HONG KONG (S&P Global Ratings) June 20, 2024--As Hong Kong's property market cools, interest in Nan Fung International Holdings Ltd. is heating up. Investors are asking us for clarity on the factors underpinning Nan Fung's stable credit quality in a tough property market, particularly as the company is at the lower end of investment grade (BBB-/Stable/--). It is also less well known than the blue-chip property names we rate, and its business model differs from that of its peers.

The Hong Kong property market remains difficult. We expect home prices to further decline by 5%-10% in 2024, due to oversupply and high interest rates. Hong Kong home prices have already fallen by 22% from August 2021 to the end of 2023. Office vacancies have increased to nearly 13% from under 10% during the same period.

In this report, we address frequently asked questions from investors about the issuer's strategy toward property development and managing rental properties. The firm's high leverage must be viewed in the context of its low gearing, in our view. We also explain how we consider its financial investments in our rating construct. Finally, we discuss what its private ownership structure means for its governance.

Frequently Asked Questions

Is Nan Fung a property developer or landlord?

In our view, Nan Fung is a property developer with a growing portfolio of rental properties.

Property development remains the core business of Nan Fung despite the increasing importance of its rental portfolio. Management of the company indicates that property development is here to stay. The company had maintained its presence in the Hong Kong property development space since 1965.

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While we estimate Nan Fung's EBITDA contribution from rental income will increase to more than 60% over the next two years, from 40% in fiscal 2023 (year ending March 31, 2023), this should be temporary. We believe the company will resume land acquisition for development when home prices in Hong Kong stabilize. In the meantime, the company will focus on managing its rental properties.

Our rating on Nan Fung uses our homebuilder (developer) criteria as we still see property development as its main business. In order for our real estate (landlord) criteria to be applicable, the company needs to demonstrate a sustained strategy of concentrating on its rental portfolio.

What is Nan Fung's exposure to property development in Hong Kong during the current downturn?

Nan Fung has one of the lowest exposures to property development among rated Hong Kong developers. It also has no exposure to residential property development in mainland China.

Nan Fung can manage the impact from continued falling home prices because its property development pipeline is limited. It has sold over 90% of Lohas Park 10, a mass-market housing complex in Tseung Kwan O, a Hong Kong suburb. The firm sold most of the residences in fiscal 2023 before home prices took a deeper dive. The company's decision not to replenish any major development projects since 2017 has also proven prescient.

Nan Fung's remaining projects are selling very slowly as they are mainly luxury properties with a high price tag. The company only has seven key projects lined up. Three are small-scale projects under development. The remaining four are completed.

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How is Nan Fung's rental portfolio performing amid the downturn in Hong Kong's office sector?

We expect Nan Fung's rental income to grow to HK$2.5 billion in fiscal 2024, and to HK$2.6 billion in fiscal 2025, from HK$2.4 billion in fiscal 2023, due to new rental properties.

The company opened its flagship project in Hong Kong, Airside, in September 2023. Due to stiff challenge in the office sector, office occupancy rate at Airside was 13% as of Sept. 30, 2023, while the project's retail space was better with 67% occupied. Another office building in Shanghai, Yi Fung Place (formerly C8), will open in late 2024. The ramp-up of these two assets will be gradual due to weak office demand, yet any additional tenants will bring rental income.

Including the two new assets above, Nan Fung's portfolio of rental properties will increase to 13.2 million square feet (sq. ft.) by fiscal 2025 from 11.4 million sq. ft. as of fiscal 2023. In total, the company will have more than 34 assets in its rental portfolio.

Existing rental properties, particularly office assets, are facing pressure. Occupancy rates, excluding Airside, have dropped slightly in the six months ending Sept. 30, 2023. Average occupancy rate was at 91% in Hong Kong, 85% in mainland China, and 69% overseas. This compares with 92% in Hong Kong, 87% in mainland China, and 71% overseas as of end-fiscal 2023. A move to convert offices to laboratory space has temporarily lowered the overseas occupancy rate. Capital expenditure will likely be about HK$3.5 billion in fiscal 2025.

Diversification across asset classes and geography will partially offset office pressure. Nan Fung's laboratory assets are still performing well. About 60% of rental income is from office, 25% is from retail, and 15% is from laboratory and others. Hong Kong, mainland China, and overseas (the U.S. and the U.K.) each contributes about a third to rental income.

How do we monitor Nan Fung's financial risks given the volatility of its leverage?

We take a holistic view by considering Nan Fung's leverage, as measured by debt-to-EBITDA, and gearing, as measured by debt to debt-plus-equity.

