Apple Hospitality REIT, Inc. - Quarter Report: 2016 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

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FORM 10-Q

 

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☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2016

☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ TO _______

 

Commission File Number 001-37389

 

(Exact name of registrant as specified in its charter)

 

(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 ☒  No  ☐

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒  No ☐

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  ☐    No  ☒

Number of registrant’s common shares outstanding as of November 1, 2016: 223,362,926

Apple Hospitality REIT, Inc.

Form 10-Q

Index

 

This Form 10-Q includes references to certain trademarks or service marks.  The Courtyard by Marriott®, Fairfield Inn by Marriott®, Fairfield Inn & Suites by Marriott®, Marriott® Hotels, Renaissance® Hotels, Residence Inn by Marriott®, SpringHill Suites by Marriott® and TownePlace Suites by Marriott® trademarks are the property of Marriott International, Inc. or one of its affiliates.  The Embassy Suites by Hilton®, Hampton Inn by Hilton®, Hampton Inn & Suites by Hilton®, Hilton®, Hilton Garden Inn®, Home2 Suites by Hilton® and Homewood Suites by Hilton® trademarks are the property of Hilton Worldwide Holdings Inc. or one or more 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.

PART I.    FINANCIAL INFORMATION

Item 1.      Financial Statements

Apple Hospitality REIT, Inc.

Consolidated Balance Sheets

(in thousands, except share data)

See notes to consolidated financial statements.

Apple Hospitality REIT, Inc.

Consolidated Statements of Operations and Comprehensive Income

(Unaudited)

(in thousands, except per share data)

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2016				2015				2016				2015
Revenues:
Room		$	255,269			$	221,978			$	698,759			$	628,982
Other			21,202				18,577				59,835				56,299
Total revenue			276,471				240,555				758,594				685,281
Expenses:
Operating			69,082				59,024				187,370				170,781
Hotel administrative			20,866				17,684				57,921				52,248
Sales and marketing			21,329				18,524				59,244				53,502
Utilities			10,543				9,505				25,862				25,222
Repair and maintenance			10,478				9,245				29,167				27,771
Franchise fees			11,834				10,360				32,212				29,069
Management fees			9,205				8,491				26,189				24,081
Property taxes, insurance and other			14,787				10,450				40,315				33,727
Ground lease			2,615				2,496				7,587				7,504
General and administrative			2,623				5,175				12,511				14,421
Transaction costs			36,452				842				37,861				7,891
Loss on impairment of depreciable real estate assets			5,471				0				5,471				0
Depreciation			37,343				32,351				104,651				94,205
Total expenses			252,628				184,147				626,361				540,422
Operating income			23,843				56,408				132,233				144,859
Interest and other expense, net			(10,156	)			(9,302	)			(28,519	)			(24,265	)
Gain on sale of real estate			0				0				0				15,358
Income before income taxes			13,687				47,106				103,714				135,952
Income tax benefit (expense)			7				(138	)			(616	)			(872	)
Net income		$	13,694			$	46,968			$	103,098			$	135,080
Other comprehensive income (loss):
Unrealized gain (loss) on interest rate derivatives			4,261				(5,978	)			(7,934	)			(6,437	)
Cash flow hedge losses reclassified to earnings			0				0				0				785
Comprehensive income		$	17,955			$	40,990			$	95,164			$	129,428
Basic and diluted net income per common share		$	0.07			$	0.27			$	0.57			$	0.74
Weighted average common shares outstanding - basic and diluted			190,563				175,069				180,004				182,247

 

See notes to consolidated financial statements.

Apple Hospitality REIT, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

 

See notes to consolidated financial statements.

Apple Hospitality REIT, Inc.

Notes to Consolidated Financial Statements

(Unaudited)

1.  Organization and Summary of Significant Accounting Policies

Organization

  

Apple Hospitality REIT, 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 is a self-advised REIT that invests in income-producing real estate, primarily in the lodging sector, in the United States.  The Company’s fiscal year end is December 31.  The Company has no foreign operations or assets and its operating structure includes only one reportable segment.  The consolidated financial statements include the accounts of the Company and its subsidiaries.  All intercompany accounts and transactions have been eliminated.  Although the Company has interests in potential variable interest entities through its purchase commitments, it is not the primary beneficiary as the Company does not have any elements of power in the decision making process of these entities, and therefore does not consolidate the entities.  As of September 30, 2016, the Company owned 236 hotels with an aggregate of 30,299 rooms located in 33 states.

On May 18, 2015, the Company’s common shares were listed and began trading on the New York Stock Exchange (“NYSE”) under the ticker symbol “APLE” (the “Listing”).  In connection with the Listing, effective May 18, 2015, the Company completed a 50% reverse share split.  As a result of the reverse share split, every two common shares were converted into one common share.  All common shares and per share amounts for all periods presented have been adjusted to reflect the reverse share split.  See Note 8 for additional information about the reverse share split.

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 2015 Annual Report on Form 10-K.  Operating results for the three and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the twelve month period ending December 31, 2016.

Use of Estimates

The preparation of the financial statements in conformity with United States 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.

Reclassifications

Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period presentation with no effect on previously reported net income, shareholders’ equity or cash flows.

Comprehensive Income

Comprehensive income includes net income and other comprehensive income (loss), which is comprised of unrealized gains (losses) and other adjustments resulting from hedging activity.

Net Income Per Common Share

Basic net income per common share is computed based upon the weighted average number of shares outstanding during the period.  Diluted net income per common share is calculated after giving effect to all potential common shares that were dilutive and outstanding for the period.  There were no potential common shares with a dilutive effect for the three and nine months ended September 30, 2016 and 2015.  As a result, basic and dilutive net income per common share were the same.

Accounting Standards Recently Issued

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842), which amends the existing accounting standards for lease accounting, including requiring lessees to recognize most leases on their balance sheets as right-of-use assets and lease liabilities, as well as making targeted changes to lessor accounting.  Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The standard is effective for annual and interim periods beginning after December 15, 2018 with early adoption permitted.  The standard requires a modified retrospective transition approach for all leases existing at, or entered into after, the date of initial application, with an option to use certain transition relief.  The Company is currently evaluating the impact of adopting the new standard on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting, which simplifies several aspects of the accounting for employee share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows.  The standard is effective for annual and interim periods beginning after December 15, 2016 with early adoption permitted.  Some provisions of the standard require a retrospective transition approach.  The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments, which is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows.  The standard is effective for annual and interim periods beginning after December 15, 2017 with early adoption permitted.  The standard requires a retrospective transition approach where practicable.  The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements.

2.  Merger with Apple REIT Ten, Inc.

Effective September 1, 2016, the Company completed its previously announced merger with Apple REIT Ten, Inc. (“Apple Ten”) (the “merger”), which merger and related transaction proposals were approved by each company’s respective shareholders, as applicable, on August 31, 2016.  Pursuant to the Agreement and Plan of Merger entered into on April 13, 2016, as amended on July 13, 2016 (the “Merger Agreement”), Apple Ten merged with and into 34 Consolidated, Inc., a wholly-owned subsidiary of the Company (“Acquisition Sub”), at which time the separate corporate existence of Apple Ten ceased and Acquisition Sub became the surviving corporation in the merger.  Acquisition Sub was formed solely for the purpose of engaging in the merger and had not conducted any prior activities.  Immediately following the effective time of the merger, the name of Acquisition Sub was changed to Apple REIT Ten, Inc.  As a result of the merger, the Company acquired the business of Apple Ten, a real estate investment trust, which immediately prior to the effective time of the merger, owned 56 hotels located in 17 states with an aggregate of 7,209 rooms.

Upon completion of the merger, each issued and outstanding unit of Apple Ten (consisting of a common share and related Series A preferred share) (each, an “Apple Ten unit”) was converted into the right to receive (i) 0.522 (the “unit exchange ratio”) common shares of the Company, with cash in lieu of fractional shares, and (ii) $1.00 in cash, and each issued and outstanding Series B convertible preferred share of Apple Ten was converted into the right to receive (i) a number of common shares of the Company equal to 12.11423 multiplied by the unit exchange ratio, with cash in lieu of fractional shares, and (ii) an amount in cash equal to 12.11423 multiplied by $1.00, resulting in the issuance of a total of approximately 48.7 million common shares of the Company and a total payment of approximately $93.6 million in cash, including $0.2 million for fractional shares, to Apple Ten shareholders.  The cash payment was funded through borrowings on the Company’s revolving credit facility.  The Company’s common shares totaling 174.7 million prior to the merger remained outstanding following the merger, resulting in approximately 223.4 million common shares outstanding upon completion of the merger.  Also, as a result of the merger, the Company, through its wholly-owned subsidiary, assumed all of Apple Ten’s assets and liabilities at closing.  

The Company has accounted for the merger in accordance with the Accounting Standards Codification (“ASC”) 805, Business Combinations.  The Company is considered the acquirer for financial reporting purposes, which requires, among other things, that the assets acquired and liabilities assumed from Apple Ten be recognized at their acquisition date fair values.  For purpose of accounting for the transaction, the aggregate value of the merger consideration paid to Apple Ten shareholders was estimated to be approximately $1.0 billion, and is comprised of approximately $956.1 million for the issuance of approximately 48.7 million common shares of the Company valued at $19.62 per share, which was the closing price of the Company’s common shares on August 31, 2016 (the date that the merger was approved), and $93.6 million in cash.

