Bond investors long ago made up their minds about Hong Kong risk. Government debt now yields about 3 per cent more than US treasury bonds. Fears the currency peg will break have raised interest levels across the economy.
Everywhere, that is, except in the property market, where returns remain stubbornly below every other investment benchmark. Yields on office property remain a piffling 4.5 to 5.9 per cent. Two explanations exist; either bond traders have got it wrong or rents are set to surge.
Yet the market is, as they say, the market. Investors previously used US treasury yields as the benchmark for valuing Asian assets with currency pegs to the US dollar. That was fine when US and Hong Kong rates were pretty much in line, but what about now? Denial of the deflationary wind buffeting the SAR is a common condition. Something similar seems to be affecting the sluggish office market. Yields have risen just 150 basis points, with prices of actively traded office floors remarkably resilient.
Unlike the housing market, commercial property should trade according to normal investment principles. But, with rents slipping, investors seem oblivious to the impact of higher interest. The reason is relatively illiquid conditions and owners' reluctance to realise a loss.
Something similar happened in the 1995 downturn, when prices of strata-title office floors bought by highly leveraged speculators fell more than 50 per cent in an orgy of deposit defaults. Yet, even in that difficult period, real Hong Kong interest rates never hit today's levels and rents remained firm.
Leases of Hong Kong offices typically last three years. Few contracts have upward-only rental reversions so common in markets like Britain. Tenants are free to re-negotiate according to prevailing conditions.
The first extensive addition to Central stock for years will come with projects on the Central reclamation and former Hilton Hotel site. New offices in fringe Central, Tsim Sha Tsui, Causeway Bay and Quarry Bay will add to the glut. On the demand side, the much-hyped arrival of mainland firms proved to be just that, and the financial sector is going through a down-scaling. In short, Hong Kong faces what is known as an over-rented market.