Hong Kong's limited housing supply has long been a burden for home affordability. Now it's helping to save the city's residential market from a sharp correction amid COVID-19 fallout. S&P Global Ratings believes retail and commercial properties could have a harder time recovering from prolonged economic stress in the city.

Even without lockdowns and curfews as elsewhere, comprehensive pandemic measures in Hong Kong have exacerbated pre-existing economic problems. The special administrative region's GDP has shrunk for a fifth straight quarter, on year-on-year comparisons as of Sept. 30, 2020, and unemployment stands at a 16-year high of 6.4%.

In our view, rated property companies have buffers to make it through another year. After this, supply again will prove a deciding factor for credit quality, especially given structural changes, such as work-from-home trends, widely anticipated for global office space.

Unemployment Is The New Drag On Home Prices

We anticipate Hong Kong residential property prices will fall a further 5% in 2021 after sliding by about 7% as at end-October from their peak in June 2019. The key indicator of more weakness ahead is jobs. The unemployment rate is potentially still rising. During the past two decades, Hong Kong property prices tended to bottom only when the jobless rate had peaked or was about to peak (see chart 1).

Chart 1

A shortage of housing remains a safeguard against larger price plunges, in our view. During 2010-2019, private housing completions averaged 13,500 units a year, down about 30% from the previous decade; meanwhile the population has been rising (see chart 2). Falling vacancy rates demonstrate the supply tightness. Private housing vacancies steadily dropped to 3.7% last year from 6.8% in 2002. In the absence of a major population net outflow, housing supply will likely remain tight over the next three to five years. Furthermore, another pillar, low interest rates, will continue to underpin demand.

Chart 2

Pent-Up Demand Will Uphold Volumes

We believe transaction volumes in the primary residential market will rebound in 2021 as social distancing measures gradually ease. From January to September 2020, total transactions by volume dropped only moderately, by 9%. Secondary market transactions jumped 10% over the period, while primary transactions plunged by 41%. We believe this drop was mainly due to developers holding back project launches amid the pandemic. On the other hand, the resilient performance of the secondary market highlights solid pent-up demand.

In our view, rated developers including Sun Hung Kai Properties Ltd. (SHKP; A+/Stable/--), CK Asset Holdings Ltd. (A/Stable/--), and Nan Fung International Holdings Ltd. (BBB-/Stable/--) will be able to weather the impact of slowing sales in 2020, given their strong balance sheets and solid market positions. For example, mass-market residential projects launched by CK Asset in Lohas Park in late June and SHKP in Tin Shui Wai in mid-September have been well received. We estimate 40%-50% of units were sold in just a few weeks after their launches, and at a decent premium to secondary homes in those neighborhoods.

Retail Will Be Subdued For Longer

We believe landlords will continue renewing most of their retail leases at lower rates in 2021. Retail sales have been hit hard by the pandemic, reduced tourism, and high unemployment.

Most landlords will also likely provide special rental concessions to their retail tenants next year, albeit probably less than in 2020. Footfall in retail malls has partially recovered since August as the pandemic and restrictions eased in Hong Kong. However, we don't expect a meaningful year-on-year growth in 2021, given tourism remains sluggish and unemployment high. That said, further downside from the low base in 2020 is limited.

Rated landlords with high exposure to high-end shopping are more exposed, in our view, than peers focused on the mass market. Luxury retail sales have suffered nearly their biggest declines on record (see chart 3). This could result in steeper negative rental reversions (i.e., lower rents on new leases) and higher rental concessions for rated landlords that mainly operate mid- to high-end retail outlets, such as Hongkong Land Holdings Ltd. (A/Stable/--), IFC Development Ltd. (A/Stable/--), and Swire Pacific Ltd. (A-/Stable/--). Luxury retail sales will not recover to pre-COVID levels next year, because some travel restrictions will likely remain in place until at least mid-year. We expect a moderate decline in 2021, off this year's low base.

Nondiscretionary retail, such as supermarkets, has been resilient. As such, we anticipate less rental pressure for Link Real Estate Investment Trust (Link REIT: A/Stable/--), given supermarket and foodstuffs account for more than 20% of its trade mix. From April to September 2020, tenant sales from this segment rose about 14% year on year. This partially offset weakness in Link REIT's other segments, including a 20%-25% tenant sales drop in food & beverage and general retail.

Chart 3

We also expect minimal rental pressure for Goodman Hong Kong Logistics Partnership (Goodman HK: BBB+/Stable/--) because it mainly operates high quality industrial warehouses and data centers, which benefit from a tight supply in Hong Kong. For instance, Goodman HK has already secured a minimum 15-year lease pre-commitment for its Goodman Tsuen Wan West Building 1 development on the back of robust demand for data centers.

