Hong Kong's commercial real estate (CRE) sector is working through its worst downturn since the Asian financial crisis. S&P Global Ratings expects the sharpest pain to be felt by lower-tier or financially aggressive property firms, and the small banks most exposed to these entities.

Recent data speak to the scale of this downturn. Hong Kong's grade-A office property values have dropped by 40% from the peak in 2018. Headcount among the regional headquarters of multinational firms in the city are down about one-third to roughly 132,000 as of end-2023. Retail rents have slipped 13% from the pre-pandemic era.

We define lower-tier property firms to be mostly small landlords that own office and retail properties. Small developers will also get squeezed if they have exposure to these office and retail properties.

Hong Kong's large banks are not immune. As of June 2024, two major banks in the city, Hongkong and Shanghai Banking Corp. and its subsidiary Hang Seng Bank Ltd., reclassified about 8%-10% of their loans in Hong Kong CRE as credit-impaired. The banks viewed the loans as problem loans even though a significant portion of the borrowers were still current on payments of interest and principal. This reflected cash flow strains amid high interest rates and low rental yields. Despite this reclassification, the banks did not incur any material loan-loss provisions related to these exposures.

The reclassification reflected the steepening refinancing risk of borrowers. It also suggests that other lenders may also shortly recognize some portion of their Hong Kong CRE loan book as impaired.

We assume further that the current high interest rates are squeezing landlords and developers that borrowed to fund projects. Increases in interest costs caused the net earnings of major landlords and developers to drop by 8% in 2023.

Moreover, individual investors or other small property firms that borrowed to fund properties on the expectation that rental yields would cover their costs are typically now finding that is not the case. We believe some of these investors may be forced to sell properties at hefty discounts, amplifying the downturn.

Many have also increased leverage on their properties. Especially during the period of low interest rates before 2022, most of those nonprime property owners used cheap financing from small banks or nonbank financial institutions to buy property. This has encouraged lending at high loan to value (LTV) levels, which has gotten some borrowers in trouble.

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Hong Kong's CRE Drop--A Global Story With Chinese Characteristics

The office sector will have hard time to absorb rising supply.   Hong Kong's declining office rents and rising vacancies are part of a story that is now well told. The global CRE sector has been hit by work-from-home trends since the COVID outbreak.

Hong Kong's downturn has been less affected by such trends. However, the post-pandemic economic recoveries in the city and in mainland China have been weaker than we initially expected. As a result, leasing demand from mainland China corporates and local expansion have fallen short of property firms' expectations.

Since 2019, the number of regional headquarters of multinational firms based in Hong Kong has dropped 13%, according to the Hong Kong Census and Statistics Department. The volume of staff these firms employed in Hong Kong has dropped by 32% to just 132,000 people by end of 2023.

According to Jones Lang LaSalle, the city's grade-A office vacancy rate was 13.4% as of end-August 2024, more than double the pre-pandemic (November 2019) level.

Meanwhile, supply keeps rising. From the fourth quarter of 2024 through to end-2026, 7.9 million square feet (sq. ft.) of new grade-A office space will likely come to the Hong Kong market, equal to about 9% of the total stock now in the city.

Prospective tenants cannot absorb all the new space. This includes The Henderson, a futuristic glass-and-steel tower that recently launched in Hong Kong's central business district, which is only about 60% leased. It was built on a US$3 billion plot of land, reportedly the world's most expensive building site when Henderson Land Development Co. Ltd. bought it in 2017.

Hong Kong's vacancy problem will be particularly hard on recent and impending new completions, or projects that entered construction during 2018-2022. Landlords will have a hard time finding tenants for these sites.

• Grade-A office rentals dropped 5% in the first eight months of 2024, according to the Hong Kong government.
• We assume the city's grade-A office rents will fall about 7% this year, and another 5% in 2025.

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Structural Changes To Depress Hong Kong Retail

Hong Kong retail sales have been soft, in line with a weak economy. Moreover, an increasingly entrenched habit among locals to make shopping trips across the border in neighboring Shenzhen is also hitting Hong Kong retail (see "Hong Kong Retail Property: Survival Of The Fittest," July 7, 2024, and "Hong Kong Retail Property: Can The Resilience Last?" March 26, 2024, published on RatingsDirect.

We expect the retail sales pressure to continue into 2025 given the challenges in the sector. An increase in interest by consumers in international online shopping sites--such as mainland China's Taobao.com--are also eating into traffic at physical stores. For the first eight months of 2024, Hong Kong retail sales were down 8% year on year.

Some streets in popular shopping districts are seeing steep declines in rents amid vacancy rates of 20%-plus. Retail-focused buildings in prime retail districts typically have vacancy rates of around 10%.

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Strains In Hong Kong CRE Are Spilling Over To Banks

Hong Kong's CRE downturn will likely weigh on banks' asset quality, especially for smaller lenders that are heavily exposed to that market. Property development and investment loans in Hong Kong accounted for about 16% of systemwide total lending as of end-June 2024. Out of this, about 9% was related to mainly commercial (including office and retail) and industrial properties, while the remaining 7% was to residential properties, by our estimate.

