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Foreign Investment in Korea's Real Estate Markets: Will Capital Invest in 1999? 17th January 1999 By Pietro A. Doran, Managing Director, The John Buck Company (Korea), Ltd. The John Buck Company (JBC) is the leading international real estate consulancy in Korea
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To read the media accounts of foreign investment activity in the Korean real estate market one would think that there has been a steady stream of transactions taking place. For example, a recent article (as published in an English language Korean journal) reported that foreign purchasing of Korean real estate exceeded 10.23 million square meters of land throughout the nation. It further notes that of the total, 1.33 million pyong ( 43%) was "purchased in the form of joint ventures, 1.08 million pyong (35%) by ethnic overseas Koreans and 630,000 pyong (20%) by local subsidiaries of foreign firms. The article attributes the rise in land acquisitions by foreigners to increased purchases of factory land and sites for the construction or acquisition of discount stores. Finally the article notes that in terms of total land area, that purchased by foreigners in December exceeded by a factor of 3.7 times the monthly average before the government fully liberalized the domestic real estate market.Without doubt, foreign investment continues to expand in Korea and the progress that the country has made in overcoming economic difficulties has been impressive. However, it is also important to avoid interpreting the above statistics as indicating a sudden rush by foreign investors to purchase Korean real estate. It is also erroneous to infer that this increased activity is directly correlated to the liberalization of the market which occurred in June 1998. Utilizing the numbers above and a careful reading of the information presented, it becomes evident that the vast majority of land transactions that have occurred, totaling 63% of acquisitions, were actually in the form of industrial and single purpose retail, both of which were legally permissible for purchase by foreigners prior to the June 1998 liberalization. Also, it is important to note that a significant number of the reported transactions (43%) were not actually title acquisitions of property but rather acquired interest in joint ventures - therefore a very liberal interpretation of a "transaction". In the case of discount stores, it is evident that the combination of a cheaper won with the need of local owners to dispose of large property holdings to improve liquidity positions was the actual motivator of land acquisitions by foreign interests and not a change in investment regulations. Finally, it should also be noted that the purchase of property by local subsidiaries (20%) was again wholly within the right of these firms to undertake prior to June 1998 and that this increase has more to do with falling land and building values than changes in investment law. As for purchases of housing by ethnic overseas Koreans this can be seen as among the most positive outcomes of the liberalization movement. After all, if those who know Korea best are reluctant to invest, then what chance is there that foreign interest with little experience or knowledge of the local market will do so? Some caution should be applied to this classification of buyer in the attempt to ascertain correlation between market liberalization and foreign investment. It can be argued that most overseas Koreans continue to maintain strong family ties to Korea. Therefore, the housing purchase trend may primarily be attributable to a fulfillment of traditional desire to provide a purchased home for family members or to ensure a place of abode for the eventual return to Korea in the event of retirement or business relocation. Lower pricing has certainly motivated higher transaction activity from this category of residential purchasers. Of course, the speculative player can't be dismissed as a potentially significant player in this market, but is this investor class really an indicator of foreign movement in the domestic market? The answer is no. Although this investor class may provide positive support for the overall housing construction industry, it's activities are purely speculative and not based upon careful economic analysis of intrinsic market fundamentals. It is not evident that this kind of activity would be beneficial to the real estate market in the long term given its purely speculative nature. In fact, this investor class may motivate a shift in resources to the development of higher end housing rather then middle to low income housing that continues to be in short supply. In the final analysis, the positive tone of the article is misleading in its message and should not be taken as an indicator of actual foreign investment trends in the market. The fact is that transactions by foreign investors, whether office buildings to support current business activities in Korea or purely investment plays by international real estate funds and institutional investors has not yet become a reality. Certainly one can point to the acquisition of the Hannam Chain building by Volvo and the sale of 8 floors of Samsung's Namdaemun building to HSBC as an indicator of increased foreign purchase of real estate. However, again, one should be reminded that in both cases, this type of purchase was legal prior to June 1998 and both were already actively pursuing these