Hong Kong is gradually returning to normal, with widening vaccinations and only some sporadic, quickly contained COVID-19 clusters. For the property sector, this means malls and restaurants are getting more traffic, residential activity is likely to quicken, and more office workers are back at their desks. Nonetheless, S&P Global Ratings anticipates a long journey to full recovery, with the office segment arriving last.

Office properties will be the laggard, in part because of secular demand shift due to work-from-home arrangements. While operating conditions will remain challenging for retail landlords in 2021, the worst should be behind them as rental concessions taper on stabilizing retail sales. That said, lingering travel restrictions will prevent a resumption to peak levels.

Credit profiles of rated developers will remain largely stable propped up by strong balance sheets, solid market positions, and support from the resilient residential segment. That said, negative demand shocks due to prolonged population net outflow could alter our view.

Landlords with higher office exposures, especially to non-core areas, will likely face prolonged rental pressure. However, under a severe sensitivity test applied to our rated Asia-Pacific office landlords, rated Hong Kong landlords should still have sufficient headroom to withstand the overall impact (see "Property In Transition: Remote Working Not Lights Out For Asia-Pacific Office Players," published on RatingsDirect on April 7, 2021).

Office: Tenants' Bargaining Power Surges

Office landlords will likely offer more accommodating terms to new tenants and renewals over the next one to two years. Office occupancy and rental reversion (or new rents after expiry) across all districts have been under protracted downward pressure. Vacancies in Central, the prime business district, more than quadrupled from a low in 2018. The city's overall office vacancies also logged the highest rate since at least the early 2000s, attributable to an unprecedented negative net absorption of 2.7 million square feet (sq ft) of office space during 2020.

Tenant mix could also face further reshuffling over the coming two to three years. Multinational financial institutions have given up floor space in Central to cut costs amid changing work arrangements. Meanwhile, returned space is being filled by largely by mainland Chinese financial institutions. This will likely result in more concentrated exposure to the financial services industry, while tenant quality will likely slip given smaller or more regional nature of incomers.

We believe "decentralization" will continue over the next 12 months as cost-conscious corporates continue to relocate to non-core areas, at least for their back-office functions. Prime locations such as Central may start to attract tenants again if rents fall to an attractive enough level. Flight to quality, and therefore, "recentralization," could happen over two to three years' time, although this is yet the dominating driver.

As such, we believe vacancies may peak and rental rates may stabilize for office properties owned by IFC Development Ltd., Hongkong Land Holdings Ltd., and CK Asset Holdings Ltd. in Central in 2022. While any hits to occupancy for offices owned by Sun Hung Kai Properties Ltd. (SHKP) in West Kowloon and Swire Pacific Ltd. in Quarry Bay should be manageable due to their high quality facilities, pressure on rental rates there could be heavier and more prolonged than their peers in Central. This is reflected in the narrowing spot rent difference between Central and Hong Kong Island East to about HK$62 per sq ft in the first quarter of 2021 from the peak of about HK$94 in February 2019. During the past three years, the average spot rent difference between the two districts was HK$83 per sq ft.

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Ultimately, however, "recentralization" will unlikely offset the outflow, given a resurgence in rents would drive demand for non-core area offices in the longer term. Furthermore, high grade office supply in Hong Kong will leap by over 2 million sq ft in 2021 and over 3 million sq ft 2022, from under 1 million sq ft in 2020. All of the new supply will be coming from non-core areas, mainly in East Kowloon, Cheung Sha Wan, and Quarry Bay. Government proposals to convert five parcels of commercial land in Kai Tak to residential use in March will reduce about 12% of the district's commercial space and could partially curb potential oversupply in what was slated to be a secondary business hub.

Rated Hong Kong landlords will still have headroom to withstand a degree of earnings pressure from lower rents and higher vacancy rates. Their credit robustness, as well as their faith in Hong Kong's prime office market, could be tested during the upcoming auction of the New Central Harbourfront site, touted as the last development spot on the Central waterfront. It will also be a challenge for the winning bidder, given the substantial professional design and hefty lumpsum premium requirements.

Retail: Rental Concessions Will Subside

Although operating conditions will remain challenging in 2021, retail landlords should see retail sales stabilizing over the coming quarters given the easing pandemic situation and a gradual rollout of vaccination across the city. This is despite average sales from December 2020 to February 2021, the traditional retail peak season, being much lower compared with those of past years. They hit a level only similar to early 2010s, due to persistent social-distancing measures and travel curbs.

