Overview
Chesapeake Lodging Trust (the “Trust”) is a self-advised real estate investment trust ("REIT") that was organized in the state of Maryland in June 2009. We are focused on investments primarily in upper-upscale hotels in major business and convention markets and, on a selective basis, premium select-service hotels in urban settings or unique locations in the United States of America (“U.S.”). We completed our initial public offering (“IPO”) in January 2010 and own 21 hotels as of the date of this filing.
Substantially all of our assets are held by, and all of our operations are conducted through, Chesapeake Lodging, L.P., our operating partnership (the “Operating Partnership”). In order for us to qualify as a REIT, neither the Trust nor the Operating Partnership can operate hotels directly. Therefore, the Operating Partnership leases its hotels to taxable REIT subsidiaries (each, a “TRS”), which are wholly owned subsidiaries of the Operating Partnership and are treated as TRSs for federal income tax purposes. The TRSs then engage hotel management companies to operate the hotels pursuant to management agreements.
Our corporate office is located at 4300 Wilson Boulevard, Suite 625, Arlington, Virginia 22203. Our telephone number is (571) 349-9450.
Industry and Trust Background
Historically, the lodging industry in the U.S. has been cyclical in nature. Lodging industry performance is a function of lodging demand and supply and generally, correlates with macroeconomic conditions. Fluctuations in lodging demand are caused largely by general economic and local market conditions, which affect levels of business and leisure travel. Fluctuations in lodging supply typically are driven by levels of overall lodging demand as extended periods of strong lodging demand growth tend to encourage new hotel development and an increase in lodging supply. However, the rate of lodging supply growth is also influenced by a number of additional factors, including availability and cost of capital, construction costs, local market considerations, and considerations of alternatives for and best uses of properties.
From 2003 to 2008, pricing of hotels in the U.S. appreciated well in excess of the hotels’ underlying performance, primarily driven by record levels of debt financing. Beginning in 2008, the U.S. lodging industry experienced a significant downturn due to a decline in consumer and business spending as a result of the weakness in the global economy, particularly the turmoil in the credit markets, erosion of consumer confidence and increasing unemployment. As a result, lodging demand from both leisure and business travelers decreased significantly in 2008 and 2009. This decreased demand for hotel rooms, together with increases in lodging supply in 2008 and 2009 due to the completion of hotels under development before the global recession began, resulted in declines in occupancy and reductions in average daily rate (“ADR”) as hotels competed more aggressively for guests. These events had a substantial negative impact on revenue per available room (“RevPAR”). According to STR, Inc. ("STR"), a leading source of lodging industry information, RevPAR declined 16.7% in 2009, the largest decline recorded since they began tracking the U.S. lodging industry, and a significantly larger decline than the two previous lodging industry downturns in 1991 and 2001-2002.
From 2008 through early 2010, a significant correction in the value of hotels occurred, primarily as a result of the impact of the economic downturn on the lodging industry. In addition, during this period, due to the widely publicized credit crisis, the market for commercial mortgage backed securities was virtually closed, and many traditional real estate lenders, such as national and regional banks and insurance companies, saw their balance sheets impaired, which resulted in a severe contraction in available debt financing for hotels, which further impacted hotel values.
The Trust was founded to capitalize on the opportunity created by this lodging industry downturn. Since completing our IPO in 2010 and through the first half of 2015, we took advantage of industry conditions to acquire our current portfolio of 21 hotels, consisting of
6,479
rooms, at prices generally below replacement cost, with attractive yields and upside potential. We have followed a disciplined strategy to acquire hotels generally concentrated in the central business districts of top U.S. lodging markets, which historically have had high barriers-to-entry. Our portfolio reflects our strong efforts to establish geographic diversification, with hotels in eight states and the District of Columbia, but maintains a clear focus on the most important U.S. lodging markets.
The lodging industry has recovered significantly since our IPO. Industry-wide RevPAR from 2010 through 2017 increased 57.2%, as reported by STR, and in 2013, surpassed the prior peak established in 2007, as a result of continued improvements in hotel occupancy levels and ADR, and below historical average growth in lodging supply. These positive lodging fundamentals moderated over the last couple years however. In 2016, the rate of lodging demand growth (1.7%, as reported by STR) decreased as compared to the several years prior while the rate of lodging supply growth (1.6%, as reported by STR) approached historical average levels. In 2017, lodging demand rebounded by increasing 2.7% while lodging supply increased
by 1.8%, resulting in industry-wide RevPAR increasing by 3.0%, as reported by STR. Several industry prognosticators, including STR, expect similar levels of RevPAR growth over the next few years as that experienced by the industry in 2017.
We continue to believe our hotel portfolio is well positioned for future performance and long-term real estate value appreciation as a result of our focus on high-quality hotels located in major U.S. lodging markets. However, recognizing that the industry is now entering the ninth year of the current lodging and economic cycle, we expect limited, if any, acquisition activity for the remainder of the lodging cycle and we may increasingly evaluate opportunities to dispose of hotels that we believe have maximized their values.
Business Strategy
Our goal is to deliver strong total returns to our shareholders in the form of the appreciation of our assets and our ability to return funds to our shareholders in the form of dividends. We intend to pursue the following strategies to achieve this goal:
Identify and pursue value-added investments at our hotels.
We employ value-added strategies designed to improve the operating performance and value of our hotels. We have focused a significant portion of our efforts on identifying and pursuing investments to promote the competitive positioning and operations of our hotels, and we intend to continue our aggressive efforts in this regard. Examples include the approximate $7 million renovation and repositioning of the Hotel Adagio San Francisco in 2012, enabling the hotel to become part of the Marriott Autograph Collection; the approximate $5 million we spent in 2012 to create 35 additional guestrooms on the top two, previously vacant, floors of the W Chicago – City Center; and in 2014, the completion of three major investments, including the approximate $37 million comprehensive renovation at our W Chicago – Lakeshore, the approximate $25 million comprehensive renovation of our former W New Orleans to re-brand the hotel as the Le Meridien New Orleans, and the approximate $8 million comprehensive renovation of our former Holiday Inn New York City Midtown – 31st Street to re-brand the hotel as the Hyatt Herald Square New York.
Optimize the branding and management of our hotels.
We regularly evaluate opportunities to re-brand certain hotels by determining which brands are available in the market, seeking to quantify the potential improvement in revenue generation and profitability that a hotel might experience under a new brand. We analyze these opportunities by reviewing the revenue data of the local competitive set of hotels that are branded most similarly to the proposed new brand for the hotel, which data we obtain from a third party, STR. Based on this data, we project the expected revenue for the hotel with the new brand and use hotel industry standards for profit margins, and our own operating history, to calculate potential profits. We then compare the potential profits to the expected capital costs to bring the hotel into compliance with the standards of the proposed new brand to calculate a return on investment, which we use to determine whether it is in our shareholders’ interests to undertake the re-branding project. Examples of our deployment of this strategy can be found in the repositioning of the previously independent Hotel Adagio San Francisco to become part of the Marriott Autograph Collection in 2013, and the conversions of our former W New Orleans to the Le Meridien brand and our former Holiday Inn New York City Midtown – 31st Street to the Hyatt brand in 2014. Likewise, we continually evaluate the performance of the third parties managing each of our hotels and evaluate whether a hotel might perform better under different managerial control. In this regard, we review the operating performance of the hotel and compare that with its local competitive set and industry standards, as well as our experience in our dealings with the 10 management companies currently operating our hotels. In accordance with this strategy, we replaced the management company operating our two hotels located in New York in October 2016 and the brand management company operating our hotel located in Denver in December 2017. We will continue to pursue a change in a hotel’s management company when we determine the benefits of a change outweigh the costs.
Selectively expand our hotel portfolio through new investments.
We may continue our efforts to grow our business by acquiring additional hotels that meet our qualitative and quantitative investment criteria, which may change depending upon our assessment of, among other things, our cost of capital, liquidity, and expectations regarding future lodging industry fundamentals and macroeconomic conditions. We have and will continue to focus our efforts on upper-upscale hotels operating under national franchise brands located in the top 25 U.S. Metropolitan Statistical Areas, in close proximity to major market demand generators that are attractive to business travelers. Our team may continue to target acquisitions that we believe would strengthen the overall quality of our hotel portfolio and further diversify the portfolio by market, customer type and brand. While we anticipate that we would continue to focus on acquiring hotels that are proven leaders in market share, setting the rates in the market and providing superior meeting space, services or amenities, and in good physical condition, we may be opportunistic in evaluating acquisition opportunities that might involve near-term renovations, re-branding or management changes under the methods described above. From a financial perspective, we expect to be conservative in our underwriting of the potential returns on investment when evaluating any new acquisition opportunities, which we believe is prudent given the cyclical nature of the lodging industry, and the lack of certainty as to the duration of any growth period.
Evaluate opportunities to redeploy capital.
We regularly review the hotels in our portfolio to ensure that they continue to meet our investment criteria. If we were to conclude that a hotel’s value has been maximized, or that it no longer fits within our financial or strategic criteria, we may seek to sell the hotel and plan to use the proceeds, net of any retirement of related debt, to supplement our capital for use in future investments in our existing or new hotels or to reduce the Trust's overall leverage. In accordance with this strategy, we sold the Courtyard Anaheim at Disneyland Resort, an upscale hotel located in a market with a
significant increase in lodging supply expected, for $32.5 million in 2014 and used the net proceeds to partially fund the subsequent acquisition of the JW Marriott San Francisco Union Square, a high-quality hotel located in the favorable San Francisco market, for a purchase price of $147.2 million in 2014; and more recently, we sold The Hotel Minneapolis, Autograph Collection, a hotel located in a market that is continuing to experience a significant increase in lodging supply, for $46.0 million and used the net proceeds to repay outstanding debt.
