Over the past several decades, real estate project financing (PF) has repeatedly triggered economic disturbances in Korea, with no fundamental remedies in sight until now. Project sponsors are at the heart of this issue, investing minimal equity while heavily relying on guarantees from third parties, such as construction firms, to push forward development projects entirely on debt. This financing structure is unheard of in major advanced countries. Korea needs to reform its unique PF structure by augmenting capital and reducing dependence on guarantees.

Ⅰ. Introduction: Deep-rooted Issue of Real Estate Project Financing

Recently, project financing (PF) in the real estate sector has been a material risk factor for the Korean economy. In four years, PF exposure, encompassing both loans and guarantees, surged to approximately 160 trillion Korean won, up from below 100 trillion won in 2019 (Figure 1). When quasi-PF loans, such as those collateralized by land and loans from the Community Credit Cooperatives, or Saemaul Geumgo, are included, the total exposure climbs to a staggering 230 trillion won (Financial Supervisory Service, May 2024). Late last year, TAEYOUNG E&C filed for a workout program, and more than 20 general construction contractors declared bankruptcy. To prevent the PF crisis from spreading throughout the financial system and broader economy, including the construction sector, the Korean government has enacted short-term measures, such as expanding PF guarantees and providing emergency liquidity provisions.

However, the issue of real estate PF is not new but deep-rooted, recurring over several decades. PF insolvency is at the heart of the 2011 savings bank crisis, which led to bank runs that triggered the collapse of about 30 savings banks, affecting over 100,000 customers. In 2013, alarming growth in PF exposure, especially in the nonbanking sector, raised calls for interventions to mitigate risk. By 2019, large-scale debt guarantees provided by securities firms to PF projects became a notable concern. In 2022, the Legoland crisis set off a credit crunch in the bond market.

Despite these repeated crises arising from real estate PF, fundamental improvements have not been made. What are the underlying causes of these persistent issues, and how can they be effectively addressed?

The root cause of real estate PF problems stems from an outdated financial structure characterized by minimal equity and high reliance on guarantees. Typically, developers, as project sponsors, invest only 3% of the total project cost as equity, financing the remaining 97% through debt. An analysis of over 300 PF projects launched in 2021~23, totaling 100 trillion won, finds that while the average total project cost per project was 374.9 billion won, developers invested only 11.8 billion won (3.2%) as equity, with the overwhelming majority of 363.1 billion won (96.8%) secured through debt (Table 1). The project breakdown by type shows that the equity ratio was lower for residential projects (2.9%) compared to commercial ones (4.3%) and lower in provincial regions (2.3%) than the capital area (3.9%). Such heavy debt dependence is not a recent phenomenon but has been a long-standing practice. A survey of 464 real estate PF loans, including 366 housing PF loans, held by four major banks back in 2009 finds that the equity ratio was just 4.2% for housing PF and 6.0% for non-housing PF (Kim and Sakong, 2009; Kim and Seo, 2010).

Due to the high-risk nature and uncertain success prospects of real estate PF projects, along with minimal equity investment from project sponsors (developers), financial institutions cannot readily provide PF loans. In Korea, however, construction firms that secure contracts from developers effectively guarantee the repayment of PF loans (Figure 2) and commit to completing the construction under any circumstances through a completion guarantee agreement. If the developer fails to pay construction costs on time, this agreement obligates the construction firm to complete the project, even out of its pocket. Often, the completion guarantee agreement includes a provision stipulating that if the developer fails to repay the PF loan, the construction firm will assume the repayment obligation. When the construction firm has a low credit rating or is small or medium-sized, real estate trust firms or securities companies sometimes step in to provide the necessary guarantees.

Unlike Korea, major advanced countries maintain a high equity ratio of 30~40% for real estate PF projects (Figure 3, left). In the US, financial institutions require at least one-third, or 33%, of the total project cost as equity for PF loan approval. While this ratio may be slightly lower depending on project feasibility, it rarely falls below 20%. As expected, developers do not shoulder the entire equity burden alone. They generally directly put in at least 10% of the total equity capital and raise the remaining 90% by bringing in other equity investors, such as real estate investment trusts (REITs), pension funds, construction firms, and financial institutions.

