The last quarter of 2019 will be the busiest quarter so far for China’s Real Estate (RE) tech startups in terms of filings, with co-working space provider Ucommune and one co-living provider trying to list on Wall Street. Danke Apartment is seeking to raise up to USD 100 million by listing on the New York Stock Exchange (NYSE), aiming to become the second listed long-term apartment company.
On November 5, China witnessed the initial public offering (IPO) of the first long-term apartment rental company, Qingke Apartment (QK: NASDAQ), with a USD 17 per share. This Morgan Stanley-backed firm’s stock price closed at USD 16.5 on November 14, in less than its ten trading days after its IPO. Market reactions towards QK weighed on Qingke’s counterpart Danke Apartment’s path to its IPO, raising concerns over the next chapter in co-living’s stock performance in the public market.
Qingke’s stock price is plummeting drastically while Danke Apartment is waiting to be vetted and still struggling to find the key to sustainable and healthy growth.
The macro environment in RE market has leaned towards rentals worldwide, especially in the case of the millennial demographic. Increasing numbers of adults are looking towards renting as a viable option to housing ownership. This trend goes in favor of Real Estate Investment Trust (REITs) and long-term apartment businesses. In a mature market like the US or Japan, there are long-established players, like Japanese firm Daito Trust (founded in 1974) and American REIT Equity Residential (founded in 1966).
In China, up until recently, the leasing market remained relatively underdeveloped, with a meager stock of mass mid-end apartments. Regulatory factors have been starting to shift in favor of rentals. In May 2018, the central government reiterated the statement of ‘houses for living, not for speculating,’ offering continued support for the residential leasing market. In December 2018, rents and housing loans became deductible in the new individual income tax. With such favorable macro factors, an array of long-term rental housing businesses is set to seize the market opportunity and develop rapidly.
Competition continues to intensify, with the burgeoning activities of mergers and acquisitions (Memor Home’s acquisition of Shunwei Capital-backed Yujian Apartment in Feb 2019) and IPOs (Danke and Qingke).
Business models – meet the popular asset-light models among startups
Developers, RE brokers, hotels and startups have flooded into the market in the last five years. Long-term apartment businesses can fall into ‘centralized’ and ‘dispersed’ by concentration level; or ‘asset-heavy’ and ‘asset-light’ by asset structure.
The market barriers to entry remain low, and we found four major players there. RE standard developers develop their properties, acquire existing properties, and launch their long-term apartment brands under an asset-heavy and centralized model. This model is a preferable choice for established players to generate a higher internal return rate (IRR) and optimize asset management. In the mature market, we expect more developers and startups will transform towards this model.
Startups are divided into two groups – they either choose a centralized model or dispersed model.
Though most startups are backed by high-profile and well-funded investors, they found themselves staying comfortable enough to run an asset-light model, which will not apply too much pressure on liquidity and has a shorter payback period. Besides, a fast-scaling speed also helps the brand build mindshare among customers. However, for dispersed choosers, managing scattered apartments requires more service costs when adding to the number of apartments. This model has a weaker cost advantage, and it is hard to take advantage of the economies of scale effect. Cost-saving strategies and brand differentiation will thus play an essential role in improving operating efficiency for players here. Looking ahead, compared to a centralized model that makes it easier to provide a co-living space and create a community culture, dispersed apartment operators need to rethink and seek ways of increasing tenant engagement.
The long-term rental housing business remains a small slice of China’s rental housing market. Ziroom, a long-term apartment subsidiary of the country’s largest RE broker Homelink, is an absolute leader regarding apartment units under operation. According to Northeast Securities, as of Oct 2018, Ziroom’s penetration in Beijing achieved only 0.37%, the square meter quantity of listings under its management as of the whole rental housing market.
Rental flat operators like Ziroom have been accused of pushing up leasing prices when Beijing’s average rents rose 21.9% (year-over-year) in July 2018. Graduates and white-collar workers are still the primary demand drivers of these long-term rental flat businesses, thanks to their needs for convenience and quality services. In that case, charging a 20% - 30% premium seems a reasonable price, according to Northeast Securities research.
An example – Danke Apartment’s debt financing story
Like another RE player, Ucommune, Danke has been ramping up the cost at the same speed with its revenue over the past three years. The company has around 391,000 units of apartments under its management in 13 cities in China, resulting in an operating loss of USD 324 million during the first three quarters in 2019, a threefold increase on the USD 100 million loss recorded last year.
The business margins are meager, driven mainly by the high rental cost – and this is one kind of cost that Danke can avoid or slash massively in the short term.
A weak balance sheet fails to ensure the company can raise more funding at a favorable price and thus maintain good liquidity.
The company itself has chosen a high-risk way to drive growth, debt financing. In cooperation with financial institutions like commercial banks, Danke offers debt financing to residents, who will pay the rent in the first month in an entire lease term (typically one year), and the next 11 months of rent will be financed. The annual interest rate for the loans ranges from 5% to 6.5%, and Danke will eliminate the so-called service fee (part of interests actually) for clients entering into annual financing agreements.
Danke is also required to place cash deposits with the bank it borrowed money from. 68% of residents signed debt financing agreements with Danke as of September 30, 2019. By saying that, Danke is running its business based on the considerable Customer Acquiring Cost (CAC) if using debt financing was considered as a way of incenting customers to make purchase decisions.
Foreign examples – more financing tools, but core competency remain unsolved
Equity Residential, with more than fifty-year history, is trading at 11.27X revenue multiple as of December 21, 2019, with a market cap of USD 30.1 billion. The company owns 80,299 apartments in six key markets in the US. It recorded strong performance in terms of balance sheet in Q3 2019 by capturing favorable demographic trends and strong market demand in the regions it operates.
It continued to reduce its debt-to-EBITDAre ratio to 5.3x in Q3 2018, from 6.8x in 2013, fending off the possible risks of rising interest rates. Another REIT American Homes 4 Rent manages 52,537 residential units across 22 states in the US. Its net debt to adjusted EBITDA stands at 4.6x, maintaining a conservative debt level.
These two companies both have higher occupancy rates compared to their Chinese counterparts, representing higher capital utilization efficiency.
Chinese long-term apartment operators have been exploring various ways to finance since 2017. Common routes are long-apartment specialized debts and asset securitization, such as Asset-backed Securities (ABS), Commercial Mortgage Back Securities (CMBS) and REITs.
Asset-heavy businesses often issue debts to finance. On the other hand, asset-light companies prefer to launch securitization schemes – for instance, CYPA’s REITs (CNY 270 million) and Mofang’s ABS (CNY 350 million).
These new financing tools – quasi-REITs and asset securities – are gaining traction in assisting businesses; however, residential leasing marketers are struggling in translating scaling into profits, especially for asset-light operators. Although people will always need to find a place to live, it can be challenging for the operators to raise rental fees, due to customers’ willingness to pay and regulations. In the long term, compressing refurnish costs, acquiring supply sources and boosting turnaround are expected to be the best solutions to ease its aching business model. This could still be a challenging job.