Maintain our conservative capital structure to preserve financial flexibility.
Since our IPO in 2010, we have maintained discipline in targeting an overall debt level not to exceed 40% of the aggregate value of all of our hotels (as calculated in accordance with our revolving credit facility). At the same time, we have secured long-term, low interest rate financing on favorable terms. We believe our strong balance sheet offers us the dual benefit of the ability to move rapidly to capitalize on favorable investment opportunities, as well as to maintain or increase the level of dividends we pay our shareholders over time.
Hotel Operating Agreements
The following are general descriptions of our management agreements, franchise agreements and TRS lease agreements:
Management agreements
We have entered into management agreements with third parties to manage our hotels. Our hotel managers generally have sole responsibility and authority for the hotel’s day to day operations and provide all managerial and other hotel employees, oversee operations and maintenance, prepare reports, budgets and projections and provide other administrative and accounting support services. We structure our hotel management agreements to allow us to closely monitor the performance of our hotels and to ensure, among other things, that our third-party managers: (1) implement an approved business and marketing plan; (2) implement a disciplined capital expenditure program; and (3) establish and prudently spend appropriate furniture, fixtures and equipment (“FF&E”) reserves.
Our current management agreements generally provide for base management fees ranging from 2% to 4% of gross hotel revenues and incentive compensation if hotel operating income, as defined in the management agreements, exceeds certain performance thresholds. The incentive management fee is generally calculated as a percentage of hotel operating income after we have received a priority return on our investment in the hotel. The terms of our management agreements generally range from five to 20 years initially, with certain extension and renewal periods. In addition, we may, in certain circumstances, terminate each of the management agreements before the expiration of the initial term if the particular hotel fails to meet specified performance objectives, generally targeted levels of RevPAR and gross operating profit, for specified periods. In addition, certain management agreements impose conditions with respect to (1) levels of mortgage loan financing and (2) conveyances of the hotel or any direct or indirect interest therein to third parties.
Franchise agreements
Of our 21 current hotels, 11 operate pursuant to franchise agreements with hotel brand companies and 10 operate pursuant to management agreements with hotel brand companies that allow them to operate under their respective brands. Under the 11 franchise agreements, we generally pay a royalty fee ranging from 3% to 6% of room revenues and up to 3% of food and beverage revenues, plus additional fees for marketing, central reservation systems, and other franchisor costs that amount to between 1% and 5% of room revenues. The terms of our franchise agreements generally range from 10 to 20 years initially, with certain extension and renewal periods. The franchise agreements specify certain management, operational, recordkeeping, accounting, reporting and marketing standards and procedures with which we must comply. The agreements also obligate us to comply with the franchisor’s standards and requirements with respect to training of operational personnel, safety, maintaining specified insurance, the types of services and products ancillary to guest room services that may be provided by us, display of signs, and the type, quality and age of FF&E included in guest rooms, lobbies and other common areas. In addition, certain franchise agreements impose conditions with respect to (1) levels of mortgage loan financing and (2) conveyances of the hotel or any direct or indirect interest therein to third parties.
TRS lease agreements
Our TRS lease agreements are inter-company agreements between our property-owning subsidiaries and our TRS lessees. These agreements generally contain customary terms for third-party lease agreements, including customary terms regarding lease payments and other expenses.
Tax Status
We have elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we currently distribute at least 90% of our REIT taxable income (determined before the deduction for dividends paid and excluding any net capital gains) to our shareholders. We believe that we have operated and it is our current intention to continue to operate in satisfaction of these requirements and to meet the qualifications for taxation as a REIT. As a REIT, we generally will not be subject to federal income tax on that portion of our taxable income that is currently
distributed to shareholders. If we fail to qualify for taxation as a REIT in any taxable year, we will be subject to federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and may not be able to qualify as a REIT for four subsequent taxable years. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property, and to federal income and excise taxes on our undistributed taxable income. In addition, taxable income from activities conducted by our TRSs are subject to federal and state income taxes.
Seasonality
Demand in the lodging industry is affected by recurring seasonal patterns. For non-resort properties, demand is generally lower in the winter months due to decreased travel and higher in the spring and summer months during the peak travel season. For resort properties, demand is generally higher in the winter months. We expect that our operations will generally reflect non-resort seasonality patterns. Accordingly, we expect that we will have lower revenue, operating income and cash flow in the first and fourth quarters and higher revenue, operating income and cash flow in the second and third quarters. These general trends are, however, expected to be greatly influenced by overall economic cycles.
Competition
We believe that competition for the acquisition of hotels is highly fragmented. We face competition from institutional pension funds, private equity investors, other REITs and numerous local, regional, national, and foreign owners, including franchisors. Some of these entities may have substantially greater financial resources than we do and may be able and willing to accept more risk than we can prudently manage. Competition generally may increase the bargaining power of property owners seeking to sell and reduce the number of suitable investment opportunities offered to us.
The hotel industry is highly competitive. Our hotels compete with other hotels and, to a lesser extent, lodging alternatives (e.g., Airbnb, HomeAway and VRBO) for guests in each market in which we operate. Competitive advantage is based on a number of factors, including location, convenience, brand affiliation, room rates, range of services and guest amenities or accommodations offered, and quality of customer service. Competition is often specific to the individual market in which a hotel is located and includes competition from existing and new hotels operated under brands in the relevant segments. Increased competition could harm our occupancy, ADR and RevPAR, or may require us to provide additional amenities or make capital improvements that we otherwise would not have to make, which may reduce our profitability.
Regulation
Our hotels are subject to various covenants, laws, ordinances and regulations, including regulations relating to common areas and fire and safety requirements. We believe each of our hotels has the necessary permits and approvals to operate its business, and each is adequately covered by insurance.
Americans with Disabilities Act
Our hotels must comply with Title III of the Americans with Disabilities Act of 1990 (“ADA”) to the extent that such hotels are “public accommodations” as defined by the ADA. Under the ADA, all public accommodations must meet federal requirements related to access and use by disabled persons. The ADA may require removal of structural barriers to access by persons with disabilities in certain public areas of our hotels where such removal is readily achievable. Although we believe that the hotels in our portfolio substantially comply with present requirements of the ADA, we have not conducted a comprehensive audit or investigation of all of our hotels to determine our compliance, and one or more hotels may not be fully compliant with the ADA. Noncompliance with the ADA could result in the incurrence of additional costs to attain compliance. The obligation to make readily achievable accommodations is an ongoing one, and we will continue to assess our hotels and make alterations as appropriate in this respect.
Environmental matters
Our hotels are subject to various federal, state and local environmental laws that impose liability for contamination. Under these laws, governmental entities have the authority to require us, as the current owner of the property, to perform or pay for the cleanup of contamination (including hazardous substances, waste or petroleum products) at, on, under or emanating from the property and to pay for natural resource damages arising from such contamination. Such laws often impose liability without regard to whether the owner or operator or other responsible party knew of, or caused such contamination, and the liability may be joint and several. Because these laws also impose liability on persons who owned the property at the time it became contaminated, it is possible we could incur cleanup costs or other environmental liabilities even after we sell properties. Contamination at, on, under or emanating from our properties also may expose us to liability to private parties for costs of remediation and/or personal injury or property damage. In addition, environmental laws may create liens on contaminated sites in favor of the government for damages and costs it incurs to address such contamination. If contamination is discovered on our properties, environmental laws also may impose restrictions on the manner in which the property may be used or businesses may be operated, and these restrictions may require substantial expenditures. Moreover, environmental contamination can affect
the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property on favorable terms or at all.
Some of our properties may have contained historic uses which involved the use and/or storage of hazardous chemicals and petroleum products (
e.g.
, storage tanks, gas stations, dry cleaning operations) which, if released, could have impacted our properties. In addition, some of our properties may be near or adjacent to other properties that have contained or currently contain storage tanks containing petroleum products or conducted or currently conduct operations which utilize other hazardous or toxic substances. Releases from these adjacent or surrounding properties could impact our properties.
Independent environmental consultants have conducted Phase I environmental site assessments on all of the properties in our portfolio and we intend to conduct Phase I environmental site assessments on any properties we may acquire in the future. Phase I site assessments are intended to discover and evaluate information regarding the environmental condition of the surveyed property and surrounding properties. These assessments do not generally include soil samplings, subsurface investigations or an asbestos survey. None of the existing Phase I site assessments revealed any past or present environmental condition that we believe would have a material adverse effect on our business, assets or results of operations. However, the assessments may have failed to reveal all environmental conditions, liabilities or compliance concerns. Material environmental conditions, liabilities or compliance concerns may have arisen after the review was completed or may arise in the future; and future laws, ordinances or regulations may impose material additional environmental liability.
In addition, our hotels are subject to various federal, state, and local environmental, health and safety regulatory requirements that address a wide variety of issues, including, but not limited to, storage tanks, air emissions from emergency generators, storm water and wastewater discharges, lead-based paint, mold and mildew, and waste management. Some of our hotels routinely handle and use hazardous or regulated substances and wastes as part of their operations, which are subject to regulation (
e.g.
, swimming pool chemicals). Our hotels incur costs to comply with these environmental, health and safety laws and regulations and could be subject to fines and penalties for non-compliance with applicable laws. However, we are aware of no past or present environmental liability for non-compliance with environmental laws that we believe would have a material adverse effect on our business, assets or results of operations.
Certain hotels we currently own or those we acquire in the future contain, may contain, or may have contained, asbestos-containing material (“ACM”). Environmental, health and safety laws require that ACM be properly managed and maintained, and include requirements to undertake special precautions, such as removal or abatement, if ACM would be disturbed during maintenance, renovation, or demolition of a building. Such laws regarding ACM may impose fines and penalties on building owners, employers and operators for failure to comply with these requirements or expose us to third-party liability. However, we manage such ACM under asbestos operations and maintenance plans, which we have developed and implemented at each of our hotels where there is known ACM or for which suspected ACM is present.
