The Future of Offline Retail

Part I: Commercial Real Estate Needs a New Lease on Life

Vacant storefronts on Broadway in Soho, New York City

Anyone who has walked around Soho in New York City over the last few months has probably asked themselves “why on earth is every other storefront empty?” Some have been vacant for months — even years. On Broadway, eighteen different storefronts claim to be “available for lease” on the six blocks between Houston and Canal. That’s three empty storefronts per block on some of the world’s highest-end retail real estate.

A map tracking all current retail vacancies in Manhattan

While much attention has been paid to the disruption e-commerce has wrecked on traditional retail, the “future of offline retail” is a fascinating topic of focus for General Catalyst.

We’ve engaged in lively discussions with brokers, top brands, tech companies, real estate owners, and marketing agencies, which has led us to this initial conclusion: a mismatch has evolved between the demand of new, digitally-native retailers (who need less offline space and want flexible short-term agreements) and the incentives of the commercial real estate (CRE) owners (particularly in highly trafficked commercial areas like Soho, who need to sign long term ~10+ year leases at premium rents). To date, solutions have focused on the evolving needs of brands and retailers. However, the market needs to first address this fundamental challenge for real estate owners.

GC has made a number of investments at the intersection of retail and real estate. We’re proud investors in technology companies that help retailers create seamless and targeted omnichannel experiences for their customers (i.e., Newstore and Index), digitally native D2C brands that have explored and, in the case of Warby Parker, pioneered various kinds of physical stores and omnichannel models (i.e., Outdoor Voices, M.Gemi, The Honest Company), and (iii) businesses that are evolving the thinking around traditional uses of commercial (and residential) real estate space (i.e., ClassPass, HubHaus, Bowery Farming, Cover, Airbnb, and Deliveroo). But, to date, our portfolio does not include companies that address this fundamental challenge for real estate owners. We obviously believe in the promising and ever-changing future of retail — both online and offline — and would be excited to collaborate with founders working to address the specific challenge of real estate supply and retail demand.

In part II of this series, we will outline the various business models that have emerged to solve this market mismatch. First, it’s helpful to dig into the motivations of both the demand (retailers) and supply (CRE owners).

Demand: Retailers & Brands

A handful of drivers have been shifting retailers’ demand for offline retail from long-term, permanent locations meant to drive topline sales to shorter and more flexible offline storefronts. These serve both as brand marketing for medium/large brands and allow smaller, less- capitalized companies to test offline retail in a cost-effective way.

• Legacy retailers and brands have been shuttering stores and struggling to grow via traditional store expansion. Suburban malls have seen declining foot traffic, and up to a quarter of them are expected to disappear over the next five years. There just aren’t as many traditional retailers looking for long term leases, especially in categories like clothing and electronics. This is in part driven by ecommerce penetration and the rise of Amazon, but also by the decline of the Middle Class’s purchasing power).
• The last decade has seen the rise of digitally-native, Direct to Consumer (D2C) brands that have a different offline footprint than brands of the past. Companies like Bonobos, Birchbox, and Warby Parker first helped pioneer the “showroom” or “guideshop” concept. Increasingly, new brands like Casper, Glossier and Allbirds have used their (limited) offline storefronts as a way for customers to experience the brand in person. These retailers often employ a shorter-term offline retail strategy to help create buzz with temporary “pop-ups” instead of investing in a network of permanent locations like their predecessors.
• Millennial consumers are increasingly looking for discovery and experiences as part of today’s offline retail journey. “Experiential marketing” has become its own category, with brands shifting marketing dollars towards an experiential channel, like pop-ups, in the hopes of delighting their potential and existing customers.

Outdoor Voices (a GC portfolio company) ran a 4-week Pop-Up Store at “The Grove” in Los Angeles, which included an outdoor mini climbing wall

With demand for offline retail space evolving toward shorter, more flexible leases that support a a more experiential and brand marketing use case, it’s important to remember that offline retail is not dead. Even as ecommerce penetration increases from 15% today in the U.S. to 30% over the next 5 years, that still means 70% of retail purchases will still happen offline.

Even with that said, the nature and function of offline retail, however, is changing.

Supply: CRE Owners

Despite this clear shift in demand, the incentives of retail CRE owners to sign long term leases remain the same.

Three key drivers are behind this:

• CRE owners are structurally motivated to sign long term leases. CRE investments are predicated on an initial capital outlay for construction funded through the predictable cash inflows from 10–20 year rental agreements signed with tenants. The concept of instead signing 10 one-year leases with separate retailers doesn’t lend itself to the current CRE investment model. While some landlords are coming around to the “new paradigm” of shorter leases, many are firmly holding onto the idea they will be able to find a 10+ year tenant.
• This second driver is largely NYC-specific, and helps explain the stubbornly high rent prices that have driven the huge number of vacancies in SoHo and beyond. In the years after the 2008 market crash, there was a gold rush of foreign investment into NYC real estate, which significantly drove up rents (downtown Manhattan rents ballooned by 75% between 2010 and 2014). New and refinanced CRE mortgages were underwritten to these higher rental rates. Four years ago, the decline in demand for traditional long term retail leases started to become more stark as legacy retailers struggled and new D2C brands emerged. Some retailers went out of business before their lease ended, others didn’t renew. Faced with a slew of current and pending vacancies, CRE owners started to slowly lower rents, but have been constrained by their mortgages; many calculated if they fully lowered their rents to meet current demand, they would default on their agreements with the banks. Most owners decided they would rather (or were forced to) leave their property vacant and wait for the next long term tenant (and in the meantime use the loss on the vacant property to shelter other income).
• For every lease an owner signs, no matter if it’s for 10 years or 9 months or 3 weeks, the owner has to negotiate a “tenancy agreement,” which takes time and amounts to significant legal fees. Many owners determine it isn’t worth the relatively small amount of revenue generated for short-term leases. Additionally, there’s also the concern that a short-term tenant could obviatethe owners’ ability to sign a long-term lease should one materialize quickly. Given these challenges, many CRE owners have decided to leave their storefronts vacant instead and wait for the next 10+ years tenant.

Even CRE owners that want to meet this change in demand are often structurally prohibited from doing so. In some ways it seems that until the entire investment and ownership model around commercial real estate changes, the long term incentive of CRE owners to sign long leases will remain unchanged. Ultimately, this provides an opportunity to find a solution for CRE owners within the current structure of CRE investing (or, perhaps even to explore alternative ways of investing in and securitizing commercial real estate).

In Part II of this post, we’ll evaluate some of the business models that have emerged to date to address the mismatch in supply and demand in the retail real estate market.

Update: Part II of this series was published on November 17th, 2017 on Women’s Wear Daily online: https://wwd.com/business-news/business-features/think-tank-general-catalyst-11052233/