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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

Commission File Number 000-53603

 

Apple REIT Nine, Inc.

(Exact name of registrant as specified in its charter)

 

 

(804) 344-8121

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o  No x

 

Number of registrant’s common shares outstanding as of May 1, 2010: 121,954,466

 

 

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APPLE REIT NINE, INC.
FORM 10-Q

INDEX

 

				Page Number
PART I. FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited)
		Consolidated Balance Sheets — March 31, 2010 and December 31, 2009		3
		Consolidated Statements of Operations - Three months ended March 31, 2010 and 2009		4
		Consolidated Statements of Cash Flows — Three months ended March 31, 2010 and 2009		5
		Notes to Consolidated Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		28
	Item 4.	Controls and Procedures		28
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings (not applicable)
	Item 1A.	Risk Factors (not applicable)
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		29
	Item 3.	Defaults Upon Senior Securities (not applicable)
	Item 4.	(Removed and Reserved)
	Item 5.	Other Information (not applicable)
	Item 6.	Exhibits		31
Signatures				33

 

This Form 10-Q includes references to certain trademarks or service marks.  The Hampton Inn®, Hampton Inn and Suites®, Homewood Suites® by Hilton, Embassy Suites Hotels® and Hilton Garden Inn® trademarks are the property of Hilton Worldwide or one or more of its affiliates.  The Courtyard® by Marriott, Fairfield Inn® by Marriott, Fairfield Inn and Suites® by Marriott, TownePlace Suites® by Marriott, SpringHill Suites® by Marriott, Residence Inn® by Marriott and Marriott® trademarks are the property of Marriott International, Inc. or one of its affiliates.  For convenience, the applicable trademark or service mark symbol has been omitted but will be deemed to be included wherever the above referenced terms are used.

 

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PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

 

Apple REIT Nine, Inc.

Consolidated Balance Sheets

(in thousands, except share data)

 

		March 31, 2010			December 31, 2009
		(unaudited)
Assets
Investment in real estate, net of accumulated depreciation of $23,911 and $18,213, respectively		$	774,470		$	687,509
Cash and cash equivalents		319,827			272,913
Due from third party managers, net		5,249			2,591
Other assets, net		22,082			19,500
Total Assets		$	1,121,628		$	982,513
Liabilities
Notes payable		$	58,367		$	58,688
Accounts payable and accrued expenses		3,232			6,420
Total Liabilities		61,599			65,108
Shareholders’ Equity
Preferred stock, authorized 30,000,000 shares; none issued and outstanding		—			—
Series A preferred stock, no par value, authorized 400,000,000 shares; issued and outstanding 114,848,474 and 98,509,650 shares, respectively		—			—
Series B convertible preferred stock, no par value, authorized 480,000 shares; issued and outstanding 480,000 shares, respectively		48			48
Common stock, no par value, authorized 400,000,000 shares; issued and outstanding 114,848,474 and 98,509,650 shares, respectively		1,130,369			968,710
Distributions greater than net income		(70,388		)	(51,353		)
Total Shareholders’ Equity		1,060,029			917,405
Total Liabilities and Shareholders’ Equity		$	1,121,628		$	982,513

 

See accompanying notes to consolidated financial statements.

 

The Company was initially capitalized on November 9, 2007 and commenced operations on July 31, 2008.

 

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Apple REIT Nine, Inc.

Consolidated Statements of Operations

(Unaudited)

(in thousands, except per share data)

 

		Three Months Ended March 31, 2010			Three Months Ended March 31, 2009
Revenues:
Room revenue		$	24,093		$	16,637
Other revenue		2,383			2,046
Total hotel revenue		26,476			18,683
Rental revenue		5,297			—
Total revenue		31,773			18,683
Expenses:
Operating expense		7,589			4,854
Hotel administrative expense		2,184			1,408
Sales and marketing		2,397			1,685
Utilities		1,395			868
Repair and maintenance		1,232			912
Franchise fees		1,004			788
Management fees		818			671
Taxes, insurance and other		2,130			1,345
General and administrative		1,310			839
Acquisition related costs		2,151			1,028
Depreciation expense		5,698			2,652
Total expenses		27,908			17,050
Operating income		3,865			1,633
Interest expense, net		(84		)	(83		)
Net income		$	3,781		$	1,550
Basic and diluted net income per common share		$	0.04		$	0.03
Weighted average common shares outstanding - basic and diluted		104,768			45,554
Distributions declared and paid per common share		$	0.22		$	0.22

 

See accompanying notes to consolidated financial statements.

 

The Company was initially capitalized on November 9, 2007 and commenced operations on July 31, 2008.

