Ever since the collapse of Everr in 2021, there's been a huge amount of talk about China's real estate. woses. Countless commentators on both YouTube and the mainstream media have been talking about how China's economy will collapse due to the implosion of its real estate market. But even as China has taken up all the media headlines, it's important to knowe that it is not the only country facing real estate problems.

In fact, it may not even be the worst off. Since peaking in 2021, the average home price in China has declined by about 9% South Korean Home prices peaked at about the same time. Since then, they've declined by 133% the sharpest decline in recent history. Not only have home price declines been sharper, but South Korea has almost twice the amount of household debt as a percentage of GDP compared to China, the vast majority of which is related to real estate.

The reason that China's real estate troubles have gained so much more attention is because much of the debt was held by a few massive developers like Evergrand, which imployed spectacularly in South. Korea. Most of the debt is instead held by individuals and small landlords. So while there are no headline grabbing debacles like ever, Grand the situation is just as bad, if not worse.

In this video, we'll take a deep dive into the unique structure of South Korea's real estate market and how this may lead to one of the worst property crises in modern history. Due to its high population and Rapid urbanization. over the past few decades, South Korea has some of the most expensive real estate in the world. Before the recent decline in prices.

The average home in South Korea cost it about 26 times the median household income. For comparison, the average home in the US costs just seven times the median household income. Of course, most young people can't afford to buy a home or even afford the down payment on a mortgage, so they instead rent. Let's say, you want to rent a house that costs $100,000 The monthly rent would be about $5,000 per year.

After 2 years, you've paid a total of $10,000 of rent to the landlord. This is the normal system of renting around most of the world, and you can do this in South Korea as well. But South Korea also has another system. If you don't want to pay monthly rent, you can instead put up a rental deposit.

The deposits generally range from 60 to 80% of the value of the home. For example, let's say your deposit for this home was $70,000 For the next 2 years, you can live in the house rent free. After 2 years, your lease ends and the landlord gives you back the $70,000 This raises a couple of questions. Firstly, if you have $70,000 for a deposit, you almost have enough to buy the house outright.

Why not just save up a little more and buy the house? In the vast majority of cases, the renter doesn't have $70,000 They instead get a loan from A bank. Let's say, the interest rate on the loan is 5% You'll pay $3,500 of Interest per year, which is less than the rent you would have paid under a normal lease. This raises another question. If the bank is willing to lend you $70,000 for the deposit, why can't they just lend you the full $100,000 to buy the house? There are two reasons.

Firstly, most rental deposit terms are only only 2 years in length. While traditional mortgages can be as long as 30 years. Because of this, the bank considers these loans to be less risky and is willing to give them to people with lower credit scores. Secondly, the loan is ultimately collateralized by the house that belongs to the landlord.

If the landlord defaults on the deposit, the bank can liquidate the house. In this case, the house is worth $100,000 while the deposit is only $70,000 The $30,000 difference effectively acts as a down payment. Because of this, the renter only needs to give the bank a much smaller deposit than they would for a traditional mortgage. So now we've explained why this system is popular among renters.

But what about landlords? What's in it for them? There are a couple benefits for landlords. Evictions can be a long, tedious, and expensive process for landlords. With the rental deposit system, a tenant is much less likely to stay in the home after their lease expires. If they don't leave, they don't get their deposit back.

While the deposit is mostly the bank's money, around 10% of it still has to be paid from the renter's own money. This provides a strong motivation for the tenant to leave. Once The lease expires. Instead of receiving monthly rent payments, the landlord gets an interest-free loan.

They can invest this money and keep whatever gains they make. They could invest it in government bonds or a certificate of deposit, but this will only provide a very low yield. They could invest it in the stock market, but this is considered too risky and most banks don't allow this. In most cases, the landlord invests the money to buy even more real estate.

For example, if you get 70% of the value for renting out your first house to buy a second house of the same value, you just need to put up 30% of your own money. You can then collect another deposit by renting out the second house and use that to pay back the deposit on your first house and so on. Even better, if real estate prices rise, you can collect an even bigger deposit on the second house and have some money left over. It's structured almost like a Ponzi scheme where money from new depositors is used to pay back the old ones.

As real estate prices have generally risen over the past decade or so, this system has worked great. It's not uncommon for individual landlords to own dozens of houses, so. why is it the case that South Korea has this unique rental deposit system when no other country uses it? The rental deposit system dates all the way back from ancient times, back when the Korean economy was mostly agrarian. Farmers would receive one big cash windfall each year when they sold their Harvest.

Throughout the rest of the year, they didn't have any income so it didn't make sense to have monthly rent payments. At that time, A sophisticated banking system did not yet exist, so landlords would accept large deposits from farmers in exchange for being allowed to use their land. This was the only way they could raise funds to ire new land or make other Investments. With the rental deposit system already being accepted as part of Korean culture starting in the 1960s and70s, the government actively encouraged it.

