Game over for property bubble

Last Monday, Financial Secretary John Tsang Chun-wah warned in an address to the Legislative Council that property sales were falling sharply and speculated as to what kind of downturn this anticipated. 'The transaction volume has greatly fallen,' he said. 'Although the prices have not yet fallen to a level ... deemed satisfactory, this can perhaps be seen as a kind of soft landing, which I think is largely not a bad thing. ... 'It is still my worry that there could be another bubble being formed.' With all due respect, Tsang is arriving a little late at this observation. There is an emerging consensus among property analysts and those in the industry that Hong Kong's epic property boom (during which residential prices have risen 43 per cent since 2009, according to Centaline Property Agency) has finally run its course. The only question remaining is, how big will this downturn be? To get a sense of where the market is moving, one needs to get to grips with what is driving it. The short answer is interest rates, government housing policy and the mainland economy, and each exerts its own effect on home prices. Tsang presented evidence of a downturn, saying that flat prices fell 2 per cent during the third quarter, the first quarterly decline since the end of 2008. Transactions in that quarter fell a thumping 41 per cent from the preceding quarter. Fissures are emerging at the edge of the market. According to the Hong Kong Monetary Authority, cases of negative equity (where the market value of a home is less than the outstanding mortgage) rose from 48 in the second quarter to 1,653 in the third quarter. The numbers are a small fraction of total homes owned, but the rapid rise hints at a trend. 'Transactions have dropped a lot,' says Mahlon Campbell, director of Home Buyer Hong Kong Consultancy, which advises expatriates on home purchases. 'Landlords have realised that buyers are becoming cautious, and during the past two months landlords tried to drop their prices. But say they dropped their prices by 10 per cent - that's still well above where prices were two years ago.' Nicole Wong, regional head of property research for CLSA, says: 'Property prices have dropped, but it's a fake drop, because people have been unable to sell.' An influential Barclays Capital report released on November 4 projected a 25 to 30 per cent fall in Hong Kong's residential market. Other anecdotal evidence can be seen in mortgage rate rises. Standard Chartered said on November 18 that it would raise interest rates on its one-month home loans, based on the Hong Kong interbank offered rate (Hibor), by half a percentage point, to a range of 2.5-3 per cent. (Hibor is the rate at which banks lend to one another.) Such rate rises directly impair Hongkongers' ability to finance flats. 'Mortgages at 2.5 per cent plus might seem cheap, but rental yields are also low,' Wong says. 'A lot of better-quality properties are leased at 2-3 per cent yields. It used to be more attractive to buy, but now that it costs the same, in terms of tenant income and monthly mortgage expense, there is little advantage to owning.' Andrew Lawrence, head of property research at Barclays Capital and the author of the November report, also homes in on the impact of rising interest rates. His survey of private equity real estate funds leads him to believe that banks are tightening their lending to the property sector, with the rates for such loans having risen generally 2-2.5 per cent since March. 'A 225 basis point [2.25 per cent] rise in mortgage rates in the last eight months is a sign that credit is tightening,' Lawrence says. 'Hong Kong banks have limited Hong Kong dollar liquidity because of the growth in lending and the shift out of Hong Kong dollar deposits and into yuan.' He projects a further 1.5 to 2 per cent rise in bank interest costs for property loans over the next 18 months. This reflects an expectation of an increase in banks' sense of the risk involved in lending to the property sector and not of rising rates from the US Federal Reserve, which is also affecting lending to the big developers. (See sidebar.) Ken Leung, Citigroup's Hong Kong property analyst, says mainland firms have been borrowing in Hong Kong because of tighter lending restrictions on the mainland, which have increased demand for loans and raised interest rates in Hong Kong. There is evidence in support of that view. Hong Kong mortgages have been rapidly moving away from a bias for Hibor-based loans towards prime-rate mortgages. Hibor-based loans - mortgages based on Hibor plus a spread - were the norm six months ago, reflecting the vast stashes of depositors' money banks had to lend. They were happy to lend at a premium to their very low deposit rates. But banks have no control over Hibor, and therefore they are not allowed to reprice the Hibor mortgages that they have given customers. They do have the authority, though, to reprice prime rates higher, as that rate is determined by each bank. The move to prime mortgages effectively returns pricing power to the banks amid a rising sense of the risk involved in lending in the property sector. That is a somewhat technical issue, but the switch from Hibor to prime loans is an important indicator of the increasing scarcity of capital available to banks to lend against mortgages. The higher the ratio of prime to Hibor mortgages, the more conservatively banks view the market. The Monetary Authority's September Residential Mortgage Survey shows prime-rate loans made up 51.3 per cent of new mortgages that month, and Hibor-based loans made up 46.2 per cent. In January, 92.2 per cent of all mortgages were being signed on a Hibor basis. So mortgage rates are rising, and new mortgages are skewing towards prime-rate loans that can be adjusted at a bank's discretion. The impact has been falling transaction volumes and declining prices. There are other factors contributing to the city's brewing property decline. General gloom about the global economy and investing emanating from the euro zone is depressing interest in a major purchase such as a flat; mainland economic growth is slowing; and the Hong Kong government has greatly expanded the supply of land for sale for residential developments. Wong notes that the government is oversupplying the market with new land for residential development. She estimates the government aims to provide land for 20,000 new flats each year, a 52 per cent increase over the 13,000 units a year sold over the past five years. 'The market is contracting, interest rates are going up, economic growth is slowing down, and Hong Kong is due for some oversupply,' Wong says. Lawrence is also focused on the economic outlook. The much discussed possibility of a hard economic downturn in China (which he defines as 5.5 per cent GDP growth for China next year) could conceivably wipe out as much as 45 per cent of the value of Hong Kong flat prices, he says. A severe economic downturn on the mainland hurts the Hong Kong property market in two ways: it suppresses both local and mainland demand for real estate. The impact of mainland investors on Hong Kong property is much debated. Some (such as Lawrence) feel the impact is overstated. Others say the mainland effect is substantial. Citigroup's Leung says mainland investors buy 9.5 per cent of all Hong Kong properties coming onto the market. However, in the luxury residential market, they account for more than 30 per cent of the volume, he says. If China eases liquidity, that could release renewed demand from the mainland for Hong Kong flats. News arrived last week that the People's Bank of China will cut the reserve requirement ratio (a form of credit easing) for five rural credit co-operatives in the eastern province of Zhejiang. The move to ease restrictions for a handful of small institutions may have been symbolic, but it portends - perhaps - the start of a credit easing cycle in China in general and more relaxed controls on property lending in particular. Beijing no doubt has plenty of other initiatives up its sleeve, and the unpredictability of its policy moves makes it hard to predict the near-term health of the mainland economy and the volume of mainland money that will flow into Hong Kong property. Equally, it is impossible to pin down other big external variables, such as how the euro-zone sovereign debt crisis will play out. But this much is clear: by all accounts, after a massive rally, Hong Kong's property prices are declining.