The Next Circle Theorem

If you have never driven past a seemingly endless line of trucks on a motorway heading for Shanghai city center, you cannot understand the Next Circle Theorem. Or maybe you can. Perhaps you have encountered a similarly endless succession ­of trucks on a motorway heading for Paris, Milan, New York, Los Angeles…

These traffic jams, the air pollution and the wasted work hours that come with them are a worldwide problem. So far, nobody has really come up with a good solution. My purpose here is not to offer a “killer-app” solution. From my perspective as a logistics real estate developer in China, I want to explain how we have come to this situation and what will be the consequences on logistics real estate developers and investors if we do nothing about it.

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I believe the source of these traffic jams is that we, developers, have been using one single analogy to develop our business over the last 30 years. Analogy instead of innovation.

Innovation is hard; it takes time, creativity and a level of disciplined, focused mental energy that is difficult to achieve.  

Innovation is dangerous. It is expensive, and there is always a serious risk of failure.

Innovation is also unfair. The innovator often does not reap the fruits of their labor; clever opportunists do.

In contrast, using an analogy is simple, clear and easy to justify: “it will work because it’s always been working like that.” You can easily raise money with a pitch based on an analogy. And the best part is that you even get to call it innovation! “Incremental innovation” is the term often used.

And to be honest, more often than not, using an analogy works! In business, radical changes are rare. So are black swans. Incremental improvements are much more common in business because they are easy to imagine, safe to implement and straightforward to finance.

What have we been doing in logistics real estate development lately? Innovation? Analogy?

Definitely analogy; we can summarize this in the “Next Circle Theorem,” which is the subject of this article.

First, this article will describe the unconscious analogic pattern that all developers apply when they go for their next development project.

Then it will explain why this pattern has severe flaws.

Finally, this article will explore alternative behaviors that may alleviate these flaws.

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So, what is the “Next Circle Theorem” all about?

Don’t look it up on Wikipedia. It is not a patented eye-opener that seeks to explain the world to the God-fearing ears of the layman. No.

I just made it up.

Simply put, the Next Circle Theorem is this: “once a logistics market has matured, developers will draw a straight line and build their next logistics park 5km to 10km further from the city center”.

Here is why.

Once a developer has identified a mature logistics sub-market, he will be confronted with a difficult situation for this location:

-      A lack of space will mean the land is unavailable or very pricey.

-      The local governments will no longer see logistics as a desirable activity, so they will set up high entry barriers, like high tax commitments, or might simply forbid logistics activity on their territory.

So, what’s next? Of course, the next best solution is to hunt for land a few kilometers further from this mature market. The rationale is that the total cost of the new project will be lower than in the original mature location and rents will eventually increase, which will help add more value to the new project.

If you are familiar with the geography of Shanghai, here is how this looks on the ground:

Around 2010, the G15 was considered a good location for logistics. Inability to source sizeable land around that ring quickly pushed developers to look further, all the way up to the G1501.

By 2014, anything around the G1501 was considered a good location for logistics. Inability to source sizeable land around that ring quickly pushed developers to look further, all the way up to the southern districts of Taicang, eastern districts of Kunshan, and the far ends of Qingpu and Songjiang.

By 2016, these districts had matured, and local governments had shut their doors to logistics. As a result, developers went hunting a few kilometers further…

And so on… you’ve got the idea.

So, what’s wrong with that? Nothing, so far! Property values in the older circles (the inner ones) keep increasing, as do values in the outer circles, just with a little delay. It is the perfect ripple effect.

The first flaw, as we have already seen, is the negative effect on local traffic. Large trucks are much more efficient at transporting goods than smaller trucks, but only small trucks can enter cities. As a result, swarms of small trucks make ever-longer and more frequent trips to the city center, causing traffic jams and pollution. Some developers might be tempted to turn a blind eye to this, but our customers (transportation companies, 3PL, etc.) definitely care.

The second flaw hits closer to home for most developers. It is simple math: when you add a 10km distance to the city center, now driving 50km instead of 40km, you add an additional ring of 2,800 km2 of potentially eligible land. However, when you add the same 10km distance from an inner circle that is 80km from the city center—creating a new circle that is now 90km from the city center—you add more than 5,300 km2 of new land. That is almost double! Rarity drives property prices. The further you are from the city center, the less efficient this effect becomes. Consequently, property appreciation will not be as steep as you might expect.

The third flaw is even worse. Apply this theorem a few times, and you will easily find yourself building warehouses 100-150km from the city center. Is that relevant to our customers? Is a two- to three-hour drive a good value proposition for a tenant who needs to serve customers in the city? Certainly not in the context of a two-hour delivery promise. Because there is no sufficient warehouse surface supply for retailers to fulfill their commercial promise, it gives rise to ridiculous behaviors. We have all heard about JD.com or Amazon taking leases in hotel rooms and B-grade offices to use those as dispatching centers or buffer storage places. Cost is another issue. More energy, larger trucks fleets, more staff, motorway tolls… not to mention safety! Consequently, if you build those costs into the equation, your new building loses a significant amount of value.

Cost, speed, productivity, safety, pollution… there is a lot wrong with this model. We cannot go on like that. So, what could the future look like?

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The first route looks a bit gloomy. If we change nothing, delivery services will inevitably be downgraded. Distant warehouses will create long, expensive and unpredictable deliveries. Logistics will become Achilles’ heel of modern Chinese conurbations. The dumb part of smart cities. This problem is very real. Logistics, or let’s call it the ability to receive deliveries in good conditions, may become part of the criteria to assess the quality of life in a given city—the same as pollution, green space, affordable housing, taxes, urban transport, etc. In this scenario, most cities would fail on the logistics criterion.

The other route, possibly working in tandem with the first one, is the creation of a two-speed system where a limited number of city center warehouses only serve the premium segment of the market. A few warehouses with very high rents would serve customers or market segments that can afford the high delivery price.

Other routes are pure speculation, but let’s briefly review them anyway:

-      What if logistics was forcefully integrated into the city? This experiment is starting in Paris, where the municipal government is planning “logistics hotels” across the city to organize the arrival and dispatch of goods into Paris. For that, you need a very strong and centralized administrative organization.

-      What if technology got us out of trouble? Drones, automated guided vehicles/self-driving trucks, and cheap, clean energy could solve most of the problems we have listed above. However, we need a few years before those technologies are mature enough.

-      What if we used alternative transportation modes? Metro lines, rail, water, etc. It’s a tempting idea, but it does not look like a very plausible outcome.

In any case, it is clear that the Chinese logistics market is heading towards increasing differentiation.

In the past, logistics rents were roughly a function of their distance to the local consumption center.

Today, our market is split into two segments: city distribution (including but not limited to last mile) and mass storage. Those two segments follow different trajectories because they serve different purposes and their tenants have different price affordability and different economics.

The big mistake deriving from a blind use of the Next Circle Theorem would be believing that the warehouses we build in remote areas would follow the same trends as those in city distribution areas.  As we saw above, the value of warehouses located on the outer circles will certainly fail to live up to their owners’ expectations.

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Yes, the easy days when developers only had to copy existing models or invent the future by analogy… are probably coming to an end. Hard core innovation times are coming and that is good for the profession because it means developers’ skills are more than just taking an existing successful model and transferring it 10km further from the city center.

This raises a problem that developers now have no choice but to solve: how can we still be useful, relevant and create value in a world where yesterday’s theories yield diminishing returns?

I read triumphant trumpeting announcements from developers in Europe boasting that they have installed insect hotels, beehives and quinoa plantations on their logistics parks.

Come on, we can do better than that.