purchases very early on in the year. Other than some embassy purchases of land and building for chancery expansion along with some minor residential housing purchasing (typically very expensive villa or singly family residence), very few other transaction have taken place. With the recent strength in the won, even this activity is certain to slow as the exchange rate advantage continues to erode their affordability index, making the acquisition alternative increasingly less attractive, particularly when compared to other investment opportunities in other parts of Asia, that have not experienced the same recovery in their currencies against the greenback. What then is the prognosis for foreign investment in Korea? Short to mid term, the ability of the real estate market to attractive significant capital from overseas is not positive. The continued restructuring of the financial sector and the ongoing reluctance of banks to allow corporations to liquidate assets at below collateral value combines to create a high barrier to transaction. Many Korean property owners have accepted the reality of declines in the speculative value base of their assets of between 25% and 35% in even prime commercial districts. This would translate to yields migrating from historical lows of between 5% to 7% to currently anticipated transaction yields of between 9% to 11%, with secondary locations willing to trade at as high as 12% to 14%. While still significantly below foreign investment pricing of between 15% - 18%, the magnitude of the yield movements is a reflection that owners are more far more realistic in their economic assessment of value and far less inclined upon purely speculative assumptions of value. In fact, it can be argued that the Korean appraisal industry's increasing acceptance of an income based valuation approach as an integral component of appraisal methodologies will be a key determinant in the stabilization of Korean commercial values to normalized international fundamentals. Korea is a unique place and any pricing will always have to take into consideration the local environment, a key component of value, but this cannot be done in an environment devoid of economic fundamentals. This is simply not good for the long term stability and rationalization of the economy. During the last quarter of 1998, there was a noticeable lull in the earlier frenetic interest of foreign capital for the Korean market. The frustration of foreign capital towards the refusal of owners to apply, or consider, realistic market fundamentals in setting prices, the lack of enthusiasm by banks to support market stabilization, demonstrated through their objections at writing down collateral values to allow for transaction, and, frankly, the often unrealistic and draconian return requirements of foreign capital together with its fundamental lack of familiarity with the culture and history of the Korean market all have combined to ensure that no market precedent transactions trends have taken place to date (Jan 99). One promising prospect for the real estate market is the prospect of true fiduciary discipline within the financial sector, which should result from recent foreign acquisitions of certain local banks. Seen as an extremely positive indication of Korean resolve to bring stability into this historically weak sector, the movement to improve bank BIS ratios through asset disposal will accelerate the introduction of economically rational pricing expectations into the market. This will take time but, the important issue is the fact that these needed improvements to systemic structural weaknesses are taking place and quite rapidly. There is no doubt that the foreign investment community is taking keen interest in these development and are impressed by the determined pace, and success, of the governments economic reform programs. Probably the most important observation that can be made regarding the prospect of foreign investment is the fact that until there is greater movement by local investors in their own home market, it is difficult to understand why foreign investors should be willing to take the first step. For example, it has become increasingly apparent to foreign capital that local investors have been reluctant to purchase assets at what appears to be historically low auction prices. This has been true in all property sectors but most evidently within the housing, secondary commercial and land markets. Outside of the Seoul metropolitan area there is a veritable depression in land value as undeveloped property is unattractive at almost any price. These markets are the most unfamiliar and least attractive to foreign entities and will rely heavily on Korean buyers to stabilize prices. To date, this has not happened. Finally punitive tax regulations, originally implemented to discourage out of control speculative forces that once pushed annual property value increases into the double digits, are currently acting as an agent to further push property values ever lower. In the few cases in which attempts were made to consummate a transaction between Korean property owners and foreign investors, the combined impediments of capital gains and acquisition taxes (especially in the Seoul metropolitan area where cumulative acquisition tax assessment) resulted in unacceptably high transaction costs. While legislation has been introduced to address this impediment to both local and foreign investment, lack of political fortitude to reduce these burdens on