Lease modification a funny old policy

Hong Kong's lease-modification policy is fundamentally flawed

Fundamentally flawed system inevitably leaves potential developers with unrealistic premiums

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.

This is an indisputable fact.

When a development site is put to auction or tender, bidders calculate development costs in their bids. It is only the one-on-one relationship between the owner and the Lands Department in lease modifications that allows the government to attempt to implement this self-defeating departure from logic.

The second is that the Lands Department is instructed to assess the "before" value in lease modification premiums on a "cleared site" basis. The premiums are assessed on the difference between the lot's value without the modification [the "before" value] and its value with it [the "after" value]. All well and good.

However, while the cleared-site basis is correct for the "after" value, in many cases the value of the lot unmodified, the "before" value, lies in the land and buildings.

Consider a lot with an industrial-user clause built to the maximum permitted plot ratio of 15, but which is zoned for residential development. Unmodified, this lot is not a redevelopment proposition. It is inconceivable that under the unmodified lease conditions the owner would pull down such a building only to build another one, and yet, in spite of this, the Lands Department is bound by policy to allow only the cleared-site value.

The premium sought well exceeds the increase in value the lease modification brings about.

Then let's look at a site in, say, Deep Water Bay, restricted under the existing lease to development of a single residence of 5,000 square feet with a beautiful 5,000 sqft single residence on site, which is zoned for more intensive residential development. It is eligible for a lease modification to allow development in accordance with the town plan.

Under the existing lease the value of the lot is clearly the land and buildings. That is what the owner had to pay for it and what, if he were to sell, it would fetch.

But should the owner seek a lease modification, he would be credited only with the site value of the lot for development as a single residence. The premium sought is, again, in excess of the value conferred.

I have addressed the Development Bureau on these issues for years, both when I was in the Lands Department and since retirement, all to no avail.

What can one say other than that it's a funny old policy and an even more funny old Development Bureau that doesn't give a damn about making it work properly?

Well, words like "disgraceful", "inexcusable" and "maladministration" spring to mind.

This article appeared in the South China Morning Post print edition as: Lease modification a funny old policy