I've noticed that everyone is really interested in getting the inside scoop. The response to our last video about South Korea was huge. People were asking me to go into more detail about the whole "Jeonse" housing crisis, so let's dive deeper into it today.
Rising Housing Prices in South Korea
The South Korean real estate market has been making headlines lately with its share of ups and downs. Don't worry, we'll cover the domestic market in our next video. For now, back to South Korea. Housing prices there have been on the rise since the 1997 Asian financial crisis. Considering that one-fifth of South Korea's population is crammed into Seoul, it's no surprise that prices have skyrocketed.
When former President Moon Jae-in took office, he vowed to curb the country's housing bubble. He introduced a whopping 25 policies aimed at cooling down the market, including tightening mortgage lending, restricting loans for high-end properties, and raising property taxes.
But guess what? Despite his efforts, housing prices continued to soar during his term. It got so bad that Moon Jae-in found himself apologizing repeatedly for the situation. He even admitted to feeling helpless, as if he had exhausted all possible solutions.
The Role of Jeonse in the Housing Crisis
So why did South Korea's housing prices refuse to budge and instead surged even higher? To understand this, we need to talk about "Jeonse" – a unique rental system in South Korea used for approximately 60% of rental properties.
Here's how Jeonse works: Instead of paying monthly rent, tenants give the landlord a large lump-sum deposit, typically around 50% to 80% of the property's value. This deposit is known as "Jeonse money." Let's say you have a property worth 2 million won. In a typical rental situation, you might pay 5,000 won per month. However, with Jeonse, you wouldn't pay any monthly rent but would give the landlord a deposit of 1.2 million won upfront.
For the duration of the lease, usually two years, you wouldn't owe the landlord any rent, and they wouldn't pay you any interest on the deposit. At the end of the lease term, the landlord returns the 1.2 million won, and you go your separate ways.
You might be wondering, "If I had 1.2 million won, wouldn't it be better to just buy a place?" You're right, but most renters don't have that kind of cash lying around. They borrow it from the bank. With a bank loan at, say, a 4% interest rate, they only need to pay around 4,000 won per month in interest to live in a 2 million won property. Considering the usual rent of 5,000 won, they're essentially saving 1,000 won each month.
Now, you might ask, "If I can get a loan for 1.2 million won, why not just get a mortgage and buy?" The key difference is that the Jeonse loan is a short-term loan for two years, while mortgages typically span 10, 20, or even 30 years. Young people, in particular, are reluctant to shoulder the burden of a long-term mortgage, making Jeonse an appealing option.
This explains why Jeonse is incredibly popular among young adults in their 20s in South Korea. While the homeownership rate in South Korea is 56%, meaning just over half of the population owns their homes, the rest rely on rentals, with Jeonse being a significant contributor. The low-interest-rate environment made Jeonse an extremely attractive option.
It seems like a win-win for everyone involved, right? Renters prefer Jeonse, banks benefit from issuing more loans, and landlords receive a large sum of money upfront. But there's a catch.
The Risks and Consequences of Jeonse
This system, where tenants borrow from banks to give money to landlords who then deposit it back into banks, seems pointless, doesn't it? Landlords don't just keep the Jeonse money in the bank; they invest it, aiming for higher returns than the potential rental income.
While the stock market is an option, its returns are not always guaranteed, and it carries significant risks. So, the primary investment avenue for landlords is, you guessed it, real estate.
Imagine buying a 2 million won property with a 30% down payment, costing you 600,000 won. You rent it out through Jeonse and immediately recoup 1.2 million won. Essentially, you've acquired a property and pocketed an extra 600,000 won. Of course, you have a mortgage to pay, but it's still a brilliant cash flow management hack.
Theoretically, as long as you can keep the property rented and the housing prices rise, you can repeat this cycle indefinitely and buy up all the properties in South Korea. In reality, there was a famous case of a Mr. Kim who owned a staggering 1,139 apartments in Seoul, earning him the nickname "Apartment King."
The Jeonse system, in essence, created a massive leverage system in the South Korean housing market. Consider this: South Korea's household debt-to-GDP ratio surpassed 100%, exceeding that of most major economies, including the United States, China, and Japan. According to the Korea Economic Research Institute, factoring in the leverage from Jeonse could push this ratio to a staggering 157%, making it the highest globally.
Leverage itself is like dry kindling; it needs a spark to ignite it. And that spark came in the form of low-interest rates during Moon Jae-in's presidency. With interest rates so low, it was almost inevitable for housing prices to surge. The situation was exacerbated by the COVID-19 pandemic in 2020, which triggered global quantitative easing. Despite lockdowns, capital markets boomed, money flowed freely, and South Korea's exports thrived. At the same time, the pandemic disrupted housing supply chains, leading to soaring demand and stagnant supply, further fueling the fire under housing prices. This phenomenon wasn't unique to South Korea; it was a global trend, except in China.