When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Indoor air quality issues can also stem from inadequate ventilation, chemical contamination from indoor or outdoor sources, and other biological contaminants, such as pollen, viruses and bacteria. Indoor exposure to airborne toxins or irritants above certain levels can be alleged to cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold or other airborne contaminants at any of our properties could require us to undertake a costly remediation program to contain or remove the mold or other airborne contaminants from the affected property or increase indoor ventilation. In addition, the presence of significant mold or other airborne contaminants could expose us to liability from third parties if property damage or personal injury occurs. We are not presently aware of any indoor air quality issues at our properties that could result in a material adverse effect on our business, financial condition or results of operations.
Employees
As of February 9, 2018, we had 14 employees. All persons employed in the day to day operations of our hotels are employees of the management companies engaged by our TRS lessees to operate such hotels.
Available Information
We maintain an Internet site, www.chesapeakelodgingtrust.com, which contains additional information concerning the Trust. We make available free of charge through our Internet site our reports that have been filed or furnished with the Securities and Exchange Commission (the “SEC”) as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the SEC. We also post on our Internet site our Code of Business Conduct and Ethics, Principles of Corporate Governance, and the charters of our Audit, Compensation, and Nominating and Corporate Governance Committees of our board of trustees. We intend to disclose on our website any changes to, or waivers from, our Code of Business Conduct and Ethics. Information on our Internet site is neither part of nor incorporated into this Form 10-K.
Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition or results of operations could suffer, our ability to make cash distributions to our shareholders could be impaired, and the trading price of our common shares could decline. You should know that many of the risks described may apply to more than just the subsection in which we grouped them for the purpose of this presentation.
Risks related to our business and hotels
The lodging industry is highly cyclical in nature, and we cannot assure you if or how long the growth period of the current lodging cycle will last.
The performance of the lodging industry has historically been closely linked to the performance of the general economy and, specifically, growth in U.S. GDP. Fluctuations in lodging demand and, therefore, operating performance, are caused largely by changing general economic and local market conditions, which subsequently affect levels of business and leisure travel. The global economic downturn from late 2007 through 2009 led to a significant decline in demand for goods and services provided by the lodging industry, lowered occupancy levels and significantly reduced room rates. Demand for goods and services provided by the lodging industry generally trails improvement in economic conditions, but since 2010 and through 2017, the lodging industry has recovered faster and stronger than the U.S. economy generally, with industry-wide RevPAR increasing 57.2% over that period, as reported by STR. However, there can be no assurance of either any further increase in lodging demand from current levels or of the timing or extent of any such lodging demand growth. If lodging demand weakens, our operating results and profitability, and the value of our hotels, could be adversely affected. A slowdown in U.S. economic growth or contraction of the U.S. economy, if experienced, would likely have an adverse impact on our revenues and negatively affect our profitability.
In addition to general economic conditions, new lodging supply is an important factor that can affect the lodging industry’s performance and overbuilding has the potential to further exacerbate the negative impact of an economic downturn. After experiencing several years of significantly below historical average growth, lodging supply growth approached historical average levels with increases in lodging supply of 1.8% and 1.6% in 2017 and 2016, respectively, as reported by STR. Room rates and occupancy, and thus RevPAR, tend to increase when lodging demand growth exceeds lodging supply growth. When lodging supply growth exceeds lodging demand growth, occupancy tends to decrease and room rates and RevPAR can experience limited increases or even decrease. A reduction or slowdown in growth of lodging demand or increased growth in lodging supply could result in returns that are substantially below expectations or result in losses, which could have a material adverse effect on our business, financial condition, results of operations and cash available for distributions to our shareholders.
We may not be able to successfully grow our business or generate sufficient operating cash flows to sustain or increase distributions to our shareholders.
Our ability to grow our business and sustain or increase distributions to our shareholders depends on many factors, including the financial performance of our hotels, the availability of additional attractive acquisition opportunities that satisfy our investment strategies, and our success in identifying and consummating the acquisitions on favorable terms. We compete for investment opportunities with other lodging REITs and real estate investors, some of which have substantially greater financial resources than we do. This competition may limit the number of suitable investment opportunities offered to us or have the effect of increasing the bargaining power of hotel owners seeking to sell hotels, making it more difficult for us to acquire new hotels on attractive terms or at all. Our ability to commit to purchase specific properties will depend, in part, on the amount of our available cash and financial resources at a given time. We cannot assure you that we will be able to acquire hotels with attractive returns or will not seek hotels with greater risk to obtain the same level of returns. Furthermore, there can be no assurance that our current hotels will continue to generate sufficient operating cash flows to enable us to sustain or increase the amount or rate of distributions we make to our shareholders.
Because our officers have broad discretion to invest our available cash and the proceeds of financing transactions, they may make investments where the returns are substantially below expectations or which result in net operating losses.
Our officers have broad discretion, within the general investment policies established by our board of trustees, to invest our available cash and proceeds of financing transactions and to determine the timing of such investments. In addition, our investment policies may be amended or revised from time to time at the discretion of our board of trustees, without a vote of our shareholders. Such discretion could result in investments that may not yield returns consistent with investors’ expectations or with which you may not agree. These factors may increase the uncertainty, and thus the risk, of investing in our shares. Our failure to invest our available funds effectively, or to find suitable hotels to acquire in a timely manner or on acceptable terms, could result in returns that are substantially below expectations or result in losses, which could have a material adverse effect on our business, financial condition, results of operations, and cash available for distributions to our shareholders.
We cannot assure you that we will be able to identify additional assets that meet our investment objectives, that we will be successful in consummating any investment opportunities we identify, or that one or more investments we may make will generate revenue, income or cash flow. Our inability to do any of the foregoing could materially and adversely affect our results of operations and cash flows and our ability to make distributions to our shareholders.
Our success depends on key personnel whose continued service is not guaranteed.
We depend on the efforts and expertise of our president and chief executive officer, our executive vice president and chief financial officer, and our executive vice president and chief operating officer to manage our day to day operations and strategic business direction. The loss of their services, and our inability to find suitable replacements, could have an adverse effect on our operations.
Our returns could be negatively impacted if our third-party hotel managers do not manage our hotels in our best interests.
Since U.S. federal income tax laws restrict REITs and their subsidiaries from operating or managing a hotel, we do not operate or manage our hotels. Instead, we lease all of our hotels to our TRSs and our TRSs retain third-party managers to operate our hotels pursuant to management agreements. Our cash flow from the hotels may be adversely affected if our managers fail to provide quality services and amenities or if they, our hotel brand companies, or their respective affiliates fail to maintain a quality brand name. In addition, our hotel managers or their affiliates may manage, and in some cases may own, may have invested in or may have provided credit support or operating guarantees to hotels that compete with our hotels, any of which could result in conflicts of interest. As a result, our hotel managers may make decisions regarding competing lodging facilities that are not in our best interests.
We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel (for instance, setting room rates). Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, ADR and RevPAR, we are not able to force the management company to change its method of operation of our hotels. If necessary, we generally will attempt to resolve issues with our hotel managers through discussions and negotiations. However, if we are unable to reach satisfactory results through discussions and negotiations, we may choose to litigate the dispute or submit the matter to third-party dispute resolution. Our ability to seek redress against a management company for a violation of the terms of the applicable management agreement with our TRS may be limited by the terms of the applicable management agreement. In the event that we need to replace any of our management companies, we may be required by the terms of the management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels.
Funds spent to maintain licensed brand standards or the loss of a brand license may reduce cash available for shareholder distributions.
All of our hotels operate under licensed brands, either through management or franchise agreements with hotel brand companies that permit us to do so, and we anticipate that some of the hotels we acquire in the future also will operate under licensed brands. We are therefore subject to the risks inherent in concentrating our hotels in licensed brands owned by a limited number of hotel brand companies. These risks include reductions in business following negative publicity related to one of our licensed brands or the hotel brand company that owns one of our licensed brands, or arising from or after a dispute with a hotel brand company.
The maintenance of the brand licenses for our hotels is subject to the hotel brand companies’ operating standards and other terms and conditions. Hotel brand companies periodically inspect our hotels to ensure that we and our lessees and hotel managers follow their standards. Failure by us, our TRSs, or one of our hotel managers to maintain these standards or other terms and conditions could result in a brand license being terminated. If a brand license terminates due to our failure to make required improvements or to otherwise comply with its terms, we may also be liable to the hotel brand company for a termination payment, which will vary by hotel brand company and by hotel. As a condition of our continued holding of a brand license, a hotel brand company could also possibly require us to make capital expenditures, even if we do not believe the capital improvements are necessary or desirable or will result in an acceptable return on our investment. Nonetheless, we may risk losing a brand license if we do not make hotel brand company-required capital expenditures.
If a hotel brand company terminates the brand license, we may try either to obtain a suitable replacement brand or to operate the hotel without a brand license. Additional consolidation of hotel brand companies may further hinder our ability to find a suitable replacement brand by reducing the number of available alternatives. The loss of a brand license could materially and adversely affect the operations or the underlying value of the hotel because of the loss of associated name recognition, marketing support and centralized reservation systems provided by the hotel brand company. A loss of a brand license for one or more hotels could materially and adversely affect our revenues. This loss of revenues could, therefore, also adversely affect our financial condition, results of operations and cash available for distributions to our shareholders.
Our business may be adversely affected by consolidation in the lodging industry.
