Apple Hospitality REIT, Inc. - Quarter Report: 2016 June (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 June 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)

 

Virginia		26-1379210
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
814 East Main Street Richmond, Virginia		23219
(Address of principal executive offices)		(Zip Code)

 

(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 August 1, 2016: 174,670,726

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)

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 June 30, 2016, the Company owned 179 hotels with an aggregate of 22,961 rooms located in 32 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 six months ended June 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 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 six months ended June 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 periods beginning after December 15, 2018, and interim periods within those years, 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 periods beginning after December 15, 2016, and interim periods within those years, 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.

          

2.  Merger Agreement with Apple REIT Ten, Inc.

On April 13, 2016, the Company, Apple REIT Ten, Inc. (“Apple Ten”) and 34 Consolidated, Inc., a wholly-owned subsidiary of the Company (“Acquisition Sub”), entered into an Agreement and Plan of Merger, as amended on July 13, 2016 (the “Merger Agreement”).  The terms and conditions of the Merger Agreement provide that Apple Ten will merge with and into Acquisition Sub, with Acquisition Sub being the surviving corporation in the merger and remaining a wholly-owned subsidiary of the Company (the “merger”).  Acquisition Sub was formed solely for the purpose of engaging in the merger and has not conducted any prior activities.  As of June 30, 2016, Apple Ten owned 56 hotels with 7,209 rooms.  Under the terms of the Merger Agreement, each issued and outstanding unit of Apple Ten (consisting of a common share and related Series A preferred share) (each, an “Apple Ten unit”), other than those Apple Ten units with respect to which statutory dissenters’ rights of appraisal have been properly exercised, perfected and not subsequently withdrawn or lost under Virginia law, will be converted into the right to receive (i) 0.522 (the “unit exchange ratio”) common shares of the Company and (ii) $1.00 in cash, and each issued and outstanding Series B convertible preferred share of Apple Ten will be 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 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 $93.4 million in cash to Apple Ten shareholders (assuming no exercise of dissenters’ rights).  The current outstanding Company common shares will remain outstanding.  As a result of the merger, the Company, through its wholly-owned subsidiary, will assume all of Apple Ten’s assets and liabilities at closing, which include approximately $262 million of debt as of June 30, 2016.  

If the merger closes, the advisory and related party arrangements with respect to Apple Ten and its advisors, as described in more detail in Note 7, will terminate.  The merger is subject to approval by Apple Ten shareholders and the proposed issuance of common shares by the Company in the merger is subject to approval by the Company’s shareholders.  In addition to the shareholder approvals, the merger is subject to other customary closing conditions, therefore there is no assurance that the merger will occur.  Shareholder meetings for each company are scheduled for August 31, 2016.  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 these activities, the Company incurred approximately $1.2 million in expenses for the six months ended June 30, 2016, and anticipates that the Company’s total merger costs will be approximately $4 million.

3.  Investment in Real Estate

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

As of June 30, 2016, the Company owned 179 hotels with an aggregate of 22,961 rooms located in 32 states.  There were no acquisitions during the six month period ended June 30, 2016.  During the six month period ended June 30, 2015, the Company acquired two 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 six months ended June 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 June 30, 2016, the Company had outstanding contracts for the potential purchase of four additional hotels for a total purchase price of $81.1 million.  The newly constructed Atlanta Home2 Suites was acquired on July 1, 2016, the same day the hotel opened for business.  The remaining three hotels are under construction and are expected to be completed and opened for business over the next 12 months from June 30, 2016, 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 June 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 purchase price for the Atlanta Home2 Suites was funded through borrowings under the Company’s $540 million revolving credit facility and it is anticipated that the purchase price for the remaining outstanding contracts will be funded similarly if a closing occurs.

