ITEM 1. BUSINESS
(a) GENERAL
OVERVIEW
Innkeepers USA Trust ("Innkeepers") is a self-administered real estate investment trust ("REIT"), which commenced operations on September 30, 1994. Innkeepers initially acquired an 87.7% equity interest in Innkeepers USA Limited Partnership (with its subsidiary partnerships, the "Partnership" and collectively with Innkeepers, the "Company") which owned seven hotels with an aggregate of 851 rooms. At December 31, 1997, Innkeepers owned interests in 56 hotels with an aggregate of 6,703 rooms (the "Hotels") through its 82.1% interest in the Partnership.
The Company has implemented a strategy of utilizing multiple lessees and hotel management companies for its hotel properties. The Company leases 47 of the Hotels to JF Hotel, Inc. (or other entities under common ownership, collectively the "JF Lessee") and leases nine Hotels to affiliates of Summerfield Hotel Corporation (the "Summerfield Lessee" and, together with the JF Lessee, the "Lessee") pursuant to percentage leases (the "Percentage Leases"). The Percentage Leases allow the Company to participate in increased revenue from the Hotels by providing for the payment of rent based on percentages of room revenues. The JF Lessee has entered into management contracts with Residence Inn by Marriott, Inc., a subsidiary of Marriott International, Inc. ("Marriott"), the largest operator of upscale extended-stay hotels in the United States, to manage 20 of the Residence Inn Hotels and with another third-party manager to manage two of the Hotels. The Summerfield Lessee has entered into management contracts with another affiliate of Summerfield to manage the nine Summerfield Hotels.
UPSCALE EXTENDED-STAY SEGMENT
The Company's acquisition strategy focuses primarily on upscale extended-stay hotels. Smith Travel Research ("Smith Travel") defines the upscale extended-stay hotel segment as those extended-stay hotels having an average daily rate ("ADR") of $85 or greater.
Upscale extended-stay hotels are distinguishable from mid-priced, economy and budget extended-stay hotels generally as follows:
EXTENDED-STAY HOTELS
The Company believes the demand for upscale extended-stay rooms substantially exceeds the available supply in its market, which the Company expects will allow its Hotels to continue to provide attractive returns to the Company in the near term. Over the longer term, the Company believes that new supply will continue to be limited in its target markets by the relatively high barriers to entry in those markets. High barriers to entry include scarcity and high cost of land, extensive permit and approval requirements, the relatively long lead time required to develop an upscale extended-stay hotel, particularly in the New England and Pacific coast states, and the relatively high costs associated with such development.
The upscale extended-stay hotel concept was developed by Jack P. DeBoer and Rolf E. Ruhfus, Trustees of the Company, who co-founded both the Residence Inn and Summerfield Suites brands. The Company believes its relationships with Marriott, Summerfield and Messrs. DeBoer and Ruhfus, affiliates of each of which own equity interests in the Company, have provided and will provide the Company with attractive opportunities to acquire additional upscale extended-stay hotels.
RELATIONSHIPS
To implement its multi-lessee/operator strategy, the Company has formed relationships with the owners and operators of two of the premier brands in the upscale extended-stay segment, Marriott and Summerfield.
Marriott. The Company currently owns 38 Residence Inn hotels, including 20 that are managed by Marriott. Marriott's management of Company-owned Hotels enables the Company to realize the benefits of Marriott's resources and hotel operations experience and enhances the Company's ability to grow. The Company believes that its relationship with Marriott has and may, in the future, provide the Company access to Residence Inn developers and potential sellers to which it might not otherwise have meaningful access. The Company expects that Marriott will manage certain additional Residence Inn hotels that may be acquired in the future, although no assurance can be given in this regard. Marriott currently owns 298,334 Common or Preferred Units.
Summerfield. The Company currently owns nine Summerfield brand hotels (including six Summerfield Suites hotels, two Sierra Suites hotels, and one Sunrise Suites hotel), all of which are leased and managed by Summerfield. Mr. Ruhfus, Chairman of the Board of Summerfield, is also a Trustee of the Company. The Company also has a right of first refusal to acquire certain Summerfield Suites or Sierra Suites Hotels developed in the future by Summerfield. Under that arrangement, the Company has retained Summerfield to develop a 113 room Sierra Suites hotel in Westborough, Massachusetts. The total estimated cost of development of this hotel is approximately $7,900,000 and the development is expected to be completed in the first half of 1998. Affiliates of Summerfield currently own 1,937,947 Common Units.
THE HOTELS
The following charts set forth certain information with respect to the Hotels at December 31, 1997:
- ---------- * Contains a total of 1,057 bedrooms
RECENT DEVELOPMENTS
On December 30, 1997, the Company purchased a portfolio of eight Residence Inn hotels for an aggregate purchase price of $59,500,000. The hotels purchased are as follows: Altamonte Springs, Florida (128 rooms), Ontario, California (200 rooms), Columbus (East), Ohio (80 rooms), Fort Wayne, Indiana (80 rooms), Indianapolis, Indiana (88 rooms), Lexington, Kentucky (80 rooms), Louisville, Kentucky (96 rooms) and Winston-Salem, North Carolina (88 rooms). The Company funded the purchase with available cash and the Line of Credit.
On January 11, 1998, the Company purchased a 120-room Residence Inn hotel located in Bothell (Seattle Northeast), Washington, for a cash purchase price of $11,750,000. The purchase price was funded through the Company's Line of Credit.
On January 14, 1998, the Company purchased a portfolio of five Residence Inn hotels for an aggregate purchase price of $83,000,000. The hotels purchased are as follows: Bellevue, Washington (120 rooms); Lynnwood, Washington (120 rooms); Tukwila, Washington (144 rooms); Vancouver, Washington (120 rooms); and Lake Oswego (Portland South), Oregon (112 rooms). The Company assumed existing indebtedness of $59,320,000 and funded the balance of the purchase price through the Line of Credit.
On February 19, 1998, the Company obtained a new line of credit (the "Line of Credit"). The Line of Credit is uncollateralized and has a maximum borrowing amount of $250,000,000. The interest rate on the Line of Credit is LIBOR plus 122.5 to 162.5 basis points, a reduction from the LIBOR plus 175 basis points interest rate on the old line of credit. The old line of credit was extinguished. The Company was amortizing loan origination fees and costs incurred in connection with the old line of credit over its original three-year term. When the old line of credit was extinguished and replaced with the Line of Credit, those loan origination fees and costs were expensed immediately and recognized as an extraordinary loss of approximately $2,750,000.
On February 19, 1998, the Company refinanced $40,000,000 of borrowings outstanding under the Line of Credit with a new term loan (the "Third Term Loan"), which bears interest at a 7.02% fixed annual rate. The Third Term Loan has scheduled principal amortization over a twenty year term, with equal monthly payments of $292,467 commencing on April 11, 2000. Interest on the outstanding balance of the Third Term Loan will accrue at 12.02% if the outstanding principal balance is not paid in full by March 11, 2010. The Company anticipates repaying the remaining balance of the Third Term Loan on or before March 11, 2000. Seven Hotels collateralize the Third Term Loan.
In connection with obtaining the (uncollateralized) Line of Credit, the Hotels securing the old line of credit were released. At February 19, 1998, 28 of the Company's hotel properties collateralized its other long-term debt, including the Third Term Loan.
On March 4, 1998, the Company's Board of Trustees declared a first quarter distribution of $0.28 per common share to shareholders of record on March 27, 1998. The distribution is payable on April 21, 1998. The 1998 first quarter distribution represents a $0.02, or 7.7%, increase over the 1997 fourth quarter distribution.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company is in the business of acquiring equity interests in hotel properties. See the Consolidated Financial Statements and notes thereto included in Item 8 on this Form 10-K for certain financial information required to be included in response to this Item 1.
(c) NARRATIVE DESCRIPTION OF BUSINESS
GENERAL
The Company is a self-administered Maryland REIT which owned equity interests in the 56 Hotels with an aggregate of 6,703 rooms as of December 31, 1997. A wholly-owned subsidiary of Innkeepers owns an approximate 82.1% interest in and is the sole general partner of Innkeepers USA Limited Partnership. The Hotels are owned both by Innkeepers USA Limited Partnership directly and by various subsidiary partnerships.
INTERNAL GROWTH STRATEGY
The Percentage Leases are designed to allow the Company to participate in growth in room revenue at the Hotels by providing for the payment of rent based upon percentages of room revenues ("Percentage Rent"). Under the Percentage Leases, once room revenues at a Hotel reach a specified level (a "Revenue Break Point"), the Company receives between 68% and 70% of incremental room revenues. For the year ended December 31, 1997, room revenues from each of the Hotels exceeded the Revenue Break Point for the payment of the higher tier of Percentage Rent under the applicable Percentage Lease. Each Percentage Lease also provides for a fixed annual base rent ("Base Rent"). The Percentage Leases generally provide that annual Base Rent and the Revenue Break Points for the payment of Percentage Rent will be adjusted annually based on changes in the CPI.
