8 minute read 24 Sep 2019
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Shedding old habits: The looming revolution in retail real estate

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EY Oceania

Multidisciplinary professional services organization

8 minute read 24 Sep 2019

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The race is on for ever-shorter delivery times. But keeping up with consumer-led disruption is having a major effect on supply chain logistics, retail businesses and, ultimately, the future of industrial real estate. 

If you want to know who’s changing Australia’s $15 billion industrial real estate and retail landscape, you don’t need to peer behind the veil of a large investment fund. Look around at the evening commuters tapping away on their phones: with each online purchase, they’re not just satisfying their consumer urges, they’re creating profound challenges for owners and users of distribution centres, stores and logistics operators across the country.

Three years ago, 93 per cent of retail revenue came from purchases at bricks and mortar shopfronts. By 2021 that’s predicted to drop to 81 per cent, with some retailers estimating the drop could be even greater. 

That drop is coinciding with a huge increase in online deliveries. In the US, forecasts suggest e-commerce deliveries will rise from around the current 50 million per day to around 100 million packages by 2026. In China, that number is already close to 100 million each day.

While Australia’s market is less mature, less populated and has built less physical retail than the US, it is following a similar trajectory, with forecasts suggesting that by 2020 one in ten items in Australia will be bought online.  

But it is not just volume having a disruptive effect on operating models for industrial players. It’s the race for quicker delivery times, to satiate a growing market predisposed to instant gratification over brand loyalty, that wants online shopping delivered not just on the same day, but within hours.

China is facing the challenge head on: 70 percent of packages are delivered same day, with research suggesting some ecommerce giants now make just under 60 per cent of mainland deliveries within 12 hours.

The challenge, and opportunity, for real estate players in Australia and elsewhere is balancing the need to respond to this rapid systemic change while making sure existing assets, from shopfronts to outer suburban warehouses, aren’t rendered redundant.

While delivery times of seven and ten days may be seen as okay for some products, over the next year or two, next day is going to be the minimum acceptable offer for most retailers.
Martin Conneally
EY Global and Asia-Pacific Logistics and Fulfilment Capability Leader

Martin Conneally is EY Global and Asia-Pacific Logistics and Fulfilment Capability Leader. He says omnichannel retailing is forcing companies to seriously reconsider what their bricks and mortar spaces could - or should - be used for. “What’s your company’s future real estate and fleet strategy?” Conneally says.

“While delivery times of seven and ten days may be seen as okay for some products, over the next year or two, next day is going to be the minimum acceptable offer for most retailers,” Conneally says. “But real competitive advantage will come with same day delivery, or even better, delivery under two to four hours.”

What that means, he says, is that there’s a conceivable near future where retail stores become critical as logistics hubs for online click and collect, to service customers with the proximity that a distribution centre can’t.

As consumers start to reward companies that get products into their hands (or onto their doorsteps) in hours, not days, it will necessitate a radical change in supply, warehousing and logistics to facilitate this new model of retailing that combines clicks with bricks.

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Change is coming

A store, a distribution centre or something in between?

The nature of retail is being reshaped, which means all points of the supply chain are being reconfigured.

Traditionally, supply logistics has been modelled around four standard ‘linear’ tiers: the supplier, the national distribution centres, regional distribution centres and retail stores. Now retailers are being forced to look at six or seven ‘highly networked’ tier structures that add in supplier drop-shipping (where the retailer organises for goods to be sent direct from manufacturer to consumer), and various levels of intermediate inventory points in the store network.

Instead of one large warehouse serving an entire city, for example, businesses could end up requiring 10 to 20 smaller distribution points across any given city or state, Conneally says. Billion dollar retailing companies in Australia are already investigating ways to use hub store concepts, micro fulfilment centres or ‘darkstores’ to do this.

“While customers may be paying for such premium delivery times today, in the future it’s expected this practice will be so commonplace it’s no longer a basis for competitive differentiation,” says Conneally. “That really starts to raise strategic questions about where you have your distribution centres and what happens in the distribution centre versus what happens in a store.”

“The days of one size-fits-all fulfilment is long gone. Not all states and cities work in the same way, meaning Australia’s complex geography and demography requires tailored ‘customer first’ responses intra-state and inter-state.” says Conneally.

Percentage of packages delivered same day in China

70%

parcelandpostaltechnologyinternational.com

The days of one size-fits-all fulfilment is long gone. Australia is a complex geography and demography requiring tailored ‘customer first’ responses intra-state and inter-state. Not all states and cities work in the same way
Martin Conneally
EY Global and APAC Logistics and Fulfilment Capability Lead Partner

As retailers, now and in the future, grapple with how they meet rising consumer expectations, and the mix of bricks and mortar versus the online experience, the question naturally follows of where existing stores should be located. The answer might not always match current reality, particularly once multi-channel consideration is applied to each store’s territory using sophisticated scenario modelling.

That can require a total rethink. Is it just a store? Is it a hub store with a broader volume of inventory and availability? Is it a darkstore? Is it a micro logistical operation? Considering these questions means businesses may end up reimagining not just the financial configuration of the business, but the entire real estate footprint.

“Historically the use of back room space has been minimised as much as possible [in shopfronts]. In certain stores, this is being challenged and front of store space is being reduced in favour of having mini fulfilment hub operations in the back of store space,” says Conneally.

There’s even potential for retailers to hold stock other than their own, turning their own back room space into a distribution point for multiple brands.

