Retailer Leasing Strategy for a Wired World
The Real Estate Transformation Group
Property Strategies for the Information Agesm
Submitted to The Journal of Applied Real Property Analysis on February 2, 1998.
Copyright © 1998. All Rights Reserved. Mark Borsuk.
The advent of online shopping creates a dilemma for retail property owners and merchants over the value of location based shopping. In several years a third of US households will be able to buy an ever widening selection of goods and services online. Retailers must meet the consumer in Cyberspace. A marginal shift of sales online will disproportionately impact store profitability. The third sales channel requires radically altering location based merchandising strategy by reducing stores and store size. Retailers need to significantly cut the length of leases and maintain flexibility with multiple short-term options along with having early termination rights. The death of distance impact rents. Changing geocentric shopping habits also affects property values. Retail property owners and tenants should welcome the creation of a trading market for leased space.
Table of Contents
I. Online shopping's impact on retail leasing.
Online shopping is not a new idea, nor is speculation about how it would impact retailers and space demand. What is new is how quickly it is going to impact retail property. Until recently it was an over the horizon issue but now it is in view. The rapid diffusion of INFOTECH into daily life has compressed the time for merchants to change how and where they sell.
At the start of the millennium, just two years away, real property investors and lenders will confront a radically changing demand milieu for retail space brought about by the popularization of online buying. Strategically and financially having an online presence makes sense for retailers. This will require restructuring the sales channel away from location based selling.
Stores will not disappear but merchants will question their preeminence as the most productive sales channel. Recognizing the need for a cyberpresence will be an epiphany for many retailers and cause them to question their leasing strategy. A very different leasing strategy will emerge.
INFOTECH diminishes location based selling's advantages and shifts the balance of negotiating power to the tenants. 1 Merchants will require far shorter lease terms, with multiple options, and expanded early termination rights. Landlords who understand the structural change ahead will accommodate tenants but at a cost. Investor and lender expectations will also undergo a significant change. INFOTECH's widening influence requires new techniques for evaluating retail tenants and for finding ways to transfer the risk of owning and leasing retail space.
II. Information technology is driving structural
INFOTECH reflects the Zeitgeist. INFOTECH is the integration of computer hardware, software, computer networking and telecommunications into daily life. It became a mass market phenomenon around 1994 with the commercialization of the Internet, the availability of powerful home PCs, laptops and easier software. Rapidly falling prices, greater capabilities and the Internet's popularity continue to strengthen INFOTECH's influence on society. One consequence is impacting commercial space demand.
INFOTECH severs place from activity. Work no longer needs a workplace and shopping no longer needs a shop. The shift to online shopping should not come as a surprise. The Harvard Business Review carried an extended article on the topic in 1967. While not directly addressing the impact on real estate, it forcefully argued the benefits of a telepresence. 2 In 1982, retailers were urged to use scenario planning that considered the possibility of online shopping in store location decisions. 3 Despite these prescient studies, it is only in the last few years that geocentric shopping habits have been seriously questioned. 4
Around 1996 consumers saw the value of online shopping after the complementary technologies coalesced. This is not usually the case with many new inventions and technological breakthroughs since they lack clearly defined applicability. 5 Today, INFOTECH offers an order-of-magnitude gain for consumers in life-style choice and convenience. This is especially true for time spent on non-recreational shopping.
The consumer benefits of INFOTECH have far reaching consequences because of the network economies of scale. 6 As more people get wired, the informational attributes associated with goods become separated and distinct from the physical good. It makes shopping less rewarding when product and price comparisons are available online along with the ability to purchase. The networked economy will significantly transform the interaction between retailers and customers along with the requisite space demand.
III. INFOTECH's consequences for retail property.
INFOTECH's ubiquity has first, second and third order consequences. See Exhibit A. The first order consequence is a change in consumer geocentric shopping habits. The second order consequence occurs when retailers either lead or follow their customers online causing a migration of in-store sales to Cyberspace and hurting individual store performance. Once recognized, merchants will radically alter their sales channel matrix. This will include changing leasing strategy. The third order consequence will impact rental rates, property values, and lender and investor expectations. Landlords seeking tenants will need to evaluate them in a new way. Property owners must consider the adaptive reuse potential of their properties. The cascading consequences reflect the unique characteristics of information technology and its rapid diffusion through American society.
INFOTECH's Impact on Retail Space Demand
IV. INFOTECH's impact on consumer habits and expectations.
Radio is an example of how information technology changes society and consumer expectations. 7 Military applications were one of the early ideas for using radio. Likewise the military designed the Internet to withstand a nuclear attack on the communication infrastructure. The early enthusiasts for radio were hobbyists. Likewise, the early users of the Internet were academics and computer enthusiasts. The standardization of parts and protocols created the 1920s' "radio mania." This led to the development of a national market for consumer products, along with homogenizing the culture and world view. By the 1980's the online world was developing and became a mass market in the mid-1990s. Email addresses and Web pages are de rigueur. Communicating with people worldwide and having previously unimaginable information readily available are creating expectations about what can be done in a wired world. One changing expectation is where and when to shop.
The advent of the automobile is an example of technology displacing one form of activity with another. In less than fifteen years automobiles displaced horses as the primary means of transportation. 8 See Exhibit B.
While mechanical innovation transformed activities over years and decades, information technology can quickly displace existint practices. The Pony Express and silent movies are examples. The telegraph replaced the Pony Express in nineteen months 9 and the talkies decimated the silent movie industry within two years after commercialization. 10 In each case there was a rapid and immediate acceptance of the transformation.
How fast do high-tech products and services permeate the society? Exhibit C shows how quickly households adopt information technology once the technology becomes commercially available. It took radio eight years and TV seven years to become resident in thirty-five percent of households. Thereafter, it only took radio eight more years to reach seventy-five percent of the households, and TV made the jump within five years. 11 Radio and TV represent broadcasting, a one-to-many technology. The disadvantage, unlike the phone, is that one listener or viewer can not interact with another listener or viewer.
