Hong Kong: Basic Framework for Owners of Old Properties in Negotiations

Stephen Chung

Managing Director

Zeppelin Real Estate Analysis Limited

May 2005

Recently a friend who owns a residential unit in an old building (built in the 1960s) has received an initial offer from the real estate agent representing a real estate developer who wishes to acquire and redevelop their site. While on one hand the friend seems happy that the property has attracted redevelopment interest, on the other he is also concerned that he and the other owners may not be a good match in the pending negotiation with the developer. Without any particular reference to this or any other real estate redevelopment cases, the following should provide a basic calculative framework for owners who encounter similar situations: 

A)     Fundamental formula for real estate development = a simplified version is: 

Redeveloped Property Value (or Price) ¡V Land Acquisition Cost ¡V Construction Cost = Redevelopment Profit [note: costs such as transaction fees, legal fees, professional fees, bank interests etc are deemed to have been included in the above broad items, else the formula would be exceedingly long for our purpose here] 

If no redevelopment profit is estimated to be feasible, the real estate developer in a normal circumstance will not go ahead with the project (site acquisition) at all. Even if there is redevelopment profit, the real estate developer will still have to consider if the return margin is good enough for him or her given the risk and trouble the redevelopment project will entail. This profit margin can be different for different developers, different times, and / or different market conditions.  

B)     Thus, what a real estate developer is willing to offer for the purchase of a particular site is = based on the above: 

Land Acquisition Cost = Redeveloped Property Value ¡V Construction Cost ¡V Redevelopment Profit (i.e. the minimum required by the developer). Some people term this ¡¥land acquisition cost¡¦ as the ¡¥residual land value¡¦.  

Whatever term is used, this represents the total monetary amount for which collectively the owners of the old property / site can expect to sell the property. As to how this total amount is split up between the owners largely depends on the ¡§as is¡¨ value / price of each of the units owned respectively by each owner. 

As to whether the developer will be successful in the acquisition depends largely on 1) the good faith, intent, and negotiation process between the owners and the developer; 2) the land price offered being higher than what the property can be sold for ¡§as is¡¨, i.e. higher than what the existing owners can get via selling their properties as old units; and 3) the land price offered being not only higher but also high enough to entice the owners to sell.  

How high is high enough in turn depends on the market sentiment and conditions, the personal circumstances of the owners (eager to sell or not etc), the negotiating effectiveness, and the degree of ¡¥under-development¡¦ (or un-utilized potential) of the site. This under-development can be in terms of quantity (more units or floor area can be built), use (e.g. from industrial to retail use), reduced obsolescence (e.g. adding fiber optics), and / or a combination of the foregoing. In short, the higher the degree of ¡¥under-development¡¦ is, the higher is the chance of having a successful site acquisition deal. Here¡¦s why. 

C)    Example = say there is an old residential property sitting on a 10,000 ft2 site with an allowable plot ratio* of 8 (meaning the site allows some 80,000 ft2 of building floor area to be built on it) yet the current old building is only 40,000 ft2 in floor size. Assume a newly redeveloped residential building can be sold for HK$10,000 / ft2 of building floor area, then a new redeveloped building will fetch a total of HK$10,000 / ft2 x 80,000 ft2 = HK$800M. Assume the developer requires 25% of this HK$800M as profit = HK$200M, and that construction costs another HK$2,500 / ft2 x 80,000 ft2 = HK$200M, and that no land premiums to the government is payable, then the remaining HK$400M can be offered (subject to negotiation tactics etc by both sides etc) to the owners as the land price.  

Now assume the price per floor area for the current ¡¥as is¡¦ building averages HK$5,000 / ft2 x 40,000 ft2 = HK$200M, this means on average each owner of the old property can look forward to receiving twice as much as what he / she can sell the unit for in the open market to another unit / home purchaser. While this in itself cannot guarantee a successful deal between the owners and the developer, as such cases can be very complex business-wise, legal-wise, and financial-wise, the enticement nonetheless exists. Conversely, if the current old building already has some 70,000 ft2 x HK$5,000 / ft2 = HK$350M, the owners will not find the developer¡¦s offer of HK$400M overly attractive as this is only 1/7 more that what they may expect via selling the units in the normal market.  

Naturally, the above is only a simple illustration seeking to provide a basic outline for old property owners involved in real estate acquisition and negotiation, and is not meant to substitute for proper professional advice and assistance where needed.  

Plot ratio* = in simplified terms, this guides the maximum building floor area that can be built on the site and is expressed in so many times the site area.  

Note = floor areas used in the plot ratio calculations are / can be different from those used in marketing / sales / construction etc but such differences have not been taken into account for the purpose of this article.

Notes: The article and/or content contained herein are for general reference only and are not meant to substitute for proper professional advice and/or due diligence. The author(s) and Zeppelin, including its staff, associates, consultants, executives and the like do not accept any responsibility or liability for losses, damages, claims and the like arising out of the use or reference to the content contained herein.  

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