Will the Dark Store Distribution Strategy Survive Past the Pandemic?

Originally published by Wealth Management

With many retailers closing locations during the pandemic, e-commerce sellers took the opportunity to reposition dark stores in urban locations as mini warehouses. But now that the U.S. retail sector seemed to have gained a position of relative strength and many people have eagerly come back to in-person shopping, will that strategy continue to be a sound one? 

According to Benjamin Conwell, senior managing director and practice leader for the e-commerce and electronic fulfillment specialty practice group in the Americas for real estate services firm Cushman & Wakefield, demand for “dark stores” in urban neighborhoods is not a temporary fad, but a trend that isn’t going away. That’s because e-commerce and omni-channel operators see them as a cost-effective way to get close enough to their customers to provide 30-miniute to 60-minute delivery, he notes. 

High fuel prices and extraordinary growth in industrial rents are helping maintain this demand, since transportation costs now make up a larger-than-ever portion of logistics companies’ spend, notes Brandon Isner, head of retail research for the Americas with real estate services firm CBRE. He estimates that transportation-related expenses now make up between 45 to 70 percent of their total costs. Conversely, fixed facility costs, which include real estate, make up just 3 to 6 percent of the overall figure. 

In addition, industrial rent growth over the past few years has far outpaced the growth in retail rents, so it makes sense for e-commerce and multi-channel operators to have a large network of dark store distribution sites, even if they offer just curbside pickup, Isner notes. Over the past year, industrial rent growth across the country has averaged 12.5 percent, according to real estate services firm Savills, and that has been considered a slowdown. During the same time period, retail rent growth has reached only 2.5 percent, according to Isner, and that was the highest level recorded since the first quarter of 2017. 

Meanwhile, there are also advantages for using retail locations in urban locations as distribution space that go beyond efficiency of operations, Isner notes. For example, such locations leave an opportunity for retailers to maintain an interpersonal relationship with their customers, rather than relying exclusively on third-party representatives. “And the beauty of using a retail [location] for this type of use is that they are already well-positioned to handle high levels of traffic,” he says. 

Who’s occupying dark stores? 

Tenants utilizing dark-store space as distribution facilities are commonly retailers that either already have a large e-commerce platform of their own or have partnered with a third-party e-commerce operator, according to Jacob Ryan, an investment sales broker with real estate services firm Northmarq. The pandemic accelerated the demand for direct-to-consumer delivery at a record pace, requiring retailers to quickly find ways to cut costs and get products into customers’ hands as quickly as possible. 

“The most logical place to turn was to start leveraging assets already under their control and converting under-utilized retail space to distribution and logistical support square-footage,” Ryan notes. 

Many of such tenants are grocers, including Whole Foods and regional grocery chains, according to Conwell, though he adds that apparel and soft goods retailers were early adopters of the dark store concept. 

Rapid delivery start-ups, including Gorillas, Jokr, Fridge No More and Gopuff, which promise doorstep delivery of everything from eggs to pizza in as little as 10 minutes, also occupy dark stores. But such concepts initially accumulated a lot of investment capital, some, including Gopuff, opened hundreds of locations nationally and expanded faster than the demand for their services and existing infrastructure justified, notes Conwell. Now, some of them are pulling back. 

During the depth of the pandemic, this alternative use helped boost retail occupancy, which endured a myriad of challenges in recent years, from low consumer sentiment to e-commerce competition to supply chain disruptions. That lull in retail activity, however, has ended quickly, according to Isner. 

“In-person retail is back,” agrees Ryan. “Consumers emerged from the pandemic in a big way, and discretionary spending data supports that. The in-store experience provides us the touch and feel that we all desire.” 

In the third quarter, national retail vacancy averaged 5.0 percent, one of the lowest levels on record, according to CBRE research. And in the first half of 2022, U.S. store openings outpaced store closings by 2,517, notes Isner. 

Under these conditions, and taking into account the growth in retail rents, using the dark store distribution strategy is becoming more challenging, he says. But an even bigger challenge is overcoming community opposition to the use of dark stores as distribution facilities, with the corner grocery store becoming a mystery space with paper taped over the windows. 

“These don’t go over well with city councils as they don’t make for vibrant streetscapes, notes Conwell. So, while he expects demand for these types of spaces to continue to be strong, “it doesn’t come without hair.” 

In New York City, for example, community complaints about dark stores used as rapid delivery sites have caused the city to implement new regulations making it illegal to paper over retail windows and requiring the tenants to open functioning storefronts, according to an Insider report. In order to comply, some of the tenants set up indoor kiosks for online shoppers to pick up their items in-person. 

With the strong return of in-person shopping, these tensions may go away by themselves, in Ryan’s view. He notes that he doesn’t expect a big uptick in new leases executed for the specific purpose of using dark stores as distribution facilities. Rather, during lease renegotiations, tenants may ask to use some of their existing in-store space to be converted and utilized for e-commerce needs.