As more fully described in Note 5, effective September 1, 2016, upon completion of the merger, the Company assumed approximately $145.7 million in mortgage debt, prior to any fair value adjustments, secured by nine properties.  The Company also assumed the outstanding balance on Apple Ten’s credit facility totaling $111.1 million, which was terminated and repaid in full on September 1, 2016 with borrowings on the Company’s revolving credit facility.

 

All costs related to the merger are being expensed in the period they are incurred and are included in transaction costs in the Company’s consolidated statements of operations.  In connection with the merger, the Company has incurred approximately $37.6 million in merger costs (including approximately $33.8 million of costs incurred to defend and reflect the proposed settlement (which remains subject to court approval) of the ongoing lawsuit related to the merger discussed in Note 10) for the nine months ended September 30, 2016.

In connection with the issuance of approximately 48.7 million common shares to effect the merger, the Company incurred approximately $1.2 million in issuance costs including legal, accounting and reporting services.  These costs were recorded by the Company as a reduction of shareholders’ equity.

As contemplated in the Merger Agreement, in connection with the completion of the merger, the advisory and related party arrangements with respect to Apple Ten and its advisors, as described in more detail in Note 7, were terminated.

As more fully described below, the Company is in the process of finalizing its valuation of the acquired assets and liabilities for the merger, which is expected to be finalized during 2016.  Accordingly, the purchase price allocation adjustments are preliminary and final estimates of fair value may be significantly different from these preliminary estimates.  The following table summarizes the Company’s preliminary purchase price allocation for the merger, which represents its best estimate of the fair values of the assets acquired and liabilities assumed on September 1, 2016, the effective date of the merger (in thousands):

The preliminary allocation of the purchase price requires a significant amount of judgment and was based upon valuations and other analyses described below that are currently being finalized.  The Company has engaged a valuation firm to assist in the analysis.  The methodologies and significant inputs and assumptions used in deriving estimates of fair value vary and are based on the nature of the tangible or intangible asset acquired or liability assumed.  The fair value of land, building and improvements, furniture, fixtures and equipment, and identifiable intangible assets was developed based on the cost approach, market approach or income approach depending on available information and compared to a secondary approach when possible.  The fair value of debt was estimated based on contractual future cash flows discounted using borrowing spreads and market interest rates that would be available to the Company as of the acquisition date for the issuance of debt with similar terms and remaining maturities.  Significant inputs and assumptions associated with these approaches included estimates of future operating cash flows and discount rates based on an evaluation of both observable market data (categorized as Level 2 inputs under the fair value hierarchy) and unobservable inputs that reflect the Company’s own internal assumptions and calculations (categorized as Level 3 inputs under the fair value hierarchy).  No goodwill was recorded in connection with the merger.

In connection with the merger, the Company acquired four properties with three existing ground leases, with remaining terms of approximately 26, 46 and 84 years, excluding any option periods to extend the initial lease term.  The Company has the option to extend the term of the lease with 26 years remaining beyond its initial term up to four times for 30 years each renewal period.  There are no renewal options on the other leases.  The three leases assumed were valued at below market rates and as a result the Company recorded intangible assets totaling approximately $10.0 million, which are included in other assets, net in the Company’s consolidated balance sheets.  The value of each lease intangible is amortized over the term of the respective lease and the amortization is included in ground lease expense in the Company’s consolidated statements of operations.  The ground leases are classified as operating leases, and rental expense is recognized on a straight-line basis over the remaining term of the respective lease.

The aggregate amounts of the estimated minimum lease payments pertaining to all of the ground leases assumed in the merger, for the five years subsequent to September 30, 2016 and thereafter are as follows (in thousands):

The following unaudited pro forma information for the three and nine month periods ended September 30, 2016 and 2015, is presented as if the merger, effective September 1, 2016, had occurred on January 1, 2015, and is based on assumptions and estimates considered appropriate by the Company.  The pro forma information is provided for illustrative purposes only and does not necessarily reflect what the operating results would have been had the merger been completed on January 1, 2015, nor is it necessarily indicative of future operating results.  The pro forma information does not give effect to any cost synergies or other operating efficiencies that could result from the merger.  Amounts are in thousands except per share data.

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Total revenue		$	325,924			$	309,835			$	949,760			$	885,015
Net income		$	59,981			$	61,057			$	177,183			$	173,419
Basic and diluted net income per common share		$	0.27			$	0.27			$	0.79			$	0.75
Weighted average common shares outstanding - basic and diluted			223,403				223,799				223,399				230,977

 

3.  Investment in Real Estate

The Company’s investment in real estate consisted of the following (in thousands):

As of September 30, 2016, the Company owned 236 hotels with an aggregate of 30,299 rooms located in 33 states.  Effective September 1, 2016, the Company completed the merger with Apple Ten, which added 56 hotels, located in 17 states, with an aggregate of 7,209 rooms.  As shown in the table setting forth the preliminary purchase price allocation for the merger in Note 2, the total real estate value of the merger was estimated to be approximately $1.3 billion.  The purchase price allocation is based on preliminary measurements of fair value and is subject to change.  The purchase price allocation for the merger represents the Company’s best estimate of fair value and the Company expects to finalize the valuation and complete the purchase price allocation during 2016.

On July 1, 2016, the Company closed on the purchase of a newly constructed 128-room Home2 Suites hotel in Atlanta, Georgia, the same day the hotel opened for business, for a purchase price of approximately $24.6 million.  The Company used borrowings under its revolving credit facility to purchase the hotel.  No goodwill was recorded in connection with this acquisition.

For the 57 hotels acquired during the nine months ended September 30, 2016 (including the 56 hotels acquired in the merger and one hotel acquired on July 1, 2016), the amount of revenue and operating income (excluding merger and other acquisition related transaction costs) included in the Company’s consolidated statements of operations from the date of acquisition through September 30, 2016 was approximately $25.0 million and $9.5 million, respectively.

During the nine month period ended September 30, 2015, the Company acquired five hotels.  The following table sets forth the location, brand, manager, date acquired, number of rooms and gross purchase price for each hotel acquired during the nine months ended September 30, 2015.  All dollar amounts are in thousands.

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

As of September 30, 2016, the Company had outstanding contracts for the potential purchase of three additional hotels for a total purchase price of $56.5 million.  All three hotels are under construction and are expected to be completed and opened for business in the first half of 2017, at which time closing on these hotels is expected to occur.  Although the Company is working towards acquiring these three hotels, there are many conditions to closing that have not yet been satisfied and there can be no assurance that a closing on these hotels will occur under the outstanding purchase contracts.  The following table summarizes the location, brand, date of purchase contract, expected 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 outstanding at September 30, 2016.  All dollar amounts are in thousands.

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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.  The Company intends to use borrowings under its $540 million revolving credit facility to purchase hotels under contract if a closing occurs.

During the third quarter of 2016, the Company identified two properties for potential sale (the Dallas, Texas Hilton hotel and the Chesapeake, Virginia Marriott hotel).  In October 2016, the Company entered into separate contracts for the sale of these properties for a total combined gross sales price of approximately $66.3 million.  The contracts are subject to a number of conditions to closing and therefore there can be no assurance that closings will occur.  If the closings occur, each of these sales are expected to be completed within three to six months of September 30, 2016.  At closing, the mortgage loan secured by the Dallas, Texas Hilton hotel, with an outstanding balance of approximately $27.4 million as of September 30, 2016, would be assumed by the buyer with the buyer receiving a credit for the amount assumed.  The Company plans to use the net proceeds from the sale to pay down borrowings on its revolving credit facility.  Due to the change in the anticipated hold period for each of these hotels, the Company reviewed the estimated undiscounted cash flows generated by each property (including its sale price, net of commissions and other selling costs) and determined that the Chesapeake, Virginia Marriott’s estimated undiscounted cash flows were less than its carrying value; therefore the Company recognized an impairment loss of approximately $5.5 million in the third quarter of 2016 to adjust the basis of this property to its estimated fair value, which was based on the contracted sale price, net of broker commissions and other estimated selling costs, a Level 1 input under the fair value hierarchy.  If both closings occur, the total combined net gain resulting from these two sales is estimated to be approximately $11.4 million.  The estimated net gain is calculated as the total combined sales price, net of commissions and selling costs, less the third quarter 2016 impairment loss noted above and a combined net book value totaling approximately $48.9 million as of September 30, 2016.  Since the contracts for the sales of these properties had not been finalized as of September 30, 2016, the assets and liabilities related to these properties have not been classified as held for sale in the Company’s consolidated balance sheet at September 30, 2016.

4.  Dispositions

During the nine months ended September 30, 2015, the Company sold 19 properties in two separate transactions for a total sales price of approximately $208.5 million, resulting in a gain on sale of approximately $15.4 million, which is included in the Company’s consolidated statements of operations for the nine months ended September 30, 2015.  Of the 19 hotels sold, 18 hotels were sold on February 26, 2015 for $206.4 million, resulting in a gain on sale of approximately $15.6 million and one hotel was sold on June 1, 2015 for $2.1 million, resulting in a loss of approximately $0.3 million.  The proceeds from the sale transactions were used primarily to repay the outstanding balance under the Company’s revolving credit facility, with the increased availability used to fund hotel acquisitions during 2015.  The Company’s consolidated statements of operations include operating income of approximately $2.0 million for the nine months ended September 30, 2015 relating to results of operations for the 19 hotels for the respective periods of ownership (the consolidated statements of operations for the three months ended September 30, 2015 did not contain any operating activity for these hotels, as they were sold prior to the beginning of the period).  The sale of these properties did not represent a strategic shift that has, or would have, a major effect on the Company’s operations and financial results, and therefore the operating results for the periods of ownership of these properties are included in income from continuing operations for the nine months ended September 30, 2015.  There were no dispositions during the nine month period ended September 30, 2016.