Unlike radio and TV, the Internet is a network. It is a one-to-one, one-to-many, many-to-one, or many-to-many information medium. More importantly it is a self-reinforcing network for users. To participants its intrinsic value is apparent. Metcalfe's Law defines the value of a network by stating the value of a network increases exponentially as the size of the network grows arithmetically. For example, when the Fax was gaining popularity only a small annual increase in connected units was necessary to double the value to users.
Currently, eighteen percent of households are online. 12 Thirty-six percent will be online in 2000. 13 Put another way, it will probably take seven years for the Internet to go from early adopters to becoming a household appliance. Further, if online use parallels TV's diffusion it would only take nine years to reach fifty percent of households. Exhibit D lists some important individual user characteristics. 14
Currently, PC households represent 43% of total households. 15 Almost all new PCs come with a modem and software for connecting to the Internet. PCs priced in the $800 to $1,000 range are expanding the market. Between 1996 and 1997 there was a 22% increase in PC households. This is the Model T-ization of the home PC. It is an information appliance. Services like WEB TV will accelerate the trend. In addition, the use of cable TV for Internet service is likely. Approximately sixty-five percent of households have cable. 16 The cumulative impact of these and other developments is to quickly drop the admission price for entering the online world.
The Internet's penetration beyond fifty percent of households is problematic. A large segment of the population will not find the wired world compelling or useful. They are the Sidelined Citizens numbering seventy-one million. 17 This is not surprising since many will remain satisfied to go shopping, contact others by phone instead of email, bank in person or by mail instead of online, and meet face to face instead of joining a virtual community. Thus, the impact of a wired world will be negligible for a number of retailers but for many others it will create techno-turbulence.
V. INFOTECH's influence on life-style.
INFOTECH allows work to be done without a workplace. In simple terms many people now carry their office in the form of a portable computer. The "office in a box" gives them all the necessary flexibility, power, and connectivity they enjoy at their desktop PC. INFOTECH's inexorable move to cheaper, smaller and more powerful computers preordains location freedom for many workers. By allowing employees greater choice of where and when to work, corporations benefit from the trend of nomadic work.
Telecommuting, in its broadest sense, is a life-style option whose time has come. There are approximately eleven million telecommuters 18 who are no longer forced to waste time commuting when the work can come to them. Competition for knowledge workers and bottom-line business considerations require employers to offer this amenity. 19
The INFOTECH enabled remote work option has important implication for online shopping. While telecommuting is available only to a minority of workers,20 those who are office bound will nevertheless expect an Internet connection in the cafeteria, break room or at their desk. They will expect to be wired.
Individuals and families having "time-stressed" life-styles are a key group of potential online shoppers. They have little time to accomplish what they desire. However, time pressure extends beyond urban professionals into the general population of singles and two income households.
On the maintenance-leisure continuum, maintenance/restocking shopping is more inconvenient than pleasurable. This sets the stage for a reaction against the "automobile as human prothesis" life-style characteristic for most people. Reducing travel time by shopping online would fulfill one important goal for them. This stands the location mantra on its head. In other words, the premium location off the interstate exit becomes less convenient than buying online. It also appeals to those people who can not match their schedules with store hours. AOL reports forty percent of member shopping takes place between 10:00 p.m. and 10:00 a.m. 21
The perceived lack of time may be attributable to the growing integration of work and leisure into a "seamless web" with all the attendant problems and conflicts, like taking a laptop on vacation or relying on day care. 22 Not surprisingly, women feel more stressed than men, and stress rises with income and education. 23 The availability of useful shopping sites online will rapidly accelerate the diffusion of online buying into the home, especially for higher income and educated consumers. Their migration online presents an attractive incentive for traditional retailers to get online.
Also consider "me-time." Me-time represents the time-stressed individual's effort to buy back time taken up by unfulfilling activities like non-recreational shopping. 24 Those seeking more "me-time" may very well pay a premium to receive goods and services delivered to the home like groceries [www.peapod.com] or by ordering movie tickets online [www.moviefinder.com. . The emergence of "me-time" reflects a life-style choice now available online for a growing array of products and services. While in the past, many goods and services could be ordered by phone, it was largely an urban phenomenon offered to a few. Online shopping offers it to many.
A collateral aspect of the time starved debate is how online usage impacts TV watching. One explanation for the general sense of lack of time is that the quantity of TV viewing restructures daily life. 25 This greatly benefits advertisers and retailers. However, a counter trend is emerging. Online usage is crowding out TV viewing time. 26 This has important implications for the marketers of goods and services.
INFOTECH fosters remote work and online buying. INFOTECH also unleashes very powerful forces that challenge present thinking about where people go and how technology influences activities. The post-WWII history of movie theaters offers an interesting preview of how INFOTECH could impact retail space demand.
Movie theaters declined by sixty-four percent from 1948 to 1992. However, almost eighty percent of the decline took place within fifteen years from 1948 to 1963. Another way to illustrate the decline is the fall in inflation-adjusted ticket sales. Between 1951 and 1961 sales declined by 38% from almost eight billion to five billion dollars. In 1981, twenty years later, ticket sales were roughly at the same level. 27 See Exhibit E.
Decline in Movie Theater Facilities
Source: US Census of Business, US Census of Service Industry. Data for movie theaters with payroll, excludes drive-ins. SIC code 7832.
The fifteen years from 1948 to 1963 also saw the explosive growth in TV households. Household ownership went from less than 1% in 1948 to over 90% in 1963. 28 TV did not replace the movies but it had a profound impact on patronage leading to a pronounced decline in the number of locations. Despite a revival in movie attendance it is not difficult to still find abandoned theaters in the cities and older suburbs.
The other factor working against movie theaters was the audience's sustained migration to the suburbs.29 In the present context, this past demographic shift could be analogized to the declining need to physically shop for goods and services.
