Service Properties Trust - Quarter Report: 2013 September (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2013

 

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

(Exact Name of Registrant as Specified in Its Charter)

 

 

Two Newton Place, 255 Washington Street, Suite 300, Newton, Massachusetts 02458

(Address of Principal Executive Offices)  (Zip Code)

 

617-964-8389

(Registrant’s Telephone Number, Including Area Code)

 

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

 

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

 

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

 

 

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

 

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of November 4, 2013: 139,831,549

 

 

 

HOSPITALITY PROPERTIES TRUST

 

FORM 10-Q

 

September 30, 2013

 

INDEX

 

		Page
PART I	Financial Information (unaudited)
	Item 1. Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets — September 30, 2013 and December 31, 2012	1
	Condensed Consolidated Statements of Income and Comprehensive Income — Three and Nine Months Ended September 30, 2013 and 2012	2
	Condensed Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2013 and 2012	3
	Notes to Condensed Consolidated Financial Statements	4
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
	ITEM 3. Quantitative and Qualitative Disclosures About Market Risk	40
	Item 4. Controls and Procedures	41
	Warning Concerning Forward Looking Statements	43
	Statement Concerning Limited Liability	47
PART II	Other Information
	Item 6. Exhibits	48
	Signatures	50

 

References in this Form 10-Q to “HPT”, “we”, “us” or “our” include Hospitality Properties Trust and its consolidated subsidiaries unless otherwise expressly stated or the context indicates otherwise.

 

 

Part 1    Financial Information

 

Item 1.  Financial Statements

 

HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(amounts in thousands, except share data)

 

		September 30,			December 31,
		2013			2012
ASSETS
Real estate properties, at cost:
Land		$	1,472,184		$	1,453,399
Buildings, improvements and equipment		5,853,908			5,445,710
		7,326,092			6,899,109
Accumulated depreciation		(1,708,065		)	(1,551,160		)
		5,618,027			5,347,949
Cash and cash equivalents		17,118			20,049
Restricted cash (FF&E reserve escrow)		30,333			40,744
Other assets, net		236,387			226,383
		$	5,901,865		$	5,635,125
LIABILITIES AND SHAREHOLDERS’ EQUITY
Unsecured revolving credit facility		$	193,000		$	320,000
Unsecured term loan		400,000			400,000
Senior notes, net of discounts		2,295,027			1,993,880
Convertible senior notes, net of discount		8,478			8,478
Security deposits		28,023			26,577
Accounts payable and other liabilities		97,585			132,032
Due to related persons		15,187			13,696
Dividends payable		5,166			6,664
Total liabilities		3,042,466			2,901,327
Commitments and contingencies
Shareholders’ equity:
Preferred shares of beneficial interest, no par value, 100,000,000 shares authorized:
Series C preferred shares; 7% cumulative redeemable; zero and 6,700,000 shares issued and outstanding, respectively, aggregate liquidation preference of zero and $167,500, respectively		—			161,873
Series D preferred shares; 7 1/8% cumulative redeemable; 11,600,000 shares issued and outstanding, aggregate liquidation preference of $290,000		280,107			280,107
Common shares of beneficial interest, $.01 par value; 200,000,000 shares authorized; 139,831,549 and 123,637,424 shares issued and outstanding, respectively		1,398			1,236
Additional paid in capital		3,847,958			3,458,144
Cumulative net income		2,485,302			2,384,876
Cumulative other comprehensive income		10,704			2,770
Cumulative preferred distributions		(274,820		)	(253,426		)
Cumulative common distributions		(3,491,250		)	(3,301,782		)
Total shareholders’ equity		2,859,399			2,733,798
		$	5,901,865		$	5,635,125

 

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

 

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HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(Unaudited)

(in thousands)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2013			2012			2013			2012
Revenues:
Hotel operating revenues		$	348,908		$	251,722		$	990,436		$	741,775
Rental income		62,731			73,915			186,799			220,863
FF&E reserve income		636			4,431			1,828			12,033
Total revenue		412,275			330,068			1,179,063			974,671
Expenses:
Hotel operating expenses		249,862			184,566			705,054			527,806
Depreciation and amortization		76,048			66,566			221,926			192,206
General and administrative		13,094			10,336			37,156			32,333
Acquisition related costs		1,090			84			3,180			1,648
Loss on asset impairment		5,837			—			8,008			889
Total expenses		345,931			261,552			975,324			754,882
Operating income		66,344			68,516			203,739			219,789
Interest income		18			116			97			233
Interest expense (including amortization of deferred financing costs and debt discounts of $1,584, $1,694, $4,620 and $4,648, respectively)		(37,986		)	(34,854		)	(108,188		)	(101,660		)
Gain on sale of real estate		—			10,602			—			10,602
Equity in earnings of an investee		64			115			219			236
Income before income taxes		28,440			44,495			95,867			129,200
Income tax benefit (expense)		(873		)	163			4,559			(3,908		)
Net income		27,567			44,658			100,426			125,292
Excess of liquidation preference over carrying value of preferred shares redeemed		(5,627		)	(5,040		)	(5,627		)	(7,984		)
Preferred distributions		(5,199		)	(10,138		)	(21,393		)	(32,048		)
Net income available for common shareholders		$	16,741		$	29,480		$	73,406		$	85,260
Net income		$	27,567		$	44,658		$	100,426		$	125,292
Other comprehensive income (loss):
Unrealized gain (loss) on TravelCenters of America common shares		(7,849		)	737			8,000			2,820
Equity interest in investee’s unrealized gains (losses)		13			35			(68		)	31
Other comprehensive income (loss)		(7,836		)	772			7,932			2,851
Comprehensive income		$	19,731		$	45,430		$	108,358		$	128,143
Weighted average common shares outstanding		139,764			123,577			135,030			123,553
Basic and diluted earnings per common shares:
Net income available for common shareholders		$	0.12		$	0.24		$	0.54		$	0.69

 

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

 

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HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

