UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K [X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the Fiscal Year Ended December 31, 1996 OR [ ]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934 [NO FEE REQUIRED] Commission File Number 1-11527 HOSPITALITY PROPERTIES TRUST Maryland 04-3262075 (State of incorporation) (IRS Employer Identification No.) 400 Centre Street, Newton, Massachusetts 02158 617-964-8389 Securities registered pursuant to Section 12(b) of the Act: Class Name of each exchange on which registered Common Shares of Beneficial Interest New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the voting stock of the registrant held by non-affiliates was $734,515,113 based on the $32.50 closing price per share for such stock on the New York Stock Exchange on March 26, 1997. For purposes of this calculation, 264,595 Common Shares of Beneficial Interest, $0.01 par value ("Shares") held by HRPT Advisors, Inc. ("Advisors"), 4,000,000 Shares held by Health and Retirement Properties Trust ("HRP"), and an aggregate of 6,335 shares held by the trustees and officers of the registrant, have been included in the number of shares held by affiliates. Number of the registrant's Shares, outstanding as of March 26, 1997: 26,871,395
DOCUMENTS INCORPORATED BY REFERENCE Part III of this Annual Report on Form 10-K is incorporated herein by reference from the definitive Proxy Statement of Hospitality Properties Trust (the "Company") dated March 28, 1997 for its annual meeting of shareholders currently scheduled to be held on May 20, 1997. --------------- CERTAIN IMPORTANT FACTORS The Company's Annual Report on Form 10-K contains statements which constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Those statements appear in a number of places in this Form 10-K and include statements regarding the intent, belief or expectations of the Company, its Trustees or its officers with respect to the declaration or payment of dividends, the consummation of additional acquisitions, policies and plans of the Company regarding investments, dispositions, financings, conflicts of interest or other matters, the Company's qualification and continued qualification as a real estate investment trust or trends affecting the Company's or any hotel's financial condition or results of operations. Readers are cautioned that any such forward looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contained in the forward looking statement as a result of various factors. Such factors include without limitation changes in financing terms, the Company's ability or inability to complete acquisitions and financing transactions, results of operations of the Company's hotels and general changes in economic conditions not presently contemplated. The accompanying information contained in this Form 10-K, including the information under the headings "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations", identifies other important factors that could cause such differences. THE AMENDED AND RESTATED DECLARATION OF TRUST OF THE COMPANY, DATED AUGUST 21, 1995 A COPY OF WHICH, TOGETHER WITH ALL AMENDMENTS THERETO (THE "DECLARATION"), IS DULY FILED IN THE OFFICE OF THE DEPARTMENT OF ASSESSMENTS AND TAXATION OF THE STATE OF MARYLAND, PROVIDES THAT THE NAME "HOSPITALITY PROPERTIES TRUST" REFERS TO THE TRUSTEES UNDER THE DECLARATION COLLECTIVELY AS TRUSTEES, BUT NOT INDIVIDUALLY OR PERSONALLY, AND THAT NO TRUSTEE, OFFICER, SHAREHOLDER, EMPLOYEE OR AGENT OF THE TRUST SHALL BE HELD TO ANY PERSONAL LIABILITY, JOINTLY OR SEVERALLY, FOR ANY OBLIGATION OF, OR CLAIM AGAINST, THE TRUST. ALL PERSONS DEALING WITH THE TRUST, IN ANY WAY, SHALL LOOK ONLY TO THE ASSETS OF THE TRUST FOR THE PAYMENT OF ANY SUM OR THE PERFORMANCE OF ANY OBLIGATION.
HOSPITALITY PROPERTIES TRUST 1996 FORM 10K ANNUAL REPORT <TABLE> <CAPTION> Table of Contents Part I Page <S> <C> <C> Item 1. Business..................................................................... 1 Item 2. Properties................................................................... 20 Item 3. Legal Proceedings............................................................ 21 Item 4. Submission of Matters to a Vote of Security Holders.......................... 21 Part II Item 5. Market for the Registrant's Common Shares and Related Stockholders Matters 21 Item 6. Selected Financial Data...................................................... 22 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................................. 24 Item 8. Financial Statements and Supplementary Data.................................. 26 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................................................................. 26 <CAPTION> Part III To be incorporated by reference from the Company's definitive Proxy Statement for the annual meeting of shareholders currently scheduled to be held on May 20, 1996, which is expected to be filed not later than 120 days after the end of the Company's fiscal year. Part IV Item 14. Exhibits, Financial Statement Schedules and Report on Form 8K................ 27 </TABLE>
Item 1. Business The Company. The Company is a real estate investment trust ("REIT") formed to acquire, own and lease hotels to unaffiliated tenants. At December 31, 1996 the Company owned 82 hotels with 11,728 rooms or suites located in 26 states, purchased for approximately $813 million. The Company was formed in February 1995 as a subsidiary of Health and Retirement Properties Trust ("HRP"), a healthcare REIT. In March 1995, the Company acquired 21 Courtyard by Marriott(R) Hotels for approximately $179.4 million. In August 1995, the Company completed an initial public offering of 8,325,000 Shares at an initial public offering price of $25.00 per Share, raising gross proceeds of $208.1 million which were principally used to repay indebtedness due to HRP and to acquire an additional 16 Courtyard by Marriott(R) Hotels for approximately $149.6 million. In early 1996, the Company completed a follow-on offering of an additional 14,250,000 common shares of beneficial interest (the "Follow-on Offering") raising net proceeds of approximately $360 million. Such proceeds and proceeds from borrowings were used to acquire, through subsidiaries, 11 Wyndham Garden(R) Hotels for approximately $135.3 million, 18 Residence Inn by Marriott(R) Hotels for approximately $172.2 million and an additional 16 Courtyard by Marriott(R) Hotels for approximately $176.4 million. The Company's principal growth strategy is to expand its investments in hotels and to set minimum rents which produce income in excess of the Company's cost of raising capital. The Company seeks to provide capital to unaffiliated hotel operators who wish to divest their properties while remaining in the hotel business as tenants. The Company believes that its operating philosophy affords it opportunities to find high quality hotel investment opportunities on attractive terms. In addition, the Company's internal growth strategy is to participate through percentage rents in increases in Total Hotel Sales (including gross revenues from room rentals, food and beverage sales and other services) at the Company's hotels. The Company is organized as a Maryland real estate investment trust. The Company's principal place of business is 400 Centre Street, Newton, Massachusetts 02158, and its telephone number is (617) 964-8389. As of December 31, 1996 the Company's portfolio consisted of 82 hotels, located in 26 states. Information with respect to hotel revenues by state is contained in Item 2. Number of Number of State Hotels Rooms - ----- --------- --------- Arizona 8 1,164 California 10 1,470 Delaware 1 152 Florida 3 449 Georgia 7 978 Illinois 3 514 Indiana 1 149 Iowa 1 108 Maryland 3 406 Massachusetts 8 1,072 Michigan 2 281 Minnesota 2 358 Missouri 2 298 New Jersey 3 416 New Mexico 1 112 New York 3 403 North Carolina 4 534 Ohio 1 106 Pennsylvania 4 567 Rhode Island 1 148 South Carolina 1 108 Tennessee 3 399 Texas 3 405 Virginia 3 462 Washington 3 522 Wisconsin 1 147 ---- ------ 82 11,728 ==== ====== 1
The Hotels, Leases and Management Agreements. The Company's Courtyard by Marriott(R) and Residence Inn by Marriott(R) hotels are leased to special purpose subsidiaries ("Host I" and "Host II," respectively) of Host Marriott Corporation ("Host") and are managed by subsidiaries ("Marriott I" and "Marriott II," respectively) of Marriott International, Inc. ("Marriott"). The Company's Wyndham Garden(R) hotels are leased to a subsidiary ("Wyndham I") of Wyndham Hotel Corporation ("Wyndham") and are managed by a subsidiary ("Wyndham II") of Wyndham. Each of Host I, Host II and Wyndham I are herein referred to as "Lessees" and each of Marriott I, Marriott II and Wyndham II are herein referred to as "Managers." The annual rent payable to the Company for its 82 hotels ("Hotels") totals $81.3 million in base rent plus percentage rent ranging from 5% to 8% of increases in Total Hotel Sales (as defined below) over a base year level. In addition, 5% of Total Hotel Sales is required to be escrowed periodically by the Lessee or the Manager as a reserve for renovations and refurbishment of the hotels. "Total Hotel Sales" means all revenues and receipts of every kind derived from guests or customers related to the operation of the hotels and has the same meaning as "Gross Revenues" under the Company's leases. The hotels have an average age of approximately six years and, for their fiscal year 1996, had average occupancy of 80.5% and an average daily rate per room ("ADR") of $81.31. Under the leases and management agreements, the hotels are currently operated as Courtyard by Marriott(R), Residence Inn by Marriott(R) and Wyndham Garden(R) hotels. Courtyard by Marriott(R) hotels are designed to attract both business and leisure travelers. A typical Courtyard by Marriott(R) hotel has 145 guest rooms. The guest rooms are larger than those in most other moderately priced hotels and predominately offer king sized beds. Most Courtyard by Marriott(R) hotels are situated on well landscaped grounds and typically are built around a courtyard containing a patio, pool and socializing area that may be glass enclosed depending upon location. Most of these hotels have lounges or lobbies, meeting rooms, an exercise room, a small laundry room available to guests and a restaurant or coffee shop. Generally, the guest rooms are similar in size and furnishings to guest rooms in full service Marriott(R) hotels. In addition, many of the same amenities as would be available in full service Marriott(R) hotels are available in Courtyard by Marriott(R) hotels, except that restaurants may be open only for breakfast buffets or serve limited menus, room service may not be available and meeting and function rooms are limited in size and number. According to Marriott, as of December 31, 1996, 286 Courtyard by Marriott(R) hotels were open and operating nationally. The Company believes that the Courtyard by Marriott(R) brand is a leading brand in the limited service segment of the United States hotel industry. Residence Inn by Marriott(R) hotels are designed to attract business, governmental and family travelers who stay more than five consecutive nights. Residence Inn by Marriott(R) hotels generally have between 80 to 130 studios, one-bedroom, and two-bedroom suites. Most Residence Inn by Marriott(R) hotels are designed as a cluster of residential style buildings with landscaped walkways, courtyards and recreational areas. Residence Inn by Marriott(R) hotels do not have restaurants. All offer complimentary continental breakfast and most provide a complimentary evening hospitality hour. In addition, each suite contains a fully equipped kitchen and many have fireplaces. Most Residence Inn by Marriott(R) hotels also contain swimming pools, exercise rooms, business centers and guest laundries. According to Marriott, as of December 31, 1996, 221 Residence Inn by Marriott(R) hotels were open and operating nationally. The Company believes that the Residence Inn by Marriott(R) brand is the leading brand in the extended stay segment of the United States hotel industry. Wyndham Garden(R) hotels are mid-size, full service hotels located primarily near suburban business centers and airports which are designed to attract business travelers and small business groups in suburban markets. Each hotel contains 140 to 250 rooms and approximately 1,500 to 5,000 square feet of meeting space. The amenities and services provided at these hotels are designed to meet the needs of the upscale business traveler. Amenities and services in each room include desks large enough to accommodate personal computers, longer phone cords, high wattage light bulbs for reading, room service and access to 24-hour telecopy and mail/package service. The meeting facilities at Wyndham Garden(R) hotels generally can accommodate groups of between 10 and 200 people and include a flexible meeting room design, 2
exterior views, additional phone lines and audiovisual equipment. Wyndham Garden(R) hotels also feature a lobby lounge, most of which have a fireplace, a library typically overlooking a landscaped garden and a swimming pool. In addition, many Wyndham Garden(R) hotels contain a whirlpool and an exercise facility. Unlike many other mid-priced hotels, each Wyndham Garden(R) hotel contains a cafe restaurant that serves a full breakfast, lunch and dinner menu. The Company believes that the Wyndham Garden(R) brand is one of the leading brands in the full service suburban segment of the United States hotel industry. The principal features of the Company's leases and management agreements for the hotels are as follows: o Each of the hotels is the subject of a separate lease. However, in the event any of these leases is defaulted, the Company may declare all of the leases with such Lessee to be in default. o The initial lease terms expire between 2010 and 2012. o At the end of the initial lease terms, each Lessee has 3 or 4 consecutive 10 to 15 year renewal options totaling 36 to 48 years. Renewal options may be exercised only on an all or none basis for all hotels leased to a particular Lessee. o The leases require minimum rent payments aggregating $81.3 million per year. o In addition to minimum rents, the leases of the hotels require percentage rents equal to 5% to 8% of Total Hotel Sales in excess of Total Hotel Sales in a base year. Percentage rents are calculated on a combined basis for all hotels leased to a particular Lessee. o The leases and management agreements for the hotels require that 5% of Total Hotel Sales be escrowed periodically to fund refurbishments and renovations to these hotels ("FF&E Reserves"). Funds in the FF&E Reserves are pooled for all hotels leased to a particular Lessee and generally may be withdrawn only for capital improvements. o Under certain circumstances, the Company may be required to fund major repairs to the hotels, in which event annual base rents will be increased by a minimum of 10% of the amount funded. o A security deposit equal to a full year's base rent is retained by the Company as security for each Lessee's obligations under the leases of the hotels. Provided that the Lessee does not default under any of such leases, the Company must repay the security deposit to the Lessee at the expiration of the leases, including renewal terms, if any. No interest will be paid by the Company on the security deposit and it will not be escrowed. o The leases of the hotels are net leases requiring the Lessee to pay all operating expenses, including taxes and insurance and any applicable ground rent. Under the management agreements for the hotels, substantially all of the Lessees' operating responsibilities have been delegated to the Managers. o The management agreements for the Company's Courtyard by Marriott(R) and Residence Inn by Marriott(R) hotels may be canceled by the Lessee (with the consent of the Company) on a hotel by hotel basis if specified performance levels are not achieved by the Manager. Similarly, in the event that the leases for individual hotels were terminated, the Company or the successor lessee would be able to cancel the corresponding management agreements on a hotel by hotel basis if specified performance levels are not achieved. o The management agreements for the Company's Courtyard by Marriott(R) and Residence Inn by Marriott(R) hotels are not cross defaulted with each other nor with the leases for these hotels. Accordingly, if one or more of such management agreements were defaulted and terminated, the Lessee and the Company will be able to continue the affiliation with Marriott and use the Courtyard by Marriott(R) or Residence Inn by 3
Marriott(R) hotels brand name and chain services under the remaining agreements. Also, if the leases for these hotels were defaulted and terminated, the Company and any successor lessee will be able to continue the affiliation with Marriott and use the Courtyard by Marriott(R) or the Residence Inn by Marriott(R) hotels brand name and chain services under existing management agreements. o The management agreements for the Company's Courtyard by Marriott(R) and Residence Inn by Marriott(R) hotels expire between 2012 and 2020. Such management agreements provide for up to two or three consecutive 12 to 15 year renewal terms. o Borrowings in respect of each of the Company's Courtyard by Marriott(R) and Residence Inn by Marriott(R) hotels are limited in accordance with a formula set forth in such management agreements to no more than 70% of the allocable purchase price of each such hotel in the case of a borrowing secured by a single hotel, or 60% of the aggregate allocable purchase prices of such hotels in the case of a borrowing secured by two or more of such hotels on a combined basis. o Management fees payable to the Managers for operation of the hotels are subordinated to minimum rents due to the Company. All related company charges payable by any Lessee to the Lessee's parent or other affiliates of Host are likewise subordinated to rents due to the Company. Developments since December 31, 1996. On January 3, 1997, the Company, through a new subsidiary, acquired a 388-room full service hotel in Salt Lake City, Utah (the "Salt Lake Hotel"), for $44 million. Additionally, the Company has committed to fund up to $3.75 million for planned improvement costs to complete certain upgrades to the hotel facilities. Upon purchase, the hotel was flagged as a full service Wyndham(R) hotel and the Company entered into a long-term lease for the operation of the Salt Lake Hotel with an affiliate (Wyndham III) of Wyndham Hotel Corporation (Wyndham). In connection with the transaction, Wyndham funded a $4.7 million cash security deposit under the lease, and another affiliate of Wyndham contributed approximately $5.3 million (the "Guarantee Deposit") to the purchase price. Upon the Salt Lake Hotel achieving certain operating thresholds or lease expiration other than by event of default, the Company must refund the $5.3 million Guarantee Deposit. Fundings for the planned improvements discussed above and refunding of the Guarantee Deposit will increase base rent on the property by approximately 11.1% of amounts so funded. The initial term of the lease expires in 2012 and Wyndham III has four consecutive renewal options of 12 years each. The lease requires minimum rent of approximately $3.78 million annually initially. Other terms of the lease for the Salt Lake Hotel are substantially similar to those for the Company's 11 Wyndham Garden(R) hotels. At the option of the Company, Wyndham I and Wyndham III may be required to merge and the leases and management agreement with respect to the Salt Lake Hotel and the Company's 11 Wyndham Garden(R) hotels, will be combined as a single group of cross-defaulted leases. Investment Policy and Method of Operation. The Company's strategy for increasing Cash Available for Distribution (as defined below) per Share is to provide capital to unaffiliated hotel operators who wish to divest their properties while remaining in the hotel business as tenants. Most other public hotel REITs seek to control the operations of hotels in which they invest by leasing those properties to affiliated tenants. In many cases affiliated management entities also manage such hotels. To achieve its objectives, the Company seeks to operate as follows: maintain a strong capital base of shareholders' equity; invest in high quality properties operated by unaffiliated hotel operating companies; use moderate debt leverage to fund additional investments which increase Cash Available for Distribution per Share because of positive spreads between the Company's cost of investment capital and rent yields; design leases which require minimum rents and provide an opportunity to participate in a percentage of increases in gross revenues at the Company's hotels; when market conditions permit, refinance debt with additional equity or long term debt; and pursue diversification so that the Company's Cash Available for Distribution is received from diverse properties and operators. "Cash Available for Distribution" as used herein means net income from operations, plus depreciation and amortization and certain non-cash items (all computed in accordance with generally accepted accounting principles) and less Company owned funds reserved for renovations and refurbishments and adjusted for non-recurring items, if any. 4