Consolidation among hotel brand companies or other participants in the lodging industry may increase the negotiating leverage of the resulting companies, which might result in us incurring increased franchise or management fees. Following the 2016 acquisition of Starwood Hotels & Resorts Worldwide, Inc. by Marriott International, Inc. ("Marriott"), our hotels primarily operate under licensed brands, each of which offer differing guest amenities and may be associated with different loyalty reward programs, owned by three main hotel brand companies. The consolidation of two or more hotel brand companies may cause our financial condition and results of operations to be even more dependent on the success and reputation of a limited number of owners of these licensed brands. As of February 9, 2018, 10 of our hotels are managed or franchised by Marriott; six of our hotels are managed or franchised by Hyatt Hotels; and three of our hotels are managed or franchised by Hilton Worldwide. In addition, to the extent that consolidation among hotel brand companies adversely affects the loyalty reward program offered by one or more of our hotels, customer loyalty to those hotels may suffer and demand for guestrooms may decrease. Furthermore, because each hotel brand company relies on its own network of reservation systems, hotel management systems and customer databases, the integration of two or more networks may result in a disruption to operations of these systems, such as disruptions in processing guest reservations, delayed bookings or sales, or lost guest reservations, which could adversely affect our financial condition, results of operations and cash available for distributions to our shareholders.
Our ability to maintain quarterly distributions to our shareholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.
As a REIT, we are required to distribute at least 90% of our REIT taxable income (determined before the deduction for dividends paid and excluding net capital gains) each year to our shareholders. Future downturns in our operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements which may be required by the hotel brand companies, may impact our ability to declare or pay distributions to our shareholders. The timing and amount of distributions are in the sole discretion of our board of trustees which considers, among other factors, our financial performance, debt service obligations and debt covenants, capital expenditure requirements, and the number of our shares outstanding. We intend to continue to pay regular quarterly dividends but cannot assure you that we will continue to generate sufficient cash in order to fund distributions in the same aggregate amounts as we have paid in the past or at all.
Among the factors which could adversely affect our results of operations and our distributions to shareholders is the failure of our TRSs to make required rent payments because of reduced net operating profits or operating losses, or increased debt service requirements and capital expenditures at our hotels, including capital expenditures required by the hotel brand companies. Among the factors which could reduce the net operating profits of our TRSs are decreases in hotel revenues and increases in hotel operating expenses. Hotel revenue can decrease for a number of reasons, including increased competition from a new supply of hotel rooms and decreased demand for hotel rooms. These factors can reduce both occupancy and room rates at our hotels.
We lease all of our hotels to our TRSs, and our TRSs are subject to hotel operating risks, including risks of sustaining operating losses after payment of hotel operating expenses, including management fees. These risks can adversely affect the net operating profits of our TRSs, our operating expenses, and cash available for distributions to our shareholders.
Compliance with covenants in our revolving credit facility, unsecured term loan, and other debt instruments may limit our freedom to operate our business and impair our ability to make distributions to our shareholders.
The terms of our revolving credit facility, unsecured term loan, and other debt instruments require us to comply with customary financial and other covenants, including covenants that:
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require us to maintain minimum debt service coverage ratios;
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require us to maintain minimum levels of tangible net worth;
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limit our ability to make certain investments;
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prevent us from incurring total debt in excess of a percentage of our total asset value;
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prohibit us from making annual distributions to our shareholders in excess of 90% of our funds from operations, or FFO, over time, except for such distributions as may be required to enable us to maintain our qualification as a REIT for U.S. federal income tax purposes, and prohibit us from making any distributions to shareholders while there is a continuing event of default;
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impose concentration limitations on the value and other characteristics of hotels comprising the borrowing base of the revolving credit facility and unsecured term loan; and
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limit our ability to engage in a change in control transaction without causing the amounts outstanding under the revolving credit facility and unsecured term loan to become immediately due and payable.
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These restrictions may interfere with our ability to obtain financing or to engage in other business activities, which may inhibit our ability to grow our business and increase revenues. If we fail to comply with any of these requirements, then the related indebtedness, and any other debt containing cross-default or cross-acceleration rights for our lenders, could become
immediately due and payable. We cannot assure you that we could pay all of our debt if it became due, or that we could continue in that instance to make distributions to our shareholders and maintain our REIT qualification.
Certain of our existing mortgage loan agreements contain “cash trap” provisions that
could limit our ability to make distributions to our shareholders.
Certain of our mortgage loan agreements contain cash trap provisions that may be triggered if the performance of the affected hotel or hotels declines. If the provisions in one or more of these mortgage loan agreements were triggered, substantially all of the cash flow generated by the hotel or hotels affected would be deposited into cash management accounts for the benefit of the lenders until the affected hotel or hotels' performance improved to the levels required in the mortgage loan agreements. If triggered, the lenders would use the cash in the cash management accounts to fund certain items, including debt service, deposits into reserves held in escrow for normal replacement of FF&E, property improvement plans, real estate taxes, and property insurance, and hotel operating expenses. As a result, if triggered, these cash trap provisions could affect our liquidity and our ability to make distributions to our shareholders.
If we are unable to repay or refinance our revolving credit facility, unsecured term loan, and other debt, we may be unable to sustain or increase distributions to our shareholders and our share price may be adversely affected.
Borrowings under our revolving credit facility, unsecured term loan, and our other existing and future debt subject us to many risks, including the risks that:
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our cash flow from operations will be insufficient to make required payments of principal and interest;
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our debt may increase our vulnerability to adverse economic and industry conditions;
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we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing cash available for distributions to our shareholders, funds available for operations and capital expenditures, future business opportunities or other purposes;
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the terms of any refinancing may not be as favorable as the terms of the debt being refinanced; and
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the terms of our debt may limit our ability to make distributions to our shareholders and therefore adversely affect the market price of our shares.
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If we do not have sufficient funds to repay our debt at maturity, it may be necessary to refinance this debt through additional debt financing, or from funds raised through private or public offerings of debt or equity securities. Adverse economic conditions could cause the terms on which we borrow or refinance to be unfavorable or otherwise impair our ability to raise necessary funds through the capital markets. If we are unable to refinance our debt on acceptable terms, we may be forced to dispose of hotels on disadvantageous terms or at times which may not permit us to receive an attractive return on our investments, potentially resulting in losses adversely affecting cash flow from operating activities. We have placed, and may continue to place, mortgages on our hotels to secure our debt. To the extent we cannot meet our debt service obligations, we risk losing some or all of those hotels to foreclosure.
Interest expense on our debt may limit our cash available to fund our growth strategies and shareholder distributions.
Higher interest rates could increase debt service requirements on floating rate debt and could reduce funds available for operations, distributions to our shareholders, future business opportunities or other purposes.
Failure to hedge effectively against interest rate changes may adversely affect our results of operations and our ability to make shareholder distributions.
We have obtained in the past, and may continue to seek in the future, various forms of interest rate protection-such as swap agreements, interest rate cap contracts or similar agreements-to hedge against the possible negative effects of interest rate fluctuations. However, we cannot assure you that any hedging will adequately mitigate the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations thereunder. In addition, we may be subject to risks of default by hedging counterparties.
Joint venture investments could be adversely affected by our lack of sole decision-making authority, our reliance on a co-venturer’s financial condition, and disputes between us and our co-venturers.
We may co-invest in the future with third parties through partnerships, joint ventures or other entities, acquiring non-controlling interests in or sharing responsibility for managing the affairs of a property, partnership, joint venture or other entity. In such event, we would not be in a position to exercise sole decision-making authority regarding the property, partnership, joint venture or other entity. Investments in partnerships, joint ventures or other entities may, under certain circumstances, involve risks not present were a third party not involved, including the possibility that partners or co-venturers might become bankrupt or fail to fund their share of required capital contributions. Partners or co-venturers may have economic or other business interests or goals which are inconsistent with our business interests or goals, and may be in a position to take actions contrary to our policies or objectives. Such investments may also have the potential risk of impasses on decisions, such as a sale, because
neither we nor the partner or co-venturer would have full control over the partnership or joint venture. Disputes between us and partners or co-venturers may result in litigation or arbitration that would increase our expenses and prevent our officers and/or trustees from focusing their time and effort on our business. Consequently, actions by, or disputes with, partners or co-venturers might result in subjecting hotels owned by the partnership or joint venture to additional risk. In addition, we may in certain circumstances be liable for the actions of our third-party partners or co-venturers.
We and our hotel managers rely on technology in our operations and failures, inadequacies, interruptions, security breaches or cyber-attacks affecting our service could harm our business.
The execution of our business strategy is heavily dependent on the use of technologies and systems, including the Internet, to access, store, transmit, deliver and manage information and processes. Although we believe we have taken commercially reasonable steps to protect the security of our systems, there can be no assurance that such security measures will prevent failures, inadequacies or interruptions in system services, or that system security will not be breached through physical or electronic break-ins, computer viruses and attacks by hackers. Disruptions in service, system shutdowns and security breaches could have a material adverse effect on our business.
Similarly, our third-party hotel managers are dependent on information technology networks and systems, including the Internet, to access, store, transmit, deliver and manage proprietary and customer information. These complex networks include reservation systems, hotel management systems, customer databases, call centers, administrative systems, and third-party vendor systems. These systems require the collection and retention of large volumes of personally identifiable information of hotel guests, including credit card numbers. Our hotel managers may store and process such proprietary and customer information both on systems located at the hotels we own and other hotels operated by our third-party managers, their corporate locations and at third-party owned facilities, including for example, in a third-party hosted cloud environment. These information networks and systems can be vulnerable to threats such as system, network or Internet failures; computer hacking or business disruption; cyber-terrorism; viruses, worms or other malicious software programs; and employee error, negligence or fraud. The risks from these cyber threats are significant. We rely on the security systems of our hotel managers to protect proprietary and customer information from these threats. Any compromise of our hotel managers’ networks could result in a disruption to operations, such as disruptions in fulfilling guest reservations, delayed bookings or sales, or lost guest reservations. Any of these events could, in turn, result in disruption of the operations of the hotels we own, in increased costs and in potential litigation and liability. We maintain insurance against cyber threats; however, these policies contain varying limits, and some claims may be subject to sublimits. As a result, we do not expect that these policies would provide a total recovery of all potential losses we might incur if a hotel manager's network were compromised. In addition, public disclosure, or loss of customer or proprietary information could result in damage to the hotel manager’s reputation and a loss of confidence among hotel guests and result in reputational harm for the hotels owned by us and managed by them, which may have a material adverse effect on our business.
