The Hang Lung Ambition

52 Pages·2015·2.86 MB·English

13 April 2015

The Hang Lung Ambition
Q&A on Hang Lung Properties’ ambitious wealth-building endeavour

Jonas Kan
(852) 2848 4439
[email protected]
See important disclosures, including any required research certifications, beginning on page 46.
The Hang Lung Ambition
13 April 2015

Contents

Q1 Are commercial properties in China worth owning? 1
How much value can systematic and professional
Q2 13
management create for retail properties?
Is HLP a credible vehicle through which to play the
Q3 emergence of premier retail property managers in 19
Greater China?
Are there aspects of this ambitious wealth-building
Q4 33
exercise that have been overlooked?
Company section: Hang Lung Properties 41

Please also see:
Swire Properties: more on the Cheung Kong/Hutch’s Bold Move: The Hong Kong Property Toolkit:
‘nurturing reward’ Q&A on the prospect of the group A step-by-step guide to the past,
becoming a global play, with a present and future of the Hong Kong
valuation to match Property Sector
10 April 2015 9 February 2015 Autumn 2013
Jonas Kan, CFA (852) 2848 4439 Jonas Kan, CFA (852) 2848 4439 Jonas Kan, CFA (852) 2848 4439
([email protected]) ([email protected]) ([email protected])
The Hang Lung Ambition
13 April 2015

Contributing Daiwa
Thoughts on HLP’s ambitious wealth-building
Analyst:
endeavour

About 10 years ago, HLP embarked on an ambitious wealth-building venture
in the property space, entailing utilising the over HKD20bn in profit it stands
to realise from Hong Kong’s residential property sector to fund a series of
ambitious investments in China in an attempt to transform itself into a
leading player in the commercial property sector in Greater China.
Jonas Kan, CFA
(852) 2848 4439 That this is a special endeavour deserving investors’ attention is not in
[email protected]
doubt, but how this ambition has been priced into HLP shares has changed
in recent years. That is to say, from 2005-11, HLP traded like a rising star in
global property, but since then, its valuation has been notably derated.

Although the company’s gross rentals and BVPS rose at decent CAGRs of

12% and 6%, respectively, from 2011-14, its current share price of
HKD24.15 represents a 40% drop from its peak of HKD40.30 in 2010.

In this report, we spell out our thoughts on the major issues relating to the
sector and HLP itself that we think investors should consider in assessing
whether HLP’s shares are undergoing a structural derating, or now
represent a rare opportunity to buy into an ambitious, yet safe and reliable
vehicle through which to play the long-term potential of prime commercial
property assets in Greater China.
This report comes after our 9 February publication on Cheung Kong
Group’s latest reorganisation, which we believe could attract global investor
interest in Hong Kong family business groups, including HLP, all of which
are trading at notable discounts to the market values of their property and
business assets. A special aspect to HLP is that its strategy is probably the
most simple and focused of the Hong Kong family business groups, and that
the value-creation potential associated with professional and systematic
management of retail property assets which has already been well-
demonstrated by various premier names in global property is something we
expect to see at HLP.
In what follows, we attempt to help investors understand what we see as the 4
major questions pertaining to the commercial property sector in Greater
China, and to HLP as a vehicle through which investors can obtain exposure
to this area.
Jonas Kan, Head of Hong Kong and China Property
The Hang Lung Ambition
13 April 2015
The HHang Lunng Ambition
13 April 22015

Quuesstioon 1

AAre commmerrcial proopertties in Chinaa
worthh owwningg?

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The Hang Lung Ambition
13 April 2015

Q1: Are prime commercial properties in China worth owning?

Notwithstanding the various concerns associated with the China commercial property sector, such as over-supply,
the lack of a sizeable middle class and office-based employment in China, we contend that there are assets in this
sector that are worth owning. However, we would hasten to add that investors should be selective in their choice of
asset and take a long-term view. We advocate focusing on property companies that have developed – or are in the
process of developing – the specialised skills needed to preserve or enhance the value of their commercial
properties over time, and on those that already have (or are in the process of accumulating) a critical mass of
income-producing assets in China, capable of expanding their portfolios without putting excessive strain on their
balance sheets.

In general, we see prime commercial properties as an asset class that benefits from an expanding population, and
the wealth and economic prosperity of any city; and as we see it, China is no exception to this. Generally, a safe
and attractive way to play the rise of a large, populous and growing economy is to own prime commercial
properties, and in our view, China is no exception.

