100 Billion Yuan Is Pouring Into the Long-Term Rental Market Through ABS. How Will That Change the Renting Business?

After Lianjia, China's largest real estate brokerage, and Country Garden, its largest developer, the country's largest property investor has now entered the long-term rental apartment business too.

Ping An, the insurance giant, has spent recent years buying its way into becoming the second-largest shareholder of developers including Country Garden, CIFI, Sunac, and China Fortune Land Development. It holds 8.95% of Country Garden and a full 40% of Sunac. As of the third quarter of 2018, Ping An held 47.6 billion yuan worth of investment property.

This hidden property giant, which until now had mostly just taken stakes in developers, is stepping onto the field itself. On December 25, 2018, its subsidiary Ping An Real Estate applied to issue a rental housing ABS (asset-backed securities product) worth 5 billion yuan in total, with an 18-year term, and won approval from the Shanghai Stock Exchange.

At the end of 2017, Ping An Real Estate bought the Landsea Senlan project in Waigaoqiao, in Shanghai's Pudong New Area, with 752 units. The property rights and future rental income from that project are the underlying assets of the first, 1.068-billion-yuan tranche of Ping An's 5-billion-yuan ABS.

Here is how it works. A tenant signs a lease and then owes the rental company money every month or every quarter for the next year — a cash flow you can predict. The rental company packages that cash flow into a securities product and sells it to investors. That is ABS.

Ping An packaged 18 years of future rent from these 752 units and sold it to investors for 1.068 billion yuan, an average of 78,900 yuan per unit per year. Investors who buy the ABS collect interest (out of the rental income), which is not much different from buying an ordinary wealth management product. The rental company, for its part, no longer has to wait for rent to trickle in month by month; it gets its investment back early and puts the money into new projects.

Rent is usually stable and predictable. At the end of April last year, the China Securities Regulatory Commission and the Ministry of Housing and Urban-Rural Development jointly issued a new policy to promote the securitization of rental housing assets, encouraging companies to securitize their rental assets. Issuing ABS is becoming more and more popular among companies in the long-term rental apartment business.

Investors buy these companies' ABS because the returns are steady and, for a low-risk product, the expected yield is high. The senior tranche of Ziroom's "Ziroom No. 1," called "PR Ziroom You," carries a coupon rate of 5.39%, paid four times a year. By comparison, ICBC's one-year deposit rate is currently 1.95%, and Yu'ebao's seven-day annualized yield is 2.63%.

For a long-term rental apartment company, the appeal of an instrument like ABS is obvious. Ping An turned 18 years of future rent or sale proceeds from these units into cash at once — a large pile of money that appeared "out of thin air."

With more cash in hand, it can go on taking units off landlords.

Ping An says the 5-billion-yuan ABS is only its seed capital: next it plans to build 2 million rental apartments.

And because the supply of empty homes in first-tier cities like Beijing, Shanghai, and Shenzhen is finite, a big company with a funding advantage can pay above market to take units, win a monopoly position in those cities' rental markets, and then push rents up.

That is what ABS does, and it is why long-term rental apartment companies like Ziroom and Mofang keep issuing it to raise money. With more than 100 billion yuan flowing in and ABS in fashion as a financing tool, the rental market in Chinese cities — and the way the business is run — has already changed.

Raising money this way has other advantages. Unlike equity financing, ABS does not dilute the stakes of the controlling shareholder or the management team. Unlike debt financing, it is less exposed to shifts in bank credit policy, and there are no restrictions on what the money can be used for.

Ziroom, for example, has raised equity only once — a 4-billion-yuan Series A in 2018 — but has already issued 2.5 billion yuan of ABS. Mofang Apartment has raised about $500 million across three rounds and has issued 350 million yuan of ABS. That is nothing like a more traditional rental platform such as Lianjia, which financed itself almost entirely by diluting equity, raising nearly 10 billion yuan over four rounds plus a 3-billion-yuan strategic investment from Vanke.

Once money began pouring in faster through ABS, the nature and the scale of the risk in this rental business changed as well.

