The Asia Report episode 2: “The ebbs and flows of the property cycle”

Ronnie Chan is chairman of Hang Lung Group and Hang Lung Properties. For more than 25 years, he has personally penned the shareholder letters. Under his guidance, Hang Lung successfully navigated the Asian Financial Crisis and emerged as one of the largest property conglomerates in Hong Kong.

Listeners will find his commentary (written without the benefit of hindsight) especially useful in understanding the ebbs and flows of the property cycle.

The insights gleamed from his letters has greatly improved my understanding, and it’s a pivotal part of my investment framework when it comes to looking at both property and property related companies.

Extracts from shareholder’s letters

1991

The various sectors of the investment property market performed differently in the period under review. Retail space and offices, for example, were at very different points in their respective market cycles. While the former sector to some extent slowed down due to moderating growth in consumption, it remained healthy for the most part.

The same, however, cannot be said of the office market, at least not for class-A properties. Supply/demand imbalance caused rental rates to fall as did capital value.

1992

Entering 1992, we recognized that interest rates would be falling and anticipated an increase in capital values.

As long as rental yields are higher than interest rates and the demand/supply relationship is favorable, we will continue to buy rental properties.

1993

Pursuing a peak as it approaches is a fools’ game that we will not be drawn into.

1994

At present, almost all sectors of the real estate market have entered into a consolidation phase. Both offices and high-end residential units have seen prices peaked. Not only has capital value which may be affected by speculation, stopped rising, even rental rates which is a reflection of real demand have moderated somewhat.

This is not a result of lack of demand; prices have simply risen to such an extent that they have met with resistance from the end users. Certain companies have moved their non-core operations to peripheral locations, and in certain cases, have even left Hong Kong altogether. Expatriate staff, on the other hand, have begun to invade middle-class residential locations which are traditionally the domain of local people.

These phenomena, however, should not be overly alarming since new demand for space remains strong; they only confirm to us that market forces are alive and at work. The slowering and ever slight pull back of prices are good for Hong Kong’s long-term competitiveness and we should support them.

…

Analyzing the methods of profit growth for an actively managed property investment firm such as ours, there are basically three avenues. The most fundamental is rent increase as a result of either supply shortage or value creation such as improving or changing the usage of space. Inflation alone also tends to gradually push up rentals.

The second way is by adding new properties to our portfolio – either through acquisition or through constructing new facilities.

The third is by selling matured properties.

1994

The reason the office market is weak is three fold. First, prices – both rent and capital value – have risen so much in 1992-1993 that they are simply not sustainable. Tenants are not only forced to use space more efficiently, many of them are driven out of high rent districts such as Central into outlying areas.

In certain extreme cases, companies have moved their non-essential departments or even their entire operation out of Hong Kong and into Southern China, South East Asia or even Australia.

Second, the craze over China in late 1992 and throughout 1993 has subsided by the first half of 1994. Foreign companies, especially financial institutions, which rushed into Hong Kong earlier are no longer expanding. Third, the massive supply of offices related to the new airport railway is pointing towards an oversupply situation.

The combination of these factors is powerful and has driven prices down in some cases by 35% from the peak. Rents have fallen less resulting in higher yields.

…

Now that the bear market is here, the virtue to exercise is no longer “tenacity” but “patience”. As far as purchasing properly is concerned, one must withstand temptation and do nothing until the market begins to rise again. By alternating between tenacious buying and patient waiting, money is made.

1996

In the second half of 1996, sentiments for buying rental properties returned and in the process, bid up prices. Many of the purchasers were speculators whose appetites were for shops, offices and high-end residences.

The market remained active until the spring of 1997 when, with the exception of shops, it quickly died down.

We took advantage of this window of opportunities and sold about HK$1.2 billion worth of matured of non-core properties. The profit resulting therefrom was very good. After fiscal year end, we have continued to dispose of commercial space since buyers are still there.

1998

Realizing that attractive opportunities to buy investment properties will unlikely surface in the near future, we had turned to purchasing land for residential developments. We perceived good potential in that sector. Together with the Mass Transit Railway Corporation (MTRC), we will build 128,000 square meters of high-end units on top of the Kowloon Station. The three towers of 72 stories each will have an unobstructed view of the entire harbor.

1999

The first problem is oversupply due to the relocation of the airport. Before, buildings on the Kowloon peninsula were limited to 20 stories. (This was why Kowloon was less visually attractive than Hong Kong Island. The view from Kowloon across the harbor was far better than the other direction.) Now the restriction is gone.

Since it is not easy to assemble big pieces of land given strata title of most buildings, legislation will have to be introduced to force redevelopment. The process is already on its way and the potential additional space can only be measured in the millions of square meters.

Second, the Central district is spreading both to the east and to the west. This is not to mention the pockets of office which are springing up in traditionally industrial or residential areas such as Quarry Bay to Kwun Tong. Those buildings are becoming increasingly luxurious to lure tenants away from established office markets. With much lower rents, they will register certain successes.