The E-Commerce Imperative

Impact on Industrial and Retail Real Estate

E-Commerce Imperative
2013

Introduction
Change is a constant, but technology is what dictates the pace of those changes. This holds true for commercial real estate as much as anything else and there is no other property type where change is currently playing out so quickly as in the retail arena. The retail marketplace will change more over the next ve years than it has over the past twenty. These shifts are being entirely driven by the accelerated encroachment of e-commerce. This is playing out even as the marketplace has yet to fully rebound from the worst economic downturn since the Great Depression. But the uctuations in consumer behavior that we saw over the past few years as shoppers retreated to a frugality from which they are only now beginning to emerge will be dwarfed in the long-term by the changes engendered by the rise of e-commerce. Yet, these changes have hardly been limited to playing out in just the bricks-and-mortar retail world. These shifts are certainly more visible as they play out at our local shopping centers and malls because we all shop, but there is just as radical a shift occurring behind the scenes in the industrial marketplace. Over the next few years, the overwhelming majority of new retail development willin factbe industrial. And the overwhelming majority of new industrial development willin factbe retail.

The commercial real estate marketplace has never seen anything approaching what is currently taking place in terms of the merger of two major property types. Were not saying that the division between retail and industrial space is becoming blurred. There have always been big box, furniture and discount retail concepts that have mined the warehouse world for no-frills sales space and that hasnt changed. And retailers will always need distribution center space to keep them supplied and their shelves stocked. That certainly hasnt changed. What has changed is the rise of e-commerce and the increasing need of those distribution centers to not only keep shopping center shelves stocked, but to directly interact with the rising e-commerce consumer class. This may sound like a minor change in the way that the global distribution chain works. But its not. Its a sea change. In this paper we will explain to you the changes that are currently reshaping both marketplaces from a commercial real estate point of view. In putting this report together, we have compiled the writings and analyses of our top brokerage, corporate services and research professionals and the input of our top people active not only in the industrial world, but the retail landscape. We hope that you nd this paper enlightening and that it helps you to not only understand the major changes that are impacting the commercial real estate world, but that we are able to assist you in understanding how to respond, exploit and benet from the shifts underway with true meaning and insight that extends beyond mere buzzwords and ashy graphics.

Over the next few years, the overwhelming majority of new retail development willin factbe industrial. And the overwhelming majority of new industrial development will in factbe retail.

Garrick H. Brown, Editor

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E-Commerce Imperative
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The Rise Of Online Sales

Tech Boom 2.0
We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Bill Gates made this prophetic statement in his 1996 book, The Road Ahead. There may be no other statement that so perfectly summarizes the impact that technology has had on the day-to-day lives of human beings over the past few decades. Yet, this declaration certainly applies equally to the impact of technology on commercial real estate. Those of us who were around during the rst tech boom in the late 1990s may remember some of the predictions that were made then. Ofce demand would dry up as workers became more mobile and telecommuting became the norm. Data centers would emerge as the hot new commercial real estate product type. And, perhaps most importantly, the ood of dot. com retailers like Pets.com and eToys.com would threaten the very existence of bricks and mortar retail. Of course, the dot.coms went dot.bomb in 2001 and all of those early prognostications went by the wayside. Meanwhile, it was back to business as usual for the ofce market and the once white-hot data center market virtually imploded overnight. And the gloom and doom that had hung over the heads of bricks and mortar retailers lifted overnight. Instead of seeing a shifting paradigm that anticipated the eventual impact of online sales, we instead saw aggressive bricks and mortar growth and one of the largest retail development cycles in the history of the United States. But the internet never went away. Fast forward to just over a decade later and the United States is in the midst of Tech Boom 2.0. But this time its different. Instead of being driven by venture capital fueled startups with little in the way of proven business plans, this one is being fueled by the most protable companies in the world outside of big oil. And the internet is still at the heart of it. The number of worldwide internet users has jumped from roughly one billion (in 2000) to a current estimate of about 2.5 billion. It is estimated that 16 million gigabytes of new data are created each day and that data will increase by over 800% over the next ve years. And this number is only continuing to grow thanks both to cheaper technologies and to new mediums; the smartphone and the tablet. Perhaps most importantly, seemingly overnight, all of those pre-dot.bomb predictions of the late 1990s/early 2000s are suddenly seeming all too accurate. Nearly every major trend at work in the world of commercial real estate today is directly or indirectly as a result of the impact of tech. In the ofce market, while we continue to see growth from the medical, media and energy sectors, tech is what is overwhelmingly driving growth. Yet, even as tech users are behind much of the nations occupancy growth, overall ofce space usage is simultaneously shrinking thanks to tech. The average amount of ofce space per user has dropped from about 250 square feet per user in 2000 to about 167 square feet per worker today. This has mostly come about as a result of increased workplace mobility (thanks to wireless devices; laptops, smartphones and tablets) and radical new ofce layouts pioneered in the tech sector (and now spreading to other users) that replaced cubicles with communal space as users sought more creativity and collaboration with their workforce. Meanwhile, after years of languishing, the data center marketplace has returned to health with a ood of retail and wholesale demand driving a new wave of development across the United States even as new options have increasingly become available via containerized space and the cloud. But, of course, nowhere have the changes been as profound as in the retail and industrial arenas. Though Pets.com and nearly every other dot.com retailer went the way of the dinosaur, the likes of Apple, Netix and Amazon killed the record store, the video rental store and are in the process of doing the same to the mass market big box bookstore. The rise of
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E-Commerce Imperative
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e-commerce has only accelerated with the advent of the smartphone. And while technology will never completely replace the shopping experience, competition from the internet has emerged as the greatest single challenge (more so than the lingering effects of the downturn) facing the bricks and mortar retail world today. It is clearly a game changer, with radically different implications for different retail sectors. Though it is still all about the internet, this boom is really about mobile technologywhich is becoming the dominant way of accessing the internet as it also becomes one of the most dominant forces ever created for managing our lives, whether in the realms of our business or social concerns.

E-Commerce Annual Retail Sales Growth

Online vs. Traditional
2,500
1,877 2,014 1,915 2,105 2,189

20% 15% 10% 5% 0% -5%

2009 U.S. Retail 2010 2011 2012 2013 2014 Online % Change U.S. Online Retail Retail % Change Y/Y Change %

2,000
Growth in $B

1,777

The Rise of E-Commerce

Over the past few years, an average of half a billion new smartphone users annually have come online worldwide. E-commerce had been averaging gains of 10% annually throughout much of the past decade, but these numbers have skyrocketed in recent years.

