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1
Why Real Estate Developments Can Make Huge Profits
in Hong Kong?
by Dr Edward CY Yiu Associate Professor
Urban Studies Programme
Chinese University of Hong Kong
A Talk to Department of Economics & Finance,
CityU, 8 March 2014
2
How Big is the Difference?
• From 2010 to 2013 – Interest rate increased 20%; – Housing Rent increased by40%; – Housing Price increased by 80%.
3
Benchmarking of EBITDA Margin
Company EBITDA
Margin 2012
SHKP 40%
Swire
Properties
68%
Link REIT 69%
Company Gross Profit
2012
URA 123%
Avenue by
URA
237%
Company EBITDA
Margin 2012
SJMH 10%
Giordano 19%
Macau casino 24%
Why Developers
Can Outperform
Others and
Achieve
Excessively High
Margins?
4
4 Ways of Making Profits
• Monetary Policy (negative real interest rate) – borrowing capacity determines winners
• Too Big To Fail (Government Bailout)
• Land Policy (monopolistic and limited land supply, oligopoly real estate supply, …)
• Development Financial Engineering (PPP, RDI, Concessions, …)
Negative Real Interest Rate
• Gordon Growth Model
– Constant rental growth rate (g)
– Discount rate (r)
( ) ( ) ( )
( ) ( )
( ) ( )
( ) ( )
g r T g r
a
r
g a
r
g a
r
g a
r
g a
r
a P
T
t t
t
T
T
> -
=
+
+ =
+
+ + +
+
+ +
+
+ +
+ =
=
-
-
and if
1
1
1
1
1
1
1
1
1
1
1
1
3
2
2 1 0 K
Negative Real Interest Rate a = $200,000
g = 2%
Discount
Rate (r)
% change Property Price
%
change
Scenario 1 r = 6% $5,000,000
Scenario 2 r = 5% 1% $6,666,666 33%
Scenario 3 r = 4% 1% $10,000,000 50%
Scenario 4 r = 3% 1% $20,000,000 100%
Scenario 5 r = 2.5% 0.5% $40,000,000 100%
Scenario 6 r = 2.1% 0.4% $200,000,000 400%
When Discount Rate Comes
Close to Expected Growth Rate,
Property Price Increase can be
Non-linear
0
50
100
150
200
250
2.10% 2.5% 3% 4% 5% 6%
Property Price ($m) v. Discount Rate (%)
[assume g=2%]
Negative Real Interest Rate drives Property Price Up
• Both theoretically sound; and • The only one empirically confirmed in the
following 3 dimensions!
• It is empirically valid in the past data; • It is empirically valid in other countries; • It is empirically valid in prediction (future).
Theoretical Logic
• RIR = -4.17% in Feb. 2013
• mortgage payment < rent;
• hibor (0.23%) < inflation rate (4.4%)
• mortgage rate (2.25%) < yield rate (3.3%)
• rental growth in 2012 (13%)
• price growth in 2012 (28%)
• -RIR tempts people to borrow and invest in the housing markets to reap "no-risk" returns and to hedge inflation!
• -RIR enlarges the wealth disparity!! http://news.hkheadline.com/dailynews/headline_news_detail_columnist.asp?id=231
644§ion_name=wtt&kw=222
Casual Observations
• confirmed the negative relationship hypothesis:
• ignore the risk premium first.
1996 2001 2006 2011
HIBOR % 5.48 3.44 4.21 0.27
CPIA yoy % 6.31 -1.60 2.03 5.51
RIR -0.83 5.04 2.18 -5.24
HPI (yr end) 134.5 73.8 93.8 181.1
Why RIR is Negative in HK?
• Currency Board Arrangement
• Currency exchange rate is fixed!
– Linked Exchange Rate (peg) US$1 = HK$7.8;
• Interest rate is fixed!
– If the rate does not follow the US's, arbitrage can make no-risk profit!! (carry-trade)
• Inflation does not follow
– Economic conditions very different from the US;
– When the economic conditions are opposite, then
– Either a LOW INTEREST RATE + HIGH INFLATION;
– Or a HIGH INTEREST RATE + HIGH DEFLATION.