 

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Apple REIT Nine, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

 

		Three Months Ended March 31, 2010			Three Months Ended March 31, 2009
Cash flows from operating activities:
Net income		$	3,781		$	1,550
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation		5,698			2,652
Amortization of deferred financing costs, fair value adjustments and other non-cash expenses, net		27			81
Straight-line rental income		(1,465		)	—
Changes in operating assets and liabilities:
Increase in funds due from third party managers, net		(2,635		)	(1,503		)
(Increase) decrease in other assets, net		507			(386		)
Decrease in accounts payable and accrued expenses		(1,950		)	(190		)
Net cash provided by operating activities		3,963			2,204
Cash flows used in investing activities:
Cash paid for acquisitions, net		(88,409		)	(25,963		)
Deposits and other disbursements for potential acquisitions, net		(1,918		)	(153		)
Capital improvements		(5,391		)	(233		)
Decrease (increase) in capital improvement reserves		132			(100		)
Investment in other assets		—			(3,240		)
Net cash used in investing activities		(95,586		)	(29,689		)
Cash flows from financing activities:
Net proceeds related to issuance of common shares		162,845			118,135
Redemptions of common stock		(1,252		)	—
Distributions paid to common shareholders		(22,816		)	(9,889		)
Payments of notes payable		(240		)	(123		)
Deferred financing costs		—			(64		)
Net cash provided by financing activities		138,537			108,059
Increase in cash and cash equivalents		46,914			80,574
Cash and cash equivalents, beginning of period		272,913			75,193
Cash and cash equivalents, end of period		$	319,827		$	155,767
Non-cash transactions:
Notes payable assumed in acquisitions		$	—		$	4,175

 

See accompanying notes to consolidated financial statements.

 

The Company was initially capitalized on November 9, 2007 and commenced operations on July 31, 2008.

 

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Apple REIT Nine, Inc.

Notes to Consolidated Financial Statements

 

1.  Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with the rules and regulations for reporting on Form 10-Q.  Accordingly, they do not include all of the information required by accounting principles generally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  These unaudited financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in its 2009 Annual Report on Form 10-K.  Operating results for the three months ended March 31, 2010 are not necessarily indicative of the results that may be expected for the twelve month period ending December 31, 2010.

 

2.  General Information and Summary of Significant Accounting Policies

 

Organization

 

Apple REIT Nine, Inc. together with its wholly owned subsidiaries (the “Company”) is a Virginia corporation that has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes.  The Company was formed to invest in hotels, residential apartment communities and other income-producing real estate in selected metropolitan areas in the United States.  Initial capitalization occurred on November 9, 2007, when 10 Units, each Unit consisting of one common share and one Series A preferred share, were purchased by Apple Nine Advisors, Inc. (“A9A”) and 480,000 Series B convertible preferred shares were purchased by Glade M. Knight, the Company’s Chairman and Chief Executive Officer.  The Company began operations on July 31, 2008 when it purchased its first hotel.  The Company’s fiscal year end is December 31.  The Company has no foreign operations or assets and its operating structure includes two segments, hotels and a ground lease.  The consolidated financial statements include the accounts of the Company and its subsidiaries.  All intercompany accounts and transactions have been eliminated.

 

As of March 31, 2010, the Company owned 38 hotels (five purchased during the first quarter of 2010, 12 acquired in 2009 and 21 acquired during 2008).  The Company’s real estate portfolio also includes approximately 410 acres of land and improvements located on 111 sites in the Ft. Worth, Texas area (acquired in April 2009) that are being leased to a subsidiary of Chesapeake Energy Corporation (“Chesapeake”) for the production of natural gas.

 

Significant Accounting Policies

 

Use of Estimates

 

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

 

Other Assets

 

Included in other assets, net on the Company’s consolidated balance sheet is a 24% ownership interest in Apple Air Holding, LLC (“Apple Air”), purchased by the Company for $3.2 million in cash in January 2009.  The other members of Apple Air are Apple REIT Six, Inc., Apple REIT Seven, Inc. and Apple REIT Eight, Inc.  The interest was purchased to allow the Company access to two Lear jets for acquisition, asset management and renovation purposes.  The Company has recorded its share of income and losses of the entity under the equity method of accounting and adjusted its investment in Apple Air accordingly.  The Company’s ownership interest was approximately $2.7 million and $2.8 million at March 

 

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31, 2010 and December 31, 2009, respectively.  For the three months ended March 31, 2010 and 2009, the Company recorded a loss of approximately $110,000 and $100,000, respectively, as its share of the net loss of Apple Air, which primarily relates to the deprecation of the aircraft.  The loss is included in general and administrative expense in the Company’s consolidated statements of operations.

 

Offering Costs

 

The Company is raising capital through a best-efforts offering of its Units by David Lerner Associates, Inc., the managing underwriter, which receives a selling commission and a marketing expense allowance based on proceeds of the Units sold.  Additionally, the Company has incurred other offering costs including legal, accounting and reporting services.  These offering costs are recorded by the Company as a reduction of shareholders’ equity.  As of March 31, 2010, the Company had sold 115.2 million Units for gross proceeds of $1.3 billion and proceeds net of offering costs of $1.1 billion.  On April 15, 2010, the Company extended its best-efforts offering until April 25, 2011. As a result, the offering will continue until all Units have been sold or until April 25, 2011, whichever occurs sooner.

 

Rental Income

 

During April 2009, the Company entered into a ground lease with a subsidiary of Chesapeake, the second-largest independent producer of natural gas in the United States and guarantor of the lease.  The lease has an initial term of 40 years with five renewal options of five years each, exercisable by the tenant.  Rental payments are fixed and have determinable rent increases during the initial lease term and reset to market during the first year of the renewal period.  Rental payments are required to be made monthly in advance.  Under the lease, the tenant is responsible for all operating costs associated with the land including, maintenance, insurance, property taxes, environmental, zoning, permitting, etc. and the tenant is required to maintain the land in good condition.  The lease is classified as an operating lease and rental income is recognized on a straight line basis over the initial term of the lease.  Rental revenue includes $1.5 million of adjustments to record rent on the straight line basis for the three months ended March 31, 2010.  Straight line rental receivable is included in other assets, net in the Company’s consolidated balance sheet and totaled $6.1 million and $- as of March 31, 2010 and 2009.

