People get intimate in good times and bad, so taking exposure to the leisure hotel industry while values are at all-time lows could be a wise counter-cyclical investment, argues Alchemy Japan, an asset management and advisory firm that operates the country’s 10th largest chain of love hotels.
Asset prices are dependent on the availability of leverage – and since banks and finance companies have been reluctant to lend during the financial crisis, property prices have dropped and capitalisation rates (net operating income divided by property price) are at record highs, says Garry Frenklah, Alchemy’s Asia ex-Japan representative. Japanese lenders’ innate conservatism means that fewer still are prepared to lend against love hotels, he adds.
As a result, he notes that deals are closing in the 25-30% cap-rate range. The sale of the Japan Leisure Hotels (JLH) portfolio, the first significant transaction executed since the financial crisis, traded in June last year at 35%, a historic high. By comparison, the typical cap rate for hotel deals in the US is 6-8% at present, notes Frenklah.
The buyer of the JLH assets was able to re-trade two of the hotels within two months of purchase and has recently disposed of a third at rumoured cap rates of 23-25%, says Frenklah, suggesting that cap rates may be coming off their peaks and prices are starting to recover.
However, the deal also demonstrates the perils of getting in at the wrong level. JLH had to sell the portfolio following the exit of its largest shareholder, DKR Oasis, due to the hedge fund’s liquidation.
Still, firms such as Orix and Tokyo Star Bank – the sector’s biggest lenders – have tentatively started to re-enter the market, adds Frenklah, meaning cap rates are likely to continue to fall.
Investors should consider buying now, he says, especially given that love-hotel net cash flows are very high, at 10-14% a year in yen (and higher when swapped into higher-yielding currencies).
“This is a unique play on something that is seemingly everything-proof,” says Frenklah.
There are different portfolios available, he notes, including one available from a large foreign institution that had bought at a low cap rate and now wants to exit for purely strategic reasons. Alchemy has managed the portfolio for years, so has intimate knowledge of the assets.
Foreigners can invest directly in Japanese land and property without restrictions and with or without leverage, says Frenklah, adding that Alchemy can package investments as any combination of pure debt, hybrids or equity via special-purpose companies.
The potential to make money is substantial, he adds. Japan’s love hotel industry is huge – its ¥4.2 trillion ($54 billion) in revenue exceeds that of the entire UK hotel industry. It is also very fragmented: the 448 rooms managed by Alchemy make it the 10th biggest operator in an industry with an estimated 625,000 rooms, and the top 10 operators account for less than 1% of the market.
There is a massive consumer base for this ubiquitous industry: every single day 2.5 million people, or 2% of Japan's population, use love hotels, with 70% in the 20-30 age bracket. That’s hardly surprising, since there is little privacy for most Japanese: the average person has 18 square metres of living space, and it is common for three generations to share the same accommodation.
In addition, profitability is very high: love hotel rooms are typically used several times a day, with a turnover rate of 236% for the industry and 265% for the hotels managed by Alchemy, and operating margins at 45-50% of sales.
For those investors put off by the thought of investing, it may provide some comfort that Japan’s love hotels are government-regulated and legal. Alchemy’s hotels hold licences identical to those of a Hyatt or a Hilton, there is no social stigma within the country and no systemic involvement by organised crime, says Frenklah.
Moreover, Alchemy says it is the only foreign asset manager in the industry that serves institutional investors and complies with the disclosure, reporting, audit and transparency requirements of sophisticated investors.
And on a final point, one of Alchemy’s founders is a former Australian public servant. Greig McAllan, the firm’s chief executive of group operations, was formerly head of Tourism Australia for North Asia. One would think he knows a thing or two about hospitality.