Japan’s hotel industry has been an illusive target for international investors with just a fraction of the lodging inventory today flying the banner of foreign brands. Indeed, Japan has not historically invited global investment in its own economy. Now, however, the winds of change may bring opportunity to hotel investors with Japanese initiatives to reform and globalize the country’s financial system - commonly referred to as the country’s “Financial Big Bang.”

To set these events in perspective, we look first to history. In the last 50 years, Japanese investors and bankers believed firmly that real estate values would always rise, making property, including hotels, one of the safest ways to invest. In turn, banks lent aggressively to companies investing in hotels, sometimes up to the total amount of the project, including land. This practice frequently created the potential for over-leveraged, high-risk development, particularly in areas where assumptions of continuous increases in real estate values proved invalid in recent years. 

Indeed, many real estate markets stagnated, values dropped and lending institutions racked up large portfolios of distressed assets. The hard assets in Japan’s hotel industry have been under-performing, and inflation in property values can no longer be counted on to put a property in the black. Under pressure to manage hotel assets, key questions are being posed. What types of strategies and investments are required to promote recovery in Japan’s hotel market? What steps must be taken to reinvigorate Japan’s real estate market? 

The parent companies of hotels are finally looking at whether they should buy, sell, hold or reposition properties. Yet significant barriers to international investment exist. Japan’s financial system, business culture and belief in the intrinsic value of real estate are dramatically different than in the West. Hotel buyers and sellers remain widely separated in part because of important differences in how properties are valued. And there is a general consensus in the United States that Japan’s real estate markets have not yet hit bottom.  This notwithstanding, recent improvements in the Japanese yen against the U.S. dollar and in the public stock markets, makes some economists believe that the Japanese economy overall is poised for a turnaround. 

As to the hotel industry, this period of transition in Japan’s hotel industry may open the door to international hotel investors and operators. Lower interest rates and access to debt in Japan add to the attractiveness of investments. And simplification of the bankruptcy law in Japan will make it easier for investors to buy out assets. Passage was anticipated for late 1999, although the bill is still in preparation for discussion and vote in the Diet. Additional laws designed to encourage liquidation of distressed assets are also in ample discussion and with their potential implementation, some facilitation of what has historically been a difficult process may be seen.

This special report on Japan’s hotel industry speaks to how the industry has been structured, the condition of lodging markets and what can be expected as a new transaction market in Japan’s hotel industry begins to emerge.

Domestic Travel Dominates

Japan is unique among Asian tourism markets in that its tourism sector depends primarily on domestic rather than international demand. Nevertheless, in 1998, foreign visitor arrivals reached 4.11 million of which 2.4 million were leisure travelers, while 1.7 million were traveling on business. This means that only a fraction of potential foreign guests visit Japan. By contrast, much larger numbers of the Japanese people - more than 10 percent of the population - travel overseas every year. 

Of foreign visitors, Asian countries account for the lion’s share with 54.5% of the total. An additional 19.2% come from North America, while 21.1% are accounted by travelers in Europe, while much of the remainder come from South America, Australia and New Zealand. Foreign visitors overwhelmingly visited three cities in Japan, led by Tokyo. Of the total, fully 62% visited Japan’s capital city, while 22% visited Osaka and 16% went to Kyoto.

The lack of foreign incoming tourism in the past has been largely due to the high costs of travel within Japan.  Historically, Japan has been perceived as a high-cost destination for foreign travelers. This has been supported by media reports, which have often cited extremely high prices in Tokyo for meals and the like. 

Who Owns Japan’s Hotels? 

The history and structure of Japan’s hotel industry differs markedly from lodging companies in other parts of the world.  In Japan any hotel for commercial or public use is under the control of the Ministry of Health (MOH), and the facilities are subject to the ministry’s approval under the commercial lodging facility law, including standards for room size to serve Western visitors. In addition, Japan’s Ministry of Transportation (MOT) sets separate standards for tourism promotion, including rules for “satisfactory circumstance for tourists,” clearing the minimum rooms space of more than 13 square meters for Western type of accommodations. 
 

While Japan’s hotel industry has been maturing for well over a century, it is in the last 30 years that the country has experienced a rapid expansion of hotel supply. Large corporations in other industries moved aggressively into the hotel business by taking advantage of abundant debt financing. In turn, these companies typically viewed hotel investments as a way to produce a cash flow to support expansion of the parent business, as well as to confer prestige as a corporate symbol or representation of the parent company’s image. Most of Japan’s hotel companies, as a result, are under the umbrella of large corporations or corporate groups.

Railway companies and developers dominate ownership in Japan’s hotel industry. (Figures l and 2: Hotel Distribution and Room Supply by Type of Owner/Operator) Railroads have rushed into hotel investment since the 1960s to showcase their land-mark buildings and flags at terminal stations, expecting a business synergy in gearing up their housing and commercial development along with railway lines. Seibu Railway, for example, owns the Prince hotel chain, while Tokyu and Kintetus own the Tokyu and Miyako hotel chains. This is not surprising given the central role that the railways have played in the country. In contrast to a country like the United States where motels and other accommodations serving motorists have evolved, Japan’s transportation system is very much focused around train service. Japanese travelers can reach almost any part of the country within a day by rail. 