4.  Dispositions

During the six months ended June 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 six months ended June 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 (loss) of approximately $(0.1) million and $2.0 million for the three and six months ended June 30, 2015 relating to results of operations for the 19 hotels for the respective periods of ownership.  The sale of these properties does not represent a strategic shift that has, or will 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 three and six months ended June 30, 2015.  There were no dispositions during the six month period ended June 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”).  The Company initially borrowed $50 million under the $150 million term loan facility and may borrow the remaining $100 million at any time on or before October 5, 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 is also required to pay quarterly an unused fee at an annual rate of 0.25% on the unused portion of the $150 million term loan facility during the quarter.  The Company also entered into two forward interest rate swap agreements, which beginning on September 30, 2016 will 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 have been and will be 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 within the next nine months.

As of June 30, 2016 and December 31, 2015, the details of the Company’s revolving credit facility, $425 million term loans and $150 million term loan facility 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 June 30, 2016.

          

Mortgage Debt

As of June 30, 2016, the Company had approximately $399.6 million in outstanding property level debt secured by 31 properties, with maturity dates ranging from November 2016 to October 2032, stated interest rates ranging from 0% to 6.50% and effective interest rates ranging from 3.66% 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 June 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 June 30, 2016 and thereafter are as follows (in thousands):

          

          

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 June 30, 2016 and 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 June 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 six months ended June 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 losses of approximately $5.5 million and $0.2 million during the three months ended June 30, 2016 and 2015, respectively, and unrealized losses of approximately $12.2 million and $0.5 million during the six months ended June 30, 2016 and 2015, respectively, to other comprehensive income (loss).  There was no ineffectiveness recorded on designated cash flow hedges during the three and six months ended June 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 $1.0 million and $0.3 million during the three months ended June 30, 2016 and 2015 and unrealized losses of approximately $1.9 million and $0.6 million during the six months ended June 30, 2016 and 2015 from accumulated other comprehensive loss to interest and other expense, net.  Approximately $4.8 million of the net unrealized losses included in accumulated other comprehensive loss at June 30, 2016 is expected to be reclassified into interest and other expense, net within the next 12 months.  Also, during the second quarter of 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 $14.3 million and $2.1 million as of June 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 six months ended June 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.  As of June 30, 2016, there have been no changes to the contracts and relationships discussed in the Company’s 2015 Annual Report on Form 10-K, other than the Merger Agreement and related transactions discussed herein.  Below is a summary of the related party relationships in effect and transactions that occurred during the six months ended June 30, 2016 and 2015.

Glade M. Knight, Executive Chairman of the Company, is currently Chairman and Chief Executive Officer of Apple Ten.  Apple Ten’s advisors, Apple Ten Advisors, Inc. (“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 serves as President of Apple Ten.

Subcontract Agreement with A10A

The Company has a subcontract agreement with A10A.  Under the agreement, A10A has subcontracted its obligations under its advisory agreement with Apple Ten to the Company.  The Company provides to Apple Ten the advisory services contemplated under the A10A advisory agreement and receives 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 is 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.  Total advisory fees earned by the Company from Apple Ten for the six months ended June 30, 2016 and 2015 totaled approximately $1.2 million in each period, 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

The Company provides support services to Apple Ten and its advisors, A10A and ARG, which have agreed to reimburse the Company for its costs in providing these services.  Total reimbursed costs received by the Company from these entities for the six months ended June 30, 2016 and 2015 totaled approximately $1.7 million and $1.3 million, respectively, and are recorded as a reduction to general and administrative expenses in the Company’s consolidated statements of operations.  As of June 30, 2016 and December 31, 2015, total amounts due from Apple Ten, A10A and ARG for reimbursements under the cost sharing structure totaled approximately $0.1 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.  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.  As part of the cost sharing arrangements, certain day-to-day transactions may result in amounts due to or from the Company, Apple Ten, A10A and ARG.  To efficiently manage cash disbursements, the Company, Apple Ten, A10A or ARG may make payments for any or all of the related companies.  Under the cash management process, each of the companies may advance or defer up to $1 million at any time.  Each month, any outstanding amounts are settled among the affected companies.  This process allows each company to minimize its cash on hand, which, in turn, reduces the cost of each company’s credit facility.  The amounts outstanding at any point in time are not significant to any of the companies.

