(This essay was published in Hong Kong Economic Journal on 5 April 2017.)
Property prices have once again scaled new heights (despite the heavy punitive stamp duties), demonstrating conclusively that regulatory constraints do not work. Demand management is futile in the face of a massive shortage of housing units. The scale of the shortage can be surmised by the gap in cumulative family formation numbers and new housing units completed over the past 30 years.
The cumulative number of marriages in Hong Kong from 1986-2016 was 1,745,000. Over the same period, the cumulative number of new domestic housing units built was 1,572,000. Assuming demolished units amounted to about 10 per cent of the new supply, then the net increase was only 1,414,000 units.
The unmet cumulative housing demand in terms of the number of units over the past three decades is enormous. The mushrooming of sub-divided units in the private sector is a natural outcome of the shortage. Factors like quantitative easing, low interest rates, Mainland buying, and runaway speculation are relevant, but these are not the most important drivers of housing shortage in Hong Kong.
Clearing the backlog of cumulative shortages and meeting the continuing demand for housing units will be a major policy priority for the incoming Chief Executive. It will require a fresh understanding of the ‘complex causes’ of these persistent shortages that have appeared over the past three decades.
This is too difficult and complex a problem to blame it on a single factor: Donald Tsang for failing to provide more land and housing units, or greedy property developers for withholding land and housing supply, or government policy to maximize land revenues, or crony capitalism and plutocracy.
The main reason for our land and housing shortages has been our failure to grasp the full impact of China’s opening and global economic integration on Hong Kong: it has created enormous prosperity that has fuelled the demand for housing. As property prices escalated, it also created a huge disparity in propertied wealth between the ‘haves’ and ‘have-nots’ to foment a huge political divide and dissent. And one must remember that the ‘have-nots’ still demand housing even though they can ill afford it. Our failure to anticipate the growth in demand has blinded us to the need to increase our land supply aggressively.
Increasing Land Supply
Between 1945 and 1995, real property prices in the US did not increase despite rising prosperity. Increases in housing demand were met by increasing housing supply by building more units and larger units (or suburbanization) so that real prices remained steady. Prices then began to rise rapidly in the late 1990s and eventually began to correct and collapse a decade later.
Why did US property prices rise in the late 1990s when they had been stable for so long? Harvard economist Edward Glaeser provided the only convincing answer to this puzzle. Global economic integration that began in the 1980s created unprecedented economic prosperity. The government also relaxed rules for mortgage lending. This encouraged homeownership and a robust growth in the demand for housing. Restrictive planning and building regulations, however, held back development so housing supply failed to respond fast enough to the new rapidly rising demand. As a result, property prices began to surge in the late 1990s.
Glaeser found property prices increased more in cities where regulatory restrictions were worse, like Boston, New York, and San Francisco. Regulatory demands increased and became more complex, resulting in development delays. Regulations also created opportunities for more interest groups to delay development by lobbying against a particular development proposal.
In Hong Kong, regulatory restrictions are also an important cause of land supply and development delays. Consider the three most important sources of land supply: (1) land reclamation, (2) urban renewal, and (3) conversion of New Territories land – both green and brown sites.
The first two sources of land supply have been unimportant for quite some time. Land reclamation has essentially slowed to a snail’s pace as has urban renewal because redevelopment of built-up urban areas is a very difficult process. Increasingly new land has to be found from the conversion of New Territories land. But for a number of reasons this process has also become very protracted.
The basic principle used by the government is to charge premiums of 100% of the increase in value for conversion of New Territories land. The premium is calculated as the difference between the government’s assessed ‘after’ and ‘before’ values. This is a correct approach, but disagreements between the developer and the government over the assessed values can delay development sometimes for very long periods of time.
Disagreements may arise in the assessment of the ‘before’ value. Land in the New Territories was no longer restricted to farming uses after the court ruling on the Melhado Case (1983). The value of land in the New Territories became higher than its pure agricultural value. These uses must not require any building structures, but can include such things as open storage, storage of container boxes, vehicle parking and the like—for convenience these can be called Melhado uses. Disagreements may arise because the value of Melhado uses of the land can vary with location and over time.
The ‘before’ value of land has increased enormously over time. Containerization of shipping and China’s opening created a huge demand for storage space. The recently Shenzhen-listed S. F. Express worth US$25 billion was an early beneficiary of permitted Melhado uses of land in the New Territories. The logistics industry in Hong Kong would have suffered enormously without these sites (known as brown field sites).
The government calculates the ‘before’ value assuming it is cleared land, which is not always the case. There may be buildings and structures existing on the land that command an economic value, and will incur a cost to demolish and for activities to be relocated. Government ignores these factors. The resulting estimated premium may therefore be inflated and not acceptable to the developers.
Another source of disagreement is the assessment of the ‘after’ value. The government often fails to take into account the development costs incurred in demolishing and rebuilding an existing facility. For example, a pre-existing transport exchange that has to be demolished and rebuilt later is omitted in the calculation of the premium. The result again is to produce inflated values.
Some years ago HKU had to bear the exorbitant full cost of relocating an existing 47-year-old water tank servicing the Kennedy Town area in preparation for a new campus. Government rules necessitated HKU pay the demolishing and rebuilding costs of this replacement public utility, so the public received a brand new replacement water tank free of charge. Developers are unlikely to be so accommodating.
When disagreement over the premium occurs, developers will wait for market conditions to change in their favor because a lower premium is demanded only when government expects the market to soften in the future. The problem is that for three decades the property market has not adjusted downwards (except during the Asian financial crisis), making it less likely for developers to accept what the government is prepared to offer.
Development has thus been delayed for decades as a result of government intransigence in refusing to set proper premiums. By the late 1980s, the relative gap between the prices of private residential units and the bidding prices for building construction was widening. This reflected in part the higher transactions cost of coming to an agreement on land premiums. The gap has persisted up to the present time and even through the Asian financial crisis, which suggests that it is unaffected by external macroeconomic factors (see Figure 1).
Figure 1: HK Private Property Price Index and Building Works Tender Price Index, 1980- 2016
Source: Ratings and Valuation Department and Rider Levett Bucknall
Clearly there is room for government to set premiums that are more reflective of true values and costs. Failure to do so will continue to delay development at a time when land conversion provides the most promising avenue for increasing new land supply.
Some believe that government should resume land resumption and threaten to slap a punitive tax on the leaseholders if they fail to develop it within a specified time. Governments in some countries have used eminent domain to force development, but their experiences show it is far from evident that that this provides either a cheaper or faster solution for recovering land.
The transactions cost of assembling and clearing land for conversion cannot be eliminated by administrative fiat. Such an approach also has the downside of damaging the integrity and security of private property rights with negative impacts on long-term property values and the rule of law, and obviously is politically divisive.
A more effective and efficient example from other countries has been to task developers with the provisioning of both public and private housing developments. But the key to success has always depended on setting the correct premium or making appropriate provision for development gain.
In the long term, government cannot rely solely upon land conversion in the New Territories to meet housing demand (as well as other development uses of land). It will have little choice but to reinstitute a program of land reclamation as soon as possible. In Hong Kong only 6% of our land has been reclaimed, while 20% of the land in Singapore has been reclaimed. We are definitely behind the curve and the sooner we lay down plans for land reclamation, the better off we will be in shaping long-term expectations.
Next week I will look at the pressures on housing from population changes and how we address the housing problem will be critical to the government’s future financial health and for reducing the divide in society.