Investment strategies underpinned by ‘megatrends' - such as demographics, urbanisation, technology and climate change - have attracted significant capital and attention, both before and since the pandemic, says Nicholas Brinckmann, managing director, Hansainvest Real Assets. 

For proponents, ‘megatrends' represent clear forward indicators of future real estate sector demand drivers. However, investors that chase ‘megatrends' without stress-testing assumptions, rigorous due diligence and asset business plans risk failure. In this article, we examine some of the pitfalls of binary megatrend thinking - not to negate the validity of many of the underlying trends, but to demonstrate the fluidity of often assumed one-way demand drivers. 

Futurologist Matthias Horx famously characterised megatrends as "avalanches in slow motion". Megatrends represent deep-rooted social, political, technological and economic changes that unfold gradually (and later rapidly). In real estate, these trends - both separately and in combination - embed large-scale behavioural changes which influence long-term demand across sectors.  

Logistics: technology and urbanisation

Let's start with the e-commerce trend, which combines the technology and urbanisation megatrends. Online shopping continues to support occupational demand for large logistics assets, a tailwind that the pandemic has exacerbated. The trend is undeniable, but commerce penetration levels across pan-European logistics investment markets varies widely. Southern European markets are much less mature than Northern European counterparts.

But that does not infer North-South divide in e-commerce penetration supports greater investment in Southern European in a megatrend catchup. Long-term shopping trends are also informed by cultural and behavioural differences (e.g., Southern Europeans, with warmer weather, typically enjoy physical shopping more than their Northern European cousins). 

At the macro level, inflationary pressures, and geopolitical tensions, present tail risks to future logistics real estate demand. Euro area inflation will peak at 7.7% in July, forecasts Goldman Sachs, while downgrading the bloc's economic growth in 2022 from 3.9% to 2.5%.

Rising energy prices may hurt margins in energy-intensive warehouses, while lorry driver shortage in some markets intensifies competition between supply-chain operators and pushes up wages. Higher operating costs will eventually be passed on to consumers.

Higher prices and lower growth will hurt e-commerce demand and weigh on logistics rental growth. We have not seen evidence yet, as limited supply of logistics space continues to lag demand due to delays to construction, rising costs and labour shortages. But the megatrend underpinning logistics real estate demand may be at risk of running out of steam. 

This stagflationary scenario is not inevitable but its probability is rising, exacerbated by geopolitical tensions which has shone a spotlight on the EU's reliance on Russian gas. This will particularly impact productivity in gas-dependent Germany and Italy. Taken together, these factors dilute the "up-only" e-commerce megatrend narrative and is a reminder that investing based solely on megatrends can be misguided.

Investment strategies that isolate locations where the tailwinds remain robust and the headwinds are less pronounced will be the winners.  This requires a nuanced analysis of trends and counter-trends, rather than relying the ubiquity of a megatrend.

Residential: urbanisation and demographics 

European urbanisation, and ageing demographics, are routinely cited as a long-term structural tailwind for demand across the lifecycle of rented residential real estate.

The urbanisation megatrend thesis purports that demand for rented single and multi-family residential in cities is underpinned by growth in population, immigration and economic activity. Demand is further strengthened by the allure of cities among working-age populations as epicentres of career opportunity, innovation, culture, leisure and education, which supports demand drivers for associated sectors (e.g., offices, student accommodation, leisure real estate, etc.). 

This undoubtedly creates opportunities for investors, but it is an uneven process. The pandemic has clearly slowed momentum, as cities' appeal and centrality in working life has faded due to home-working, which looks to be morphing into hybrid working models. As ever, these trends remain fluid with variations between cities, markets and industries.

In some top metropolises, market momentum is slowing due to a lack of available space, and B-cities are outstripping them. In crowded megacities, in particular, micro-location is also a key factor.

Those who are not close to the market notice too late when no one wants to live or work in certain areas. Other locations often become so expensive that the valuation alone becomes a risk.

The demographics megatrend thesis purports that an ageing population equates to rising demand for later living housing and care homes, uncorrelated to the economic cycle.

