Hong Kong - Protests, Housing, Collusion, Cartels – Here’s The Reality.

Peter Churchouse, Portwood Capital Ltd.

Writing because I'm trying to understand how the current unrest is likely to affect the long-term interests of the city's developers. Would love to hear your views!”

Journalist from Canada.

Such was the missive that appeared on my system yesterday.

My comments to him are below.

Land Policy is Fiscal Policy in Hong Kong

·        Hong Kong has long endured high housing costs which are ultimately down to the fact that land policy in Hong Kong is de-facto fiscal policy. All land is owned by the government and leased to occupiers for varying periods of time. Government therefore relies hugely on land related revenues (land sales, premiums for change of use, stamp duties, etc) which have often made up 30% or more of total government revenues.

·        This allows them to keep other taxes low. Only a small number of households actually pay income tax, and a very small number actually pay the maximum possible personal income tax rate of 15.5%. In fact a married couple with two children would not pay that full rate until income reached about US$450,000 per year.

·        Profits tax is also low AT 16.5%. There is no capital gains tax, no estate duty, no VAT, no tax on dividends.  

·        There is an inbuilt fiscal incentive on Government’s part to keep land (and property) prices high. This routinely means that 50% - 60% of households cannot realistically afford to service a mortgage on a typical small flat at the bottom quartile of the price range. In turn this means that Hong Kong’s government provides subsidized housing for approximately 50% of the population.

·        Therefore we should view government driven high land/property prices as effectively a transfer payment from business and more well off households to the lower end of the income spectrum. 

·        Policy is  -“Make housing (and other property) very expensive through high land prices, take that cash and build subsidized government housing and keep taxes low.”

Affordability as an issue in social discontent – but not the only thing.

·        The affordability problems, squalid housing are factors in the unrest that Hong Kong experiences right now. But only one of several factors.

·        On the basis of size, average apartment sizes are the smallest in the developed world at around 475 sq ft per unit. The average size in Singapore is almost twice this level, and even in China it is about 65% higher than in HK. Vast numbers of people live in absurdly cramped, squalid conditions. Many regard this as unacceptable for a developed country that has one of the highest per capita GDP in the world, and huge reserves of cash on a per capita basis.

·        Affordability - Our analysis suggests that only about 40% to 45% of Hong Kong households could realistically service a mortgage out of income for an apartment priced at the lower quartile of the price range.

·        Bear in mind that most tier 1 cities around the world are facing their own public pressures and discontent due to worsening housing affordability. 

·        Blame central banks for this to a large extent. Low rates around the world have pushed capital into financial assets – stocks, bonds and real estate. If you are not an owner of these assets, chances are that you have underperformed financially in the past decade. Central bank policies have therefore widened the wealth and income gap in many major economies, and worsened housing affordability in many cities and countries.

·        Other issues in Hong Kong relate to democracy that was promised under the Basic Law but has not been delivered. 

·        Education and health care issues are of concern. 

·        Some see the policy of allowing 150 people every day from the mainland to enter Hong Kong to live (approx 55,000 per year) as hurting access to housing and other services.

HK Government Controls all land and has not made it available for housing.

·        Hong Kong’s situation is made worse by government’s long running refusal to provide more land for housing. For example, for the thirty years leading up to 2003, private housing production was in the range of 24,000 to 29,000 units per year. It then fell to around 8,000 to 13,000 units per year in the following decade, below half previous levels. 

·        As government controls the supply of land, the affordability problem, which is partly driving current protests, can be laid fairly and squarely at the feet of the HK Government. It has simply refused to provide the land needed to house the population. It’s inaction in this (and many other areas) has angered people in all parts of Hong Kong society. That is why the support for the protests is so high.

·        Demand for housing is also driven by low nominal and low real interest rates. As we know rates in recent years have been at record low levels, at a time when unemployment has been less than 3%, household income has been growing at around 3% - 5% per annum, and the banks have been flush with liquidity, and population has been rising steadily.

The Blame game – blame the developers: Collusion – No: Cartel – No.

·        It is not valid to lay the blame for HK’s woeful housing conditions at the feet of the private sector developers. Developers buy whatever land government puts up for auction or tender, develop it and sell or rent the floor space produced.

·        It is also not true to state (as many media folks do) that there is collusion between government and developers. Collusion is the secret agreement between two or more parties to defraud the public or others of their rights. There is absolutely no evidence that the government and developers engage in such behavior.

·        The media also frequently refers to the “developer cartel”. A cartel exists where companies join together to control prices of goods and/or services. Again I have never seen any evidence that Hong Kong’s developers engage in this practice. 

·        However there has been evidence from time to time that telecom companies may have done this. Furthermore most knowledgeable observers in Hong Kong agree that lawyers, accountants and medical practitioners get together to set prices to be used in their industries, not to mention bankers, investment bankers and other such service providers. 

·        Developers compete openly and aggressively both for land purchases as well as sales of their end product. They do not fix prices amongst themselves.

Impacts on developers.

1.     Earnings of developers have been affected by the fact that land supply has been so limited that they have been unable to produce the numbers of residential units that they used to produce. But prices have risen so that has helped to compensate for lower volumes of unit sales. 

2.     Net/net developers generally have posted subdued earnings growth in recent years, much lower growth rates than the cousins in China.

3.     If government releases more land that could potentially boost earnings growth.

4.     Since the GFC of 2008 Hong Kong housing has experienced 5 corrections ranging from 5% to around 22%. The sixth correction is taking place now. These corrections have all been of short duration but do affect earnings of developers in the sector.

5.     Developers in Hong Kong may experience risk to their Profit and loss accounts but virtually zero risk to their balance sheets. Therefore the developer sector involves minimal to zero systemic risk to HK’s financial system. Most of the developers in Hong Kong have net debt to equity ratios of well below 20%, the lowest in the developed world by far. 

6.     They also have substantial portfolios of rental property that provide steady and pretty reliable rental income. That eases any potential balance sheet pain from any major downturn in residential property sales, or residential prices.

7.     Government introduced eight rounds of measures to cool housing prices since the GFC. Some of these measures have in fact favoured developers at the expense of people trying to buy and sell in the secondary market. Recent policies to lift mortgage loan to value ratios will also help developers.

8.     Tax on unsold properties held by developers may hit P&L accounts. But developers are not in the habit of holding onto to large portfolios of completed units unless they are intending to rent them out.

9.     Developers are easy to blame for housing woes. And no one really is going to complain too much if developers are somehow punished even if they have not done anything nasty or illegal. They may not be fuzzy, warm, cosy folks but they are equally not involved in flakey practices in terms of fraudulent or illegal activities that the media often attributes to them.

10. Government may choose to build on whatever land it has itself for subsidized housing, rather than sell it for private housing (Singapore model) – but it would have government revenue impacts and does not meet the need/desire of people to own their own home. Such a strategy may reduce the opportunities for developers.

11. The current residential market is down about 6% or so at this point from its June 2019 high point. How much further down it goes is largely about social/political pressures and the economic effects it is having. This is making an already slowing economy slow further. HK is basically in a technical recession partly driven by domestic conditions but also driven by trade issues, and a slowing China economy. This is likely to slow housing demand further. Even if the political uncertainty dissipates, economic uncertainty will still persist.

12. My best guess and applying certain models that we have used in the past suggest prices could correct by about 15% from their June high by mid 2020.

13. Interest rates are likely to remain low so that should be somewhat supportive to demand and prices.

14. Any exogenous shocks such as a financial crisis in China/US/Europe/Asia will make that call way too optimistic.

Analysts; David Evans, Thomas Tung