5.  Debt

$965 Million Credit Facility

On May 18, 2015, the Company entered into an amendment and restatement of its unsecured $345 million credit facility, increasing the borrowing capacity to $965 million, reducing the annual interest rate and extending the maturity dates.  The unsecured “$965 million credit facility” is comprised of (i) a $540 million revolving credit facility with an initial maturity date of May 18, 2019 (the “revolving credit facility”) and (ii) a $425 million term loan facility with a maturity date of May 18, 2020, consisting of three term loans, of which $212.5 million was funded on May 18, 2015, $110.0 million was funded on July 1, 2015, and $102.5 million was funded on August 14, 2015 (the “$425 million term loans”).  Subject to certain conditions including covenant compliance and additional fees, the revolving credit facility maturity date may be extended one year and the amount of the total credit facility may be increased from $965 million to $1.25 billion.  The Company may make voluntary prepayments in whole or in part, at any time.  Interest payments on the $965 million credit facility are due monthly and the interest rate, subject to certain exceptions, is equal to an annual rate of the one-month LIBOR (the London Inter-Bank Offered Rate for a one-month term) plus a margin ranging from 1.50% to 2.30%, depending upon the Company’s leverage ratio, as calculated under the terms of the credit agreement.  In conjunction with the $425 million term loans, the Company entered into two interest rate swap agreements, which effectively fix the interest rate on $322.5 million of the outstanding balance at approximately 3.10%, subject to adjustment based on the Company’s leverage ratio, through maturity.  See Note 6 for more information on the interest rate swap agreements.  The Company is also required to pay quarterly an unused facility fee at an annual rate of 0.20% or 0.30% on the unused portion of the revolving credit facility, based on the amount of borrowings outstanding during the quarter.

 

$150 Million Term Loan Facility

 

On April 8, 2016, the Company entered into an unsecured $150 million term loan facility with a syndicate of commercial banks (the “$150 million term loan facility”), consisting of a term loan of up to $50 million that will mature on April 8, 2021 (the “$50 million term loan”) and a term loan of up to $100 million that will mature on April 8, 2023 (the “$100 million term loan,” and collectively with the $50 million term loan, the “$150 million term loans”).  The Company initially borrowed $50 million under the $150 million term loan facility on April 8, 2016 and borrowed the remaining $100 million on September 30, 2016.  The credit agreement contains requirements and covenants similar to the Company’s $965 million credit facility.  The Company may make voluntary prepayments in whole or in part, at any time, subject to certain conditions.  Interest payments on the $150 million term loan facility are due monthly and the interest rate is equal to an annual rate of the one-month LIBOR plus a margin ranging from 1.45% to 2.20% for the $50 million term loan and 1.80% to 2.60% for the $100 million term loan, depending upon the Company’s leverage ratio, as calculated under the terms of the credit agreement.  The Company also entered into two interest rate swap agreements which, beginning on September 30, 2016, effectively fix the interest rate on the $50 million term loan and $100 million term loan at 2.54% and 3.13%, respectively, subject to adjustment based on the Company’s leverage ratio, through maturity.  See Note 6 for more information on the interest rate swap agreements.  Proceeds from the $150 million term loan facility were used to pay down outstanding balances under the Company’s revolving credit facility with the intent to use the increased availability to repay scheduled mortgage debt maturities through the end of the first quarter of 2017.

As of September 30, 2016 and December 31, 2015, the details of the Company’s revolving credit facility, $425 million term loans and $150 million term loans were as set forth below.  All dollar amounts are in thousands.

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The credit agreements governing the $965 million credit facility and $150 million term loan facility contain mandatory prepayment requirements, customary affirmative covenants, negative covenants and events of default.  The credit agreements require that the Company comply with various covenants, which include, among others, a minimum tangible net worth, maximum debt limits, minimum interest and fixed charge coverage ratios, limits on dividend payments and share repurchases and restrictions on certain investments.  The Company was in compliance with the applicable covenants at September 30, 2016.

Mortgage Debt

As of September 30, 2016, the Company had approximately $474.3 million in outstanding property level debt secured by 34 properties, with maturity dates ranging from November 2016 to June 2026, stated interest rates ranging from 0% to 6.25% and effective interest rates ranging from 3.80% to 6.52%.  The loans generally provide for monthly payments of principal and interest on an amortized basis.  The loans are generally subject to defeasance or prepayment penalties if prepaid.  The following table sets forth the hotel properties securing each loan, the interest rate, loan assumption or origination date, maturity date, the principal amount assumed or originated, and the outstanding balance prior to any fair value adjustments or debt issuance costs as of September 30, 2016 and December 31, 2015 for each of the Company’s debt obligations.  All dollar amounts are in thousands.

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The aggregate amounts of principal payable under the Company’s total debt obligations (including mortgage debt, the revolving credit facility and term loans), for the five years subsequent to September 30, 2016 and thereafter are as follows (in thousands):

 

Upon completion of the merger on September 1, 2016, the Company assumed approximately $145.7 million in mortgage debt, prior to any fair value adjustments, secured by nine properties.  This assumed mortgage debt had maturity dates ranging from February 2017 to October 2025 and stated interest rates ranging from 4.15% to 6.25%.  A fair value premium adjustment totaling approximately $6.2 million was recorded upon the assumption of above market rate mortgages.  The total fair value adjustment will be amortized as a reduction to interest expense over the remaining term of the respective mortgages using a method approximating the effective interest rate method.  The effective interest rates on the applicable debt obligations ranged from 3.80% to 4.23% at the date of assumption.  The Company incurred loan origination costs related to the assumption of the mortgage obligations totaling approximately $0.6 million.  Such costs are amortized over the period to maturity of the applicable mortgage loan, as an addition to interest expense.

6.  Fair Value of Financial Instruments

Except as described below, the carrying value of the Company’s financial instruments approximates fair value due to the short-term nature of these financial instruments.

Debt

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 a debt obligation with similar credit terms and credit characteristics, which are Level 3 inputs under the fair value hierarchy.  Market rates take into consideration general market conditions and maturity.  As of September 30, 2016, the carrying value and estimated fair value of the Company’s debt were approximately $1.3 billion and $1.4 billion, respectively.  As of December 31, 2015, both the carrying value and estimated fair value of the Company’s debt were approximately $1.0 billion.  Both the carrying value and estimated fair value of the Company’s debt (as discussed above) is net of unamortized debt issue costs related to term loans and mortgage debt for each specific year.

Derivative Instruments

Currently, the Company uses interest rate swaps to manage its interest rate risks on variable rate debt.  Throughout the terms of these interest rate swaps, the Company pays a fixed rate of interest and receives a floating rate of interest equal to the one month LIBOR.  The swaps are designed to effectively fix the interest payments on variable rate debt instruments.  These instruments are recorded at fair value and are included in accounts payable and other liabilities in the Company’s consolidated balance sheets.  The fair values of the Company’s interest rate swap agreements are determined using the market standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts, which is considered a Level 2 measurement under the fair value hierarchy.  The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.  The following table sets forth information for each of the Company’s interest rate swap agreements outstanding as of September 30, 2016 and December 31, 2015.  All dollar amounts are in thousands.

 

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The Company assesses, both at inception and on an ongoing basis, the effectiveness of its qualifying cash flow hedges.  For swaps designated as cash flow hedges, the changes in fair value on the effective portion are recorded to accumulated other comprehensive income (loss), a component of shareholders’ equity in the Company’s consolidated balance sheets.  Changes in fair value on the ineffective portion of all designated hedges are recorded to interest and other expense, net in the Company’s consolidated statements of operations.  For terminated or matured swaps that were not designated as cash flow hedges (including four swaps, of which two matured or terminated in the first quarter of 2015, one terminated in the second quarter of 2015 and one terminated in the second quarter of 2016), the changes in fair value were recorded to interest and other expense, net in the Company’s consolidated statements of operations.  Other than the fair value changes associated with the terminated interest rate swap for which hedge accounting was discontinued during the first half of 2015 as discussed below, fair value changes for derivatives that were not in qualifying hedge relationships for the three and nine months ended September 30, 2016 and 2015 were not material.

To adjust qualifying cash flow hedges to their fair value and recognize the impact of hedge accounting, the Company recorded unrealized gains (losses) of approximately $4.3 million and $(6.0) million during the three months ended September 30, 2016 and 2015, and approximately $(7.9) million and $(6.4) million during the nine months ended September 30, 2016 and 2015, respectively, to other comprehensive income (loss).  There was no ineffectiveness recorded on designated cash flow hedges during the three and nine months ended September 30, 2016 and 2015.  Amounts reported in accumulated other comprehensive loss will be reclassified to interest and other expense, net as interest payments are made on the Company’s variable-rate derivatives.  The Company reclassified unrealized losses of approximately $0.9 million and $0.8 million during the three months ended September 30, 2016 and 2015, and unrealized losses of approximately $2.9 million and $1.0 million during the nine months ended September 30, 2016 and 2015 from accumulated other comprehensive loss to interest and other expense, net.  Approximately $3.9 million of the net unrealized losses included in accumulated other comprehensive loss at September 30, 2016 is expected to be reclassified into interest and other expense, net within the next 12 months.  Also, during the nine months ended September 30, 2015, the Company reclassified $0.8 million of unrealized losses from accumulated other comprehensive loss to net income which was associated with the $100 million terminated swap agreement as discussed below.  Amounts recorded to accumulated other comprehensive loss totaled approximately $10.0 million and $2.1 million as of September 30, 2016 and December 31, 2015, respectively. 

