Service Properties Trust - Quarter Report: 2004 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2004

 

OR

 

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

 

Commission File Number 1-11527

 

HOSPITALITY PROPERTIES TRUST

 

Maryland	04-3262075
(State of Organization)	(IRS Employer Identification No.)
400 Centre Street, Newton, Massachusetts 02458
617-964-8389

 

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, and (2) has been subject to such filing requirements for the past 90 days. Yes   ý   No   o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b–2 of the Exchange Act). Yes   ý   No   o

 

Number of registrant’s common shares of beneficial interest, $0.01 par value per share, outstanding as of November 3, 2004: 67,203,229

 

 

HOSPITALITY PROPERTIES TRUST

 

FORM 10-Q

 

September 30, 2004

 

INDEX

 

PART I	Financial Information (Unaudited)
	Item 1. Financial Statements
	Consolidated Balance Sheet – September 30, 2004 and December 31, 2003
	Consolidated Statement of Income – Three and Nine Months Ended September 30, 2004 and 2003
	Consolidated Statement of Cash Flows – Nine Months Ended September 30, 2004 and 2003
	Notes to Consolidated Financial Statements
	Item 2.
	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.
	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.
	Controls and Procedures
	Warning Concerning Forward Looking Statements
	Statement Concerning Limited Liability
PART II	Other Information
	Item 2.
	Unregistered Sales of Equity Securities and Use of Proceeds
	Item 6.
	Exhibits
	Signatures

 

 

References in this Form 10-Q to the “Company”, “HPT”, “we”, “us” or “our” refer to Hospitality Properties Trust and its consolidated subsidiaries unless otherwise noted.

 

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PART I            Financial Information

Item 1.  Financial Statements

 

HOSPITALITY PROPERTIES TRUST

 

CONSOLIDATED BALANCE SHEET

(dollars in thousands, except share data)

 

		September 30, 2004				December 31, 2003
		(Unaudited)
ASSETS
Real estate properties, at cost:
Land		$	460,748			$		461,631
Buildings, improvements and equipment		2,732,757				2,717,876
		3,193,505				3,179,507
Accumulated depreciation		(555,202			)	(494,299			)
		2,638,303				2,685,208
Cash and cash equivalents		3,491				6,428
Restricted cash (FF&E Reserve escrows)		45,532				55,755
Other assets, net		11,268				14,210
		$	2,698,594			$		2,761,601
LIABILITIES AND SHAREHOLDERS’ EQUITY
Revolving credit facility		$	80,000			$		201,000
Senior notes, net of discounts		621,570				621,245
Mortgage payable		3,840				3,881
Security and other deposits		175,304				175,304
Accounts payable and other liabilities		61,995				68,244
Due to affiliate		5,268				1,336
Dividends payable		—				45,063
Total liabilities		947,977				1,116,073
Commitments and Contingencies
Shareholders’ equity:
Preferred shares of beneficial interest, no par value, 100,000,000 shares authorized:
Series A preferred shares; 9 1/2% cumulative redeemable; none and 3,000,000 shares issued and outstanding,respectively, aggregate liquidation preference none and $75,000, respectively		—				72,207
Series B preferred shares; 8 7/8% cumulative redeemable;3,450,000 shares issued and outstanding, aggregate liquidation preference $86,250		83,306				83,306
Common shares of beneficial interest; $0.01 par value; 100,000,000 shares authorized, 67,203,229 and 62,587,079 issued and outstanding, respectively		672				626
Additional paid-in capital		1,859,936				1,669,411
Cumulative net income		1,045,313				954,078
Cumulative preferred distributions		(47,852			)	(40,092			)
Cumulative common distributions		(1,190,758			)	(1,094,008			)
Total shareholders’ equity		1,750,617				1,645,528
		$		2,698,594		$	2,761,601

 

The accompanying notes are an integral part of these financial statements.

 

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HOSPITALITY PROPERTIES TRUST

 

CONSOLIDATED STATEMENT OF INCOME

(Unaudited)

(in thousands, except per share data)

 

		Three Months Ended September 30,							Nine Months Ended September 30,
		2004				2003			2004			2003
Revenues:
Hotel operating revenues		$	136,861			$	72,338		$	378,780		$	140,498
Rental income		30,312				48,163			95,326			160,251
FF&E reserve income		4,660				4,318			14,243			14,132
Interest income		159				44			185			335
Total revenues		171,992				124,863			488,534			315,216
Expenses:
Hotel operating expenses		94,896				51,064			259,216			97,168
Interest (including amortization of deferred financing costs of $686, $626, $2,058 and $1,853, respectively)		12,530				11,508			37,775			31,910
Depreciation and amortization		28,713				26,859			86,158			77,075
General and administrative		5,146				4,535			14,353			12,400
Loss on early extinguishment of debt		—				—			—			2,582
Total expenses		141,285				93,966			397,502			221,135
Income before gain on sale of real estate		30,707				30,897			91,032			94,081
Gain on sale of real estate		—				—			203			—
Net income		30,707				30,897			91,235			94,081
Preferred distributions		(1,914			)	(3,695		)	(7,760		)	(11,085		)
Excess of liquidation preference over carrying value of Series A preferred shares		—				—			(2,793		)	—
Net income available for common shareholders		$		28,793		$	27,202		$	80,682		$	82,996
Weighted average common shares outstanding		67,191				62,587			66,268			62,572
Basic and diluted earnings per common share:
Net income available for common shareholders		$		0.43		$	0.43		$	1.22		$	1.33

 

The accompanying notes are an integral part of these financial statements.

