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 Analyst: Thoughts on HLP’s ambitious wealth-building 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 [email protected] That this is a special endeavour deserving investors’ attention is not in 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 Hang Lung Ambition 13 April 2015 Question 1 Are commercial properties in China worth owning? - 1 - 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) 1,37070 1,36060 1,360 50 40 30 20 10 0 Xi'an Wuxi Hefei Jinan Dalian Tianjin Harbin Beijing Wuhan Ningbo Fuzhou Suzhou Nanjing Taiyuan Nanning Guiyang Qingdao Kunming Chengdu Shanghai Wenzhou Shenzhen Shenyang Hangzhou Changsha Nanchang Chongqing Zhengzhou Changchun Guangzhou Shijiazhuang China - overall 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. - 2 - 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.