Faced with this inferno, Moon Jae-in's policies were like trying to extinguish a raging fire with a garden hose. They had minimal impact. By 2022, the average price of an apartment in Seoul had shot past 1 million US dollars, equivalent to 7 million yuan, with per-square-meter prices hitting an astounding 22,000 US dollars. In the affluent Gangnam district, prices soared to a jaw-dropping 70,000 yuan per square meter, or 500,000 yuan.
Landlords, tenants, and banks were ecstatic, their faces beaming with delight. But we all know that leverage is a double-edged sword. It magnifies both profits and losses. The higher the leverage, the greater the gains when prices rise, but the opposite is also true.
The Downfall: Interest Rate Hikes and the Unraveling
In 2022, inflation reared its ugly head in the United States, prompting the Federal Reserve to raise interest rates by over 5% within a year. South Korea, feeling the heat, followed suit. As we've discussed, inflation is a formidable economic beast. The Korean won plummeted against the US dollar, leaving the Bank of Korea with no choice but to raise interest rates.
Interest rate hikes are the bane of any leverage-fueled game. Let's revisit our Jeonse example to understand why. Remember the tenant who borrowed 1.2 million won at a 4% interest rate, paying 4,000 won per month? With the rate hike, that monthly payment jumps to 6,000 won, making it more expensive than simply renting directly for 5,000 won. Why bother with the hassle of Jeonse and the huge deposit?
And this is just the beginning. As interest rates rose, the "reverse Jeonse" phenomenon emerged, with over 1 million tenants opting out of their Jeonse contracts. Landlords, too, were hit hard by the rate hikes.
In South Korea, over 80% of mortgages are based on floating interest rates, meaning the monthly interest payment fluctuates with market conditions. During the low-interest-rate period, monthly payments were manageable. But as rates increased, so did the burden. While China's mortgage system, based on the Loan Prime Rate (LPR), is somewhat similar to a floating rate system, it differs from the United States, where over 95% of mortgages have fixed interest rates.
With fixed-rate mortgages, the interest rate at which you borrow remains the same for the entire loan term, typically 30 years. This means if you secure a mortgage at 5%, your rate remains 5% for the next three decades, regardless of market fluctuations or the Federal Reserve's actions. The risk lies with the bank, not the borrower.
Consequently, in a fixed-rate environment, borrowers tend to be more sensitive to interest rate changes. Knowing that their rate is locked in for the long haul, they approach mortgages with greater caution. This explains why the US housing market witnessed a surge in prices during the low-interest-rate period. With 30-year mortgage rates below 4%, it felt like free money, encouraging people to enter the market.
In contrast, countries like South Korea and China, with their reliance on floating rates, expose existing borrowers to the full force of interest rate fluctuations. A mere 3% increase in interest rates in South Korea meant that everyone with a mortgage had to cough up an extra 3,000 won per month in interest payments. While a 3% increase might seem bearable, the leverage amplifies the impact.
For those who had maxed out their leverage using Jeonse, like Mr. Kim with his over 1,000 apartments, the additional 3,000 won per property translated into a financial earthquake. Combined with tenants choosing to break their Jeonse contracts, the situation became catastrophic.
In October 2020, Mr. Kim was found dead, the cause undisclosed. His story is not an isolated incident. Numerous real estate speculators who exploited the Jeonse system faced similar fates, either going bankrupt or fleeing their debts. The Jeonse deposits, once considered safe and secure, were suddenly in jeopardy.
Despite insurance companies backing most Jeonse contracts, over 2,000 cases of deposit fraud were reported last year, involving a staggering 700 billion won. This year, the estimated losses from Jeonse are projected to reach a jaw-dropping 1.8 trillion won. Tragically, there have already been four reported suicides linked to Jeonse debt in South Korea this year.
Desperate landlords were left with no choice but to offload their properties. In January 2023, the number of homes listed for sale in South Korea reached 750,000, the highest since 2012. Prices plummeted, with some areas experiencing a 30-40% drop. Transaction volumes dwindled by 70%.
Government Intervention and the Uncertain Future
Faced with a looming real estate crisis, what could the South Korean government do? They did what governments often do: they intervened to rescue the market. The new president, Yoon Suk-yeol, took a different approach than his predecessor, opting to unwind many of Moon Jae-in's restrictive housing policies.
Mortgage regulations were relaxed, property taxes were reduced, and loan incentives were introduced. However, as we all know, the most potent tool for market control is interest rates. Recognizing this, the Bank of Korea hinted at potential rate cuts by the end of the year to stimulate the economy and the housing market.
Ironically, even before the rate cuts materialized, rising rental prices made Jeonse appealing again. The housing market seemed poised to repeat its old tricks. It's a vicious cycle that the real estate market can't seem to escape. Prick it, and it deflates; stimulate it, and it runs wild.
At the heart of it all is the excessive leverage that underpins the system. This, in a nutshell, is the story of the South Korean real estate market crisis—its rise, fall, and uncertain future. Now, I know what you're thinking: enough about South Korea, what about China? Well, that's a story for another time.