Hong Kong's major landlords are benefiting from past conditions and actions. Strong balance sheets and good financial management are protecting against elevated vacancies and falling asset valuations. S&P Global Ratings estimates that most office landlords would still have relatively low gearing even in a remote scenario where fair value dropped by another 30%.

This is not to say the pain isn't real. Hong Kong's office markets are under strain from weakening capital-market activities in the city and less leasing demand from mainland China corporates. The city's grade-A office rents will likely decline another 5% this year, adding to a 6.5% drop in 2023. Higher interest rates will also eat into owners' profit and related credit metrics, including EBITDA interest coverage.

We expect the vacancy rate to remain relatively high at about 10% for offices in the prime business district, known as Central. And it would be even up to the high teens for the outskirts of Central or other business districts. Yet new towers are sprouting up, many commissioned during exuberant conditions that earlier prevailed. One relative bright spot for Hong Kong is that hybrid working is not as deep or commonplace compared with other markets.

Hybrid Working Has Not Hit As Hard For Hong Kong

Compared with global peers, Hong Kong office landlords are not as challenged by hybrid-working practices. Office usage in the special administrative region remains high unlike for counterparts in the U.S. or Europe.

Hong Kong's small homes, short commute times, and excellent public transport have encouraged workers to return to offices. In a previous study conducted by the property services firm CBRE, 90% of respondents in Hong Kong worked in the office at least three days a week. This was higher than global and regional averages.

Multinationals are more likely to offer staff more flexibility to work from home. Local and smaller firms, as well as government departments, have pushed for a return to the pre-pandemic norm of staff being present in offices on most days.

Chart 1

Chart 2

Tenant Upgrades An Advantage For Landlords With Prime Quality, Location

Vacancy rates are set to stay high given ample supply. Colliers, a broker, expects 7.9 million square feet (sq. ft.) of new grade-A office space will arrive in Hong Kong over 2024-2026. Vacancies in Central rose to 9.9% at December 2023, versus office vacancy rates in noncore areas such as Kowloon East and Island East in the range of 14%-19%.

Chart 3

Major landlords, especially rated landlords, will continue to benefit from lower vacancy rates than the market. This is thanks to their assets' prime locations, good amenities, and convenient transport connectivity. Occupancy levels for the offices of Hongkong Land Holdings Ltd., IFC Development Ltd., and Swire Pacific Ltd. 's offices in Central have stayed high, at above 90% as of June 2023.

Charts 4

Changes are afoot

At the same time, office owners in Hong Kong are quickly catching up with the need to adopt new green requirements to attract new tenants. Tenant demand for green-certified office space is rising, especially from multinationals. According to real-estate consultancy JLL, the rental premium is also relatively high in Hong Kong because only 30%-40% of grade-A office buildings have "ESG" credentials.

One example is The Henderson, a new grade-A office building in the outskirts of Central with a Platinum certificate from green evaluators BEAM Plus, LEED, and WELL. Slated to open in the latter part of this year, the building has obtained committed occupancy approaching 50% pre-leased despite weak demand in the city, while some other recent new buildings only have less than 30% committed pre-leased.

The Quayside demonstrates the competitive advantage of ESG credentials as well as active lease management and support from anchor tenants. The development is a joint office building owned by Link REIT and Nan Fung International. The Quayside has a Platinum certificate and less than 2% vacancy as of September 2023. This compares to a vacancy rate of close to 20% in Kowloon East, the district in which the building sits.

Chart 5

Grade-A Office Rents Won't Likely Fall As Much This Year

We expect the city's grade-A office rent will decline about 5% in 2024, easing from the 6.5% drop in 2023. Demand from mainland China-based companies has yet to return to pre-pandemic highs. According to CBRE, Chinese firms accounted for just 10% of new leasing activity in 2023, down from 15%-20% in 2019.

More leasing enquiries are likely this year as capital-market activities revive. Auditing firms including Deloitte expect IPO volume could rise to HK$100 billion in 2024, versus just HK$46 billion in 2023.

Chart 6

Higher Cap Rates Are Negative For Property Valuations

Office landlords or companies that have a large portfolio of office assets will likely report valuation losses in the coming results for 2023. Hysan Development (unrated) just reported significant fair-value loss on its investment properties for 2023 while Swire Properties (unrated) telegraphed fair-value losses in a recent profit warning.