The Company's day-to-day operations are conducted by HRPT Advisors, Inc. ("Advisors"), the Company's investment advisor. Advisors originates and presents investment opportunities to the Company's Board of Trustees. As a REIT, the Company may not operate hotels. The Company has entered into leases (the "Leases") with each Lessee and management agreements (the "Management Agreements") with each Manager for operation of the hotels. The Company's Leases require the Lessee to pay all operating expenses, including taxes and insurance and to pay to the Company minimum rents plus percentage rents based upon increases in gross revenues at the hotels. Acquisition Policy. The Company is committed to pursuing growth through the acquisition of additional hotels and intends to pursue acquisition opportunities. Generally, the Company prefers to purchase and lease multiple hotels in one transaction because the Company believes cross default covenants and all or none renewal rights for multiple hotels enhance the credit characteristics of its leases and the security of its investments. In implementing its acquisition strategy, the Company considers a range of factors relating to proposed hotel purchases including: (i) historical and projected cash flows; (ii) the competitive market environment and the current or potential market position of each proposed hotel; (iii) the availability of a qualified lessee; (iv) the physical condition of the proposed hotel and its potential for redevelopment or expansion; (v) the estimated replacement cost and proposed acquisition price of the proposed hotel; (vi) the price segment in which the proposed hotel is operated; and (vii) the strength of the particular national hotel management organization, if any, with which the proposed hotel is or may become affiliated; and (viii) the hotel brand under which the hotel operates or is expected to operate. In determining the competitive position of a prospective hotel, the Company examines the proximity of the proposed hotel to business, retail, academic and tourist attractions and transportation routes, the number and characteristics of competitive hotels within the proposed hotel's market and the existence of any barriers to entry within that market, including zoning restrictions and financing constraints. While the Company focuses on the acquisition of upscale limited service, extended stay and full service hotel properties, it also considers acquisitions in all segments of the hotel industry. An important part of the Company's acquisition strategy is to identify and select qualified and experienced hotel lessees and managers. The Company intends to continue to select hotels for acquisition which will enhance the diversity of its portfolio in respect to location, brand name, lessees and managers. The Company has no policies which would limit the purchase price or the percentage of its assets which may be invested in any individual hotel or invested in hotels leased to a single lessee or managed by a single manager or operated with a single franchise affiliation. Other Investments in Real Estate. Although the Company emphasizes direct wholly owned investments in its hotels, it may, in its discretion, invest in joint ventures, mortgages and other real estate interests, consistent with its qualification as a REIT. The Company may invest in real estate joint ventures if it concludes that by doing so it may benefit from the participation of coventurers or that the opportunity of the Company to participate in the investment is contingent on the use of a joint venture structure. The Company may invest in participating, convertible or other types of mortgages if it concludes that by doing so it may benefit from the cash flow or any appreciation in the value of the subject property. Convertible mortgages are similar to equity participation because they permit the lender to either participate in increasing revenues from the property or convert some or all of that mortgage into equity ownership interests. At all times, the Company intends to make its investments in such a manner as to be consistent with the requirements of the Internal Revenue Code of 1986, as amended (the "Code") to qualify as a REIT. Disposition Policies. The Company has no current intention to dispose of any hotels, although it reserves the right to do so. The Company currently anticipates that disposition decisions, if any, will be made by the Company based on (but not limited to) factors such as the following: (i) potential opportunities to increase revenues and property values by reinvesting sale proceeds; (ii) the proposed sale prices; (iii) the strategic fit of the hotel with the rest of the Company's portfolio; (iv) the potential for, or the existence of, any environmental or regulatory problems; (v) the existence of alternative uses or needs for capital; and (vi) the maintenance of the Company's 5
qualification as a REIT. For a description of certain tax consequences arising from disposition of hotels, see "Taxation of the Company." Financing Policies. The Company currently intends to employ conservative financial policies in pursuit of its growth strategies. Although there are no limitations in the Company's organizational documents on the amount of indebtedness it may incur, the Company currently intends to pursue its growth strategies while maintaining a capital structure under which its debt will not exceed 50% of its total market capitalization. The Company may from time to time re-evaluate and modify its current borrowing policies in light of then current economic conditions, relative costs of debt and equity capital, market values of properties, growth and acquisition opportunities and other factors and may increase or decrease its ratio of debt to total market capitalization accordingly. The Board of Trustees of the Company may determine to obtain a replacement for its current credit facilities or to seek additional capital through additional equity offerings, debt financings, securitizations, retention of cash flow (subject to satisfying the Company's distribution requirements under the REIT rules) or a combination of these methods. To the extent that the Board of Trustees decides to obtain additional debt financing, the Company may do so on a secured or unsecured basis. Any mortgages may be recourse, non-recourse or cross collateralized and may contain cross default provisions. The Company has not established any limit on the number or amount of mortgages that may be placed on any single property or on its portfolio as a whole. The Company may also seek to obtain other lines of credit (both secured or unsecured) or to issue securities senior to the Shares, including preferred shares of beneficial interest and debt securities (either of which may be convertible into Shares or be accompanied by warrants to purchase Shares) or to engage in securitization transactions which may involve a sale or other conveyance of the Company's hotels to subsidiaries or to unaffiliated special purpose entities. The Company may also finance acquisitions through an exchange of properties or through the issuance of additional Shares or other securities. The proceeds from any financings by the Company may be used to pay distributions, to provide working capital, to refinance existing indebtedness or to finance acquisitions and expansions of existing or new properties. Advisors. Advisors is a Delaware corporation owned by Barry M. Portnoy and Gerard M. Martin. Advisors' principal place of business is 400 Centre Street, Newton, Massachusetts and its telephone number is (617) 332-3990. Advisors provides management services and investment advice to the Company. Advisors also acts as the investment advisor to HRP and has other business interests. The Directors of Advisors are Gerard M. Martin, Barry M. Portnoy and David J. Hegarty. The officers of Advisors are David J. Hegarty, President and Secretary, John G. Murray, Executive Vice President and Chief Financial Officer, John A. Mannix, Vice President, Thomas M. O'Brien, Vice President, Ajay Saini, Vice President and Treasurer, and David M. Lepore, Vice President. Mr. Murray and Mr. O'Brien are also officers of the Company. Effective January 1, 1997, Adam D. Portnoy resigned as Vice President of Advisors and as an officer of the Company to pursue other interests. In the ordinary course of their business, Advisors is occasionally involved in litigation, including the following matters to which the Company is not a party. Early in 1995, HRP commenced a foreclosure action to enforce indemnities given in connection with the surrender of certain leaseholds to, and the purchase of certain properties by, HRP in 1992. In May 1995, the defendants in the foreclosure action and parties related to HRP's former tenants and sellers asserted cross claims against HRP and others, including Advisors, Messrs. Portnoy and Martin and others, including Sullivan & Worcester which acts as counsel to HRP, Advisors and the Company. The same cross-claim defendants were served in late February 1996 in an additional action in a federal court. The cross claims and separate claims allege, among other things, fraud (including violations of federal securities laws), conflicts of interest, breach of fiduciary duties, legal malpractice, civil conspiracy and violations of 18 U.S.C. ss.1962 (RICO) in connection with the leasehold surrenders, the transactions and indemnities underlying the foreclosure action and certain related transactions, and that the foreclosure defendants and third party plaintiffs suffered substantial damages as a result. HRP, Advisors and other parties to this dispute have sought arbitration of all arbitrable claims arising from this dispute pursuant to the contract under which the dispute originated, and an arbitration proceeding is now underway. The Company has been informed that additional related actions have been brought against HRP, Advisors and other defendants in the original cross claims. The amounts claimed against HRP and such other defendants are material. The Company has been informed that HRP, Advisors and the other cross claim defendants intend to defend themselves in the actions or otherwise to pursue such claims and rights which they may have. The outcome of those pending claims and proceedings cannot be predicted. The Company is not a party to any of these actions. 6
Employees. The Company is an advised REIT and has no employees. Services which would otherwise be provided by employees are provided by Advisors pursuant to the Advisory Agreement (described below) and by the Managing Trustees and officers of the Company. Advisors, which administers the day-to-day operations of the Company, has 47 full-time employees and three active directors. Competition. The hotel industry is highly competitive. Each of the hotels is located in an area that includes other hotels. Increases in the number of hotels in a particular area could have a material adverse effect on occupancy rates and average daily rates of the hotels located in that area. Agreements with the operators of the hotels restrict the right of each operator and its affiliates for a limited period of time to own, build, operate, franchise or manage any other hotel of the same brand within various specified areas around the Company's hotels. Neither the operator nor its affiliates are restricted from operating other branded hotels in the market areas of any of the hotels, and after such limited period of time, the Managers and their affiliates may also compete with the hotels by opening, managing or franchising additional hotels under the same brand name in direct competition with the Company's hotels. The Company expects to compete for hotel acquisition and financing opportunities with entities which may have substantially greater financial resources than the Company, including, without limitation, other publicly owned REITs, banks, insurance companies, pension plans and public and private partnerships. These entities may be able to accept more risk than the Company can prudently manage, including risks with respect to the creditworthiness of hotel operators. Such competition may reduce the number of suitable hotel acquisition or financing opportunities available to the Company and increase the bargaining power of hotel owners seeking to sell or finance their properties. Seasonality. The effects of seasonality, if any, are discussed in Management's Discussion and Analysis. Regulatory Matters. Hotel properties are subject to various laws, ordinances and regulations, including regulations relating to restaurants and other food and beverage operations and recreational facilities such as swimming pools, activity centers and other common areas. The Company believes that each of its hotels has the necessary permits and approvals required to enable the Lessee and or Manager to operate the hotels in the manner contemplated by the Leases and the Management Agreements. The Company requires its Lessees and Managers to maintain such required permits and approvals. Under various environmental laws, a current or previous owner or operator of real property may be liable for the costs of removal or remediation of hazardous or toxic substances on, under, in or emanating from such property. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances, and the liability under such laws has been interpreted to be strict, meaning that liability is imposed without regard to fault. Liability under such laws has also been interpreted to be joint and several, meaning that any current or previous owner or operator or other responsible party might be liable for the entire amount of the cleanup and remediation costs for a contaminated site. In addition, the presence of hazardous or toxic substances, or the failure to remediate such property properly, may adversely affect the market value of the property, as well as the owner's ability to sell or lease the property or to borrow using such property as collateral. Persons who arrange for the disposal or treatment of hazardous or toxic substances may also be liable for the costs of removal or remediation of such substances at the disposal or treatment facility, whether or not such facility is or ever was owned or operated by such person. In addition, certain environmental laws and common law principles govern the responsibility for the removal, encapsulation or disturbance of asbestos containing materials ("ACMs") when these ACMs are in poor condition or when a property with ACMs is undergoing renovation or demolition. Such laws could also be used to impose liability upon owners or operators of real properties for release of ACMs into the air that cause personal injury or other damage. The Company received a Phase I environmental assessment report for each of the hotels. The purpose of these reports is to identify, to the extent reasonably possible and based on reasonably available information, any existing and potential conditions resulting from hazardous or toxic substances, including petroleum products and ACMs, at the hotels. The scope of the Phase I environmental assessments generally included: (i) a review of available maps, aerial photographs and past and present uses of the site; (ii) an inspection of appropriate public records; and (iii) in certain cases, limited inquiries of governmental agencies having jurisdiction over certain environmental matters. Each Phase I environmental assessment also includes an on site visual inspection 7
of the Hotel to assess visual evidence of past or present on site waste disposal, visible surface contamination, potential sources of soil and groundwater contamination, above surface and subsurface storage tanks, visible drums, barrels and other storage containers, current waste streams and management practices, ACMs and polychlorinated biphenyl transformers. In addition, as part of the Phase I environmental assessment, abutting properties and nearby sources of potential contamination are identified through publicly available information and evaluated for potential impact on the hotels, to the extent reasonably possible. In some instances, the Company also caused additional investigations to be conducted with respect to certain of the hotels. Some of the hotels are located on or near properties with former or existing underground or above ground storage tanks used to store petroleum or other hazardous products, or on which activities involving hazardous substances have been or currently are being conducted. The Company is aware of petroleum contaminated soil and/or groundwater at several hotels from former or existing on-site or nearby service stations, leaking underground storage tanks or storage drums. In addition, the Company believes that some of the hotels may have been constructed on sites at which fill materials containing hazardous substances were used and that one of the hotels was constructed over abandoned oil and gas wells. The Company is also aware of several hotels that are located in a "Superfund" area or an area of regional groundwater contamination. The Company does not believe that these instances of on-site or regional contamination and historical or current activities will have a material adverse effect on the Company's business or results of operations. However, the Company cannot predict whether modifications of existing laws or regulations, the adoption of new laws or regulations or changes in conditions at the hotels may have a material adverse effect on the Company's business or results of operations in the future. Except as described above, the Company is not aware of any environmental condition with respect to the hotels that could have a material adverse effect on the Company's business or results of operations. No assurances can be given, however, that the Phase I environmental assessments undertaken with respect to the hotels have revealed all potential environmental liabilities, that any prior owner or operator of the real property on which the hotels are located did not create any material environmental condition not known to the Company, or that a material environmental condition does not otherwise exist as to any one or more of the hotels. Under Title III of the Americans with Disabilities Act ("ADA"), a hotel with more than five rooms for rent is considered both a "public accommodation" and a "commercial facility." Under the public accommodations provisions of the ADA, the Company, as owner of the hotels, is obligated to make reasonable accommodations to patrons who have physical, mental or other disabilities. This includes the obligation to remove architectural and communication barriers at the hotels when doing so is "readily achievable" and to ensure that alterations to the hotels performed after January 26, 1992 conform to the specific requirements of the ADA implementing regulations. The Leases require the Lessee to comply with the ADA with respect to the hotels. The Lessee will also generally be obligated to remedy any ADA compliance matters from the applicable FF&E Reserve, its own funds, financing by third parties or financing provided by the Company (which would increase base rent under the Leases). Taxation of the Company. Based upon certain representations described below, in the opinion of Sullivan & Worcester LLP, counsel to the Company ("Company Counsel"), the Company has been organized in conformity with the requirements for qualification as a REIT beginning with its taxable year ending December 31, 1995, and its currently proposed method of operation as represented by the Company will enable it to satisfy the requirements for such qualification. This opinion is conditioned upon the assumption that the Leases, the Company's Declaration of Trust and Bylaws and all other legal documents to which the Company is a party will be complied with by all parties thereto and upon certain representations made by the Company as to certain factual matters relating to the Company's organization and intended or expected manner of operation. In addition, this opinion is based on the law existing and in effect on the date thereof. The Company's qualification and taxation as a REIT will depend upon the Company's ability to meet on a continuing basis, through actual operating results, asset composition, distribution levels and diversity of stock ownership, the various qualification tests imposed under the Code discussed below. While the Company has represented that it will operate in a manner so as to satisfy on a continuing basis the various REIT qualification tests, Company Counsel will not review compliance with these tests on a continuing basis, and no assurance can be given that the Company will satisfy such tests on a continuing basis. 8
In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, entities, such as the Company, that invest primarily in real estate and that otherwise would be treated for federal income tax purposes as corporations, are generally not taxed at the corporate level on their "REIT taxable income" that is currently distributed to shareholders of the Company ("Shareholders"). This treatment substantially eliminates the "double taxation" that generally results from the use of corporations. If the Company fails to qualify as a REIT in any year, however, it will be subject to federal income taxation as if it were a domestic corporation, and its Shareholders will be taxed in the same manner as shareholders of ordinary corporations. In such an event, the Company could be subject to potentially significant tax liabilities, and therefore the amount of cash available for distribution to its Shareholders would be reduced or eliminated. The Company elected REIT status for the taxable year ended December 31, 1995 and currently expects to continue to operate in a manner that permits it to retain REIT status in each taxable year thereafter. There can be no assurance, however, that this expectation will be fulfilled, since qualification as a REIT depends on the Company's continuing to satisfy numerous asset, income and distribution tests described below, which in turn will be dependent in part on the Company's operating results. The following summary is based on existing law, is not exhaustive of all possible tax considerations and does not give a detailed discussion of any state, local, or foreign tax considerations, nor does it discuss all of the aspects of federal income taxation that may be relevant to a Shareholder in light of his or her particular circumstances or to certain types of Shareholders (including insurance companies, tax-exempt entities, financial institutions, broker-dealers, foreign corporations and persons who are not citizens or residents of the United States) subject to special treatment under the federal income tax laws. General. In any year in which the Company qualifies as a REIT, in general it will not be subject to federal income tax on that portion of its REIT taxable income or capital gain which is distributed to Shareholders. The Company may, however, be subject to tax at normal corporate rates upon any taxable income or capital gain not distributed. Notwithstanding its qualification as a REIT, the Company may also be subject to taxation in certain other circumstances. If the Company should fail to satisfy either the 75% or the 95% gross income test (as discussed below), and nonetheless maintains its qualification as a REIT because certain other requirements are met, it will be subject to a 100% tax on the greater of the amount by which the Company fails either the 75% or the 95% gross income test, multiplied by a fraction intended to reflect the Company's profitability. The Company will also be subject to a tax of 100% on net income from any "prohibited transaction" as described below, and if the Company has (i) net income from the sale or other disposition of "foreclosure property" which is held for sale to customers in the ordinary course of business or (ii) other non-qualifying income from foreclosure property, it will be subject to tax on such income from foreclosure property at the highest corporate rate. In addition, if the Company should fail to distribute during each calendar year at least the sum of (i) 85% of its REIT ordinary income for such year, (ii) 95% of its REIT capital gain net income for such year, and (iii) any undistributed taxable income from prior years, the Company would be subject to a 4% excise tax on the excess of such required distribution over the amounts actually distributed. The Company may also be subject to tax in certain circumstances if it disposes within ten years of their acquisition of assets acquired in a tax-free reorganization (although no such transaction is currently contemplated). The Company may also be subject to the corporate alternative minimum tax. The Company will use the calendar year both for federal income tax purposes, and for financial reporting purposes. In order to qualify as a REIT, the Company must meet, among others, the following requirements: Share Ownership Tests. The Company's Shares must be held by a minimum of 100 persons for at least 335 days in each taxable year (or a proportional number of days in any short taxable year). In addition, at all times during the second half of each taxable year, no more than 50% in value of the outstanding Shares of the Company may be owned, directly or indirectly and by applying certain constructive ownership rules, by five or fewer individuals, which for this purpose includes certain tax-exempt entities. However, for purposes of this test, any Shares held by a qualified domestic pension or other retirement trust will be treated as held directly by its beneficiaries in proportion to their actuarial interest in such trust rather than by such trust. 9
