Operators, investors on the lookout for distressed hotel assets in Japan

The distressed opportunities make great entry points into Japan’s promising hospitality market.

The second half of 2020 brought only a little more hope to the hospitality sector than the first, and international borders have remained effectively closed to tourists. Prospects are certainly not expected to change significantly as long as the number of COVID-19 cases worldwide does not see a steep decrease.

Therefore, Savills says the prevailing circumstances could lead to the emergence of distressed opportunities, which will make great entry points into the market. Many international hotel operators and investors have maintained an interest in the promising Japanese hotel market and will likely see the downturn as an opportunity to buy up distressed assets.

The shift towards management contracts may also create opportunities for investors willing to take more operational risk. According to Savills, although most owners currently prefer a fixed-rent lease, few operators presently have the financial capacity to undertake fixed-rent lease contracts. Investors who wish to take more operational risk may find struggling owners who are comfortable only with fixed leases but cannot find suitable operators.

That said, risk is mounting in the credit market. According to the Small and Medium Enterprise Agency, a majority of the pandemic loans to small and medium-sized companies have already matured or will mature between spring and summer 2021. If the current challenging operating environment persists, banks may reconsider forbearance. Even if refinancing is possible, favourable financing terms may not be applicable any more given the more uncertain market prospects. Although the distressed market has been quiet thus far, the emergence of a more active distressed market may be in the offing.

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Having been particularly negatively impacted by the pandemic, the hospitality industry will likely see increased bankruptcy rates, leading to a more active distressed market. Many international hotel operators and investors have maintained interest in the rapidly growing local hotel market and will likely see the downturn as an opportunity to snatch up properties that would not have been up for sale in a healthy market.

Presently, even several famous Japanese hotels have been closed or disposed of. However, their established brands and networks, as well as advantageous physical attributes will not disappear and will remain valuable to international investors with the financial wherewithal to survive the COVID-19 storm. Furthermore, multiple domestic players are active. One example is Prince Hotel, a hotel subsidiary of Seibu Holdings, that plans to expand its new brand, Prince Smart Inn, to 100 properties by 2030. Hence, given the ongoing activity in the market and this sector’s continuing popularity, it would probably be better not to wait too long in anticipation of deeply discounted opportunities.

Other good targets could come from regions beyond major cities. Some owners in these regional areas are only thinly capitalised but possess lodgings with good value-add potential. While budget hotels generate forecastable profits and therefore become easy acquisition targets, the performance of Japanese traditional inns depends heavily on the operator at hand. As such, skilful operators could find underperforming properties and significantly improve their operating indicators. Moreover, regional markets have been more resilient to the negative impacts of COVID-19, thus making the wait-and-see strategy more effective than in urban markets.

Elsewhere, some hotels developed by condominium developers are likely to experience more difficult times as they tend to have a small number of rooms and are generally located in less favourable locations. As such, the prices of these hotels could be significantly adjusted to an economically viable level for potential buyers who wish to convert them into other uses such as serviced apartments, satellite offices for teleworking, or possibly subscription use. For this category of hotels, investors may want to wait long enough to see necessary adjustments materialise before acting.

Lastly, two and three-star hotels may resort to consolidation for survival. Many investors would like to acquire operating platforms in Japan, and because sizable franchises and chains provide more value, players who are able to bring consolidation to the table should enjoy portfolio premiums.

A shift toward operating contracts

There is an increasing number of hotels without operators, typically those newly built by real estate companies. Although there were prospective operators during the planning stages of these hotels a few years ago, many of them have exited due to the pandemic. Currently, most owners prefer a fixed-rent lease, and occasionally accept a fixed-rent plus revenue sharing payment structure. However, few operators presently have the financial capacity to undertake fixed-rent lease contracts.

As a result, some hotel owners in desperate need of operators have started accepting management contracts. While hotel owners with other thriving businesses are still able to maintain a wait-and-see attitude regarding their empty hotels, the trend of shifting toward management contracts seems inevitable and should accelerate if the pandemic persists and hotel owners run out of options. Some costs, such as FF&E will more likely be incurred by hotel owners rather than operators going forward, adding greater financial stress on the former.

This shift in the operating structure could create opportunities for experienced hotel investors who are willing to take more operational risk and feel comfortable with management contracts. These investors may also be able to find risk-averse owners and take their properties off their hands with some discount. Smaller owners with only a few hotels may be more willing to exit rather than opting for management contracts because they cannot mitigate increased operational risk by diversification.

Read the full report here.