Item 1. Business
Apple Hospitality Two, Inc. (the “Company”), a Virginia corporation, was formed on January 17, 2001, with the first investor closing on May 1, 2001. The Company merged with Apple Suites, Inc. on January 31, 2003 and results of Apple Suites operations are included in the Company’s results from February 1, 2003. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.
The Company is a real estate investment trust (“REIT”) that owns extended-stay hotels. The REIT Modernization Act, effective January 1, 2001, permits REIT’s to establish taxable businesses to conduct certain previously disallowed business activities. The Company has wholly-owned taxable REIT subsidiaries (collectively, the “Lessees”), which lease all of the Company’s hotels from wholly-owned qualified REIT subsidiaries. The hotels are operated and managed by affiliates of either Marriott or Hilton under hotel management agreements.
In 2005, the Company engaged UBS Investment Bank to assist in reviewing and evaluating various strategic alternatives for the Company. Those alternatives include a possible sale of the Company, merger or listing. The Company cannot provide any assurances that it will initiate any of these alternatives.
Website Access
The address of the Company’s Internet website is www.applehospitality.com. The Company makes available through its Internet website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC.
Growth Strategies
The Company’s primary objective is to enhance shareholder value by increasing funds from operations and cash available for distributions. The Company seeks to increase operating cash flow and enhance its value through internal growth and renovations. The Company’s internal growth strategy is to utilize its asset management expertise to improve the quality of its hotels by aggressively managing its room rates, renovating, redeveloping, partnering with industry leaders in hotel management and franchising its hotels with leading brands in the industry. All of these factors can improve hotel operational performance and customer satisfaction, which in turn can improve financial results.
The Company believes that completed and planned renovation and redevelopment activities as well as market penetration will increase revenue per available room (“RevPAR”) at its hotels. As required by its various management agreements, the Company is committed to funding a percentage of gross revenue per month for certain capital expenditures for periodic replacement or refurbishment of furniture, fixtures and equipment. The Company has approximately $7.2 million held in escrow for future furniture, fixture and equipment purchases at December 31, 2005. During 2003, the Company began a major renovation program for its hotels to enhance revenue per available room. This program concluded in the middle of 2004. Total capital expenditures in the program were approximately $56 million and included 26 hotels. The Company continues to selectively renovate hotels as the return on investment warrants.
The Company continuously monitors its portfolio and will, where appropriate, selectively acquire or dispose of properties based on specific market conditions. Based on the performance and location of two hotels, the Company has entered into contracts to sell these properties for a gross sale price of $5.8 million. These transactions should be completed in the first quarter of 2006.
Financing
Substantially all of the Company’s hotels are encumbered by mortgage debt. The Company’s bylaws require board of director approval for debt above certain levels. Debt levels are reviewed quarterly by the board to ensure reasonableness in relation to the Company’s assets. Although there can be no assurance about the need for additional debt, it is anticipated that cash from operations and the Company’s existing revolving line of credit will meet substantially all of the Company’s cash requirements.
Industry and Competition
The Company believes that the hotel industry is highly competitive. Each of the Company’s hotels is located in a developed area that includes other hotels and competes for guests primarily with other extended-stay hotels in its immediate vicinity and secondarily with other hotels in its geographic market. An increase in the number of competitive hotels in a particular area could have a material adverse effect on the occupancy, average daily rate (ADR) and RevPAR of the Company’s hotels in that area. The Company believes that brand recognition, location, price and quality (of both the hotel and the services provided) are the principal competitive factors affecting its hotels. Additionally, general economic conditions in a particular market or nationally can impact the performance of the hotels.
Hotel Operating Performance
The Company owns 49 Residence Inn by Marriott hotels, consisting of 5,947 suites, and 17 Homewood Suites by Hilton hotels, consisting of 1,922 suites. The Company has contracted to sell two of the Residence Inn by Marriott hotels, consisting of 179 suites. The results of these two hotels have been classified as discontinued operations. Total revenues for the hotels in continuing operations totaled $225.4 million, $210.5 million and $192.6 million for the years ended December 31, 2005, 2004 and 2003. For those same periods, the hotels achieved average occupancy of 78%, 76% and 74%, ADR of $100, $95 and $91 and RevPAR of $78, $72 and $67. The overall increase in RevPAR reflects the increase in business of newly renovated hotels and the overall improvement in the hospitality industry.
Franchise and Management Agreements
Residence Inn Hotels
The Company’s Residence Inn hotels are subject to management agreements under which Residence Inn by Marriott, Inc. (the “Manager”) manages the hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years. The agreements generally provide for payment of base management fees, which are calculated annually as a percentage of sales, and incentive management fees over a priority return (as defined in the management agreements). Incentive management fees (IMF) are currently
payable only if and to the extent there is sufficient cash flow from the hotels after consideration of qualifying debt service and after consideration to a priority return on investment, including property improvements. Amounts not currently payable are deferred and are payable in future years only if and to the extent there is sufficient cash flow from future operations or upon sale or refinancing of the hotels after consideration to a priority return to the Company (as defined in the management agreements), which is generally 12%. In the event of early termination of the management agreements, the Manager will receive additional fees based on the unexpired term and expected future base and incentive management fees. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied. Marriott also charges system fees to operate as a Residence Inn by Marriott and for the right to use its brand services including its reservation system.
Homewood Suites Hotels
The Company’s 17 Homewood Suites hotels are managed by Promus Hotels, Inc. (“Promus”), a wholly owned subsidiary of Hilton under the terms of separate management agreements, as part of the Homewood Suites by Hilton franchise. The initial term is generally 15 years with no option to renew; however, two hotel properties in this portfolio have renewal options of two five year periods each. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied.
Promus manages day-to-day operations of the Company’s Homewood Suites hotels. Promus charges fees for this function, which are calculated as a percentage of revenue. Incentive management fees are calculated, for certain properties, on the basis of operating profit of the hotels. Promus also charges a fee, calculated as a percentage of suite revenue, for franchise licenses to operate as a Homewood Suites by Hilton and to participate in its reservation system.
Related Parties
The Company has significant transactions with related parties. These transactions cannot be construed to be arm’s length, and the results of the Company’s operations could be different if these transactions were conducted with non-related parties.
The Company, through a wholly owned subsidiary, has an advisory agreement with Apple Hospitality Five Advisors, Inc., (AFA), whereby the Company receives advisory fee revenue equal to 0.1% to 0.25% of total equity contributions received by Apple Hospitality Five, Inc., plus certain reimbursable expenses in exchange for Company personnel performing advisory and real estate acquisition due diligence for Apple Hospitality Five, Inc. AFA is 100% owned by Glade M. Knight, the Company’s Chairman and CEO.
The Company also provides support services to Apple Six Advisors, Inc. (A6A), Apple REIT Six, Inc., and Apple REIT Seven, Inc. A6A provides day to day advisory and real estate due diligence services to Apple REIT Six, Inc. A6A is 100% owned by Mr. Knight. Each of these companies has agreed to reimburse the Company for its costs in providing these services. Mr. Knight is Chairman and Chief Executive Officer of Apple Hospitality Five, Inc., Apple REIT Six, Inc. and Apple REIT Seven, Inc. Additionally, the Company’s Board of Directors has members that are also on the Board of Directors of Apple Hospitality Five, Inc., Apple REIT Six, Inc. or Apple REIT Seven, Inc.
Employees
During 2005, all employees involved in the day-to-day operation of the Company’s hotels were employed by the management companies engaged pursuant to the hotel management agreements. At December 31, 2005, the Company had 31 employees.
Environmental Matters
In connection with each of the Company’s hotel acquisitions, the Company obtains a Phase I Environmental Report and such additional environmental reports and surveys as are necessitated by such preliminary report.
Based on such reports, the Company is not aware of any environmental situations requiring remediation at its properties, which have not been or are not currently being remediated as necessary. No material remediation costs have or are expected to occur.
Item 1A.
Item 1A. Risk Factors
The following list describes several risk factors which are applicable to the Company:
The Company is subject to the risks of hotel operations.
The Company’s hotels are subject to all of the risks common to the hotel industry. These risks could adversely affect hotel occupancy and the rates that can be charged for hotel rooms as well as hotel operating expenses, and generally include:
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increases in supply of hotel rooms that exceed increases in demand;
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increases in energy costs and other travel expenses that reduce business and leisure travel;
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reduced business and leisure travel due to continued geo-political uncertainty, including terrorism;
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adverse effects of declines in general and local economic activity;
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adverse effects of a downturn in the hotel industry.
The Company does not have control over market and business conditions.
Changes in general or local economic or market conditions, increased costs of energy, increased costs of insurance, increased costs of products, increased costs and shortages of labor, competitive factors, fuel shortages, quality of management, the ability of a hotel chain to fulfill any obligations to operators of its hotel business, limited alternative uses for the building, changing consumer habits, condemnation or uninsured losses, changing demographics, changing traffic patterns, inability to remodel outmoded buildings as required by the franchise or lease agreement and other factors beyond the Company’s control may reduce the value of properties that the Company owns and cash available to make distributions to the shareholders may be reduced.
Adverse trends in the hotel industry may impact the Company’s properties.
The success of the Company’s properties will depend largely on the property operators’ ability to adapt to dominant trends in the hotel industry as well as greater competitive pressures, increased consolidation, industry overbuilding, dependence on consumer spending patterns and changing demographics, the introduction of new concepts and products, availability of labor, price levels and general economic conditions. The success of a particular hotel brand, the ability of a hotel brand to fulfill any obligations to operators of its business, and trends in the hotel industry may affect the Company’s income and the funds it has available to distribute to shareholders.