In order to ensure compliance with the foregoing share ownership tests, the Company has placed certain restrictions on the transfer of its Shares to prevent additional concentration of Share ownership. Moreover, to evidence compliance with these requirements, under Treasury Regulations the Company must maintain records which disclose the actual ownership of its outstanding Shares. In fulfilling its obligations to maintain records, the Company must and will demand written statements each year from the record holders of designated percentages of its capital stock disclosing the actual owners of such Shares (as prescribed by the Treasury Regulations). A list of those persons failing or refusing to comply with such demand must be maintained as a part of the Company's records. A Shareholder failing or refusing to comply with the Company's written demand must submit with his tax return a similar statement disclosing the actual ownership of Shares of the Company and certain other information. In addition, the Company's Declaration of Trust provides restrictions regarding the transfer of its Shares that are intended to assist the Company in continuing to satisfy the Share ownership requirements. Asset Tests. At the close of each quarter of the Company's taxable year, the Company must satisfy two tests relating to the nature of its assets (determined in accordance with generally accepted accounting principles). First, at least 75% of the value of the Company's total assets must be represented by interests in real property, interests in mortgages on real property, shares in other REITs, cash, cash items, government securities and qualified temporary investments. Second, although the remaining 25% of the Company's assets generally may be invested without restriction, securities in this class may not exceed (i) in the case of securities of any one non-government issuer, 5% of the value of the Company's total assets or (ii) 10% of the outstanding voting securities of any one such issuer. Where a failure to satisfy the 25% asset test results from an acquisition of securities or other property during a quarter, the failure can be cured by disposition of sufficient non-qualifying assets within 30 days after the close of such quarter. The Company intends to maintain adequate records of the value of its assets to maintain compliance with the 25% asset test, and to take such action as may be required to cure any failure to satisfy the test within 30 days after the close of any quarter. Gross Income Tests. The Company must satisfy three source of income tests in each taxable year. The three tests are as follows: The 75% Test. At least 75% of the Company's gross income for the taxable year must be "qualifying income." Qualifying income generally includes (i) rents from real property (as defined below); (ii) interest on obligations secured by mortgages on, or interests in, real property; (iii) gains from the sale or other disposition of interests in real property and real estate mortgages, other than gain from property held primarily for sale to customers in the ordinary course of the Company's trade or business ("dealer property"); (iv) dividends or other distributions on shares in other REITs, as well as gain from the sale of such shares; (v) abatements and refunds of real property taxes; (vi) income from the operation, and gain from the sale, of property acquired at or in lieu of a foreclosure of the mortgage secured by such property ("foreclosure property"); (vii) commitment fees received for agreeing to make loans secured by mortgages on real property or to purchase or lease real property; and (viii) qualified temporary investment income. When the Company receives new capital in exchange for its Shares or other capital stock (other than dividend reinvestment amounts) or in a public offering of five-year or longer debt instruments, income attributable to the temporary investment of such new capital in stock or a debt instrument, if received or accrued within one year of the Company's receipt of the new capital, is qualifying temporary investment income. Rents received by the Company will qualify as "rents from real property" in satisfying the gross income requirements only if several conditions are met. Rents received from a tenant will not qualify as rents from real property if the Company, or an owner of 10% or more of the Company, directly or constructively owns 10% or more of such tenant. Thus, in order for gross income from a Hotel to qualify as rents from real property, the Company must not own, directly or constructively (applying constructive ownership rules under the Code), 10% or more of any lessee (the "10% ownership test"). Such constructive ownership rules generally provide that, if 10% or more in value of the Shares of the Company is owned, directly or indirectly, by or for any person, the Company is considered as owning the stock owned, directly or indirectly, by or for such Person. With respect to the 10% ownership test, the Company does not own and does not intend to acquire, directly or constructively, stock of any lessee. There can be no assurance, however, that the Company will be able to monitor and enforce such restrictions, nor will Shareholders necessarily be aware of shareholdings attributed to them under the attribution rules. The Company has 10
represented (which representation Sullivan & Worcester LLP has relied upon in rendering its opinion herein on REIT qualification) that it will satisfy the 10% ownership test. If rent attributable to personal property leased in connection with a lease of real property is greater than 15% of the total rent for the taxable year under or in connection with the lease, then the portion of rent attributable to such personal property will not qualify as rents from real property. Accordingly, the rents attributable to the Company's personal property leased under or in connection with a lease of the real property comprising a hotel must not be greater than 15% of the rents received under the applicable lease. The rent attributable to the Company's personal property for a hotel is the amount that bears the same ratio to total rent for the taxable year as (i) the average of the adjusted bases of the Company's personal property of such hotel at the beginning and at the end of the taxable year bears to (ii) the average of the aggregate adjusted bases of both the Company's real and personal property of such hotel at the beginning and at the end of such taxable year (the "Adjusted Basis Ratio"). The Company has represented (which representation Company Counsel has relied upon in rendering its opinion herein on REIT qualification) that the allocation of purchase price with respect to each Hotel is accurate and that not more than 15% of the rent for each taxable year with respect to each of the hotels or any other hotel property acquired by the Company in the future will be attributable to the Company's personal property under the foregoing rules. In addition, the Company intends not to acquire additional personal property for any hotels if such acquisition would cause the Adjusted Basis Ratio for such hotels to exceed 15%. While the Company believes that the allocation for tax purposes of the purchase price for the hotels to the personal property is accurate, there can be no assurance that the Service will not assert that a different allocation is appropriate and that more than 15% of the rents received under a Lease is attributable to personal property under the foregoing rules, or that a court would not uphold such assertion. If such a challenge were successfully asserted, the Company could fail the 15% Adjusted Basis Ratio as to one or more of its leases, which in turn could cause it to fail to satisfy the 75% or 95% gross income test and to fail to qualify as a REIT. An amount received or accrued, directly or indirectly with respect to any real or personal property, will not qualify as "rents from real property" for purposes of the 75% or the 95% gross income test if the determination of such amount depends in whole or in part on the income or profits derived by any person from such property (except that an amount so derived or accrued generally will not be excluded from "rents from real property" solely by reason of being based on a fixed percentage or percentages of receipts or sales). In addition, the Company must not manage the property or furnish or render services to the tenants of such property, except through an independent contractor from whom the company derives no income. There is an exception to this rule permitting a REIT to perform certain customary tenant services of the sort which a tax-exempt organization could perform without being considered in receipt of "unrelated business taxable income." The 95% Test. In addition to deriving 75% of its gross income from the sources listed above, at least 95% of the Company's gross income for the taxable year must be derived from the above described qualifying income, dividends, interest, or gains from the sale or other disposition of stock, securities and real property that is not dealer property. Dividends and interest on any obligations not collateralized by an interest in real property are included for purposes of the 95% gross income test, but not for purposes of the 75% gross income test. For purposes of determining whether the Company complies with the 75% and the 95% gross income tests, gross income does not include income from prohibited transactions. A "prohibited transaction" is a sale of dealer property (excluding foreclosure property); however, it does not include a sale of property if such property is held by the Company for at least four years and certain other requirements (relating to the number of properties sold in a year, their tax bases, and the cost of improvements made thereto) are satisfied. See "-- Taxation of the Company -- General" above. Gain realized by the Company on the sale of any dealer property generally will be treated as income from a prohibited transaction that is subject to a 100% penalty tax. Under existing law, whether property is dealer property is a question of fact that depends on all the facts and circumstances with respect to the particular transaction. The Company intends to hold the hotels for investment with a view to long-term appreciation, to engage in the business of acquiring, owning and developing the hotels and other hotel properties acquired by the Company in the future, and to make such occasional sales of such hotels as are consistent with the Company's 11
investment objectives. Based upon the Company's investment objectives, the Company believes that overall, the hotels should not be considered dealer property and that the amount of income from prohibited transactions, if any, will not be material. The Company believes that, for purposes of both the 75% and the 95% gross income tests, its investment in the hotels will generally give rise to qualifying income in the form of rents, and that gains on sales of the hotels generally will also constitute qualifying income. The Company also believes that, for purposes of the 95% gross income test, if the portion of rent attributable in any case to furniture, furnishings, equipment and operating equipment were to be recharacterized as payments from a deemed financing of such items, any gross income attributable to such payments would be qualifying gross income in the form of interest and such interest income would not cause the Company to be unable to satisfy the 75% gross income test. Even if the Company fails to satisfy one or both of the 75% or the 95% gross income tests for any taxable year, it may still qualify as a REIT for such year if it is entitled to relief under certain provisions of the Code. These relief provisions will generally be available if: (i) the Company's failure to comply was due to reasonable cause and not to willful neglect; (ii) the Company reports the nature and amount of each item of its income included in the tests on a schedule attached to its tax return; and (iii) any incorrect information on such schedule is not due to fraud with intent to evade tax. If these relief provisions apply, however, the Company will nonetheless be subject to a 100% tax on the greater of the amount by which it fails either the 75% or the 95% gross income test, multiplied by a fraction intended to reflect the Company's profitability. The 30% Test. The Company must derive less than 30% of its gross income for each taxable year from the sale or other disposition of (i) real property held for less than four years (other than foreclosure property and involuntary conversions); (ii) stock or securities (including certain interest rate swap or cap agreements) held for less than one year; and (iii) property in a prohibited transaction. The Company does not anticipate that it will have difficulty in complying with this test. However, if extraordinary circumstances were to occur that gave rise to dispositions of hotels within four years after the respective dates of the Company's acquisition thereof, the Company may be unable to satisfy the 30% test. The Company may temporarily invest working capital in short term investments, which may include shares in other REITs. Although the Company will use its best efforts to ensure that its income generated by these investments will be of a type which satisfies the 75% and 95% gross income tests, there can be no assurance in this regard (see discussion above of the "new capital" rule under the 75% test). Moreover, the Company may realize short-term capital gain upon sale or exchange of such investments, and such short-term capital gain would be subject to the limitations imposed by the 30% gross income test. Foreclosure Property. The Company will be subject to tax at the maximum corporate rate (currently 35%) on income from any "foreclosure property," other than income that would be qualified income under the 75% gross income test, less expenses directly connected with the production of such income. However, gross income from any such foreclosure property will qualify under the 75% and the 95% gross income tests. Foreclosure property is defined as any real property (including interests in real property) and any personal property incident to such real property, acquired by a REIT as the result of a REIT having bid in such property at foreclosure, or having otherwise reduced such property to ownership or possession by agreement or process of law, after there was a default (or default was imminent) on a lease of such property or on an indebtedness which such property secured and for which the REIT makes a proper election to treat such property as foreclosure property. However, a REIT will not be considered to have foreclosed on a property where it takes control of the property as a mortgagee in possession and cannot receive any profit or sustain any loss except as a creditor of the mortgagor. Under the Code, property generally ceases to be foreclosure property with respect to a REIT on the date which is two years after the date such REIT acquired such property (or longer if an extension is granted by the Secretary of the Treasury). However, the foregoing grace period is terminated and foreclosure property ceases to be foreclosure property on the first day (i) on which a lease is entered into with respect to such property which, by its terms, will give rise to income which does not qualify under the 75% gross income test or any amount is received or accrued, directly or indirectly, pursuant to a lease entered into on or after such day which will give rise to income which does not qualify under the 75% gross income test, (ii) 12
on which any construction takes place on such property (other than completion of a building, or completion of any other improvement, where more than 10% of the construction of such building or other improvement was completed before default became imminent), or (iii) which is more than 90 days after the day on which such property was acquired by the REIT and the property is used in a trade or business which is conducted by the REIT (other than through an independent contractor from whom the REIT itself does not derive or receive any income). As a result of the rules with respect to foreclosure property, if a Lessee defaults on its obligations under a Lease for a Hotel and the respective Manager is not available to manage such Hotel after the Company terminates the Lessee's leasehold interest therein, and the Company is unable to find a replacement lessee for such Hotel within 90 days of such foreclosure and unable to find an independent contractor to manage it, gross income from hotel operations conducted by the Company from such property would cease to qualify for the 75% and the 95% gross income tests. (Advisors should qualify as an independent contractor which could operate foreclosure property for up to two years.) In such event, the Company might be unable to satisfy the 75% or the 95% gross income test, resulting in its failure to qualify as a REIT. Annual Distribution Requirements. In order to qualify as a REIT the Company is required to distribute dividends (other than capital gain dividends) to its Shareholders with respect to each year in an amount at least equal to (A) the sum of (i) 95% of the Company's REIT taxable income (computed without regard to the dividends paid deduction and the Company's net capital gain) and (ii) 95% of the net income (after tax), if any, from foreclosure property, minus (B) the sum of certain items of non-cash income (from certain imputed rental income and income from transactions inadvertently failing to qualify as like-kind exchanges). Such distributions must be paid in the taxable year to which they relate, or in the following taxable year if declared before the Company timely files its tax return for such year and if paid on or before the first regular dividend payment after such declaration. To the extent that the Company does not distribute all of its net capital gain or distributes at least 95%, but less than 100%, of its REIT taxable income, as adjusted, it will be subject to tax on the undistributed amount at regular capital gains or ordinary corporate tax rates, as the case may be. The Company will also be required to distribute currently as a dividend an amount equal to the earnings and profits of any corporation it may acquire in a tax-free reorganization (although no such transaction is currently contemplated). The Company intends to make timely distributions sufficient to satisfy the annual distribution requirements described in the first and last sentences of the preceding paragraph. It is possible that the Company may not have sufficient cash or other liquid assets to meet the 95% distribution requirement, due to timing differences between the actual receipt of income and actual payment of expenses on the one hand, and the inclusion of such income and deduction of such expenses in computing the Company's REIT taxable income on the other hand. To avoid any problem with the 95% distribution requirement, the Company will closely monitor the relationship between its REIT taxable income and cash flow and intends, if necessary, to borrow funds in order to satisfy the distribution requirement. However, there can be no assurance that such borrowing would be available at such time. If the Company fails to meet the 95% distribution requirement as a result of an adjustment to the Company's tax return by the Service, the Company may retroactively cure the failure by paying a "deficiency dividend" (plus applicable penalties and interest) within a specified period. Failure to Qualify. If the Company fails to qualify for taxation as a REIT in any taxable year and the relief provisions do not apply, the Company will be subject to tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. Distributions to Shareholders in any year in which the Company fails to qualify as a REIT will not be deductible by the Company, nor generally will they be required to be made under the Code. In such event, to the extent of current and accumulated earnings and profits, all distributions to Shareholders will be taxable as ordinary income, and, subject to certain limitations in the Code, corporate distributees may be eligible for the dividends received deduction. Unless entitled to relief under specific statutory provisions, the Company also will be disqualified from reelecting taxation as a REIT for the four taxable years following the year during which qualification was lost. Other Issues. In the case of certain sale leaseback arrangements, the Service could assert that the Company realized prepaid rental income in the year of purchase to the extent that the value of a leased property exceeds the purchase price paid by the Company for that property. In litigated cases 13
