Mixed-use implies real estate assets that include a meaningful component of three or more land uses in the same or adjoining structures. The most common recent vintage mixed-use assets include residential, retail and parking. The most complex mixed-use assets will often include office and hospitality, sometimes stacked vertically like the proverbial wedding cake.
Many real estate investors and lenders historically shied away from mixed-use, seeing complexity, risk and difficulty in underwriting, but as the asset class has grown in size, and a long-term track record has been better documented, the merits of this investment target are increasingly clear and compelling.
While mixed-use investments may pose slightly different, and some additional, risks compared to single-use buildings, they offer strong valuations and outsized long-term performance prospects that translate into predictable income and compelling long-term total returns.
WHEN ONE-PLUS-ONE EQUALS THREE
The primary case for investing in mixed-use assets is that the combining of uses generates revenue and value premiums that exceed the incremental cost of delivery or acquisition. In other words, mixed-use assets get better rents.
Market data largely supports this. Apartment buildings, as one example, with a strong ground-level retail program can often generate a 5 percent or better rent premium to adjacent and similar buildings without this synergistic mix of uses occurring in the building.
Mixed-use buildings also provide some product diversification within the same asset/investment. For example, if the office component of a mixed-use building suffers because that local market becomes soft, the residential and retail components of the same building may continue to produce revenue growth.
The valuation equation is also attractive to real estate investors. Mixed-use assets are often valued more favorably than single-use assets, primarily because the long-term performance of the assets is more certain, partly because mixed-use assets are perceived as “sexier” or perhaps more durable, and also because the mix of uses can create some downside protection. Because the certainty of return over a longer period of time is perceived as greater, investors are willing to pay more for the same income stream.
OPPORTUNITIES IN MIXED-USE
Development is the most widely available entry path to mixed-use ownership, partly because there is relatively little existing stock and because the assets are so desirable they tend to be traded less frequently than single-use assets.
The asset class lends itself particularly well to “build-to-core,” or develop for long-term ownership strategies, as the income and debt rebalancing potential is great, whereas returns from single-use construction might have to be realized at least partially through trading and run a greater risk of becoming obsolete.
There are certainly opportunities to buy core, or mixed-use assets, which many investors are drawn to because of the anticipated steady cash flow. Buying stabilized assets will, in concept, produce lower returns than participating in construction, but with much less execution risk, and many investors find the trade-off acceptable.
Value-add opportunities in mixed use — “fixing” or updating poorly executed, poorly operated, aging or misunderstood assets — may be particularly attractive to investors with some appetite for additional risk compared to acquiring stabilized mixed-use assets but without the construction risk and sometimes entitlement risk of new development.
Mixed-use buildings are hard to design, hard to build and hard to operate. This results in a higher frequency of underperforming assets than with single-use construction. The talented investor can find, even in today’s high-priced market, assets that are flawed but remediable, with strong near-term upside potential both in income and valuation if the performance gap can be closed.
The dislocation in the retail industry today is both an added risk and an opportunity, particularly in urban markets where tenancies and customer dynamics have changed faster than the buildings themselves in many cases. Similarly, parking is an important revenue-producing component in many mixed-use buildings, and talented investors can fix or enhance the revenue from under-managed, poorly designed or badly marketed parking, adding considerable value to the asset with limited investment, and in a short period of time.
Mixed-use assets also present opportunities to generate strong returns by changing the mix of uses. For example, an asset with a large component of underperforming, or just unleased, office space can often be repositioned as residential, or repositioned into a different office format — creative or shared office, for instance.
Finally, there are opportunities for converting single-use buildings into mixed-use, ideally achieving both the revenue upside and the value enhancement described above. Adding ground-floor retail, creating differentiation in the residential mix, combining assets to add parking to an under-parked asset are examples of this. Not easy to do, but there is an increasingly broad array of talented developers/owners/operators who have the expertise to do it and a track record of doing so that investors can underwrite.
HOW TO INVEST IN MIXED-USE
Finding the right investment vehicle or entry point for mixed-use is challenging. Opportunities to gain access to the asset class through REITs and other traded vehicles are still limited. While some publicly owned developer/owner/operators do mixed-use, most continue to be single-use focused (apartment, office or industrial, for example) which Wall Street still prefers.
The space lends itself particularly well to direct investing — particularly development or value-add strategies — for large investors that can identify and manage investments with the sponsor (developer) without an intermediary. Mixed-use investing is capital competitive, like all assets today — but some institutional capital is still not compatible with the complexity of mixed-use development or repositioning, leaving strong opportunities with large private investors, clubs, family offices and so forth.
The key difficulty with the direct investing approach is that the universe of developers doing this work is limited, many are already well capitalized, and while there are smaller or emerging property companies moving into this space, new players are inherently harder to underwrite.
Many talented mixed-use developer/owner/operators offer comingled fund vehicles, which provide investors of a wider range of investment size access to this asset class. These fund vehicles provide opportunities to invest with a seasoned practitioner without intermediaries, and to achieve some asset diversification. The limitation is that most of these funds are discretionary, leaving the investor little input to the execution of the strategy or the specific investments undertaken.
Many, although certainly not all, mixed-use owner/operators are regionally focused, which provides some concentration risk, but may be attractive for investors interested in focusing their investments in key markets or their local market. Many of these fund operators function like “local sharp shooters,” which is a compelling orientation for mixed-use.
Large investment management companies with an “allocator model” also provide access to this asset class. While most do not have dedicated mixed-use investment vehicles, there are fund style investment opportunities that will heavily weight mixed-use assets, and this is likely to become more widely available in years to come.
These vehicles provide access to the space at a lower dollar entry point, and because funds will be invested with a wider array of developer/owner/operators, there is some sponsor diversification, which may (or may not) be appealing to investors. The potential downside of these vehicles is that the fee load can be considerable.
At a smaller level, many of the crowdfunding vehicles include mixed-use assets, and this provides an interesting opportunity for smaller capital providers to target and select specific assets with a lower commitment level. Although this approach does not provide the professional asset management, underwriting and oversight that the above vehicles provide, it can be a fun way for enterprising investors to begin engaging with assets of this type.
Investors, particularly those with a long-term view, can generate compelling returns and predictable current income by investing in mixed-use assets. No longer esoteric and more accessible even to smaller investors through new and evolving investment channels, mixed-use provides an attractive additional real estate investment opportunity, particularly for the sophisticated investor interested in participating in the creation of vibrant urban places.
Adam Ducker is a managing director at RCLCO (formerly Robert Charles Lesser & Co.)