Political Uncertainty and the Real Estate Risk Premiums in Hong Kong

Abstract

This study investigates the effects of political uncertainty associated with the 1997 repossession of Hong Kong by China on the real estate market. Such effect is reflected in the change in the real estate risk premiums. A model is derived to estimate the trend of real estate risk premium for each subsector of the real estate market from observable market data. The results suggest that there was a discrete jump in the risk premiums when the 1997 issue was revealed to the public in 1983, indicating investor concern about the post-1997 future of Hong Kong. The increase in the risk premium is much more obvious in nonresidential real estate than in the residential sector. This is probably due to its dual nature (an investment good as well as a good for self-consumption) and the effects of rent control, which only applies to the residential units. However there is also very strong evidence that investor confidence has been increasing recently, thus leading to a decline in the implied post-1997 risk premium, although the increasing confidence is still not sufficient to bring the risk premium back to pre-1983 levels. If the concern about the repossession of Hong Kong by China turns out to be unnecessary after 1997, a re-valuation of the risk premium will take place. This will bring the risk premium level back to the pre-1983 level, assuming no other significant changes have taken place. Other things being equal, such revaluation will result in a one-time discrete increase in property prices. This is in contrast to the common view that investors have already discounted the 1997 Hong Kong/China issue completely.