involving sale leasebacks which have considered this issue, courts have concluded that buyers have realized prepaid rent where both parties acknowledged that the purported purchase price for the property was substantially less than fair market value and the purported rents were substantially less than the fair market rentals. Because of the lack of clear precedent, complete assurance cannot be given that the Service could not successfully assert the existence of prepaid rental income. Depreciation of Properties. For tax purposes, the Company's real property generally is depreciated on a straight line basis over 40 years and personal property owned by the Company generally is depreciated over nine years. Taxation of Shareholders. Taxation of Taxable Domestic Shareholders. As long as the Company qualifies as a REIT, distributions made to the Company's taxable domestic Shareholders out of current or accumulated earnings and profits (and not designated as capital gain dividends) will be taken into account by them as ordinary income and will not be eligible for the dividends received deduction for corporations. Distributions that are designated as capital gain dividends will be taxed as long-term capital gains (to the extent they do not exceed the Company's actual net capital gain for the taxable year) without regard to the period for which the Shareholder has held its Shares. However, corporate Shareholders may be required to treat up to 20% of certain capital gain dividends as ordinary income. To the extent that the Company makes distributions in excess of current and accumulated earnings and profits, these distributions are treated first as a tax-free return of capital to the Shareholder, reducing the tax basis of a Shareholder's Shares by the amount of such excess distribution (but not below zero), with distributions in excess of the Shareholder's tax basis being taxed as capital gains (if the Shares are held as a capital asset). In addition, any dividend declared by the Company in October, November or December of any year and payable to a Shareholder of record on a specific date in any such month shall be treated as both paid by the Company and received by the Shareholder on December 31 of such year, provided that the dividend is actually paid by the Company during January of the following calendar year. Shareholders may not include in their individual income tax returns any net operating losses or capital losses of the Company. Federal income tax rules may also require that certain of the Company's minimum tax adjustments and preferences be apportioned to Shareholders. In general, any loss upon a sale or exchange of Shares by a Shareholder who has held such Shares for six months or less (after applying certain holding period rules) will be treated as a long-term capital loss, to the extent of distributions from the Company required to be treated by such Shareholder as long-term capital gains. Investors (other than certain corporations) who borrow funds to finance their acquisition of Shares in the Company could be limited in the amount of deductions allowed for the interest paid on the indebtedness incurred in such an arrangement. Under Section 163(d) of the Code, interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment is generally deductible only to the extent of the taxpayer's net investment income. An investor's net investment income will include the dividend and (if the investor so elects) capital gain dividend distributions he receives from the Company; however, distributions treated as a nontaxable return of the Shareholder's basis will not enter into the computation of net investment income. Under Section 469 of the Code, taxpayers (other than certain corporations) generally will not be entitled to deduct losses from so-called passive activities except to the extent of their income from passive activities. For purposes of these rules, distributions received by a Shareholder from the Company will not be treated as income from a passive activity and thus will not be available to offset a Shareholder's passive activity losses. Taxation of Tax-Exempt Shareholders. The Service has ruled that amounts distributed by a REIT to a tax-exempt employees' pension trust do not constitute unrelated business taxable income ("UBTI"). Subject to the discussion below regarding a "pension-held REIT," based upon such ruling and the statutory framework of the Code, distributions by the Company to a Shareholder that is a tax-exempt entity would not constitute UBTI, provided that the tax-exempt entity has not financed the acquisition of its Shares with "acquisition indebtedness" within the meaning of the Code, that the Shares are not otherwise used in an unrelated trade or business of the tax-exempt entity, and that the Company, consistent with its present intent, does not hold a residual interest in a REMIC. 14
If any pension or other retirement trust that qualifies under Section 401(a) of the Code ("qualified pension trust") holds more than 10% by value of the interests in a "pension-held REIT" at any time during a taxable year, a portion of the dividends paid to the qualified pension trust by such REIT may constitute UBTI. For these purposes, a "pension-held REIT" is defined as a REIT if (i) such REIT would not have qualified as a REIT but for the provisions of the Code which look through such a qualified pension trust in determining ownership of shares of the REIT and (ii) at least one qualified pension trust holds more than 25% by value of the interests of such REIT or one or more qualified pension trusts (each owning more than a 10% interest by value in the REIT) hold in the aggregate more than 50% by value of the interests in such REIT. Information Reporting and Backup Withholding Tax. The Company will report to its domestic Shareholders and to the Service the amount of dividends paid for each calendar year, and the amount of tax withheld, if any, with respect thereto. Under the back-up withholding rules, a Shareholder may be subject to backup withholding at the rate of 31% with respect to dividends paid unless such Shareholder (i) is a corporation or comes within certain other exempt categories and, when required, demonstrates this fact or (ii) provides a taxpayer identification number, certifies as to no loss of exemption from backup withholding, and otherwise complies with applicable requirements of the backup withholding rules. A Shareholder that does not provide the Company with its correct taxpayer identification number may also be subject to penalties imposed by the Service. Any amount paid as backup withholding is available as a credit against the Shareholder's income tax liability. In addition, the Company may be required to withhold a portion of capital gain distributions made to any Shareholders who fail to certify their non-foreign status to the company. See "Certain United States Tax Considerations for Non-U.S. Shareholders." Backup withholding is not an additional tax. Rather, the tax liability of persons subject to backup withholding will be reduced by the amount of tax withheld. If withholding results in an overpayment of taxes, a refund may be obtained provided that the required information is furnished to the Service. Other Tax Considerations. Possible Legislative or Other Actions Affecting Tax Consequences. Shareholders should recognize that the present federal income tax treatment of investment in the Company may be modified by legislative, judicial or administrative action at any time and that any such action may affect investments and commitments previously made. The rules dealing with federal income taxation are constantly under review by persons involved in the legislative process and by the Service and the Treasury Department, resulting in revisions of regulations and revised interpretations of established concepts as well as statutory changes. No assurance can be given as to the form or content (including with respect to effective dates) of any tax legislation which may be enacted. Revisions in federal tax laws and interpretations thereof could affect the tax consequences of an investment in the Company. State and Local Taxes. The Company and its Shareholders may be subject to state or local taxation, and the Company may be subject to state or local tax withholding requirements, in various jurisdictions, including those in which it or they transact business or reside. The state and local tax treatment of the Company and its Shareholders may not conform to the federal income tax consequences discussed above. Consequently, prospective Shareholders should consult their own tax advisors regarding the effect of state and local tax laws on an investment in the Shares. Certain United States Tax Considerations Non-U.S. Shareholders. The following is a discussion of certain anticipated U.S. federal income and U.S. federal estate tax consequences of the ownership and disposition of Shares applicable to non-U.S. Shareholders of such Shares. The discussion is based on current law and is for general information only. The discussion does not address either aspects of U.S. federal taxation other than income and estate taxation or all aspects of U.S. federal income and estate taxation. The discussion does not consider any specific facts or circumstances that may apply to a particular non-U.S. Shareholder. In general, a non-U.S. Shareholder will be subject to regular United States income tax with respect to its investment in the Company if such investment is "effectively connected" with the non-U.S. Shareholder's conduct of a trade or business in the United States, or if the non-U.S. Shareholder is a nonresident alien individual who is present in the United States for 183 days or more during the taxable year. A corporate non-U.S. Shareholder that receives income that is (or is treated as) effectively connected with a U.S. trade or business may also be subject to the branch profits tax under Section 884 of the 15
Code, which is payable in addition to regular United States corporate income tax. The following discussion will apply to non-U.S. Shareholders whose investment in the Company is not so effectively connected and who are not individuals present in the U.S. for 183 days or more during the taxable year. A distribution by the Company that is not deemed to be attributable to gain from the sale or exchange by the Company of a United States real property interest and that is not designated by the Company as a capital gain dividend will be treated as an ordinary income dividend to the extent that it is made out of current or accumulated earnings and profits. A distribution by the Company that is designated as a capital gain dividend will generally not be subject to withholding except to the extent that such dividend is attributable to the sale or exchange by the Company of United States real property interests, as described below. Generally, an ordinary income dividend will be subject to a United States withholding tax equal to 30% of the gross amount of the dividend unless such withholding is reduced by an applicable tax treaty. A distribution of cash in excess of the Company's earnings and profits will be treated first as a nontaxable return of capital that will reduce a non-U.S. Shareholder's basis in its Shares (but not below zero) and then as gain from the disposition of such Shares, the tax treatment of which is described under the rules discussed below with respect to disposition of Shares. A distribution in excess of the Company's earnings and profits may be subject to 30% dividend withholding if at the time of the distribution it cannot be determined whether the distribution will be in an amount in excess of the Company's current and accumulated earnings and profits. If it is subsequently determined that such distribution is, in fact, in excess of current and accumulated earnings and profits, the non-U.S. Shareholder may seek a refund from the Service. The Company expects to withhold United States income tax at the rate of 30% on the gross amount of any such distributions made to a non-U.S. Shareholder in any tax year unless (i) a lower tax treaty applies and the required form evidencing eligibility for that reduced rate for such tax year is filed with the Company or (ii) the non-U.S. Shareholder files IRS Form 4224 for such tax year with the Company claiming that the distribution is "effectively connected" income. For any year in which the Company qualifies as a REIT, distributions by the Company that are attributable to gain from the sale or exchange of a United States real property interest will be taxed to a non-U.S. Shareholder in accordance with the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"). Under FIRPTA, such distributions are taxed to a non-U.S. Shareholder as if such distributions were gains "effectively connected" with a United States trade or business. Accordingly, a non-U.S. Shareholder will be taxed at the normal capital gain rates applicable to a U.S. Shareholder (subject to any applicable alternative minimum tax and a special alternative minimum tax in the case of non-resident alien individuals). Distributions subject to FIRPTA may also be subject to a 30% branch profits tax in the hands of a foreign corporate Shareholder that is not entitled to treaty exemption. The Company will be required to withhold from distributions to non-U.S. Shareholders, and remit to the Service, 35% of the amount of any distribution that could be designated as capital gain dividends to the extent that such dividends are attributable to the sale or exchange by the Company of United States real property interests. Tax treaties may reduce the Company's withholding obligations. If the amount of tax withheld by the Company with respect to a distribution to a non-U.S. Shareholder exceeds the Shareholder's United States liability with respect to such distribution, the non-U.S. Shareholder may file for a refund of such excess from the Service. In this regard, it should be noted that the 35% withholding tax rate on capital gain dividends corresponds to the maximum income tax rate applicable to corporations but is higher than the 28% maximum rate on capital gains of individuals. The United States Treasury issued proposed regulations on April 22, 1996 (the "Proposed Regulations") which, if adopted, would affect the United States taxation of dividends paid to a non-U.S. Shareholder. Under the Proposed Regulations, to obtain a reduced rate of withholding under treaty, a non-U.S. Shareholder generally would be required to provide an Internal Revenue Service Form W-8 certifying such non-U.S. Shareholder's entitlement to benefits under the treaty. The Proposed Regulations also provide rules to determine whether, for purposes of determining the applicability of a tax treaty, dividends paid to a non-U.S. Shareholder that is an entity should be treated as paid to the entity or to those holding an interest in the entity. The Proposed Regulations are generally proposed to be effective with respect to dividends paid after December 31, 1997, subject to certain transition rules. The foregoing discussion is not intended to be a complete discussion of the provisions of the Proposed Regulations, and Shareholders are urged to consult their tax advisors with respect to the effect the Proposed Regulations would have if adopted. 16
If the Shares fail to constitute a "United States real property interest" within the meaning of FIRPTA, a sale of the Shares by a non-U.S. Shareholder generally will not be subject to United States taxation unless (i) investment in the Shares is effectively connected with the non-U.S. Shareholder's United States trade or business, in which case, as discussed above, the non-U.S. Shareholder would be subject to the same treatment as U.S. Shareholders on such gain or (ii) the non-U.S. Shareholder is a nonresident alien individual who was present in the United States for 183 days or more during the taxable year, in which case the nonresident alien individual will be subject to a 30% tax on the individual's capital gains. The Shares will not constitute a United States real property interest if the Company is a "domestically controlled REIT." A domestically controlled REIT is a REIT in which at all times during a specified testing period less than 50% in value of its shares is held directly or indirectly by non-U.S. Shareholders. It is currently anticipated that the Company will be a domestically controlled REIT, and therefore that the sale of Shares will not be subject to taxation under FIRPTA. However, because the Shares will be publicly traded, no assurance can be given that the Company will continue to be a domestically controlled REIT. If the Company did not constitute a domestically controlled REIT, whether a non-U.S. Shareholder's sale of Shares would be subject to tax under FIRPTA as a sale of a United States real property interest would depend on whether the Shares were "regularly traded" (as defined by applicable Treasury Regulations) on an established securities market (e.g., the NYSE, on which the Shares will be listed) and on the size of the selling Shareholder's interest in the Company. If the gain on the sale of the Shares were subject to taxation under FIRPTA, the non-U.S. Shareholder would be subject to the same treatment as a U.S. Shareholder with respect to such gain (subject to applicable alternative minimum tax and a special alternative minimum tax in the case of nonresident alien individuals). In any event, a purchaser of Shares from a non-U.S. Shareholder will not be required under FIRPTA to withhold on the purchase price if the purchased Shares are "regularly traded" on an established securities market or if the Company is a domestically controlled REIT. Otherwise, under FIRPTA, the purchaser of Shares may be required to withhold 10% of the purchase price and to remit such amount to the Service. Federal Estate Tax. Shares owned or treated as owned by an individual who is not a citizen or resident (as defined for United States federal estate tax purposes) of the United States at the time of death will be includible in the individual's gross estate for United States federal estate tax purposes unless an applicable estate tax treaty provides otherwise. Backup Withholding and Information Reporting Requirements. The Company must report annually to the Service and to each non-U.S. Shareholder the amount of dividends paid to and the tax withheld with respect to such holder. These information reporting requirements apply regardless of whether withholding was reduced or eliminated by an applicable tax treaty. Copies of these information returns may also be made available under the provisions of a specific treaty or agreement to the tax authorities in the country in which the non-U.S. Shareholder resides. United States backup withholding tax (which generally is a withholding tax imposed at the rate of 31% on certain payments to persons that fail to furnish the information required under the United States information reporting requirements) will generally not apply to dividends paid on Shares to a non-U.S. Shareholder at an address outside the United States. The payment of the proceeds from the disposition of Shares to or through the United States office of a broker will be subject to information reporting and backup withholding at a rate of 31% unless the owner, under penalties of perjury, certifies, among other things, its status as a non-U.S. Shareholder, or otherwise establishes an exemption. The payment of the proceeds from the disposition of Shares to or through a non-U.S. office of a broker generally will not be subject to backup withholding and information reporting. In the case of proceeds from a disposition of Shares paid to or through a non-U.S. office of a U.S. broker or paid to or through a non-U.S. office of a non-U.S. broker that is (i) a "controlled foreign corporation" for United States federal income tax purposes or (ii) a person 50% or more of whose gross income from all sources for a certain three-year period was effectively connected with a United States trade or business, (a) backup withholding will not apply unless the broker has actual knowledge that the owner is not a non-U.S. Shareholder, and (b) information reporting will not apply if the broker has documentary evidence in its files that the owner is a non-U.S. Shareholder (unless the broker has actual knowledge to the contrary). 17
Any amounts withheld under the backup withholding rules from a payment to a non-U.S. Shareholder will be refunded by the Service (or credited against the non-U.S. Shareholder's United States federal income tax liability, if any), provided that the required information is furnished to the Service. As discussed above, the United States Treasury issued the Proposed Regulations which also would, if adopted, alter the information reporting and backup withholding rules applicable to non-U.S. Shareholders. Among other things, the Proposed Regulations would provide certain presumptions under which a non-U.S. Shareholder would be subject to backup withholding and information reporting until the Company receives certification from such shareholder of non-U.S. status. As noted, the Proposed Regulations are generally proposed to be effective with respect to dividends paid after December 31, 1997, subject to certain transition rules. The foregoing discussion is not intended to be a complete discussion of the provisions of the Proposed Regulations, and Shareholders are urged to consult their tax advisors with respect to the effect that the Proposed Regulations would have if adopted. Other Tax Consequences. The Company and its Shareholders may be subject to state or local taxation in various state or local jurisdictions, including those in which it or they transact business or reside. There may be other federal, state, local or foreign income, or estate and gift, tax considerations applicable to the circumstances of a particular investor. Shareholders should consult their own tax advisors with respect to such matters. ERISA Plans, Keogh Plans and Individual Retirement Accounts. General Fiduciary Obligations. Fiduciaries of a pension, profit-sharing or other employee benefit plan subject to Title I of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") ("ERISA Plan") must consider whether their investment in the Company's Shares satisfies the diversification requirements of ERISA, whether the investment is prudent in light of possible limitations on the marketability of the Shares, whether such fiduciaries have authority to acquire such Shares under the appropriate governing instrument and Title I of ERISA, and whether such investment is otherwise consistent with their fiduciary responsibilities. Any ERISA Plan fiduciary should also consider ERISA's prohibition on improper delegation of control over or responsibility for "plan assets." Trustees and other fiduciaries of an ERISA plan may incur personal liability for any loss suffered by the plan on account of a violation of their fiduciary responsibilities. In addition, such fiduciaries may be subject to a civil penalty of up to 20% of any amount recovered by the plan on account of such a violation (the "Fiduciary Penalty"). Also, fiduciaries of any Individual Retirement Account ("IRA"), Keogh Plan or other qualified retirement plan not subject to Title I of ERISA because it does not cover common law employees ("Non-ERISA Plan") should consider that such an IRA or Non-ERISA Plan may only make investments that are authorized by the appropriate governing instrument. Fiduciary Shareholders should consult their own legal advisers if they have any concern as to whether the investment is inconsistent with any of the foregoing criteria. Prohibited Transactions. Fiduciaries of ERISA Plans and persons making the investment decision for an IRA or other Non-ERISA Plan should also consider the application of the prohibited transaction provisions of ERISA and the Code in making their investment decision. Sales and certain other transactions between an ERISA Plan, IRA, or other Non-ERISA Plan and certain persons related to it are prohibited transactions. The particular facts concerning the sponsorship, operations and other investments of an ERISA Plan, IRA, or other Non-ERISA Plan may cause a wide range of other persons to be treated as disqualified persons or parties in interest with respect to it. A prohibited transaction, in addition to imposing potential personal liability upon fiduciaries of ERISA Plans, may also result in the imposition of an excise tax under the Code or a penalty under ERISA upon the disqualified person or party in interest with respect to the ERISA or Non-ERISA Plan or IRA. If the disqualified person who engages in the transaction is the individual on behalf of whom an IRA is maintained (or his beneficiary), the IRA may lose its tax-exempt status and its assets may be deemed to have been distributed to such individual in a taxable distribution (and no excise tax will be imposed) on account of the prohibited transaction. Fiduciary Shareholders should consult their own legal advisers if they have any concern as to whether the investment is a prohibited transaction. 18
