South Korean housing market hindered by traditional system

This time last year, South Korea's property market couldn't have looked bleaker. National home prices had been falling or, at best, remained flat for 12 straight months - a situation exacerbated in July last year, when apartment transactions in Seoul plummeted by 80 per cent in a month after the expiration of temporary tax cuts that had been designed to kick-start the market.

It was the worst slowdown since 2004, and few could see an end to the pain. Unmoved by low prices and successive interest rate cuts, South Koreans, already heavily leveraged compared to their global counterparts, increasingly opted to rent rather than buy. As homes languished on the market and the rental sector tightened, a loss of faith in the housing market seemed the only explanation.

The depth of the dip was underscored in a recent report by Nomura, a Japanese investment bank, which notes that South Korea is the only property market in Asia which has failed to bounce back from the global economic crisis. House prices have gained only 11 per cent from December 2008 levels, compared with Hong Kong (134 per cent), India (104 per cent), the mainland (94 per cent), Taiwan (85 per cent), Malaysia (68 per cent) and Singapore (32 per cent), according to the report.

Recognising the threat this posed to the national economic recovery, the government stepped in to reinstate tax cuts for homebuyers, effective from August 28 last year. Almost immediately, the market moved in a positive direction.

Nomura noted the turning point, describing South Korea's property market as "nascent", and forecasting that its recovery will gain momentum in 2014/15. "This should raise both GDP growth [from 2.8 per cent in 2013 to 4 per cent in 2014], and CPI inflation [from 1.3 per cent to 2.3 per cent], while reducing the current account surplus [from 5.8 per cent of GDP to 4.1 per cent], paving the way for a 25 basis point rate hike to 2.75 per cent in December 2014," it predicts.

However, that would depend on the orderly abolition of "jeonse" - South Korea's unique housing lease contract system, which leaves large amounts of potential home deposits locked in the rental doldrums.

Derek Long, a director of arc4, a Britain-based housing and data consultancy, explains that jeonse is a legacy of the Korean war, after which the urbanisation of South Korea lagged behind other industrialised nations. "As a result, the government committed to a rapid expansion in the number of housing units. Because bank lending was targeted at economic growth, a 19th-century version of an ancient instrument, jeonse, emerged as an alternative to conventional home ownership."

The system involves the tenant paying a hefty deposit in return for living rent-free, usually for two years. The landlord would invest the deposit and obtain enough return to negate the need for a rental payment. "Jeonse worked well, as long as the economy [stock market] was growing and landlords had capital growth," Long says.

As the South Korean economy matured, and the Japanese economy stalled in the 1990s, jeonse became increasingly less attractive to landlords, according to Long, especially as home prices fell when the post-war rapid expansion started to produce an oversupply. "When the world recession kicked in, the economy and rate of return on investment fell even further."

Now, the market is "stuck": households fear a capital loss, or negative equity, if they buy - so there is a big demand for jeonse as a major quasi-rental form, Long says. "However, landlords have little interest in supplying more jeonse homes because they are often ageing and new suppliers fear the same capital loss - and can't make the return they need." The laws of supply and demand "are not working", he says. Jeonse prices have risen every week for 18 months straight, yet are not resulting in increased supply. "The long-term weakness of jeonse as a product is that often landlords are using their jeonse deposits to part-finance their own jeonse deposit on another property. This translates to rapid price rises throughout the value chain as landlords play leapfrog, jumping over each other's increase."

Kwon Young-sun, a Hong Kong-based economist at Nomura Holdings, agrees that the jeonse system no longer supports economic growth. "An orderly abolition of jeonse would likely increase Korea's potential GDP growth because the inefficiently large security deposits [amounting to 34 per cent of GDP in 2012] could be released for more productive investments or reduced debt.

As a result, demand for jeonse would be converted into either house purchases [which should increase construction investment], or monthly rental, which should reduce household leverage."

A housing recovery and a robust current account surplus should also boost the South Korean currency, keeping the won among the regional outperformers this year, amid broad-based strength of the US dollar, Nomura's report says.

Long's view is that "a cocktail of measures" is needed to remedy the housing market failure: steady, though not rapid, economic growth; supply-side interventions that support more conventional rental models; and "possibly government transitional interventions along the lines of the UK social landlords, whose objectives are much more long-term". These could be coupled with a transition to ownership, part-ownership or transfer to commercial landlords once there is less dependence on jeonse. "In Korea, reshaping the housing market will be a long haul. But it will make for happier citizens and a stronger economy."