An economic downturn and concern about terrorist activities could adversely affect the travel and lodging industries and may affect hotel operations for the Company’s hotels.
As part of the effects of an economic downturn, the lodging industry could experience a significant decline in business caused by a reduction in travel for both business and pleasure. Consistent with the rest of the lodging industry, the hotels the Company owns or acquires may experience declines in occupancy and average daily rates due to the decline in travel. Any kind of terrorist activity within the United States, including terrorist acts against public institutions or buildings or modes of public transportation (including airlines, trains or buses) could lessen travel by the public, which could have a negative effect on any of the Company’s hotel operations. Any terrorist act directly against or affecting any of the Company’s properties would also negatively affect operations. The Company’s property insurance will typically cover losses for property damage to the properties if there are terrorist attacks against the Company’s properties. However, the Company is not insured for losses arising from terrorist attacks against other properties or against modes of public transportation (such as airlines, trains or buses), even though such terrorist attacks may curtail travel generally and negatively affect the Company’s hotel operations.
There may be business interruption due to natural disaster.
Being in the real estate industry, the Company is exposed to natural disasters both locally and nationally, and although management believes there is adequate insurance to cover this exposure, there can be no assurance that such events will not have a material adverse effect on the Company’s financial position and results of operations.
The hotel industry is seasonal.
The hotel industry is seasonal in nature. Generally, occupancy rates and hotel revenues are greater in the second and third quarters than in the first and fourth quarters. As a result of the seasonality of the hotel industry, there may be quarterly fluctuations in results of operations of properties leased to subsidiaries. As a result, the Company may need to enter into short-term borrowing in certain periods in order to offset these fluctuations in revenues and to make distributions to shareholders.
There may be operational limitations associated with management and franchise agreements affecting the Company’s properties and these limitations may prevent the Company from using these properties to its best advantage for the Company’s shareholders.
Apple Hospitality Management, Inc. and Apple Suites Management, Inc., the Company’s wholly-owned taxable REIT subsidiaries (or their subsidiaries), operate all of the properties pursuant to franchise or license agreements with nationally recognized hotel brands. These franchise agreements contain specific standards for, and restrictions and limitations on, the operation and maintenance of the Company’s properties in order to maintain uniformity within the franchiser system. The Company does not know whether those limitations may conflict with its ability to create specific business plans tailored to each property and to each market.
The company faces competition in the hotel industry, which may limit its profitability and return to its shareholders.
The hotel industry is highly competitive. This competition could reduce occupancy levels and rental revenues at the Company’s properties, which would adversely affect its operations. The Company faces competition from many sources. It faces competition from other hotels both in the immediate vicinity and the geographic market where the Company’s hotels are located. Over-building in the hotel industry will increase the number of rooms available and may decrease occupancy and room rates. In addition, increases in operating costs due to inflation may not be offset by increased room rates. The Company also faces competition from nationally recognized hotel brands with which the Company will not be associated.
The Company’s qualification as a real estate investment trust involves the application of highly technical and complex provisions of the Internal Revenue Code.
The rules governing REIT’s are highly technical and complex. They require ongoing compliance with a variety of tests that depend, among other things, on future operations. While the Company expects to satisfy these tests and will make its best efforts to do so, it cannot ensure it will qualify as a REIT for any particular year, or that the applicable law will not change and adversely affect it and its shareholders.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
As of December 31, 2005, the Company owned 49 Residence Inn by Marriott hotels comprised of 5,947 suites and 17 Homewood Suites by Hilton hotels comprised of 1,922 suites for a total of 66 hotels comprised of 7,869 suites. The hotels are located in various states. Two of the Residence Inn hotels, comprised of 179 suites, are reported as held for sale and are excluded from the following table which shows the location of each hotel, the date of construction, the date acquired, encumbrances, initial acquisition cost, gross carrying value and the number of suites of each hotel.
Real Estate and Accumulated Depreciation
As of December 31, 2005
(Dollars in thousands)
Real Estate and Accumulated Depreciation
As of December 31, 2005
(Dollars in thousands)
Investment in hotels at December 31, 2005, consisted of the following (in thousands):
For additional information about the Company’s properties, refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 3.
Item 3. Legal Proceedings
The Company is not presently subject to any material litigation nor, to its knowledge, is any litigation threatened against the Company or any of its properties, other than routine actions arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on the Company’s business or financial condition or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Shares
There is currently no established public market in which the Company’s common shares are traded. The per share estimated market value is deemed to be the offering price of the shares, which is currently $10.00 per share. This is supported by the fact that the Company is currently selling shares to the public at a price of $10.00 per share through its Dividend Reinvestment Plan and, the Company is repurchasing shares at $10.00 from shareholders. On December 31, 2005, there were approximately 11,000 beneficial shareholders of the Company’s common shares.
Distributions totaling $33.4 million, $37.6 million, and $54.2 million were paid to the common shareholders and Series C convertible shareholders during 2005, 2004 and 2003. Distributions were paid in an amount of $0.80, $0.90 and $1.50 per share for the years ended December 31, 2005, 2004 and 2003. The $1.50 per share in 2003 includes a special distribution of approximately $.50 associated with the Company’s merger with Apple Suites, Inc. Currently the Company pays a distribution on a quarterly basis. In 2005 the quarterly distribution was at a rate of $0.20 per share. The timing and amounts of distributions to shareholders are within the discretion of the Company’s Board of Directors. Future distributions will depend on the Company’s results of operations, cash flow from operations, economic conditions and other factors such as working capital and capital expenditure requirements, as well as requirements under federal income tax provisions for qualification as a REIT.
Non-Employee Directors Stock Option Plan and Incentive Plan
The Company’s board of directors has adopted and the Company’s shareholders have approved a Non-Employee Directors Stock Option Plan and an Incentive Plan. The options issued under each plan convert to Units. Each Unit is equal to one common share and one Series A Preferred share of the Company. As of December 31, 2005, there were 202,402 options outstanding.
Dividend Reinvestment Plan
During the first quarter of 2004, the Company instituted a dividend reinvestment plan. The purpose of the plan is to provide the Company’s shareholders with a convenient and inexpensive way to increase their investment in the Company by reinvesting their dividends to purchase additional Units. As of December 31, 2005, 1.6 million Units have been issued under the dividend reinvestment plan, representing $16.2 million in proceeds to the Company.
Share Redemption Program
The Company has instituted a share redemption program to provide its shareholders who have held their Units for at least one year with the benefit of limited interim liquidity, by presenting for redemption all or any portion of their Units at any time and in accordance with certain procedures. Once this time limitation has been met, the Company may, subject to certain conditions and limitations, redeem the Units presented for redemption for cash, to the extent that the Company has sufficient funds available to fund the redemption. If Units are held for the required one-year period, the Units may be redeemed for a purchase price equal to the lesser of: (1) $10.00 per unit; or (2) the purchase price per Unit that was actually paid for the Units. The board of directors reserves the right, in its sole discretion, at any time and from time to time, to waive the one-year holding period, reject any request for redemption, change the purchase price for redemptions or otherwise amend the terms of, suspend, or terminate the share redemption program. Redemption of units, when requested, will be made quarterly on a first-come, first-served basis. Prior to the implementation of the Dividend Reinvestment Plan in the first quarter of 2004, the redemptions were funded as part of the Company’s Additional Share Option Plan. Funding for the
redemption of Units will come from the proceeds the Company receives from the sale of Units under its dividend reinvestment plan. The Company’s board of directors, in its sole discretion, may choose to suspend or terminate the share redemption program or reduce the number of Units purchased under the share redemption program if it determines the funds otherwise available to fund the share redemption program are needed for other purposes. For the year ended December 31, 2005, the Company redeemed approximately $9.3 million, representing approximately 928,576 Units. The following is a summary of redemptions during the fourth quarter of 2005:
Issuer Purchases of Equity Securities
(1) The maximum number of Units that may be redeemed in the current calendar year is three percent (3.0%) of the weighted average number of Units outstanding at the end of the previous calendar year.
Preferred Shares
The Company’s articles of incorporation authorize issuance of up to 15 million additional preferred shares. No preferred shares other than the Series A preferred shares and the Series B and C convertible preferred shares have been issued. The Company believes that the authorization to issue additional preferred shares benefits the Company and its shareholders by permitting flexibility in financing additional growth, giving the Company additional financing options in corporate planning and in responding to developments in business, including financing of additional acquisitions and other general corporate purposes. Having authorized preferred shares available for issuance in the future gives the Company the ability to respond to future developments and allows preferred shares to be issued without the expense and delay of a special shareholders’ meeting. At present, the Company has no specific financing or acquisition plans involving the issuance of additional preferred shares and the Company does not propose to fix the characteristics of any series of preferred shares in anticipation of issuing preferred shares other than the Series A preferred shares and Series C convertible preferred shares. The Company cannot now predict whether or to what extent, if any, additional preferred shares will be used or if so used what the characteristics of a particular series may be. The voting rights and rights to distributions of the holders of common shares will be subject to the prior rights of the holders of any subsequently-issued preferred shares. Unless otherwise required by applicable law or regulation, the preferred shares would be issuable without further authorization by holders of the common shares and on such terms and for such consideration as may be determined by the board of directors. The preferred shares could be issued in one or more series having varying voting rights, redemption and conversion features, distribution (including liquidating distribution) rights and preferences, and other rights, including rights of approval of specified transactions. A series of preferred shares could be given rights that are superior to rights of holders of common shares and a series having preferential distribution rights could limit common share distributions and reduce the amount holders of common shares would otherwise receive on dissolution.
