TT-877 (Tourism Edition) -- What Hotels Really Make on their Investment

Japan Travel
* * * * * * * * 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,, 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: Okinawa is now one of the top destinations in Japan. Midscale
hotels are at JPY7,000 to JPY15,000 per night, and 5-star hotels are
charging between JPY30,000 to JPY80,000 yen a night and this is

VJ: In terms of building and construction cost: Okinawa construction
costs are around JPY1,000,000/tsubo (35 sq. ft.) to
JPY1,200,000/tsubo, depending on the scale of the hotel. Taking a
100-room business hotel (a so-called "limited scale" hotel) as an
example, we are looking at 4 tsubo gross GFA or about 150 sq. ft.
Factoring in the lobby and the net usable area, we are looking at a
usable space of about 520 tsubo (18,480 sq. ft.). Construction cost
would be around JPY520m plus land cost of about JPY250m. Since Okinawa
business hotels are now currently enjoying an 80% occupancy rate, at
an ADR of JPY7500, the rates are about 20% under those of Osaka and
Tokyo. This makes it much more interesting for investors to come and
survey the Okinawa hospitality market.

VJ: Land and construction costs are both much lower than mainland
Japan. So all-in-all, even building a hotel in Okinawa and leasing it
out to an exclusive operator will still provide an annual positive
cash flow with a viable exit strategy as well - so long as it is in a
good location and has a good operator. Investment interest is
escalating thanks to the direct flights coming in daily from across
Asia, as well as mainland Japan.

[Continued below...]

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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 an
investors point of view, depending on land cost & construction cost.
This is where LMJ comes in. We start tendering to various construction
companies to get the best deal in terms of cost of construction and
getting the land acquisition in place. Concurrently we look for the
best hotel operator to fit the project. The going cap rates are around
5% to 5.3%, varying from project to project. So if we are able to
achieve 7% yields, we will definitely see at least 5% profit at 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 Japanese resident you can probably enjoy 80% financing with
local banks in Okinawa, with interest rates ranging from 1.5 to 2%.
Non residents have the option of using various international banks
that have branches in Japan, such as Bank of China, Shinsei, and Tokyo
Star Bank - which typically offer 65% finance at 2% interest. SPC
(Special Purpose Companies) can also be financed as long as the
project makes sense and location is prime. Non residents can also
obtain a loan based on an SPC structure, which they can finance to
about 70%~75%.

*** 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 = JPY 1 billion, land cost = JPY 400 million to JPY
500 million, so you have a total cost of about JPY 1.5 billion; ii)
Master lease agreement yearly of about JPY 110 million to JPY 120
million; iii) Yielding 8% on total project cost (i.e., lets say 30%
equity is required to start the project so around JPY450 million to
JPY 500 million required capital; iv) Interest and principal on
borrowings of JPY 1 billion principal/25 years is annually
JPY40,000,000 + interest of 20,000,000 total = JPY60 million, and cash
in hand of JPY 50 million to JPY 60 million. Your IRR is about 10 to
13%. This will mean an exit at 5.5% cap.

*** 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 JPY 1.5 billion, you will
normally have a straight forward master lease contract or a management
contract for 10 to 20 years depending on the terms and conditions.
That said, if we believe in the project, we will consider a Fix +
Variable scheme.

[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 main cost are property tax, maintenance fees, insurance,
CapEx, etc. In the Okinawa market after deducting all this, the owners
would probably still get about 5.5%.

*** 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 JPY 1 million yen.

*** 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: Usually it's around 1% to 3% of your gross sales.

*** 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: Usually it will take about 6 months depending on the actual condition
of the building. As long as it meets all building requirements act it should
be completed within 6 months.

*** 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.

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

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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