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Online Buying Creates New House Rules

Retail developers at the Cyberspace Casino are hearing a new cry at the tables: "Everyday tech takes the shop out of shopping." The crowd's old refrain, "location, location, location," seems dated. The developers' betting partners, the national retailers, seem less interested in the location game and more interested in the online odds. Wall Street, the pit boss, never one to miss out on a sure thing, is making millions from the online gold rush.

Will retail developers learn to play by the new house rules or just keep enough change for bus fare? Doing a little forward planning before entering the new game can keep developers winning in a wired world.

The online community The online merchants' spectacular 1998 Christmas season made it unmistakably obvious that online buying is the new sales channel. What are the implications of the everyday tech revolution, and how does it impact retail property development?

Everyday tech is the integration of computer hardware, software, networks and telecommunications into daily life. It severs place from activity, making possible work without a workplace. Everyday tech also changes expectations about how, when and where to shop.

Everyday tech is an example of the network effect, in which the value of a particular item increases exponentially as the number of items grows arithmetically. An example is the fax machine. In the mid 1980s, the value of the fax to users was doubling or tripling. Soon no one could afford to be without one. The same social and economic phenomenon is occurring in the online world.

The ubiquity of everyday tech accelerates the growth of the wired world. Already, 38% of adults (age 16 and older) use the Internet. Next year the total will be nearing 50%. More importantly, women reached gender parity last year as Internet users; soon they will reach parity as online buyers. Perhaps the single biggest error made by many retailers and the retail real estate community was to assume women would not, or could not, embrace the new medium. This bit of gender myopia gave Internet retailers the lead time to become formidable competitors to their location-bound rivals.

What works online? The key to understanding what works online is to screen goods through a prism of merchant service. At one end of the spectrum are the typical self-service items, national brands, house brands and goods of uniform quality. In many instances, the customer's only contact with the retailer is at the checkout counter.

Conversely, at the other end of the spectrum are goods that require a tactile and aesthetic judgment, are non-standard or require full service. A good rule of thumb is that the more experiential and less commodity-like the product, the greater the likelihood the customer will go to the store. Clothes are working well online despite most observers' reservations.

The emergence of the online sales channel confronts developers with the unpleasant reality that retailers are merchandisers first and site locators second. The primacy of the location-based sales channel obscured the distinction before the advent of online buying. Cyberspace rapidly erodes the traditional retailer's advantages of convenient location, everyday low price and wide product selection. The online world replicates them far better.

A recent Merrill Lynch analysis, titled "Internet's Potential Impact on Retail Real Estate," projects that shoppers will spend $28 billion for goods online next year. Merrill Lynch notes that about 60% of Internet sales will shift from stores, with the rest coming from catalogs.

One subject rarely discussed in retail real estate is how sales migration can affect the profitability of stores. Retailers are concerned with new stores opening nearby. It could be a sister store or competitor. Either way, sales volume would suffer. Similarly, the online sales channel is a direct competitor to the store. In cyberspace it doesn't matter whether the transaction takes place with the retailer or the retailer's competition. The result is the same: The sale migrates from the store.

Some argue that expanding sales will minimize the initial impact of online buying on store economics. The presumption is that new and existing customers will continue to buy in the same old way - i.e., shop in the store. However, it is patently fallacious to believe that as more people move online, they will continue to trudge to the store when they can have the convenience of online buying from their home, office or dorm room.

Visions for the future: INFOTECH SCAN and WiredLease Forward-thinking retailers understand they must undergo a radical transformation to prosper in a wired world. They must rethink their investment objectives in the sales channel matrix. There are now three sales channels: the store, the catalog and the online presence. The old retail model grew sales and profits by store expansion. The model is no longer sacrosanct.

Online sales characterizes the negative symbiosis developing between retailers and developers. No longer do they share the common goal of locating the best site to do the most volume and receive the highest rent. Now the retailer has another sales channel, potentially more lucrative and without the headache of the store.

Still, the location-based sales channel will remain a reality for many retailers. Let's fast-forward into the future and consider some visionary ideas that will maintain the viability of the physical store.

The developer and retailer could perform an INFOTECH SCAN as part of their due diligence to establish the site's viability. INFOTECH SCAN is a site-selection tool for determining whether the retailer's best customers move to cyberspace. For developers, it acts to screen potential tenants.

Conceptually, INFOTECH SCAN answers three questions. First, is the retailer's mix of goods and services likely to do well online? Second, are the retailer's customers likely to conduct their transactions online? Third, how profitable are the online customers?

Retailers recognizing the need for sales channel reformation know that their leases are too inflexible for the shift ahead. They will begin negotiating for space in a radicallydifferent way using the WiredLease.

Conceptually, the WiredLease begins with an entry strategy calling for a two- to four-year initial term and multiple one-year options. The operations strategy allows the tenant to downsize and relocate within the property. Finally, the exit strategy provides the retailer with the right to terminate early, go dark or assign the lease with full novation.

Retailers and Wall Street The critical player in the game is Wall Street, the second player to recognize the power of online buying. Wall Street's great influence over retail property is due to the rapid securitization of real estate in the 1990s. As of February 1999, the REIT market capitalization was $132 billion and the CMBS market was approaching $270 billion.

Unfortunately, moving assets from private hands to the public market has unpleasant side effects. When retail properties are subjected to the vicissitudes of tightly coupled trading markets, their value becomes hostage to sentiments wholly unrelated to the performance of the underlying assets.

