Digital transformation is coming to the commercial property sector, but its leaders are laggards. Disruptive pressures are building, and intermediaries like AirBnB and WeWork are already resetting the rules.

Compare the construction subsector of property — where little has changed about the way we build buildings since the late 1930s — to the automotive industry. The latter is in the midst of tremendous innovation and automation. Manufacturing, likewise, is on the cusp of radical change as its leaders imagine how to shift efficiently from a linear process to a completely different one.

Structural shifts around commercial real estate (CRE) are set to impact the industry just as profoundly, despite a culture rooted in a highly conservative mindset that resists change — especially in office and industrial subsectors.

Pressure has been most obviously felt in the retail sector, with shopping centres struggling to adopt business models and value propositions that keep pace with the structural shifts in the businesses of their customers: retailers.

Horses and buggies

An attitude of ‘if it isn’t broken, why fix it’ has entrenched a lack of commitment by commercial real estate companies to rethinking their business for the digital age.

Understanding their model sheds light on this pervasive mindset. In its most simple form the business of commercial real estate companies — whether developers, fund managers, or both — is to realise asset appreciation over time combined with a high-yielding asset operation. The yield on commercial real estate assets has traditionally been driven by better rents and rent stability — that is, longer-term rents to tenants with high covenant strength.

Over the last few years, the retail sector of the commercial real estate industry (especially shopping centres) has been the hardest hit as these assets aren’t yielding what they used to.

Ecommerce is key to this change. It has given shoppers choice and convenience they could not access before — making the shopping centre less relevant. Meanwhile, retailers realised they needed to embrace ecommerce to compete and meet shopper expectations. Convenience is a powerful driver in shopping decisions.

This continues today with the ecommerce offering expanding to deliver added convenience, more choice, and improved customer experience.

Furthermore, retailers who have understood the power of combining ecommerce and physical retailing solutions — or more simply a store network — have realised:

  • They need less physical retail space to sell their inventory;
  • They also require more logistics (warehousing) space to fulfil orders;
  • Combining customer-centric services such as click-and-collect or click-and-return yields great retail sales;
  • Analytics allows them to serve shoppers better through personalisation, deliver new products to meet consumer needs, segment shoppers to improve their conversion and deliver new value propositions that evolve to remain relevant for shoppers.

Technology and data have allowed retailers like Amazon to deliver a convenience that is highly appreciated by shoppers.

Experience counts

Amazon understands that people don’t want to waste their time on mundane/necessity-based shopping. If they go shop it needs to be about the experience — whether in-store or as a social activity. If you had the choice to go shopping for paper towels and dishwasher soap or spending quality time with friends or family, what would you rather do?

Retailers that are failing are doing so because they haven’t embraced digital transformation and have failed to invest in experience. This includes traditional service levels such as offering a choice of items in store, as well as the ability to browse and purchase a greater selection in-store through digital when choices are limited.

The commercial real estate industry was steadfast in its desire to ignore the impact that e-commerce would have on its business or on that of its customers — and wasn’t prepared for it. Since at its core it relies on rental income and longer-term leases, it is adjusting to a new world where rental income has dropped significantly (30-50 per cent in some cases) and leasing periods have shrunk.

With too much retail space available, it’s a renter’s market.

On top of that, the retailers’ business model itself has changed significantly. For instance, a retailer may do very well in a particular trade area through its online offering while struggling in store in the same area. The commercial property industry wasn’t ready to model the impact of a store’s presence on online sales within a trade area. This has led to rent reductions, abatements, and greater leasing incentives as solutions to keep retailers in place to avoid dealing with vacancies.

Yet all this mitigation has a negative impact on asset yield and value appreciation. This has been reflected in the share price of commercial retail real estate companies in both Australia and in the UK — with similar share price trends for companies operating in the retail sector.

Comparisons are odious, but…

The commercial retail real estate industry is reminiscent of the music industry when the MP3 format was first adopted by consumers. The music industry refused to budge, adamant it would stick to its album pricing model and not sell songs individually. It also fought legal battles against anyone who was threatening its long-established model — a situation which was exacerbated by the ease of piracy and mass distribution enabled by the internet.

It took years, but eventually, the industry accepted that it was smarter to take advantage of the digital age than to litigate against it.

Too many commercial retail real estate companies desperately clinging on to their rental income expectations — because it underpins their entire model and few are ready to transform for the digital age.

In the Sydney market, many smaller retailers have had to relocate or close their stores as they cannot afford the rents landlords are expecting. A recent report by Cushman and Wakefield corroborates these trends, indicating that even major brands such as Target are actively pursuing strategies to lower their rental costs.

