There might be many reasons why someone buys a property that produces no monthly income. Maybe it's a tax shelter or maybe it's a speculation play. Here's a response I wrote to a reader recently on why the jeonse strategy discussed in these articles can be a real winner, despite receiving no rental income.
- How to buy an apartment in Korea for $5,000
- Sokcho real estate investing – Part 1: A commercial property in the heart of a shopping district for $3,000.
- Sokcho real estate investing – Part 2: An oceanview apartment for $10,000
- Sokcho real estate investing - Part 3: Why Sokcho?
The jeonse strategy is not a rental income cashflow strategy. But some members of the Seoul Real Estate Investing Meetup ran the numbers for rental income vs the jeonse strategy and found that jeonse strategy returns beat rental income strategies under certain conditions. (See the conclusion at the end of the article.)
I'll go into more details, but in a nutshell, investing using other people's jeonse money is a net-worth building strategy (or you can think of it as an appreciation play). If you're looking to get passive income through rental income, then this strategy may not apply, unless you have many, many properties. I'll talk about this more later on in the article.
First off, before trying this strategy, an investor must find these things:
- A steadily appreciating market. Seoul, with its big swings up and down, is too volatile (or adds more risk).
- A market where the jeonse is 85% or higher relative to the purchase price. This reduces the amount of cash needed to make the purchase.
- A discount to the purchase price. As with all investments, you want to make sure you made money at the purchase.
So how does this work?
So, let's say you're able to find a discounted property in a steady market (we'll use Sokcho for this example, but other markets exist).
The owner wants $150,000. You know tenants are willing to put around $95,000 in jeonse to live in the area, rent free. You're able to negotiate down to $100,000 (based on example in this article).
Once you have an agreement, you put down earnest money of $5,000. You market the property for a tenant and find someone who agrees to the $95,000 jeonse. You schedule a "double closing" in which the tenant moves in on the same day you take possession of the property. The $95,000 in jeonse from the tenant and the $5,000 you put down as a deposit goes to the owner. The owner gets his or her $100,000. The tenant gets a place to live. You now own the unit.
You have, in essence, received a 0% interest loan from your tenant.
But so what? You're not making money off rent? So what's the point?
Here's where factor #1 - buying in a steadily increasing market - comes into play.
A steadily appreciating market
In two years, when the contract is up and assuming the market has appreciated to say $105,000 for jeonse deposits, you can either:
- ask for $10,000 more in jeonse from the existing tenant
- find a new tenant who is willing to pay $105,000
Let's say your tenant wants to leave, and you find someone else who wants to pay $105,000 in jeonse to live there.
You take the $105,000 from the new tenant and give back $95,000 to the old tenant. The old tenant leaves and finds a new place to live.
The new tenant moves into the property, and you pocket the difference a difference of $10,000 between what the new tenant gave you and your repayment to the old tenant.
You pay yourself back $5,000, and you have a $5,000 profit left over.
So, in two years, you've doubled the money you paid to "purchase" this property.
What if the market doesn't go up? What if there's a downturn?
There's certainly that risk.
That's why buying in a steadily appreciating market is important. But now factor #2 - buying in a market where the jeonse is 85% or higher relative to the property value - also comes into play.
A market where the jeonse is 85% or higher relative to the property value
What did you risk to take ownership of this apartment? Your initial investment has to be small enough so that you limit your downside risk.
If, a worst-case scenario, the market takes a severe downturn, and the jeonse rate drops dramatically to, say, $50,000 from our initial $95,000, you won't have enough to pay back your tenant. What happens?
The property becomes their property, and you lose your initial investment.
While that's not a good thing, investing is all about limiting the downside risk and maximising the upside potential.
However, here's where factor #3 - buying at a discount to the purchase price - comes into play.
a discount to the purchase price
Since you bought at a discount, in the event of a downturn (or, to put it simply, if you wanted to cash out right away), you can turn around and sell it for a profit.
If you sell it for $120,000 (and assuming $150,000 was indeed the market price), this will still be a great deal for someone else.
You pay off the $95,000 to your tenant, and you pocket $25,000 (essentially turning your $5,000 into $25,000).
Is this like a flip then (or wholesaling as it's called, when you don't actually improve the property and just turn around and resell a property for a profit)?
In a sense, yes.
But the jeonse strategy differs in these ways:
- You're getting the money to buy these houses at a 0% loan from your tenant.
- You can hold onto the property, and every two years when the jeonse rises, you'll continue to get back some cash flow (like a dividend that pays annually, not monthly).
It still sounds a bit risky.
You definitely need to choose your market wisely and buy the right property at the right price. And you need to limit how much you pay out of pocket.
Why would the owner sell at a discount? Why would people use jeonse instead of just buying a property if the jeonse price is so close to the purchase price?
Owners: They might be selling for a variety of reasons. Maybe they don't want the hassle of managing this type of strategy because they're not professional real estate investors. Or maybe they just want the cash and don't want to worry about having tenants. And also, keep in mind, this:
Let's say the original owner paid $90,000 in cash for this property. He can now get $95,000 in jeonse. That represents a $5,000 return on investment (ROI). So, the original owner's ROI is much lower than yours based on how much of his own money went into the deal. This might not make sense for him, but it might be great for you. He may be looking to put his investment into a higher yielding property or maybe he'll use the capital to buy several properties using low jeonse strategies that he's learned from you!
Tenants: They might only be looking to live in the area temporarily. Maybe their company moved them there. Or maybe they're worried about a downturn in the market and don't know prices well enough to feel comfortable buying. The bottom line: Not all tenants are professional investors, and therefore you, as a market expert, have an advantage.
So, while you need to wait a while to realize your returns, over the long haul, your return can be very high. In fact, we projected a compounded rate of return of 81% for the investor Imagine that - getting 81% compounded annual returns on an investment. Even Buffett would smile at that. And Charlie probably would, too.
Of course, 81% is only a prediction for now, so we'll see if the investors actually earn that over time.
However, the investors learned the strategy from another investor who has purchased hundreds of properties this way.
What do you think? Would you buy a property that earned no rental income? Let us know your thoughts.
(Banner photo by Teddy Cross, Flickr)