Yiannis G. Mostrous, editor of the Silk Road Investor, says Hong Kong's real estate market lagged others recently, and pent-up demand is strong.

The Hong Kong economy has been strong of late and continues to make improvements that started in 2003. The unemployment rate is down to 3.6%, and the median household income has risen to a new peak around US$3,000 per month.

As inflation rises, Hong Kong will have negative real interest rates for some time. Because of the currency peg, Hong Kong will most likely follow the US rate policy, which will lead to a large amount of funds flowing into the local economy, particularly because mainland China remains strong.

But the real estate market should benefit the most, and there are good reasons for that.

Real estate is a cyclical industry. In Hong Kong's case, there's strong pent-up demand because of the low transactions in the past two years, particularly in the low end of the market. The last time Hong Kong experienced a structural upturn in housing prices was from 1985 to 1997. Prices rose every year, except in 1995, and gained 720 percent.

Prices have been stabilizing for two years, and the market's now ready for the next leg up. After a disappointing 2006, last year was much better with residential prices increasing by around 10%. See the chart below.

Housing supply was low in 2007, and the same is expected for 2008. During the real estate downturn from 2002-04, land sales were cut back. They resumed in May 2004. And since then, the process has been quite slow because of new regulations. As a result, inventories remain quite low. And I don't expect that developers will sell at discounts while the market remains tight.

The influence of the mainland also shouldn't be underestimated. According to executives at Cheung Kong Holdings (OTC: CHEUY.PK), 20% of the buyers in its latest residential development, which will be completed in the first quarter of 2008, are Mainland Chinese. Other property developers have reported similar trends. Demand remains genuine and is also picking up at the lower end. Speculation is still in its early stages.

Cheung Kong has done well since I added to the portfolio more than a year ago; it's up 70%. The company has one of the biggest residential land banks in Hong Kong: 17.3 million square feet. It's a respectable player in the mainland, too. The stock trades at relatively cheap valuations, especially compared to the more leveraged construction plays. Cheung Kong is a conglomerate and has more room for upside and better downside support. Cheung Kong is a buy.

A more recent portfolio addition, Bank of China Hong Kong (Hong Kong: 2388, OTC: BHKLY) is the number one mortgage bank in HK and as such is well positioned to benefit from the pick-up in the property sector. It strong deposit franchise also gives it funding flexibility. It also offers a solid and sustainable dividend yield of 4 percent. Buy Bank of China Hong Kong.

For more leverage to the theme, I recommend Henderson Land Development (Hong Kong: 12, OTC: HLDCY). Although the company has a smaller residential land bank of 5.8 million square feet, it also has 31.7 million square feet of agricultural land that could be converted into residential land. (In comparison, Cheung Kong has 15 million square feet of agricultural land). According to industry experts, this will take place gradually in the next few years.

Henderson also has around 150 million square feet in mainland land bank, one of the largest among Hong Kong-based developers. Even with short-term drawbacks in the Chinese property market, long-term growth will be an additional kicker for the company.

Valuation wise, Henderson is also one of the cheapest developers, and I expect this gap to close this year. Henderson Land Development is the new addition to the Alternative Holdings Portfolio.

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