The Tragedy of Korean Apartments: Pre-sales and Jeonse Were to Blame

The pre-sale and jeonse systems are unique housing construction financing methods specific to South Korea, rarely found elsewhere in the world except for China. These two systems are structured such that individual debt directly becomes construction funds, playing a crucial role in significantly reducing financial costs for construction companies. However, there is a downside: pre-sale buyers bear the full risk if the construction company defaults.

In real estate policy, it is impossible to simultaneously achieve three goals: financial stability, housing stability, and minimizing fiscal burden. One of these must be sacrificed, leading to a trilemma. Korea has prioritized minimizing fiscal burden and housing stability, thereby increasing housing supply. In this process, financial stability has been sacrificed, which is cited as one of the fundamental causes of the current household debt problem and financial system instability.

The equity ratio of Korean developers averages only about 3%. This signifies a leverage structure that is extremely dependent on pre-sale payments. In contrast, overseas developers like those in the US secure an average of over 30% equity from the developer and various institutional funds at the start of a project. This high equity ratio strictly evaluates project feasibility and acts as a buffer to absorb shocks from economic fluctuations. Korea's structure is vulnerable to issues like oversupply during economic downturns, which exacerbates housing market instability.

South Korea's household credit, including all credit not just housing-related loans, has increased 4.3 times over the past 23 years. Jeonse loans, in particular, have surged approximately 6.6 times over the past decade, significantly contributing to the rise in household debt. Since 2022, policy loans like the Special Bogeumjari Loan have rapidly increased, further expanding the scale of household debt. This increase in lending could add potential risks to the financial system.

South Korea was very late in adopting advanced loan regulations. The loan-to-value (LTV) ratio was only introduced in 2002, meaning loans were made without LTV regulation before then. The debt-to-income (DTI) ratio began to be fully implemented around 2005-2006. The current Stress DSR (Debt Service Ratio) is taking over 10 years to complete its three phases, indicating the long time it takes to introduce regulations. This delay in regulatory implementation has contributed to the increase in household debt and overheating of the real estate market.

An increase in nominal GDP can create an illusion of a temporary drop in the household debt ratio. However, such a decline does not necessarily signify financial safety. Income growth in specific sectors, such as the semiconductor industry, can raise the overall average and distort the debt ratio, while vulnerable borrowers' debt burden can remain high. The true risk arises when the debt growth rate exceeds the income growth rate, and the debt problem should not be overlooked simply due to GDP growth.

During financial crises, the United States responds by immediately treating non-performing loans as losses, removing distressed assets, and adjusting balance sheets. Defaulted companies are exited from the market, and rapid restructuring is used to manage systemic risk. In contrast, Korea's crisis response is very slow, with a tendency to delay loss treatment and restructuring of distressed assets. This difference can impede the Korean system's resilience in the event of a financial crisis.

The Legoland incident was a case of securitizing non-residential real estate PF (project financing) into ABCP (asset-backed commercial paper) and circulating it in the short-term money market. This incident contained structural risks that could have escalated into a bank run in the short-term financial market. It is pointed out that the rapid liquidity crunch in the short-term money market could spread defaults, thus resembling the risks of the 2008 global financial crisis. This event clearly demonstrated the vulnerabilities of Korea's real estate financial system.

Hangang Mansion is known as the beginning of the pre-sale system in South Korea's housing finance history, and some also point to it as the root cause of the country's real estate problems. At that time, due to a lack of housing construction funds, the pre-sale method was introduced, benchmarking mansion sales cases in Japan. This system allowed construction companies to receive funds from residents in advance to cover construction costs before building homes, and it subsequently became the primary model for housing supply in Korea.

The pre-sale system was introduced to increase housing supply while minimizing the government's fiscal burden. It was a method where homes were constructed with funds received in advance from residents, rather than direct government investment. At the time, pre-sale advertisements allocated units on a first-come, first-served basis, intending to quickly secure resident funds for construction. While this system helped alleviate the government's fiscal burden and expand housing supply, it also generated various side effects.

The collapse of the Wow Citizen Apartment in 1969 is remembered as a prime example of shoddy construction that occurred primarily in public housing supply. At that time, approximately 15,000 housing units were supplied, and poor construction was identified. These apartments were built as part of relocation measures for residents of shantytowns, and safety management was neglected due to the urgent need for housing. This incident sparked social discussion about housing supply methods and construction quality.

In the past, for loan apartments, there are records where the exchange rate fluctuation risk was transferred to pre-sale buyers, as their installment payments were linked to the exchange rate. An example confirms that when the exchange rate rose from 400 won to 480 won per dollar, the monthly payment increased from 19,986 won to 23,986 won. This shows that the amount pre-sale buyers paid in installments could vary according to foreign exchange market fluctuations. Such a system imposed unpredictable additional burdens on residents, undermining housing stability.

Abolishing the pre-sale system entails many practical difficulties. If the system were abolished, the rights of those awaiting subscriptions could disappear or decrease, leading to their backlash. Furthermore, it is intricately linked with current housing supply systems like the housing price cap, making it difficult to abolish the pre-sale system in isolation. It is pointed out that institutional reform could cause conflicts among various stakeholders, thus requiring a cautious approach and social consensus.

As a structural alternative, the securitization of long-term fixed mortgages collateralized by rental housing has been proposed. This aims to shift away from the existing reliance on jeonse deposits and instead fund construction through long-term fixed-rate loans. By pooling long-term fixed-rate loans and creating mortgage-backed securities (MBS), it becomes possible to provide long-term construction loans to villa developers. This method aims to increase the stability of construction financing through financial market advancement, but its actual implementation date is uncertain as it requires legal amendments. This system could play a crucial role in enhancing financial stability and ensuring sustainable housing supply.

Strengthening household loan management creates a trade-off problem, as it can reduce housing supply. In countries like the US, provider financing is separated from individual loans, allowing for continuous housing supply based solely on rental yields. Korea also needs to shift the primary bearer of debt from individuals to corporations to break this vicious cycle. That is, construction and rental businesses should take out loans to supply housing, and individuals should then rent or purchase from these corporations. This is discussed as a way to ensure financial stability while maintaining a smooth housing supply.

With strengthened regulations on multi-homeowners, private rental providers are inevitably decreasing. This can lead to a supply shortage in the rental market, and the absence of other players to fill this gap poses a risk. If there is strong resistance to corporate rental businesses entering the market, then public rental housing remains the only alternative. To increase predictability in the rental market and maintain stable supply, it is time to clarify the roles of private and public sectors and discuss institutional alternatives. A decrease in private rental supply could lead to housing instability, so policy preparations are needed.