KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

KDI FOCUS The Role of Capital Structure in Real Estate Project Financing: Risk, Cost, and Policy Implications

By examining project-level data on real estate project financing (PF), I find that higher equity ratios are associated with lower overall risk and reduced project costs. This finding supports policy measures aimed at strengthening capital structures without unduly constraining PF activity. If regulatory lending limits are to be introduced, they should target only low-equity PF projects. Moreover, preferred shares should be recognized as regulatory-eligible equity capital, and the deferral of capital gains tax should be made permanent to encourage in-kind land contributions. It is equally important to address regulatory arbitrage involving Project Finance Vehicles (PFVs), which are often exploited to pursue large-scale developments with minimal capital.

- The government has announced measures to expand PF equity capital, but without disclosing project-level data, there is no empirical basis to assess whether this expansion sufficiently reduces risk.

- Empirical analysis finds that expanding PF equity capital lowers risks across presale, default, postdefault recovery failure, and post-completion refinancing failure.

- PF capital expansion reduces construction, f inancing, and other costs, which in turn lowers total project costs.

- Increases in PF equity ratios diminish contractors’ guarantee risk, reduce construction costs, and thereby lessen completion risk.

- The current plan properly combines capital requirements with incentives, but specificity and effectiveness should be improved.

- PF lending caps should apply only to loans on low-equity projects, not to all PF loans.

- Policy incentives should extend to preferred shares as eligible PF equity capital to attract more equity investors.

- The capital gains tax deferral for in-kind land contributions should be permanent.

- PFVs have enabled undercapitalization in large projects, and prudential regulation and supervision on par with project REITs should be introduced in stages for PFVs to close regulatory arbitrage and strengthen the capital base.

Summary

Policy Study KOR A Study on Property Tax Incidence

This study examines the incidence of property taxes, focusing on whether the property tax, which is levied on the property owner when the owner and the user are different, is passed on to the user. If the tax is borne by the owner, it acts as a capital tax; if passed to the user, it functions as a consumption tax. Additionally, if the revenue from the tax is used to improve local environments, it could be considered a benefit tax.

Through empirical analysis, the study explores how changes in the comprehensive property tax system affect housing rental prices. The findings show that these changes have little impact on the rental market. No evidence was found to suggest that rental prices increase as the publicly assessed value rises near the taxable threshold. Moreover, using a difference-in-differences method to compare rental prices before and after the policy change, the analysis confirms that the strengthened system did not lead to higher rental prices for properties subject to the tax.

In conclusion, the results suggest that the tax is best viewed as a capital tax. Taxing housing assets may reduce investment and hinder the efficient allocation of capital. Since South Korea's property tax level is in line with the OECD average, it is important to minimize changes to the system, analyze its effects, and then proceed with reforms.

Summary

Policy Study KOR Economic Effects of Capital Gains Tax on Housing

This study examines the economic effects of South Korea’s capital gains tax reforms on housing, focusing on the lock-in effect ― a contraction in housing transactions following higher tax rates. In 2017, amid a prolonged housing boom, the government raised capital gains tax rates for multi-homeowners. Analysis of transaction volumes and prices around the announcement and implementation reveals a pre-reform surge in sales and gifts, followed by a post-reform decline. A temporary suspension of the tax in 2019 again triggered a short-term uptick in transactions during the grace period.

These findings suggest the tax policy failed to achieve its intended goal of stabilizing the housing market. The lock-in effect, compounded by low policy credibility, likely contributed to diminished public trust in housing policy. Moving forward, housing tax reforms should be anchored to fundamental taxation principles, prioritizing efficiency and equity while promoting system stability to ensure predictable obligations for taxpayers and bolster confidence in the housing market.

Summary

Research Monograph KOR Korean Unique Regulations in Housing Market

We study regulations in the housing market, which are very unique and have great influences in Korea. Due to COVID-19, the housing market have experienced rapid changes. Thus, the government responded boldly with unprecedented policies. Among others, 3 special regulations are on the table for discussion. The first is the Land Transaction Permit, which was implemented to reduce demand on housing in specific regions. Second, the Price Cap on New Houses is investigated for housing supply policy. The final is a regulation on the contract renewal claims in the housing rental market.