 

Earnings Per Common Share

 

Basic earnings per common share is computed as net income divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is calculated after giving effect to all potential common shares that were dilutive and outstanding for the period.  There were no shares with a dilutive effect for the three months ended March 31, 2010 or 2009.  As a result, basic and dilutive outstanding shares were the same.  Series B convertible preferred shares are not included in earnings per common share calculations until such time that such shares are converted to common shares.

 

Recent Accounting Pronouncements

 

In June 2009, the Financial Accounting Standards Board (“FASB”) issued a pronouncement (Accounting Standards Update No. 2009-17) which amends its guidance surrounding a company’s analysis to determine whether any of its variable interests constitute controlling financial interests in a variable interest entity.  This analysis identifies the primary beneficiary of a variable interest entity as the enterprise that has both of the following characteristics:  (a) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.  Additionally, an enterprise is required to assess whether it has an implicit financial responsibility to ensure that a variable interest entity operates as designed when determining whether it has the power to direct the activities of the variable interest entity that most significantly impact the entity’s economic performance. The new pronouncement also requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity and enhanced disclosure about an enterprise’s involvement with a variable interest

 

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entity.  This pronouncement was adopted by the Company in the first quarter of 2010.  The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

 

3.  Real Estate Investments

 

Hotel Acquisitions

 

The Company acquired five hotels during the first three months of 2010.  The following table sets forth the location, brand, manager, gross purchase price, number of hotel rooms and date of purchase by the Company for each property.   All dollar amounts are in thousands.

 

Location

Brand

Manager

Gross Purchase Price

Rooms

Date of Purchase

Houston, TX

Marriott

Western

$

50,750

206

1/8/2010

Albany, GA

Fairfield Inn & Suites

LBA

7,920

87

1/14/2010

(a)

Panama City, FL

TownePlace Suites

LBA

10,640

103

1/19/2010

Clovis, CA

Homewood Suites

Dimension

12,435

83

2/2/2010

Jacksonville, NC

TownePlace Suites

LBA

9,200

86

2/16/2010

Total

$

90,945

565

 

(a)          Purchase contract includes a provision for an additional $500,000 to be paid to the seller if certain earnings targets are met over the 15 months subsequent to acquisition.

 

The purchase price for these properties was funded primarily by the Company’s on-going best-efforts offering of Units.  The Company also used the proceeds of its on-going best-efforts offering to pay approximately $2.2 million in acquisition related costs, including $1.8 million, representing 2% of the gross purchase price for these properties, as a brokerage commission to Apple Suites Realty Group, Inc. (“ASRG”), 100% owned by Glade M. Knight, the Company’s Chairman and Chief Executive Officer, and approximately $400,000 in other acquisition related costs, including title, legal and other related costs.  These costs are included in acquisition related costs in the Company’s consolidated statements of operations for the three months ended March 31, 2010.

 

The Company leases all of its hotels to its wholly-owned taxable REIT subsidiary (or a subsidiary thereof) under master hotel lease agreements.

 

No goodwill was recorded in connection with any of the acquisitions.

 

As of March 31, 2010, the Company owned 38 hotels, located in 15 states with an aggregate of 4,465 rooms and consisted of the following:  seven Hilton Garden Inn hotels, four Homewood Suites hotels, 11 Hampton Inn hotels, five Courtyard hotels, three Residence Inn hotels, two SpringHill Suites hotels, three Fairfield Inn hotels, two TownePlace Suites hotels and one full service Marriott hotel.  Additionally, the Company is in the process of constructing a SpringHill Suites hotel in Alexandria, Virginia which is expected to be completed over the next 12 months.  Upon completion, it is expected that the hotel will contain approximately 152 guest rooms and will be managed by Marriott.  To date the Company has incurred $2.5 million in construction costs and anticipates the total construction costs to be approximately $20-$25 million.

 

Land and Land Improvements

 

In February 2010, the Company agreed to sell back to Chesapeake two of the 113 sites originally purchased from Chesapeake in April 2009 and release Chesapeake from their associated lease obligation. The sales price for the two sites was equal to the Company’s original purchase price, approximately $2.6 million.  The Company earned and received rental income for the period held totaling approximately $240,000.

 

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As of March 31, 2010, the Company owned approximately 410 acres of land and land improvements located on 111 sites in the Ft. Worth, Texas area that are being leased to Chesapeake for the production of natural gas.  Chesapeake is a publicly held company that is traded on the New York Stock Exchange.  Chesapeake is the second-largest independent producer of natural gas in the United States with interests in approximately 38,000 net drill sites.

 

Total Real Estate Investments

 

At March 31, 2010, the Company’s investment in real estate consisted of the following (in thousands):

 

Land		$	123,636
Land Improvements		95,940
Building and Improvements		529,382
Furniture, Fixtures and Equipment		46,934
Construction in Progress		2,489
		798,381
Less Accumulated Depreciation		(23,911		)
Investment in real estate, net		$	774,470

 

As of March 31, 2010, the Company had outstanding contracts for the potential purchase of 14 additional hotels for a total purchase price of $254.1 million.  Of these 14 hotels, four are under construction and should be completed over the next 12 months.  The other 10 hotels are expected to close within the next six months.  Although the Company is working towards acquiring these hotels, there are many conditions to closing that have not yet been satisfied and there can be no assurance that closings will occur under the outstanding purchase contracts.  The following table summarizes the location, brand, number of rooms, refundable (if the seller does not meet its obligations under the contract) contract deposits paid, and gross purchase price for each of the contracts.  All dollar amounts are in thousands.

