This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Toby Hudson, manager of Schroder Hong Kong Equities, sorts the commerical property facts from the fiction
Recent scaremongering by market commentators on the state of the Hong Kong property market might have led some investors to believe all the hyperbole. A meteoric rise in residential property prices, the government imposition of a stamp duty and worries over a hike in US interest rates are paraded as the usual suspects on why the fundamentals, and prospects, of Hong Kong’s listed property developers are in the doldrums. However, in our view, reinforcement of a market mantra does not automatically make it true.
So, what is the outlook for the Hong Kong property market and its firms? Although the residential property market is admittedly frothy, and affordability is stretched, most of the larger listed property names have relatively little exposure to the residential sector (only 5-30% in most cases). Over many years these companies have steadily built up large portfolios of investment property holdings in the office and retail sectors in Hong Kong and China, and this has significantly diluted their exposure to the local housing market. As such, even if residential prices were to correct from current levels, the downside to net asset values would be limited.
Meanwhile, the Hong Kong commercial property market remains in good health. Vacancy rates are close to record lows, the supply outlook for office and retail property is very limited for many years to come and the demand for space is supported by continued healthy levels of economic activity in Hong Kong and China. Rents in most segments of the market are still on an upward trend as a result.
As importantly for investors, and mostly ignored by the bearish commentators, the stock prices of these listed companies have diverged dramatically from the physical markets in recent years, such that the stocks are already discounting a negative outlook for rents and capital values.
Most tellingly, many share prices in the sector are trading at the same absolute levels as we saw in 2006/07, when the Fed Fund rate was still 5%+, and well before the on-set of any QE. In the intervening years rents have risen materially – supporting higher capital values – and investment portfolios have grown as new projects have been completed.
Having corrected on the back of fears over US ‘tapering’, the stock prices of listed property firms are now trading at very significant discounts to Net Asset Value (NAV) – of between 40-50% (see table on previous page). These huge discounts are at near crisis levels, and far wider than seen on average through the cycle in Hong Kong, despite the relatively benign outlook for commercial property and the strength of the companies’ balance sheets. The stocks, therefore, already look to be pricing in a sharp rise in bond yields and valuation cap rates and a downturn in the residential market, long before any of this is evident in the physical market.
We therefore think it is far too simplistic to argue that rising US rates and the risk of a correction in the residential market necessarily makes all Hong Kong property stocks unattractive. Although the outlook is far from clear as we look toward the tapering of QE, the eventual rise in US rates and the ongoing rebalancing of the Chinese economy, we need to balance both the risks inherent in these forecasts with the potential rewards on offer from heavily discounted share prices.