The experience of movie theater landlords should raise concern about how quickly technological and demographic changes can shift the demand for space. But could it happen to retail space?
Some important prognosticators are already suggesting it can. The 1998 issue of Emerging Trends in Real Estate, a major bellwether of institutional sentiment, devotes substantial space to explain the Internet's impact on retail property demand. 30 Reading between the lines, Emerging Trends is speculating the merchant's former geographic advantage diminishes with the advent of the third sales channel. The interesting point is that the commentary appears before similar concerns from retailers, securities analysts and lenders.
State and local governments are another constituency fearing the migration of sales from their jurisdictions. They stand to lose retail sales tax revenue. 31 This tax generates almost 50% of state revenues. Dependence on retail sales taxes has distorted municipal finance by encouraging the over-concentration of retail without regard to the longer term consequences of developing a sustainable tax base.32 Currently, there is before Congress legislation seeking to prevent or restrict state and local taxation of retail transactions. 33
Will a change in work and home life accelerate the migration of customers online? Is the "smart money" overreacting to a perceived change in geocentric shopping habits? Should the retail sales tax dependent governments be tightening their belts? What forces are pushing retailers to change their sales channel strategy?
VI. Online shoppers and online buying.
The popularization of online shopping depends on a number of interrelated factors coalescing: a broad array of competitively priced merchandise, a large customer base, security, and merchant participation. A powerful constituency is actively promoting resolution of the remaining barriers to establish a robust buying environment. In addition, a number of "killer apps" are emerging to spur consumers online. In 2000 all these interrelated events will converge. Exhibit F entitled A Future History of Online Shopping is indicative of what lies ahead.
The scope of what sells in Cyberspace is evolving. Using today's technology maybe a third of goods and services work. It is useful to imagine moving along a continuum when thinking about what will work online. On one side there are commodity goods like toilet paper, Heinz catsup, and HP laser printers, moving all the way over to unique items like a sable fur coat. Commodity goods and services mainly sell on price with very little value added by the retailer. Increasingly, retailers will have an incentive to move these items to Cyberspace. At the other end of the continuum are the retailers who offer items requiring aesthetic, tactile and kinetic judgments necessitating physical presence. The continuum acts as a screen for anticipating what others perceive as working online.
Another way to look at what works online is to consider self-service shopping. The absence of a sales person to offer guidance and opinion covers a broad spectrum of goods and services. Self-selection also suggests that many things sold in self-service stores could work online.
Goldman Sachs developed an "Internet Retail Index" to rank merchandise categories for their online sales potential.34 Categories with the highest potential were books, music, software, prescription drugs, computers, electronics and office products. Those considered to have the least current potential for migrating online were home furnishings, specialty apparel, auto parts, department stores, off price apparel, variety discounters and perishable food. The Goldman Sachs taxonomy parallels the continuum analysis and the author's tenant screen 35 with one important exception: apparel. If apparel works in catalogs it will work online. In 1996, three of the ten largest catalogers ranked by sales sold apparel: J.C. Penney [www.jcpenney.com], Spiegel [www.spiegel.com] and Lands' End [www.landsend.com] . 36
There is no evidence women will not shop online. However, there has been a significant lag in women going online. Presently, the ratio is about 58-42 favoring men.37 One explanation for fewer women online is an insufficient quantity of content for women's interest. The situation is rapidly changing as magazines and Internet developers provide content. 38 Over the next several years the gap will close. 39 However, gender parity is not the critical issue for retailers but rather, the ratio of buyers. This has more importance since women make many of the purchase decisions and do most of the buying.
The risk of consumer credit card theft is minimal over the Internet. 40 Nevertheless, consumer concerns remain. The SET ("Secure Electronic Transaction") protocol introduced last year by VISA and MasterCard will overcome public doubts by adding additional protection above SSL ("Secure Sockets Layer") encryption commonly found in web browsers. In addition, in 1998 digital certificates integral to the SET security system for consumes and merchants will begin circulating. Another issue is the ability of credit card associations and the other financial intermediaries to indirectly accelerate growth of online shopping by adjusting merchant charges and other fees to reflect the lower risk of SET purchases and possible operational efficiencies gained by online transactions. 41
Experience suggests online shopping will not affect store sales just as catalog shopping did not appreciably impact store sales. The historical record supports this view but it will be a faulty guide to the networked economy of the Information Age.
The Direct Marketing Association, a trade group, estimates catalog orders are about 4% of total consumer sales. There is very little evidence that catalog shopping has cannibalized store sales.42. Rather, anecdotal evidence suggests the reverse: catalog sales help target future locations. However, when examining whether online shopping has a propensity to cannibalize store sales, each retailer's product category and customer profile requires assessment. It is misleading to analyze aggregate numbers.
Retailers should review the Morgan Stanley research report. The study suggests the growth of mail order is a reasonable proxy for the growth of online shopping volume. In discussing the impact of innovative retail concepts (category killers, catalogs, and home/TV shopping), the analysts could not decide whether online shopping would have an impact on how retailers do business, i.e., store based retailing. 43 But they suggested Internet retailing could grow 3-5 times faster than mail-order. 44
There are three attributes that set online shopping apart from catalog shopping. These attributes create a fundamentally different experience for shoppers in ways not possible in the store or from a paper catalog.
Community is the first attribute that distinguishes the online world from catalogs. Retailers need to familiarize themselves with the virtual community concept popularized in the book net gain. 45 Net gain is a blueprint for the commercial online business model. In essence, community means adding value for the customers who become active participants. The virtual community concept is rapidly gaining support among academics, analysts, consultants and practitioners. 46 The online book seller, 47 On the negative side virtual communities will likely reduce margins. 48
Other examples of virtual communities are PikeNet [www.pike.net] and Auto-by-Tel [www.auto-by-tel.com]. PikeNet is not a retail site but a service site for the commercial real estate community. It offers marketing and analysis tools for commercial real estate brokers, analysts and investors. The site naturally leads to networking and may ultimately become the precursor for a national multiple listing service. Auto-by-Tel offers automobile buyers pricing and product information, side-by-side comparisons, expert opinions, user input, links to other useful sites and feedback from purchasers. Why should the buyer go anywhere else to start looking? This is an example of how the community can provide immediate and useful information.
