After rallying by as much as 27 percent in 2016, Asia Pacific REITs had a correction in October and November and ended the year with a 10 percent total return.
Since then, the performance has been stable and the REITs are now about 5 percent higher than the trough we saw in mid-November.
The correction was triggered by geopolitical concerns, especially the effects of Donald Trump’s presidency on interest rates and the wider economy. But some sub-sectors, such as Hong Kong retail, have seen weaker fundamentals in the past two years.
Since malls exist to facilitate retail trading between retailers and customers, retail sales growth is a key determinant of mall performance in the medium to long term.
Since early 2015, Hong Kong’s retail sales growth has been falling, driven by consolidation in the luxury and jewelry trade.
Without the expectation of further sales growth, retail rents have fallen from its peak in 2012 and 2013, with some premises, mostly street shops that dominate prime shopping areas, seeing falls of as much as 30 percent.
This fall contrasts with continued rental growth in the office and residential markets which are supported by more robust demand.
After a year of retooling, however, retail sales stabilized, showing improvement almost every month in the second half of 2016.
Although negative retail sales growth may persist for several more months, we may be seeing light at the end of the tunnel. We expect retail sales growth to finally turn positive in 2017.
As with all economic recoveries, the self-healing of Hong Kong retail is driven by both retooling by existing players and innovation by new ones.
There have been high-profile shop closures, such as Page One and A&F’s Central Flagship stores.
However, existing players have adapted to the new economic reality. An iconic Central street shop, for example, has leased its space to a sports retailer instead of a luxury retailer, reflecting changes in taste and demand.
Similarly, a leading tea restaurant chain has refocused its brand toward the mass market, introducing measures such as new menu items to regain its innovative image.
These measures, taken collectively, will remold the retail offering to better suit Hong Kong’s ever evolving needs.
Once retail sales stabilize, we believe that retail rents should follow.
Two distinct negatives, however, may continue to weigh on the retail sector.
First, since the Hong Kong dollar is pegged to the US dollar, the United States entering an interest rate upcycle means that Hong Kong is likely to enter an upcycle as well.
Thus, a retail sector that is still retooling may not generate enough sales and rental growth to sustain interest rate increases.
However, long-term interest rates seem to be on a more gradual increase than short-term rates.
Using the latest available forward curve, 10-year US interest rates will rise by 13 bps in a year and 21 bps in two years, which is less than the market’s expectation of a 52 bps increase in short-term rates one year out.
In other words, the market is not expecting a material increase in interest rates in 2017. This level of increase would provide some breathing room for the retail sector to retool.
Second, web retailing, as expected, has begun to take a foothold in Hong Kong, with some consultants estimating as much as 5 percent of retail sales now conducted online.
However, much online sales are driven by existing retailers, and a continued physical presence would help them strengthen their online brand.
This marketing effect is not lost to the web-only retailers. One of them even decided to open physical shops to further penetrate its target markets, and other startups have targeted physical locations such as flower market stalls.
We believe that, similar to Australia, web retailing can complement physical retailing when retailers decide to expand both channels instead of focusing on one.
While it will take some time to develop the precise economic model, embracing web-retailing can actually help existing retailers and mall operators gain further traction.
Hong Kong retailing is in its early days of recovery, and not every indicator is back to normal. However, the sector as a whole has stabilized, and it can be an upside surprise for 2017.
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