The e-commerce revolution took a long time to build up, but now an online flood led by Amazon is sweeping away weak hands. One-third of malls may close in the next decade, even as retail sales rise to new record highs.

Last week, we discussed Amazon’s blowout $35.7 billion quarter and how U.S. consumer spending and retail sales have rebounded to new all-time highs. The 2016 holiday season was the biggest in history—growing 4% over 2015 to $658.3 billion. Retail sales grew 4.1% in the first quarter of 2017 compared to Q1 2016, or $45 billion bigger (ex autos, food service and fuel), even though the Easter holiday is in the second quarter.

And yet, 2017 is on pace to record more retail store closings than any time before. It has everything to do with technology.

The false dawn of online retailing in the late 1990’s and ensuing stock market bubble seem like a distant memory now. But today, consumers are much more comfortable making purchases of a much wider variety than when the internet bubble popped. Now online shopping is becoming the norm. Ironically, it was brick and mortar that was building its own bubble in the 1990’s, part of the last push of a long period of oversizing the physical U.S. retail footprint. Urban Outfitters' CEO is one of the latest retail leaders to point out the U.S. market is oversaturated with a bubble in retail space.

He isn’t the first CEO to think so, nor the first to notice something wicked was coming the way of brick and mortar retail. Howard Schultz, the former CEO of Starbucks, marked the 2013 holiday shopping season as the moment online retailing had finally arrived. He began Starbucks’ fourth quarter investor conference call by declaring:   

“The truth is that traditional brick and mortar retailing is at an inflection point. No longer are many retailers only required to compete with stores on the other side of the street. They are now required to compete with stores on the other side of the country. ...many, many retailers who are going to have a hard time navigating through what I believe will not be December-ish problem, this is going to be an ongoing issue and it’s going to happen faster than people think in terms of the way people are shopping and how they are spending their time, and the value that you can get on the web.”

Schultz made news with his comments at the time, which seemed to explain the holiday season’s odd results. That year big retailers disappointed, and yet total retail sales and consumer spending measures made new record highs. "We are navigating through what I believe to be a significant sea-change," Schultz told CNBC the next morning. "We're going to be talking about this for quite some time. I would not want to be a traditional brick and mortar retailer that did not have mobile payments, that did not have social and digital media. Those companies are going to find themselves significantly challenged in 2014 and beyond."

Schultz’s sea-change proved prescient. He’s now retired, but the mobile payment system he implemented at Starbucks reached 29% of all U.S. Starbucks transactions in the 4th quarter of 2016.

The sea-change Schultz noticed in the 2013 holiday shopping season was not just about its surprisingly large size. It exhibited a substantial structural shift. And it happened so fast, in fact, that UPS was unable to make all its deliveries on time—causing many unhappy customers and a great deal of bad publicity.

Schulz saw e-commerce’s tipping point. In the past, the holiday shopping season in the U.S. had a reliable timing that planners in the retail sector came to rely on. December 16-20 was known as "Peak Week" due to the huge surge in volume of gifts ahead of the holidays. Using supercomputers and algorithms to monitor, measure and predict its logistics, UPS expected to pick up more than 34 million packages Monday, December 16, and deliver 29 million packages on Tuesday—which would be a single day record for the world's largest package delivery company. To ramp up to meet this expected surge of record volume, UPS hired 55,000 seasonal employees. But they would not be enough.  

UPS underestimated demand badly, and a late surge in package volume forced the company to scramble. On December 23, 2013, UPS delivered more than 31 million packages, the most ever—six days later than the expected peak and 13% more packages than the prior peak day in 2012. As UPS explained, its holiday season was:

“…negatively impacted by the challenges of the compressed peak season coupled with an unprecedented level of online shopping that included a surge of last-minute orders. In an effort to maintain service standards and commitments, UPS took extraordinary measures deploying additional equipment and people. For example, the company utilized 85,000 temporary employees, 30,000 more than planned.”

The “surge of last minute orders” UPS experienced was powered, in part, by the introduction of Amazon Prime, which offered free two-day delivery to subscribers. Empowered by Amazon Prime, shoppers could now wait longer than ever to lock in their purchases for the holiday—and they took full advantage. It blindsided everyone, including FedEx, which endured its own last minute scramble.

And there was no going back. The next year, in 2014, Amazon Prime customers ordered "more than 10 times as many items with same-day deliveries" during the holiday shopping season than in 2013.

Shopping’s New Normal

Schultz’s sea-change symbolizes the moment online retailing reached critical mass. It is not simply a change in where people shop, but how people shop.  Consumer behavior has changed. In the 1990’s, you weren’t supposed to share your info or transact with strangers on the internet, and you should definitely never, ever meet someone you met online in the real world. Now we order rides from strangers who pick us up at our house and pay them with our phones.

