Terrie's Take 877 (Tourism Edition) - What Hotels Really Make on their Investment

Terrie's Take terrie at mailman.japaninc.com
Mon Dec 12 09:13:29 JST 2016

* * * * * * * * TERRIE'S (TOURISM) TAKE - BY TERRIE LLOYD * * * * * *
A bi-weekly focused look at the tourism sector in Japan, by Terrie 
Lloyd, a long-term technology and media entrepreneur living in Japan.

Tourism Sector Edition Sunday, Dec 12, 2016, Issue No. 877

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+++ What Hotels Really Make on their Investment

The slow march to legalizing minpaku (Airbnb-style) services continues, 
with leaks by the nation's conservative media at regular intervals. On 
December 4th, the Nikkei gave us a little more insight into the fight 
going on over minpaku legislation which is slated to be passed in Q2 
next year. We already know that the government is favorably predisposed 
to allowing Airbnb type accommodation to take root in Japan, and that it 
is considering relaxing the current minimum stay from six days to a more 
practical two.

At the same time, though, the hotel industry is clearly pushing back, 
causing the government to plan a cap on the number of nights that a 
location can be used as informal accommodation, after which it will need 
to be upgraded to comply with proper rules and regulations governing 
hotels, inns, and guest houses. That cap is being mooted as 180 days a 
year, which is certainly much better than the rumored 30 days the hotel 
industry is asking for.

There has been a lot of commentary recently about the damage that Airbnb 
is doing to the hotel industry, although frankly with the occupancy 
rates still so high, it's difficult to see just what that damage might 
be at this stage. In fact, occupancy rates at Tokyo hotels are falling 
slightly, and in July they were down 3% over the same month last year, 
but, and this is important, average occupancy at the top 18 hotels is 
still at 83.2%. At our travel business, www.japantravel.com, the 
shortage of hotel rooms is affecting business, and as an example, last 
week we had to turn down a request for 30 rooms at the end of the year 
in Osaka (which has an even worse supply situation than Tokyo) because 
we couldn't find any space among the 15 hotels we called.

To shine a light on just how difficult things really are (or not) for 
hotel operators, we contacted a number of experts in the hotel sector 
and asked them to give us some insight into the costs and returns of 
running a hotel business at the moment. We dug into the actual cost of 
establishing a hotel, either by building or converting an office 
building, and the operating and capital returns that can be expected. 
Our two respondees were Mr. Seth Sulkin of Pacifica Capital, a property 
investment, development, and management company based in Akasaka, and 
Mr. VJ Daswani of Land Max Japan in Okinawa.

*** TT: What is the average price per room for a typical 
midscale/upscale hotel in Tokyo, Osaka, Sapporo, Kyoto and Naha (or 
elsewhere in Okinawa)?

SS: Tokyo has the highest Average Daily Rates (ADR) in Japan, but new 
luxury hotels in Kyoto such as the Four Seasons and Ritz Carlton are now 
surpassing Tokyo at high seasons with more than JPY100,000 per night. 
Osaka is narrowing the gap with Tokyo on a consistent basis. According 
to the latest August 2016 data from Jones Lang LaSalle, Tokyo mid-scale 
and limited service was averaging about JPY10,500, and JPY35,000 for 
luxury. Osaka was JPY10,100 for mid-scale/limited service and JPY19,800 
for luxury. Regional cities like Sapporo and Naha are typically 20%-30% 
below Osaka.

VJ: In Okinawa, the average price per room is about JPY1 million per 
tsubo (3.3 sq. m.). So as an example, if I build a 36-room hotel where 
each room is about 26 sq. m. (7.8 tsubo), with a lobby lounge, I would 
expect to buy the land for around JPY100 million, the hotel itself would 
cost around JPY400 million, and my Gross Operating Profit (GOP) would be 
around JPY50 million annually.

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*** TT: What is a typical yield/cap rate in each the above cities? In 
reality, from owner side, is there big difference between a property 
used under a lease agreement and one under a management contract - in 
terms of exit cap rate?

SS: In Tokyo, REITs are buying business hotels with cap rates of around 
4.5%. Unlike other types of commercial property, investors not only look 
at the cap rate, but the price per key (room). In both Tokyo and Osaka, 
recent transactions per key have gone up dramatically, i.e. JPY75-JPY80 
million, compared with JPY20-JPY30 million only 1-2 years ago. The 
spread on cap rates in Osaka is probably around 50 basis points higher 
than Tokyo, while regional cities are probably running 6%-7%.

VJ: To build a hotel from scratch we are looking at 7% yields from a 
Lease agreement, at least 10% from a Management contract, and 5% to 6% 
minimum for an exit.

SS: There is an interesting industry debate on hotels with leases versus 
management agreements. For upscale or luxury hotels, there is really no 
choice but to accept a management agreement, so I don't believe there is 
much difference in pricing. Japanese REITs are buying both business 
hotels with leases and full service hotels with management contracts, or 
leases with variable rent.

*** TT: What is a typical Japanese bank financing structure in terms of 
period and interest rate. Also, what about LTV or LTC?

SS: REITs borrow on a portfolio basis and get the lowest interest rates, 
but also typically seek lower leverage. For stabilized hotels, private 
funds seeking can obtain up to 80% of value at interest rates of 
1%-1.5%. Since the global financial crisis, the trend has been longer 
loans of 5-7 years.

VJ: As a non-Japanese resident, you can get financed at a 60%/40% equity 
ratio, on a loan term of 25 years and interest rate of 2%.

*** TT: What is the normal range of investor IRR in the Japanese hotel 
sector as of now? What's your prediction 24 months from now?