Long-term rental apartments are a rental business, but renting out homes is not a fast way to make money

The usual model works like this: companies like Ziroom, Mofang, and Vanke first sign long leases with landlords to lock up a steady supply of homes. They renovate the units in a plain, clean style, add Wi-Fi and electronic locks, throw in services like regular cleaning, and re-let them at a higher price.

They can charge more than an individual landlord mainly because Chinese law does little to protect tenants. For a young tenant working far from home, renting from a company that runs things by the book usually means avoiding the risk and the hassle of an unreliable landlord.

These platforms have grown fast in recent years. By the estimate of 58.com, Anjuke, and Ganji.com, there were 1,200 long-term rental apartment brands in 2018, operating more than 2 million units.

The fastest-growing of them is Ziroom, which manages more than 500,000 units.

Ziroom began as Lianjia Group's housing asset management division. From May 2016 it took over all the business of Lianjia's former Ziroom division and has since focused on managing housing assets.

Ziroom is not listed, but two documents show a good deal about how it has expanded: the CITIC Securities · Ziroom No. 1 Rent Installment Trust Beneficiary Rights Asset-Backed Special Plan Prospectus and the CITIC Securities · Ziroom No. 1 Rent Installment Trust Beneficiary Rights Asset-Backed Special Plan Tracking Rating Report, June 29, 2018.

Ziroom has always concentrated on three first-tier cities — Beijing, Shanghai, and Shenzhen — because young people there earn more and can pay more.

By the end of 2016 it was already China's largest apartment management and operating company: 350,000 units under management, 800,000 tenants served in total, eight centralized apartment buildings in Beijing and Shanghai combined, more than 300 billion yuan of housing assets under management, and revenue of 1.073 billion yuan, up 2,852% year on year.

By the end of 2017 it managed more than 500,000 units, 43% more than the 350,000 of 2016, and revenue reached 2.754 billion yuan, up 156.75%.

Fast growth, though, does not make this a good business.

First, when it grows on its own resources, Ziroom pays landlords more than it collects from tenants at any given moment, which leaves a funding gap.

According to the CITIC Securities · Ziroom No. 1 Rent Installment Trust Beneficiary Rights Asset-Backed Special Plan Prospectus, Beijing Ziroom Asset Management usually signs three-year contracts with individual owners, and occasionally four- or five-year ones. The prospectus does not say how Ziroom pays landlords after signing, but the financial figures allow an estimate.

At the end of 2017, Ziroom had liabilities of 7.485 billion yuan, of which 5.605 billion yuan was receivables, mainly rent collected in advance and deposits. A rough calculation: across 500,000 units, that is 11,300 yuan of advance payment per unit, roughly two to four months' rent on a single room.

Ziroom's accounts payable came to 889 million yuan, mostly commissions owed to the channels that source units and money owed to renovation, appliance, and furniture suppliers. Averaged out, each of the 500,000 units accounts for 1,778 yuan of payables. That figure is not especially large on Ziroom's balance sheet, which suggests it most likely pays landlords quarterly.

In other words, Ziroom pays landlords on a three-month cycle and collects from tenants on a three-month cycle. There is a price gap between what goes out and what comes in, but the timing is about the same, so the rent does not sit on Ziroom's books helping it expand.

It also gives money back to keep customers: a discount on the service fee for tenants who renew, to make renewal more likely.

Second, there is the pressure of empty units. However often a platform pays its landlords, it has signed multi-year leases with them; if a tenant moves out and no one takes the place, the platform is stuck with an empty home.

Combined with consumer loans, ABS makes money move faster through the long-term rental apartment business

There are two ways for a long-term rental apartment company to issue ABS: with consumer loans attached, or without.

A Ziroom tenant who pays quarterly is simply paying rent. A tenant who pays monthly has to sign a loan agreement on top of the housing lease — the tenant becomes a borrower, paying interest at an annual rate of 6.27%.

In practice the tenant pays more than 6.27%. That figure is the ratio of fees to a year's rent. But apart from the first month, the principal in use shrinks every month, so the true annualized rate is 12.36%.

