South Korea’s $35 Billion ‘Labor of Love’; Developer Struggles to Build a City From Scratch

South Korea’s $35 Billion ‘Labor of Love’

Developer Struggles to Build a City From Scratch

IN-SOO NAM

Updated Dec. 3, 2013 7:35 p.m. ET

A pagoda stands beside Songdo’s Central Park Canal. The Northeast Asia Trade Tower, background, opens next August. Gale International

SEOUL—About a decade ago, a huge tract of land reclaimed from the Yellow Sea west of Seoul was a barren wasteland. Today it is a city named Songdo with a population of 67,000, Korea’s tallest tower and a green oasis modeled on New York’s Central Park. On Wednesday, President Park Geun-hye is scheduled to join the developers of Songdo’s centerpiece—a $35 billion business district—for a ceremony welcoming Songdo’s latest office tenants: the World Bank’s Korea office and the Green Climate Fund, a United Nations organization.But Songdo has been a financial disappointment for its developer, a venture of U.S. developer Gale International and Posco Engineering & Construction.

The venture has gotten fees and has been able to get back the equity it put into the project, less than $100 million. But other than that, the developer hasn’t earned any profits for the 12 years of work it has put into building Songdo, which is technically part of the larger city of Incheon.

“It’s really been more of a labor of love from Gale’s standpoint than an investment return,” says Jonathan Thorpe, a Gale senior executive vice president.

The developers say the main cause of Songdo’s disappointing financial results is the global financial downturn, which made financing scarce and slowed demand for retail and office space. While Songdo’s condominiums have sold well, about half of the commercial space in Songdo’s gleaming office skyscrapers is empty because the business district has struggled to attract tenants.

The district, originally scheduled to be completed in 2012, is about half finished, with about 50 million square feet built. Officials now predict it will be finished in 2017 or 2018.

Financial returns also will be limited for Gale and Posco because of a concession they made in 2010 during a restructuring of Songdo’s debt, giving up 50% of the future profit to the city of Incheon. The restructuring and changes to the development plan were necessary partly because the cash flow of the project had fallen to the point that uncertainty was growing over repaying about $2.5 billion of debt held by a bank group led by Shinhan Bank.

As part of that restructuring, the maturity date on that debt was extended to 2016 from 2014. Also, Posco agreed to guarantee a portion of the loan. In exchange, the Korean construction company, which already had the rights to build the majority of the residential projects, got rights to build the rest. Otherwise, it would have been put out for competitive bid.

Also as part of the deal, the government allowed the developer to temporarily build more residential than office space, which has been less in demand.

But five years after the financial crisis, Gale continues to experience challenges in Songdo. Its struggles underscore the pitfalls facing real-estate developers and others who invest in emerging markets on the hopes that governments will succeed in making the business environment more hospitable.

Gale executives say Korea has made progress in doing this. But Gale also has had disagreements with the government over issues such as design, the mix of residential and commercial space and the amount of incentives that the government would provide, according to former and current Gale executives.

John Hynes III, who was chief executive of Gale, said in an interview last week that he stepped down from Gale in 2010 partly out of frustration over what he called “turbulence” between Gale and the Korean government.

“It basically became a Korean project with an American name only at the wheel,” he said.

Park Kwon-soo, an official at the Incheon Free Economic Zone Authority, denied that Gale’s role has been diminished. “Overall you can’t say Gale’s role has been reduced to a second place or limited to a supporting one,” he said.

Stanley Gale, the founder of Gale International, who added the role of chief executive when Mr. Hynes left, said in an email that the government “has done much of what they set out to do” and that his company’s relationship with the government “has been a process that has evolved and improved year after year.”

Songdo means “island of pine trees” in Korean and was the name of an island in the Yellow Sea that was part of the reclamation project. Korea envisions turning Songdo into a regional finance and business hub for Northeast Asia to compete with high-tech metropolises such as Singapore and Hong Kong.

This was an ambitious goal more than a decade ago when planning for Songdo began gaining traction. At that time, China was growing fast and seemed on pace to dwarf Korea in economic might.

To attract foreign business and investment to Songdo, Korea decided to bring in a non-Korean developer to lead Songdo, which was master-planned by New York-based architecture firm Kohn Pederson Fox.

The government also created a special economic zone that would offer businesses tax breaks and streamlined regulations.

Early demand was especially strong for condominiums, with the local press reporting lines of buyers when they first went up for sale. About 20 million square feet in condos have been sold.

But demand for office space was slower. Gale officials say one of the problems with filling office space all along has been that government incentives have been available for foreign companies but not for domestic companies. That has made it difficult for Songdo to attract law firms, accounting firms and other service companies that the foreign companies need.

“If you don’t have a thriving domestic economy in that area, it’s going to be more difficult to attract international investors,” says Tom Murcott, a Gale executive vice president.

But mayors and government officials in other parts of the country didn’t want their tenants lured away. “Clearly you can’t give such tax favors to each and every company,” says Ryu Young-yong, a director at the Ministry of Trade, Industry and Energy. “It relates to a matter of fairness with other Korean companies operating in other parts of the country.”