Asia

Has Hong Kong peaked? (Part II of III)

According to the Wall Street Journal, Hong Kong is in a frenzy following the arrival of a giant inflatable duck in Victoria Harbour.

The WSJ even reports that the Hotel (…no connection to OfWealth…) is offering a “Giant Yellow Duck package” with “breathtaking duck views”. Well, I suppose that some people will buy almost anything…

In Part I: Has Hong Kong peaked? we looked at how Hong Kong property (real estate) has rocketed up in price over the past decade. In other words it’s not just the big yellow duck that has been inflated. Also I outlined some of the factors that can make Hong Kong’s real estate prices more volatile than most other markets. Today I’ll turn to some of the specifics of the current market.

Hong Kong Real Estate is expensive

Prices are high. Savills, the property agent, was recently offering a newly built, two bedroom, 47 square metre (506 square feet) apartment for US$1.5 million. Yes, that’s US dollars…not Hong Kong ones. It works out as US$31,172 per square metre (US$2,896 per square foot). Apartments, admittedly large ones, have changed hands for as much as US$60 million in recent months.

According to a Demographia, a consulting company that conducts an annual affordability study for housing, homes in the city cost an average 13.5 times gross (pre-tax) median income in January.

This places Hong Kong firmly into Demographia’s “severely unaffordable” category, which applies to any city with a ratio above 5. In fact it makes it the least affordable market out of 81 surveyed, behind second placed Vancouver in Canada (with a ratio of 9.5) and third placed Sydney in Australia (8.3).

Hong Kong does have much lower taxes than most places, so net (after-tax) incomes are much higher. The top rate of personal income tax is 17% of earnings. (Also there is no tax on dividend income, capital gains or inheritance. No wonder so many people want to achieve permanent residency there…)

…even the low tax rates can’t fully justify the inflated property valuations.

But even the low tax rates can’t fully justify the inflated property valuations. London in England is another financial centre with a lot of rich foreigners that help wealthy locals to bid up prices. Hong Kong has its mainland Chinese, London has its Russians, and both have their investment bankers.

In London the ratio of home prices to gross median incomes is 7.8, making it the 6th least affordable city in the world. However the top rate of income tax paid by Londoners is 45%.

There are a lot of complicating factors at play. But put simply – our favourite way at OfWealth – well paid Londoners keep around 55% of their incomes and the well paid of Hong Kong keep 83%. This broadly means that for every unit of gross income earned, people in Hong Kong keep 1.5 times as much net income as Londoners get to keep (83% divided by 55% equals 151%).

By dividing Hong Kong’s ratio of home prices to median earnings by 1.5 we get a rough idea of how it compares to London, adjusted for income tax rates. So 13.5 divided by 1.5 is 9.0, still well above London’s 7.8 (and only just behind Vancouver’s 9.5). And remember, London is still defined as “severely unaffordable” by Demographia.

Hong Kong prices would need to fall by two thirds before they qualify as affordable.

In other words Hong Kong real estate prices are extremely high, even taking account of the low tax regime. Demographia defines “affordable” as anything with a ratio of under 3.0. So even at the adjusted level of 9.0, Hong Kong prices would need to fall by two thirds before they qualify as affordable. This would take them back to levels last seen in early 2004 (see chart in Part I: Has Hong Kong peaked?).

That sounds a bit excessive perhaps. But on the other hand median incomes in Hong Kong only rose 20% between 2001 and 2011. Real estate prices were up 120% over the same period, and are now up over 160% since 2001. A fall in property prices of 30% to 50% certainly seems possible.

Two big factors are acting to slow the market. On 22 February the government doubled the stamp duty, a transaction tax, on all transactions over HK$ 2 million (USD$ 258 thousand). This follows a number of tax changes since 2010 which have been designed to slow down price increases.

The volume of transactions was already down 40% between 2010 and 2012 and is expected to fall again this year. A fall in volumes is usually a lead indicator for falling prices, as sellers start to cut prices to make a sale.

On the same day that stamp duty was increased, banks in Hong Kong were told put aside more capital for their mortgage lending. This means they must charge more interest on the mortgage loans if they want to preserve profits (return on equity).

The big banks such as HSBC, Bank of China, Hang Seng and Standard Chartered have already increase rates by 0.25%. However mortgage rates in general still remain low, typically in the range 2.4% to 3.5%. Despite these low rates people in Hong Kong typically spend around half of their incomes on housing costs.

China and Asia have been booming but money has been cheap. Similar situations occurred in the USA up to 2006 and places such as Spain and the UK in Europe

These ultra low rates, a symptom of the Hong Kong dollar’s peg to the US dollar (see Part I: Has Hong Kong peaked?), are a big factor in the creation of the bubble. China and Asia have been booming but money has been cheap. Similar situations occurred in the USA up to 2006 and places such as Spain and the UK in Europe. Asset bubbles are very often inflated on the back of cheap credit.

But now, with the government clamping down and mortgage rates on the rise, a number of analysts are expecting prices to fall in 2013. For example Deutsche Bank analysts are predicting a fall of 20% this year.

There are plenty of reasons to believe that Hong Kong real estate is heading downwards. It could even fall sharply and surprisingly quickly. I’ll turn to how this could affect the stock market in part III. It could be time to duck out of Hong Kong stocks and shares.

Stay tuned OfWealthers…

Until next time,

Rob Marstrand,

robmarstrand@ofwealth.com

Do you live in Hong Kong or have experience of living there? Let us know your thoughts on the current situation? Leave your comments below.

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.