Commercial properties are essentially property assets used by corporations, retailers, etc., for commercial activities
– be it retailing or office-based business activities. (Note that we consider hotels and serviced apartments as
comprising a different type of property asset class, and hence, refer only to retail and office property assets in this
discussion on commercial property.) Generally, the rise in wealth and population of a city leads to an increase in
total retail spending in that city. Similarly, the rise in the level of office-based economic activities and corporate
profit also normally results in an increase in the total rents that can be paid by the corporations in that city, which in
turn, exerts upward pressure on the aggregate capital value of the commercial property assets in that city. In this
light, it would follow that the total market value of China’s commercial property sector should become very large, as
long as the country’s economy continues to expand.

China: number of cities by population
Population Number
Over 10m 12
5-10m 75
1-5m 214
301
Source: China Statistical Year Book, CEIC

Major cities in China in terms of population
(m)
1,37700
1,36600 1,360
50
40
30
20
10
0
hina - overall Chongqing Shanghai Beijing Tianjin Chengdu Guangzhou Shenzhen Suzhou Shijiazhuang Wuhan Harbin Wenzhou Zhengzhou Qingdao Hangzhou Xi'an Nanjing Ningbo Hefei Changchun Fuzhou Shenyang Nanning Changsha Jinan Kunming Wuxi Dalian Nanchang Guiyang Taiyuan
C
Source: Datastream, Daiwa

Notwithstanding the sizeable aggregate value of commercial property assets in China, the sector faces a number of
challenges, particularly as relates to per-square-foot rentals and capital values. In our opinion, there are 3 features
that make commercial property in China a challenging sector to play.

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The Hang Lung Ambition
13 April 2015

First, most of China’s major cities are located on flat land, which means that the size of these cities can continue to
expand as “more rings” are added to the geographical spread of these cities. Take Beijing as an example. The total
size of the city has expanded exponentially compared with the early 1980s, with the city having growth outward to
form a sixth ring, with more in all likelihood to come over time. According to the China Statistical Yearbook, in 2014
there were at least 19 cities in China that were are larger than 10,000sq km (to give some context, Hong Kong
occupies about 1,000sq km in terms of area).

China’s 4 Autonomous municipalities and provincial capitals
Provincial capitals Population (m) City area (sq km)
Shanghai* 24.2 6,340
Beijing* 21.1 16,411
Tianjin* 14.7 11,917
Chongqing* 29.7 82,374
Guangzhou 12.9 7,249
Hangzhou 8.8 16,571
Nanjing 8.2 6,587
Jinan 7.0 8,177
Changsha 7.2 11,816
Chengdu 14.3 12,121
Fuzhou 7.3 13,066
Wuhan 10.2 8,494
Hohhot 3.0 17,200
Zhengzhou 9.2 7,446
Taiyuan 4.3 6,977
Shenyang 7.3 12,980
Shijiazhuang 10.5 15,848
Changchun 7.5 20,604
Nanchang 5.2 7,402
Harbin 10.0 53,068
Guiyang 4.5 8,034
Hefei 7.6 11,445
Xi'an 8.6 10,108
Kunming 6.6 21,012
Haikou 2.2 2,305
Urumqi 2.6 13,788
Lhasa 0.5 29,518
Nanning 7.2 22,112
Yinchuan 2.1 8,874
Lanzhou 3.6 13,086
Xining 2.0 7,665
Source: CEIC
*the 4 autonomous municipalities

Second, based on our market research , many provincial and local governments see high-rise office buildings and
upmarket shopping malls as “symbols of prosperity” and, hence, generally have a tendency to supply the market
with abundant land to develop into commercial properties, without paying sufficient attention to whether there is
sufficient economic demand for them. Indeed, it is not uncommon for local governments to “subsidise” the
developers to embark on commercial property projects by granting them lower-cost residential GFAs, so that the
developers can make enough profit on the residential proportion of these projects to fully fund the construction of
the large commercial property complexes next to them. As a consequence, it is typical for many cities in China to
have several CBDs.

The third factor is related to the mechanism for allocating capital in China. In many other markets around the world,
the availability of capital tends to be a powerful factor restraining the construction and completion of unproductive
property projects. However, in China, such a restraint has not been as effective, probably because China’s
economy started off as a command economy, and probably still is to a large extent. Note that over 50% of China’s
GDP comes from fixed asset investments, and over the past 17 years, China’s M2 has expanded at a CAGR of 17%
per year, resulting in a situation where China’s M2 at the end of 2014 was USD19.7tn, 70% larger than that of the
US.

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The Hang Lung Ambition
13 April 2015

China: M2
(CNYbn)
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: CEIC

But what compounds the situation further is that in China, it is arguable that capital has not been properly priced in
the past, such that some large SOEs or other entities have easier access to capital from the banks, and may not
bother that much about the returns on that capital. What makes matters worse is that creating more CBDs helps
the sale of land, which is often one of the largest sources of capital for many local governments. As a result, while
demand for commercial property in China is growing, the supply of commercial property space is also increasing.
Compared with existing stock levels, we estimate that the annual supply of commercial property space in many
cities in China could be in the magnitude of 40-50% of the existing stock, which is certainly a recipe for a near-term
supply-and-demand imbalance.