Links to other useful Web sites strengthen the sense of community. For example, Amazon.com and Barnes & Noble pay a commission for becoming the exclusive book store on their partners' sites. It would be similar to a rock climbing club receiving a commission every time one of its members purchases a book from a specific book store. Another form of community service is L.L. Bean's [www.llbean.com] link to National, State and local parks. The site contains significant information on each park along with L.L. Bean's clothing and accessory recommendations. The essence of community validates Metcalfe's Law. No paper catalog is able to create the positive feedback customers have when connected to an virtual community.
The second attribute is selection and information content. Amazon.com offers a selection of in-print books vastly larger than any Barnes & Noble superstore. Auto sites like Auto-by-Tel can provide more specifications and ancillary information than any dealer or side-by-side comparison. Travelocity [www.travelocity.com] provides the lowest air fare quickly without human intervention, and tickets may be purchased online. These and hundreds of other sites give consumers the necessary information to make intelligent product comparisons and purchase decisions. The online world breaks the manufactures and retailers' strangle hold on information and shifts power to the consumer.
The third attribute is custom marketing and customer service. Once a customer places an order or provides an email address, the retailer can anticipate the customer's requirements by analyzing her shopping pattern. Just remembering a customer's last purchase is a desirable feature. The merchant's site can alert the customer through email of new items likely to appeal to them, special discounts, promotions or order opportunities, and myriad of other suggestions likely to appeal to the customer. Customers can express their preferences in surveys, contests and discussion forums all done online. This becomes a valuable source of marketing data leading to product differentiation and value added. The paper catalog pales in comparison to the immediacy of the response and impact customized marketing can have on customers. In addition, handled properly, the interaction strengthens the customer's sense of community.
The unique nature of online shopping demonstrates the danger of comparing the online world to the catalog experience. 49 Rather, the evidence strongly suggests online shopping has the attributes for driving sales out of stores. Further, as traditional catalogers move online, consumers will begin to expect the same from retailers. In a perverse way, the traditional catalogers who had little impact on store sales may train their customers to shop outside the store. This would be an example of the law of unintended consequences at work.
E. Killer apps spur shopping.
The usefulness of the Internet increases as new services come online. This in turn spurs others to join and the cycle repeats itself. Killer applications ("killer apps") are services that meet a widely perceived and unmet need. Online shopping benefits directly from the development of killer apps. Examining several potential killer apps demonstrates the Internet's virtuous cycle: offering useful services thereby increases its value to participants and encourages more to join.
Probably the killer app with the widest appeal for consumers is "bill presentment", an electronic bill paying service through banks or other intermediaries. 50 This market is attractive for Microsoft and Netscape 51 since bill presentment is a powerful inducement to get wired.
Another potential killer app is grocery shopping. Several services are providing perishable and non-perishable items in selected areas like Boston, Chicago and the San Francisco Bay Area. Some people swear by them and seventy-five percent of the members are women. 52 Andersen Consulting's association with ShopLink indicates the potential for the online grocery business. 53
Automobile shopping is one killer app being promoted by manufacturers to meet widespread consumer dissatisfaction. Many no longer wish to play "let's make a deal" at the dealership. 54 Chrysler predicts one in four customers will buy cars over the Internet within four years. 55 Women are especially happy with the change since in too many instances they are not treated as equals.
INFOTECH is drastically accelerating the pace of change. In the last four years the Internet grew explosively. There was a rapid increase in wired consumers and a sense of a cultural shift taking place. Today, Web and email addresses are a normal part of radio and TV broadcasting. Newspapers and magazines carry them in advertising and as part of the format. In summary, there are powerful political, economic and cultural forces pushing to make the wired world work.
In 1998 online shopping will go mainstream as it hits the tipping point. The tipping point is the threshold after which gradual increases turn into an epidemic.56 Over the next several years there will be a rapid increase in online shopping as more households become wired, use credit cards over the Net, and find a huge selection of goods and services available along with communities of interest. 57
In the year 2000 online shoppers will tell their friends, "How did I live without it!" The online world will be a mass market phenomenon with online shopping considered a "routine activity." Exhibit F A Future History of Online Shopping suggests the trajectory for online shopping.
A Future History of Online Shopping portrays how events could unfold over the next three years that would bring a vast number of consumers online thereby shifting sales from space to Cyberspace.
VII. Online shopping's impact on store economics.
The transition year for retailers getting on the Web is 1998. Last year traditional retailers like Wal-Mart, The Gap, and Barnes and Noble came online. Many other quality retailers will join the "me too" stampede. They are no longer holding back because of the belief there would be few consumers online. This year represents the time for the "me too" retailers to seek first mover advantage, if still available, and build brand name awareness.
Opening up the third sales channel presents retailers with a potential dilemma. If they try to maintain competitive advantage by getting online, they risk cannibalizing store sales. There are two interrelated concerns. First, does offering merchandise online cannibalize in-store sales? If so, to what extent will sales migrate? Second, what does the growth of an online customer base portend for locating additional stores in existing trade areas and stores in new areas?
As noted previously when examining whether online shopping has a propensity to cannibalize store sales, each retailer's product category and customer profile requires assessment. It is misleading to analyze aggregate numbers for retail sales. The question is: where does the selection of goods and services fall on the continuum, and what is the propensity of the retailer's customer to shop online?