For the hotels leased by the JF Lessee, the Company earned Percentage Rent in excess of Base Rent on all of the hotels except the Residence Inn in Atlanta, Georgia. For the hotels leased by the Summerfield Lessee, the Company earned Percentage Rent in excess of Base Rent on the Sierra Suites hotels located in Atlanta, Georgia and Phoenix, Arizona. The Summerfield Lessee agreed that for 1997 and 1998, the Base Rent payable for the six Summerfield Suites and the Sunrise Suites hotel shall be an amount equal to the Percentage Rent that would be payable under the formulas set forth in the applicable Percentage Leases if such respective hotels achieved the room revenues budgeted for such periods. In 1999 and subsequent years, Base Rent for these hotels shall be reduced from the levels applicable in 1997 and 1998, but the Percentage Rent formula will remain the same (subject to certain adjustments based on increases in the CPI). In addition, during the remainder of 1997 and 1998, the Base Rent payable for five of the Summerfield hotels (which excludes the Summerfield Suites - West Hollywood, California, the Sunrise Suites - Tinton Falls, New Jersey and the two Sierra Suites hotels) is the aggregate of the Base Rent amounts set forth in the Percentage Leases for such five hotels for the period on a consolidated basis, to the effect that any rent paid in excess of Base Rent for any of these five hotels shall be credited to the aggregate Base Rent payable for any or all of the other hotels in the group.
The Company seeks to increase Percentage Lease payments through the following; (i) employing asset managers to work with the Lessee and operators to direct marketing programs and sales management policies at the Hotels, (ii) selective renovation of the Hotels, (iii) the possible
development of new hotels on a selected basis, and (iv) the rebranding and repositioning of existing hotels on a limited and selected basis.
Sales Management
The JF Lessee uses market-oriented sales management programs to coordinate, direct and manage the sales activities of personnel located at each Hotel it operates or oversees. Weekly sales reports are generated by each salesperson through the daily input of data that identifies all sales related activities which have taken place during the day (e.g., appointments, sales calls, direct mailings, incoming calls) and the results of such actions (e.g., appointments made, literature sent, rooms reserved). Each salesperson also inputs any comments made by prospective or existing customers, the potential for new or continued business and the timing of the follow-up action required. Additionally, sales reports permit management to promptly evaluate a salesperson's productivity as measured by the quantity of sales calls, sales call results and number of group bookings. These sales reports also allow comparisons of the ongoing sales efforts at the applicable Hotel to the marketing and business plan established for each Hotel and allow management to adapt the marketing and business plan accordingly. The third-party managers, including Marriott, use focused, well-developed sales management programs at the Hotels operated by those managers. The JF Lessee employs six regional managers to oversee sales and marketing efforts at the Lessee-operated Hotels, and to review those efforts at Hotels managed by third-parties, including Marriott.
Capital Improvements, Renovation and Refurbishment
The Percentage Leases require the Lessee to maintain the Hotels in a condition that complies with their respective Franchise Licenses and the Marriott Management Agreements, among other requirements. In addition, the Company may upgrade the Hotels as needed to meet competitive conditions and preserve asset quality and will renovate Hotels when the Company believes the investment in renovations will provide an attractive return to the Company through increased revenue under the Percentage Leases or is otherwise in the best interests of the Company.
This strategy is designed to enhance internal revenue growth, to preserve and increase the value of each Hotel and to maintain or increase each Hotel's market share. The Company will schedule renovations to the Hotels in order to implement this strategy and as otherwise may be required by a particular franchisor in accordance with the applicable Franchise License or by Marriott pursuant to the Marriott Management Agreements.
The Percentage Leases obligate the Company generally to make available to the Lessee an amount equal to 4% or 5% of room revenue, on a monthly basis, for use by the Lessee (or Marriott, under the Marriott Management Agreements) to repair or replace furniture and equipment at the Hotels. The Company's obligation is cumulative and carries forward to the extent that such amounts are not used by the Lessee (or Marriott).
ACQUISITION STRATEGY
The Company has developed a multi-brand upscale extended-stay acquisition focus which has positioned the Company as a leading owner of upscale extended-stay hotels in the Company's target markets. The Company's primary acquisition strategy includes acquiring hotels that are (i) upscale extended-stay hotels, (ii) located in markets with relatively high barriers to entry or strong demand characteristics and (iii) located near other hotels owned by the Company thereby allowing the Lessee to enhance revenue by capitalizing on local knowledge and directing overflow business to Company-owned hotels. The Company also seeks to selectively acquire under-performing hotels to which the Company can add value through repositioning in the market, reflagging to premium hotel brands or renovation. The Company has increasingly emphasized the acquisition of hotel portfolios in order to capitalize on the Company's efficiency and experience in acquisition analysis and transaction structuring. This emphasis has enabled the Company to more rapidly expand its hotel portfolio.
Acquisition of Upscale Extended-Stay Hotels
The Company focuses on acquiring upscale extended-stay hotels because of the strong performance of that segment, which has resulted primarily from (i) the prevailing social and economic changes that are increasing the demand for upscale extended-stay hotels, including the increasing tendency of businesses to conduct on- and off-site training to employees, corporate out-sourcing and the use of consultants, and the general increased mobility of the United States workforce, (ii) the ability to generate a more consistent revenue stream than traditional hotels due to higher average occupancies and longer average stays, and (iii) the demand for hotel rooms by guests who stay longer than five consecutive room nights has substantially exceeded the number of currently existing extended-stay hotel rooms, according to industry sources. The Company also believes that its relationships, particularly with Marriott, will provide it with opportunities to acquire desirable hotel properties, primarily in the upscale, extended-stay segment, through noncompetitive bid situations on terms that may be generally more favorable than those available in traditional brokered transactions.
Target Markets
The Company's focus is on markets that have high barriers to entry, such as in New England and the Pacific coast states, which are characterized by scarcity or high cost of available land, extensive permit approval requirements, restrictive zoning, stringent local development laws, a relatively long lead time required to develop an upscale extended-stay hotel and the high costs associated with such development. In addition, the Company seeks out submarkets within favorable regions that have multiple fast-growing demand generators, such as major office or manufacturing complexes, airports, major colleges and universities and medical centers with convenient access to major thoroughfares. The Company believes that its focus on
these target markets has been a major factor in the Hotels achieving occupancy, ADR and RevPAR that exceed industry averages. Additionally, the Company seeks Hotels in proximity to the Company's existing Hotels, where the Company may draw upon its knowledge of local market conditions, develop certain economies of scale and cross market among the Hotels in the cluster.
Acquisition of Under-performing Hotels
Although the primary focus of the Company is on the upscale extended-stay segment, the Company will from time to time consider acquisition of under-performing mid-priced and full service hotels that have the potential for strategic repositioning in the market, reflagging to a premium franchise brand or renovation. Generally, hotels that meet the Company's investment criteria include (i) poorly managed hotels that have the potential for increased performance following the introduction of a quality management team, (ii) hotels in deteriorated physical condition that could benefit significantly from renovations, or (iii) hotels in attractive locations that the Company believes could benefit significantly by changing franchises to a brand the Company believes is superior, such as Hampton Inn or Courtyard by Marriott.
Development
The Company has retained a Summerfield affiliate to develop a Sierra Suites hotel in Westborough, Massachusetts. The Company has committed to fund the development costs of this hotel which are estimated to be approximately $7,900,000. The Company expects the development to be completed in the first half of 1998. A Summerfield affiliate will lease the hotel under a Percentage Lease with terms substantially similar to the leases for the Company's two current Sierra Suites hotels. A Summerfield affiliate will retain an interest in the hotel which entitles it to a payment equal to 15% of the excess of the value of the hotel two years after it opens over its development cost. The fee is expected to be paid in Common Units.
The Company may pursue the development and construction of additional hotels in accordance with the Company's development and underwriting policies. Risks associated with additional development and construction activities may include: the abandonment of development opportunities explored by the Company; construction costs of a hotel may exceed original estimates due to increased materials, labor or other expenses, which could make completion of the hotel uneconomical; operating results at a newly completed hotel are dependant on a number of factors, including market and general economic conditions, competition and market acceptance; financing may not be available on favorable terms for the development of a hotel; and construction and stabilization may not be completed on schedule, resulting in increased debt service expense and construction costs. Development activities are also subject to risks relating to the inability to obtain, or delays in obtaining, all necessary zoning, land-use, building, occupancy, and other required governmental permits and authorizations. The occurrence of any of the events described above could adversely affect the Company's ability to achieve its projected yields on hotels under development and could adversely affect the Company's ability to make expected distributions.