 

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HOSPITALITY PROPERTIES TRUST

 

CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

(in thousands)

 

		Nine Months Ended September 30,
		2004			2003
Cash flows from operating activities:
Net income		$	91,235		$	94,081
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		86,158			77,075
Amortization of deferred financing costs as interest		2,058			1,853
Amortization of non-cash deferred gain		(2,214		)	—
FF&E reserve income and deposits		(22,504		)	(18,904		)
Deferred percentage rent		2,167			850
Loss on early extinguishment of debt		—			2,582
Gain on sale of real estate		(203		)	—
Changes in assets and liabilities:
Decrease (increase) in other assets		2,130			(4,078		)
(Decrease) increase in accounts payable and other		(11,188		)	1,122
Increase in due to affiliate		3,932			3,643
Cash provided by operating activities		151,571			158,224
Cash flows from investing activities:
Real estate improvements		(9,367		)	(281,110		)
Increase in security and other deposits		—			16,872
Proceeds from sale of real estate		7,750			—
Cash used in investing activities		(1,617		)	(264,238		)
Cash flows from financing activities:
Proceeds from issuance of common shares, net		192,684			—
Proceeds from issuance of senior notes		—			296,997
Repayment of senior notes		—			(150,000		)
Redemption of Series A preferred shares		(75,000		)	—
Draws on revolving credit facility		245,000			251,000
Repayments of revolving credit facility		(366,000		)	(147,000		)
Distributions to common shareholders		(141,813		)	(135,150		)
Distributions to preferred shareholders		(7,760		)	(9,916		)
Deferred finance costs paid		(2		)	(2,836		)
Cash (used in) provided by financing activities		(152,891		)	103,095
Decrease in cash and cash equivalents		(2,937		)	(2,919		)
Cash and cash equivalents at beginning of period		6,428			7,337
Cash and cash equivalents at end of period		$	3,491		$	4,418
Supplemental cash flow information:
Cash paid for interest		$	46,644		$	34,022
Non-cash operating activities:
Property transferred in lease default		4,920			—
Non-cash investing and financing activities:
Property managers’ deposits in FF&E reserve		20,281			16,446
Purchases of fixed assets with FF&E reserve		(32,478		)	(45,574		)

 

The accompanying notes are an integral part of these financial statements.

 

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HOSPITALITY PROPERTIES TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousand, except per share data)

 

Note 1.  Basis of Presentation

 

The accompanying consolidated financial statements of Hospitality Properties Trust and its subsidiaries have been prepared without audit.  Certain information and footnote disclosures required by generally accepted accounting principles for complete financial statements have been condensed or omitted. We believe the disclosures made are adequate to make the information presented not misleading. However, the accompanying financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2003. In the opinion of management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included. All intercompany transactions and balances between Hospitality Properties Trust and its subsidiaries have been eliminated. Our operating results for interim periods and those of our tenants are not necessarily indicative of the results that may be expected for the full year.

 

Note 2.  Revenue Recognition

 

We report hotel operating revenues for managed hotels in our consolidated statement of income. Hotel operating revenues, consisting primarily of room sales and sales of food, beverages and telephone services are generally recognized when services are performed. Our rights to share in the operating results of our managed hotels in excess of minimum returns due us are generally determined based upon annual calculations. Hotel operating income in excess of the minimum returns due to us under our management agreements is recognized when all contingencies are met and the income is earned. Deferred hotel operating income was $1,083 and $3,546 for the three and nine months ended September 30, 2004, respectively, and zero for the three and nine months ended September 30, 2003, respectively.

 

We recognize rental income from operating leases on a straight line basis over the life of the lease agreements. Percentage rent is recognized when all contingencies are met and rent is earned. Deferred percentage rent was $900 and $2,167 for the three and nine months ended September 30, 2004, respectively, compared with $389 and $850 for the three and nine months ended September 30, 2003, respectively.

 

We own all the FF&E reserve escrows for hotels leased to our taxable REIT subsidiary. Some of our third party leases provide that FF&E reserve escrows are owned by us. Other third party leases provide that FF&E reserve escrows are owned by the tenant and we have a security and remainder interest in the escrow account. When we own the escrow account, payments by our third party tenants into the escrow are reported by us as FF&E reserve income. When we have a security and remainder interest in the escrow account, tenant deposits are not included in revenue.

 

Note 3.  Shareholders’ Equity

 

On February 23, 2004, we sold 4,000,000 of our common shares of beneficial interest at $43.93 per share in a public offering. As part of this offering we granted the underwriters a 30-day option to buy an additional 600,000 common shares of beneficial interest to cover over allotments which they exercised in full on March 8, 2004. Net proceeds, from both these sales, after underwriting and other offering expenses, were $192,684. We used these proceeds to reduce borrowings outstanding under our revolving credit facility.

 

On April 12, 2004, we redeemed all of our outstanding 9 ½% Series A preferred shares at their liquidation preference of $25 per share plus accrued and unpaid distributions of $0.0792 per share. This redemption was funded with borrowings under our revolving credit facility. Pursuant to the Securities and Exchange Commission’s clarification on Emerging Issues Task Force Topic D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock, the $2,793 excess of the liquidation preference of the redeemed shares over their carrying amount was charged to additional paid-in capital and deducted from net income to determine net income available to common shareholders in the calculation of earnings per share.

 

On July 15, 2004, we paid $0.5546875 per share distribution to our Series B preferred shareholders. On September 1, 2004, we declared a $0.5546875 per share distribution to Series B preferred shareholders of record on October 1, 2004. This amount was paid on October 15, 2004.

 

6

 

On August 20, 2004, we paid a $0.72 per share distribution to our common shareholders for the quarter ended June 30, 2004. On October 1, 2004, we declared a distribution of $0.72 per share to common shareholders of record on October 19, 2004, for the quarter ended September 30, 2004. We plan to pay this amount on or about November 19, 2004.

 

On September 15, 2004, we granted 14,650 common shares pursuant to our Incentive Share Award Plan valued at $42.64 per common share, the closing price of the common shares on the New York Stock Exchange on that day, to our officers and employees of our advisor, Reit Management & Research LLC.

 

Note 4.  Indebtedness

 

We have a $350,000, interest only, unsecured credit facility. Our credit facility matures in June 2005 and may be extended at our option to June 2006 upon our payment of an extension fee. The interest rate (3.1% per annum at September 30, 2004) is LIBOR plus a spread. As of September 30, 2004, we had $80,000 outstanding on our credit facility and $270,000 available for acquisitions and general business purposes.

 

Note 5.  Real Estate Properties

 

During the nine months ended September 30, 2004, we provided $7,500 of funding for planned tenant improvements to certain of our hotels, which resulted in a $757 increase in our annual minimum rents and returns.

