Office rental yields set to rise

Over the past month, Hong Kong’s office sales market started to consolidate, following a strong period of recovery that started in the second quarter of 2009. The correction was triggered by a number of factors including the recent volatility in global stock markets; the worsening of the European debt crisis; negative impact from tightening measures on the Mainland as well as buyers’ resistance to prices which had surged over 75% in the previous 13 months.

According to Knight Frank, Grade-A office prices recorded a 2.7% fall in April—the largest month-on-month decline since February 2009. Prices slipped a further 1.5% in May. Price dips were seen in all major Grade-A office districts during the month. Sheung Wan and Tsim Sha Tsui fared the worst, with prices declining 2.4% and 1.9% after surging over 89.3% and 67.0%, respectively. Central also saw prices edge down 1.4%.

Investment sentiment soured after the Labour Day, depressing office sales activity. Sales slowed notably after an active April, as buyers became increasingly cautious. Deals involved mainly small floor plates during the month, such as a 1,820-sq-ft unit in Lippo Centre in Admiralty sold for HK$28.6 million or HK$15,700 per sq ft, and a mid-floor unit in East Point Centre in Causeway Bay sold for HK$16.6 million or HK$12,500 per sq ft.

While the sales market weakened, the leasing sector remained active, particularly in non-core business areas. The substantial space vacated by an insurance giant in The Lee Gardens in Causeway Bay has been filled quickly, thanks to the revival of corporate expansion activity. Shinewing, a Mainland accounting firm, leased a whole floor in The Lee Gardens last month, while Burberry moved into the same building, vacating their previous space in Convention Plaza Office Tower in Wan Chai. Currently, there are no whole floors available for lease in The Lee Gardens.

Vacant space in Kowloon East also decreased rapidly over the past month, as the district continued to see major leasing deals. Nike committed to three floors with a total area of about 79,000 sq ft in Exchange Tower in Kowloon Bay, while an engineering firm took up 80,000 sq ft of space in Landmark East in Kwun Tong. Some major office buildings have already achieved full occupancy, including Exchange Tower and Manhattan Place in Kowloon Bay as well as Tower One of Landmark East in Kwun Tong. As Kowloon East’s vacancy rate has dropped to a single-digit level, leasing activity in the area will slow in the coming months, due to limited availability.

Despite the downward adjustment in office prices, the recovery of office rents showed no signs of abating. The average Grade-A office rents grew a further 1.1% in May after going up 1.4% in April. Notable rent increases of 2.9% and 2.5% were seen in Sheung Wan and Wanchai respectively. Rents in Admiralty and Kowloon East edged up 2.3% and 1.5%, respectively. Central recorded a mild growth of 1.2% in May, after rebounding 21.2% in the previous eight months.

Xavier Wong, Greater China Head of Research at Knight Frank, says Hong Kong’s office market cycle has come to the point where rental yields have ceased to decline and are showing signs of a fresh uptrend. Between early 2009 and early 2010, when the office market was in its initial phase of recovery, the average price of Grade-A offices surged more than 70%, far exceeding the average rent growth of about 15%. During the same period, Grade-A office rental yields plunged from 5.3% to 3.3%, according to the Rating and Valuation Department. This was a phase when property investors priced in a full recovery of the real economy, but the leasing market had yet to catch up. However, as the office sales market enters a consolidation period and leasing demand continues to pick up, yields are set to rise in the coming months.

Mr. Wong says a big question mark hanging over the market at the moment is whether the sovereign debt crisis in Europe will deepen and spread to other parts of the world. If the crisis worsens, it could give rise to a banking crisis and affect international trade, with the trade credit market being frozen. However, if the crisis in Europe can be contained without seriously affecting the credit market and international trade, leasing demand in Hong Kong’s office market should be sustained and rents should continue to rise. This would lay the ground for a fresh upturn in office prices when rental yields claw back to higher levels.

Table 1: Hong Kong Grade-A office rentals (May 2010)