All the signs point to a sharp correction in property market

At last week's meeting of the Pacific Basin Economic Council, former Hongkong and Shanghai Banking Corp chairman David Eldon worried over Hong Kong's future. At the end of last month, American magazine BusinessWeek came out with a cover story proclaiming 'Hong Kong: It's back!'.

Judging by BusinessWeek's past record, said Mr Eldon, that was a sure-fire signal a downturn was just around the corner.

It is beginning to looks as if Mr Eldon was right and that BusinessWeek has once again lived up to its unwitting reputation of being a late-cycle prophet - at least as far as Hong Kong's property market goes.

With other banks expected to follow Bank of China, which over the weekend raised its effective mortgage rate by another 0.25 percentage point, analysts are forecasting a shake-out that will drive speculators from the market.

The result, according to Merrill Lynch property analyst Clifford Lam, is likely to be a correction that drives residential property prices down by as much as 25 per cent over the next year or so.

Not everyone is so bearish, but even those with more moderate views believe prices at the luxury end of the market are likely to dip by 10 per cent or more over the coming months as speculative buyers are sent packing.

The signs are already there. In a desperate attempt to bump up sales, Cheung Kong (Holdings) is asking buyers in its newest development for an initial deposit of just 5 per cent. As many as 400 flats out of 1,057 in Sun Hung Kai Properties' Arch in West Kowloon, launched in April, are already for sale on the secondary market as buyers try to resell their properties for a fast buck rather than shoulder higher interest rates.

With secondary market transaction volumes down by 12 per cent last month, after an earlier round of mortgage rate increases, prices of flats in some developments are already softening.

If mortgage rate rises do blow a little froth off luxury property prices, it can only be healthy for the market as a whole. Top-end price rises have far outstripped average increases recently.

Since the market bottomed out in mid-2003, average residential prices have risen by about 70 per cent. Luxury flats, however, have doubled in price, reflecting the disproportionate number of purchasers buying property in hope of capital gains rather than to live in.

If they are not already, those buyers will soon begin to feel the pain of higher rates. According to Morgan Stanley, the rise in luxury prices has depressed top-end rental yields to a record low of 2 per cent. With mortgage rates expected to rise by up to a percentage point before the end of the year, the squeeze is set to tighten.

That is by no means all bad news. The easy availability of cheap money has allowed speculators to crowd more cautious genuine buyers out of the market. According to Mr Lam, the affordability of residential property has fallen sharply over the past couple of years, with average flat prices shooting up to 12 times average annual household income today from about 6.5 times in early 2003. Only plentiful liquidity has kept the market afloat.

Now that liquidity is drying up, Mr Lam compares the situation to that in 1994, when a 2.5-percentage-point rise in interest rates drove prices down by 20 per cent. A similar magnitude decline is needed today, he believes, to bring rental yields back into positive territory and to restore prices to levels owner-occupiers can afford.