Special Fiduciary and Prohibited Transactions Considerations. The Department of Labor ("DOL"), which has certain administrative responsibility over ERISA Plans as well as over IRAs and other Non-ERISA Plans, has issued a regulation defining "plan assets." The regulation generally provides that when an ERISA or Non-ERISA Plan or IRA acquires a security that is an equity interest in an entity and that security is neither a "publicly offered security" nor a security issued by an investment company registered under the Investment Company Act of 1940, the ERISA or Non-ERISA Plan's or IRA's assets include both the equity interest and an undivided interest in each of the underlying assets of the entity, unless it is established either that the entity is an operating company or that equity participation in the entity by benefit plan investors is not significant. The regulation defines a publicly offered security as a security that is "widely held," "freely transferable" and either part of a class of securities registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or sold pursuant to an effective registration statement under the Securities Act (provided the securities are registered under the Exchange Act within 120 days after the end of the fiscal year of the issuer during which the offering occurred). The Company's Shares are registered under the Exchange Act. The regulation provides that a security is "widely held" only if it is part of a class of securities that is owned by 100 or more investors independent of the issuer and of one another. However, a security will not fail to be "widely held" because the number of independent investors falls below 100 subsequent to the initial public offering as a result of events beyond the issuer's control. The regulation provides that whether a security is "freely transferable" is a factual question to be determined on the basis of all relevant facts and circumstances. The regulation further provides that, where a security is part of an offering in which the minimum investment is $10,000 or less, certain restrictions ordinarily will not, alone or in combination, affect a finding that such securities are freely transferable. The restrictions on transfer enumerated in the regulation as not affecting that finding include: any restriction on or prohibition against any transfer or assignment which would result in a termination or reclassification of the Company for federal or state tax purposes, or would otherwise violate any state or federal law or court order; any requirement that advance notice of a transfer or assignment be given to the Company and any requirement that either the transferor or transferee, or both, execute documentation setting forth representations as to compliance with any restrictions on transfer which are among those enumerated in the regulation as not affecting free transferability, including those described in the preceding clause of this sentence; any administrative procedure which establishes an effective date, or an event prior to which a transfer or assignment will not be effective; and any limitation or restriction on transfer or assignment which is not imposed by the issuer or a person acting on behalf of the issuer. The Company believes that the restrictions imposed under the Company's Declaration and Bylaws on the transfer of Shares do not result in the failure of the Shares to be "freely transferable." Furthermore, the Company believes that at present there exist no other facts or circumstances limiting the transferability of the Shares which are not included among those enumerated as not affecting their free transferability under the regulation, and the Company does not expect or intend to impose in the future (or to permit any person to impose on its behalf) any limitations or restrictions on transfer which would not be among the enumerated permissible limitations or restrictions. However, the final regulation only establishes a presumption in favor of a finding of free transferability, and no guarantee can be given that the DOL or the Treasury Department will not reach a contrary conclusion. Assuming that the Shares will be "widely held" and that no other facts and circumstances exist which restrict transferability of the Shares, the Company has received an opinion from Company Counsel that the Shares should not fail to be "freely transferable" for purposes of the regulation due to the restrictions on transfer of the Shares under the Company's Declaration and Bylaws and that under the regulation the Shares are publicly offered securities and the assets of the Company will not be deemed to be "plan assets" of any ERISA Plan, IRA or other Non-ERISA Plan that invests in the Shares. If the assets of the Company are deemed to be plan assets under ERISA: (i) the prudence standards and other provisions of Part 4 of Title I of ERISA would be applicable to investments made by the Company; (ii) the person or persons having investment discretion over the assets of ERISA Plans which invest in the Company would be liable under the aforementioned Part 4 of Title I of ERISA for investments made by the Company which do not conform to such ERISA standards unless Advisors registers as an investment adviser under the 19
Investment Advisers Act of 1940 and certain other conditions are satisfied; and (iii) certain transactions that the Company might enter into in the ordinary course of its business and operation might constitute "prohibited transactions" under ERISA and the Code. Item 2. Properties General. As of December 31, 1996, the Company's hotels consist of 53 Courtyard by Marriott(R) hotels, 18 Residence Inn by Marriott(R) hotels, and 11 Wyndham Garden(R) hotels, with 11,728 rooms in 26 states. These hotels have an average age of approximately six years and the Company believes that the physical plant of each hotel in which it has invested is suitable and adequate for its present and any currently proposed uses. The hotels are all leased to the Lessees and operated by the Managers. See "Business -- The Hotels, Leases and Management Agreements." The following table summarizes certain information about the properties as of December 31, 1996. All dollar figures are in thousands. Total Number of Number of Investment at Annual Base State Hotels Rooms December 31, 1996 Rent - ----- ------ ----- ----------------- ---- Arizona 8 1,164 $ 67,628 $ 6,604 California 10 1,470 110,081 10,580 Delaware 1 152 12,830 1,210 Florida 3 449 38,882 3,780 Georgia 7 978 67,977 6,584 Illinois 3 514 39,879 3,811 Indiana 1 149 8,973 880 Iowa 1 108 8,034 780 Maryland 3 406 34,967 3,340 Massachusetts 8 1,072 71,919 6,970 Michigan 2 281 12,209 1,180 Minnesota 2 358 18,276 1,813 Missouri 2 298 16,934 1,620 New Jersey 3 416 33,096 3,170 New Mexico 1 112 12,543 1,190 New York 3 403 29,761 2,850 North Carolina 4 534 33,113 3,190 Ohio 1 106 6,741 650 Pennsylvania 4 567 46,353 4,450 Rhode Island 1 148 10,507 1,020 South Carolina 1 108 6,053 580 Tennessee 3 399 32,785 3,189 Texas 3 405 29,430 2,830 Virginia 3 462 40,331 3,870 Washington 3 522 44,442 4,369 Wisconsin 1 147 8,943 850 ------- -------- -------- -------- 82 11,728 $842,687 $ 81,360 ======= ======== ======== ======== Certain of the hotels are currently and from time to time may be made subject to mortgages securing the Company's lines of credit, secured borrowings of the Company's subsidiaries or other secured borrowings. See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Liquidity and Capital Resources." The right to occupy the land underlying 10 of the hotels was acquired by an assignment of leasehold interest under long-term ground leases. In each case, the remaining term of the ground lease (including renewal options) is in excess of 42 years, and the ground lessors are unrelated to the sellers and the Company. 20
Rent payable under the 10 ground leases is the responsibility of the Company's Lessees and is generally calculated as a percentage of Hotel revenues. Eight of the 10 ground leases require minimum annual rent ranging from approximately $90,000 to $502,900 per year. If a ground lease terminates, the Lease with respect to the Hotel on such ground-leased land will also terminate. If a Lessee does not perform such obligations under the ground lease or elects not to renew any ground lease, the Company must perform such obligations under the ground lease or renew such ground lease in order to protect its investments in the affected Hotel. Any pledge of the Company's interests in a ground lease may also require the consent of the applicable ground lessor and its lenders. Item 3. Legal Proceedings Although in the ordinary course of business the Company is or may become involved in legal proceedings, the Company has a limited operating history and is not aware of any material pending legal proceeding affecting any of the hotels for which it might become liable. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of shareholders during the fourth quarter of the year covered by this Form 10-K. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's Shares are traded on the New York Stock Exchange (symbol: HPT). The following table sets forth for the periods indicated the high and low closing sale prices for the Shares as reported in the New York Stock Exchange Composite Transactions reports since the Company's initial public offering. 1995 High Low August 22 to September 30 27 24 1/2 Fourth Quarter 26 3/4 24 3/8 1996 High Low First Quarter 27 7/8 25 1/2 Second Quarter 27 24 5/8 Third Quarter 26 7/8 25 Fourth Quarter 29 1/2 25 The closing price of the Shares on the New York Stock Exchange on March 26, 1997 was $32.50 per Share. 21
As of March 4, 1997, there were 850 Shareholders of record and the Company estimates that as of such date there were approximately 38,000 beneficial owners of the Shares. Information about the Company's dividends paid is summarized in the table below. Dividends are generally paid in the quarter following the quarter to which they relate. Dividend Annualized Per Share Dividend Rate 1995 Third Quarter $0.24 $2.20 Fourth Quarter 0.55 2.20 1996 First Quarter $0.58 $2.32 Second Quarter 0.58 2.32 Third Quarter 0.59 2.36 Fourth Quarter 0.59 2.36 All dividends declared have been paid. The Company intends to continue to declare and pay future dividends on a quarterly basis. In order to qualify for the beneficial tax treatment accorded to REITs by Sections 856 through 860 of the Code, the Company is required to make distributions to shareholders which annually will be at least 95% of the Company's "real estate investment trust taxable income" (as defined in the Code). All distributions will be made by the Company at the discretion of the Board of Trustees and will depend on the earnings of the Company, cash available for distribution, the financial condition of the Company and such other factors as the Board of Trustees deems relevant. The Company intends to distribute substantially all of its "real estate investment trust taxable income" to its shareholders. Item 6. Selected Financial Data The following table sets forth selected financial and operating data on an historical and a pro forma basis for the Company for the years ended December 31, 1995 and 1996. The pro forma data for 1995 are unaudited and presented as if the Company's formation transactions, primarily the acquisition and leasing of the 37 hotels acquired in 1995 and the Company's initial public offering of Shares, and certain other transactions had been consummated as of the date or for the period presented. The pro forma data are not necessarily indicative of what the actual financial position or results of operations would have been, nor do they purport to represent the financial position or results of operations for future periods. The following selected and pro forma financial and operating data should be read in conjunction with the financial statements and the notes thereto included beginning at page F-1 of this 22
Report on Form 10-K. <TABLE> <CAPTION> Historical Pro Forma Historical --------------------- ----------------- ------------------ February 7, 1995 (Inception) to Year Ended Year Ended December 31, 1995 (1) December 31, 1995 December 31, 1996 (In thousands, except per Share data) <S> <C> <C> <C> Operating Data: Revenues: $ 19,531 $ 33,308 $ 69,514 Rental income 4,037 6,424 12,169 FF&E reserve income 74 144 946 -------- -------- -------- Total revenues 23,642 39,876 82,629 Expenses: Interest 5,063 -- 5,646 Depreciation and amortization 5,820 9,229 20,398 General and administrative 1,410 2,616 4,921 -------- -------- -------- Total expense: 12,293 11,845 30,965 -------- -------- -------- Net income $ 11,349 $ 28,031 $ 51,664 ======== ======== ======== Net income per share $ 2.51 $ 2.22 $ 2.23 Weighted average shares outstanding . 4,515 12,601 23,170 Balance Sheet Data (as of December 31): Real estate properties, net $326,752 $326,752 $816,469 Total Assets 338,947 338,947 871,603 Total debt -- -- 125,000 Shareholders' equity 297,951 297,951 645,208 Other Data: Cash available for distribution (2) $ 13,156 $ 30,836 $ 60,794 Cash provided by operating activities (3) 14,140 31,820 61,743 Cash used in investing activities(3) . 303,652 303,652 448,678 Cash provided by financing activities(3) 291,647 268,481 422,873 Cash available for Distribution per share(2)$2.91 $2.45 $2.62 <FN> (1) From inception on February 7, 1995 until completion of its initial public offering on August 22, 1995, the Company was a 100% owned subsidiary of HRP. The Company was initially capitalized with $1.0 million of equity and $163.3 million of debt. The debt was provided by HRP at rates which were lower than the market rates which the Company would have paid on a stand alone basis. Accordingly, the Company does not believe that its results of operations while it was a wholly owned subsidiary are comparable to subsequent periods. (2) Some REITs use funds from operations ("FFO"), representing net income, calculated in accordance with generally accepted accounting principles, adjusted for non-recurring items, before real estate depreciation and amortization as a measure of financial performance. Because of the impact of FF&E Reserves on the Company's calculation of FFO which results from the fact that the FF&E Reserves from certain Leases are included in FFO (and by the Company), the Company does not believe FFO represents a meaningful measure of its performance or offers a meaningful basis for comparison of its performance with that of other public hotel REITs. Instead, the Company believes that the best measure of its financial performance is Cash Available for Distribution, which it defines as net income from operations, plus depreciation and amortization and other non-cash charges and less Company income reserved for renovations and refurbishment (i.e., the FF&E Reserves) and adjusted for other than non-cash items and non-recurring items, if any. Moreover, the Company believes that Cash Available for Distribution provides a meaningful basis for comparison of the Company's performance with the performance of other public hotel REITs provided that appropriate amounts are reserved for renovations and refurbishment in all cases. 23
(3) Amounts are computed on a pro forma basis in accordance with generally accepted accounting principles, except that cash provided by (used in) operating activities excludes the effect on cash resulting from changes in current assets and current liabilities. The Company does not believe that these excluded items are material to net cash provided by operating activities. </FN> </TABLE> Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Overview The Company was organized on February 7, 1995 and commenced operations on March 24, 1995 with the acquisition of its first 21 hotels. The Company completed its initial public offering of shares and acquired an additional 16 hotels on August 22, 1995. Since it has been recently formed and has limited historical financial data, the Company believes it is meaningful to an understanding of its present and ongoing operations to discuss the Company's pro forma results of operations as well as its historical results of operations. The following discussion should be read in conjunction with the financial statements and the notes thereto included elsewhere herein. Pro forma results and percentage relationships set forth in the financial highlights section and in such financial statements may not be indicative of the future operations of the Company. Historical and Pro Forma Results of Operations Year Ended December 31, 1996 versus Pro Forma Year Ended December 31, 1995 The Company's assets increased to $871.6 million as of December 31, 1996 from $338.9 million at December 31, 1995. The increase primarily resulted from three hotel portfolio acquisitions completed during 1996. In March and April of 1996, the Company acquired 16 Courtyard by Marriott(R) hotels for $176.4 million and 18 Residence Inn(R) by Marriott hotels for $172.2 million. In May 1996, the Company acquired 11 Wyndham Garden(R) hotels for $135.3 million. These acquisitions were funded through the use of cash on hand, borrowings on the Company's line of credit, and the net proceeds form the offering of 14,250,000 shares in April 1996. Total revenues in 1996 were $82.6 million versus pro forma 1995 revenue of $39.9 million. Total revenues were comprised principally of base and percentage rent of $69.5 million and FF&E reserve income of $12.2 million in 1996 versus $33.3 million and $6.4 million, respectively, in the pro forma period. The Company's results of operations in 1996 are reflective of the growth in the number of owned hotels to 82, from 37 at year end 1995. The leases for the Company's 82 hotels at December 31, 1996 call for base rent of $81.3 million annually, versus $32.9 million for the 37 hotels owned at December 31, 1995. During 1996, the Company earned revenue of approximately $1.2 million ($0.05/share) in percentage rents from its portfolio of 53 Courtyard hotels, reflective of continued increases in Total Hotel Sales at these properties. Total expenses in 1996 were $31.0 million, including interest expense and depreciation and amortization of $5.6 million and $20.4 million, respectively, versus pro forma 1995 expenses of $11.8 million, including depreciation and amortization of $9.2 million. A portion of the hotels purchased in 1996 were financed with proceeds from the Company's line of credit which was ultimately repaid with prepayable floating rate mortgages. Such debt financing in 1996 gave rise to the $5.6 million of interest expense referred to above, versus zero for pro forma 1995, when the Company did not use third-party debt. The substantial increase in the number of hotels owned by the Company has also proportionately increased the Company's general expense levels, including depreciation and amortization and general and administrative expenses. Net income in 1996 was $51.7 million ($2.23 per share) and cash available for distribution for the period was $60.8 million ($2.62 per share), based in both cases on average outstanding shares for the period of 23,170,000. This compares with pro forma 1995 net income of $28.0 million ($2.22 per share) and cash available for distribution of $30.8 million ($2.45 per share), based in both cases upon 13,600,900 outstanding shares. This 7% growth in CAD is primarily related to the effects of the Company's 1996 hotel acquisitions and 24