Past experience with catalogs shows adding a second sales channel did not noticeably retard store sales and was useful for selecting new locations. What will be the impact of adding a third sales channel? If few consumers shift their buying online or they substitute online for catalog shopping, then there is likely to be little if any migration. However, the interactive nature of online shopping is a far different experience than catalog and in-store shopping. It is likely consumers will shift a portion of their purchasing both from stores and catalogs to Cyberspace.
Retailers know the shift need only be marginal to impact store profitability. In 1997 at the ICSC Research Conference a presentation entitled Are New Store Sales New?: How The Department Stores Assess Sales Transfer And Incremental Sales Gains discussed the loss of sales either from new competition (sales diversion) or by adding another store in the trade area (sales transfer). Sales transfer is the polite term for cannibalization. One analysis of cannibalization suggested that a mere seven percent shift in store sales could drive down profitability by almost fifty percent. The sluggishness decline of variable costs as sales fall is one explanation for the dramatic change in profitability. Analysts following retail stocks also recognize the impact on store profitability of migrating sales. 58 If online buying is in effect the equivalent of sister-store migration, then a shift of sales online will have a noticeable impact on store performance.
Even expanding sales for the retailer does not necessarily negate the impact. The natural growth of retail sales, i.e., retailing is not a zero sum game, could initially mask the online effect. However, if a growing share of the sales increase flowed online, then store performance would likely suffer.
Closely related to the marginal sales shift dilemma is the increasing difficulty in locating or repositioning stores in a wired world. The fundamental assumption for site selection relies upon Reilly's Law of Retail Gravitation and subsequent refinements.59 Reilly's Law assumes consumers have a preference based on a number of factors for traveling to one location over another. This is a spatial world model, not a wired one. Online buying from home or work requires no travel decision. Rather, the influences of mindspace, site branding and convenience exert themselves in the decision. The greater the propensity of customers to shop online, the less useful spatial analysis. 60 Today, retailers making location decision need to consider the wired shopper.
In the early stage of online shopping going mainstream, how will retailers know if their customers are online? They need to move beyond demographics and psychographics to technographics. Technographics reflects a person's propensity to accept and use high-tech products and services. Since getting online by PC or TV is the "sine qua non" to entry into cybershop, knowing a given population's willingness to embrace INFOTECH is critical. For instance, retailers whose customers are wired are more likely to consider shopping online than those who do not have access either at home or work.
Today's demographic and psychographic data broken down by zip code or trade area will not provide the necessary information. This gap in knowledge will send the wrong signals to those analyzing the placement of new stores and repositioning locations. The customer data market is not offering this critical information.
It is possible by analyzing telephone service areas to develop an estimate of the online population within a specific geographic boundary. The first three digits of the seven digit local phone number correspond to a service area. The estimate requires knowing the total number of modem connections (dial-up ports) for each Internet Service Provider (ISP) and the ratio of ports to users. The next step requires contacting the ISPs to learn the number of POPs (points of presence phone numbers) they maintain within each area code and the number of non-dedicated phone circuits assigned to each POP number. Analyzing the above information yields the potential number of online users within a defined area which retailers can use along with their traditional demographic data to plan sales channel strategy. For example, it could help them decide whether to open a new store, add another store within the same trade area or to downsize an exiting store into a different format.
A portion of the information is publicly available in Boardwatch Magazine [www.boardwatch.com]. Boardwatch lists ISPs nationwide by area code. There are over 4,000 ISPs in the US and Canada. Developing market intelligence about local concentrations of online users is critical to reaching the estimated 41.9 million shoppers online in 2001 61 and selecting the most profitable channel mix.
The interrelationship between store economics and technology orientated customers has ominous implications for retailers without an online presence. They face the prospect of losing sales to their competitors in Cyberspace and having sales migration erode individual store performance. Retailers moving online also face the prospect of cannibalizing their own store based sales and performance. Finally, whether traditional retailers go online or not, they face significant competition from stealth competitors.
VIII. Stealth Competitors.
Stealth competitors are a new phenomenon in retailing. 62 See Exhibit G. They come out of nowhere and capture mindshare (attention). Retailers lacking a presence online can easily be blindsided by stealth competitors who can quickly neutralize the value of location and exert pressure on prices. 63
B. Stealth-A competitors.
Amazon.com is one of the most successful stealth competitors. It competes directly with Barnes & Noble, Crown Books, and Borders but has no physical presence. The lack of real estate, store employees, almost no inventory and other cost savings provides a tremendous competitive advantage. Morgan Stanley's Internet Retailing Report contains an important case study for retailers on the guerrilla war raging between Amazon.com and Barnes & Noble. Their struggle receives continual financial press coverage and is a cause célèbre for online merchants.
The conflict between Amazon.com and Barnes & Noble offers important lessons for retailers. One is stealth competitors immediately begin lowering prices. If the retailer seeks to match the stealth competitor, it can lead to a price cutting death spiral. Established retailers seeking to meet the new price online create pricing discrepancies between their stores and Web sites. This gives customers an incentive to shop online hurting store performance. Stealth competitors also steal market share. First movers capture mindshare that may not be easily recaptured by established merchants, especially when they sell commodified goods and services. These are some of the potential disadvantages for retailers who delay getting on the Web. However, it gets worse.
To date, stealth competitors have been undercapitalized raiders, relying on their wits and new technology to challenge established, well capitalized retailers They are the Stealth-A competitors. However, what happens when established retailers like Wal-Mart enter a new market, leveraging their brand name equity, technological skills and merchandising prowess to become a formidable competitor overnight. They are the Stealth-B competitors.
Another stealth competitor is membership organizations like netMarkets [www.netmarkets.com]. netMarkets aggregates products and services, sells at a very low mark-up, has manufactures ship directly to members and thereby negates the need for holding inventory. 64 Like COSTCO in the physical world, online membership organizations could quickly steal sales from traditional, non-wired retailers.
Whatever form stealth competitors take, they are a serious threat to retailers by diverting sales into Cyberspace. Even when traditional retailers launch a site, they risk cannibalizing sales from their stores. Wall Street understands the implications.
