Some big investors are sounding the alarm over Hong Kong real estate after years of price rises amid concerns over expected interest rate hikes, while others argue the continued influx of capital is justified.

BlackRock, for instance, is steering clear of all types of Hong Kong property assets after their "phenomenal" rise in value, John Saunders, Asia-Pacific head of real estate at the world's biggest fund house, told AsianInvestor

Commercial real estate prices in Hong Kong rose by around 22% last year, faster than almost any other major city, and they have more than tripled in value in the past decade, according to data provider Real Capital Analytics (RCA). Office property prices in Central stood at $4,983 per square foot per annum at end-2017, up from $3,570 at end-2013, according to property services firm JLL.

Hong Kong has even replaced London's West End as the world's most expensive office location, according to research published in November by property services firm Cushman & Wakefield.

A key issue with Hong Kong's property market is that it “imports inflation from China and pays for it with US [interest] rate policy”, said Saunders. “With China growth lower than it has been and the spectre of rising [US] rates, they make Hong Kong look like an expensive place as far as real estate goes.”

Hong Kong will inevitably be affected by such moves as its currency is pegged to the US dollar and therefore the two markets' rate cycles tend to be closely correlated.

Beijing is targeting 6.5% GDP growth for 2018 and last year the US Federal Reserve indicated it would raise its rates another three times in 2018. But some economists have speculated that the central bank may accelerate that pace. 

Capitalisation rates (the rate of return on a real estate investment property based on the income it is expected to generate) in Hong Kong have compressed “phenomenally”, Saunders said. 

“If you think about the potted history from the 2008 financial crisis onwards: the US cuts interest rates to zero, China continues to grow fast till 2012-2013, so property prices – and all asset prices – in Hong Kong go on a phenomenal run.”

Yields for all types of Hong Kong real estate range from slightly under 2% to slightly over 3%, said Saunders (see graph). “That looks mighty expensive in a rising rate environment in my view.”

Asia office property yields, 2011-2017 
(Click for full view)

Rising interest rates tend to be seen as bad for real estate because they mean a higher cost of borrowing and higher required yields for investors in light of the higher risk-free rate. That said, rate hikes also tend to indicate rising inflation and a healthier economy, which are positive for rental growth, Saunders said — as long as they are slow and steady.

“HUGE SUMS”

Meanwhile, others are more bullish than BlackRock on Hong Kong real estate.

Denis Ma, Hong Kong head of research at property consultancy JLL, said the willingness of investors to pay huge sums for deals reflects their underlying confidence in the market’s outlook. As examples, he cited the sale of a major portion of The Center office tower for HK$40.2 billion ($5.15 billion) and The Link Reit’s disposal of a portfolio of 17 neighbourhood malls for HK$23 billion late last year.

Vacancy in the Central Grade A office market (the most modern and well-located buildings) is standing at just 1.4%, Ma told AsianInvestor. And investors see the completion of transport infrastructure connecting the city with the Greater Bay Area as an additional catalyst for a retail market that is in the early stages of recovery following a three-year slump.

“So, yes, capital values [in Hong Kong] have definitely shot up over the past year," noted Ma, "but there is definitely enough momentum in the economy to support demand growth and rents over the medium term.”

VALUE-ADDED

To compensate for the shrinking returns and rising rate risk in Hong Kong, some investors are shifting their attentions to lower-quality property assets that can be worked a bit harder to generate more income.

In its March report, Emerging Trends in Real Estate Asia Pacific 2018, PwC noted an uptick in interest among foreign core fund managers for higher-risk property investments in Hong Kong, including so-called ‘value-added’ real estate.

Unlike ‘core’ real estate investments, value-add properties are those that have management or operational problems, require physical improvement and/or suffer from capital constraints.

Hong Kong provides good scope for such deals because the rental differential between Grade A and Grade B buildings is much greater than in other markets, the PwC report said. Hence foreign and local players are looking for potential repositioning deals, very often with co-working or co-living potential in mind.

An extended feature on investing into Asia-Pacific real estate will appear in the upcoming April/May issue of AsianInvestor magazine.