Intertwined Extraneous Factor - US Currency
• US Currency strength – when US$ is weak (as in the 2000s); – foreigners find HK's factors of production
cheaper; – attracts foreign funds inflow from strong
currency countries into HK to speculate on the negative RIR.
– Normally, US currency goes in the same direction of nominal interest rate;
– It aggravates the negative RIR effects.
US currency index drops from 120 to 70 and back to 80
US interest rate drops from 6.25% to 0.25%
1/2000
1/2008
1/2013
Prediction of a Housing Bubble in Oct. 28, 2009
The prediction was made when the CCL = 75;
The recent peak was 123;
Now it is 117!
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1434312
Yiu, C.Y. (2009/07/15) Negative Real Interest Rate and Housing Bubble Implosion - An Empirical Study in Hong Kong, SSRN
When did the Negative Real Interest Rate start?
The prediction was made when the real interest rate
just started to drop to negative zone (Nov. 2008);
It is – 4.17% (in Feb. 2013)
Asian Financial Crisis 1997 - HK
RIR v. HPI yoy of HK
RIR v. HPI yoy of HK
Subprime Crisis 2007 - US
Real Interest Rate of US - Negative 2003 - 2005
• Negative 2% in 2003 - 2006;
• Subprime crisis in 2007;
• Now, RIR is positive because of deflation.
US Annual Housing Return v. RIR
A More Robust Empirical Test
2010 JFMPC 14(3), 257-270
Econometric Models' Results
Strongly significant NEGATIVE effects of both positive and negative RIR,
but the impact of negative RIR on housing return is almost 5 TIMES stronger!
-2.61%
-0.83%
Why Excessive Profits?
•Developers know very well about the relationship, and can:
•Buy more land
•Borrow more money from bankers
•Sell less (reduce supply)
•Money supply is exogenous
•Land supply is monopolized
•Property supply is oligopolized
24
3-party supply control
• Tri-party works together to monopolize money-land-property (MLP) supply;
• MLP-supply determines space value and therefore investment demand.
Control Government Bankers Developers
Land & Use
Money & Credit
Property & Type
25
Too Big To Fail • Moral Hazards • When property price dropped in 2003, the government took
all measures to stop it, including: – Stopping land sales; – Stopping subsidized housing (HOS) constructions; – Lend interest-free money for buyers to buy flats; – Open up the housing markets to international buyers; – Investment immigrants could invest property to fulfill
the required investment amount. • Bankers and developers are too big to fail?
– If they earn money, it is their rights; – But if they lose a lot of money, they would be bailed out.
• i.e. returns are developers’ and bankers’, risk is taxpayers’ !
26
How Big Are Developers? Company Ticker Mkt Cap (US$ in Million) 2013
CKH 1 36,596
SHKP 16 34,123
HLD 12 15,766
Sino Land 83 8,224
NWD 17 8,548
Kerry Prop 683 8,599
Great Eagle 41 2,251
Hang Lung Prop 101 14,903
HKL 14,163
Hysan Dev 14 4,939
Swire Prop 1972 15,694
Wharf (H) 4 25,381
Link REIT 823 11,569
Total Mkt Cap 200,756 https://markets.jpmorgan.com/research/email/v8a880j2/GPS-1267943-0
= 9.2% of total
Mkt Cap of
Stock Ex HK
27
Government’s Supportive Roles in the Housing Sector
Govt’s Roles in Housing Market
Sole Land Supplier
(18% land sale income excl. other
related taxes)
Biggest Developer and Housing Owner (Public Housing)
Policy Maker and Law Enforcer
Users (Quarters)
and Facilitators
(Loans)
BANKS
/ HKMC Monetary
Policy
Govt
cannot let
housing
price drop
Income
Bank
Risk
Negative equity
and unemployment
Private
Housing
Market (50%
households
are owners)
HOS [20%]
(by lucky
draw)
PRH [30%
households]
(by queuing)
Private
Renters
[15%]
Investors
Development
Control
Developers
28
Land Policy
• Monopoly of land supply – 99.9% of land are owned by the Government – Land grants are in leasehold interests (mostly in 50-year tenure) – Land Resumption Ordinance allows resumption of land without
compensating hope value – Only 24% of land area are zoned for development – Government wears 2 hats: a landlord and an enforcer of land policy and
regulations (Conflict of Interests) – Government, when in the capacity of a landlord, does not have to
comply with Administrative Law • Limited land supply (There is NO High-Land-Price-Policy)
– Max 50 ha land sale per annum from 1985 to 1997. – Land sale was virtually suspended from 2000 to 2008.