related financing activity as well as growth in percentage rent to $1.2 million in 1996 from $0.4 million in the 1995 pro forma period. During April 1996, the Company completed an offering of 14,250,000 common shares of beneficial interest raising net proceeds of approximately $358 million to fund its acquisitions and more than doubling its equity capitalization and shares outstanding. Cash flow provided by (used for) operating, investing and financing activities was $61.7 million, ($448.7 million) and $422.9 million, respectively, for the year ended December 31, 1996. February 7, 1995 (Inception) Through December 31, 1995 Total revenues from Inception through December 31, 1995 were $23.6 million, which included base and percentage rent of $19.5 million and FF&E reserve income of $4.0 million. Total expenses for the period were $12.3 million, including interest expense and depreciation and amortization of $5.0 million and $5.8 million, respectively. Net income for the period was $11.3 million ($2.51 per share) and cash available for distribution for the period was $13.2 million ($2.91 per share), based in both cases on average outstanding shares for the period of 4,515,000. From Inception until completion of its initial public offering on August 22, 1995, the Company was a 100% owned subsidiary of HRP and was initially capitalized with $1 million of equity and $163.3 million of debt. The debt was provided by HRP at rates which were lower than the market rates which the Company would have paid on a stand alone basis. Accordingly, the Company does not believe that its results of operations while it was a wholly owned subsidiary of HRP are comparable to subsequent periods. Cash flow provided by (used for) operating, investing and financing activities was $14.1 million, ($303.7 million) and $291.6 million, respectively, for the year ended December 31, 1996. Pro Forma Year Ended December 31, 1995 The pro forma results of operations assume that the Company's formation transactions, the initial public offering of shares and the acquisition and leasing of the 37 hotels and related transactions all occurred on January 1, 1995. On this pro forma basis, total revenues would have been $39.9 million (principally base and percentage rents of $33.3 million and FF&E reserve income of $6.4 million). Total expenses would have been $11.8 million (including depreciation and amortization of $9.2 million and general and administrative expenses of $2.6 million). Net income would have been $28.0 million or $2.22 per share, and cash available for distribution would have been $30.8 million or $2.45 per share, based in both cases upon 12,600,900 shares outstanding. Liquidity and Capital Resources The Company's primary source of cash to fund its dividends and day to day operations is the base and percentage rent it receives. Base rent is paid monthly in advance and percentage rent is paid either monthly or quarterly in arrears. This flow of funds from rent has historically been sufficient for the Company to pay dividends and meet day to day operating expenses. The Company believes that its operating cash flow will be sufficient to meet its operating expenses and dividend payments. In order to fund acquisitions and to accommodate occasional cash needs which may result from timing differences between the receipt of rents and the need to pay dividends or operating expenses, the Company has entered into a line of credit arrangement was with DLJ Mortgage Capital, Inc. ("DLJMC"). The line of credit is for up to $200 million, all of which was available at December 31, 1996. Drawings under the line of credit are secured by first mortgage liens on certain of the Company's hotels. Funds may be drawn, repaid and redrawn until maturity, and no principal repayment is due until maturity. The line of credit matures on December 31, 1998; however, upon request and subject to certain terms and conditions, the Company has the right (but not the obligation) to convert amounts outstanding at maturity, if any, into an amortizing mortgage loan due on December 31, 2008. Interest on borrowings under the line of credit are payable until maturity at a spread above LIBOR; and interest during the extended term, if any, will be set at market rates at the time the loan is extended. During 1996, subsidiaries of the Company issued $125 million of commercial mortgage-backed securities ("Notes") in an unregistered 144A offering. The Notes are non-recourse notes sold to the public and secured by the Company's subsidiaries' assets including 18 Residence Inn by Marriott(R) and 11 25
Wyndham Garden(R) hotels. The Notes carry interest that floats with one-month LIBOR plus a spread and are due December 1, 2001, but may be prepaid by the Company at any time without penalty. In connection with this issuance of Notes, the Company entered into interest rate cap agreements for $125 million (notional amount) with a major financial institution (the "Cap Counterparty") which limit the Company's maximum interest rate exposure to 7.6925% on this debt. The Company expects to use existing cash balances, borrowings under the Line of Credit and/or net proceeds of offerings of equity or debt securities to fund future hotel acquisitions. To the extent the Company borrows on the line of credit, the Company will explore various alternatives in both the timing and method of repayment of such amounts. Such alternatives may include incurring long term debt. On December 24, 1996, the Company's Shelf Registration for up to $500 million of securities, including debt securities, was declared effective by the Securities and Exchange Commission (SEC). An effective Shelf Registration enables HPT to issue specific securities on an expedited basis by filing a prospectus supplement with the SEC. On January 8, 1997, the Company acquired a 381-room full service hotel in Salt Lake City, Utah, for $44 million. The hotel is leased to Wyndham Hotel Corporation and has been rebranded as a Wyndham(R) hotel. The Company's net cash funding for this acquisition was approximately $34 million for which it used cash then on hand, which was generated primarily from the Notes offering. Although there can be no assurance that the Company will consummate any debt or equity security offerings, the Company believes it will have access to various types of financing in the future, including debt or equity securities offerings, with which to finance future acquisitions. Seasonality The Company's hotels have historically experienced seasonal differences typical of the hotel industry with higher revenues in the second and third quarters of calendar years compared with the first and fourth quarters. This seasonality is not expected to cause fluctuations in the Company's rental income because the Company believes that the revenues generated its hotels will be sufficient for the lessees to pay rents on a regular basis notwithstanding seasonal fluctuations. Inflation The Company believes that inflation should not have a material adverse effect on the Company. Although increases in the rate of inflation may tend to increase interest rates which the Company may be required to pay for borrowed funds, the Company has a policy of obtaining interest rate caps in appropriate circumstances to protect it from interest rate increases. In addition, the Company's leases provide for the payment of percentage rent to the Company based on increases in total sales, and such rent should increase with inflation. Item 8. Financial Statements and Supplementary Data The financial statements, related notes, schedule and reports of independent public accountants for the Company are included following Part IV, beginning on page F-1, and identified in the index appearing at Item 14(a). The financial statements for HMH HPT Courtyard, Inc. and HMH HPT Residence, Inc. as of January 3, 1997 and for the period the ended and the report of independent public accountants begin on page F-13. Item 9. Changes in and Disagreements on Accounting and Financial Disclosure None. 26
PART III The information in Part III (Items, 10, 11, 12 and 13) is incorporated by reference to the Company's definitive Proxy Statement, which is expected to be filed not later than 120 days after the end of the Company's fiscal year. PART IV Item 14. Exhibits, Financial Statements, Schedule and Reports on Form 8-K. <TABLE> <CAPTION> (a) Index to Financial Statements and Financial Statement Schedules <S> <C> Hospitality Properties Trust Financial Statements: Report of Independent Public Accountants......................................... F-1 Consolidated Balance Sheet as of December 31, 1995 and December 31, 1996......... F-2 Consolidated Statement of Income for the period February 7, 1995 (inception) to December 31, 1995 and year ended December 31, 1996................ F-3 Consolidated Statement of Shareholders' Equity for the period February 7 , 1995 (inception) to December 31, 1995 and year ended December 31, 1996................ F-4 Consolidated Statement of Cash Flows for the Period February 7, 1995 (inception) to December 31, 1995 and year ended December 31, 1996................ F-5 Notes to Consolidated Financial Statements........................................ F-6 Report of Independent Public Accountants......................................... F-10 Schedule III - Real Estate and Accumulated Depreciation.......................... F-11 HMH HPT Courtyard, Inc. Financial Statements: Report of Independent Public Accountants......................................... F-13 Balance Sheet as of December 29, 1995 and January 3, 1997........................ F-14 Statement of Income for the period from inception through December 29, 1995 and the fiscal year ended January 3, 1997........................................ F-15 Statement of Shareholder's Equity for the period from inception to December 29, 1995 and the fiscal year ended January 3, 1997...................... F-16 Statement of Cash Flows for the period from inception to December 29, 1995 and the fiscal year ended January 3, 1997................... F-17 Notes to Financial Statements.................................................... F-18 HMH HPT Residence, Inc. Financial Statements: Report of Independent Public Accountants......................................... F-22 Balance Sheet as of January 3, 1997.............................................. F-23 27
Statement of Income for the period from inception through January 3, 1997....... F-24 Statement of Shareholder's Equity for the period from inception through January 3, 1997.......................................................... F-25 Statement of Cash Flows for the period from inception through January 3, 1997.......................................................... F-26 Notes to Financial Statements.................................................... F-27 </TABLE> All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. Exhibits: 3.1* Declaration of Trust of the Registrant 3.2* Bylaws of the Registrant 4.1* Form of Share Certificate 8.1 Opinion of Sullivan & Worcester LLP as to certain tax matters 10.1* Purchase-Sale and Option Agreement dated as of February 3, 1995 by and among HMH Courtyard Properties, Inc., HMH Properties, Inc. and Hospitality Properties, Inc., as amended 10.2** Fifth Amendment to Purchase-Sale and Option Agreement dated February 26, 1996, by and between IIIT and IIMII Properties, Inc. 10.3* Form of Courtyard Management Agreement between HMH Courtyard Properties, Inc., d/b/a HMH Properties, Inc. and Courtyard Management Corporation 10.4* Form of First Amendment to Courtyard Management Agreement between Courtyard Management Corporation and Hospitality Properties, Inc. and Consolidation Letter Agreement by and between Courtyard Management Corporation and Hospitality Properties, Inc. 10.5* Form of Lease Agreement between Hospitality Properties, Inc. and HMH HPT Courtyard, Inc. 10.19** Form of Lease Agreement between HMH HPT Residence Inn, Inc. and Hospitality Properties Trust 10.10* Advisory Agreement(+) 10.11 Form of Revolving Credit Agreement by and between the Company and DLJ Mortgage Capital, Inc., as amended and restated on December 29, 1995, as further amended by Amendment No. 1, dated February 26, 1996 10.12 Amendment, dated November 25, 1996 to the Revolving Credit Agreement, amended and restated on December 29, 1995, by and between the Company and DLJ Mortgage Capital, Inc. 10.13** Form of Residence Inn Management Agreement between HMH Properties, Inc. and Residence Inn by Marriott(R), Inc. 10.14* Hospitality Properties Trust 1995 Incentive Share Award Plan(+) 10.15*** Promissory Note in the amount of $125,000,000 dated as of November 25, 1996 from HPTRI Corporation and HPTWN Corporation to Column Financial Inc. 10.16*** Loan Agreement dated as of November 25, 1996 by and between HPTRI Corporation and HPTWN Corporation, as borrowers, and Column Financial Inc., as lender 10.17*** Form of Deed of Trust, Assignment of Leases and Rents and Security Agreement from HPTRI Corporation, as Trustor, to Chicago Title Insurance Company, as Trustee, for benefit of Column Financial, Inc. 28
10.18*** Trust and Servicing agreement dated as of November 25, 1996 by and among Hospitality Properties Mortgage Acceptance Corp., as Depositor, AMRESCO Management, Inc., as Servicer, and The Chase Manhattan Bank, as Trustee 10.19 Lease Agreement by and between HPTSLC Corporation, as landlord, and WIIC Salt Lake Corporation, as tenant, dated January 1997 12 Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant 23.1 Consents of Arthur Andersen LLP 23.2 Consent of Sullivan & Worcester LLP (included in Exhibit 8.1 to this Registration Statement) 27 Financial Data Schedule 99 Certain Investment Considerations - ----------------------- Each exhibit marked by an (*) or a (**) is incorporated by reference to the corresponding document or instrument filed as an exhibit to the Company's Registration Statement on Form S-11 (File No. 33-93330) or File No. 333-1433, respectively. Each exhibit marked with a (***) is incorporated by reference to the corresponding document or instrument filed as an exhibit to the Company's Current Report on Form 8-K dated December 4, 1996. (+) Management contract, compensatory plan or agreement. 29
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Trustees and Shareholders of Hospitality Properties Trust: We have audited the accompanying consolidated balance sheet of Hospitality Properties Trust (the "Company") as of December 31, 1995 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for the period from February 7, 1995 (inception) to December 31, 1995 and the year ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hospitality Properties Trust as of December 31, 1995 and 1996, and the results of operations and its cash flows for the period from February 7, 1995 (inception) to December 31, 1995 and the year ended December 31, 1996, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Washington, D.C. January 10, 1997 F-1
<TABLE> <CAPTION> HOSPITALITY PROPERTIES TRUST CONSOLIDATED BALANCE SHEET (Dollars in thousands) As of As of December 31, 1995 December 31, 1996 ----------------- ----------------- <S> <C> <C> ASSETS Real estate properties, at cost: Land $ 62,311 $ 143,462 Buildings and improvements 270,261 699,225 --------- --------- 332,572 842,687 Less accumulated depreciation (5,820) (26,218) --------- --------- 326,752 816,469 Cash and cash equivalents 2,135 38,073 Rent receivable 322 1,671 Restricted cash (FF&E Reserve) 5,342 7,277 Other assets, net 4,396 8,113 --------- --------- $ 338,947 $ 871,603 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Security deposits $ 32,900 $ 81,360 Debt -- 125,000 Dividends payable 6,930 15,846 Due to affiliate 770 2,376 Accounts payable and accrued expenses 396 1,813 --------- --------- Total liabilities 40,996 226,395 Shareholders' equity: Preferred shares of beneficial interest, no par value, 100,000,000 shares authorized, none issued -- -- Common shares of beneficial interest, $.01 par value, 100,000,000 shares authorized, 12,600,900 and 26,856,800 shares issued and outstanding 126 269 Additional paid-in capital 297,962 656,253 Cumulative net income 11,349 63,013 Dividends (paid or declared) (11,486) (74,327) --------- --------- Total shareholders' equity 297,951 645,208 --------- --------- $ 338,947 $ 871,603 ========= ========= </TABLE> See accompanying notes. F-2
<TABLE> <CAPTION> HOSPITALITY PROPERTIES TRUST CONSOLIDATED STATEMENT OF INCOME (Amounts in thousands, except per share data) February 7, 1995 Year Ended (Inception) to December 31, December 31, 1995 1996 ----------------- -------------- <S> <C> <C> Revenues: Rental income $19,531 $69,514 FF&E reserve income 4,037 12,169 Interest income 74 946 ------- ------- Total revenues 23,642 82,629 ------- ------- Expenses: Interest (including amortization of deferred finance costs of $24 and $341, respectively) 5,063 5,646 Depreciation and amortization of real estate assets 5,820 20,398 General and administrative 1,410 4,921 ------- ------- Total expenses 12,293 30,965 ------- ------- Net Income $11,349 $51,664 ======= ======= Weighted average Shares outstanding 4,515 23,170 Net income per Share $ 2.51 $ 2.23 ======= ======= </TABLE> See accompanying notes. F-3
<TABLE> <CAPTION> HOSPITALITY PROPERTIES TRUST CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Dollars in thousands) Additional Cumulative Number Of Common Paid-In Net Shares Shares Capital Income Dividends Total --------- ------ ---------- ---------- --------- ----- <S> <C> <C> <C> <C> <C> <C> Initial capitalization as of February 7, 1995 (Inception) 40,000 $ -- $ 960 $ -- $ -- $ 960 Issuance of Common Shares of Beneficial Interest, net 12,560,000 126 296,980 -- -- 297,106 Stock grants 900 -- 22 -- -- 22 Net income -- -- -- 11,349 -- 11,349 Dividends (paid or declared) -- -- -- -- (11,486) (11,486) ---------- ---------- ---------- ---------- ---------- ---------- Balance at December 31, 1995 12,600,900 126 297,962 11,349 (11,486) $ 297,951 Issuance of Common Shares of Beneficial Interest, net 14,250,000 143 358,136 -- -- 358,279 Stock grants 5,900 -- 155 -- -- 155 Net income -- -- -- 51,664 -- 51,664 Dividends (paid or declared) -- -- -- -- (62,841) (62,841) Balance at December 31, 1996 26,856,800 $ 269 $ 656,253 $ 63,013 $ (74,327) $ 645,208 ========== ========== ========== ========== ========== ========== </TABLE> See accompanying notes. F-4
<TABLE> <CAPTION> HOSPITALITY PROPERTIES TRUST CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in thousands) February 7, 1995 (Inception) to For the Year Ended December 31, 1995 December 31, 1996 ----------------- ----------------- <S> <C> <C> Cash flows from operating activities: Net income $ 11,349 $ 51,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization 5,820 20,398 Amortization of deferred finance costs as interest 24 341 FF&E reserve income (4,037) (12,169) Changes in assets and liabilities: Increase in rent receivable and other assets (182) (1,566) Increase in accounts payable and accrued expenses 396 1,926 Increase in due to affiliate 770 1,149 --------- --------- Cash provided by operating activities 14,140 61,743 --------- Cash flows from investing activities: Real estate acquisitions (328,148) (491,638) Increase in security deposits 32,900 48,460 Payments for purchase option (4,500) -- Purchase of FF&E reserve (3,904) (5,500) --------- --------- Cash used in investing activities (303,652) (448,678) --------- --------- Cash flows from financing activities: Draws on credit facility -- 115,650 Repayments of credit facility -- (115,650) Issuance of debt -- 125,000 Proceeds from issuance of shares, net 198,088 358,279 Borrowings and advances from HRP 165,241 -- Payments on borrowings and advances from HRP (65,241) -- Dividends paid (4,556) (53,925) Financing costs (1,885) (3,931) Purchase of interest rate cap -- (2,550) --------- --------- Cash provided by financing activities 291,647 422,873 --------- --------- Increase in cash and cash equivalents $ 2,135 $ 35,938 Cash and cash equivalents at beginning of period -- 2,135 --------- --------- Cash and cash equivalents at end of period $ 2,135 $ 38,073 ========= ========= Supplemental cash flow information: Interest paid $ 5,039 $ 4,652 Non-cash financing activities: Issuance of shares to HRP 100,000 -- Cancellation of indebtedness to HRP (100,000) -- Non-cash investing activities: Property managers' deposits in FF&E reserve 3,862 12,100 Purchases of fixed assets with FF&E reserve (2,424) (15,665) </TABLE> See accompanying notes. F-5
HOSPITALITY PROPERTIES TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per Share and percent data) 1. Organization and Commencement of Operations Hospitality Properties Trust (HPT) was incorporated in the state of Delaware on February 7, 1995. Subsequently, HPT became a Maryland real estate investment trust and effected a 400-for-1 split of its common shares of beneficial interest (the Shares). HPT, which invests in income producing hotel and lodging related real estate, was a 100% owned subsidiary of Health and Retirement Properties Trust (HRP) from its inception through August 22, 1995, when it completed its initial public offering of Shares (the IPO). HRP remains an affiliate of HPT, owning approximately 15% of HPT's issued and outstanding Shares as of December 31,1996. HPT commenced operations on March 24, 1995 and, through December 31, 1996, acquired 82 hotels and related replacement and refurbishment reserves (the FF&E Reserves) directly and through subsidiaries. The properties of HPT and its subsidiaries (the Company) are leased to and managed by subsidiaries (the Lessees and the Managers) of companies unaffiliated with HPT: Host Marriott Corporation; Marriott International, Inc. (Marriott); and Wyndham Hotel Corporation. 2. Summary of Significant Accounting Policies Consolidation. These consolidated financial statements include the accounts of HPT and its subsidiaries. All intercompany transactions have been eliminated. Real estate properties. Real estate properties are recorded at cost. Depreciation is provided for on a straight-line basis over the estimated useful lives ranging up to 40 years. The Company periodically evaluates the carrying value of its long-lived assets in accordance with Statement of Financial Accounting Standards No. 121 (SFAS 121), which it adopted on January 1, 1996. The adoption of SFAS 121 had no effect on the Company's financial statements. Cash and cash equivalents. Highly liquid investments with maturities of three months or less at date of purchase are considered to be cash equivalents. The carrying amount of cash and cash equivalents is equal to its fair value. Deferred interest and finance costs. Costs incurred to secure certain borrowings are capitalized and amortized over the terms of the related borrowing, and were $1,861 and $5,352 at December 31, 1995 and 1996, respectively, net of accumulated amortization of $24 and $313, respectively. Revenue recognition. Rental income from operating leases is recognized on a straight line basis over the life of the lease agreements. Additional rent and interest income is recognized as earned. Net income per share. Net income per share is computed using the weighted average number of shares outstanding during the period. The Company has no common share equivalents. Financial Instruments--Interest Rate Cap Agreements. During 1996, in connection with a $125,000 debt issuance, certain subsidiaries of HPT entered into interest rate protection agreements to limit the Company's exposure to risks of rising interest rates. The cost of the agreements was capitalized and is being amortized over the life of the related borrowing as an adjustment to interest expense. Amounts receivable from the counterparties to the cap agreements are accrued as adjustments to interest expense. At December 31, 1996, the carrying value of such agreements was $2,498 (net of accumulated amortization of $52) and the fair value of such agreements was $2,756. During 1996 interest rates did not exceed the interest rate cap amounts and no balances were receivable under the cap agreements at December 31, 1996. Use of estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts. Actual results could differ from those estimates. F-6
