Bricks-and-mortar retail provides a way of offsetting business constraints for pure e-commerce players. By Darya Frolova, CBRE Investment Management.
Even before the current pandemic, the retail sector faced mounting pressure from increasing rates of e-commerce penetration and shifting consumer behaviour. Retailers pivoted online and prioritised distribution efficiency as real estate investors adopted an increasingly cautious approach towards the sector.
These tendencies became further entrenched over the past year and a half as mobility restrictions negatively affected engagement with physical retail. This simultaneously catalysed logistics sector growth. Current market fundamentals justify investor enthusiasm, but medium-term risks to the sustainability of e-commerce activity are potentially being overlooked.
There are several potential deterrents to e-commerce growth that physical retail can readily provide a solution to. We specifically assess the impact of digital advertising and goods fulfilment on retailer profitability. We also consider the environmental and social impact associated with e-commerce. While we expect online retailing to account for a greater share of total sales over time, necessitating a net reduction of total retail floor space, we also believe that physical stores can help operators navigate the risks associated with a fast-changing retailing environment.
A game changer
Shoppers have pivoted online as the pandemic spread across the world. In the US, consumers spent more than $1 in every $5 online. A similar trend was evident across Europe, where physical shopping was most affected by virus containment measures and e-commerce growth rates reached historic proportions. Ecommerce Europe, an association representing companies selling goods and services online to consumers in Europe, expects that the pandemic will accelerate e-commerce adaptation by nearly a decade. We concur. Consumer behaviour has changed permanently, and proportionally more time will be spent shopping online with mobile devices driving the boom.
The pandemic-induced e-commerce push has resulted in an overwhelmingly positive public perception of its relevance. Euromonitor is now forecasting that e-commerce sales worldwide will increase by 60% from 2020 to 2025. To bring that number into perspective it should be noted that overall retail sales growth and store-based retail sales are forecasted at 31% and 23% over the same period. This suggests that store-based sales would get increasingly cannibalized by those online, leading to subsequent closures of more stores, a trend that was accelerated by the pandemic.
Digital has become an attractive way for new retailers to test their business models without incurring large upfront costs or making medium- to long- term leasing commitments. New business applications in retail grew by 54% in the US in 2020 according to the US Census Bureau. Many of these fledgling retail entrepreneurs will, at least initially, rely on online channels. However, as digital retail becomes saturated with competition, other well-established Direct-to-Consumer (OTC) e-commerce players are increasingly considering bricks-and-mortar retail to complement their offer as they gain scale. So, what is pushing them to consider physical store expansion?
Digital advertising costs: CAC as a new rent
E-commerce has become a very crowded space, making it more expensive for retailers to differentiate through advertising and build lasting customer loyalty. Simultaneously, the reach of digital marketing is decreasing due to the rise of ad blocking software and customers becoming overwhelmed by intrusive digital ads. This is reflected in rising customer acquisition costs (CAC), which can be approximated by dividing marketing costs spent by the total number of customers acquired in a period.
As the average CAC metric is difficult to approximate, we can instead measure the increase in online marketing costs per customer by looking at the digital advertising costs per internet user in a country. In the US, digital advertising spend per internet user has seen tremendous growth of 46% over the period 2017-2020. The UK and Germany witnessed slightly more subdued growth of 26% and 16% respectively during the same period.
While some industries had to cut digital advertising in 2020 because of Covid-19 slowdowns e.g. Travel and Automotive, other industries such as Healthcare & Pharma and Consumer Electronics have thrived. Retail remained the largest digital ads spender in 2020 at $28.2bn, increasing its annual spending by +3,1% due to an acceleration of e-commerce activity. Despite the continued growth in digital advertising spend, the reality is the barriers to entry are very low. However, barriers for building a sufficient degree of scale through advertising are high in the digital world due to supply saturation. This suggests that digital advertising costs will continue to increase as e-commerce grows.
‘Having physical locations can support e-commerce in managing profitability in the environment of rising advertising expenses.’
Darya Frolova, associate, European Real Assets Research Team, CBRE Investment Management
Having physical locations can support e-commerce in managing profitability in the environment of rising advertising expenses.