Chapter 2 analyzes the direct and indirect price effects of the Land Transaction Permit (LTP), a selective regulation introduced in 2020 for high-priced houses in Seoul to stabilize skyrocketing prices. The LTP is an administrative regulation that requires local governments to permit transactions in designated "areas," and as of 2022, the total area covered by the LTP is about 9% of Seoul's land area.Houses in the LTP zone can only be purchased by buyers who are either homeless or will eventually become single-family homeowners, and they must actually live in the houses for two years immediately after purchase. In this study, we analyzed the price and transaction volume of LTP regulated and unregulated houses, focusing on "Jamsil-dong, Samsung-dong, Daechi-dong, and Cheongdam-dong," which were designated in June 2020. In the regulated area, the LTP scheme directly reduced transaction volumes by 38.3% and prices by 4.3% compared to unregulated areas. However, the LTP scheme unexpectedly had a positive price appreciation effect on homes located closer to the regulated areas. When unregulated dwellings are categorized according to their distance from the regulated area, we estimate that dwellings closer to the regulated area increased in price by 2.3% relative to dwellings further away, and this effect is larger the closer they are to the regulated area. It appears that some of the demand in the regulated area shifts to nearby unregulated areas with higher substitutability. The different direction of the direct effect on regulated areas and the indirect effect on nearby areas suggests that selective regulation, such as LTP, may not be the right regulatory approach to achieve the goal of stabilizing the housing market.

The next chapter, Chapter 3, examines the effects of the Price Cap on New Houses. This price cap, which limits the price of new homes, is one of the controversial regulations that raises concerns that it may limit housing supply in the future. However, this study's analysis found no evidence that the price cap reduces the supply of new homes. Although the pre-sale price cap limits the profits of housing construction projects, it is operated by reflecting all the costs of land and construction for housing supply. Even if the prices of newly supplied homes are limited by the price cap during the period when the housing price is on the rise, the sales of new homes is likely to increase as well. Thereby housing development projects are profitable enough to cover all the costs. Therefore, there appears to be no empirical evidence for concerns that future housing supply will be reduced by this price cap implemented during the housing market boom. However, these results are contradictory to the results of existing studies, so caution needs to be taken when interpreting them further.

Chapter 4 investigates the price impact of the deposit control imposed on the housing repo contract in Korea, known as Jeonse. Jeonse is a unique housing repo contract in Korea where the landlord borrows a deposit from the tenant, using the house as collateral. The tenant is granted the right to occupy the house during the contract period at the expense of the deposit’s opportunity cost. In July 2020, the Korean legislature passed a law granting tenants the right to renew the Jeonse contract once, with the new deposit amount not exceeding a 5% increase from the original amount. While this new regulation has been heavily criticized as the primary driver of the surge in Jeonse deposits during the pandemic, its actual price impact has not been properly estimated.

We estimate the value of the Jeonse renewal option monthly using option pricing techniques, based on reasonable assumptions about the housing price process and information gathered from the current term structure of interest rates. Our estimation results indicate that the deposit control regulation raised Jeonse deposits nationwide by only 0.97% and by 4.80% in Seoul at the time of the introduction of the regulation, a magnitude significantly lower than previously discussed in both media and academic circles. Furthermore, we demonstrate that the renewal option does not have any intrinsic value over the past 10 years, suggesting that the option can be considered pure insurance against an unexpected increase in the equilibrium level of Jeonse deposits by the time of expiry. Based on the background of the regulation and the results of our analysis, we provide policy suggestions.

Summary

Policy Study KOR Inflation Expectations Through the Lens of the Slack in the Real Estate Asset Market

This study examines inflation expectations implied in the real estate asset market. Land is an asset that accounts for more than half of South Korea's national wealth and, like labor, is an essential input factor despite its inelastic supply. Based on this idea, we examine whether a similar regularity as the Phillips curve observed in the labor market is also observed in the real estate asset market. The main results are as follows. First, an increase in the relative price of land can be a pass-through, transferring inflationary pressure over the years. Second, comparing the existing expected inflation indices, an expected inflation rate extracted from the real estate asset market can provide additional information. Third, theoretical analysis shows that the relative price of land and expected inflation can be positively correlated in general equilibrium.

Summary

Research Monograph KOR Housing Market Regulations and Housing Supply: Focusing on LTV, DSR, Property Tax, and the Improvement of Pre-Sale Housing

The Korean government often implements financial regulations, such as the Loan-to-Value (LTV) and Debt-Service-Ratio (DSR), ratios, to stabilize the housing market. This study investigates the effectiveness of these policies in the housing market and, if effective, determines whether they enhance the utility for housing consumers.