Income taxes. The Company elected to be taxed as a Real Estate Investment Trust (REIT) under Sections 856 through 860 of the Internal Revenue Code of 1986 (the "Code"), commencing with its first taxable year ended December 31, 1995, and intends to conduct its operations so as to continue to qualify as a REIT under the Code. As a REIT, the Company generally will not be subject to Federal income tax on its net income that it currently distributes to shareholders. Qualifications and taxation as a REIT depends on the Company's ability to meet certain dividend distribution tests, stock ownership requirements and various qualification tests prescribed in the Code. During 1996 the Company created several new 100% owned subsidiaries primarily for the purpose of acquiring and owning real estate. Such subsidiaries are all qualified REIT subsidiaries. Subsequent to the IPO the dividends paid by the Company for 1995 ($0.79 per share) were 100% ordinary taxable income and for 1996 ($2.34 per share) were 85% ordinary taxable income and 15% return of capital. 3. Real Estate Properties The Company's 82 hotel properties are leased pursuant to long term operating leases expiring between 2010 and 2012. The leases provide for various automatic renewal terms generally totaling 36-48 years unless the Lessee properly notifies the Company in accordance with the leases. Each lease is a triple net lease and generally requires the Lessee to pay: base rent, percentage rent of between 5% and 8% of increases in total hotel sales over a base year, 5% FF&E reserve escrows, and all operating costs associated with the leased property. Each Lessee posted a security deposit equal to one year's base rent. The FF&E reserve may be used by the Manager and Lessee to maintain the properties in good working order and repair. If the FF&E reserve is not available to fund such expenditures, the Lessees may require the Company to fund such expenditures, in which case annual base rent will be increased by a minimum of 10% of the amount so funded. Under the management agreements with affiliates of Marriott, borrowings secured by certain of the Company's hotels are limited, according to a formula, to amounts less than 60% to 70% of the allocable purchase price of the hotel securing the borrowings. Future minimum lease payments to be received by the Company during the remaining initial terms of its leases total $1,267,320 ($81,360 annually). As of December 31, 1996, the weighted average initial term of the Company's leases was 15.6 years, and the weighted average total term (including all renewal options) was 54.6 years. 4. Indebtedness As of December 31, 1996, the Company had no borrowings outstanding under its $200,000 revolving acquisition credit facility ("Credit Facility") which provides for interest on borrowings at one-month LIBOR plus a premium. Borrowings, if any, may be repaid and reborrowed as necessary until December 31, 1998, at which time outstanding balances may, at the Company's option (subject to lender consent), be either repaid or converted into a 10-year loan. The Credit Facility is secured by certain assets of HPT and one of its subsidiaries. The weighted average interest rate on Credit Facility borrowings outstanding during 1996 was 7.05%. There were no borrowings outstanding at any time under the Credit Facility during the 1995 period. During 1996, certain subsidiaries of the Company issued $125,000 of notes (Notes) through the issuance of certificates of participation. The Notes require payment of interest only through their maturity in December 2001, at which time the principal balance is due. The Notes are prepayable at any time without penalty. Interest on the Notes is equal to one month LIBOR plus a premium. The Notes are non-recourse to HPT and its subsidiaries and are secured by first mortgages on hotels owned by certain subsidiaries of the Company having a net carrying value of $310,000 at December 31, 1996. Approximately $30,820 of annual minimum lease payments are attributed to such hotels. Generally, the terms of the Notes limit the ability of certain subsidiaries of the Company to incur significant secured or unsecured liabilities and restrict the use of proceeds, if any, from the sale or other disposition of assets, if any. The Notes carried a weighted average interest rate from their date of issuance to December 31, 1996 of 6.32%. At December 31, 1996, the Notes carried an interest rate of 6.07%. The carrying amount of the Notes is equal to their fair value. F-7
5. Transactions with Affiliates The Company has an agreement with HRPT Advisors, Inc. ("Advisors") whereby Advisors provides investment, management and administrative services to the Company. Advisors is owned by Gerard M. Martin and Barry M. Portnoy. Messrs. Martin and Portnoy are Managing Trustees of HPT and HRP. Mr. Portnoy is also a partner in the law firm which provides legal services to the Company. The Company's officers are also employees of the Advisor. Advisors is compensated at an annual rate equal to 0.7% of HPT's average real estate investments up to the first $250,000 of such investments and 0.5% thereafter. Advisory fees earned for the period from February 7, 1995 (inception) to December 31, 1995 and the year ended December 31, 1996 were $1,292 and $3,915, respectively. As of December 31, 1996, Advisors owned 250,000 shares of HPT. Incentive advisory fees are paid to Advisors in restricted Common Shares based on a formula, not to exceed 2 cents per weighted average share. The Company accrued $463 in incentive fees during 1996 to be paid in restricted Common Shares in 1997. No incentive fees were due for the 1995 period. HRP owns 4,000,000 shares of HPT, 3,960,000 shares of which it received in consideration of cancellation of a loan receivable totaling $99,000 from the Company. Under the provisions of the Company's Incentive Share Award Plan, 100,000 Common Shares have been reserved for issuance to officers of the Company, consultants to the Company and Independent Trustees of the Company. Each of the three Independent Trustees of HPT were awarded 300 shares under this plan in each of 1995 and 1996. In 1996, 5,000 shares were granted to officers of the Company under this plan and no shares were granted in 1995. Share grants expense is recognized over the related expected service period (one year) based on the market value of shares on the grant date and totaled $101 during 1996 and $10 during the 1995 period. 6. Concentration At December 31, 1996, the Company's 53 Courtyard by Marriott(R) hotels are leased to a subsidiary (Host I) of Host Marriott Corporation (Host) and managed by a subsidiary of Marriott International, Inc. (Marriott). The Company's 18 Residence Inn by Marriott(R) hotels are leased to a subsidiary (Host II) of Host and managed by a subsidiary of Marriott. The Company's 11 Wyndham Garden(R) hotels are leased to a subsidiary (Wyndham I) of Wyndham Hotel Corporation (Wyndham) and managed by another Wyndham subsidiary. The percentage of the Company's annual minimum rents and equity investment attributable to each Lessee are approximately: Host I--63%; Host II--21%; and Wyndham I--16%. The Company's 82 hotels contain 11,728 rooms and are located in 26 states, with 5% to 12% of its hotels in each of California, Massachusetts, Georgia, and Arizona. 7. Pro Forma Information (Unaudited) In April 1996, the Company completed an offering of 14,250,000 common shares of beneficial interest and the acquisition of 45 additional hotels. If such transactions occurred on January 1, 1996, unaudited pro forma 1996 revenues, net income and earnings per share would have been $96,775, $59,330 and $2.22, respectively. In the opinion of management, all adjustments necessary to reflect the effects of the transactions discussed above have been reflected in the pro forma data. The unaudited pro forma data is not necessarily indicative of what the actual consolidated results of operations for the Company would have been for the year indicated, nor does it purport to represent the results of operations for the Company for future periods. F-8
8. Selected Quarterly Financial Data (Unaudited) The following is a summary of the unaudited quarterly results of operations of the Company for 1995 and 1996. <TABLE> <CAPTION> 1995 1996 --------------------------- ------------------------------------------------------------- Third Fourth First Second Third Fourth Quarter(1) Quarter Quarter Quarter Quarter Quarter ---------- ------- ------- ------- ------- ------- <S> <C> <C> <C> <C> <C> <C> Revenues $7,853 $9,998 $10,334 $23,011 $24,878 $24,406 Net income 3,623 6,989 6,622 14,623 15,446 14,973 Net income per share .24(2) .55 .53 .56 .58 .56 <FN> (1) HPT's IPO occurred August 22, 1995 and accordingly the third quarter 1995 figures for revenues and net income partially relate to periods prior to the IPO. (2) Represents the per share amount of net income from the IPO date to September 30, 1995. </FN> </TABLE> F-9
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Trustees and Shareholders of Hospitality Properties Trust: We have audited in accordance with generally accepted auditing standards the consolidated financial statements of Hospitality Properties Trust and have issued our report thereon dated January 10, 1997. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule on pages F-11 and F-12 is the responsibility of Hospitality Properties Trust's management and is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Washington, D.C. January 10, 1997 F-10
<TABLE> <CAPTION> HOSPITALITY PROPERTIES TRUST SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1996 (Dollars in millions) Gross Amount at Initial Costs December 31, 1996 ----------------------------- -------------------------------------------- Subsequent Encum- Buildings & Costs Buildings & Accumulated Date of Depreciation Description brances Land Improvements Capitalized Land Improvements Total Depreciation Acquisition Life <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> 53 Courtyard by $ -- $ 91 $389 $2 $ 91 $391 $482 $(13) 1995/1996 5-40 years Marriott(R) hotels 18 Residence Inn by Marriott(R) 70 39 124 -- 39 124 163 (2) 1996 5-40 years hotels 11 Wyndham Garden(R) hotels 55 13 115 -- 13 115 128 (2) 1996 5-40 years ------------------------------------------------------------------------------------- Total $ 125 $143 $628 $2 $143 $630 $773 $(17) ===================================================================================== </TABLE> The accompanying notes are an integral part of this schedule. F-11
HOSPITALITY PROPERTIES TRUST NOTES TO SCHEDULE III DECEMBER 31, 1996 (In thousands) (A) The change in total cost of properties for the period from February 7, 1995 (inception) to December 31, 1996 is as follows: 1995 1996 ---- ---- Balance at beginning of period $ -- $305,447 Additions: Hotel acquisitions and capital expenditures 305,447 468,050 -------- -------- Balance at close of period $305,447 $773,497 ======== ======== (B) The change in accumulated depreciation for the period from February 7, 1995 (inception) to December 31, 1996 is as follows: 1995 1996 ---- ---- Balance at beginning of period $ -- $ 3,679 Additions: Depreciation expense 3,679 13,022 ------- ------- Balance at close of period $ 3,679 $16,701 ======= ======= F-12
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To HMH HPT Courtyard, Inc.: We have audited the accompanying balance sheets of HMH HPT Courtyard, Inc. (the "Company") as of January 3, 1997 and December 29, 1995, and the related statements of operations, shareholder's equity and cash flows for the fiscal year ended January 3, 1997 and for the period March 24, 1995 (inception) through December 29, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of HMH HPT Courtyard, Inc. as of January 3, 1997 and December 29, 1995, and the results of its operations and its cash flows for the fiscal year ended January 3, 1997 and for the period March 24, 1995 (inception) through December 29, 1995, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Washington, D.C. February 28, 1997 F-13
<TABLE> <CAPTION> HMH HPT COURTYARD, INC. BALANCE SHEETS January 3, 1997 and December 29, 1995 (in thousands, except share data) ASSETS 1996 1995 ---- ---- <S> <C> <C> Advances to manager $ 5,100 $ 3,984 Due from Marriott International, Inc. 3,481 2,218 Security deposit 50,540 32,900 -------- -------- Total assets $ 59,121 $ 39,102 ======== ======== LIABILITIES AND SHAREHOLDER'S EQUITY Due to Host Marriott Corporation $ 4,793 $ 1,508 Deferred gain 39,570 12,908 -------- -------- Total liabilities 44,363 14,416 -------- -------- Shareholder's equity: Common stock, no par value, 100 shares authorized, issued and outstanding -- -- Additional paid-in capital 15,478 25,406 Retained deficit (720) (720) -------- -------- Total shareholder's equity 14,758 24,686 -------- -------- $ 59,121 $ 39,102 ======== ======== </TABLE> See Notes to Financial Statements. F-14
<TABLE> <CAPTION> HMH HPT COURTYARD, INC. STATEMENTS OF OPERATIONS For the Fiscal Year Ended January 3, 1997 and for the Period March 24, 1995 (inception) through December 29, 1995 (in thousands) 1996 1995 ---- ---- <S> <C> <C> REVENUES $ 94,161 $ 37,813 EXPENSES Rent 46,495 19,379 FF&E contribution expense 9,289 3,810 Base and incentive management fees paid to Marriott International, Inc. 18,318 5,156 Other expenses 9,677 5,859 Total operating expenses 83,779 34,204 OPERATING PROFIT BEFORE AMORTIZATION OF DEFERRED GAIN AND CORPORATE EXPENSES 10,382 3,609 Amortization of deferred gain 2,351 675 Corporate expenses (2,235) (1,059) INCOME BEFORE INCOME TAXES 10,498 3,225 Provision for income taxes (4,199) (1,322) NET INCOME $ 6,299 $ 1,903 </TABLE> See Notes to Financial Statements. F-15
<TABLE> <CAPTION> HMH HPT COURTYARD, INC. STATEMENTS OF SHAREHOLDER'S EQUITY For the Fiscal Year Ended January 3, 1997 and for the Period March 24, 1995 (inception) through December 29, 1995 (in thousands) Additional Common Paid-In Retained Stock Capital Deficit -------- ------- --------- <S> <C> <C> <C> Net assets contributed by Host Marriott Corporation $ -- $ 25,406 $ -- Dividend to Host Marriott Corporation -- -- (2,623) Net income -- -- 1,903 ------ -------- -------- Balance, December 29, 1995 -- 25,406 (720) Net liabilities contributed by Host Marriott Corporation -- (9,928) -- Dividend to Host Marriott Corporation -- -- (6,299) Net income -- -- 6,299 ------ -------- -------- Balance, January 3, 1997 $ -- $ 15,478 $ (720) </TABLE> See Notes to Financial Statements. F-16
<TABLE> <CAPTION> HMH HPT COURTYARD, INC. STATEMENTS OF CASH FLOWS For the Fiscal Year Ended January 3, 1997 and for the Period March 24, 1995 (inception) through December 29, 1995 (in thousands) 1996 1995 ---- ---- <S> <C> <C> OPERATING ACTIVITIES: Net income $ 6,299 $ 1,903 Adjustments to reconcile net income to cash provided by operating activities: Amortization of deferred gain (2,351) (675) Changes in operating accounts: Increase in Due to Host Marriott Corporation 3,285 1,082 Decrease in prepaid rent 329 2,531 Increase in due from Marriott International, Inc. (1,263) (2,218) -------- -------- Cash provided by operations 6,299 2,623 -------- -------- FINANCING ACTIVITIES: Dividend to Host Marriott Corporation (6,299) (2,623) -------- -------- CASH AND CASH EQUIVALENTS, end of period $ -- $ -- -------- -------- SUPPLEMENTAL INFORMATION, NON-CASH ACTIVITY: Balances transferred to the Company by Host Marriott Corporation upon commencement of leases Advances to manager $ 1,116 $ 3,984 Prepaid rent 329 2,531 Security deposits 17,640 32,900 Accrued expenses -- (426) Deferred gain (29,013) (13,583) -------- -------- Net (liabilities)/assets contributed by Host Marriott Corporation $ (9,928) $ 25,406 ======== ======== </TABLE> See Notes to Financial Statements. F-17
HMH HPT COURTYARD, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation HMH HPT Courtyard, Inc. (the "Company") was incorporated in Delaware on February 7, 1995 as a wholly-owned indirect subsidiary of Host Marriott Corporation ("Host Marriott"). The Company had no operations prior to March 24, 1995 (the "Commencement Date" or "Inception"). On the Commencement Date, affiliates of Host Marriott (the "Sellers") sold 21 Courtyard properties to Hospitality Properties Trust ("HPT"). On August 22, 1995, HPT purchased an additional 16 Courtyard properties from the Sellers. On March 22, 1996 and April 4, 1996, a total of 16 additional Courtyard properties were purchased by HPT for a total of 53 Courtyard hotels (the "Hotels"). The Sellers contributed the assets and liabilities related to the operations of such properties to the Company, including working capital advances to the manager, prepaid rent under leasing arrangements and rights to other assets as described in Note 2. Such assets have been accounted for at the historical cost. Fiscal Year The Company's fiscal year ends on the Friday nearest to December 31. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenues Revenues represent house profit from the Hotels because the Company has delegated substantially all of the operating decisions relating to the generation of house profit from the Hotels to Marriott International, Inc. (the "Manager" or "Marriott International"). House profit reflects the net revenues flowing to the Company as lessee and represents total hotel sales less property level expenses excluding depreciation and amortization, real and personal property taxes, lease payments, insurance, contributions to the property improvement fund and management fees. Corporate Expenses The Company operates as a unit of Host Marriott utilizing Host Marriott's employees, centralized system for cash management, insurance and administrative services. The Company has no employees. All cash received by the Company is deposited in and commingled with Host Marriott's general corporate funds. Operating expenses and other cash requirements of the Company are paid by Host Marriott and charged directly or allocated to the Company. Certain general and administrative costs of Host Marriott are allocated to the Company, principally based on Host Marriott's specific identification of individual cost items and otherwise based upon estimated levels of effort devoted by its general and administrative departments to individual entities. In the opinion of management, the methods for allocating corporate, general and administrative expenses and other direct costs are reasonable. It is not practicable to estimate the costs that would have been incurred by the Company if it had been operated on a stand-alone basis, however, management believes that these expenses are comparable to the expected expenses levels on a forward-looking basis. F-18
Concentration of Credit Risk The Company's largest asset is the security deposit (see Note 3) which constitutes 85% of the Company's total assets as of January 3, 1997. The security deposit is not collateralized and is due from HPT at the termination of the Lease. Deferred Gain Host Marriott contributed to the Company deferred gains relating to the sale of the 53 Courtyard properties to HPT in 1995 and 1996. The Company is amortizing the deferred gains over the initial term of the Lease. NOTE 2. LEASE COMMITMENTS On the Commencement Date, the Company entered into a lease for 21 Courtyard properties. On August 22, 1995, the Company entered into a lease for an additional 16 Courtyard properties. On March 22, 1996 and April 4, 1996, the Company entered into a lease for an additional 16 Courtyard properties (collectively, the "Lease"). The initial term of the Lease expires in 2012. Thereafter, the Lease automatically renews for three consecutive twelve-year terms at the option of the Company. The Company is required to pay rents equal to aggregate minimum annual rent of $50,540,000 ("Base Rent") and percentage rent equal to 5% of the excess of total hotel sales over base year total hotel sales ("Percentage Rent"). A pro rata portion of Base Rent is due and payable in advance on the first day of thirteen predetermined accounting periods. Percentage Rent is due and payable quarterly in arrears. Additionally, the Company is required to make payments when due on behalf of HPT for real estate taxes and other taxes, assessments and similar charges arising from or related to the Hotels and their operation, utilities, premiums on required insurance coverage, rents due under ground and equipment leases and all amounts due under the terms of the management agreements described below. The Company is also required to provide the Manager with working capital to meet the operating needs of the Hotels. The Sellers had previously made advances related to the Hotels and transferred their interest in such amounts to the Company in the amount of $3,984,000 and $1,116,000 in 1995 and 1996. The Lease also requires the Company to escrow, or cause the Manager to escrow, an amount equal to 5% of the annual total hotel sales into an HPT-owned furniture, fixture and equipment reserve (the "FF&E Reserve"), which is available for the cost of required replacements and renovation. Any requirements for funds in excess of amounts in the FF&E Reserve shall be provided by HPT ("HPT Fundings") at the request of the Company. In the event of HPT Fundings, Base Rent shall be adjusted upward by an amount equal to 10% of HPT Fundings. The Company is required to maintain a minimum net worth equal to one year's base rent. For purposes of this covenant, the deferred gain is excluded from the calculation of net worth. As of January 3, 1997, future minimum annual rental commitments for the Lease on the Hotels and other non-cancelable leases, including the ground leases described below, are as follows (in thousands): Other Operating Lease Leases ----- ------ 1997 ...................................... $ 50,540 $ 2,343 1998 ...................................... 50,540 2,005 1999 ...................................... 50,540 1,720 2000 ...................................... 50,540 1,572 2001 ...................................... 50,540 1,519 Thereafter.................................. 555,940 9,159 ---------- ---------- Total minimum lease payments.......... $ 808,640 $ 18,318 ========== ========== The land under eight of the Hotels is leased from third parties. The ground leases have remaining terms (including all renewal options) expiring between the years 2039 and 2067. The ground leases provide for rent based on specific percentages of certain sales subject to minimum amounts. The minimum rentals are adjusted at various anniversary dates throughout the lease terms, as F-19