• Oligopoly of property development – Huge sum of land premium set a high barrier. – Giant 4 (Big 11) developers take almost all the shares. – Land banks more than the government. – Collusion is easy and possible. – Virtually no foreign competitors (local knowledge and insider
information are crucial, see below)
Land (for all uses)
Private Housing Units to be built
Bef 1997 < 50 ha Ave. 26,000
2011/12 36.8 ha 9,450
2012/13 30.2 ha 10,150
2013/14 25.8 ha 13,550
Target - 20,000
Restrictive Land Supply
30
Limited Land Supply
• Peng, R. and Wheaton, W.C. (1994) Effects of Restrictive
Land Supply on Housing in Hong Kong: An Econometric Analysis, JHR 5(2), 263-291. – “When restrictions lead to an anticipated reduction in overall
land supply, the housing market (correctly) expects higher future housing rents, … capitalized into higher current housing prices.”
0
5000
10000
15000
20000
25000
30000
35000
40000
0.0
50.0
100.0
150.0
200.0
250.0
300.0
HPI Completions (RVD)
Land Use Area (ha)-
2010 SIN 2012 HK
Res. 10,000 (14%) 9,760 (9.5%)
Ind./Com. 9,700 (13%) 2,300 (2.1%)
Green 5,700 (8%) ~73,000 (66%)
GIC 5,400 (8%) 3,700 (3.5%)
Total 71,000 109,200
Land is NOT limited but is at the sole discretion of
the government.
Zoning Effects: SIN v HK
Country/ city
GDP per Capita
Ave. Living
Area (sf)
Per Person
(sf)
US 51,704 2,476 ~800
Taiwan 38,357 1,119 ~370
SIN 60,799 1,044 323
Tokyo 35,855 667 ~220
Shanghai 9,055 560 194
HK 50,936 452 161
Ave per person living area of HK = 0.5 of SIN
Price to Income Ratio:
HK 2011 = 12.6, 2012 = 15
SIN 2011 = 4.4
36
Collusions
• 2003: Hunghom Peninsula case and Mr Leung Chin Man (BD Director).
• 2013: An alleged bribery case brought against former Chief Secretary for Administration, Mr. Rafael Hui in connection with several directors of Sun Hung Kai Properties (SHKP), the largest property developer of commercial buildings in Hong Kong.
37
Development Financial Engineering
• Private Public Partnership (PPP), such as BOT, BOOT, Sale and Leaseback, … (公私營合作模式)
• Concessions (發水) • Land Premium Waiver (地價減免) • Residual Development Intensity
(剩餘發展規模)
38
PPP
Developer: NWD
main contractor: Hip Hing
Project Outcome: • TDC have a world class
CEC at no capital cost;
• NWD took 2 world class
hotels, an office tower
and a serviced
apartment tower at no
land cost;
• The site was gifted by
the Govt in 1984.
Ma Wan Park and
the Park Island
Develop 5,000 residential units, GFA = 3.7 million s.f.
Conditions:
Provide a public theme park of 2 million s.f.
SHK has to invest $1 billion in the park
SHK bears the costs of relocation of villagers
Cyberport (or Bel Air?)