Downward Rental Reversions For Offices To Surface

Rising office vacancies point to negative rental reversions in 2021 (see chart 4a). In particular, spot office rents in traditional prime business districts, such as Central, have dropped by more than 20% from a peak in early 2019 to a level now similar to the fourth quarter of 2015 (see chart 4b). In our view, spot prices in prime locations have further to fall, in part due to a continuation in decentralization (i.e. tenants moving to less-prime and cheaper locations).

Economic uncertainty could also limit the pool of prospective tenants, including those from mainland China, which have supported the remarkable rental growth in recent years. This will exert negative rental reversion pressure on office properties owned by rated landlords and developers such as IFC, Hongkong Land, CK Asset, and Swire Pacific. That said, rental reversions only affect the portion of leases coming to expiry. We estimate lease expiries in 2021 varies at 12%-25% of these companies' Hong Kong office portfolios.

We expect decentralization to continue, as companies reap the benefits of lower rents. Spot rents in less prime districts have been more stable than in prime districts, dropping by 12% in East Kowloon since early 2019 and 7% in Island East. Office properties owned by Swire Pacific and Link REIT in those areas could be more resilient during the downturn. For example, Swire Pacific's office buildings, One Island East in Quarry Bay and Three Pacific Place in Wan Chai, have benefited from the relocation of the Securities and Futures Commission and an investment firm, PAG, from Central.

Chart 4a

Chart 4b

Most Are Built To Withstand

Our sensitivity analysis (table below) shows rated landlords have adequate rating buffers. To trigger potential negative rating actions, their Hong Kong retail and office rental income would need to drop to at least their fiscal 2015 levels. In our view, this is unlikely to happen because negative office rental reversions for prime office properties only began in the third quarter of 2020. For example, Swire Pacific was still recording positive office rental reversion as at end September 2020, and Hongkong Land only dropped new rents in its Central office portfolio in the third quarter of 2020. Furthermore, non-core asset disposals, such as Swire Pacific's recent sale of its Cityplaza office building, may help to enhance rating buffers.

Although IFC has a thinner rating buffer than peers, its Hong Kong retail and office rental income grew robustly by about 18% from fiscal 2015 to fiscal 2019. Even if rents continue to hover around the current low levels, we believe it will take at least three to four years before such rental growth will be fully eliminated. That's because rental reversions only affect a portion of the rental portfolio. During the past down cycle, it took three years for Swire Pacific's Hong Kong retail and office rental income to drop by about 15%-20% from its peak in 2001 to trough in 2004.

In the longer run, demand in Hong Kong's premium office spaces could further be supported by the development of the Greater Bay Area (which includes cities in the Pearl River Delta of China and Macau) and the city's solid IPO pipeline. Since our rated developers and landlords operate mainly premium office properties in prime locations, we believe their underlying portfolios have enduring value. We also think Hong Kong is less vulnerable to structural shifts in office demand post-COVID than other markets (see next section).

Link REIT has the highest exposure to retail rentals among our rated Hong Kong property companies. In our view, the trust has an adequate rating buffer due to its resilient mass-market exposure. For the half-year ending September 2020, negative reversions amounted to only 2.6% of its retail portfolio.

For Hong Kong developers, the expected rebound in home sales volume should shield them from weaknesses in their rental portfolios.

Structural Change: Why Hong Kong Is Less Vulnerable To WFH Trends

COVID-19 has sparked a secular shift in office demand globally. In our view, work-from-home (WFH) will continue to be adopted, to a lesser capacity, even after the COVID crisis has passed. This supports our negative view on global office space. However, in Hong Kong, the WFH impact could be slower and lower. This city has one of the smallest average home space per person in the world, making working from the office more appealing to many employees. Commutes are relatively short and public transportation is convenient.

Even with these distinctive factors supporting incentives to work in the office in Hong Kong, a global paradigm shift might still change the local landscape. Employers have incentive to reassess their needs for office space and some may find options to reduce floor space and save on rent.

Although new premium-grade office supply in traditional prime business districts are still scarce over the next one to two years, major projects in Central such as the Hutchison House redevelopment by CK Asset, and the Murray Road Car Park redevelopment by Henderson Land Development Company Ltd. (unrated) will gradually come online starting in 2023.

The pipeline could also be replenished by other large commercial land auctions including the New Central Harborfront commercial site adjacent to International Finance Center, the redevelopment of a site at Caroline Hill Road in Causeway Bay, and various remaining lots in Kai Tak, site of the old airport. Perhaps the best indicator for the office sector's prospect would be the reception and success of these auctions or rather their withdrawal or flop.

A Note On Our Coronavirus Assumptions

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

• Swire Pacific's Asset Sale Eases Tight Rating Headroom, Nov. 10, 2020
• Sun Hung Kai's Diversified Property Portfolio Will Offset Tough Operating Environment, Sept. 11, 2020
• Past Gains Help Hong Kong Property Companies Face Another Round Of Disruption, March 30, 2020.