Export powerhouse South Korea is surviving the real estate downturn better than many other Asian economies, but prospects vary markedly by region. Mark Faithfull reports

South Korea remains a conundrum. With its real estate market open to foreign investment since 1998, this fledgling property player has managed the journey from emerging to emerged market in little more than two decades and now exports everything from consumer electronics to cars. Yet despite its reliance on - now plunging - international consumer demand, its real estate market is holding up better than those of many of its Asian counterparts.

To understand this apparent contradiction requires a keen appreciation of the fundamentals that have brought it to its current point, says Pietro Doran, chairman of Doran Capital Partners. "There is a big misconception that the South Korean real estate market is full of distressed opportunities and we hear a lot of funds selling investors the idea of properties with a potential 20% capital gain and 15% IRR. That is patently not going to happen."

However, Doran divides the country broadly into two markets, what he describes as the "Republic of Seoul and the rest of the country". Capital Seoul - like Tokyo in Japan - dominates investor thinking. Its metropolitan area is home to 23 million people (48% of the population) and 70% of the country's conglomerates. With a time-consuming planning system, a dominance of the market by owner occupiers and historical vacancy rates of only 1%, Seoul has weathered the economic storm remarkably well so far.

"Seoul has very low reliance on major international corporates, which tend to have subsidiary offices here rather than major regional flagships," Doran points out. "Because planning is notoriously long-winded the supply pipeline has been slow and steady and most corporates have expanded into their current buildings as owner occupiers. The downturn has not meant that they need to downsize." The availability of major office buildings remains low and vacancy rates are still hovering below 2%.

"There has been a fall in the prices achieved recently but this is more focused on sellers that have made a decision to convert their property holdings into cash," says Doran. "They have priced to sell, but most deals are being done at the asking price or above."

However, the situation outside Seoul is not so rosy, although the latest economic figures suggest a bottoming-out might be near. South Korea's quarterly economic growth is expected to be near zero for the first quarter of 2009, a positive development for an economy that shrank 5.6% in the last quarter of 2008, its worst performance in 11 years.

"Although it is not easy to predict, we think it possible that the economy may log slightly positive growth in the current quarter," says Kwon Soon-Woo, a senior economist at Samsung Economic Research Institute.

Industrial output rose 1.3% in January from a month earlier, marking the first rebound in four months, although it tumbled a record 25.6% from a year earlier. The government predicts that the country's trade surplus may top a record $4bn (€3bn) in March thanks to a sharp drop in imports.

JPMorgan noted in a recent report: "South Korea and Taiwan act as bellwethers for emerging economies. Despite rapidly falling global demand and cross-border trade volumes, the two countries have sent hopeful signals for a global economic recovery."

In a bid to release lending, South Korean banks are poised to issue covered bonds as part of their long-term funding strategies, which would allow them to shore up their capital bases, diversify their funding options and lower their margins. Kookmin Bank and Woori Bank have indicated their interest in this route.

"There is no easy way to get through the credit crisis," says Keum Hee Oh, director of structured finance at Fitch Ratings, Seoul. "Risk is beyond anyone's control, but investors need to be educated about covered bonds, and this process will take time."

The government has also decided to expand tax exemptions for large-scale foreign-invested companies in the country's free economic zones (FEZ). Several free economic zones exist around the country including Incheon, Busan-Jinhae, Gwangyang and New Songdo City - the new city that Korea plans to become an Asia gateway.

"The currency is down massively and the economy has slowed down. Consumption is declining. The government is doing a lot to stimulate the market and is trying to attract investment both regionally and internationally," adds Jane Kim, manager at Korea Tourism Investment Center.

Much of that strategy - outside Seoul - has been focused on mega-projects. New Songdo City is strategically located close to Seoul and is linked by bridge to Incheon airport. Saemangeum Gusan FEZ is being developed as a mixed business and tourism city and Ham Jung of the investment strategy division for the FEZ points out: "The project involved reclamation of the land plus natural islands - providing 401 square kilometres of new land in a very land-constrained country," she says. "Of that, 76 square kilometres have been given FEZ status with industrial plus residential to create a new city. Also an international marine zone is being developed, aimed at attracting Chinese and Japanese tourists."

John Stinson, regional director, capital markets Asia Pacific at DTZ, adds: "South Korea's economy has really stuttered, while domestic pension funds have taken the opportunity to divest some of their holdings. Overseas companies are getting exposure to the office market but there is not much rental growth. But currently the economy is very reliant on car manufacturing, and is tied to the US economy."

But he points to a resilient market. "I don't think Asia has deteriorated as badly as the US or Europe. It has had to cope with financial problems and SARS."

Doran agrees, and although he believes that international investment will be much more reluctant to consider Korea's regions than Seoul, he points out that many of these areas have been dealing with a gradual downturn in their local economies for a decade.

"The fact is, everyone wants to live in Seoul and the new approach of leisure and work cities outside the capital is taking time for the Koreans to adjust to," he says. "Cities like Taean [another area designated for redevelopment] have been exporting jobs to China for a long time, they have become used to tough economic conditions."

Doran rebuts the notion that opportunities do not exist. "What you need is a really detailed knowledge of the cities in which you invest and how they work," he says. "The office vacancy rate in Taean is running at about 12% but we have a building there fully let. That's because you need to know your market, know your location and manage the hell out of your assets."