		For the Nine Months Ended September 30,
		2013			2012
Cash flows from operating activities:
Net income		$	100,426		$	125,292
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		221,926			192,206
Amortization of deferred financing costs and debt discounts as interest		4,620			4,648
Straight line rental income		(272		)	(243		)
Security deposits replenished (applied to payment shortfalls)		1,355			(17,493		)
FF&E reserve income and deposits		(22,458		)	(16,631		)
Loss on asset impairment		8,008			889
Equity in earnings of an investee		(219		)	(236		)
Gain on sale of real estate		—			(10,602		)
Deferred income taxes		(7,094		)	(643		)
Other non-cash (income) expense, net		(1,044		)	161
Changes in assets and liabilities:
Increase in other assets		(7,791		)	(5,679		)
Decrease in accounts payable and other liabilities		(21,806		)	(15,354		)
Increase (decrease) in due to related persons		(10,433		)	8,347
Cash provided by operating activities		265,218			264,662
Cash flows from investing activities:
Real estate acquisitions and deposits		(214,607		)	(150,500		)
Real estate improvements		(198,165		)	(195,089		)
FF&E reserve fundings		(40,606		)	(67,652		)
Net proceeds from sale of real estate		—			34,204
Cash used in investing activities		(453,378		)	(379,037		)
Cash flows from financing activities:
Proceeds from issuance of common shares, net		393,475			—
Proceeds from issuance of preferred shares, net		—			280,107
Proceeds from unsecured term loan		—			400,000
Proceeds from issuance of senior notes, net of discount		299,661			491,975
Redemption of preferred shares		(167,500		)	(236,250		)
Repayment of senior notes		—			(387,829		)
Repurchase of convertible senior notes		—			(70,576		)
Borrowings under revolving credit facility		418,000			378,000
Repayments of revolving credit facility		(545,000		)	(527,000		)
Deferred financing costs		(2,545		)	(6,394		)
Distributions to preferred shareholders		(21,394		)	(32,048		)
Distributions to common shareholders		(189,468		)	(166,789		)
Cash provided by financing activities		185,229			123,196
Increase (decrease) in cash and cash equivalents		(2,931		)	8,821
Cash and cash equivalents at beginning of period		20,049			8,303
Cash and cash equivalents at end of period		$	17,118		$	17,124
Supplemental cash flow information:
Cash paid for interest		$	120,753		$	120,153
Cash paid for income taxes		1,945			1,535
Non-cash investing activities:
Hotel managers’ deposits in FF&E reserve		$	22,084		$	17,452
Hotel managers’ purchases with FF&E reserve		(73,101		)	(101,381		)
Non-cash financing activities:
Issuance of common shares		$	2,128		$	2,533

 

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

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 1.  Basis of Presentation

 

The accompanying condensed consolidated financial statements of Hospitality Properties Trust and its subsidiaries, or HPT, we, our or us, are unaudited. Certain information and disclosures required by U.S. generally accepted accounting principles, or GAAP, 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 condensed consolidated 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, 2012, as amended, or our 2012 Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments considered necessary for a fair presentation, have been included in these condensed consolidated financial statements.  These condensed consolidated financial statements include the accounts of HPT and its subsidiaries, all of which are 100% owned directly or indirectly by HPT.  All intercompany transactions and balances have been eliminated. Our operating results for interim periods and those of our managers and tenants are not necessarily indicative of the results that may be expected for the full year. Reclassifications have been made to the prior year’s condensed consolidated financial statements to conform to the current year’s presentation.

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates.  Significant estimates in the condensed consolidated financial statements include the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets and impairment of real estate and intangible assets.

 

We have determined that each of our taxable REIT subsidiaries, or TRSs, is a variable interest entity, or VIE, as defined under the Consolidation Topic of the Financial Accounting Standards Board, or FASB, Accounting Standards CodificationTM.   We have concluded that we must consolidate each of our TRSs because we are the entity with the power to direct the activities that most significantly impact the VIEs’ performance and we have the obligation to absorb the majority of the potential variability in gains and losses of each VIE, with the primary focus on losses, and are, therefore, the primary beneficiary of each VIE.  The assets of our TRSs were $26,517 as of September 30, 2013 and consist primarily of amounts due from certain of our hotel managers and working capital advances to certain of our hotel managers.  These assets can be used to settle obligations of both us and our TRSs.  The liabilities of our TRSs were $37,688 as of September 30, 2013 and consist primarily of security deposits we hold and amounts payable to certain of our hotel managers.  Creditors have recourse to both us and our TRSs for these liabilities.

 

Note 2.  New Accounting Pronouncements

 

In January 2013, we adopted FASB Accounting Standards Update No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This update requires companies to report, in one place, information about reclassifications out of accumulated other comprehensive income, or AOCI. Companies are also required to present details of reclassifications in the disclosure of change in AOCI balances. The update was effective for interim and annual reporting periods beginning after December 15, 2012 with early adoption permitted. The implementation of this update did not cause any material changes to the disclosures in, or the presentation of, our condensed consolidated financial statements.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 3.  Revenue Recognition

 

We report hotel operating revenues for managed hotels in our condensed consolidated statements of income and comprehensive income. We generally recognize hotel operating revenues, consisting primarily of room and food and beverage sales, when services are provided. Our share of the net operating results of our managed hotels in excess of the minimum returns due to us, or additional returns, are generally determined annually. We recognize additional returns due to us under our management agreements at year end when all contingencies are met and the income is earned. We had no deferred additional returns for the three and nine months ended September 30, 2013 and 2012.

 

We recognize rental income from operating leases on a straight line basis over the term of the lease agreements except for one lease in which there is uncertainty regarding the collection of future rent.  Rental income includes $173 and $272 for the three and nine months ended September 30, 2013, respectively, of adjustments necessary to record rent on the straight line basis and ($52) and $243 for the three and nine months ended September 30, 2012, respectively, of adjustments necessary to record rent on the straight line basis.

 

We determine percentage rent due to us under our leases annually and recognize it at year end when all contingencies have been met and the rent is earned. We had deferred percentage rent of $464 and $1,746 for the three and nine months ended September 30, 2013, respectively, and $919 and $3,481 for the three and nine months ended September 30, 2012, respectively.

 

We own all the capital expenditure reserves, or FF&E reserves, for our hotels. We do not report the amounts which are escrowed as FF&E reserves for our managed hotels as FF&E reserve income. We report deposits by our third party hotel tenants into the escrow accounts as FF&E reserve income.

 

Note 4.  Per Common Share Amounts

 

We calculate per common share amounts using the weighted average number of our common shares of beneficial interest, $.01 par value, or our common shares, outstanding during the period. We had no dilutive common share equivalents at September 30, 2013 or 2012.

 

Note 5.  Shareholders’ Equity

 

Distributions

 

On each of January 15, 2013, April 15, 2013, July 15, 2013 and October 15, 2013, we paid a quarterly distribution on our Series D preferred shares of $0.4453125 per share, or $5,166, which was paid to shareholders of record as of December 28, 2012, March 28, 2013, June 28, 2013, and September 30, 2013, respectively.

 

On each of February 15, 2013 and May 15, 2013, we paid a quarterly distribution on our Series C preferred shares of $0.4375 per share, or $2,931 which was paid to shareholders of record as of January 31, 2013 and April 30, 2013, respectively.