1,500 1,000 500

143 165 190 221 254

292

As the economy began to emerge from the recession in 2010, the trend became clear. While overall retail sales increased by about 5.6% in 2010, online sales growth increased by 15.3%. The following year, 2011, saw total Annual online retail sales growth has topped the 15% retail sales growth of just 2.0%. Meanwhile, online sales mark for three consecutive years, tripling or more the rate increased by 15.1%. Last year, 2012, we saw overall of overall retail sales growth in the United States. This retail sales growth of 5.1%. But online sales grew by trend will only continue and intensify going forward. 16.3%. We anticipate that this trend will only continue to escalate, with retail sales growth averaging in the 4% to 5% range over the next few years, while e-commerce continues to grow at a rate of three times that, or more.
Excludes motor vehicles, gas stations, food and beverage stores, health & personal care, food services & drink places. Source: Citi Research; Department of Commerce

While an improving economy has been part of this trend, the real driving force behind the disparity in e-commerce and overall retail sales growth has been the adoption of new technologiesthe impact of smartphones and tablets on online sales driving most of this surge. According to the most recent data from the commerce department, Nowhere have we seen a greater total e-commerce sales in the United States in Q4 2012 accounted shift than in the world of retail for $59.5 billion (a 4.4% quarterly increase and 15.6% annual jump) and equated to 5.4% of all retail sales. However, keep in while technology will never mind that these numbers include auto sales, as well as gasoline, completely replace the shopping and so dont just represent what we would deem traditional bricks and mortar retailers. Still, in a recent study, Deloitte predicted that experience, competition from the e-commerce will account for 30% of all U.S. retail sales by 2030. internet has emerged as the greatest We agree with Deloittes assessment that online sales will eventually single challenge facing the bricks reach those levels. The good news for landlords, mall owners and traditional storefront retailers is that we dont anticipate them and mortar retail world today. signicantly exceeding that 30% mark. The fact is that e-commerce will never fully replace the bricks and mortar shopping experience. But the bad news is that it is engendering massive changes in the marketplace that are occurring now and we think that Deloittes estimate of 30% penetration by 2030 may, in fact, be overly conservative. The change may come much sooner than that.
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E-Commerce Imperative
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The Bricks and Mortar Fallout

It should come as little surprise that the retail sectors that have been most impacted are those where consumers have most embraced online shopping. Certainly media has taken the biggest hit, with iTunes almost single-handedly wiping out the record store (something Napster was never able to accomplish), streaming movies taking out video rental stores (Netix over Blockbuster) and e-readers largely displacing the big box bookstore (the last major player, Barnes & Noble, is planning on closing about half of their remaining storefronts over the next ve years). But those certainly have not been the only categories impacted, nor will they be the last. Video game stores have, so far, weathered the storm. They have done this largely by making deals with video game manufacturers to offer content not available online and through generating additional sales through the purchase and resell of used games. Still, with every new game system upgrade one has to wonder how long it will be until streaming game media might begin to do to this sector what it did to others. Many are watching the U.S. Online Retail Sales looming release of Sonys PlayStation 4 later this year to see what it may mean for sector leaders like GameStop, By Category GamerDoc and Play N Trade. Computer & It should come as little surprise that a quick review of the Commerce Departments e-commerce statistics Food & beverage points towards where some of the greatest challenges 2% Toys & hobby for traditional retailers have emerged. According to the 3% Office latest data available, computers and consumer electronics equipment & supplies Apparel & account for 22% of all online U.S. sales. Apparel and 4% accessories 18% Health & accessories followaccounting for 18% of total sales personal care 5% volume. Books, music and video sales account for 9% of Furniture & home Books music total online sales. Food and beverage sales sit at the other furnishings Auto & parts video 7% 9% 8% end of the spectrumaccounting for just 2% of all online retail sales and demonstrating the fact that, despite the continued efforts of many traditional grocers to build Computers and consumer electronics account for over one their e-commerce platforms, these have still not been fth of all online retail sales. widely adopted by consumers. Meanwhile, though auto and parts account for 8% of all online sales, this has had little impact on traditional storefront automotive parts retailers or car dealerships. The opposite is true in the case of ofce suppliesthough they only account for 4% of all online salesthis sector has been signicantly impacted by e-commerce. Staples remains the segment leader here, partially due to their e-commerce penetrationbut online sales are increasingly taking centerstage for all of the retailers in this category. Meanwhile, all of the major players here are looking to shrink their physical presence as they grow online. This also holds true of the former number two and three players, Ofce Depot and OfceMaxwho recently merged. This move should energize the new company as they face down staples and their rst order of business will be to boost their online presence while closing underperforming stores and shrinking their existing store format of 15,000 to 25,000 square feet to 10,000 square feet or less.
Source: Commerce Department

Other 22%

consumer electronics 22%

Consumer electronics has also seen a massive impact. There are a number of reasons for this. Citi Research and Perception Research Services International recently conducted a comprehensive survey of smartphone users which asked the simple question, What do you use your smartphone to shop for? Over 50% of respondents replied that they use smartphones to shop for electronics and/or apparel. In the case of consumer electronics, this is directly linked to the trend of showrooming. When Circuit City collapsed in 2008, most retail analysts assumed that this would translate into immediate market share for their primary competitor, Best Buy. But this did not happen. Instead, Amazon and Walmart absorbed much of their previous market share. Pricing certainly played a role in this (remember that their bankruptcy came while the world economy was in a freefall just two months after the near nancial collapse of September 2008), as consumers retreated

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E-Commerce Imperative
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Impact of Smartphones & Tablets

into frugality. However, e-commerce certainly played an additional role in this. Nowhere has the trend of showrooming impacted retailers more than in the consumer electronics specialty. This is where we see consumers visiting storefront retail to inspect products personally, often while scanning the internet on their smartphones to nd cheaper deals online. Consumer electronics (including computer sales) have been most impacted by this trend simply because these are big ticket items where savvy shoppers are nding the best values online. This is partially due to the inherent cost advantage that e-commerce players have over bricks and mortar retailers. They have cheaper overhead; cheaper rents, fewer employees and, typically cheaper transportation costs. All of this usually translates into cheaper pricing out of the gate. However, there is the additional impact of state and local sales tax.

Source: Citi Research, Perception Research Services Limited

While consumers are responsible for paying state and local sales taxes on items that they purchase via the internet in most U.S. states, a mechanism for collecting these taxes has never been created. For example, in California, if a consumer purchases a $1,000 at screen television set directly from a traditional storefront retailer like Best Buy, they are generally looking at an additional $70 to $80 in local sales taxes (depending upon the locality). But when it comes to online sales, the picture becomes much more convoluted. For example, if the online retailer has a physical presence in the state, they may pay that tax as part of their transaction no differently than if they were buying it from a bricks and mortar retailer. However, if the internet retailer had no presence in California, they would not be asked to pay that tax. Of course, they are still legally responsible for itand are required by law to state it on their annual income taxes but few do. The net result is that the current system leaves an estimated $28 billion annually in unpaid local state sales taxes on the table, while also creating an additional pricing edge for online retailers. Remember that most already have a cost advantageso that $1,000 at screen at Best Buy is likely $850 to $900 at most online. And then, in addition to this, the lack of a sales tax collection apparatus equates to another 7% to 8% discount to shoppers. There is legislation currently before Congress, sponsored by the International Council of Shopping Centers and major retailers that would essentially close this loophole. The Marketplace Fairness Act of 2013 had, as this report went to press, passed the Senate and earned the support of President Obama. However, it may nd challenges in the House of Representatives, where many conservative Republicans have denounced it as a new tax. Regardless, most political analysts feel that this bill or a reasonable facsimile will eventually passif not in this legislative session, sometime soon. Major opposition is being led by eBay, though Amazonthe worlds largest e-commerce player by farhas voiced its support for the bill. Regardless, this has implications for online only e-commerce players (that we will discuss later in this report) and retailers alikebut it has been one of the driving factors behind the disproportionate impact of showrooming on consumer electronics and computer retailers. In the case of Best Buy, this has translated into plans to focus their growth efforts on their new small format (typically 3,000 square feet or less) Best Buy mobile concept. But this is not an example of a retailer pursuing an alternate growth

The impact of showrooming is realparticularly for big ticket items where traditional storefront retailers not only face a pricing disadvantage in terms of overhead costs, but are also currently disadvantaged by the uneven application of state and local sales taxes. Electronics is the category most impacted by showroomingit is also the category that recent polls have shown are where shoppers are most likely to use their smartphones to shop.