The Government's equity contribution will be based on the land value assessed
at the time of grant of the development right;
PCG's capital contribution is estimated at $7 billion.
Why PCG? Any tendering process?
Government Share of the Profit? $4 b
41
Free Land Premium - URA
Items (HK$ million) 2009 2010 2011 2012 2013
Revenues 1,413 9,663 3,647 3,690 5,341
Surplus with land
premium waiver
(4,685) 6,993 2,159 2,431 4,292
Accumulated surplus
with land premium
waiver
(41) 6,977 9,186 11,770 16,207
Land Premium
Waived
(216) (3,177) (922) (64) (1,018)
Surplus without land
premium waiver
(4,675) 3,841 1,287 2,520 3,419
Accumulated surplus
without land premium
waiver
(1,366) 2,475 3,762 6,282 9,701
% of waiver to
surplus
45% 43% 3% 24%
http://www.ura.org.hk/media/1736032/p97_financial_highlights.pdf
42
Land Premium Negotiations
• “…a modification is a contractual negotiation between landlord and tenant and should not be disclosed to any third party until the deal is done…”
• Land Premium Negotiation is a black-box process: – No Public Scrutiny
– No Judicial Review
– No Evaluation or Auditing Process
43
Land Premium Case – Yan On Hospital
• Only 54% of the site was used to build a hospital;
• The remaining 46% of the site was rezoned to build private residential development;
• Land premium $0.61b in 2004; • Hill Paramount was sold in 2010 with total
considerations of $3.5b; • i.e. profit > $1.6b. • Profit rate > 100% Audit Commissioner Report
http://www.aud.gov.hk/pdf_e/e59ch04.pdf (26 Oct 2012):
44
6 Types of Concessions
1. Disregarded GFA (Carpark and loading/unloading
areas excluding PTT
2. Disregarded GFA other than carpark and L/UL
areas (e.g. plant rooms and similar services)
3. Disregarded GFA in hotel under B(P)R 23A(3)
4. Exempted GFA of green features under JPN 1,2
5. Exempted GFA of amenity features and other
exempted areas
6. Bonus GFA
7. Unclassified Concessions
Typical Concessions
• Typical concessions include carparking space, balconies,
working platforms, bay windows, clubhouses, utility,
recreational facilities, amenties, …
Cohorts Balcony Workin
g
Platfor
m
Externa
l Wall
Bay
Window
Others
(Clubho
use, …)
GFA SFA UR (%)
1972 36 0 45 0 0 850 793 93%
1986 0 0 75 16 907 817 90%
1993 0 0 61 52 48 945 732 77%
2010 22 16 132 34 7 1,030 785 76%
http://hk.apple.nextmedia.com/news/art/20101016/14559693
Concessions – Harbour City
case • Wharf Properties Ltd and Ano v. Eric Cumine Associates,
Architects Engineers & Surveyors and Others Privy Council
Appeal No. 45 of 1989, 1991 WL 1124849 (Privy Council), [1991] 2
HKLR 6, [1991] HKLY 747; [1991] 52 BLR 8, [1991] 2 HKLR 154,
CACV000052/1988, CL 48/1985, and HCA 13431H/1983;
Omission to
claim
Non-
accountable
gfa (sm)
Hotel gfa
concessions
(sm)
Dedication
gfa bonus
(sm)
Harbour City 6,029 5,722
Ocean Centre 1,839
Marco Polo
Hotel
1,184
Prince Hotel 1,480
Sub-total 6,029 2,664 7,561
Total 16,254
Plot Ratio Transfer
• Dedication and Surrender (to public use) • So called Bonus GFA;
• stipulated in s.22 of the Building (Planning) Regulation.
• If the dedication of set-back area for public passage or surrender of land for road widening at ground level is consented/acquired by the Government,
• bonus GFA that equals to five times the area surrendered/dedicated or less than 20% of the permissible plot ratio, whichever is the less, may be granted in return for the private area surrendered/dedicated to the public.
• HSBC ground floor concourse.