 

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Location		Brand		Rooms		Deposits Paid			Gross Purchase Price
Holly Springs, NC		Hampton Inn		124		$	100		$	14,880	(a)
Ft. Worth, TX		TownePlace Suites		140		500			18,460		(a)/(b)
Jacksonville, NC		Fairfield Inn & Suites		79		125			7,800
Santa Ana, CA		Courtyard		155		100			24,800		(a)
Miami, FL		Hampton Inn & Suites		121		150			11,900
Boise, ID		Hampton Inn & Suites		186		125			22,370
Rogers, AR		Hampton Inn		122		125			9,600
Rogers, AR		Homewood Suites		126		125			10,900
St. Louis, MO		Hampton Inn		190		125			23,000
St. Louis, MO		Hampton Inn & Suites		126		125			16,000
Kansas City, MO		Hampton Inn		122		125			10,130
Oklahoma City, OK		Hampton Inn & Suites		200		125			32,000
Anchorage, AK		Embassy Suites		169		50			42,000
Lafayette, LA		SpringHill Suites		103		3			10,232		(a)/(b)
				1,963		$	1,903		$	254,072

 

(a)          The hotels are currently under construction. The table shows the expected number of rooms upon hotel completion and the expected franchise.

(b)         If the seller meets all of the conditions to closing, the Company is obligated to specifically perform under the contract.  As the properties are under construction, at this time, the seller has not met all of the conditions to closing.

 

Four of the hotels under contract require the Company to assume approximately $49.5 million in mortgage debt.  Each of these loans provide for monthly payments of principal and interest on an amortized basis.

 

As there can be no assurance that all conditions to closing will be satisfied, the Company includes deposits paid for hotels under contract in other assets, net in the Company’s consolidated balance sheets, and in deposits and other disbursements for potential acquisitions in the Company’s consolidated statements of cash flows.  It is anticipated that the purchase price (less any debt assumed) for the outstanding contracts will be funded from the proceeds of the Company’s on-going best-efforts offering of Units and cash on hand if a closing occurs.

 

On October 14, 2009, the Company entered into a ground lease for approximately one acre of land located in downtown Richmond, Virginia.  The lease terminates on December 31, 2098, subject to the Company’s right to exercise two renewal periods of ten years each.  The Company intends to use the land to build two nationally recognized brand hotels.  Under the terms of the lease the Company has a “Study Period” to determine the viability of the hotels.  The Company can terminate the lease for any reason during the Study Period, which originally ended on April 14, 2010, and was extended for six months to October 14, 2010.  After the Study Period, the lease continues to be subject to various conditions, including but not limited to obtaining various permits, licenses, zoning variances and franchise approvals.  If any of these conditions are not met the Company has the right to terminate the lease at any time.  Rent payments are not required until the Company decides to begin construction on the hotels.  Annual rent under the lease is $300,000 with adjustments throughout the lease term based on the Consumer Price Index.  As there are many conditions to beginning construction on the hotels, there are no assurances that the Company will construct the hotels or continue the lease.

 

4.  Notes Payable

 

In conjunction with the acquisition of seven hotel properties, the Company assumed approximately $57.6 million in debt.  The following table summarizes the hotel location, interest rate, maturity date and

 

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the principal amount assumed associated with each note payable outstanding as of March 31, 2010 and December 31, 2009.  All dollar amounts are in thousands.

 

Location		Brand		Interest Rate (1)		Maturity Date		Principal Assumed			Outstanding balance as of March 31, 2010			Outstanding balance as of December 31, 2009
Lewisville, TX		Hilton Garden Inn		0.00	%	12/31/2016		$	3,750		$	3,750		$	3,750
Duncanville, TX		Hilton Garden Inn		5.88	%	5/11/2017		13,966			13,704			13,754
Allen, TX		Hilton Garden Inn		5.37	%	10/11/2015		10,787			10,538			10,585
Bristol, VA		Courtyard		6.59	%	8/1/2016		9,767			9,607			9,640
Round Rock, TX		Hampton Inn		5.95	%	5/1/2016		4,175			4,085			4,110
Austin, TX		Homewood Suites		5.99	%	3/1/2016		7,556			7,406			7,448
Austin, TX		Hampton Inn		5.95	%	3/1/2016		7,553			7,402			7,445
								$	57,554		$	56,492		$	56,732

 

(1)   At acquisition, the Company adjusted the interest rates on these loans to market rates and is amortizing the adjustments to interest expense over the life of the loan.

 

The Company estimates the fair value of its debt by discounting the future cash flows of each instrument at estimated market rates consistent with the maturity of the debt obligation with similar credit policies.  Market rates take into consideration general market conditions and maturity.  As of March 31, 2010, the carrying value and estimated fair value of the Company’s debt was $58.4 million and $54.3 million.  As of December 31, 2009, the carrying value and estimated fair value of the Company’s debt was $58.7 million and $56.7 million.  The carrying value of the Company’s other financial instruments approximates fair value due to the short-term nature of these financial instruments.

