Hong Kong retail landlords face a difficult choice this year. S&P Global Ratings believes they can either preserve rental rates or occupancy rates, but not both. In our view, landlords will focus on keeping tenants.

Retailers will be price-sensitive on lease rates because they are struggling with more than a typical downturn. Hong Kong is losing shoppers to mainland China's vast and efficient online markets as well as easing access and quicker speeds for trips across the border. This shift may be structural.

We believe rated landlords could manage our base case of 5%-10% rate cuts on newly signed leases (negative rental reversion) this year. Our stress tests show that even a further 10% in negative rental reversions wouldn't breach downside triggers. In contrast, hits to EBITDA, debt leverage and valuations would multiply if occupancy rates slipped. The situation could be more dire for those that lack the resources to invest in promotion and marketing.

The Cross-Border Crush

Hong Kong landlords aren't standing down in the face of structural threats. They are investing more in promotions and taking some steps to win back Hong Kong business and grab a bigger slice of the local pie.

Sun Hung Kai Properties' retail sales at its shopping malls jumped 10% for the recent Chinese new year holiday, versus the previous year's holiday week. Swire Properties (unrated) reported a similar story for the Christmas holidays, noting that footfall in its mostly high-end Pacific Place mall rose on a Christmas campaign.

In our view, however, they are up against some major forces. Pockets of improvement aren't likely to be harbingers of a turnaround.

Chart 1

The cyclical and, likely, structural shifts facing Hong Kong retailers include:

Changes in tourism and spending patterns continue to take a toll on Hong Kong retail.  Trips across the border are easier than ever, thanks to better and faster transport logistics. Authorities in both Hong Kong and mainland China have also relaxed visa and other requirements to cross the border.

So far, more of the traffic is outbound. Last year, outbound travel by Hong Kong residents increased 45%, and is 13% higher than pre-pandemic levels. This is driven in part by nearby visits to places like Shenzhen--where service offerings such as food and beverages can be 40%-50% cheaper than Hong Kong from the same franchise.

At the same time, tourist arrivals to Hong Kong are only 70% of 2018 levels while their per capita spending declined 20% year on year during the first nine months of 2024.

Chart 2

Cross-border e-commerce deals are luring non-discretionary spending.  Mainland Chinese e-commerce platforms are dedicating more resources to grab market share in Hong Kong. They offer Hong Kong consumers a wide variety of consumer goods at competitive prices especially with Hong Kong dollar tracking stronger than Chinese renminbi over the past 24 months.

For example, late last year the e-commerce platform Taobao Hong Kong (owned by Alibaba Group) rolled out an HK$1 billion incentive program that includes free shipping and product discounts. As a result, Taobao Hong Kong's gross merchandise volume jumped by a double digit, year on year, on the "Double-Eleven" (Nov. 11) shopping day, one of the largest in China.

In our view, this competition is here to stay.

Further negative wealth effects could also hurt overall consumption.  In our view, the retail situation is exacerbated by the negative wealth effect of Hong Kong's faltering residential property market, with prices down nearly 30% since the peak in 2021. This cyclical factor may not lift this year, with the recovery in housing prices slipping out of view (see "Distress Event Could Derail Hong Kong's Home-Price Stabilization," published on RatingsDirect on Feb. 5, 2025).

Lost Occupancy Hits Harder Than Rent Cuts

Given the competitive strains on Hong Kong's retailers, even the most premier mall owners might prioritize preserving occupancy at the cost of lowering rent. Lower rents would likely cause less immediate damage to recurring cash flows than losing tenants altogether.

Positive rental reversions on retail operations have already been narrowing, or even turning negative, for some of the issuers. For example, Link REIT signed new leases at lower rents for its markets and cooked food stalls and we expect this trend to spread to their other facilities over the coming months (see "Link REIT 'A' Ratings Affirmed On Sufficient Financial Buffer Against Softer Hong Kong Retail Sentiment; Outlook Stable," on Dec. 15, 2024).

We forecast 5%-10% negative rental reversions for rated landlords' retail-space leases this year. If we apply a further 10% in a downside scenario, the effect on leverage, as measured by the ratio of debt to EBITDA, will still be less than 0.1x. This is manageable for the rated landlords, in our view, assuming steady occupancy. That said, if landlords start to lose tenants due to the prolonged retail downturn, the impact for EBITDA hence debt leverage could multiply.

Leverage Of Rated Landlords Would Weaken By 0.1x-0.3x Under Our Downside Scenario

Our stress test piled on an additional 10% negative rental reversion or 10 percentage points decline in occupancy in fiscal 2025 over our base case:

Table 1

Gearing Could Be Vulnerable On Asset Devaluation

Hong Kong's landlords started this prolonged downturn with very sturdy balance sheets. This credit strength (measured by debt to debt-plus-equity), often presented as a metric in financial covenants, could deteriorate as asset values could go down amid market weakness.

So far, valuation has not been marked down meaningfully on property companies' balance sheets. Major Hong Kong property companies recorded an average of 2.5% of revaluation loss of their investment properties portfolio throughout 2021-2023. We believe revaluations will likely be downward, given the continued strain on rents. This year could also see more transactions, including potential discounted deals, that provide market benchmarks for valuations.

Even some of Hong Kong largest landlords could dispose of retail assets in this downcycle. For example, New World Development (unrated), confirmed on Jan. 24, 2025, that it has been negotiating with potential buyer of K11 Art Mall, an iconic property in Tsim Sha Tsui's tourist-busy district.

Real estate companies with more aggressive assumptions could face bigger revaluation hits

Not all valuations are born equal. Investment properties are typically valued by capitalizing rental income, combined with reference to recent comparable sales transactions available in the market.

We don't know the exact assumptions Hong Kong's major property companies use, but calculate the implied cap rates by taking into account the annual rental income and disclosed book values for investments. This shows that the cap rates used by Hong Kong property companies in their valuation model could vary widely--the ones with more aggressive choices of cap rates, i.e. lower cap rates, could take larger impairment hits, causing deterioration in gearing.

Table 2

Few Places To Hide

The doors to mainland China's competitive offerings are open and not likely to close again. This is a structural change for retailers--but what about for their landlords? Can they finesse the situation?

In our view, only to a certain extent. We believe marketing and promotional efforts could help them outperform peers and take market share from other local shopping districts. Malls have the flexibility to attract foot traffic through operational improvements such as enhancing assets, reshuffling tenant mixes, and offering loyalty programs such as free parking. Hence, we expect the shopping malls operated by rated property companies to maintain stable occupancy. They could also continue to grab market share from high street and individual strata-title retail properties.

Prioritizing high occupancy means rents will be the factor that could, potentially, be weak for the foreseeable future. Unless mainland China gets a lot more expensive, or the flows across the border are restricted again, Hong Kong shoppers will keep going where the best deals are.

Most of Hong Kong property companies have diversified lines of businesses. Over time, this will offset risks from structural threats to individual business models. It won't help much this year. The property market is in pain across segments in Hong Kong, spanning residential and office as well as retail. Real estate companies have few places to hide.

Related Research

• Hong Kong's Office Market: With Rents Down, Valuations Will Follow," Feb. 12, 2025
• Distress Event Could Derail Hong Kong's Home-Price Stabilization, Feb. 5, 2025
• Link REIT 'A' Ratings Affirmed On Sufficient Financial Buffer Against Softer Hong Kong Retail Sentiment; Outlook Stable, Dec. 15, 2024