In May 2015, concurrent with the Listing, the Company amended and restated its credit facility, at which time it repaid its $100 million term loan and terminated its $100 million interest rate swap, which was scheduled to mature in March 2019.  At inception, this swap was designated as a cash flow hedge for accounting purposes, and from inception of the swap through March 2, 2015, the swap was a fully effective hedge, and therefore the changes in the fair value through this date were recorded in accumulated other comprehensive loss, a component of shareholders’ equity in the Company’s consolidated balance sheets, which totaled $0.8 million as of March 2, 2015.  In the first quarter of 2015, the Company announced its intent to pursue a listing of its common shares on a national securities exchange and to enter into a modified credit facility and, as a result of this decision, it was determined that the cash flows being hedged were no longer probable of occurring through the maturity date of the swap.  Therefore, the Company discontinued hedge accounting, and subsequent changes in fair value were recorded to interest and other expense, net in the Company’s consolidated statements of operations.  The termination of the swap in May 2015 resulted in a cash settlement totaling approximately $1.1 million, the fair value at the time of settlement.  As a result, the Company realized a loss of approximately $1.1 million during the nine months ended September 30, 2015 related to the swap termination, of which approximately $0.8 million previously recorded to accumulated other comprehensive loss ($0.3 million was recorded during the first quarter of 2015) was reclassified as an increase to transaction costs with the remaining amount recorded to interest and other expense, net in the Company’s consolidated statements of operations.

7.  Related Parties

The Company has, and is expected to continue to engage in, 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 if these transactions were conducted with non-related parties.  The Company’s independent members of the Board of Directors oversee and annually review the Company’s related party relationships (including the relationships discussed in this section) and are required to approve any significant modifications to the existing relationships, as well as any new significant related party transactions.  The Board of Directors is not required to approve each individual transaction that falls under the related party relationships.  However, under the direction of the Board of Directors, at least one member of the Company’s senior management team approves each related party transaction.

Effective September 1, 2016, the Company completed its merger with Apple Ten, resulting in the termination of the subcontract agreement with Apple Ten Advisors, Inc. (“A10A”) and related transactions with Apple Ten discussed in the Company’s 2015 Annual Report on Form 10-K and additional related party transactions.  No other new significant related party transactions occurred during the nine months ended September 30, 2016.  Below is a summary of the related party relationships in effect and transactions that occurred during the nine months ended September 30, 2016 and 2015.

Prior to the merger, Glade M. Knight, Executive Chairman of the Company, was Chairman and Chief Executive Officer of Apple Ten.  Apple Ten’s advisors, A10A and Apple Realty Group, Inc., formerly known as Apple Suites Realty Group, Inc. (“ARG”), are wholly owned by Mr. Knight.  Mr. Knight is also a partner and Chief Executive Officer of Energy 11 GP, LLC, which is the general partner of Energy 11, L.P.  Justin G. Knight, the Company’s President and Chief Executive Officer, and a member of the Company’s Board of Directors, also served as President of Apple Ten prior to the merger.

Merger and Related Transactions

As contemplated in the Merger Agreement, in connection with the completion of the merger, the advisory and related party arrangements with respect to the Company, Apple Ten and Apple Ten’s advisors, A10A and ARG, were terminated.  Pursuant to the terms of the termination agreement, dated April 13, 2013, the advisory agreement, property acquisition/disposition agreement and subcontract agreement with respect to the Company, Apple Ten, A10A and ARG, discussed below, were terminated effective immediately after the effective time of the merger on September 1, 2016, and no fees were paid as a result of the termination of these agreements.  As a result, Apple Ten no longer pays the various fees that were paid to the Company under the subcontract agreement and A10A no longer subcontracts its advisory services to the Company.  Additionally, effective September 1, 2016, Apple Ten no longer has any advisory contracts with A10A or ARG.  Both the advisory fees and reimbursed costs received by the Company from Apple Ten were recorded as general and administrative expense by Apple Ten and reductions to general and administrative expense by the Company and, therefore, the termination of the subcontract agreement had no financial impact on the combined company after the effective time of the merger.  Subsequent to the merger, the Company will continue to provide support services to ARG for activities unrelated to Apple Ten.  Also, as discussed below, upon completion of the merger, Apple Ten’s 26% interest in Apple Air was acquired by the Company.  As part of the merger transaction, the officers and Executive Chairman of the Company received a combined 3.1 million common shares of the Company and $6.0 million in exchange for their ownership interests in Apple Ten, including amounts assigned to others.

Subcontract Agreement with A10A Prior to the Merger

Prior to the merger, the Company had a subcontract agreement with A10A.  Under the agreement, A10A subcontracted its obligations under its advisory agreement with Apple Ten to the Company.  The Company provided to Apple Ten the advisory services contemplated under the A10A advisory agreement and received an annual fee ranging from 0.1% to 0.25% (based on Apple Ten’s operating results) of total equity proceeds received by Apple Ten, and was reimbursed by Apple Ten for the use of the Company’s employees and corporate office and other costs associated with the advisory agreement, as described below.  Prior to the merger, advisory fees earned by the Company from Apple Ten for the nine months ended September 30, 2016 and 2015 totaled approximately $1.6 million and $1.9 million, and are recorded as a reduction to general and administrative expenses in the Company’s consolidated statements of operations.

Support Services to Apple Ten, A10A and ARG Prior to and After the Merger

Prior to the merger, the Company provided support services to Apple Ten and its advisors, A10A and ARG, which agreed to reimburse the Company for its costs in providing these services.  After the merger, the Company will continue to provide support services to ARG for activities unrelated to Apple Ten.  Total reimbursed costs received by the Company from these entities for the nine months ended September 30, 2016 and 2015 (including Apple Ten, A10A and ARG prior to September 1, 2016 and ARG thereafter) totaled approximately $2.3 million and $2.1 million, respectively, and are recorded as a reduction to general and administrative expenses in the Company’s consolidated statements of operations.  As of September 30, 2016, total amounts due from ARG for activities unrelated to Apple Ten, and as of December 31, 2015, total amounts due from Apple Ten, A10A and ARG for reimbursements under the cost sharing structure totaled approximately $0.2 million and $0.3 million, respectively, and are included in other assets, net in the Company’s consolidated balance sheets.  Under this cost sharing structure, amounts reimbursed to the Company include both compensation for personnel and office related costs (including office rent, utilities, office supplies, etc.) used by each company during these periods.  The amounts reimbursed to the Company are based on a good faith estimate of the proportionate amount of time incurred by the Company’s employees on behalf of Apple Ten, A10A and ARG prior to the merger, and ARG for activities unrelated to Apple Ten after the merger.  Effective September 1, 2016, as part of the cost sharing arrangement, certain day-to-day transactions may result in amounts due to or from the Company and ARG for activities unrelated to Apple Ten.  To efficiently manage cash disbursements, the Company or ARG may make payments for the other company.  Under the cash management process, each company may advance or defer up to $1 million at any time.  Each quarter, any outstanding amounts are settled between the companies.  This process allows each company to minimize its cash on hand and reduces the cost for each company.  The amounts outstanding at any point in time are not significant to either of the companies.  Prior to the merger, Apple Ten, A10A and ARG (for activities both related and unrelated to Apple Ten) were part of the cost sharing structure and participated in this cash management process.

Apple Air Holding, LLC (“Apple Air”)

The Company, through a wholly-owned subsidiary, Apple Air, owns a Learjet used primarily for acquisition, asset management, renovation and public relations purposes.  Prior to the merger, Apple Air was jointly owned by the Company (74%) and Apple Ten (26%), with Apple Ten’s ownership interest accounted for as a minority interest, which as of December 31, 2015, totaled approximately $0.7 million, and was included in accounts payable and other liabilities in the Company’s consolidated balance sheet.  Effective September 1, 2016, with the completion of the merger, the Company acquired Apple Ten’s 26% equity interest in Apple Air for a total allocated purchase price of approximately $0.7 million, which approximated the fair market value at the time of acquisition based on third party market comparisons, resulting in a 100% equity ownership interest in Apple Air and the elimination of Apple Ten’s minority interest.

The aircraft is also leased to affiliates of the Company based on third party rates, which was not significant during the reporting periods.  The Company also utilizes aircraft, owned through two entities, one of which is owned by the Company’s Executive Chairman, and the other, its President and Chief Executive Officer, for acquisition, asset management, renovation and public relations purposes, and reimburses these entities at third party rates.  Total amounts incurred during the nine months ended September 30, 2016 and 2015 were approximately $0.2 million and $0.1 million, respectively, related to aircraft owned through these two entities and are included in general and administrative expenses in the Company’s consolidated statements of operations.

8.  Shareholders’ Equity

Distributions

For the three months ended September 30, 2016 and 2015, the Company paid distributions of $0.30 per common share for a total of $57.2 million and $52.6 million, respectively.  For the nine months ended September 30, 2016 and 2015, the Company paid distributions of $0.90 and $0.97 per common share for a total of $161.9 million and $176.8 million, respectively.  Additionally, in September 2016, the Company declared a monthly distribution of $0.10 per common share, totaling $22.3 million, which was recorded as a payable as of September 30, 2016 and paid in October 2016.  As of December 31, 2015, a monthly distribution of $0.10 per common share, totaling $17.4 million, was recorded as a payable and paid in January 2016.  These accrued distributions were included in accounts payable and other liabilities in the Company’s consolidated balance sheets.