The Company will also seek to obtain certain of the benefits of development without incurring certain of the risks of development, by (a) acquiring newly-developed hotels or (b) contracting with developers to build hotels that the Company will buy upon completion.
PROPERTY OPERATIONS
The JF Lessee
The Company believes that the quality of the on-site hotel operators is important to the future growth in Percentage Lease revenue from the Hotels. The JF Lessee leases 47 of the Hotels pursuant to the Percentage Leases and operates 25 of the Hotels. Marriott operates 20 Residence Inn hotels pursuant to the Marriott Management Agreements. Marriott is the largest operator of upscale extended-stay hotels in the U.S. The Company believes that Marriott's management of Hotels will enable the Company to realize the benefits of Marriott's resources and broad-based hotel operations experience in order to enhance the Company's ability to grow.
The JF Lessee is owned by Mr. Fisher and Mr. Shaw (the Chairman and Chief Operating Officer, respectively, of the Company) and employs currently approximately 1,150 people. Under the Percentage Leases, the JF Lessee generally is required to perform or provide for all operational and management functions necessary to operate the Hotels. Such functions include accounting, periodic reporting, ordering supplies, advertising and marketing, maid service, laundry, and repair and maintenance. The JF Lessee employs six regional managers who oversee the operation of all of the Hotels. The Lessee is entitled to all revenue from the Hotels after payment of rent under the Percentage Leases and other operating expenses, including any management fees payable to third-party managers.
The JF Lessee-leased Hotels not operated under Marriott Management Agreements are operated under franchise agreements and are licensed as Hampton Inn, Residence Inn, Sheraton Inn, Comfort Inn or Holiday Inn Express hotels. The Company has paid or will pay the cost of obtaining or transferring certain franchise license agreements to the JF Lessee. For the hotels which do not require a franchise transfer fee, the Company has advanced to the JF Lessee the working capital deposit required under the JF Lessee's management agreements with Marriott. The franchise and management agreements require the payment of fees based on a percentage of hotel revenue. These fees are paid by the JF Lessee. The franchisors periodically inspect their licensed hotels to confirm adherence to their operating standards. See "Properties -- The Percentage Leases" for further information on the Percentage Leases.
Marriott Management
The Marriott Management Agreements allow the hotels subject thereto to be operated as Residence Inn hotels for an initial term of 13 years, provided that the hotels maintain the standards of the Residence Inn system. The Marriott Management Agreements may be extended by Marriott for an additional term if the Company has achieved a specified return on its initial investment. Marriott may terminate one or more of the Marriott Management Agreements upon the occurrence
of certain events, including the JF Lessee's failure to make any payment or perform other covenants under the Marriott Management Agreements or a bankruptcy of the JF Lessee or the Company. If a Marriott Management Agreement is terminated for any reason other than a default by Marriott, the hotel to which the agreement relates will not be entitled to operate thereafter as a Residence Inn. Marriott may be terminated as manager of a hotel if certain performance criteria set forth in the relevant Marriott Management Agreement are not met in any two consecutive years beginning with the third anniversary of the acquisition of the hotel, subject to certain exceptions and cure rights. In that event, the JF Lessee may enter into a then-current form of Residence Inn franchise license and, subject to Residence Inn system requirements and to the JF Lessee being a then-approved franchisee, continue to operate the hotel as a Residence Inn hotel.
The JF Lessee is responsible for making all payments to Marriott under the Marriott Management Agreements, and the Company is secondarily liable for certain of the JF Lessee's obligations. Under each Marriott Management Agreement, the JF Lessee is required to pay to Marriott a base management fee, a system fee and a marketing fee equal to specified percentages of certain revenues at the relevant Hotel, and an incentive management fee equal to a specified percentage of the JF Lessee's annual net operating income with respect to the Hotel, after payment of Rent under the Percentage Lease for the Hotel.
DeBoer Hotels
On November 1, 1996, the Company completed the acquisition of seven Residence Inn hotels ("the DeBoer Hotels") from affiliates of Jack P. DeBoer (the "DeBoer Group"). The DeBoer Hotels were acquired from the DeBoer Group for a total purchase price of approximately $108.5 million, consisting of (i) approximately 4,063,329 Preferred Units, with a value of $11.00 per Preferred Unit at the time of issuance, (ii) the assumption and immediate repayment of approximately $38.4 million of outstanding mortgage indebtedness and (iii) the assumption of the approximately $24.9 million of assumed indebtedness. Additionally, in connection with the acquisition of the DeBoer Hotels by the Company, Marriott received Common Units having a deemed value of $500,000 (the "Release Units") in exchange for releasing the existing management contracts relating to such Hotels.
The Preferred Units are convertible at any time into Common Units on a one-for-one basis and, beginning in November 1998, may be redeemed for an amount of cash equal to the then-trading value of a common share or, at the option of the Company, one common share. Assuming full redemption of all Common Units and Preferred Units and the issuance of common shares in exchange therefor, the DeBoer Group would own approximately 10% of the common shares currently outstanding. Following the acquisition of the DeBoer Hotels, Jack P. DeBoer joined the Company's Board of Trustees. Marriott has the right, on or after the first anniversary of the issuance of the Release Units, to redeem each Release Unit for an amount of cash equal to the then-trading value of a Common Share on the NYSE or, at the option of the Company, one common share.
Annual preferred distributions of $1.10 are payable on each Preferred Unit, which may increase to up to $1.155 for each Preferred Unit, based on increases in dividends payable on the common shares. Due to the potential adverse tax consequences to members of the DeBoer Group that may result from a sale of the DeBoer Hotels, the Company has agreed with the DeBoer Group that for a period of up to ten years following the closing of the acquisition of the DeBoer Hotels, (i) any taxable sale of a DeBoer Hotel will require the consent of the applicable members of the DeBoer Group and (ii) the Company will maintain at all times outstanding indebtedness of at least approximately $40 million, subject to reduction upon the occurrence of certain events, including certain redemptions or taxable transfers of Preferred Units by the applicable members of the DeBoer Group. In the event that the Company fails to maintain the required level of indebtedness, the Company will be liable for any resulting income tax liabilities incurred by the applicable members of the DeBoer Group.
COMPETITION
For Guests
The hotel industry, and the upscale extended-stay and mid-price segments of the lodging market in which the Company operates, is highly competitive. Competitive factors within the industry include room rates, quality of accommodations, name recognition, service levels, reputation, reservation systems, convenience of location and the supply and availability of alternative lodging. The Hotels compete with other existing and new hotels in their geographic markets. The extended-stay and mid-price segments of the hotel industry have become more competitive recently, as several new competitors have entered the market. Many of the Company's competitors have substantially greater marketing and financial resources than the Company and the Lessee. Each of the Hotels is located in a developed area that includes other hotels, many of which are competitive with the Hotels in their locality. The number of competitive hotels in a particular area could have a material adverse effect on the revenues derived from the Hotels or hotels acquired in the future. Further, there can be no assurance that new or existing competitors will not significantly reduce their rates or offer greater convenience, services or amenities or significantly expand or improve their hotels in the market in which the Company competes or markets in which it will compete, thereby materially adversely affecting the Company's business and results of operations.
For Acquisitions
Competition exists for investment opportunities in upscale extended-stay and mid-price hotels from entities organized for purposes substantially similar to the Company's objectives as well as other purchasers of hotels. The Company may be competing for such hotel investment opportunities with entities that have substantially greater financial resources than the Company or better relationships with franchisors, sellers or lenders. These entities may also generally be able to accept more risk than the Company prudently can manage. Competition may generally reduce
the number of suitable hotel investment opportunities offered to the Company and increase the bargaining power of property owners seeking to sell, thereby increasing prices.
BUSINESS RISKS
Dependence on Payments under Percentage Leases; Lack Of Control
Certain rules relating to the qualification of a REIT prohibit a REIT from operating hotels. Therefore, the Company leases the Hotels to the Lessee pursuant to the Percentage Leases. The Company's primary source of revenue is rent payments under the Percentage Leases. The Company must rely on the Lessee and any third-party managers retained by the Lessee, such as Marriott and Summerfield, to operate effectively the Hotels in a manner that generates sufficient cash flow to enable the Lessee to make the rent payments under the Percentage Leases. Ineffective operation of the Hotels may result in the Lessee being unable to pay rent to the Company, including the higher tier percentage rent necessary for the Company to fund its current level of distributions to shareholders.