The attitudes of landlords are coloured by the fact that real estate is one of the few asset classes that appreciates over time instead of depreciating, and a recognition that any reduction in rental income can be softened by remixing the asset with different operators — or different categories that shoppers could be more interested in. This has been seen in shopping centres opening up casual dining precincts that deliver a better offering than the traditional food court and a new experience mix for shoppers.

Money on the table

So as much as disruption has significantly affected industries around it, the commercial retail real estate model isn’t yet that disrupted. However, major players are still missing obvious opportunities to increase their assets’ total returns by improving the yield generated by the assets’ operations. To do that, they need to embrace digital transformation and stronger customer-centricity.

Longer-term investors are also yet to embrace digital transformation to maximise their shareholders’ return on investment by rethinking the core components of customers, competition, data, innovation, and value of their current business.

Shorter-term investors — such as alternative investment firms like The Blackstone Group or Brookfields — will find it harder to digitally transform their assets to maximise yield due to their typical investment horizons of 5-6 years in their opportunistic funds.

And that may be fine for now. But when you look at possible competitors and possible disruptors you can see that middlemen will feel squeezed and will decide to change models, customers may become competitors, and the model will decline in time if the fundamentals of operating in the digital world are not embraced.

Infrastructure and technology-driven disruption have allowed new competitors to give incumbents a run for their money. Amazon is a clear example. But we have also started to see major tenants — the sector’s customers — becoming competitors. Companies such as Woolworths are developing and operating their own small shopping centres that deliver convenience for shoppers closer to home and with more strategic complementary retail choices than a major shopping centre would.

Not all of the commercial property sector has been immune to sharp disruptive change. In commercial hospitality real estate (i.e. hotels) we have witnessed disruption by companies such as AirBnB, which approached the business with a completely different model and carved out market share from the hotel industry.

The gig economy

Likewise, about seven years ago, the commercial office real estate industry became concerned by major trends indicating significant growth in the freelancing economy and the adoption of flexible workforces. At the heart of this is employee work environment flexibility, driven by activity-based work with an output focus — and no particular need for desks in the CBD!

Companies with office exposure faced the possible decline of CBD office space and began exploring the value of smaller commercial office offerings in satellite locations to service the imminent droves of freelancers.

The trend wasn’t far off — the freelance economy has grown and continues to — and companies have shrunk their floor space as a result of accommodating flexible work arrangements. What wasn’t clear was the growth of co-working space and the intermediation that WeWork would create.

Commercial real estate companies that took this trend seriously — such as The GPT Group — explored the impact of technology on office space and how technology could help maximise space productivity. At first, this involved looking at application-based services such as Liquid Space and how it catalogued underused space that could be commercialised. Eventually, GPT created its own co-working space offering through a subsidiary called Space & Co to service this new market opportunity.

However, even then the offering doesn’t reflect customer experience expectations. That’s because neither the digital transformation not the digital mindset adjustment required was ultimately adopted. Not to mention the focus on rethinking customers, competition, data, innovation.

It competitors like WeWork, without the hindrance of incumbent thinking, have imagined and embraced new ways of servicing the market.

WeWork appeared to be the saviour for those commercial office real estate companies who feared an increase in vacancies in their CBD offices. Its proposal was simple: we will take three to five floors and commercialise the space.

Great! Problem solved. The commercial office real estate companies would continue to get their rental income. Disaster averted. But WeWork is a business born in the digital age, that understands how it needs to operate in this era of data, innovation, and constantly rethinking customers, competition, and value.

It has started to focus on longer-term renters and enterprise clients, and its model is starting to look like an intermediation strategy. As an example it has secured major clients such as IBM and Verizon for its new, from-the-ground-up high-profile building in Brooklyn called Dock 72, under a new brand called Powered by We.

Having amassed significant data on the ideal office locations and office layouts, it uses machine learning as a competitive advantage over CRE companies to determine every element of its offering.

WeWork is also purchasing property instead of renting from landlords and negotiating new lease agreements that will help reduce its rental cost exposure.

The company is a classic disruptor. It has effectively positioned itself to steal customers from CRE companies and then service those clients on WeWork’s terms in their own buildings. It thinks of itself as a technology company with real estate assets. Perhaps this is how CRE companies should start thinking of themselves.

The shape of disruption

Disruption has a familiar shape (see chart), whether it’s newspaper advertising, analog film sales or desktop operating systems. The revenue growth for incumbents looks comfortable and even robust, right up until the moment they go over the cliff.

Even though commercial real estate companies and funds weighted towards office space have done very well over the last few years (as reflected in some of the stock charts below), WeWork is poised to disrupt the commercial office real estate industry — much like Amazon has done to the data centre industry — and in some cases to logistics assets too.