defined in the agreements. Total minimum lease payments exclude Percentage Rent which was $716,000 and $271,000 for fiscal year 1996 and the period March 24, 1995 through December 29, 1995. NOTE 3. SECURITY DEPOSIT HPT holds $50,540,000 as a security deposit for the obligations of the Company under the Lease (the "Security Deposit"). The Security Deposit is due upon termination of the Lease. NOTE 4. INCOME TAXES The Company and Host Marriott are members of a consolidated group for federal income tax purposes. Host Marriott has contributed the Security Deposit and deferred gain without contributing their related tax attributes and have agreed that the Company will not be responsible for any tax liability or benefit associated with the Security Deposit or deferred gain. Accordingly, no deferred tax balances are reflected in the accompanying balance sheets. There is no difference between the basis of assets and liabilities for income tax and financial reporting purposes other than for the Security Deposit and the deferred gain. The components of the Company's effective income tax rate follow: 1996 1995 ---- ---- Statutory Federal tax rate......................... 35.0% 35.0% State income tax, net of Federal tax benefit....... 5.0 6.0 --- --- 40.0% 41.0% The provision for income taxes consists of the following (in thousands): 1996 1995 ---- ---- Current-Federal.................................... $3,674 $1,129 State.................................. 525 193 ------ ------ $4,199 $1,322 ====== ====== All current tax provision amounts are included in Due to Host Marriott Corporation on the accompanying balance sheets. NOTE 5. MANAGEMENT AGREEMENTS The Sellers' rights and obligations under management agreements (the "Agreements") with the Manager were transferred to HPT and then through the Leases to the Company. The Agreements have an initial term expiring in 2013 with an option to extend the Agreements on all of the Hotels for up to 30 years. The Agreements provide that the Manager be paid a system fee equal to 3% of hotel sales, a base management fee of 2% of hotel sales ("Base Management Fee") and an incentive management fee equal to 50% of available cash flow, not to exceed 20% of operating profit, as defined ("Incentive Management Fee"). In addition, the Manager is reimbursed for each Hotel's pro rata share of the actual costs and expenses incurred in providing certain services on a central or regional basis to all Courtyard by Marriott hotels operated by the Manager. Base Rent is to be paid prior to payment of Base Management Fees and Incentive Management Fees. To the extent Base Management Fees are so deferred, they must be paid in future periods. If available cash flow is insufficient to pay Incentive Management Fees, no Incentive Management Fees are earned by the Manager. Pursuant to the terms of the Agreements, the Manager is required to furnish the Hotels with certain services ("Chain Services") which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Chain Services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries. In addition, the Hotels participate in Marriott's Courtyard Club program. The cost of these programs are charged to all hotels in the system. F-20
The Company is obligated to provide the Manager with sufficient funds to cover the cost of (a) certain non-routine repairs and maintenance to the Hotels which are normally capitalized; and (b) replacements and renewals to the Hotels' property and improvements. Under certain circumstances, the Company will be required to establish escrow accounts for such purposes under terms outlined in the Agreements. Pursuant to the terms of the Agreements, the Company is required to provide Marriott International with funding for working capital to meet the operating needs of the hotels. Marriott International converts cash advanced by the Company into other forms of working capital consisting primarily of operating cash, inventories, and trade receivables. Under the terms of the Agreements, Marriott International maintains possession of and sole control over the components of working capital, and accordingly, the Company reports the total amounts so advanced to Marriott International as a component of Due from Marriott International, Inc. Upon termination of the Agreements, the working capital will be returned to the Company. NOTE 6. REVENUES As discussed in Note 1, hotel revenues reflect house profit from the Company's hotel properties. House profit reflects the net revenues flowing to the Company as lessee and represents all gross hotel operating revenues, less all gross property-level expenses, excluding depreciation, management fees, real and personal property taxes, lease payments, insurance, contributions to the property improvement fund and certain other costs, which are classified as operating costs and expenses. The following table presents the detail of house profit for the fiscal year ended January 3, 1997 and for the period March 24, 1995 (inception) through December 29, 1995 (in thousands): 1996 1995 ---- ---- Hotel Sales: Rooms $164,738 $ 66,968 Food and beverage 14,167 6,225 Other 7,138 2,999 -------- -------- Total hotel sales 186,043 76,192 -------- -------- Rooms (A) 34,858 14,713 Food and beverage (B) 12,133 5,044 Other operating departments (C) 1,904 827 General and administrative (D) 19,956 7,768 Utilities (E) 7,200 2,955 Repairs, maintenance and accidents (F) 6,930 2,899 Marketing and sales (G) 2,290 1,121 Chain services (H) 6,611 3,052 -------- -------- Total expenses 91,882 38,379 -------- -------- Revenues (House Profit) $ 94,161 $ 37,813 ======== ======== (A) Includes expenses for linen, cleaning supplies, laundry, guest supplies, reservations costs, travel agents' commissions, walked guest expenses and wages, benefits and bonuses for employees of the rooms department. (B) Includes cost of food and beverages sold, china, glass, silver, paper and cleaning supplies and wages, benefits and bonuses for employees of the food and beverage department. (C) Includes expenses related to operating the telephone department. (D) Includes management and hourly wages, benefits and bonuses, credit and collection expenses, employee relations, guest relations, bad debt expenses, office supplies and miscellaneous other expenses. (E) Includes electricity, gas and water at the properties. (F) Includes cost of repairs and maintenance and the cost of accidents at the properties. (G) Includes management and hourly wages, benefits and bonuses, promotional expense and local advertising. (H) Includes charges from the Manager for Chain Services as allowable under the Agreements. F-21
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To HMH HPT Residence Inn, Inc.: We have audited the accompanying balance sheet of HMH HPT Residence Inn, Inc. (the "Company") as of January 3, 1997 and the related statements of operations, shareholder's equity and cash flows for the period March 22, 1996 (inception) through January 3, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of HMH HPT Residence Inn, Inc. as of January 3, 1997, and the results of its operations and its cash flows for the period March 22, 1996 (inception) through January 3, 1997, in conformity with generally accepted accounting principles. Arthur Andersen LLP Washington, D.C. February 28, 1997 F-22
<TABLE> <CAPTION> HMH HPT RESIDENCE INN, INC. BALANCE SHEET January 3, 1997 (in thousands, except share data) <S> <C> ASSETS Advances to manager $ 2,230 Due from Marriott International, Inc. 1,506 Security deposit 17,220 ------- Total assets $20,956 ======= LIABILITIES AND SHAREHOLDER'S EQUITY Due to Host Marriott Corporation $ 1,416 Deferred gain 15,149 ------- Total liabilities 16,565 ======= Shareholder's equity: Common stock, no par value, 100 shares authorized, issued and outstanding -- Additional paid-in capital 4,391 Retained earnings -- ------- Total shareholder's equity 4,391 ------- 20,956 ======= </TABLE> See Notes to Financial Statements. F-23
<TABLE> <CAPTION> HMH HPT RESIDENCE INN, INC. STATEMENT OF OPERATIONS For the Period from March 22, 1996 (inception) through January 3, 1997 (in thousands) <S> <C> REVENUES $ 27,418 -------- EXPENSES Rent 12,839 FF&E contribution expense 2,505 Base and incentive management fees paid to Marriott International, Inc. 6,191 Other expenses 2,204 -------- Total operating expenses 23,739 -------- OPERATING PROFIT BEFORE AMORTIZATION OF DEFERRED GAIN AND CORPORATE EXPENSES 3,679 Amortization of deferred gain 859 Corporate expenses (825) -------- INCOME BEFORE INCOME TAXES 3,713 Provision for income taxes (1,511) -------- NET INCOME $ 2,202 ======== </TABLE> See Notes to Financial Statements. F-24
<TABLE> <CAPTION> HMH HPT RESIDENCE INN, INC. STATEMENT OF SHAREHOLDER'S EQUITY For the Period March 22, 1996 (inception) through January 3, 1997 (in thousands) Additional Common Paid-In Retained Stock Capital Earnings ------ ---------- -------- <S> <C> <C> <C> Net assets contributed by Host Marriott Corporation $ -- $ 4,391 $ -- Net income -- -- 2,202 Dividend to Host Marriott Corporation -- -- (2,202) ------- --------- --------- Balance, January 3, 1997 $ -- $ 4,391 $ -- </TABLE> See Notes to Financial Statements. F-25
<TABLE> <CAPTION> HMH HPT RESIDENCE INN, INC. STATEMENT OF CASH FLOWS For the Period March 22, 1996 (inception) through January 3, 1997 (in thousands) <S> <C> OPERATING ACTIVITIES: Net income $ 2,202 Adjustments to reconcile net income to cash provided by operating activities: Amortization of deferred gain (859) Changes in operating accounts: Increase in Due to Host Marriott Corporation 1,416 Decrease in other assets 949 Increase in due from Marriott International, Inc. (1,506) -------- Cash provided by operations 2,202 -------- FINANCING ACTIVITIES: Dividend to Host Marriott Corporation (2,202) -------- CASH AND CASH EQUIVALENTS, end of period $ -- ======== SUPPLEMENTAL INFORMATION, NON-CASH ACTIVITY: Balances transferred to the Company by Host Marriott Corporation upon commencement of leases Advances to manager $ 2,230 Prepaid rent 949 Security deposit 17,220 Deferred gain (16,008) -------- Net assets contributed by Host Marriott Corporation $ 4,391 ======== </TABLE> See Notes to Financial Statements. F-26
HMH HPT RESIDENCE INN, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation HMH HPT Residence Inn, Inc. (the "Company") was incorporated in Delaware as a wholly-owned indirect subsidiary of Host Marriott Corporation ("Host Marriott"). The Company had no operations prior to March 22, 1996 (the "Commencement Date" or "Inception"). On the Commencement Date, affiliates of Host Marriott (the "Sellers") sold 5 Residence Inn properties to Hospitality Properties Trust ("HPT"). The Sellers sold an additional 13 Residence Inn properties to Hospitality Properties Trust on April 4, 1996 for a total of 18 Residence Inn hotels (the "Hotels"). The Sellers contributed the assets and liabilities related to the operations of such properties to the Company, including working capital advances to the hotel manager, prepaid rent under leasing arrangements and rights to other assets as described in Note 2. Such assets have been accounted for at the historical cost. Fiscal Year The Company's fiscal year ends on the Friday nearest to December 31. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenues Revenues represent house profit from the Hotels because the Company has delegated substantially all of the operating decisions relating to the generation of house profit from the Hotels to Marriott International, Inc. (the "Manager" or "Marriott International"). House profit reflects the net revenues flowing to the Company as lessee and represents total hotel sales less property level expenses excluding depreciation and amortization, real and personal property taxes, lease payments, insurance, contributions to the property improvement fund and management fees. Corporate Expenses The Company operates as a unit of Host Marriott utilizing Host Marriott's employees, centralized systems for cash management, insurance and administrative services. The Company has no employees. All cash received by the Company is deposited in and commingled with Host Marriott's general corporate funds. Operating expenses and other cash requirements of the Company are paid by Host Marriott and charged directly or allocated to the Company. Certain general and administrative costs of Host Marriott are allocated to the Company, principally based on Host Marriott's specific identification of individual cost items and otherwise based upon estimated levels of effort devoted by its general and administrative departments to individual entities. In the opinion of management, the methods for allocating corporate, general and administrative expenses and other direct costs are reasonable. It is not practicable to estimate the costs that would have been incurred by the Company if it had been operated on a stand-alone basis, however, management believes that these expenses are comparable to the expected expense levels on a forward-looking basis. F-27
Concentration of Credit Risk The Company's largest asset is the security deposit (see Note 3) which constitutes 82% of the Company's total assets as of January 3, 1997. The security deposit is not collateralized and is due from HPT at the termination of the Lease. Deferred Gain Host Marriott contributed to the Company deferred gains relating to the sale of the Residence Inn properties to Hospitality Properties Trust. The Company is amortizing the deferred gains over the initial term of the Lease. NOTE 2. LEASE COMMITMENTS On the Commencement Date, the Company entered into a lease (the "Lease") for the Hotels with HPT. The initial term of the Lease expires in 2010. Thereafter, the Lease automatically renews for one ten-year term and two consecutive 15-year terms, unless the Company properly notifies HPT in accordance with the Lease. The Company is required to pay rents equal to aggregate minimum annual rent of $17,220,000 ("Base Rent") and percentage rent equal to 7.5% of the excess of total hotel sales over 1996 total hotel sales ("Percentage Rent"). A pro rata portion of Base Rent is due and payable in advance on the first day of thirteen predetermined accounting periods. Percentage Rent is due and payable quarterly in arrears. Additionally, the Company is required to make payments when due on behalf of HPT for real estate taxes and other taxes, assessments and similar charges arising from or related to the Hotels and their operation, utilities, premiums on required insurance coverage, rents due under ground and equipment leases and all amounts due under the terms of the management agreements described below. The Company is also required to provide the Manager with working capital to meet the operating needs of the Hotels. The Sellers had previously made advances related to the Hotels and transferred their interest in such amounts to the Company in the amount of $2,230,000 in 1996. The Lease also requires the Company to escrow, or cause the Manager to escrow, an amount equal to 5% of the annual total hotel sales into an HPT-owned furniture, fixture and equipment reserve (the "FF&E Reserve"), which is available for the cost of required replacements and renovation. Any requirements for funds in excess of amounts in the FF&E Reserve shall be provided by HPT ("HPT Fundings") at the request of the Company. In the event of HPT Fundings, Base Rent shall be adjusted upward by an amount equal to 10% of HPT Fundings. The Company is required to maintain a minimum net worth equal to one year's base rent. For purposes of this covenant, the deferred gain is excluded from the calculation of net worth. As of January 3, 1997, future minimum annual rental commitments for the Lease on the Hotels and other non-cancelable leases, including the ground lease described below, are as follows (in thousands): Other Operating Lease Leases ----- --------- 1997 ..................................... $ 17,220 $ 259 1998 ..................................... 17,220 231 1999 ..................................... 17,220 207 2000 ..................................... 17,220 228 2001 ..................................... 17,220 120 Thereafter................................. 154,980 2,160 ---------- ---------- Total minimum lease payments......... $ 241,080 $ 3,205 ========== ========== The land under one of the Hotels is leased from a third party. The lease has an initial term expiring in 2021 with two extension periods of a total of 20 years. Annual ground rent is equal to the greater of minimum rent or 3% of annual gross sales. F-29
NOTE 3. SECURITY DEPOSIT The Lessor holds $17,220,000 as a security deposit for the obligations of the Company under the Lease (the "Security Deposit"). The Security Deposit is due upon termination of the Lease. NOTE 4. INCOME TAXES The Company and Host Marriott are members of a consolidated group for federal income tax purposes. Host Marriott contributed the Security Deposit and deferred gain without contributing their related tax attributes and have agreed that the Company will not be responsible for any tax liability or benefit associated with the Security Deposit or deferred gain. Accordingly, no deferred tax balances are reflected in the accompanying balance sheet. There is no difference between the basis of assets and liabilities for income tax and financial reporting purposes other than for the Security Deposit and the deferred gain. The components of the Company's effective income tax rate follow: Statutory Federal tax rate......................... 35.0% State income tax, net of Federal tax benefit....... 5.7 ----- 40.7% ===== The provision for income taxes consists of the following (in thousands): Current-Federal.................................... $ 1,300 State.................................... 211 -------- $ 1,511 ======== All current tax provision amounts are included in Due to Host Marriott Corporation in the accompanying balance sheet. NOTE 5. MANAGEMENT AGREEMENTS The Sellers' rights and obligations under management agreements (the "Agreements") with the Manager were transferred to HPT and then through the Lease to the Company. The Agreements have an initial term expiring in 2013 with an option to extend the Agreements on all of the Hotels for up to 30 years. The Agreements provide that the Manager be paid a system fee equal to 4% of hotel sales, a base management fee of 2% of hotel sales ("Base Management Fee") and an incentive management fee equal to 50% of available cash flow, not to exceed 20% of operating profit, as defined ("Incentive Management Fee"). In addition, the Manager is reimbursed for each Hotel's pro rata share of the actual costs and expenses incurred in providing certain services on a central or regional basis to all Residence Inn hotels operated by the Manager. Base Rent is to be paid prior to payment of Base Management Fees and Incentive Management Fees. To the extent Base Management Fees are so deferred, they must be paid in future periods. If available cash flow is insufficient to pay incentive management fees, no incentive management fees are earned by the Manager. Pursuant to the terms of the Agreements, the Manager is required to furnish the Hotels with certain services ("Chain Services") which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Chain Services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries. The Company is obligated to provide the Manager with sufficient funds to cover the cost of (a) certain non-routine repairs and maintenance to the Hotels which are normally capitalized; and (b) replacements and renewals to the Hotels' property and improvements. Under certain circumstances, the Company will be required to establish escrow accounts for such purposes under terms outlined in the Agreements. F-29
Pursuant to the terms of the Agreements, the Company is required to provide Marriott International with funding for working capital to meet the operating needs of the hotels. Marriott International converts cash advanced by the Company into other forms of working capital consisting primarily of operating cash, inventories, and trade receivables. Under the terms of the Agreements, Marriott International maintains possession of and sole control over the components of working capital, and accordingly, the Company reports the total amounts so advanced to Marriott International as a component of Due from Marriott International, Inc. Upon termination of the Agreements, the working capital will be returned to the Company. NOTE 6. REVENUES As discussed in Note 1, hotel revenues reflect house profit from the Company's hotel properties. House profit reflects the net revenues flowing to the Company as lessee and represents all gross hotel operating revenues, less all gross property-level expenses, excluding depreciation, management fees, real and personal property taxes, lease payments, insurance, contributions to the property improvement fund and certain other costs, which are classified as operating costs and expenses. The following table presents the detail of house profit for the period March 22, 1996 (inception) through January 3, 1997 (in thousands): Hotel Sales: Rooms................................................. $ 47,479 Other ............................................... 2,621 -------- Total hotel sales.............................. 50,100 -------- Expenses: Rooms (A)............................................. 9,632 Other operating departments (B)....................... 540 General and administrative (C)........................ 4,240 Utilities (D)......................................... 2,034 Repairs, maintenance and accidents (E)................ 2,538 Marketing and sales (F)............................... 2,746 Chain services (G).................................... 952 -------- Total expenses................................. 22,682 -------- Revenues (House Profit)...................................... $ 27,418 ======== (A) Includes expenses for linen, cleaning supplies, laundry, guest supplies, reservations costs, travel agents' commissions, walked guest expenses and wages, benefits and bonuses for employees of the rooms department. (B) Includes expenses related to operating the telephone department. (C) Includes management and hourly wages, benefits and bonuses, credit and collection expenses, employee relations, guest relations, bad debt expenses, office supplies and miscellaneous other expenses. (D) Includes electricity, gas and water at the properties. (E) Includes cost of repairs and maintenance and the cost of accidents at the properties. (F) Includes management and hourly wages, benefits and bonuses, promotional expense and local advertising. (G) Includes charges from the Manager for Chain Services as allowable under the Agreements. F-30
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HOSPITALITY PROPERTIES TRUST By: /s/ John G. Murray John G. Murray President and Chief Operating Officer Dated: March 28, 1997 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, or by their attorney-in-fact, in the capacities and on the dates indicated. <TABLE> <CAPTION> Signature Title Date <S> <C> <C> /s/ John G. Murray President and March 28, 1997 John G. Murray Chief Operating Officer /s/ Thomas M. O'Brien Treasurer and Chief March 28, 1997 Thomas M. O'Brien Financial Officer Trustee _______________________ John L. Harrington /s/ Arthur G. Koumantzelis Trustee March 28, 1997 Arthur G. Koumantzelis Trustee _______________________ William J. Sheehan /s/ Gerard M. Martin Trustee March 28, 1997 Gerard M. Martin /s/ Barry M. Portnoy Trustee March 28, 1997 Barry M. Portnoy </TABLE>