 

5.  Related Parties

 

The Company has significant transactions with related parties.  These transactions cannot be construed to be at arm’s length and the results of the Company’s operations may be different than if conducted with non-related parties.

 

The Company has a contract with ASRG, to acquire and dispose of real estate assets for the Company.  A fee of 2% of the gross purchase price or gross sale price in addition to certain reimbursable expenses is paid to ASRG for these services.  As of March 31, 2010, payments to ASRG for services under the terms of this contract have totaled approximately $15.3 million since inception.

 

The Company is party to an advisory agreement with A9A to provide management services to the Company.  An annual fee ranging from 0.1% to 0.25% of total equity proceeds received by the Company, in addition to certain reimbursable expenses, are payable for these services.  A9A has entered into an agreement with Apple REIT Six, Inc. (“AR6”) to provide certain management services to the Company.  The Company will reimburse A9A for the cost of the services provided by AR6.  A9A will in turn reimburse AR6.  Total advisory fees and reimbursable expenses incurred by the Company under the advisory agreement are included in general and administrative expenses and totaled approximately $810,000 and $460,000 for the three months ended March 31, 2010 and 2009.  Of this total expense, $287,000 and $124,000 were fees paid to A9A and $523,000 and $336,000 were expenses reimbursed by A9A to AR6 for the three months ended March 31, 2010 and 2009.

 

ASRG and A9A are 100% owned by Glade M. Knight, Chairman and Chief Executive Officer of the Company.

 

Mr. Knight is also Chairman and Chief Executive Officer of AR6, Apple REIT Seven, Inc. and

 

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Apple REIT Eight, Inc.  Members of the Company’s Board of Directors are also on the Board of Directors of AR6, Apple REIT Seven, Inc. and Apple REIT Eight, Inc.

 

6.  Shareholders’ Equity

 

The Company has a Unit Redemption Program to provide limited interim liquidity to its shareholders who have held their Units for at least one year.  Shareholders may request redemption of Units for a purchase price equal to 92% of the price paid per Unit if the Units have been owned for less than three years, or 100% of the price paid per Unit if the Units have been owned more than three years. The maximum number of Units that may be redeemed in any given year will be three percent of the weighted average number of Units outstanding during the 12-month period immediately prior to the date of redemption. The Company reserves the right to change the purchase price of redemptions, reject any request for redemption, or otherwise amend the terms of, suspend, or terminate the Unit Redemption Program.  During the three months ended March 31, 2010, the Company redeemed 120,742 Units in the amount of $1.3 million under the program.  There were no redemptions in the first quarter of 2009.

 

7.  Series B Convertible Preferred Stock

 

The Company has issued 480,000 Series B convertible preferred shares to Glade M. Knight, Chairman and Chief Executive Officer of the Company, in exchange for the payment by him of $0.10 per Series B convertible preferred share, or an aggregate of $48,000.  The Series B convertible preferred shares are convertible into common shares pursuant to the formula and on the terms and conditions set forth below.

 

There are no dividends payable on the Series B convertible preferred shares.  Holders of more than two-thirds of the Series B convertible preferred shares must approve any proposed amendment to the articles of incorporation that would adversely affect the Series B convertible preferred shares.

 

Upon the Company’s liquidation, the holder of the Series B convertible preferred shares is entitled to a priority liquidation payment before any distribution of liquidation proceeds to the holders of the common shares.  However, the priority liquidation payment of the holder of the Series B convertible preferred shares is junior to the holders of the Series A preferred shares distribution rights.  The holder of a Series B convertible preferred share is entitled to a liquidation payment of $11 per number of common shares each Series B convertible preferred share would be convertible into according to the formula described below.  In the event that the liquidation of the Company’s assets results in proceeds that exceed the distribution rights of the Series A preferred shares and the Series B convertible preferred shares, the remaining proceeds will be distributed between the common shares and the Series B convertible preferred shares, on an as converted basis.

 

Each holder of outstanding Series B convertible preferred shares shall have the right to convert any of such shares into common shares of the Company upon and for 180 days following the occurrence of any of the following events:

 

(1) substantially all of the Company’s assets, stock or business is sold or transferred through exchange, merger, consolidation, lease, share exchange, sale or otherwise, other than a sale of assets in liquidation, dissolution or winding up of the Company;

 

(2) the termination or expiration without renewal of the advisory agreement with A9A, or if the Company ceases to use ASRG to provide property acquisition and disposition services; or

 

(3) the Company’s common shares are listed on any securities exchange or quotation system or in any established market.

 

Upon the occurrence of any conversion event, each Series B convertible preferred share may be converted into a number of common shares based upon the gross proceeds raised through the date of conversion in the Company’s $2 billion offering according to the following table:

 

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In the event that after raising gross proceeds of $2 billion, the Company raises additional gross proceeds in a subsequent public offering, each Series B convertible preferred share may be converted into an additional number of common shares based on the additional gross proceeds raised through the date of conversion in a subsequent public offering according to the following formula: (X/100 million) x 1.20568, where X is the additional gross proceeds rounded down to the nearest 100 million.

 

No additional consideration is due upon the conversion of the Series B convertible preferred shares. The conversion into common shares of the Series B convertible preferred shares will result in dilution of the shareholders’ interests.