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strategy via a smaller format than it is of a retailer seeking to branch out into an entirely new category. In terms of their traditional box stores, Best Buy is looking to radically downsize. With once protable CD and DVD sales gone and the impact of showrooming cutting into the sales of major electronics, the chain is looking to shrink their old format of 30,000 to 40,000 square feet to the 20,000 square foot range. In the meantime, the chain will be closing far more of its traditional outlets than opening new locations over the next few years as it looks to right size its presence in the new marketplace.

The New Retail Marketplace

Against this backdrop it should come as no surprise that most hard goods retail chains today are focused on building their Omni-Channel Retail Platforms; combining bricks and clicks to fend off the challenge of (so far) purely online players like Amazon. Though luxury retailers and discount chains have returned to growth mode when it comes to bricks and mortar locations, most hard goods retailers are currently in retrenchment mode. Most chains are either in extremely cautious or no growth mode, with some actively closing underperforming locations or reducing store sizes to maximize sales per foot in their physical locations. Instead of opening new storefronts, most of them are sinking their capital expenditures budgets into beeng up their internet and supply chain presence in order to compete in the new digital age.

2013 2014 Retailer Growth HOT

Fitness/Health/Spa Concepts Drug Stores Thrift Stores DECLINING Grocery (Smaller Format Concepts) Discount Grocers Ethnic Grocers Organic Grocers Upscale Grocers Fast Food Fast Casual Automotive Discounters Dollar Stores Off-Price Apparel Pet Supplies Sporting Goods Wireless Stores Banks

Retail expansion in the United States is currently being driven Terranomics, the retail division of Cassidy Turley by two factors; the continued downgrade of the middle class in Northern California, produces an annual report consumer to discount shopper and the impact of e-commerce. which tracks the growth plans of roughly 2,700 major Luxury and discount retailers are back in growth mode, as are national chains. This years report, released in late food and service related concepts that compete little with the April 2013, found that major retail and restaurant internet. chains have plans to expand by as many as 36,042 new units throughout the United States over the next year. This number is derived from information shared directly by retailers, media reports, data contained within the quarterly reports of publicly traded retailer and restaurant chains, information shared by brokers specializing in retail and restaurant space nationally and numerous third party data providers. The good news for retail landlords is that the potential unit growth of 36,000+ units we are currently tracking is up almost 9% over last years totals. Retailers continue to return to growth mode after the record lows of 2009 and 2010. However, the retail sectors that are expanding have changed. The most active segment, in terms of planned units, is by far the restaurant sector. The restaurant chains that we are tracking currently have plans to add as many as 15,439 new units throughout the United States over the next year. This accounts for nearly 43% of all planned retailer growth over the next year. It also reects an increase of 17% over planned growth totals posted last year (12,814 units). In past years, this sector typically accounted for no more than one third of all planned unit growth but this dynamic has increasingly shifted in the face of e-commerce. The weak economic recovery also continues to impact retailer growth plans. Though luxury retailers are back in cautious growth mode, high street expansion numbers are but a fraction of overall U.S. retail growth. Meanwhile, middle class consumers remain in frugality mode, and so while we see few mid-priced players looking for new space, we continue to see large increases in demand from the dollar store/discounter category. We are currently tracking growth requirements that
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could add 1,858 new units over the next year, up 10% over last year. We know of at least four major dollar store chains are planning on opening between 300 or more new stores annually in 2013 and 2014. Home related retail growth plans have also increased substantiallya reection we believe on the improving residential real estate market to which this sectors fortunes are closely tied. We are now tracking requirements that could add as many as 1,244 new home related retail stores across the United States (this category includes hardware, doit-yourself, furniture and furnishings stores) over the 2013 2014 Retailer Growth NOT next yearan increase of 17% over last years totals.
Bookstores Video Stores Do-It-Yourself Home Stores DECLINING Mid-priced apparel Mid-priced grocery (particularly unionized) Office Supplies Stationary/Gift Shops Shipping/Postal Stores And Casual Dining (Older, Struggling Concepts Shrinking)

DECLINING

Pet and Farm growth totals are up by 14% over last yearwith most of the 382 potential new units over the next year likely to come from the still strong pet supplies sector. Sporting goods planned growth is up 17%--we are now tracking 348 potential new units. And, lastly, the Supermarket, Hypermarket and Category Killer sector is also seeing increased growth. We are currently tracking as any as 1,120 planned new units for this categoryan increase of 9% over the planned growth totals we tracked one year ago. In terms of the biggest losers, the greatest annual decline in planned new units came from the Apparel sector. We are now tracking 4,427 potential new units over the next year, a decline of 10% over totals we tracked a year ago. The Books/Cards/Gifts sector also saw a sharp decline of 34%--we are now tracking just 371 in potential new storefronts from this category.

The sharpest declines in retailer store counts are coming from mid-priced hard goods retailers that are contending not only with increased competition from discount concepts but the increasing encroachment of e-commerce players. As a result, most hard goods retailers are shifting their capital expenditure budgets away from bricks and mortar store growth and towards building their e-commerce or Omni-channel retailing platforms in order to adapt.

The Cellular category is nally slowing, with many markets nally nearing saturation and most of the planned growth that we are tracking coming either from Best Buy Mobile or smaller franchise operators. We are now tracking planned unit growth of 921 units for the next 12 monthsa gure that has fallen 30% from last year. Consumer Electronics planned growth has fallen by 40% over the past year; we are now tracking just 229 units that may come online over the next year. Surprisingly, planned drug store growth fell by 50% over the past yearto a current planned store count of 220 units. However, we see this as more of a reection that two of the big three players in this arena (CVS and Walgreens) are waiting to see what happens with Rite Aid and their debt issues. Though Rite Aid does have nancing to make it for at least a few more years, they are in consolidation mode and have been selling off real estate. We expect nal growth totals for both CVS and Walgreens to likely come close to 200 units each, though much of this may be driven by acquisition in the year ahead. Lastly, the ofce supply sector also saw declining numbers. We are now tracking planned growth of just 155 new units, down 33% from last year. However, that does not mean they wont be active. Look for plenty of relocation/downsize deals from this sector as nearly every major player in this category seeks to move away from 15,000 to 25,000 square foot footprints down to the 5,000 to 10,000 square foot range. Nearly all of the growth we are tracking is coming from food related or service related retail. Meanwhile, nearly all of the categories that are shrinking are active hard goods retailers. The common denominator here is e-commerce. The growing concepts are those that compete the least with the internet. The contracting ones are generally those that compete the most. Look for this trend to only accelerate over the next few years.
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E-Commerce Takes Center Stage for New Development

