(Bloomberg) -- South Korea’s property market risks an accelerated slide triggered by quirks in renting practices, an outcome that would put its sputtering economy under more pressure and test the confidence of investors already spooked by recent financial sector turmoil.

The vulnerability stems from the common choice of tenants to stump up outsized deposits known as jeonse for landlords instead of paying monthly rent. This widespread practice supplies property owners with leveraged cash, putting jeonse at the heart of real estate speculation and financial imbalances in the country.

Deposits for an apartment in Seoul peaked at almost 678 million won ($530,000) last year. Those who don’t have sufficient savings for the deposits can take out special bank loans, adding a fault line to an ecosystem that gooses the market on the way up, while potentially magnifying losses when things turn down. 

“Jeonse can easily amplify risks in a time of crisis,” said Park Won Gap, a property analyst at Kookmin Bank. “It may become a bigger factor this year for the economy than high interest rates or a potential recession.”

The Bank of Korea and most economists still expect the property downturn to remain contained as a modest and even desirable correction. But economists warn that a deeper real estate slump, fueled by changes in jeonse use, can’t be ruled out.

A sharper slide in the property market would hit private spending in the economy, denting consumer and corporate confidence and potentially hurting President Yoon Suk Yeol’s chance of winning next year’s parliamentary elections. It might also reignite the pressure on credit markets that flared up last year in South Korea after the default of a Legoland Korea developer.

The concern stems from a feedback loop that can form as interest rates rise and property values fall. 

Higher borrowing costs prompt would-be tenants to switch to monthly payments. As jeonse become less popular, they get smaller, and at a critical point, landlords struggle to secure enough deposits from new renters to pay back jeonse to tenants reaching the end of rental contracts. That can force owners to dump property at steep discounts and fuel the cycle.

Figures from last year show monthly rent outnumbered jeonse in rental contracts for the first time on record.

House prices fell 4.4% in February from the elevated levels of the previous year. Around a quarter of all landlords would face difficulty paying back jeonse if prices fall by 10%, according to the Korea Research Institute for Human Settlements. 

“Jeonse and purchase prices are falling and they are feeding off each other,” Kim Woong, director general of research at the BOK, said last month at a news conference after the central bank slashed its economic growth forecast, partly on property-market concerns.

The rising number of unsold home offerings and the decreasing appetite for mortgage loans indicate that many buyers still consider housing to be too expensive after explosive price growth in recent years.

During the pandemic when the BOK’s key rate fell to as low as 0.5%, apartment sales in Seoul soared and bank lending to households topped 1,000 trillion won at one point.

In an interview last month, BOK Governor Rhee Chang-yong pointed to the sharp gains in home prices in the previous two years. “The current situation is a good adjustment period,” he said.

Combined with jeonse loans of about 1,058 trillion won ($828 billion), South Korea’s total debt among households amounts to 2,925 trillion won, the Korea Economic Research Institute said in a report this month. That would raise the household debt-to-gross domestic product ratio to 157%, the highest among 60 countries tracked by the Institute of International Finance.

Most of South Korea’s household debt linked to real estate is charged at a floating interest rate, making the nation’s housing market much more sensitive to rate hikes compared with other countries, according to An Young-jin, an economist at SK Securities Co.

While the housing market has found some relief recently following government measures and expectations for no more central bank rate hikes, the outlook continues to generate concern given the significant size of housing supply scheduled over the next year or two, An said.

Struggling Developers

The property market falls are also adding to woes for construction companies already struggling to sell housing. The number of unsold homes nationwide surpassed 75,000 in January, the highest level since 2012, according to the Ministry of Land, Infrastructure and Transport. That’s more than a five-fold jump from just a year and a half ago.

Real estate companies are pulling out all the stops to try and sell property.

Among unusual sales tactics in cities outside Seoul, one developer offered the chance to win a Mercedes Benz for buyers at an apartment complex. Another developer put up Chanel handbags and Apple AirPods as possible prizes for visitors to its model house. One site in the country’s southeast gives buyers a gold bar as a token of appreciation.

The BOK and government have already pledged policy support worth tens of billions dollars to reassure investors after the government-backed developer of Legoland Korea missed its debt payment last fall. 

At the heart of the problem was project financing, a type of short-term debt many local developers take advantage of based on the expectation that they can start repaying it by selling homes before construction is completed.

Now as the housing market wobbles, even a small credit-related event could rekindle risks associated with project financing, according to a NICE Investors Service Co. report last month.

“It’s like SVB,” Lee Kang Wook, a general manager for ratings at NICE, said, referring to Silicon Valley Bank, the US bank that collapsed earlier this month, jolting global markets and raising doubts about the stability of the financial sector. SVB was unable to back its bond portfolio with cash.

“You must sell these homes to repay the PF loans if you’re a developer,” he said. “Companies that have borrowed more than they can handle will become an issue.”

--With assistance from Jaehyun Eom and Hooyeon Kim.

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