Convenience rules the day. Armed with smartphones, now shoppers in brick and mortar stores can instantly compare the price of the item in front of them with the same and similar items for sale at other retailers (physical and virtual) around the world. This is great for the consumer, because this technology empowers them with unprecedented price information, but  it is potentially bad for the physical retailer they are standing in because many “showroom shoppers” do not buy from the store—even when they’re in it. They just might purchase the same item from another store and have it shipped to their home, all while standing in the same spot.

The smart consumer of the 21st century is more frugal than ever before, which is intensifying competition among retailers to the extreme. It is also driving innovation, such as Amazon Prime, as companies respond to the needs of the smart, comparing consumer.  Woe betide the retailer who doesn’t price match. Consumers benefit tremendously because this acts as a huge deflationary force holding down prices. But this environment of increased competition will also have a deflating effect on retailer margins, putting pressure on profits. This increased consumer pricing power comes at the expense of retailers—and those with high costs and low margins the most.

This is bad news for brick and mortar because it’s not exactly a low cost method to deliver goods.  It costs money to do.  It costs even more money to do well. And it’s getting harder to do.

Stood Up at the Showroom?

Signs of trouble for brick and mortar retailers had been showing well before 2013.  As the economy bounced out of the recession, retailers struggled to bring shoppers back through their doors. Foot traffic took a downturn during the Great Recession, like any recession.  But this time the foot traffic rebound. 

As the exurbs blew up in the crash, vehicle miles travelled also seemed to peak, and online sales kept growing, retailers knew they had to defend market share and attract shoppers. By the sea-change in 2013, foot traffic was still bleeding, and one analyst speculated to the Wall Street Journal that “many of those shoppers may never be coming back.” Despite retailers’ best efforts, consumers deflected online en masse causing the Journal to conclude: “across a number of retailers, their defensive strategies don't seem to be panning out.”

Retailers received roughly half the holiday traffic in 2013 as they did just three years before. ShopperTrak’s network of 60,000 shopper-counting devices monitored declines of 28.2% in 2011, 16.3% in 2012 and 14.6% in 2013. And they kept falling, even on Black Friday—the peak day for foot traffic when retailers go all out to attract shoppers.  Finally, in 2016, ShopperTrak data showed a slowdown in the bleeding.  When looking at the combined period of Thanksgiving night and Black Friday—the new “extended Black Friday,” due to the number of retailers who began opening their doors before midnight a few years ago—ShopperTrak monitored shopper visits only down 1% this past year compared to 2015.

Knock-on Foodcourt KnockOuts

Fewer trips to the mall also translated to fewer meals consumed nearby. Since 2000, casual dining had already experienced lower customer traffic in nine out of thirteen years going into Schultz’s 2013 sea-change. And just like retail foot traffic, casual dining traffic did not rebound coming out of the Great Recession and instead reaccelerated downward in 2012 and 2013.

In the wake of the seismic shift of the 2013 holiday shopping season, Sbarro, the Italian Restaurant chain ubiquitous in the mall segment, immediately announced in January it would close 150 locations. Two months later Sbarro filed for bankruptcy—its second bankruptcy filing in less than 3 years. Hot Dog on a Stick, another fixture in food courts, went right to bankruptcy in January 2014. It got trapped into high leases signed during a brief hot market in the early 2000’s only to see mall traffic abruptly collapse.

Value-chains and brands overexposed to weak malls and retail centers run the highest risk of popping along with the retail bubble. This will accelerate an ongoing structural adjustment to rebalance the commercial real estate market, underpinned by a new set of fundamentals.

U.S. Supersaturation

Even before the Great Recession, retail in the U.S. was past the point of supersaturation. The industry built itself into a bubble, as we noted last week, Urban Outfitters CEO recently pointed out: “[r]etail square feet per capita in the United States is more than six times that of Europe or Japan. And this doesn’t count digital commerce.” So, if you add on top of that the billions of new e-commerce merchants currently operating today, then you have some idea of the massive retail capacity that’s been built up.

When the Great Recession hit, retail space per capita in the U.S. finally began to come back to earth.

How low it has yet to go is unclear, but Costar estimates the U.S. may need to shed a billion square feet, fast. Generations of retail developments built under the old normal are being reevaluated. The industry has certainly come a long way.

Mall development delivered 375+ million square feet of new space per year in the 1970’s, and then it continued to plow ahead for two decades. By 2000, development had slowed down by half—or about 144 million square feet per year. And today there are still ~1,200 malls in the U.S, according to the International Council of Shopping Centers (ICSC).

Overall, malls have performed better than other shopping-center categories, which have experienced larger sales declines. Relative mall overperformance is led by a core of around 300 strong properties. The top one-fifth of the best malls generate more than two-thirds of all mall revenues, while B and C malls (roughly 550 properties) only account for 28% of all mall sales.

