The diffusion of computer hardware, software and telecommunications - infotech - into everyday life is rapidly challenging whether work needs a workplace and shopping needs a shop.
Infotech severs place from activity, thereby reducing retail space demand. In cyberspace, all addresses are desirable. This belies the belief that landlords and tenants share a common destiny based on location. The issue of technology-induced space redundancy, previously considered decades away, is now a question of how soon and how much. Retailers are likely to begin changing their location-based leasing strategy in three to five years as online shopping takes off.
What must owners do to preserve their investment? They need to analyze the type of tenants likely to benefit from reducing some or all of their physical locations, the characteristics of tenants continuing to require space, and how to adapt surplus space.
An infotech-induced demand shift portends an adverse change in property values. How will this affect individual properties? What additional analysis is necessary to gauge the risk? These are the questions investors must confront in the information age.
Tenants to worry about
Infotech creates new retail tenant winners and losers for landlords. Landlords require a different selection criteria. New questions include how quickly could the tenant's sales migrate to cyberspace and will the tenant downsize the store or prematurely terminate the lease.
As online shopping gains acceptance during the next three to five years, the early candidates are box shops: retailers selling commodity goods on the basis of price. Merchants offering brand-name products like clothing, books, CDs, software, computers, car parts, bulk consumables, personal care and pharmacy items all will have an incentive to exploit online shopping to improve profitability. Others seeking to gain the same advantage are those carrying large physical inventories of standardized goods.
Online retail competitors are another risk for landlords. The new competitors are value-added merchants and market-access providers; they do business without a physical presence. Other sellers like private-label catalogs and manufacturers also can reap the benefits of being online.
Consider the value-added merchant CUC International (http: www.cuc.com): It has no physical presence but offers a huge selection of 250,000 discounted name-brand items. Access providers offer whatever is available in the market; Amazon Books (http: www.amazon.com) offers 1 million book titles at a discount without a store. Lands' End Inc., the private-label cataloger, now has a presence on the World Wide Web (http: www.landsend.com) where special pricing of overstocked items can instantly be communicated to online customers to fine-tune inventory levels. Manufacturers may also migrate some of their outlet locations to cyberspace. This would significantly reduce the cost of maintaining stores and inventory.
Tenants to seek
Merchants offering non-commodity goods, like those having tactile and kinetic quality, are better choices. Examples include paint, furniture and fabric stores, fashion boutiques, and restaurants and cafes. Other winners are service providers requiring a physical presence like medical and dental offices, shoe repair, entertainment, and users that attract people to socialize, like bowling alleys, community centers and libraries.
However, landlords should hesitate before considering a "destination tenant" as an attractive candidate. The location draw might be ephemeral as the product or service finds acceptance online.
Impact on retail property values
Infotech by shifting a portion of sales into cyberspace likely will cause higher vacancies and operating expenses for landlords. They can expect an increase in tenant turnover expense because of faster format obsolescence and higher improvement allowances. In addition, landlords will have to pay more brokerage and legal fees because of quicker turnover. The cumulative impact would depress property values.
The information age will transform the industrial age's geocentric pattern of shopping. It will add to the investors' risk. Infotech will influence acquisition price, increase holding costs and cause a legacy use discount on disposition. (In this reference, a legacy use discount refers to a property's inappropriate layout and use that depresses its value. Changing these factors would require additional investment.) Investors must examine their assumptions, and fiduciaries need to consider infotech's impact. One impact will be to evaluate properties for adaptive reuse as part of their pre-acquisition analysis. By creating greater uncertainty, infotech also creates opportunities for developers and owners who understand the trend.
Question investment assumptions
The assumptions implicit in commercial real estate investment mask the changing nature of demand in the information age. Consider the following assumptions:
Existence has a utility. The mere existence of property can no longer be assumed to imbue it with value.
Desirable properties take a long time to become obsolete. Investors no longer can rely on the traditional demand-supply cycle to support value when infotech is severing location from activity.
Stable economic trends are indicative of maintaining value. Infotech will exert a powerful influence on space demand in an otherwise growing economy.
There is a long-term upward bias in retail rents. Nominal rents have tended to increase over time. Infotech's erosion of the location premium gives tenants the power to dictate rent.
Infotech does not exacerbate the underlying problems of retail tenants. Landlords must contend with excess space, the ongoing consolidation of retailers by bankruptcy, reduction in marginal and duplicative stores, and consumer burn-out, frugality and boredom. Infotech's impact in three to five years only worsens the situation.
