Through my work, I have come across many overseas fund managers in the past years. Many of them asked me why prices of real estate stocks in Hong Kong are still significantly lower than their high points recorded more than a decade ago, even though property prices are so high today. They also wondered why property stocks have a high net asset value (NAV) discount rate.
Take blue chip real estate stocks as an example. The NAV discount rate is usually more than 40 percent. The rate for second and third-tier real estate stocks can be as high as 70 or 80 percent. Is that a matter of market failure? Note that the phenomenon has been going on for nearly 10 years. The market cannot possibly have failed for such a prolonged period of time. Could analysts have been over-optimistic in that they have overestimated the value and profitability of real estate stocks? In my opinion, this is not a sound argument either. Even if certain analysts are overly positive, that cannot explain the big share price discount.
Could high financial risks affect the valuation of real estate companies in Hong Kong? The truth is that local real estate developers are in a healthy financial condition. Most blue chip property stocks have a debt rate ratio of under 25 percent, and their recurring rental income is high. It is said that the stock market is nine months ahead of the property market. So, does the high NAV discount of real estate stocks imply property prices will fall in the future? In theory, yes. But in practice, even if local housing prices fall by 10 percent, the impact on the NAV is only slightly higher than 10 percent, given that local property developers do not have much debt. So unless market expectations of falling property prices persist, the NAV discount rate of blue chip property stocks will not be more than 40 percent.
Still, what is the reason for the discrepancy? To answer the question, it is necessary to explain the meaning of NAV. Simply put, when a company sells all its properties at market prices, the amount of money, minus liabilities, is the NAV. In Hong Kong, most Chinese-owned real estate companies are family businesses and operate over generations. The chances of these companies selling all their properties are low. For their small shareholders, NAV is merely wealth on paper. Holding the shares of a real estate company does not mean investors have any stake in the company’s assets. They do not benefit directly if the prices of the company’s properties increase. This explains why there is an NAV discount.
More than 20 years ago, however, the NAV discount for blue chip property stocks was not as high as today. How come? I believe that has something to do with the amount of properties in the old asset portfolios held by the real estate companies. In the past, real estate developers primarily developed properties to be sold in the market. They would then spend the sales revenue on investing new projects. This way, the companies’ NAV and profitability could keep expanding. Today, property developers own a relatively larger amount of properties, which they hold for a long period of time and make rental income out of the properties. Rarely do they sell the properties. This approach means these companies do not grow as fast as in the past and their valuation is affected. As a result, the NAV discount is big.
That is not to say real estate stocks have no investment value. There is a lower limit to the NAV discount of a company. If the price of a stock is too low, the company and its major major shareholders will buy and hold more shares to prop up the share price, as they are well aware of the real value of their company. Besides, real estate stocks are attractive to investors who are after steady income, given that real estate companies enjoy higher recurring rental income today and offer quite good dividends.
（Qiu Zhuowen, DBS Bank (Hong Kong) Hong Kong Real Estate Industry Analyst）
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