Japan, the Netherlands, and Australia also maintain a relatively high equity ratio of 30~40% for real estate PF projects. Developers directly invest 33~50% of the total equity capital and raise the remainder by attracting other investors. Examples are Japan’s large commercial facilities in Tokyo, such as Roppongi Hills and Akihabara UDX, which had equity ratios of 37% and 36%, respectively. In Australia, although loans were approved for establishments with equity ratios of 20% or less before the 2008 global financial crisis, the required ratio was raised from 25% to 40% after the crisis and further raised beyond 40% in 2022 to ensure financial soundness.

In most advanced economies, including the US, Japan, and the Netherlands, the common practice is to finance the construction costs only through PF loans after using equity capital to secure land and obtain construction permits. In the US, PF loans primarily refer to construction loans (Figure 3, right). These loans are obtained solely to cover construction costs after securing land and permits. The Netherlands allows bank loans accessible only after acquiring construction permits following land purchase. In contrast, in Korea, developers have very minimal equity capital, which results in financing most land and construction costs and other expenses through PF loans. Their equity capital covers only about 10% of the land cost as a down payment, with the balance financed through a bridge loan. Afterward, the bridge loan is refinanced into the main PF loan upon obtaining permits and commencing construction. Accordingly, Korea is susceptible to refinancing risks, as refinancing may fail due to permit rejection or doubts about project feasibility, leading to insolvency. However, major economies do not face such refinancing risks since equity capital covers land costs.

Meanwhile, in major countries, it is rare to find third-party payment guarantees from entities other than developers. Developers, who are also project sponsors, agree to repay loans using their other assets in case of contingencies. Generally, third parties like construction companies do not provide these guarantees. Instead, construction firms only commit to completing construction as scheduled. Because this completion guarantee is tied solely to the timely payment of construction costs, it fundamentally differs from Korea’s completion guarantee agreement, where the construction firm must complete the project unconditionally and may even have to repay the developer’s debt in some cases.

Ⅲ. Problems with the Low-Equity, High-Guarantee Structure

What specific challenges arise from the low-equity and highguarantee financing structure? First of all, the share of small-scale developers continues to expand, hindering the sound growth of the industry (Figure 4). Suppose a developer invests only 10 billion won as equity capital in a large-scale project worth 400 billion won, with potential dividends of several tens of billions of won upon completion. This combination of low equity investment and high profitability incentivizes opportunistic behaviors among developers, who seek quick returns. As a result, small-scale developers flood the market. By 2020, the number of registered developers exceeded 60,000. This structure makes it difficult for large and reliable developers with substantial capital and extensive experience to emerge.

Moreover, the low-equity and high-guarantee structure compromises the assessment of project feasibility. Feasibility assessment is crucial given the inherent high risks of real estate development projects. Which party is best positioned to evaluate project feasibility? In general, investors who put their own money into risky projects or their creditors would be the most diligent in checking it. However, in Korea, because developers do not increase their equity input, they do not attract investors. That is, there are no equity investors to carry out rigorous assessments. On the lender’s side, since large construction companies, real estate trust companies, or securities firms provide loan guarantees, financial institutions like banks have little incentive to look closely into the feasibility. Also, credit rating agencies are in a tight spot to issue meaningful risk warnings, as they cannot help but be conscious of their clients, the developers, because they typically assess project feasibility at the request of developers, despite being professional evaluation institutions.

In the broader economy, issuing loans primarily reliant on third-party guarantees without proper feasibility tests exacerbates macroeconomic volatility. Because of guarantees, lenders often overlook project feasibility and other microeconomic details in their lending decisions. Instead, they prioritize macroeconomic variables such as interest rates and real estate market conditions, which are more easily assessed. All in all, this approach leads to increased loan issuance during economic booms and sharp declines during recessions. In 2008~22, PF exposure grew by an annual average of 26% (15 trillion won) above the long-term trend, followed by an average annual decrease of 13% (8 trillion won) in 2011~19 due to the savings bank crisis. However, following the COVID-19 crisis, PF exposure again surged by an annual average of 10% (13 trillion won) until 2022, before the steep slowdown after the Legoland crisis in late 2022 (Figure 1, Gap). The US Office of the Comptroller of the Currency (OCC) also identified the key risk associated with commercial real estate loans as economy-dependent volatility (OCC, 2022).