IX. Wall Street likes online shopping.
Wall Street has a favorable view of online shopping and stealth competitors. Over time, securities analysts will pressure retailers to get wired and reformat the sales channel by de-emphasizing stores. One sobering fact about Wall Street's attitude bears repeating. The stock market capitalization of Barnes and Noble, a 1000 store chain is $2.2 bn. The market capitalization for storeless Amazon.com is $1.5 bn. 65 Surely, when the retailer without stores has almost seventy percent of the market capitalization as the market leader, the stock market is thinking about a very different future for retailing. If market prescience is to be believed, the retail real estate community needs to pay attention.
In 1997 four major Wall Street firms issued reports analyzing online shopping between February and August. Each analysis took a different approach in estimating the importance of online shopping for retailing. Morgan Stanley's report covered a comprehensive number of interrelated issues relevant to retailers. 66 Goldman Sachs went on to develop an index to reckon the migration potential of goods and service into Cyberspace. 67 Bear Stearns looked at the impact on selected retailers. 68
The most significant real estate insight came from Robertson Stephens' analysts. 69 They confronted the cannibalization issue directly.
Bear Stearns demonstrated the point by analyzing how online competition would impact a planned Borders Superstore. 71
Wall Street's fascination with online shopping should concern traditional retailers. Analysts' comments and writings send important signals to the investor and lender communities about companies, their strategies, and prospects in a wired world. Goldman Sachs noted:
In July 1997 Barrons' carried an important article about the growth of online commerce. The article noted the prospects for online shopping were good and growing for a variety of retailers. This is another indication the market expects an aggressive push into online retailing. 73
X. The third transformation in space use. Over the last decade corporations and financial institutions moved to reduce the amount of space they used and the intensity of use. They sought to increase shareholder value and align corporate strategy with real estate use. The advent of online shopping forces retailers to confront similar issues. See Exhibit H.
INFOTECH's Impact on Space Use
The movement to re-engineer and downsize organizations to increase shareholder value has drawn attention to their real estate holdings. Leased and owned space is now an asset for advancing the firm's strategic goals and no longer a fixed cost of doing business. This represents a radical change in thinking.
The emphasis on increasing shareholder value has had a profound impact on the role of real estate in organizations. Over the last decade, manufacturing and service firms aligned space demand with corporate strategic goals. Cost reduction and rationalization followed. Firms directly linked real estate to the business plan and developed financial metrics for evaluating how space influences return on investment. Corporations needed to analyze real estate's contribution to the firm's strategic goals. This recognition grew from the efforts of academics, industry groups, and management consultants to correctly price and manage occupancy costs.74 The results are favorable, and one large office user reported slashing occupancy costs by fifty percent. 75 The senior management understood they could do with less space, that space costs had to align with corporate investment goals, and that all real estate decisions had to further shareholder value. 76
The banks and other financial institutions are going through the same space reduction process to achieve increased profitability made possible by technology. Traditional branch banking is being evaluated along with online banking and smaller units operating in supermarkets and other convenience locations. Many bank branches are redundant. In total they occupy more space, 250 million square feet, than general merchandise department stores.77 One analyst predicts, "Half of today's 60,000 branches will likely be gone by the end of the decade." 78
In addition, branch transaction costs cannot compare with online banking. According to Wells Fargo Bank the cost of doing a transaction over the Internet is $0.01 while the same transaction at a branch costs $1.07. 79 Household online banking is rapidly increasing. In 1996, 2.5 million households (3.1 %) banked online. By 2002, the number could reach 18 million (18.6%). 80 These are very compelling reasons for bankers to rethink their business model of branch banking to reduce real estate and overhead costs.
The retailers, especially their Chief Financial Officers (CFO) and planners are not immune to this trend. They know a body of heuristics and metrics are available to reduce space demand. Consulting firms are also examining the implications of online retailing. In 1996 a study by Deloitte & Touche on electronic commerce found that a retailer with superior locations and low cost leases would not have an advantage in a wired world. 81 The growing popularity of shopping online gives CFOs reason to question the assumptions underlying the location based sales channel. There are compelling reasons to reduce inventory and rent expenses.
There is an additional reason for retailers and property owners to be mindful of INFOTECH's impact. A new class of corporate raiders will rise: the Cybersurgeons. They will meld the techniques developed over the last decade into their valuation models and, in the case of retail, leverage the value of the third channel.
Retailers and corporations alike with large holdings of space amenable to downsizing will become their prey. In future corporate battles, Cybersurgeons will substitute software for staff to reduce headcount, impose telework programs on employees to cut back on space needs, sell corporate holdings and renegotiate leases. In the coming retail battles, they will aggressively pursue the third sales channel by creating strong incentives to get consumers online, reduce sales staff and the number of stores. Cybersurgery will force landlords and lenders to become unwilling participants in retailer machinations.
Consumers are moving from marketplace to the marketspace. 82 Many in the retail and real estate community will reject the possibility of space disintermediation choosing to believe "that which is, ought to be." However, INFOTECH acts to disintermediate retail space. The time is quickly passing when one could dismiss the online sales channel as a fad, like hula hoops. 83
XI. Retailer leasing strategy is headed in the wrong direction.
Consultants are pointing out the problems inherent in retailers not changing their real estate strategy. 84 The corporate experience along with the trend in branch banking to generate greater shareholder value is having an impact.
The Winter 1996-97 issue of Ernst & Young's Retail News, discussed the importance of real estate for retailers and the need to treat real estate as a core competency integrated into overall corporate strategy. "Real Estate Strategies for Retailers" discussed the ramification of rapid format obsolescence, the need to test new concepts, and the need by senior management to consider the implications of leasing and financing decisions. Other consulting firms are also sending out similar smoke signals.
Ernst & Young expanded on their real estate theme in a survey released in June 1997.85 The survey's breadth was impressive. There were 252 respondents with average sales of $1.3 billion per year. They had an average of 230 locations containing 25,000 sq. ft. per location and 73% were leased. The three most important variables for siting store location were sales potential, population, and geographic location.
