I thought it is a good idea to integrate all these ideas together and put together my prediction of Hong Kong Property market in 2011.
Long time ago, I cited the following chart depicting the supply condition of Hong Kong residential market (private sector):
Photo: HK Government
Government pledged to increase supply of land, and as the property prices went through the roof, we have seen a land auction “spree”, if you like, where the government has sold more than 5 million square feet of residential floor area with record proceeds:
Photo: Lands Department
The average land cost for all sites sold in government land auction in 2010 was HK$8,082 per square foot, which would be a record year if we exclude the only site sold in 2008, of which the land cost was HK$13,348 per square foot for a tiny 1,236 square feet project (we can safely say that the single site sold was not quite representative). Also worth noting is that in the previous peak of the property market in 2007-08, the average land cost for all the sites sold in 2007 was only HK$5,723 per square foot. This reflects developers’ increased interest in luxury segment of residential market, such that they were willing to pay premium prices for superior locations which (in their views) can be developed into premium housing.
Despite land auction “spree”, the impact to the actual supply in 2011 is minimal, because it normally takes at least 3 to 4 years in order to complete the constructions (not the mention delays, which are not uncommon). The more immediate increase of supply would rather come from another land auction spree in 2007, in which the government has also made more than 5 million square feet of residential floor area available to the market.
For instance, some 1.8 million square feet of residential floor area in Pak Shek Kok is scheduled to be completed in 2011 or 2012 according to Sino Land (83.HK), which has bought those sites in 2007 with its joint venture partners. Indeed, the forecast supply for 2010 and 2011 rose from the record low of about 7,200 units in 2009 to 14,260 units in 2010 and 10,960 units in 2011. Despite the rebound, supply is still low compared to historical average of about 18,600 units per year in the private sector. The government’s pledge to supply about 20,000 units in private sector is yet to be realised
Is the supply not enough? I have pointed out that population growth in Hong Kong is now minimal, and median household income today is not much different from 10 years ago.
Photo: HK Government
Photo: HK Government
If population growth is almost negligible, and if income is hardly higher than that 10 years ago, the true reasons of real estate market boom has to be found elsewhere. My previous analysis suggested that money supply growth correlated with increase or decrease in home prices. In fact, money supply growth seemed to lead movements in home prices by 5 to 6 months.
What I have not tried to explain was how money supply growth came from. Although many people cited that weak US dollar is responsible, the story is not as straightforward as I pointed out in my previous analysis. In short, because of the currency peg with the US dollar, inflow into Hong Kong dollar denominated assets will drive up demand for HK dollar, thus the currency. The Hong Kong Monetary Authority (HKMA) will in turn have to buy US dollar from banks and sell HK dollar, thus increasing the Hong Kong dollar money supply. Thus US dollar weakness is not the key, rather, the strength of Hong Kong dollar relative to US dollar is the key, as that will effectively force HKMA to sell Hong Kong dollar in the market. As a result, increased demand in HK dollar will not adjust through price, but through supply.
As Hong Kong real estate has become pretty much driven by money flow, it is important to forecast money flow in order to make any serious predictions on property market. There are two main forces which are channelling money into Hong Kong property market. The first one is quantitative easing in the United States, in which the Federal Reserves injects money into its banking system. Excess liquidity is looking for return, and thanks to strong Asian economic growth, Asian real estate including Hong Kong real estate seems to be a good place to put the money. The second force is Chinese buyers, who have been buying Hong Kong property (especially the luxury segment) over the past few years or so.
If the main driving force of Hong Kong property prices is money flow, and if two of the main sources of inflow are quantitative easing and Chinese buyers, there are basically four possible scenarios concerning capital inflow into Hong Kong.
1. Quantitative Easing and Chinese Buyers continue to drive capital flow, thus home prices in Hong Kong
2. Quantitative Easing continues to drive money flow, but Chinese Buyers retreat
3. Quantitative Easing ends and/or interest rates increase, but Chinese Buyers continue to buy
4. Quantitative Easing ends and/or interest rates increase, and Chinese Buyers retreat
There are of course a lot of possible intermediate scenarios between these four discrete scenarios. But based on the above 4 scenarios, I think the most possible scenario would be something in between scenario 3 and 4.
The reason for the end of quantitative easing and/or interest rates increase is that economic growth seems to be picking up of late, and inflationary pressure has emerged even in developed countries. For instance, inflation has been more than 1% higher than the stated target of Bank of England for almost a year now, and Eurozone inflation has started edging up despite austerity and worries on the future of the monetary union. Recent increase in US Treasury Yield and the closing of the spread between 30-year and 10-year Treasury Yield suggested that the Federal Reserves is unlikely to extend or enlarge the quantitative easing programme after they have finished the pledged US$600 billion purchases, and an early interest rate hike in 6 to 12 months will be a real possibility. If that happens, the liquidity driven Hong Kong property market will be under pressure as the Fed exits their unconventional monetary policy.
