Office market looks promising
Life might be better in the Hong Kong office market than the residential market next year.
Home prices are not likely to climb dramatically. Average income is forecast to rise only 2.8 per cent, rental yields are already less than blue-chip equity dividend yields, and rental income is insufficient to cover mortgage instalments. Mortgage rates are also poised to surge higher when the hot money leaves Hong Kong. Nevertheless, prevailing home prices should be sustainable if income stays firm and interest rates remain relatively low.
But the office market, especially among grade-A and B properties, looks better. The main reasons are the large differential between rents for grade-A and B offices in Central and other districts, and the lack of new supply in all office grades.
As recently as September, average rents of Central grade-A offices recorded by the Ratings and Valuation Department was $301 per square metre, while the figure was as low as $122 in Wan Chai and Causeway Bay, and $130 in North Point and Quarry Bay. The cheaper properties, which are just as good in terms of working environment, will be a powerful incentive for non-finance tenants to move away from Central.
Recent transactions reveal that rental yields are falling in the Central area. For example, yields on some grade-A office units at 9 Queen's Road Central are as low as 1.6 per cent, while a unit in ICBC Building is a more reasonable 4 per cent. Recent advertisements suggest that even some units at Lippo Centre can be purchased at a yield of only 3 per cent.
Actual yields after deducting management fees, rates and tax will be even lower. Property investment counters with grade-A and B office holdings outside Central will probably earn sharply higher rental income when existing leases are renewed next year.
All this brings me to an excellent company, but trading at rich valuation. The value of Hang Lung Properties (HLP) is relatively easy to evaluate compared to other residential property development companies as all of its properties for sale are completed. What catches the eye is the huge embedded profit from its available housing stock.
For the financial year ended June 2005, HLP is forecast to record sales of $8.29 billion and earn profit of $3.17 billion from four major residential projects.
According to my estimates, the company will close out this year with group sales of $10.7 billion, up 136 per cent year on year, and operating profit of $4.76 billion, up 66 per cent. Taking into account its minority interest in the Aqua Marine development, net profit should be $3.54 billion, up 71 per cent, or $0.965 per enlarged share.
Value of the property investment business standing alone from June 2007 onwards could be $8.6 per enlarged share. Keep in mind that office and shop rentals do fall when times are tough.
The company is planning to issue 370 million new shares at an offer price of $12, a level which appears very close to the company's present value.
The placement will bring in proceeds of $4.4 billion, which will boost its firepower to acquire more land. The company has said it intends to buy land in China, but given the possibility of a slowdown in the mainland residential property market, I believe that will probably not happen in the near term.
Taking into account present value of net profits of the coming three fiscal years, free cash distributable after setting off all current liabilities, and present value of property leasing business, I got a total present value of $13.7 per share, so the offer price of $12.15 is probably close to fair value.
Bear in mind that actual selling prices, sales volume and profit from sales could be lower than my estimates.
Value investors should take advantage of any considerable declines in the share price of HLP to acquire a stake in this excellent company.
Henry Chan is the deputy head of research at Quamnet. He does not own shares in HLP.