In 2017, Westfield Corporation, a large retail landlord, established OneMarket, a platform to facilitate the sharing of data and know-how between retailers, brands, venues, and other partners. Westfield’s main U.S. and U.K. portfolio has since merged into Unibail-Rodamco, forming Europe’s largest commercial real estate company and one of the world’s largest retail landlords. Following the merger, OneMarket was spun off as an independent company. As of July 2019, it seems to be burning cash quickly while not generating significant traction.lxxxvi The initiative seems to have fallen between the cracks during the change in ownership and management at its parent company.
OneMarket’s failure to take off shows how hard it is for landlords to sustain long-term investment in the development of innovative tech platforms. Building competitive advantage with technology is a long and arduous process that requires perseverance and significant outlays. Consider the financial losses incurred by Amazon over nearly two decades while it reinvested its free cash into research and development of new initiatives. It is hard to imagine a real estate company showing similar resolve, much less so a real estate investment trust (REIT) that is traded in a public market and is expected to generate regular dividends.
Consider AmazonGo, Amazon’s futuristic convenience store concept. In Seattle, Chicago, San Francisco, and soon New York City, shoppers can walk into the store, take whatever they like, and walk out—just like the lady in the nineteenth-century department store. But this time, no “hysteria” or illegal activity is involved. Various scanners, cameras, and sensors across the store
© The Author(s) 2020 41
D. Poleg, Rethinking Real Estate, https://doi.org/10.1007/978-3-030-13446-4_5 figure out what goods are picked up, and the customer’s Amazon account is charged automatically, as if by magic.
As tech strategist Ben Thompson pointed out,lxxxvii AmazonGo is not just an example of what technology can do, but of the “economics of tech” as a whole. The economics boil down to the difference between fixed and marginal costs. Convenience stores, for example, have human employees who are paid by the hour. These humans spend a certain amount of time on each customer. As a result, more customers lead to more work and, in turn, more costs. This does not mean that traditional retail operators do not enjoy economies of scale. But even at scale, a major share of their costs grows in tandem with sales. Traditional retail scale means distribution efficiencies, leverage with suppliers and providers, and pooled marketing expenses. But an employee’s time costs almost the same whether you have one store or one thousand.
Now, let’s consider the economics of tech. Technology companies make extremely high upfront investments—developing proprietary hardware, software, and products—but then have much lower marginal costs to serve any additional customer as the business grows. This is also the logic behind venture capital investment in technology companies: “spend a lot of money upfront to develop and build a product, and take advantage of minimal marginal costs to make it up in volume”.lxxxviii
In Amazon’s case, this means that the operating costs of its unmanned checkout system are more or less the same whether it works for five minutes or five hours, regardless of how many items are sold each day. As a result, Amazon’s brick-and-mortar store can achieve much higher operating margins than its “traditional” competitors. The high upfront investment required to develop the technology also means that unless Amazon opens hundreds or thousands of stores, it will never recoup its investment in developing the initial technology. And indeed, Bloomberg reports that the company is hoping to open 3000 such stores across the U.S. by 2021.lxxxix
One could argue that real estate companies also make large investments and then reap dividends as people use their space over many years. In addition, technology can never be just a one-time, upfront investment since software, databases, and hardware require ongoing maintenance and updates. This is true, but there is still a difference between traditional real estate and technology investments: Done right, technology reaps far larger dividends through leaps in efficiency and reductions in the cost of opening and operating each store, and in the amount of space required to generate the same amount of revenue. The returns are of a different order of magnitude, and so is the risk.
Amazon is willing to bet huge sums in upfront investment in order to redefine the economics of offline retail and build a product that, once ready, can scale quickly and efficiently. Note that we’re using the word “bet”, as it is not yet clear whether Amazon will be able to scale its unmanned retail stores. Most traditional landlords and retailers do not have the audacity or the capital to build comparable advantages.1 But even landlords that have the necessary vision and financial resources face structural constraints that limit their ability to innovate.
