Best Use

Best Use / 2018-04-30 / Nick Sallnow-Smith

My title is a real estate term. It captures the idea that for every plot of land there is a “best use”. A use which will create the most value from that site, given its location and nature. Rural sites with good soil are likely to have agriculture as their best use. A site near a busy port, perhaps logistics use. City centres with good transport naturally supports commercial and residential. So what, I hear you say. That’s obvious! But let me emphasise two key aspects of this.

First, this is not simply about the site owner “making money”. If the best use is found, the community gains the most benefit. The value of the site deployed to its best use reflects the activity that people in the community will pay the highest price for; which in turn reflects what they value most. Second, how do you discover the “best use”? In a supposedly “free market” economy like Hong Kong’s you might expect the best use to be discovered through competition between investors who have differing ideas of what use might be most profitable. Of course the winning bidder might be wrong and lose money. The natural function of competition will allow failures as well as successes but will, over time, discover what is most valued by the community at large. Is this what happens here? Unfortunately not.

One legacy of the lands system established by the British in the 19th century has been that every site leased from the Government has a use attached to it. And while that use can be changed, the process of change is laborious, time consuming and expensive. Laborious because the Town Planning approval process allows for objections and appeals which delays any change of use, perhaps for years. Expensive because Lands Department will charge a premium before permitting the change of use set down in the lease. And that premium is calculated to equal the entire uplift in value of the site resulting from the change of use. Think for a moment what this means. In a free economy with secure property rights, the incentive to convert the use of a site is precisely the gain the investor can make. As I noted earlier, rather than thinking enviously of the profit earned by the investor, it is crucial to see that the reason for his gain is the greater value to the community of the new use. That old warehouse that no one wants, is converted to a residential building that will be in great demand. But if the financial incentive to convert that site is removed, the risk the investor takes (he may be wrong about future demand for the new use) may be too much. The conversion never takes place. The unused warehouse remains, and no value is created for the community. In fact matters are worse than Lands Department removing 100% of the gain from change of use. The way in which the premium is calculated today fails to allow for some costs which a developer may incur. More than 100% of the gain is taxed away as a consequence. This means the only change of use that occurs typically relies on an assumption that price will rise during the development period. Developers are then accused of being “speculators”!

The great 19th Century French economist, Frederic Bastiat, always emphasized the importance of what is “not seen” in an economy. You may see the investment made with taxes raised by the government. You do not see the private investment that might have been made, had the citizens not had their wealth taxed away. Here too, you “see” the unused agricultural land owned by large developers, you do not see what use they may have made of it, had their incentive to develop not been removed by land policies. The accusing finger points at the lazy “hoarding” developer, not the Government’s own land policies.

The loser is the community at large. Now you may argue that there must be some “planning” of land use, that some basic infrastructure needs to be planned. Fair enough but let’s consider a couple of examples of how damaging is the micro-management practiced by the Government of every single site in Hong Kong. For many years the business community has been concerned about the shortage of international school places. One might expect investors, seeing this demand, to buy cheaper sites in the NT and build schools to meet demand. But the site would need to be zoned for educational use before this can be done. Sites available are therefore limited to the few Government schools sites which they have been prepared to make available. A free market might have generated many schools but “free market” Hong Kong-style cannot.

My second example is the Central Market site on Queen’s Road Central. For some 15 years this has been unused, despite being a very valuable site in the middle of the city. In a free market, that site would have been bid for and developed many years ago. Think again about Bastiat’s “unseen”. Had that site been used for something the community valued – offices, retail, f&b, whatever it might have been – it would have generated millions of dollars of revenue by now. Those millions would have represented value to the users of that site – the shopping public, office tenants etc. Yet nothing has been done. Of course work is underway now but the 15 years of delay is value gone forever. And the use has never been tested for “best use” by a public tender. It has been decided by the Administration, who are thereby putting themselves in the place of the public as the arbiter of what the community wants.

This represents another of Bastiat’s “unseens”. Debate on lands issues tends to be focused on privately held sites (the agricultural land I mentioned earlier for example), yet the Government holds a huge bank of sites itself. Do these get converted to “best use” for the community? Very rarely. The problem again is incentives. The owner of a privately held site in a free market experiences direct financial incentives to find the best use, which reflects community demand. I have explained why those incentives are damagingly diluted by land policies. But the government land bank is even less incentivised to be used in the best way. For example, all those disused schools sites where falling rolls led to closures. Any change to a new use could generate opposition. Some will think their own ideas of use are better, others will oppose development next door to their own site. For the civil service, dealing with this political “noise” is a much bigger incentive to do nothing, than the lost gain in value to the community is an incentive to brave that noise. And of course the are always excuses available. It will be argued there is no “consensus” on what should be done with the site. Of course no such consensus could ever exist. But a free market allows everyone to express their “view” with the only consensus required being agreement to the freedom to trade.

Let me finish with an analogy. Most people have grown up with Government “planned” environments all their lives, and find it hard to see why planning doesn’t work. Just think about restaurants. Suppose land use planning was even more “micro”. Suppose not only did the owner’s lease state that the site must be used as a restaurant but also which cuisine must be served; Cantonese, French, Thai, Indian, Japanese etc. If the owner felt he could make a better return switching his steak house to a vegetarian offer, as people eat less meat, suppose he had to pay a premium equal to the difference in value that he might achieve. He would not bother to spend money on the conversion. As tastes in food changed in the community, which they do all the time, restaurateurs would be prevented from accommodating those changes of taste. Historic Government planners would have fixed the restaurant offer. Attempts to change it would meet the claim that there was no “consensus” on the food which might be served in any particular outlet. But a consensus  is not needed. The public will vote with their wallets if they are permitted to do so. Poorly supported cuisines will close, new ones will open. This is what a free market does, invisibly serving the community. It is a pity we don’t have a free market in land in Hong Kong. Instead we have a widespread misunderstanding that the reason we have high land prices ,and an inappropriate mix of land use, is because we have ‘too free’ a market, when the opposite is the truth!

Nick Sallnow-Smith



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