The retail industry buzzword of the next few years will be Omnichannel retailing. More retailers are shifting their capital expenditure budgets away from new store development and focusing instead upon the growth of their e-commerce platforms. The adoption of this strategy has been widespread. For example, after years of growing their bricks and mortar retail presence by as many as 60 to 80 new stores annually, Kohls has been among the leaders in this shift. They currently have about 13 new stores remaining in their development pipeline, but as these stores open over the next twelve months, the Wisconsin-based retailer is putting new store development on holdinvesting instead on building its e-commerce platform and boosting e-commerce sales numbers which, so far, have proven disappointing to Wall Street. Pressure from Wall Street is one of the major driving factors here, although this strategy is not exclusive to just publicly traded retailers. Meanwhile, we continue to see a number of major players making strong moves to bolster their Omni-channel presence. Abercrombie & Fitch has slowed the growth of its bricks and mortar locations to just a few new higher end malls and continues to close underperformers. However, the chain is boosting its CapEx budget for online commercethey reported a 52% increase in online holiday sales growth for 2012. The Ascena Retail Group, owner and operator of the dressbarn, maurices, Bryant, Justice and Catherines womens apparel concepts, is also in the process of bringing its e-commerce platform in-house. While Coach stores have returned to growth mode in the bricks and mortar arena (mostly, however, with outlet locations), the retailer is signicantly boosting investment in their e-commerce platform this year. Footlocker is signicantly boosting investment in its online platform, even as it is mostly closing underperforming bricks and mortar stores. The chain recently boosted its capital expenditure budget by 35% across all of its brands to roughly $220 million for the coming year, with the overwhelming majority of it focused on Omni-channel growth. The Gap, already an industry leader in integrating their Omnichannel efforts, is implementing a system that will allow for e-commerce order fulllment at local bricks and mortar locations, allowing for national next and second day delivery.

This 1.3 million square foot Amazon fulllment center in Murfreesboro, Tennessee is but one of 15 mega warehouse properties for Amazon that have come online over the past couple of years.

Amazon: The Real Category Killer

While smaller retail chains and independents have long referred to the mega-stores of Walmart, Target and countless other hypermart operators as category killers, the category killer of the new MIllenia is clearly Amazon. Half direct retail, half internet clearinghouse for thousands of independent vendors that sell their goods through their system, Amazon is the e-commerce leader. Their total sales volume over the past year is just under $64 billion, with Q2 sales expected to possibly reach as high as $16.2 billion. Year-over-year North American sales growth has been 25% (2009), 46% (2010) and 43% (2011). Overall annual revenue growth has consistently been above the 20% mark. Its hard to argue with success and you can measure Amazons success by the growing size of its real estate footprint. As this report went to press, they had nearly 50 million square feet of space under lease with nearly 46 million square feet of that being fulllment center space. Amazon continues to grow aggressively as it seeks to lower shipping costs and chases the goal of same day delivery (for which it currently has pilot programs in multiple cities). In January, the Seattle-based giant announced it signed lease agreements to ll three new fulllment centers of more than 1 million square feet each (in Texas, New Jersey and Northern California). Our sources tell us that Amazons goal is to reach 90 million square feet of distribution center space by 2016; that is an amazing 40 million square feet of growth over the next three years.
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Macys continues to expand and improve upon its inventory system as it seeks a zero real estate growth solution to its Omni-channel expansion. The chain now can service online orders through roughly one third of its 841 stores, but will boost those capabilities to about 500 stores by the end of this year. Michael Kors, after years of having their e-commerce division run and operated by Nordstrom, is in the process of bringing their platform in-house. The entire ofce supplies sector, ranging from Ofce Depot/OfceMax and segment leader Staples, is nding that online penetration is where sales growth is. Nearly every major chain is in the process of both downsizing their physical presence in terms of unit count and footprint (relocating from 15,000 to 25,000 square foot locations to those of 10,000 square feet or less) as existing leases expire. Signet Jewelers, operator of Kays and Jared, is increasing their online focus. Though the chain has returned to conservative growth mode for bricks and mortar locations, they reported online holiday sales in 2012 were up nearly 40% at a time in which foot trafc at retail locations was generally down. Though the luxury jeweler has returned to limited bricks and mortar growth in high street locations, Tiffany is also signicantly boosting investment in their e-commerce platform in 2013. Urban Outtters is implementing a system that will allow for e-commerce order fulllment at local bricks and mortar locations, allowing for national next and second day delivery. Walmart continues to grow on all fronts; through its superstore concepts and its new smaller format grocery (Neighborhood and Express) and online. The chain is testing same day delivery in select markets and will be testing online delivery lockers in a dozen stores starting in June. These lockers will allow for customers to order goods to be delivered to local stores, typically with abbreviated delivery times, where they can pick them up at their convenience. Williams-Sonoma continues to be among the market leaders in hardline retail e-commerce performance. Though they are continuing to grow bricks and mortar locations at an extremely conservative pace for their namesake concept as well as West Elm and Pottery Barn, investment in their supply chain and tech are what is growing their three current growth initiatives; global expansion, growth of existing brands and the launching of new business. More signicant investment in e-commerce platforms has not been limited to hard goods retailers. Though the restaurant sector has seen limited impact from online sales, Dominos Pizza estimated that about one third of their incoming orders now are digital and the chain continues to build its platform to take market share from other national, regional and local players. We have also seen signicant increases in e-commerce investment from other select retail service categories; both Weight Watchers and Nutrisystems are increasing their investments in e-commerce platforms nding that anonymity and ease of use is of huge benet to their target clientele. Of course, with all of the focus on Omni-channel growth, it is only inevitable that there would be major consequences for the bricks and mortar arena. And we are already starting to see that play out.
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Of course, this all is playing out with signicant impact on bricks and mortar retail landscape. If Omni-channel retailing is the buzzword for retailers, experiential retail is the new buzzword for landlords. With food-related users (grocery and restaurants) now accounting for almost 60% of all the planned retail unit growth in the United States (this number has traditionally been around 40%) and most hard goods retailers increasingly focused on e-commerce platform growth, we are seeing a radical shift in shopping center tenant mixes. The traditional neighborhood center will largely ride out these changes with minimal impact. The bread and butter tenants of this space have always been a mix of restaurant users, local service providers (dry cleaners, tax preparation, etc.) and the two user types that have seemed most impervious to e-commerce so far, grocery and drug stores. On the other hand, the mall arena is quickly becoming bifurcated into trophies versus trash. The mall retailers that remain in cautious growth mode are only looking for the top mall space and Class A properties are beneting from this. However, in most U.S. markets, we are not seeing enough growth activity to spill over to Class B projects. The result is that a clear delineation is occurring; the mall landscape is quickly becoming quality and then, everything else. The top malls are adopting to more food users and shifting their tenant mixes to bring in more entertainment components. Experiential retail is about providing shoppers with something that they cannot get online and the smart operators are doing everything they can to boost the cultural and entertainment offerings of their properties. This trend will only intensify going forward.

