China apartment rental start-ups: In arrears

Emphasizing the importance of seizing opportunities when they are presented, Xiaomi founder Lei Jun once observed that “Even a pig can fly if it stands at the center of a whirlwind.” It is an expression frequently coined by Chinese VC investors when chasing market trends that may equally well take flight or crash to earth.

For a relatively brief period from 2018, long-term apartment rental start-ups fit this profile. They packaged up unfashionable leasing into a business model that promised venture capital-style returns. It was hoped they could become a source of stable, affordable housing for the middle and lower classes. However, by the end of last year, the pig’s tailwinds were weakening. COVID-19 may turn out to be its endgame.

The two leading platforms are Qingke and Danke, which listed in the US in late 2019 and early 2020, respectively. Both inevitably took a hit earlier in the year when China was under lockdown and their response was dubious, according to a recent legal action. The companies are accused of forcing landlords to cut rents without passing on any of the reduction to tenants.

Regulators in Shenzhen launched an investigation into Danke in February, targeting not only the dispute with landlords but also the company’s rental loan arrangements.

“This is an issue of people’s livelihoods – it touches a very sensitive nerve for the government. There could be a policy change, resulting in less support for these platforms,” says a researcher who has followed the sector for several years.

More than 40 long-term rental businesses have gone under this year, according to Beke Research, a division of US-listed online property services platform Ke Holdings. From Youke and Chaoke in Hangzhou to Lanyue in Shanghai and Chengpu in Guangzhou, the tide of bankruptcies is spreading nationwide. Tens of thousands of landlords and tenants have been adversely affected.

Flawed system

The purpose of rental platforms is to source properties from landlords and identify tenants, offering a degree of standardization in terms of product quality and perhaps offering a range of residential services. Remove the platform and the landlord’s instinctive reaction is repossess the property, but tenants might already have paid a year’s rent in advance through a rental loan agreement.

These stand-offs can deteriorate quickly and unpleasantly. Landlords have been known to suspend water and electricity supplies and change locks on the doors to force out tenants. Meanwhile, tenants often run into difficulty when asking banks to cancel rental loan agreements that have been brokered by platforms.

These agreements typically come with incentives – a 10% discount if the tenant takes out a loan to pay one year’s rent upfront. Once a lease ends, a platform like Qingke repays the outstanding loan in a lump sum within one month. Not all industry participants operate in this way. Some continue making monthly repayments in the name of the tenant because the interest rates are attractively low.

Worried that the system was ripe for abuse – platforms could take out multiple loans against a single tenant, leveraging that individual’s credit to secure low-cost capital – regulators said last December that rental loans must not exceed 30% of overall rental income by 2022. It put Qingke and Danke under enormous pressure because they rely on rental loans for about two-thirds of rental revenue.

Qinke CEO Guangjie Jie defended his company’s business practices, claiming that it was an early adopter of rental loans and none of them had become non-performing. VC investors agree up to a point.

“A rental loan is a normal financial tool; it is just a consumer loan or installment payment. Young people use them to pay for mobile phones in installments. Why can’t they use the same took for the rental? The problem is when it gets abused through deception and coercion,” argues one manager, who has an interest in one of the leading platforms.

In a bind

Further guidance was released following the post-COVID-19 disputes. First, a rental loan cannot be included in the lease contract. There must be a separate contract and tenants are told they can choose not to use it. Second, rent paid by the platform to the landlord shouldn’t exceed rent collected from the tenant, and there must be no duration mismatch between rent collection and payment schedules.

“I support the new policy; it is good for long-term development. China’s real estate market went through a similar process. There was abnormal development and it became almost a financial industry with sky-high leverage. It was good that the government stepped in and cracked down on speculation,” says a second investor with exposure to the space. He adds that he has yet to sell down his position.

While central government intervention might represent a sensible piece of rebalancing, local policies can be far stricter. For example, in Hangzhou, one of the hardest-hit area by the rental platform bankruptcies, regulators banned local banks from issuing rental loans.

Moreover, the Hangzhou authorities now require the creation of a special deposit account for centralized management of a platform’s entire rent-related revenue. Two month’s rent from each contract is held in reserve as a risk prevention fund. This can be used to compensate evicted tenants or to help resolve disputes between landlords and tenants.

All new rentals from 2020 and 30% of existing stock is now covered.  Xiangyu, the city’s largest apartment rental brand with 50,000 units, has already placed RMB150 million ($22 million) in reserve and expects its total commitment to be RMB500 million. Other platforms have reportedly vacated the city.

The fundamental flaw in the apartment rental business model is the adoption of a consumer-internet approach characterized by huge discounts as market share is prioritized ahead of near-term sustainability. “For a business like Didi Chuxing, you burn money to achieve a certain scale and then you start to make money. For real estate projects, it is a unit model. The profitability of every single unit matters. If you don’t make money from the beginning, you won’t be able to make money by accumulating units or by achieving a status of monopoly,” says Yating Zhou, head of property research at China Renaissance Group-owned Huajing Securities.

This pursuit of scale almost regardless of cost has contributed to an overall rise in rents – exactly the opposite of what the government wanted to achieve. An extreme example is the now-bankrupt Guangzhou Chengpu. It was paying landlords an average of RMB6,800 in August 2019 but charging tenants only RMB3,400. This is before additional expenses such as decoration and maintenance are considered.

A report issued by DTZ in May 2019 calculated the various costs and concluded that it would be hard for the industry to generate a return in excess of 2%. China’s benchmark interest rate is around 4% and banks often charge small and medium-sized enterprises 10% or more.

Without relatively low-cost funding in the form of rental loans, it is debatable whether long-term apartment rental businesses can survive.

However, there are other business models that might be more sustainable. There are two basic approaches: decentralized, whereby the likes of Qingke and Danke lease single apartments from individual landlords; and centralized, which involves taking out leases on entire buildings. Mofang Apartment, Anxin Apartment and Cjia.com are among the leaders in this area.

Decentralization was attractive because it could deliver significant scale at short order, but bankruptcies in this segment of the market have prompted a rethink.

David Wei, a founding partner of Vision Knight Capital, is an investor in Anxin, a centralized apartment brand under hotel chain operator Home Inns Group. He tells AVCJ that Anxin sees plenty of opportunities in the current market environment. The company has just made one acquisition, and a second will be announced soon.

Bleak outlook

For Danke and Qingke, the future remains uncertain. The former priced its IPO at $13.50 per share in January. The stock is now at $2.30 and Jing Gao, Danke’s founder and CEO, is under investigation for business activities before he founded the company. COO Guodong Gu also resigned due to personal reasons.

The company posted a net loss of RMB1.2 billion for the three months ended March, up from RMB816 million a year earlier. Its total loss for 2019 was RMB3.4 billion. Danke is trying to raise a RMB8 billion fund to invest in centralized long-term rental apartment assets. The Kunshan government has agreed to provide support.

Qingke’s shares are currently trading at $4.14, down from $17 at time of IPO. Turnover is zero some days. Losses amounted to RMB498.2 million for the 12 months ended September 2019. In the first half of 2020, they were RMB416.8 million, compared to RMB301.5 million a year earlier.

Since April, Qingke has been transferring a large number of properties to Jianrongjiayuan, a long-term rental apartment platform under China Construction Bank. Ultimately, the company will become an asset-light business, responsible for managing properties and bearing no capital risk.

Despite this bleak outlook, there are still optimists, who point to the potential of digitization in property rentals. “We’ve experienced ups and downs. If the business has core value, it will make a return. In fact, if they stop expanding, they would already be profitable,” the second investor says, referring to decentralized models. 

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