Treasure island

Private equity real estate firms are looking to capitalize on Hong Kong's recovery. But as China's development continues unabated, will the mainland's economic emergence eventually threaten the city's prosperity? By Robin Marriott

On June 30, 1997, Chris Patten, the last governor of Hong Kong, delivered his farewell speech as Britain handed the province back to the People's Republic of China after 150 years of rule.

“The story of this great city,” Patten said, “is about the years before this night and the years of success that will surely follow it.”

That same day, Tung Chee-hwa, head of the new Special Administrative Region handpicked by Beijing, delivered a similar address at his inauguration.

“Hong Kong and China are whole again,” he said.“We value this empowerment and we will exercise our powers prudently and responsibly.”

Almost ten years later, it can be argued that both statements have proved reasonably correct as Hong Kong appears to be flourishing under Beijing's guidance. The Hang Seng Index is currently riding a six-year high. The number of tourists to Hong Kong rose 11.2 percent in August to 2.4 million, more than half of whom came from mainland China, according to the city's tourism board. Luxury shopping brands such as Louis Vuitton, Chanel and Prada are enjoying strong trade as Hong Kong's retail sales are up nearly 7 percent this year. And hotels are running at almost 90 percent capacity while the city's restaurants are humming with conference delegates and businessmen.

Underlining the confidence in the seemingly harmonious marriage, private equity real estate firms have been actively buying up property assets in Hong Kong. In March, Morgan Stanley Real Estate Fund bought the DBS Bank building for HK$655 million ($84 million; €66 million). The following month, the investment bank teamed up with Gateway Capital and Pamfleet to acquire the Hang Seng Bank Building for HK$2.3 billion. And in recent months, Macquarie Global Property Advisors paid out HK$2.4 billion for the Grand Millennium Plaza block and approximately $300 million for Vicwood Plaza.

Hong Kong's recent economic performance is partially due to China's red glow and the positive fallout that occurred after the country's entrance into the World Trade Organization. International finance companies have set up shop in Hong Kong in order to service Beijing, Shanghai and other major cities. At the same time, a growing number of Chinese companies are capitalizing on their newly found freedom by raising money on Hong Kong's stock exchange, thereby encouraging the establishment of a further wave of advisory, legal and accounting firms. According to the Hang Seng, China-related companies now account for 41 percent of the exchange's market capitalization.

“We can become a kind of New York of China,” says Peter Kok, general manager of one of Hong Kong's largest developers, Swire Properties. “If a company wants to go fundraising, Hong Kong is the place to go. It is legally established enough to go through this exercise.”

But given Hong Kong's current interdependence with China, potential trouble spots are emerging, many of which could have a negative impact on the island's real estate market and beyond. As Shanghai makes it way towards becoming a leading financial center, it is challenging Hong Kong for economic supremacy—and in doing so, potentially drawing away the financial, legal and advisory firms that make up much of Hong Kong's economic base. In addition, Hong Kong's property markets have been on a three-year upswing following the SARS after-effects of 2003, leading to speculation that the market may be due for a correction. Even more pressing problems were discussed by the Nobel Prize-winning economist Milton Friedman in a recent Wall Street Journal article, where he argued that Hong Kong was abandoning the laissez-faire economic policies that spurred its financial success.

Given the mixture of positive and negative signals, there are many real estate professionals who view the markets in Hong Kong with some trepidation. And while several private equity real estate firms are investing in the region, there are others who believe that the upside potential remains limited.

“Back in the mid-1990s there were worries that Singapore would become the pre-eminent financial center, but Hong Kong with China doesn't have to work that hard,” says John So, head of fund management in Asia for Grosvenor, the Duke of Westminster's property company. “With China, Hong Kong has a huge advantage. But I won't invest because yields are low and rents are at an all-time high, so where is the margin? The question is: When is the market due for a major correction?”

Despite such pessimism, Hong Kong continues to maintain its credentials as an international financial center. It has the biggest stock exchange in Asia, even ahead of Japan, in terms of the amount of equity raised. And the Hong Kong economy, the world's 11th largest, currently boasts a GDP growth rate around 6.6 percent despite having a population of just 7 million.

Nevertheless, Hong Kong has suffered from a trio of economic shocks that began the very year China took control. Following the Asian financial crisis in 1997, Hong Kong repositioned itself as an IT center just as the technology bubble burst. When Hong Kong stepped up its bid to become a bigger tourist attraction, SARS hit. By early 2004, office rents had fallen by 75 percent.

Remarkably, rents and office values have suddenly bounced back to pre-1997 levels and there is a feeling that Hong Kong is blossoming now that it is becoming comfortable as part of China. Strong demand for office space is coming from bank, finance and law firms, driving up rents by 14 percent in the first half of 2006 after a massive 75 percent rise in 2005.

While demand is strong, the supply side of the equation suggests that rents and capital values will remain equally high given the paucity of new office development. Though York House by Hong Kong Land, a 115,000-square-foot office building, has just been completed, it is the only new office scheme on tap until 2010.

One factor holding back supply is the Chinese government, which is reluctant to allow Hong Kong to reclaim more land from its shrinking harbor. And experts point out that current Hong Kong chief executive, Donald Tsang, who took office in March 2005, has no intention of ruining his chances of re-election by offending Beijing. As a result, there is not much threat to existing office owners from would-be developers.

“It is difficult to get land from the government in Hong Kong,” complains one developer, who did not wish to be identified. “You have to come up with an offer which they think is acceptable first before they put the land up for auction.”

