Service Properties Trust - Quarter Report: 2015 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended June 30, 2015

 

OR

 

☐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)

 

 

 

 

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 ☒  No ☐

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See 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 ☐  No ☒

 

Number of registrant’s common shares of beneficial interest, $.01 par value per share, outstanding as of August 9, 2015:    151,485,368

 

 

 

 

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HOSPITALITY PROPERTIES TRUST

 

FORM 10-Q

 

June  30, 2015

 

INDEX

 

 

References in this Quarterly Report on 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.

 

 

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Part IFinancial Information

 

Item 1.  Financial Statements

 

HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(dollars in thousands, except share data)

 

 

 

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

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HOSPITALITY PROPERTIES TRUST

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(in thousands, except per share data)

 

 

 

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)

 

 

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

 

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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, 2014, or our 2014 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 our subsidiaries, all of which are 100% owned directly or indirectly by HPT. All intercompany transactions and balances with or among our consolidated subsidiaries 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 our condensed consolidated financial statements include the allowance for doubtful accounts, purchase price allocations, useful lives of fixed assets, impairment of real estate and the valuation of 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’ economic performance and we have the obligation to absorb losses or the right to receive benefits from each VIE that could be significant to the VIE, and are, therefore, the primary beneficiary of each VIE.  The assets of our TRSs were $36,630 and $27,023 as of June 30, 2015 and December 31, 2014, respectively, and consist primarily of amounts due from, and working capital advances to, certain of their hotel managers.  The liabilities of our TRSs were $61,567 and $50,528 as of June  30, 2015 and December 31, 2014, respectively, and consist primarily of security deposits they hold from and amounts payable to certain of their hotel managers.  The assets of our TRSs are available to satisfy our TRSs’ obligations and we have guaranteed certain obligations of our TRSs.

 

Note 2.  New Accounting Pronouncements

 

In February 2015, the FASB issued Accounting Standards Update, or ASU, No. 2015-02, Consolidation.  Among other things, this update changes how an entity determines the primary beneficiary of a VIE.  This ASU is effective for interim and annual reporting periods beginning after December 15, 2015, with early adoption permitted.  We are currently in the process of evaluating the impact, if any, this ASU will have on our condensed consolidated financial statements.

 

In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheets as a direct deduction from the associated debt liability.  This ASU is effective for interim and annual reporting periods beginning after December 15, 2015 and requires retrospective application.  This ASU is not expected to cause any changes to our condensed consolidated financial statements other than the reclassification of debt issuance costs from assets to contra liabilities on our condensed consolidated balance sheets.    

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue From Contracts With Customers, which outlines a comprehensive model for entities to use in accounting for revenue arising from contracts with customers. This ASU states that “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” While this ASU specifically references contracts with customers, it may apply to certain other transactions such as the sale of real estate or equipment. In July 2015, the FASB approved a one year deferral of the effective date for this ASU to interim and annual reporting beginning after December 15, 2017.  We are continuing to evaluate this guidance; however, we do not expect its adoption to have a material impact on our condensed consolidated financial statements.

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Note 3.  Revenue Recognition

 

We report hotel operating revenues for managed hotels in our condensed consolidated statements of comprehensive income. We generally recognize hotel operating revenues, consisting primarily of room and food and beverage sales, when goods and services are provided.

 

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 scheduled future rent increases.  Rental income includes $1,511 and $2,056 for the three and six months ended June 30, 2015, and $539 and $1,106 for the three and six months ended June 30, 2014, respectively, of adjustments necessary to record scheduled rent increases under certain of our leases, the deferred rent obligations under our TravelCenters of America LLC, or TA, agreements and the estimated future payments to us by TA for the cost of removing underground storage tanks on a straight line basis.  See Note 10 for further information regarding our TA agreements.  Other assets, net, includes $23,450 and $21,866 of straight line rent receivables at June 30, 2015 and December 31, 2014, respectively.

 

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 no deferred estimated percentage rent for the three and six months ended June 30, 2015 and $698 and $1,572 of deferred estimated percentage rent for the three and six months ended June 30, 2014, respectively.  In connection with our lease modification with TA in June 2015, we recorded $2,048 of percentage rent during the three months ended June 30, 2015.  See Note 10 for further information regarding these agreements.

 

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 basic earnings per common share by dividing net income by the weighted average number of common shares outstanding during the period.  We calculate diluted earnings per share using the more dilutive of the two class method or the treasury stock method.  Unvested share awards and other potentially dilutive common shares, including contingently issuable common shares under the previous terms of our business management agreement with Reit Management & Research LLC, or RMR LLC, if any, and the related impact on earnings, are considered when calculating diluted earnings per share. The following table provides a reconciliation of the weighted average number of common shares used in the calculation of basic and diluted earnings per share:

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Note 5.  Shareholders’ Equity

 

Common Share Issuances

 

During the six months ended June 30, 2015, we issued 63,119 of our common shares to RMR LLC as part of the business management fees payable by us under our business management agreement. See Note 10 for further information regarding and recent amendments to this agreement.

