Last Mile Submarkets & Business Models
New economy and last mile real estate is situated in industrial and manufacturing zoning districts within cities and are subject to regulations that control bulk & area, lot coverage and building heights in addition to where use intensities can be located. As ‘m-zones’ become the center of attention and house businesses, essential infrastructure and services that drive urban economies, we examine submarkets, land use and potential new models for structuring deals between the various stakeholders in these critical areas.
Submarket dynamics
In any given densely populated metro area, land allocated for industrial use is constrained as a percentage of total land area, a function of historical land use policy, local zoning regulations and market forces. Meanwhile, the ‘industrial’ category includes a broad mix of essential and economic activities that take place under its umbrella creating a dynamic mix of commerce, manufacturing, utility, networks, infrastructure and services all competing for limited land area and congested transportation routes in these zones. Cities themselves, or quasi-government organizations closely connected to them, also tend to control significant portions of property in the last mile, adding to the list of factors that create barriers to entry for these submarkets.
Finite supplies of last mile land area has implications on two fronts: 1) the most obvious and important to investors and professionals transacting in these markets being supply and demand impacts on lease rates, asset values and market prices and 2) less visibly, on the underlying technology and companies conducting business in industries that fuel growth within. These stakeholders, and market makers, require and benefit from coordination and collaboration throughout the entire last mile ecosystem in order for these areas to flourish in digital and networked economies.
To this end, PropCos and OpCos with stakes throughout the last mile ecosystem must advance strong working relationships with local governments, policy, planning, engineering and design stakeholders to promote and support successful private sector investments in bricks & mortar assets, infrastructure, automation and mobility technology. In order to accommodate the ecosystem’s future development beyond the first wave of redeveloping the lower-hanging fruit provided by obsolete buildings and environmentally contaminated vacant land, forward efforts in last mile submarkets will require even deeper collaboration among all parties involved.
Due to the nature of enterprises operating in industrial submarkets, these uses often require specific structural, MEP, HVAC and design components resulting in high project capital costs for these specialized facilities. As a result of extensive physical improvements and faced with relatively limited land area to conduct business, rooted occupiers tend to be stickier at these locations than in other residential, commercial or mixed land use designations. On the other hand, legacy uses and common long-term ownership in the last mile provide a stock of properties that are physically obsolete and therefore candidates for assemblage and redevelopment. Along with user purchases, physical specifications of existing buildings and design requirements for modern, automated fulfillment and distribution centers continue to drive pricing metrics [AEBOV] and underscore the importance, and demand, for properties with market ceiling heights, column spacing, parking & loading and accessibility.
Market rents, changing markets
Demand from tenants and users driving market rents in last mile submarkets are part of the story, changing property ownership in last mile areas zoned for warehousing, fulfillment and distribution uses provides additional context for understanding supply’s role in the rent and value calculus. By understanding control, scrutinizing land uses, zoning classifications and industrial zone geography further by overlaying data about transaction parties and pricing, investors can make more educated projections on rents and market conditions in the future. Tenant site requirements, new construction project pipelines, sales data and locational intelligence layers provide more insight into how last mile submarkets will evolve and to what extent they could potentially support higher rents than are currently ‘market’. It’s fairly clear to see the number of compelling factors that support investment in this asset class, however looking at the ecosystem holistically is valid considering the sophistication of operations occurring inside building walls throughout the last mile and can even identify opportunities for outperformance.
It makes sense that industrial rents have been increasing since at least 2014, and clear why they have accelerated over the last 24 months. At some point, this market activity invites a deeper inspection into the ecosystem beyond ‘comps’ to ascertain where market rents and asset values are when fully taking into account changing tenant business models in a sector that has experienced frenzied activity in recent years. Have innovation and changing business models been fully baked into rising rents and asset prices? And, as a comparison specifically to e-commerce ‘industrial’ real estate, are retailers paying a proportionate percentage of revenue for real estate occupancy costs in line with what they are accustomed to paying for prime bricks and mortar shopping district locations (5%-15% of gross sales rule of thumb I’ve heard retail leasing brokers discuss, I’ve seen financials for restaurants in Manhattan near 30%). Foot traffic, brand visibility, marketing, advertising all happen online now and play out on digital media, commerce and social networks. The point: rent in ‘industrial’ versus ‘retail’ real estate shouldn’t be driven solely by physical location and generic market rents for e-commerce tenants when there are other data and technology that can be used in determining appropriate occupancy costs.
