New tax will lead developers to build smaller units and slow down the market

HONG KONG, 10 July 2018 – The upward march of housing prices will slow in the second half after the Government introduced a new vacancy tax and restrictions on the Pre-sale Consent Scheme, according to JLL's mid-year forecast released today. Still, housing prices are likely to go up a further 7% in coming six months. To safeguard sell-through rates, developers will likely build smaller flats. The average size of new flats has already decreased by about 40% over the past 6 years.

Smaller units, more affordable pricing and developers' financing have contributed to strong sales in the primary market in the first half with developers being able to sell over 50% of units launched at most new projects.

At the end of June, the Government announced six new initiatives to address the city's housing woes. Among these was the much speculated vacancy tax for the primary market. According to Transport and Housing Bureau, there was an estimated 9,000 vacant units in the primary market at the end of 2017. The number of vacant units in the primary market as a proportion of all vacant units in the market has increased from 8% in 2012 to 21% in 2017.

In response, developers will likely build smaller flats to mitigate the additional development risks arising from the new tax. This will keep lump sums affordable and help safeguard sell-through rates. The average size of units under construction has decreased by 40% from 1,022 sq ft in 2013 to 600 sq ft so far this year.

The Government's decision to introduce additional initiatives to address the city's housing issues at a time when interest rates are rising and the current market cycle is already in its latter stages comes with risks. When the market does turn, all these cooling measures introduced in recent years could exacerbate any downturn, leading to a market freefall. Moreover, an increasing number of buyers have been relying on developer financing, which charges higher interest rates and require no stress test on buyers. In a market correction, developers could also be in trouble given high holding costs associated with vacancy tax. Under these circumstances, the government should assess these cooling measures carefully.

In April, the Land Supply Task Force—a group set-up by the Government to address Hong Kong's long-term housing problems—released its report and recommendations on how to solve the shortage of land supply in Hong Kong. Amongst the suggestions was further land reclamation. Yet land reclamation can only provide 490 hectares of land supply and it will take a significant amount of time to have works completed and the land prepared for development. Joseph Tsang, Managing Director at JLL, suggested that the Government focus on unlocking the potential in the 760 hectares brownfield sites scattered around the New Territories, which the Government has yet to pursue. Brownfield sites will be a more effective and faster option for generating land supply than through land reclamation.

Tsang said: "Under the new tax, developers will adopt a more cautious pricing strategy in new luxury launches to ensure all units are sold. Mass residential projects, on the other hand, are likely to be less affected given the sustained demand for smaller units. Developers are also likely to be less aggressive when bidding for sites in the future to offset the additional development risks brought about by the new tax. However, whether lower land prices will translate into lower housing prices will depend on prevailing market sentiment. Combined with the imminent interest rate hikes and increased volatility in equity markets, we expect the run-up in housing prices to ease in the second half after growing 8.6% in the first half. Still, housing prices remain on track to grow in the range of 10-15% for the full year."

With the vacancy rate bordering 10-year lows, an increasing number of occupiers shifted their focus away from Central to other office markets on Hong Kong Island and Kowloon. In particular, upcoming new Grade A offices drew strong tenant interest with over 80% of the floor space pre-let by the end of the first half at One Taikoo Place in Quarry Bay (87%) and One Hennessy in Wanchai (81%). 

PRC firms remained as an important driver of demand in Central though expansion and new set-up requirements from the cohort slowed in the first half, accounting for 32% of all new lettings (in terms of floor area leased), compared to 41% in the second half of 2017. The lack of availability also led to PRC firms with larger and more urgent requirements having to look at options beyond Central. Only 30% of the floor space attributed to new lettings from PRC firms was in Central in the first half compared with 65% in 2017.

The growth of co-working in Hong Kong continued to gather pace with operators leasing about 315,800 sq ft in Grade A offices in the first half, triple the total amount leased in 2017. The uptick in demand was led by the arrival of mainland China operators into the city with the likes of Atlas and KR Space leasing Grade A offices to establish their first locations in Hong Kong.

Vacancy rates tightened across all of the city's major office markets, contributing to vacancy in overall market falling from 5.1% at the end of 2017 to 4.2% at the end of the first half, the lowest in nearly two years.

Central's Grade A office average rent grew 4.3% to HKD 123.7 per sq ft in the first half. 

Paul Yien, Regional Director of HK Markets at JLL, said: "The strong levels of pre-leasing we've seen in a number of new Grade A offices is unprecedented and shows how tight office supply has become. As a result, the rental gap between traditional core and non-core office areas has widened. As at the end of the first half, rental markets in non-core locations was trading at a discount of up to 56% against the city's traditional core areas, further encouraging yet more tenant decentralisation. Overall, we expect rents will grow in the range of 5-10% for the full year with office markets on Hong Kong Island to record the strongest growth."

The three-and-a half year slump in Hong Kong's retail property market appears to be over with high street shop rents growing 0.6% y-o-y in the second quarter—offsetting a decline of a similar magnitude in the first quarter— after having fallen by 44% since the third quarter of 2014. Prime shopping centres rents climbed 0.5% higher in the first half.