 

On June 1, 2015, we granted 2,500 of our common shares valued at $30.59 per share, the closing price of our common shares on the New York Stock Exchange on that day, to each of our five Trustees as part of their annual compensation.

 

On June 8, 2015, we issued 1,490,000 of our common shares as partial payment to acquire 5,019,121 shares of class A common stock of Reit Management & Research Inc., or RMR Inc.  See Note 10 for further information regarding this transaction.

 

Distributions

 

On each of January 15, 2015, April 15, 2015 and July 15, 2015, we paid a $0.4453 per share distribution, or $5,166, to our Series D preferred shareholders.

 

On February 24, 2015, we paid a $0.49 per share distribution, or $73,466, to our common shareholders. On May 21, 2015, we paid a $0.50 per share distribution, or $74,981, to our common shareholders.  On July 13, 2015, we declared a $0.50 per share dividend, or $75,743, to our common shareholders of record on July 24, 2015.  We expect to pay this amount on or about August 20, 2015.

 

Other Comprehensive Income (Loss)

 

Other comprehensive income (loss) represents the unrealized gain (loss) on the 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

 

Our principal debt obligations at June 30, 2015 were: (1) our $319,000 of outstanding borrowings under our $750,000 unsecured revolving credit facility; (2) our $400,000 unsecured term loan; (3) an aggregate outstanding principal amount of $2,425,000 of public issuances of senior unsecured notes; and (4) an aggregate outstanding principal amount of $8,478 of public issuances of convertible senior unsecured notes. 

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Our $750,000 unsecured revolving credit facility is available for general business purposes, including acquisitions.  The maturity date of our unsecured revolving credit facility is July 15, 2018 and, subject to the payment of an extension fee and meeting certain other conditions, we have an option to extend the stated maturity date by one year to July 15, 2019. Borrowings under our unsecured revolving credit facility bear interest at a rate of LIBOR plus a premium, which was 110 basis points at June 30, 2015. We also pay a facility fee on the total amount of lending commitments, which was 20 basis points per annum at June 30, 2015. Both the interest rate premium and the facility fee are subject to adjustment based upon changes to our credit ratings. As of June 30, 2015, the interest rate payable on borrowings under our unsecured revolving credit facility was 1.29%. The weighted average annual interest rate for borrowings under our unsecured revolving credit facility was 1.28% for both the three and six months ended June 30, 2015 and 1.25% for both the three and six months ended June 30, 2014.  As of June 30, 2015 and August 9, 2015, we had $319,000 and $334,000 outstanding under our unsecured revolving credit facility, respectively.

 

Our $400,000 unsecured term loan, which matures on April 15, 2019, is prepayable without penalty at any time.  The amount outstanding under our unsecured term loan bears interest at a rate of LIBOR plus a premium, which was 120 basis points at June 30, 2015.  The interest rate premium is subject to adjustment based on changes to our credit ratings. As of June 30, 2015, the annual interest rate for the amount outstanding under our unsecured term loan was 1.38%. The weighted average annual interest rate for borrowings under our unsecured term loan was 1.38% for both the three and six months ended June 30, 2015, and 1.35% and 1.36% for the three and six months ended June 30, 2014, respectively.

 

Our credit agreement for our unsecured revolving credit facility and unsecured term loan also includes a feature under which maximum borrowings under our unsecured revolving credit facility and unsecured term loan may be increased up to $2,300,000 on a combined basis in certain circumstances. Our credit agreement for our unsecured revolving credit facility and unsecured term loan and our unsecured notes indenture and its supplements provide for acceleration of payment of all amounts outstanding upon the occurrence and continuation of certain events of default, including, in the case of our credit agreement, a change of control of us, which includes RMR LLC ceasing to act as our business manager. Our credit agreement for our unsecured revolving credit facility and unsecured term loan and our senior unsecured notes indenture and its supplements also contain a number of covenants that restrict our ability to incur debt in excess of calculated amounts, 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 credit agreement for our unsecured revolving credit facility and unsecured term loan and our senior unsecured notes indenture and its supplements at June 30, 2015.

 

Note 7.  Real Estate Properties

 

At June 30, 2015, we owned 293 hotels and 191 travel centers which are operated under 14 operating agreements.

 

During the six months ended June 30, 2015, we funded $72,482 for improvements to certain of our properties which, 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 $5,608.  See Notes 10 and 11 for further information about our fundings of improvements to certain of our properties.

 

On March 16, 2015, we acquired a 300 room hotel located in Rosemont, IL for $35,500 excluding related acquisition costs. 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.

 

 

 

 

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We added this Holiday Inn and Suites® branded hotel to our management agreement with InterContinental Hotels Group, plc, or InterContinental. The pro forma impact of including the results of operations of this acquisition from the beginning of the period is not material to our condensed consolidated financial statements.  See Note 11 for further information regarding our InterContinental agreement.

 

On April 28, 2015, we acquired a land parcel adjacent to one of our hotels for $750, excluding acquisition costs. See Note 10 for further information regarding this acquisition.