Apple Air Holding, LLC (“Apple Air”)

The Company, through a jointly-owned subsidiary, Apple Air, owns a Learjet used primarily for acquisition, asset management, renovation and public relations purposes.  Apple Air is 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 June 30, 2016 and December 31, 2015, totaled approximately $0.8 and $0.7 million, respectively, and is included in accounts payable and other liabilities in the Company’s consolidated balance sheets.  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 six months ended June 30, 2016 and 2015 were approximately $0.1 million in each period related to aircraft owned through these two entities and are included in general and administrative expenses in the Company’s consolidated statements of operations.

Merger Agreement and Related Transactions

Concurrently with the execution of the Merger Agreement, as discussed in Note 2, on April 13, 2016, the Company, Apple Ten, A10A and ARG entered into a termination agreement (the “termination agreement”).  Pursuant to the terms of the termination agreement, the existing advisory agreement, property acquisition/disposition agreement and subcontract agreement with respect to the Company, Apple Ten, A10A and ARG, discussed above, will be terminated effective immediately after the effective time of the merger, and no fees will be payable as a result of the termination of these agreements.  As a result, if the merger is completed, Apple Ten would no longer pay the various fees currently paid to the Company under the subcontract agreement and A10A would no longer subcontract its advisory services to the Company.  Additionally, Apple Ten would no longer have any advisory contracts with A10A or ARG after the merger.  Both the advisory fees and reimbursed costs received by the Company from Apple Ten are 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 will have no financial impact on the combined company after the effective time of the merger.  Also under the Merger Agreement, Apple Ten’s 26% interest in Apple Air would be one of the assets acquired by the Company if the merger is completed.

Under the proposed merger, if completed, the officers and Executive Chairman of the Company would receive 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.

8.  Shareholders’ Equity

Distributions

For the three months ended June 30, 2016 and 2015, the Company paid distributions of $0.30 and $0.3267 per common share for a total of $52.4 million and $60.8 million, respectively.  For the six months ended June 30, 2016 and 2015, the Company paid distributions of $0.60 and $0.6667 per common share for a total of $104.7 million and $124.2 million, respectively.  Additionally, in June 2016, the Company declared a monthly distribution of $0.10 per common share, totaling $17.5 million, which was recorded as a payable as of June 30, 2016 and paid in July 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.

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 (“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 Plan in January 2016.  From implementation through the termination of the Plan, the Company purchased approximately 1.3 million of its common shares under the 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.  In June 2016, the Board of Directors approved a one-year extension of the program authorizing share repurchases up to an aggregate of $475 million.  The Company plans to continue to consider opportunistic share repurchases under its $475 million share repurchase program.  The program may be suspended or terminated at any time by the Company.  If not terminated earlier, the program will end in July 2017.

          

During the six months ended June 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 June 30, 2016, the Company has accrued approximately $3.6 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 sheets as of June 30, 2016.  Compensation expense recognized by the Company under the 2016 Incentive Plan is included in general and administrative expense in the Company’s consolidated statements of operations and totaled approximately $1.7 million and $3.6 million for the three and six months ended June 30, 2016, respectively.  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 $1.0 million and $3.2 million in general and administrative expense in the Company’s consolidated statements of operations for the three and six months ended June 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 six months ended June 30, 2016, the Company recognized approximately $0.4 million and $0.8 million, respectively, of share based compensation expense related to the unvested restricted share awards.

          

10.  Subsequent Events

In July 2016, the Company paid approximately $17.5 million, or $0.10 per outstanding common share, in distributions to its common shareholders.

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

On July 1, 2016, the Company closed on the purchase of a newly constructed 128-room Home2 Suites in Atlanta, Georgia, the same day the hotel opened for business.  The gross purchase price was $24.6 million.