Valuation of Real Estate Assets
The Company continually monitors events and changes in circumstances that could indicate that the carrying amounts of the real estate, both operating properties and properties under construction, in which it has an ownership interest, may not be recoverable. When indicators of potential impairment are present which indicate that the carrying amounts of real estate may not be recoverable, the Company assesses the recoverability of these assets by determining whether the carrying value will be recovered through the undiscounted future operating cash flows expected from the use of the asset and its eventual disposition. In the event that such expected undiscounted future cash flows do not exceed the carrying value, an impairment loss is recorded.
Projections of expected future cash flows require estimates of future market rental income amounts subsequent to the expiration of current lease agreements, property operating expenses, discount rates, the number of months it takes to re-lease the property and the number of years that property is held for investment, among other factors. The use of inappropriate assumptions in the future cash flow analysis would result in an incorrect assessment of the property’s future cash flows and fair value, and could result in the misstatement of the carrying value of real estate and net income.
During the second quarter of 2005, the Company engaged UBS Investment Bank to assist in reviewing and evaluating various strategic alternatives for the Company. Those alternatives include a possible sale of the Company, merger or listing. The Company cannot provide any assurance that it will initiate or complete any of these strategic alternatives.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial data for the years ended December 31, 2005, 2004, 2003, 2002 and the period from January 17, 2001 through December 31, 2001. Certain data has been derived from the Company’s audited financial statements and notes thereto. This data should be read in conjunction with Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such Statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, but are not limited to, the ability of the Company to implement its acquisition strategy and operating strategy; the Company’s ability to manage planned growth; changes in economic cycles and competition within the extended-stay hotel industry. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore there can be no assurance that such statements included in this annual report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the results or conditions described in such statements or the objectives and plans of the Company will be achieved. In addition, the Company’s qualification as a real estate investment trust involves the application of highly technical and complex provisions of the Internal Revenue Code. Readers should carefully review the Company’s financial statements and the notes thereto, as well as the risk factors described in the Company’s filings with the Securities and Exchange Commission and included in Item 1A of this report.
Overview
The Company is a real estate investment trust (REIT) that owns upscale, extended-stay hotels. The Company was formed on January 17, 2001, with the first investor closing commencing on May 1, 2001. At December 31, 2005, the Company owned 66 hotels within different markets in the United States. The hotels were acquired in five portfolios; 10 hotels were acquired in September 2001, 15 were acquired in March 2002, 23 were acquired in August 2002, one was acquired in January 2003, and 17 were acquired on January 31, 2003. The performance of the Company’s hotels can be influenced by many factors, including local hotel competition, local and national economic conditions and the performance of the individual managers assigned to its hotels. In evaluating financial condition and operating performance, the Company focuses on revenue measurements such as occupancy, average daily rate and revenue per available room and expenses such as hotel operating expenses, general and administrative expenses and other expenses described below. During 2005 the Company experienced significant improvement in its financial results due to a major renovation program it completed in 2004 and the overall hospitality industry improvement. The Company continually monitors the profitability of its properties and attempts to maximize shareholder value by timely disposal of properties. At the end of 2005, the Company committed to selling two under-performing assets. The properties are Residence Inns in Charlotte, North Carolina and Spartanburg, South Carolina. The Company recorded a discontinued operations loss of $3.4 million based on the anticipated net sale proceeds less the properties’ net book value.
Results from Continuing Operations for Years 2005 and 2004
Hotels Owned
At December 31, 2005 the Company owned 66 hotels, with a total of 7,869 suites. Of the Company’s 66 hotels, 49 are Residence Inn by Marriott properties consisting of 5,947 suites, and 17 are Homewood Suites by Hilton properties consisting of 1,922 suites. Two of the Residence Inn hotels, in Charlotte, North Carolina and Spartanburg, South Carolina, are reported as held for sale and are excluded from the following table which shows the location of each hotel, the date acquired, and the number of suites of each hotel.
Management Agreements
Residence Inn Hotels
The Company’s Residence Inn hotels are subject to management agreements under which Residence Inn by Marriott, Inc. (the “Manager”) manages the hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years. The agreements generally provide for payment of base management fees, which are calculated annually as a percentage of sales, and incentive management fees over a priority return (as defined in the management agreements). Incentive management fees (IMF) are currently payable only if and to the extent there is sufficient cash flow from the hotels after consideration of qualifying debt service and after consideration to a priority return on investment, including property improvements.
Amounts not currently payable are deferred and are payable in future years only if and to the extent there is sufficient cash flow from future operations or upon sale or refinancing of the hotels after consideration to a priority return to the Company (as defined in the management agreements), which is generally 12%. In the event of early termination of the management agreements, the Manager will receive additional fees based on the unexpired term and expected future base and incentive management fees. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied.
Incentive fees are payable on a portfolio by portfolio basis for Residence Inn properties. The Company has three portfolios of multiple hotels (Res I, Res II and Res III) plus one stand-alone hotel. Each of these portfolios has separate management agreements which are subject to this calculation. The Company records incentive management fee exposure when it is considered probable that these fees will be paid which is generally when they become payable. For the years ended December 31, 2005 and 2004, the Company incurred and paid incentive management fees of $1.3 million and $0.3 million.
The following table summarizes deferred incentive management fees (DIMF) under these management agreements (dollars in millions).
No amounts of DIMF were recorded upon the acquisition of Res I and Res II as the fair value of these amounts were not readily determinable and payment was not considered probable.
In addition to the base management and incentive management fees required by the management agreements, the Company is also required to pay certain shared services which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Shared services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, public relations and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries. For the years ended December 31, 2005 and 2004, total fees incurred under the Marriott agreements were $19.1 million and $18.4 million, or 10.9% and 11.3% of revenue provided by the Marriott managed properties.
Homewood Suites Hotels
The Company’s 17 Homewood Suites hotels are managed by Promus Hotels, Inc. (“Promus”), a wholly owned subsidiary of Hilton Hotels Corporation (“Hilton”) under the terms of separate management agreements, as part of the Homewood Suites by Hilton franchise. The initial term is generally 15 years with no option to renew; however, two hotel properties in this portfolio have renewal options of two five year periods each. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied. Promus charges fees for this function, which are calculated as a percentage of revenue. Incentive management fees are calculated, for certain properties, on the basis of operating profit of the hotels. No incentive management fees were earned in 2005 or 2004. Promus also charges a fee, calculated as a percentage of suite revenue, for franchise licenses to operate as a Homewood Suites by Hilton and to participate in its reservation system. For the years ended December 31, 2005 and 2004, total expenses for franchise fees, management fees, advertising expenses and other reimbursable services were $6.2 million and $6.0 million, or 11.9% and 11.8% of revenue, provided by the Hilton managed properties for each of those years.
Related Party Transactions
The Company has significant transactions with related parties. These transactions cannot be construed to be arm’s length and the results of the Company’s operations could be different if these transactions were conducted with non-related parties.
The Company, through a wholly owned subsidiary, has an advisory agreement with Apple Hospitality Five Advisors, Inc., (AFA), whereby the Company receives advisory fee revenue equal to 0.1% to 0.25% of total equity contributions received by Apple Hospitality Five, Inc., plus certain reimbursable expenses in exchange for Company personnel performing advisory and real estate acquisition due diligence for Apple Hospitality Five, Inc. AFA is 100% owned by Glade M. Knight, the Company’s Chairman and CEO. For the years ended December 31, 2005 and 2004, the company earned and received advisory fee revenue of approximately $0.7 million in both years. These amounts are included in other revenue.
The Company also provides support services to Apple Six Advisors, Inc. (A6A), Apple REIT Six, Inc., and Apple REIT Seven, Inc. A6A provides day to day advisory and real estate due diligence services to Apple REIT Six, Inc. A6A is 100% owned by Mr. Knight. Each of these companies has agreed to reimburse the Company for its costs in providing these services. The Company started providing these services in the second quarter of 2004. For the years ended December 31, 2005 and 2004, the Company received reimbursement of its costs totaling approximately $2.1 million and $0.6 million. Mr. Knight is Chairman and Chief Executive Officer of Apple Hospitality Five, Inc., Apple REIT Six, Inc. and Apple REIT Seven, Inc. Additionally, the Company’s Board of Directors has members that are also on the Board of Directors of Apple Hospitality Five, Inc., Apple REIT Six, Inc. or Apple REIT Seven, Inc.
Results of Operations for Years 2005 and 2004
During 2005, the Company experienced improvements in operations as compared to the prior year. Better economic conditions in many of its markets and completion of hotel renovations in 2004 led to an increase in RevPAR by 8% over the prior year. The Company anticipates continued improvement in 2006. However, as the Company will continue to selectively renovate hotels and since general economic conditions can not be projected, there can be no assurance that the improvements will continue.
Revenues
The Company’s principal source of revenue is hotel suites revenue and related other revenue. For the years ended December 31, 2005 and 2004 the Company had total hotel revenue from continuing operations of $225.4 million and $210.5 million. For the years ended December 31, 2005 and 2004, the hotels achieved average occupancy of 78% and 76%, ADR of $100 and $95 and RevPAR of $78 and $72. ADR, or average daily rate, is calculated as room revenue divided by number of rooms sold, and RevPAR, or revenue per available room, is calculated as occupancy multiplied by ADR. The increase in RevPAR is a result of overall improvement in the hospitality industry and completion of the renovation of 26 hotels during 2004. During the renovation program, suites were taken out of service. The Company will continue to focus on maximizing revenue through increased room rates, as it is not anticipated that occupancy will increase from its current level.