 

On May 15, 2015, we acquired a 364 room full service hotel located in Denver, CO for $77,250, excluding acquisition costs.  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.

 

 

 

 

We added this Crowne Plaza® branded hotel to our management agreement with InterContinental.  See Note 11 for further information regarding our InterContinental agreement.  The pro forma impact of including the results of operations of this acquisition from the beginning of the period is not material to our condensed consolidated financial statements.

 

In May 2015, we ceased marketing for sale and removed from held for sale status one Marriott by Courtyard®  branded hotel with a carrying value of $4,143.  

 

On June 1, 2015, we entered agreements with TA to acquire and leaseback 14 travel centers it owned and certain assets it owned at 11 properties we lease to TA for an aggregate purchase price of approximately $397,400.  In June 2015, we acquired 12 of these travel centers and certain assets at 10 properties TA leases from us for an aggregate purchase price of $227,877.  We also agreed to acquire from, and leaseback to, TA five travel centers it is developing for purchase prices equal to TA’s development costs, which are estimated to be approximately $118,000.  The acquisition of these five travel centers is expected to occur as development of these travel centers is completed before June 30, 2017.  See Note 10 for further information regarding this transaction and our TA agreements.  The following table summarizes our preliminary allocation of the acquisition cost to the estimated fair value of the assets we acquired as of June 30, 2015, in connection with this transaction.

 

 

On June 9, 2015, we sold five TA branded travel centers for net proceeds of $45,042.  As a result of this sale, we recorded an $11,015 gain on sale of real estate in the three months ended June 30, 2015.  See Note 10 for further information regarding this transaction.

 

On July 23, 2015, we acquired a portfolio of nine extended stay hotels with 1,094 suites located in eight states for $85,000, excluding closing costs.  We converted these hotels to Sonesta ES Suites® branded hotels and added them to our management agreement with Sonesta International Hotels Corporation, or Sonesta.  See Note 10 for further information regarding this transaction and our Sonesta agreement.

 

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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 separate consolidated federal corporate income tax returns and are subject to federal, state and foreign income taxes.  Our consolidated income tax provision included in our condensed consolidated statements of 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 six months ended June 30, 2015, we recognized income tax expense of $640 and $931, respectively, which includes $51 and $75, respectively, of foreign taxes and $589 and $856, respectively, of state taxes.  During the three and six months ended June 30, 2014, we recognized income tax expense of $455 and $1,071,  respectively, which includes $40 and $71, respectively, of foreign taxes and $437 and $1,022, respectively, of state taxes and ($22) and ($22), respectively, of federal taxes.

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Note 9.  Segment Information

 

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Note 10. Related Person Transactions

 

We have relationships and historical and continuing transactions with TA, RMR LLC, its parent, RMR Inc., Sonesta and others related to them, including other companies to which RMR LLC provides management services and which have trustees, directors and officers who are also trustees, directors or officers of us, RMR Inc. or RMR LLC. For further information about these and other such relationships and certain other related person transactions, please refer to our 2014 Annual Report and our Current Reports on Form 8-K filed with the Securities and Exchange Commission, or the SEC, on June 5, 8, 12, 22, 25 and July 28, 2015.  

   

TA:  TA was formerly our 100% owned subsidiary until it was spun out to our shareholders in 2007.  As of June 30, 2015, we owned 3,420,000 of TA’s common shares, representing approximately 8.9% of TA’s outstanding common shares, and we are TA’s largest shareholder.  TA is our largest tenant and property operator.

 

On June 1, 2015, we entered a transaction agreement, or the TA Transaction Agreement, with TA, pursuant to which, among other things, (i) we and TA agreed to expand and subdivide the lease pursuant to which we then leased to TA 144 properties that TA primarily operates under the “TravelCenters of America,” “TA” and related brand names, which we historically referred to as the TA No. 1 lease and which we refer to in this Note as the Prior TA lease, into four amended and restated leases, or the New TA leases, (ii) we agreed to purchase from TA 14 travel centers and certain assets it owned at 11 properties we lease to TA for an aggregate of $279,400 and we agreed to leaseback those 25 properties to TA under the New TA leases, (iii) TA agreed to purchase from us five travel centers that we then leased to TA under the Prior TA lease for an aggregate of $45,042 and (iv) we agreed to purchase from TA five travel centers upon the completion of their development at a purchase price equal to their development costs, including the cost of the land, which costs are estimated to be not more than $118,000 in the aggregate and we agreed to leaseback these development properties to TA under the New TA leases. The terms of the TA Transaction Agreement were approved by special committees of our Independent Trustees and TA’s independent directors, none of whom are directors or trustees of the other company.  Each special committee was represented by separate counsel.  In June 2015 we completed the following transactions pursuant to the TA Transaction Agreement:

 

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As of June 30, 2015, we leased to TA a total of 151 travel centers under the New TA leases and 40 travel centers under the TA No. 5 agreement.