a sector traditionally viewed as rife with corruptive speculative activity has precluded any true action. Is there hope for integration of the real estate market into the global arena and will foreign capital flow into the real estate market? Yes, but in terms of the true opportunity funds and institutional investors it appears this will not occur until at least the second half of 1999. Impediments to transaction will remain until Korean property owners place priority on liquidity rather than pride and banks are forced to write down non-performing assets and induce the sale of property of insolvent owners at economically reasonable levels (foreclosure). It can be argued that the first tentative steps have already been taken. The recent auction of Non-performing (NPL) asset back (real estate) loans has already opened an exciting new chapter in the evolution of Korea's property industry. As a pioneer in the development of the Asset Back Securities market (ABS), the Korea Asset Management Company (KAMCO) successfully completed the first auction of NPL's to foreign buyers. Attracting the participation by leading investment banks and US property funds, the sale of these securities and the establishment of a joint venture special purpose company (SPV) to handle the administration and work out of these portfolios was interpreted as a show of Korean resolve to restructure the banking sector. The success of this auction was two-fold: 1) the sale attracted teams of foreign property and debt specialists who, for the first time, gained familiarity with the country's unique property infrastructure on a legal, commercial and cultural basis, and; 2) instilled confidence in the foreign investment community in Korea's determination to resolve its economic problems. The success of this auction will undoubtedly motivate foreign investors to reassess the long-term prospects of Korea's real estate industry. In what property sectors will foreign investment most likely take place? Other than the case of NPL auctions, the most likely near prospects are to be found in serviced apartments (primarily a development opportunity), prime commercial office (CBD locations), and the hotel sector (4 - 5 star with the exception of some 3 star transactions which will be of more interest to overseas Koreans or second tier Asian investors). Limited one-off transactions (involving end-users not portfolio institutional investors) will occur within the secondary office and residential markets where price flexibility and market liquidity is highest. However, these transactions will not be true indicators of a general market turn. It is also true that land sales in areas that can support large-scale discount retail will also continue to be attractive through 1999. Following on discount center construction, entertainment development (e.g. multi-screen cineplex) is an extremely promising arena with a greater possibility for geographic diversification. However, because the development of these centers will require a strong long-term relationship between developer and operator, most capital will remain hesitant to undertake the investment risk until economic fundamentals improve. It should also be mentioned that large-scale tourism and infrastructure projects could be attractive to foreign investors but only in the event that sophisticated financing packages are structured to provide attractive and internationally competitive long-term returns. However, it seems likely that these type of projects will not find active investment interest from foreign capital until the domestic economy shows concrete signs of recovery and growth. In all probability, the Seoul Metropolitan Area will remain the most attractive market catchment area for the majority of foreign real estate capital. As investors become more familiar and knowledgeable about Korea, large cities such as Pusan (large population), Cheju (tourism) and Kwangju (historical interest) will become of greater interest to investment funds but this will take time and great effort on the part of government and industry to compete with the Seoul market. Furthermore, the majority of US capital interest in these secondary urban markets will be focused towards the hotel, retail and entertainment development with very little near term interest in either the office or residential sectors. Korea has made remarkable progress in the restructuring of its economy. The Korean people have shown extraordinary courage and fortitude in addressing the crisis that has effected the entire nation. Through these determined efforts to welcome foreign investment into all sectors of the economy, the nation has gained the attention of the international investment community. The foreign media is full of positive assessments of Korea's struggle to restructure its economic base. As among the few true democracies in Asia, Korea has also earned the reputation for political stability and economic pragmatism. With these documented strengths there isn't any doubt that capital will vote to invest in the property markets of Korea and sooner rather than later. By Pietro A. Doran, Managing Director, The John Buck Company (Korea), Ltd. The John Buck Company (JBC) is the leading international real estate consultancy in Korea
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The views expressed here may not necessarily reflect those of Orient Pacific Century or partners of the Asia Pacific Management Forum
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