The Company’s current annual distribution rate, payable monthly, is $1.20 per common share.  On April 23, 2015, the Company’s Board of Directors, in anticipation of the Listing, reduced the annual distribution rate from $1.36 per common share to the current annual distribution rate, effective with the June 2015 distribution.

Reverse Share Split

In connection with the Listing, effective May 18, 2015, the Company completed a 50% reverse share split.  As a result of the reverse share split, every two common shares were converted into one common share, reducing the number of issued and outstanding common shares from 372.2 million to 186.1 million on the effective date.  The common shares have the same respective voting rights, preferences and relative, participating, optional or other rights, and qualifications, limitations or restrictions as set forth in the amended and restated articles of incorporation in effect immediately prior to the effective date of the reverse share split.  All common shares and per share amounts for all periods presented have been adjusted to reflect the reverse share split.

Issuance of Common Shares and Stock Options

On September 1, 2016, in connection with the completion of the merger, as described in Note 2, the Company issued a total of 48.7 million common shares to Apple Ten shareholders.  Based on the $19.62 per share closing price of the Company’s common shares on August 31, 2016 (the date the merger was approved), the total estimated value of the common shares issued by the Company in the merger was approximately $956.1 million.  In connection with the issuance of these shares, the Company incurred approximately $1.2 million in issuance costs including legal, accounting and reporting services.  These costs were recorded by the Company as a reduction of shareholders’ equity.  Additionally, pursuant to the terms of the Merger Agreement, all of Apple Ten’s outstanding stock options were exchanged for stock options to acquire a total of 203,041 common shares of the Company at an exercise price of $19.17 per share.

Share Repurchases

In connection with the Listing, the Board of Directors approved a modified “Dutch Auction” tender offer to purchase up to $200 million in value of the Company’s common shares (the “Tender Offer”), which commenced on May 18, 2015 and expired on June 22, 2015.  Upon expiration, the Company accepted for purchase approximately 10.5 million of its common shares, at a purchase price of $19.00 per common share, for an aggregate purchase price of approximately $200 million, excluding fees and expenses related to the Tender Offer.  The total common shares accepted for purchase represented approximately 97% of the common shares properly tendered and not properly withdrawn at the purchase price of $19.00 per common share.  Payment for shares accepted for purchase occurred on June 24, 2015, and the shares purchased were retired.  The Company incurred approximately $0.6 million in costs related to the Tender Offer which were recorded as a reduction to shareholders’ equity in the Company’s consolidated balance sheets.  The Company funded the Tender Offer and all related costs primarily from borrowings under its $965 million credit facility.  

During 2015, the Company’s Board of Directors authorized a share repurchase program of up to $500 million through July 7, 2016.  Effective July 8, 2015, as part of the implementation of the program, the Company established a written trading plan (“2015 Plan”) that provided for share repurchases in open market transactions that was intended to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended.  To be able to more effectively respond to market conditions, the Company terminated the 2015 Plan in January 2016.  From implementation through the termination of the 2015 Plan, the Company purchased approximately 1.3 million of its common shares under the 2015 Plan, at a weighted-average market purchase price of approximately $17.62 per common share, for an aggregate purchase price of approximately $22.4 million, including the purchase of approximately 20,000 of its common shares in January 2016, at a weighted-average market purchase price of approximately $18.10 per common share for an aggregate purchase price of approximately $0.4 million and approximately 1.2 million of its common shares in the third quarter of 2015 at a weighted-average market purchase price of approximately $17.59 per common share for an aggregate purchase price of approximately $21.2 million.

In June 2016, the Board of Directors approved a one-year extension of the share repurchase program authorizing share repurchases up to an aggregate of $475 million.  The program may be suspended or terminated at any time by the Company.  If not terminated earlier, the program will end in July 2017.  Effective September 2, 2016, as part of the implementation of this program, the Company established a written trading plan (“2016 Plan”) that provides for share repurchases up to an aggregate of $400 million in open market transactions that is intended to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended.  The timing of share repurchases and the number of common shares to be repurchased under the 2016 Plan will depend upon prevailing market conditions, regulatory requirements and other factors.  The 2016 Plan does not obligate the Company to repurchase any specific number of shares and may be suspended at any time at its discretion.  The Company had not repurchased any common shares under the 2016 Plan as of September 30, 2016.  Repurchases under the 2015 Plan have been funded, and the Company intends to fund repurchases under the 2016 Plan, with availability under its revolving credit facility.

During the nine months ended September 30, 2015, the Company redeemed approximately 0.8 million common shares at a price of $18.40 per common share, or a total of approximately $14.9 million under its previous share redemption program that was terminated following the April 2015 redemption.

9.  Compensation Plans

In May 2014, the Board of Directors adopted the Company’s 2014 Omnibus Incentive Plan (the “Omnibus Plan”), and in May 2015, the Company’s shareholders approved the Omnibus Plan.  The Omnibus Plan permits the grant of awards of stock options, stock appreciation rights, restricted stock, stock units, unrestricted stock, dividend equivalent rights, performance shares and other performance-based awards, other equity-based awards, and cash bonus awards to any employee, officer, or director of the Company or an affiliate of the Company, a consultant or adviser currently providing services to the Company or an affiliate of the Company, or any other person whose participation in the Omnibus Plan is determined by the Compensation Committee of the Board of Directors to be in the best interests of the Company.  The maximum number of the Company’s common shares available for issuance under the Omnibus Plan is 10 million.

In February 2016, the Compensation Committee of the Board of Directors (“Compensation Committee”) approved an executive incentive plan (“2016 Incentive Plan”), effective January 1, 2016, and established incentive goals for 2016.  Under the 2016 Incentive Plan, participants are eligible to receive a bonus based on the achievement of certain 2016 performance measures, consisting of operational performance metrics (including targeted Modified Funds from Operations per share, Comparable Hotels revenue per available room growth and Adjusted Hotel EBITDA Margin growth) and shareholder return metrics (including shareholder return relative to a peer group and total shareholder return).  The components of the operational performance metrics and shareholder return metrics are equally weighted and the two metrics each account for 50% of the total target incentive compensation.  The range of potential aggregate payouts under the 2016 Incentive Plan is $0 - $15 million.  Based on performance through September 30, 2016, the Company has accrued approximately $2.8 million as a liability for potential executive bonus payments under the 2016 Incentive Plan, which is included in accounts payable and other liabilities in the Company’s consolidated balance sheet as of September 30, 2016 and in general and administrative expense in the Company’s consolidated statement of operations for the nine months ended September 30, 2016.  As a result of lower anticipated 2016 performance, during the three months ended September 30, 2016, the Company reduced the previously recorded accrual by approximately $0.8 million, resulting in a reduction to general and administrative expense for the period.  Approximately 25% of awards under the 2016 Incentive Plan, if any, will be paid in cash, and 75% will be issued in stock under the Omnibus Plan, two-thirds of which would vest at the end of 2016 and one-third of which would vest at the end of 2017.  During 2015, a comparable executive incentive plan was approved by the Compensation Committee (“2015 Incentive Plan”) that was effective January 1, 2015, and the Company recorded approximately $2.6 million and $5.8 million in general and administrative expense in the Company’s consolidated statements of operations for the three and nine months ended September 30, 2015.

Share Based Compensation Awards

During the first quarter of 2016, the Company issued 304,345 common shares earned under the 2015 Incentive Plan (net of shares surrendered to satisfy tax withholding obligations) at $19.87 per share, or approximately $6.0 million in share based compensation.  Of the total shares issued, 146,279 shares were unrestricted at the time of issuance, and the remaining 158,066 restricted shares will vest on December 31, 2016.  Of the total 2015 share based compensation, approximately $4.5 million was recorded as a liability as of December 31, 2015, which was included in accounts payable and other liabilities in the Company’s consolidated balance sheets and the remaining $1.6 million, which is subject to vesting on December 31, 2016, will be recognized as compensation expense proportionately throughout 2016.  For the three and nine months ended September 30, 2016, the Company recognized approximately $0.4 million and $1.2 million, respectively, of share based compensation expense related to the unvested restricted share awards.

10.  Legal Proceedings

Moses, et al. v. Apple Hospitality REIT, Inc., et al.

As previously reported in the 2015 Form 10-K, on April 22, 2014, Plaintiff Susan Moses, purportedly a shareholder of Apple REIT Seven, Inc. (“Apple Seven”) and Apple REIT Eight, Inc. (“Apple Eight”), now part of the Company, filed a class action against the Company and several individual directors on behalf of all then-existing shareholders and former shareholders of Apple Seven and Apple Eight, now part of the Company, who purchased additional shares under the Apple REITs’ Dividend Reinvestment Plans (“DRIP”) between July 17, 2007 and February 12, 2014 (Susan Moses, et al. v. Apple Hospitality REIT, Inc., et al., 14-CV-3131 (DLI)(SMG)).  

