Dark mystery behind 'jeonse'

By Peter S. Kim

The Korean stock market is still reeling from the pyramid scheme using contracts for difference (CFD), which was used to ramp up stocks over many years until everything collapsed within days. The Korean prosecutors arrested the alleged mastermind Ra Deok-yeon, head of an unregistered investment consulting firm, and his associate. The stocks of the nine listed companies had been carefully ramped up for years, gradually spreading the scheme to over 1,000 mostly unsuspecting high-net-worth individuals with exposure amounting to almost 1 trillion won. Symbolic of years of policy stimulus during the pandemic, another major scandal involving the residential property market is emerging.

There has been a series of suicides in recent weeks from victims of a home rental scam by an individual now known as the "Villa King." The culprit organized a group of accomplices who combined bought 2,700 villa flats with help from bank loans. He conspired with real estate brokers and advisers and then leased the homes at inflated prices under a "key money" system known in Korea as "jeonse."

Jeonse is a unique home rental system in Korea, where tenants, instead of monthly rent, provide landlords with a deposit, often 50 percent or more of the property's market value. Landlords keep the lump sum during the tenant's stay but must repay the same principal amount when the two-year term ends. In the latest scandal, some 690 homes were seized and auctioned off by the creditor banks after the property values fell well below the jeonse prices, leaving little or no money for tenants whose rights are secondary to the banks that issue the loans. Most of the tenants have been evicted from their rented homes, unable to retrieve their jeonse deposits.

Jeonse originated in the 1970s as a form of peer-to-peer financing, as Korea's rapid industrialization caused a China-like wave of urbanization taking farmers to cities. It was difficult for the working class to access loans from banks, and interest rates charged were often over 20% annually. The jeonse system was a convenient arrangement between cash-strapped landlords and asset-poor tenants. Over the past 50 years, jeonse has been gradually replaced with actual home ownership or monthly rental with the spread of mortgage lending and, more recently, a zero interest rate policy.

I have postulated that jeonse is on a structural decline due to its outdated role as Korea constructs a developed financial system. For the past 20 years, the pace of the jeonse system phase-out has been picking up, with monthly rental taking its place. With rising property prices, even jeonse has become too expensive for many as the jeonse to value ratio has rocketed up, with some key areas reaching almost 100 percent of the underlying value of the property. Also, millennials increasingly prefer monthly rent over jeonse due to either lack of the lump sum or little appreciation for saving. The rising jeonse ratio is a natural force of the financial system forcing out an outdated scheme via a broader banking system and declining demographics.

For the landlords, jeonse was an easy way to secure a lump sum which is either used as stable income via interest or used to buy extra property. During decades of property market boom, homeowners used jeonse to acquire the principal to buy an additional home, which is great when the property market continues to rise behind economic and population growth. But with a plummeting birthrate about to halt real demand for property, the aging population will begin reducing their heavy exposure to properties (except for very exclusive areas).

Secondly, the Korean government's clampdown on property market policies has forced punitive tax bills for multiple homeowners, forcing landlords to draw down their use of jeonse money to purchase additional homes. Even with the current higher interest rates, the declining trend for jeonse is likely to continue as more banks are urged by the Korean government to offer favorable mortgage loans to the working class. Ultimately, jeonse's role in a developed economy like South Korea is coming to a close.

The phasing out of jeonse as a shadow banking instrument has two key effects on the Korean economy, one bad (for the working class) and one good (for middle-upper class). The negative is that the tenants are forced to pay monthly cash for rent instead of using their nest egg for jeonse. The cash flow squeeze is a meaningful shift for the working class, given their tightening disposable income. As a result, the working class is finding it harder to find dwellings in preferred areas, having to migrate gradually away from the city center. The choices are to seek cheaper jeonse or opt for monthly rent.

Many foreign investors have asked why Korean tenants would lay out an enormous amount of key money when they can purchase the underlying property with some help from banks. The most common reason is that 50 percent of the market value of a home is not enough for the working class to buy their own residence, even with some financing, in a location they truly want, like Gangnam. Another reason is that many prioritize mobility, as many families prefer to move locations based on schools according to the age of their kids. But for most lower-income classes, key jeonse is the only way to secure accommodation given their financial means. For over a decade, working-class tenants had to endure a "silent recession," where rising home prices and jeonse accelerated the wealth gap causing social discord. The hardship of the lower income class and the widening income class gap were central themes in the super-popular "Squid Game" and the Oscar-winning movie "Parasite".

On the positive side, the phasing out of shadow banking provides extra liquidity to the economy as more money is released. The lump sum that was used either in deposits or the property market for the landlord is now freed up for investments or consumption. Unfortunately, as a result, the widening of the income gap is worsened, causing social and political problems. However, the rising demand for financial assets in place of residential property is a long-term structural trend and positive at a macro level.

Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.