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2013

The New Bulk Paradigm

It is no secret that since the 1980s, and accelerating through the 1990s to today, that the industrial building base in the United States has increasingly shifted away from its manufacturing roots and towards supporting a complex global distribution chain. The outsourcing of manufacturing capabilities, whether to the Far East, Mexico or other offshore locations has been the name of the game. Certainly there are many changes afoot in the manufacturing sector. The automotive sector has rebounded from near collapse during the recession. Meanwhile, we continue to see a minor trend of on and near-shoring of manufacturing jobs. Chinas boom has led to an emerging middle class and strong demand for increased wages. The average hourly wage of a Chinese worker in 2001 was $0.35 per hour. That gure quadrupled by 2011 (the latest year for which data is available) to $1.63 per hour. But this has been a minor trend so far. What remains to be seen is whether the advent of the 3-D printer may accelerate this trend and possibly lead to a renaissance of American manufacturing assuming that this may radically lower costs for some light manufacturing processes. But even as the United States has shipped its manufacturing plants and jobs overseas over much of the past thirty years, the goods that they produced still largely ended up in the hands of the American consumer, mostly shipped in on shipping containers from the Far East. A recent study by global logistics consultancy group, IMS Worldwide, found that the goods within 20,000 shipping containers typically translate into one million square feet of warehousing needs throughout the national supply chain. In 2012, approximately 44 million shipping containers full of goods were delivered to the United States destined for American retail outlets. This equates to roughly 2.2 billion square feet of warehousing need along the distribution chain. Industrial demand and building design shifted with this paradigm. The factories that produced goods were replaced by warehouses and distribution centers to serve the global supply chain bringing goods from overseas manufacturing bases to American retail outlets. Since the mid-1990s, the dominant industrial building type has been the distribution warehouse, particularly the bulk distribution warehouse. These buildings, whether located in port cities, inland port cities or as hubs along the distribution chain typically followed a simple basic template. A typical regional distribution center for a major retail chain might be 150,000 square feet in size and handle the daily supplying of 25 stores throughout a geographic area. Depending on the type of retailer and whether other back ofce functions might be handled at these locations, these buildings may employ as few as 30 employees, or as many as 100but typically parking needs were minimal.
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Anatomy of the Old Bulk Warehouse

Typically 100,000 square feet or larger in size Ideally located near interstate arterials, air cargo hubs, ports or rail More stacking of goods required Heavier load oors Greater ceiling heights (ideally 24 or more) Sprinkler systems More dock and/or drive in doors for trucks 20 or more docks/doors for trucks ideal Cross-docking capabilities a plus. Additional land for parking trucks a plus Parking to accommodate low levels of employees This is the type of buildings that has dominated industrial development, demand, leasing and sale activity since the late 1990s. Yet, changes in the supply chain driven partially by the impact of e-commerce are radically changing this paradigm. Dollar General opened this million square foot distribution center in Bessemer, Alabama last year. This facility serves their supply chain throughout the southeast. The chain is planning on opening 635 new stores in 2013 while also seeking to beef up its e-commerce presence.

Size Matters
The new bulk warehouse is even bigger. This has almost entirely been driven by the impact of e-commerce. The clearest examples come from the pure e-commerce players themselvesthose, like Amazon, that (at least for now) have no bricksand-mortar retail presence. Without hundreds of bricks-and-mortar retail locations to supply across dozens of major metropolitan markets, the need for multiple, mid-sized distribution centers simply isnt there for most pure e-commerce players. Fewer, but much larger, distribution centers strategically placed to result in the fastest shipping time and lowest shipping costs to major population centers is what it is all about. In the fast moving world of e-commerce, even these relatively new strategies are rapidly evolving. Amazon remains the giant and the model for all other purely online e-commerce players. Amazon currently has about fty million square feet of distribution center space in the United States and is looking to expand those capabilities to as much as 90 million square feet of space by 2016. They are growing their distribution chain capabilities by as much as a million square feet at a time, having signed multiple build-to-suit development deals across various inland port markets across the country for new mega bulk warehouse facilities to be built with an average size in the low seven digits. Amazons astounding growth, however, reects the new imperative in e-commerce; the ability to provide same or next day delivery. This is a trend impacting all of the players in e-commerce, whether we are talking about third-party logistics rms that service the supply chain, online only retailers or traditional bricks-and-mortar retailers looking to boost their e-commerce platforms and provide better Omni-channel retail options to compete.

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Those very same bricks-and-mortar retailers are typically proceeding with one of two strategies; integrating their traditional retail store distribution chain with e-commerce order fulllment or complex, limited growth strategies. Macys would be the primary example of a retailer seeking a limited to no-growth strategy. This has largely been driven by the fact that they own a considerable amount of their department store real estate. Starting last year, the chain had been experimenting with four locations where it set aside considerable blocks of space for regional e-commerce fulllment. Reportedly, In the new bulk mega all of the stores involved in this beta test were underperforming locations that the chain owns outright. Our sources have told us that warehouse paradigm, buildings they plan to expand this experiment in the months ahead, though it is unclear how comprehensively. of 300,000 square feet are

normal. Half a million square This strategy has an obvious plus to retailers in terms of limiting any new capital expenditures, but could be highly problematic. For one foot distribution centers are thing, it requires state of the art inventory control systems to be in not uncommon and deals for place and the kind of strict inventorying of goods that becomes much more complex when spread across more locations. Secondly, most million square foot facilities are department stores have room on their docks for only one or two (at most) delivery trucks at a time. Logistics issues can clearly become happening with regularity. an issue, not only in bringing goods in and out of the store but also in terms of where they are kept within a store. If they are kept on the sales oor, there are greater inventory control challenges. Yet, for some smaller chains this might make senseparticularly if they have solid inventory systems in place, proper amounts of backroom warehousing space in their appointed locations and if their primary goal is creating regional next day delivery capabilities.
But the overwhelming majority of bricks and mortar retailers are looking to combine their traditional supply chains with the capability to directly ll online orders to customers. And that means that they have to go larger. Not just because their warehouses will carry more goods and see more trafc (which they will), but because of the very nature of e-commerce fulllment itself. The new retailer driven regional distribution center/e-commerce fulllment center may still supply 25 stores throughout a geographic area daily, but now it also lls the direct orders of as many as 25,000 customers daily. In the new bulk mega warehouse paradigm, buildings of 300,000 square feet are normal. Half a million square foot distribution centers are not uncommon and deals for million square foot facilities are happening with regularity. The 30 to 100 employees who may have served the needs of supplying 25 outgoing store bound trucks daily can now be 400 to 1,200 employees needed for the meticulous task of individually pulling each online order for a customer. And because this is retail (albeit in a warehouse setting), demand surges during the holiday sales season so facilities have to be able to accommodate workforces that may double or more depending upon seasonal demand.

In terms of pure numbers, demand for distribution space to serve the needs of e-commerce, retailers, third-party logistics players is now, and will remain for the foreseeable future, the single largest driving force behind industrial growth in the United States.
These changes in user tastes have evolved extremely quickly. Some of the national markets that we track have reported to us that over the past ve years the average size of major distribution center leases signed has essentially doubled. This has been a driving force in the industrial sectors strong recovery as of late. The fact of the matter is that in terms of pure
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numbers (total square footage) demand for distribution space to serve the needs of e-commerce, retailers, third-party logistics players is now, and will remain, the single largest driving force behind industrial growth in the United States for the foreseeable future. But there is a new paradigm to understand behind the new mega bulk warehouse. It isnt just about size alone. This may prove to be problematic both for space users looking to grow quickly and for landlords hoping to backll vacancies in their large, but older, warehouse properties. There are a number of other building features besides sheer size that are critical for this new wave of users.

Anatomy of the New Bulk Warehouse

At least 300,000 square feet or larger in size; 500,000 square foot buildings are common and one million square foot facilities are not rare Must be located near interstate arterials, air cargo hubs, ports or rail Must be located near FedEx or UPS hubs Ideally situated in Free Trade Zones or other tax incentivized industrial parks Even greater stacking of goods required Heavier load oors Greater ceiling heights (ideally 32 or more) ESFR sprinkler systems required due to greater amount of workers and goods. Even more dock and/or drive in doors for trucks 40 or more docks/doors for trucks usually a minimum Cross-docking capabilities often a necessity The Cherry Logistics Center in Newark, California is an example of a mid-size mega bulk warehouse. This 580,000 square foot project near the Port of Oakland in Northern California is actually small compared to many of the projects out there. However, it is emblematic of what little new speculative construction we are seeing--despite strong demand from mega-users, most speculative construction has been in the form of buildings 600,000 square feet or less that are divisible.