 

On February 22, 2013, we paid a quarterly distribution on our common shares of $0.47 per share, or $58,110, to shareholders of record on January 31, 2013.  On May 24, 2013, we paid a quarterly distribution on our common shares of $0.47 per share, or $65,677, to shareholders of record on April 26, 2013.  On August 23, 2013, we paid a quarterly distribution on our common shares of $0.47 per share, or $65,681, to shareholders of record on July 26, 2013.  On October 10, 2013, we declared a $0.48 per share distribution to our common shareholders of record on October 25, 2013. We expect to pay this amount on or about November 22, 2013.

 

Common Share Issuances

 

On March 22, 2013, we sold 16,100,000 of our common shares at a price of $25.55 per share in a public offering for net proceeds of $393,475 after underwriting discounts and other offering expenses.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

On May 15, 2013, we granted 2,000 of our common shares valued at $30.69 per share, the closing price of our common shares on the New York Stock Exchange, or NYSE, on that day, to each of our five Trustees as part of their annual compensation.

 

On September 13, 2013, pursuant to our equity compensation plan, we granted an aggregate of 84,125 of our common shares, valued at $27.42 per share, the closing price of our common shares on the NYSE on that day, to our officers and certain employees of our manager Reit Management & Research LLC, or RMR.

 

Preferred Share Redemption

 

On July 1, 2013, we redeemed our 6,700,000 outstanding 7.00% Series C cumulative redeemable preferred shares at the stated liquidation preference of $25 per share plus accrued and unpaid distributions to the date of redemption.  We reduced net income available for common shareholders by $5,627, which represented the amount by which the liquidation preference for our Series C cumulative redeemable preferred shares that were redeemed exceeded our carrying amount for those preferred shares as of the date of redemption.

 

Other Comprehensive Income (Loss)

 

Other comprehensive income (loss) represents the unrealized gain (loss) on the TravelCenters of America LLC, or TA, shares we own and our share of the comprehensive income (loss) of Affiliates Insurance Company, or AIC.  See Note 10 for further information regarding these investments.

 

Note 6.  Indebtedness

 

We have a $750,000 unsecured revolving credit facility that is available for general business purposes, including acquisitions. The maturity date of our revolving credit facility is September 7, 2015 and, subject to the payment of an extension fee and meeting certain other conditions, includes an option for us to extend the stated maturity date by one year to September 7, 2016. In addition, our revolving credit facility includes a feature under which maximum borrowings may be increased to up to $1,500,000 in certain circumstances. Borrowings under our revolving credit facility bear interest at a rate of LIBOR plus a premium of 130 basis points. We also pay a facility fee of 30 basis points per annum on the total amount of lending commitments under our revolving credit facility. Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings. As of September 30, 2013, the interest rate payable on borrowings under our revolving credit facility was 1.48%.  The weighted average annual interest rate for borrowings under our revolving credit facility was 1.49% and 1.50% for the three and nine months ended September 30, 2013, respectively, and 1.58% for the nine months ended September 30, 2012.  We had no amounts outstanding under our revolving credit facility during the three months ended September 30, 2012. As of September 30, 2013, we had $193,000 outstanding and $557,000 available under our revolving credit facility.

 

We have a $400,000 unsecured term loan.  Our term loan matures on March 13, 2017, and is prepayable without penalty at any time.  In addition, our term loan includes a feature under which maximum borrowings may be increased to up to $500,000 in certain circumstances. Our term loan bears interest at a rate of LIBOR plus a premium, which was 145 basis points as of September 30, 2013. The interest rate premium is subject to adjustment based on changes to our credit ratings.  As of September 30, 2013, the interest rate for the amount outstanding under our term loan was 1.64%.  The weighted average interest rate for the amount outstanding under our term loan was 1.64% and 1.65% for the three and nine months ended September 30, 2013, respectively, and 1.70% for both the three months ended September 30, 2012 and for the period from March 12, 2012 (the date we entered into the term loan agreement) to September 30, 2012, respectively.

 

Our credit facility agreement and our term loan agreement provide for acceleration of payment of all amounts due thereunder upon the occurrence and continuation of certain events of default, including a change of control of us and the termination of our business management agreement with RMR.  Our revolving credit facility agreement and our term loan agreement contain a number of covenants that restrict our ability to incur debt in excess of calculated amounts,

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

restrict our ability to make distributions under certain circumstances and generally require us to maintain certain financial ratios.  We believe we were in compliance with the terms and conditions of our revolving credit facility agreement and our term loan agreement at September 30, 2013.

 

On June 6, 2013, we issued $300,000 of 4.5% unsecured senior notes due 2023 in a public offering for net proceeds of $297,115 after underwriting discounts and other offering expenses.

 

Note 7.  Real Estate Properties

 

At September 30, 2013, we owned 475 properties consisting of 291 hotels and 184 travel centers that were operated under 11 management or lease agreements.

 

During the nine months ended September 30, 2013, we funded $238,771 of improvements to certain of our properties that pursuant to the terms of our management and lease agreements with our hotel managers and tenants resulted in increases in our contractual annual minimum returns and rents of $19,135.  See Notes 10 and 11 for further information about our fundings of improvements to certain of our properties.

 

On May 17, 2013, we acquired a 426 room full service hotel located in Duluth, GA for $29,700, excluding related acquisition costs of $253.  We accounted for this transaction as a business combination.  The following table summarizes our allocation of the acquisition cost to the estimated fair value of the assets we acquired.

 

Land		$	2,000
Building		24,300
Furniture, fixtures and equipment		3,400
		$	29,700

 

On June 28, 2013, we acquired the fee interest in the Royal Sonesta Hotel New Orleans in New Orleans, LA, or the New Orleans Hotel, for $120,500, excluding related acquisition costs, from the third party owner from which we previously leased this hotel.  We accounted for this transaction as an acquisition of assets. In connection with this acquisition, we incurred acquisition costs of $309 which we capitalized and we reclassified $18,958 of intangible assets related to our previous leasehold interest in the hotel to land and building.  The following table summarizes our allocation of the acquisition cost based on the estimated relative fair value of the assets we acquired.

 

Land		$	12,564
Building		108,245
		$	120,809

 

Simultaneously with this acquisition, the lease with the third party terminated and we entered into an amended and restated management agreement with Sonesta International Hotels Corporation, or Sonesta. See Notes 10 and 11 for further information about this agreement.

 

On July 1, 2013, we acquired the fee interest in a travel center in Montgomery, NY we previously leased from a third party and subleased to TA.  We also acquired land parcels adjacent to three of our other travel centers and leased these to TA.  The aggregate consideration for these transactions was $6,325.  See Note 10 for further information about these transactions.

 

On August 1, 2013, we acquired a 219 room full service hotel located in Florham Park, NJ for $52,750, excluding related acquisition costs of $859. We accounted for this transaction as a business combination. The following table summarizes our preliminary allocation of the acquisition cost to the estimated fair value of the assets we acquired.