The Company cannot operate the Hotels or participate in the decisions affecting the daily operations of the Hotels. Other than as set forth in the applicable Percentage Lease, the Company does not have the authority to require a Hotel to be operated in a particular manner, or to govern any particular aspect of its operation (e.g., setting room rates). Thus, even if the Company's management believes a hotel is being operated inefficiently or in a manner that does not result in a maximization of rent to the Company, the Company cannot require a change in the method of operation. The Company is limited to seeking redress only if the Lessee violates the terms of the Percentage Leases, and then only to the extent of the remedies set forth therein.
Risk of Rapid Growth; Dependence on Lessees and Third-Party Managers
The Company's ability to grow depends upon the ability of the Lessee and any third-party manager retained by the Lessee, such as Marriott or Summerfield Suites Management Company, L.P. (the "Summerfield Manager"), to manage effectively the Hotels, as well as any additional hotels in which the Company invests. The Lessee's or any third-party managers' ability to operate additional hotels under Percentage Leases or management agreements, as applicable, with current staffing levels and office locations, may diminish as the Company acquires additional hotels. Such growth may require the Lessee or managers to hire additional personnel, engage additional third-party managers and operate in new geographic locations. In order to qualify as a REIT, the Company cannot operate the Hotels or participate in decisions affecting the daily operations of the Hotels. The Lessee has limited assets and generally the Lessee must generate sufficient cash flow from the operation of the Hotels, after payment of all operating expenses, to fund the Lessee's rent obligations under the Percentage Leases. There can be no assurance that the Lessee or their third-party managers will effectively operate the Hotels. In the event that the Lessee and their third-party managers fail to effectively operate the Hotels, the Company's internal growth strategy and acquisition strategy would be more difficult to achieve and, therefore, cash available for distribution could be adversely affected.
Availability of Capital
The ability of the Company to implement its growth strategy depends on access to capital necessary to invest in additional hotels through the use of borrowings, subsequent issuances of common shares or other securities or operating cash flow. Access to capital, and in particular equity capital, may be negatively affected by recession or negative perceptions about the performance of or prospects for the real estate industry in general, the hotel industry specifically and, more particularly, the Company.
Operating Costs and Capital Expenditures; Hotel Renovation
Hotels in general, including the Hotels, have an ongoing need for renovations and other capital improvements, particularly in older structures, including periodic replacement of furniture and equipment at the hotels. Under the terms of the Percentage Leases, the Company is obligated to pay the cost of certain capital expenditures at the Hotels and pay for furniture, fixtures and equipment. If these expenses exceed the Company's estimate, the additional cost could have an adverse effect on the cash available for distribution to shareholders. In addition, the Company may acquire hotels in the future that require significant renovation. Renovation of hotels involves certain risks, including construction cost overruns and delays, uncertainties as to market demand
or deterioration in market demand after commencement of renovation and the emergence of unanticipated competition in the local geographic market.
Operating Risks
The Hotels are subject to all operating risks common to the hotel industry. The hotel industry has experienced volatility in the past, as have the Hotels, and there can be no assurance that such volatility will not occur in the future. These risks include, among other things, economic recessions; competition from other hotels; over-building in the hotel industry which has adversely affected occupancy, ADR and RevPAR; increases in operating costs due to inflation and other factors, which increases have not in recent years been, and may not necessarily in the future be, offset by increased room rates; dependence on business and commercial travelers and tourism; strikes and other labor disturbances of hotel employees for hotels acquired by the Company in the future; increases in energy costs and other expenses of travel; and adverse effects of general and local economic conditions. These factors could decrease room revenue of the Hotels and adversely affect the Lessee's ability to make payments of rent under the Percentage Leases to the Company, including payments at the higher tier Percentage Rent levels.
Risks of Operating Hotels under Franchise Licenses and Marriott Management Agreements
The continuation of the franchise licenses under which certain of the Hotels are operated is subject to specified operating standards and other terms and conditions. The franchisors that have issued or will issue the franchise licenses periodically inspect their licensed hotels to confirm adherence to their operating standards. The failure of the Company or the Lessee to maintain such standards respecting a Hotel or to adhere to such other terms and conditions could result in the loss or cancellation of a franchise license. The Marriott Management Agreements will allow the Hotels subject thereto to be operated as Residence Inn hotels so long as the Company does not breach its obligations under the Percentage Leases relating to such Hotels. Continued operation of such Hotels as Residence Inn hotels also requires the Company to make capital improvements as required by Marriott to maintain the hotel in accordance with system standards. It is possible that a franchisor or Marriott, as applicable, could condition the continuation of a franchise license or a Marriott Management Agreement, as applicable, on the completion of capital improvements which management or the Board of Trustees determines are too expensive or otherwise not economically feasible in light of general economic conditions or the operating results or prospects of the affected hotel. In that event, the management or the Board of Trustees may elect to allow the franchise license or Marriott Management Agreement to lapse or be terminated. In addition, when the term of a franchise license or a Marriott Management Agreement expires, the franchisor or Marriott has no obligation to issue a new franchise license or management agreement, as applicable, for the hotel. The loss of a franchise license or a Marriott Management Agreement could have a material adverse effect upon the operations or the underlying value of the Hotel covered by the franchise license or a Marriott Management Agreement because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor or Marriott. The loss of a franchise license or Marriott Management Agreement
for one or more of the Hotels could also have a material adverse effect on rent under the Percentage Leases and cash available for distribution to shareholders.
Investment Concentration in Single Industry; Emphasis on Upscale Extended-Stay Market Segment; and Emphasis on Residence Inn and Hampton Inn Hotels
The Company's current growth strategy is to acquire operating hotels, primarily upscale extended-stay hotels. The Company will not seek to invest in assets selected to reduce the risks associated with an investment in the hotel industry, and is subject to risks inherent in concentrating investments in a single industry and in a single market segment within that industry. The Company intends to emphasize the acquisition of Residence Inn hotels in its acquisition strategy. The Company will be subject to risks inherent in concentrating investments in any franchise brand, in particular the Residence Inn, Summerfield Suites and the Hampton Inn brands, such as a reduction in business following any adverse publicity related to a brand, which could have an adverse effect on the Company's Rent under the Percentage Leases and cash available for distribution to shareholders.
Concentration of Investments in California, Florida, Washington, Texas and Michigan
Ten of the 56 Hotels are located in California, five are located in each of Florida and Washington and four are located in each of Texas and Michigan. The concentration of the Company's investments in California, Florida, Washington, Texas and Michigan could result in adverse events, or conditions which affect those areas in particular, such as economic recessions and natural disasters, having a more significant negative effect on the operations of the combined Hotels, and ultimately cash distributions to shareholders of the Company, than if the Company's investments were more geographically diverse.
Ownership Limitation
In order for the Company to maintain its qualification as a REIT, not more than 50% in value of its outstanding shares of beneficial interest may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities). Furthermore, if any shareholder or group of shareholders of the Lessee owns, actually or constructively, 10% or more of the shares of beneficial interest of the Company, the Lessee could become a related-party tenant of the Company and the Partnership, which likely would result in loss of REIT status for the Company. For the purpose of preserving the Company's REIT qualification, the Company's Declaration of Trust prohibits direct or indirect ownership (taking into account applicable ownership provisions of the Code) of more than 9.8% of the outstanding common shares or any other class of outstanding shares of beneficial interest by any shareholder or group (including affiliates of Mr. Fisher) subject to adjustment under certain circumstances (the "Ownership Limitation"). Generally, the shares of beneficial interest owned by related or affiliated owners will be aggregated for purposes of the Ownership Limitation. Any transfer of shares of beneficial interest that would prevent the Company from continuing to qualify as a REIT
under the Code will be void ab initio, the intended transferee of such shares will be deemed never to have had an interest in such shares, and such shares will be designated "Shares-in-Trust." Further, the Company shall be deemed to have been offered Shares-in-Trust for purchase at the lesser of the market price (as defined in the Declaration of Trust) on the date the Company accepts the offer and the price per share in the transaction that created such Shares-in-Trust (or, in the case of a gift, devise or non-transfer event (as defined in the Declaration of Trust), the market price on the date of such gift, devise or non-transfer event). Therefore, the record holder of shares of beneficial interest in excess of the Ownership Limitation will experience a financial loss when such shares are redeemed, if the market price falls between the date of purchase and the date of redemption.
