City should act to soften blow of correction

As a demand driven market, Hong Kong’s property market is highly influenced by the city’s economic performance. And as a small and open economy, its performance in turn is closely tied to the ebb and flow of external environment. This is evident when looking at the historic performance of the property market, where all broad based market corrections over the past 30 years have followed significant external economic events.

After almost 10 years of uninterrupted growth, Hong Kong’s economy is now at the crossroads. A protracted trade war between the US and China and citywide disruptions arising from anti-government protests since June have seen growth grind to a halt. The latest Purchasing Managers’ Index readings, which have plummeted to their lowest levels since the Global Financial Crisis (GFC), point to the city entering a technical recession in 3Q19.

The local property market has recovered and broadly grown in tandem with the underlying economy since the GFC. Market rents and capital values have at least doubled across all sectors over the past decade and remain at near record high levels. The only outlier has been the retail property market which has tumbled by over 40% since peaking in 2014; a result of the mainland China’s anti-corruption measures.  

With growth forecasts for the local economy being revised downwards, there is a growing consensus that the property market has reached a cyclical peak. Signals are also appearing in the government land sales market, which is often viewed as a barometer for the property market’s medium term prospects.

The lack of a rental growth story has led to investors stepping back to reassess the market situation. Weakening demand for commercial property has seen vacancy rates steadily rise across the market. Office rents look like they have peaked and retail rents have slid over the past half year after stabilising in the middle of last year. The appetite of buyers to further chase down yields has evaporated. In the residential sector, sales volumes have fallen noticeably in recent months putting pressure on developers in the primary market to lower prices. And with the government pushing to implement the highly publicised vacancy tax as early as December, the downside risks on housing prices will only increase as more supply hits the market.

In view of the drop off in demand for commercial real estate, we have revised our rental growth forecast for the market. We now expect Grade A office rents to end the year slightly lower and correct by 15-20% in 2020. For retail property, we forecast street shop rents to decline 10-15% in 2019 and a further 5-10% in 2020.

Though Central Banks around the world, including HKMA, have been slashing benchmark rates, borrowing costs in Hong Kong have actually been rising. This anomaly is largely a result of higher HIBOR rates arising from a tighter local money market as well as the city’s commercial banks not passing through the higher rates during the tightening cycle. This situation will ultimately reverse if the US Fed continues to cut rates, which we think it will. But borrowing rates over the short-term are likely to trend higher.

With the Hong Kong property market potentially on the cusp of a broad based correction, we believe that there are two critical steps that the government must take to cushion the market’s downside risks and create an environment that will allow for a more normal growth trajectory when the market recovers.

Firstly, as we have long stated, it needs to remove some of the demand suppression measures introduced over the past 10 years in its bid to contain housing prices. By increasing LTV ratios and loosening the application of the Double Stamp Duty for upgraders, the government could release some of the pent-up demand that has built up in the market to offer some support for sliding house prices.  The government’s latest relaxation of LTV ratios is the right initiative, but it would be more meaningful if it comes earlier.

Secondly, it must quickly review its internal valuation benchmarks. The failure to solicit a winning bid for the commercial development site at Kai Tak highlights the valuation gap between the government and private sector. If this situation continues, land supply will be interrupted and supply-demand imbalances will re-occur. We believe that it is essential for the government to continue to commit to its medium-to-long-term housing supply strategy to ensure market stability.

This article was originally published in the SCMP on 13/11/2019.