WITH the territory's economic and property booms, it seems amazing that Hong Kong's private sector construction activity as a proportion of gross domestic product (GDP) is at a 20-year low. In a new report by HG Asia, private sector building activity, as a percentage of GDP, halved over the past decade. Stephen Brown, head of research at HG Asia, said in the report the fall in construction activity was due to the impact of the property provisions of Annex Three of the Joint Declaration, which continued to bite the market. He said this annex encoded a land premium tax, which essentially confiscated profits on most urban redevelopment. Paragraph Four of Annex Three to the Joint Declaration implemented the '50-hectare rule' on the granting of new land, but this was rather a minor point. 'Although it restricts somewhat the government's ability to put supply on to the market, it has proven to be somewhat flexible in practice,' said Mr Brown. The key to the structural inability of the local property market to meet demand with increased supply lay in the much more critical, but less remarked upon, Paragraph Five of the Annex, he said. Paragraph Five states 'modifications of the conditions specified in leases granted by the British Hong Kong Government may continue to be granted before July 1, 1997 at a premium equivalent to the difference between the value of the land under the previous conditions and its value under the modified conditions'. 'So, at one simple stroke of the pen an effective 100 per cent redevelopment tax on lease modifications was enshrined in the Joint Declaration encoding previous practice,' said Mr Brown. 'This tax is payable in cash, in advance, and is entirely at the developers' risk.' However, it is undeniable that developers who had afforded to pay premiums for modifications of leases on redevelopment projects have reaped hefty profits from the property price rallies in recent years. The key to making development profits depends on a developer's ability to negotiate favourable premiums terms with the government. Mr Brown described the premium payable to the government as a unique disincentive to redevelop and an insurmountable barrier to entry for new players. 'Hong Kong's urban blight is a visible testimony to the fact the arithmetic of redevelopment simply does not work in most circumstances,' he said. But developers exploited the fact some properties' old leases allowed alternative uses within their original terms of grant - which means a redevelopment will require no premium payment. Recent examples include Wharf's Harbour City redevelopment and Times Square, Swire Properties' activities in Quarry Bay and the Peninsula extension. Also, Lee Gardens Hotel, whose foundations were laid in 1967 for residential use, was then converted into a hotel and is now being turned into an office building. Possible redevelopment of the Sheraton and Hilton hotels is also motivated by the same legal position. Mr Brown said supply from redevelopment activity in the private sector as prices rose, would apparently fall as most sites with multi-use old leases were now redeveloped. 'Indeed, it is the inappropriateness of this approach to urban development policy, which, when combined with the peg, produces the overpowering cocktail of negative real interest rates and a structurally inflexible market,' he said. 'This form of development taxation has been tried by only one other government, to the best of my knowledge.' The approach was enshrined in, and subsequently ridiculed from, the statute books in the United Kingdom some 20 years ago under the socialist Labour Party's Community Land Act which sought to confiscate the 'super-profits' of 'nasty' property developers, he said. The act was accused of removing the incentive to develop and it was feared supply would subsequently collapse causing severe social and economic consequences, he said. It is public knowledge negotiations with the Hong Kong Government on modifications of land uses have been a time-consuming process - which results in delays of property redevelopments and subsequently affects supply. In response to escalating criticism and public pressure, the government recently promised to speed up the processing of modifications on change of land uses, particularly for residential purposes, to help increase supply. The HG Asia report attempts to assess the key common motivating factors behind recent property 'booms and busts' in London and Tokyo, as well as the 1982 Hong Kong collapse. Its focus is based on the prospects of the office market going bust, which acts as a proxy for the general economic health of a service economy such as Hong Kong's. It said until July 1, 1997, when the property provisions of Annex Three could theoretically be removed, it was inevitable that effective demand would solely be controlled by the price mechanism, against the backdrop of limited supply. Because of the currency peg, the capital values, given the absence of a socio-economic crisis in China, would be determined by long-term US dollar-denominated yield structures, it said. It expected the US long-bond yield would harden to 6.5 per cent by the middle of next year, providing further underpinning to capital values. This is despite the fact the report conceded looming oversupply in the established office centres should be imminent. Given the high levels of pre-letting for buildings such as the Gateway and Dorset House, which total about two million square feet, these levels of supply were perfectly compatible with a continuing firm level of vacancy rates, it said. 'We believe that the inevitable development of fully fledged foreign exchange, consumer credit, insurance and fixed interest markets, all of which are currently immature, will, at some stage, provide a quantum yardstick in established financial centres,' said Mr Brown. These activities were the dominant source of office demand in established financial centres, he said.