Real estate and construction companies are also major players in the hotel industry as they have seized opportunities to expand their businesses and showcase construction innovation and quality. However, these entities have not promulgated the development of chain operations as they might have in other environments elsewhere in the world. And while most international airlines outside of Japan have moved on from their earlier parentage of hotel company subsidiaries (Air France, Pan Am, American Airlines and United Airlines, to name a few), the major airline companies in Japan have retained and expanded hotel company subsidiaries.  Japan Airlines, for example, owns Nikko Hotels, while ANA airlines owns ANA Hotels. The airlines’ presence, while modest in the context of the total hotel rooms supply, gives them strategic locations in Japan’s major gateway cities from north to south. 

According to the MOH, by 1998 the number of hotels and Ryokan in Japan had grown to 76,751 properties with a total of some 1,564,792 rooms of which hotels amount to 7,769 properties with 582,564 rooms only. The hotel rooms registered with MOT amounted to 1,041 properties with 187,558 rooms in 1998. 

Hotel Brands - Domestic and International 

While large numbers of Japan’s hotel properties have been targeted toward Japanese guests, many accommodations have been designed in a Western style. The industry has provided the Japanese public with a Western style living environment, as a result. 

There are, however, no official standards classifying hotels in Japan. As a result, Japanese hotel owner/operator companies have not clearly distinguished developments by brands, grades or characteristics of products. For example, Prince Hotel Chain owns and operates first-class facilities. At the same time, it also owns and operates many mid-market, limited-service facilities and resorts with the
same hotel brand. Similar lack of distinctions can also be seen in the resort segment. 

Using Arthur Andersen benchmarking data, we have analyzed the distribution of rooms supply by segments in four hotel categories: Deluxe, First Class, Economy/Budget and Resort. Of the total database (204,914 rooms), almost 54% are in the Economy/Budget category. (Figure 3: Japanese Hotel Rooms Supply by Segments of Hotel Categories)

Because most hotels are owned by large corporations in other industries, few Japanese hotel brands are associated with “pure” hotel companies. The railways, airlines, developers and construction firms that own and operate hotels generally own their brands and do not contract out to professional hotel companies. Owners of first class hotels such as Imperial, Okura, New Otani and Palace are the exception, functioning more closely to the management company model seen in the United States.

Meanwhile, the presence of international hotel brands in Japan’s hotel markets has remained low for many reasons. 
 

Our analysis shows that the top 10 Japanese brands have 447 properties offering 103,073 rooms (Figure 4: Top 10 Local Branded Hotels). International hotel brands represented in Japan, inclusive of those with management contract, franchising, and other affiliation include 51 properties with just 18,789 rooms. (Figure 5: Presence of International Hotel Brands) International brands thus represent, based on the MOH statistic, 0.66% of the hotels and 3.2% of the rooms in Japan. 
 

Japan’s Hotel Segments
 

Japan’s domestic hotel segments fall into several, general categories to accommodate leisure and business travelers, as well as community needs. Note, however, that the Japanese hotel industry includes few long-stay facilities. Demand for these accommodations is low due to the fact that Japanese workers do not have long paid holidays. Travel, as a result, is restricted to shorter periods, and most places in Japan can be reached within a day’s journey.  Our benchmarking figures show how rooms are divided among Deluxe, First Class, Economy/Budget and Resort.

Here, however, we look at how Japan’s domestic hotel segments have evolved in the last few decades.
 
 

The Challenge of Reform and Restructuring

Large-scale investments by Japanese corporations drove rapid expansion of the country’s hotel industry during the last 30 years. The motivations for such investment were often not economic, but rather related to such factors as a company’s desire for a high-profile corporate symbol or faith in the intrinsic value of property. Many owners did not focus on the hotel business as their core business. 

Now it is clear that innovative restructuring of the hotel industry is essential. There is less consensus, however, about what changes are required on the road back to health. We can summarize these challenges in the following points: Oversupply of hotel facilities with implementations of:

• poor and not matured hotel investment and project development techniques; and 
• lack of clear definitions of the responsibilities and relations among owner-investor-developer and operator. 

Poor social recognition that hotel industry is a specific business and industry area. Innovative restructuring is necessary for many properties. And such restructuring often comes down to two basic strategies in the hotel business. One is reducing costs of operations. The other strategy involves gaining a better differentiation of the product. In the case of the Japanese hotel industry, both areas require attention. Cost reductions, of course, require hard choices. And personnel costs are among the most significant areas to manage in a hotel operation. To what extent hotel operators can reduce personnel costs is one of the most critical issues, particularly given the traditions of lifetime employment in Japan. 

Reducing personnel costs, for example, could be promoted by employing part-time staff. But this will not work unless there is a way to effectively train these employees. Currently, hotel employees are trained in one area of specialty. Training staff to be multi-functional would offer a way to significantly reduce personnel costs and improve quality. With that in mind, transfer of knowledge must also be addressed. In addition to person-to-person training, there is a need to develop training manuals and documents that would allow hotels to standardize operations across all properties and pass on knowledge to new staff systematically.

