Developers, Hotels and Brokers Are All Piling Into Long-Term Rental Apartments. The Rent Isn't What They're After

Financial innovation in real estate.

China cannot seem to stop buying homes.

Last year the country sold 13 trillion yuan worth of new commercial housing, equal to half of all household savings. Its three largest developers — Country Garden, Vanke and Evergrande — each sold more than 500 billion yuan worth.

Renting, by comparison, looks like a stopgap for tenants and, for brokers, a sideline to selling homes.

Then, all at once, the big developers that used to look down on renting charged into the market. Country Garden has finished an apartment project in Shanghai. Vanke has leased out 80% of a Beijing building where ten years cost 1.8 million yuan. Evergrande is raising 10 billion yuan for the business.

Beyond those three, high-volume sellers such as China Merchants Shekou and Longfor have converted part of their unsold stock into long-term rental apartments. Brokers have their own brands: Lianjia's Ziroom Apartments, World Union's Hongpu Apartments, 5i5j's Xiangyu. Even hotel groups such as Home Inn and Huazhu have started them.

The number of renters really is growing.

Orient Securities Research Institute estimates that China's rental housing market reached 1.14 trillion yuan in 2017, with 191 million people renting nationwide. The demand is there. And as more Chinese cities roll out policies to attract talent, people will cluster further into first- and second-tier cities, where the appetite for rentals may grow stronger still.

Government incentives are probably the bigger driver. In 2016 the NDRC proposed a housing system that treats renting and buying as equals; the State Council followed with concessions that let commercial buildings be converted to rentals, with water, power and gas charged at residential rates. Local governments, Zhejiang's among them, have promised more credit for rental housing projects, so long as the risk stays controlled.

Through all of it, whether a rental operator buys the land, builds and leases on its own or simply sublets from other landlords, the business comes down to the same thing: give tenants better service, then charge more rent.

Long-term rentals are the better experience, and almost none of them make money

Their appeal is standardized service and steadier relations among landlord, operator and tenant. Uniform renovation and management also help build a brand.

For a landlord, signing a long lease with a broker like Ziroom or World Union means handing the flat over to be renovated and taking it back when the term ends. In between there is one counterparty, rent arrives on schedule, and whatever goes wrong in the flat is usually the broker's problem. Tenants get a version of the same deal.

For the operators, the risk and the pressure lie in getting hold of the flats — and then in the rent advanced to landlords, the renovation and the rest of the running costs, all of which eat cash.

Vanke's Port Apartment, for instance, takes long leases — usually 10 to 15 years — on derelict factories, office buildings and homes held by state firms, local governments and village collectives, then converts them into apartments to rent. China Merchants Shekou spent 276 million, 374 million and 469 million yuan on apartment renovation in 2015, 2016 and 2017.

The upfront spending is enormous. A company that converts finished, unsold stock also has to count what it paid years earlier for the land and the construction.

For a developer the arithmetic is worse. Good locations have rent-to-price ratios that are too low; the cheap sites are ones few people will live on. In China's first-tier cities it routinely takes 60 to 80 years of rent to earn back the price of a flat — by which point the 70-year limit on land rights may have run out. Rent out a home at 30 and you may die before it pays for itself.

Rising rents could shorten that, but a developer still has to lay out a great deal of money to build first. Against the margin and the speed of simply selling homes, renting is both thinner and slower. Some cities now release land on the condition that only rental housing be built on it, not homes for sale.

Han Shi, a vice president and CEO at Longfor Group, told Securities Daily last year, flatly, that Goyoo was not thinking about profit for three years. Vanke chairman Yu Liang told the company's 2017 interim results briefing that a return of 1% to 2% on long-term rentals would already satisfy him.

Lianjia, the biggest broker by transaction volume, incubated the long-term rental brand Ziroom in-house and runs it separately. Ziroom CEO Xiong Lin said in 2017 that his apartments needed 95% occupancy just to produce steady cash flow — never mind profit.