 

Land		$	5,098
Building		43,404
Furniture, fixtures and equipment		3,540
Intangible assets		708
		$	52,750

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

We have included the results of our 2013 hotel acquisitions in our condensed consolidated financial statements from the date of acquisition. The pro forma impact of including the results of operations of these hotels from the beginning of the period is not material to our condensed consolidated financial statements.

 

One of the travel centers we leased to TA under our TA No.1 lease, located in Roanoke, VA, was taken in August 2013 by eminent domain proceedings brought by the Virginia Department of Transportation, or the VDOT, in connection with certain highway construction.  The TA No. 1 Lease provides that it terminates with respect to a property upon a taking of the property as the result of any eminent domain proceeding.  Under the terms of the TA No. 1 lease, the annual rent payable to us is reduced by either (i) 8.5% of the amount of the proceeds we receive from that taking or, at our option, (ii) the annual fair market value rent of the property. There are ongoing negotiations among the VDOT, TA, and us regarding the amount of compensation to be paid for the taking and regarding a possible short term lease of the property to us for sublease to TA. We expect that TA will continue to operate this travel center pursuant to a sublease until October 2014.  The VDOT's estimate of fair market value for the taking is $6,280. We recorded a $5,837, or $0.04, per share loss on asset impairment during the three months ended September 30, 2013 to reduce the carrying value of this property to the $6,280 compensation amount proposed by the VDOT.  We and TA have engaged an appraiser to review the VDOT's estimate. Given the preliminary stages of these negotiations, there can be no assurance concerning what additional compensation, if any, would be payable to us or HPT as a result of the taking or what leasing arrangements, if any, will be entered into and the date at which we will cease to operate this travel center.

 

In September 2013, we entered an agreement to acquire a 223 room full service hotel located in Orlando, FL for a purchase price of $21,000, excluding closing costs. We plan to convert this hotel to a Sonesta branded hotel and add it to our Sonesta agreement (see Notes 11 and 12 for more information regarding the Sonesta agreement). We currently expect to acquire this hotel during the first quarter of 2014; however, this acquisition is subject to customary closing conditions and we can provide no assurance that we will acquire this property in that time or at all or that the terms of the acquisition will not change.

 

At September 30, 2013, one of our hotels was held for sale. See Note 12 for further information relating to our hotel held for sale.

 

Note 8. Income Taxes

 

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, and, accordingly are generally not subject to federal and most state income taxation on our operating income provided we distribute our taxable income to our shareholders and meet certain organization and operating requirements.  We are subject to income tax in Canada, Puerto Rico and certain states despite our REIT status.  Also, we lease our managed hotels to our wholly owned TRSs that, unlike most of our other subsidiaries, file a separate consolidated federal corporate income tax return and are subject to federal, state and foreign income taxes.  Our consolidated income tax provision included in our condensed consolidated statements of income and comprehensive income includes the income tax provision related to the operations of our TRSs and certain state and foreign income taxes incurred by us despite our REIT status.

 

During the three and nine months ended September 30, 2013, we recognized a current income tax expense of $899 and $2,535, respectively, which includes $420 and $1,317, respectively, of federal taxes, $16 and $78, respectively, of foreign taxes and $463 and $1,140, respectively, of certain state taxes that are payable without regard to our REIT status and TRS tax loss carry forwards. In addition, during the three and nine months ended September 30, 2013, we recognized a deferred tax benefit of $26 and $7,094, respectively, related primarily to the restructuring of certain of our TRSs.

 

8

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

During the three and nine months ended September 30, 2012, we recognized a current income tax (benefit) expense of ($276) and $4,550, respectively, which includes ($410) and $1,921, respectively, of federal taxes, $26 and $78, respectively, of foreign taxes and $108 and $2,551, respectively, of certain state taxes that are payable without regard to our REIT status and TRS tax loss carry forwards. In addition, during the three and nine months ended September 30, 2012, we recognized a deferred tax (benefit) expense of $113 and ($642), respectively, related to a basis difference at our Puerto Rico and New Orleans hotels and Canadian tax losses available to offset future income.

 

9

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 9.  Segment Information

 

		For the Three Months Ended September 30, 2013
		Hotels			Travel Centers			Corporate			Consolidated
Hotel operating revenues		$	348,908		$	—		$	—		$	348,908
Rental income		8,171			54,560			—			62,731
FF&E reserve income		636			—			—			636
Total revenues		357,715			54,560			—			412,275
Hotel operating expenses		249,862			—			—			249,862
Depreciation and amortization		51,476			24,572			—			76,048
General and administrative		—			—			13,094			13,094
Acquisition related costs		1,090			—			—			1,090
Loss on asset impairment		—			5,837			—			5,837
Total expenses		302,428			30,409			13,094			345,931
Operating income (loss)		55,287			24,151			(13,094		)	66,344
Interest income		—			—			18			18
Interest expense		—			—			(37,986		)	(37,986		)
Equity in earnings of an investee		—			—			64			64
Income (loss) before income taxes		55,287			24,151			(50,998		)	28,440
Income tax expense		—			—			(873		)	(873		)
Net income (loss)		$	55,287		$	24,151		$	(51,871	)	$	27,567
		For the Nine Months Ended September 30, 2013
		Hotels			Travel Centers			Corporate			Consolidated
Hotel operating revenues		$	990,436		$	—		$	—		$	990,436
Rental income		24,765			162,034			—			186,799
FF&E reserve income		1,828			—			—			1,828
Total revenues		1,017,029			162,034			—			1,179,063
Hotel operating expenses		705,054			—			—			705,054
Depreciation and amortization		149,703			72,223			—			221,926
General and administrative		—			—			37,156			37,156
Acquisition related costs		3,180			—			—			3,180
Loss on asset impairment		2,171			5,837			—			8,008
Total expenses		860,108			78,060			37,156			975,324
Operating income (loss)		156,921			83,974			(37,156		)	203,739
Interest income		—			—			97			97
Interest expense		—			—			(108,188		)	(108,188		)
Equity in earnings of an investee		—			—			219			219
Income (loss) before income taxes		156,921			83,974			(145,028		)	95,867
Income tax benefit		—			—			4,559			4,559
Net income (loss)		$	156,921		$	83,974		$	(140,469	)	$	100,426
		As of September 30, 2013
		Hotels			Travel Centers			Corporate			Consolidated
Total assets		$	3,651,637		$	2,212,253		$	37,975		$	5,901,865