Gaining scale in the digital realm has become precarious and is highly sensitive to changing advertising costs. We view CAC has becoming the equivalent of a “rent” for e-commerce retailers. As competition for customers’ attention increasing online, CAC could become a catalyst to alter sentiment in favour of physical retail. With digital “rents” becoming unsustainable for many online-only retailers, physical space becomes a viable and cost-effective alternative.
Before the advent of e-commerce, shoppers bore the burden of the last mile journey from their homes to their nearest distribution hub, often a physical store, to purchase products. This activity was both unpaid labour and a reduced distribution cost for the retailer. Customers have now shifted this activity on to the retailer and in the process have become accustomed to frictionless distribution, and this requires a re-evaluation of fulfilment options as part of customer service.
A survey conducted by the Baymard Institute highlights that nearly 50% of digital shoppers abandon their carts due to costs of online purchases being too high, while 19% of respondents do not purchase products through online channels because of the long delivery times. E-commerce marketplaces have made same- and next-day delivery a market standard, regardless of customers’
unwillingness to pay surcharges. The pandemic experience brought fulfilment constraints into the spotlight as the influx of online transactions brought spikes in the number of deliveries and returns, consequently slowing both. Accenture reported that, on average, retailers took 2.8 days to fulfil orders in 2020, compared to 1.8 days the previous year. A physical location functioning as service point or logistics facility can enable faster delivery times for the customer, which is important when providing a competitive service.
As a result of the accelerated growth of e-commerce, deliveries have also become more expensive. Amazon has seen its sales soar but has also experienced fulfilment costs pressuring profitability. Although the effect has been mixed and therefore arguably caused by low margin products being bought through marketplaces, it has exposed weaknesses in the speed of product fulfilment from warehouses as part of the customer service. According to a McKinsey study of delivery costs in a catchment area of Berlin, for a retailer operating under cost minimization constraints, same-day delivery is likely to be unprofitable whether at scale or not. In terms of servicing the customer, Buy-online pick-up in store (BOPIS) or curb side pick-up from a network of stores is a more cost-efficient model, with a last-mile delivery option only logical from a cost perspective where next day delivery is already established.
BOPIS is a powerful evolution in retail, especially since it emerged from shopper demand during the period of Covid-19 rather than operational savings. According to GlobalData, pick up of online orders from stores grew by 103% last year in the US, while shipping orders from stores grew by 80%. A network of stores can better cater to areas where no extensive warehouse network exists while bringing retailers closer to customers than traditional distribution facilities.
Looking at the example of Germany, where Amazon has a dense network of 11 warehouses, large retailers may reach the same catchment by refitting their stores into fulfilment centres where extra services are offered when purchases are picked up. According to McKinsey, connecting 30 stores in Germany to the grid would be enough to reach almost half of the German population and come close to matching Amazon’s current footprint
Reducing number of returns
In addition to fulfilment costs, there are those associated with reverse logistics, or the process of dealing with returned purchases. While offering a flexible return policy
is often part of an online retailer’s proposition, online players aim to further reduce number of returns and its associated cost.
It is estimated that about 50% of Zalando products are returned across markets. Spikes in return rates can hamper profitability and have led Asos in issuing unexpected profit warnings. Returns are often free or come at a low cost for customers, but can be catastrophic for retailers when spikes occur, and hit the bottom line when sales grow.
According to a 2020 Financial Times article, the cost of processing returns is 20% of the original e-commerce sales price. Retailers who operate online, therefore, invest heavily in technology to reduce the volume of items returned due to wrong fit, as well as further sharpen lenient return policies. With 50% of all returns attributed to fitting errors, simply allowing customers to inspect purchases at pick-up can solve many issues. The costs of renting physical space for fitting and evaluating merchandise may prove to be a cost-effective proposition for retailers, especially if stores are located strategically to captive customers.
A consumer survey conducted by UPS in 2019, highlights that consumers ship returns but also personally bring them to stores when a convenient store option is available. Some retailers may find it advantageous to adopt bricks-and-mortar into return hubs allowing them to streamline the returns process, while cutting down on costs incurred from last-mile and pick-up locations.