SS: It has been interesting to look at the boom in business hotel 
development over the last 1-2 years. Based on our estimates, we believe 
Japanese investors are taking development risk in exchange for a yield 
of 4%-4.5% which is less than what a REIT is getting for a stabilized 
hotel.  With a lease, there is typically no upside for the investor. 
REITs sometimes structure a base rent and variable portion above a 
certain performance hurdle. The IRR will mostly depend on leverage and 
hold period so there is no way to generalize, so cap rates of 4%-4.5% in 
Tokyo would be typical.  Cap rates have been trending lower so as long 
as RevPAR (ADR adjusted for occupancy) continues to rise, I would expect 
the price per key to continue going up and for cap rates to fall slightly.

VJ: Let me give you a specific example of our expectations: i) Project 
cost for 100 rooms = JPY1 billion, land cost = JPY400 million to JPY500 
million, so you have a total cost of about JPY1.5 billion; ii) Lease 
agreement of about JPY110 million to JPY120 million; iii) Yield of 8% on 
a 30% equity stake in JPY450 million to JPY500 million; iv) Interest on 
borrowings of JPY1 billion principal = JPY60 million, and cash in hand 
of JPY50 million to JPY60 million. These factors should give us an IRR 
of about 10% to 13%, and on an exit of around JPY2.1 billion, a return 
of 5.5%.

*** TT: What is the typical hotel lease structure and how does a hotel 
owner charge rent from the operator? If it's "Fix+Variable", what is the 
% of each? Also, is the variable rate based on the hotel's net operating 
income? Alternatively, what's the % of the total revenue that is 
expected in rent?

VJ: Right now, for investments of less than JPY1.5 billion yen, you will 
normally have a straight forward lease contract for 10 to 20 years.

[Continued below...]

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*** TT: What are the Fees the owner has to pay after the rent? (i.e.. 
real estate tax, insurance, other fixed charges)? Alternatively, what % 
of rent can the owner expect to receive (i.e., net cash inflow)?

SS: The main owner costs are property tax, insurance, capex and FF&E 
reserve. For business hotels, owners should expect 4%-4.5% net yields.

VJ: The only thing for us in Okinawa is the property tax which is 
typically around JPY1 million to JPY3 million, plus some miscellaneous 
fees of about JPY2 million annually. Of course the company has to pay 
income taxes just like any corporate business, but these can be offset 
by salaries and other operating costs.

*** TT: What is the real estate tax for a typical hotel property in 
major cities?

SS: It varies widely on location, size of land and building, so there is 
no way to give an average

VJ: For a small hotel in Naha it's typically around JPY2 million.

*** TT: What is the % of total revenue that owners are obliged to pay 
for insurance?

SS: Unless you have an international operator demanding earthquake 
coverage, insurance is cheap and is not normally a material expense item.

VJ: For us it's around 3% to 5% of operating costs annually.

*** TT: What is the normal range of conversion costs (per sqm) 
converting an office building into a midscale or upscale hotel in Tokyo? 
What about secondary cities like Fukuoka or Naha?

SS: I would say that construction costs in most parts of Japan are 
basically the same, although Okinawa might be somewhat lower. The real 
difference in new construction or conversion cost depends on the grade 
of the hotel and the nature of FF&E.

*** TT: How long does an office conversion that creates a 150-200 bed 
hotel take usually?

SS: There are few companies other than Pacifica actively engaging in 
conversions of that scale. Most conversions are probably less than 100 
rooms or are not hotels, but hostels or other simple accommodation 
facilities. For a true hotel conversion, the actual construction period 
would depend on the age of the building and other factors, but should be 
in the range of 6-12 months. For hostels, it could be even shorter.

VJ: I am unfamiliar with conversions because in Okinawa we have a 
problem with land scarcity and we struggle to find empty buildings, LOL.

*** TT: Any other pointers for readers interested in the hotel 
investment sector?

SS: There are few quality hotels available for sale and when they do 
come on to the market, bidding competition is severe. Japanese REITs 
have been the main buyers, but some foreign private funds and foreign 
REITs have managed to make some acquisitions as well. There are more 
business hotels available, but since these are typically fixed-term 
leases with no upside, these are seen as stable but low-return 
investments. Given the pipeline of business hotel developments in Tokyo 
and especially Osaka, I would expect an oversupply of business hotel 
rooms within 1-2 years. I think upscale and luxury will outperform 
business hotels going forward, as these are harder to develop and the 
supply remains small relative to growing demand.

Our thanks for assistance with this Take, go to:

SS: Mr. Seth Sulkin
CEO, Pacifica Capital K.K.
seth.sulkin at pacifica-cap.com

Company Profile:
Pacifica Capital looks for three types of properties: raw land, empty 
office buildings for conversion, and existing hotels that can be 
renovated and re-branded. For conversion, we are looking primarily in 
Tokyo, but will also look at good locations in Osaka and Kyoto. The 
building should be current earthquake code and the GFA should ideally be 
5,000-10,000 m2. Ideally, there should be windows on four sides, but we 
can consider buildings with less. We would buy the property and handle 
the entire development process. We are open to working with passive 
investors, but are not looking for active co-development partners. We 
are certainly happy to pay fees to people who can introduce good 
projects and help us with the acquisition.

VJ: Mr. VJ Daswani
vjdaswani1 at gmail.com

Company Profile:
Land Max Japan is a Real Estate company primarily focused on Okinawa and 
Tokyo. We specialize in the hospitality sector, buying up old buildings 
/refurbishing them and making them cash flow positive within 6-8 months 
of resuming operations.

...The information janitors/

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Written by: Terrie Lloyd (terrie.lloyd at japaninc.com)

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