Anatomy of the New Mega Bulk Warehouse

Access to good temporary labor sources for seasonal work (College towns a plus) Additional land for parking trucks usually a necessity Parking to accommodate high levels of employees a mustsome distribution centers may as much as quadruple their workforce during the holiday sales season depending upon the type of retail

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2013: The Year of Same Day Delivery

2013 is the year of same day delivery. Amazon currently has about 50 million square feet of warehouse distribution space throughout the United States. They plan to boost that number to 90 million square feet by 2016 and are actively shopping multiple million square foot warehouse requirements across multiple major U.S. markets. Many have speculated that this might be a tax play, with Amazon seeking to cut deals with individual states (and they have signed a few) in order to get ahead of the game should the ICSC-backed Main Street Fairness Act becomes enacted into law. This is the legislation that would essentially take away the loophole that leaves billions of uncollected state sales tax on the table with most online sales. Yet, this piece of legislation only recently began to gain traction. Amazon has been rapidly expanding its national presence for the last few years. No, getting ahead of the sales tax issue is not what is driving their growth. Amazons goal is simple; to conquer the bricks and mortar world by creating the rst workable same day delivery infrastructure. Though it remains to be seen if same day delivery can actually be done in a workable way (previous attempts have always collapsed under the costs involved), the race is on. Amazon is already beta testing a service in ten major U.S. markets. They are not the only online player in the gameeBay is testing a concept in two markets and Google recently announced plans to launch a service in San Francisco that may serve as a model for rolling out to other cities. Yet, as frightening as this may sound to some bricks-and mortar retailers, this is actually where many of them may already have an advantage. With local outlets already in place, for many retailers the issue will just be one of tackling the supply chain and logistical challenges of truly integrating their online and bricks and mortar presence to serve in this capacity. Which is why, for many retailers, this has become the big challenge of the next couple of years and why many will be focusing much of their capital expenditures budgets towards IT and logistics, rather than new stores or remodels. This year will be the rst that Target is expected to spend as much on their supply chain and technology infrastructure as they do on new store and remodel investment. Meanwhile, Macys, Nordstrom and Walmart are all also integrating their online platform with their stores for inventory management and order fulllment. In fact, Nordstrom has been testing a same day delivery pilot since 2011 and may be the most ahead of the game. Regardless, the concept is simpleutilize your entire infrastructure (warehouses and retail storefronts) to fulll e-commerce sales. Macys has been exploring that concept with a number of its stores, but they have also joined with Target and Walgreens in partnering with eBay in testing a mutual service that might offer same day delivery. Meanwhile, Walmart has a pilot in four markets, and also recently made the extremely outside the box (and possibly just thinking out loud statement) that they were looking at a number of options to create same day delivery functionality, even that of utilizing in-store customers to deliver goods to their neighbors. The race is on and existing bricks and mortar retailers actually do have two advantages over Amazon. They have stores in place (though they might not yet have the infrastructure necessary) and they have the one thing that Amazon still does not havethe physical locations that make it easier for customers to return goods. We might not see workable systems online until next year and we will likely never see this in truly rural locations. However, with that infrastructure in place it is almost a given that national next day delivery might start to become the norm. But as scary as this may sound to bricks and mortar players, the good news is that this is where traditional storefront retailers that perfect their Omni Channel platforms may be able to compete with Amazon in the digital world.
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The E-Commerce Crunch

In our quarterly national reports, Cassidy Turley tracks the industrial markets of 68 major metropolitan areas throughout the United States. As of the close of Q1 2013, we were tracking a vacancy rate across all of these markets of 8.5%. Net absorption in these trade areas totaled 32 million square feet over the rst three months of the year. This was the second consecutive quarter in which the market posted near record levels of occupancy growth. Over the course of Q4 2012, the market absorbed a whopping 41 million square feet of spacethe largest amount of quarterly net absorption that we have recorded in nearly twenty years. For the sake of this paper, we decided to expand our statistics to include the entire United States. Our coverage of all of the major markets leaves few holes, however, there are some rural pockets that our normal quarterly numbers simply do not cover. Though the overwhelming majority of e-commerce distribution center activity has occurred within the major metropolitan areas that we already cover, there has been some activity as well in ideally situated rural communities that give easy access to multiple nearby major markets and where land and real estate costs are generally cheaper. Our survey indicated that as of the close of Q1 2013 the total size of the entire U.S. industrial market was 19.8 billion square feet spread across nearly 530,000 buildings. Nearly 1.8 billion square feet of this space was vacant, equating to a total vacancy rate of 8.9%. On the surface, it would be easy to assume that across 1.8 billion square feet of industrial vacancy, that nding second generation space to service demand for mega bulk industrial product wouldnt be a problem. Unfortunately, this assumption is wrong. Removing any property from this survey that was not at least 300,000 square feet in size or that was any other industrial use that could not accommodate warehouse or distribution uses and the nations total inventory drops just over three billion square feet. Approximately 327 million square feet of that space (10.7%) is vacant and available. Yet, most of that space still wont work. The average age of the national inventory of properties in this size range is 27 years old. For what modern e-commerce fulllment centers need, the majority of this space is functionally obsolescent.

National Industrial Market

Net Absorption, New Construction (Million SF) & Vacancy Trend

125

12% 10% 8% 6% 2007 4Q 2008 4Q 2009 4Q 2010 4Q 2011 4Q 2012 4Q 4% 2% 0%

100
75 50 25

0
(25) (50) (75) (100) Total Inventory: 19.8 Billion Square Feet Net Absorption New Construction Vacancy

While there is over 1.8 billion square feet of currently vacant and available industrial space throughout the United States, very little of it offers the size, features or amenities demanded by the modern e-commerce distribution user.

Modern users are seeking higher ceilings (32 or more) and more dock doors (cross docking preferred). They need oors that can accommodate heavier loads for stacking. They need more advanced ESFR and HVAC systems than what most traditional warehouse and distribution buildings used to offer. Many of these new requirements have only come into play over the last few years. And so we took our national survey and further reduced it to just those buildings built over the past ten years that were most likely to offer the modern features that todays space users require. In doing so, we found a national inventory of 780 million square feet. Approximately 90 million square feet of this space was vacant (11.6%) and available as of the close of Q1 2013. But those numbers still include a large number of buildings that are problematic for the wave of new users that is driving demand. Many of these still do not offer the features we already detailed, much less the requisite amounts of available land or parking that are necessary for e-commerce distribution centers. In fact, of the entire 19.8 billion square foot U.S. industrial market, we estimate that roughly 0.2% of that space, or roughly 40 million square feet, is suitable for active e-commerce distribution requirements in the marketplace

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Mega Bulk Industrial Market

Net Absorption, New Construction (Million SF) & Vacancy Trend

45 30 15

25%

20%
15% 10%

This is problematic. The current active requirements from Amazon alone (through 2016) are roughly 40 million square feet. Yet, it is unlikely that any of the existing second generation space in the marketplace would be suitable for these requirements. As of late, Amazon has been working with a typical footprint of one million square feet. And most of those buildings have extensive mezzanine space covering most, if not the entirety, of the structure. This is why nearly all of the deals that they have completed over the past couple of years have been build-to-suits. But Amazon is not the only player in this market. One of the largest recent deals that we have tracked was Williams Sonomas lease of 751,000 square feet of space at the Middlesex Center in South Brunswick, New Jersey. While this was not a build-to-suit deal, the building that Williams Sonoma is taking was already being built speculatively for this type of user in mind.