 

On April 15, 2004, we sold a Summerfield Suites hotel located in Buckhead, Georgia to an unaffiliated third party for $7,750 and recognized a $203 gain on the sale. This hotel was included in a portfolio of 31 hotels managed by InterContinental Hotels Group, PLC, or InterContinental. Pursuant to the terms of our agreement with InterContinental, the minimum return due for that portfolio has been reduced by $775 annually.

 

Note 6.  Lease Termination

 

Upon effectiveness of our new management agreement with Prime Hospitality Corp., or Prime, on January 1, 2004, we settled all our outstanding claims with Prime arising from its lease default in July 2003. The balance of the retained deposits and the value of other property received from Prime pursuant to the settlement, totaling approximately $44,281, is being amortized into our income on a straight line basis over the initial 15 year term of Prime’s new management contract for the affected hotels. We amortized $738 and $2,214 into income for the three and nine months ended September 30, 2004, respectively. The unamortized balance of $42,067 at September 30, 2004, is included in accounts payable and other liabilities in the accompanying consolidated balance sheet.

 

Note 7.  New Accounting Pronouncement

 

In January 2003, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, or FIN 46, that was effective for all enterprises with variable interest entities created after January 31, 2003. In December 2003, FASB issued a revised FIN 46 which provided for the deferral of the effective date of the interpretation to January 1, 2004, for variable interest entities created prior to January 31, 2003. The adoption of FIN 46 had no effect on our financial statements.

 

7

 

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

 

Overview

 

The following information should be read in conjunction with financial statements and notes thereto included in this quarterly report and with our Annual Report on Form 10-K.

 

Hotel Industry Conditions

 

As a result of terrorism concerns, the war with Iraq and the impact of a recessionary economy, the U.S. hotel industry experienced significant declines in occupancy, revenues and profitability in 2001, 2002 and 2003. These declines primarily arose from reduced business travel. During the first nine months of 2004, some of our hotels’ operators experienced improved operating results versus the first nine months of 2003, while others continued to experience declines in the operating performance versus the first nine months of 2003. During 2003, tenants under three leases for an aggregate of 51 hotels failed to pay rents due to us and we subsequently entered new long term operating agreements for these hotels, the last of which became effective January 1, 2004. Under these new agreements we expect our future income and cash flows from the 51 hotels will be less than the rents we previously received.

 

Leases and Operating Agreements

 

As of September 30, 2004, each of our 285 hotels was included in one of eight combinations of hotels which are either leased to one of our wholly owned taxable REIT subsidiaries, or TRSs, and managed by an independent hotel operating company, or leased to a third party. At September 30, 2004, we had 177 managed hotels and 108 leased hotels versus 52 managed hotels and 199 leased hotels at September 30, 2003. Our consolidated statement of income includes hotel operating revenues and expenses of our managed hotels, and only rental income from our leased hotels. Additional information regarding the terms of our leases and management agreements is included in the table on pages 15 and 16.

 

Results of Operations (dollar amounts in thousands, except per share amounts)

 

Three Months Ended September 30, 2004 versus 2003

 

Total revenues for the 2004 third quarter were $171,992, a 37.7% increase over revenues of $124,863 for the 2003 third quarter. This increase is primarily due to the conversion of 74 previously leased hotels to managed hotels and our 2003 hotel acquisitions.

 

Our managed hotels had operating revenues for the 2004 third quarter of $136,861, an 89.2% increase over hotel operating revenues of $72,338 for the 2003 third quarter. Our managed hotels had operating expenses for the 2004 third quarter of $94,896, an 85.8% increase over hotel operating expenses of $51,064 for the 2003 third quarter. The increases in hotel operating revenues and expenses were caused primarily by the increase in the number of managed hotels in 2004 due to: (i) the change of nine Marriott International, Inc., or Marriott, hotels from leased to managed hotels after the 2003 second quarter; (ii) the initiation of a new management agreement on December 31, 2003, for 64 hotels previously leased to Candlewood Hotel Co., or Candlewood, and the 12 hotels purchased from Candlewood on that day; and (iii) the initiation of a new management agreement on January 1, 2004, for the 24 hotels previously leased to Prime.

 

Hotel operating revenues at our 177 managed hotels, were $136,861 for the 2004 third quarter, an increase of 2.1% from hotel operating revenues of $133,986 for the 2003 third quarter which includes revenues for periods prior to our ownership of some of these hotels and for periods when some of the hotels were leased from us by third parties. The increase in revenues is attributable primarily to the strengthening lodging market that has resulted in improved occupancy and average daily room rate at many of our hotels offset by lower revenues at our former Summerfield Suites by Wyndham^® and Wyndham^® hotels, which are in the process of being rebranded as Staybridge Suites^® and Prime

 

8

 

Hotels & Resorts^SM, respectively. Hotel operating expenses for these hotels were $92,985 for the 2004 third quarter, an increase of 0.9% from hotel operating expenses of $92,694 for the 2003 third quarter which includes expenses for periods prior to our ownership of some of these hotels and for periods when some of the hotels were leased from us by third parties. This increase is due primarily to increased wage and benefit costs partially offset by lower franchise related costs at certain of our rebranded hotels. Certain of our managed hotels had net operating results that were $1,762 less than the minimum returns due to us in the 2003 third quarter. This amount has been reflected in our consolidated statement of income as a reduction to hotel operating expenses in the 2003 third quarter because the minimum returns were funded by our managers. There were no fundings of minimum returns by our managers in the 2004 third quarter.

 

Rental income for the 2004 third quarter was $30,312, a 37.1% decrease from $48,163 for the 2003 third quarter. This decrease is primarily a result of the elimination of $19,041 of rental income for 97 of our hotels which were previously leased to third parties but are now managed by independent hotel operating companies. This decrease was partially offset by increased rental income resulting from our funding of improvements at certain of our leased hotels in 2003 and 2004.