General Risks of Investing in Real Estate
The Hotels are subject to varying degrees of risk generally incident to the ownership of real property. Income from the Hotels may be adversely affected by adverse changes in national economic conditions, adverse changes in local market conditions due to changes in general or local economic conditions and neighborhood characteristics, competition from other hotels, changes in interest rates and in the availability, cost and terms of mortgage funds, the impact of present or future environmental legislation and compliance with environmental laws, the ongoing need for capital improvements, particularly in older structures, changes in real estate tax rates and other operating expenses, adverse changes in governmental rules and fiscal policies, civil unrest, acts of God, including earthquakes, hurricanes and other natural disasters (which may result in uninsured losses), acts of war, adverse changes in zoning laws, and other factors which are beyond the control of the Company.
Real estate investments are relatively illiquid. The ability of the Company to vary its portfolio in response to changes in economic and other conditions is limited. In particular, the Company may not sell any of the DeBoer Hotels in a taxable transaction for a period of up to ten years following the closing of the Offering, without the consent of the applicable members of the DeBoer Group. Certain provisions of the Marriott Management Agreement may also limit or delay the Company's ability to sell or refinance the Hotels subject to such agreement.
Each Percentage Lease specifies comprehensive insurance to be maintained on each of the Hotels, including liability, property and casualty and extended coverage. Management of the Company believes that such specified coverage is of the type and amount customarily obtained by owners of hotels similar to the Hotels. Percentage Leases for subsequently acquired hotels will contain similar provisions. However, there are certain types of losses, generally of a catastrophic nature, such as earthquakes, floods and hurricanes, that may be uninsurable or not economically insurable and which may impact certain of the Hotels.
All ten of the Hotels in California are located in areas that are subject to earthquake activity. These Hotels are located in areas of high seismic risk and some were constructed under pre-1985 building codes. No assurance can be given that an earthquake would not render
significant damage to the Hotels that have been constructed in compliance with more recent building codes, or are in areas of lower seismic risk. Additionally, areas in Florida where five of the Hotels are located may experience hurricane or high-wind activity. The Company has earthquake insurance policies on the Hotels located in California and hurricane insurance policies on the Hotels located in Florida. The Company's management and Board of Trustees has used and will use its discretion in determining amounts, coverage limits and deductibility provisions for insurance, with a view to maintaining appropriate insurance coverage on the Company's investments at a reasonable cost and on suitable terms, and may from time to time elect not to carry earthquake or hurricane insurance. This may result in insurance coverage that, in the event of a substantial loss, would not be sufficient to pay the full current market value or current replacement cost of the Company's lost investment. Inflation, changes in building codes and ordinances, environmental considerations, and other factors also might make it not feasible to use insurance proceeds to replace a hotel after it has been damaged or destroyed. Under such circumstances, the insurance proceeds received by the Company might not be adequate to restore its economic position with respect to a Hotel.
Conflicts of Interest
Conflicts of interest exist between the Company, the JF Lessee and Messrs. Fisher (Chairman of the Board of Trustees, Chief Executive Officer and President of the Company and the majority shareholder of the JF Lessee) and Shaw (Executive Vice-President and Chief Operating Officer of the Company and the minority shareholder in the JF Lessee) with respect to the negotiation and enforcement of the terms of the Percentage Leases with the JF Lessee. Conflicts also exist related to possible adverse tax consequences to Mr. Fisher and his affiliates upon a sale, refinancing or prepayment of indebtedness secured by certain Hotels contributed to the Company by his affiliates. Additionally, the Company relies substantially on Mr. Fisher and conflicting demands on his time occur, which could lead to decisions which do not reflect solely the interests of the Company's shareholders. Mr. Fisher and his affiliates may develop new hotels, subject to certain limitations, which may materially affect the amount of time Mr. Fisher has available to devote to the affairs of the Company. Hotels developed by Mr. Fisher and his affiliates could compete with the Hotels or hotels acquired in the future by the Company. Mr. Shaw also has conflicting demands on his time, including serving as President of the JF Lessee and spending significant time in that capacity.
Mr. DeBoer, who is one of the largest shareholders of the Company, on a fully diluted basis, and who serves as a Trustee of the Company, and certain of his affiliates have in the past, and continue to be, involved in the development of hotels, including extended-stay hotels. Mr. DeBoer is the President, Chairman of the Board and a major shareholder of Candlewood Hotel Company, Inc. ("Candlewood"), a public hotel company that is the owner, operator and franchisor of Candlewood hotels, an economy extended-stay hotel chain founded by Mr. DeBoer. Hotels developed by Mr. DeBoer and his affiliates, including Candlewood hotels, may compete with the Company's hotels for guests, and other hotel companies with which Mr. DeBoer is affiliated, including Candlewood, may compete with the Company for acquisition opportunities.
Accordingly, the interests of the Company and Mr. DeBoer could be different in connection with matters relating to the Company's Hotels or proposed acquisitions that are competitive with hotels owned or being considered for acquisition or development by Mr. DeBoer and his Affiliates.
Due to the potential adverse tax consequences to the DeBoer Group that may result from the sale of or refinancing or prepayment of indebtedness associated with the DeBoer Hotels, the Company has agreed with the DeBoer Group that, for a period of up to ten years following the closing of the acquisition of the DeBoer Hotels, (i) any taxable sale of a DeBoer Hotel will require the consent of the applicable members of the DeBoer Group, which may cause the Company to be unable to sell some or all of the DeBoer Hotels in circumstances in which it would be advantageous to do so, and (ii) the Company will maintain the Required Indebtedness.
Messrs. Fisher and Shaw and Mr. Ruhfus are the principal equity owners of the JF Lessee and the Summerfield Lessee, respectively. There is a conflict of interest with respect to the enforcement, termination or extension of the Percentage Leases and the negotiation of the terms of any future percentage leases between the Lessee and the Company. The economic interests of Messrs. Fisher and Shaw and Mr. Ruhfus in the Lessee may result in decisions relating to the Company's enforcement of its rights under the Percentage Leases that do not solely reflect the interests of the Company's shareholders.
Mr. Ruhfus is a Trustee of the Company and an equity owner of the Summerfield Lessee and the Summerfield Manager, and certain of his affiliates have in the past been, and continue to be, involved in the development of hotels, including extended stay hotels. Mr. Ruhfus is Chairman of the Board and a principal shareholder of Summerfield, which is the developer and franchisor of Summerfield Suites and Sierra Suites hotels. Hotels developed by Mr. Ruhfus and his affiliates, including Summerfield Suites and Sierra Suites hotels, may compete with the Hotels for guests, and other hotel companies with which Mr. Ruhfus is affiliated may compete with the Company for acquisition opportunities. Accordingly, the interests of the Company, Mr. Ruhfus and Summerfield could differ with respect to the Hotels or proposed acquisitions that are competitive with hotels owned or being considered for acquisition or development by Mr. Ruhfus and his affiliates.
LEVERAGE
To the extent the Company continues to incur debt, its debt service requirements will reduce cash available for distribution to shareholders. Variable rate debt, such as the Line of Credit, creates higher debt service requirements if interest rates increase, which may decrease cash available for distribution to shareholders. There can be no assurances that the Company will be able to meet its debt service obligations. To the extent that it cannot meet its debt service obligations, the Company risks the loss of some or all of its assets to foreclosure or forced sale. Changes in economic conditions could result in higher interest rates on variable rate debt, including borrowings under the Line of Credit, reduce the availability of debt financing generally or at rates deemed favorable to the Company, reduce cash available for
distribution to shareholders and increase the risk of loss upon a sale or foreclosure. The Company also may obtain one or more forms of interest rate protection on variable rate debt (e.g., swap agreements or interest rate cap contracts) and will consider additional long-term fixed-rate financing to further hedge against the possible adverse effects of interest rate fluctuations. Adverse economic conditions could cause the terms on which borrowings become available to be less favorable than at present. In such circumstances, if the Company is in need of capital to repay indebtedness in accordance with its terms or otherwise, it could be required to liquidate one or more investments in Hotels or lose one or more Hotels to foreclosure, either of which could result in a material financial loss to the Company.
ENVIRONMENTAL MATTERS
Under various federal, state and local laws and regulations, an owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on such property. Such laws often impose such liability without regard to whether the owner knew of, or was responsible for, the presence of hazardous or toxic substances. Furthermore, a person that arranges for the disposal or transports for disposal or treatment of a hazardous substance at a property owned by another may be liable for the costs of removal or remediation of hazardous substances released into the environment at that property. The costs of remediation or removal of such substances may be substantial, and the presence of such substances, or the failure to promptly remediate such substances, may adversely affect the owner's ability to sell real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the Hotels, the Company, the Partnership or the Lessee, as the case may be, may be potentially liable for any such costs.