From the standpoint of individual financial institutions, guarantees enhance microprudential stability but can also induce “no-questionasked- investments,” thereby undermining macroprudential stability and causing systemic risks. A common example is the payment guarantees provided for mortgage-backed securities (MBS) just before the 2008 global financial crisis. At that time, many financial firms invested heavily in MBS without adequately evaluating the soundness of the underlying subprime mortgages, relying instead on these payment guarantees. When the underlying assets became insolvent, massive losses ensued from these large-scale investments, triggering the financial crisis (Holmstrom, 2015).

After all, the low-equity and high-guarantee structure metastasizes risks into society by subpar assessments for project feasibility, noquestion-asked investments, and higher volatility. In the event of default, small-sized developers have already gone out of business, leaving construction firms that provided guarantees to repay the loans in full. While some large ones may survive, others like TAEYOUNG E&C collapse. Defaults by construction firms hurt the soundness of the lending financial institutions. To prevent the spread of systemic risks reverberating into the construction and financial industries, the government resorts to direct and indirect public funds, such as expanding PF loan guarantees and providing emergency liquidity. As a result, taxpayers’ money is used to fix developers’ failures. As seen in the Legoland crisis, when securities issued with PF loans as collateral default, the bond market tightens, leading to losses for investors and high interest rates for securities issuers (Figure 2).

Ⅳ. Understanding Korea’s Distorted PF Structure

What led to Korea’s distorted low-equity and high-guarantee PF structure, unlike advanced countries? Developers in both major countries and Korea prefer to minimize their investment to maximize their share of development profits because attracting equity investors would mean sharing these profits. In major countries, insufficient equity from developers halts PF projects, whereas, in Korea, projects can proceed even with minimal equity investment. Korea’s distinct financing structure is born of this difference.

Most advanced countries, including the US, Japan, and Australia, adhere to PF principles, making it unworkable to pursue PF projects without adequate equity capital. The core principle is to raise funds based on project feasibility rather than the creditworthiness of project participants. Even when guarantees are necessary, they are provided solely by project sponsors, not third parties. During the loan screening process, financial institutions require an equity capital investment of around 30%, as the developer’s equity is crucial in determining both project feasibility and the borrower's repayment ability.

On the contrary, Korea adheres to (i) the circumstances unique at the time of PF introduction and (ii) the pre-sale system, which together create the unique PF structure that allows developers to pursue projects with minimal equity and reliance on guarantees. Following the 1997 Asian financial crisis, the government required construction firms to lower their debt-to-equity ratios from 900% to below 200%, prompting the adoption of PF as construction companies could no longer afford large-scale debts themselves (Choi and Jang, 2021). Back then, developers were small-sized entities without equity investors, and construction firms were relatively larger, leading to the creation of a distorted form of PF where developers borrowed and construction companies provided guarantees.

The pre-sale system further reinforced this structure (Figure 2). Korea uniquely permits the use of down payments and progress payments from buyers of pre-sold apartments or multi-housing complexes (with 30 or more units) as construction costs. This system enables developers to cover construction costs with buyer funds, needing to finance only land costs. Consequently, the proportion of the loan amount in the total project cost is reduced, allowing developers to undertake projects with minimal equity investment.

