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NEW YORK - As e-tailing continues to broaden and mature, many retailers as well as retail real estate owners and managers increasingly will be challenged, and some traditional shopping space may become redundant.

Those were among the many views and findings presented by Moody's Investors Service at a May investors briefing in New York City titled, "The Impact of the Internet on Retailers and Real Estate."

Internet retail sales have grown tremendously in just a few years. Electronic shopping is attracting a more mainstream clientele as it matures. This trend may pose a threat to the profits of some marginal bricks-and-mortar retailers and weak retail properties, according to Moody's.

On the other hand, some traditional retailers already recognize the Internet as a means to increased traffic, sales and profit. It's not so much a war between the "bricks" and "clicks," but a period of increased competition that will require the retail industry to sharpen its growth and marketing strategies, rethink some of its formats, improve its distribution systems and hone its management skills.

Last year, Internet retail sales reached $36 billion, up from $5 billion just two years ago, according to Marie Menendez, vice president and senior analyst of Moody's Corporate Finance Group. Retail Websites grew tenfold in the first 10 months of 1999, and now total about 30,000 or more sites.

An estimated 26 million Americans shopped online during last year's holiday season, according to Moody's. During the holiday season of 1999 the Internet captured 3% to 4% of all retail sales, according to Moody's.

The Internet is seeing a retail buyer base that more closely resembles the population at large. Different types of people increasingly are buying a more widespread array of goods - far beyond the early Internet staples of computers and electronics. Shoppers are using the Internet to buy apparel, health and beauty aids, toys, luxury goods and other products that until recently were the backbone of in-store purchasing.

Although Internet sales represent a small share of total retail activity, the scale has reached a threshold that retail real estate owners and operators cannot ignore, warns Moody's.

Winners and losers Certainly the ratings agencies are not ignoring the trend. The Internet "poses a challenge to real estate in general and CMBS in particular because of the added uncertainty of assessing credit risk in existing properties," says Sally Gordon, vice president and senior analyst in Moody's CMBS department. "While the long-term impact is difficult to gauge, its impact will not be trivial."

Retail space is the largest single property type in the CMBS market, representing 27% of all collateral. The potential erosion of sustainable cash flows in retail properties warrants attention, according to Moody's.

"The most compelling trend is that Internet users are becoming more numerous, shopping more frequently and spending more online than before,' concludes a report prepared by Gordon.

The Internet will not make all stores obsolete, but it will displace enough sales from certain retailers or retail formats to challenge profitability and growth plans and erode already narrow margins, predicts Moody's.

The impact will be uneven. Some retailers and formats have more cause for alarm while others will remain virtually impervious to the Internet, reports Gordon.

Those shopping destinations most at risk will be marginal retail outlet centers, mediocre tertiary regional malls and some power centers. The effects could be more dramatic in the event of an economic downturn, which Moody's believes will happen over the lifespan of 10-year bonds.

Such a downturn could result in marginal retail operations suffering "a quick but not necessarily painless death," says Gordon. "As a result, the effects of the Internet could widen among shopping centers/malls and retailers."

"The Internet will play a big part in separating the wheat from the chaff" in terms of physical retail properties, echoes John Kriz, a Moody's managing director in the REIT group.

In terms of regional malls, Kriz says that high-end fashion malls are in the best position to withstand e-commerce threats, as are strong regional malls that offer a diverse merchandise mix and serve as social destinations as well as shopping meccas.

"Weak malls will increasingly struggle, and there will be a greater division between the strong and the weak, with the weak properties dropping more severely," he says.

Community centers should hold their own, especially those anchored by grocery stores. Wal-Mart and other discounters pose more of a threat to these locations than the Internet, largely due to the Internet's inherent requirement of expensive fulfillment mechanisms for delivering groceries in an already low-margin business.

Of all retail sub-sectors, power and outlet centers appear the most vulnerable to Internet threats. The electronics and appliances usually sold at power centers are the backbone of Internet commerce, and the discount pricing found at outlets can be found on the Web as well.

Predictions Kriz made what he called some "bold predictions" for retail real estate. Kriz believes Internet commerce will eventually put an end to percentage rents. Internet selling makes it impossible to figure any kind of meaningful sales per square foot, thus more leases will be all base rent and not a percentage of sales, he predicts.

Many retailers will no doubt be using both stores and the Internet to increase identity and sales and accommodate delivery and returns. The retailers who are capitalizing on both channels will be preferred tenants and assets to property operators.

"Traditional retailers who sell online are in effect using the physical store as a giant, fixed marketing tool," says Gordon. "Maintaining an ongoing presence in consumers' mental space is part of the value of maintaining a presence in physical space."

In other words, traditional retailers who sell online will look at rent on physical space as a marketing cost. This blurring of real estate rent and marketing has potential implications for property owner/operators and shows why percentage rents could have less value. "In-store sales could fail to fully measure a retailer's success at the corporate level or the value of a given location," according to Moody's.

The Internet will point to "an acute need to reconfigure space and devise new retail formats," says Kriz. Malls and retail destinations may need to beef up their entertainment value to attract foot traffic, and owner/operators will need to experiment with concepts and adapt space to its best use.

Moody's reports that online competition could prompt change in a store's inventory management, and therefore affect desired store sizes and real estate layouts. One inventory model uses the store as a quasi-showroom: a broad inventory coupled with a narrow depth of stock, corollary to what a consumer can order online.

Many traditional retailers already have an advantage over Internet start-ups in developing brand identity and consumer loyalty. Several already have established an Internet presence. Forty-six of the 100 largest retailers in the United States sell on the Internet as well as through traditional outlets.

Whether it is a traditional retailer, a crossover merchant or a pure-play retailer (one who only sells online), the steps to profitability in embracing e-commerce are the same. An online retailer has to first attract potential customers to the Website, capture those visitors as buyers and then turn customers into repeat buyers. Industry leader estimates that it has to keep a customer for 2.5 years before earning a profit from that customer, according to Moody's.

Debunking myths Nevertheless, Internet retailers are more profitable than previously thought. Profits have been achieved by 36% of pure-play Internet retailers who have been in business for more than a year; 50% of traditional retailers with crossover businesses; and 79% of catalog merchants who also sell online, reports Moody's. Catalog retailers are best poised to handle Internet ordering and fulfillment, having similar systems and infrastructure in place.

"Not all retailers will be able to meet the financial requirements of having an Internet presence," says Menendez. Expansion plans of traditional retailers may shift to build an Internet presence rather than more stores. Retailers without direct fulfillment capabilities will have to build or acquire them.

Some traditional retailing giants with deep pockets are already at work, such as Wal-Mart. "If these giants want to dominate a market and are aggressive, they can certainly outlast a with a small venture capital pocket and a few people," according to Gordon.

What's the optimal plan for retailers going forward? "Exploit the Internet as an alternate delivery channel to build some synergy with the physical retail outlet," advises Moody's. "Provide a venue for returns, capitalize on brand identity and use the shopping center/mall presence as ongoing marketing."

* Different types of people increasingly are buying a more widespread array of goods, far beyond the early Internet staples of computers and electronics.

* Shopping centers most at risk will be marginal retail outlet centers, mediocre tertiary regional malls and some power centers.

* E-tailing may put an end to percentage rents because of difficulty in calculating meaningful sales per sq. ft.

* Store sizes and layouts may be dramatically altered because of changes in inventory management.

* Profits have been achieved by 36% of pure-play Internet retailers that have been in business for more than a year.

Source: Moody's Investors Service

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