 

Income from reserves for future renovations and refurbishment, or FF&E reserves, represents amounts paid by our tenants into restricted accounts owned by us, the purpose of which is to accumulate funds for future capital expenditures. The terms of our leases require these amounts to be calculated as a percentage of total sales at our hotels. FF&E reserve income for the 2004 third quarter was $4,660, a 7.9% increase from FF&E reserve income of $4,318 for the 2003 third quarter. This increase was primarily due to increased levels of hotel sales in 2004 versus 2003 at certain of our recently modernized hotels. This increase is partially offset by ten Marriott hotels which were converted from leased to managed hotels after the 2003 third quarter. The amounts which are escrowed as FF&E reserves for our managed hotels and for leased hotels where the FF&E reserves are owned by our tenants are not reported as FF&E reserve income in our consolidated statement of income.

 

Interest income for the 2004 third quarter was $159, a 261.4% increase from $44 for the 2003 third quarter. The increase was primarily due to higher average cash balances in the 2004 third quarter.

 

Total expenses for the 2004 third quarter were $141,285, a 50.4% increase over total expenses of $93,966 for the 2003 third quarter. The increase is primarily due to our recognition of hotel operating expenses for a larger number of hotels in the 2004 third quarter than in the 2003 third quarter, and increases resulting from our hotel acquisitions during 2003.

 

Interest expense for the 2004 third quarter was $12,530, an 8.9% increase from interest expense of $11,508 for the 2003 third quarter. The increase was primarily due to higher average borrowings during the 2004 third quarter partially offset by a lower weighted average interest rate during the 2004 third quarter.

 

Depreciation and amortization expense for the 2004 third quarter was $28,713, a 6.9% increase over depreciation and amortization expense of $26,859 for the 2003 third quarter. This increase was due principally to the depreciation for 12 hotels acquired after the 2003 third quarter and the impact of the purchase since January 1, 2003, of depreciable assets with funds from FF&E reserve accounts owned by us.

 

General and administrative expenses for the 2004 third quarter were $5,146, a 13.5% increase from general and administrative expenses of $4,535 for the 2003 third quarter. This increase is due principally to $533 of due diligence costs incurred in the 2004 third quarter in connection with a failed potential acquisition and the costs associated with the additional 12 hotels acquired in December 2003.

 

Net income for the 2004 third quarter was $30,707, a 0.6% decrease from net income of $30,897 for the 2003 third quarter. The decrease resulted from the investment and operating activity discussed above. Net income available for common shareholders for the 2004 third quarter was $28,793, or $0.43 per share, a 5.8% increase, from net income available for common shareholders of $27,202, or $0.43 per share, for the 2003 third quarter. The increase resulted from the investment and operating activity discussed above and reduced preferred share distributions due to the redemption of our Series A preferred shares on April 15, 2004, which was offset on a per share basis by our issuance of 4.6 million common shares of beneficial interest in the first quarter of 2004.

 

9

 

Nine Months Ended September 30, 2004 versus 2003

 

Total revenues for the first nine months of 2004 were $488,534, a 55.0% increase over revenues of $315,216 for the first nine months of 2003. This increase is primarily due to the conversion of 121 previously leased hotels to managed hotels and our 2003 hotel acquisitions.

 

Our managed hotels had operating revenues for the first nine months of 2004 of $378,780, a 169.6% increase over hotel operating revenues of $140,498 for the first nine months of 2003. Our managed hotels had operating expenses for the first nine months of 2004 of $259,216, a 166.8% increase over hotel operating expenses of $97,168 for the first nine months of 2003. The increases in hotel operating revenues and expenses were caused by the increase in the number of managed hotels in 2004 due to: (i) our July 2003 acquisition of 16 hotels and the initiation of a management agreement for these hotels; (ii) the change of 13 Marriott hotels from leased to managed hotels after the 2003 first quarter; (iii) the initiation of a new management agreement on December 31, 2003, for 64 hotels previously leased to Candlewood and the 12 hotels purchased from Candlewood on that day; and (iv) the initiation of a new management agreement on January 1, 2004, for the 24 hotels previously leased to Prime.

 

Hotel operating revenues of our 177 managed hotels at September 30, 2004, were $390,781 for the first nine months of 2004, an increase of 0.9% from hotel operating revenues of $387,436 for the first nine months of 2003 which includes revenues for periods prior to our ownership of some of these hotels and for periods when some of the hotels were leased from us by third parties. The increase in revenues is attributable primarily to the strengthening lodging market that has resulted in improved occupancy and average daily room rate at many of our hotels offset by lower revenues at our former Summerfield Suites by Wyndham^® and Wyndham^® hotels, which are in the process of being rebranded as Staybridge Suites^® and Prime Hotels & Resorts^SM, respectively. Hotel operating expenses for these hotels were $264,320 for the first nine months of 2004, an increase of 0.4% from hotel operating expenses of $263,377 for the first nine months of 2003 which includes expenses for periods prior to our ownership of some of these hotels and for periods when some of the hotels were leased from us by third parties. This increase is due primarily to increased wage and benefit costs partially offset by lower franchise related costs at certain of our rebranded hotels. Certain of our managed hotels had net operating results that were $4,070 less than the minimum returns due to us in the first nine months of 2004 and $5,645 less than the minimum returns due in the first nine months of 2003. These amounts have been reflected in our consolidated statement of income as a net reduction to hotel operating expenses in each year because the minimum returns were funded by our managers.

 

Rental income for the first nine months of 2004 was $95,326, a 40.5% decrease from $160,251 for the first nine months of 2003. This decrease is primarily a result of the elimination of $68,957 of rental income for 128 of our hotels which were previously leased to third parties but are now managed by independent hotel operating companies. This decrease was partially offset by increased rental income resulting from our funding of improvements at certain of our leased hotels in 2003 and 2004.

 

FF&E reserve income for the first nine months of 2004 was $14,243, a 0.8% increase from FF&E reserve income of $14,132 for the first nine months of 2003. This increase was primarily due to increased levels of hotel sales versus 2003 at certain of our recently modernized hotels. This increase is partially offset by six Marriott hotels which were converted from leased to managed hotels during 2003 and seven Marriott hotels which were converted from leased to managed in June 2004.

 

Interest income for the first nine months of 2004 was $185, a 44.8% decrease from $335 for the first nine months of 2003. The decrease was primarily due to lower average cash balances in 2004.