 

Expense related to the issuance of 480,000 Series B convertible preferred shares to Mr. Knight will be recognized at such time when the number of common shares to be issued for conversion of the Series B shares can be reasonably estimated and the event triggering the conversion of the Series B shares to common shares occurs. The expense will be measured as the difference between the fair value of the common stock for which the Series B shares can be converted and the amounts paid for the Series B shares. Although the fair market value cannot be determined at this time, expense if the maximum offering is achieved could range from $0 to in excess of $127 million (assumes $11 per unit fair market value).  Based on equity raised through March 31, 2010, if a triggering event had occurred, expense would have ranged from $0 to $76.7 million (assumes $11 per unit fair market value) and approximately 7.0 million common shares would have been issued.

 

8.  Industry Segments

 

The Company has two reportable segments:  hotel investments and real estate leased under a long-term triple-net lease.  The Company owns extended-stay and limited service hotel properties throughout the United States that generate rental and other property related income.  The Company separately evaluates the performance of each of its hotel properties.  However, because each of the hotels has similar economic characteristics, facilities, and services, and each hotel is not individually significant, the properties have been aggregated into a single operating segment.  In addition, the Company owns approximately 410 acres of land and land improvements on 111 sites in the Ft. Worth, Texas area (acquired in April 2009) that is leased to a tenant for the production of natural gas.  Under the ground lease, the Company receives monthly rental payments.  Prior to the acquisition of the land in Ft. Worth, Texas, the Company’s only reportable segment was hotel investments.  The Company does not allocate corporate-level accounts to its operating segments, including corporate general and administrative expenses, non-operating interest income and interest expense.  The following table summarizes the results of operations and assets for each segment for the three months ending March 31, 2010.  Dollar amounts are in thousands.

 

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		Hotels			Ground Lease			Corporate			Consolidated
Total revenue		$	26,476		$	5,297		$	—		$	31,773
Operating expenses		18,722			27			—			18,749
Acquisition related costs		2,151			—			—			2,151
Depreciation expense		5,140			558			—			5,698
General and administrative		—			—			1,310			1,310
Operating income/(loss)		463			4,712			(1,310		)	3,865
Interest income		—			—			436			436
Interest expense		(520		)	—			—			(520		)
Net income/(loss)		$	(57	)	$	4,712		$	(874	)	$	3,781
Total assets as of March 31, 2010		$	642,831		$	152,326		$	326,471		$	1,121,628

 

9.  Significant Tenant

 

A subsidiary of Chesapeake Energy Corporation leases properties with carrying values that represent approximately 14% of the Company’s total assets, at cost, as of March 31, 2010.  The following table presents summary financial information for Chesapeake Energy Corporation as of March 31, 2010 and December 31, 2009, and for the three months ended March 31, 2010 and 2009, as reported in its March 31, 2010 Earnings Release on Form 8-K furnished with the Securities and Exchange Commission (the “SEC”).

 

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Chesapeake Energy Corporation

Selected Financial Data

(In millions)

 

Consolidated Balance Sheet Data:

 

		March 31, 2010			December 31, 2009
Current assets		$	3,335		$	2,446
Noncurrent assets		26,953			27,468
Current liabilities		3,123			2,688
Noncurrent liabilities		14,949			14,885
Total equity		12,216			12,341

 

Consolidated Statements of Income Data:

 

		Three Months Ended
		March 31,			March 31,
		2010			2009
Total revenues		$	2,798		$	1,995
Total operating costs		1,586			11,048
Operating income/(loss)		1,212			(9,053		)
Net income/(loss)		596			(5,740		)

 

Consolidated Statements of Cash Flows Data:

 

		Three Months Ended
		March 31,			March 31,
		2010			2009
Cash provided by operating activities		$	1,183		$	1,261
Cash used in investing activities		(1,014		)	(2,367		)
Cash provided by (used in) financing activities		40			(560		)
Net increase (decrease) in cash and cash equivalents		209			(1,666		)
Cash and cash equivalents, beginning of period		307			1,749
Cash and cash equivalents, end of period		516			83

 

The summary financial information of Chesapeake Energy Corporation is presented to comply with applicable accounting regulations of the SEC.  References in these financials statements to the financial statements furnished with the SEC for Chesapeake Energy Corporation are included as textual references only, and the information in Chesapeake Energy Corporation’s filing is not incorporated by reference into these financial statements.

 

10.  Pro Forma Information (unaudited)

 

The following unaudited pro forma information for the three months ended March 31, 2009 is presented as if the acquisitions of the Company’s hotels acquired after December 31, 2008, and considered significant to the Company’s results of operations, had occurred on the latter of January 1, 2009 or the opening date of the hotel.  The five hotels acquired by the Company in the first three months of 2010 did not have significant results of operations for the period not owned by the Company.  The pro forma information does not purport to represent what the Company’s results of operations would actually have

 

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been if such transactions, in fact, had occurred on these applicable dates, nor does it purport to represent the results of operations for future periods. Amounts are in thousands, except per share data.

 

 

The pro forma information reflects adjustments for actual revenues and expenses of the hotels acquired during 2009 for the respective period prior to acquisition by the Company.  Net income has been adjusted as follows: (1) interest income and expense have been adjusted to reflect the reduction in cash and cash equivalents required to fund the acquisitions; (2) interest expense related to prior owners’ debt which was not assumed has been eliminated; (3) depreciation has been adjusted based on the Company’s basis in the hotels; and (4) transaction costs have been adjusted for the acquisition of existing businesses.