Expenses
The Company’s hotel operating expenses from continuing operations totaled $134.2 million and $126.1 million or 60% of revenue for the years ended December 31, 2005 and 2004. Operational efficiencies from increased revenue were offset by incentive fees earned by the managers for improved financial results.
Taxes, insurance and other expense from continuing operations for the years ended December 31, 2005 and 2004 was $13.8 million or 6% of revenue and $14.9 million or 7% of revenue. The decrease is due to lower insurance rates and property tax assessments negotiated by the Company. The Company will continue to aggressively manage these areas; however, continued reductions are not anticipated due to increased insurance rates from the
Company’s carriers related to their losses in 2005. Also, there is greater potential for aggressive real estate tax assessments, and thus greater real estate tax expenses, from local municipalities as real estate values increase across the country.
The Company’s general and administrative expenses for the years ended December 31, 2005 and 2004 were $2.0 million and $2.5 million or 1% of revenue in both years.
In 2005 the Company engaged UBS Investment Bank to assist in reviewing and evaluating various strategic alternatives for the Company. Those alternatives include a possible sale of the Company, merger or listing. In connection with these activities, the Company incurred $322,000 in expenses. The Company cannot provide any assurances that it will initiate or complete any of the strategic alternatives.
Depreciation expense for the years ended December 31, 2005 and 2004 was $25.7 million and $24.4 million. Depreciation expense represents expense of the Company’s 64 hotels and related personal property, as well as renovations. The increase in depreciation is due to the Company’s major renovation project in 2003 and 2004.
Interest expense was $27.4 million and $27.2 million for the years ended December 31, 2005 and 2004. In 2004 the Company capitalized interest of $496,000 associated with its renovation program, while in 2005 the Company only capitalized $184,000 due to less rooms out of service for renovation.
On November 10, 2004, the Company closed on a refinancing transaction associated with the Res II Partnership debt. In association with this transaction, the Company incurred approximately $1.8 million in loan costs which are being amortized over 10 years and also recognized a loss on early extinguishment of debt of approximately $8.8 million, which included a credit of $1.9 million related to the debt’s outstanding fair value adjustment.
Results of Operations for Years 2004 and 2003
The Company continued to experience the effects of economic weakness in some of its markets and the effects of closing rooms to complete its major renovation project for many of its hotels during the first quarter of 2004. As a result, the Company’s financial results were lower than the same period in 2003. During the remainder of 2004, the Company began to see improved economic conditions in some of its markets, and it substantially completed its major renovation program. As a result, the Company’s results for the full year exceeded the same period in 2003.
Revenues
For the years ended December 31, 2004 and 2003 the Company had total hotel revenue from continuing operations of $210.5 million and $192.6 million. For the years ended December 31, 2004 and 2003, the hotels achieved average occupancy of 76% and 74%, ADR of $95 and $91 and RevPAR of $72 and $67. The increase in RevPAR is a result of completing the renovation of 26 hotels in 2004 and improved economic conditions. During the renovation program, suites were taken out of service. This program was completed in the middle of 2004.
Expenses
The Company’s hotel operating expenses from continuing operations totaled $126.1 million or 60% of revenue and $117.0 million or 61% of revenue for the years ended December 31, 2004 and 2003. The improvement as a percentage of revenue was a result of improved RevPAR.
Taxes, insurance and other expense from continuing operations for the years ended December 31, 2004 and 2003 was $14.9 million or 7% of revenue and $12.6 million or 7% of revenue. The increase is due substantially to increased assessments and tax rates in various localities.
The Company’s general and administrative expenses for the years ended December 31, 2004 and 2003 were $2.5 million or 1% of revenue and $1.9 million or 1% of revenue. The increase is due substantially to increased reporting and accounting requirements under Section 404 of the Sarbanes-Oxley Act.
Depreciation expense from continuing operations for the years ended December 31, 2004 and 2003 was $24.4 million and $19.0 million. Depreciation expense represents expense of the Company’s 64 hotels and related personal property, as well as renovations. The increase in depreciation is due to the Company’s major renovation project in 2003 and 2004 and the acquisition of Apple Suites, Inc. in the first quarter of 2003.
Interest expense net of interest income was $26.8 million and $23.9 million for the years ended December 31, 2004 and 2003, respectively. The increase was due to a $16 million line of credit entered into by the Company in 2004 with an interest rate of LIBOR plus 2.5% and in 2003 the Company capitalized interest of $1.6 million associated with its renovation program as compared to $496,000 in 2004.
On November 10, 2004, the Company closed on a refinancing transaction associated with the Res II Partnership debt. In association with this transaction, the Company incurred approximately $1.8 million in loan costs which are being amortized over 10 years and recognized a loss on early extinguishment of debt of approximately $8.8 million, which included a credit of $1.9 million related to the debt’s outstanding fair value adjustment.
The Company incurred approximately $15.9 million in expenses in 2003 related to the Apple Suites merger. The expenses include approximately $10.2 million associated with the conversion of the series B convertible preferred shares to series C convertible shares and $5.5 million associated with the termination of the advisory agreement with ASA.
Liquidity and Capital Resources
Cash and cash equivalents
Cash and cash equivalents totaled $0.4 million at December 31, 2005 and $13.1 million at December 31, 2004. The Company plans to use this cash to pay debt service and general corporate expenses. The decrease in cash and cash equivalents is due to the partial repayment of the Company’s revolving line of credit as well as capital improvements, redemptions and distributions.
The cash flow generated from the properties owned is the Company’s principal source of liquidity. In addition, the Company had approximately $11.2 million available under its revolving line of credit at December 31, 2005.
Equity
Effective February 20, 2004, the Company instituted a dividend reinvestment plan to its shareholders. The plan provides a convenient and cost effective way to increase shareholder investment in the Company by reinvesting dividends to purchase additional Units of the Company. The uses of the proceeds from this plan may include purchasing Units under the Company’s Unit Redemption Program, enhancing properties, satisfying financing obligations and other expenses, increasing working capital, funding various corporate operations, and acquiring extended-stay hotels. As of December 31, 2005, approximately 1.6 million Units were issued under the dividend reinvestment plan representing proceeds to the Company of approximately $16.2 million, under this plan.
During 2003, the Company instituted a Unit Redemption Program to provide limited interim liquidity to the Company’s shareholders. Redemption of Units, when requested, is made quarterly on a first-come, first-serve basis. Shareholders may request redemption of Units for a purchase price equal to the lesser of: (1) the purchase price per unit that the shareholder actually paid for the unit (or the price that the shareholder actually paid for the Apple Suites, Inc. common shares, if the Units were acquired through the exchange of Apple Suites, Inc. common shares in the Company’s merger with Apple Suites, Inc.); or (2) $10.00 per unit. The Company reserves the right to change the purchase price of redemptions, reject any request for redemption, or otherwise amend the terms of, suspend, or terminate the Unit Redemption Program. During the years ended December 31, 2005 and 2004, the Company redeemed 928,576 and 882,773 Units in the amounts of $9.3 million and $8.8 million respectively. The Company currently intends to redeem shares to the extent of proceeds received from the dividend reinvestment plan.
Notes Payable
The aggregate amounts of principal payable under all of the Company’s promissory notes, for the five years subsequent to December 31, 2005 are as follows (in thousands):
The Company’s notes payable are secured by 64 of the Company’s hotels.
During 2004, the Company entered into a short-term credit facility and refinanced the debt associated with its Res II portfolio. The short-term credit facility was refinanced in April 2005, changing it to a two-year $15 million revolving line of credit. This revolving line of credit is secured by two properties and bears interest at LIBOR (4.39% at December 31, 2005) plus 2.5% per year. At December 31, 2005 the outstanding balance on the revolving line of credit was $3.8 million.
On November 10, 2004, the Company closed on a refinancing transaction with Wachovia Bank, National Association, as the lender. The refinancing involved 21 separate loans having an aggregate principal balance of $135 million. The 21 promissory notes executed in connection with the refinancing are substantially similar in that each provide a stated annual interest rate of 6.88%, each note matures on November 11, 2014 with an aggregate balloon payment of approximately $111 million, and each note provides a payment of interest only in monthly installments for the first 12 months, followed by amortized payments of principal and interest in consecutive monthly installments thereafter.
In association with the above transaction, the Company recognized a loss on early extinguishment of debt of approximately $8.8 million and incurred approximately $1.8 million in loan costs which are being amortized over 10 years.
Capital Requirements and Resources
The Company’s distribution policy is at the discretion of the Board of Directors and depends on several factors. The distribution rate for the year ended December 31, 2003 was at a rate of $1.50 per Unit outstanding, including a one time special dividend of $0.50 per Unit in January 2003. The Company declared and paid dividends of
$0.90 per Unit outstanding for the year ended December 31, 2004. In 2005 the distribution rate was $0.80 and was paid quarterly. The reduction to $0.20 per quarter in the dividend rate was a result of the Company’s investment in its renovation program. The Company’s dividends have historically included a return of capital. In 2005, 13% of the dividend was characterized as return of capital and 87% ordinary income.