On March 9, 2015, the Court entered a Memorandum and Order dismissing all claims.  On April 6, 2015, Plaintiff filed a Second Amended Class Action Complaint asserting a breach of contract claim.  Defendants moved to dismiss the Second Amended Complaint on April 29, 2015 and briefing on the motion was completed on May 27, 2015.  On September 30, 2016, the Court denied defendants’ Motion to Dismiss the breach of contract claim and dismissed the claim for breach of an implied covenant of good faith and fair dealing.  Defendants filed their Answer on October 14, 2016 and an initial conference is scheduled for February 7, 2017.

The Company believes that Plaintiff’s claims are without merit and intends to defend this case vigorously.  At this time, the Company cannot reasonably predict the outcome of these proceedings or provide a reasonable estimate of the possible loss or range of loss due to these proceedings, if any.

 

Quinn v. Knight, et al.

 

On July 19, 2016, a purported shareholder of Apple Ten, now part of the Company, commenced a derivative action in the United States District Court for the Eastern District of Virginia, captioned and numbered Quinn v. Knight, et al, Case No. 3:16-cv-610 (the "Complaint").  The Complaint names as defendants the members of Apple Ten's board of directors (the "Directors"), certain officers of Apple Ten and the Company (collectively, the "Officers"), the Company and, as a nominal defendant, Apple Ten.  The Complaint makes various allegations against the Directors, the Officers and the Company, including that (i) the Directors breached their fiduciary duties of loyalty and good faith in approving the merger by, among other things, a conflicted process that favored certain insiders and including materially false, incomplete and misleading statements in the definitive joint proxy statement/prospectus in connection with the merger and (ii) the Company and the Officers aided and abetted those alleged breaches of fiduciary duty.  The Complaint sought to enjoin the shareholder vote on the merger, and currently seeks damages, rescission, costs and attorney's fees.  On July 22, 2016, plaintiff filed a motion for expedited proceedings.  On August 5, 2016, the Court scheduled a hearing for August 26, 2016 on the plaintiff's motion to enjoin the shareholder vote on the merger.  Plaintiff's motion for preliminary injunction was denied following the hearing on August 26, 2016 and the shareholder vote on the merger occurred as originally scheduled on August 31, 2016.  On November 2, 2016, the parties reached an agreement in principle to settle the litigation for $32 million, which settlement remains subject to final court approval.  The Company has included the settlement amount in accounts payable and other liabilities in its consolidated balance sheet as of September 30, 2016 and in transaction costs in the Company’s consolidated statements of operations.  The Company anticipates that, should the settlement be completed, approximately $10 million to $15 million of the settlement amount would be funded from insurance proceeds and other parties to the settlement.  Since specific amounts have not been agreed to at this time these anticipated amounts have not been recognized in the Company’s financial statements.

11.  Subsequent Events

In October 2016, the Company paid approximately $22.3 million, or $0.10 per outstanding common share, in distributions to its common shareholders.

In October 2016, the Company declared a regular monthly cash distribution of $0.10 per common share for the month of November 2016.  The distribution is payable on November 15, 2016.

In October 2016, the Company entered into separate contracts for the sale of two properties (the Dallas, Texas Hilton hotel and the Chesapeake, Virginia Marriott hotel) for a total gross sales price of approximately $66.3 million.  See Note 3 for more information on these contracts.

In October 2016, the Company entered into a contract for the potential purchase of a hotel to be constructed in Phoenix, Arizona, for a gross purchase price of $44.1 million.  The hotel is planned to be a Hampton Inn & Suites which is expected to contain 210 guest rooms.  Although the Company is working towards acquiring this hotel, there are many conditions to closing that have not yet been satisfied, and there can be no assurance that a closing on this hotel will occur.

In November 2016, the Company entered into a $70.0 million secured mortgage loan agreement with a commercial lender, jointly secured by three properties.  The mortgage loan has an annual fixed interest rate of 3.55% and a maturity date of December 1, 2026.  At closing, the Company used the proceeds from this mortgage to reduce the borrowings on its revolving credit facility and to pay loan origination costs.

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

Forward-Looking Statements

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.  Forward-looking statements are typically identified by use of terms such as “may,” “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project,” “target,” “goal,” “plan,” “should,” “will,” “predict,” “potential,” “strategy,” and similar expressions that convey the uncertainty of future events or outcomes.  Such statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results, performance, or achievements of Apple Hospitality REIT, Inc. (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 effectively acquire and dispose of properties; the ability of the Company to successfully integrate pending transactions and implement its operating strategy; changes in general political, economic and competitive conditions and specific market conditions; adverse changes in the real estate and real estate capital markets; financing risks; the outcome of current and future litigation, including any legal proceedings that have been or may be instituted against the Company or others; regulatory proceedings or inquiries; and changes in laws or regulations or interpretations of current laws and regulations that impact the Company’s business, assets or classification as a real estate investment trust (“REIT”).  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 this 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 REIT involves the application of highly technical and complex provisions of the Internal Revenue Code.  Readers should carefully review the risk factors described in the Company’s filings with the Securities and Exchange Commission (“SEC”), including but not limited to those discussed in the section titled “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 and in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2016.  Any forward-looking statement that the Company makes speaks only as of the date of this Quarterly Report.  The Company undertakes no obligation to publicly 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.

The following discussion and analysis should be read in conjunction with the Company’s Unaudited Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q, as well as the information contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Overview

The Company is a Virginia corporation that has elected to be treated as a REIT for federal income tax purposes.  The Company is self-advised and invests in income-producing real estate, primarily in the lodging sector, in the United States.  As of September 30, 2016, the Company owned 236 hotels with an aggregate of 30,299 rooms located in 33 states.  All of the Company’s hotels operate under Marriott or Hilton brands.  The hotels are operated and managed under separate management agreements with 22 hotel management companies, none of which are affiliated with the Company.

Merger with Apple Ten

Effective September 1, 2016, the Company completed its previously announced merger with Apple REIT Ten, Inc. (“Apple Ten”), which merger and related transaction proposals were approved by each company’s respective shareholders, as applicable, on August 31, 2016.  Pursuant to the definitive merger agreement dated April 13, 2016, as amended on July 13, 2016 (the “Merger Agreement”), Apple Ten merged with and into a wholly-owned subsidiary of the Company (the “merger” or “Apple Ten merger”).  As a result of the merger, the Company acquired the business of Apple Ten, a real estate investment trust, which immediately prior to the merger, owned 56 hotels located in 17 states with an aggregate of 7,209 rooms.  Upon completion of the merger, each issued and outstanding unit of Apple Ten (consisting of a common share and related Series A preferred share) (each, an “Apple Ten unit”) was converted into the right to receive (i) 0.522 (the “unit exchange ratio”) common shares of the Company, with cash in lieu of fractional shares, and (ii) $1.00 in cash, and each issued and outstanding Series B convertible preferred share of Apple Ten received the same consideration described above on an as-converted basis, resulting in the issuance of a total of approximately 48.7 million common shares of the Company and a total payment of approximately $93.6 million in cash, including $0.2 million for fractional shares, to Apple Ten shareholders.  The cash payment was funded through borrowings on the Company’s revolving credit facility.  Based on the closing price of the Company’s common shares on August 31, 2016 (the date the merger was approved), the estimated aggregate value of the merger consideration paid to Apple Ten shareholders was approximately $1.0 billion.  The Company’s common shares totaling 174.7 million prior to the merger remained outstanding following the merger, resulting in approximately 223.4 million common shares outstanding upon completion of the merger.  Also, as a result of the merger, the Company, through a wholly-owned subsidiary, assumed all of Apple Ten’s assets and liabilities at closing.  

As more fully described in Note 5 titled “Debt” in the Company’s Unaudited Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q, effective September 1, 2016, upon completion of the merger, the Company assumed approximately $145.7 million in mortgage debt, prior to any fair value adjustments, secured by nine properties.  The Company also assumed the outstanding balance on Apple Ten’s credit facility totaling $111.1 million, which was terminated and repaid in full on September 1, 2016 with borrowings on the Company’s revolving credit facility.

 

All costs related to the merger are being expensed in the period they are incurred and are included in transaction costs in the Company’s consolidated statements of operations.  In connection with the merger, the Company has incurred approximately $37.6 million in merger costs (including approximately $33.8 million of costs incurred to defend and reflect the proposed settlement (which remains subject to court approval) of the ongoing lawsuit related to the merger discussed in Note 10 titled “Legal Proceedings” in the Company’s Unaudited Consolidated Financial Statements and Notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q) for the nine months ended September 30, 2016. 

 

As contemplated in the Merger Agreement, in connection with the completion of the merger, the advisory and related party arrangements with respect to Apple Ten and its advisors were terminated.

See Note 2 titled “Merger with Apple REIT Ten, Inc.” in the Company’s Unaudited Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q for additional information concerning the merger with Apple Ten.

Investing Activities

The Company continually monitors the profitability of its properties, market conditions, and capital requirements and attempts to maximize shareholder value by investing in properties that it believes provide superior value in the long term.  Consistent with this strategy and the Company’s focus on investing in select service hotels, in addition to completing the Apple Ten merger in the third quarter of 2016, the Company also acquired a newly constructed 128-room Home2 Suites hotel in Atlanta, Georgia on July 1, 2016, the same day the hotel opened for business, for a purchase price of approximately $24.6 million.  The purchase price for this property was funded through borrowings on the Company’s revolving credit facility.  As of September 30, 2016, the Company had outstanding contracts for the potential purchase of three additional hotels for a total purchase price of $56.5 million.  These three hotels are under construction and are expected to be completed and opened for business in the first half of 2017, at which time closings are expected to occur.