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

		For the Three Months Ended September 30, 2012
		Hotels			Travel Centers			Corporate			Consolidated
Hotel operating revenues		$	251,722		$	—		$	—		$	251,722
Rental income		22,198			51,717			—			73,915
FF&E reserve income		4,431			—			—			4,431
Total revenues		278,351			51,717			—			330,068
Hotel operating expenses		184,566			—			—			184,566
Depreciation and amortization		44,682			21,884			—			66,566
General and administrative		—			—			10,336			10,336
Acquisition related costs		84			—			—			84
Total expenses		229,332			21,884			10,336			261,552
Operating income (loss)		49,019			29,833			(10,336		)	68,516
Interest income		—			—			116			116
Interest expense		—			—			(34,854		)	(34,854		)
Gain on sale of real estate		10,602			—			—			10,602
Equity in earnings of an investee		—			—			115			115
Income (loss) before income taxes		59,621			29,833			(44,959		)	44,495
Income tax benefit		—			—			163			163
Net income (loss)		$	59,621		$	29,833		$	(44,796	)	$	44,658
		For the Nine Months Ended September 30, 2012
		Hotels			Travel Centers			Corporate			Consolidated
Hotel operating revenues		$	741,775		$	—		$	—		$	741,775
Rental income		66,237			154,626			—			220,863
FF&E reserve income		12,033			—			—			12,033
Total revenues		820,045			154,626			—			974,671
Hotel operating expenses		527,806			—			—			527,806
Depreciation and amortization		127,244			64,962			—			192,206
General and administrative		—			—			32,333			32,333
Acquisition related costs		1,648			—			—			1,648
Loss on asset impairment		889			—			—			889
Total expenses		657,587			64,962			32,333			754,882
Operating income (loss)		162,458			89,664			(32,333		)	219,789
Interest income		—			—			233			233
Interest expense		—			—			(101,660		)	(101,660		)
Gain on sale of real estate		10,602			—			—			10,602
Equity in earnings of an investee		—			—			236			236
Income (loss) before income taxes		173,060			89,664			(133,524		)	129,200
Income tax expense		—			—			(3,908		)	(3,908		)
Net income (loss)		$	173,060		$	89,664		$	(137,432	)	$	125,292
		As of December 31, 2012
		Hotels			Travel Centers			Corporate			Consolidated
Total assets		$	3,384,221		$	2,209,970		$	40,934		$	5,635,125

 

Note 10. Related Person Transactions

 

Relationship with TA

 

TA is our former 100% owned subsidiary and our largest tenant, and we are TA’s largest shareholder.  TA was created as a separate public company in 2007 as a result of its spin off from us.  As of September 30, 2013, we owned

 

11

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

2,540,000 common shares of TA, representing approximately 8.6% of TA’s outstanding common shares.  Mr. Barry Portnoy, one of our Managing Trustees, is a managing director of TA.  Mr. Thomas O’Brien, an officer of RMR and a former officer of us prior to the TA spin off, is President and Chief Executive Officer and the other managing director of TA.  Mr. Arthur Koumantzelis, who was one of our Independent Trustees prior to the TA spin off, serves as an independent director of TA.  RMR provides management services to both us and TA.

 

TA is the lessee of 36% of our real estate properties, at cost, as of September 30, 2013.  TA has two leases with us, the TA No. 1 lease and the TA No. 2 lease, pursuant to which TA leases 184 travel centers from us.  The TA No. 1 lease is for 144 travel centers that TA operates primarily under the “TravelCenters of America” or “TA” brand names.  The TA No. 2 lease is for 40 travel centers that TA operates under the “Petro” brand name.  The TA No. 1 lease expires on December 31, 2022.  The TA No. 2 lease expires on June 30, 2024, and may be extended by TA for up to two additional periods of 15 years each.  Both of these leases require TA to:  (1) make payments to us of minimum rents; (2) pay us percentage rent equal to 3% of non-fuel revenues and 0.3% of fuel revenues above applicable base year revenues subject to certain limitations; (3) pay us at lease expiration an amount equal to an estimate of the cost of removing underground storage tanks on our leased sites; and (4) maintain the leased travel centers, including structural and non-structural components.  In addition to minimum and percentage rent, TA is obligated to pay us ground rent of approximately $5,152 per year under the TA No. 1 lease.  Previously deferred rent due from TA of $107,085 and $42,915 is due in December 2022 and June 2024, respectively; however, we have not recognized any of the deferred rent as rental income or as rents receivable due to uncertainties regarding future collection.

 

We recognized rental income of $54,560 and $51,717 for the three months ended September 30, 2013 and 2012, respectively, and $162,034 and $154,626 for the nine months ended September 30, 2013 and 2012, respectively, under our leases with TA.  Rental income for the three and nine months ended September 30, 2013 and 2012 includes ($83) and ($239) and ($69) and $218, respectively, of adjustments necessary to record the scheduled rent increase on our TA No. 1 lease and the estimated future payment to us by TA for the cost of removing underground storage tanks on a straight line basis.  As of September 30, 2013 and December 31, 2012, we had accruals for unpaid amounts of $31,368 and $29,300, respectively, owed to us by TA, excluding any deferred rents, which accrued amounts are included in other assets on our condensed consolidated balance sheets.  We had deferred percentage rent under our TA No. 1 lease of $464 and $77 for the three months ended September 30, 2013 and 2012, respectively, and $1,746 and $1,277 for the nine months ended September 30, 2013 and 2012, respectively.  We have waived an estimated $307 of percentage rent under our TA No. 2 lease as of September 30, 2013 because we previously agreed to waive the first $2,500 of percentage rents under the TA No. 2 lease.  We determine percentage rent due under our TA leases annually and recognize it at year end when all contingencies are met.

 

Under the TA No. 1 and No. 2 leases, TA may request that we fund approved amounts for renovations, improvements and equipment at leased travel centers in return for increases in TA’s minimum annual rent.  We are not required to fund these improvements and TA is not required to sell them to us.  For the nine months ended September 30, 2013, we funded $63,163 for capital improvements purchased from TA under this lease provision; and, as a result, TA’s minimum annual rent payable to us increased by approximately $5,369.

 

On April 15, 2013, TA entered an agreement with Shell Oil Products US, or Shell, pursuant to which Shell has agreed to construct a network of natural gas fueling lanes at up to 100 of TA’s travel centers located along the U.S. interstate highway system, including travel centers TA leases from us.  In connection with that agreement, on April 15, 2013, we and TA amended our leases to specify the economic equivalent for natural gas sales to diesel fuel sales for the calculation of percentage rent payable to us under the leases, with the intended effect that the amount of percentage rent be unaffected by the type of fuel sold, whether diesel fuel or natural gas.  That amendment also made certain administrative changes.  Also on that date, in order to facilitate TA’s agreement with Shell, we entered into a subordination, non-disturbance and attornment agreement with Shell, whereby we agreed to recognize Shell’s license and other rights with respect to the natural gas fueling lanes at our travel centers leased to TA on certain conditions and in certain circumstances.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

On July 1, 2013, we purchased land that we previously leased from a third party and subleased to TA under the TA No. 1 lease.  Effective as of that date, rents due to that third party and TA’s reimbursement of those rents to us under the terms of the TA No. 1 lease ceased.  Also on that date, we and TA amended the TA No. 1 lease to reflect our direct lease to TA of that land and certain minor properties adjacent to existing travel centers included in the TA No. 1 lease that we purchased and to increase the annual rent payable by TA to us by 8.5% of our total investment in these properties, or $537.  See Note 7 for further information regarding these acquisitions.

