[Real Estate AtoZ] 'Equity Ratio' Emerging as the Savior for PF Crisis

Implementing Company Covers 90-95% of Project Costs with Loans
Government Eyes Raising Implementing Company's Equity Ratio
Academia: "Capital Ratio 20% Lower Compared to Overseas"
Industry: "Raising Capital Ratio May Disrupt Implementation Projects"

The fate of Taeyoung Construction, which applied for a workout (corporate restructuring) after failing to repay real estate project financing (PF) loans worth approximately 9 trillion won, will be decided on the 11th. The photo shows the Taeyoung Construction headquarters in Yeongdeungpo-gu. Photo by Yongjun Cho jun21@

Measures to increase the equity ratio in real estate project financing (PF) are being pursued. The key will be the results of a study on overseas cases related to real estate PF, which will be released in April. The Ministry of Economy and Finance and the Ministry of Land, Infrastructure and Transport commissioned this study last October to the Korea Development Institute (KDI), the Korea Institute of Public Finance, and the Korea Research Institute for Human Settlements. Most developers typically invest only 5-10% of the total project cost when taking out PF loans, so attention is focused on whether measures to raise the equity ratio and enhance PF soundness will emerge based on the study results.

PF Developed to Overcome the Limitations of Corporate Finance (CF)

Real estate PF is a type of secured loan. Unlike typical mortgage loans, it is a method of raising funds secured by the profitability of a project. It is generally used in real estate development projects such as apartment complexes that require billions of won in funding. The expected profits upon successful apartment sales and occupancy are set as collateral. This differs slightly from general corporate finance (CF), which is based on the creditworthiness of the company.

PF was originally developed to overcome the limitations of CF. For example, in CF, if a company A is struggling in other business areas besides a specific project, the financial institution risks not recovering the loan. However, with PF, even if the company’s overall credit rating is low, if a specific project is expected to generate profits, the financial institution can eliminate the risk of not recovering the loan by limiting the borrowing entity to the project itself rather than the entire company.

PF was introduced in the 1920s during oil field development projects in the United States to reduce risks associated with development failures. At that time, it was structured using mutual funds, which pooled money from individual investors. Instead of recruiting investors who could invest 1 billion won each for a 10 billion won project, investors were gathered in units of 100 million won to diversify risk. Investors invested funds expecting (secured by) profitability if the oil field development succeeded.

Real Estate PF in Korea: Difficulty in Risk Diversification

Taeyoung Construction, which is experiencing a liquidity crisis due to real estate project financing (PF), has applied for a workout. On the 5th, the construction site of Taeyoung Construction's Seongsu-dong development project located in Seongdong-gu, Seoul, has come to a halt. Photo by Jinhyung Kang aymsdream@

Korea’s real estate PF has a structure that makes risk diversification difficult. Developers invest only 5-10% of the total project cost, relying on loans from financial institutions for the rest. If the project fails, the financial institutions providing the loans bear losses of 90-95% of the total project cost. Naturally, financial institutions have no reason to fund projects under such conditions. Especially, it is difficult to be confident that developers can manage these funds. Developers can be established with only 300 million won in capital for corporations or 600 million won in asset valuation for individuals under the Enforcement Decree of the Housing Act, so many are small-scale.

What enables PF loans in this situation is the debt guarantee from construction companies. Developers raise PF loans through debt guarantees from construction companies, which are large-scale and have substantial cash reserves. From the financial institutions’ perspective, since the construction company guarantees the huge financial burden, they can provide funds to the developer.

This domestic real estate PF structure has recently become the epicenter of the real estate crisis due to the economic downturn. For example, in the case of Taeyoung Construction, which recently entered workout, the liquidity shortage of the developer caused the crisis to spread to the construction company that provided the debt guarantee.

Accordingly, the government has begun restructuring the PF system. The market expects the government to push for a plan requiring developers to cover 20% of the total project cost with equity when promoting projects.

Academia and Industry Divided on Raising Developer Equity Ratio

Some argue that even raising the equity ratio to 20% is still a weak regulation. Han Mundo, a professor in the Department of Real Estate at Seoul Digital University, said about the equity ratio increase, “While the creditworthiness and stability of developers will improve, it is still insufficient compared to overseas cases.” According to a report titled ‘Problems and Implications of Korea’s Real Estate PF Structure’ released by the Korea Institute of Finance in June last year, developers in the U.S. prepare about 30% of the total project cost, and the loan ratio for land acquisition is around 40%.

On the other hand, there are also criticisms that the level of increase in the equity ratio is excessive. A developer official said, “There are not many developers with strong capital,” adding, “From the developer’s perspective, they have no choice but to use bridge loans, and if they are required to secure 20% of the project cost, the development project itself could become difficult.”