However, it would be hasty to conclude that nursing care real estate is a safe bet. As many investors have discovered, operational real estate is complex and requires sophisticated management which differs markedly from commodity-like real estate (e.g., traditional offices and retail).

For example, assisted living and nursing homes require the provision of high-quality care services and are subjected to strict regulatory oversight. Investors acquiring existing stock would be mindful to assess quality standards (e.g., building obsolesce, care services, quality and quantity of nursing staff) and financial metrics (e.g., cashflows, operating costs and liabilities). By contrast, investments in day care centres can be very successful - despite long-term unfavourable demographics. Purist megatrend investors risk overlooking opportunities because they do not fit into their one-dimensional thinking.

In the case of both urbanisation and demographics megatrends, relative differences between European cities and markets run a spectrum. Across the continent, population age structures between the three parts of Europe - Eastern, Southern, and Western - have become less similar over time, an academic study published in 2020 suggests. It is a reminder of how megatrends can obscure broad differences between markets. 

Student accommodation: trend reversal risk

Recent history is strewn with events that have caught markets by surprise, demonstrating the regularity of "black swan", or highly improbable events (e.g., Brexit, Covid-19, Russia's invasion of Ukraine). Such events can pause, and temporarily reverse, the megatrend trajectory. For example, the structural supply and demand imbalance in many European student accommodation markets became less relevant when the pandemic prevented university attendance.

Subsequently, the duration of the pandemic embedded a behavioural shift in international students (e.g., Chinese students) attending international universities, which downgraded demand forecasts.

Universities across Europe adapted assessments of on-campus housing requirements, while student accommodation providers have reconfigured shared living spaces. Stress-testing assumptions helps to reduce investors' optimism bias and preferred real estate demand outlook. 

Offices: technology and hybrid working

The demand shock to the office sector during and after the pandemic's onset influenced how and where people work. These behavioural changes slashed office space utilisation, which obscured cash flow predictability for investors. Technology enabled the home-working era, which disrupted the office's role as the epicentre of working life.

The sector has pivoted further towards the "hotelification" of offices through amenities (e.g., wellness, catering, events, etc.).   Offices may evolve to run more like hotels, structured with management agreements. It represents a shift in the economic model for offices.

But following a nascent trend is risky. Simply adding amenities to an office will not ensure success. Not all amenity-based offices will succeed, and not all commodity-based legacy offices will fail. Investors must acquire operational expertise and conduct due diligence (e.g., office utilisation rates can be used a proxy for cash flow resilience).

Quantifying climate risk

The role of climate risk and environmental, social and governance (ESG) requirements has increased in importance across all real estate investing, with implications for due diligence, asset management, liquidity and occupancy strategies. Investors and tenants demand assets meet stringent carbon-emission and energy-sustainability targets. This requires identifying and pricing future climate risk today.

But it is not enough for investors to publicly declare the embrace of ESG requirements without understanding what this means in practice. Those investors that do not understand climate risk, will probably caught out eventually.  

For example, investors must determine how an asset will be affected by climate change-driven fluctuations in five to 10 years. Assessments will impact costs to operate real estate and eventual liquidity for a future asset sale.

Investors that have not paid sufficient attention to an individual building's climate risk, risk either asset obsolescence or need to pay substantial capex to repair the building. Often, these costs could be minimised and, in some cases avoided, with climate risk foresight.

In sectors where assets are pivoting to more operational use (e.g., offices), quantifying the financial implications of climate risk will become a dominant priority. 

Conclusion

Most megatrends are underpinned by highly persuasive and empirically well-founded rationales. However, these ideas are hypotheses of future demand drivers, which often obscure significant variation within the headline trend with significant implications for local real estate demand drivers. Investors must be vigilant to over-generalisation of demand outlooks based on megatrends. Trend or not, market knowledge, expertise and experience are essential. Craft is indispensable, and shortcuts can be dangerous. Timing and valuation are particularly important for megatrend themes.

By Nicholas Brinckmann, managing director, Hansainvest Real Assets