Some industry players point out that it is not in the interests of China or Hong Kong to allow property values to fall, suggesting that Friedman's arguments about government intervention in the local economy holds true. Nevertheless, others disagree. CY Leung, convenor of Hong Kong's executive council and chairman of Asian property services firm DTZ Debenham Tie Leung, argues that the Hong Kong government, in contrast to mainland China, refrains from intervening in the market as much as possible and that its legal system, rule of law and bilingual workforce work in Hong Kong's favor.

Such factors help to explain why investors are comfortable investing in the city. Alison Cooke of title insurance company First American says, legally speaking, Hong Kong is far more transparent than China. “In Hong Kong, information is freely available at low cost from a centralized government register,” she says. “And there is a large body of case law which gives sufficient precedent for legal practitioners to take a view on risk levels.”

Another factor in Hong Kong's favor is the relatively low property taxes compared to mainland China. On the mainland, for example, a landlord is taxed 25 to 30 percent on the gross income of his property. Furthermore, there are less straightforward deals available because of the way office developments in China were traditionally funded. Historically, speculators persuaded banks to loan them short-term money in order to cover the initial costs of construction; they then proceeded to sell off the half-completed property floor-by-floor in order to fund the remaining costs.

These so-called “strata sales,” relatively limited in Hong Kong because of more mature financing markets, make it difficult for large foreign investors to pick up an entire office building. For example, in Guangzhou, located just two hours by train from Hong Kong, one US opportunity fund offered 1.8 billion RMB ($227 million; €181 million) to buy an unleased office building that was ready to be completed next year. The owner, however, decided it would be more lucrative to sell the building floor-byfloor for 15,000 RMB a square meter.

Despite the relative attractiveness of doing business in Hong Kong relative to China, however, the special administrative region is far from a no-brainer, particularly in the current environment. As rents and office values appear to be peaking, there are signs of economic trouble on the horizon.

“[Hong Kong] is volatile and dependent on international companies,” says So. “Already we are seeing signs from the US that the economy is weakening. The housing market is flopping there. Hong Kong export numbers have been a little bit slower recently.”

Because Hong Kong arguably operates on a three-year economic cycle, some would say that the region is due for another correction. Underlining the island's dependence on the global and regional economy, including mainland China, Frederick Ma, the secretary for Financial Services and the Treasury, said in January that overseas investors have contributed 35 to 40 percent of Hong Kong's total market turnover in the past three years.

“If China goes into a slump and all of a sudden there are no more listings, no hedge funds and teams start to contract, things could change,” says So.

While there are some worries about Hong Kong's dependence on China, there are even greater worries about the region's ability to withstand the competition coming from the mainland. Playing a key part in Shanghai's development boom, for example, is a massive, deep water port that will be serviced by an entire new city, Lingang. When complete, the port and city will cover almost 300 square kilometers.

“In the future, by about 2020 I think, Shanghai will be the number one [port] because China has a bright future,” says Wang Xin, marketing manager of state-owned Shanghai Harbour City Development Group. “This new project is half the size of Singapore.”

By any measure, the development juggernaut that is China dwarfs the potential in Hong Kong. Brockton Capital, the London-based private equity real estate firm, points out that the country is building 25 million housing units a year, roughly equivalent to building the UK every 12 months. The country's massive population and growing economy, particularly on the mainland, leaves little doubt as to why China is outstripping Hong Kong in terms of property investment activity—and further implying that investors in Hong Kong might not enjoy as much capital growth as elsewhere. In the first half of 2006, China accounted for 11 percent of all activity in the Asia-Pacific region, compared with Hong Kong, which accounted for 10 percent. Over time, the slight discrepancy in those two figures will no doubt increase in China's favor.

“People are buying different kinds of real estate for investment [in China] seeing that prices go up naturally every year,” says Gary Cheung, an investment and leasing agent at DTZ's office in Guangzhou. “The rise in prices comes hand in hand with the GDP growth of around 10 percent a year.”

The perceived attractiveness of China compared with Hong Kong and a potential slowdown of Hong Kong's economy are threat enough to make some investors think twice. But there is another threat from China which could have additional long-term implications for investors in Hong Kong.

China's manufacturing base in the south of the country is producing so much pollution that, on a bad day, it is impossible to see across the bay from the island of Hong Kong to Kowloon. Just two months ago, a six-year study by the University of Hong Kong suggested bad air may be responsible for a significant jump in children being admitted to the hospital for asthma. And in recent years companies in Hong Kong have blamed the territory's air pollution for driving away some expatriates and making it more difficult to recruit foreign workers.

For now, Hong Kong is getting away with it, at least in terms of Chinese tourists. Arrivals from the mainland in the first half of the year jumped 14 percent compared to the prior year to about 6.7 million, accounting for more than half of the 12.2 million people who visited Hong Kong during the same period.

But even here there could be problems. The tourism board said the total for the year could fall short of its forecasted 27 million visitors because of the delay in opening the Lantau cable car attraction and the sluggish performance of Hong Kong Disneyland. The government has also been playing down fears that Hong Kong's competitiveness will be threatened by another Shanghai plan—the development of a new Disney theme park.

The latter is a prime example of the double-edge sword that is Hong Kong's relationship with China. On the one hand, it has benefited from the influx of capital from the mainland and the concomitant rise in rents and capital values. On the other, the boom in China and its ambitions to grow could present its gravest danger. Investors may have to guess whether the island will enjoy a second honeymoon or whether its relationship with China will soon hit the rocks.