 

In August 2013, a travel center we leased to TA was taken by eminent domain proceedings by the VDOT.  See Note 7 for further information relating to this travel center and the effects of this taking on our TA No. 1 lease.

 

Relationship with RMR

 

We have no employees.  Personnel and various services we require to operate our business are provided to us by RMR.  We have two agreements with RMR to provide management and administrative services to us: (1) a business management agreement, which relates to our business generally, and (2) a property management agreement, which relates to the property level operations of an office building, which property is adjacent to our Royal Sonesta hotel in Baltimore, MD.

 

Under our business management agreement with RMR, we acknowledge that RMR also provides services to other companies, including TA and Sonesta.  One of our Managing Trustees, Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Our other Managing Trustee, Adam Portnoy, is the son of Barry Portnoy, and an owner, President, Chief Executive Officer and a director of RMR.  Each of our executive officers is also an officer of RMR, including Ethan Bornstein, who is the son-in-law of Barry Portnoy and the brother-in-law of Adam Portnoy.  Certain of TA’s and Sonesta’s executive officers are officers of RMR.  Our Independent Trustees also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Barry Portnoy serves as a managing director or managing trustee of those companies, including TA, and Adam Portnoy serves as a managing trustee of a majority of those companies, but not TA.  In addition, officers of RMR serve as officers of those companies.

 

Pursuant to our business management and property management agreements with RMR, we incurred business management fees and property management fees of $10,744 and $8,068 for the three months ended September 30, 2013 and 2012, respectively, and $30,711 and $26,650 for the nine months ended September 30, 2013 and 2012, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated financial statements.

 

On September 20, 2013, we and RMR agreed to restructure the base business management and incentive fees payable to RMR under our business management agreement beginning in 2014, as follows:

 

·                  The base business management fees we pay to RMR will be calculated on the basis of the lower of: (i) gross historical cost of our real estate assets, as defined, or (ii) our total market capitalization.  Market capitalization will include the market value of our common shares, plus the liquidation preference of preferred shares, if any, and the principal amount of debt.  The market value of our common shares will be calculated based on the average shares outstanding multiplied by the average closing share price during the period in which the fees are earned.

 

·                  10% of the base business management fees we pay to RMR will be paid in our common shares.  The amount of our common shares granted as part of the base business management fee will be calculated based on the average closing share price during the period in which the fees are earned.

 

·                  The annual incentive fees which may be earned by RMR will be calculated based upon total returns realized by our common shareholders (i.e., share price appreciation plus dividends) in excess of benchmarks.  The benchmarks will be set by our Compensation Committee, which is comprised solely of Independent Trustees, and will be disclosed in our annual meeting proxy statements.  Incentive fees will

 

13

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

be paid in our common shares which will vest over a multiyear period and will be subject to a “claw back” in the event of certain material restatements of our financial results.

 

Effective July 2013, we, RMR and five other companies to which RMR provides management services purchased from an unrelated third party insurer a combined directors’ and officers’ liability insurance policy providing $10,000 of aggregate coverage and we also purchased from an unrelated third party insurer a separate directors’ and officers’ liability insurance policy providing $5,000 of coverage.  We paid aggregate premiums of approximately $338 in connection with these policies.

 

Relationship with Sonesta

 

On January 31, 2012, pursuant to a series of transactions, we effectively acquired entities that owned the Royal Sonesta Hotel Boston in Cambridge, MA, or the Cambridge Hotel, and had leasehold interests in the New Orleans Hotel, for approximately $150,500.  On that date, in connection with these transactions, we entered into hotel management agreements with Sonesta to manage the Cambridge Hotel and the New Orleans Hotel.  Since that time, we have rebranded additional hotels to Sonesta brands and management.  We currently lease all hotels that we own and which are managed by Sonesta to one of our TRSs.

 

In April 2012, we entered into a pooling agreement with Sonesta that combined our management agreements with Sonesta for hotels that we owned for purposes of calculating gross revenues, payment of hotel operating expenses, payment of fees and distributions and the calculation of minimum returns due to us.  We previously referred to this agreement and combination of hotels and management agreements as our Sonesta No. 1 agreement.  The management agreements for all of our hotels managed by Sonesta, excluding, until June 28, 2013, the New Orleans Hotel, were included in the Sonesta No. 1 agreement.  On June 28, 2013, we acquired the fee interest in the New Orleans Hotel from the third party owner from which we previously leased that hotel and, as a result, the lease with the third party terminated. Simultaneous with this acquisition, we and Sonesta amended and restated the prior management agreement we had with Sonesta for this hotel.  The terms of the amended and restated management agreement are substantially the same as those contained in our other management agreements with Sonesta relating to full service hotels and this management agreement was added to our pooling agreement with Sonesta.  We now refer to the pooling agreement and combination of our 22 Sonesta branded hotels and management agreements as our Sonesta agreement.  See Note 11 for further information about our management agreements with Sonesta.

 

In September 2013, we agreed to acquire a hotel in Orlando, FL for a purchase price of $21,000, excluding closing costs.  This hotel is adjacent to a Sonesta ES Suites hotel that we own and which is managed by Sonesta.  Upon acquisition of this hotel, we intend to rebrand the hotel as a Sonesta hotel.  This acquisition is subject to completion of diligence and other customary closing conditions and we can provide no assurance that we will acquire this property or that terms of the acquisition will not change.  We expect to enter into a hotel management agreement with Sonesta for this property on terms consistent with our other applicable hotel management agreements with Sonesta and add the management agreement for the property to our Sonesta agreement.

 

We are currently marketing our Sonesta hotel in Myrtle Beach, SC for sale.  We can provide no assurance that we will sell this property.  If we complete a sale of this hotel, the annual minimum return due from Sonesta is expected to decrease by an amount based on the net proceeds received.

