Hong Kong: housing market in balance?

Hong Kong’s volatile residential property market has stalled, after a characteristic euphoric surge over the past year.

During the 2nd quarter of 2008, prices fell in several segments of Hong Kong’s property market. Smaller sized apartments (Classes A to C) were especially hit badly; the price of property class C (70 – 99.9 sq. m.) in Kowloon fell 13.5% from the previous quarter.

However, property prices were strongly up over the year. The overall index rose 25.4% (19.4% in real terms) to end Q2 2008 from a year earlier, according to the Ratings and Valuation Department (RVD). The highest price increases took place in the larger Class E apartment size (160 sq. m. and over).

From July 2003 to May 2005, the residential price index soared 63% (62% in real terms). Property prices paused in 2006, but from Aug 2006 to Aug 2008 the residential price index has risen 32.4% (23.5% in real terms).

These violent price swings are typical of Hong Kong. The property bubble before the handover saw prices rise 70% (54% in real terms) from Oct 1995 to 1997. Then there was a traumatic burst, coinciding with the Asian Crisis, and property prices fell 44% in one year (Oct 1997 to 1998). From the peak to the mid-2003 trough, prices fell 66% in nominal terms (61% in real terms).

Hong Kong’s housing market has five key interlinked features:

1. Housing prices are extremely unstable.
2. House price changes are among the highest in the world.
3. Land supply is extremely limited and can be released by the government at will.
4. New property developments are concentrated among a few big developers.
5. The public housing sector is one of the biggest in the world.

The interplay among these factors makes analysis of housing market complex and predictions for future price changes difficult. Hence, it is difficult to tell whether the latest price falls is a hiccup, or worse.

Rents and yields

Prices have risen over the past three years somewhat more than rents. Indeed prices of higher-end apartments have risen by strikingly more than rents.

Mid-Level apartment gross rental yields are now at 3.7% for 120 sq m. apartments, according to Global Property Guide research (April 2008). Yields of apartments on Victoria Peak, Hong Kong’s most prestigious address, are around 2.9%.

Our yields figures are closely in line with those issued by the Hong Kong Census and Statistics Department.

Cheap money, speculation and pre-selling

Interest rate movements strongly affect Hong Kong house prices, especially as more than 90% of Hong Kong mortgages are at variable rates. As a by-produce of its fixed exchange rate regime, Hong Kong must accept US interest rates. This is sometimes awkward because U.S. interest rate movements may be counter-cyclical with Hong Kong’s economy, which is increasingly intertwined with China’s.

The Hong Kong best lending rate, the basis for mortgage interest rates, fell from around 10% in 1998, to under 5% from 2003 to early 2005. This had dramatic effects on the housing market, especially as for structural reasons, the fall in Hong Kong mortgage rates was significantly larger than the fall in US rates.

The causes of the excess fall in mortgage interest rates were threefold: 1) The gradual elimination of the Interest Rate Rules of the Hong Kong Association of Banks from 1999 to 2001; 2) Measures taken by the Hong Kong Monetary Authority to relax market entry criteria; and 3) The formation of the Hong Kong Mortgage Corporation (HKMC) in 1997, which allowed banks to offload parts of their mortgage portfolio to the HKMC and securitize the rest.

Most new properties in Hong Kong are pre-sold, i.e., sold before completion. The prevalence of pre-selling tends to accentuate Hong Kong’s house price cycles. If the market strengthens, a property investor can reap huge returns once the property is sold when it is completed. However, if the market suddenly nosedives, the buyer can minimize his losses to the reservation fee buy cancelling the agreement.

Diminishing mortgage market

However despite the reduction in mortgage interest rates, a diminishing proportion of property purchases have been financed by mortgages. Mortgage loans outstanding have dropped from 42.9% of GDP in 2003, to 35% of GDP in 2007, despite the considerable rise in transaction volumes, and in house prices.

Another illustration: when house prices rose at double digit rates in 2004 and 2005, the number of housing sale-purchase transactions shot up to more 100,000 per year. But outstanding mortgage loans grew by less than 1% annually.

It is interesting to note that while loans for houses purchase were relatively constant during the house price booms of 2004 and 2005, loans for other private purposes surged 14.5% in 2004 and 11.3% in 2005, while the overall amount of loans and advances rose only 3.3% in 2004 and 2.5% in 2005.

