Our final day of organized meetings in Hong Kong featured more extensive interaction with with decision makers from the private-sector. Government plays a much greater role in real estate development in Hong Kong than in the U.S. as it owns the land and directly develops a significant proportion of the residential stock in the form of public housing. But private developers still provide the entrepreneurial spirit behind much of HKs built environment and orchestrate the construction of least 2/3rds of HKs residential and nearly all of its commercial buildings, and thus play a significant role in shaping the city’s form and sustainability profile. My objective today is to briefly discuss my observations regarding how real estate investors and developers in Hong Kong measure success and the implications for sustainable development. It likely will not surprise the reader that the primary metric for success appears to be basically the same as it is around the world – maximizing profit.
I’ll begin with my observations from our visit to MGPA, a large institutional investor operating primarily in Asia and Europe. They make money by convincing clients to give them money to invest in real estate and by keeping them happy once they have it. Their clients’ primary goal is to make an acceptable risk adjusted return on their investment – and while they may support the concept of sustainability, it doesn’t appear to be an important factor in deciding with whom to invest. This means that decisions relating to sustainability must stand on the basis of their ability to increase risk adjusted returns.
In the simplest case (not considering taxes or leverage) the return from a real estate investment depends on just a couple of variables – how much you pay to buy or construct the building; how much rent you receive from tenants while you own it; the expenses you incur while you own the building; and how much you receive for the building when you sell it. Decisions relating to incorporating sustainable features can influence each. For example, if tenants are willing to pay a premium to locate in a green building or if green buildings lease faster, than they will generate more income, enhancing the total return. Our conversations with MGPA and others suggest that many large western corporations operating in HK do have a sustainability “box” to check – but it doesn’t seem to be among the most important criteria or one that warrants a rent premium. Green features don’t seem to be on the radar screen for small or locally-oriented companies and individual residential property buyers seem much more concerned with building wealth than sustainability.
How about the expense side? In HK, most office leases are NNN, which means the tenant pays operating expenses directly or reimburses the landlord so any cost savings associated with green features accrue to the tenant. One of the most jarring revelations from our discussion with MGPA is how insignificant operating expenses are in Hong Kong relative to rents. Rents for top-tier buildings are nearly $200 a square foot per year while expenses don’t exceed $10 per square foot. Thus operating expenses represent less than 5% of the total occupancy cost. Even if a green building could achieve a 10% reduction in operating costs – this equates to only a 0.5% reduction in total occupancy cost from the tenant’s perspective, and is unlikely to have much bearing on the space-leasing decision. The economics are better on the class B side but the general point remains the same.
The decision of whether or not to incorporate sustainability features into a building may also be influenced by expectations regarding whether they will enhance the building’s value at the time it is sold (the reversion). It may make sense to incorporate green features into new buildings or to retrofit older buildings even if they don’t generate a rent premium today, provided the investor anticipates the market will pay price premiums in the future. This is because it is cheaper to incorporate green features into a building during its initial design and construction than to add them later on. Similarly, it may be less expensive to retrofit an existing building with green upgrades upon acquisition as part of the asset management strategy. These factors do appear to be considerations to MGPA sustainability decision making.
The decision to incorporate sustainable features clearly has implications for investment returns – but risk also matters. MGPA suggests that regulatory risk may be an additional driver for sustainability, but probably not a highly significant one. If the government mandates “sustainability” standards in the future, existing property owners could be forced to spend significant capital to upgrade existing buildings, and it may make sense to mitigate this risk by incorporating the most cost effective sustainable features during initial construction or upon acquisition of an existing property even if these additional costs are not immediately recoverable.
Our meeting with the Hang Lung Development Company led to several additional “softer” observations regarding metrics for success and their implications for sustainability. Hang Lung is one of the largest public real estate companies in the world and operates primarily in Hong Kong and mainland China. Their underlying motivation appears to be the same – to maximize profit to the company’s management and shareholders, but our conversation revealed several important nuances. For one, government plays a larger and less transparent role in shaping development profitability in Hong Kong and China than in the U.S. because they directly allocate the land. If the government signals a desire for green buildings, developers will provide them even if they don’t yield maximum profit as it may help them gain control of key land parcels. Second, a developer’s reputation is extremely important to their success in this region of the world and must be carefully cultivated. Sustainable buildings may enhance the developer’s reputation and recognition and can be trumpeted as a marketing tool to secure additional land deals in the future. These considerations are clearly factors in Hang Lung’s decisions to develop sustainable buildings. Finally, our meeting with Hang Lung illuminated the fact that while profitability is essential – it is not the only metric by which a developer’s success is measured. Ego matters and can make a difference in decisions relating to sustainability. Developers in Hong Kong hold the assets they build for the long term. They want to be able to look you in the eye and say “I am the one who did this – see how beautiful, profitable, and sustainable it is.”