 

11.  Subsequent Events

 

In April 2010, the Company declared and paid approximately $8.4 million in dividend distributions to its common shareholders, or $0.073334 per outstanding common share.

 

During April 2010, the Company closed on the issuance of 7.3 million Units through its ongoing best-efforts offering, representing gross proceeds to the Company of $80.2 million and proceeds net of selling and marketing costs of $72.2 million.

 

In April 2010, the Company redeemed 186,011 Units in the amount of $1.9 million under its Unit Redemption Program.

 

Subsequent to March 31, 2010, the Company closed on the purchase of five hotels.  The following table summarizes the hotel information.  All dollar amounts are in thousands.

 

Location		Brand		Gross Purchase Price			Rooms		Date of Purchase
Miami, FL		Hampton Inn & Suites		$	11,900		121		4/9/2010
Anchorage, AK		Embassy Suites		42,000			169		4/30/2010
Boise, ID		Hampton Inn & Suites		22,370			186		4/30/2010
Rogers, AR		Homewood Suites		10,900			126		4/30/2010
St. Louis, MO		Hampton Inn & Suites		16,000			126		4/30/2010
				$	103,170		728

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Such statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.  Such factors include, but are not limited to, the ability of the Company to implement its acquisition strategy and operating strategy; the Company’s ability to manage planned growth; changes in economic cycles, including the current economic recession throughout the United States; and competition within the real estate industry.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore there can be no assurance that such statements included in the quarterly report will prove to be accurate.  In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the results or conditions described in such statements or the objectives and plans of the Company will be achieved.  In addition, the Company’s qualification as a real estate investment trust involves the application of highly technical and complex provisions of the Internal Revenue Code.  Readers should carefully review the Company’s financial statements and the notes thereto, as well as the risk factors described in the Company’s filings with the Securities and Exchange Commission.  Any forward-looking statement that the Company makes speaks only as of the date of this report.  The Company undertakes no obligation to publically update or revise any forward-looking statements or cautionary factors, as a result of new information, future events, or otherwise, except as required by law.

 

General

 

The Company is a Virginia corporation that has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes.  The Company, which has limited operating history, was formed to invest in hotels, residential apartment communities and other income-producing real estate in selected metropolitan areas in the United States.  The Company was initially capitalized November 9, 2007, with its first investor closing on May 14, 2008.  Prior to the Company’s first hotel acquisition on July 31, 2008, the Company had no revenue, exclusive of interest income.  As of March 31, 2010, the Company owned 38 hotels (five purchased during the first quarter of 2010, 12 acquired in 2009 and 21 acquired during 2008).  The Company’s real estate portfolio also includes approximately 410 acres of land and improvements located on 111 sites in the Ft. Worth, Texas area (acquired in April 2009) that are being leased to a subsidiary of Chesapeake Energy Corporation (“Chesapeake”) for the production of natural gas.  Accordingly, the results of operations include only results from the date of ownership of the properties.

 

Hotel Operations

 

Although hotel performance can be influenced by many factors including local competition, local and general economic conditions in the United States and the performance of individual managers assigned to each hotel, performance of the hotels within their respective local markets, in general, has met the Company’s expectations for the period owned.  With the significant decline in economic conditions throughout the United States, overall performance of the Company’s hotels have not met expectations.  Although there is no way to predict general economic conditions, many industry analysts believe that the hotel industry revenues are stabilizing and will be flat in 2010 as compared to 2009.  In evaluating financial condition and operating performance, the most important matters on which the Company focuses are revenue measurements, such as average occupancy, average daily rate (“ADR”) and revenue per available room (“RevPAR”), and expenses, such as hotel operating expenses, general and administrative and property taxes and insurance.

 

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Hotels Owned

 

As noted above, the Company commenced operations in July 2008 upon the purchase of its first hotel property.  The following table summarizes the location, brand, manager, gross purchase price, number of hotel rooms and date of purchase for each of the 38 hotels the Company owned as of March 31, 2010.  All dollar amounts are in thousands.

 

