A comprehensive study by the Korea Development Institute (KDI) has found that increasing the equity stake in real estate project financing (PF) from 3% to 20% can significantly lower project risks and reduce overall costs by more than 7%. The findings are based on an analysis of over 800 real estate projects in South Korea conducted between 2013 and 2025.
The report, authored by KDI Senior Research Fellow Hwang Soon-joo, provides empirical evidence supporting a shift away from the highly leveraged financing models common in the country's development sector. This research comes as the government considers long-term plans to mandate higher equity contributions for real estate developments.
Key Takeaways
- Increasing developer equity in real estate projects from 3% to 20% reduces total project costs by an average of 7.2%.
- For residential projects, the cost savings are even greater, reaching an average of 11.1%.
- Higher equity significantly lowers the minimum pre-sale rate required for a project to be successful, reducing default risk by 13 percentage points.
- The report identifies a regulatory gap in Project Financing Vehicles (PFVs), which are not subject to the same minimum equity rules as REITs or real estate funds.
- Recommendations include selective regulation, expanded investor incentives, and closing the PFV loophole to stabilize the market.
The Problem with Low-Equity Financing
For years, South Korea's real estate development market has operated on what the KDI report describes as an "ultra-low capital" structure. In this model, developers typically contribute only 3% of the total project cost as their own capital.
The remaining 97% is financed through extensive borrowing, known as project financing. To secure these large loans, developers have historically relied on guarantees from major construction companies. This practice creates a chain of financial risk.
How Project Financing Works
Project financing is a method of funding large-scale projects where the loan is repaid from the cash flow generated by the project itself. In real estate, this often means revenue from apartment pre-sales. When developers have very little of their own money invested, the lenders and construction guarantors bear most of the financial risk if the project fails.
This high-leverage model makes the entire system vulnerable. According to the KDI analysis, a downturn in the real estate market or a sudden rise in interest rates could cause developers to default. Because of the guarantees, these defaults could then trigger a domino effect, leading to financial instability for the construction companies and the lending institutions involved.
Quantifying the Benefits of Higher Equity
The KDI study moved beyond theory to provide specific data on the advantages of a higher equity stake. By modeling a shift from a 3% to a 20% equity ratio across more than 800 projects, the research identified clear benefits in risk reduction and cost savings.
Strengthening Project Viability
A key metric in residential development is the "exit pre-sale rate." This is the minimum percentage of units that must be sold in advance to generate enough revenue to repay the project's loans. A high exit pre-sale rate means the project has little room for error.
The analysis showed that increasing equity to 20% would cause the average exit pre-sale rate to drop from 59.2% to 46.3%. This 13-percentage-point decrease provides a much larger buffer for developers. Even if pre-sales are slower than expected, the project is far less likely to become non-performing and default on its loans.
Significant Cost Reductions
The study found that raising developer equity led to substantial savings:
- The average total cost for a project fell by 22.5 billion Korean won (7.2%), from 310.8 billion to 288.3 billion won.
- Residential projects saw an even larger drop of 35 billion Korean won (11.1%), from 315.1 billion to 280.1 billion won.
Where the Savings Come From
The cost reductions were primarily driven by two factors: construction costs and financial expenses. With more of their own capital, developers are less dependent on construction firms for financial guarantees. This increased negotiating power results in lower construction costs, which fell by an average of 6.4% (from 160.6 billion to 150.3 billion won).
Furthermore, a larger equity stake means a smaller loan is needed to fund the project. This directly reduces the amount of interest and other fees paid to financial institutions. The KDI analysis found that financial costs decreased by 12.6% (from 26.8 billion to 23.4 billion won) on average.
Policy Recommendations for a Stable Market
Based on its findings, the KDI report offered several suggestions for policymakers aiming to strengthen the real estate finance system. The government had previously announced a long-term goal to gradually increase the required PF equity ratio to 20%.
The report advises against a one-size-fits-all approach. It suggests that any regulations limiting total PF loan amounts should be selectively applied to projects with low equity ratios, rather than being imposed uniformly across the market. This would target the highest-risk developments without stifling well-capitalized projects.
Incentivizing Investment
To attract more capital into development projects, the report recommends broadening the definition of eligible equity. Policy benefits should extend to investors holding non-redeemable preferred shares, not just common stock. This would provide more flexibility and encourage a wider range of investors to participate.
Additionally, the report highlights the importance of making tax incentives permanent. A system that allows landowners to defer capital gains tax when contributing land to a project (in-kind contributions) is currently temporary. Making it a permanent feature would provide certainty and stimulate more land contributions for development.
Closing a Major Regulatory Loophole
Perhaps one of the most critical issues identified by the report is a regulatory blind spot concerning Project Financing Vehicles (PFVs). These special-purpose entities are widely used to manage large-scale development projects.
While similar investment structures are strictly regulated, PFVs are not. For example:
- Project REITs (Real Estate Investment Trusts) must have a minimum equity ratio of 33%.
- Real estate funds require a minimum equity ratio of 20%.
- In contrast, PFVs can proceed with projects with as little as 3% equity, facing no specific restrictions.
This gap allows high-risk, low-equity projects to continue, undermining efforts to stabilize the market. The report strongly recommends eliminating this disparity to ensure all development projects are subject to consistent and prudent financial standards.
"It is crucial to design policies carefully to preserve the positive effects of equity expansion while preventing excessive contraction of development projects," stated Senior Research Fellow Hwang Soon-joo. "Regulatory blind spots like PFVs should be eliminated, and investment incentives strengthened."
The KDI's research provides a clear, data-backed roadmap for creating a more resilient and cost-effective real estate development sector. By increasing equity requirements and closing regulatory loopholes, policymakers have an opportunity to reduce systemic risk and promote sustainable growth.