Ziroom is not licensed to make loans, so it brought in a trust company.

Ziroom takes the unit on first, then, when a monthly-paying tenant signs up, has the trust company sign with that tenant instead. That is the principle; in the Ziroom app used for signing, it is two taps on a screen. What the trust company signs with the monthly payer is a loan agreement — on paper, the trust company is extending the tenant a trust loan. Ziroom is the beneficiary of the trust plan.

So when a tenant pays rent and interest, the tenant is repaying the trust company; the trust company pays Ziroom; Ziroom pays the landlord.

The loan interest compensates the platform for the risk it carries. By the calculation above, Ziroom pays landlords quarterly, so taking monthly payments from tenants means bearing the risk of empty units and of money coming back more slowly.

The platform also has more bargaining power over monthly payers. In the rental market, "one month's deposit, three months' rent up front" is common and "one month's deposit, one month's rent" is rare; a tenant who can only pay one month at a time usually has no other option, and the platform holds the leverage.

The two rent installment trust plans Ziroom has issued with CITIC Securities, worth 2.5 billion yuan in total, both work this way: they turn loans owed by monthly-paying tenants into ABS products to raise money, which amounts to collecting at once the rent those tenants would have paid over time. And because the 6.27% annual interest charged to tenants is higher than the 5.39% annual rate paid to investors, Ziroom pockets the spread.

ABS can also be issued without consumer loans attached, using one of two kinds of underlying asset: rent, or beneficiary rights combining expected rent and expected proceeds from selling the property — that is, quasi-REITs.

Mofang Apartment is the model for ABS backed by rent. In January 2017 it issued the "Mofang Apartment Trust Beneficiary Rights Asset-Backed Special Plan Asset-Backed Securities," with tenants' rent as the underlying asset.

In Mofang's ABS, Mofang carries far more risk than Ziroom does. With Ziroom it is the tenant who enters into a borrowing relationship with the trust plan; with Mofang it is Mofang itself.

Put simply, Mofang's users are still "tenants." A user who moves out early pays the contractual penalty and owes nothing more; there is no loan to repay. But if the unit sits empty, Mofang's subsidiary still has to repay the trust plan's loan.

The real underlying asset of Mofang's ABS is the rent cash flow; the real underlying asset of Ziroom No. 1 is the consumer-loan cash flow.

Ping An Real Estate's 5-billion-yuan ABS is a quasi-REIT. The underlying assets of a quasi-REIT are future rent plus ownership of the property — which means Ping An has valued 18 years of future rent on the 752 units in the Landsea Senlan project, plus the value of the property itself, at 5 billion yuan.

ABS has sped up investment in rental housing, but it has also created new risks for property companies and tenants

Before ABS, the long-term rental apartment business did not make money. World Union, an A-share-listed company that has been in it for years, ran 35,000 units in core first- and second-tier cities at an 81% occupancy rate, according to its 2017 annual report. It took in 208 million yuan of revenue in 2017 and lost 184 million yuan; of all its projects, only Hongpu in Beijing was profitable. The losses came mainly from high operating costs: sourcing units and base rent accounted for about 55-60% of total costs, renovation for about 20%.

But once Ziroom changed the model with consumer loans and ABS, a platform could plausibly turn a profit by raising prices.

That is probably an important reason Ziroom, which started in 2015 and saw revenue explode in both 2016 and 2017, did not raise its 4-billion-yuan Series A until 2018. With ABS available, long-term rental apartment platforms could expand faster, and investors, seeing a chance to build a monopoly through rapid expansion, became willing to bet heavily.

In this business, profit stopped being just the rental yield and became: profit = rental yield + (tenant loan rate − ABS rate).

With ABS, a long-term rental apartment company gets years of future rent immediately — a large pile of "extra" cash in hand.

And with money in hand, of course, it goes on buying up homes.