 

We recognized rental income of $58,836 and $55,395 for the three months ended June 30, 2015 and 2014, respectively, and $115,626 and $110,678 for the six months ended June 30, 2015 and 2014, respectively, under our leases with TA.  On June 9, 2015, we began recognizing the $42,915 deferred rent obligation due on June 30, 2024 under the TA No. 5 agreement as rental income on a straight line basis over the remaining initial term of the lease because we believe the future payment of this amount to us by TA is reasonably assured.  Rental income for the three months ended June 30, 2015 and 2014 includes $1,390 and $408, respectively, and for the six months ended June 30, 2015 and 2014 includes $1,805 and $845, respectively, of adjustments necessary to record the scheduled rent increase under our Prior TA lease, the deferred rent obligations under our TA leases and the estimated future payment to us by TA for the cost of removing underground storage tanks on a straight line basis.  As of June 30, 2015 and December 31, 2014, we had accounts receivable from TA of $42,997 and $40,253, respectively, which amounts are included in due from related persons on our condensed consolidated balance sheets.

 

Under our leases with TA, we funded $40,415 and $21,923 for the six months ended June 30, 2015 and 2014, respectively, for qualifying capital improvements at the leased travel centers and, as a result, TA's minimum annual rent payable to us increased by approximately $3,435, and $1,863, respectively.  

 

Acquisition of Interest in our Manager:   On June 5, 2015, we and three other REITs to which RMR  LLC provides management services – Government Properties Income Trust, or GOV, Select Income REIT, or SIR, Senior Housing Properties Trust, or SNH, and collectively with GOV and SIR, the Other REITs – participated in a transaction, or the Up-C Transaction, by which we and the Other REITs each acquired an interest in RMR Inc.

 

The Up-C Transaction was completed pursuant to a transaction agreement by and among us, our manager, RMR LLC, its then sole member, Reit Management & Research Trust, or RMR Trust, and RMR Inc. and similar transaction agreements that each Other REIT entered with RMR LLC, RMR Trust and RMR Inc. RMR Trust is owned by our Managing Trustees, Barry and Adam Portnoy. Pursuant to these transactions agreements: we contributed to RMR Inc. 1,490,000 of our common shares, valued at the volume weighted average trading prices during the 20 days prior to the acquisition, and $12,622 in cash; GOV contributed to RMR Inc. 700,000 of its common shares and $3,917  in cash;  SIR contributed to RMR Inc. 880,000 of its common shares and $15,880 in cash; SNH contributed to RMR Inc. 2,345,000 of its common shares and $13,967 in cash; RMR Trust contributed to RMR Inc. $11,520 in cash, which RMR Inc. contributed to RMR LLC; RMR

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LLC issued 1,000,000 of its class B membership units to RMR Inc.; RMR Inc. issued 5,019,121 shares of its class A common stock to us, 1,541,201 shares of its class A common stock to GOV, 5,272,787 shares of its class A common stock to SNH, 3,166,891 shares of its class A common stock to SIR and 1,000,000 shares of its class B-1 common stock and 15,000,000 shares of its class B-2 common stock  to RMR Trust; RMR Trust delivered 15,000,000 of the 30,000,000 class A membership units of RMR LLC which RMR Trust then owned to RMR Inc.; and RMR Inc. delivered to RMR Trust our common shares, the common shares of the Other REITs and the cash which had been contributed by us and the Other REITs to RMR Inc.

 

The class A common stock and class B-1 common stock of RMR Inc. share ratably as a single class in dividends and other distributions of RMR Inc. when and if declared by the board of directors of RMR Inc. and have the same rights in a liquidation of RMR Inc. The class B-1 common stock of RMR Inc. is convertible into class A common stock of RMR Inc. on a 1:1 basis. The class A common stock of RMR Inc. has one vote per share. The class B-1 common stock of RMR Inc. has 10 votes per share. The class B-2 common stock of RMR Inc. has no economic interest in RMR Inc., but has 10 votes per share and is paired with the class A membership units of RMR LLC owned by RMR Trust. The class A membership units of RMR LLC owned by RMR Trust are required to be redeemed by RMR LLC upon request by RMR Trust for class A common stock of RMR Inc. on a 1:1 basis, or if RMR Inc. elects, cash. Under the governing documents of RMR Inc., upon the redemption of a class A membership unit of RMR LLC by RMR Trust, the class B-2 common stock of RMR Inc. “paired” with an equal number of class A membership units are cancelled for no additional consideration.

 

As part of the Up-C Transaction and concurrently with entering into the transaction agreements, on June 5, 2015:

 

 

 

 

As a result of the Up-C Transaction: RMR LLC became a subsidiary of RMR Inc.; RMR Inc. became the managing member of RMR LLC; through our ownership of class A common stock of RMR Inc., we currently own an indirect 16.2% economic interest in RMR LLC; through their ownership of class A common stock of RMR Inc., GOV, SIR and SNH currently have an indirect 5.0%, 10.2% and 17.0% economic interest in RMR LLC, respectively; and RMR Trust through its ownership of 1,000,000 shares of class B-1 common stock of RMR Inc., 15,000,000 shares of class B-2 common stock of RMR Inc. and 15,000,000 class A membership units of RMR LLC currently directly and indirectly has a 51.6% economic interest in RMR LLC and controls 91.4% of the voting power of outstanding capital stock of RMR Inc.

