The Bonham Circus office building in Hong Kong before (left) and after renovation. (Pamfleet)

While investment volumes in commercial real estate in Hong Kong were up strongly last year, flagship office buildings and prime development sites are beyond the reach of all but a handful of players. For most investors, more interesting opportunities lie in other, less-visible parts of the market.

Last year, records were set for investment deals in commercial property in Hong Kong—with HK$182 billion of office investment sales, 14 office deals worth over HK$1 billion, and HK$60 billion in retail property sales—and momentum has carried through into 2018.

Most high-profile deals, such as the sale of 48 floors of the Centre, a grade-A office tower in the Central district, for over US$5 billion (HK$39.2 billion), are struck by local or mainland groups, with foreign investors unable to compete. Nevertheless, the paradox of Hong Kong being increasingly interconnected with Mainland China while remaining a separate proxy for it means there is considerable interest from foreign investors and a great amount of capital seeking deals.

The special administrative region’s open economy and limited land area result in high property prices. Investable opportunities are insufficient to satisfy demand. Developers are hungry for sites, investors for trophy assets, and end-users for suitable buildings to occupy.

Having few restrictions on ownership, Hong Kong is renowned as one of the world’s most competitive real estate markets, with landlords ranging from the largest developers to wealthy local individuals. In recent years, there has been considerable foreign interest in the market, but relatively few deals have been struck. Rather than waiting for (and possibly missing) the next correction, investors who are willing to roll up their sleeves may find opportunities away from the spotlight.

Why Value-Add?

There are two main reasons why a value-add approach is viable in Hong Kong.

First, a great range of rentals is achievable. For example, in the office market, rents for grade-A space range from about HK$323 to over HK$1,615 per square meter (HK$30 to over HK$150 per sq ft) per month. If grade-B and grade-C offices are included, the range is even greater, offering the possibility of meaningful rental uplift from a grade C to B or a grade B to A space-repositioning strategy.

Second, some buildings are underperforming because most traditional private owners are not real estate experts and are content to achieve high occupancies and not necessarily maximise their overall returns.

This leads to opportunities to create value by repositioning, with the potential to execute a refurbishment facilitated by short occupational leases, minimal statutory intervention in landlord and tenant matters, and a straightforward building control system. When combined with best-practice management, cosmetic improvements and rebranding are sometimes sufficient to attract tenants paying higher rents.

For buildings that require heavy lifting—such as structural alterations, installation of new elevators, major mechanical and electrical upgrades, or work on the facade—a refurbishment project can be undertaken for a fraction of the cost and time that would be required for redevelopment. Repositioning is also less environmentally wasteful.

Decentralisation has increased in response to the rental gap between core and noncore locations, as well as the shortened travel times enabled by transport infrastructure improvements and a healthy supply of new developments away from traditional central business districts.

An office tenant could save over HK$1,076 per square metre (HK$100 per sq ft) per month by moving from the most expensive district (core Central) to a grade-A building in the cheapest district (Wong Chuk Hang or Cheung Sha Wan). Moving from core to fringe Central may save a business HK$484 per square metre (HK$45 per sq ft) per month, and a tenant leaving Island East for Kowloon East or Wong Chuk Hang could save HK$172 to $215 per square metre (HK$16 to HK$20 per sq ft) per month. Investors can take advantage of the decentralisation dynamic by repositioning buildings in noncore but transit-accessible locations.

Although almost all industrial land in the urban areas has long been rezoned for other uses, most government land leases still permit only industrial use and must be modified, with payment of a premium, before a building can be legally used for any other purpose. Over the years, only a handful of buildings have been fully upgraded and repurposed.

However, in expectation that the government may reintroduce a version of the industrial revitalisation scheme that ran from 2010 to 2016, the focus has turned to redundant industrial buildings with potential for a change of use. Industrial-to-office conversions that cater to back-office divisions of banks, finance and insurance companies, or other companies seeking large floor plates at cost-effective rents may be a viable strategy for value-add investors.

Occupier Demand

In these days of disruption, it is important to understand and try to anticipate demand from different occupier types.

In retail, the focus is not just on selling goods, but also on services that e-commerce cannot replace, such as health and beauty, education, medical, and food and beverage. Retailers are looking to provide customers with experiences ancillary to the act of purchasing goods—for example, in-store food and beverage service.

Existing retail layouts not fit for this purpose must be replanned. This requires landlords to alter the size and layout of shop units and provide tenants with the necessary mechanical and electrical services, as well as more-flexible design options.

However, existing owners of nonprime shopping centres are rarely willing to contemplate disruptive repositioning because of the time, cost, and risks involved. This means opportunities exist for investors to buy and reposition secondary retail podiums for various tenant users to target middle-income residents from the immediate catchment area.

In the office sector, design is changing quickly, enabling better working environments and more efficient ways of communicating. Occupier demand will shape the office market more than ever.

The coworking market in Hong Kong has doubled in the past two years. There are now just over 200 flexible workspaces in Hong Kong, compared with 330 in New York City and 1,136 in London, according to Instant Group, a U.K.-based brokerage firm specialising in flexible workspace and serviced offices.

Although Hong Kong has the world’s most expensive office space, the average coworking desk rate is only US$554 (HK$4,347) per month, which is 38 per cent less than a desk in London (US$897/HK$7,038) and 50 per cent less than a desk in New York City (US$1,100/HK$8,631). This range of rental rates implies upside for landlords to adopt the operator model to drive engagement with occupiers.

In the discussion of coworking versus traditional office space, it is important to consider the likely target tenant sector for a specific building given its location, size, floor plate, and other unique factors. Multinational corporations have very different requirements than those of small- to medium-sized enterprises and startups. In a value-add approach, the repositioning and letting strategy to be adopted must be tailored to suit the tenant audience and the building in question.

In the residential sector, the soaring housing prices in Hong Kong have led to a focus on making better use of smaller spaces through smart interior design. Despite enormous potential demand, there is a shortage of institutional-quality multifamily apartments for rent. However, because most residential space is sold strata-title, investors have difficulty finding suitable single-ownership buildings for conversion, and the prevailing stamp duty regime discourages investment in the residential rental sector.

Technologies such as LED lighting, wi-fi, smartphones, and cloud storage have already changed daily life. Going forward, technology will further affect the design and use of real estate.

Technologies such GPS navigation and tracking, face recognition, artificial intelligence, drones, robots, virtual reality, solar power, self-driving/self-parking vehicles, electric cars, e-pay services, health care at home, and 3-D printing will need to be incorporated, or at least allowed for, in building design. Expect change to accelerate, especially with the introduction of 5-G internet service.

As the lines dividing the ways people want to live, work, and play in buildings become less rigid, owners will look to see how they can accommodate different uses more flexibly in a property, including, for example, traditional office (which may be coworking), residential (which may be co-living), and vertical retail, as well as alternative uses such as education, senior housing, and health care. There is no playbook for investors to follow, but those who can anticipate change and position their buildings accordingly will be better able to capitalise through a value-add approach.

Andrew Moore is chief executive officer and Allan Lee is managing director of Pamfleet (HK) Limited.