0 2007 4Q 2008 4Q 2009 4Q 2010 4Q 2011 4Q (15) 2012 4Q

5% 0%

Total Inventory: 780 Million Square Feet Net Absorption New Construction Vacancy

Williams-Sonoma already occupies 1.35 million square feet within the Middlesex Center, which they use to support the distribution chain and e-commerce efforts of both their Williams-Sonoma and Pottery Barn concepts throughout the Eastern United States. Upon completion of this building in July they will occupy more than 2.1 million square feet of space at this 206-acre facility located in Northern New Jersey. Atlanta-based IDI owns and operates the property and is already moving forward with plans to speculatively build another 450,000 square foot building within the project that will likely deliver sometime early next year. We are also tracking major e-commerce distribution requirements from retailers ranging from Nordstrom to Walmart, as well as mega-distribution center requirements (with little or no e-commerce component) from retailers ranging from automotive to dollar store chains. All told, we estimate that there are at least 80 million square feet of active space requirements in the marketplace looking to land over the next three years. This shortage of available space that can service current mega requirements is universal, however, it is not evenly distributed. For example, the Los Angeles/Inland Empire market has been one of the hottest industrial market in the United States over the past 15 months, accounting for nearly 7.8 million square feet of occupancy growth since 2012 across all industrial product types. Nearly 4.6 million square feet of that total has been in mega bulk structures of 300,000 square feet or more. Meanwhile, extremely tight vacancy conditions and high levels of demand have led to something in this marketplace that we see little ofspeculative construction of mega-warehouses. This trend is mostly playing out in the Inland Empire, where communities like Ontario and Fontana are now frequently seeing speculative projects exceeding the 500,000 square foot range going forward and typically

Though we are aware of roughly 780 million square feet of mega bulk warehouse product in the United States (warehouse/distribution space above 300,000 square feet in size), and approximately 90 million square feet of that (11.6%) is vacant and available, we estimate that only about 40 million square feet of this space offers the features, functionality and land required for modern e-commerce distribution centers.

Williams-Sonoma already occupies 1.35 million square feet of space in Northern New Jersey at the Middlesex Center in South Brunswick. In April they signed a deal to add an additional 751,000 square feet of space to further support their East Coast distribution chain and e-commerce fulllment efforts.
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landing tenants before completion. Situated within a few hours drive of both the Ports of Los Angeles and Long Beach, the Inland Empire has seen the brunt of this growth simply because there is little to no vacancy within Los Angeles or Orange County and very little in the way of affordable, developable land. We broke down current vacancy trends for mega-warehouse product in four distinct regions of the United States and came up with our estimates of how much of this space was in buildings that are not only large enough to accommodate the average e-commerce distribution user but which projects also could offer most of the other building features that these tenants demand. As stated earlier, we estimate that of the roughly 90 million square feet of vacant space that currently exists in these projects, that only about 40 million might be suitable. We saw the greatest shortage of space in the Northeast U.S., where mega-bulk vacant square footage totaled 14.6 million square feet, but we estimate that only seven million of that may be viable. We found only about 7.5 million square feet of viable space in the Western U.S. out of about 13.1 million square feet of potential options. Meanwhile, total mega bulk vacancy in the Midwest accounted for 26.5 million square feet of product, with about 11.5 million square feet of that space as being potentially viable. Lastly, we found just under 14 million square feet of space in the Southern U.S. that we deemed potentially viable out of about 21.2 million square feet of total mega bulk vacancy.

Mega Bulk Viability for E-Commerce

7,500,000

11,550,000

7,000,000

13,950,000

Vacant Not Viable

Western US Midwest

Vacant Viable
Northeast Southern US

In the wake of these trends, however, we have seen a number of major developers springing into action with both speculative and build-to-suit construction levels ramping up considerably. Nearly all of these new projects are being positioned for potential e-commerce distribution use, offering higher ceilings, improved utilities, HVAC and ESFR systems, greater numbers of dock doors and, in most cases, larger amounts of land for track and employee parking. We are currently tracking 34 million square feet of space that is under development in the United States. Approximately ve million square feet of new product is underway in the Northeast U.S.; seven million square feet in the Midwest and ten million square feet in development in the Western U.S. The Southern U.S. currently leads all other regions in terms of new construction, with roughly 12 million square feet of new projects in the development pipeline. Most of these will be delivered no later than early 2014, but about 65% of this total, or 22.1 million square feet, are build-to-suit projects. Clearly there is already a shortage of space in the marketplace that can service these needs. The real question for developers is whether it is worth it to wait for build-to-suit opportunities to develop or if there may be more prot to be had in getting ahead of demand by building speculatively. Thats a huge dilemma. There is no small risk involved in building distribution facilities of 300,000 square feet or more. However, we have seen a few willing to roll the dice with projects that could potentially be divided to house smaller tenants in the 100,000 square foot range should elephant hunting go south. Meanwhile, the big question for landlords of existing vacant mega-warehouse space that currently does not meet the needs of these space users is whether to upgrade their space or not. The problem is that, depending upon the users they are
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With only limited existing second generation options to potentially service current demand, most of the substantial occupancy growth numbers that the e-commerce sector will generate over the next few years will be in the form of new constructionprimarily via build-to-suit projects. That being said, existing owners of large vacant bulk space might be able to cash in on this trend by upgrading older properties assuming they can make the hefty costs involved pencil.

E-Commerce Imperative
2013

trying to attract, these upgrades can be extremely costly and may be too cost prohibitive to pencil based upon current rents. Rents for this type of space can vary widely, depending on the size of the space leased, the modernity of the facility, the locational attributes of a space and the geographic region of the country. In general, we have seen deals done at anywhere from the $0.20 to $0.40 per square foot range for quality space, though with considerable exceptions in both directions. Regardless, we anticipate that those U.S. Mega Bulk Construction rents will be going up.
New Construction (Million SF)

14 12 10 8 6 12M SF 10M SF 7M SF 5M SF

4
2 0 Western US Midwest Northeast Southern US Currently Under Construction

New development is on the rise, including speculative development. However, we estimate that speculative development of projects 300,000 square feet or greater accounts for only about 35% of the construction currently in the pipeline. Though demand exists, developers remain hesitant to embark on such large projects without commitments already in place.

Lets assume that our estimate of 80 million square feet of e-commerce related demand over the next three years breaks down evenly to roughly 27 million square feet of occupancy growth annually. As of today, we only see about 21.2 million square feet of potentially viable second generation space in the marketplace. Of the 11.9 million square feet of new speculative space currently in the development pipeline, about half (six million square feet) will be delivered this year. And so, assuming 27 million square feet of demand in the marketplace in 2013, there will only (by year end) be about 27.2 million square feet of existing potential options for space users. Even if the impossible happened and all of this demand t perfectly into all of this supply, we would be starting 2014 with no options in the marketplace and about another 27 million square feet of demand looking to land. Assuming a lesser case growth scenario of 20 million square feet of demand annually hitting the market over the next three years, we are looking at no serviceable space within two years.