On July 19, 2016, one lawsuit was filed against the Company, Apple Ten and Apple Ten’s Board of Directors, and certain officers of each company in connection with the proposed merger.  For additional information about the lawsuit, refer to Part II, Item 1, Legal Proceedings, appearing elsewhere in this Quarterly Report on Form 10-Q.

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,” 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 and Apple REIT Ten, Inc. (“Apple Ten”) to obtain the required shareholder or other third-party approvals to consummate the proposed merger, under which Apple Ten would be merged with and into a wholly-owned subsidiary of the Company; the satisfaction or waiver of other conditions in the merger agreement governing the merger between the Company and Apple Ten; the risk that the merger or the other transactions contemplated by the merger agreement may not be completed in the time frame expected by the parties or at all; the occurrence of any event, change or other circumstances that could give rise to the termination of the merger agreement and that a termination under certain circumstances could require the Company to pay Apple Ten a termination fee; the ability of the Company to effectively acquire and dispose of properties, including properties to be acquired in the merger; the ability of the Company to successfully integrate pending transactions and implement its operating strategy, including the merger; 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, Apple Ten and others related to the merger agreement; 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 June 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 June 30, 2016, the Company owned 179 hotels with an aggregate of 22,961 rooms located in 32 states.  All of the Company’s hotels operate under Marriott or Hilton brands.  The hotels are operated and managed under separate management agreements with 20 hotel management companies, none of which are affiliated with the Company.

Merger Agreement with Apple REIT Ten, Inc.

On April 13, 2016, the Company entered into a definitive merger agreement with Apple Ten, as amended on July 13, 2016 (the “Merger Agreement”), pursuant to which Apple Ten will merge with and into a wholly-owned subsidiary of the Company (the “merger”).  As of June 30, 2016, Apple Ten owned 56 hotels with 7,209 rooms.  Under the terms of the Merger Agreement, each issued and outstanding unit of Apple Ten (consisting of a common share and related Series A preferred share) (each, an “Apple Ten unit”), other than those Apple Ten units with respect to which statutory dissenters’ rights of appraisal have been properly exercised, perfected and not subsequently withdrawn or lost under Virginia law, will be converted into the right to receive (i) 0.522 (the “unit exchange ratio”) common shares of the Company and (ii) $1.00 in cash, and each issued and outstanding Series B convertible preferred share of Apple Ten will receive 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 $93.4 million in cash to Apple Ten shareholders (assuming no exercise of dissenters’ rights).  The current outstanding Company common shares will remain outstanding.  As a result of the merger, a wholly-owned subsidiary of the Company will assume all of Apple Ten’s assets and liabilities at closing, which include approximately $262 million of debt as of June 30, 2016.  If the merger closes, the advisory and related party arrangements with respect to Apple Ten and its advisors will terminate.  The merger is subject to approval by Apple Ten shareholders and the proposed issuance of common shares by the Company in the merger is subject to approval by the Company’s shareholders.  In addition to the shareholder approvals, the merger is subject to other customary closing conditions, therefore there is no assurance that the merger will occur.  Shareholder meetings for each company are scheduled for August 31, 2016.  If all conditions to closing are satisfied, the merger is expected to close in the third quarter of 2016.  See Note 2 titled “Merger Agreement 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 proposed merger with Apple Ten.

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.  The hotel industry and the Company’s hotels overall continue to experience improvement in both revenues and operating income as compared to the prior year.  Although economic conditions in the United States have been generally favorable, 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 to mid-single digit percentage increase in revenue for the full year of 2016 as compared to 2015.  Based on recent revenue trends, the anticipated revenue growth rates for comparable hotels in 2016 are lower than the growth achieved in 2015.

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 June 30, 2016, the Company owned 179 hotels with 22,961 rooms as compared to 174 hotels with a total of 22,177 rooms as of June 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.  No hotels were acquired or sold during the six months ended June 30, 2016.  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 six months ended June 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 179 hotels owned as of June 30, 2016 (“Comparable Hotels”).  The Company defines metrics from Comparable Hotels as results generated by the 179 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.