 

We recorded a $203 gain on the sale of a Summerfield Suites hotel located in Buckhead, GA in the 2004 second quarter.

 

Total expenses for the first nine months of 2004 were $397,502, a 79.8% increase over total expenses of $221,135 for the first nine months of 2003. The increase is primarily due to our recognition of hotel operating expenses for a larger number of hotels in the first nine months of 2004 than in the first nine months of 2003, and increases resulting from our hotel acquisitions during 2003.

 

10

 

Interest expense for the first nine months of 2004 was $37,775, an 18.4% increase from interest expense of $31,910 for the first nine months of 2003. The increase was primarily due to higher average borrowings during 2004, partially offset by a lower weighted average interest rate during 2004.

 

Depreciation and amortization expense for the first nine months of 2004 was $86,158, an 11.8% increase over depreciation and amortization expense of $77,075 for the first nine months of 2003. This increase was due principally to the depreciation for 35 hotels acquired after June 30, 2003, and the impact of the purchase since January 1, 2003, of depreciable assets with funds from FF&E reserve accounts owned by us.

 

General and administrative expenses for the first nine months of 2004 were $14,353, a 15.8% increase from general and administrative expenses of $12,400 for the first nine months of 2003. This increase is due principally to the acquisition of 35 hotels discussed above.

 

In 2003 we recognized a loss of $2,582 to write off the unamortized deferred financing costs associated with $150,000 of senior notes we redeemed on February 18, 2003.

 

Net income for the first nine months of 2004 was $91,235, a 3.0% decrease from net income of $94,081 for the first nine months of 2003. Net income available for common shareholders for the first nine months of 2004 was $80,682, or $1.22 per share, a 2.8% decrease, from net income available for common shareholders of $82,996, or $1.33 per share, for the first nine months of 2003. The decrease resulted from the investment and operating activity discussed above, the $2,793 reduction to income available to common shareholders arising from our redemption of our Series A preferred shares and, additionally on a per share basis, due to our issuance of 4,600,000 common shares of beneficial interest in the first quarter of 2004.

 

Cash flow from operations was $151,571 in the first nine months of 2004, a 4.2% decrease from $158,224 in the first nine months of 2003 primarily due to the changes in items affecting net income discussed above. Cash used in investing activities was $1,617 in the first nine months of 2004, versus $264,238 in the first nine months of 2003, primarily due to the acquisition of 23 hotels in July 2003 and proceeds from the sale of a hotel in 2004. Cash used in financing activities was $152,891 in the first nine months of 2004, versus cash provided by financing activities of $103,095 in the first nine months of 2003. The significant components of the variance between periods are $192,684 proceeds from issuance of common shares in 2004 versus none in 2003, $75,000 preferred share redemption in 2004 versus none in 2003 and $121,000 net debt repayments (principally with the common share proceeds) in 2004 versus net borrowings of $251,000 in 2003. The proceeds of the 2003 borrowings were used primarily to fund our July 2003 hotel acquisitions.

 

Liquidity and Capital Resources (dollar amounts in thousands, except per share amounts)

 

Our Managers and Tenants

 

Our managers and tenants operate all of our hotels under management agreements or leases that provide for minimum returns or rents to us. Our managers pay all costs of operating and maintaining our hotels on our behalf and our tenants pay these costs for their own account. These third parties derive their funding for hotel operating expenses, FF&E reserves, and rents and returns due us generally from hotel operating revenues and, to the extent that these parties fund our minimum returns or rents under their guarantees to us, from their separate resources.

 

We define coverage for each of our eight combination hotel management agreements or leases as total hotel sales minus all expenses which are not subordinated to minimum payments to us and the required FF&E reserve contributions, divided by the minimum payments due to us. More detail regarding coverage, guarantees and other security features of our agreements is presented in the table on pages 15 and 16. Assuming our operating agreements as of January 1, 2004, had been in place during the twelve months ended September 30, 2004, four of our eight hotel combinations, representing 125 hotels, would have generated coverage of at least 1.0x. During the third quarter of 2004, five hotel combinations, representing 160 hotels, generated coverage of at least 1.0x.

 

Two hundred fourteen (214) hotels we own in six combination lease or management agreements, 76% of our total investments, at cost, are subject to full or limited guarantees. These guarantees may provide us with continued payments if combined total hotel sales less total hotel expenses and required FF&E reserve payments fail to equal or exceed amounts due to us. Our managers and tenants or their affiliates may also supplement cash flow from our hotels in order

 

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to make payments to us and preserve their rights to continue operating our hotels. Guarantee or supplemental payments to us, if any, made under any of our management agreements or leases, do not subject us to repayment obligations but, under some of our agreements, these guarantee or supplemental payments may be recovered by the third party manager or tenant from the future cash flows from our hotels after our future minimum returns and rents are paid. As of September 30, 2004, all payments due, including those payments due under management agreements or leases where hotels have generated less than 1.0x coverage during the third quarter of 2004, are current. Some of our leases and guarantees require our tenants, subtenants and guarantors to maintain minimum net worths, as defined in the agreements. However, the effectiveness of our various security features to provide uninterrupted payments to us is not assured, particularly if the revenues generated at our hotels fail to cover the payments due to us.

 

Our Operating Liquidity and Resources

 

Our principal source of funds for current expenses and distributions to shareholders are minimum returns from our managed hotels and minimum rents from our leased properties. We receive minimum returns and minimum rents from our managers and tenants monthly. We receive our share of the operating profits of our managed hotels in excess of minimum returns and percentage rents either monthly or quarterly. This flow of funds has historically been sufficient for us to pay our operating expenses, interest and distributions. We believe that our operating cash flow will be sufficient to meet our operating expenses, interest and distribution payments for the foreseeable future.

 

We maintain our status as a REIT under the Internal Revenue Code by meeting certain requirements. As a REIT, we do not expect to pay federal income taxes on the majority of our income. In 1999 federal legislation known as the REIT Modernization Act, or RMA, was enacted and became effective on January 1, 2001. The RMA, among other things, allows a REIT to lease hotels to a TRS if the hotel is managed by an independent third party. The income realized by our TRS in excess of the rent it pays to us is subject to income tax at corporate tax rates. As, and if, the financial performance of the hotels operated for the account of our TRS improves, these taxes may become material, but the anticipated taxes are not material to our consolidated financial results at this time.