The world’s largest retail landlords are structured as public REITs or as private equity funds. REITs are expected to generate regular dividends and, as such, are not ideal vessels for investment in ventures that incur years of upfront losses. In addition, U.S. REITs have a regulatory requirement to invest 75% of their assets in actual real estate and to distribute 90% of their income back to their shareholders. This means that even if they have cash to invest, they are limited in their ability to invest in new initiatives.
Private equity firms such as Blackstone or Brookfield have a better ability to stomach losses while they wait for an ultimate payout. In fact, the structure of many private equity real estate funds is almost identical to that of venture capital funds. As the name implies, such funds are private. This means they face less ongoing scrutiny from the media and retail investors, and can make long-term bets that would be hard to justify in the court of public opinion. But private equity real estate funds have their own limitations. They normally have a mandate that defines what type of assets they can invest in. As a result, they are not able to concentrate their investments in “technology” or “services”, but only in actual buildings that have hard value and can be refinanced.
Unlike traditional businesses, funds are structured in a way that focuses their efforts on the value of each building on its own. Each asset is acquired at a separate point in time, often with different partners, and with financing (a mortgage) from different lenders. As a result, the cash flow of each asset is subordinate to different interests, and the fund manager is limited in its ability to act in the long-term interests of the whole portfolio or firm. This means that investment in technology (or anything else) can be justified only if it has a positive and immediate impact on the individual building.
The ownership structure of individual assets also highlights the fact that many landlords are simply smaller than they seem. For example, a firm might manage a portfolio worth $5 billion that generates $200 million in net operating income (NOI) each year. NOI refers to all revenue generated from the property minus operating expenses. A big chunk of this income goes to pay for financing, fund management fees, and other fees. As a result, the “$5 billion landlord” might have only a few million to spare each year. In addition, most real estate funds have a limited lifetime (seven to ten years or so) and generate most of their returns in their final years, when assets are sold at a premium. This limits their ability to make discretionary investments upfront.
Many private equity firms manage several separate funds in parallel, including funds that are focused on similar assets and geographies. Here, too, each individual fund may have different investors and may be managed by different partners within the same firm. This makes it difficult to align the interests of all the managers and investors toward a strategy that benefits the long-term interests of the portfolio as a whole. Each individual fund is responsible for its own returns, and the assets within it are bought and sold based on these somewhat narrow considerations.
The partners in most private equity firms are incentivized based on returns from assets and funds they currently manage.2 Unlike traditional companies, funds are structured in a way that pays out a portion of these returns as fees to the managing partners. These partners have no incentive to forfeit fees today in order to invest in speculative innovation initiatives that might benefit assets in future funds, or in funds managed by other partners in the firm. REITs have a better structure for long-term ownership of large portfolios and allow for a more centralized allocation of resources. But as mentioned above, they have their own limitations.
To recap, the structure and mandate of large real estate companies often limits their ability to make significant investments in anything other than actual buildings (as opposed to technology and service platforms). Their structure incentivizes their managers to focus on the immediate operational income of individual buildings as opposed to long-term investment in technology and service platforms that encompass multiple buildings over longer periods.
One way to address these challenges is to split landlords into separate entities with different mandates, management teams, and investors. Indeed, this is a common strategy in the lodging industry. But there are key differences between hotel and retail assets that limit the ability of retail landlords and operators to bring together hundreds or thousands of assets under a single brand and service platform.
In the hotel industry, it is now common to split businesses into separate companies, one owning the actual property (PropCo) and another responsible for marketing and customer-facing operations (OpCo). The OpCo is an operating business that generates revenue from sales and the PropCo is an asset owner that generates revenue from rent or management fees paid by the OpCo. Many Starwood, Accor, or IHG hotels, for example, are operated by these brands on behalf of third-party landlords or on behalf of affiliate entities that own the actual real estate. Hotel brands often operate as a franchise, providing guidance, and brand-usage rights, and marketing support to the building’s owner or manager. We explore hotel ownership structures in more detail in the Housing and Lodging section.