To arrive at a balanced view on China’s commercial property sector, however, we believe there are at least 3
considerations that need to be taken into account.

1) The total commercial property stock in China’s major cities does not yet appear to have reached a
size that exceeds what those cities’ economies can support in the future. While there is a major
oversupply of commercial property space in China at this point and, this is likely to continue in the near future, if
China can grow to become an economy that rivals the US in size, and if the importance of its service sector
becomes comparable to that of mature Western economies, then this over-supply would not be permanent.
Note that New York and London have grade-A office stock of well over 20m sq m currently, based on figures
from DTZ, while that for Beijing and Shanghai is still below 10m sq m. Note also that cities like Chicago, San
Francisco and Toronto have grade-A office stock of over 5m sq m, while the corresponding grade-A office stock
amounts for the largest provincial capitals in China are still in the 1-3m sq m range.

Looked at in this light, the over-supply issue in China’s commercial property sector could partly be a
“digestion problem” resulting from some of China’s cities trying to achieve within just a few years what has
taken New York, London and many other cities much longer.

Grade-A office stock for the world’s major international cities
((mm ssqqmm))
25
20
15
10
5
0
Tokyo (Central 5 Wards) New York (Manhattan) London (Central) Hong Kong Shanghai
Source: DTZ, Daiwa

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The Hang Lung Ambition
13 April 2015

Grade-A office stock for China’s main cities
(m sq m)
9
8
7
6
5
4
3
2
1
0
Beijing Shanghai Shenzhen Guangzhou Chongqing Chengdu Shenyang Qingdao Hangzhou Nanjing
Source: Savills

2) There are factors that could restrain the increase in the number of major cities in China and the size
of their core city areas. Judging from the history of how cities globally have developed, very often, growth
in demand for city space has tended to result more in the expansion in size of an established major city,
rather than the continued emergence of new cities. Even for an economy as large as the US, we would say
that the number of major US cities is probably not a lot more than 10 – New York, Boston, Chicago, Los
Angeles, San Francisco being among them.

In China, because of the diversity of its population, geography and culture, as well as the central
government’s policy to promote the greater distribution of economic prosperity and opportunities
throughout the country, we believe the country will eventually surpass the US in having more major cities.
But we would not see the number of its cities that are of considerable importance to the country as whole
not being much more than 20. If this is the case, then it would be mainly down to about 20-30 cities to meet
China’s entire demand for commercial property space.

Daiwa’s selection of the 20 major cities in China for commercial properties
Source: Daiwa

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The Hang Lung Ambition
13 April 2015

Our observation is that pretty much none of the cities in China have robust and sophisticated long-term
town-planning driving their development. This means that the continued expansion of the nation’s cities is
likely to continue to put a strain on their social infrastructure, in particular, transport and housing. This in
turn implies that the geographical expansion of many cities in China would be constrained at some point.

Over time, we can see a situation developing whereby there is a hierarchy of cities in China, with one major
city being supported by many satellite cities in surrounding areas and, that together, they will form a large
metropolitan area, linked by efficient and modern highways and high-speed rail. It would follow then that
prime commercial properties in China’s top-20 cities would be in a better position than those in cities
outside the top 20, even though over-supply could be a lasting issue in many peripheral satellite cities.

China’s high-speed railway network

Source: Daiwa

3) Some companies and retailers should have sufficient rent-paying capability. We note that currently a
rental budget of HKD3-5/sq ft would allow a corporation to rent almost any office building in China, with the
exception of a handful of the most prime office buildings in Beijing and Shanghai. And in our view, USD3-
5/sq ft should be affordable for many international corporations as many have been paying office rents at
similar or higher levels in other cities. In Hong Kong for example, rents for prime grade-A offices in Central-
Wanchai-Causeway Bay range from USD5-20/sq ft; and based on our industry research, in London, rents
in the West End and the Bank area range from USD5-18/sq ft. Our understanding is that many cities have
office buildings commanding rents of over USD5/sq ft. If these cities can find corporations that are willing to
pay USD5/sq ft or more for some of its office buildings, we do not see why this cannot happen in China.

As for retail rents, we believe there are retailers that can achieve sales per sq ft of USD500 or more in their
stores in China, which would be a respectable level by global standards. Note that for many international
retailers, the achieved sales price for their merchandise in China is often 20% or more higher than it is in
Hong Kong, and globally on average. Thus, it would seem that at least some retailers could afford to pay
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