Internet retail continues to grow vigorously, suggesting that the phenomenon is no flash-in-the-pan. The number of retail web sites grew ten-fold in the first ten months of 1999 and now total about 30,000 or more sites. An estimated 26 million Americans shopped online between Thanksgiving and Christmas - approximately 12% of the population of the U.S. over age 16. Dot-com commercials on TV were as ubiquitous as tinsel. And Christmas Internet retail sales tripled from a year earlier, to $8-$10 billion or so in 1999 from an estimated $3 billion in 1998.

Internet shopping commands popular and press attention, but the important question is whether this format really poses a challenge to retail real estate given that it is still a small share of all retail sales. In fact, the Internet is starting to displace sales from shopping center and mall environments. Since retail space is the largest single property type in CMBS at 27% of all collateral, the potential erosion of sustainable cash flows in retail properties warrants attention. As a result, we are revisiting our review of the impact of the Internet on retail property of a year ago. Our principal observations and opinions are outlined below:

* Although Internet sales are a small share of total retail activity, the scale has reached a threshold that retail real estate owners and operators cannot ignore. We expect that the Internet will have uneven impact: It could render some retailers and formats redundant or at least erode sales growth at some retail locations, even as it has little effect on still other retailers and formats.

* We still hold to the view that the Internet would have the most impact on big box category killers, factory outlet centers and power centers, the least on neighborhood and community shopping centers anchored by grocery and/or drug stores, with regional malls falling in between.

* If real estate is about location ... location ... location, then Internet retailing - indeed all retailing - is about execution ... execution ... execution. The favorable holiday experience with shopping and shipping for many consumers should define the business agenda for many on-line retailers.

* The Internet does not obviate the need for bricks-and-mortar retailers. In some cases, traditional retailers are better positioned than pure-play Internet retailers (those that sell only on the Internet) to successfully and profitably execute sales. However, the new channel could contribute to the determination of the winners and losers in the profitability game among selected retailers and retail formats.

* The Internet is now mainstream. In general, the Internet retail consumer profile is approaching that of the population at large, which should contribute to continued growth of Internet shopping and further penetration of the medium throughout the populus. Whatever the changes in the composition of Internet customer base, the most compelling trend is that Internet users are becoming more numerous, shopping more frequently and spending more on line than before.

Affirming Our Views of the Impact on Real Estate:

The Scale of Internet Sales Is Sufficient to Challenge Some Retail Formats

Although Internet sales are a small share of total retail activity, the scale has reached a threshold that retailers and real estate owners/operators cannot ignore. Even at current levels, electronic sales could make some share of retail space redundant.

Estimates of Internet retail sales cover a wide range, but for the moment assume a mid-range estimate of $20-$30 billion in sales for 1999. Further assume that sales in shopping centers commonly range from $200 per square foot (psf) for a modest grocery-anchored neighborhood center to $400 psf for a strong regional mall. The total value of Internet retail thus captured sales that otherwise might have occurred in 50-150 million square feet (MSF) of shopping center space.

In the interests of perspective, 100 MSF is equivalent to the total inventory of regional malls, power centers and neighborhood/community shopping centers in Atlanta or Washington DC ...

or ? of the total inventory of all the power centers in 50 major cities ...

or 4%-5% of the total inventory of regional malls, power centers and neighborhood/community shopping centers in 50 major cities ...

or all of the new shopping center construction in 1999 in those same 50 major cities.

Thus in some sense, a major share of the shopping center/mall construction in major markets last year was redundant.

The Internet Will Not Replace Stores

The social and recreational value of some shopping trips for some people on some occasions will persist and cannot be satisfied online. Furthermore, some items purchased online, such as event tickets, do not displace stores sales. However, the issue is not whether the Internet will make all stores obsolete - that is utter nonsense.

The question is whether this channel will displace enough sales from certain retailers or retail formats to challenge profitability and/or growth plans of the real assets, eroding already narrow margins.

Another question is in what ways will the Internet force the reconfiguration of the retail business, defining a new set of winners and losers who more (or less) effectively capitalize on the Internet or strategically and effectively incorporate the channel into their business plans. In other words, does virtual shopping pose a real threat to retail property?

The Challenge Is Real but the Impact Will Be Uneven

The challenge to real estate comes from both pure-play Internet retailers (those that sell only on the Internet) and traditional retailers who also sell online (integrated retailers, glibly labeled bricks-and-clicks or clicks-and-mortar retailers). Some selected formats or retailers could indeed be threatened. Others could experience some erosion of the growth in sales, thus making profitability targets more difficult to achieve. Still other retail products and settings are likely to be virtually impervious to the Internet.

For example, during the 1999 holiday season, the Internet captured 3-4% of all retail sales of the types of goods sold in malls and shopping centers. However, a share on that order of magnitude is likely to equate to 7% of some types of merchandise and 0% of others ... but a 7% decline in sales is enough to result in as much as a 50% decline in profitability for some retailers.

The Internet will also have variable degrees of impact on real estate assets. Although dominant malls are somewhat immunized from the Internet, the mediocre mall positioned between two other, strongly performing malls is not so protected. The Internet challenge could be a fatal blow to marginal retail outlets and weaker retail concepts, accelerating the decline of B and C quality properties. Slightly clumsy configurations or somewhat less desirable locations could lose even their marginal status as thin profits turn into losses. Furthermore, in the event of an economic downturn (which will happen again over the life span of 10-year bonds), marginal retail operations might suffer a quick - but not necessarily painless - death. As a result, the effects of the Internet could widen the chasm between the winners and losers, both among shopping centers/malls and retailers.

For those retail segments somewhat less affected by the Internet, the market share captured by this delivery channel could undermine growth expectations even if does not presage losses. The Internet could impair the ability of some stores and/or retailers to reach growth targets, goals that are taken very seriously by publicly traded companies in particular. While only some product segments will find that four stores are sufficient in a market previously served by five, the need for further additions to store inventory is likely to be dampened for selected product areas. For example, a recent survey by Merrill Lynch of 33 major retailers found that they project opening 2,940 stores this year in the aggregate, down from 3,209 in 1999. In short, perhaps retailers' expansion plans are already being inhibited.

Vulnerability to Internet Retail Varies

Among Retail Formats

Previously we expected that the Internet would have the most impact on big box category killers, factory outlet malls and power centers; the least on neighborhood and community shopping centers anchored by grocery and/or drug stores; with regional malls falling in between. We still hold that view.

Category killers that are often housed in big box formats are having their own problems, including over-supply of space and over-crowding of retailers. This challenge is exacerbated by the Internet, as big box products are often those that sell well online, as illustrated by the fact that 60-65% of the shoppers are buying computer products, books and consumer electronics, and one-third of the shoppers are buying toys. As a result, power centers that consist of several big box category killers could be more threatened, particularly in view of the pace of new supply in this product.

The degree of the threat posed by the Internet is not defined solely by product, because the key is execution. Some product areas that are more vulnerable to cannibalization will nonetheless see selected retailers survive, even if the pool is smaller.

Nonetheless, Table 1 outlines some of the types of retail activities and, in some cases, products that face a greater challenge from the Internet and those that might be better bets. As before, given the speed of change in the industry, we might again need to revisit the issue ... same time, next year.

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