The death of a South Korean property tycoon who owned more than 1,000 apartments in the country hit the headlines this past December. Dubbed the “apartment king” by the local press, the man reportedly owed many millions of Korean won (₩1 million is equivalent to US$770) to tenants, who found themselves out of pocket with little recourse. Since then, media outlets have reported on similar “villa king” cases, with Bloomberg writing that the country is trying to contain “growing fallout from housing rental schemes that scammed millions of dollars from more than a thousand tenants.” In at least one case, local police are investigating whether organized crime was involved, according to the Korea Herald.

But alleged scams aside, South Korea’s rental market is facing a crisis because rising interest rates can lead landlords to default, according to Tsinghua University undergraduate Baiyun Jing, Chicago Booth PhD student Seongjin Park, and Booth’s Anthony Lee Zhang. Their research explains why the market is so vulnerable to interest-rate fluctuations—but also proposes a policy solution.

In much of the world, renters pay an initial security deposit followed by a monthly fee. In South Korea, tenants can do the same or opt for a system known as Chonsei, or “key money,” which has been in place since the 1960s. In Chonsei, tenants pay a larger up-front sum (often borrowed from a bank) and then live rent free for the duration of the lease, which is usually two years. When the lease is up, they get their entire security deposit back. Essentially, instead of paying monthly rent, tenants give landlords an interest-free loan.

Chonsei deposits can be substantial—as much as 50–75 percent of the market value of the property itself—but have some advantages over either renting or buying. For younger tenants, the deposits are often paid by parents, so Chonsei allows them to focus on building a career or savings. For landlords, they constitute a strong credit channel—loans that can be used to pay off the mortgage on existing properties and finance the purchase of new properties. Chonsei makes it possible for landlords to speculate and amass substantial real-estate portfolios without any preexisting capital.

Between 2012 and 2022, average deposit amounts rose 60 percent. To the researchers, it wasn’t clear why, and they analyzed the decisions made by each party. Before every transaction, landlords calculate whether an interest-free loan is more attractive than a fixed monthly rental income. For their part, Chonsei tenants usually borrow the deposit amount from a bank and pay interest on that loan, so they compare how much they’ll owe in interest to what they would otherwise pay in rent. As long as the interest payments don’t exceed rent, Chonsei is attractive.

Low interest rates produced big rental deposits

In South Korea, tenants and landlords can opt for a Chonsei arrangement, through which landlords receive a deposit from tenants in lieu of rent. The size of these deposits is closely linked to interest rates: when rates fell between 2012 and 2020, Chonsei deposits grew by more than 60 percent relative to rent, according to the research. Increasing deposits, in turn, exerted a strong upward pressure on house prices.

For example, assume that interest rates are 5 percent. A tenant could pay ₩13 million a year in rent to a landlord—or the same person could borrow ₩260 million from the bank, pay ₩13 million a year in interest to the bank, and make a no-interest loan to the landlord in lieu of rent.

But there is significant interest-rate risk. The researchers built a statistical model and tested their findings using a wealth of information including housing-market data from the Korea Real Estate Board, credit-report data from the Korea Credit Bureau, and interest-rate data from the Bank of Korea, among others.

According to the model, deposit size is closely tied to interest rates: when they fall, deposits grow. If interest rates were to fall from 10 percent to 5 percent, the deposits paid by tenants would double. Historically-decreasing rates made Chonsei attractive for property owners, who enjoyed larger interest-free loans. But when interest rates go up, deposits paid to landlords fall in value. When a lease expires, a landlord ends up returning the full deposit and collecting a smaller deposit in its place. For a property empire built on leverage, the result is default.

“We saw this coming even before the Villa King case blew up,” says Zhang. “You’ve had this system working on a two-year rental horizon with landlords borrowing like banks and hoping that the equilibrium loan size is big enough to pay back the last guy. And that worked for 10 years because interest rates kept going down.” But in 2022, when the Korean government started to hike interest rates to ward off looming inflation, property owners saw their credit supply collapse.

As the Korean government tries to stem a flow of failures and stave off a financial crash, Zhang and his colleagues propose a redesign of the Chonsei system. They recommend a hybrid Chonsei loan-rental system, in which a proportion of each deposit gets paid as monthly rent directly to landlords. This would create a buffer against fluctuations in interest rates and dramatic changes in deposit sizes. Alternatively, policy makers could introduce a tax wedge in the form of additional interest rates that Chonsei tenants would pay to banks when they take out loans for their deposit. “What we propose is a light-touch solution that works better in response to monetary policy while preserving decades of culture,” Zhang says.

While Chonsei is unique to South Korea, rising rates are not. Zhang notes that the situation could serve as a cautionary tale for global policy makers confronting credit or mortgage systems sensitive to interest-rate changes.

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