Brokers don't own the buildings, so they can pick their spots. Colliers International says about 80% of Shanghai's long-term rental supply sits in the core districts near the inner and middle ring roads, most of it along metro lines, easy to reach.

But once hiring, leasing and renovation are counted, every day a flat stands empty is another day of cost. The pressure is just as heavy. And when prices are rising, a landlord looking at a few hundred thousand yuan — sometimes more than a million — from a quick sale has little reason to honor the contract, and Ziroom has little to hold him with.

World Union, several years into the business, reported for 2017 that it ran 35,000 units in core first- and second-tier cities at 81% occupancy, earning 208 million yuan in revenue and losing 184 million. Of all its projects, only Hongpu in Beijing made money. The losses came from running costs: acquiring the flats and paying base rent took 55% to 60% of the total, renovation about 20%.

CITIC Securities calculates that a long-term rental brand paying 6% VAT and marking up sublet rent by 20% runs a net margin of about -10.3%. Widen the markup to 40% and the net margin is still only 3.4%. Rent takes 70% of the spending and renovation 10%; the rest is staff, marketing and tax.

On those numbers, few companies can be sure money comes in faster than it goes out, let alone turn a profit. For a developer with 100 billion yuan in assets or a startup valued in the tens of billions, it only adds to debts that are already heavy.

The industry is leveraged to begin with — an average liability ratio close to 80% at the end of the first quarter this year. Growing unsold inventory makes the cash cycle harder still. And since 2016 one tightening measure has followed another, further limiting how developers raise money. Figures from 10jqka's iFinD show that growth in China's property development investment peaked at 35% in 2010-2011 and slid to around 8% by 2017.

The rent won't do it, so long-term rentals are counting on two financial products

Property finance products are not new. But this year's Central Economic Work Conference stressed support for the rental market and wider channels for direct financing: more banks lending against rental housing development, more asset-backed securities (ABS), and rules drafted for real estate investment trusts (REITs).

These give rental operators the credit they need to keep cash moving.

By the end of the first quarter, China had approved seven property ABS issues worth 25.12 billion yuan. In March, Ziroom won a quota to issue 2 billion yuan of them.

Here is how it works. A tenant signs a lease and then owes the rental company money every month or every quarter for the coming year: that is a debt. The company bundles those debts into a security and sells it to investors. That is ABS.

The investor collects the interest — the rent — much as with any wealth-management product. The company, for its part, no longer waits month by month; it takes the money back early and puts it into the next project.

Ziroom issued a 500-million-yuan ABS last year, backed by apartment leases one by one.

Mofang Apartment's 350-million-yuan ABS packaged three years of future rent from 4,014 flats and sold it, occupied or not. The underlying assets are claims on small rent-installment loans — the rent-by-installment lending in Ziroom's Youjia and whole-unit rental lines.

At the end of April the CSRC and the housing ministry jointly issued a new policy pushing the securitization of rental housing, urging companies to do it.

Besides ABS, the larger instrument — the real estate investment trust — is opening up in China too. A rental operator issues shares or beneficiary certificates to raise money from investors, invests and manages property with it, then pays the combined return back to them in proportion.

Most of what a REIT raises usually goes into buying and holding properties with steady cash flow: offices, hotels, apartments, industrial space. The return comes from rent and from appreciation, and 90% of it is paid out to investors as dividends.

REITs, built on rental income or on ownership of the property itself, are far bigger than ABS, which is built only on rent still to come.

CICC puts the total value of Chinese property at the end of 2017 at about 200 trillion yuan. On its middle assumption that REITs take 2% of the market, China's REITs market would come to roughly 4 trillion yuan.

ABS or REITs, the issuer is doing the same thing: pledging a building's future income to raise money now. Developers, brokers and hotel groups are all at it — CIFI's 3-billion-yuan Lingyu shelf-registered equity REITs for long-term rentals, Country Garden's 10-billion-yuan rental housing REITs. Greentown has a no-objection letter for a 1.48-billion-yuan CMBS on hotel assets. Xinpai Apartment, backed by Huazhu, plans a 270-million-yuan ABS. Evergrande's 10-billion-yuan rental ABS quota has already been approved.

