Via Wolf Street

Big haircuts for investors amid falling rents and rising vacancies. As so often, this started well before Covid, but Covid is speeding up the process.

By Nick Corbishley, for WOLF STREET:

A case in point is the 73-storey Center office block. In late 2017, when Hong Kong’s multi-decade real estate boom was close to its vertiginous zenith, a consortium of business magnates called C.H.M.T Peaceful Development Asia Property bought 75% of the building from the city’s then-richest man Li Ka-shing for HK$40.2 billion (US$5.15 billion). According to real estate agents cited by South China Morning Post, it was the world’s most expensive transaction for a single building.

Each consortium member paid an average of HK$33,000 ($4,260) per square foot for their piece of the deal. The business plan was simple: rather than renting the office space, each member would divide the floors they owned into subdivided office units which they could then sell on to the occupants at a higher price, turning a tidy profit in the process. The plan rested on two basic assumptions:

  1. Many end-users would prefer to own their office in Central rather than pay the lofty rents;
  2. Prices for commercial real estate in Hong Kong would continue to soar, at least until the units had all been sold off.

For a while it seemed to work. In March 2019, one of the consortium members, Raymond Tsoi Chi-chung, sold the last subdivided unit on the 22nd floor for HK$35,000 ($4,520) per square foot — a 6% mark-up on the 2017 price. Two months later, another consortium member, David Chan Ping-chi, sold the 39th floor for the equivalent of HK$42,000 per square foot — 27% more than the average value paid by the consortium in 2017.

But then something strange happened: prices stopped rising, and then began falling, as the city’s real estate market was hit by the mother of all storms. First, Beijing imposed capital controls on money flowing out of China, much of which had been pouring into Hong Kong real estate. Trade tensions between the U.S and China then began escalating, leaving Hong Kong slap bang in the middle of the world’s two superpowers. Then the city was rocked by student protests, which recently met the immovable force of the Chinese Communist Party. And now, there’s the virus crisis.

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In the second quarter this year, the volume of office real estate traded in Hong Kong collapsed by 95%, according to a report by Real Capital Analytics (RCA). That was more than any other major Asia-Pacific market analyzed by RCA.

Values of Class A office buildings in the city fell last year by 7%, the first fall since 2008, according to the commercial real estate services firm JLL; and with Covid-19 thrown into the mixer this year, prices have continued to decline.

That means that the members of the C.H.M.T Peaceful Development Asia Property are now having to sell at a loss. According to a report in Hong Kong’s Sing Tao Daily, Chan Ping-chi just sold his 70% stake in the building’s 42nd floor for HK$405 million ($52.6 million), which works out at an average floor price of HK$27,100 per square foot – 18% less than Chan paid in 2017 and 35% less than what he was able to charge for the 38th floor in May 2019.

The sale marks the lowest price paid for a piece of the Center since the consortium bought it three years ago.

Given that Chan and his cohort reportedly financed their purchase of the Center with bonds paying interest rates of over 15%, if prices stay this low for long or continue to fall, the financial pressures on the consortium could soon become unbearable.

Activity picked up slowly in July, but given the wide bid-ask gaps for office buildings, the number of transactions remained low. And the few transactions that did take place traded at sharp discounts. For example, in recent days a Hong Kong-listed mainland developer reportedly took a 30% haircut on an office investment in the New Territories.

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Average office rents have also fallen for four consecutive quarters, lopping more than 23% off leasing rates since April of 2019, says JLL. In July they dropped by 0.9% city-wide compared to June, after having fallen by 13.2% through the first six months of 2020, JLL reported last month.

“Immediate leasing demand remains weak as occupiers hold off from making larger real estate decisions,” Alex Barnes, head of markets for Hong Kong at JLL said in a statement. “We expect to see more surrender space come to the market in the second half of the year as businesses realize internal occupancy strategies to save on overheads.”

By the end of June, the amount of space surrendered in Hong Kong during 2020 had already reached an 18-year high of 1.3 million square feet, according to JLL. Much of it was in the uber-expensive Central district, where the vacancy rate for grade A offices rose to 5.7%, up from 4% in February 2020 and 2.3% in July 2019. The overall vacancy rate for grade A offices in Hong Kong rose to 7.9% in July, the highest level since 2010.

Last month or two, Chinese investors appear to be coming back into the market, bolstered by the Chinese government’s recent pledge of support for Hong Kong’s status as an international financial hub. But it’s not been enough to turn the market around.

As tensions rise between the U.S. and China, some Western companies are not just downsizing their Hong Kong operations or relocating to a cheaper borough; they’re leaving Hong Kong altogether. On Wednesday, the world’s second largest asset management firm, Vanguard, announced it is exiting Hong Kong and relocating all of its China-focused operations to the mainland.

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Nearly four out of ten members of the American Chamber of Commerce in Hong Kong said in a recent survey they are considering abandoning the city due to the national security law as well as Washington’s imposition of sanctions and the revocation of Hong Kong’s preferential trade status. The EU’s outgoing envoy to Hong Kong also recently warned that the city has lost some of its appeal as a business and financial hub.

This is what sets Hong Kong’s office market apart from those of many other global business hubs. While most office markets are having to grapple with the hugely disruptive forces being unleashed by the virus crisis, Hong Kong’s is facing disruption from just about every direction, including an escalating cold war between the world’s two superpowers. By Nick Corbishley, for WOLF STREET.

Most of the fallout from the Pandemic has been postponed in the UK. But then what? Read… Small Landlords, Tenants, Lenders, Governments Grapple with “Extend-and-Pretend Forevermore”

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