The Shady Grove Music Fair near Gaithersburg, which plans to close after this summer, will be converted into a $10 million shopping center, officials of Western Development Corp. said yesterday.

Plans are to remodel the 5,000-seat theater in the round into a multi-screen movie theater and restaurant, said Herbert S. Miller, president of Western Development.

Three restaurants are planned, adjacent to the theater, one of them possibly a dinner theater, he added.

A shopping complex with a supermarket, drugstore, shops and possible offices, is planned on the 16-acre site. Completion is set for fall 1979.

The producers of Shady Grove announced a month ago that they were closing the theater after this season because the commercial productions could not compete with subsidized performances at Wolf Trap Farm Park and the Kennedy Center.

Opened as a summer tent theatre in 1962 and converted into a permanent year-round facility five years later, Shady Grove was once a preemient music house, with top stars and reecent broadway musicals.

Year-round operations were rarely successful however, and Shady Grove has been "suffering very heavy losses over the past three years," said Shelly Gross, coproducer with partner Lee Gruber.

Gruber and Gross also are closing their Painters Mill Music Fair in Owings Mill, near Baltimore, because the two theaters "just can't compete anymore."

Miller said plans are to capitalize on Shady Grove's reputation as an entertainment center by making a restaurant and theater complex the heart of the new development.

Western Development has agreed to acquire the property from Eig Enterprises Inc. and Mr. and Mrs. Thomas Oyster, the owners.

With direct access to Interstate 270, the Shady Grove site is a prime development location and one of the largest undeveloped commercial properties in the Rockville-Gathersburg corridor, Miller said.

The land is zoned for commercial use, and developers plan to make their proposals soon to Montgomery County planners.

About 160,000 square feetof buildings and 800 parking places are planned for the 16 acres. Retail stores and offices will occupy about 100,000 square feet; restaurants and the 30,000 square-feet theater, the remainder.

Turning the circular theater into a movie comples will require major renovation, including a new facade, but the high, free-span space will allow for innovative architectural work, Miller said.

If government approvals can be obtained, construction will begin after the end of summmer season, with the completion a year later.

Western Development is a Washington company that specializes in developing retial and industial complexes in medium-income and upper-income areas. Among projects it now has under way are the Great Falls Shopping Center in Virginia, the multi-million-dollar Goergetown Park retail-residential complex at Wisconsin Ave. and M St. NW, the Northern Virginia Industrial Center in Dale City and an office building at 19th and K Streets NW.