The more prosperous malls tend to be located either in high-density, affluent markets or at tourist destinations. Many of these properties have experienced double-digit growth in recent years and are holding their own against the internet. And most of these class A and class B malls are controlled by publicly traded REITs with talent, experience and access to capital that give them a competitive edge and deep war chest. But the cash generated by top properties alone creates a huge capital advantage in the race to redevelop and refresh assets to compete in the new normal.

Great Retail Retrenchment

Unsurprisingly, top-tier mall owners are putting up their cash to renovate and refresh their properties. They are investing in smart facility management and stepping up lease management and shopper support to insure their properties are well-leased and well run.

Seven or eight hundred malls might have the location, logistics and layout to survive the next decade. That leaves roughly four hundred weak hands. Going forward, stronger malls will get stronger and weaker malls will continue losing market share before ultimately folding. Like the way newspapers were put out of business by television and the internet before, leaving all but the largest cities with just one daily paper, many cities won’t be able to maintain more than one mall. And there will be many cities that won’t have even one mall.

The disparity between between top-tier, class A properties and everything is else is incredibly wide and growing. Class A and B mall operators have free cash flow and can afford to invest and modernize their malls, but many class C and D malls don’t. And they have few finance options. It's harder for underperforming malls to reinvest, because they have to look for cash. Harder still, their declining economics makes it more difficult to get financing. Worse yet, because the category is weak, borrowers are tightening lending standards outside of the A mall category.

Many owners of lower quality assets have sought to exit, but struggled in a buyer’s market now running more than a decade long. And now the bottom of this asset class is staring at an extinction-level event. Some are trapped in ten-year loans issued at the top of the cycle in 2007 that now are coming due, as mentioned in our 2017 forecast; and if they haven’t already refinanced, then they probably can’t.

It’s very hard to reposition your property without access to capital. It’s very hard to pivot much at all, without a property maintaining some special retail advantage in its trade area. Even with capital, retail reinvention is very hard to get right. JC Penney learned this the very expensive way—and for mall operators it’s no less complicated.

Geographic Reconfiguration

Not every A and B property will automatically survive. Just like not every C and D mall will be shaken out. Local and regional geographies are undergoing significant reevaluation and reconfiguration. One thing is clear:  the retail landscape is becoming more sparsely populated in a geographic battle royale.

Innovations in mobile payments and adoption of those and other internet-based technologies are working to create this critical mass of creative destruction in retail. It’s changing consumer behavior. And it’s reshaping the competitive landscape as well as the literal landscape—by shaking up the old retail site selection rubric. Showroom shopping alters the shopper’s travel dynamic, because the shopper need no longer actually travel to the retailer with the lowest cost item. Instead, the nearest or most convenient retailer will do.

In the old normal, shoppers may have been willing to drive across town to the best priced items, even if it was farther away. This dynamic helped fuel the retail explosion in edge cities and exurbs in the prior cycle. Wal-Mart was a pioneer of this geographic strategy. Charles Fishman, author of "The Wal-Mart Effect," points out that Wal-Mart’s expansion strategy under founder Sam Walton was to open stores on cheap land in locations that other retailers presumed could not support a large store. As a result of this site selection criterion, most Wal-Mart stores were situated beyond immediate population centers—particularly, outside historic downtown and urban areas.

But the new smart shopper is forgoing the trip to the far-flung megastore in favor of more proximate stores that win on convenience. Everything has to be worth the trip. Millennials will travel—300 miles for a pizza in this case—but the value proposition must be rich enough, which usually comes in the form of experience, quality, or novelty. And as these preferences and behaviors changes, it is cascading into the real estate universe and reconfiguring the economic geography of the retail landscape. Wal-Mart’s once innovative network of locations is weakening. In recent years, it has been closing underperforming stores and opening new formats in more dense areas to pivot into the sea-change.

In a long term retail price war enabled by the internet and now enflamed by its reaching critical mass, there is simply less utility for a rational economic actor in travelling long distances for the lowest-cost item. In a world where time is more valuable than ever and convenience worth a premium, it is increasingly uneconomic for consumers to drive 20 to 30 miles round trip to a supercenter to save a marginal amount.  Especially when Amazon Dash Button’s can reorder your Tide detergent or Bounty paper towels over your local wifi with the press of a button.

Roadmap in Macy’s Decision-Making

It’s illustrative to look closely at the sixty-eight stores Macy’s announced it would close earlier this year. You might presume that these were located in C or D class malls. But an analysis by CoStar found that two-thirds of them were actually in A or B class malls. CoStar’s analysis highlighted that 60% of the affected stores were within 10 miles of another Macy's. By downsizing a store, Macy’s hopes to rightsize these markets and strengthen the remaining location. Shrinking their overall presence to focus on the growth of one, solid asset—which is also more capital efficient.