The Company has ongoing capital commitments to fund its capital improvements. Through the Lessees, the Company is required, under all management agreements with the Manager, to make available to the Lessees, for the repair, replacement, refurbishing of furniture, fixtures, and equipment, an amount of at least 5% of gross revenues provided that such amount may be used for its capital expenditures with respect to the hotels.
As a result of the Company’s renovation program, the Company funded approximately $12.4 million in capital improvements in addition to the 5% requirement in 2004. During the years ended December 31, 2005 and 2004, the Company capitalized approximately $10.5 million and $22.2 million, in capital improvements to the properties. Of the amount capitalized during the year ended December 31, 2004, approximately $16 million related to the Company’s major renovation program and approximately $6 million, related to the Company’s normal furniture, fixtures and equipment expenditures. It is anticipated cash from available credit facilities and income from operations will be used to fund the Company’s ongoing debt service and capital improvement projects. Distributions to shareholders will depend on income from operations. As a result there can be no assurance that income from operations will be sufficient to fund distributions at historic levels or that distributions will not include a return of capital.
The Company believes its liquidity and capital resources are adequate to meet its cash requirements for the foreseeable future. Although there can be no assurance, the Company believes its investment in renovations and improved economic conditions will allow the Company’s cash from operations to meet its planned distributions.
Subsequent Events
In January 2006, the Company declared and distributed to its shareholders dividends in the amount of $8.3 million ($0.20 per share).
In January 2006, the Company redeemed 257,634 Units in the amount of $2.6 million.
In January 2006, through the Company’s Dividend Reinvestment Plan, 235,205 Units totaling $2.4 million were reinvested.
Impact of Inflation
Operators of hotels, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. Competitive pressures may, however, limit the operators’ ability to raise room rates. Currently the Company is not experiencing any material impact from inflation.
Seasonality
The hotel industry historically has been seasonal in nature. Seasonal variations in occupancy at the hotels may cause quarterly fluctuations in revenues. To the extent that cash flow from operations is insufficient during any quarter, due to temporary or seasonal fluctuations in revenue, the Company expects to utilize cash on hand to make distributions and required debt service.
The Company believes liquidity and capital resources are adequate to meet cash requirements for the foreseeable future.
Critical Accounting Policies
The following contains a discussion of what the Company believes to be critical accounting policies. These items should be read to gain a further understanding of the principles used to prepare the Company’s financial
statements. These principles include application of judgment; therefore, changes in judgments may have a significant impact on the Company’s reported results of operations and financial condition.
Capitalization Policy
The Company considers expenditures to be capital in nature based on the following criteria: (1) for a single asset, the cost must be at least $500, including all normal and necessary costs to place the asset in service, and the useful life must be at least one year; (2) for group purchases of 10 or more identical assets, the unit cost for each asset must be at least $50, including all normal and necessary costs to place the asset in service, and the useful life must be at least one year; (3) for major repairs to buildings, the repair must be at least $2,500 and the useful life of the asset must be substantially extended.
Impairment Losses Policy
The Company records impairment losses on hotel properties used in operations if indicators of impairment are present, and the sum of the undiscounted cash flows estimated to be generated by the respective properties are less than the properties’ carrying amounts. Impairment losses are measured as the difference between the asset’s fair value less cost to sell, and its carrying value.
Investment Policy
The purchase price of real estate properties acquired is allocated to the various components, such as land, buildings and improvements, intangible assets and in-place leases as appropriate, in accordance with Statement of Financial Accounting Standards, commonly referred to as SFAS No. 141, “Business Combinations”. The purchase price is allocated based on the fair value of each component at the time of acquisition. Generally the Company does not acquire real estate assets that have in-place leases as lease terms for hotel properties are very short term in nature. The Company has not allocated any purchase price to intangible assets such as management contracts and franchise agreements as such contracts are generally at current market rates and any other value attributable to these contracts are not considered material.
Recent Accounting Pronouncements
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123 (R) is similar to the approach described in Statement 123. However, Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Company will adopt Statement 123 (R) in the first quarter of 2006. The adoption of the statement is not anticipated to have a material impact on the Company’s results of operations or financial position.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company does not engage in transactions in derivative financial instruments or derivative commodity instruments. As of December 31, 2005, the Company’s financial instruments were not exposed to significant market risk due to foreign currency exchange risk, commodity price risk or equity price risk. The Company has issued fixed interest rate notes payable to lenders under permanent financing arrangements. The following table summarizes the annual maturities and average interest rates and estimated fair market value at December 31, 2005.
Item 8.
Item 8. Financial Statements and Supplementary Data
Report of Management on Internal Control over Financial Reporting
March 7, 2006
To the Shareholders
Apple Hospitality Two, Inc.
Management of Apple Hospitality Two, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. As defined by the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the consolidated financial statements in accordance with U.S. generally accepted accounting principles.
The Company’s internal control over financial reporting is supported by written policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the Company’s transactions and dispositions of the Company’s assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the consolidated financial statements in accordance with U.S. generally accepted accounting principles, and the receipts and expenditures of the Company are being made only in accordance with authorizations of the Company’s management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In connection with the preparation of the Company’s annual consolidated financial statements, management has undertaken an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO Framework). Management’s assessment included an evaluation of the design of the Company’s internal control over financial reporting and testing of the operational effectiveness of those controls.
Based on this assessment, management has concluded that as of December 31, 2005, the Company’s internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Ernst & Young LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements included in this report, has issued an attestation report on management’s assessment of internal control over financial reporting, a copy of which appears on the next page of this annual report.
/s/ Glade M. Knight
/s/ Bryan Peery
Glade M. Knight
Chairman and Chief Executive Officer
Bryan Peery
Chief Financial Officer
(Principal Accounting Officer)
Report of Independent Registered Public Accounting Firm
on Internal Control over Financial Reporting
The Board of Directors and Shareholders
Apple Hospitality Two, Inc.
We have audited management’s assessment, included in the accompanying “Report of Management Internal Control over Financial Reporting”, that Apple Hospitality Two, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Apple Hospitality Two, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Apple Hospitality Two, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Apple Hospitality Two, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Apple Hospitality Two, Inc., as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years ended December 31, 2005 and our report dated March 7, 2006, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Richmond, Virginia
March 7, 2006
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Apple Hospitality Two, Inc.
We have audited the accompanying consolidated balance sheets of Apple Hospitality Two, Inc. (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index of Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Hospitality Two, Inc. at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Apple Hospitality Two, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2006 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Richmond, Virginia
March 7, 2006
Apple Hospitality Two, Inc.
Consolidated Balance Sheets
(in thousands, except share data)
See notes to consolidated financial statements.
Apple Hospitality Two, Inc.
Consolidated Statements of Operations
(in thousands, except per share data)
See notes to consolidated financial statements.
Apple Hospitality Two, Inc.
Consolidated Statements of Shareholders’ Equity
(in thousands, except per share data)
See notes to consolidated financial statements.
Apple Hospitality Two, Inc.
Consolidated Statements of Cash Flows
(in thousands)
See notes to consolidated financial statements.
Note 1
General Information and Summary of Significant Accounting Policies
Organization
Apple Hospitality Two, Inc. (the “Company”), a Virginia corporation, was formed on January 17, 2001, with the first investor closing on May 1, 2001. The Company merged with Apple Suites, Inc. (Apple Suites) on January 31, 2003 and results of Apple Suites operations are included in Company results from February 1, 2003. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.
At December 31, 2005 the Company owned 66 extended stay hotels and is operated as and has annually elected to be taxed as a real estate investment trust (“REIT”). The REIT Modernization Act, effective January 1, 2001, permits a REIT to establish taxable businesses to conduct certain previously disallowed business activities. The Company has formed wholly-owned taxable REIT subsidiaries, and has leased all of its hotels to these subsidiaries (collectively, the “Lessee”).
Cash and cash equivalents
Cash and cash equivalents include highly liquid investments with original maturities of three months or less. The fair market value of cash and cash equivalents approximate their carrying value. Cash equivalents are placed with high credit quality institutions and the balances may, at times, exceed federal depository insurance limits.
Investments in hotels, net
The hotels are stated at cost, net of depreciation. Repair and maintenance costs are expensed as incurred while significant improvements, renovations, and replacements are capitalized. Depreciation is computed using the straight-line method over estimated useful lives of the assets, which are 39 years for buildings, 10 years for major improvements and three to seven years for furniture and equipment.
The Company considers expenditures to be capital in nature based on the following criteria: (1) for a single asset, the cost must be at least $500, including all normal and necessary costs to place the asset in service, and the useful life must be at least one year; (2) for group purchases of 10 or more identical assets, the unit cost for each asset must be at least $50, including all normal and necessary costs to place the asset in service, and the useful life must be at least one year; (3) for major repairs to buildings, the repair must be at least $2,500 and the useful life of the asset must be substantially extended.
The Company records impairment losses on hotel properties used in the operations if indicators of impairment are present, and the undiscounted cash flows estimated to be generated by the respective properties are less than their carrying amount. Impairment losses are measured as the difference between the asset’s fair value less cost to sell, and its carrying value.
The purchase price of real estate properties acquired is allocated to the various components, such as land, buildings and improvements, intangible assets and in-place leases as appropriate, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations”. The purchase price is allocated based on the fair value of each component at the time of acquisition. The Company generally does not acquire real estate assets that have in-place leases as lease terms for hotel properties are very short term in nature. The Company has not allocated any purchase price to intangible assets such as management contracts and franchise agreements as such contracts are generally at current market rates and any other value attributable to these contracts is not considered material.