Our ability to sustain the amount of distributions we make to our shareholders may be affected by various operating risks common to the lodging industry.
Our hotels are subject to various operating risks common to the lodging industry, many of which are beyond our control, including the following:
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competition from other hotels and lodging alternatives, including Airbnb, HomeAway and VRBO, in our markets;
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development of new hotels in our markets, which could adversely affect occupancy and revenues at the hotels we currently own or may acquire;
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dependence on business and commercial travelers and tourism;
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consolidation in the lodging industry;
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unfavorable changes in convention calendars in our markets which may negatively affect demand for guestrooms at our hotels in those markets;
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increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists;
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increases in operating costs due to inflation, increasing labor costs and other factors that may not be offset by increased room rates;
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changes in governmental laws and regulations, fiscal policies and zoning ordinances that may increase our costs of compliance with laws and regulations, fiscal policies and ordinances;
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adverse effects of international, national, regional and local economic and market conditions;
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the value of the U.S. dollar, or U.S. governmental laws, regulations, or executive orders, which may adversely affect the number of international business and commercial travelers and tourists entering the U.S. and in particular the gateway markets in which many of our hotels are located;
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unforeseen events beyond our control, such as terrorist attacks, travel related health concerns, including pandemics and epidemics, such as Zika, H1N1 influenza (swine flu), avian bird flu, SARS, and Ebola, civil unrest, political instability, regional hostilities, imposition of taxes or surcharges by regulatory authorities, travel related accidents and unusual weather patterns, including natural disasters, such as hurricanes, tsunamis, earthquakes, floods or fires;
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adverse effects of a downturn in the lodging industry; and
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risks generally associated with the ownership of hotels and real estate, as we discuss in detail below.
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These factors could reduce demand for rooms at our hotels, adversely affecting our operating results and adversely affecting the amount or frequency of distributions we make to our shareholders.
Our revenues and cash available for shareholder distributions may be affected by the seasonality of the hotel industry.
The hotel industry is seasonal in nature. This seasonality can be expected to cause quarterly fluctuations in our revenues. The first and fourth fiscal quarters tend to be our weaker periods. Our quarterly earnings may also be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to sustain the amount or quarterly rate of distributions we make to our shareholders.
The ongoing need for capital expenditures at our hotels may limit the amounts available for shareholder distributions.
Our hotels will require periodic renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment, in order to optimize their competitive position in their respective markets. Hotel brand companies, from whom we license brands for certain of our hotels, require periodic capital improvements as a condition of keeping the brand licenses. In addition, our hotel managers and lenders require that we set aside annual amounts for capital improvements to our hotels. These capital improvements may give rise to the following risks:
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construction cost overruns and delays;
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costly delays in or impediments to the receipt of zoning, occupancy and other required governmental permits and authorizations;
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a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms;
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uncertainties as to market demand or a loss of market demand after capital improvements have begun; and
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possible environmental problems.
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The costs of all these capital improvements could adversely affect our financial condition and cash available for distributions to our shareholders.
Hotel development is subject to timing, budgeting and other risks. To the extent we acquire hotels that are under development, these risks may adversely affect our operating results and may limit the amounts available for shareholder distributions.
We may in the future acquire hotels while they are under development if suitable opportunities arise, taking into consideration general economic conditions. Hotels involve a number of development risks, including risks associated with:
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construction delays or cost overruns that may increase project costs;
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receipt of zoning, occupancy and other required governmental permits and authorizations;
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development costs incurred for projects that are not pursued to completion;
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unusual weather patterns, including natural disasters, such as hurricanes, tsunamis, earthquakes, floods or fires that could adversely impact a project;
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ability to raise capital; and
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governmental restrictions on the nature or size of a project.
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To the extent we invest in hotels under development, we cannot assure you that any development project will be completed on time, within budget, or at all. The developer’s inability to complete a project on time or within budget may adversely affect the hotel’s projected operating results and limit amounts available for distributions to our shareholders.
In addition, we have made in the past and may in the future make loans to enable the developers to complete the project we have contracted to purchase. These loans might be subordinated to the developer’s primary construction financing, and therefore may expose us to risks of loss of some or all of the principal we have extended if the developer, despite our financing, is unable to complete the project timely or on budget. Any losses we incur on a loan we may extend in the future could have a material adverse effect on our financial condition, results of operations and cash available for distributions to our shareholders.
The hotel business is capital-intensive, and our inability to obtain financing could limit our growth.
Our hotels will require periodic capital expenditures and renovation to maximize their operating results in an increasingly competitive market. Acquisitions or development of additional hotels will require significant capital expenditures. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90% of our REIT taxable income (determined before the deduction for dividends paid and net of capital gains) each year to maintain our qualification as a REIT for U.S. federal income tax purposes. As a result, our ability to fund capital expenditures, acquisitions or hotel development through any retained earnings would be limited. Consequently, we rely upon
the availability of debt or equity capital to fund hotel acquisitions and improvements. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity financing which will depend on market conditions. Neither our declaration of trust nor our bylaws limits the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.
The use of Internet travel intermediaries by consumers may adversely affect our profitability.
Some of our hotel rooms are booked through Internet travel intermediaries, including, but not limited to, Travelocity.com, Hotels.com, Expedia.com, Priceline.com, Orbitz.com, and Booking.com. As these Internet bookings increase, these intermediaries may be able to obtain higher commissions, reduced room rates or other significant contract concessions from us and our hotel managers. Moreover, some of these Internet travel intermediaries are attempting to offer hotel rooms as a commodity, by increasing the importance of price and general indicators of quality (such as “three-star downtown hotel”) at the expense of brand identification. These intermediaries hope that consumers will eventually develop brand loyalties to their reservations system rather than to the brands under which our hotels are franchised. Although most of the business for our hotels is expected to be derived from traditional channels, if the amount of sales made through Internet intermediaries increases significantly, room revenues may flatten or decrease and our profitability could be adversely affected. In addition, the rise of social media reviews, including, but not limited to, tripadvisor.com, could impact our occupancy levels and results of operations as individuals might be more inclined to write about dissatisfaction than satisfaction with a hotel stay or experience.
Future terrorist attacks or changes in terror alert levels could adversely affect our growth strategies, our ability to obtain financing, our ability to insure our hotels, and our overall financial condition.
Previous terrorist attacks in the U.S. and subsequent terrorist alerts have adversely affected the travel and hospitality industries. The impact that terrorist attacks in the U.S. or elsewhere could have on domestic and international markets and our business in particular is indeterminable. It is possible that such attacks or the threat of such attacks could have a material adverse effect on our business, ability to finance our business, ability to insure our hotels, financial condition, results of operations, and/or cash available for distributions to our shareholders.
Uninsured and underinsured losses could adversely affect our operating results and the amount of cash available for distributions to our shareholders.
We maintain comprehensive insurance on each of the hotels we own, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. Various types of catastrophic losses, like hurricanes, tsunamis, earthquakes, floods and fires, losses from foreign terrorist activities, such as those on September 11, 2001, or losses from domestic terrorist activities, such as the Oklahoma City bombing on April 19, 1995, may not be fully insurable. With four hotels located in San Francisco, we are particularly sensitive to earthquake risks in that area.
In the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from the hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the hotel. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position on the damaged or destroyed hotel.
Noncompliance with governmental regulations could adversely affect our operating results.
Environmental matters
Our hotels are subject to various federal, state and local environmental laws. Although we have taken and will take commercially reasonable steps to assess the condition of our properties, there may be unknown environmental problems associated with our properties and we could become subject to strict, joint and several liability for any such contamination by virtue of our ownership interest. Under these environmental laws, courts and government agencies have the authority to require us, as the owner of a contaminated property, to clean up the property, even if we did not know of or were not responsible for the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property. Under the environmental laws, courts and government agencies also have the authority to require that a person who sent waste to a waste disposal facility, such as a landfill or an incinerator, pay for the cleanup of that facility if it becomes contaminated and threatens human health or the environment. A person that arranges for the disposal, transport 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.
Furthermore, various court decisions have established that third parties may recover damages for injury caused by property contamination. For instance, a person exposed to asbestos while staying in a hotel may seek to recover damages if he or she suffers injury from the asbestos. Lastly, some of these environmental laws restrict the use of a property or place conditions on various activities. An example would be laws that require a business using chemicals (such as swimming pool chemicals at a hotel) to manage them carefully and to notify local officials that the chemicals are being used.
The costs to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could adversely affect cash available for distributions to our shareholders. We can make no assurances that (1) future laws or regulations will not impose material environmental liabilities or (2) the current environmental condition of our hotels will not be affected by the condition of properties in the vicinity of our hotels (such as the presence of leaking underground storage tanks) or by third parties unrelated to us.
Americans with Disabilities Act and other changes in governmental rules and regulations
Under the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or in private litigants winning damages. Although we believe that our hotels substantially comply with present requirements of the ADA, we have not conducted a comprehensive audit or investigation of all of our hotels to determine our compliance, and one or more hotels may not be fully compliant with the ADA. Noncompliance with the ADA could result in the incurrence of additional costs to attain compliance. The obligation to make readily achievable accommodations is an ongoing one, and we will continue to assess our hotels and to make alterations as appropriate in this respect. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and cash available for distributions to our shareholders could be adversely affected.
We are subject to risks associated with the employment of hotel personnel, particularly with hotels that employ unionized labor, which could increase our operating costs, reduce the flexibility of our hotel managers to adjust the size of the workforce at our hotels and impair our ability to make distributions to our shareholders.
