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Mixed-Use Developments

6 min read

The Juice is Worth the Squeeze

In affordable housing and community development, nothing seems to captivate planners, developers, community advocates and government officials more than a proposed mixed-use development. Visions of welcoming coffee shops right next to convenient and carefully curated grocery stores and boutiques and neighborhood retail abound. Maybe there is office space or co-working space on the ground floor of a multifamily building. Many issues must be considered in the creation and financing of mixed-use development; however, mixed-use is not for the faint of heart but the rules can be worth navigating to make the most of a real estate opportunity. 

What is Mixed-Use Development?
Generally, a project may be classified as “mixed-use” if it provides more than one use or purpose within a shared building or development area. Mixed-use projects may include any combination of housing, office, retail, medical, recreational, commercial or industrial components. There are also more sophisticated definitions. For example, the Urban Land Institute’s Mixed-Use Development Handbook characterizes mixed-used development as one that 1) provides three or more significant revenue-producing uses (such as retail/entertainment, office, residential, hotel and/or civic/cultural/recreation); 2) fosters integration, density and compatibility of land uses; and 3) creates a walkable community with uninterrupted pedestrian connections. Often, “mixed-use” is used interchangeably with “mixed-income,” but that is not really the same. Mixed-income refers to the targeted income levels of the intended residents not the different uses of the real estate (i.e., having market-rate renters and renters that satisfy certain affordability restrictions). There can be horizontal mixed-use projects, which consist of single-use buildings within a single development with different land uses within the project, or vertical mixed-use projects, which combine different uses within the same building with more public uses on the lower floors and more private uses on the higher floors. 

Can I Do Mixed-Use Developments with Low Income Housing Tax Credits?
Of course! The short answer is yes, this is easier in the horizontal mixed-use context, but it can also be done in the context of a vertical mixed-use project, where there might be retail on the ground floor and residential units on the upper floors. Particularly in a vertical mixed-use project,  there will be some structuring involved in the ownership and financing of the project(s). You should definitely expect the possibility of ownership structuring, to minimize the risk of loss of tax benefits to the investor. If you mention ‘mixed-use’ development to your investor and/or investor’s counsel, you should expect a flurry of questions to follow: How much will the non-residential portion of the building cost? How much space will be non-residential? How much income will be generated by the non-residential space? 

These questions are important because the Low Income Housing Tax Credit investor is looking to invest in ‘residential rental property’ under Section 168 of the Internal Revenue Code, as this determination will impact the losses/depreciation that an investor may be allocated and the investor is looking to maximize eligible basis. Generally, pursuant to Section 42 of the Internal Revenue Code, no more than ten percent of a building’s eligible costs are able to go towards constructing commercial space in a LIHTC project. Section 168(e)(2)(A)(i) provides that the term ‘residential rental property’ means any building or structure if 80 percent or more of the gross rental income from such building or structure for the taxable year is rental income from dwelling units. Section 168(e)(2)(A)(ii) provides that the term “dwelling unit” means a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel or other establishment more than one-half of the units in which are used on a transient basis. After the questions, you should expect your investor to “suggest” creating a condominium regime or structuring a master lease.

Where Real Estate Law and Tax Law Meet
So what is a condominium regime? What does that mean? A condominium means a common interest community in which portions of the real estate are designated for separate ownership and the remainder of which is designated for common ownership solely by the owners of the separate ownership portions. Or said another way, a condominium regime is an ownership regime in which a building is divided into multiple units that are separately owned with individual units that are surrounded by common areas that are jointly owned and managed by the owners of the units. By creating a condominium regime, the residential portion of a mixed-use project can be isolated from the commercial component, thereby reducing or eliminating the risk that the project will not be classified as a residential rental property. So the vertical mixed-use project will have more than one owner. For example, a building may have a ‘residential unit’ and a ‘commercial unit,’ where the tax credit project is the residential unit. State laws vary on when and how a condominium regime is created, and this will impact collateral requirements for mortgage loans and the recording order for recordable closing documents. 

Another way to manage the residential rental property risk is to structure a master lease, where an affiliate of the developer becomes a master tenant of the project owner, and then, in turn, leases space out to the end users. With this structure, the gross rent income for the project attributable to non-residential uses can be limited or managed. There is, however, a balancing act, in that a developer may also want to maximize that rental income so as to increase the size of the mortgage for the project.  

More to Think About
In addition to some of the technical tax requirements, there are a number of underwriting and valuation concerns to think about in undertaking a mixed-use development. Are the uses compatible or complimentary? Are the uses even allowed? Some investors will provide a list of prohibited uses to protect the character of the project and meet regulatory requirements. Will one use underperform and create a drag on the entire project, or will a use be successful and impact your intended exit strategy? What about parking? How will maintenance and operational costs be shared between various condominium owners? 

With all these challenges, there may be some real trepidation, but a good mixed-use development can boost the profile of an entire neighborhood and kickstart much-needed economic development. So, the juice may be worth the squeeze with some detailed planning and the right market.