While leverage is an important measure for property developers, we believe gearing is also suitable for Nan Fung. This is because the company's rental income has steadily grown for more than a decade and reached a significant portion of total revenue. In our view, gearing can better reflect the company's balance sheet health and supports our assessment of its financial risk profile.

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We expect Nan Fung's ratio of debt to debt-plus-equity to remain at a low level of 27.2% as of end-fiscal 2024, and 28.0% as of end-fiscal 2025. This compares with 26.8% as of end-fiscal 2023.

We forecast leverage will increase to 13.4x in fiscal 2024 from 6.2x in fiscal 2023, and remain high at 11.6x in fiscal 2025. This is due to the absence of sizable property development project recognition and slower sales of its luxury projects.

What is Nan Fung doing to adapt to high interest rates?

Nan Fung is reducing its debt and generating more recurring rental income to manage higher interest rates.

We expect EBITDA interest coverage will weaken to 1.2x in fiscal 2024, and to 1.4x in fiscal 2025 from 3.0x in fiscal 2023. This is due to lower property development sales and rising interest expenses, which climbed to HK$1.9 billion in fiscal 2024, from HK$1.6 billion in fiscal 2023. Almost two-thirds (62%) of the firm's debt was fixed-rate as of Sept. 30, 2023, helping it manage rising interest rates. The fixed-rate portion will likely stay above half of all debt.

We believe Nan Fung's debt-servicing capability is adequate. The company's annual rental income of more than HK$2.4 billion can fully cover its interest costs. In addition, the company is managing its adjusted debt level carefully. It cut its debt by 13% to HK$30.0 billion in the period from end-fiscal 2022 to Sept. 30, 2023, to minimize the effects of higher interest rates. We expect debt levels to stay steady until fiscal 2025.

How do we account for Nan Fung's financial investment portfolio?

We applied a very positive capital structure modifier. This provides two notches of uplift to the rating.

In our view, the portfolio (worth HK$29.2 billion as of Sept. 30, 2023) is large enough to address most of the company's adjusted debt of HK$30.0 billion if it ever needs to be disposed. Importantly, the portfolio is not leveraged. This provides Nan Fung with substantial financial flexibility.

We expect the portfolio will remain valuable enough to continue to give Nan Fung a two-notch ratings uplift. The portfolio value should be stable, despite declining from HK$33.6 billion since 2021. The expectation reflects a recovering Hong Kong equity market, and a strong U.S. stock market. The company will also allocate more investment toward fixed income, which may benefit from interest rate cuts.

As we have factored in the benefits of its portfolio in the capital structure modifier, we exclude its asset value and dividend income generated from our financial ratios. Only property-related income is included in our credit metrics calculation.

Nan Fung Trinity manages the investment portfolio. The entity is a licensed asset management subsidiary of Nan Fung. Nan Fung Trinity has very limited third-party exposure.

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Industry wise, the portfolio is mainly invested in health care, technology, finance, infrastructure, and exchange-traded funds. Geographically, it is focused on Hong Kong, mainland China, and the U.S.

How do we view Nan Fung's management and governance considering its privately owned status?

We assess Nan Fung's management and governance as neutral. In our view, the company has satisfactory risk management and adequate reporting, despite concentrated ownership by the Chen family.

Nan Fung had always maintained a healthy balance sheet. Gearing remained at a modest level for over a decade with a peak of 32.1% as of end-fiscal 2018, when the firm acquired Airside. The company also makes sure recurring income from rental and dividends will fully cover interest payments. Its leverage levels are volatile and less of a focus.

Nan Fung was previously publicly listed but was taken private in 1989. While no longer compulsory, we believe it has kept its reporting standard at an adequate level. The company discloses annual financial statements audited by PricewaterhouseCoopers, and unaudited interim statements. It also publishes detailed result presentations semi-annually and make announcements of material acquisitions on its website.

Nan Fung's board of directors has eight people including three independent non-executive directors. There are also multiple governance committees, of which the conflicts, audit and risk management, and remuneration committees are comprised only of non-executive and independent non-executive directors to ensure a balanced oversight.

The main consideration for Nan Fung's management and governance lies in the concentrated family ownership through the Chen Foundation and individual family members. This may expose the firm to related-party transactions or high dividend payouts at the expense of Nan Fung's credit quality. Nevertheless, we do not see this as a critical issue given the company's satisfactory management and governance record.

Related Research

• Hong Kong's Easing Property Policy Isn't A Quick Fix For Developers, March 5, 2024
• Capping The Cap Rates: How Hong Kong Office Landlords Are Managing, Feb. 26, 2024
• Nan Fung International Holdings Ltd., Sept. 30, 2023