-sufficient neighborhoods where people meet their lifestyle needs has created a renewed interest in mixed-use development. Former mixed-use buildings continue to constitute a significant portion of the building stock along today's inner-city commercial corridors. Most of these buildings are in need of renovation and rehabilitation to stabilize them for re-use.

In addition to redevelopment efforts, the demand for newly constructed mixed-use projects is on the rise in both urban and suburban communities.

Despite the renewed interest in mixed-use development, small business owners and developers often say they find it difficult to obtain financing for these types of projects. In seeking to understand why lenders might be reluctant to finance mixed-use projects, we interviewed three Twin Cities lenders. To our surprise, we discovered not only that these lenders are actively involved in mixed-use development, but that they feel these projects can be analyzed similarly to other loans.

These lenders offered their insights regarding the application of standard tools of analysis to mixed-use projects. They also discussed some of the issues that may contribute to the complexity of mixed-use projects, and offered recommendations to others interested in financing mixed-use development.

Credit analysis of mixed-use developments

The lenders we interviewed use the same tools and skills to analyze mixed-use projects that lenders use every day to analyze commercial real estate, housing and small business loans. However, there is one main difference.

A lender analyzing mixed-use development must apply these standards to each component of the project, which can require additional time and expertise from the lender.

For example, credit analysis for mixed-use projects relies on typical measures of credit risk and project financial feasibility such as the loan-to-value ratio, the debt service coverage ratio, collateral value, and the creditworthiness of the borrower. According to Andrew Swammi at Western Bank, most community banks can apply standard lending policies to mixed-use development projects.

"Working for a community bank, I am responsible for analyzing all facets of these projects, regardless of whether they include housing, retail and/or commercial components," he said.

Lenders working for large banks with separate commercial and residential loan departments may need to develop a team with the expertise to analyze mixed-use projects.

Orlena Iversen of TCF Bank said that analysis of mixed-use development depends heavily on the scale or size of the project. Small-scale mixed-use projects typically include two main components: housing and commercial/retail.

To analyze small-scale mixed-use buildings, Iversen considers projected cash flow from the housing units based on market rents and vacancy rates, as well as projected cash flow from the business tenant based on the creditworthiness of the business. The feasibility of both components is critical to the analysis.

Mark Johnson at Richfield Bank & Trust Co. believes that, as with all projects, the experience of the borrower is an important factor in analyzing mixed-use loans. "Whenever possible, I prefer to work with a borrower who has redevelopment expertise, finances adequate to support the project in the event of a problem, good credit history, and an established track record of successful projects," he said.

Ensuring profitability for mixed-use projects

To ensure an adequate return on investment for mixed-use projects, these lenders structure the terms of repayment, interest rates, prepayment penalties and pricing of the loan to compensate for any additional time or risks involved.

They also assess the proposed project in light of current economic and market conditions, as well as those anticipated over the life of the loan. In addition, Johnson said that a lender must price the transaction appropriately and include a prepayment penalty or yield maintenance provision with all fixed-rate transactions to reduce the bank's interest rate risk.

No question, these projects can be complex to analyze. Because of this, inexperienced lenders may want to consider working with a correspondent bank or another bank with experience in mixed-use development or redevelopment. This additional expertise helps ensure thorough project analysis and proper pricing of the loan to protect the bank's investment and provide an adequate return.

Issues affecting the analysis of projects

The issues that surround mixed-use development often are related to the redevelopment or rehabilitation of aged inner-city buildings. Loan analysis of small-scale mixed-use projects can be especially arduous because of redevelopment issues, which can include:

• Building condition or deterioration due to deferred maintenance over time, vacancies, neglect, turnover in ownership, or location in high crime areas.
• Compliance with applicable codes such as zoning, building systems, business licensing, and the Americans with Disabilities Act.
• Environmental concerns such as buried tanks, asbestos, chemicals and spills left over from previous occupants.
• Buyers' knowledge of and experience with purchasing, owning and maintaining mixed-use real estate.
• Sufficiency of borrower equity and personal assets to cover the down payment, renovations and environmental cleanup.

Appraisals are critical to the analysis of mixed-use projects because they quantify these issues into a value for the real estate. Of course, the appraisal ultimately affects the amount a lender is willing to finance, and the specific components of the project have an impact on the appraised value.

The appraisal must accurately reflect the value of all the elements of the project. Unfortunately, it can be difficult for an appraiser to find comparable mixed-use properties.

Identifying and filling gaps

It is not uncommon for mixed-use projects to have technical and financial gaps because of the multiple components involved.

For example, a small business borrower who wants to purchase a mixed-use property may not have enough equity, cash flow and personal assets to cover the cost of necessary renovations, such as a new roof or interior remodeling. In another instance, a developer interested in constructing an apartment building with street-level retail space may have experience with multi-family housing but not with commercial-retail development.

In these situations, the lender may want to provide additional support to the borrower or identify other financial and technical resources to fill project gaps.

According to Johnson at Richfield Bank and Trust, sound projects must adhere to basic lender criteria, but each project needs to be evaluated on an individual basis. "Factors that deviate from standard requirements should be mitigated as much as possible," he said. "Some of those factors might include: dealing with a repayment source that is not as strong as traditional sources, an appraised value that does not support the loan amount, or projects that require public subsidies through grant or loan assistance."

Grant or loan assistance programs offered by local housing and development authorities, community-based nonprofit organizations and national organizations supporting affordable housing, small business development or historic preservation can be used for mixed-use projects. Financial or technical assistance provided by these kinds of organizations can assist both the borrower and the lender, resulting in a viable mixed-use project that did not originally meet standard loan criteria.

"Knowledge of the various community-based loan and grant programs can be integral to the success of these types of projects. While good analysis starts with the fundamentals, lenders should be willing to explore alliances that will mitigate their risk and make these projects more feasible," said Swammi.

He recommends that community lenders become familiar with the various programs, resources and organizations available to assist with mixed-use projects. He also suggests that borrowers work with a team of professionals such as attorneys, architects and contractors to fill technical gaps.

Why do mixed-use lending?

The complex nature of mixed-use development may require a lender to devote additional time, energy and resources to finance these projects. However, mixed-use development fills an important market niche in cities, suburbs and small towns.

Lenders attest to the growing demand for mixed-use property by small business owners and developers alike. Changing demographics including an influx of recent immigrants and an increasing elderly population contribute to the appeal of neighborhoods that provide housing, employment and business services within close proximity.

"Mixed-use projects might provide a lower return than conventional development, given the extra time and resources involved," Johnson said. "However, they can result in major benefits to the community, enhance the bank's reputation and establish ongoing relationships between lender and borrower."

Certainly, the complex nature of mixed-use projects and the issues that surround these deals may pose a real challenge to community lenders.

However, based on benefits to the financial institution and the community realized by these projects, it's clear that financing mixed-use development can be worth the effort.