Additionally, the government employs housing supply policies, which greatly impact the housing market. Housing provision is a lengthy and capital-intensive process. Korea supplies most of the new housing through a system known as the pre-sale policy. In fact, this system has consistently faced the challenge of overheating subscriptions for over 40 years. In light of the current housing market dynamics, Chapter 3 explores possible improvements to the existing housing supply policy.

As for the effect of financial regulation, the policy that lowers the upper limit of the LTV ratio from 70% to 40% reduces household loans by more than 31% while increasing the relative price of housing by 0.005%. If the upper limit on LTV ratios is lowered, households experience a low productivity shock, making it difficult to maintain consumption levels by increasing mortgage lending when incomes fall. As a result, they are motivated to increase savings. When the capital stock in the model economy increases due to the increase in household savings, the real interest rate falls. Wealthy households with relatively large amounts of assets reduce the share of financial assets in their asset portfolios and increase the share of housing because the real interest rate, which is the rate of return on investment in financial assets, has fallen.

The analysis in this study reveals that policies tightening household lending regulations do not effectively curtail housing prices in the long run. If the goal is long-term price stabilization, the study suggests that increasing the supply of new housing is more effective than suppressing housing demand through stricter lending regulations.

Lastly, the study proposes a new policy model for improving housing supply, especially for the younger demographic. This model seeks to address both the housing service and investment needs of younger people. Regarding public offerings and transactions of fractional ownership, housing demand is categorized into the demand for residential services and the demand for investment in housing assets. In the current pre-sale subscription method, the share of the house is divided, and public offering subscriptions are received. This method distributes shares to each subscriber in proportion to the competition rate for subscriptions. In this scenario, new housing is provided to young adults as rental properties in line with the existing subscription method to meet the need for residential demand.

Summary

KDI FOCUS Galapagos Syndrome in South Korea’s Real Estate PF, and the Need for Fundamental Structural Reform

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.

- Over several decades, real estate project financing (PF) has repeatedly destabilized the Korean economy, but fundamental improvements have not been made.

- The root cause of PF problems lies in the unique financing practice of relying almost entirely on debt, where developers invest very little equity and depend heavily on third-party guarantees.

- In Korea, the equity ratio of developers is around 3%, while in major advanced countries, it exceeds 30%.

- In major countries, land is secured with equity capital, and only construction costs are financed through loans. This approach prevents the issue of refinancing bridge loans into main PF loans, which is typical in Korea.

- In major countries, it is rare for third parties, rather than developers, to guarantee PF loans, unlike in Korea.

- The low-equity and highguarantee structure leads to more developers becoming smaller in scale and underfunded.

- The low-equity and highguarantee structure leads to poorer assessments of project feasibility, no-questions-asked investments, and increased macroeconomic volatility.

- The low-equity and highguarantee structure shifts all risks to the national economy, not developers.

- Since advanced countries base loan issuance on project feasibility and financial structure per PF principles, capital augmentation is a prerequisite for developers to obtain loans.

- However, when Korea introduced PF, the market consisted of small developers and large construction firms. This disparity led to a low-equity, high-guarantee structure, which was reinforced by the pre-sale system.

- 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.

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

- 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.

- 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.

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

- 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.

Summary

KDI FOCUS Strategies for Refining the Jeonse Deposit Return Guarantee System

Jeonse, a housing lease model unique to Korea, has long served as a cornerstone of housing security for many families. However, recent significant fluctuations in housing prices have highlighted concerns such as underwater jeonse and reverse jeonse, amplifying calls for reform. A crucial step in addressing these challenges and ensuring the stability of the jeonse system is to expand the scope of the Guarantee for a Return of Jeonse Deposit. In pursuit of this, it is important to accurately reflect risks in return guarantees and to consolidate jeonse guarantees under the unified framework of the Guarantee for a Return of Jeonse Deposit.

- As a uniquely Korean housing rental system, jeonse has enhanced housing stability for ordinary families, but recent fluctuations in the housing market have exposed the risk of tenants not getting their deposits back.

- Approximately 8 million general households in Korea reside in properties owned by others under lease contracts. Of all jeonse and wolse transactions, jeonse takes up nearly half, underscoring its sustained significance for the foreseeable future.

- Jeonse prices started to decline in the latter half of 2022, a trend expected to persist through 2024, accompanied by increasing concerns about reverse jeonse.

- While the jeonse-to-price ratio based on the publicly disclosed value decreases as the property value increases, multi-household units consistently show higher ratios than apartments, implying that the former households are at a greater risk of not recovering jeonse deposits.