Hotels held for Sale
For hotels classified as held for sale, the Company estimates the net selling price of such hotel. Net selling price is estimated as the amount at which the hotel could be bought or sold (fair value) less costs to sell. Fair value is determined considering prevailing market conditions and/or current estimated net sales proceeds from pending offers, if appropriate. If the hotel’s net selling price is less than the carrying amount of the hotel, a reserve for loss is established. Depreciation is no longer recorded on hotels held for sale. In December 2005 and January 2006, the Company entered contracts to sell two hotels and a loss on discontinued operations of $3.4 million was recorded representing the differences in fair value less selling costs and net book value.
Revenue Recognition
Revenue is recognized as earned, which is generally defined as the date upon which a guest occupies a room or utilizes the hotel’s services.
Stock Incentive Plans
The Company elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related Interpretations in accounting for its employee stock options. As discussed in Note 5, the alternative fair value accounting provided for under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company’s stock options equals the market price of the underlying stock on the date of grant and other criteria are met, no compensation expense is recognized.
Comprehensive Income
The Company recorded no comprehensive income for the years ended December 31, 2005, 2004 and 2003.
Earnings per common share
Basic earnings per common share is computed based upon the weighted average number of shares outstanding during the year. Diluted earnings per share is calculated after giving effect to all potential common shares that were dilutive and outstanding for the year. Series C preferred convertible stock is included in basic and diluted earnings per common share as these shares are considered common stock equivalents.
Income Taxes
As a REIT, the Company receives a deduction for its distributions to shareholders and is required to distribute 90% of its earnings and profits. Earnings and profits will differ from income reported for financial reporting purposes primarily due to the differences for federal income tax purposes in the estimated useful lives used to compute depreciation. The Company’s distributions are taxable to its shareholders to the extent the distribution is characterized as ordinary income. The characterization of 2005 distributions of $0.80 per share for tax purposes was 87% ordinary income and 13% return of capital, 2004 distributions of $0.90 per share for tax purposes was 55% ordinary income and 45% return of capital and 2003 distributions of $1.50 per share for tax purposes was 84% ordinary income and 16% return of capital (unaudited).
The Lessees, as taxable REIT subsidiaries of the Company, are subject to federal and state income taxes. The taxable REIT subsidiaries incurred a financial reporting and taxable loss for the years ended December 31, 2005, 2004 and 2003, and therefore did not have any federal tax expense. No operating loss benefit has been recorded in the consolidated balance sheet since realization is uncertain. Total net operating loss carry-forward for federal income tax purposes was approximately $33.0 and $22.3 million at December 31, 2005 and 2004. There are no material differences between the book and tax basis of the Company’s assets.
Sales and Marketing Costs
Sales and marketing costs are expensed when incurred. These costs represent the expense for franchise advertising and reservation systems under the terms of the hotel management agreements and general and administrative expenses that are directly attributable to advertising and promotion.
Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates.
Reclassifications
Certain amounts in the 2004 and 2003 consolidated financial statements have been reclassified in order to conform to the 2005 presentation with no effect on previously reported shareholders’ equity or net income. See also Note 11, Discontinued Operations, for discussion of reclassifications related to the pending sale of two hotels.
Summary of Recent Accounting Pronouncements
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123 (R) is similar to the approach described in Statement 123. However, Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values, pro forma disclosure is no longer an alternative. The Company will adopt Statement 123 (R) in the first quarter of 2006. The adoption of the statement is not anticipated to have a material impact on the Company’s results of operations or financial position.
Note 2
Investment in Hotels
At December 31, 2005, the Company owned 66 hotels, with a total of 7,869 suites. Of the Company’s 66 hotels, 49 are Residence Inn by Marriott properties consisting of 5,947 suites, and 17 are Homewood Suites by Hilton consisting of 1,922 suites. Two of the hotels owned are classified as hotels held for sale.
Investment in hotels consisted of the following as of December 31 (in thousands):
Acquisition of Apple Suites, Inc.
The Company entered into a merger agreement with Apple Suites on October 23, 2002. Effective January 31, 2003, Apple Suites merged with and into Hospitality Acquisition Company, the Company’s wholly-owned subsidiary (the “Merger”). Apple Suites owned, either directly or through its subsidiaries, a total of 17 upper-end extended-stay hotels throughout the United States, which comprised a total of 1,922 suites, and all of which are operated as part of the Homewood Suites by Hilton franchise system. Mr. Glade M. Knight, Chairman and Chief Executive Officer of the Company, was also the Chairman and Chief Executive Officer of Apple Suites, Inc.
Pursuant to the Merger, each Apple Suites common share, issued and outstanding immediately prior to the effective time of the Merger, was converted into the right to receive either: (i) one Unit of the Company, consisting of one common share of the Company and one Series A preferred share of the Company; or (ii) if the holder of an Apple Suites common share elected, $10.00 in cash per share, subject to a limit on the total amount of cash to be paid in the Merger. As a result of the Merger, holders of Apple Suites common shares received a total of 11,361,000 Units (valued at $8 per share for financial statements purposes) of the Company and approximately $17.8 million in cash. The Company funded the cash portion of the Merger consideration with available cash, and the Company assumed Apple Suites’ liabilities and paid certain merger costs.
In connection with the acquisition of Apple Suites, the Company paid total consideration of $185 million, including assumption of liabilities and transaction costs. Apple Suites assets and liabilities were recorded at fair value and no goodwill or intangible assets were recorded in connection with the transaction. The fair value of assets acquired and liabilities assumed were as follows:
Also, in connection with this transaction, the Company terminated its advisory contract with Apple Suites Advisors, Inc. (“ASA”) and became self advised with all employees of ASA becoming employees of the Company. To implement the termination of the advisory agreement, the Company purchased ASA. The Company acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement. Mr. Knight received a cash payment of $2 million and a non-interest-bearing promissory note, due four years after the Merger, in a principal amount of $4.48 million. The Company recognized an expense of $5.5 million related to this transaction during 2003. Also in connection with the Merger and the termination of the advisory agreement with ASA, the Company’s outstanding Series B convertible preferred shares were exchanged for 1,272,000 newly created Series C convertible preferred shares which have the same voting and distribution rights as if they had already been converted into 1,272,000 common shares (see Note 4). In connection with this transaction, the Company recognized expense of $10,152,000 in the consolidated statement of operations for the year ended December 31, 2003.
Note 3
Notes Payable
The aggregate amounts of principal payable under all of the Company’s promissory notes, for the five years subsequent to December 31, 2005 are as follows (in thousands):
Notes payable consists of the following:
The Company has a note in the original principal amount of $82 million, secured by 15 of its hotels. The term of the note is 10 years with a 25 year amortization. The note bears interest at the fixed rate of 7.4% per annum and payments are made in monthly installments of principal and interest. The loan matures in October 2012 with an aggregate balloon payment of approximately $67 million. The outstanding balance at December 31, 2005 and 2004 was approximately $79.2 million and $80.5 million.
Prior to November 10, 2004, the date of refinancing, the Company had a note encumbered by 23 hotel properties with an annual interest rate of 8.85%. The note was payable in monthly installments of principal and interest and had an outstanding balance on the date of refinancing of approximately $125 million. On November 10, 2004, the Company closed on a refinancing of this note. The refinancing involved 21 separate loans having an aggregate principal balance of $135 million. The 21 promissory notes are substantially similar in that each provide a stated annual interest rate of 6.88%, each note matures on November 11, 2014 with an aggregate balloon payment of approximately $111 million, and each note provides a payment of interest only in monthly installments for the first 12 months, followed by amortized payments of principal and interest in consecutive monthly installments thereafter. In association with this transaction, the Company incurred approximately $1.8 million in loan costs which are being amortized over 10 years using the effective interest method, and the Company recognized debt extinguishment costs in 2004 of approximately $8.8 million, which includes a credit of $1.9 million related to the debt’s outstanding fair value adjustment. The outstanding balance at December 31, 2005 and 2004 was $134.8 million and $135.0 million.
The Company has a note in the amount of approximately $50 million, secured by 10 of its hotels. The note bears a fixed interest rate of 8.08% per annum. The maturity date is January 2010, with a balloon payment of $35.4 million. The loan is payable in monthly installments including principal and interest. The outstanding balance at December 31, 2005 and 2004 was approximately $45.6 million and $47.7 million.
The Company has a note in the amount of approximately $20 million, secured by its Redmond hotel. The note provides for an applicable interest rate of 8.375% per year. The note requires consecutive monthly payments of principal and interest in the amount of $163,348. The note matures in December 2010. The outstanding balance at December 31, 2005 and 2004 was approximately $19.1 and $19.4 million.
In conjunction with the acquisition of Apple Suites, the Company assumed the following secured notes:
•
A secured note with an original principal amount of $9.5 million that bears interest at 8.3% per annum and is secured by two hotels. The note is amortized over 25 years and matures in January 2012. Payments of principal and interest are made monthly. The outstanding balance at December 31, 2005 and 2004 was approximately $9.0 and $9.2 million.
•
A secured note with an original principal amount of $7.5 million that bears interest at 8.14% per annum and is secured by one hotel. The note is amortized over 25 years and matures in September 2011. Payments of principal and interest are made monthly. The outstanding balance at December 31, 2005 and 2004 was $7.1 and $7.2 million.
•
A secured note with an original principal amount of $10.7 million that bears interest at 8.15% per annum and is secured by one hotel. The note is amortized over 25 years and matures in June 2011. Payments of principal and interest are made monthly. The outstanding balance at December 31, 2005 and 2004 was $10.0 and $10.2 million.
