Attention from regulators spells more trouble for a highly leveraged, loss-making company that’s applied the WeWork model to China’s housing market.

Shenzhen’s finance and insurance regulatory watchdogs announced a joint investigation into the rental loan practices of apartment-hunting platform Danke on Tuesday. The investigation will examine allegations that the company has exploited tenants and landlords during the Covid-19 epidemic, as well as broader concerns about financial risk in the online rental industry.

The action is a response to groups of angry users who gathered in the city to demand for rentals, according to a statement from Shenzhen authorities.

The company is accused of raising rates on its tenants during the recent Covid-19 epidemic while using the crisis as an excuse to delay payments on its own leases.

The regulators say their preliminary talks with users reveal broader risks in rental loans from Danke and other residential rental platforms in China. The situation echoes the story of peer-to-peer lending, a once-hot sector built on high-risk financial practices. Peer-to-peer lending was eventually banned after high-profile cases of fraud drew regulators’ attention.

Danke’s business model looks a lot like WeWork: The company rents apartments from owners on long-term leases, redecorates, and then rents them out to individuals on shorter-time, higher-priced contracts. Like WeWork, the company divides properties to increase revenue per square foot, removing living rooms to turn apartments into dormitory-style clusters of bedrooms with a shared kitchen and bathroom.

WeWork was forced to withdraw its IPO in September last year after investors raised concerns that this model amounts to a high-stakes gamble: if rents go down, the company’s portfolio of long-term leases at current market rates will turn into an albatross. Over 40 home rental platforms built on similar business models collapsed in 2019 after their capital chain broke.

Danke is going to cooperate with the government for the investigation, the company told TechNode via a statement. The firm added that they have “strict requirements and standards” for the application of rental loans and will record videos of users to make sure they are fully informed and voluntary. Partnered financial institutions also have strict risk control and management protocols to ensure safe capital transfer, according to the company.

High-risk loans

Branded residential apartment rentals are increasingly popular in China, especially among urban youth, thanks to rapid urbanization, rising housing prices, openness toward the rental economy concept, and supportive government policies. Instead of buying the apartments, residential home rental platforms like Danke sign long-term leases with landlords and then sublet them to tenants after renovation. This practice is widely known as the “second landlord” business.

Like rivals such as Ziroom and Qingke, Danke is scrambling to expand their physical presence in a sector where offline availability is the key. Fierce competition forced the platforms to ramp-up costs in pre-opening spending such as leases, design and renovation, and marketing. The platforms themselves have also been accused of driving up housing prices, by bidding up limited housing resources on the market, especially in much-coveted downtown areas.

The company, which raised $130 million in its New York debut this January, is operating at an operating loss of $324 million during the first three quarters in 2019, a threefold increase on the $100 million loss recorded in the same period of 2018.

With 391,000 units of apartments under its management in 13 cities in China, Danke has been exploring various ways to finance its fast-scaling business through venture capital and asset securitization. However, the most adopted and controversial funding model for Danke as well as its local peers is debt financing or rental loans.

Rental loans are a financial two-step through which companies like Danke effectively borrow against future rent payments. The companies encourage customers to pay a year’s worth of rent in advance in return for reduced service fees, and then arrange for the customers to borrow the money from a financial institution partner with Danke as guarantor. The lender then collects monthly payments from the tenant. While paying its landlords quarterly, the time gap grants home rental companies chances to control a huge amount of cash to maintain daily operation and expansion.

If tenants decide to move out early, they remain on the hook to the lender for monthly payments. It is possible to obtain a refund for the advance rent, but the process is reportedly (in Chinese) long and difficult. If the tenant defaults, Danke must repay the lender, company representatives told TechNode. A tenant who fails to pay their loan can also be evicted from their apartment.

Since Danke is ultimately responsible for the loan, while tenants pay monthly and can be evicted for non-payment, it appears that while the loans are in name made to tenants to finance advance rent, they amount to the company’s borrowing against future rent payments. However, this model puts the users as well as the platform at risk. The rental loans add leverage to residential apartment rental platforms, saysWang Shan, analyst and operating director at online stockbroker Tiger Brokers.

“Under the disguise of “releasing rental fee pressure for tenants”, the rental loan practice can be translated as the platform-benefiting measure to increase cash flow to support their expansion,” Wang told TechNode.

The bike-sharing company Ofo likewise funded operations using advance payments, relying on deposits paid by riders. When the company collapsed, millions of Chinese consumers lost their deposits.