Therefore, we believe retail landlords will need to continue to renew expiring leases at lower rates in the next 12-18 months, primarily to support occupancy and to capture the lower-spending local demand. For example, some mid-priced retailers focused on athletic gear and face masks have taken advantage to fill spaces returned by luxury or international tenants following the rental correction. Average rents for malls in Central dropped by around 12% year on year during the first quarter of 2021 to a level similar to mid-2010, post the global financial crisis.

Lower rental concessions will be driven by a partial recovery of depressed retail sales. In 2020, HK Land provided temporary rent relief to tenants, which lowered its average net rents by 23%. Retail sales at its high-end luxury mall, The Landmark, dropped about 50% during the initial stage of the pandemic in the first half of 2020. However, by December 2020, the decline had already narrowed to about 11%.

Lack of tourism still weighs

Unless travel barriers are removed and tourist numbers return in a meaningful way, retail numbers may not rebound to their peak levels seen in 2017-2018. Such a rebound is not within our expectations for 2021 given plans for border reopening are still uncertain. Hence, pressure will continue to exist on both occupancy and rental income for our rated landlords who operate mid-to-high end malls, such as IFC, Hongkong Land, SKHP, and Swire.

These landlords are diversifying their trade and tenant mix and looking to increase foot traffic. Necessity-focused, mass-market retailing, such as food and beverage, lifestyle and athletic apparel, are now becoming more prevalent. Tapping into the local demand should help moderate the rental decline and vacancies, but an increase in marketing and promotional costs could also eat into the already lower rental incomes.

On the other hand, nondiscretionary retail sales should continue to be resilient and support peers like Link REIT which benefit from a stronger demand for groceries and necessities. The overall impact on Goodman Hong Kong Logistics Partnership should also remain limited. The company's primary activity of logistics real estate will remain resilient in light of a lack of supply in high-quality warehousing space in the city.

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Residential: Stubbornly Resilient Given Undersupply

Hong Kong residential property prices will be supported by the city's buoyant housing demand, chronic shortage of land and housing supply, and the consistently low interest rate environment. Furthermore, Hong Kong's unemployment rate seems to have come off a peak of 7.2% in February 2021 to 6.8% in March and GDP saw a major revival in the first quarter of 7.8%. During the past two decades, Hong Kong property prices tend to bottom when the jobless rate has or is about to peak. This will underpin developers' residential development margins.

Total transaction volume will likely rise in 2021 due to strong pent-up demand, supporting developers' project sell-through. During the first quarter of 2021, total transactions by volume already surged by 78% from last year's low base. Total transaction volume managed to stay flat in 2020 amid the pandemic impact. Although primary residential volume fell by 27% last year, the drop was offset by a 15% volume increase from the secondary market. At the same time, prices also stayed flat in 2020, according to the Centa-City Leading index.

Over the next two to three years, residential property prices should remain resilient due to a structural supply shortage. A non-governmental organization called Our Hong Kong Foundation estimates that annual private residential completion will be 15,000 units during 2021-2025, slighty up from 14,275 units during 2011-2020. The annual completion rates will, however, slump 20% compared with 2001-2010 and are a hefty 44% down from the 1991-2000 average. The average annual increase of 32,000 households over the past decade also point to a mounting shortage.

Furthermore, major supply from new development areas in northern New Territories will only more significantly come online from 2023 onwards. The first residential land tender in Kwu Tung North was won with a bid about 40% higher than market estimates, demonstrating the confidence level of developers. New supply from the Lantau land reclamation program will be even further away if carried out, likely around 2030. These dynamics will support the credit stability of developers more focused on residential sales like SHKP, CK Asset, and Nan Fung International Holdings Ltd.

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Population Outflow: A Drag To Residential Prices?

We forecast home prices this year will partially regain lost ground from the drop in the second half of 2019, and rise by 0% to 5%. This is due to solid housing demand, shortage of land and housing supply, and the consistently low interest rates.

Although we expect Hong Kong's home prices to remain resilient and the burden on commercial property to be manageable, negative shocks to demand and supply dynamics remain a risk.

Hong Kong's population has been expanding for years, with net annual inflow averaging 32,000 annually between 2011-2019. However, due to travel restrictions and emigration, it went into a net outflow of 39,800 in 2020. While this is a small dent in the total net immigration of 248,400 over the past decade, if the contracting trend continues or intensifies, Hong Kong's deeply pent-up residential demand could be undermined. This is especially the case if the government accelerates land supply—and it has been actively exploring measures to do so.

Demand for commercial space mainly depends on the city's economic prospects. However, a meaningful outflow of professionals and talent could dampen the city's status as one of the world's leading financial centers. This would pose a stronger drag on the commercial properties.

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A Note On Our Coronavirus Assumptions

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing 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

• Property In Transition: Remote Working Not Lights Out For Asia-Pacific Office Players, April 7, 2021