At last – the long-awaited price drop in Hong Kong's residential properties?

As with many of the developed cities in the world, Hong Kong faces the phenomenon of a soaring residential property market.

As a recent Demographia survey shows, Hong Kong's bubble is a particularly big one. Hong Kong is now the world's most unaffordable city to live in, with average home prices at 17 times of gross annual median household income.

However, is this trend on the verge of change? UBS has estimated property prices to drop as much as 30% by the end of 2017. As at 11 February 2016, the Centa City Leading Index (reflecting the price level of 100 of Hong Kong's major residential estates) shows a month-on-month drop of 2.86%.

Increase in supply of land

A drop is likely for a number of reasons.  The insufficient supply of land has been a cause of the soaring prices, but it appears that supply is likely to increase. The Government is eager to explore sites for residential developments and has considered transforming country parks into residential sites. The Hong Kong Property Review 2015 shows that over 20,000 flats will be supplied in each of the next 3 years, a remarkable increase from the predicted 13,290 flats to be supplied in 2015.

Ongoing cooling measures

Cooling measures introduced by the Government have been effective in stabilising market prices. The various stamp duties and the maximum loan-to-value ratio of 60% for self-use residential properties under HK$10m  in relation to mortgages will likely stay in force until property prices drop to a level deemed reasonable by the Government.

Gradual interest rate hike

Further to the increase of the Hong Kong base rate to 0.75%, quarterly interest rate hikes are expected, which will push up the costs of taking out a mortgage, further deterring purchases and driving prices down.

Low rental value

The discrepancy between increasing property values and slowdown in rental yield also renders the residential property market a less attractive option to investors. While the house price index in Hong Kong rose by 274.2% between 2004 and April 2015, the rental index only went up by 122.2% over the same period, providing landlords with a mediocre yield of 2.2% – 2.9%.

Slowdown of economy

Finally, Hong Kong's economy has been weakened by China's economic slowdown. The significant decline of the retail sector as a result of the diminishing number of tourists from mainland China (who have been pivotal to growth of the retail sector in the past decade), has led to a series of lay-offs in the luxury retail sector and an increase in unemployment. This, and the chain effect caused to other Hong Kong business sectors, has weakened Hong Kongers' spending power and created poor market sentiment.

So will prices drop drastically? Not necessarily. Despite the economic slowdown, some Hong Kongers have already saved up for their first purchase but have been waiting for several years to 'strike' at a more reasonable price. The demand for residential properties is also partly fuelled by their buying behaviour – many consider it the ultimate goal to own a residential property. Last but not least, it is important to note that we are not currently experiencing a major economic crisis. Historically, drastic drops in price have been linked with a major external economic crisis such as the US stock market crash in 1987, China's monetary policy tightening in 1994, the Asia financial crisis in 1997, the SARS epidemic in 2003 and the global financial crisis in 2008. If no such major crisis occurs, a drastic drop is unlikely.

The drop should not be sudden either. The expected interest rate rise and the slowdown of the Hong Kong and China economy are likely to be gradual. Taking these factors into account and bearing in mind the demand for residential properties, Hong Kongers may be in for a gradual drop in price over the next 3 years.