We have entered into management agreements with third-party hotel managers to operate our hotels. Our hotel managers are responsible for hiring and maintaining the labor force at each of our hotels. Although we do not directly employ or manage employees at our hotels, we are subject to many of the costs and risks generally associated with the hotel labor force. Increased labor costs due to factors like additional taxes, minimum wage increases or requirements to incur additional employee benefits costs may adversely impact our operating costs. Several local jurisdictions in the U.S. have enacted, or have announced they are considering, legislation increasing the minimum wage applicable to hotel workers in the jurisdiction. If a jurisdiction in which we own a hotel adopts such legislation, the cost to operate the hotel may increase significantly, which could have a material adverse effect on our business, financial condition, results of operations and cash available for distributions to our shareholders.
Labor costs can be particularly challenging at those of our hotels with unionized labor. From time to time, hotel operations may be disrupted as a result of strikes, lockouts, public demonstrations (which may target our non-union hotels as well as those employing unionized labor) or other negative actions and publicity. We also may incur increased legal costs and indirect labor costs as a result of contract disputes or other events. Additionally, hotels where our managers have collective bargaining agreements with employees are more highly affected by labor force activities than others. The resolution of labor disputes or re-negotiated labor contracts could lead to increased labor costs, either by increases in wages or benefits or by changes in work rules that raise hotel operating costs. Furthermore, labor agreements may limit the ability of our hotel managers to reduce the size of hotel workforces during an economic downturn because collective bargaining agreements are negotiated between the hotel managers and labor unions. We do not have the ability to control the outcome of these negotiations.
Illiquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our hotels and harm our financial condition.
Because real estate investments are relatively illiquid, our ability to promptly sell one or more hotels in our portfolio in response to changing economic, financial and investment conditions may be limited. The real estate market is affected by many factors that are beyond our control, including:
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adverse changes in international, national, regional and local economic and market conditions;
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changes in interest rates and in the availability, cost and terms of debt financing;
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changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;
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the ongoing need for capital improvements, particularly in older structures;
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changes in operating expenses; and
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civil unrest, unusual weather patterns, including natural disasters such as hurricanes, tsunamis, earthquakes, floods or fires, which may result in uninsured losses, and acts of war or terrorism, including the consequences of the terrorist acts, such as those that occurred on September 11, 2001.
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If the investment no longer meets our ownership criteria or objectives, we may decide in the future to sell one or more of our hotels. We cannot predict whether we will be able to sell any hotel for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel.
We may be required to expend funds to correct defects or to make improvements before a hotel can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel, we may agree to lock-out provisions that materially restrict us from selling that hotel for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that hotel. These factors and any others that would impede our ability to respond to adverse changes in the performance of our hotels could have a material adverse effect on our financial condition, results of operations, and cash available for distributions to our shareholders.
Increases in our property taxes would adversely affect the amount of cash available for distributions to our shareholders.
Each of our hotels is subject to property taxes. These taxes on our hotels may increase as tax rates change and as the hotels are assessed or reassessed by taxing authorities. If property taxes increase, the amount of cash available for distributions to our shareholders may decrease.
From time to time we may be subject to litigation, which could have a material adverse effect on our financial condition, our results of operations, our cash flow and the trading price of our common shares.
Although our hotel managers are generally responsible for all aspects of the operation of our hotels, and to indemnify us for any losses resulting from litigation arising from such operations, from time to time we may be subject to litigation. Some of these claims may result in defense costs, settlements, fines or judgments against us, some of which are not, or cannot be, covered by insurance. Payment of any such costs, settlements, fines or judgments that are not insured could have a material adverse effect on our financial position, results of operations and cash available for distributions to our shareholders. In addition, certain litigation or the resolution of certain litigation may affect the availability or cost of some of our insurance coverage, which could adversely impact our results of operations and cash flows, expose us to increased risks that would be uninsured, and/or adversely impact our ability to attract officers and trustees.
Risks related to our organization and structure
Our rights and the rights of our shareholders to take action against our trustees and officers are limited, which could limit your recourse in the event of actions not in your best interests.
Under Maryland law generally, a trustee is required to perform his or her duties in good faith, in a manner he or she reasonably believes to be in our best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances. Under Maryland law, trustees are presumed to have acted with this standard of care. In addition, our declaration of trust limits the liability of our trustees and officers to us and our shareholders for money damages, except for liability resulting from:
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actual receipt of an improper benefit or profit in money, property or services; or
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active and deliberate dishonesty by the trustee or officer that was established by a final judgment as being material to the cause of action adjudicated.
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Our declaration of trust obligates us to indemnify our trustees and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each trustee or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made, or threatened to be made, a party by reason of his or her service to us. In addition, we are obligated under our declaration of trust and bylaws, and pursuant to contracts with each of them, to pay and advance the defense costs that may be incurred by our trustees and officers. As a result, we and our shareholders may have more limited rights against our trustees and officers than might otherwise exist absent the current provisions in our declaration of trust and bylaws or that might exist with other companies.
Changes to U.S. federal income tax laws could materially and adversely affect us and our shareholders.
The recently enacted Tax Cuts and Jobs Act of 2017 (the “Tax Cuts and Jobs Act”) may affect REITs generally, the geographic markets in which we operate, the trading price of our common shares and our results of operations, both positively and negatively in ways that are difficult to anticipate. The Tax Cuts and Jobs Act makes significant changes to corporate and individual income tax rates and the calculation of income taxes, as well as international tax rules for U.S. domestic corporations. As a REIT, we are generally not required to pay federal income taxes otherwise applicable to regular corporations if we comply with the various tax regulations governing REITs. Our shareholders, however, are generally required to pay income taxes on REIT dividends. The Tax Cuts and Jobs Act will affect the way in which shareholders are taxed on dividends received from owning our common shares and could impact the trading price of our common shares. In addition, because the Tax Cuts and Jobs Act lowers corporate income tax rates, investments in REITs may now be relatively less attractive than they
previously were. The Tax Cuts and Jobs Act also imposes certain additional limitations on the deduction of net operating losses, which may in the future cause us to be required to make distributions that will be taxable to our shareholders to the extent of our current or accumulated earnings and profits in order to comply with the annual REIT distribution requirements. In addition, while certain elements of the Tax Cuts and Jobs Act will not impact us directly as a REIT, they could impact the geographic markets in which we operate and the guests who stay at our hotels in ways, both positive and negative, that are difficult to anticipate.
Furthermore, many of the provisions of the Tax Cuts and Jobs Act will require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. At any time, new legislation, administrative guidance, or court decisions, in each case possibly with retroactive effect, may make it more difficult or impossible for us to qualify as a REIT.
Failure to make required distributions would subject us to tax.
In order for U.S. federal income tax not to apply to earnings that we distribute, each year we must pay out to our shareholders in distributions at least 90% of our REIT taxable income (determined before the dividends paid deduction and excluding any net capital gains). To the extent that we satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to U.S. federal income tax on our undistributed REIT taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under U.S. federal tax laws. Our only source of funds to make these distributions comes from distributions that we receive from the Operating Partnership. Accordingly, we may be required to borrow money or sell assets to make distributions sufficient to enable us to pay out enough of our REIT taxable income to satisfy the distribution requirement and to avoid U.S. federal income tax and the 4% nondeductible excise tax in a particular year. To the extent that the terms of our revolving credit facility, unsecured term loan or other debt obligations limit our ability to distribute sufficient REIT taxable income to comply with these distribution requirements, we could be subject to some U.S. federal income tax or even fail to qualify as a REIT.
Failure to qualify, or failure to remain qualified, as a REIT would subject us to U.S. federal income tax and potentially to additional state and local taxes.
We have been organized and we intend to continue to operate in a manner that will enable us to maintain our qualification as a REIT for U.S. federal income tax purposes. The REIT qualification requirements are extremely complex and interpretations of the U.S. federal income tax laws governing qualification as a REIT are limited. Accordingly, we cannot be certain that we will be successful in operating so we can qualify, or remain qualified, as a REIT.
To qualify as a REIT, we are required to satisfy several asset and income tests. Our ability to satisfy the asset tests depends upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Accordingly, there can be no assurance that the U.S. Internal Revenue Service (the “IRS”) will not contend that our TRS lease agreements, interests in subsidiaries, or interests in securities of other issuers will not cause a violation of the REIT requirements.
If we fail to qualify as a REIT in any taxable year, we will be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our REIT taxable income at regular corporate rates, and dividends paid to our shareholders would not be deductible by us in computing our REIT taxable income. In addition, we could, in certain circumstances, be required to pay an excise or penalty tax (which could be significant in amount) in order to utilize one or more relief provisions under the Internal Revenue Code to maintain our qualification as a REIT. We might need to borrow money or sell hotels in order to pay any such tax. Unless we are entitled to relief under certain Internal Revenue Code provisions, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT.
Dividends payable by REITs do not qualify for the reduced tax rates available for some dividends, which could adversely affect the value of our common shares if they are perceived as less attractive investments.
A maximum 20% tax rate applies to “qualified” dividends payable to individual U.S. shareholders. Dividends payable by REITs, however, are generally not qualified dividends eligible for the reduced rates and are taxed at normal ordinary income tax rates, although non-corporate shareholders may be eligible to take a qualified business income deduction in an amount equal to 20% of the dividends received from us. However, to the extent such dividends are attributable to certain dividends that we receive from one of our taxable REIT subsidiaries, such dividends generally will be eligible for the reduced rates that apply to qualified dividends. The more favorable rates applicable to regular corporate dividends could cause investors who are individuals to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our common shares.
If our TRS lease agreements are not respected as true leases for U.S. federal income tax purposes, we would fail to qualify as a REIT.