We believe large banks to have manageable exposure to Hong Kong's CRE firms and expect related credit losses to be contained. We define large banks as the three largest banks by assets, which are Hongkong and Shanghai Banking Corp. (including Hang Seng Bank), Bank of China (Hong Kong) Ltd., and Standard Chartered Bank (Hong Kong) Ltd. They mainly lend to the largest developers and landlords, which typically own property in prime locations, and which have pledged substantial collateral against their loans.

Secured lending comprises about 60%-70% of the loans by Hong Kong's large banks to domestic property firms. We estimate the average LTV ratio of this secured lending to be healthy at 45%-55% as of end June 2024. This provides a buffer against a significant drop in property prices, although the LTV ratio could somewhat increase following revaluations amid subdued property market conditions. Major banks typically update collateral valuations annually, or more frequently.

Unsecured loans make up about 30%-40% of the large banks' Hong Kong's CRE loans. However, such lending is mainly to conglomerates with diversified income streams. Hong Kong banks also have recourse on their loans to these landlords; this should cushion potential loan losses in a stress scenario.

We believe Hong Kong banks will likely recognize additional Hong Kong CRE loans to be credit-impaired in the second half of 2024. This will push up the sector's ratio of nonperforming assets (NPAs) to total gross loans to about 2.2% at end 2024, from about 1.9% at mid-year. The sector's NPA ratio will likely then inch down over the next two years.

Hong Kong's major banks have been subjecting their CRE portfolio to several rounds of stress testing, which has helped in identifying weakness and applying corrective measures. We also expect a likely decline in interest rates in Hong Kong will provide gradual relief for the property firms' debt-servicing capacity.

Hong Kong's Small And Midsize Banks Could Be Squeezed

Our estimate of the industrywide NPA ratio suggests the pressure from bad loans will be manageable over the next few years. However, the figure obscures what may be acute pressures percolating below the surface for small and midsize institutions, especially those with heavy CRE exposures.

We define small and midsize banks as 15 licensed banks outside of the three largest lenders in Hong Kong by assets. These lenders account for about one-third of systemwide loans. However, they account for about 42% of the total property development and investment loans in Hong Kong, based on our estimates. This means they are much exposed to the property sector in Hong Kong relative to their total lending, compared with large banks.

Small and midsize banks are also likely to be more exposed to small property-firms or developers that are aggressively leveraged or heavily exposed to nonprime properties.

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Small and midsize banks could face heightened volatility in their asset quality and credit losses over the next few years. As more CRE loans come due for refinancing over the next few years, nonperforming loans and debt restructuring pressures could increase for these banks, in our view. This will be particularly true if high vacancy rates and low rental yields lead to further strains in the debt-servicing capacity of property firms.

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Hong Kong Banks Have Been Through Many Property Market Cycles, And Will Use That Experience To Manage This Downturn

Hong Kong's banking sector has withstood severe stress through economic cycles with considerable resilience. For example, during the 1997 Asian financial crisis, the territory's private office price index fell about 52% from mid-1997 to end-1998. The index is a government measure of prices of privately owned office buildings.

During this period, rocketing interest rates impaired the debt-servicing capacity of property developers. Hong Kong banks' nonperforming loan ratio (excluding mortgages) rose to about 12.5% in September 1999, an almost fivefold increase from the pre-crisis level.

Continued declines in values of office and retail properties in the coming years could require large banks to add loan-loss provisions to cover the reduced collateral values of CRE loans. That said, their healthy loan-to-value ratios, their reliance on secured lending, or unsecured lending with recourse, will contain the strains.

In addition, a likely decline in interest rates in Hong Kong will provide gradual relief for the landlords and property firms' debt-servicing capacity and refinancing conditions, in our view. We anticipate interest rates in Hong Kong will decline from the fourth quarter of 2024, mirroring the U.S. Fed Funds rate. Following the U.S. Fed's rate cut of 50 basis points (bps) in September 2024, we expect an additional easing of 50 bps in 2024 and 125 bps in 2025.

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Commercial Property: Another Crunch For This Stress-Tested City

Hong Kong's commercial property market outlook remains challenging. We expect Hong Kong's business environment and shifting consumer preference will continue to weigh on office space and retail rentals.

The pressures on the commercial property sector will stress leveraged property developers and investors' debt-servicing capacity. While the Hong Kong banking sector was well-tested in previous property cycles, small and midsize banks in Hong Kong with concentrated exposure to the office and retail property sector could still face stress on asset quality and volatile financial performance. Major Hong Kong banks can't avoid the strain, but the challenge is likely to be manageable.

Writer: Jasper Moiseiwitsch

Digital Designer: Evy Cheung

Related Research

• Major Hong Kong Banks Can Manage Commercial Real Estate Risk, Sept. 24, 2024
• Hong Kong Retail Property: Survival Of The Fittest, July 7, 2024
• Hong Kong Retail Property: Can The Resilience Last? March 26, 2024
• Capping The Cap Rates: How Hong Kong Office Landlords Are Managing, Feb. 25, 2024