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 income for its Comparable Hotels improved during the three and six months ended June 30, 2016 as compared to the same periods in 2015.  The Company expects continued improvement in revenue and operating income for its Comparable Hotels for the remainder of 2016 as compared to 2015.  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 June 30, 2016 and 2015, the Company had total revenue of $257.6 million and $234.4 million, respectively.  For the six months ended June 30, 2016 and 2015, the Company had total revenue of $482.1 million and $444.7 million, respectively.  For the three months ended June 30, 2016 and 2015, respectively, Comparable Hotels achieved combined average occupancy of 82.2% and 81.9%, ADR of $138.16 and $131.97 and RevPAR of $113.59 and $108.09.  For the six months ended June 30, 2016 and 2015, respectively, Comparable Hotels achieved combined average occupancy of 78.2% and 78.1%, ADR of $135.79 and $129.95 and RevPAR of $106.13 and $101.53.  ADR is calculated as room revenue divided by the number of rooms sold, and RevPAR is calculated as occupancy multiplied by ADR.

During the second quarter and first half of 2016, the Company experienced stable occupancy and an increase in ADR compared to the same periods of 2015, signifying general economic strength.  Although certain markets will vary based on local supply/demand dynamics and local market economic conditions, with continued overall room rate improvement combined with stable overall demand growth compared to supply growth and the Company’s geographically diverse portfolio of upscale and upper midscale select service hotels, the Company, on a comparable basis, and industry are forecasting a low to mid-single digit percentage increase in revenue for the full year of 2016 as compared to 2015.  During the first half of 2016, the Company had approximately 25 properties under renovation, with approximately 51,000 room nights out of service.  Although the renovations for the full year are anticipated to be consistent with prior years, room nights out of service in the first half of 2016 were higher than in the first half of 2015.

          

          

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 June 30, 2016 and 2015, respectively, hotel operating expense totaled $137.4 million and $127.3 million or 53.3% and 54.3% of total revenue for each respective period.  For the six months ended June 30, 2016 and 2015, respectively, hotel operating expense totaled $264.6 million and $249.8 million or 54.9% and 56.2% of total revenue for each respective period.  Overall hotel operational expenses for the first six months of 2016 include the results of seven hotels acquired after June 1, 2015 for the full period, and for the first six 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 decreased approximately 100 and 80 basis points for the three and six months ended June 30, 2016, respectively, as compared to the same periods in 2015 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.  The Company has also been successful in reducing, relative to revenue increases, certain labor costs, hotel supply costs, maintenance costs and utility costs by continually monitoring and sharing utilization data across its hotels and management companies.  To date, only modest increases in labor cost have been experienced by the Company, however the Company anticipates labor costs are likely 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 could be impacted in certain markets due to lower unemployment rates.  With less qualified available labor the cost could increase.  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 June 30, 2016 and 2015 totaled $13.1 million and $11.7 million, respectively, or 5.1% and 5.0% of total revenue, respectively.  For the six months ended June 30, 2016 and 2015, property taxes, insurance and other expense totaled $25.5 million and $23.3 million, respectively, or 5.3% and 5.2% of total revenue, respectively.  For the Company’s Comparable Hotels, real estate taxes increased during the first half of 2016 compared to the first half 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 for both the three months ended June 30, 2016 and 2015 was $2.5 million.  For the six months ended June 30, 2016 and 2015, ground lease expense was $5.0 million for each respective period.  Ground lease expense primarily represents the expense incurred by the Company to lease land for ten of its hotel properties.

