Hong Kong's office rents will keep falling this year, and valuations likely won't be far behind. S&P Global Ratings believes the major landlords with grade-A space are among those facing downward revaluation hits.

Book valuations for major landlords have been fairly sticky, relative to the continual fall in rents over the past five years. Given rents are still falling, we could see more distressed sales of office buildings. Such transactions would provide pricing datapoints to benchmark valuations, likely leading to more aggressive fair-value hits for office assets in the city.

The news is not all bad. An increase in absorptions over the past year is a positive sign, one that suggests incremental demand may soak up some of the new supply still coming online. But demand remains weaker than in pre-pandemic times.

More Downside For Rents

Landlords are contending with economic uncertainty and rising competition from new builds. We expect they will employ more tactics to retain tenants, including deeper cuts in rent rates for renewals.

We forecast the city's grade-A office rents will likely decline by 8%-10% this year. This is steeper than our previous forecast of a 5% drop. It also implies that rents will retreat to 2012 levels.

Chart 1

Recent Uptick in Office Absorption Not Enough To Turn The Market

A rebound in capital market activities will likely keep momentum positive for absorption rates and chip away at vacancy rates. Economic stimulus in mainland China and interest rate cuts in the latter half of 2024 supported the banking and finance sector, which remains the largest demand driver. Growth in Hong Kong's wealth management sector also spurred some incremental demand from the set-up of asset management firms/family offices throughout the year.

That said, the recent uptick in absorptions in the office market has helped but not cured the city's high supply problem. Last year's net positive absorption rate (i.e. space newly leased outweighing space being vacated) was close to 1 million square feet (sq. ft.), compared with only 0.5 million sq. ft. over 2022-2023.

However, overall leasing demand is still moderate relative to pre-COVID times. Net absorption averaged a higher 1.6 million sq. ft. between 2017-2019. And the supply is still growing.

As a result, the "flight to quality" benefit is ebbing for even grade-A space, which hit a record high vacancy rate of 13.7% in July 2024 following the completion of several new buildings, per Jones Lang LaSalle. While that metric has improved to 13.2% by end-December 2024, we don't expect a quick rebound in occupancy rates.

Landlords will also have a hard time in pre-leasing new buildings. Sun Hung Kai has so far announced UBS as an anchor tenant for its office project atop the High Speed Rail West Kowloon terminus, slated for completion near year-end. The bank will pre-lease 460,000 sq. ft. out of the project's total 2.6 million sq. ft. total office area. The city expects to see more than 3 million sq. ft. of new grade-A office space likely complete over 2025: this will be the highest total since 2008.

Chart 2

Sharper Valuation Falls Are An Emerging Risk For Landlords

Investors often ask us why the valuations of investment properties held by major Hong Kong landlords, especially office buildings, seem to have declined slowly despite the downturn.

Indeed, the eight major landlords we sampled suffered an average 19% drop in office rent rates or rental income (see chart 3) from 2020-2024. Yet the fair value of their investment properties only dropped an average of 13%.

Chart 3

This is partly due to diversification in assets. Some of these landlords have sizable assets other than Hong Kong offices.

However, major landlords' property values are sticky for another simple factor: a lack of transaction data. This could now change.

Most of the major landlords have not been motivated to part ways with core grade-A office assets at downturn prices. That leaves valuers with limited transactions to benchmark valuations; so their models tend to rely on increasing discount rates to reflect higher long-term rates and risk premium. Such rates can also be sticky, however; the capitalization rate used by valuers has moderately expanded by 10 basis points (bps) to 40 bps, some even kept constant, compared with more than 200bps increase in government bond yields.

Table 1

As rents continue to fall, more office properties could go underwater (where the property value falls below the outstanding mortgage). Some may be forced to sell properties at hefty discounts, given cash flow strains amid high interest rates and low rental yields. This will provide valuers concrete data sets to make downward fair-value adjustments.

According to Colliers, last year about 40% of all big ticket investment properties transactions (HK$100 million or above) were assets sold under receivership or at a loss, up from about 20% in 2023.

More importantly, a few of these deals are en-bloc grade A offices in traditional business districts. Compared with strata-titled units in fringe areas, these transactions are more useful to valuers in appraising major landlords' assets, because of the closer build quality and asset location.

Consequently, a bigger and faster correction in major landlords' investment portfolio value may ensue.

Table 2

Rated Companies Aren't Immune

Slow burn on operating performance  

Incumbent landlords will also bear the brunt. These landlords have historically outperformed market averages, because of the prime locations of their properties, good amenities, and convenient transport connectivity.

Still, even they are finding it challenging to compete with new buildings. Many have resorted to cutting rents while also needing to pay for property upgrades to compete with the state-of-the-art new buildings. As an example IFC's office occupancy rate fell to slightly above 90% at end-2024, from 98% at end-2023. The major landlords we sampled all saw a negative rental reversion (or lower rents with new leases) in 2024, and this will likely continue.

More aggressive cuts in valuations will push up gearing for some major landlords 

Our sensitivity analysis on eight office landlords shows that a 20% further drop in their investment properties values from current levels would push up their gearing (as measured by debt to debt-plus-equity) by an average of 5 percentage points.

That level of stress implies a cumulative one-third decline in asset values from their peaks, much steeper than the 13% fair-value drop by 13% over the past five years.

Chart 4

Relative to peers in the market, the rated landlords still have low gearing. Their gearing would remain at or below 25%, even with a 20% fair value change to their investment properties values. This is a level we consider modest in our criteria ("Key Credit Factors For The Real Estate Industry"). These companies also have ample gearing headroom over their financial covenants.

This is an important edge, given lenders are becoming more selective. Amid market weakness, banks are tightening risk control and focusing on high-quality borrowers with strong collateral and low loan-to-value ratios. We believe top-end developers and landlords with strong asset quality and sound balance sheet fundamentals will be able to maintain favorable access to credit markets.

Those with outsized office exposure and higher initial gearing may see the greatest deterioration in gearing metrics. We believe individual investors and small, unlisted firms which have borrowed aggressively during periods of low interest rates are the most at risk.

Table 3

What's Next?

Interest rate cuts in the second half of last year could provide some savings on interest expenses for office landlords. However, the trajectory for interest rates is clouded after the U.S. Federal Reserve paused the cutting cycle in January 2025 amid persistent inflation. This will have a knock-on effect on issuers' cost of funding and investment properties valuation.

Some landlords have already taken action to get through another challenging year. They are reducing shareholder returns and capital expenditures, or raise funding by asset sales or equity. Ultimately, it will come down to their willingness to protect their credit quality.

Editor: Cathy Holcombe

Related Research And Criteria

Research

• Macro Effects Of Proposed U.S. Tariffs Are Negative All-Around, Feb. 7, 2025
• Distress Event Could Derail Hong Kong's Home-Price Stabilization, Feb. 5, 2025
• Hong Kong's Commercial Real Estate Downturn Is Spreading To Banks, Oct. 31, 2024
• Capping The Cap Rates: How Hong Kong Office Landlords Are Managing, Feb. 25, 2024

Criteria

• Key Credit Factors For The Real Estate Industry, Feb. 26, 2018