 

Pursuant to our management agreements with Sonesta, we incurred management, system and reservation fees payable to Sonesta of $2,797 and $1,903 for the three months ended September 30, 2013 and 2012, respectively, and $7,462 and $3,536 for the nine months ended September 30, 2013 and 2012, respectively.  These amounts are included in hotel operating expenses in our condensed consolidated statements of income and comprehensive income.  In addition, we also incurred procurement and construction supervision fees payable to Sonesta in connection with capital expenditures at our hotels managed by Sonesta of $699 and $185 for the three months ended September 30, 2013 and 2012, respectively, and $2,322 and $209 for the nine months ended September 30, 2013 and 2012, respectively.  These amounts have been capitalized in our condensed consolidated balance sheets.  Under our hotel management agreements

 

14

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

with Sonesta, routine property maintenance, which is expensed, is an operating expense of the hotels and repairs and periodic renovations, which are capitalized, are funded by us, except in the case of the New Orleans Hotel for capital expenditures incurred prior to June 28, 2013, which were borne in large part by the former lessor.

 

Under our management agreement with Sonesta, the costs of advertising, marketing, promotional and public relations programs and campaigns, including “frequent stay” rewards programs, that are intended for the benefit of all the Sonesta hotels we own, incurred by Sonesta are subject to reimbursement by us or otherwise treated as operating expenses of our hotels, subject to our approval of the applicable marketing program and cost allocation.  Sonesta has developed a guest loyalty program and marketing program for the Sonesta hotels.  Our Board and Independent Trustees agreed, effective July 1, 2013, to our reimbursement to Sonesta for these programs at rates not to exceed: 1.0% of the applicable hotel’s room revenues for the Sonesta guest loyalty program; 1.0% of the total revenues from our Sonesta managed hotels for the Sonesta marketing program; and 0.8% of the applicable hotel’s room revenues for Sonesta’s third party reservation transmission expenses.

 

The stockholders of Sonesta are Mr. Barry Portnoy and Mr. Adam Portnoy, who are our Managing Trustees, and they also serve as directors of Sonesta.  In addition, RMR also provides certain services to Sonesta.

 

Relationship with AIC

 

We, RMR, TA and five other companies to which RMR provides management services each currently own 12.5% of AIC, an Indiana insurance company.  All of our Trustees, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.  As of September 30, 2013, we have invested $5,209 in AIC.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because all of our Trustees are also directors of AIC.  Our investment in AIC had a carrying value of $5,781 and $5,629 as of September 30, 2013 and December 31, 2012, respectively, which amounts are included in other assets on our condensed consolidated balance sheets.  We recognized income of $64 and $115 for the three months ended September 30, 2013 and 2012, respectively, and $219 and $236 for the nine months ended September 30, 2013 and 2012, respectively, arising from our investment in AIC.  We and the other shareholders of AIC have purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2013 for a one year term and we paid a premium, including taxes and fees, of $6,842 in connection with that renewal, which amount may be adjusted from time to time as we acquire or dispose of properties that are included in this program.  We periodically consider the possibilities for expanding our insurance relationships with AIC to include other types of insurance and may in the future participate in additional insurance offerings AIC may provide or arrange.  We may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro rata share of any profits of this insurance business.

 

Note 11. Hotel Management Agreements and Leases

 

Marriott No. 1 agreement. Our lease with Host Hotels & Resorts, Inc., or Host, for 53 hotels which we have historically referred to as our Marriott No. 1 agreement expired on December 31, 2012. As required upon the expiration of the agreement, we paid the $50,540 security deposit we held to Host. Effective January 1, 2013, we leased these hotels to one of our TRSs and continued the previously existing hotel brand and management agreements with Marriott International Inc., or Marriott. This management agreement expires in 2024. Because we no longer hold a security deposit for this agreement, the minimum returns we receive under this agreement will be limited to available hotel cash flow after payment of operating expenses.

 

Marriott No. 234 agreement.  During the three months ended September 30, 2013, we were paid the contractual amounts due for the period under our agreement with Marriott covering 68 hotels, or our Marriott No. 234 agreement,

 

15

 

HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

which requires annual minimum returns to us of $105,347.  During the nine months ended September 30, 2013, the payments we received were $4,285 less than the minimum amounts contractually required.  Pursuant to our Marriott No. 234 agreement, Marriott provided us with a limited guarantee for shortfalls up to 90% of our minimum returns through 2019. Marriott was not required to make any guarantee payments during the three and nine months ended September 30, 2013, respectively, because the hotels generated cash flows in excess of the guaranty threshold amount (90% of the minimum returns due to us).  The available balance of this guaranty was $30,672 as of September 30, 2013. Also, during the period from September 30, 2013 to November 4, 2013, the payments we received for these hotels were $1,748 less than the contractual minimum returns due to us.

 

We currently expect to fund $11,000 of capital improvements during the remainder of 2013 to complete renovations at certain of the hotels included in our Marriott No. 234 agreement. We funded $39,000 during the nine months ended September 30, 2013. As we fund these improvements, the annual minimum returns payable to us increase by 9% of the amounts funded.

 

InterContinental agreement.  During the three and nine months ended September 30, 2013, we were paid the contractual amounts due for the periods under our agreement with InterContinental Hotels Group, plc, or InterContinental, covering 91 hotels and requiring annual minimum returns to us of $136,008. Our available security deposit was replenished by $1,355 from the net operating results these hotels generated in excess of the minimum returns due to us during the nine months ended September 30, 2013. The available balance of this security deposit was $27,909 as of September 30, 2013.  Also, during the period from September 30, 2013 to November 4, 2013, we received the minimum amounts contractually required under our InterContinental agreement.

 

When we reduce the amounts of the security deposits we hold for this agreement or any other operating agreements for payment deficiencies, we record income equal to the amounts by which this deposit is reduced up to the minimum return or minimum rent due to us. However, reducing the security deposits does not result in additional cash flow to us of the deficiency amounts, but reducing amounts of security deposits may reduce the refunds due to the respective lessees or managers who have provided us with these deposits upon expiration of the respective lease or management agreement.  The security deposits are non-interest bearing and are not held in escrow.  Under all of our hotel contracts that include a security deposit, any amount of the security deposits which are applied to payment deficits may be replenished from future cash flows from the applicable hotel operations pursuant to the terms of the respective contracts.

 

We currently expect to fund $10,557 and $56,073 of capital improvements during the remainder of 2013 and in 2014, respectively, to complete renovations at certain of the hotels included in our InterContinental agreement.  We funded $10,602 during the nine months ended September 30, 2013.  As we fund these improvements, the annual minimum returns payable to us increase by 8% of the amounts funded.

 

Sonesta agreement.  Our management agreement with Sonesta provides that we are paid a fixed minimum return equal to 8% of our invested capital, as defined in the management agreement, to the extent that gross revenues of the hotels, after payment of hotel operating expenses and base fees to Sonesta, are sufficient to do so.  In addition to recurring capital expenditures, we currently expect to fund $30,345 and $120,000 of capital improvements during the remainder of 2013 and in 2014, respectively, for renovations and other improvements at certain of the hotels included in our Sonesta agreement.  We funded $74,688 of capital improvements during the nine months ended September 30, 2013.  The annual minimum returns due to us under the Sonesta agreement will increase by 8% of the amounts funded in excess of threshold amounts, as defined.