Basic economics: supply and demand set the price. The supply of empty homes in first-tier cities is finite. Big platforms, with their advantages in credit and capital, can pay high prices to take units, winning a monopoly (or oligopoly) position in those cities' rental markets and pushing rents up.

Which makes it easier to understand why rumors of brokers hoarding homes and raising prices kept surfacing this year, and why the Beijing Municipal Commission of Housing and Urban-Rural Development and several other agencies stepped in and summoned Ziroom, Xiangyu, Danke, and others, telling them not to use money raised from bank loans and other financing channels to fight cut-throat battles over units. No enforceable policy followed that meeting.

Under the new model, long-term rental apartment companies can expand faster, but new risks lie underneath.

Cornering the supply and then raising prices rests on two big assumptions: that the supply of rentable homes in first-tier cities will not grow much, and that the urban population will keep growing.

On supply, the large-scale clearances and crackdowns on subdivided group rentals in cities like Beijing and Shanghai have in fact cut the supply of rentable homes and pushed rents up.

On population, the picture is quite different. According to data from Beike Rental, total rental transaction volume in the first-tier cities of Beijing, Shanghai, and Shenzhen in 2018 grew -23.65%, -22.83%, and -16.98% respectively against the same period of 2017. Over the same stretch, total rental transaction volume grew 5.59% in Chengdu, 5.15% in Hangzhou, 5.16% in Nanjing, 13.39% in Wuhan, 48.48% in Changsha, and 51.20% in Chongqing.

In short, fewer people are renting in Beijing, Shanghai, and Shenzhen. Given that the number of young people in China will fall 36% over the next decade, the trend is unlikely to turn around.

And Beijing, Shanghai, and Shenzhen are precisely where long-term rental apartments are most densely built. Which probably means that while the platforms keep expanding fast, the first-tier rental market is shrinking fast — their market is getting smaller, and the risk of empty apartments may grow.

They could follow the people and expand into other cities, but whether tenants there can pay enough is an open question. In 2018, Hangzhou Dingjia, a long-term rental apartment company operating mainly in Hangzhou, ran out of cash, affecting more than 4,000 tenants.

In an uncertain market, ABS raises the risk of running out of cash, because at bottom it is high leverage.

Ziroom No. 1 uses a tiered securities design. Its 500 million yuan is split into senior and subordinate tranches, with the subordinate tranche paid after the senior one. When the cash flow from the underlying asset runs into trouble, the subordinate tranche takes the hit first, which protects the senior tranche.

For Ziroom No. 1, the senior tranche raised 450 million yuan and the subordinate tranche 50 million yuan, a ratio of 9:1. When the ABS was first issued, Ziroom subscribed to the entire subordinate tranche. If losses on the project stay under 10% (50 million yuan), Ziroom bears all of them. If losses reach 20%, or 100 million yuan, Ziroom bears 50 million yuan alone (100% of its own investment) and the other investors share the remaining 50 million yuan (one-ninth of theirs).

A long-term rental apartment company that issues ABS takes on far more risk than its fellow investors. If the market holds up, it can grow several times faster than it could on its own. If the whole rental market runs into trouble and occupancy slips, its risk multiplies too.

A long-term rental apartment company involving several million landlords and tenants going bankrupt would obviously be bad. But it is no better if the business booms because rents keep climbing and more and more people are forced to pay in installments.

A product like ABS exists, in the end, because people spend before they earn. The underlying asset of an ABS is a set of predictable future cash flows; the structure connects people with spare money to people who need to spend ahead of their income. Only when many people spend ahead of their income is there much demand for ABS.

The bigger ABS story is Alipay's Huabei and Jiebei, which have issued nearly 500 billion yuan worth. Which is why, on Taobao today, you can pay in installments through Huabei even for something under 100 yuan.

If every expense in a life has to be paid in installments, then interest sits behind every purchase. Borrowers will find it very hard to accumulate wealth; lenders will accumulate it steadily.

The economy is slowing, and incomes are growing more slowly with it. At the same time, more and more businesses are building their growth on installment loans, counting on people to borrow, spend, and keep taking on debt.

Cover image: Pixabay