Phase I environmental site assessments ("ESAs") generally are obtained on hotels acquired by the Company. The Company generally intends to obtain an ESA on any other hotel acquired in the future. The ESAs are and were intended to identify potential environmental contamination for which the Hotels may be responsible. The ESAs included historical reviews of the Hotels, reviews of certain public records, preliminary investigations of the sites and surrounding properties, screening for the presence of hazardous substances, toxic substances and underground storage tanks, and the preparation and issuance of a written report. The ESAs did not include invasive procedures, such as soil sampling or ground water analysis.
The ESAs have not revealed any environmental liability or compliance concerns that the Company believes would have a material adverse effect on the Company's business, assets, results of operations or liquidity, nor is the Company aware of any such liability. Nevertheless, it is possible that these ESAs do not reveal all environmental liabilities or that there are material environmental liabilities or compliance concerns of which the Company is unaware. Moreover, no assurances can be given that (i) future laws, ordinances or regulations will not impose any material environmental liability, or (ii) the current environmental condition of the Hotels will not be affected by the condition of the properties in the vicinity of the Hotels (such as the presence of
leaking underground storage tanks) or by third parties unrelated to the Partnership, the Lessee or the Company.
TAX STATUS
The Company has elected to be taxed as a REIT under Sections 856-860 of the Internal Revenue Code of 1986, as amended (the "Code"), commencing with its short taxable year ended December 31, 1994. If the Company qualifies for taxation as a REIT, with certain exceptions, the Company will not be subject to federal income tax at the Company level on its taxable income that is distributed to its shareholders. A REIT is subject to a number of organizational and operational requirements, including a requirement that it currently distribute at least 95% of its annual taxable income. Failure to qualify as a REIT will render the Company subject to federal income tax (including any applicable minimum tax) on its taxable income at regular corporate rates and distributions to the holders of Common Shares in any such year will not be deductible by the Company. If the Internal Revenue Service were to challenge successfully the tax status of the Partnership as a partnership for federal income tax purposes, the Partnership would be taxable as a corporation. In such event, the Company would likely cease to qualify as a REIT for a variety of reasons. Although the Company does not intend to request a ruling from the Service as to its REIT status or the partnership status of the Partnership, the Company has, in the past, obtained the opinion of its legal counsel that, as of the date of the opinion, the Company qualifies as a REIT. The opinion was based on certain assumptions and representations and is not binding on the Service or any court. Even if the Company qualifies for taxation as a REIT, the Company may be subject to certain federal, state and local taxes on its income and property.
ITEM 2.
ITEM 2. PROPERTIES
The following tables set forth certain information with respect to the Hotels that were owned by the Company as of December 31, 1997.
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(1) Represents the hotels' room revenue from the date of acquisition by the Company. (2) Represents Percentage Lease revenue from the Lessee to the Company calculated in accordance with the Percentage Leases. (3) Represents the occupancy, ADR and RevPAR of the Hotels for the year including the period, if any, prior to ownership by the Company. (4) Excludes results from the following eight Residence Inn hotels acquired December 30, 1997: Altamonte Springs, FL; Fort Wayne, IN; Indianapolis, IN; Lexington, KY; Louisville, KY; Ontario, CA; Winston-Salem, NC; Columbus East, OH.
THE PERCENTAGE LEASES
Each Percentage Lease contains provisions similar to those described below, and the Company intends that future percentage leases with respect to additional hotels it may acquire will contain similar provisions.
Percentage Lease Terms. Each Percentage Lease has a non-cancelable term of at least ten years, subject to earlier termination upon the occurrence of defaults thereunder and certain other events described in the Percentage Lease. Certain of the Percentage Leases contain renewal terms of up to 15 years, at the Lessee's option.
Amounts Payable Under the Percentage Leases. During the term of each Percentage Lease, the Lessee is obligated to pay to the Partnership (i) the greater of a fixed annual Base Rent or Percentage Rent, and (ii) certain other amounts, including interest accrued on any late payments or charges (the "Additional Charges"). Percentage Rent is based on percentages of room revenues for each of the Hotels. For all Percentage Leases, both the Base Rent and the Revenue Break Point in each Percentage Rent formula are (a) adjusted annually for inflation and (b) in the case of the certain of the Hotels managed by Marriott, increased to specified levels (not tied to inflation) in the first years after execution. With respect to adjustments for inflation, the adjustment will be calculated at the beginning of each calendar year based upon the change in the CPI during the prior calendar year. The Company receives between 30% and 36.5% of room revenue up to the Revenue Break Point and between 68% and 70% of room revenue in excess of the Revenue Break Point. The Base Rent for seven of the Hotels leased to the Summerfield Lessee reduces in 1999, as described in "Internal Growth Strategy" above, and beginning in 2000 will adjust annually for inflation.
Other than real estate and personal property taxes, ground lease rent (where applicable), the cost of certain furniture and equipment and certain capital expenditures, and property and casualty insurance (for the hotels leased by the JF Lessee), which are obligations of the Company, the Percentage Leases require the Lessee to pay Base Rent, Percentage Rent, Additional Charges and the operating expenses of the Hotels (including insurance, utility and other charges incurred in the operation of the Hotels) during the terms of the Percentage Leases. The Percentage Leases also provide for rent reductions and abatements in the event of damage or destruction or a partial taking of any Hotel.
Maintenance and Modifications. Under the Percentage Leases, the Company is required to pay for capital improvements at each Hotel. In addition, the Percentage Leases obligate the Company to make available to the Lessee for the repair, replacement and refurbishment of furniture and equipment in the Hotels, when and as deemed necessary by the Lessee, an amount equal to 4% or 5% of room revenues, per month on a cumulative basis. The Company's obligation is carried forward to the extent that the Lessee has not expended such amount, and any unexpended amounts remain the property of the Company upon termination of the Percentage Leases. In addition, the Company intends to cause the expenditure of amounts in excess of the obligated amounts if necessary to comply with the reasonable requirements of any franchise license or Marriott Management Agreement and otherwise to the extent that the Company deems such expenditures to be in the best interests of the Company. Otherwise, the Lessee is required, at its expense, to (i) maintain the Hotels in good order and repair, (ii) pay for all operating expenses of the Hotels and (iii) comply with the requirements of any Company loan agreement (to the extent applicable to property operations or cash management), any franchise agreement and the Marriott Management Agreements.
The Lessee, at its expense, may make non-capital and capital additions, modifications or improvements to the Hotels, provided that such action does not significantly alter the character or purposes of the Hotels or significantly detract from the value or operating efficiencies of the Hotels. All such alterations, replacements and improvements shall be subject to all the terms and provisions of the Percentage Leases and become the property of the Company upon termination of the Percentage Leases. The Company owns, with respect to the Hotels, substantially all personal property (other than inventory, linens and other nondepreciable personal property) not affixed to, or deemed a part of, the real estate or improvements thereon, except to the extent that ownership of such personal property would cause the rent under a Percentage Lease not to qualify as "rents from real property" for REIT income test purposes.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not presently involved in any material litigation, nor, to its knowledge, is any material litigation threatened against the Company or its properties, other than routine litigation arising in the ordinary course of business and which is expected to be covered by the Company's liability insurance.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The information called for in this item is incorporated by reference from the "Corporate Information" section of the Company's 1997 Annual Report, filed as Exhibit 13.1 to this Form 10-K.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information called for in this item with respect to the Company and its predecessor is incorporated by reference from the "Selected Financial Data" section of the 1997 Annual Report filed as Exhibit 13.1 to this Form 10-K.
With respect to the JF Lessee, the following table sets forth selected historical financial data for the years ended December 31, 1997, 1996 and 1995 and the period September 30, 1994 (inception) through December 31, 1994. The following selected financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included, or incorporated by reference, herein.
JF LESSEE SELECTED HISTORICAL FINANCIAL DATA (IN THOUSANDS)
(1) The JF Lessee has elected status as a Subchapter S corporation for federal income tax purposes and, generally, pays no corporate level tax on its net income.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information called for in this item with respect to the Company and its predecessor is incorporated by reference from the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the 1997 Annual Report, filed as Exhibit 13.1 to this Form 10-K.
The following is a discussion of the results of operations for the JF Lessee.
Comparison of Year Ended December 31, 1997 ("1997") to the Year Ended December 31, 1996 ("1996")
The JF Lessee had total revenue for 1997 of $124,503,000, consisting of $117,170,000 of room revenue and $7,333,000 of other revenue. Room revenue increased by $58,669,000, or 100% from $58,501,000 for 1996. This increase was primarily due to the number of Hotels leased increasing from 18 at January 1, 1996 to 32 at January 1, 1997 and to 47 at December 31, 1997.