 

Our Investment and Financing Liquidity and Resources

 

Various percentages of total sales at most of our hotels are escrowed as FF&E reserves. As of September 30, 2004, there was $45,895 on deposit in these escrow accounts, of which $45,532 was held directly by us and reflected on our consolidated balance sheet as restricted cash. The remaining $363 is held in an account owned by one of our tenants and is not reflected on our consolidated balance sheet. We have a security and remainder interest in this account owned by our tenant. During the first nine months of 2004, $20,281 was contributed to these accounts by our hotel managers and $36,369 was spent from these accounts to renovate and refurbish our hotels.

 

In order to fund acquisitions and to accommodate occasional cash needs that may result from timing differences between our receipt of rents and returns and our desire or need to make distributions or pay operating expenses, we maintain a revolving credit facility with a group of commercial banks. Our credit facility matures in June 2005 and may be extended at our option to June 2006 upon our payment of an extension fee. Borrowings under the credit facility can be up to $350,000 and the credit facility includes a feature under which the maximum amount available for borrowing may be expanded to $700,000, in certain circumstances. Borrowings under our credit facility are unsecured. Funds may be drawn, repaid and redrawn until maturity, and no principal repayment is due until maturity. Interest on borrowings under the credit facility (3.1% per annum at September 30, 2004) is payable at a spread above LIBOR. As of September 30, 2004, we had $80,000 outstanding under this facility.

 

At September 30, 2004, we had $3,491 of cash and cash equivalents and $270,000 available to be drawn under our revolving credit facility. We expect to use existing cash balances, borrowings under our credit facility or other lines of credit and net proceeds of offerings of equity or debt securities to fund future property acquisitions.

 

At September 30, 2004, we had no commitments to purchase additional properties. However, we expect to fund $2,600 to the FF&E reserves for two of our Marriott hotel portfolios in the fourth quarter of 2004 with funds from existing cash balances or borrowings under our credit facility. Our minimum annual rent for these hotels will increase by 10% of the amounts we deposit into these FF&E reserve accounts, which amounts are in addition to recurring FF&E reserve funding from hotel operations.

 

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Pursuant to the agreement we entered with InterContinental in 2003 for management of 15 hotels, we agreed to fund $20,000 for rebranding costs and other capital improvements during the next fifteen months. As part of this agreement, InterContinental will provide us with a $20,000 deposit to secure its obligations under the management agreement that we will not escrow. As of September 30, 2004, $10,000 of these fundings have occurred and the balance is expected to be funded over the next fifteen months. Pursuant to the agreement we entered with Prime in 2003 for management of 36 hotels, we agreed to fund $25,000 for rebranding costs and other capital improvements during the next fifteen months. As of September 30, 2004, $10,000 of funding has occurred and the balance is expected to be funded during the next fifteen months. We expect to fund these obligations by using cash on hand or borrowings under our revolving credit facility.

 

Our debt maturities (other than our revolving credit facility) are as follows: $150,000 in 2008; $50,000 in 2010; $3,272 in 2011; $125,000 in 2012 and $300,000 in 2013. As of September 30, 2004, we had one mortgage note with a balance of $3,840 we assumed in connection with our acquisition of a hotel.  This mortgage note requires monthly payments of principal and interest and is expected to have a principal balance of $3,272 at maturity in 2011. None of our other debt obligations require principal or sinking fund payments prior to their maturity date.

 

When amounts are outstanding on our revolving credit facility and as the maturity dates of our credit facility and term debt approach, we will explore alternatives for the repayment of amounts due. Such alternatives may include incurring additional debt and issuing new equity securities. As of September 30, 2004, we had $2,086,672 available on our shelf registration. An effective shelf registration allows us to issue public securities on an expedited basis, but it does not assure that there will be buyers for securities offered by us. Although there can be no assurance that we will consummate any debt or equity security offerings or other financings, we believe we will have access to various types of financing, including investment grade debt or equity securities offerings with which to finance future acquisitions and to pay our debt and other obligations.

 

On February 23, 2004, we sold 4,000,000 of our common shares of beneficial interest at $43.93 per share in a public offering. On March 8, 2004, we sold an additional 600,000 common shares of beneficial interest at $43.93 per share pursuant to an over allotment option granted to the underwriters. Net proceeds, from both these sales, after underwriting and other offering expenses, were $192,684. These proceeds were used to reduce borrowings outstanding under our revolving credit facility.

 

On April 12, 2004, we redeemed all of our outstanding 9 ½% Series A preferred shares at their liquidation preference of $25 per share plus accrued and unpaid distributions of $0.0792 per share. This redemption was funded with borrowings under our revolving credit facility.

 

On July 1, 2004, a distribution of $0.72 per common share was declared with respect to 2004 second quarter results and was paid to shareholders on August 20, 2004, using cash on hand and borrowings under our credit facility. On October 1, 2004, we declared a distribution of $0.72 per share to common shareholders of record on October 19, 2004.  This amount will be paid on or about November 19, 2004.

 

On July 15, 2004, we paid $0.5546875 per share distribution to our Series B preferred shareholders. On September 1, 2004, we declared a $0.5546875 per share distribution to Series B preferred shareholders of record on October 1, 2004. This amount was paid on October 15, 2004.

 

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As of September 30, 2004, our contractual obligations were as follows:

 

		Payment due by period
		Total			Less than 1 year				1-3 years				3-5 years				More than 5 years
Long Term Debt Obligations		$	708,840		$	14			$	80,126			$		150,148		$	478,552
Ground Lease Obligations (1)		19,296			210				2,237				2,237				14,612
Total		$	728,136		$		224		$		82,363		$	152,385			$		493,164

 

(1)           Nine of our hotels are on leased land. In each case the ground lessors are unrelated to us. Generally, payment of ground lease obligations are made by our tenants or managers. However, if a tenant or manager fails to perform obligations under a ground lease or elects not to renew any ground lease, we might have to perform obligations under the ground lease or renew the ground lease in order to protect our investment in the affected hotel.