 

Pursuant to the transaction agreements, we and each Other REIT agreed to distribute half of the shares of class A common stock of RMR Inc. received in the Up-C Transaction to our respective shareholders as a special distribution, and RMR Inc. agreed to facilitate this distribution by filing a registration statement with the SEC to register the shares of class A common stock of RMR Inc. to be distributed and by seeking a listing of those shares on a national stock exchange upon the registration statement being declared effective by the SEC.

 

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The distribution of shares of class A common stock of RMR Inc. that we and the Other REITs have agreed to make to our and the Other REITs’ shareholders will be made only after a registration statement, including a prospectus, is declared effective by the SEC.

   

Amendment and Restatement of Management Agreements with RMR LLC: As part of the Up-C Transaction, on June 5, 2015, we and RMR LLC entered into the amended business management agreement, which amended and restated our pre-existing business management agreement with RMR LLC and the amended property management agreement, which amended and restated our pre-existing property management agreement with RMR LLC. Our amended business management agreement and amended property management agreement are referred to together in this Note as our amended management agreements. Our amended management agreements were effective as of June 5, 2015.

 

Our amended management agreements have terms that end on December 31, 2035, and automatically extend on December 31st of each year for an additional year, so that the terms of the agreements thereafter end on the 20th anniversary of the date of the extension. We have the right to terminate each amended management agreement: (i) at any time on 60 days’ written notice for convenience, (ii) immediately upon written notice for cause, as defined therein, (iii) on 60 days’ written notice given within 60 days after the end of any calendar year for a performance reason, as defined therein, and (iv) by written notice during the 12 months following a change of control of RMR LLC, as defined therein. RMR LLC has the right to terminate the amended management agreements for good reason, as defined therein.

 

If we terminate one or both of our amended management agreements for convenience, or if RMR LLC terminates one or both of our amended management agreements for good reason, we have agreed to pay RMR LLC a termination fee in an amount equal to the sum of the present values of the monthly future fees, as defined therein, for the terminated amended management agreement(s) for the remaining term. If we terminate one or both of our amended management agreements for a performance reason, as defined therein, we have agreed to pay RMR LLC the termination fee calculated as described above, but assuming a remaining term of 10 years.    We are not required to pay any termination fee if we terminate one or both of our amended management agreements for cause or as a result of a change of control of RMR LLC.

 

Accounting for Investment in RMR Inc.: On June 5, 2015, we acquired 5,019,121 shares of class A common stock, or 33.5%, of RMR Inc.  The value of our common shares issued to RMR Inc. is valued differently for accounting purposes than as stated in the respective transaction agreements.  The transaction agreements calculate the value of our common shares using a 20 day volume weighted average trading price, or $57,817.  For accounting purposes, the common shares are valued at the closing price of those shares on the date of the transaction, or $55,922.  We account for this investment under the cost method of accounting and have recorded this investment at fair value (Level 3 inputs as defined in the fair value hierarchy under GAAP).  We have determined the fair value of the RMR Inc. investment to be $129,722 as of June 5, 2015, based on valuing RMR Inc. using comparable company multiples.  We have concluded, for accounting purposes, that the consideration paid for this investment in RMR Inc.’s class A common stock represented a discount to the fair value of these shares.  As a result, we have recorded other liabilities of $73,800.  Our investment in RMR Inc. is included in other assets in our condensed consolidated balance sheets.  The carrying value of our investment in RMR Inc., including transaction costs, is $132,296 as of June 30, 2015.  The other liabilities are included in accounts payable and other liabilities in our condensed consolidated balance sheets and are being amortized on a straight line basis over the 20 year life of the business and property management agreements with RMR LLC as a reduction to business management fee expense and property management fee expense, which are included in general and administrative and hotel operating expenses, respectively, in our condensed consolidated statements of comprehensive income.  Amortization of this other liability included in general and administrative expense for the three months ended June 30, 2015 totaled $231.

 

RMR LLC Management Fees and Reimbursements: We recognized business and property management fees of $9,468 and $10,925 for the three months ended June 30, 2015 and 2014, respectively, and $28,464 and $20,585 for the six months ended June 30, 2015 and 2014, respectively. The business management fees for the six months ended June 30, 2015, include estimated 2015 incentive fees of $8,822, based on our common share total return as of June 30, 2015.  The actual amount of incentive fees payable to RMR LLC for 2015, if any, will be based on our common share total return for the two year period ended December 31, 2015, and will be payable in 2016.  The business management fees recognized for the three months ended June 30, 2015, reflect the reversal of ($205), which is the amount by which the estimated 2015 incentive fee

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accrued as of March 31, 2015 exceeded the amount of that fee estimated as of June 30, 2015.  Although no incentive fee was ultimately payable to RMR LLC for 2014, business management fees we recognized for the three and six months ended June 30, 2014 include $1,445 and $2,296, respectively, of then estimated 2014 incentive fees that would have been payable in common shares after the year end 2014 based on our common share total return as of those respective 2014 periods.