In addition, the industry also needs to develop new purposes for hotels. Community and city hotels would benefit by being repositioned as places for interchange and events - above and beyond the occasional or once-in-a-lifetime event like weddings. Currently, these event costs are high and the demand is restricted, as a result. However, there may be significant opportunity for hotels to grow if these costs are reduced. Few hotels, however, are looking for ways to promote their business at a lower cost.

Will a Hotel Transaction Market Emerge?

We believe that pressure to manage under-performing hotel assets portends change for Japan’s hotel industry and opportunity for real estate investors and hotel operators. However, there are significant
hurdles to overcome in developing a transaction market for hotel properties. Indeed, such a market is embryonic at best in today’s Japan when it comes to transactions between Japanese sellers and foreign investors.

Few such transactions have taken place. But there are signs of change. And Japan offers highly attractive potential for international investors. It is, for example, one of the few countries where financial institutions will provide debt to finance hotel deals. 

Transactions are already taking place in Japan’s lodging industry between Japanese companies. Some hotel owners, for example, are seeking to expand an existing business by buying properties. In addition, we also see several cases of foreign investors who have expressed interest, if not intention to purchase Japanese hotel properties. Clearly, international hotel operators have been interested in gaining a
presence in the world’s second largest economy. Some international chains want to establish or strengthen brand presence in Japan so that out-bound Japanese travelers will book rooms in their overseas
locations. In addition, international investors have been seeking investment opportunities to realize solid gains or upside as properties are repositioned and Japan’s economy turns around. For any kind of investor, the potential to invest in under-performing assets is an intrinsic opportunity to invest new money.
What stands in the way of foreign investment in Japan’s hotel industry as the industry looks for paths to recovery? The approach to property valuation is one of the biggest hurdles. On the vendor side, Japanese hotel owners and operators typically use a cost approach to valuation based upon the amount they have invested in a property. On the buy side, foreign investors in particular are looking for cash flow. Their due diligence focuses on internal rates of returns, discounted cash flow and current yields. 

The income approach to valuation, however, is a new concept in Japan, where transactions have historically been priced based on cost and comparable sales approaches for decades. Indeed, it has only been in recent years that Japanese organizations have considered an income valuation approach. Japanese investors and owners have historically believed that there was a certain “intrinsic” value in land and buildings and continued appreciation in such value was inevitable. Thus even a poorly performing property could be expected to be in the black after a few years by virtue of property appreciation alone. This reliance on real estate value appreciation has thus frequently compensated for otherwise poor results at the operating profit level. 

Creating a further hurdle to transactions are varying standards for accounting and operations. Buyers want to have information based on international standards—a uniform system of accounts. Traditional accounting systems in Japan, however, do not make financial information about the hotel operation easily accessible, and there is a lack of transparency in financial statements. Even the definition of “Average Daily Rate” differs, depending on the hotel. 

In addition, there are few established professional management companies in Japan. As a result, it is difficult to rely on cash flow numbers that hotel companies present. International investors wonder how they can evaluate the last three years’ cash flow, when there is so much uncertainty about results in the next year with the new management.

Nor do hotel properties even in the same chain necessarily share similar procedures or ways of operating.  Manuals documenting operational processes and standards are almost non-existent. And issues relating to the operational aspects of the business are often deferred until after a deal is closed.

In the meantime, buyers have been taking a wait-and-see stance, given a wide gap between “bid and ask” prices. This stalemate is unlikely to break unless, for example, value opportunities are unlocked as a result of repositioning and rebranding opportunities that might exist. What occurred in the United States in the recession of the early 1990s may be instructive. Investors ignored hotel transactions until the capital structure of these properties changed. As financial institutions were forced to foreclose on under-performing hotels, loans were “written down.” These lower prices attracted buyers. And as demand accelerated for hotel properties, prices rose again to the benefit of the U.S. hotel industry and its long-term health.

Hurdles and Opportunities

Going forward, key issues will dominate Japan’s hotel industry as international investors seek to gain a foothold: 
 

Conclusion

As has been suggested in the above survey of Japan’s hotel industry, there are a number of challenges that hospitality companies will need to address if they are to capitalize on the many opportunities that lie ahead in the next millennium. And, unfortunately, there will be no short cuts to resolution of most of these challenges.  They will require fresh approaches and dedication to not only the strategic issues involved, but also the people, process and technology issues that must support the way forward organizationally.

Some of the initiatives that Japan’s hospitality leadership may need to embrace include reengineering of organizations and processes, renovation, repositioning and rebranding of product and new approaches to the deployment of capital through mergers and acquisition, refinancing of assets and the development of strategic alliances. In the absence of some of these proactive approaches, change will inevitably be wrought by the consumer market place, on the one hand, and creditors to this industry, on the other. We are confident, however, that these challenges can be met and that Japan’s hotel industry will move to a position of strength in the next millennium. 

(Ryu Iwaya and Katsuhiro Goto are member firm Partners and Directors, Hospitality and Leisure Services, Global Management Directions Co. Ltd., a Global Corporate Finance Division of Arthur Andersen’s practice in Japan. They are based in Tokyo.)

©Arthur Andersen