For developments to use buyer funds, a pre-sale guarantee from the Korea Housing & Urban Guarantee Corporation (HUG) should be obtained (Figure 2). However, HUG requires a prerequisite for this guarantee called “conditional transfer of project rights” from the developers. This agreement stipulates that in case a “pre-sale guarantee incident” occurs due to prolonged construction suspension caused by reasons like the project sponsor’s bankruptcy, the developer transfers all associated rights, including those related to the project site and the building under construction, to HUG, excluding the PF loan obligations. In such contingencies, this legal instrument effectively makes PF-loan-providing financial institutions subordinate creditors to HUG without any collateral. Therefore, guarantees from construction firms or other entities are required in advance. Additionally, HUG put forth another prerequisite that mandates construction firms to provide joint guarantees for the obligations HUG bears to home buyers. Since HUG requires third-party guarantees throughout the process of utilizing buyer funds, development projects can proceed without developers needing to invest much equity.

Ⅴ. Reform Directions for the Mid-to-Long Term

Despite the recent slowdown in the upward trend in PF loans, it may accelerate again as interest rates decline, potentially triggering another crisis. Because of a clear tendency of real estate market improvement when interest rates decline, the number of PF loans tends to rise as interest rates fall and real estate market conditions are more favorable (Table 2). What are the strategic remedies to fundamentally overhaul real estate PF, which has tenaciously persisted through the past and present, and also potentially the future?

As clear as the causes of the PF issue are, the direction for reform becomes equally apparent: raising the equity ratio to levels comparable to those in major advanced countries and abolishing third-party guarantees, such as those provided by construction companies. In principle, individual firms should have the autonomy to determine their capital structure. However, institutional intervention is deemed necessary due to negative externalities, such as subpar assessments of project feasibility, indiscriminate investments, and the expansion of systemic risks.

What are the ways to increase the equity ratio? This calls for regulations mandating equity capital increases, together with support measures to be discussed later. As examined earlier, the underlying reason for Korea’s lower equity ratio for developers is its financing structure that allows development projects to move along with little equity investment. Expanding capital requires tearing down this structure. Specifically, “direct regulation,” which imposes a minimum equity ratio when developers take on PF loans, or “indirect regulation,” which mandates financial institutions to set aside a larger amount of loan loss provisions when providing PF loans to developers with lower equity ratios, can be considered. For instance, under the business lending category of “High-Volatility Commercial Real Estate,” the US requires banks to reserve the amount of loan loss provisions (or bank capital) 1.5 times greater than general business loans. This regulation applies to loans for projects where project sponsors do not meet the minimum investment of 15% equity capital based on the total project value (=total project cost + development profit) (OCC, 2022). In addition, another essential regulation is limiting thirdparty guarantees. Without such regulations, the policy objective of encouraging more equity investment would be hard to achieve. Even with various support measures in place, developers will avoid seeking equity investors and monopolize substantial development profits without them.

The prudent direction would be to raise the equity ratio to the level of advanced economies and abolish third-party guarantees. To that end, Korea should introduce regulations on capital augmentation.

Some express concerns that transitioning to the advanced economy’s financial structure may constrain the housing supply. Despite such a possibility, the reform should not go for maintaining a structure that allows small-sized developers to monopolize profits and socialize risks. This policy shift can lower housing supply costs by increasing equity and reducing dependency on guarantees. A survey of about 100 major PF market participants by Choi (2012) finds that respondents expected construction firms to reduce construction costs by an average of around 10% if their guarantee provisions were scrapped, as their burden would decrease. Lower construction costs can contribute to mitigating the potential reduction in housing supply. Also, the proposed structure can improve the stability of the housing supply rather than just increasing its quantity. Since low-feasibility projects cannot attract sufficient equity investment, they lack the impetus to launch from the outset, eliminating risk factors beforehand.

Conversely, promising projects with sufficient equity investment can run to completion more smoothly, withstanding external shocks such as interest rate hikes or real estate market downturns. Nevertheless, if housing supply concerns remain strong, it would be worth considering applying stricter equity requirements to non-residential development projects first and gradually expanding to residential ones.

While regulations to increase capital may constrain the quantity of housing supply, they are expected to improve its stability.

On the other hand, some others argue that capital increase is impractical in effect given Korea’s prevalence of small-sized developers and a limited pool of equity investors. However, even in a business environment unfavorable to scaling up developers, there are examples of small developers growing into conglomerates, such as MDM and SHINYOUNG, as well as developers affiliated with large corporate groups like SK D&D and kt estate. Other than those, as of 2022, there are more than 25 large developers in Korea with annual sales exceeding 30 billion won. More proactive efforts should be made to promote the growth of developers to achieve a larger scale.