Rent in the information age
Infotech favors retail tenants over landlords, lessens the premium paid for location and provides retailers with greater options. This shifts the space demand equation.
The landlord's dilemma arises from how retailers calculate what they are willing to pay for rent and how tenants will bargain in the future. Retailers need to keep their rent cost within a pre-determined percentage of gross sales. Tight control over fixed and variable costs allows retailers to target a set return on sales. The amount paid as rent could decline if retailers sought to make rent a variable instead of fixed cost by paying only a percentage of in-store sales as rent.
Product costs are another variable in the rent equation. If the cost to obtain goods declines because of the impact of information technology on distribution costs, then the retailer is likely to reduce the selling price. This sets in motion a chain reaction lowering rent. Falling prices without an offsetting increase in unit volume or unit price will produce lower gross revenue. Lower gross revenue provides the tenant with less money to spend on rent and still keep the rent-to-sales and return-on-sales ratios intact.
Rent based only on a percentage of in-store sales, restructuring of the distribution channel and the advent of retailers generating significant sales in cyberspace will create downward pressure on rents. If such a trend develops, then retail property owners must respond to preserve the value of their properties.
Adaptive reuse of retail properties
Owners who anticipate change should begin seeking tenants less influenced by cyberspace, broaden their tenant mix to include non-retailers, and consider adaptive reuse.
Adaptive reuse is rehabilitating property for a better use. Examples include developing urban lofts from manufacturing and storage facilities and converting bank branches into telecommute centers. In the same way centers, malls, department stores and "big-boxes" can be adapted for new uses. However, not all attempts at adaptive reuse will be successful or preserve value.
Consider a 1 million-square-foot mall when the rent no longer supports the property. Possible new uses could include a theme residential development (Paris in the 1920s) with part of the parking lot converted into a green belt; a wellness and convalescent center (Health World); a continuing education and training facility (Learning Land); and a one-stop interment and vertical cemetery (the Necropolis).
In addition to the financial cost of the conversion, the project would have to overcome zoning, use restrictions and community objections.
Tax law creates another roadblock to adaptive reuse. It inhibits conversion by stretching deductions over long periods, limits rehabilitation credits to a small class of structures, does not permit expensing of demolition costs and does not recognize that infotech causes "extraordinary obsolescence" to buildings.
Despite these and many other problems, investors will have to consider converting a number of retail properties to other uses. Hoping that the market will come back is not going to be the winning strategy in the information age.
"Prudent expert" and infotech
Many retail properties are owned by institutional investors like pension funds, insurance companies and real estate investment trusts, some of which have fiduciary obligations.
Real estate investment fiduciaries under the Employee Retirement Income Security Act and states adopting the "Prudent Investor Act" have to consider general economic trends in their asset allocation decisions.
Failing to heed infotech's pervasive impact on the overall economy and commercial real estate in particular would not be prudent. In addition, the attempt to reduce risk and increase return by including commercial property, as an asset class, in a diversified investment portfolio remains an unproven assumption in modern portfolio theory.
Thus, individual and institutional investors should weigh the impact of infotech in their investment decision.
Infotech and investment decisions
Investors need to consider infotech's impact from two standpoints: pre-acquisition and ownership.
At the pre-acquisition stage the investor has considerably wider latitude in the selection process. Questions to consider are:
Will the tenant's customers shift to online purchasing? How will this impact vacancies, cash flow, rents and percentage rents?
Can replacement tenants be found less susceptible to online sales migration? At what cost? What will they pay for rent?
If the property no long supports retail, what other uses will sustain cash flow and value? What will be the cost to convert? Will lenders finance the conversion? Will there be an adequate return?
What is the property's upside in the information age? Will there be a discount on disposition for legacy use?
Will acquiring the property add excessive risk to the portfolio? Can the anticipated return be realized over a shorter holding period?
Owners need to consider how infotech will affect cash flow and value over their expected holding period.
The issue of legacy use discount is important. Can the property be adapted to preserve value at an acceptable price or sold before the market fully discounts its use?
Further, the momentum to securitize the commercial property market will subject values to greater volatility at an accelerating rate.
These suggestions only begin to consider the issue. Much remains to be done to characterize and assess the risk.
This shifts the investment risk from the portfolio to a specific property analysis.
The implications of infotech for retail property place fiduciaries under an obligation to consider its impact before investing or continuing to hold property.
Mark Borsuk ([email protected]) is managing director of The Real Estate Transformation Group, San Francisco.This article is adapted from a presentation at the IREM midyear convention last June; the full presentation can be found at http: www.telecommute.org/borsuk5.html.