Several trends help explain Wall Street's shifting stance toward retail development. First, stock analysts following retailers will increasingly reward companies and their management for leveraging the online sales channel. In turn, they will punish the laggards. A number of national retailers seeking to become cyber-savvy will curtail new store openings, reduce the number of stores in existing trade areas, and convert some stores to showrooms sans inventory.

Second, market sentiment is shifting against REITs that have a disproportionate number of tenants susceptible to online sales migration. Green Street Advisors, an independent research firm concentrating on the securities of REITs, is already adjusting the value of retail portfolios subject to the impact of online buying.

Third, credit rating agencies like Moody's are raising a red flag over how online buying affects the ability of borrowers to service debt and the value of retail real estate as collateral. Thus, the market may come down hard on retail developers taking the same old approach. Smart developers should consider strategies for adaptive reuse.

Two factors drive adaptive reuse opportunities: cheap real estate and imagination. The first is a function of how quickly commodity-goods sellers flee traditional retail locations like big boxes, power centers, large community centers and some malls. Developers should keep in mind that drugstores and grocery stores are not immune from online competition.

The second requirement is having the imagination to spot the unfilled need. A big box could become a vertical pet cemetery. A power center could be fashioned into a themed residential community - with, say, an art deco theme. A community center might perfectly accommodate assisted living, convalescent care or Alzheimer's daycare. These conversion opportunities may seem outlandish until one considers that the property could remain vacant for a long time.

MetaSpace, the ultimate frontier This idea transcends the limitations of physical space by integrating cyberspace into retail. It is the new frontier for visionary developers. Today, MetaSpace is only an idea, but it could soon define an entirely new way of creating retail space.

The archetype project for a wired world, MetaSpace represents the third-order impact of the everyday-tech revolution. The first-order impact was the diffusion of information technology throughout society. The second-order impact is online buying's negative effect on retail space. The third-order impact is the synthesis of space and cyberspace for retailing.

MetaSpace is a new form of retailing, providing retailers with the means of fulfilling customers' rapidly escalating expectations. It transcends the store's physical limitations by completely integrating cyberspace into the store. MetaSpace gives showroom, demonstration and service tenants a heretofore unimagined use of cyberspace and physical space.

Tenants for MetaSpace could include: Outpost tenants. Outpost tenants are firms seeking to leverage space in new ways. They are embryonic enterprises best described as a business plan floating through cyberspace. "Fit-2-U" is an example of a hypothetical outpost tenant. "Fit-2-U" is a body-scanning center for clothing that offers two services. The first is taking precise measurements for custom clothing. The measurement software adheres to a universal standard that allows clothing manufacturers worldwide to make custom clothes.

The second role of "Fit-2-U" is showcasing individual designers and manufacturers. In the showroom, customers can view themselves in individually created outfits, feel the fabric and place the order, or upload their scan to the "Fit-2-U" website for later viewing and purchase. The integration of the retail space and the Meta-Space website hosting "Fit-2-U" is seamless.

Wired retailers. Wired retailers are astute traditional retailers seeking to leverage the value of the online sales channel. Their store format is likely to change into a showroom with minimal inventory and highly mobile fixtures. One example is the sporting goods store. Much of the inventory would disappear. Inventory would give way to interactive displays, allowing customers to experience the feel and fit of the glove or club. A fully integrated website would contain greater details about the products, including perhaps a video clip of the inventor or signature athlete demonstrating the item.

Manufacturers. The consumer-direct channel will achieve viability in a wired world. Many manufacturers are itching to go direct. Potential customers include the wired lifestyle families, SOHO (small office & home office) businesses and knowledge workers. Herman Miller is an example [].

Service providers. Going to the dentist requires a physical presence, as do many other services. MetaSpace would draw them. Service tenants would include restaurants and specialty markets, fitness and grooming, medical, dental and wellness, educational firms, and non-profit and government entities.

Wired lifestyle exhibitors. In a throwback to the days of the Midway, temporary tenants would present their goods and services. The presentations envisioned are similar to those performed at trade shows but include a cyberspace counterpart on the MetaSpace website. The Midway is a constantly changing arena to entertain, enlighten and educate patrons about everything from HTML programming to making Peking Duck.

Making money from MetaSpace * Intellectual property. An integral part of MetaSpace is development and operation of a website, a critical task developers must undertake either through partnering or creating it in-house. One outcome of the MetaSpace design process is creation of a patent or other valuable intellectual property rights. This presents IP licensing income opportunities along with licensing the project's name and image.

* Telecommunications. Developers must enter the telecommunications infrastructure and service business. While the idea may seem farfetched, office developers like Equity Office Properties are aggressively entering the business. Until recently, a retailer's bandwidth requirement was minimal. Expect rapid change as retailers seek to meet their customers in cyberspace and enhance the in-store experience. Developers are in the best position to capitalize on their tenants' needs. They can seize the opportunity at the inception of the project by designing and installing the necessary cabling, routing and switching infrastructure to maximize bandwidth. Developers may also derive income from designing software for integrating cyberspace into physical space.

* Advertising revenue. MetaSpace would attract great interest for product tie-ins, infomercials via video streaming on the Net, or a project magazine featuring articles about the tenants.

The transition from a geocentric to a cybercentric world is in its infancy. One must prepare for the coming online buying revolution as it roils the property and capital markets. Remember the wisdom of the ancient who said, "It is better to make the house rules than to play by them."

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