China apartment rental platforms: Illogical letting

The prospects for long-term apartment rentals in China appear strong thanks to a combination of real demand and policy support. Real estate services player JLL estimates that 200 million people rent their homes, creating a market worth more than RMB1 trillion ($141 billion) a year. Yet the penetration of branded long-term providers was only 1.8% in 2018, compared to 46% in US. Assuming China reaches a mere 11.2% by 2024, that represents a huge commercial opportunity.

Meanwhile, over the past two years, the government has thrown its support behind long-term rentals as an antidote to sky-high property prices. The hope is that rentals can be a source of stable, affordable housing for the middle and lower classes.

These perceived tailwinds have not been enough to prevent a string of bankruptcies in the space. Recent casualties include Nanjing-based Lejia and Zhengzhou-based Yueru. Several of these platforms had VC backers. Yujian, one of the leading operators in Shanghai, raised approximately $50 million across two rounds from Shunwei Capital among others. The business was shuttered last year.

Amidst this turmoil, Q&K group – operator of the Qingke platform, with backers such as Morgan Stanley Private Equity Asia and Crescent Point – is pursuing an IPO in the US. The company’s prospectus offers previously unseen insights into the precarious financial models and overly aggressive expansion strategies that appear to be responsible for the closures. According to investors and industry participants, a lack of regulatory oversight has allowed pockets of misbehavior to undermine strong fundamentals.

“There is nothing wrong with the financial tools being used. When my friend leases her apartment to ZiRoom [one of the platforms], she gets paid four years of rental upfront. If landlords can benefit from these tools, why can’t the platforms? There must be better supervision and more transparency for tenants,” one investor tells AVCJ. These sentiments were recently echoed by Xipeng Pan, CEO of Shenyang-based operator Lepai, who noted that fostering the healthy development of China’s relatively young rental market – it is less than five years old – requires more time and care.

Financial gymnastics

Launched in 2012, Qingke leases apartments from landlords and rents them out to individuals. The business model involves substantial capital outlays to cover renovation costs and prepayments to landlords, so the company offers discounts of 5% and 10%, respectively, to tenants who pay six or 12 months’ rent upfront. Qingke pays the interest on the loans.

What appears to be a normal commercial promotion is actually the industry’s go-to business development strategy – and a huge potential pitfall. These rental platforms number among the thousands of relatively small, privately owned businesses in China that struggle to obtain bank loans. If lenders don’t reject these customers out of hand, citing high credit risks, they charge high interest rates. Qingke and its peers effectively use their tenants’ credit to secure low-cost capital.

As of June, 11 financial institutions were providing installment loans for nearly two-thirds of Qingke’s let inventory. “Approved loan proceeds covering up to 24 months’ rentals are transferred to our account at the inception of the lease… The proceeds from rental installment loans have helped us finance our capital expenditure on decorating and furnishing newly sourced apartments,” the prospectus says.

When a lease is terminated, Qingke must repay the outstanding loan in a lump sum within one month. Not all industry participants operate in this way. Yujian, for example, allegedly continued making monthly repayments in the name of the tenant even after departure. If a new tenant moved into the same property, it would arrange an additional loan. The company crumbled under the weight of these liabilities. 

The social impact of these failures is significant. There is considerable anecdotal evidence of tenants being evicted by their landlords but feeling obliged to maintain loan payments once the company stopped doing so for fear of damaging their personal credit rating. 

These precarious financial arrangements were exacerbated by the aggressive pursuit of market share. Several of the now bankrupt platforms operated a “high in-low out” model, whereby the prepayments they made to landlords were up to 40% above the market rate and rental fees charged to tenants were artificially low. As a result, they were making a loss on every room rented out. This was fine provided new tenants were being recruited and loans underpinned by their credit supported new acquisitions.

Emphasizing speed and scale rather than medium-term or even long-term paths to profitability is not unusual in China’s start-up landscape. It is up to VCs to separate wheat from chaff. One investor tells AVCJ that WeWork – the US-headquartered private equity-backed co-working space operator that recently abandoned an IPO – has employed the high in-low out model on numerous projects in China.