- The deposit return guarantee system ensures that if leaseholders fail to meet their return obligations, a guarantor agency will refund the deposit. Presently, guarantees from public guarantor agencies amount to around 170 trillion won.

- Due to a marked rise in guarantee-related incidents from 2022 onwards, the application requirements for the refund guarantee were tightened in May 2023.

- Low-priced houses are mostly excluded from the deposit refund guarantee due to stricter eligibility requirements.

- Regrettably, the jeonse deposit return guarantee system does not adequately shield vulnerable tenants from the risk of not retrieving their deposits, as the guarantee fee rate does not accurately reflect the actual risks involved.

- The Guarantee for a Refund of Jeonse Deposit (HUG) has a lower guarantee fee rate compared to other products, especially against the actual incidence rate of guarantee defaults. Hence, guarantee fee rates should be recalibrated to accurately represent risks, taking into account the actual default rates.

- Since recalibration of guarantee fee rates might increase the rates for lower-priced houses, short-term remedies targeting vulnerable households are necessary.

- As the Guarantee for Jeonse Deposit Loan can drive up jeonse prices by expanding jeonse loans, mitigation is necessary by mandating the purchase of deposit refund guarantees during jeonse loan acquisition process.

- A hybrid guarantee system that utilizes escrow not only ensures the protection of the tenant’s deposit but also allows for the application of LTV regulations, typically exclusive to home mortgages, across all housing types.

- In addressing the inherent weaknesses of the jeonse model, all related guarantee products should be consolidated within one unified framework while adjusting and differentiating guarantee fee rates.

- It is essential to expand the scope and availability of market price data for jeonse properties and strengthen the duties and responsibilities of realtors.

Summary

Policy Study KOR Price Spillover Effects in Housing Market: Reconstruction of Apartment

This paper studies price spillover effects in housing market, utilizing a policy change on apartment reconstruction. Under the circumstance of various years built of houses in Seoul, the policy on reconstruction applies to a part of houses in Seoul. However, the policy change may affect the whole housing market via spillover effects of the policy.

To investigate spillover effects, I suggest an extended version of difference- in-difference model that captures both the direct and spillover effects of the policy. Using thorough data on apartments in Seoul, combined with geographical information, I found a significant spillover effect that diminishes with the distance from apartments in the process of reconstruction. Meanwhile, the direct effect is found insignificant. The spillover effect seems to make it hard to capture the direct effect of the policy since the prices of houses near the reconstruction apartments follow the prices of the reconstruction apartments. In sum, the spillover effect of the policy was a crucial factor in the housing market of Seoul in 2018.

This study finds a type of externalities which is prevalent in housing market. This spillover effect must be taken into account when policies are applied not only to the whole market, but to a part of the houses.

Summary

Research Monograph KOR The Economic Implication of Land Purchase: A Study on the Net Purchase of Land by Corporate Sector Over the Long Term

This study uncovers the fact that Korean companies have been purchasing a large amount of land from households for about 40 years using various statistics such as national accounts and corporate financial data and examines empirically the incentives of corporations to purchase land.

We argue that the accumulation of land assets over a long period of time by Korean corporations is an unusual phenomenon. From 1975 to 2018 in which South Korea's sectoral national accounts statistics exist, the large net purchases of land by Korea's non-financial corporations from the household sector have been observed every year except before and after the foreign exchange crisis in 1998 and the global financial crisis in 2008. We find that among OECD countries Japan in the 1960s to early 1990s is the only case where the non- financial corporations had purchased a large amount of land from the household sector every year such as South Korea.

Firms can purchase land for either productive or speculative activities. In the case of productive activities, we investigate a hypothesis that companies' demand for land could have increased significantly, especially since the 2000s, due to the changes in the industrial structure of South Korea. We use the Economic Census by Statistics Korea (2010, 2015) to show that firms in the place where service industries are more agglomerated are likely to purchase more land than those resided in less service-intensive areas. By using a firm- level micro dataset, KIS-DATA, to estimate the elasticity of land as a firm's production input, we also show that the contribution of land to production has increased significantly after the 2000s.

Unlike capital goods such as equipment and buildings, the land does not suffer from depreciation and its supply is inelastic, so the land is an investment good that can benefit from rising prices as the economy develops. Companies, thus, could have speculative incentives to invest part of their operating profits on land. We use the Economic Census by Statistics Korea (2010, 2015) to show that some firms experiencing positive operating profits and decreased production facilities are likely to purchase land. This suggests that the net purchases of land by corporations could occur in part due to their speculative motive.

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