 

The business management fees we recognized for the 2015 and 2014 periods are included in general and administrative expenses in our condensed consolidated financial statements.    The property management amounts are included in property operating expenses or have been capitalized, as appropriate, in our condensed consolidated financial statements and are comprised of fees we recognized under both our pre-existing property management agreement and our amended property management agreement.    In accordance with the terms of our pre-existing business management agreement, we issued 63,119 and 54,423 of our common shares to RMR LLC for the six months ended June 30, 2015 and 2014, respectively, as payment for portions of the base business management fees we recognized for those periods.    Our amended business management agreement requires that 100% of the management fees due to RMR LLC be paid by us in cash.

 

Pursuant to our pre-existing and amended management agreements with RMR LLC, we are responsible for paying all of the property level operating costs at the one office building we own which is attached to a hotel we own.  These property level costs include certain payroll and related costs, which costs are generally incorporated into rents charged to our office tenants at this building.  The total of the property management related reimbursements we paid to RMR LLC was $29 and $15 for the three months ended June 30, 2015 and 2014, respectively, and these costs are included in hotel operating expenses in our condensed consolidated financial statements for these periods.  In addition we have historically awarded share grants to certain RMR LLC employees under our equity compensation plan and we accrue estimated amounts for such share grants throughout each year based upon historical practices.  The amounts accrued for share grants to RMR LLC employees were $647 and $877 for the three months ended June 30, 2015 and 2014, respectively, and $1,383 and $1,115 for the six months ended June 30, 2015 and 2014, respectively, and these amounts are included in our general and administrative expenses in our condensed consolidated financial statements for these periods.

    

Sonesta:  As of June 30, 2015, Sonesta was managing 22 of our hotels pursuant to long term management agreements.  Pursuant to these management agreements, we incurred management, system, reservation fees and reimbursement of certain guest loyalty, marketing program and third party reservation transmission expenses payable to Sonesta of $5,887 and $4,717 for the three months ended June 30, 2015 and 2014, respectively, and $10,401 and $8,330 for the six months ended June 30, 2015 and 2014, respectively.  These amounts are included in hotel operating expenses in our condensed consolidated statements of 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 $323 and $1,203 for the three months ended June 30, 2015 and 2014, respectively, and $676 and $1,750 for the six months ended June 30, 2015 and 2014, respectively.  These amounts have been capitalized in our condensed consolidated financial statements. 

 

On April 28, 2015, we acquired a building and land parcel adjacent to a hotel we own which is managed by Sonesta for $750, excluding closing costs.  This land was added to that hotel property and constitutes invested capital under our Sonesta agreement.

 

In July 2015, we acquired a portfolio of nine extended stay hotels with 1,094 suites located in eight states for $85,000, excluding closing costs.  In connection with this acquisition, we entered into a long term management agreement for Sonesta to manage these hotels.  The terms of the management agreement are substantially consistent with the terms of our other management agreements with Sonesta for extended stay hotels, and this management agreement was combined with our other Sonesta hotel management agreements under our existing pooling agreement with Sonesta.  We expect to invest approximately $45,000 to substantially renovate these hotels in connection with their conversion to the upscale, extended stay Sonesta ES Suites® hotel brand.

   

AIC:  As of June 30, 2015, our investment in AIC had a carrying value of $6,910, which amount is included in other assets on our condensed consolidated balance sheets.  We recognized income of $23 and $125 related to our investment in AIC for the three months ended June 30, 2015 and 2014, respectively, and $95 and $28 for the six months ended June 30, 2015 and 2014, respectively.  Our other comprehensive income includes unrealized gains (losses) on securities held for sale

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which are owned by AIC of ($64) and $23 for the three months ended June 30, 2015 and 2014, respectively, and ($19) and $41 for the six months ended June 30, 2015 and 2014, respectively.

 

In June 2015, we and the other shareholders of AIC renewed our participation in an insurance program arranged by AIC.  In connection with that renewal, we purchased a three-year combined property insurance policy providing $500,000 of coverage annually with the premium to be paid annually and a one year combined policy providing terrorism coverage of $200,000 for our properties.  We currently expect to pay AIC an aggregate annual premium, including taxes and fees, of approximately $2,656 in connection with these policies for the policy year ending June 30, 2016, which amount may be adjusted from time to time as we acquire and dispose of properties that are included in this insurance program. 

 

Note 11. Hotel Management Agreements and Leases

 

As of June 30, 2015, 290 of our hotels are leased to our TRSs and managed by independent hotel operating companies and three are leased to third parties.