The company’s prospectus shows that 68% of Danke’s residents signed debt financing agreements with the platform as of September 30, 2019, with loan size hitting RMB 3.16 billion.

Additionally, over-expansion bolstered by rental loans leave the platform, which has a weak balance sheet, vulnerable when they can’t maintain a healthy occupancy rate. Lower occupancy rate means that the platform has to cover with its own expenses the leasing costs for vacant apartments, Wang explained, adding that “the capital chain will break if the situation continues.”

Coronavirus outbreak triggers domino effect

Covid-19 outbreak acts as the trigger for the recent struggles of Danke and China’s residential house renting platforms.

Many platforms have increased their housing inventories to prepare for the apartment rental market boom typical after the Chinese New year. The unexpected epidemic forced much of China to a standstill, leaving the prepared houses untaken, Wang said.

Some of the explosive business practices Danke adopted during the Covid-19 outbreak reflects the company’s cash pressure. The firm released a new policy in early February, demanding that a 30-day rent-free period from landlords because national policies regarding the outbreak. However, it is still collecting rent from tenants and increasing rents on quarantined people.

Angered users seek social media platforms to express their discontent. In a post on Sina’s consumer complaint resolution platform Black Cat, an anonymous Shanghai user said Danke staff called on Feb. 8, asking for a one-month rent suspension on an apartment in Pudong District.

“I rejected the proposition immediately over the phone, but the staff told me to wait for further notice from the company. I believe the landlords are on equal legal footings with the platform. How can they just “notify” us about the rental suspension, even though I said “no”?? Furthermore, my apartment has been rented out to tenants by the platform, so there’s no legitimate reason to not to pay me the rent,” the user said.

Dissatisfied owners who encountered rental payment delays are forcing tenants to leave their apartments. A Weibo user with the handle Qianxiaoruo says she has no home to return to, since the owner of her apartment will force her to leave the apartment if Danke can’t pay before Feb. 22.

The company released a public letter on Monday, apologizing to its users and saying that it never intended to take advantage of the epidemic. The company also declared that it would offer special deals to lower the pressure for users.

Danke confirmed on Weibo that it’s helping some landlords to claim their apartments on Tuesday. On Feb. 3, the company announced it would return one month’s rent to tenants in Wuhan, as well as offer rent cuts to tenants in other cities.

Ziroom, another apartment rental major in the country, suffered a similar PR crisis after releasing similar exploitative policies during the epidemic.

Wang characterized these moves as an attempt by the platforms to “pass the crisis to homeowners.” The moves especially hurt owners who purchase their real estate with bank loans, she added: “Banks are not making cuts on mortgage payments.”

Struggles in China’s housing rental industry

In addition to Danke, excessive leverage threatens peers like Ziroom, Qingke, and smaller companies. Dozens have already collapsed after under the pressure of loans.

Regulators are seeking to deleverage and de-risk the economy. State authorities have released in December guidelines to control the home rental market, specifying that rental loans should be no more than 30% of the company’s rental incomes. Those with higher proportions have to meet the requirement before the end of 2020.

“Shenzhen’s investigation of rent loans is actually helping China’s residential apartment rental platforms to deleverage. While also weathering the repercussions of the epidemic, long-term apartment rentals, which have been under ‘barbaric growth’ so far, should return to a more rational development path.” said Wang.

Negative news coverage since late January and the regulators’ intervention has brought down Danke’s share prices. The newly listed company was already suffering from a knock from the epidemic in late January. Danke shares tumbled $13.5 to its lowest point of $11.8 on Feb. 18, the day the investigation was announced. Troubled circumstances are expected to weigh on its first-ever quarterly report, although shares are recording an uptick as the epidemic stabilizes.

The company itself is attempting to deleverage from within. Although the 68% of rental loan users are still high and more than twice the 30% government guideline, it is down from 91.3% in 2017 and 75.8% in 2018.

It’s likely that regulators will order the company to increase its de-leverage process as China pushes control over financial risks across industries. More importantly, they would probably have to do so in a manner and timetable approved by the regulators.

Danke isn’t the only Chinese rental company that adopts these risky practices. With Danke’s case, the government is sending a clear signal that it has its eyes on rental loans. Danke peers like Ziroom and Nasdaq-listed Qingke should beware.

Emma Lee is Shanghai-based tech writer, covering startups and tech happenings in China and Asia in general. We are looking for stories related to tech and China. Reach her at lixin@technode.com. More by Emma Lee

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