This model is prevalent in the hospitality industry for five main reasons. First, it enables different investors to get exposure to separate products, according to their risk appetite and mandate. Some investors may only wish to own real estate assets, while others are happy to invest in operating businesses. Second, taking real estate off the books frees up cash that the operator can invest in branding, general marketing, technology, general management, and other activities that improve its ability to draw and serve customers in each of its buildings. Third, splitting assets and operations into separate entities may create tax efficiencies. Fourth, separate OpCos and PropCos leave room for various tax benefits and accounting maneuvers.
These four reasons are equally valid for retail and hospitality assets. The difference between these types of assets lies in the fifth reason: transaction costs. Let’s see how.
Consummating an exchange between a hotel and a guest carries very high transaction costs. A traveler needs to find a place to stay in, often in a new location (triangulation); she needs to make an advance booking and secure it with a down payment of some sort (transfer); and she needs to believe the hotel and her room will actually be there once she arrives and that they will be safe enough to spend a night or take a shower in (trust).3 These transaction costs make it critical for hotels to have recognizable and trusted brand names, as well as centralized marketing and distribution platforms.4
When it comes to retail assets, the situation is more complex. A potential customer is often looking for a specific product, but not for a specific location (“I need to buy a new phone” vs. “I am looking for a room in central London”). This means that triangulation applies primarily to the cost of figuring out where the product is. This does not mean that the location of a retail store is irrelevant, but that the main driver behind the customer’s action is the product—compared to booking a hotel, when the customer must go to central London and can choose which specific hospitality product to pay for. In the retail case, the customer wants to buy a new phone and can choose which specific location to go to or order from.
In other cases, retail customers are not looking to buy anything specific and are only looking to pass the time. A potential customer might choose to go to a retail project because it is easy to access by foot, car, or public transport. This means triangulation is less of a challenge because the customer simply goes to a nearby store or stores and has fewer options to choose from. More accurately, triangulation becomes a hyper-local problem, helping the customer decide which side of the street to go to. This creates other opportunities, but for now let’s focus on the fact that hotels and retail projects face different triangulation costs.
Transfer costs were historically less of a challenge for retail projects, since products bought in a physical store were normally not booked or paid for in advance (at least not until recently). And trust is also less critical since the retail customer is only visiting the store for a few minutes, as opposed to spending the whole night or taking a shower. Most importantly, most retail projects aggregate multiple product brands. While a hotel attracts customers and communicates its value by putting a name (e.g. Hilton) on its front door, a retail project attracts shoppers by putting Zara, H&M, Uniqlo, Sephora, and dozens of other names on its façade. The customer often buys a product from a branded retailer within the landlord’s project, but not from the landlord itself.
In short, when it comes to retail, the building is where the products are found; when it comes to lodging, the building is the product. As a result, the retail platforms that emerge to lower the cost of triangulation, transfer, and trust are focused on finding, paying for, and delivering products, not buildings. By helping consumers find the products they want, these platforms can substitute landlords altogether. For example, a customer who buys an item on Amazon or Taobao does not need to visit a store at all. In comparison, a customer who makes a booking on Expedia is still going to visit—and pay for— an actual physical room in a hotel (or apartment building).
As a consequence, retail landlords that wish to remain relevant face a more complex challenge. They also face more severe consequences in case they fail. Some of the largest retail landlords are already hard at work to reshape their organizations, invest in innovative technologies and companies, and acquire new capabilities.
Landlords of the Future
In March 2019, Stephen Ross, the Chairman of Related Properties formally opened The Shops & Restaurants at Hudson Yards, a one-million-square-foot mall on Manhattan’s West Side. New York City is not famous for its shopping malls. And retail projects are not the most popular investment of Q1 2019. It remains to be seen whether this mall will do well, but it is already clear that its developer is taking a different approach, one that points a possible way forward for other companies in the space.