Moreover, the pool of prospective equity investors is not as narrow as some suggest. Capital contributions to development projects present a high-risk, high-return investment opportunity due to the potential for substantial development profits. Over 100:1 subscription rates for pre-sale apartments in prime locations illustrate the significant profit-sharing potential for home buyers. If potential equity investors, including construction companies, pension funds, financial firms, and REITs, can also share in these high-profit margins, they would be incentivized to bear these risks for high returns. Construction firms and pension funds are not constrained by regulatory restrictions on real estate development investments, and some are already participating in equity investments. According to financial laws like the Act on the Structural Improvement of the Financial Industry, while financial institutions can own 5~20% of the common stock of non-financial companies, they can make investments within this upper limit, with few restrictions on preferred stock investments. Recently, aside from conservative banks, insurance companies, securities firms, asset management firms, and real estate trusts have shown interest in equity investments or directly undertaking projects. While construction companies, pension funds, and financial firms remain cautious about equity investments due to possible civil complaints and a sluggish real estate market, they are expected to increase equity investments if social consensus or governmental initiatives favor this approach to resolving the structural issues in real estate PF.

In particular, REITs, which are indirect real estate investment firms, are not subject to investment restrictions and are well-capitalized. They also have accumulated expertise in development projects and have expressed willingness to invest substantial amounts if developers seek equity investors. In the US, REITs serve as major equity investors and direct participants in real estate projects as developers.

Even in environments unfavorable for scaling up, some developers have started small and grown into conglomerates, while others are affiliates of large corporations.
The pool of potential equity investors is not limited.

Since REITs serve two positive functions, invigorating their equity investments or nurturing their direct involvement as project sponsors would benefit society. Firstly, REITs socialize massive development profits. They are required by law to offer at least 30% of their shares for public subscription. To be exempt from this obligation, public investment institutions such as pension funds and mutual aid associations, representing the general public’s interests, must own at least 50% of the REIT’s shares. Either way, the development profits benefit society. Secondly, REITs maintain equity ratios comparable to those in the major advanced countries per minimum equity ratio regulations under the Real Estate Investment Company Act (REIT Act).

According to the Act, REITs can borrow only up to twice their equity, which equates to a minimum equity ratio of 33% of the total project cost (= total assets = equity + debt). As an exception, REITs can borrow up to ten times their equity through a special decision by the general meeting of shareholders, which requires votes from at least two-thirds of the attending shareholders and at least one-third of the total issued shares. Even then, a minimum equity ratio of 9% is still required. As of 2023, the average equity ratio of 137 development REITs undertaking projects was 27.3%, and the average equity ratio of general development REITs, excluding policy-type development REITs with the public sector, was 40.6% (Table 3). These figures are significantly higher than the average equity ratio of 3% for typical PF projects.

Because REITs socialize development profits and are already subject to equity ratio regulations, it is desirable to revitalize their equity investments or foster their direct participation as project sponsors.

Considering the long-term policy directions discussed above, what short-term steps should be taken? Korea has long suffered from the low-equity and high-guarantee structure, so increasing the equity ratio all at once would be challenging and might even cause serious side effects. Therefore, during the transition, introducing lenient capital augmentation regulations should be the first step to create a need for developers to increase their capital or attract equity investors, simultaneously with various support policies to encourage capital increases.

There should be detailed and practical discussions to determine specific policies and support mechanisms for capital augmentation. Below are examples of support policies from major advanced countries that can serve as references for future policy discussions.

(Tax Incentives) The Low-Income Housing Tax Credit (LIHTC) program in the US offers tax reduction benefits to developers that increase the housing supply for low-income households through residential development projects. If a developer allocates 20~40% of total project units to low-income families, the US government grants a tax credit equivalent to approximately 9% of the project cost to the developer, who then shares the credits with equity investors, attracting them more easily.