Returns to a physical store are also the cheapest option for retailers, and most importantly it is in stores that retailers can prepare a product for re-sale. It is also important to note that store design is important for processing returned goods. The cost of using distribution centres or 3Pls for returns is more expensive and results in a longer processing period. This of course prolongs when a refund is issued, which can potentially jeopardize the customer-retailer relationship. Facilitating in-store returns can be highly economical as well as contribute to higher customer retention rates.
Environmental and social impact
A recent study of last-mile delivery published in Environmental Science & Technology journal indicates that GHG emissions from shopping at pure physical retailers were estimated to be higher than those of omnichannel. Pure e-commerce players with no physical presence were shown to produce the highest GHG emissions when compared to omni-channel and physical channel.
The scope of the study includes the GHG footprint from last mile delivery and last mile consumer transport from store to home in the case of bricks-and-mortar. For regions where consumers often walk or cycle to the shops, as in China or the Netherlands, the study has shown that there is no evident reduction to be achieved in GHG emission from last-mile delivery.
The analysis accessed GHG emissions from the number of products bought, warehouse storage, delivery, and packaging activities. It was argued that online purchases have the highest environmental impact as the products bought online are typically not bought at bulk, require more packaging, and come from different distribution centres.
As shopping in physical stores can produce fewer GHG emissions and requires less packaging, bricks-and-mortar retail may provide a more environmentally responsible way of operating and help mitigate legislative risks for omnichannel and e-commerce players. The assessment of effects from packaging conducted by the European Commission in a 2020 report for the opportunities and threats for the Circular Economy arising from e-commerce discovered that additional demand of almost 1.5 million tons of cardboard and around 26 thousand tons of light density polyethylene foil are generated by e-commerce in Europe.
This equates to 490 thousand tons of extra CO2 released during the production of these materials. When multiplied by the growth rate of e-commerce in Europe since 2017 when data was collected, this extrapolates to about 750 thousand tons of extra CO2 released in 2020 due to the production of raw packaging materials for European e-commerce alone. Used packaging products are also difficult to recycle, which puts in perspective the current wastefulness of the industry. As e-commerce penetration inevitably grows, the increased efforts of countries striving to achieve carbon neutrality will likely lead legislative efforts to reduce and offset carbon released in packaging production and promote recyclability of packaging.
Returns emissions and landfill concerns
There is a trail of emissions when consumers return goods to sellers, but shockingly, many of the returned products head to landfill because reverse logistics often makes it uneconomical to prepare products for successive re-selling. It is estimated by Optoro, a company that helps companies such as Ikea to streamline their returns, that only about half of the products that American consumers return go back on sale again. Returns infrastructure was found to create 15 million tons of CO2 emissions annually in the US.
Furthermore, £5 billion of returned goods were found to end up in US landfills, equivalent to the amount of waste produced by five million people in a year. Central pick-up locations such as lockers and physical retail points could help curtail the negative environmental impact from packaging waste, lower the amount of returns and add value through traffic reduction. Physical service points, such as shops, may also better cater to a new trend: consumers who care about how their purchases affect the planet and communities. Addressing the wastefulness of returns through physical retail may help e-commerce players foster customer loyalty and mitigate potential legislative risks.
Implications for retail real estate
The retail sector has been under pressure for quite some time with e-commerce being one of its biggest disruptors. In this paper, we discussed several potential deterrents to e-commerce growth. We conclude that physical retail will remain relevant by helping address these risks.
We expect a reduction of total retail floor space to continue. This is in response to physical retail’s legacy footprint being optimised in favour of capital light logistics, which in turn is fuelling the growth of e-commerce. As a consequence, retail leases will become more profitable for physical retailers and less profitable for investors over the short-term due to oversupply lagging this reduction in demand.
However, over the medium to longer-term, physical stores will still be necessary for retailers. As e-commerce reaches a saturation point, omnichannel players and larger pure online-only players will be compelled to assets that are experiential and can serve as advertising platforms and fulfilment centres.
The retail sector continues to evolve, and its future trajectory should not be limited by yesterday’s thinking. Its purpose is expanding from being purely transactional to accommodating human needs and aspirations. Stores that will thrive, need to tap into emotion and human connection. But they also need to be convenient for the customer and environmentally sustainable. This of course has space implications. The repurposing of retail, from both physical and functional perspectives, will be necessary in a post-pandemic world to rekindle the customer-retailer relationship.