The recovery of the high street shop rental market has coincided with the general recovery of the retail sector. Led by robust domestic consumption and an improving inbound tourism market, retail sales grew 13.7% y-o-y over the first five months. Sales seen across all categories were markedly higher compared with 2017 with sales of jewellery and watches recording the strongest growth, up 22.8% y-o-y.

Mass retailers, notably personal care and pharmacy retailers, along with F&B operators were among the most active in the leasing market. Luxury retailers were also more active but remained focused on portfolio optimisation rather than expansion.

Terence Chan, Head of Retail at JLL, said: "Though high street shop rents appear to have finally bottomed out, we still believe that an L-shaped recovery remains ahead given that the bulk of demand we see in the market continues to be from retailers with lower rental budgets. As a result, we expect the rents of high street shops and prime shopping centres to grow in the range of 0-5% for the full year,"

"Looking forward, growing residential populations and the increasing supply of retail floor space in non-traditional retailing areas is going to change the retail market landscape. A total of 7.5 million sq ft of new sizable shopping centres will be completed between 2018 and 2022. The annual average of 1.5 million sq ft is 74% higher than the annual average over the past 10 years. About 75% of the new supply will be in non-traditional retailing areas such as Tseung Kwan O, Yuen Long and  Shatin. These areas are likely to gather strong interest from retailers as they are among the top 10 fastest growing districts, in terms of resident populations" he added.

Imbalances in Hong Kong's external trading sector along with uncertainties in the outlook for global trade saw leasing demand in the warehouse market ease in the first half of 2018. Although the total value of exports and imports was up 10.7% y-o-y and 11.9% y-o-y, respectively, through the first five months, container throughput was down 3.0% y-o-y. The growth in external trade was largely supported by growth in air-freight cargo (up 4.6% y-o-y) and cross-border trucking (up 14.2% y-o-y).

As a result, leasing demand was largely from tenants having to relocate owing to sales and redevelopment activity. The planned redevelopment of Winner Godown in Tsuen Wan saw Dongnam Logistics and Kenxinda Technology relocate to Hutchison Logistics Centre (28,300 sq ft) and Roxy Industrial Centre (10,500 sq ft) in Kwai Chung, respectively. MOL Logistics was forced to relocate to Ever Gain Building in Shatin (38,700 sq ft) from Ever Gain Building (No. 3) in Shatin after Mapletree unified the ownership at the building.

With demand easing, warehouse rents grew by just 0.3% in the first half, having recorded a 0.3% drop in the second quarter of 2018. Moreover, the rental market for ramp-access warehouses appears to be softening once again as several landlords sought to increase rent-free-periods against a slight uptick in the overall vacancy rate, from 6.1% to 6.9% during the first half.

Looking ahead, the warehouse market faces challenges from a potential trade war between the US and China. Denis Ma, Head of Research at JLL, said: "Depending on the severity of the tariffs imposed, a trade war between the US and China could dampen Hong Kong's trading position as early as the second half of this year. Still, against a supply constrained market and the completion of new infrastructure, which will help boost demand, we expect vacancy rates to remain range-bound. Against this backdrop, rentals should continue to grow mildly in the range of 0-5% in 2018".

Total investment into commercial and industrial property amounted to HKD 97.5 billion in the first half, down 32.4% compared with the second half of 2017 but up 91.4% y-o-y. This marked the highest level of investment into the market for the first half over the past 10 years.

The office sector continued to draw the greatest share of investment, accounting for 65% of the total investment volume in the first half. The HKD 62.9 billion ploughed into the sector was just 0.5% shy of the half-year record high set in the second half of 2017 and up 148.6% y-o-y. Volume was padded by strong investor interest in en-bloc office buildings with 13 en-bloc buildings changing hands, accounting for about 71% of the total investment into the sector.

With vacancy at extremely tight levels across the market, investors were also betting big that there would still be room for further rental growth. As a result, the market continued to witness a string of record breaking transactions, including a number of floors in the Central strata-titled office sales market transacting comfortably over HKD 50,000 per sq ft. Against this backdrop, capital values of Grade A offices surged by 10.8%.

PRC buyers remained as a driving force in the market, pouring HKD 29.1 billion into the office market, or 46.2% to the total office investment volume in the first half. The amount invested was a 'half-year' record high. They continued to be largely focused on Grade A office buildings with high visibility and along the waterfront of Victoria Harbour.

Joseph Tsang, Managing Director at JLL, said: "Looking ahead, we expect investor appetite for offices to remain strong given the extremely tight vacancy environment and scope to further push rents. PRC investors will continue to seek bulk deals in the market but with more diversified strategies. With the Government focused on the city's housing sector, the review of the industrial building revitalisation scheme appears to taken a back seat. As a result, investor interest in industrial properties will likely remain thin until further notice. With the retail recovery gaining traction, we expect to continue to see more investors enter the market though their focus will likely remain in 'neighborhood' malls.  All in all, we expect capital values of high street shops to increase by 0-5%, warehouses to increase by 10-15% and Grade A offices  to increase by 15-20% this year."

"Looking forward, we expect interest in 'Alternatives' such as carparks, data centres, senior housing, education and student housing to gather increasing interest as investors try to extract value in a market where property prices are already at record high levels." he concluded.