And in the current house price boom, loans for house purchases rose 8.96% y-o-y to 2Q 2008 while loans for other private purposes surged 30%. The overall loan portfolio rose by only 3.8% over the same period.

Clearly, Hong Kong residents have been borrowing to invest in the housing market, but using loans rather than mortgages to do so.

In line with the US, Hong Kong’s best lending rates rose to 8% in April 2006. They remained there until Oct 2006 before being slightly adjusted downward. With US interest rates brought down to 2% in April 2008, Hong Kong’s rate also eased to 5.25%.

Construction and housing supply

Since the most recent phase of the Hong Kong property bull market actually began before the recent fall in interest rates, clearly other factors than interest rates are at work. Arguably, a reduction in dwelling completions has overlapped with, and accentuated the property boom.

Hong Kong has a population of 7 million and land area of 1,104 sq. km., about the same as New York City (pop. 8.2 million and land area 1,214 sq. km). As a city, Hong Kong does not have real suburbs where the population can spill over (some workers commute across the border to mainland China, but strict immigration rules limit this). Because of this, property prices in Hong Kong are sensitive to changes in the dwelling stock.

The British handover in 1997 in theory lifted the annual supply constraint on new land sales. Tung Chee-hwa, the post-transition chief executive, pledged in 1997 to construct 250,000 dwellings units for the next ten years despite the ongoing housing slump. From 1998 to 2004, an average of 28,000 dwellings was completed annually.

After Tung stepped down in March 2005, completions dropped to around 17,000 per year in 2005 and 2006. In 2007, only 10,471 dwellings were added to the stock of 1,079,243 private domestic units.

With the increase in completions, vacancy rates rose - from 5.4% in 2000, to 6.8% in 2003. Then after 2004 housing demand picked up, and vacancy rates gradually dropped to 4.9% in 2007.

Tenancy Laws

The deregulation of the private rental market provided an additional push to the housing market. In July 2004, the government relaxed the provisions of the Landlord and Tenant (Consolidation) Ordinance. It removed security of tenure and made lease termination easier and faster. Landlords can also evict errant tenants easier.

With tenure security removed, previous tenants, especially rich foreigners and expatriates, may have perceived that rental are now less stable forcing them to purchase property.

Public housing

The strong presence of the government in providing housing in Hong Kong tends to distort house prices. Around 45% of 2,479 million residential flats in Hong Kong are under the public housing scheme, mainly through the Hong Kong Housing Authority (HKHA).

As of March 2008, about 29% of Hong Kong's population lives in public rental housing (PRH) estates. While it actually declined from 31% in 2004, it was still one of the highest rates in the world. There are around 726,600 PRH units. The government also provides interim housing to some households for households not eligible for permanent public housing.

Since 1978, the government had sold 455,800 subsidized flats to low and middle income households through the different programs such as the Home Ownership Scheme (HOS), the Private Sector Participation Scheme (PSPS) and the Tenants Purchase Scheme (TPS).

In 2003, the government decided to scrap set goals for homeownership rate and ceased the production and sale of HOS flats. The PSPS and TPS were also terminated. Owner-occupancy rate increased from 28% in 1981 to 57% in 2004, before sliding down to 53% in 2007.

The deregulation of the housing market seems to benefit the private rental sector. The percentage of the population living in the private rental sector grew from 12% in 2004 to 14% in 2007.

Final verdict

Interest rates in Hong Kong were slashed by a total of 1.5 percentage points to 2% in October 2008, matching interest rate cut in the US. This can help the housing market burst further. However, the global economic slowdown is a greater threat. The collapase of financial institutions in the US and Europe will definitely resonate to Hong Kong.

In September 2008, transaction levels were down to the two-year low. Banks have tightened lending - especially to expatriates without Hong Kong-sourced income. In addition, valuations seem clearly over-extended. Yields are very low.

The decline seems to be most visible in the high-end market, which is likely to be most affected by the credit crunch, by lay-offs at investment banks due to the US financial turmoil.

Rapid economic growth, which helped fan the flames of speculation, is quickly loosing steam. The economy expanded by 8.05% in 2004, the highest since 1988. It was followed by a 7.08% growth in 2005, 7.02% in 2006 and 6.3% GDP growth in 2007. The economy is expected to slowdown to 4% in 2008 and 2% in 2009.

A housing market slowdown is imminent within the foreseeable future, unless the government suddenly relaxes immigration rules or completely halts all construction activities. But as always, Hong Kong has an infinite ability to surprise.