 

Marriott No. 1 agreement. Our management agreement with Marriott International, Inc., or Marriott, for 53 hotels provides that as of June 30, 2015 we are to be paid an annual minimum return of $68,147 to the extent that gross revenues of the hotels, after payment of hotel operating expenses and funding of the FF&E reserve, are sufficient to do so.  We do not have any security deposits or guarantees for our minimum returns from the 53 hotels included in our Marriott No. 1 agreement.  Accordingly, the returns we receive from these hotels managed by Marriott are limited to available hotel cash flows after payment of operating expenses and funding of the FF&E reserve. We realized returns of $17,027 and $18,771 during the three months ended June 30, 2015 and 2014, respectively, and returns of $34,033 and $33,807 during the six months ended June 30, 2015 and 2014, respectively, under this agreement.  Marriott’s management and incentive fees are only earned after we receive our minimum returns.

 

We funded $1,711 for capital improvements at certain of the hotels included in our Marriott No. 1 agreement during the six months ended June 30, 2015. We currently expect to fund $2,000 for capital improvements during the remainder of 2015 under this agreement. As we fund these improvements, the annual minimum returns payable to us increase by 10% of the amounts funded.

 

Marriott No. 234 agreement.  Our management agreement with Marriott for 68 hotels provides that as of June 30, 2015 we are to be paid an annual minimum return of $106,198.  We realized returns of $28,026 and $26,330 during the three months ended June 30, 2015 and 2014, respectively, and returns of $53,032 and $50,136 during the six months ended June 30, 2015 and 2014, respectively, under this agreement.  During the six months ended June 30, 2015, our available security deposit was replenished by $780 from the payments we received during the period in excess of the minimum payments due for the period.  The available balance of this deposit was $780 as of June 30, 2015.  Pursuant to our Marriott No. 234 agreement, Marriott has provided us with a limited guarantee which expires in 2019 for shortfalls up to 90% of our minimum returns, after the available security deposit has been depleted.  Marriott was not required to make any guarantee payments to us during the three and six months ended June 30, 2015, because the hotels generated net operating results in excess of the guarantee threshold amount (90% of the minimum returns due to us).  The available balance of the guarantee was $30,672 as of June 30, 2015. 

 

We funded $3,000 for capital improvements at certain of the hotels included in our Marriott No. 234 agreement during the six months ended June 30, 2015. We currently expect to fund $6,500 for capital improvements during the remainder of 2015 under this agreement. As we fund these improvements, the annual minimum returns payable to us increase by 9% of the amounts funded.

 

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Marriott No. 5 agreement. We lease one hotel in Kauai, Hawaii to Marriott.  This lease is guaranteed by Marriott and we realized $2,529 and $2,501 of rent for this hotel during the three months ended June 30, 2015 and 2014, respectively, and $5,058 and $5,002 of rent during the six months ended June 30, 2015 and 2014, respectively.  The guarantee provided by Marriott with respect to this leased hotel is unlimited.

 

InterContinental agreement. Our management agreement with InterContinental for 93 hotels provides that as of June 30, 2015, we are to be paid annual minimum returns and rents of $149,778.  We realized minimum returns and rents of $36,702 and $34,875 during the three months ended June 30, 2015 and 2014, respectively, and minimum returns and rents of $72,016 and $69,749 during the six months ended June 30, 2015 and 2014, respectively, under this agreement.  We also realized additional returns of $3,177 under this agreement for the three and six months ended June 30, 2015.  Pursuant to our InterContinental agreement, InterContinental has provided us with a security deposit to cover minimum payment shortfalls, if any.  During the six months ended June 30, 2015, we were paid the minimum returns and rents due to us and our available security deposit was replenished by $8,284 from the payments we received during the period in excess of the minimum payments due for the period. The available balance of this security deposit was $41,251 as of June 30, 2015.

 

Under this agreement, InterContinental is required to maintain a minimum security deposit of $37,000. In January 2014, we entered into a letter agreement with InterContinental under which the minimum security deposit balance required to be maintained during 2015 will be reduced by two dollars for every dollar of additional security deposit InterContinental provides to us.  As of June 30, 2015, InterContinental had provided us $2,772 of additional security deposits, which reduced the minimum security deposit amount required to $31,456. We refunded the additional security deposit to InterContinental in July 2015. 

 

On each of March 16, 2015 and May 15, 2015, we amended our management agreement with InterContinental in connection with our acquisitions of two hotels. As a result of the amendments, the annual minimum returns due to us increased by an aggregate of  8% of our investment in the two hotels. 

 

We currently expect to fund $34,750 for capital improvements to certain hotels, including $24,750 related to the recently acquired hotels described above, under our InterContinental agreement during the remainder of 2015 and 2016. We did not make any of these fundings during the six months ended June 30, 2015.  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 to be paid an annual minimum return equal to 8% of our invested capital, as defined in the management agreement ($73,385 as of June 30, 2015), to the extent that gross revenues of the hotels, after payment of hotel operating expenses and certain fees to Sonesta, are sufficient to do so.  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. We realized returns of $18,738 and $11,205 during the three months ended June 30, 2015 and 2014, respectively, and returns of $26,799 and $13,300 during the six months ended June 30, 2015 and 2014, respectively, under this agreement.

