Publications

- December 1, 2019: Vol. 6, Number 11

Q&A: The retail ‘e-volution’ and five predictions about the industry through 2025

by KC Conway with Mike Consol

Is traditional retail truly in demise? Is online retailing truly the force that is driving legacy retailers into bankruptcy? Where are savvy brick-and-mortar retailers finding new spaces to sell their wares?

The CCIM Institute’s third quarter commercial real estate report tackled the retail industry and all its problems in a research paper titled Retail e-Volution: Predictions for 2025. The paper is filled with surprising and enlightening information (read the complete report at this link: https://bit.ly/32tEw2G). Its author, CCIM Institute chief economist KC Conway, summarized the report for Real Assets Adviser editor Mike Consol.

There has been liberal use of the term “retail apocalypse” to describe the shakeout among retailers.

I am not a fan of that term because it connotes that everything is dying and going away in retail, and that is not the case. Consumer spending is growing and has continued to grow, all post-recession. Retail had been evolving since the ancient seaport days. Evolution is better terminology than apocalypse.

Your report contained five predictions about the evolution of retail. Let’s walk through them. One has to do with online retail sales.

Today, only about 10 percent of total retail sales are online, a small number compared to all the retail bankruptcies and store closings. You would assume from the headlines that nine out of 10 things are bought online, and that is not the case. We really have not scratched the surface on growth in online retail. Our prediction is that by 2025 we should be easily looking at 20 percent of all retail activity being online, and that is a very conservative estimate because we will probably see 25 percent or 30 percent.

Among online sales you mention “casual dining.” Dining online?

Casual dining is a nice way of saying “fast food.” Chick-fil-A is probably the Amazon of casual dining because it has already developed dining apps and is developing sophisticated additional drive-through lanes for people who order online so they can pick up their food at a faster drive-through window. We are a society that wants everything immediately and on-the-go. This is how fast food or casual dining restaurants are tapping into the potential of online. It is a huge growth area. We think Chick-fil-A is probably the leader, and McDonald’s probably needs the most improvement.

You also talk in the report about redefining brick-and-mortar. How so?

Retail’s growth is going to be in repurposing their operations for greater alignment with services. Rather than standalone stores, retail is going to increasingly become part of something. A good example is retail aligning with hospitality. Hotels have had a good run but is meeting some headwinds when it comes to increasing their revenue, considering that room rates and occupancy are already at historically high levels. To improve margins they have to pack more into the hotel, and retail is looking at how to lower its physical costs. So, we are seeing retail come into hospitality and developing loyalty programs that align with hospitality, much like the airlines did. One example is Restoration Hardware and what it’s doing with Marriott and Hilton, filling their lobbies and common areas with furnishings, ridding hotels of that cost, which is as much as 5 percent to 7 percent of the average hotel’s operating costs per year. Restoration Hardware also puts QSR codes on the furniture pieces so hotel guests can scan it, check the price and order it while staying at the hotel. For hotels, they offload an expense and pick up revenue on commissions from furniture sales. For the retailer, it cuts physical occupancy costs and can more directly target its consumer audience.

Another really good concept is called Great Wolf Lodge that started up in Minnesota and has worked its way down through the middle part of the country to Colorado, Georgia, North Carolina. Their properties are well-
located business hotels and have brought the retail into the hotel, which means they don’t have to operate or staff it. They brought in stores from Build-A-Bear, Disney, Chick-fil-A, Dunkin’ Donuts and so on. The hotel doesn’t have to absorb the cost and it gets 15 percent of sales. That is a pretty good deal.

There is also Starbucks, which took over the iconic Crate and Barrel store on Michigan Avenue in Chicago, a 48,000-square-foot store, and is reopening it with a new roastery concept that has everything going on — co-working, entertainment, restaurants, a museum that shows how the beans are roasted.

What is the prediction on last-mile fulfillment?

A couple of things. One of the myths is that online retail is expanding because it is more profitable, and the data shows it is not. If you read retailers’ earnings reports they will show Walmart or Target or Home Depot are experiencing 20 percent to 30 percent year-over-year growth in online sales, but the profit margin is not so good. That’s a big issue. The Amazon model of buying a bunch of Mercedes vans and going to houses isn’t working out very profitably, so you have entities like Walmart that are experimenting more with in-store pickup. Kroger, on the grocery side, is looking at partnering with Walgreens, which has a heavy concentration of stores. The idea is your online grocery order from Kroger will be available for pick-up at your neighborhood Walgreens.

What about autonomous trucks? What is the timeline for their availability?

Autonomous trucking actually is here. I will give you two examples. Each night Walmart launches a fleet of autonomous trucks that move across the horizontal interstates between about 11 p.m. and 5 a.m. UPS is experimenting with it right now between Dallas and Phoenix and, this will blow your mind, the state of Florida passed legislation this summer that will authorize autonomous trucking on every state and federal highway. Florida has dealt with the technology, the insurance, the liability, all of that is done, so I think the autonomous trucking got here a lot quicker than most people realize.

Is there a human monitor aboard these autonomous trucks?