From here, it is possible to examine the stalwart metric of market rent even further, although in reality, deals are negotiated and markets tend to move based on conventional indicators due to precedent and even more difficult negotiations that would be required to re-invent Propco business models and landlord-tenant relationships. Given the prices being paid for leased assets in last mile submarkets, it is advantageous for owners/investors to examine how much pure market comps dictate the amount e-commerce companies will pay for rent. Will simple ‘market rent’ metrics always be the most relevant benchmark as the activity and technology taking place inside become as important as the physical location of the real estate? Are market rents too arbitrary for specialized assets located in the last mile?
Evolving business models
As discussed in a previous blog post, changing income and operating expense line items provide potential avenues for reallocating these fundamental financial components as business models evolve. For example, if fulfillment labor costs are reduced after investing in more automation, robotics and SaaS, then theoretically (and irrespective of other line items to communicate a point) this means there is more room to pay in rent. We’ll use this backdrop to further discuss how evolving business models can impact last mile real estate and the ecosystem.
Whether it is office leasing models altered by WeWork taking advantage of market dislocations and changing economies or hotels competing with Airbnb for travelers, tech-driven, changing business models affecting physical real estate is not new. On a day to day basis, no property type displays transforming business models to the naked eye as retail real estate. As traditional storefront retail’s reincarnation, e-commerce real estate consists of property occupied by DTC brands, e-commerce retailers fulfilling online orders from warehouses, delivery service apps running dark stores, ghost kitchens, ‘micro-warehouses’ and grocery-store chains running bolted-on or standalone automated micro-fulfillment centers (MFCs) or as Ahold Delhaize owned The Giant Company refers to these facilities— ‘warerooms’. The distinctions may get lost in the press, but ‘micro-warehouse’ models (some of which are permitted uses in commercial districts as well) used by delivery apps for example, are not the same as MFCs, which are automated. Just because a warehouse is small, localized and e-comm driven doesn’t mean it is efficient, makes money and a desired neighbor. Business models with questionable prospects, even if they are well capitalized pose as a potential threat to property operations by disrupting income streams.
Investors of leased assets in the last mile face increasing challenges in sourcing suitable investment opportunities amid intense competition as they currently do not benefit from natural-fit access to new partner relationships that have emerged from e-commerce real estate owner-occupiers and technology solutions providers. Since user-occupiers are often willing to pay a premium to secure the most mission-critical sites, investors are faced with challenges ranging from a lack of investment product, to reaching for lesser quality submarkets, to having to achieve benchmark leasing to generate yield. Leading industrial real estate companies are already in the early innings of adding services and layers of technology to their core leasing businesses, similar to what I referred to as ‘stacking uses’ in my Jan 21 post.
Lease Innovation and Deal Structuring
As businesses and ‘OpCos’ evolve in the last mile, lease structures and terms could eventually modify as well by moving beyond arbitrary market rent metrics dictating a foundation off of which taking rents are negotiated. As software platforms can connect to a POS in a bricks and mortar retail store, similarly, e-commerce sales processed through online payment software can calculate sales in real time and rents can be determined based on that data. Automating rent collection can enable in more frequent payments from tenant to landlord and avoid the need for monthly billing and collection processing.
Landlord-tenant arrangements can also be restructured with respect to capital costs by creating partnerships and redefining ‘tenant’ improvement allowances and how that money is allocated for space buildout and interior ‘infrastructure’. For example, an owner that shares in the cost of installing systems that can accommodate robot pickers and also shares more in the revenue generated by a tenant’s e-commerce business. Shorter and more flexible lease terms, percentage rent clauses for e-commerce real estate and other creative ‘partnership’ models are areas that can be modernized to reconfigure typical lease structures.
Looking further out and acknowledging the significant obstacles that exist, merchant products for settling online and in-store payments via blockchain technology and smart contracts could eventually impact how leases are written. In turn, this innovation could provide a solution to the lack-of-trust realities and aversion to transparency that exist between owners and tenants. Crypto economies are already developing solutions for blockchain payments and when taking this technology into consideration, it’s clear to see where some people anticipate things are headed. Although it is not yet fully clear how these innovations applied to the above use applications will impact the industry, this post can not be considered complete without flagging them as, at minimum, topics to review more closely in a future post.
Thanks for reading.
