Peter's Perspective
18th August 2015 by Peter Churchouse

Hong Kong Real Estate – Bull AND Bear?

Last week I sat down with Bloomberg anchor Rishaad Salamat. He asked me why I was bullish on property, Hong Kong property in particular. He was a bit surprised because I am known to be bearish on some parts of the property market. But I am bullish on others.

The causes of these differences in outlook are rooted in one primary factor: China policy.

Rish’s initial focus was on the luxury goods sector in Hong Kong. The headlines tell of high-end watch, jewellery and luxury goods shops closing down, shuttering their premises and clamouring for rent concessions from landlords.

Why? Primarily China’s anti-corruption drive. Recent years have seen China’s wealthy pouring into Hong Kong buying literally cases of designer watches, jewellery and fashion goods to ferry north as gifts for business partners. Such largesse can now land you in jail, or worse.

Luxury goods sales in Hong Kong have hit the skids, down 17% year on year. And with it, rentals of “street front” high end retail shops in popular tourist haunts are down 13% to 20% year to date.

They are likely to head further south I believe.

But the mass market retail sector, which accounts for by far the bulk of retail sales and retail space, is doing OK. Sales are up a modest 3%. Following a steady rise since 2009, prices and rentals for “normal” shops and malls have leveled out and are likely to trade sideways to modestly down in the coming months (See Figure 1).

Hong Kong's Retail Rental Indices for Prime Street Shop Rent and Shopping Center Rent from Q1 2003 - Q1 2015.

But it is a different story for the territory’s office market and its higher end housing market.

Again policy is the driver. China is opening up and liberalising its capital account and that is shaping the real estate markets in Hong Kong (and to a lesser extent real estate markets in other countries).

The rafts of initiatives making it easier to trade China’s stock markets, foreign exchange markets and freeing up capital flows into and out of China are boosting demand for office space in Hong Kong.

Large numbers of China brokers, money managers, insurance companies and ancillary services providers are setting up shop in Hong Kong. Vacancy rates in the office market have fallen to record lows of around 3.2% for the market as a whole. In the prime central financial district vacancies are a meagre 1.4 % as at end of July (See Figure 2).

Grade A Office Vacancies in Hong Kong have fallen to Frictional Levels in mid-2015.

Space is tight, and of course, office rentals are rising. From a 12% slide in the period from 2011 to end of 2014, they are now up by 5% year-to-date and set to continue higher in the near term.

And all those new “bums on seats” in the newly occupied office space need to be housed. These folks are at the upper end of the pay scales. So lo and behold, the upper end of the housing market is now benefitting nicely.

The luxury housing market has underperformed the mass housing market by 30% to 35% since the GFC in both rentals and prices (See Figure 3).

Hong Kong's Residential Price Index from October 1997 to July 2015. Showing that High End Housing has massively underperformed Mass Housing.

The financial services sector has been more into headcount reduction than addition in recent years. Well that is now reversing and middle and upper end of the housing market is playing catch-up. Luxury housing rentals were down by about 6.5% in 2014, and are up 6% so far this year. Prices of high end housing are moving up again, in line at least with the mass market (Figure 4).

Residential Rental Index Performance from Oct 1997 - July 2015, with Oct 1997 = 100.

Shares of the major property companies in Hong Kong have slid back in recent weeks as China’s extended bull market has hit some speed bumps.

We like that. Here are companies whose underlying business is on the up and up, but share prices are in retreat in sympathy with an overheated China market. This will provide a great entry point to access great companies that are doing good business in a space where their pricing power is rising.

Our focus is on companies that have substantial exposure to the office market and residential, both the luxury and mass markets. And we are cautious on the retail, hotels, and the industrial sector.

Good investing,

Peter

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