Nobody is on them. The autonomous trucks from Walmart are chaperoned. A convoy of as many as seven trucks will have an escort vehicle in the front and back, a minivan or smaller vehicle with drivers who can take control if a problem occurs. Otherwise, the trucks are running fully autonomous on compressed natural gas rather than diesel, so they don’t even stop to refuel. The autonomous trucks in Florida have transportation people talking about something similar to an air traffic control system. When an autonomous truck is launched next year in Florida it will register the launch of that truck with an autonomous truck control center that will co-pilot that truck from when it departs to its final destination.

What about advances in warehouse design?

The warehouse designs we are seeing are interesting. The vertical supply chain in warehousing is coming back because land requirements have grown from a land-to-building ratio of, say, 3-1 or 4-1 to 7-1, so you have doubled your land need and your land costs in markets like New York and Miami and San Francisco and L.A., which are just not feasible, so we are seeing new designs going vertical. There is one under development in New York City that is a vertical e-commerce warehouse, so it’s multistory and allows the trucks to drive up ramps on the side of the building to their designated floor and warehouse. It also allows truck trailer pads to be stored underneath. The vertical design gets the land-to-building ratio back to 3-1.

Your report also predicts adaptive reuse of retail space will be the most influential trend in retail between now and 2025. Elaborate on that.

We identified that adaptive reuse activity is greater than all the self-storage properties in the country, so it is a pretty big property type by itself. It is being driven by the huge supply of retail that is going dark, and that presents two problems: One, it’s a blight on a community when there are a lot of empty storefronts. Two, it presents a tremendous financial issue for local governments that get about 60 percent of their tax revenue from property taxes, and the biggest source is from commercial real estate. If you don’t do something with these empty stores and get them back to productive use, their value drops and what they pay in taxes drops, which means you’re looking at a very serious local government funding shortfall. Adaptive reuse is the way out of that.

I will give you two good examples of adaptive reuse. In Nashville, a few years ago there was a retail center called Hundred Oaks Mall that pretty much died after losing its anchor tenants. Vanderbilt Health System bought it for a needed expansion, and it converted this mall into mixed-use with multifamily housing for students going through the medical school; they added medical offices for doctors, and they kept some retail and restaurants, and it became very successful.

The second one has to do with a company known as Monmouth, for which I serve on the board of directors. Monmouth is a publicly traded industrial REIT and a few years ago it had the opportunity to become involved with a failed mall in Mesquite, Texas. We worked with a developer and FedEx to convert the entire mall into a fulfillment center. Here was a mall that became a solution to last-mile delivery.

We are seeing tons of examples of adaptive reuse, and it’s one of the key solutions to putting these empty big-box and department stores and dead malls back to a productive use, as well as creating an investment opportunity for developers.

Your final prediction is that retail will become more litigious by 2025. Why is that?

When you look at the volume of retail that is going dark or closing — this year over 10,000 store closings and 20,000 store closings from 2017 through 2019 — and that there is several billion square feet of U.S. retail space — 24 square feet per U.S. resident, the most in the world — about half of which is expected to go dark, it means we are going to see a lot more store closings. When a retailer closes, whoever owns that property is going to appeal their property tax rate, so the property taxes get reduced, and that creates a funding shortfall the local government has to deal with. If the real estate asset isn’t put back to productive use, the local government will need to raise property taxes by 20 percent to 25 percent in the coming years. This is the sleeper issue out there.

The report also debunks some myths, such as the real culprit behind retail bankruptcies. What did your research find to be the true culprit?

This was surprising because everybody assumes that it must be Amazon and online retail sales that has caused all these store closings and bankruptcies. We found that is not the case. Most of what we have seen to date in retail bankruptcies and store closings is due to the overleveraging of retailers. The seeds of that problem go back to the 1980s and the era of leveraged buyouts led by firms like KKR, which saw retail as a great growth industry and figured they could buy and merge and leverage retailers to the hilt because they were growing so fast they can pay the debt down the road. That worked until the mid-90s when we started seeing the creation of Amazon and online retailing, followed by the global financial crisis. Then retail was no longer a growth industry adding stores and seeing physical retail sales grow.

Two examples I like to use as a good contrast are Barnes & Noble and Toys “R” Us. What in the world is a Barnes & Noble bookseller still doing in existence after what Amazon did to Borders and the bookselling industry? The answer is Barnes & Noble didn’t leverage, it didn’t have a lot of debt, and that enabled the company to buy time to reinvent itself and add services. You go into a Barnes & Noble today and you’ve got a Starbucks, an office supply store and co-working in some stores.

Contrast that with Toys “R” Us, which was leveraged to the hilt. The senior debt holders decided they didn’t like retail anymore, especially when they assumed Walmart was going to crush Toys “R” Us with toy sales. That put Toys “R” Us into bankruptcy, then out of business. All that was left was the giraffe and the name. They are trying to come back with less than a half-dozen stores in 5,000- to 10,000-square-foot footprints versus its old format of 40,000 square feet. Toys “R” Us is a real good living example of where overleveraging absolutely killed a retailer, while the absence of leveraging allowed Barnes & Noble to survive.

Going forward, though, the growth in online sales will be much more pronounced. When you look at how many retailers still have a leveraged debt problem, combined with the growth of online retail, the outlook is pretty dire for physical retail.

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