Destructive Creation

The idea of creative destruction was introduced in 1913 by German sociologist Werner Sombart and was developed and popularized by Austrian economist Joseph Schumpeter. In Schumpeter’s version of this theory, new innovation by entrepreneurs sustained long-term economic growth, even as it destroyed the value of existing companies. Think Polaroid after digital photography or what’s happening to video stores with the advent of Netflix and On-Demand. The fundamental idea here is that the process of creation also destroys.

I believe there is another form of creative destruction, which is nicely illustrated by the catastrophic asteroid strike that apparently took out the dinosaurs. While the dinosaurs were obliterated, small mouse-like mammals were able to survive and, without dinosaurs to snack on them, were able to get bigger and smarter and eventually take over. To me it is clear that this too is a form of creative destruction.

This version of creative destruction is, in a sense, the opposite of the other. The process of destruction also creates. Perhaps we should instead call it destructive creation.

The recent events on Wall Street were much like an asteroid strike to our economy. Established companies were weakened or destroyed. The world changed almost overnight.  And most of us were worse off for it. At the risk of being accused of understatement, it was tough on the retail business. Yes, for some of the discounters it has been like a surprise trip to Disney World. But for most of the others and for anyone involved in retail real estate, “surprise colonoscopy” is probably a better analogy.

The question is whether the winners in this latest round of economic destruction have already been declared (the discounters) or whether there remains opportunity for companies that are struggling to rise from the ashes.

First, let’s look at it from the retailer’s perspective. Yes, for the most part demand is down but so are rents. And markets once impossible to get into now have vacancies. While weak demand is likely temporary, low rents can be (almost) forever – at least if you’re aggressive at negotiating the option rents.  This means that savvy retailers have the opportunity to position themselves now for a bright future filled with rainbows and unicorns and low rents.

But… there are a lot of reasons to be cautious. Low rents alone are not an opportunity. The major costs of operating retail stores are not the rent but wages and inventory.  If the location is not right and the store needs to go dark, the low rent won’t seem like a blessing as much as a slightly reduced curse. At some level this is obvious. But giving a mortgage to a person that can’t possibly make the payments is obviously a bad idea. Yet it was done – over and over.

In addition, growth at the expense of proper marketing, merchandising and training is a recipe for problems. The fact is that history is littered with the corpses of retailers that grew without discipline.

I fully expect to see some retailers go into deal-making mode without the discipline to make sure the sites work and that operations is up to the task. We have a word for uncontrolled growth in the human body. It is called cancer. And like cancer, companies that embark on a campaign of undisciplined growth will experience pain and suffering. And yes, some of them will die.

On the real estate front, shopping center owners are starting to solicit tenants they used to disdain – mom & pops as well as other types of uses not traditionally found in “first-class shopping centers” (to quote the lease language often used). I think this is a welcome change and is a great example of destructive creation. The cookie-cutter nature of many centers will be eliminated as unique stores and uses are wooed into the best centers. Though the struggling centers will die, the first-rate shopping centers will become more interesting, have low vacancies, and prosper.

However, if this trend gets out of control we can imagine conversations like “We’ve recently come to the conclusion that a tool and die shop is just what we need in this center. And 4 bucks a square foot gross sounds great.”  OK, I’m kidding. But if the “creation” in destructive creation gets TOO creative, many centers may find themselves with long-term leases they regret – low rents and lousy co-tenancy.  Again the opportunity is there. But so are the risks.

We have likely yet to see the ultimate winners of this asteroid strike. But when we look back we should expect to find that the winners are those companies that combined opportunism with strong discipline to make smart and strategic decisions every step of the way. And this process will likely see the destruction of weaker, less disciplined players.