Regulators in Shenzhen are investigating financing in the online rental segment after a landlord dispute with Danke Apartment tipped them off to systemic risk within the industry.

Danke Apartment, also known as Phoenix Tree Holdings Ltd in the West, leases apartments from individual owners on a long-term basis. It then renovates and furnishes these properties before renting them to new tenants, who usually pay Danke up to one year of rent through financing, according to the company. The government now aims to stem the practice of long-term rent financing because of the risk of such platforms being unable to meet obligations to landlords and tenants in the case of a liquidity shortage.

After the coronavirus outbreak, the company began withholding fees payable to landlords to support tenants struggling under the circumstances. However, Danke repeatedly declined requests from tenants, who already paid their rent in advance, for payments related to the policy. The move triggered a wave of protest and criticism from landlords and tenants, which eventually came to the attention of a subcommittee of the Shenzhen Municipal Committee of the Communist Party of China.

Danke later opened an application channel on February 10 for tenants to receive compensation. Regarding landlords’ complaints, Danke told KrASIA on Wednesday the company was “not forcing them to waive fees, but rather negotiating with them to help tenants go through the hard times, addressing a government proposal.”

Upon further inquiry, the subcommittee then asked Shenzhen finance watchdogs, including the Shenzhen Municipal Financial Regulatory Bureau, to conduct an investigation on financial institutions backing Danke’s and other rental companies’ financing operations.

Last December, the Ministry of Housing and Urban-Rural Development of China, as well as the China Banking and Insurance Regulatory Commission, made an official recommendation stating that rental companies should rein in rental loans to below 30% of their total incomes, to reduce structural risk, by the end of 2022.

Dozens of online housing rental platforms that had relied on this rent financing model for new funds in China have gone bust, which is what led to the December recommendation. These include Hangzhou-based Dingjia, which was established in 2016 and ceased operations in 2018. After the company filed for bankruptcy, users who paid their rent in advance were still on the hook for loans despite having lost access to their apartments.

The authorities’ moves aim to discourage Shenzhen financial institutions from providing risky loans to rental platforms, with institutions in other cities expected to follow suit. While decreasing risk, the regulation also threatens Danke’s cash flow.

“While we plan to reduce such ratio to below 30% by the end of 2021, we cannot assure you that we would be able to meet the requirement of the [recommendation] within the required timeframe or that our business operations, cash flow or financial condition would not be negatively affected,” the company warned investors in its IPO prospectus.

In the first nine months of 2019, 67.9% of Danke’s tenants paid rent through loans. The percentage was 75.8% in 2018 and 91.3% in 2017. Danke gained RMB 3.1 billion (USD 434.5 million) from rent financing in the first three quarters of last year, but returned nearly RMB 1.8 million (USD 246.1 million) to financial institutions due to early termination of the leases, or defaults by the residents on loan repayment.

Danke sought to raise USD 201 million by going public on the New York Stock Exchange last January. The company floated 9.6 million shares at USD 13.50 apiece, and managed to raise USD 129.6 million.

As of September, Danke had been operating over 400,000 apartment units in 13 cities across China, a 166-fold increase since 2016. However, the company incurred net losses of nearly RMB 1.4 billion (USD 191.6 million) in 2018 and RMB 2.5 billion (USD 352 million) from January to September 2019.