UC - Change of site
classification • Widening of street:
– Island Resort project at Siu Sai
Wan was changed from Class B
to Class C, due to an increase of
street width;
– There are now substantial
remaining plot ratio.
• Marriage value:
– Two Class B sites married and
forms a Class C site;
– Who owns the extra unused gfa?
UC - OZP Conditions
• Planning Approval Condition:
– 13 carparking space should be restricted for the church users only;
– There are now substantial
remaining plot ratio.
• Incompliance?:
– CKH sold 11 out of the 13 carparking space to 3rd parties;
– The Church agreed the sale;
Our Lady of
Mount Carmel
Church Case
UC - OZP Conditions are NOT Enforcable?!
• Government said they have no right to enforce the conditions, and have no intention to follow up the case;
• LD - no restriction of carpark sale;
• BD - not related to health and safety;
• TPB - no restriction of carpark sale.
Approved Building Plan shows that the carparks are for church use only
UC - Lease Conditions
• Estoppel:
– A.G. v Fairfax Ltd [1997] HKLRD
243;
– What is an European Villa?
– Is a 14-storey building an European
Villa? If it has been allowed to be
built for 40 years, then …
• No limit of height:
– The height restriction is waived!
– A tower of 38-storey was built!
– Profit increased by 400%!
Residual Development Intensity
• Maximum permissible gross floor area
= site area x designated plot ratio;
• i.e. gfa = sa x pr;
• Max plot ratio is 10.0;
• Max site coverage is 40%;
• Max gfa = 1,000 x 10 = 10,000 sm.
• 25 storey x 400sm@ = 10,000 sm.
• Covered area = 400sm (40% sa).
• If only 10-storey was built,
• Then 6,000 sm gfa remain.
• RDI = 6,000 sm
Each floor area
= 400sm
25-
storey
Site area = 1,000sm
pr = 10, sc = 40%
10-
storey
How RDI makes extra profit?
• In plot ratio calculations, all the 4 lots are
combined as one site area;
• But in DMC and land sales, the 4 lots are
separately owned;
• When there are some remaining gfa in
the plot ratio calculations, which owner of
the 4 lots owns them?
RDI: Who moves my cheese?
• RDI is valuable, but:
– It is NOT a tangible asset;
– It has NOT yet existed;
– It is just a rights (or a potential
opportunity);
– Yet,
– It comes from the land;
– It cannot be separated from the site area
(gfa=saxpr);
– Who owns the site, who owns the rights!
RDI: CINAT case
• Cinat Co. Ltd. v AG, PC Appeal No. 31/1994, [1995] 1
HKLR 128, from CACV000131/1993 and
HCMP003876/1992
• At no. 121 King's Road, North Point, there is a triangular
piece of land (IL no. 2273 S.A. and R.P.) was reserved
by the Government for MTR station.
• The then owner had agreed to dedicate the
triangular site for public purpose.
• In return, the triangular site area had been counted in the
calculation of bonus site coverage and bonus plot ratio
for the development of Carson Mansion.
• But the Government did not sign the Deed.
RDI: CINAT case • Is there any development potential of the subject
site?
• Interestingly, the appellant paid $12m to buy the
triangular site and made application for a
development of 36-storey commercial buildings.
The BA rejected the application by stating that
"...the permissible plot ratio and site coverage ...
have been almost fully utilised."
57
RDI: Mei Foo Sun Chuen Stage 8
Site Area : 183, 480 sf
Was originally an oil depot
Redeveloped in 1985
MFSC: Plot Ratio Calculations
• gfa = site area
x plot ratio
• Site area =
183,480 sf
• Included the
remaining LPG
tank (hidden
line)
MFSC: Who owns the Remaining
plot ratio
• Who owns the 1.0224 remaining pr?
• If site area excluded the LPG plant, it
should be owned by Stage 8 owners;
• But the site area included the LPG plant,
and can the owner of the LPG plant claims
all the remaining plot ratio of the whole site?
• The Government says YES!
• Making huge profit from thin air?