 

We do not have any security deposits or guarantees for our hotels managed by Sonesta.  Accordingly, the returns we receive from hotels managed by Sonesta are limited to available hotel cash flows after payment of operating expenses.  Sonesta’s incentive management fees, but not its other fees, are only earned after we receive our minimum returns, and we may cancel these management agreements if approximately 75% of our minimum returns are not paid for certain periods.

 

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HOSPITALITY PROPERTIES TRUST

Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

See Note 10 for further information regarding our relationship with Sonesta.

 

Wyndham agreement.  On August 1, 2013, we acquired a full service hotel in Florham Park, NJ for $52,750, excluding the closing costs, and added it to our Wyndham Worldwide Corporation, or Wyndham, agreement. Our annual minimum returns under the Wyndham agreement increased by $4,220 to $24,698 and the limited guaranty provided by Wyndham increased by $6,656 to $35,656 upon closing of this hotel acquisition (and the annual maximum guarantee payment amount increased by $3,328 to $17,828).  Our guarantee from Wyndham expires in 2020.  The available balance of this guarantee was $18,349 as of September 30, 2013.

 

We currently expect to fund $21,664 and $25,874 of capital improvements in 2013 and 2014, respectively, to complete renovations at certain of the hotels included in our Wyndham agreement, including $10,000 related to the Florham Park, NJ hotel described above. We funded $46,880 of this amount during the nine months ended September 30, 2013. As we fund these improvements, the annual minimum returns payable to us increase by 8% of the amounts funded.

 

Other management agreement and lease matters.  As of November 4, 2013, all payments due to us from our managers and tenants under our other operating agreements were current.  Minimum return and minimum rent payments due to us under some of these other hotel management agreements and leases are supported by guarantees.  The guarantee provided by Hyatt Hotels Corporation, or Hyatt, with respect to the 22 hotels managed by Hyatt is limited to $50,000 ($15,304 remaining at September 30, 2013). The guarantee provided by Carlson Hotels Worldwide, or Carlson, with respect to the 11 hotels managed by Carlson is limited to $40,000 ($21,642 remaining at September 30, 2013).  The guarantee provided by Wyndham for the lease with Wyndham Vacation Resorts, Inc., or Wyndham Vacation, is unlimited. The guarantee provided by Marriott with respect to the one hotel leased by Marriott (Marriott No. 5 agreement) is unlimited.

 

Guarantees and security deposits generally.  Certain of our managed hotel portfolios had net operating results that were, in the aggregate, $15,258 and $20,300 less than the minimum returns due to us for the three months ended September 30, 2013 and 2012, respectively, and $44,475 and $46,697 less than the minimum returns due to us for the nine months ended September 30, 2013 and 2012, respectively. When managers of these hotels are required to fund the shortfalls under the terms of our operating agreements or their guarantees, we reflect such fundings (including security deposit applications) in our condensed consolidated statements of income and comprehensive income as a reduction of hotel operating expenses. The reduction to hotel operating expenses was $4,445 and $12,791 in the three months ended September 30, 2013 and 2012, respectively, and $12,597 and $30,483 in the nine months ended September 30, 2013 and 2012, respectively. We had shortfalls at certain of our managed hotel portfolios not funded by the managers of these hotels under the terms of our operating agreements of $10,813 and $9,840 during the three months ended September 30, 2013 and 2012, respectively, and $31,878 and $16,210 during the nine months ended September 30, 2013 and 2012, respectively, which represents the unguaranteed portion of our minimum returns from Marriott and Sonesta. Each of our guarantees and our security deposits under the InterContinental and Marriott No. 234 agreements may be replenished by future cash flows from the hotels in excess of our minimum returns.

 

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Notes to Condensed Consolidated Financial Statements

(dollars in thousands, except per share data)

 

Note 12.  Fair Value of Assets and Liabilities

 

The table below presents certain of our assets carried at fair value at September 30, 2013, categorized by the level of inputs, as defined in the fair value hierarchy under GAAP, used in the valuation of each asset.

 

					Fair Value at Reporting Date Using
					Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
Description		Total			(Level 1)			(Level 2)			(Level 3)
Investment securities (1)		$	19,939		$	19,939		$	—		$	—
Property held for sale (2)		$	4,074		$	—		$	—		$	4,074

 

(1)         Our investment securities, consisting of our 2,540,000 shares of TA, which are included in other assets in our condensed consolidated balance sheets, are reported at fair value which is based on quoted market prices (Level 1 inputs).  Our historical cost basis for these securities is $9,267.  The unrealized gain for these securities as of September 30, 2013 is included in cumulative other comprehensive income in our condensed consolidated balance sheets.

 

(2)         Our property held for sale consists of one Sonesta ES Suites hotel in Myrtle Beach, SC we were marketing for sale at September 30, 2013. We estimated the fair value less costs to sell of this hotel using standard industry valuation techniques and estimates of value developed by hotel brokerage firms (Level 3 inputs).  We recorded a $2,171, or $0.02 per share, loss on asset impairment during the three months ended June 30, 2013 to reduce the carrying value of this hotel to its estimated fair value, less cost to sell.

 

In addition to the investment securities included in the table above, our financial instruments include our cash and cash equivalents, restricted cash, rents receivable, revolving credit facility, unsecured term loan, senior notes and security deposits. At September 30, 2013 and December 31, 2012, the fair values of these additional financial instruments were not materially different from their carrying values, except as follows:

 

		September 30, 2013						December 31, 2012
		Carrying			Fair			Carrying			Fair
		Amount			Value			Amount			Value
Senior Notes, due 2014 at 7.875%		$	300,000		$	316,789		$	300,000		$	333,360
Senior Notes, due 2015 at 5.125%		280,000			291,145			280,000			298,926
Senior Notes, due 2016 at 6.3%		275,000			303,484			275,000			306,078
Senior Notes, due 2017 at 5.625%		300,000			323,728			300,000			335,173
Senior Notes, due 2018 at 6.7%		350,000			397,921			350,000			417,293
Senior Notes, due 2022 at 5%		500,000			498,013			500,000			531,343
Senior Notes, due 2023 at 4.5%		300,000			294,923			—			—
Convertible Senior Notes, due 2027 at 3.8%		8,478			8,858			8,478			9,092
Unamortized discounts		(9,973		)	—			(11,120		)	—
Total financial liabilities		$	2,303,505		$	2,434,861		$	2,002,358		$	2,231,265

 

We estimate the fair value of our indebtedness using discounted cash flow analysis and currently prevailing market interest rates (Level 3 inputs).

 

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