Hong Kong's lease-modification policy is fundamentally flawed

Everyone in Hong Kong - at least everyone who knows anything about property, and that is everyone - knows that when it comes to lease modifications, the premium payable is assessed on the basis of 100 per cent of the value increase the change confers.

This is consistent with economic principles and elegant in its theory. However, few involved in assessing and negotiating those premiums know that this policy is fundamentally flawed, in that it requires the Lands Department in many cases to assess premiums that exceed the increase in value that the lease modification confers.

This inevitably makes the premiums asked unacceptable to developers and renders the policy unworkable. And it isn't working. Or at least it isn't working as it should.

The first of these aberrations, is what is termed "costs contingent on development". Under this, the Development Bureau requires the Lands Department not to take account of certain costs which, despite being essential to bringing the new development to completion, are perceived to be costs that should not be allowed in assessing the premium.

An example is replacing a public transport interchange, necessary to implement a new development project.

To appreciate the precise effect of this departure from logic, it is necessary to have an understanding of how the values of sites are assessed. The approach adopted is that known as the "residual valuation". Under this approach, the value of the completed development is assessed and from that are deducted costs. Allowances are made for the timing of the different cash flows and for "developers' profit" and the residual figure is the land value. Failure to take into account costs to complete the development results in the premium exceeding the increase in value by the amount of disallowed costs.