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Bubble in Hong Kong market now looks quite likely

HONG KONG: An asset bubble in the Hong Kong property market is looking increasingly likely. Homebuyers "high" on low interest rates, like drink drivers made careless by alcohol, seem increasingly indifferent to the long consequence of their decisions.

Home prices have now rallied 36% since the end of 2008. Still, many choose to believe prices are affordable, citing the current affordability ratio (monthly mortgage repayment divided by the average household income) at 37% versus a 20-year average of 48%.

But I think the home price to income ratio, which focuses on the steadier factor of income, rather than the more volatile mortgage rate, is a much better reference point to gauge longer-term affordability.

Annual median household income (for households living in private housing) was HK$23,000 (RM9,809) in 1997. Since then it has ranged narrowly by just 25% from a low of HK$20,000 (reached during the Severe Acute Respiratory Syndrome scare in 2003), to a high of HK$25,000.

Meanwhile, the prime-based mortgage rate, which in Hong Kong is usually on a floating base, has swung by almost 200% over the past five years, from close to 2% in 2004 and currently, to 5.4% in mid-2006.

This leaves the home price to income ratio in Hong Kong standing at a rather uncomfortable 14 times, beyond the previous peak in 2008 and just shy of the pre-Asian financial crisis level of close to 15 times in 1997.What does a 14 times home price to income ratio mean exactly?

For an average Hong Kong household that saves 30% of its income a ratio of 14 times means it will take some 46 years to pay off a 500 sq ft unit.

The only circumstance in which a 14 times home price to income ratio can therefore be judged "affordable'" is when it is accompanied by a fast and sustained income growth, which was the case in the 1990s.

With the Hong Kong economy maturing, and income growth between 1997-2009 having crawled at less than 1% per annum, it will be very challenging to argue that a 14 times home price to income ratio is affordable. So the key question is, can prices continue to climb off such a staggering level?

We think a property market bubble in Hong Kong now looks quite likely. This is because property prices are generally determined not by how reasonable they are, but by the changes in marginal supply and demand (that is, new supply versus new demand). Supply at the margin is forecast at some 12,000 to 13,000 units per annum between 2010 and 2012 -- some 40% below the normal take-up level.

Given how low supply is, a small increase in demand at the margin will be magnified into substantial price increases. And if interest rates remain at a low level for a prolonged period, many people will be given the leeway to take risks which they cannot afford over the longer term, which might eventually lead to a stage when price rises generate investment demand, which then fuels further price rises.

As investment demand will expand much faster than the inflexible physical supply, prices will rise sharply and the market will enter the bubble stage.

And there is not much that the Hong Kong government can, or will do.

Many are lobbying for the government to increase land supply substantially. We think this is the wrong route to take, because a major change in land supply policy is an interference not with the immediate, overheating, property market, but with the market a few years down the road when the economy can be in a very different place.

So, what can prick the bubble/slow down the rally? If and when interest rates start to pick up, every 100 basis points uptick in mortgage rates will push up the affordability ratio by about 3 percentage points.

So a 5% mortgage rate combined with another 10 percentage point rally in property prices will lift the affordability ratio to beyond 50%. And what is more important is that it will also mean mortgage rates will stand meaningfully above rental yields and bring pressure to bear on property investors.

For end-users, however, before the uptrend reverses things might be quite painful. Buying at current levels could mean longer-term risk.

Not making the jump right now could, on the other hand, mean a very painful year or two, when one's purchasing power is substantially eroded. For those end-users who are brave enough to stand firm and say no to buying a home at 14 times price to income ratio, there are alternatives to hedge the bet.

Shares in listed real estate agency Midland Realty Holdings, for example, are highly leveraged to the local residential market cycle.

The shares have risen some 300% from their March 2009 trough and given the negligible transaction costs, returns from holding the Midland shares would have been three times fatter than returns earned on physical property, and with much less liquidity risk. – South China Morning Post

Nicole Wong is the regional head of property research at CLSA
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