To start with, the mall at Hudson Yards is located at the heart of the largest real estate development project in the history of the U.S., surrounded by 17 million square feet of offices, apartments, and retail spaces, representing a total investment of about $25 billion.xc In contrast, the classic American mall is a creature of the suburbs. Most of the 1500 or so enclosed malls built across the U.S. between 1956 and 2005xci are islands of commercial activity, flanked by giant parking lots, in a sea of low-density housing and highways. After 2005, hardly any new enclosed malls have been built, and many have shut down.
Those classic malls were usually anchored by one large department store or more, taking up the most coveted ground-floor corner and entrances. The mall at Hudson Yards, on the other hand, is divided into smaller stores and its single luxury department store tenant, Neiman Marcus, is only on the fifth floor. As mentioned above, the mall also has a full “Floor of Discovery” dedicated to digitally native brands and new retail concepts. The mall also puts a strong emphasis on dining, as reflected in its official name, The Shops & Restaurants at Hudson Yards. It is telling that the word “Restaurants” is absent from the name of Related’s older New York City mall, The Shops at
Columbus Circle. In 2003, when that mall opened, shopping was enough of an attraction.
But the most interesting thing about Related’s approach is its relationship with the brands and infrastructure powering the new mall and the buildings that surround it. In addition to being a real estate developer and operator, Related also has a fund management business, Related Fund Management, that allocates third-party capital to real estate projects and other related operations and service companies. In addition, Related is affiliated with RSE, a private investment vehicle that invests in technology, media, dining, and entertainment ventures. RSE was established by Related’s Chairman. While RSE is a separate investment vehicle, its portfolio companies are listed on Related’s main website as part of the company’s “family of brands”.
These multiple investment platforms give Related the flexibility to differentiate its projects from other real estate companies and potentially capture a larger share of the value generated by its operations. RSE is an investor in several of the tenants at the Hudson Yards mall, including Bluestone Lane Café, KĀWI, and Fuku. RSE is also an investor in Resy, a reservation management system that is used by Hudson Yards visitors to book tables at the project’s various restaurants.
While RSE’s investments have some synergies to Related’s core business, the company uses its fund management business (RFM) to integrate its real estate and branded operating platforms more closely. In March 2019, for example, Related acquired Quiet Logistics, a provider of fulfillment services to digitally native brands such as Bonobos, Mack Weldon, and Away Luggage. The acquisition was done in partnership with Greenfield Partners, a logistics investment specialist. Related plans to use the new platform to offer tenants a more comprehensive solution—including physical retail stores, physical fulfillment centers, and the service layer required to sell across multiple channels.
As retail analyst Richie Siegel pointed out, many independent brands “reject Amazon fulfillment services, mainly to avoid sharing their data”xcii with a potential competitor. (Amazon is notorious for launching private label alternatives for some of the best-selling products on its site.) In consequence, Siegel believes that “independent logistics companies like Quiet have a lot of running room ahead of them.” Unlike Amazon (or even Walmart), landlords are in a better position to align their interests with branded retailers.
In 2005, Related acquired Equinox, an upscale gym operator. Related helped Equinox expand to some of the best locations across the U.S., as well as to new market segments and service categories. In turn, Equinox’s brand and devoted membership base helped anchor and differentiate some of Related’s residential and commercial projects. In 2019, Equinox opened its first hotel, located across from the Hudson Yards mall. The hotel is focused on wellness, providing guests with access to professional-grade sports facilities (“cryotherapy chambers”), specialized dining options (“jet-lag tonics”), and access to an “on-call sleep coach”. Equinox plans to open additional hotels in major global cities over the next few years.xciii
The relationship between Related’s real estate development, fund management, and venture investment vehicles is not always clear, but they are often … related. This diversity of mandates, businesses, and management teams enables the group to do things that would be difficult for real estate investment trusts (REITs) and traditional private equity funds.