One of the requirements for us to qualify as a REIT is that we are required to satisfy two gross income tests, pursuant to which specified percentages of our gross income must be passive income, such as rent. For the rent paid pursuant to the hotel leases with our TRSs, which constitutes substantially all of our gross income, to qualify for purposes of the gross income tests, the TRS lease agreements must be respected as true leases for U.S. federal income tax purposes and must not be treated as service contracts, joint ventures or some other type of arrangement. We attempt to structure our TRS lease agreements so that the leases will be respected as true leases for U.S. federal income tax purposes, but there can be no assurance that the IRS will agree with this characterization. If our TRS lease agreements are not respected as true leases for U.S. federal income tax purposes, we will not be able to satisfy either of the two gross income tests applicable to REITs and likely would lose our REIT qualification for U.S. federal income tax purposes.
If our TRSs fail to qualify as a “taxable REIT subsidiary” under the Internal Revenue Code, we would fail to qualify as a REIT.
Rent paid by a lessee that is a “related party tenant” of ours is not qualifying income for purposes of the two gross income tests applicable to REITs. We lease all of our hotels to our TRSs. So long as any TRS lessee qualifies as a TRS, it will not be treated as a “related party tenant” with respect to our hotels that are managed by a qualifying independent hotel management company. We believe that each of our TRSs qualify to be treated as a TRS for U.S. federal income tax purposes, but there can be no assurance that the IRS will not challenge the status of our TRSs for U.S. federal income tax purposes or that a court would not sustain such a challenge. If the IRS were successful in disqualifying one or more of our TRSs from treatment as a TRS, it is possible that we would fail to meet the asset tests applicable to REITs and substantially all of our income would fail to qualify for the gross income tests. If we failed to meet either the asset or gross income tests, we would likely lose our REIT qualification for U.S. federal income tax purposes.
If our hotel managers do not qualify as “eligible independent contractors,” or if our hotels are not “qualified lodging facilities,” we would fail to qualify as a REIT.
Each hotel with respect to which our TRS lessees pay rent must be a “qualified lodging facility.” A “qualified lodging facility” is a hotel, motel, or other establishment more than one-half of the dwelling units in which are used on a transient basis, including customary amenities and facilities, provided that no wagering activities are conducted at or in connection with such facility by any person who is engaged in the business of accepting wagers and who is legally authorized to engage in such business at or in connection with such facility. We believe that all of the hotels leased to our TRSs are qualified lodging facilities. Although we intend to monitor future acquisitions and improvements of hotels, the REIT provisions of the Internal Revenue Code provide only limited guidance for making determinations under the requirements for qualified lodging facilities, and there can be no assurance that these requirements will be satisfied in all cases.
If our hotel managers do not qualify as “eligible independent contractors,” we will likely fail to qualify as a REIT for U.S. federal income tax purposes. Each of the hotel management companies that enters into a management contract with one of our TRSs must qualify as an “eligible independent contractor” under the REIT rules in order for the rent paid to us by our TRSs to be qualifying income for our REIT income test requirements. Among other requirements, in order to qualify as an eligible independent contractor, a hotel manager must not own more than 35% of our outstanding shares (by value) and no person or group of persons can own more than 35% of our outstanding shares and the ownership interests of the hotel manager, taking into account only owners of more than 5% of our shares and, with respect to ownership interests in such hotel managers that are publicly traded, only holders of more than 5% of such ownership interests. Complex ownership attribution rules apply for purposes of these 35% thresholds. Although we monitor ownership of our shares by our hotel managers and their owners, and certain provisions of our declaration of trust are designed to prevent ownership of our shares in violation of these rules, there can be no assurance that these ownership levels will not be exceeded.
Provisions of our declaration of trust may limit the ability of a third party to acquire control of the Trust, even if our shareholders believe the change of control is in their best interest.
Common share and preferred share ownership limits
Our declaration of trust provides that, unless an exemption were to be granted by our board of trustees, no person may directly or indirectly own more than 9.8% in value or in number of shares, whichever is more restrictive, of the aggregate outstanding common shares or more than 9.8% in value or in number of shares, whichever is more restrictive, of the aggregate preferred shares of any class or series then outstanding. These ownership limitations, as well as certain other limits intended to protect our REIT qualification, may prevent an acquisition of control of the Trust by a third party without our board of trustees’ approval, even if our shareholders believe the change of control is in their interest.
Authority to issue shares of beneficial interest
Our declaration of trust authorizes our board of trustees to issue up to 400,000,000 common shares and up to 100,000,000 preferred shares without approval of our shareholders. The board’s authority to issue additional shares and to determine the rights of any series of preferred shares without shareholder approval could be used as an anti-takeover defense. For example, our board could create a new series of preferred shares with special voting, conversion, or control rights that could make a takeover more difficult. Accordingly, issuances of additional shares may have the effect of delaying or preventing a change in control of the Trust, including transactions at a premium over the then-prevailing market price of our common shares, even if shareholders believe that a change of control is in their interest.
Certain provisions of Maryland law could inhibit changes in control
Certain provisions of Maryland law may have the effect of deterring a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide the holders of our common shares with the opportunity to realize a premium over the then-prevailing market price of our common shares. The “business combination” provisions of Maryland law generally prohibit certain business combinations (including a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities) between us and an “interested shareholder” (defined generally as any person who beneficially owns 10% or more of our then outstanding voting shares or an affiliate or associate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of our then outstanding voting shares) or an affiliate thereof for five years after the most recent date on which the shareholder becomes an interested shareholder. After the five-year prohibition, any business combination between us and an interested shareholder generally must be recommended by our board of trustees and approved by the affirmative vote of at least (1) 80% of the votes entitled to be cast by holders of our outstanding voting shares; and (2) two-thirds of the votes entitled to be cast by holders of our outstanding voting shares of other than shares held by the interested shareholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested shareholder. These super-majority vote requirements do not apply if our common shareholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested shareholder for its shares. These provisions of Maryland law do not apply, however, to business combinations that are approved or exempted by a board of trustees prior to the time that the interested shareholder becomes an interested shareholder. Pursuant to the statute, our board of trustees has by resolution exempted business combinations between us and any other person, provided that such business combination is first approved by our board of trustees (including a majority of our trustees who are not affiliates or associates of such person), and such resolution may not be repealed, amended or altered without the approval by the shareholders of the Trust. Further, under our declaration of trust, a trustee may be removed at any time, but only with cause, at a meeting of the shareholders by the affirmative vote of the holders of not less than two-thirds of the shares then outstanding and entitled to vote generally in the election of trustees.
The “control share” provisions of Maryland law provide that “control shares” of a Maryland corporation (defined as shares which, when aggregated with other shares controlled by the shareholder (except solely by virtue of a revocable proxy), entitle the shareholder to exercise one of three increasing ranges of voting power in electing trustees) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our shareholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, our officers and our personnel who are also our trustees. Our bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of our common shares. Our bylaws prohibit the repeal, amendment or alteration of this provision without the approval by the shareholders of the Trust; however, there can be no assurance that this provision will not be amended or eliminated at some time in the future.
The “unsolicited takeover” provisions of Maryland law permit our board of trustees, without shareholder approval and regardless of what is currently provided in our declaration of trust or bylaws, to implement takeover defenses, some of which (for example, a classified board of trustees) we do not yet have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring or preventing a change in control of us under the circumstances that otherwise could provide the holders of our common shares with the opportunity to realize a premium over the then-current market price. Our board has resolved to opt out of the “unsolicited takeover” provisions of Maryland law, and that resolution may not be repealed absent the approval by the shareholders of the Trust; however, there can be no assurance that the resolution adopted by the board will not be amended or eliminated at some time in the future.
Our ownership limitations may restrict or prevent you from engaging in certain transfers of our shares.
In order to maintain our REIT qualification, no more than 50% in value of our outstanding shares may be owned, directly or indirectly, by five or fewer individuals (as defined in the U.S. federal income tax laws to include certain entities) at any time during the last half of each taxable year following our first year. To preserve our REIT qualification, our declaration of trust contains a common share ownership limit and a preferred share ownership limit and other related limitations on transfer. Generally, any common shares owned by affiliated owners will be added together for purposes of the common share ownership
limit, and any shares of a given class or series of preferred shares owned by affiliated owners will be added together for purposes of the preferred share ownership limit.
If anyone transfers shares in a way that would violate the common share ownership limit or the preferred share ownership limit, or prevent us from continuing to qualify as a REIT under the U.S. federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the common share ownership limit or the preferred share ownership limit. If this transfer to a trust fails to prevent such a violation or our continued qualification as a REIT, then the initial intended transfer shall be null and void from the outset. The intended transferee of those shares will be deemed never to have owned the shares. Anyone who acquires shares in violation of the common share ownership limit or the preferred share ownership limit or the other restrictions on transfer in our declaration of trust bears the risk of suffering a financial loss when the shares are redeemed or sold if the market price of our shares falls between the date of purchase and the date of redemption or sale.
Our ownership of our TRSs will be limited and our transactions with our TRSs will cause us to be subject to a 100% penalty tax on certain income or deductions if those transactions are not conducted on arm’s-length terms.
A REIT may own up to 100% of the equity interest of an entity that is a corporation for U.S. federal income tax purposes if the entity is a TRS. A TRS may hold assets and earn income that would not be qualifying assets or income if held or earned directly by a REIT, including gross operating income from hotel operations pursuant to hotel management agreements. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation.
Our TRSs will pay U.S. federal income tax and applicable state and local income tax on its taxable income, and its after-tax net income will be available for distribution to us but is not required to be distributed by such TRSs to us. We believe that the aggregate value of the stock and securities of our TRSs have been and will be less than 20% of the value of our total assets (including our TRSs’ stock and securities). Furthermore, we monitor the value of our investments in our TRSs for the purpose of ensuring compliance with TRS ownership limitations. There can be no assurance, however, that we will be able to comply with the TRS ownership limitations discussed above.