At least in the near-term, demand for this type of space is only going to increase and those increases are likely to be substantial. Because of the size and unique attributes of this type of space, the majority of these requirements will continue to be met by build-to-suit development. This is certainly the case at the larger end of the spectrum, where developers are still extremely reticent to gamble with speculative development of structures that are larger than 600,000 square feet in size. However, there are unique opportunities in the marketplace for those builders willing to assume some risk. We are seeing more developers rolling the dice with speculative constructionparticularly with mega bulk warehouses that could be divided to service the needs of 100,000 to 300,000 square foot users. Because of the lag time involved in build-to-suit construction and the current rush of e-commerce, traditional retail and third-party logistics rms to secure this type of space, many will be willing to pay a premium for speed to market. Many publicly traded retailers in particular are now under great pressure to demonstrate that they are beeng up their Omni-channel presence. Meanwhile, we also see some limited opportunities for landlords of existing large bulk warehouses that are vacant. Providing that they can upgrade their buildings to provide the basic building features demanded by these users, many may nd this the key to backlling their empty space. Of course, this will only work if their properties meet the other list of attributes required by these userssuch as locations that offer premium access to rail, ports, interstate arterials or air cargo hubs and, perhaps most importantly, additional land. However, the challenge here will be cost. In some cases, particularly for older product that is already bordering on functional obsolescence, the cost of upgrading HVAC and ESFR systems alone may be too prohibitive to make the nancials work, much less those faced by trying to raise ceilings, add mezzanine space or create cross-docking facilities. Still, with a shortage of available space in the marketplace and demand on the rise, look for pricing for mega bulk productboth in terms of lease and sale ratesto rapidly escalate over the next 24 months.
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The Road Ahead

Retail routinely goes through seismic shifts; the rise of the suburban shopping mall; the ebb and ow of the department store sector; the emergence of the category killers; the ascent (and now the shrinking) of the big boxes. Consumer tastes evolve, the pendulum swings back and forth and the marketplace adapts. E-commerce is nothing new, but its growth has nally reached a tipping point and we are in the midst of one of those seismic shifts. As challenging as this may seem, those retailers who see this as an opportunity will be the ones that end up on top. And, no, the traditional shopping center will never go away. But retail landlords who dont understand the nature of these changes and react to them properly will face a bumpy road ahead. Meanwhile, owners of industrial properties also need to understand the nature of the beast if they want to capitalize on the current wave of demand from mega-distribution users. Sound real estate strategies are critical across the board. In conclusion, we would like to leave you with a brief outline that summarizes both the challenges and opportunities that lay ahead.

The Road Ahead

Shopping center vacancies will continue to fall at a modest rate as overall retailer growth plans are up, however, there has been a massive shift in terms of who is expanding. There are two forces currently impacting retail demand in the United States; the economy and the impact of e-commerce. Continued weak recovery has meant strong growth from dollar stores, discounters and off-price retailers. Luxury shoppers are back and high-end chains are also in growth mode (though these numbers are always small and mostly limited to high street retail and trophy shopping center locations). With the middle class consumer still in frugality mode, mid-priced concepts are in extremely conservative growth mode at best, or in contraction. The rise of e-commerce has meant stiff competition for mid-priced hard goods retailers. Most are focusing their immediate efforts on building their e-commerce platforms and are streamlining their bricks and mortar presence. Concepts that dont, or only minimally compete, with e-commerce is where we are seeing some of the strongest bricks and mortar growth. Restaurants lead the way, grocery stores are hot (new smaller concepts are expanding though many traditional players are contracting) and service related retailers are the strongest sectors. Big box users are mostly shrinking their footprints, particularly in those sectors most impacted by e-commerce (consumer electronics, ofce supplies, etc.). The tenant mixes for shopping center landlords are radically shifting away from hard goods. Experiential retail means creating a shopping environment that builds around dining and entertainment options. The current trend is of the strongest shopping centers getting stronger and the weak getting weaker. Class A in nearly every U.S. market has improved, but there has not been enough demand to spill over to Class B projects outside of a few of the strongest markets. Class C struggles everywhere. After years in which there was virtually no retail development outside of Texas (with the exception of outlet centers), retail developers are slowly returning. Mixed-use urban development (and redevelopment) is hot but suburban is not. This may begin to change by 2014 when the return of housing development may begin to provide new suburban rooftops for retailers to follow. New mall and lifestyle projects are focused on beeng up dining and entertainment options, but the trophies still see hard goods growth. Power centers are increasingly looking to grocery retailers to ll empty big boxes and shift tenant mixes. Neighborhood centers are seeing the least change. Going forward, the return of the housing market will bring GDP back to normal levels by 2014. The return of housing values will mean the return of the middle-class consumer by 2016 and an increase in retail demand from the long MIA mom-and-pop sectormost of these startups use home equity loans as their initial line of funding.
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E-Commerce Imperative
2013

While the economy will continue to exert less downward pressure on bricks and mortar retail demand, the impact of e-commerce will continue to exert more pressure. Most major hard goods retailers will continue to focus the lions share of their growth efforts on building their e-commerce platforms and distribution chains over the next three to four years. In terms of net absorption, industrial has led all other commercial real estate product types since the end of the recession. The majority of this growth has been driven by demand for mega distribution centers. Demand for mega bulk distribution centers will only be on the increase over the next couple of years. But most of the existing vacancy that exists in the market does not meet the criteria of what these users need. Build-to-suits have served most of the larger (500,000+ square feet) distribution center requirements over the past three years and will likely continue to do so. We are seeing an increase in speculative developmentsavvy developers are creating divisible mega bulk warehouses in order to hedge their bets with more traditional distribution center users should they struggle to nd a mega-user. Though some owners of existing older properties may prove to be successful in landing new mega-tenants, the majority of the space in the market that is more than just a few years old is obsolete to many of these users, Upgrades might be an option for some, however, these can sometimes be almost as costly as just erecting a new building. Even with a slight uptick in development, our study of supply and demand trends indicates that there will continue to be a shortage of this type of space over the next three years. Both sales and lease pricing is likely to increase during this period.

Credits
Chief Economist: Kevin Thorpe, Chief Economist/Principal USA Research 202.266.1161 Kevin.Thorpe@cassidyturley.com Contributors: Garrick Brown, Director of Research Research, Northern California 916.329.1559 GBrown@ctbt.com Chris Jantz, Vice President Brokerage, Phoenix 602.224.4485 Chris.Jantz@cassidyturley.com Arty Maharajh, Vice President Research, Los Angeles 213.330.0959 Arty.Maharajh@cassidyturley.com
21 | Cassidy Turley

Editor: Garrick Brown, Director of Research Research, Northern California 916.329.1559 GBrown@ctbt.com

Graphic Design: James Molgaard, Graphic Designer Art Department, Northern California 415.568.3427 JMolgaard@ctbt.com

Michelle Clifford, Senior Research Analyst Research, New Jersey 201.518.7523 Michelle.Clifford@cassidyturley.com Craig Kovaleski, Vice President Brokerage, San Jose 408.436.3668 Craig.Kovaleski@ctbt.com

Jennifer Edwards, Research Manager USA Research 202.463.1104 Jennifer.Edwards@cassidyturley.com Jason Tolliver, J.D., Vice President Research, Indianapolis (317) 639-0549 Jason.Tolliver@cassidyturley.com