Private companies can experiment over time, without the scrutiny of Wall Street analysts and mom-and-pop shareholders. But the world’s largest retail portfolios are (still) owned by publicly traded REITs. As mentioned above, such REITs are required to invest most of their capital into actual real estate assets and to distribute nearly all of their income back to shareholders on a regular basis. Can REITs innovate within these constraints? They are certainly trying to.
Simon Property Group, a REIT, sponsors an early-stage venture capital fund, Simon Ventures, that invests in start-ups at the intersection of retail and technology. Its investments include Appear Here, a marketplace for shortterm retail space; Foursquare, a location data platform; Bird, a ridesharing company; FabFitFun, a subscription box service for cosmetics products; Dirty Lemon, a beverage company; and MeUndies, a maker and distributor of underwear. The last two are digitally native brands that are experimenting with new ways to sell their wares. Dirty Lemon allows customers to order its health drinks by sending a text message. MeUndies offers a subscription for underwear—sending shoppers a new pair each month.
Simon Ventures is also an investor in Deliv, a start-up that helps retailers handle last-mile fulfillment. This echoes Related’s investment in Quiet Logistics, but with two key differences: (1) Simon is only a financial investor and did not fully acquire the company, and (2) other retail REITs have also invested in Deliv, including Macerich, Westfield, and GGP. This means that none of the landlords get to control a unique technology or operating platform. On the other hand, retailers might appreciate the ease of using the same fulfillment solution across hundreds of malls owned by four of the world’s largest REITs.
Simon is making an effort to integrate physical and online retail. The company is collaborating with Dropit, a start-up that enables shoppers to leave their bags at the mall and have them delivered to their homes. In January 2019, Simon company announced RetailConnect, a new “fulfillment as a service” solution that will help mall-based retailers “to fulfill e-commerce orders without allocating additional space, staffing, hardware, and software”. The service will operate out of specialized depots within select Simon malls, starting in the Dallas-Fort Worth area. The plan is to gradually enable brands to offer same-day delivery, in-store pick, and curbside delivery.xciv
Simon also operates a program that allows shoppers to return goods purchased from select online retailers. Instead of packing, shipping, and waiting for a refund, shoppers can bring items directly to Simon malls and receive immediate credit. Just like Amazon and Alibaba, Simon is striving toward a seamless integration of online and offline shopping. And while Alibaba and Amazon are launching physical locations, Simon plans to launch a new consumer- facing digital platform in 2019.
Simon is able to fund such innovations within the constraints of a REIT, thanks to the size of its operations. The company owns and operates over 200 retail properties, including 118 shopping malls and had a market cap of over $57 billion as of April 2019. Allocating a fraction of its revenue to innovation can add up to tens or hundreds of millions each year. The scale of Simon’s portfolio also makes it easier to justify such investments—if successful, they can be deployed quickly across hundreds of properties. Having a foothold in many of the largest cities in the U.S. also makes it feasible (and worthwhile) for it to offer logistics solutions to online retailers.
The growing importance of scale might explain the consolidation wave that is sweeping major REITs in recent years. In 2017, Unibail-Rodamco SE acquired Westfield Corporation to form the world’s second largest shopping mall owner and operator. In 2018, GGP, one of America’s oldest and largest retail REITs, was acquired by Brookfield Property Partners, one of the world’s largest owners and operators of commercial real estate. Brookfield has also made efforts to acquire Intu, one of the U.K.’s largest retail REITs. Brookfield has a variety of public and private investment vehicles and multiple mandates that allow it to invest in operating businesses as well as in retail, office, industrial, and other real assets. In theory, this puts it in a better position to build a platform that integrates physical and digital retail, fulfillment, and other relevant services.
The convergence of digital and physical channels means that the business of retail landlords is increasingly governed by the economics of tech. As we pointed out earlier, these economics entail significant upfront investments that (may) lead to dramatic reduction in the marginal cost of serving each new customer. In other words, the growing role of technology is intensifying returns to scale in the physical retail industry. As a result, being big and integrated is becoming an advantage in the battle to remain relevant. Small landlords will not be eliminated, but they will have to rely on third-party operators or find new ways to partner with companies that can contribute operations and marketing resources (including existing OpCo, but also companies that have not yet emerged).
