The risky business of dream factories

If you want to buy office or industrial space and convert it into flats in Hong Kong, the price is about 30 per cent lower than for residential space - and there's no stamp duty.

The down side is that these conversions can be illegal, so you'd have to be willing to live under the sword of a Lands Department crackdown - such as the current one in the New Territories - and, if you're caught, the maximum penalty for such lease breaches is a HK$200,000 fine or a year in prison, according to a Buildings Department spokesman.

But enforcement of the regulations has been light, and the appetite for flat space has been voracious.

The properties in question are zoned for mixed use - as offices or for commercial, industrial or warehouse purposes - and there is a scramble under way to covert the spaces into residences.

Sheung Wan agent Joanne Cheung Miu-wah of On Tai Property says demand for property zoned for office or commercial use has been so keen, there's little supply left.

'In the past two months, it has all gone. The sudden interest in office or industrial-zoned property is because of the stamp duty,' she says.

The prime properties are those designated Office DMC, meaning deed of mixed covenant. The status means a building has been zoned for mixed use as residential, office and commercial use, or as industrial and warehouse space.

It is common for the upper floors, say, floors nine to 30, to be zoned residential. On the lower floors, officially zoned for office use, with 10 units per floor, it's common to find perhaps three or more being used illegally as residences.

As Hong Kong has not had a meaningful industrial economy since the 1980s and the demand for residential space has been so high, DMC and warehouse buildings have seen a gradual rise in the number of units used for residential purposes.

The financial rewards are high, and, so far, the risk of enforcement has been low. Although a spokesman for the Lands Department says 'the government's position is clearly stated', given the way authorities were pressured into enforcing the rules on illegal flat structures in the New Territories, they don't seem keen to wade into the issue of residential use of properties zoned for other purposes.

When asked how many people had been fined or jailed for illegal flat conversion, the Buildings Department spokesman says: 'We have no statistics on that. We have no survey.'

Enforcing the rules involves a lot of red tape, such as serving notice and getting permission to enter and inspect, according to a senior Lands Department surveyor.

'It's multi-disciplinary,' he says, which seems to mean that it requires the buildings, lands and fire departments to talk to one another.

Clarity finally came from the Development Bureau: 'We act on complaints,' an employee says. 'As soon as we receive a complaint, we will act to see if regulations are being broken.'

That reluctance to enforce has given rise to a wave of illegal flat conversions. Not only do people want to save money, but they also have the idea that it's glamorous, funky and bohemian to live in a converted office or industrial loft space, says Christopher Dillon, an entrepreneur and author of books about Asian real estate.

'But the reality here is they are square concrete boxes,' he says. 'It's not like London's Docklands. There are no attractive arches, decorative wrought ironwork or hardwood floors. Most were built cheaply to last a short time.'

In 2005, Dillon bought a 3,500 sq ft sixth-floor space with a 3.5-metre ceiling, in what he describes as the 'canyon of industrial buildings on the way to Ocean Park'.

Zoned industrial, he used the front half of his unit as an office and the back as a photography studio. Every year the Immigration Department came around, looking for illegal immigrants.

Would he have lived there? 'No, it was a typical industrial building, fairly noxious environment, noisy, with asbestos and all sorts of chemicals. Not suitable for kids.'

Safety wasn't great either, he recalls. Many owners failed to agree on repairs, leading to 'deferred maintenance'. But having paid HK$500 per square foot in 2005, he was happy to sell for HK$3,000 per square foot in 2010.

So why doesn't the government rezone the old empty buildings? 'Developers have an interest in the status quo,' says Dillon. The Lands Department says owners may apply to change the use of industrial buildings, but not to use them as residences.

Property consultant and investor Paul Burke hunted for doors without business signs when looking for an office space to convert into a residence. The first obstacle was getting a realistic mortgage valuation because the block had few transactions, which are the basis of such valuations.

Burke paid HK$1.9 million in January 2009 for a 632 sq ft gross (550 sq ft net) office unit in a 28-year-old Queen's Road Central mixed-use building, for its closeness to Central and popularity with foreigners. He gutted the unit and spent another HK$600,000 on a high-end renovation. 'I could have spent less, but it paid off when I sold it. You can't escape basic work with a commercial unit.'

Renting or buying a commercial unit may be 30 per cent cheaper, but expect a big plumbing and electrical fittings bill - 'you may start with just a toilet', warns Burke, who forked out HK$150,000 to upgrade these alone and installed 42 sockets, at HK$500 each fitted, for a total of HK$70,000.

As far as compliance goes, there was plenty to do. Burke needed a valid certificate and had to install fire extinguishers, emergency lighting and a fireproof front door with no spy hole. 'I had 17 fire sprinklers in 550 square feet. The Buildings Department came round and didn't mind I was there at all,' he says.

At the end of the day, Burke did well. After two years he sold in February for HK$4.2 million, having spent a total of HK$2.5 million. He was surprised when his buyer, an expatriate, achieved monthly rent of HK$28,000, for a healthy 8 per cent annual return on investment.

But not all such investments end as happily as Burke's. Aside from the possibility of a fine and prison time, there is a serious risk of not being able to sell.

Concerns about title and the legality of use are likely to deter potential buyers making this investment illiquid.