(Promoting REITs) In 1992, the US introduced the Umbrella Partnership Real Estate Investment Trust (UPREIT) program, which defers capital gains tax on land when it is contributed in kind to a REIT. Before UPREITs, landowners had to pay substantial capital gains tax immediately upon transferring the real estate property. However, UPREITs allow landowners to defer this tax until years after the land transfer when the development project is completed and profits are distributed. Consequently, in-kind contributions by landowners surged, and the REIT industry expanded by over 100% in just two years (Roh, 2023). For scaling up REITs, Japan introduced the Sponsor REIT system to facilitate the transfer of assets from large banks to REITs and to oversee financing and asset management. As a result, as of 2021, the top two REITs by market capitalization are sponsored by large banks in Japan (Kim, 2021).

(Limited Relaxation of the Separation of Banking and Commerce) In Japan, the largest developers, including Mitsui Fudosan Realty and Mitsubishi Jisho Design Inc., are predominantly bank-affiliated real estate companies. These major developers were established before the 1960s when regulations restricting banks’ investments in nonfinancial firms were less stringent. Currently, regulatory measures for the separation of banking and commerce prohibit banks from owning more than 5% of the voting shares of developers. However, in 2017, banks were permitted to develop their real estate properties for rental purposes, provided there was a request from the local community to stimulate the local economy, leading many regional banks to begin undertaking real estate development projects. For instance, Nakakyo Bank reconstructed its branch building into an 11-story complex, using the first two floors as its office and the remaining floors as rental housing from 2022. Japan’s approach seems to be minimizing the adverse effects of relaxing the separation principle in allowing banks’ participation in development projects for rentals, not sales, only at the request of the local community. In addition, the US permits the Federal Savings Associations, a type of bank, to engage in real estate development projects through their subsidiaries (OCC, 2022).

During the transition, it is necessary to implement support policies that encourage capital increases.

Ⅵ. Conclusion

In South Korea, the recurrent risk posed by real estate project financing (PF) has remained a persistent challenge since the 2011 savings bank crisis, with meaningful improvements still elusive. The crux of the issue lies in the financing structure, where project sponsors typically inject only minimal equity, approximately 3%, while the remaining 97% is borrowed and secured by third-party guarantees, primarily from construction companies. This financing model is virtually unheard of in major advanced economies. Moving forward, addressing these challenges requires cardinal reform of the PF structure by mandating higher equity investments from project sponsors and decreasing the dependency on external guarantees.

Furthermore, establishing a comprehensive database for real estate PF is a high priority. This sector lacks both financial data and project feasibility information. The widely accepted notion of a 5% equity ratio, often cited by previous studies, media reports, and industry insiders, is not based on official statistics. The Ministry of Land, Infrastructure and Transport, financial authorities, credit rating agencies, Housing and Urban Guarantee Corporation (HUG), and real estate trust companies do not systematically collect data on finances and businesses across all projects. Effective policy-making cannot be done without the “eyes” to identify issues or the “tools” to address them. Presently, the absence of such “eyes” makes it difficult to understand the existing conditions, hindering regular monitoring and early risk detection. In other words, the current financing structure only allows for reactive measures after insolvencies arise. Therefore, it is essential to regularly collect and disclose comprehensive financial and operational data by project and company, as well as post-completion outcomes and profitability metrics for all development projects. This approach will foster transparency and proactive risk management in real estate project financing.

The acute lack of data on real estate PF makes it difficult to even stay current, which in turn only allows temporary measures during crises and hinders regular monitoring or early crisis detection.
A database system should be set up to collect official statistics on financial and business information by project and company.

CONTENTS

• Ⅰ.  Introduction: Deep-rooted Issue of Real Estate Project Financing
  
  Ⅱ. Causes of PF Problems: Low Equity and High Reliance on Guarantees
  
  Ⅲ. Problems with the Low-Equity, High-Guarantee Structure
  
  Ⅳ. Understanding Korea’s Distorted PF Structure
  
  Ⅴ. Reform Directions for the Mid-to-Long Term
  
  Ⅵ. Conclusion