So a company that builds an apartment block need not wait fifty or sixty years, or longer, to get its money back. It can pull the money forward with a financial product and invest it again.

Property finance began in America, and there are successes there

American REITs date to the early 1950s. In 1960 the U.S. Congress, through the Internal Revenue Code of 1960, first set out their rules and legal standing, covering offices, homes, industrial space, retail, warehouses and hotels.

REITs widen where a property company can get money and speed up how fast it turns over, which matters a great deal for expansion and for profit. Starwood and Marriott both grew quickly by pledging their property through REITs. And from early on, U.S. regulators made REITs trade much like stocks, so investors could buy and sell them easily.

The clearest case in the past twenty years of raising money through REITs and then buying rivals one after another to lead an industry is probably Equity Residential (EQR), one of the largest apartment landlords in the United States.

EQR was the first American apartment company to go public. It develops and acquires high-quality apartments and then manages them. Having expanded by acquisition, it pulled back geographically, exiting one non-core market after another.

Between its 1993 listing and 2000, EQR issued REITs 43 times and raised US$3.219 billion, most of it to buy buildings and rent them out. By the end of 2017 it ran about 78,000 apartments and took in US$2.471 billion.

Part of EQR's success is that American rent-to-price ratios are high: the national average pays a purchase back in about 19 years. Renting there was profitable to begin with.

Rent is 99% of EQR's revenue, and its operating profit reached US$847 million. It made another US$4.065 billion selling properties in 2016. Rent and appreciation both returned money to investors, and steadily. Its market value today is about 140 billion yuan. Vanke, the most valuable property company in China, books more than 40 times EQR's annual revenue and is worth about 310 billion yuan.

Outside the United States, REITs markets have been growing as well. By the end of 2017, more than 30 countries and regions had issued them, and the net value of REITs worldwide was about US$1.69 trillion. American products alone accounted for 43.8% of that, Japan 9.6%, Hong Kong 7.64%.

CICC, though, lists what holds Chinese REITs back: no clear legal or regulatory authority, double taxation that suppresses the yield, too few quality properties worth securitizing, and a shortage of firms and people who know how to manage them. What has been issued so far resembles a REIT in form but is not one — inefficient, and low-yielding.

By its calculation, the roughly 3% yield on Chinese REITs is about the same as most existing asset plans, ABS among them, and far below the roughly 12% in the United States. That will limit how much money they can raise.

But so long as investors believe prices can't fall, property finance brings a new risk

Buying land and putting up buildings take a great deal of money, so one core strength of a Chinese property company is really its ability to borrow.

Only borrowed money keeps the machine running and the expansion quick. It has also left several developers with very high net debt ratios.

Encouraging developers and rental operators to issue ABS and REITs adds one more way to finance that expansion.

But if it still takes seventy or eighty years of rent to pay for a Chinese flat, ABS and REITs only let a company spend seventy or eighty years of income now. They do not fix what worried these companies in the first place: renting doesn't make money.

The new products bring in more money, and more money pushes developers to expand — more land, more buildings. But when what stands behind that money is a business that doesn't earn, the risk keeps growing.

There are limits on what a developer may do with cash raised against rental apartments. Still, as long as renting loses money, the companies in it have every reason to route that money through complicated instruments back into land — new parcels, new buildings — while consumers keep borrowing to buy. Securitization stretches credit that once rested on banks and the government across a far wider set of borrowers. The risk piles up.

Ben Bernanke, the former Fed chairman, once said that in a world of perfect markets there would be no bankruptcies.

In a country whose governments live off land, the people who build homes and the people who buy them agree that growth depends on property. And since the government means to keep growth going, prices have little room to fall. That is the expectation developers and buyers share, and it sends the money they make straight back into the market. Chinese property looks like a perfect market.

The trouble is that nothing really is.

Charts by Gong Fangyi; cover image from Pixabay.