Rents paid to us by our TRSs may not be based on net income or profits to qualify as “rents from real property.” We receive “percentage rents” calculated based on gross revenues of the hotels subject to leases to our TRSs - not on net income or profits. We believe our rents reflect normal business practices in this regard but there can be no assurance the IRS will agree.
If the IRS determines that the rents charged under our leases with our TRSs are excessive, their deductibility may be challenged at the TRS level, and we could be subject to a 100% excise tax on “re-determined rent” or “re-determined deductions” to the extent rents exceed an arm’s length amount. We believe our rents reflect normal business practices in this regard but there can be no assurance the IRS will agree.
U.S. federal income tax provisions applicable to REITs may restrict our business decisions regarding the potential sale of a hotel.
The U.S. federal income tax provisions applicable to REITs provide that any gain realized by a REIT on the sale of property held as inventory or other property held primarily for sale to customers in the ordinary course of business is treated as income from a “prohibited transaction” that is subject to a 100% excise tax. Under existing law, whether property, including hotels, is held as inventory or primarily for sale to customers in the ordinary course of business is a question of fact that depends upon all of the facts and circumstances with respect to the particular transaction. We intend to hold our hotels for investment with a view to long-term appreciation, to engage in the business of acquiring and owning hotels, and to make occasional sales of hotels consistent with our investment objectives. There can be no assurance, however, that the IRS might not contend that one or more of these sales are subject to the 100% excise tax. Moreover, the potential application of this penalty tax could deter us from selling one or more hotels even though it otherwise would be in the best interests of us and shareholders for us to do so. There is a statutory safe harbor available for a limited number of sales in a single taxable year of properties that have been owned by a REIT for at least two years, but that safe harbor likely would not apply to all sales transactions that we might otherwise consider. As a result, we may not be able to vary our portfolio promptly in response to economic or other conditions or on favorable terms, which may adversely affect us.
Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.
The REIT provisions of the Internal Revenue Code substantially limit our ability to hedge our liabilities. Any income from a hedging transaction we enter into to manage risk of interest rate changes with respect to borrowings made or to be made to acquire or carry real estate assets does not constitute “gross income” for purposes of the 75% or 95% gross income tests. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-
qualifying income for purposes of both of the gross income tests. As a result of these rules, we may need to limit our use of advantageous hedging techniques or implement those hedges through a TRS. This could increase the cost of our hedging activities because the TRSs would be subject to tax on gains or expose us to greater risks associated with changes in interest rates than we would otherwise want to bear. In addition, losses generated by our TRSs will generally not provide any tax benefit, except for being carried forward against future taxable income generated by those TRSs.
The ability of our board of trustees to revoke our REIT qualification without shareholder approval may cause adverse consequences to our shareholders.
Our declaration of trust provides that our board of trustees may revoke or otherwise terminate our REIT election, without the approval of our shareholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. If we cease to be a REIT, we would become subject to U.S. federal income tax on our REIT taxable income and would no longer be required to distribute most of our REIT taxable income to our shareholders, which may have adverse consequences on our total return to our shareholders.
The ability of our board of trustees to change our major corporate policies may not be in your interest.
Our board of trustees determines our major corporate policies, including our acquisition, disposition, financing, growth, operations and distribution policies. Our board may amend or revise these and other policies from time to time without the vote or consent of our shareholders.
If we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud. As a result, our shareholders could lose confidence in our financial results, which could harm our business and the trading price of our common shares.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We may in the future discover areas of our internal control that need improvement. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal control over financial reporting and have our independent auditors annually issue their own opinion on our internal control over financial reporting. Though we invest substantial resources in maintaining adequate control over our financial reporting and financial processes, we cannot be certain that we will be successful. Furthermore, as we grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective. If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the market value of our shares. Additionally, the existence of any material weakness or significant deficiency would require management to devote significant time and incur significant expense to remediate any such material weaknesses or significant deficiencies and management may not be able to remediate any such material weaknesses or significant deficiencies in a timely manner.
Risks related to share ownership
We may be unable to generate sufficient cash flows from our operations to make distributions to our shareholders at any time in the future.
We are generally required to distribute to our shareholders at least 90% of our REIT taxable income (subject to certain adjustments and excluding any net capital gains) each year for us to maintain our qualification as a REIT under the Internal Revenue Code, which requirement we currently intend to satisfy, and we must distribute 100% of our REIT taxable income, including capital gains, to eliminate U.S. federal tax liability. To the extent we satisfy the 90% distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to U.S. federal income tax on our undistributed REIT taxable income.
Subject to maintaining our REIT qualification, we intend to continue to make regular quarterly distributions to our shareholders, but no assurances can be made that we will continue to generate sufficient income to distribute aggregate amounts in the future similar to those distributed in the past. Our board of trustees has the sole discretion to determine the timing, form and amount of any distributions to our shareholders. Our board of trustees will make determinations regarding distributions based upon, among other factors, our historical and projected results of operations, financial condition, cash flows and liquidity, maintenance of our REIT qualification and other tax considerations, capital expenditure and other expense obligations, debt covenants, contractual prohibitions or other limitations and applicable law and such other matters as our board of trustees may deem relevant from time to time. The per share amount of future distributions also will be affected by the number of common and preferred shares that are outstanding from time to time.
Among the factors that could impair our ability to make distributions to our shareholders are:
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our inability to invest our available cash;
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our inability to realize attractive risk-adjusted returns on our investments;
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unanticipated expenses that reduce our cash flow;
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defaults in our investment portfolio or decreases in the value of the underlying assets; and
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the fact that anticipated operating expense levels may not prove accurate, as actual results may vary from estimates.
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As a result, no assurance can be given that the level of any distributions we make to our shareholders in the future will achieve a market yield or increase or even be maintained over time, any of which could materially and adversely affect the market price of our shares.
In addition, distributions that we make to our shareholders will generally be taxable to our shareholders as ordinary income. However, a portion of our distributions may be designated by us as long-term capital gains to the extent that they are attributable to capital gain income recognized by us or may constitute a return of capital to the extent that they exceed our earnings and profits as determined for tax purposes. A return of capital is not taxable, but has the effect of reducing the basis of a shareholder’s investment in our shares.
The market price of our shares may vary substantially, which may cause the value of your investment to fluctuate.
The trading prices of equity securities issued by REITs have historically been affected by changes in market interest rates. One of the factors that may influence the price of our shares in public trading markets is the annual yield from distributions on our common or preferred shares as compared to yields on other financial instruments. An increase in market interest rates, or a decrease in our distributions to shareholders, may lead prospective purchasers of our shares to demand a higher annual yield, which could reduce the market price of our shares.
Other factors that could affect the market price of our shares include the following:
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actual or anticipated variations in our quarterly results of operations;
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changes in market valuations of companies in the hotel or real estate industries;
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changes in expectations of future financial performance or changes in estimates of securities analysts;
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fluctuations in stock market prices and volumes;
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issuances of common or preferred shares or other securities in the future;
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the addition or departure of key personnel;
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announcements by us or our competitors of acquisitions, investments or strategic alliances; and
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unforeseen events beyond our control, such as terrorist attacks, travel related health concerns including pandemics and epidemics, such as Zika, H1N1 influenza (swine flu), avian bird flu, SARS, and Ebola, civil unrest, political instability, regional hostilities, increases in fuel prices, imposition of taxes or surcharges by regulatory authorities, travel related accidents and unusual weather patterns, including natural disasters, such as hurricanes, tsunamis, earthquakes, floods or fires.
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Future issuances of our common shares may depress the market price of our common shares and have a dilutive effect on our existing shareholders.
From time to time we may issue common shares to raise capital or for other business purposes. Future issuances, or the issuance of our common shares in connection with future hotel or business acquisitions, or the perception that such issuances might occur, may cause the market price of our common shares to decline. In addition, future issuances of our common shares may be dilutive to existing shareholders.
Our share repurchase program could affect the price of our common shares and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our common shares.
In September 2015, we announced that our board of trustees authorized the repurchase of up to $100.0 million of our outstanding common shares. Under the share repurchase program, we are authorized to repurchase, from time-to-time, our outstanding common shares on the open market or in privately negotiated transactions in the U.S. The timing and amount of share repurchases will be determined based upon our evaluation of market conditions and other factors. The share repurchase program may be suspended, modified or discontinued at any time, and we have no obligation to repurchase any amount of our common shares under the program. Repurchases pursuant to our share repurchase program could affect our share price and increase the volatility of the trading of our common shares. The existence of a share repurchase program could also cause our share price to be higher than it would be in the absence of such a program and could potentially reduce the market liquidity for our shares. There can be no assurance that any share repurchases will enhance shareholder value because the market price of our common shares may decline below the levels at which we repurchased shares of common shares. Although our share repurchase program is intended to enhance long-term shareholder value, short-term share price fluctuations could reduce the program’s effectiveness. As of the date of this report, we have not repurchased any of our outstanding common shares under the share repurchase program and there can be no assurance that any of our outstanding common shares will be repurchased under the program in the future.
Future issuances of debt or equity securities ranking senior to our shares may adversely affect the market price of our shares.
In the future, we may decide to issue equity securities ranking senior to our common shares. In addition, we may decide to issue debt securities in the future ranking senior to our common and any preferred shares, and it is possible that these securities will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Additionally, any convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common shares and may result in dilution to owners of our common shares. We and, indirectly, our shareholders, will bear the cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in the future will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of any future issuances. Thus holders of our shares will bear the risk of future issuances reducing the market price of our shares, lowering the per share amount of distributions we may pay and diluting the value of their investment in us.
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Item 1B.
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Unresolved Staff Comments
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None.