During the third quarter of 2016, the Company identified two properties for potential sale (the Dallas, Texas Hilton hotel and the Chesapeake, Virginia Marriott hotel).  In October 2016, the Company entered into separate contracts for the sale of these properties for a total combined gross sales price of approximately $66.3 million.  The contracts are subject to a number of conditions to closing and therefore there can be no assurance that closings will occur.  If the closings occur, each of these sales are expected to be completed within three to six months of September 30, 2016.  At closing, the mortgage loan secured by the Dallas, Texas Hilton hotel, with an outstanding balance of approximately $27.4 million as of September 30, 2016, would be assumed by the buyer with the buyer receiving a credit for the amount assumed.  The Company plans to use the net proceeds from the sale to pay down borrowings on its revolving credit facility.  If both closings occur, the total combined net gain resulting from these two sales is estimated to be approximately $11.4 million.  The estimated net gain is calculated as the total combined sales price, net of commissions and selling costs, less an impairment loss of approximately $5.5 million recorded during the third quarter of 2016 (to adjust the basis of the Chesapeake, Virginia Marriott hotel to its estimated fair value) and a combined net book value totaling approximately $48.9 million as of September 30, 2016.  See Note 3 titled “Investment in Real Estate” in the Company’s Unaudited Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q for additional information concerning these contracts.

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 Company’s hotels as compared to other hotels within their respective local markets, in general, has met the Company’s expectations for the period owned.  Although improvement moderated in the third quarter of 2016, the hotel industry and the Company’s hotels overall continue to experience improvement in both revenues and operating results as compared to the prior year.  Economic conditions in the United States have been generally favorable, however there is no way to predict future economic conditions, and there are certain factors that could negatively affect the lodging industry and the Company, including but not limited to, increased hotel supply in certain markets, labor uncertainty both for the economy as a whole and the lodging industry in particular, global volatility and government fiscal policies.  The Company, on a comparable basis (as defined below), and industry are forecasting a low single digit percentage increase in revenue for the full year of 2016 as compared to 2015, with the trend expected to continue into 2017.  Based on recent revenue trends, the Company’s revenue growth rate for comparable hotels in 2016 is lower than the growth achieved in 2015, primarily due to inconsistent demand in certain markets and increased hotel supply meeting demand growth in others, limiting the Company’s ability to increase rates.

In evaluating financial condition and operating performance, the most important indicators 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 expenses and other expenses described below.

As of September 30, 2016, the Company owned 236 hotels with 30,299 rooms as compared to 177 hotels with a total of 22,782 rooms as of September 30, 2015.  Results of operations are included only for the period of ownership for hotels acquired or disposed of during the current reporting period and prior year.  During the nine months ended September 30, 2016, the Company acquired 56 hotels in the Apple Ten merger effective September 1, 2016 and one additional new hotel on July 1, 2016.  No hotels were sold during this period.  During 2015, the Company acquired one new and six existing hotels (between June 1, 2015 and October 31, 2015) and sold 19 hotels (18 of which were sold on February 26, 2015 and one of which was sold on June 1, 2015).  As a result, comparability of results for the three and nine months ended September 30, 2016 and 2015 as discussed below is significantly impacted by these transactions.

The following is a summary of the results from operations of the Company’s hotels for their respective periods of ownership by the Company.

 

 

The following table reflects certain operating statistics for the Company’s 236 hotels owned as of September 30, 2016 (“Comparable Hotels”).  The Company defines metrics from Comparable Hotels as results generated by the 236 hotels owned as of the end of the reporting period.  For the hotels acquired during the current reporting period and prior year, the Company has included, as applicable, results of those hotels for periods prior to the Company’s ownership using information provided by the properties’ prior owners at the time of acquisition and not adjusted by the Company.  This information has not been audited, either for the periods owned or prior to ownership by the Company.  For dispositions, results have been excluded for the Company’s period of ownership.

 

The following table reflects certain operating statistics for the 180 hotels owned by the Company prior to the Apple Ten merger, prepared on the same basis as described above for Comparable Hotels.

 

The following table reflects certain operating statistics for the 56 hotels acquired in the Apple Ten merger, prepared on the same basis as described above for Comparable Hotels.

 

As discussed above, hotel performance is impacted by many factors, including the economic conditions in the United States and each individual locality.  Economic indicators in the United States have generally been favorable, which continues to positively impact the overall lodging industry.  As a result, the Company’s revenue and operating results for its Comparable Hotels improved during the three and nine months ended September 30, 2016 as compared to the same periods in 2015.  The Company expects continued improvement in revenue and operating results for its Comparable Hotels for the remainder of 2016 as compared to 2015, although at a slower rate than in recent years.  The Company’s hotels in general have shown results consistent with industry and brand averages for the period of ownership.

The Company’s principal source of revenue is hotel revenue consisting of room and other related revenue.  For the three months ended September 30, 2016 and 2015, the Company had total revenue of $276.5 million and $240.6 million, respectively.  For the nine months ended September 30, 2016 and 2015, the Company had total revenue of $758.6 million and $685.3 million, respectively.  For the three months ended September 30, 2016 and 2015, respectively, Comparable Hotels achieved combined average occupancy of 80.1% and 80.3%, ADR of $134.75 and $132.51 and RevPAR of $107.97 and $106.37.  For the nine months ended September 30, 2016 and 2015, respectively, Comparable Hotels achieved combined average occupancy of 78.5% and 78.7%, ADR of $134.90 and $130.78 and RevPAR of $105.96 and $102.86.  ADR is calculated as room revenue divided by the number of rooms sold, and RevPAR is calculated as occupancy multiplied by ADR.

During the third quarter and first nine months of 2016, the Company experienced stable occupancy combined with an increase in ADR compared to the same periods of 2015, resulting in a modest increase in RevPAR.  Year to date, the Company’s Comparable Hotels results have slightly exceeded industry averages, however for the third quarter were slightly below industry averages.  The third quarter results were impacted by several factors, including increased concentration from the Apple Ten merger in weaker markets, such as Chicago, Illinois, Houston, Texas, and Oklahoma City, Oklahoma, reduced results in Austin, Texas and Miami, Florida, and a limited presence in higher performing markets such as Philadelphia, Pennsylvania and Minneapolis, Minnesota.  The Company anticipates that with its geographically diverse portfolio of upscale and upper midscale select service hotels, on a comparable basis, overall RevPAR growth for the full year will approximate industry averages.  Although certain markets will vary based on local supply/demand dynamics and local market economic conditions, with continued overall room rate improvement combined with expected stable overall demand growth compared to supply growth, the Company, on a comparable basis, and industry are forecasting a low single digit percentage increase in revenue for the full year of 2016 as compared to 2015 (which is slightly lower than the prior quarter’s forecast), with the trend expected to continue into 2017.

Hotel operating expense consists of direct room operating expense, hotel administrative expense, sales and marketing expense, utilities expense, repair and maintenance expense, franchise fees and management fees.  For the three months ended September 30, 2016 and 2015, respectively, hotel operating expense totaled $153.3 million and $132.8 million or 55.5% and 55.2% of total revenue for each respective period.  For the nine months ended September 30, 2016 and 2015, respectively, hotel operating expense totaled $418.0 million and $382.7 million or 55.1% and 55.8% of total revenue for each respective period.  Overall hotel operational expenses for the first nine months of 2016 include the results of seven hotels acquired between June 1, 2015 and October 31, 2015 for the full period, one hotel acquired on July 1, 2016 from the date of acquisition, as well as the results of the 56 hotels acquired in the Apple Ten merger for the month of September 2016, and for the first nine months of 2015 included the results of the 19 hotels sold until the respective dates of sale.  For the Company’s Comparable Hotels, hotel operating expense as a percentage of revenue increased (decreased) approximately 40 and (30) basis points for the three and nine months ended September 30, 2016, respectively, as compared to the same periods in 2015.  During the third quarter of 2016, the Company experienced increases in labor costs as a percentage of revenue, which was the primary cause of the increase in hotel operating expense.  The Company anticipates labor costs are likely to continue to grow at increased rates due to government regulations surrounding wages, healthcare and other benefits and other government-related initiatives, such as the “living wage” increase, which could negatively impact operating expenses in certain markets moving forward.  Additionally, labor costs have been and could be impacted in certain markets due to lower unemployment rates.  With less qualified available labor, costs have increased.  The decrease in hotel operating expense as a percentage of revenue for the nine months ended September 30, 2016 is primarily due to the overall increase in ADR for these hotels, favorable utility costs and the relatively fixed nature of certain operating costs such as management costs, certain utility costs and minimum supply and maintenance costs, which decline as a percentage of revenue as revenue increases, partially offset by the increase in labor costs described above.  Although operating expenses will increase as revenue increases, the Company will continue to work with its management companies to reduce costs as a percentage of revenue where possible while maintaining quality and service levels at each property.

Property taxes, insurance, and other expense for the three months ended September 30, 2016 and 2015 totaled $14.8 million and $10.5 million, respectively, or 5.3% and 4.3% of total revenue, respectively.  For the nine months ended September 30, 2016 and 2015, property taxes, insurance and other expense totaled $40.3 million and $33.7 million, respectively, or 5.3% and 4.9% of total revenue, respectively.  The increase as a percent of revenue from 2015 is due primarily to the receipt in 2015 of approximately $1.8 million in settlement proceeds, net of costs, from the Deepwater Horizon Economic and Property Damages Settlement Program related to damages suffered at several of the Company’s hotels as a result of the Gulf of Mexico oil spill in 2010.  For the Company’s Comparable Hotels, real estate taxes increased during the first nine months of 2016 compared to the first nine months of 2015, with tax increases at certain locations due to the reassessment of property values by localities related to the improved economy, partially offset by decreases at other locations due to successful appeals of tax assessments.  With the economy continuing to improve, the Company anticipates continued increases in property tax assessments during the remainder of 2016.  The Company will continue to appeal tax assessments in certain jurisdictions to attempt to minimize tax increases as warranted.