When liquidity is so fragile, all kinds of external shocks can break the financing chain. In Yueru’s case, the straw that broke the camel’s back was three consecutive years of declining rental uptake.

Qingke after-discount rental spread margin has fallen over the past two years, but it was still 20% for the nine months ended June 2019, while the average occupancy rate was above 90%. However, the company recorded a net loss of RMB373 million for the period, largely due to a 60% year-on-year increase in operating costs against a 43% increase in revenue.

Competing models

It is worth noting there are two basic business models in the long-term apartment rental space: decentralized and centralized. The former comprises operators, such as Qingke, that acquire single apartments from individual landlords; the latter, which includes Mofang Apartment, Anxin Apartment and Cjia.com, take out leases on entire buildings. 

Speaking to AVCJ last year, Derek Shen, executive chairman of leading decentralized player Danke, compared the two models in this way: “Operating costs are lower under the centralized model because the operator owns the whole building, but the pace of expansion is slow because it’s difficult to acquire high-quality properties for leasing purposes. The de-centralized model requires the operator to acquire individual apartments, so costs are higher, but the business can scale quickly.” 

There has been a gravitation towards the decentralized model in recent years because of the scale opportunity. However, rapid growth must be financially sustainable. All the bankruptcies involve decentralized players. 

“Mofang has achieved profitability for the projects in nearly all of the cities in which it operates,” Qiqi Zhang, a managing director at Warburg Pincus, told AVCJ after the company closed its Series D round in March. Mofang operates entire buildings in prime locations that appeal to urban professionals. The tenant renewal rate is 50%, according to Zhang. As of June, only 5.1% of Qingke’s tenants had remained in their units through the end of the contracted lease term, according to the prospectus.

The two largest decentralized operators, ZiRoom and Danke, both seem to be weathering the storms. As a spinout from leading real estate agency HomeLink, ZiRoom is able to tap HomeLink’s customer base. The company secured a $500 million Series B in June from investors like Tencent Holdings and Sequoia Capital China. Warburg Pincus is also an investor. Gordon Ding, a managing director at the firm, previously noted that Ziroom had higher customer satisfaction scores than its peers due to advantages in ”client acquisition, mobile internet application, big data collection and day-to-day operations.”

Danke closed a $500 million Series C round earlier this year with contributions from Ant Financial, Tiger Global Management and Joy Capital. The company has launched initiatives to improve service quality, including establishing an internal supply chain to source building materials following reports of sickness among tenants in a rival’s newly renovated units. 

Erhai Liu, founder of Joy Capital, claims that Danke’s scale and data collection and analysis capabilities give it more scope to work on health and safety. “We have invested in Danke for four consecutive rounds. All investors in the rental space know it’s a long-term war,” he told Caijing.

Blue-collar benefits

While the centralized versus decentralized distinction appears significant, most investors do not view it as the ultimate arbiter of whether a company is good or bad. David Wei, founding partner at Vision Knight Capital, believes there are two key credentials. First, the target’s occupancy rate should be above 90%. Second, returns should come no later than 20% into the leasing period; for example, if the platform leases a building for five years, that project should turn a profit by the end of year one.

Vision Knight is an investor in Anxin, which in May merged with Douhao, an apartment brand under hotel chain operator Home Inns Group, giving it access to more than 100,000 beds. Anxin tends to focus on corporate clients rather than individuals. It leases entire buildings or floors and provides four-person and six-person rooms with bunk beds. When one occupant leaves, the employer assigns the bed to someone else. Anxin has an occupancy rate of 95% and an average return period of 18 months. 

Wei prefers consistent blue-collar providers like Anxin to what he describes as mainstream, white-collar service offerings. “This model doesn’t have a high turnover rate and customer acquisition costs are lower,” he explains. “Young, white-collar workers in China change jobs quite often and they have higher expectations in terms of living environment. It’s much easier to operate blue-collar apartments.”   

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• Topics
• Greater China
• Real estate
• Technology
• Expansion
• Early-stage
• China
• Growth capital
• Venture
• Warburg Pincus Asia
• Joy Capital
• Vision Knight Capital