•
A secured note with an original principal amount of $50 million that bears interest at 9% per annum and is secured by 11 hotels. The note is amortized over 25 years and matures on September 2010. Payments of principal and interest are made monthly. The outstanding balance at December 31, 2005 and 2004 was $46.9 million and $47.6 million.
In 2005 the Company refinanced its $16 million dollar secured line of credit (originally entered into in 2004). The short-term credit facility was changed to a two-year $15 million revolving line of credit. This revolving line of credit is secured by two properties and bears interest at LIBOR (4.39% at December 31, 2005) plus 2.5% per year. At December 31, 2005 the outstanding balance on the revolving line of credit was $3.8 million.
The Company has an unsecured promissory note due to its Chairman and CEO. The note was part of the purchase price of ASA. The principal and interest are due on January 31, 2007. The outstanding balance at December 31, 2005 and 2004 was $4.2 million and $3.9 million.
The fair value of the Company’s notes payable at December 31, 2005 was approximately $387.0 million. The carrying value of $376.6 million approximated fair value at December 31, 2004.
Note 4
Shareholders’ Equity
The Company raised equity capital through a best efforts offering of Units by David Lerner Associates, Inc. (the “Managing Dealer”). One Unit consists of one common share and one Series A preferred share of the Company. Through the close of the offering on November 26, 2002, 30.1 million Units were sold netting the Company $270,000,336. An additional 11.4 million Units were issued in 2003 as part of the merger with Apple Suites.
Also in connection with the Apple Suites merger, all of the Company’s 240,000 Series B convertible preferred shares were exchanged for 1,272,000 Series C convertible preferred shares of the Company. Expense related to the issuance of the Series B convertible preferred shares was determined based on the fair value of the Series B convertible preferred shares at conversion date in excess of amounts paid by these individuals. The fair value was determined to be $8 per share at the date of the Merger. The holders of the Series B convertible preferred shares, including Mr. Knight, would have otherwise been entitled to receive 1,272,000 Units upon conversion of the Series B convertible preferred shares in connection with the termination of the Company’s advisory agreement with ASA and the Company’s property acquisition/disposition agreement with Apple Suites Realty Group, Inc. (“ASRG”). The new Series C convertible preferred shares have a liquidation preference comparable to the Series B convertible preferred shares, in that holders of Series C convertible preferred shares will receive no payments in liquidation for their Series C convertible preferred shares until holders of Units are paid in full for their Series A preferred shares. The Series C convertible preferred shares have the same voting rights and rights to receive dividend distributions as if they had already been converted to common shares.
The Series C convertible preferred shares will be convertible into Units upon and for 180 days following the occurrence of either of the following events: (1) the Company transfers substantially all of the Company’s assets, stock or business as a going concern, whether through exchange, merger, consolidation, lease, share exchange or otherwise, other than a sale of assets in liquidation, dissolution or winding up of the Company’s business; or (2) the Company lists the Company’s Units on a national securities exchange or quotation system or in any
established market. Upon the occurrence of either triggering event, each Series C convertible preferred share will be convertible into one Unit, subject to adjustment to reflect stock dividends on, or split, subdivision or combination of, the Company’s common shares.
The Company’s articles of incorporation authorize issuance of up to 15 million additional preferred shares. No preferred shares other than the Series A preferred shares and the Series B and C convertible preferred shares (discussed above) have been issued. The Company believes that the authorization to issue additional preferred shares benefits the Company and its shareholders by permitting flexibility in financing additional growth, giving the Company additional financing options in corporate planning and in responding to developments in business, including financing of additional acquisitions and other general corporate purposes. Having authorized preferred shares available for issuance in the future gives the Company the ability to respond to future developments and allows preferred shares to be issued without the expense and delay of a special shareholders’ meeting. At present, the Company has no specific financing or acquisition plans involving the issuance of additional preferred shares and the Company does not propose to fix the characteristics of any series of preferred shares in anticipation of issuing preferred shares other than the Series A preferred shares and Series C convertible preferred shares. The Company cannot now predict whether or to what extent, if any, additional preferred shares will be used or if so used what the characteristics of a particular series may be. The voting rights and rights to distributions of the holders of common shares will be subject to the prior rights of the holders of any subsequently-issued preferred shares. Unless otherwise required by applicable law or regulation, the preferred shares would be issuable without further authorization by holders of the common shares and on such terms and for such consideration as may be determined by the board of directors. The preferred shares could be issued in one or more series having varying voting rights, redemption and conversion features, distribution (including liquidating distribution) rights and preferences, and other rights, including rights of approval of specified transactions. A series of preferred shares could be given rights that are superior to rights of holders of common shares and a series having preferential distribution rights could limit common share distributions and reduce the amount holders of common shares would otherwise receive on dissolution.
Note 5
Stock Incentive Plans
The Company elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related Interpretations in accounting for its employee stock options. The alternative fair value accounting provided for under SFAS No. 123, “Accounting for Stock-Based Compensation,” (“FASB 123”) requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company’s stock options equals the market price of the underlying stock on the date of grant and other criteria are met, no compensation expense is recognized.
For purposes of SFAS No. 123 pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. As the options are exercisable within six months of the date of grant, the full impact of the pro forma adjustment to net income is disclosed below. Amounts shown in thousands, except per share data.
Pro forma information regarding net income and earnings per share is required by FASB 123, under the fair value method described in that statement. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2005, 2004 and 2003: risk-free interest rates of 4.0%, 4.14% and 4.06%; expected volatility of approximately 0.236, 0.272 and 0.244; expected dividend yields of 8%, and expected lives of approximately 10 years. Fair value of options granted was $0.74, $1.00 and $0.72.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility.
Stock compensation expense included in the Statement of Operations for year ended December 31, 2003 was $10,176,000, attributable to the conversion of all 240,000 Series B convertible preferred shares to Series C convertible preferred shares. The amount of stock compensation expense that would have been recognized had the fair value method prescribed under SFAS No. 123 been applied is also $10,176,000, as the Merger, defined in Note 2, triggered the conversion of the Class B convertible preferred shares under a known conversion ratio. No stock compensation expense was included in the Statement of Operations for the years ended December 31, 2005 and 2004.
On April 30, 2001, the Board of Directors approved a Non-Employee Directors Stock Option Plan (the “Directors Plan”) whereby Directors, who are not employees of the Company or affiliates, automatically receive options to purchase stock for five years from the adoption of the plan. Under the Directors Plan, the maximum number of shares to be issued is equal to 45,000 plus 1.8% of the number of Units sold in excess of 3,157,895 Units. This plan currently relates to the initial public offering of 20,157,895 Units and the additional offering of 10,000,036 Units; therefore, the maximum number of shares to be issued under the Directors Plan is currently 531,001. The options expire 10 years from the date of grant.
On April 30, 2001, the Board of Directors approved an Incentive Stock Option Plan (the “Incentive Plan”) whereby incentive awards may be granted to certain employees of the Company or affiliates. Under the Incentive Plan, the maximum number of Units to be issued is equal to 35,000 plus 4.625% of the number of shares sold in the initial offering in excess of 3,157,895 plus 4.4% of the total number of Units sold in additional offerings. This plan also currently relates to the initial public offering of 20,157,895 Units and the additional offering of 10,000,036 Units; therefore, the maximum number of Units that can be issued under the Incentive Plan is currently 1,261,252.
Both plans generally provide, among other things, that options be granted at exercise prices not lower than the market value of the Units on the date of grant. Under the Incentive Plan, at the earliest, options become exercisable at the date of grant. The optionee has up to 10 years from the date on which the options first become exercisable to exercise the options. In 2005, 2004 and 2003, the Company granted 47,210, 33,372, and 33,212 options to purchase shares under the Directors Plan. Additionally, in 2003, the Company converted 45,888 options granted under the Apple Suites Director’s Plan to Company options with the same terms and agreements. No options have been granted under the Company’s Incentive Plan. Activity in the Company’s share option plans during 2005, 2004 and 2003 is summarized in the following table:
Note 6
Management Agreements
Residence Inn Hotels
The Company’s Residence Inn hotels are subject to management agreements under which Residence Inn by Marriott, Inc. (the “Manager”) manages the hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years. The agreements generally provide for payment of base management fees, which are calculated annually as a percentage of sales, and incentive management fees over a priority return (as defined in the management agreements). Incentive management fees (IMF) are currently payable only if and to the extent there is sufficient cash flow from the hotels after consideration of qualifying debt service and after consideration to a priority return on investment, including property improvements. Amounts not currently payable are deferred and are payable in future years only if and to the extent there is sufficient cash flow from future operations or upon sale or refinancing of the hotels after consideration to a priority return to the Company (as defined in the management agreements), which is generally 12%. In the event of early termination of the management agreements, the Manager will receive additional fees based on the unexpired term and expected future base and incentive management fees. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied.
Incentive fees are payable on a portfolio by portfolio basis for Residence Inn properties. The Company has three portfolios of multiple hotels (Res I, Res II and Res III) plus one stand-alone hotel. Each of these portfolios has separate management agreements which are subject to this calculation. The Company records incentive management fee exposure when it is considered probable that these fees will be paid which is generally when they become payable. For the years ended December 31, 2005, 2004 and 2003, the Company incurred and paid incentive management fees of $1.3 million, $0.3 million and $0.5 million.
The following table summarizes deferred incentive management fees (DIMF) under these management agreements (dollars in millions).