As office rents and occupancies remain soft, heightened interest rates are also putting upward pressure on cap rates, squeezing office valuations.

We expect the impact to credit profiles to be manageable. This is because most landlords have relatively low gearing, as measured by debt to debt plus equity. Our sensitivity analysis on eight office landlords shows:

• A 15% fair-value drop of their investment properties would push their average gearing to 25% over 2024--which we consider modest under our criteria. This is even after these companies have, on average, already seen fair value drop by up to 10% over the past three years; these revaluations include assets relating to retail/hotel/offices.
• If we factor in 30% of fair value change to sampled landlords' investment properties, their average gearing rises to 30% over 2024. This level of gearing would be pushing up against the bounds of our "modest" category under our criteria (see "Key Credit Factors For The Real Estate Industry," Feb. 26, 2018). This would still be on par with regional peers and well below global peers (at 40% average gearing).

Chart 7

We also believe the hit to overall asset values will be much lower than in our stress tests. Sizable and growing non-Hong Kong office income adds to the landlords' resilience. For example, these companies on average generate more than half of their revenue from outside their Hong Kong office portfolio. Many of these landlords have sizable exposure to Hong Kong retail, which is seeing positive rental reversions (new leases signed at higher rates than the old) amid improving retail sales and visitor arrivals in the city.

Table 1

Sound Financial Management Will Mitigate Higher Rates

Some companies have already reduced their distributions, including the REITs that are mandated to distribute most of their income. We expect this trend to continue as companies refinance their maturing debt at higher rates than a few years ago.

Landlords have a good track record on capital management, including choices on fixed or floating rate debt to mitigate interest-rate risk. Our sampled landlords on average have 46% of their debt in fixed rates.

We expect the potential interest cost increase will or have eaten up to 8% of the eight sampled companies underlying profit or distributable income for 2023. Correspondingly, we estimate their EBITDA interest coverage could decline to an average of 4.6x in fiscal 2023, from 6.1x in fiscal 2022 and 7.7x in fiscal 2021 (fiscal years ranges can be found in footnote to chart 9).

Chart 8

Chart 9

Additionally, we expect landlords to control spending, thus reducing their debt and interest burden. For example, Wharf REIC's use of floating-rate borrowings saw its average cost of debt triple from 1.4% in June 2022 to 4.7% by June 2023. However, the company partly mitigated the impact by reducing its net debt by 16% over the same period.

Our economists forecast the U.S. will start cutting interest rates in mid-2024 (see "Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking," published on RatingsDirect on Nov. 27, 2023). Given the Hong Kong dollar's peg to the U.S. dollar, the Federal Reserve's easing will potentially reduce the cost of capital in Hong Kong. This should help companies to lower the interest burden in the next one to two years.

Buffers Won't Last Forever

Hong Kong landlords enjoyed nearly a decade of exuberant conditions before the current malaise began. As a result, they have large financial cushions that are helping them buy time and also preserving credit profiles which, by nature, build in downside and expectations that booms tend to settle or reverse.

Chart 10

The landlords we rate also tend to own land in the most desirable locations. As rents drop, some tenants will take the opportunity to upgrade, and this flight to quality is another strength for the major landlords.

As such, some weaker players in the market, mostly the office owners in noncore locations, are already feeling outsized pain. In some cases vacancies are 50%, leading to much larger valuation markdowns relative to market leaders, and some fire-sales of office buildings.

Without, ultimately, a revival in end-demand, bigger problems could start to spread to the bigger landlords. Their buffers won't last forever.

Digital design: Evy Cheung.

Appendix

Table 2

Table 3

Related Research and Criteria

• Real Estate Digest, Feb. 12, 2024
• Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking, Nov. 27, 2023
• Economic Outlook Asia-Pacific Q1 2024: Emerging Markets Lead The Way, Nov. 27, 2023
• Hong Kong Developers Can Push Through The Unfolding Downturn, Nov. 7, 2023
• Industry Top Trends Update 2023 Asia-Pacific: Real Estate Investment Trusts, July 18, 2023
• Asia-Pacific Office REITs: Rising Stress Is Manageable For Most, June 15, 2023
• Key Credit Factors For The Real Estate Industry, Feb. 26, 2018