 

Debt Covenants

 

Our debt obligations at September 30, 2004, were our revolving credit facility, our $625,000 of publicly issued term debt and our $3,840 mortgage note. Our public debt is governed by an indenture. This indenture and related supplements and our credit facility agreement contain a number of financial ratio covenants which generally restrict our ability to incur debts, including debts secured by mortgages on our properties in excess of calculated amounts, require us to maintain a minimum net worth, restrict our ability to make distributions under certain circumstances and require us to maintain other ratios. As of September 30, 2004, we were in compliance with all of our covenants under our indenture and its supplements, our credit agreement and our mortgage note.

 

Neither our indenture and its supplements nor our bank credit facility contain provisions for acceleration which could be triggered by our debt ratings. However, under our revolving credit agreement, our senior debt rating is used to determine fees and the interest rate applied to borrowings.

 

Our public debt indenture and its supplements contain cross default provisions to any other debts of $20,000 or more. Similarly, a default on our public debt indenture would be a default on our revolving credit facility.

 

As of September 30, 2004, we had no commercial paper, derivatives, swaps, hedges, joint ventures or partnerships. As of September 30, 2004, our secured debt obligations were limited to one mortgage note of $3,840 secured by a single property. None of our debt documentation requires us to provide collateral security in the event of a ratings downgrade.

 

Management Agreements, Leases and Operating Statistics

 

As of September 30, 2004, we owned 285 hotels which are grouped into eight combinations and managed by or leased to separate affiliates of hotel operating companies including InterContinental, Marriott, Host Marriott Corporation, or Host, Barcelo Crestline Corporation, or Barcelo Crestline, Prime, and BRE/Homestead Village, LLC, or Homestead.

 

The tables on the following pages summarize the key terms of our management agreements and leases and include statistics reported to us or derived from information reported to us by our managers and tenants. These statistics include occupancy, average daily rate, or ADR, room revenue per available room, or RevPAR, and coverage of our minimum rents or owner’s priority returns. We consider these statistics and the management agreement or lease security features also presented in the tables on the following pages, to be important measures of our managers’ success in operating our hotels and of the likelihood of their continuing to make payments to us. However, none of this third party reported information is a direct measure of our financial performance.

 

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Hotel Brand		Courtyard by Marriott®		Residence Inn by Marriott®		Marriott®/Residence Inn by Marriott®/ Courtyard by Marriott®/ TownePlace Suites by Marriott®/SpringHill Suites by Marriott®(1)		Residence Inn by Marriott®/Courtyard by Marriott®/ TownePlace Suites by Marriott®/ SpringHill Suites by Marriott®
Management Agreements and Leases
Number of Hotels		53		18		35		19
Number of Rooms/Suites		7,610		2,178		5,382		2,756
Number of States		24		14		15		14
Tenant		Subsidiary of Host Subleased to Subsidiary of Barcelo Crestline		Subsidiary of Host Subleased to Subsidiary of Barcelo Crestline		Our TRS		Subsidiary of Barcelo Crestline
Manager		Subsidiary of Marriott		Subsidiary of Marriott		Subsidiary of Marriott		Subsidiary of Marriott
Investment at September 30, 2004 (000s) (2)		$ 554,516		$ 185,467		$ 455,655		$ 274,222
Security Deposit (000s)		$ 50,540		$ 17,220		$ 36,204		$ 28,508
End of Current Term		2012		2010		2019		2015
Renewal Options (3)		3 for 12 years each		1 for 10 years, 2 for 15 years each		2 for 15 years each		2 for 10 years each
Current Annual Minimum Return/Rent (000s)		$ 55,340		$ 18,528		$ 47,291		$ 28,508
Percentage Return/Rent (4)		5.0%		7.5%		7.0%		7.0%
Other Security Features		HPT controlled lockbox with minimum balance maintenance requirement; subtenant and subtenant parent minimum net worth requirement.		HPT controlled lockbox with minimum balance maintenance requirement; subtenant and subtenant parent minimum net worth requirement.		Limited guarantee provided by Marriott.		Limited guarantees provided by Barcelo Crestline and Marriott.
Operating Statistics
Return/Rent Coverage (5) (6):
Year ended 12/31/03		1.0x		1.0x		0.8x		0.7x
Twelve months ended 9/30/04		1.2x		1.0x		0.9x		0.8x
Quarter ended 9/30/04		1.4x		1.1x		1.1x		0.7x

 

(1)   On June 18, 2004, the final 7 of the 35 hotels in this combination were changed from a lease with subsidiaries of Marriott and into a lease with our TRS.  As of September 30, 2004, all 35 hotels were operated by subsidiaries of Marriott under a management contract with our TRS.

(2)   Excludes expenditures made from FF&E reserves funded from hotel operations, but includes amounts funded by us separately from hotel operations.

(3)   Renewal options may be exercised by the tenant or manager for all, but not less than all, of the hotels within each combination of hotels.

(4)   Each management contract or lease provides for payment to HPT of a percentage of increases in total hotel sales over base year levels as additional rent or return.

(5)   We define coverage as combined total hotel sales minus all expenses which are not subordinated to minimum payments to us and the required FF&E reserve contributions (which data is provided to us by our tenants or operators), divided by the minimum return payments or rent due to us.

(6)   Represents data for comparable fiscal periods for the hotels managed by Marriott.