No amounts of DIMF were recorded upon the acquisition of Res I and Res II as the fair value of these amounts were not readily determinable and payment was not considered probable.
In addition to the base management and incentive management fees required by the management agreements, the Company is also required to pay certain shared services which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Shared services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, public relations and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries. For the years ended December 31, 2005, 2004 and 2003, total fees incurred under the Marriott agreements were $19.1 million, $18.4 million and $17.4 million or 10.9%, 11.3%, and 11.6% of revenue provided by the Marriott managed properties.
Homewood Suites Hotels
The Company’s 17 Homewood Suites hotels are managed by Promus Hotels, Inc. (“Promus”), a wholly owned subsidiary of Hilton Hotels Corporation (“Hilton”) under the terms of separate management agreements, as part of the Homewood Suites by Hilton franchise. The initial term is generally 15 years with no option to renew; however, two hotel properties in this portfolio have renewal options of two five year periods each. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied. Promus charges fees for this function, which are calculated as a percentage of revenue. Incentive management fees are calculated, for certain properties, on the basis of operating profit of the hotels. No incentive management fees were earned in 2005 or 2004. Promus also charges a fee, calculated as a percentage of suite revenue, for franchise licenses to operate as a Homewood Suites by Hilton and to participate in its reservation system. For the years ended December 31, 2005, 2004 and 2003, total expenses for franchise fees, management fees, advertising expenses and other reimbursable services were $6.2 million, $6.0 million and $5.3 million, or 11.9%, 11.8% and 11.9% of revenue, provided by the Hilton managed properties for each of those years.
Note 7
Related Parties
The Company has significant transactions with related parties. These transactions cannot be construed to be arm’s length and the results of the Company’s operations could be different if these transactions were conducted with non-related parties.
Prior to January 31, 2003, the Company was externally-advised and had contracted with ASA to advise and provide day to day management services to the Company. In accordance with the contract, the Company paid ASA a fee equal to .1% to .25% of total equity contributions received by the Company in addition to certain reimbursable expenses. Concurrent with the Company’s merger with Apple Suites on January 31, 2003, the Company terminated its advisory contract with ASA and became self-advised. To implement the termination of the advisory agreement, the Company purchased ASA. The Company acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement. Mr. Knight received a cash payment of $2 million and a non-interest-bearing promissory note, due four years after the Merger, in a principal amount of $4.48 million. The Company recognized an expense of approximately $5.5 million related to this transaction during 2003. Also in connection with the Company’s Merger and the termination of the advisory agreement with ASA, the Company’s outstanding Series B convertible preferred shares were exchanged for 1,272,000 newly created Series C convertible preferred shares which have the same voting and dividend rights as if they had already been converted into 1,272,000 common shares (see note 2).
The Company, through a wholly owned subsidiary, has an advisory agreement with Apple Hospitality Five Advisors, Inc., (AFA), whereby the Company receives advisory fee revenue equal to 0.1% to 0.25% of total equity contributions received by Apple Hospitality Five, Inc., plus certain reimbursable expenses in exchange for Company personnel performing advisory and real estate acquisition due diligence for Apple Hospitality Five, Inc. AFA is 100% owned by Glade M. Knight, the Company’s Chairman and CEO. For the years ended December 31, 2005, 2004 and 2003, the company earned and received advisory fee revenue of approximately $0.7 million, $0.7 million and $0.3 million. These amounts are included in other revenue.
The Company also provides support services to Apple Six Advisors, Inc. (A6A), Apple REIT Six, Inc., and Apple REIT Seven, Inc. A6A provides day to day advisory and real estate due diligence services to Apple REIT Six, Inc. A6A is 100% owned by Mr. Knight. Each of these companies has agreed to reimburse the Company for its costs in providing these services. The Company started providing these services in the second quarter of 2004. For the years ended December 31, 2005 and 2004, the Company received reimbursement of its costs totaling approximately $2.1 million and $0.6 million. Mr. Knight is Chairman and Chief Executive Officer of Apple Hospitality Five, Inc., Apple REIT Six, Inc. and Apple REIT Seven, Inc. Additionally, the Company’s Board of Directors has members that are also on the Board of Directors of Apple Hospitality Five, Inc., Apple REIT Six, Inc. or Apple REIT Seven, Inc.
Note 8
Quarterly Financial Data (unaudited)
The following is a summary of quarterly results of operations for the years ended December 31, 2005 and December 31, 2004, in thousands, except per share data:
Note 9
Pro Forma Information (unaudited)
The following pro forma information for the year ended December 31, 2003 is presented as if the acquisition of Apple Suites, Inc. occurred on January 1, 2003. The pro forma information does not purport to represent what the Company’s results of operations would actually have been if such transactions, in fact, had occurred on January 1, 2003, nor does it purport to represent the results of operations for future periods. Merger related costs associated with the Apple Suites merger have been excluded from the pro forma results, as they are associated with the merger and are non-recurring operating expenses. Amounts shown in thousands, except per share data.
Note 10
Industry Segments
The Company owns extended-stay hotel properties throughout the United States that generate rental and other property related income. The Company separately evaluates the performance of each of its hotel properties. However, because each of the hotel properties has similar economic characteristics, facilities, and services, the properties have been aggregated into a single segment. All segment disclosure is included in or can be derived from the Company’s consolidated financial statements.
Note 11
Discontinued Operations
The Company adopted FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (FAS 144) as of January 1, 2002. FAS 144 requires, among other things, that the primary assets and liabilities and the results of operations of the Company’s investment in hotels which have been sold subsequent to January 1, 2002, or are held for disposition subsequent to January 1, 2002, be classified as discontinued operations and segregated in the consolidated statements of operations and balance sheets. Hotels classified as held for sale generally represent hotels that are under contract for sale and are expected to close within the next twelve months.
Based on the performance and location of two of its Residence Inn hotels, Charlotte, North Carolina and Spartanburg, South Carolina, the Company committed at the end of 2005 to sell the two properties. The results of operations for the years ended December 31, 2005, 2004 and 2003 for these properties are classified on the Consolidated Statements of Operations in the line item “Loss from discontinued operations”. Included in discontinued operations for the year ended December 31, 2005, is the estimated loss on sale of $3.4 million. This loss is based on the anticipated sale proceeds and the net book value of the properties. The Company expects to complete these transactions in the first quarter of 2006.
The following table sets forth the components of discontinued operations for these hotels for the years ended December 31, 2005, 2004 and 2003 (in thousands):
Note 12
Subsequent Events
In January 2006, the Company declared and distributed to its shareholders dividends in the amount of $8.3 million ($0.20 per share).
In January 2006, the Company redeemed 257,634 Units in the amount of $2.6 million.
In January 2006, through the Company’s Dividend Reinvestment Plan, 235,205 Units totaling $2.4 million were reinvested.
Item 9.
Item 9. Changes in and Disagreement with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Senior management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation process, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective and that there have been no changes in the Company’s internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Since that evaluation process was completed, there have been no significant changes in internal controls or in other factors that could significantly affect these controls.
See Item 8 for the Company’s Report of Management on Internal Control over Financial Reporting and the Company’s Independent Registered Accounting Firm’s attestation report regarding internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by Items 401, 405 and 406 of Regulation S-K will be set forth in the Company’s 2006 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 10, the 2006 Proxy Statement is incorporated herein by this reference.
Item 11.
Item 11. Executive Compensation
The information required by Item 402 of Regulation S-K will be set forth in the Company’s 2006 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 11, the 2006 Proxy Statement is incorporated herein by this reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
The information required by Items 201(d) and 403 of Regulation S-K will be set forth in the Company’s 2006 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 12, the 2006 Proxy Statement is incorporated herein by this reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Item 404 of Regulation S-K will be set forth in the Company’s 2006 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 13, the 2006 Proxy Statement is incorporated herein by this reference.
Item 14.
Item 14. Principal Accounting Fees and Services
This information required by Item 9(e) of Schedule 14A will be set forth in the Company’s 2006 Proxy Statement. For the limited purpose of providing the information necessary to comply with this Item 14, the 2006 Proxy Statement is incorporated herein by this reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
1. Financial Statements of Apple Hospitality Two, Inc.
Report of Management on Internal Control over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting-Ernst & Young LLP
Report of Independent Registered Public Accounting Firm-Ernst & Young LLP
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003
Notes to Consolidated Financial Statements
These financial statements are set forth in Item 8 of this report and are hereby incorporated by reference.
2. Financial Statement Schedules
Schedule III-Real Estate and Accumulated Depreciation (Included at the end of this Part IV of this report)
3. Exhibits
Incorporated herein by reference are the exhibits listed under “Exhibits Index” to this Report
SCHEDULE III
Real Estate and Accumulated Depreciation
As of December 31, 2005
(Dollars in thousands)
SCHEDULE III
Real Estate and Accumulated Depreciation
As of December 31, 2005
(Dollars in thousands)
(1) The cost basis for Federal Income Tax purposes approximates the basis used in this schedule.
(2) Reclassification to hotels held for sale includes a loss of $3.4 million in 2005 on discontinued operations.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
APPLE HOSPITALITY TWO, INC.
By:
/s/ GLADE M. KNIGHT
Date: March 9, 2006
Glade M. Knight,
Chairman of the Board,
Chief Executive Officer, and
President (Principal Executive Officer)
By:
/s/ Bryan Peery
Date: March 9, 2006
Bryan Peery,
Chief Financial Officer (Principal Financial and Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Exhibit Index
* Denotes Compensation Plan.