Hong Kong property market

Last November, in an address to the Legislative Council about the state of the Hong Kong property market, Financial Secretary John Tsang Chun-wah warned: "It is still my worry that there could be another bubble being formed."

The statement only seemed to egg buyers on - Hong Kong home prices have climbed 12 per cent in the year to date, and in March they passed the all-time high seen in 1997.

Flat prices are up an eye-watering 85 per cent since the start of 2009, according to Centaline property index. (See chart).

It's an extraordinary run considering the global context of gloom, in particular a euro-zone crisis that rumbles on and on, and the economic slowdown unfolding in the mainland and Hong Kong economies.

The government is talking about ways to cool the market. Chief Executive Leung Chun-ying on August 30 announced a 10-point plan aimed at increasing housing supply, and last week announced that two sites at the former Kai Tak airport will be set aside for permanent residents.

What to make of this market? Any prospective first-time property owner looking at a giant 20-year mortgage would find prices daunting. The government measures add another element of risk - that is, that they might bring a load of new flats onto the market, scuttling prices.

All said, while it still makes sense for a new family to buy a flat for long-term use, buying for investment looks risky.

To get to that view, one first has to understand the underpinnings for the bull market now under way.

This can be summed up as "interest rates, interest rates, interest rates", says Sylvia Wong, a property analyst for UOB Kay Hian. Hong Kong interest rates track those of the US, thanks to the dollar peg. And it's no accident that the boom started in 2009, or just after the Fed radically lowered interest rates in response to the global credit crisis. The Fed funds target rate stood at 0.25 per cent at the start of 2009, where it remains today.

This has had a kind of mechanical effect on Hong Kong property prices. Banks have been feeding cheap cash to people to buy flats, and prices keep going up. This fact, combined with Hong Kong's full employment and strong income levels have virtually assured continuous prices rises.

"Interest rates have stayed low, supply has not picked up, and unemployment has stayed low. When you have those three factors it is difficult for property prices to fall," says Adam Osborn, manager of Schroder Asia Pacific Property Securities Fund.

Low interest rates have made this market surprisingly affordable, despite the record price rises. David Ng of Macquarie Research says mortgage payments take up 60 per cent of the average Hongkonger's income, assuming a 20-year mortgage, on a 538 sq ft flat with a 30 per cent down payment. "The mortgage burden is high but it's not as scary as 1997," says Ng, referring to the previous peak.

Meanwhile, the market has seen a low volume of new flats being built. Citibank says there were fewer than 10,000 units built in 2011, versus an average of 19,466 flats constructed each year in the period 1996-2011.

Catherine Cheung, head of investment strategy and research, Citibank Global Consumer Group, estimates that the government measures will bring about 20,000 new units into Hong Kong over the next few years, which will only have a moderate impact on supply. Cheung says the government wants to create housing for young families seeking their first home, but it is careful not to create the conditions for a price crash, as was seen in 1997 following heavy government intervention in this market.

"We are very positive on the Hong Kong property market," says Colet Ng, the head of mortgages for Bank of China (Hong Kong). "We expect the Hong Kong government will support stable growth."

Nevertheless, there is a compelling bear argument to be made for Hong Kong property. That points to the economic slowdown unfolding in Hong Kong and the mainland. The slowdown could easily turn into recession, translating into lower income growth and then a property market correction.

"The Hong Kong government has revised down forecasted economic growth from 3 per cent to 2 per cent, whereas property prices have risen 12 per cent in the year to date. The gap is too wide … property price growth has exceeded income growth," says Ng of Macquarie.

Meanwhile, low interest rates, the powerful engine that has propelled this market, cannot be taken for granted.

Mortgage rates rose about 1.65 per cent at the end of 2011, according to Andrew Lawrence, a Barclays property analyst, thanks to technical factors such as diverting of bank lending to mainland firms. The rate rise contributed to a 10 per cent drop in the prices for Hong Kong flats at the end of last year.

Mortgage rates have since stabilised and home prices resumed their upwards rise in 2012, but last year's wobble showed the sensitivity of this market to interest rate rises.

The US Fed has only pledged to keep interest rates low through 2014. Someone taking out a 20-year mortgage today might note that they would be exposed to rate changes beyond that year, and that interest rates can only go up.

"Interest rates will be a major uncertainty in two years' time or five years' time. If they go up very suddenly, housing prices could go down by a lot," says Cheung.

Meanwhile, there are signs of softness in the market. Citibank research shows, for example, that developers apply a 10 per cent premium to existing properties in the same district, as compared to a 20 per cent to 30 per cent premium seen in the 2009-10 market boom. This suggests that developers are starting to discount new properties, to get them selling.

The volume of property transactions is volatile month to month, and is well below the levels seen in 2009-10. (See chart.)

"The transaction volume is low compared to what we call a good property market," says Buggle Lau Ka-fai, chief analyst at Midland Realty.

Josh Matthews, a Canadian consultant, has had a 1,600 sq-ft flat in Jardines Lookout on the market for two years. While Matthews has raised his price twice, he is now getting serious about selling, and is considering a cut to the listed price to get the job done. "The only reason I'm selling is because I think the market is going down. The rental situation is depressing, but the run-up in the price has been so much," says Matthews.

The market softness is particularly noticeable among the investment market, or people who buy flats for trading gains, not for their own use. This segment is more sensitive to the ebb and flow of mainland money, which is exposed to the mainland economic growth slowdown.

Demand by mainland investors for new homes worth less than HK$12 million dropped to 21.6 per cent in the second quarter from the peak of 35.5 per cent last year, according to Centaline Property Agency.

Cheung of Citibank says 60 per cent of Hong Kong property transactions do not involve mortgages - the flats are bought in full with cash, typically as an investment. This kind of purchase makes sense in the context of an ever-rising market. But if prices started to fall, these buyers would disappear, pulling out a major source of demand from this market.

Rich investors looking to flip properties are also running against a special stamp duty (imposed in 2011), which involves a 15 per cent tax on properties held for six months or less. This has pulled a lot of people out of the market who buy and sell flats with an eye on a quick trading profit.

Such buyers are also constrained by a regulation that caps bank mortgages at 50 per cent of the value of properties worth HK$10 million or more.

While property has worked as a great investment in recent years, prices have risen to a level that makes it look less attractive. Rent generated on luxury properties translates into a yield of about 2.5 to 2.7 per cent, says Paul Louie, a Nomura property analyst. That's not exciting given the high risks of this market, the potential illiquidity of the asset (try selling in a downturn) and the hassles and costs of owning a property (taxes, maintenance, insurance, and the rest).

Louie says property stocks give investors the same exposure, but with greater tradability and better yields, noting that Sun Hung Kai Properties and Cheung Kong (Holdings) pay dividend yields of 3.6 per cent, and Champion Reit pays 6 per cent. "From an investing angle it's better to buy property stocks," says Louie.

All of which suggests this is a risky time to buy property, especially for investment purposes.

"Our current assumption is that Hong Kong property prices will fall 10 per cent over the next 12 months due to deteriorating affordability and policy risk," says Callum Bramah at Macquarie Research.

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