Percentage Lease payments and hotel operating expenses for 1997 were $57,486,000 and $61,320,000, respectively. Percentage Lease payments and hotel operating expenses increased by $30,020,000 or 109% and $29,046,000 or 90%, respectively from $27,466,000 and $32,274,000 for 1996, respectively. These increases were primarily due to the number of Hotels leased increasing from 18 at January 1, 1996 to 32 at January 1, 1997 and to 47 at December 31, 1997. Net income for 1997 was $3,487,000. Net income increased $2,777,000, or 391%, from $710,000 for 1996.
Departmental profit as a percentage of gross operating revenue increased to 79.2% in 1997 from 77.2% in 1996. Net income as a percentage of gross operating revenue increased to 2.8% in 1977 from 1.1% in 1996. These increases were due primarily to operational efficiencies achieved in 1997.
Comparison of Year Ended December 31, 1996 ("1996") to the Year Ended December 31, 1995 ("1995")
The JF Lessee had total revenue for 1996 of $62,723,000, consisting of $58,501,000 of room revenue and $4,222,000 of other revenue. Room revenue increased by $34,089,000, or 139.6% from $24,412,000 for 1995. This increase was primarily due to the number of Hotels leased increasing from seven at January 1, 1995 to 18 at January 1, 1996 and to 32 at December 31, 1996.
Percentage Lease payments, hotel operating expenses and overhead expenses for 1996 were $27,466,000, $32,274,000, and $2,273,000, respectively. Percentage Lease payments, hotel operating expense and overhead expenses increased by $16,198,000 or 143.8%, $18,578,000 or 135.7%, and $1,321,000 or 138.8%, respectively from $11,268,000, $13,696,000 and $952,000 for 1995, respectively. These increases were primarily due to the number of Hotels leased increasing from seven at January 1, 1995 to 18 at January 1, 1996 and to 32 at December 31, 1996. Net income for 1996 was $710,000. Net income increased $319,000, or 81.6%, from $391,000 for 1995.
Departmental profit as a percentage of gross operating revenue remained relatively constant at 77.2% and 76.2% for 1996 and 1995, respectively. Net income as a percentage of gross operating revenue remained relatively constant at 1.1% and 1.5% for 1996 and 1995, respectively.
Liquidity and Capital Resources
The JF Lessee's principal source of revenue is the revenue derived from the hotels it operates under lease from the Company. The JF Lessee is dependent on this revenue to provide cash for the payment of its operating expenses, insurance, overhead and Percentage Lease payments. The JF Lessee is dependent upon the cash flow from operating activities to meet substantially all of its liquidity needs, including working capital and distributions to its shareholders. The JF Lessee does not currently have any established borrowing facilities. The JF Lessee believes that its cash flow provided by operating activities will be sufficient to meet its liquidity needs.
Net cash flow from operating activities was $4,656,000 in 1997. Net cash flow used in investing activities was $118,000 in 1997, which consisted primarily of the collection of affiliate advances and the purchase of marketable securities. Net cash flow used in financing activities was $2,226,000 in 1997, which consisted of distributions paid to its shareholders.
Seasonality of Hotel Business
The hotel industry is seasonal in nature. Historically, the operations of the Hotels have generally reflected higher occupancy rates and ADR during the second and third quarters.
Inflation
Operators of hotels, including the JF Lessee and any third-party managers retained by the JF Lessee, in general possess the ability to adjust room rates quickly. However, competitive pressures have limited and may in the future limit the ability of the JF Lessee and any third-party manager retained by the JF Lessee to raise room rates in response to inflation.
Impact of Year 2000
The year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any computer program that has date sensitive software may recognize a date using "00" as the year 1900 rather than as the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in a similar normal business activities.
The JF Lessee has recently assessed its internal computer systems and believes that the current systems used will properly utilize dates beyond December 31, 1999. The JF Lessee has been informed that its third party managers are in the process of studying the year 2000 issue, including inquiries of their vendors. Upon completion of the management companies' studies, which is expected in late 1998, the JF Lessee will determine the extent to which it is vulnerable to the third parties' failure to remediate their own year 2000 issues and the costs associated with resolving this issue.
Forward Looking Statements
Management's discussion and analysis of financial condition and results of operations 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, including, without limitation, statements containing the words "believes," "anticipates," "expects" and words of similar import. Such forward-looking statements relate to future events and the future financial performance of the JF Lessee, and involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the JF Lessee to be materially different from the results or achievements expressed or implied by such forward-looking statements. The JF Lessee is not obligated to update any such factors
or to reflect the impact of actual future events or developments on such forward-looking statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Pursuant to the General Instructions to Item 305 of Regulation S-K, the quantitative and qualitative disclosure called for by this Item 7A. and by Item 305 of Regulation S-K are inapplicable to the Company at this time.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are incorporated by reference from the Financial Statements included in the 1997 Annual Report, filed as Exhibit 13.1 to this Form 10-K.
INNKEEPERS USA TRUST
Report of Independent Accountants
Consolidated Balance Sheets at December 31, 1997 and 1996
Consolidated Statements of Income for the years ended December 31, 1997, 1996 and 1995
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995
Notes to Consolidated Financial Statements
The following financial statements are included herein on the pages indicated.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders JF Hotel
We have audited the combined balance sheets of JF Hotel (as described in Note 1) as of December 31, 1997 and 1996, and the related combined statements of income, shareholders' equity and cash flows for the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Companies' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits 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 financial statements referred to above present fairly, in all material respects, the combined financial position of JF Hotel as of December 31, 1997 and 1996, and the results of their operations and their cash flows for the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles.
Coopers & Lybrand L.L.P.
Memphis, Tennessee March 23, 1998
JF HOTEL COMBINED BALANCE SHEETS December 31, 1997 and 1996 (in thousands, except share data)
The accompanying notes are an integral part of these combined financial statements.
JF HOTEL COMBINED STATEMENTS OF INCOME For the years ended December 31, 1997, 1996 and 1995 (in thousands)
The accompanying notes are an integral part of these combined financial statements.
JF HOTEL COMBINED STATEMENTS OF SHAREHOLDERS' EQUITY for the years ended December 31,1997, 1996 and 1995 (in thousands, except share data)
The accompanying notes are an integral part of these combined financial statements.
JF HOTEL COMBINED STATEMENTS OF CASH FLOWS For the years ended December 31, 1997, 1996 and 1995 (in thousands)
The accompanying notes are an integral part of these combined financial statements.
JF HOTEL NOTES TO COMBINED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
JF Hotel, Inc., JF Hotel II, Inc. and JF Hotel III, Inc. (collectively "JF Hotel" or the "JF Lessee") are under common control and were formed primarily to lease and operate hotels owned by Innkeepers USA Trust ("Innkeepers") through Innkeepers USA Limited Partnership and its subsidiaries (collectively the "Partnership," and together with Innkeepers, the "Company"). As of December 31, 1997, approximately 82.1% of the Partnership was owned by the Company. The principal shareholders of the JF Lessee are Jeffrey H. Fisher, who is the President, Chief Executive Officer and Chairman of the Company, and Frederic M. Shaw, who is the Executive Vice-President and Chief Operating Officer of the Company. The JF Lessee commenced the leasing and operation of seven hotels (the "Initial Hotels") on September 30, 1994 and at December 31, 1997 leased 47 hotels (the "JF Leased Hotels") from the Company.
The Lessee operates 25 of the Hotels, Residence Inn by Marriott, Inc. ("RIBM", a wholly-owned subsidiary of Marriott International, Inc.) operates 20 of the Hotels, and an unaffiliated party operates two of the Hotels. The financial statements of the 20 hotels operated by RIBM are maintained on a 52/53 week period basis. The 1996 fiscal year ended on January 3, 1997 and the 1997 fiscal year ended on January 2, 1998.
CASH AND CASH EQUIVALENTS
All highly liquid investments with a maturity of three months or less when purchased are considered to be cash equivalents. Cash equivalents are placed with reputable institutions and the balances may at times exceed federal depository insurance limits.
The carrying amount of cash and cash equivalents approximates fair value.
MARKETABLE SECURITIES
Marketable securities, which primarily consist of 113,950 and 83,050 shares of the Company's common stock at December 31, 1997 and 1996, respectively, are classified as available for sale and are carried at market value. The appreciation in value of the marketable securities, since purchase, is recorded in shareholders' equity until realized.
INVENTORY
Inventory, consisting of food and beverage, is stated at the lower of cost (generally, first-in, first-out) or market. Linens and uniforms are expensed as incurred.
PREPAID EXPENSES
Prepaid expenses consist primarily of prepaid insurance.
