‘Floor flipping’ in Hong Kong’s office market is booming, but for how long?

Strata-title office deals in Hong Kong are flourishing, hitting US$3.8 billion in the first half of 2018. That is double the value of a year earlier, according to figures from Real Capital Analytics. But will it continue?

October 02, 2018

Strata transactions allow investors to buy sections of office buildings that may be too expensive or risky for an individual or single company to purchase outright. Investors that have bought floors in a building then have the potential to flip them, selling the space on often for a sizable profit in the current price environment.

“The surge in strata-title deals in Hong Kong over the past year has been underpinned by a strong and sustained increase in office prices,” says Denis Ma, head of the Hong Kong Research team at JLL. Prices climbed 17.5 percent in 2017 and are already up 10.8 percent through the first half of 2018.

High and rising prices reflect Hong Kong’s status as the most expensive office rental market in the world. Prime office rents are up an average of 6.2 percent per year over the past three years. Rents in Central have increased 9.3 percent per year.

The tight leasing market is also fuelling investor interest in the sector. “Vacancy rates in most of the city’s Grade A office sub-markets, with the exception of Kowloon East, are now below 2 percent,” notes Ma. “In addition, buyers from mainland China and record-breaking transactions in the government land sales market have reset valuation benchmarks.”

Hong Kong is by far the world’s biggest market for strata office sales, with transactions totalling US$38.9 billion since 2013. The New York City Metro area trails with US$31.7 billion. Tokyo is a distant third on US$20.7 billion.

Transaction activity focused on prime locations

Given their strong fundamentals, most of the strata deal activity thus far has centred on the prime markets.

“Investors remain keen on Grade A offices, since only 25 percent of the stock in those markets is stratified,” says Ma. “Any new addition that expands the playing field – especially in the city’s traditional core office markets of Central, Wanchai/Causeway Bay and Tsim Sha Tsui, along with Hong Kong East – are therefore in high demand.”

Prospective activity is spreading though, notes Ma. “We are starting to see more investors looking at properties in the city’s decentralised office markets to capitalise on the strong interest in strata-titled properties and where there is more room for growth.”

Properties held by companies, rather than individuals, are also more sought-after. “The transfer of shares incurs stamp duty of just 0.2 percent,” explains Ma. “That compares to 8.5 percent for a direct property transaction.”

To date, strata-titled office transactions have been dominated by local investors, in particular wealthy individuals. However, the developing market is bringing a shift in players as well.

“If anything, we’ve seen more property funds active in the market in recent years, although their overall involvement remains low,” says Ma.

Will the market frenzy continue?

While demand remains hot for now, the big question is whether heady growth in Hong Kong’s strata deal market can be sustained.

The city’s office market historically has proven a good long-term investment, with total returns over the past 30 years averaging approximately 19 percent per annum. But where pricing goes will be key.

“We are increasingly seeing vendors asking for over HKD 50,000 per square foot in the Central office market,” notes Ma. “At those prices, it would require rents to trade at well above historic record highs for the property just to generate a yield of 2.5 percent.”

In a rising interest rate environment, future transaction activity will boil down to whether buyers feel confident they can drive up rentals sufficiently. Meanwhile, the low yields associated with such high prices will likely limit the future pool of buyers to end-users and long-term investors.

How will office demand evolve?