Some of the findings were startling. Most respondents believed their current real estate plans were only good for two to five years but had thirteen year average lease terms. Nearly a third of the retailers lacked an overall real estate strategy. Finally, there was a significant gap between corporate strategy and real estate practices.
In a wired world retailers cannot afford negative arbitrage by making long-term real estate commitments while executing short-term strategies. Retailers need to elevate real estate planning to a core competency similar to merchandising and supply chain management. Store leasing should be flexible enough to accommodate format obsolescence, shorter tenancy, exit strategies and plans for reuse of redundant space. Increasing shareholder value dictates such action.
The progression of software retailer, Egghead, from stores, to catalogs, to online was a natural evolution. Its subsequent transformation into a purely Internet merchant offers important insights about the future of selling commodity goods and services.
Egghead, a software retailer, operated in a highly volatile market. It grew rapidly to about 210 stores located in strip centers concentrated in California, Massachusetts, New York, Oregon and Washington. In 1996 Egghead activated an online site for selling software and other products. The site is one the busiest sites on the Web averaging 150,000 hits a day. On January 1, 1997 it realigned its retail operations by cutting in half the number of stores (156 to 79). In addition, it enlarged the size of a number of them to better meet the competition. This drastic move reduced Egghead's presence in 54 geographic areas down to 24. Surviving stores were in densely populated areas with significant concentrations of PC owners and high mean income levels. Egghead intentionally made purchasing on the Web a better deal to drive business online. Prices were 5% cheaper than in the store or from the catalog. In January 1998 Egghead announced the closure of all remaining stores and its transformation into an Internet merchant offering software and related items. 86
The real estate implications of Egghead's online move proves the strategy behind
China's former leader, Deng Xiao Ping's slogan:
What this means is that merchandising is more important than location. Retailers will look beyond their location sales channel when they see sales migrating online with an attendant decline in store performance. They will also realize they no longer share a common goal with property owners based on location. Instead, INFOTECH creates a negative symbiosis. Few are likely to emulate Egghead's strategic shift but it will embolden other retailers to eliminate or downsize locations as part of integrating an online presence into the sales channel matrix.
Flexibility is the key to leasing strategy in a wired world. However, flexibility for the tenant is at the expense of the landlord. Thus, retailers who embark on reformatting the sales channel will need to compensate landlords in some measure for the possibility of shorter terms or reduction in space. Lenders will also have to go through the same soul searching process. Ultimately, after the shouting dies down profit opportunities will dictate pragmatic solutions. The tenant's need for flexibility, when properly structured, can be reduced to the cost of termination and measured against the anticipated gain from freeing resources in one channel for deployment to another.
Inducing flexibility into the retail lease will not be easy. Today, few landlords can accept the networked economy's fundamental truth: INFOTECH severs place from activity and the concomitant shift in negotiating leverage. In a real estate context, Metcalfe's Law also suggests power flows to the tenants because of the inverse relationship between the value of the network, the Internet, and the value of the location, the store. That is, when activities move from physical space to Cyberspace they enhance the value of the network and depress the value of the location. While retailers should not expect to win many battles soon, staying focused on this strategy is necessary to build flexibility into their leases.
The illustrations below present some of the necessary changes retailers must make to their leasing strategy. They incorporate INFOTECH's dictates and reflect a number of contemporary practices seen in a new light. These options are not free, but failing to pay the price in the short run will multiply the cost many times for them in the long run.
INFOTECH promotes space disintermediation by reducing the location premium imputed in rent. The rent commanded for space is likely to change and retailers will consider how they can bargain for cheaper rent or persuade landlords to allow them to convert the fixed rent obligation into a variable rent based on a percentage of gross sales. Changing rent to a variable cost would give retailers greater flexibility in managing their sales channel strategy. It is almost impossible to contemplate this change in the short term. Nevertheless, INFOTECH's impact on space requires retailers to continually consider the issue in their leasing strategy.
There are several concerns related to percentage for retailers. 87 One would be not allowing the landlord to impute an unnatural breakpoint in sales thus increasing the rent as sales migrated online. Another is the Virtual Emporium [www.vemporium.com] problem.
The Virtual Emporium is a store allowing customers to surf the Net and purchase selected goods and services online. 88 In effect, it offers training wheels to the curious who lack access to the Internet and those who wish to learn how to shop online. One potential problem ahead for retailers would be if the Virtual Emporium were also a tenant in the same center or mall and their customers ordered from a resident retailer's online site. The landlord could very well claim the sale counted towards the tenant's percentage rent. Many similar questions will arise on this topic in the years ahead.
Flexibility of the use clause is important for retailers. Not only must they be able to sublease or assign redundant space, but they should bargain for the right to expand, contract, and relocate the store within a project. An example of the need for subleasing flexibility would be if a retailer decided to downsize into a showroom format and offered the balance of the space to a complimentary subtenant with the space becoming something like a cosmetics department. Most landlord drafted leases would bar such an outcome.
The Ernst & Young survey highlights the mismatch between store format longevity and lease term. One solution is to take a significantly shorter initial term with multiple short-term options. Obtaining a three to five year initial term with short-term options would be one way to hedge the need for space and to maintain sales channel flexibility.
Early lease termination is not a new retail strategy. 89 Some retailers bargain for the right when they go to an uncertain market. The tactic takes on renewed value as the online sales channel gains prominence. Retailers will consider the full panoply of exit strategies to maintain sales channel flexibility. Early termination could be based on the failure to meet minimum sales targets or be exerciseable after a certain number of years. It could be a one-time right, or only exerciseable at specific times, or exerciseable on an ongoing basis.