“That’s businesses looking at geographies and demographics and making those stores much tighter propositions for that area. It’s all about providing availability and service as fast as you can, as cheaply as you can.”

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The shift

Is it the end of industrial warehouses?

As automation marches on, what can industrial landlords do to protect their assets and their business models?

Industrial estates have long been perceived as characterless precincts filled with utilitarian buildings, serviced by an army of trucks and delivery vehicles. Inside, warehouses still ring with the clamour of workers’ voices over the noise of forklifts, conveyor belts and shifting pallet jacks.

But over the next decade, this will change: store-based automation is quiet and electronic. Even fulfilment centres and darkstores on industrial fringes or in the heart of suburban growth corridors, will be places of dulled, muffled sounds. And far fewer workers.

The past two decades have seen a three to four percent compounding annual growth rate of not just salaries and wages but also on fuel, property, and utilities. At the same time, productivity continues to be a challenge. Coupled with advances in technology and improved affordability of automation and automated supply chain technology, it now makes automation not only viable but increasingly necessary. 

The rise of drop shipping as a preferred method of online retailing is also seeing warehouses morph into distribution points for individual units for individual customers, rather than a logistic point for unit multiples and pallets sent to a network of bricks and mortar stores.

Where five years ago an automated facility had an estimated 12 to 14 year payback period, now it can be as quick as one to four years for specific robotic and AGV (automated guided vehicle) technology, or five to seven years for more substantial equipment. In some instances, automating key parts of a distribution centre costs as little as $1 million to $2 million dollars.

It means automation is not just a play for the large businesses: smaller companies are starting to realise they need site automation because of the fragmentation of picking customer orders for drop shipping.

“You can get a $50,000 AGV, which is just like a little box that goes under a moveable shelf, pallet or a stack of totes and tubs and moves them around based on a virtual grid pattern,” says Conneally. “Where automation in the past has meant $20 million or $40 million systems on a large footprint, we’re now starting to see these types of systems being installed by smaller retailers, and operating in areas that aren’t much bigger than a conference meeting room.”

We’re now starting to see automation systems being installed by smaller retailers, and operating in areas that aren’t much bigger than a conference meeting room.
Martin Conneally
EY Global and Asia-Pacific Logistics and Fulfilment Capability Leader

More immediately, however, for the holders of large industrial books, the rise of automation means that existing industrial footprints face potential challenges such as increased floor load that comes with adding large-scale, intensive automation technology. As a consequence, there are big plays for large automated distribution centres to meet demand.

The real question becomes: what can be done with existing sites, and how do landlords with existing warehouses need to position themselves? If, for example, brownfield sites require upgrades that could take between 12 and 18 months for smaller investments in automation, or up to three years for larger automation footprints, what becomes of their current and future value proposition?

Even if clients are not asking for automation today, do owners of these old distribution centres up the specs, and attempt to futureproof through building or renovating? Some are now looking to cut up their 20,000 sqm footprints to make smaller more flexible units while others are contemplating simply offloading their book of ageing, traditional distributions centres.

For non-industrial customer centres such as petrol stations or shopping centres, it is about transforming their existing footprints into more productive and revenue-generating spaces. Headway is already being made across shopping centres to make them places where you come for experiences, not simply traditional shopping.

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Hope is not a strategy

Flexibility key to the industrial sector’s future

Disruption means it is even more critical that businesses can answer strategic questions that are be asked of industrial, commercial and retail spaces.

Traditional warehouse space still serves a purpose and demand isn’t going to drop precipitously in the immediate future. But while old-style assets will undoubtedly become less attractive, even if landlords and companies decide on the path of automation, there are risks in chasing future rewards.

“If tenants require more specialised facilities, this may not only drive up costs but also make assets less flexible when it comes to a change of tenant,” says Lucas Meaney, Associate Director, EY Oceania, Real Estate Advisory Services. “For landlords, that means they have to accept a larger risk being tied to the incumbent tenant.”

A landlord’s wealth is generally the aggregate of its property value, which is a function of the rental income that those assets earn. This means that any expenditure on a property, including upgrades to its automation capabilities, needs to be very clearly assessed against the upgrade’s ability to create a proportional uptick in rental income.

Adding complexity to a landlord’s decision is the lag between capex spend on future-proofing and realising the rental value of that. “The successful landlords will be the ones that can cater to their tenants. But with more intelligent capital integrated into the tenancies, these must also be managed.”

There is also historical inertia baked into the operational models of many industrial real estate players. With typically less volume in sales and leasing activity, industrial property responds to different drivers than other sectors which shift sharply according to population growth, interest rates and consumer sentiment. “Interest in the sector usually only ramps up when there is a key activity shift, such as a resources boom or change to delivery models,” says Meaney.

“Often the most successful investments for landlords have been the urban fringe located sites that can operate profitably as industrial tenancies, then when the city expands and their highest-and-best use is no longer industrial, the site is repurposed to residential, commercial or light-industrial,” says Meaney.

“It means that as consumer trends change faster and more dynamically, the future potential of industrial sites will have a greater bearing on its value and attractiveness today,” he says. It’s yet another thing industrial landlords and retailers will have to consider.

While many retailers and industrial landlords are on the front foot, keeping pace is as much a question of management strategy as it is finding the right approach to adopting technology and automation. “You’ve got to have a willing executive team in place,” says Conneally, “and if they’re not averse to change, they can be very successful.”

Summary

As the demand for shorter delivery times increases, industrial landlords and retailers will need to reimagine and reorganise their traditional business models.

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By

EY Oceania

Multidisciplinary professional services organization