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Love hotel fund gets started: first specialist pink RE fund for Japan
By John Dodd
January 26, 2005
Although a taboo subject, many of Japan's 20+ million couples have experienced
the pleasures of one of Japan's estimated 17,000 love hotels at some time or
other. Whether a loss of innocence with a teenage sweetheart at the trendy
Maruyama-cho district in Shibuya, or a furtive illicit liaison at a hotel
cluster near a Tomei Freeway off-ramp, love hotels are an intimate part of the
nation's culture.
Unfortunatyely for future generations, the love hotel business is in trouble.
Due to over-expansion during the bubble of the late 80's and early 90's, a time
when rooms cost up to $1 million each to build and furbish, a number of
industry leaders and small chain operators are now in serious financial
distress. It seems that the only way out for many of these companies is either
substantial restructuring, or closure and sale of their assets. The problem is,
because of the unsalubrious nature of the asset class, few conventional
Japanese REITs are brave enough to make the necessary investment--and so the
original lender banks remain on the hook and the debts continue to fester.
Even the more adventurous foreign REITs have stayed away from pink real estate,
despite the strong returns. This is partly out of deference to their Japanese
institutional investors who feel uncomfortable with the industry, and partly
because many foreign institutional investors have rules forbidding such
adventures. As a result, there are only three to four foreign investment funds
dabbling in love hotel properties as a profitable side business--and you won't
find any of them in the press.
This situation changed in April (2004), however, when three enterprising
foreign partners launched Japan's first foreign love hotel specialist
investment fund, announcing that they had successfully raised $10 million from
European institutional and private investors. The new fund is MHS Capital
Partners, and the successful raising of cash probably signals the beginning of
a new era for love hotel investment. Indeed, just as the consumer credit
industry bore a stigma until legitimized by some enterprising foreign firms,
MHS sees the love hotel industry undergoing a similar transformation.
The Opportunity
Industry statistics about the love hotel industry are hard to come by - not
surprisingly, given that neither the Tokyo Stock Exchange nor any other
exchange in the land will allow the likes of Aine, a Shizuoka-based network of
150 hotels, and Kato Pleasure Group, an Osaka network of 50 hotels, to list.
It's not a profit issue holding the exchanges back. MHS estimates that the
average love hotel enjoys 78.8 stays per room per month (that's right, about
2.6 couples per night, every day of the month!), and has average sales of
[yen]530,323 ($4,821) per room per month, or roughly 6,614 yen ($60) per
couple--enough to give APA hotel a run for its money. MHS reckons that after
all costs, operators are able to pull down an EBIT (earnings before income tax)
of 270,000 yen ($245.45) per room per month, or a return of anything up to 45%,
valued on today's property valuations.
Unfortunately, with no where to get capital for their operations, many of these
companies are being sunk by their humungous property debts, and dissolving the
companies appears the only way to return the industry back to health. MHS's
plan is to buy distressed hotel properties in the range of $2~3 million each,
and refurbish them to give them a new lease of life.
In probably what has to be one of the most fascinating jobs in Japan right now,
the three-man team is analyzing available properties and hopes to close on its
first deal by June 2004. Their abilities are significantly boosted by the
talents and experience of founding partner Miro Mijatovic, an Australian lawyer
whose background of four years of legal, tax, and financial services to
Tokyo-based love hotel operators has earned him "insider" status in this very
closed industry. The remainder of the team consists of operations specialist
Kiwi Hamish Ross, a long-term resident of Tokyo with deep banking and
commercial experience, and American Scott Delaney, a global finance expert with
the investor relationships.
As partner Hamish Ross says, "This is not an industry where you can go out and
buy a list of real estate available for sale. By the time the public knows of a
property becoming available, it's been well and truly picked over." Instead the
MHS team uses their focus on love hotel clusters around freeway offramps to go
Upfront and negotiate directly with operators--many of whom are also
owners--they feel could be under financial pressure. The strategy is paying
off.
MHS Capital Partners overall mission appears to be serving as a catalyst in
what they hope will become a burgeoning, but niche, sector of the Japanese real
estate investment scene. Using their numbers, according to which 30% of
operators are in financial trouble, then we can assume the sector size is about
6,000 love hotels with an average value of [yen]200-300 million ($1.81-2.72
million) each, or a total asset value of about [yen]1.09-1.63 trillion ($12-18
billion).
Business Model
The MHS business model is a simple but seemingly lucrative one, especially when
one compares the anticipated quarterly 15% operating ROI being offered to
investors, against the 8% or less ROI being offered by ordinary commercial
REITs. The fund intends to acquire three distressed hotels this year, and after
acquisition, focus on both operating the businesses and looking for ways to
appreciate the capital value of the properties. The operations improvement will
be by strategic alliances with friendly operators, while the capital gains are
expected from the Japanese economy's return to health.
MHS expects that with both sources of income combined, investors could be
enjoying yields of up to 25% over the full 5-year term of the fund. MHS also
notes that a strong contributor to the likelihood of improved property values
is that of increasingly restrictive building codes, limiting the number of new
establishments--thus driving up the demand for existing sites.
Although a number of love hotel operators are in trouble, Ross assures us that
the industry as a whole is still doing fine. According to Leisure Hotel
("leisure" here being a polite word for "love"), the only magazine covering the
industry, love hotels are Japan's highest tax-paying industry, forking out even
more than pachinko parlors. Furthermore, with the introduction of such
innovations as in-room karaoke, pool tables, video games, etc., the demand for
love hotels among the key audience of 18- to 25-year-olds is increasing.
Traditionally, this sexually active group has used the hotels as a means of
escaping parents and siblings while learning the arts of amour. And they show
no signs of slowing down ...
But this age group is also very discerning and spurns old facilities in favor
of those being continually refurbished. This is tough on the groups whose cash
is locked up in bank interest repayments, and thus worsens the gap between the
financially sound and those who were overexposed. A key MHS strategy will be to
buy the out-of-favor hotels and quickly refurbish and upgrade these
properties--which at today's rates can be done for just 20% of what it cost 10
to 15 years ago. The MHS target will be establishments with 25 to 40 rooms, a
size that they say is both manageable and marketable.
Tanaka-san, Was That You I Saw?
Ever interested in social trends, we did ask Ross about the likely demographic
of love hotel users. Initially he gave us the tactful response that no one
really knows--not least because customers don't want to meet the manager and
staff, and so everything is highly automated. Even the garages have noren, the
neck-high curtains that block the view of outsiders as patrons get out cars.
But when pressed, he admitted it is common knowledge that remote hotels near
highway offramps have a high level of patronage by cheating couples,
particularly office managers and their subordinates. Thus investors can relax
knowing that human nature is proven to be remarkably consistent around the
world ... And the old adage, "if you don't use it, you lose it", is well
understood in Japan!
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