 

Our Sonesta agreement does not require FF&E escrow deposits.  Under our Sonesta agreement, we are required to fund capital expenditures made at our hotels.  We funded $23,909 for renovations and other capital improvements to hotels included in our Sonesta agreement during the six months ended June 30, 2015.  We currently expect to fund approximately $48,851 for renovations and other capital improvements during the remainder of 2015 and 2016 under this agreement, including $45,000 related to the nine hotels we acquired in July 2015. The annual minimum returns due to us under the Sonesta agreement increase by 8% of the amounts funded in excess of threshold amounts, as defined therein. See Note 10 for further information regarding our relationship with Sonesta.

 

Wyndham agreement. Our management agreement with Wyndham Hotel Group, or Wyndham, for 22 hotels provides that as of June 30, 2015, we are to be paid annual minimum returns and rents of $27,695.  We realized returns of $6,907 and $6,704 during the three months ended June 30, 2015 and 2014, respectively, and returns of $13,770 and $13,239 during the six months ended June 30, 2015 and 2014, respectively, under this agreement. Pursuant to our Wyndham agreement, Wyndham has provided us with a limited guarantee, which is limited to $35,656 ($4,679 remaining at June 30,

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2015), subject to an annual payment limit of $17,828 and which expires on July 28, 2020.  During the six months ended June 30, 2015, Wyndham made $1,903 of guarantee payments to us. The guarantee provided by Wyndham with respect to the lease with Wyndham Vacation Resorts, Inc., or Wyndham Vacation, for part of one hotel is unlimited.

 

We funded $3,446 for renovations and other capital improvements to hotels included in our Wyndham agreement during the six months ended June 30, 2015.  We currently expect to fund approximately $5,554 for capital improvements to certain hotels during the remainder of 2015 under this agreement.  As we fund these improvements, the annual minimum returns payable to us increase by 8% of the amounts funded.

 

TA agreements.  See Note 10 for information about our TA agreements.

 

Other management agreement and lease matters. As of August 9, 2015, 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  ($13,962 remaining at June 30, 2015).  The guarantee provided by Carlson Hotels Worldwide, or Carlson, with respect to the 11 hotels managed by Carlson is limited to $40,000  ( $23,799 remaining at June 30, 2015).

 

Guarantees and security deposits generally.  Net operating results of our managed hotel portfolios exceeded the minimum returns due to us in the three months ended June 30, 2015.    Certain of our managed hotel portfolios had net operating results that were, in the aggregate, $4,449 less than the minimum returns due to us in the three months ended June 30, 2014 and $11,443 and $25,291 less than the minimum returns due to us for the six months ended June 30, 2015 and 2014, respectively.  When the managers of these hotels 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 comprehensive income as a reduction of hotel operating expenses.  There was no reduction to hotel operating expenses in the three months ended June 30, 2015 or 2014 and reductions to hotel operating expenses were $1,903 and $5,331 in the six months ended June 30, 2015 and 2014, respectively.  We had shortfalls at certain of our managed hotel portfolios not funded by the managers of these hotels of $4,450 in the three months ended June 30, 2014 and $9,540 and $19,960 in the six months ended June 30, 2015 and 2014, respectively, which represents the unguaranteed portions of our minimum returns from Marriott and from Sonesta.  When we reduce the amounts of the security deposits we hold for any of our operating agreements for payment deficiencies, we record income equal to the amounts by which the deposit is reduced up to the minimum returns or minimum rent due to us.  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.  Certain of our guarantees and our security deposits may be replenished by future cash flows from the applicable hotel operations pursuant to the terms of the respective operating agreements.  When our guarantees and our security deposits are replenished by cash flows from hotel operations, we reflect such replenishments in our condensed consolidated statements of comprehensive income as an increase to hotel operating expenses.  We had $14,976 and $8,120 of guarantee and security deposit replenishments during the three months ended June 30, 2015 and 2014, respectively.  We had $16,189 and $2,574 of guarantee and security deposit replenishments during the six months ended June 30, 2015 and 2014, respectively. 

 

 

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Note 12.  Fair Value of Assets and Liabilities

 

The table below presents certain of our assets carried at fair value at June 30, 2015, categorized by the level of inputs, as defined in the fair value hierarchy under GAAP, used in the valuation of each asset.

 

 

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In addition to the investment securities included in the table above, our financial instruments include our cash and cash equivalents, restricted cash, rents receivable, investment in RMR Inc., unsecured revolving credit facility, unsecured term loan, senior unsecured notes and security deposits. At June 30, 2015 and December 31, 2014, the fair values of these additional financial instruments approximated their carrying values in our condensed consolidated balance sheets due to their short term nature or variable interest rates, except as follows:

 

 

 

At June 30, 2015, we estimated the fair values of our senior unsecured notes using an average of the bid and ask price of our then outstanding issuances of senior unsecured notes (Level 2 inputs).  We estimated the fair value of our convertible senior unsecured notes using discounted cash flow analyses and currently prevailing market interest rates (Level 3 inputs) because no market quotes or other observable inputs for these notes were available at June 30, 2015 and December 31, 2014.