Companies like WeWork understand the need to strike the right balance of useful technology and kinds of experiential qualities that create spaces people want to work in while managing a work-life balance that is healthy. A good example of this is a new building in London at 22 Bishopsgate (http://twentytwolondon.com/).

Commercial logistics real estate has fared much better. Ecommerce has driven up the demand for warehousing. Last-mile fulfillment has become an important area of logistics, and assets that are closer to cities have performed better than gigantic structures in the middle of nowhere. A testament to this trend in demand for logistics is Goodman’s stock price: it has doubled in less than five years.

Embracing technology

CRE technology has become a hot area of capital investment over the last couple of years. Ranging from solutions that cut out the middle man in a residential transaction, to IoT sensors that gather geospatial usage data or proactively manage building management systems, advances in CRE technology will become primarily beneficial to developers as they use innovations to build or deliver buildings that are adaptable and future-ready.

Commercial real estate companies could be much more valuable — and could counter the risk of disruptors — by embracing digital transformation and by thinking more like technology companies. It’s only a matter of time before they will need to transform in order to grow their value. Yes, some have embarked on the journey — such as Westfield, Mirvac, and The GPT Group. But many more need to start.

The industry needs to be much more customer-centric. Its leaders need to consider how to service customers to support their business and their success. What do their customers need to succeed? What are their current pain points? Is it fulfilment from store orders? Is it staffing? Is it targeted marketing?

Ultimately they need to be seen as an extension of their customers’ business — a true partner, not a landlord.

Mirvac and GPT’s embrace of digital, data, and innovation — although far from what it could be — has still yielded results  that are reflected in their share prices.

The GPT Group has focused on using data to improve its assets’ usability, working closely with a leading provider — SkyFii — to help them draw out insights from all the data they collect.

Mirvac has an innovation team and is working towards rapid experimentation to identify new value opportunities and asset improvement opportunities.

Westfield has for a long time been the market leader in investing in technology and customer experience. It has taken some big gambles and learned some invaluable lessons. It has experimented with a digital lab called Westfield Labs that explored many of the digital trends affecting commercial real estate and retail. That subsequently evolved into One Market — a dedicated business with a “mission to give physical retail a competitive advantage by providing access to innovative technologies that accelerate speed-to-market in a cost-effective way”.

Five points of focus

The sector needs to recognise that digital transformation is not an easy or quick process and to accept the lessons of those who have gone before it. Encyclopedia Brittanica took 20 years to transform. From print to CD-ROM to online, Brittanica evolved with the mindset that it shouldn’t defend its old business model but instead embrace a model that would seek to understand the needs of its core customers. The medium was not its core mission — editorial quality and educational service were. By the time it printed its last copy, print only represented one per cent of its revenue.

Commercial real estate companies need to focus on the five domains of strategy that digital is changing:

  1. harness customer networks;
  2. build platforms, not just buildings;
  3. turn data into assets;
  4. innovate by rapid experimentation; and
  5. adapt their value proposition.

They need to rethink their customers, understand the customer network paradigm and how it has impacted the path to purchase. There is a need for a customer network strategy that considers customer network behaviours. They need to define a platform business model, understand asymmetric competition threats, disintermediation, and intermediation that digital has facilitated. Finally they must realise what their competitive value train is composed of to understand competition as leverage.

The sector needs to rethink data not only as an intangible asset but as a strategic business asset. It must have a data strategy in order to understand the impact of big data (unstructured data) and how to turn data into business value. Companies like Amazon and Netflix continuously use data to improve their offering and increase sales.

Innovation in the digital age is about rapid experimentation. Leaders need to accept that smart failure is OK, understand the importance of divergent and convergent experiments, adopt the principles of experimentation, and know how to scale up their innovations. 

Both Google and Netflix admit that only ten per cent of what they try works out and gets scaled.

Intuit India ran an experiment with only three staff members to see if they could help Indian farmers increase their revenue from crops by ten per cent. They ran three rapid experiments with no product building. The third experiment ended up being successful and resulted not only in achieving a 20 per cent increase in revenue from crops for the Indian farmers who participated but it turned into a billion-dollar opportunity for Intuit as it scaled it into a product called Fasal.

In most cases, incumbents have ended up in a position where they are too easily disrupted as a result of technological advancements that have allowed disruptors to rethink the traditional business model and acquire the incumbents’ customers.

Incumbents have simply not been agile and proactive enough to disrupt themselves to thrive, pedalling along to maintain income, stay relevant, and avoid decline but with no real plan for growth in the digital age.

Those that have survived and thrived have done so because they have rethought their business.

In commercial real estate, asset class value growth is sustained by refreshing assets, developing on-trend precincts and increase the yield achievable by the asset. Currently, the industry, in general, is missing out on improving asset income generation.

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