Danke (Part 2): Unravelling the Collapse of a Real Estate Ponzi Scheme

Previously in Part 1, we provided background information on Danke's history and business model.

In this second installment of the Danke series, we analyze the company's collapse by examining Danke's financial statements and relevant news reports to identify the key factors that contributed to and could have potentially predicted the company's downfall.

In Part 3, we provide a recap of the rise and fall of Danke, as well as discuss some of the questions, issues brought up, and lessons learnt from the collapse of this real estate Ponzi scheme.

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A Recap of 2020: Danke's IPO and Downfall

2020 marked Danke's most successful year in terms of the company's IPO in January, and also saw the company's gradual decline and eventual collapse.

Here we present a timeline of major events starting from the company's zenith in January to its collapse by the end of December the same year.

Timeline of Danke's collapse

As of January 13th 2020, Danke's stock was trading at $2.86 per share.

UPDATE: Trading of Danke stock was suspended on March 15th, 2021, and the company's American depository shares were subsequently delisted from the NYSE on April 6th, 2021.

Explaining the Collapse of Danke

A combination of factors allowed for Danke's rapid rise and contributed to its ultimate fall. Specifically, Danke expanded rapidly by leveraging the rent loans it obtained as part of three-way rent financing schemes the company engaged in with renters and partner banks. Since rent loans were a relatively new innovation, there were no regulations surrounding how or when upfront loan proceeds could be used, and Danke was able to use most, if not all, of the upfront proceeds to lease new properties, renovate the apartments, and rent them out. Moreover, Danke offered a premium to attract property owners and guaranteed monthly payments to landlords even if their properties were not rented out, causing the company's leasing expenses to explode as part of a loss-making expansion. Ultimately, with the COVID-19 pandemic as a final trigger, many parts of China entered lockdown, causing Danke to be unable to find enough renters to continue supporting its unsustainable expansion and triggering the Ponzi scheme to ultimately collapse.

We discuss these factors in further detail below.

#1: Aggressive Growth Fueled by Excessive Rent Loan Debt and Loose Regulations

Leveraging Rent Loans

Rather than accepting monthly payments from renters as is typically the case with real estate rental companies, Danke encouraged renters to pay for the entire year's (and occasionally even two years') worth of rent in advance. Since many of Danke Apartment's renters were young working professionals who generally don't have much savings, Danke partnered with licensed financial institutions (primarily Tencent's WeBank) to facilitate rent financing for renters who could not afford to pay an entire year's worth of rent in advance, as explained in Part 1.

As part of the rent financing scheme, the renter pays Danke the first month's rent upfront, then signs a three-way contract with Danke and a partner bank to grant an additional loan equal to the remaining 11 months' (or occasionally 23 months') worth of rent to Danke, which the renter pays back in monthly installments to the bank. In order to incentivize renters to opt for the rent financing scheme rather than paying regular monthly rent payments, the monthly loan repayment amount renters had to pay under a rent financing scheme was usually structured to be significantly lower than the required monthly rent payment amount had renters chose not to opt for the scheme.

Without any regulatory restrictions on rent loans, Danke was able to use the entire 12 months' worth of rent prepayments (i.e. first month's rent payment and remaining 11 months' worth of rent from the loan) immediately to lease more properties from landlords. Since Danke only had to pay landlords monthly but the entire year's worth of rent would have already been granted upfront to Danke, each individual renter who enrolled in a rent financing scheme allowed Danke to lease up to 12 new properties (or 24 if two years' worth of rent were paid upfront). Furthermore, Danke launched China's first rent loan asset-backed security (ABS) in 2018, which not only increased the company's leverage, but also reduced its skin-in-the-game during expansion.

Tightening Regulations - Too Little, Too Late

In 2017, 91.3% of Danke's renters were enrolled in a rent financing scheme. In 2018, a substantial number of rental companies with a heavy reliance on similar or identical rent financing schemes as Danke's went bankrupt in several Chinese cities, leading many local governments to request rental companies to reduce their reliance on rent loans. Consequently, Danke reduced its percentage of renters enrolled in rent financing schemes to 75.8% the same year.

A step further in 2019, the Chinese regulators issued a draft proposal (i.e. a proposal that will come into effect in the future) stating that real estate rental companies must limit the proportion of their rental income that comes from rent financing to no more than 30%. In line with the stricter regulations, Danke further reduced its percentage of renters enrolled in rent financing schemes to 65.9%, although this reduction was far from sufficient to prevent the company's built-up, unstable financial fundamentals from collapsing later on.

Note: although Danke reduced its reliance on rent financing in accordance with the regulatory developments, the company nevertheless still urged renters who were not enrolled in a rent financing scheme to pre-pay for multiple months' (if not an entire year's) worth of rent in advance.

#2: Ballooning Leasing Expenses Driving A Loss-Making Expansion

A Business Model with Very Slim Profit Margins

Although Danke expanded rapidly and its revenues grew year-on-year, the company's expansion was loss-making as the expenses associated with expansion far overweighed any increases in revenue. The diagram below from Danke's Q1 2020 earnings report breaks down the costs associated with a rented-out apartment unit, as well as a vacant (i.e. either not yet rented out but ready-to-move-in or still in the pre-move-in renovation stage) apartment. In both cases, leasing costs constitute a significant proportion of revenues/loss, while the profit margin for rented-out units is very slim. Interestingly, the premium paid for third-party contractor services proudly provided by Danke for rented-out units (shown in the diagram below as "cost of services") represents only a small proportion of revenues.

Danke apartment revenue and costs
Source: Danke Q1 2020 Earnings Report

A Look at the Numbers - Exploding Operating Expenses Driven by High Leasing Costs

A snippet from Danke's 2019 annual report (below) shows the company's operating expenses as a percentage of total revenues. As a whole, Danke's operating expenses are extremely high at 133.3%, 145.6% and 144.2% of total revenues in 2017, 2018 and 2019 respectively. The overall increasing trend is largely due to the rising leasing costs, where rental (i.e. leasing) cost constituted 77.9% of total revenues in 2017, and increased to 81.2% in 2018 and 89.8% in 2019. According to the company's financial reports, other components of Danke's operating expenses have also increased due to a rise in the cost of services provided to residents and an increase in incentive fees.

Danke's operating expenses
Source: Danke 2019 Annual Report

A Look at the Numbers - Danke's Growing Net Loss

Danke's exploding expenses and costly expansion is reflected in an overall trend of increasing net loss, from RMB272 million in 2017 to RMB1.37 billion in 2018, and subsequently RMB3.4 billion in 2019.

Danke's annual losses
Source: Danke 2019 Annual Report

#3: COVID-19 - The Final Trigger

With the outbreak of COVID-19, Wuhan locked down on January 23rd, 2020 and other parts of China quickly followed suit. Since China's lockdowns occurred during Chinese New Year, many office workers were stuck in their hometowns and could not return to the cities where they worked. This led to a substantial decline in the number of new renters looking for or renewing apartments, and put a significant financial strain on an already unstable Danke, whose business model was primarily maintained by aggressively finding new renters and obtaining rent financing loans to cover existing leasing costs. With the worsening economic climate as the COVID-19 pandemic spread, funding from other sources (primarily bank loans) also became increasingly scarce and expensive.

As scandals surrounding Danke began to break out in February and March, the company lost more and more of its credibility. Even after the first wave of the pandemic was under control in April and office workers returned to work, property owners and renters were still deterred from leasing or renting through Danke, thereby further escalating the company's decline.