 

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Hotel Brand		Staybridge Suites by Holiday Inn®		Candlewood Suites®		Prime Hotels and ResortsSM/ AmeriSuites®		Homestead Studio Suites®		Total/ Range/ Average (all investments)
Management Agreements and Leases
Number of Hotels		30		76		36		18		285
Number of Rooms/Suites		3,694		9,220		5,250		2,399		38,489
Number of States		16		29		19		5		38
Tenant		Our TRS		Our TRS		Our TRS		Subsidiary of BRE/Homestead Village LLC
Manager		Subsidiary of InterContinental		Subsidiary of InterContinental		Subsidiary of Prime		Subsidiary of BRE/Homestead Village LLC
Investment at September 30, 2004 (000s) (1)		$ 415,708		$ 590,250		$ 425,920		$ 145,000		$ 3,046,738
Security Deposit (000s)		$ 26,872 (2)		—		—		$ 15,960		$ 175,304
End of Current Term		2023		2028		2018		2015		2010-2028 (average 14.9 years)
Renewal Options (3)		2 for 12.5 years each		2 for 15 years each		2 for 15 years each		2 for 15 years each
Current Annual Minimum Return/Rent (000s)		$ 36,097		$ 60,000		$ 26,000		$ 15,960		$ 287,724
Percentage Return/Rent (4)		7.5%		7.5%		(5)		10.0%		5-10%
Other Security Features		Limited guarantee provided by InterContinental		Limited guarantee provided by InterContinental.		Limited guarantee provided by Prime.		Homestead parent guarantee and $15,960 letter of credit.
Operating Statistics
Return/Rent Coverage (6):
Year ended 12/31/03		0.7x		0.8x		1.0x		1.1x		0.7x -1.1x
Twelve months ended 9/30/04		0.7x		0.8x		1.1x		1.2x		0.7x -1.2x
Quarter ended 9/30/04		0.9x		0.9x		1.0x		1.2x		0.7x -1.4x

 

(1)   Excludes expenditures made from FF&E reserves funded from hotel operations, but includes amounts funded by us separately from hotel operations.

(2)   Additional security deposit of $10,000 to be funded prior to December 31, 2005.

(3)   Renewal options may be exercised by the tenant or manager for all, but not less than all, of the hotels within each combination of hotels.

(4)   Each management contract or lease provides for payment to HPT of a percentage of increases in total hotel sales over base year levels as additional return or rent.

(5)   Agreement provides for payment to us of 50% of cash flow after payment of operating costs, funding the capital reserve, payment of our priority return and reimbursement to Prime of working capital and guaranty advances, if any.

(6)   We define coverage as combined total hotel sales minus all expenses which are not subordinated to minimum payments to us and the required FF&E reserve contributions (which data is provided to us by our tenants or operators), divided by the return payments or minimum rent due to us. For some combinations, amounts have been calculated using data for periods prior to our ownership of certain hotels and prior to commencement of operating agreements.

 

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The following tables summarize the operating statistics, including occupancy, ADR and RevPAR reported to us by our hotel operators by management agreement or lease for the periods indicated for our 285 hotels.

 

						Third Quarter (1)								Year to Date (1)
				No. of
Management/Lease		No. of		Rooms
Agreement		Hotels		/Suites		2004			2003			Change		2004			2003			Change
ADR
Host (no. 1)		53		7,610		$	100.08		$	94.70		5.7%		$	100.02		$	95.84		4.4%
Host (no. 2)		18		2,178		93.97			92.37			1.7%		94.11			93.46			0.7%
Marriott		35		5,382		93.74			92.45			1.4%		94.33			92.24			2.3%
Barcelo Crestline		19		2,756		86.85			82.85			4.8%		91.17			88.87			2.6%
InterContinental (no. 1)(2) (3)		30		3,694		91.10			91.74			-0.7%		89.93			90.64			-0.8%
InterContinental (no. 2)(2) (3)		76		9,220		54.88			54.12			1.4%		56.04			55.08			1.7%
Prime(3)		36		5,250		73.09			69.80			4.7%		74.31			70.06			6.1%
Homestead		18		2,399		51.04			46.25			10.4%		49.81			47.93			3.9%
Total/Average		285		38,489		$	79.05		$	76.11		3.9%		$	79.81		$	77.03		3.6%
OCCUPANCY
Host (no. 1)		53		7,610		75.7		%	68.1		%	7.6 pt		72.6		%	64.3		%	8.3 pt
Host (no. 2)		18		2,178		83.9		%	81.1		%	2.8 pt		80.0		%	77.7		%	2.3 pt
Marriott		35		5,382		85.1		%	80.0		%	5.1 pt		78.7		%	75.3		%	3.4 pt
Barcelo Crestline		19		2,756		75.9		%	70.4		%	5.5 pt		75.7		%	69.2		%	6.5 pt
InterContinental (no. 1)(2) (3)		30		3,694		80.9		%	78.5		%	2.4 pt		77.2		%	76.7		%	0.5 pt
InterContinental (no. 2)(2) (3)		76		9,220		78.3		%	76.8		%	1.5 pt		71.3		%	73.1		%	-1.8 pt
Prime(3)		36		5,250		62.6		%	69.7		%	-7.1 pt		63.9		%	70.3		%	-6.4 pt
Homestead		18		2,399		78.7		%	80.1		%	-1.4 pt		80.5		%	76.7		%	3.8 pt
Total/Average		285		38,489		76.9		%	74.8		%	2.1 pt		73.4		%	71.9		%	1.5 pt
RevPAR
Host (no. 1)		53		7,610		$	75.76		$	64.49		17.5%		$	72.61		$	61.63		17.8%
Host (no. 2)		18		2,178		78.84			74.91			5.2%		75.29			72.62			3.7%
Marriott		35		5,382		79.77			73.96			7.9%		74.24			69.46			6.9%
Barcelo Crestline		19		2,756		65.92			58.33			13.0%		69.02			61.50			12.2%
InterContinental (no. 1)(2) (3)		30		3,694		73.70			72.02			2.3%		69.43			69.52			-0.1%
InterContinental (no. 2)(2) (3)		76		9,220		42.97			41.56			3.4%		39.96			40.26			-0.8%
Prime(3)		36		5,250		45.75			48.65			-6.0%		47.48			49.25			-3.6%
Homestead		18		2,399		40.17			37.05			8.4%		40.10			36.76			9.1%
Total/Average		285		38,489		$	60.79		$	56.93		6.8%		$	58.58		$	55.38		5.8%

 

(1)        Includes data for the calendar periods indicated, except for our Courtyard by Marriott^®, Residence Inn by Marriott^®, Marriott Hotels Resorts and Suites^®, TownePlace Suites by Marriott^®, and SpringHill Suites by Marriott^® branded hotels, which include data for comparable fiscal periods.

(2)        2003 includes data for periods prior to our ownership of some hotels.

(3)        2003 includes data for periods some hotels were not operated by the current manager.

 

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