Technology is shaking up all real estate assets but its challenge to physical retail is unique. Technology does not simply change the way retail spaces are designed, operated, and valued. Instead, it questions whether these spaces should exist at all. People need homes to live in and office spaces to work in. Goods need manufacturing and storage facilities. But in a world of digital storefronts and ubiquitous logistical networks, are physical stores necessary? In theory, the answer is no.
Put differently, physical retail emerged to solve a set of temporary problems that might no longer exist. In the past, there were high costs for buyers and sellers to find and trust one another. There were high costs to transfer goods and payments. There were high costs to ensuring each side honors the terms of sale. Technology reduces or eliminates these costs.
This does not mean that physical retail will cease to exist. It doesn’t even mean that it will ultimately be worth less or take up less space. But it does
mean that, compared to other types of real estate, the evolution of physical retail is less constrained and harder to predict. Technology does not simply enable this evolution, it requires it.
The bundling and unbundling of retail landlords and spaces will result in businesses that are very different from the ones that dominated the twentieth century. They will be not just different, but also harder to categorize and define. The word “landlord” might no longer be appropriate. Owners who want to succeed must become businesses that combine multiple assets with a thicker layer of services, mix new assets and capabilities, and have the infrastructure to tie everything together. In many cases, achieving this would entail splitting into separate specialized entities, possibly more than two. To succeed, the operating layer(s) will have to address new types of transaction costs and reduce new types of friction.
Facing customers, that means:
• Using curation to reduce the time required to sift through an endless number of options;
• Providing real-time information on which goods are available in-store;
• Providing multiple purchasing and financing options online and in store;
• Providing delivery and pick-up options as well as easy ways to handle returns and exchanges;
• Providing a place to discover new inventions and learn new life skills; and
• Creating environments rich with the things that are becoming scarce in our world dominated by technology: human interaction, natural elements, things and activities that can be experienced with all five senses.
Facing retailers, that means:
• Making it easy for brands to set up physical stores with minimal upfront costs and commitment;
• Providing an array of logistical and financial services that allow brands to focus on what they do best while offering services on par with those of much larger retailers;
• Providing data and analytics to help brands improve their physical stores;
• Helping brands get a full picture of their customers’ journey by integrating with systems used to manage other sales and marketing channels;
• Providing easy access to a network of additional physical (and digital) locations to enable brands to scale quickly once they have a winning product; and
• Creating an environment and an event calendar that attract customers who have many other ways to spend their free time.
7 Rethinking Physical Retail Properties
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It’s no coincidence that many of these points sound like a description of early department stores. Those stores bridged a gap between “buildings” and “brands” and employed many of the strategies that are required to succeed in the twenty-first century: they created environments that surprise and delight, introduced new cultural and dining experiences, made use of the latest technologies, centralized non-operational management functions, provided free delivery, and tapped into the aspirations and values of existing and potential customers.
By the end of the twentieth century, retail was dominated by malls that were carbon copies of one another, isolated from their surroundings, and filled with identical brands. Such malls reflected the peak of the era of mass manufacturing and mass media. As we will see in the Logistics and Industrial section, we now live in an era of small-batch manufacturing and fragmented distribution. This provides an opportunity for retail estate companies to make retail properties more exciting and more valuable than ever.
To be clear, we are not saying that landlords should start opening their own convenience stores; we are using Amazon as an example of why landlords would struggle to make other necessary investments in technology.
Short term compared to the decades or longer it might take to build a proper tech-enabled business.
For a detailed analysis of how hospitality platforms “commoditize” trust, see Ben Thompson, “Airbnb and the Internet Revolution”, Stratechery, last modified July 1, 2015, https://stratechery.com/2015/ airbnb-and-the-internet-revolution/.
Hotel operators are now competing with new types of branded booking platforms. We address these dynamics in the Housing and Lodging section.