On the Chinese buying interest, it will very much depends on how aggressive the tightening actions of the Chinese government will be. Although it is commonly assumed that Chinese Yuan appreciation will be good for Hong Kong property because home prices in Hong Kong will look cheaper and inflation in Hong Kong will be higher, there is also a downside for this argument. Chinese Yuan appreciation is essentially a tightening policy from the Chinese perspective. If, together with more interest rate hikes and reserve requirement ratio increases, economic growth in China will slow, and there will be a danger that the Chinese property bubble is going to burst. Even though it is in the Chinese government interest not to create a recession in China, when it comes to moderating economic activities, no government can claim to be omnipotent. If tightening in China continues, there might be a real possibility of a spill over to Hong Kong property market.
Other scenarios that I have not explicitly discussed in the above 4 scenarios also include worsening of the Euro Crisis. If that happens, investors will leave risk assets and look for safe assets.
How about policy risks?
The extra stamp duty has heightened the perceived policy risks in the Hong Kong property market, but the real impact on Hong Kong property prices has been remarkably negligible. New record prices transactions have been reported and transaction volume has been back to normal. I expect the impact on prices to be minimal, but there is a danger that because buyers now cannot re-sell their newly-bought property in 2 years, there will be a supply squeeze in the secondary market, which will lead to panic buying in coming months.
Hong Kong government tried to show its determination in curbing home prices. The next possible curbing measures (if any) might be announced in the 2011-12 Budget on 23 Feb 2011. It is too early to say that the government is definitely going to announce something, but that is probably the first thing to watch for the year 2011.
On the balance
If above predictions about quantitative easing/interest rate materialise, and if China aggressively tightens policy, that might well be the game changing moment of the Hong Kong real estate market. The question is whether that will happen, but when that will happen. My own prediction conservatively assumes that interest rate hike in the US will happen in 6 to 12 months, while the consensus view seems to believe that it will not happen for another year or two. And whether tightening in China will bring serious consequence is well debatable because China will not want to see any significant slowdown, such that there is a belief that China will be flexible in changing policy if signs of slowdown are obvious.
Overall, if money flow continues to be favourable for the next 12 months, my bull case will be an upside of 10-15% for 2011, and under my more pessimistic view of interest rates increases in 6-12 months time, my bearish case suggests that Hong Kong property market will turn soften in 12 months time, and might have correction in 2012.
Commercial Real Estate
Similar to residential real estate, Hong Kong commercial real estate has recovered strongly in terms of both rents and capital values. In particular, Central Grade A Office has performed very strongly rents have increased 33.3% from Jan to Nov 2010, and capital value increased 35.5% in the same period, and vacancy dropped to a mere 3% according to Jones Lang LaSalle. Retail segment has also grown strongly as local consumption rebounded strongly and tourists spending increased.
Although they certainly have different driving forces, I believe the commercial and residential markets are exposed to some similar major driving forces. This is demonstrated by the fact that the residential and commercial real estates cycles in Hong Kong have been quite synchronous. It is also worth noting that the capital values of Hong Kong Grade A office recovered since early 2009, pretty much together with the residential market on the back of massive unconventional monetary stimulus (quantitative easing I), while office rents only bottomed out in late 2009. The rise in capital values in 2009 was driven by yield compression due to record low interest rates, rather than any improvement in rental values, which improved markedly only in 2010. So the commercial properties space, in my view, in exposed to similar risks that residential market is exposed to, namely, money flow. The only risk that commercial real estate in Hong Kong does not face is policy risk, as it has nothing to do with home ownership, so that it is much less likely for politicians to express any concerns on higher office rents, for example.
Physical Market vs. Stocks Market
For the physical market, I am looking for a more stable 2011, with a bull case of 10-15% upside for all properties, while the main risk would be premature money outflow, which will almost certainly break the bull market.
For the stock market, despite strong performances in the real estate market in the past 2 years, there has been a huge divergence in stock performances between property investors (landlords) and property developers. Intuitive explanations might be that because most property investors hold portfolios which are mostly composed of commercial real estates, they are arguably exposed to much less policy risk than developers, whose main businesses are building and selling mostly residential units. But when we look further back into the history, we can actually see that property investors’ stock prices recovered more strongly in the early recovery of 2003 than developers, and developers only are only catching up at a relatively late stage of the up-cycle. Below are the charts showing the share prices performances (rebased) of Cheung Kong (1.HK) and Hysan (14.HK) in 2003 and 2009 recovery and subsequent years. Similar patterns can also be obtained for other property stocks.
There are no easy explanations of the outperformance of property investors in early recovery. But if history is a good guide, this is certainly something to bear in mind.
Another worth-noting point is that, there is a certain conventional wisdom that stock market performances lead real estate market performances. Despite the huge correction in developers stocks after the announcement of extra stamp duty, developers stocks are regaining some ground, that would suggest that the real estate market is yet to turn south.
How does this observation feedback into my real estate market forecast? I believe that home prices in Hong Kong will not turn negative in the next 3-6 months, and extra-stamp-duty-induced supply squeeze will likely fuel the another round of rapid price increase, and this makes the bull case of 10-15% increase in price achievable. In 6-12 months time, however, if economic growth is going faster in the developed countries and inflation returns, we will see higher interest rates and liquidity will be removed as central banks exit from unconventional policy tools. By the end of 2011, I believe we will see a much less favourable environment in Hong Kong real estate market, and will be headed for a correction in 2012.