Location

Brand

Manager

Gross Purchase Price

Rooms

Date of Purchase

Tucson, AZ

Hilton Garden Inn

Western

$

18,375

125

7/31/2008

Santa Clarita, CA

Courtyard

Dimension

22,700

140

9/24/2008

Charlotte, NC

Homewood Suites

McKibbon

5,750

112

9/24/2008

Allen, TX

Hampton Inn & Suites

Gateway

12,500

103

9/26/2008

Twinsburg, OH

Hilton Garden Inn

Gateway

17,792

142

10/7/2008

Lewisville, TX

Hilton Garden Inn

Gateway

28,000

165

10/16/2008

Duncanville, TX

Hilton Garden Inn

Gateway

19,500

142

10/21/2008

Santa Clarita, CA

Hampton Inn

Dimension

17,129

128

10/29/2008

Santa Clarita, CA

Residence Inn

Dimension

16,600

90

10/29/2008

Santa Clarita, CA

Fairfield Inn

Dimension

9,337

66

10/29/2008

Beaumont, TX

Residence Inn

Western

16,900

133

10/29/2008

Pueblo, CO

Hampton Inn & Suites

Dimension

8,025

81

10/31/2008

Allen, TX

Hilton Garden Inn

Gateway

18,500

150

10/31/2008

Bristol, VA

Courtyard

LBA

18,650

175

11/7/2008

Durham, NC

Homewood Suites

McKibbon

19,050

122

12/4/2008

Hattiesburg, MS

Residence Inn

LBA

9,793

84

12/11/2008

Jackson, TN

Courtyard

Vista

15,200

94

12/16/2008

Jackson, TN

Hampton Inn & Suites

Vista

12,600

83

12/30/2008

Pittsburgh, PA

Hampton Inn

Vista

20,458

132

12/31/2008

Fort Lauderdale, FL

Hampton Inn

Vista

19,290

109

12/31/2008

Frisco, TX

Hilton Garden Inn

Western

15,050

102

12/31/2008

Round Rock, TX

Hampton Inn

Vista

11,500

93

3/6/2009

Panama City, FL

Hampton Inn & Suites

LBA

11,600

95

3/12/2009

Austin, TX

Homewood Suites

Vista

17,700

97

4/14/2009

Austin, TX

Hampton Inn

Vista

18,000

124

4/14/2009

Dothan, AL

Hilton Garden Inn

LBA

11,601

104

6/1/2009

Troy, AL

Courtyard

LBA

8,696

90

6/18/2009

Orlando, FL

Fairfield Inn & Suites

Marriott

25,800

200

7/1/2009

Orlando, FL

SpringHill Suites

Marriott

29,000

200

7/1/2009

Clovis, CA

Hampton Inn & Suites

Dimension

11,150

86

7/31/2009

Rochester, MN

Hampton Inn & Suites

White

14,136

124

8/3/2009

Johnson City, TN

Courtyard

LBA

9,880

90

9/25/2009

Baton Rouge, LA

SpringHill Suites

Dimension

15,100

119

9/25/2009

Houston, TX

Marriott

Western

50,750

206

1/8/2010

Albany, GA

Fairfield Inn & Suites

LBA

7,920

87

1/14/2010

Panama City, FL

TownePlace Suites

LBA

10,640

103

1/19/2010

Clovis, CA

Homewood Suites

Dimension

12,435

83

2/2/2010

Jacksonville, NC

TownePlace Suites

LBA

9,200

86

2/16/2010

Total

$

616,307

4,465

 

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Of the Company’s 38 hotels owned at March 31, 2010, five were purchased during the first three months of 2010.  The total gross purchase price for these five hotels, with a total of 565 rooms, was $90.9 million.

 

During 2009, the Company acquired land in Alexandria, Virginia totaling $5.1 million, for the planned construction of a SpringHill Suites hotel to be completed over the next 12 months.  Upon completion, it is expected that the hotel will contain approximately 152 guest rooms and will be managed by Marriott.  To date the Company has incurred $2.5 million in construction costs and anticipates the total construction costs to be approximately $20-$25 million.

 

The purchase price for these properties, net of debt assumed, was funded primarily by the Company’s on-going best-efforts offering of Units.  The Company assumed approximately $53.8 million of debt secured by six of its hotel properties and $3.8 million of unsecured debt in connection with one of its hotel properties.  The following table summarizes the hotel location, interest rate, maturity date and the principal amount assumed associated with each note payable outstanding as of March 31, 2010. All dollar amounts are in thousands.

 

Location		Brand		Interest Rate (1)		Maturity Date		Principal Assumed			Outstanding balance as of March 31, 2010
Lewisville, TX		Hilton Garden Inn		0.00	%	12/31/2016		$	3,750		$	3,750
Duncanville, TX		Hilton Garden Inn		5.88	%	5/11/2017		13,966			13,704
Allen, TX		Hilton Garden Inn		5.37	%	10/11/2015		10,787			10,538
Bristol, VA		Courtyard		6.59	%	8/1/2016		9,767			9,607
Round Rock, TX		Hampton Inn		5.95	%	5/1/2016		4,175			4,085
Austin, TX		Homewood Suites		5.99	%	3/1/2016		7,556			7,406
Austin, TX		Hampton Inn		5.95	%	3/1/2016		7,553			7,402
								$	57,554		$	56,492

 

(1)          At acquisition, the Company adjusted the interest rates on these loans to market rates and is amortizing the adjustments to interest expense over the life of the loan.

 

Land and Improvements and Lease

 

In April 2009, the Company acquired approximately 417 acres of land on 113 sites in the Ft. Worth, Texas area for approximately $147 million from Chesapeake.  Simultaneous to the closing, the Company entered into a ground lease with Chesapeake for the 113 sites.  Chesapeake is using the land for natural gas production.  In February 2010, the Company agreed to sell back to Chesapeake two of the 113 sites originally purchased from Chesapeake in April 2009 and release Chesapeake from their associated lease obligation. The sales price for the two sites was equal to the Company’s original purchase price, approximately $2.6 million.  The Company earned and received rental income for the period held totaling approximately $240,000.  The lease has an initial term of 40 years and annual rent ranging from $15.2 million to $26.9 million with the average annual rent being $21.4 million.  Under the lease, Chesapeake is responsible for all operating costs of the real estate.

 

Chesapeake is a publicly held company that is traded on the New York Stock Exchange.  Chesapeake is the second-largest independent producer of natural gas in the United States with interests in approximately 38,000 net drill sites.

 

Results of Operations

 

The following is a summary of the Company’s consolidated financial results for the three months ended March 31, 2010 and 2009:

 

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