The idea was that landlords would use the deposit money to either Finance the construction of new homes or other business. Endeavors This access to cheap Capital would accelerate. Economic Development This policy indeed worked, but as we will see shortly, it might have worked too well. The core problem with the rental deposit system is that it implicitly relies on home.

home price is always going up. The deposit is a percentage of the home's value. If the value increases by the time the lease ends, you can rent it out again to a new tenants and receive an even larger deposit. You can use this to pay back the old tenants deposit, keeping the remainder as profit.

Conversely, if the home's value decreases, the next deposit will be smaller than the last one, and the landlord has to make up the difference from his own pocket. For the past decade or so, real estate prices have been stable and gradually increasing. Following the pandemic. In 2020, prices surged by almost 20% Due to low inflation.

The South Korean Central Bank has been lowering interest rates over the past decade. During the pandemic, they lowered their key policy rate down to just .25% The rate on the 10-year Government Bond fell to as low as 1.4% Furthermore, unprecedented government stimulus caused the economy to Surge. once lockdown restrictions were eased. Remember that renters borrow money and pay interest on their deposits.

The lower the interest rate, the lower will be your monthly payment. In 2021, consumers had more disposable income than they ever had in the past, and interest rates were lower than they had ever been in the past. This means more and more people were able to afford bigger homes. This surge in demand ultimately caused home prices to increase by about 20% by the end of 2021.

Remember that the only way landlords make money is by investing the deposits. Because interest rates were now so low, they made almost nothing by putting their money into a bank or buying government bonds. so their only option was to use the money to invest in new houses. This caused home prices to appreciate.

still further. At the peak of the market fervor, landlords would use their deposits to purchase homes which already had tenants. For example, if a house was worth $500,000 but already had a tenant with a $400,000 outstanding deposit, a new landlord only has to pay the difference of $100,000 to buy the home. With this method, individual landlords were able to amass real estate empires of hundreds of houses funded almost entirely by rental deposits.

On a macro level, this caused South Korea's household debt to GDP ratio to Surge to above 100% greater than any other Advanced economy. In fact, it was even higher than the US de to GDP ratio. Immediately prior to the 2008 Financial crisis in 2022, the Co era government stimulus finally started to take its toll. with inflation Rising above 6% the highest level in more than a decade.

The Korean Central Bank responded by aggressively raising interest rates. By the end of 2022, the yield on the 10-year Government Bond tripled from the pandemic low of 1.4% to more than 4% Higher interest rates meant that renters had to pay much higher pay pays on the loans they took out to fund their deposits. This means they could only afford smaller deposits, so they had to move to cheaper homes. This was disastrous for many overleveraged landlords.

They now had to start renting out their apartments at lower prices, thus receiving smaller deposits. These deposits were not enough to pay back the deposits on previous leases when they came due. Individual landlords who own large numbers of properties are colloquially referred to as Villa Kings Starting in 2022, hundreds of them started to default on thousands of rental deposits. If A landlord does doesn't pay back the deposit, the house will be foreclosed and auctioned off.

However, many of these landlords use traditional mortgages to purchase the homes in the first place. On top of that, in many cases, there are outstanding real estate taxes Under Korean law. mortgages and real estate taxes have seniority over rental deposits, so if real estate prices fall dramatically, renters can be left holding the bag. This is especially catastrophic for renters who borrowed, in some cases, hundreds of thousands of dollars.

Even if their landlord defaults, the renters are still stuck with this massive debt owed to the bank. Thus, a collapse in real estate prices can leave both the landlords and tenants financially ruined. In late 2022, one of these Villa Kings who owned hundreds of apartment units, was unable to make good on his deposits in real estate taxes. Having lost everything, he was found dead in his home in an apparent suicide.

Tens of thousands of renters have also been financially ruined, leading many of them to protest on the streets. Over the past 2 years, The Leverage In the real estate market has rapidly unwounded with bankruptcy liquidations, putting new Supply on the market This has caused a 13% decline in real estate prices, giving up most of the pandemic era gains. With that being said, there are reasons to be optimistic. After peaking at above 6% in the summer of 2022, inflation in South Korea has declined to about 3% in December of 2023, Most analysts believe the Bank of Korea will begin reducing interest rates sometime this year.

When this happens, we will likely see a recovery in home prices. And despite the increase in interest rates, rental deposit schemes are still cheaper than traditional rental contracts. In most cases, as of 2023, almost 60% of South Korean renters still choose deposit schemes over monthly rent. So despite the fact that thousands of Koreans are facing Financial ruin thanks to the country's unique rental deposit system, it doesn't look like things will change anytime soon.

All right guys, that wraps it up for this video: What do you think about rental deposits? Do you think it's a good system, or is it unnecessarily risky? Let us know in the comment section below. As always, thank you so much for watching and we'll see you in the next one. Wall Street Millennial Signing out.