Kung Hei Fat Choy. The Year of the Dog is almost upon us. With all the preparation ahead of Chinese New Year and the flu season, I have been running around like a chicken with its head cut off (pun intended and reference to the outgoing Year of the Rooster).
How does the math work?
This week, we are just going to keep it brief and share two bits of news on the Hong Kong property market that I find very difficult to reconcile.
Datapoint #1 – Financing for The Center
The first datapoint is from the financing arrangement for the HK$40.2bn purchase of The Center (a Grade A office building in fringe Central).Embed from Getty Images
According to the Hong Kong Economic Journal, the purchasers are in the process of arranging a US$2.05bn (HK$16bn) three-year loan. In order to boost interest from lenders, the interest rate has been adjusted up from HIBOR plus 140bps to HIBOR plus 160bps. Although one month interbank rates have recently fallen to 0.65%, they were as high as 1.16% as of 2 January 2018. For 2018-to-date, one month HIBOR has averaged 0.91% suggesting that the interest rate for this US$2.05bn loan should be around 2.51%
In addition to the three-year loan, the purchasers are also arranging a one year mezzanine loan of HK$16.5bn at 8.0%. YES, 8.0%.
Datapoint #2 – Landlord Cuts Retail Rent by 60% for New Tenant
The second datapoint relates to the letting of a storefront in Fringe Central. According to the Hong Kong Economic Journal, a street front store in Lyndhurst Terrace has just been let for HK$85,000/month. The new tenant is a wine shop who has signed a three-year lease. The previous tenant ran a perfume shop and had been paying HK$200,000/month.Embed from Getty Images
Over the past 3.5 years, the rent has fallen by 57.5%. As the shop was purchased for HK$91.2mn in 2012, the new HK$85,000/month rent works out to a gross yield of 1.1%. Over the past three years, the passing yield has compressed from 2.6% to 1.1%.
How do you reconcile these without using the “Trophy Asset” argument?
When I read these two stories, I just scratch my head on how the math would work here. You’ve got a consortium buying a “Trophy Asset” for HK$40.2bn and seemingly financing 81% of the price with short-term money (one and three-year loans). With interest rates going up and Central banks winding down QE and starting to reduce their balance sheet, it seems likely that financing costs would only go up when the loans rollover.
Secondly, as the retail shop example show, rents do not always go up. For the shop owner who had bought in 2012 hoping that the 2.6% entry-yield could be improved with rental increases, rather than rising, the entry yield has more than halved to 1.1%. Unless it was an all-cash purchase, otherwise, it must be a negative carry now.
Now, I know the die-hard bulls would argue that the price has gone up and hence the capital gains have more than offset the rental decline. But if current yields are only 1.1% and the latest lease has shown that the fairy tale of ever rising rents is clearly broken, what would entice the next Greater Fool to up the next bid?
As the tide of easy money start to recede, we will soon find out who’s been swimming without their swimming trunks on.Embed from Getty Images