Several variations are possible. The kick-out right whereby the tenant ceases all operations based on the failure to meet a predetermine sales target. The go dark right whereby the tenant remains in possession but only pays occupancy costs, terminating all other operations. The tenant could also have the right to put the space back to the landlord for a predetermined payment. Obtaining an exit right is another matter. Nevertheless, the development of the online sales channel requires an exit strategy to be incorporated into the lease.
The rise of the networked economy diminishes the value of location for landlords and retailers. It also dictates the need for retailers to change where and how they lease space. The lease provision changes outlined above only begin to suggest the scope of transformation ahead in the landlord-tenant relationship as a result of sales channel reformation.
XII. The Landlord's strategy for a wired world.
Maintaining rents and values in a wired world requires property owners and investors to understand INFOTECH's influence on consumers and the reaction of retailers. This is not the time to develop a "strategic hamlet" mentality. It is the time to begin analyzing the problem. The analysis begins by discarding many of the metaphors used to discuss the online world. They confuse thinking by using real estate terminology to think about an abstraction, i.e., Cyberspace. Once detached from misleading metaphors, landlords can begin to screen tenants less influenced by INFOTECH. Investors also need to consider how a retail property may serve other uses since adaptive reuse may become a necessity.
Effective strategy requires property owners to understand online shopping's consequences. However, trying to fathom the forces unleashed is difficult since Cyberspace is the antithesis of real estate: it is an abstraction where no there exists. Thus, our metaphors imprison our thinking. We use metaphors to call up visual images allowing us to understand and experience one kind of thing in terms of another. Using a real estate metaphor like cybermall creates confusion. The image of the mall bears no relationship to the void of Cyberspace. Exhibit I lists Tired & Wired examples of how our metaphors and terminology must change before we can understand the role of retail space in a wired world.
Tired & Wired
The best tenants will be those who offer goods and services not easily moving to Cyberspace, who can add value in the store, or who provide unique services. Using a screen to vet retailers will assist property owners to choose those likely to remain and thrive in their space.
Landlords should ask:
E. A trading market for retail space.
INFOTECH's disintermediative nature for retail space may also become reintermediative. INFOTECH allows the networking of Wall Street trading markets with the owners and users of leased retail space. Perhaps it is not too soon to speculate on the creation of a national market for trading the right to use leased space. The commodity and options markets offer an analog. Retailers could hedge their space needs. This would allow them to quickly adjust the sales channel mix by increasing and decreasing physical space. A new class of real property speculators would provide liquidity to the market. Conversely, landlords would develop hedging techniques to safeguard their investments. INFOTECH can fundamentally change the attendant risks of owning and leasing retail space.
XIII. Up ahead structural change.
INFOTECH creates a third channel for merchants to sell and ushers in an era of reassessing retail property values. See Exhibit K. Many types of goods and services work online with a wide selection of sites. Sales migrating online will degrade financial performance. Retailers will react by where they locate stores, how many stores are within a trade area and the size of locations. Sales channel reformation requires merchants to change leasing strategy. They need to shorten the initial term, obtain multiple short term renewal options, develop exit strategies, and revise rents.
Landlords must not react to events but instead seize the opportunity inherent in the structural shift ahead. INFOTECH may ultimately create the solution for redundant space: the development of a trading market for leased retail space.
*The Real Estate Transformation Group advises property owners, tenants and lenders on the impact of information technology on commercial real estate. The firm specializes in retail property. In addition to consulting, Mr. Borsuk is a retail leasing broker and real property attorney. Mailing address: 1626 Vallejo Street, San Francisco, CA 94123-5116, (415) 922-4740, FAX 922-1485, firstname.lastname@example.org.
1 Mark Borsuk, THIRD WAVE CHATZPAH: retailer leasing strategy for a wired world,
paper presented at the Financial, Credit and Internal Audit Executives Conference,
National Retail Federation, San Diego, CA, September 22, 1997. (http://www.TheSpacePlace.net/tenant_brokerage/columns/chutzpah.htm)
Web sites cast big shadow over real estate leasing strategy, Discount Store News, January 5, 1998.
THIRD WAVE CHUTZPAH: retailer leasing strategy for a wired world. (http://www.TheSpacePlace.net/tenant_brokerage/columns/chutzpah.htm)
Cybermalling-A Retail Death Sentence?, Journal of Property Management, March/April 1997.
Third Wave Wipeout: Do retailers need landlords in a wired world? (http://www.TheSpacePlace.net/tenant_brokerage/columns/wipeout.htm) The Challenge of Information Technology to Retail Property, Urban Land, February 1997. (http://www.uli.org/pubs/ulmain.htm)
Will On-line Shopping Impact Retail Leasing? (http://www.mihalovic.com/tenant_brokerage/columns/icsc.htm)
Technology complicates real estate investing, Pensions & Investments, January 20, 1997.
THIRD WAVE TSORIS: Do Real Estate Investment Fiduciaries and Appraisers Have Greater Liability in the Information Age? (http://www.telecommute.org/borsuk6.htm)
THIRD WAVE WIPEOUT: INFOTECH's Impact on Retail Space Demand, (http://www.telecommute.org/borsuk5.html)
Third Wave Wipeout: Commercial Property Investment in the Information Age., Inman Real Estate News, June 25, 1996. (http://www.inman.com/news/9606/960625g.htm)
Is Commercial Real Estate Investing Still Profitable in the Information Age?, Real Estate Forum, June, 1996.
What Is the Impact of INFOTECH On Commercial Real Estate?, SIOR Professional Report, Spring, 1996. (draft http://www.telecommute.org/borsuk3.html)
Don't be a Cyberputz, California Real Estate Journal, March, 1996. (draft http://www.telecommute.org/borsuk4.html)
Real Estate Tax Policy for the Information Age, Real Estate Review, Winter, 1996. (draft http://www.telecommute.org/borsuk.html)
Commercial Real Estate: Road Kill On The Info Highway?, Microtimes, October 1995. (http://www.microtimes.com/realestate.html) (2/2/98)
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