          

General and administrative expense for the three months ended June 30, 2016 and 2015 was $5.1 million and $3.7 million, respectively, or 2.0% and 1.6% of total revenue, respectively.  For the six months ended June 30, 2016 and 2015, general and administrative expense was $9.9 million and $9.2 million, respectively, or 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, the Company provides to Apple Ten the advisory services contemplated under their advisory agreement, and the Company receives fees and reimbursement of expenses payable under the advisory agreement from Apple Ten, both of which are reductions to general and administrative expenses.  During the second quarter of 2015, Apple Ten reached the top tier of fees under its advisory agreement resulting in the recognition of approximately $0.3 million in additional advisory fees by the Company during this period.  The increase in general and administrative expense for both the second quarter and first half of 2016 as compared to the prior year was due to 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.  The increase for the six months ended June 30, 2016 as compared to the prior year was partially offset by reduced legal costs associated with litigation.

          

Transaction costs for the three months ended June 30, 2016 and 2015 were approximately $1.1 million and $5.8 million, respectively.  For the six months ended June 30, 2016 and 2015, transaction costs were approximately $1.4 million and $7.0 million, respectively.  Transaction costs for the six months ended June 30, 2016 consist primarily of costs related to the pending merger with Apple Ten pursuant to the Merger Agreement discussed herein totaling approximately $1.2 million and other acquisition related costs.  The Company will continue to incur costs related to the merger until the merger is completed or the Merger Agreement is terminated.  Transaction costs for the six months ended June 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 $0.9 million, which consisted primarily of costs to defend the A7 and A8 mergers class action lawsuit and (iii) acquisition related costs totaling approximately $0.3 million.

          

          

Depreciation expense for the three months ended June 30, 2016 and 2015 was $33.8 million and $31.1 million, respectively.  For the six months ended June 30, 2016 and 2015, depreciation expense was $67.3 million and $61.9 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 due to the increase in the number of properties owned as a result of the acquisition of seven hotels in 2015 and renovations completed throughout 2016 and 2015.

Interest and other expense, net for the three months ended June 30, 2016 and 2015 was $9.6 million and $7.2 million, respectively, and is net of approximately $0.1 million and $0.04 million of interest capitalized associated with renovation projects, respectively.  For the six months ended June 30, 2016 and 2015, interest and other expense, net was $18.4 million and $15.0 million, respectively, and is net of approximately $1.0 million and $0.6 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 half of 2016 as compared to 2015 which is attributable to borrowings to fund the Company’s tender offer and share repurchase program in 2015 and the acquisition of seven hotels between June 1, 2015 and October 31, 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 six 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 six months ended June 30, 2016 and 2015 (in thousands).

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2016				2015				2016				2015
Net income		$	54,718			$	44,245			$	89,404			$	88,112
Depreciation of real estate owned			33,594				30,906				66,848				61,395
(Gain) loss on sale of real estate			-				271				-				(15,358	)
Amortization of favorable and unfavorable leases, net			119				133				381				2,156
Funds from operations			88,431				75,555				156,633				136,305
Transaction costs			1,116				5,825				1,409				7,049
Non-cash straight-line ground lease expense			817				849				1,636				1,699
Modified funds from operations		$	90,364			$	82,229			$	159,678			$	145,053

 

 

EBITDA is a commonly used measure of performance in many industries and is defined as net income excluding interest, income taxes and depreciation and amortization.  The Company believes EBITDA is useful to investors because it helps the Company and its investors evaluate the ongoing operating performance of the Company by removing the impact of its capital structure (primarily interest expense) and its asset base (primarily depreciation and amortization).  In addition, certain covenants included in the Company’s indebtedness use EBITDA, as defined in the specific credit agreement, as a measure of financial compliance.

The Company considers the exclusion of certain additional items from EBITDA useful, including: (i) the exclusion of transaction costs and gains or losses from sales of real estate as these 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 following table reconciles the Company’s GAAP net income to EBITDA and Adjusted EBITDA for the three and six months ended June 30, 2016 and 2015 (in thousands).

Hotels Owned

           

As of June 30, 2016, the Company owned 179 hotels with an aggregate of 22,961 rooms located in 32 states.  The following tables summarize the number of hotels and rooms by brand and by state:

 

The following table summarizes the location, brand, manager, date acquired or completed and number of rooms for each of the 179 hotels the Company owned as of June 30, 2016.