The US Federal Reserve raised interest rates in March and hinted it could do so six more times by the end of the year.
The Hong Kong Monetary Authority has copied this move, but it does not necessarily mean Hong Kong’s commercial banks will match the US’s pace and frequency during the rest of the year, writes Hannah Jeong of Colliers.
Commercial real estate investors in Hong Kong watch closely for any pronouncements from the Federal Reserve, the US central bank, on the direction of interest rates as they are acutely aware of how they could impact their investment returns.
The peg between the Hong Kong and US dollar makes any US interest rate movements particularly relevant to the Hong Kong Monetary Authority (HKMA), the Fed’s counterpart in the territory, as Hong Kong’s base rate moves according to the Fed’s interest rate decisions.
Programme for higher rates
On March 16, the Fed announced an increase of a quarter of a percentage point in the US base interest rate and suggested it could raise it six more times this year, up to a total of 100 basis points, as it tries to fulfil its mandate of full employment and keeping the annual inflation rate to about 2%.
On the following day, the HKMA raised its benchmark interest rate by 25 bp to 0.75%, stating that it would “continue to closely monitor market situations, with a view to maintaining stability in Hong Kong’s financial and monetary systems”. It noted that geopolitics, macroeconomic developments and the pandemic may affect the pace and frequency with which the Fed changes rates this year.
Hong Kong’s base rate moves according to a pre-set formula: either 50 basis points above the lower end of the prevailing target range for the US federal funds rate, which is 0.25-0.5% now, or the average of the five-day moving averages of the overnight and one-month Hong Kong Interbank Offered Rates (HIBORs), whichever is the higher.
Typically, a US rate increase would ring alarm bells for commercial real estate investors in Hong Kong because of the potential for higher borrowing costs. However, the HKMA noted in its statement that the Hong Kong interbank rate does not increase automatically when the Fed rate does and that banks will make their own decisions based on supply and demand.
Also of relevance to the Hong Kong property market, as well as interest rates, is that a direct link between the capitalization, or cap rate, which commercial real estate investors commonly use as their rate of return, and Hong Kong interest rates is not apparent anyway.
Importance of cap rate
The cap rate is a key concern to commercial real estate investors because it reflects their expected return over the amount they have invested. If an interest rate hike increases an investor’s risk, it will expand the cap rate, or investment risk, at the same time.
Interest rates are not the only factor that affects the cap rate, however. Investors also look at, for example, inflation, liquidity, capital controls, supply, and demand – a key driver of the Hong Kong market – and the economic outlook.
A lower cap rate usually corresponds to a higher valuation, a better prospect of returns and a lower level of risk, while a higher cap rate suggests relatively lower prospects of return, hence a higher level of risk.
One only has to look back to the three years from 2005 to 2008 for evidence that the correlation between the cap rate and interest rates is not rock solid in Hong Kong. In that time, the cap rate narrowed despite a hike in the 3-month HIBOR.
Even if the HKMA decides to increase interest rates by the same amount as the US for the rest of the year, there are three reasons to think they will have only a mild impact on commercial real estate investors’ risk in Hong Kong:
- We expect the HKMA to move slower in increasing interest rates to minimise any negative economic impact.
- Too much capital is chasing the limited amount of quality assets available in the Hong Kong market. A large number of funds have raised new money in 2022 and investors are eager to find good acquisition opportunities in the market. This competition will counterbalance the potential cap rate expansion.
- Geopolitical tensions might increase the inflation rate faster than the interest rate and this is highly likely to keep Hong Kong in negative interest rate territory - where the interest rate is below the inflation rate. Despite uncertainty about the future of the Covid-19 pandemic, which is likely to slow investors’ decision-making, the negative real interest rate will be able to offer a good buffer to investors.
With a mild pressure from the interest rate hike, commercial real estate investors can take solace from evidence that the direct link between higher interest rates and lower investment values in Hong Kong is not as established as one might assume.
As long as investors are not highly geared, the expected interest rate hikes will not put immediate pressure on the market.