REVENUE RECOGNITION
Revenue is recognized as earned. Credit evaluations are performed and an allowance for doubtful accounts is provided against accounts receivable which are estimated to be uncollectible.
FRANCHISE FEES
The cost of obtaining franchise licenses, for hotels subject to such licenses, is paid by the Company, and the continuing franchise fees (generally a percentage of room revenue) are paid by the JF Lessee.
JF HOTEL NOTES TO COMBINED FINANCIAL STATEMENTS
ADVERTISING COSTS
Advertising costs are expensed as incurred. Included in franchise and marketing fees are fees (generally a percentage of room revenue) payable to marketing funds of the franchisors which were $3,303,000, $1,728,000, and $868,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
PERCENTAGE LEASE EXPENSE
Each JF Leased Hotel is leased by the Company to the JF Lessee under a percentage lease agreement ("Percentage Lease"). The Percentage Lease for each JF Leased Hotel provides for the payment to the Company of monthly percentage rent based on fixed percentages of gross room revenue in excess of certain specified levels. The Percentage Lease for each JF Leased Hotel provides for minimum base rents in the event that percentage rents do not exceed base rents.
Percentage lease expense is recognized as due to the Company under the Percentage Leases from lease inception.
INCOME TAXES
The JF Lessee has elected S corporation status under the Internal Revenue Code. Accordingly, the shareholders of the JF Lessee are taxed on an individual basis on their proportionate share of the JF Lessee's taxable income. Consequently, no provision for income taxes has been reflected in the financial statements.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. DUE FROM AFFILIATES
At December 31, 1996, Due From Affiliates consisted of unreimbursed capital expenditures and principal payments due from the Partnership and amounts owed to partnerships controlled by the shareholders of the JF Lessee. These amounts were repaid in 1997.
3. SHARE APPRECIATION RIGHTS
In 1994, the JF Lessee granted to certain officers an aggregate of 70,000 share appreciation rights ("SARs") based on the performance of the Company's common shares. The SARs' vest over a four year period, have been granted at an exercise price of $10.00 and have a maximum term of ten years. In 1997, the JF Lessee granted to certain employees and officers an aggregate of 300,000 SARs, which vest over four or five year periods, have an exercise price of $13.25 and a maximum term of ten years. No SARs have been exercised as of December 31, 1997. At December 31, 1997 and 1996, the JF Lessee has recognized $196,000 and $234,000, respectively, in compensation cost related to the SARs, which is included in Lessee Overhead in the accompanying combined statements of income.
4. COMMITMENTS AND RELATED PARTY TRANSACTIONS
The JF Lessee has future lease commitments for office space through 1998. Minimum future rental payments under those noncancelable operating leases is approximately $135,000 in 1998.
JF HOTEL NOTES TO COMBINED FINANCIAL STATEMENTS
4. COMMITMENTS AND RELATED PARTY TRANSACTIONS, CONTINUED
Rent expense, excluding Percentage Lease expense, was $135,000, $219,000, and $40,700 for the years ended December 31, 1997, 1996 and 1995, respectively.
The JF Lessee has future minimum base lease commitments under the Percentage Lease agreements to the Company through 2012. Minimum future base lease payments under the Percentage Lease agreements are as follows (in thousands):
The JF Lessee paid base rents of $25,580,000, $10,212,000 and $4,793,000, and percentage rent, in excess of base rents, of $31,906,000, $17,254,000 and $6,475,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
RIBM operates 20 of the Hotels under management agreements with the JF Lessee (the "RIBM Management Agreements"). The RIBM Management Agreements, generally, have an initial term of 13 years and provide for a base fee of 2% of gross revenues at the managed hotels and an incentive fee which is 50% of available cash flow, as defined. For seven of the Hotels only, the RIBM Management Agreement provides for an incentive fee of 65% of available cash flow up to 3.5% of gross revenue and 50% of available cash flow thereafter. The agreement also contains penalties for early termination. Amounts due to RIBM under the RIBM Management Agreements are included in Payable to Manager in the accompanying combined balance sheet. The right to operate the 20 hotels as Residence Inns is contained in the RIBM Management Agreement. In lieu of a franchise fee, the RIBM Management Agreements provide for a system fee of 5% of gross revenues at the RIBM managed hotels. The system fee is included in franchise and marketing fees in the accompanying combined statements of income.
Two of the JF Leased Hotels are operated under management agreements with an unaffiliated party with terms of 5 years and providing for a base fee of 2% of gross revenues and an incentive fee based on the performance of the hotels managed.
The Company has reimbursed the JF Lessee $100,000, $100,000, and $40,000 for the use of office facilities for the years ended December 31, 1997, 1996 and 1995, respectively. The Company has advanced to the JF Lessee the working capital deposit required under the RIBM Management Agreements. These advances are included in other liabilities in the accompanying combined balance sheet. Percentage Lease expense due to the Company, which remains unpaid at December 31, 1997 and 1996, is included in Due to Partnership in the accompanying combined balance sheet. The Company has also guaranteed the JF Lessee's obligations under its franchise licenses (and is liable for certain of the JF Lessee's obligations under the Marriott Management Agreements), generally in exchange for certain rights to substitute a replacement lessee as the franchisee (or as the parties to the Marriott Management Agreement) if the Company terminates the related Percentage Lease.
JF HOTEL NOTES TO COMBINED FINANCIAL STATEMENTS
5. EMPLOYEE BENEFIT PLAN
In July 1996, the JF Lessee began sponsoring a defined contribution employee benefit plan (the "Plan"). Substantially all employees who are age 21 or older and have at least one year of service, as defined, are eligible to participate in the Plan. Employees may contribute up to 15% of their compensation to the Plan, subject to certain annual limitations. The JF Lessee currently does not contribute to the Plan. The JF Lessee absorbs certain administrative expenses of the Plan.
On October 1, 1997, the JF Lessee established a self-insured health plan for its employees. The JF Lessee has made a provision for reported and unreported claims incurred as of December 31, 1997. The JF Lessee also maintains individual and aggregate stop loss policies.
6. SUBSEQUENT EVENTS
In January 1998, the Company acquired and leased six hotels to the JF Lessee under Percentage Leases.
REPORT OF INDEPENDENT ACCOUNTANTS
Our report on the consolidated financial statements of Innkeepers USA Trust is included in Exhibit 13.1 of this Form 10-K. In connection with our audits of such financial statements, we have also audited the related financial statement schedule on pages 41 through 43 of this Form 10-K.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
Coopers & Lybrand L.L.P.
Memphis, Tennessee March 23, 1998
INNKEEPERS USA TRUST SCHEDULE 3 - REAL ESTATE AND ACCUMULATED DEPRECIATION AT DECEMBER 31, 1997
Notes to Schedule 3 - Real Estate and Accumulated Depreciation
1. Collateral for the $190 million Line of Credit. 2. Collateral for various mortgage notes. 3. Collateral for the $30 million First Term Loan. 4. Collateral for the$42 million Second Term Loan. 5. Collateral for the Interim Loan.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated herein by reference from the Company's definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to its Annual Meeting of Shareholders to be held on May 6, 1998.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated herein by reference from the Company's definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to its Annual Meeting of Shareholders to be held on May 6, 1998.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated herein by reference from the Company's definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to its Annual Meeting of Shareholders to be held on May 6, 1998.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference from the Company's definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days after the year covered by this Form 10-K with respect to its Annual Meeting of Shareholders to be held on May 6, 1998.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a) FINANCIAL STATEMENTS
The following Financial Statements are included in this report on the pages indicated.
All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto.
With the exception of the consolidated financial statements and the accountants' report thereon listed in the above index, the information referred to in Items 1,5, 6 and 7, and the supplementary quarterly financial information referred to in Item 8, all of which is included in the 1997 Annual Report to Shareholders of Innkeepers USA Trust and incorporated by reference into this Form 10-K Annual Report, the 1997 Annual Report to Shareholders is not to be deemed "filed" as part of this report.
(b) REPORTS ON FORM 8-K
None.
(c) EXHIBITS
LIST OF EXHIBITS
(d) FINANCIAL STATEMENT SCHEDULES
Schedule 3 - Real Estate and Accumulated Depreciation at December 31, 1997.
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.
INNKEEPERS USA TRUST
March 26, 1998 /s/ Jeffrey H. Fisher ---------------------------------------- Chairman of the Board and President
March 26, 1998 /s/ David Bulger ---------------------------------------- Treasurer (Principal Financial Officer)
March 26, 1998 /s/ Gregory M. Fay ---------------------------------------- Vice-President of Accounting (Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
LIST OF EXHIBITS