JAPAN: An Introduction to Real Estate – Bengoshi

Trends in the Real Estate Market in Japan – Hotels and Data Centres

In the Japanese real estate market, two trends are drawing significant attention: a spike in hotel acquisitions and the rise of data centres.

Recent trends in the hotel market

The travel sector in Japan has recovered and is now exceeding pre-pandemic levels. According to the statistical data on overnight guests published by the Japan Tourism Agency, the total number of overnight guests in June 2024 was 50.36 million (up 9.9% from the same month in 2019 and up 6.3% from the same month in 2023). Of these, 13.47 million were foreign travellers (up 40.5% from the same month in 2019 and up 40.7% from the same month in 2023).

The industry faces serious challenges with labour shortages – a legacy of low occupancy rates during the pandemic. However, against the backdrop of a weak yen in Japan and low interest rates compared to other jurisdictions, the hotel market continues to attract strong interest from foreign investors. This interest is further bolstered by the trend of rising inflation, which is stimulating investments in inflation-resistant real estate, such as residential, hotel and retail properties.

The separation of hotel ownership and operation has recently been increasing in Japan. Traditionally, Japanese hotel companies owned the hotel assets (including the land and building) and operated the hotels on their own, but this has been an impediment to growth because of the difficulty of making flexible capital investments.

Due to the pandemic, an increasing number of companies, led by certain traditional railway companies, have adopted an asset-light strategy that separates hotel asset ownership from hotel operations, and there have been several large-scale transactions where hotel assets have been sold to foreign real estate funds, while hotel operations have been carried out by a separate entity which may or may not have been sold to, or appointed by, the purchaser of the assets – this includes cases where the existing hotel operator is maintained for the hotel.

There is also an interest in acquiring hotel operators, often within the same transaction as the hotel asset sale but through different channels in the acquisition structure. There are benefits to separating asset holding and operation, so direct ownership or trust beneficial interests of real property are sold in a real estate acquisition, while operations are sold through a share acquisition of the hotel operator. This two-pronged acquisition involves more experts and consultants than pure asset sales or pure M&A.

There has also been an increase in hotel development and redevelopment, as hotel purchasers have pivoted from focusing on occupancy rates to ADR (the average daily rate or average revenue per room). This is reflected in large-scale renovations undertaken by many high-end hotels to improve ADR, and the increased development of new luxury hotels, with major global operators opening new high-priced brands in major cities such as Tokyo and Kyoto, as well as in resort destinations such as Niseko (Hokkaido) and Okinawa.

Data centres in Japan

Key drivers and challenges

The exponential growth in digitalisation has spurred demand for data centres which, in turn, has catalysed a surge in new data centre construction and investment projects in Japan by major domestic real estate developers and new foreign data centre operators.

Japan recognises this market expansion and includes data centres as a key component of the national strategy, with the goal of transforming Japan into Asia’s largest data centre hub. The development of data centres, particularly in rural areas, is being actively encouraged, and subsidies are being enhanced to back these development efforts. The fundamental policy, released in 2022, is to follow an ambitious aim to establish a dozen or more regional data centre locations across Japan within five years. This initiative has a dual purpose  – to decentralise data centres to rural areas, and to manage the swift augmentation of digital needs and data traffic. This will support the increasing demands of AI data centres.

There are environmental concerns tied to data centres, given their substantial energy consumption. Data centre operators and owners are expected to render green data centre services, not only for the decarbonisation targets of the owners and their investors, but also for the environment, social and governance (ESG) management of their clients. Undertaking energy-saving and environmentally friendly initiatives also helps boost profitability amid rising electricity prices.

To tackle the substantial energy consumption of large data centres, it will be crucial to meet ESG challenges through various strategies, such as onsite/off-site power purchase agreements and procuring environmental value.

Japan’s Rationalisation of Energy Use Law was recently revised to include the data centre industry in the benchmark system. As a result, companies must regularly report their power usage effectiveness as a benchmark indicator.

Development and operation

Due to the increase in construction costs and the intensification of competition within the construction contracting industry, unique arrangements are becoming necessary in construction projects. For other types of real estate, it is common for general contractors to handle the entire development of the property. However, for data centres, it is becoming increasingly common to limit the scope of work of the general contractor to core and shell construction, while specialised contractors handle the mechanical, electrical and plumbing work. In such cases, the parties need to consider contractual provisions on the construction periods of the two work scopes, interface risks, and remedies for defects discovered.

Regarding licensing, the need for licences under the Telecommunications Business Act depends on the extent of the property owner’s involvement in the development and operation of the data centre. Typically, if the property owner only leases real estate with major facilities, such as power supply equipment, to a data centre operator, there is no need for a licence under the Telecommunications Business Act. Conversely, if the property owner offers operational services – such as, providing functions that enable communication with third parties, or that enable individuals to send and receive email via a server – they may be classified as a “telecommunications carrier”, which is a licensed entity.

As with other real estate investments in Japan, funds investing in data centres often adopt fund structures known as TMK and GK-TK. However, unlike other real estate investments, fund structures vary based on factors such as customers, the services provided by the operator or owner, and licence requirements. A thorough review of the fund structure is also required to account for the tax implications of the investments.

Finally, risk analysis is a vital component for the success of a data centre business in Japan. There are numerous issues, including legal and tax concerns, licensing, ESG considerations, securing customers and power, disputes, construction risks, and potential increases in construction and utility costs. Considering that the data centre business is a relatively new venture in Japan, many players are assessing how to address various project-specific issues. The type of debt financing, for instance, can vary depending on the project, with some data centre debt financing being conducted through project finance, as opposed to pure real estate financing, or real estate financing that incorporates elements of project finance.