Hong Kong-based Odyssey Capital Group is shaking up Japan’s fragmented boutique hospitality sector one Ryokan at a time, as visitor numbers soar across the country.
Government-led reforms, the Tokyo 2020 Olympics and other major events are energising Japan’s tourism market, as the government aims for 40m inbound visits by 2020.
“Japan is experiencing an unprecedented growth rate in tourism, both domestic and international, mainly due to structural issues and structural demand drivers,” said Odyssey co-founder and president Daniel Vovil told APAC Real Estate.
Japan’s positive tourism story has attracted many hotel investors to the country over the years, however Vovil and his team have taken a slightly different path to most.
Shousenkaku Kagetsu (source: Odyssey Capital)
Odyssey launched its Japan Boutique Hospitality fund in June last year and expects to raise between US$300m and US$500m in equity, giving the strategy with about US$1bn in investment firepower.
“There is an undersupply of beds for this increased inbound tourism, in fact there is a deficit of rooms in places like Osaka and regional areas,” Vovil said.
“Then there is an ever greater shortage in boutique luxury, which has the largest demand and the most limited supply, especially in secondary cities.”
Japan’s tourism story
In 2016, Japanese Prime Minister Shinzō Abe laid out ambitious plans to double the number of foreign visitors coming into Japan by 2020 to breathe life into the country’s weakening economy.
The Abe government has relaxed visa requirements for China and other Asian countries since 2012, sparking an explosion in tourism largely driven by Chinese visitors.
International arrivals to Japan have grown from less than 10m in 2010 to more than 30m in 2018, according to the Japan National Tourism Organisation. And Japanese authorities have a longer term goal of reaching 60m inbound visitors by 2030.
Vovil said the government had allowed low-cost carriers into major and regional airports in a bid to make inbound tourism easier and more affordable.
Japan is going all-in on casinos too after the government passed laws last year to grant casino licences for the first time, with ambitions to become a major gaming market.
In addition to the government reforms, the country is hosting major events like the Rugby World Cup this year, the 2020 summer Olympic games and the Osaka-Kansai World Expo in 2025.
In turn, the surge in tourism has precipitated a wave of new hotel supply that has some hoteliers concerned.
According to CBRE, the forecast number of hotel rooms opening in the nine major cities across Japan between 2019 and 2021 has risen 2.5 times during the year to June 2019, from around 30,000 to 80,000.
Kyoto has had the highest ratio of new rooms to existing stock at 51%, followed by Osaka at 32%, and Tokyo at 24%.
That said, boutique hospitality in Japan could stand to benefit, as most of the new supply coming online in places like Tokyo and Osaka will be made up of limited-service hotels.
According to Savills, the average daily rates (ADRs) of limited-service hotels were likely to stay flattish.
“Upscale hotels, with very limited supply pipeline, are expected to perform better, supported by strong demand from inbound customers who are willing to pay a premium for higher-quality accommodation,” the Savills research team said in a note earlier this year.
Boutique broken down
“Boutique luxury is a very tight market – out of all the supply coming on between now and the Olympics, 85 percent of it is in the limited service and business hotel market,” Vovil said.
“But we’ve identified three strategies within boutique luxury that we’re focusing our value-add investment proposition: Ryokans, converting historical buildings into luxury accommodation and boutique hotels.”
Ryokans are traditional Japanese inns, where you wear might a customary yukata garment in its tatami-matted rooms and enjoy hot spring baths.
These bed and breakfast-style properties are typically family-run – something that Odyssey sees as an advantage for them.
Vovil said many ryokans were undermanaged, run by husband and wife teams who were approaching retirement and looking for an exit.
He noted many properties in the largely fragmented ryokan market are undervalued, meaning Odyssey had been able to get a minimum of an 8 per cent net cash flow yield on some of those assets and further drive yields to as much as 15%.
The co-founder said the ryokan strategy focused on improving marketing strategy, operations and management, as well as some basic renovations and improvements.
In August 2018, the team acquired its first ryokan, Shousenkaku Kagetsu, in Niigata, which is a short haul from Tokyo via shinkansen high-speed train.
The second part of the investment strategy focuses on converting historic buildings into luxury accommodation.
A case in point is the fund’s US$20m acquisition of a street of 24 machiya or period shop houses in Kyoto, with plans of an integrated urban resort with a Michelin 3-star restaurant.
Then there is Project Mori, which is a historical building constructed in 1938 that is getting converted into a 90-room luxury boutique hotel in Kitakyuushu.
Odyssey is also acquiring boutique hotels, which offer larger rooms and combine modern and traditional architecture.
The strategy purchased Hotel Owan, renamed Hotel Owan Hanam, in Kyoto in October last year and shortly raised the ADRs, which the team believed were undervalued.
As Vovil explained, the majority of Asian visitors coming into Japan travelled with families or groups and required larger room sizes and greater in-room amenity than the average boxy hotel room.
The overall strategy has acquired five projects so far, with another 10 projects ready to be acquired by the end of the capital raise final close.
Bringing boutique to investors
The boutique hospitality strategy has proven to be a hit with investors, particularly Asian investors.
The strategy is targeting a levered IRR of more than 15%, which includes an 8% preferred dividend paid half-yearly.
“Originally when we launched, our target were high-net-worth (HNW) investors and we thought we would raise US$100m,” Odyssey’s Vovil said.
“However, we received a lot of interest from institutions, which were very interested in a differentiated deal flow-type strategy that was cash flow based.”
He said the strategy had received strong interest from a range of investors, including a major Korean institution, Singaporean insurers, Asian family offices and HNW investors.
The strategy also appealed to a few large private equity real estate funds, however they were more interested in portfolio opportunities due to the small ticket sizes of ryokans and other assets.
The fund has focused on mid-sized hospitality real estate assets, meaning most deals are valued between US$5m and US$50m.
And in terms of an exit, the Odyssey team and its investors may IPO the fund; sell the portfolio to a suitable buyer like a PE real estate fund; or sell off the assets individually.
To be sure, investing in Japan’s hotel market faces risks such as a potential oversupply in rooms, frequent natural disasters and the spectre of currency depreciation.
Real estate investors are also treading in unfamiliar territory, as extended late cycle conditions persist for property globally.
Yet hotel investment in Japan surged during the first half of 2019 following a sluggish performance in 2018.
Japanese hotel deals rose 10% year-on-year to 195bn yen during the first half of this year, according to Real Capital Analytics.
Transactions such as Japan Hotel REIT’s 64.2bn (US$561m) acquisition of the Hilton Tokyo Odaiba in January this year shows just how tight the market is, paying an appraisal direct cap rate of 3.9%, according to Savills.
The same can be said for Sekisui House REIT, which purchased a 40% stake in the Ritz-Carlton Kyoto for 17.8bn yen at a 3.3% cap rate.
With low cap rates and limited investment stock around, hotel investors are feeling the pressure.
“[We have] about 40 people on the ground in Japan, made up of members of their advisory board, asset managers and execution team, and we would have not been able to gain access to our transactions without them,” he said.
“Often, we’re dealing with bank portfolios, government assets or vendors who you need a relationship with before they will start communicating with you, so bringing all of these parties together and execute has been the secret weapon of our fund.”