Hong Kong Residential - Cooling but not crashing

The Hong Kong residential market has been sliding for nearly a year. How severe will the correction be?

19th May 2016

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The Hong Kong (HK) residential market has entered a period of heightened uncertainty, with recent price declines and volatility (Chart 1).  Both mass market and luxury residential prices have fallen 11.0% and 7.3% respectively1 .  While these price corrections look small in comparison to gains over the last decade, the market consensus is that prices will continue to fall through 2016 due to a combination of increased economic and political headwinds, likely increases in US interest rates, new supply and stretched price-to-income ratios.  The remainder of this article looks at the forces influencing HK residential property prices.  In our view, the market is set to cool, but not crash.

Heating up…

From 2009-14, HK’s economy and asset prices were substantially boosted by a combination of ultra-low interest rates2 and very strong economic output on the mainland.  Soaring activity on the mainland bolstered the HK equity market and financial services sector, as HK was used as a major conduit for Chinese firms to access global capital markets.  Greater prosperity on the mainland flowed through HK property markets, with strong demand for residential real estate from wealthier PRC citizens looking for diversification.  

Such a strong economy would normally have occasioned higher interest rates, but rates in HK remain close to 0% due to the HKD peg.  Indeed actually with inflation, the real interest rate was heavily negative. The other major impact of ultra-low interest rates in the US was a fall in USD, which had flow-through effects on the HKD. The most significant movement was against the RMB; from mid-2008 until early-2014, the HKD depreciated closed to 15% against the CNY.  The fall made HKD denominated goods, services and financial assets relatively cheap for mainland buyers.

The inevitable result of this market imbalance was rapid capital flows from low yielding cash into risk assets, driving prices of the latter upwards.  According to HK’s Rating and Valuation Department data (“RVD”), domestic property prices almost trebled between the end of 2008 and the end of 2015. 

…and cooling down

Each of the factors that supported HK’s economy from 2010-2014 started to show significant adjustment through 2015.  The Chinese economy has been slowing as it attempts to rebalance away from an investment/export led growth model and concerns about the strength of the mainland economy have clearly impacted HK.  In addition, the HKD softening trend started to unwind with more significant appreciation against the RMB (+9%) over the last twelve months. As well as dampening the price competitiveness of HK’s exports, it has made HK assets less affordable for mainland buyers. 

In addition, HK policy rates followed US policy rates upwards following the Federal Reserve’s 25 bps rate hike in December.  Whilst turbulence in global financial markets in the first quarter of 2016 has somewhat dampened expectations for subsequent rises, consensus is still for another 50 bps of increases in the US by year end.

Economic chills started to permeate the residential market midway through 2015, manifesting in a sharp decline in volumes.  January 2016 saw the lowest ever recorded number of secondary transactions at 1,983.  February 2016 saw only 217 primary transactions, the lowest monthly level since November 2008.  Inevitably, in a market with heavily declining transaction volumes pricing impact will begin to be experienced and this has accelerated in 2016 to date. 

So what next for the market?

HK’s residential market remains expensive by global stands; we estimate current prices are 17.4 times median income (Chart 2), which is well above the long term average of 11.6 times.  Our central economic forecast is for relatively lacklustre wage growth over the next three years, which means a reversion to mean in the price/income ratio is likely to primarily be driven by price adjustments.  This would imply a further price decline of 20-25% over the next two to three years.

Ordinarily, when an economy is weakening, interest rates are more likely to go down than up; loose policy can be very supportive of asset prices even in an environment of lacklustre growth. But HK is in the position where rising interest rates will have to be absorbed even if the domestic economy is weak, by virtue of its USD peg. On latest data as Q4 2015, the mortgage payment to income ratio is at 63%, well below the 93% experience during the 1997 Asian Financial Crisis, but well above the 1995-2014 average of 46%3.  Assuming a 100bps increase in mortgage interest rates and a reversion to the long-term ratio of affordability implies a 30% fall in prices.  

However there are three aspects which suggest that price corrections may not be as dramatic as implied by this mean reversion analysis.  First, developable land in HK is extremely scarce.  Land reclamation has proven insufficient to meet fundamental demand: in the period from December 2008 to December 2015, HK’s population grew by 360,400 while only 75,000 new private properties were completed (Chart 3); in essence the market has been structurally undersupplied for nearly a decade4

Secondly, HK remains a lowly leveraged residential market. The most recent data from the Census and Statistics department suggests that over 50% of HK homes are owned without a mortgage. We estimate that the aggregate LTV ratio for the private residential sector in HK is 19% which implies it is sub-40% even for those homeowners with mortgages.  The impact of rising rates on mortgage affordability in HK should be relatively muted as a result.  Thirdly, there have been a number of policy initiatives aimed at cooling the housing market since 2012, including stamp duty increases, LTV caps and stress tests.5  Since February 2013, all new mortgage applicants have been tested at spot-rate plus 300 bps.  Given these policy measures, default and negative equity are very unlikely to be systemic issues. Purchases from outside the Special Administrative Region have become very limited since restrictions were put in place.

Conclusions

Rapid appreciation in HK’s residential prices is far from unique. It is partly the result of factors that have characterised asset markets since the Great Financial Crisis.  Ultra-loose monetary policy and low returns on cash have pushed money into risk assets and residential property has benefitted particularly in “global cities” where there is strong demand due to demographic trends and tight supply.  Normalisation of central bank policy is likely to be the ultimate fundamental driver of stabilisation in global residential markets but the effects of this – as and when it happens – will be much wider felt than just in HK’s residential market. 

Price and interest coverage ratios are signalling that the market is hot.  It is rational to expect an improvement in these ratios, i.e. falling prices, over the next two to three years.  However other unique features of HK’s market should help stabilise prices.  Price and interest coverage ratios are very unlikely to converge to global averages given the gain in house prices over the last decade, which has been a huge exercise in wealth creation. These wealth gains will not be easily eradicated.  Ultimately HK remains an attractive place to live and do business in a regional and global context.  This supports fundamental demand, which when combined with supply-side dynamics, should ensure current pricing trends reflect a healthy market correction, not a crash.

 

 

1. “Mass” from Class A, B & C from RVD and “Luxury” from Colliers Residential Price Index. Data as April 2016.

2. A function of the peg-mechanism between the HKD and the USD.

3. Assuming 70% LTV on a 45sqm apartment for 20 year tenor.

4. Average household size according to Census & Statistics Department is 2.9 which implies an undersupply of around 50,000 units.

5. Stamp duty can be as high as 15% for non-permanent residents. LTV caps range from 40%-70% depending on property value and whether it is for owner-occupation or self-use. 

6. Latest data is at 3% of total transactions vs. 11% in late 2011 pre-policy restrictions.

 

 

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