Why HK office market will continue to do well

June 22, 2016 16:52
Many office hubs have  diversified to host different industries, including finance in Central, retailing in Island East, and corporate back office in Kowloon East. Photo: Internet

The US Federal Reserve has decided to keep interest rates unchanged, making it improbable for the federal funds rate to have a 1 percent increase in 2016, which has been the consensus expectation at the beginning of the year.

For the remainder of the year, market consensus is to expect two increases, bringing the total hike to 0.5 percent.

Moreover, the Fed reconfirmed that keeping inflation at around 2 percent is a major policy goal.

Since inflation pressure has been smaller than they originally expected in the beginning of the year, the Fed has signaled that rate increases in 2017 and 2018 will be more moderate than previously expected.

The slower inflation pressure is a reflection of multiple factors, including a global oversupply in some industries, such as steel and concrete, and technological advances that lowered transaction costs in some industries.

In other words, the existing investment environment of ample liquidity and low base interest rate will continue to be the norm for the foreseeable future.

In the short term, this more benign environment supports pricing of real estate and related instruments such as real estate investment trusts and real estate stocks.

However, decades of research have consistently showed that real estate rents correlate positively with long-term inflation.

Thus, if the current round of weaker inflation expectation leads to a downgrade of long-term inflation forecasts, expected medium- to long-term rent increases may also be downgraded.

Since real estate price is ultimately anchored on rent expectations, a weaker rental forecast could lead to price uncertainty independent of interest rate movements.

Fortunately, Hong Kong has recorded rental increases, especially in office rents, this year. This suggests that the city's position as a hub for corporate headquarters remains entrenched.

Traditionally, the strongest tenant demand came from finance and related industries, but gradually Hong Kong has drawn in other industries, such as international retail brands in Island East.

Our common law system and mature transportation infrastructure, among other factors, have kept interest in Hong Kong despite our high office rents.

For western companies, Hong Kong can serve as regional headquarters for Asia or China; and for Chinese companies, the city's talent pool can help them establish a globally oriented organization.

The Grade A office vacancy rate in Hong Kong is currently about 2 percent. Given that a 5 percent vacancy rate is typically seen as the equilibrium, Hong Kong’s office market remains tight.

Vacancy rates of the major districts range from less than 1 percent in Island East to about 4.5 percent in Kowloon East, which are all below the equilibrium level.

Upcoming office supply is also manageable. The average supply of Grade A office space between 2016 and 2020 is about 1.6 million square feet per year, which is in line with the 10-year average between 2006 and 2015.

Given the existing 2 percent vacancy rate currently observed, the market is currently undersupplied by about 2.4 million square feet – one and a half years of our current pipeline.

New office districts have gradually become more entrenched.

Kowloon East, for example, ha seen significant supply increases virtually every year for the last 10 years, but its vacancy rate has now dropped to below 5 percent.

Various office nodes have also diversified to host different industries, including finance in Central, retailing in Island East, and corporate back office in Kowloon East.

The diversification increases the appeal of the districts, as each district continues to evolve to better serve a particular clientele.

It also creates a natural clientele for each district, and this improves the health of the overall Hong Kong office market by reducing demand swings created by relative price movements.

For instance, since luxury brands now see Island East as a better fit, a relative reduction in Central rents is not likely to lure them into leaving Island East.

Furthermore, in any city, the stability of a real estate market is correlated with its total size.

In some smaller cities, such as Perth, the total office stock is so small that a single new building can add 5 to 10 percent of space to the market, and a major tenant’s expansion can soak up almost all vacancy.

This generally leads to shorter and more volatile real estate cycles.

Hong Kong, on the other hand, has added over 50 million square feet of Grade A office space since 1990, expanding its total Grade A stock to about 80 million square feet, a level comparable to that of London and New York.

While real estate is by nature a cyclical industry, we believe that the larger stock, built with each passing cycle, will dampen the overall volatility and further enhance the Hong Kong office market’s position as a core asset class for domestic and overseas investors.

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Chief Investment Officer, Admiral Investment Ltd.