WHAT PREMIUM THE HONG KONG PROPERTY MARKET?

Implications: Given that the Hong Kong property market, in particular the residential sector, is regarded as one of the key measures, if not the barometer of the economic health of the city region, it is not surprising that “what state the market” inevitably surfaces, be it during a chat over a coffee in Starbucks, a discussion over dinner amongst friends or a debate around a boardroom table on a new strategic initiative here in Hong Kong.

Analysis:

Given the current buoyancy of the market, we tend to forget the major corrections in 1997/98 that followed the Asian financial crisis with residential values falling by as much as 70% in some cases and commercial values up to 50% with the consequence that several hundred thousand households moved, virtually overnight, from a world of asset appreciated to negative equity. Similarly the 54 months of deflation that followed, compounded by the impact of SARS, all now seem to be a dim memory but they all remain a useful reality check reflecting the interdependence of Hong Kong with the regional and world economy and a reminder that property markets are by their nature cyclical and what goes up can also come down!

However, fortunately Hong Kong was not to be held down and bounced back and the recovery that has occurred over the last two and a half years is a reflection of the strengths of Hong Kong – the underlying resilience of the economy, its ability to adjust to changing circumstances and the strength of the offer – be it transparency, the rule of law, the ease of doing business and the absence of any restrictive barriers to entrepreneurship.

As a result, we saw in 2006 a continuation of the upward movement in prices and rents that was characteristic of the market in 2005. Much of the focus centered on the office sector where, because of limited supply, rents in Central again topped the HK$100 per square foot (psf) mark, having been as low as HK$30 psf only two and half years earlier. Similarly, as a result of strong institutional interest and, some would say, excessive liquidity, we saw office initial yields falling to as low as 3% and office buildings being injected into REITs at even lesser multiples, which in turn raised questions as to sustainability of such levels in the longer term. When potential investors rationalize what were previously “difficulties and constraints” and re-brand these as “opportunities”, then it is probably time to step back and take a view!

On the residential front, the story in 2006 was largely about the luxury residential market with Hong Kong setting a world record when a parcel of land on the Peak was sold by auction for HK$42,196 psf. However, there were other examples of serious interest in this segment of the market with a site in Kowloon Tong also setting new levels of value. This focus can, of course, be directly attributed to the renewed interest of regional investors, large bonuses paid by most finance houses, cashing in on Stock Market gains and the part now being played by an ever growing group of Mainland entrepreneurs, many of whom have become millionaires as a result of taking their companies public in Hong Kong.

The mass market, however, attracted less attention and any gains were modest, if at all in some cases. This, of course, is a reflection of the changing demographics of Hong Kong where our population growth has slowed dramatically and may even, in fact, be in negative territory and where we are now reliant largely on newly weds and upgraders to drive this part of the market. Production has fallen significantly to some 15,000 units per year from a historic average of 35,000 units per annum and it is in my view likely to stay at these lower levels unless there is a significant change in Government’s immigration/population policy. It is not surprising, therefore, that the major developers are now looking north for the majority of their development projects as there is just not enough to sustain them here in Hong Kong.

On the retail front, we again saw significant uplift in rents, largely driven by our visitors from the Mainland and overseas, but this was tempered by some resistance from tenants, particularly those operating in the food and beverage arena who claimed that rents levels were no longer affordable and many landlords adopted a pragmatic approach so as to maintain their tenant mix. Many hotels also had a record year both in terms of room rate and occupancy with “no room at the inn” signs on the door during the key months of October and November and indications are that we may face an even tighter supply situation for the foreseeable future with the loss of the Hyatt Hotel in Kowloon and the likely demise of the Ritz Carlton in Central.

Enough, however, of the past. What does 2007 hold, how will Hong Kong continue to justify its premium in comparison with its competitors in the region and on a balanced score card basis what are the strengths on which we should capitalize and where are the weaknesses that we hope the new Chief Executive will seek to address over the five year period of his tenure?

In terms of projections, whilst the demand for office space will remain strong in Central and rents will reflect this, I believe we are now beginning to see some serious resistance to rental levels in other locations. As a result there will be some easing in decentralized districts as well as increased focus on KowloonBay and in due course on the ICC above the Kowloon MTRC station and Airport Interchange at Union Square. This, I believe, to be important in the context of Hong Kong’s competitiveness because, based on recent surveys, only London heads Hong Kong when a meaningful comparison of occupational costs is undertaken and we well exceed both Shanghai and Singapore and now even Tokyo. On the residential front, whilst the mass market is likely to remain quiet, I see continued interest in the luxury sector with growth in values of up to 20%. Retails rents and prices are pretty full now as well, so that whilst there will be quite a lot of movement and activity, I envisage it will take place at current rental and price levels.

All this bodes well, of course, if you look at Hong Kong in the round and we do have distinct advantages over cities such as Shanghai and Singapore, not least that of location and the ever growing economic and infrastructural interface with the PRD and Southern China. Inclusion of Hong Kong and Macau in the 11^th 5 Year Plan by the Mainland authorities and recognition of the need to maintain the international brand, I believe, are positive in terms of our strategic direction. There are also many other attributes, some of which I have mentioned earlier, that warrant the premium that Hong Kong attracts both in terms of capital values and rents.

However, there are clearly issues and challenges that need to be addressed if we are to maintain our status as a premier international city. Not least is the issue of air quality but I would suggest that the challenge goes much further than that and centers on the how we plan and manage our city in the future. A land disposal system which is driven by highest and best use; a planning system which seeks to support that income generating regime rather than adopt a holistic and sustainable approach based on community and lifestyle considerations; and policies which still rely on the development community to fund and undertake cultural, heritage and urban regeneration initiatives, all require a fresh look. Whilst they possibly could have been justified on the grounds of expediency at a stage when Hong Kong was in growth mode in the 1980’s and 1990’s, and many of the population were in “transit mode”, there is the need to adopt a new mindset and approach to match the growing aspirations of a community that now seeks to have a say in the future of the city. Not that these need be permanent impediments to the quality of the offer but the long term sustainability of the property market and values and rents is inextricably linked to the quality of the living and working environment.

It is encouraging to see many of these issues being flushed out during the current CE election debates but the key to enhancing the quality of Hong Kong’s offer will be way the new Chief Executive, through listening and engagement, develops innovative policies and solutions which have the support of the majority and then is prepared to champion those initiatives and move them forward.

At the moment, I think it is possible to argue that the premium is justifiable but it could potentially be whittled away unless we are proactively seen to address the challenges surrounding the sustainability of that offer which require a brave approach to difficult decisions.