 

 Ground Lease Expense

 

Ground lease expense for the three months ended September 30, 2016 and 2015 was $2.6 million and $2.5 million, respectively.  For the nine months ended September 30, 2016 and 2015, ground lease expense was $7.6 million and $7.5 million, respectively.  Ground lease expense primarily represents the expense incurred by the Company to lease land for 14 of its hotel properties, including four acquired in the Apple Ten merger effective September 1, 2016.

 

General and administrative expense for the three months ended September 30, 2016 and 2015 was $2.6 million and $5.2 million, respectively, or 0.9% and 2.2% of total revenue, respectively.  For the nine months ended September 30, 2016 and 2015, general and administrative expense was $12.5 million and $14.4 million, respectively, or 1.6% and 2.1% of total revenue for each respective period.  The principal components of general and administrative expense are payroll and related benefit costs, legal fees, accounting fees and reporting expenses.  In addition, through August 31, 2016, the Company provided to Apple Ten the advisory services contemplated under their advisory agreement, and the Company received fees and reimbursement of expenses payable under the advisory agreement from Apple Ten, both of which were reductions to general and administrative expenses.  Effective September 1, 2016, in connection with the completion of the Apple Ten merger, the advisory agreement was terminated and the Company no longer receives the fees and reimbursement of expenses payable under the advisory agreement from Apple Ten.  Since both the advisory fees and reimbursed costs received by the Company from Apple Ten were recorded as general and administrative expense by Apple Ten and as reductions to general and administrative expense by the Company, the termination of the advisory agreement had no financial impact on the combined company after the effective time of the merger.

The decrease in general and administrative expense for both the third quarter and first nine months of 2016 as compared to the prior year was due primarily to a decrease in compensation expense.  Based on the Company’s performance through September 30, 2016 in relation to the operational performance and shareholder return metrics of the executive incentive plan effective January 1, 2016 (“2016 Incentive Plan”), the accrual for potential executive bonus payments was reduced during the third quarter of 2016 by approximately $0.8 million, resulting in a decrease in executive compensation expense for the three and nine months ended September 30, 2016 of approximately $3.4 million and $3.0 million, respectively, as compared to the same periods in 2015.  The decrease in compensation expense was partially offset by an increase in share based compensation expense.  As a result of listing the Company’s common shares on the New York Stock Exchange effective May 18, 2015 (the “Listing”), the Company added a share based component to its executive compensation incentive plan in 2015, with compensation recognized over a two year period and, as a result, 2016 executive compensation expense includes recognition of share based compensation from both the 2015 and 2016 executive compensation incentive plans.

 

Transaction costs for the three months ended September 30, 2016 and 2015 were approximately $36.5 million and $0.8 million, respectively.  For the nine months ended September 30, 2016 and 2015, transaction costs were approximately $37.9 million and $7.9 million, respectively.  Transaction costs for the nine months ended September 30, 2016 consist primarily of (i) costs related to the Apple Ten merger discussed herein totaling approximately $37.6 million (including approximately $33.8 million of costs incurred to defend and reflect the proposed settlement (which remains subject to court approval) of the ongoing lawsuit related to the Apple Ten merger discussed herein) and (ii) other acquisition related costs totaling approximately $0.3 million.  Transaction costs for the nine months ended September 30, 2015 consist primarily of (i) costs related to the Board of Directors’ review and evaluation of strategic alternatives, including the Listing totaling $5.8 million, (ii) costs related to the Company’s merger with Apple REIT Seven, Inc. and Apple REIT Eight, Inc. on March 1, 2014 (“A7 and A8 mergers”) totaling approximately $1.0 million, which consisted primarily of costs to defend the A7 and A8 mergers class action lawsuit and (iii) acquisition related costs totaling approximately $1.1 million.

Loss on impairment of depreciable real estate assets was approximately $5.5 million for the three and nine months ended September 30, 2016, and relates to the Chesapeake, Virginia Marriott hotel that the Company identified for potential sale during this period.  See Note 3 titled “Investment in Real Estate” in the Company’s Unaudited Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Quarterly Report on Form 10-Q for additional information concerning this impairment loss.

Depreciation expense for the three months ended September 30, 2016 and 2015 was $37.3 million and $32.4 million, respectively.  For the nine months ended September 30, 2016 and 2015, depreciation expense was $104.7 million and $94.2 million, respectively.  Depreciation expense primarily represents expense of the Company’s hotel buildings and related improvements, and associated personal property (furniture, fixtures, and equipment) for their respective periods owned.  The increase was primarily due to the increase in the number of properties owned as a result of the Apple Ten merger effective September 1, 2016, the acquisition of one hotel on July 1, 2016 and seven hotels in 2015 and renovations completed throughout 2016 and 2015.

Interest and other expense, net for the three months ended September 30, 2016 and 2015 was $10.2 million and $9.3 million, respectively, and is net of approximately $0.2 million in each period of interest capitalized associated with renovation projects.  For the nine months ended September 30, 2016 and 2015, interest and other expense, net was $28.5 million and $24.3 million, respectively, and is net of approximately $1.2 million and $0.8 million of interest capitalized associated with renovation projects, respectively.  The increase in interest expense was primarily due to an increase in the Company’s average outstanding borrowings during the first nine months of 2016 as compared to 2015 which is primarily attributable to (a) mortgage debt assumed in the Apple Ten merger effective September 1, 2016 and (b) borrowings to fund (i) the cash payment portion of the Apple Ten merger, (ii) the repayment of Apple Ten’s outstanding balance on its extinguished credit facility assumed in the merger, (iii) the acquisition of eight hotels (seven between June 1, 2015 and October 31, 2015 and one on July 1, 2016) and (iv) the Company’s tender offer and share repurchase program in 2015.  The impact of higher debt balances was partially offset by a reduction in the average interest rate incurred on the Company’s total outstanding debt.  Also, the first nine months of 2015 includes a loss of approximately $0.4 million recorded to interest and other expense, net related to the change in fair value in the Company’s interest rate swap terminated in May 2015, from the time that it was no longer designated as a cash flow hedge during the first quarter of 2015 through the termination date.

Non-GAAP Financial Measures

The Company considers the following non-GAAP financial measures useful to investors as key supplemental measures of its operating performance: Funds from Operations (“FFO”), Modified FFO (“MFFO”), Earnings before Interest, Income Taxes, Depreciation and Amortization (“EBITDA”), and Adjusted EBITDA (“Adjusted EBITDA”).  These non-GAAP financial measures should be considered along with, but not as alternatives to, net income, cash flow from operations or any other operating GAAP measure.  FFO, MFFO, EBITDA and Adjusted EBITDA are not necessarily indicative of funds available to fund the Company’s cash needs, including its ability to make cash distributions.  Although FFO, MFFO, EBITDA and Adjusted EBITDA, as calculated by the Company, may not be comparable to FFO, MFFO, EBITDA and Adjusted EBITDA as reported by other companies that do not define such terms exactly as the Company defines such terms, the Company believes these supplemental measures are useful to investors when comparing the Company’s results between periods and with other REITs.

The Company calculates and presents FFO in accordance with standards established by the National Association of Real Estate Investment Trusts (“NAREIT”), which defines FFO as net income (computed in accordance with generally accepted accounting principles (“GAAP”)), excluding gains or losses from sales of real estate, extraordinary items as defined by GAAP, the cumulative effect of changes in accounting principles, plus real estate related depreciation, amortization and impairments, and adjustments for unconsolidated partnerships and joint ventures.  Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time.  Since real estate values instead have historically risen or fallen with market conditions, most real estate industry investors consider FFO to be helpful in evaluating a real estate company’s operations.  The Company further believes that by excluding the effects of these items, FFO is useful to investors in comparing its operating performance between periods and between REITs that report FFO using the NAREIT definition.  FFO as presented by the Company is applicable only to its common shareholders, but does not represent an amount that accrues directly to common shareholders.

The Company further adjusts FFO for certain additional items that are not in NAREIT’s definition of FFO, including: (i) the exclusion of transaction costs as these costs do not represent ongoing operations and (ii) the exclusion of non-cash straight-line ground lease expense as this expense does not reflect the underlying performance of the related hotels.  The Company presents MFFO when evaluating its performance because it believes that it provides further useful supplemental information to investors regarding its ongoing operating performance.

The following table reconciles the Company’s GAAP net income to FFO and MFFO for the three and nine months ended September 30, 2016 and 2015 (in thousands).

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Net income		$	13,694			$	46,968			$	103,098			$	135,080
Depreciation of real estate owned			37,114				32,121				103,962				93,516
Gain on sale of real estate			-				-				-				(15,358	)
Loss on impairment of depreciable real estate assets			5,471				-				5,471				-
Amortization of favorable and unfavorable leases, net			132				133				513				2,289
Funds from operations			56,411				79,222				213,044				215,527
Transaction costs			36,452				842				37,861				7,891
Non-cash straight-line ground lease expense			843				829				2,479				2,528
Modified funds from operations		$	93,706			$	80,893			$	253,384			$	225,946