As weaker malls die off, survivors are freer to compete in their respective geographies. This shrink to grow strategy is widespread and driving retailers to shed square feet very fast. That puts a lot of secondary and tertiary malls in the crosshairs for more store closures. Examining Macy’s, for example, the same CoStar analysis found another 44 pairs of stores within 10 miles of each other.

In this massive retail retrenchment, many properties become extremely vulnerable. When anchor tenants Macy's, Sears, and J.C. Penney go suddenly in a down market it puts intense pressure on retail operators. Losing multiple anchor tenants at once can be terminal for a property. It can trigger common co-tenancy clauses, which allow smaller tenants to break their leases when anchor tenants leave (or gain huge leverage in negotiations for rent concessions).

Unfortunately, the conditions are ripe for this to materialize in many markets, and it’s happening now.

Convenience Won’t Kill Quality of Place

The new age of technologic convenience consumers will squeeze certain retail segments brutally hard. Ordering convenience items online is becoming nearly thoughtless, thanks to the Internet of Things and products like Amazon’s Dash Buttons. Making convenience-oriented purchases so easy completely eliminates the need to travel for these items.

This will be the death blow for many convenience-dominant properties, like strip malls and big box buildouts. The Great Recession brought a new era of price sensitivity. Millennials can be extremely frugal and will bear the scars of the financial crisis in a way that Depression survivors did. Brick and mortar is just not the cheapest method for the delivery of goods. Warehouses with automated bots and delivery drones may be.

The winning malls are differentiating themselves by returning to strengths that made them work in the first place. As private commons, they provide spaces for social engagement, experience and enrichment. When Victor Gruen designed the world’s first enclosed regional mall in Edina, Minnesota in 1956, he saw the mall as the center of Edina life. It was an inviting place where people would socialize and hold public events, just like a traditional public square. Modern malls became dependable, all-weather hangouts with arcades, movie theaters and food courts.

These are templates for the types of experiences that millennials crave. As consumer behavior sheds former modes of mass consumption, it presents opportunities to grow into these new experienced-based preferences. Malls succeeded by offering more variety under one roof that any other competitor, with the size and space to adapt to every season and promotional campaign. And many malls can compete and win with this old formula.

Rightsizing the Right Sites

Size and location are the fatal flaws built into many retail properties today. Acreage is still an asset, but only for the right end use in the right location. Size may yet be an advantage for large retail properties, but only in their next life following adaptive reuse.

There is too much retail square footage overall; and it’s in the wrong places. In some cases there isn’t enough of the right kind of retail—particularly in urban clusters nearby newly dense residential populations. Demographics still dominate, and where people choose to locate will always drive commercial real estate development. Today, Americans are moving closer to work and into density. Urban in-flight is creating enormous infill pressure, while simultaneously weakening suburban markets and rural areas.

And there is a very long runway left ahead. Internet retail spending as a percentage of total sales is still only a small fraction. This might only be the end of the second inning, though the game shows all signs of accelerating from here. The e-commerce creep that began disrupting individual categories, like bookstores (i.e. Borders) and electronics (i.e. Circuit City) was just a warmup. Apparel, the most bubblicious category blowing up now, is a much larger category. Convenience larger still. Next in line will be grocery, where Amazon and other retailers are pivoting into similar behavioral and preference shifts. Then auto malls, which generate enormous tax receipts for local municipalities but are likely to be disrupted by fleets of autonomous vehicles that drive the cost of transit so low there will be little rationale for individual car ownership.

We’re already on pace for record store closures this year. And as online retailers start running up the score, many more brick and mortar players will drop out of the game. Industry will be challenged to reimagine and refit thousands more greyfield properties as entire mall ecosystems go extinct. This will create a huge swell of greyfield inventory across the country, likely in clusters. If these properties are not redeveloped or un-developed (and returned to nature), they will sit idle and unproductive.

The good news is there is record retail demand and sales are at all time highs, so everyone is fighting over a larger pie that is has been growing roughly twice as fast as GDP. Store openings are booming. But with digital disruption coming from all angles, investing and operating in today’s environment is simultaneously exciting and terrifying.

Can unprecedented churn in the market absorb this inventory and avoid the retail apocalypse? Can “new” retail and non-retail uses, like medical office, institutional or government, fill the gap? What types of end uses can be adapted on retail greyfields? What are the more imaginative concepts, like urban farming oases and agrihoods?

In future installments of this series we’ll answer these questions and dive further into the future of adaptive reuse in this greyfield wave.

If your greyfield requires adaptive reuse contact BL about reinventing your site.

Read the previous installment: Clicks Overcome Bricks as Retail Stores Crushed Under the Weight of Amazon

Read the next installment: Retail Apocalypse Or Renaissance? U.S. May Have Record Store Closings AND Openings In 2017

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