Hong Kong office rents under pressure as mainland Chinese demand slows

After posting gains for the better part of the last two years, Hong Kong’s office market is nearing an inflection point as demand weakened through the first half of 2016. While extremely low vacancy rates have played a part in curtailing net take-up, office rents – which serve as a barometer of market health – also are showing signs of strain, with growth slowing and even declining in the city’s key office markets through the first half.

The fact that weakness is now starting to appear in the market should not be surprising. Outside of Central, rents have only managed to eke out moderate growth in recent years despite vacancies steadily declining across the market. In some instances, rents have barely moved despite vacancies hovering below less than 2 per cent and way belowfrictional levels; extremely unusual in a market like Hong Kong where office rents can surge by more than 50 per cent in a calendar year.

Mainland Chinese demand, which has been a pillar of support for the local office market over the past two years, is also starting to show signs of slowing. Although the share of mainland demand in Central increased further in the first half, accounting for 37 per cent of all new lettings by floor space leased, it was noticeably lower in the second quarter. Moreover, the total amount of floor space leased by mainland occupiers in Central will likely fall below the 375,000 sq ft leased in 2015.

A drop-off in mainland Chinese demand potentially spells trouble for the market. Although China has accounted for less than 40 per cent of new lettings, it has been the key reason behind the recovery of the Central office market, with most of the high watermarks set in the rental market being set by mainland Chinese occupiers. MNCs continue to contribute to a large piece of the leasing market but they remain very cost sensitive, with the bulk of new lettings through the first half being driven by cost saving relocation.

Although underlying factors driving the growth of mainland occupiers in the city’s office market remain largely intact, growth is likely to moderate to a more sustainable pace moving forward. The launch of the Shenzhen-Hong Kong Stock Connect, for example, is unlikely to lead to a significant uptick in demand given that most mainland Chinese securities trading and asset management firms that will participate in the programme already have a presence in the city.

So if Chinese demand, which has largely been representative of demand from the banking and finance sector, begins to moderate, it begs the question; what will be the sources of demand growth over the near term?

The insurance sector has been one of the few surprises. According to data from the Office of the Commissioner of Insurance (OCI), mainland Chinese spent HK$31.6 billion on insurance policies in 2015, which is almost 30 per cent more than the previous year and 400 per cent more than 2011 levels. To meet the surge in demand, the sector has added about 21,000 in headcount over the past five years, with 12,500 being added in the last two years alone. To accommodate business growth, insurers have leased and purchased over 3 million sq ft of Grade A office space since 2011.

Much of this demand, however, has been largely met in decentralised office markets such as Hong Kong East and in locations outside of Tsimshatsui in Kowloon. Data from the OCI suggests that mainland Chinese continued to visit Hong Kong to purchase insurance policies in the first quarter though the sector has come under increased scrutiny from mainland regulators concerned that the purchasing of insurance policies is being used as a means to circumvent China’s strict capital controls.

Another potential source of demand has been the arrival of co-working space operators. US-based WeWork, for example, leased about 150,000 sq ft of office space to establish their presence in the city in the first half. Though this requirement was spread over two locations it does mark one of the largest fresh requirements from an industry segment in the year to date. Whether the trend towards co-working offices can be sustained over the longer-term, however, remains to be seen given that operators will eventually need to backfill these offices.

Demand from the banking and finance sector outside of mainland Chinese corporates remains thin with a number of US and European banks continuing to trim local headcount. Brexit is likely to further weaken growth from this cohort moving forward.

So without a clear catalyst for demand growth, Hong Kong’s office market looks like it is nearing a cyclical peak, a situation that is likely to be compounded with the completion of new supply in decentralised locations such as Hong Kong East and Kowloon East. In fact, we are already starting to see rents slip in some of the Kowloon office markets.

Still, with current vacancy rates at such low levels, the correction in rent may not be as severe nor widespread as in previous down cycles. Our latest forecast is for rents to retreat by less than 15 per cent over the next three years.

Denis Ma is head of research at JLL

The following numbers were updated in the 7th paragraph: To meet the surge in demand, the sector has added about 21,000 in headcount over the past five years, with 12,500 being added in the last two years alone.