AMENDMENT NO. 2 TO FORM S-11
Table of Contents

As filed with the Securities and Exchange Commission on May 3, 2005

Registration No. 333-123065


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


AMENDMENT NO. 2

TO

FORM S-11

FOR REGISTRATION

UNDER

THE SECURITIES ACT OF 1933

OF SECURITIES OF CERTAIN REAL ESTATE COMPANIES


DIAMONDROCK HOSPITALITY COMPANY

(Exact Name of Registrant as Specified in its Governing Instruments)


10400 Fernwood Road, Suite 300, Bethesda, Maryland 20817, (301) 380-7100

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

William W. McCarten

Chief Executive Officer

DiamondRock Hospitality Company

10400 Fernwood Road, Suite 300, Bethesda, Maryland 20817

(301) 380-7100

(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent For Service)


Copies to:

Gilbert G. Menna, Esq.

Suzanne D. Lecaroz, Esq.

Goodwin Procter LLP

Exchange Place, 53 State Street

Boston, MA 02109

(617) 570-1000

 

David C. Wright, Esq.

Cyane B. Crump, Esq.

Hunton & Williams LLP

951 E. Byrd Street

Richmond, Virginia 23219-4074

(804) 788-8200


Approximate date of commencement of proposed sale to the public:    As soon as practicable after this Registration Statement becomes effective.

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement of the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box.  ¨


CALCULATION OF REGISTRATION FEE


               
Title of Securities Being Registered    Proposed
Maximum
Aggregate
Offering
Price(1)
   Amount of
Registration
Fee
 

Common Stock, par value $.01 per share

   $ 384,500,000    $ 45,500 (2)

               
(1) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(o) of the Securities Act of 1933, as amended.
(2) $20,500 of the registration fee was paid with the initial filing of the Registration Statement on March 1, 2005.

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until this registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.



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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED MAY 3, 2005

 

PROSPECTUS

 

26,087,000 Shares of Common Stock

 

DIAMONDROCK HOSPITALITY COMPANY

 

LOGO

 

We are a self-advised real estate company that owns, acquires and invests in upper upscale and upscale hotel properties located primarily in North America. This is our initial public offering of common stock and no public market currently exists for our common stock. We are offering 26,087,000 shares of common stock and 815,000 shares of common stock are being offered by the selling stockholders described in this prospectus. We will not receive any of the proceeds from the sale of shares of common stock by the selling stockholders. Concurrent with the completion of this offering, we are selling directly to Marriott shares of our common stock at the initial public offering price in an amount equal to the lesser of $15.0 million or that number of shares which, when combined with Marriott’s existing holdings, will represent a 9.8% ownership interest in our company upon completion of this offering.

 

We expect to qualify as a real estate investment trust, or REIT, for federal income tax purposes and will elect to be taxed as a REIT under the federal income tax laws for the taxable year ending December 31, 2005 and subsequent taxable years.

 

We currently expect the initial public offering price of our common stock to be between $10.50 and $12.50 per share. We intend to apply to have our common stock listed on the New York Stock Exchange under the symbol “DRH”.

 

Shares of our common stock are subject to ownership limitations that we must impose in order for us to qualify, and maintain our status, as a REIT.

 

See “ Risk Factors” beginning on page 20 of this prospectus for certain risk factors relevant to an investment in shares of our common stock.

 

     Per Share

   Total

Public offering price

   $                 $             

Underwriting discount(1)(2)

   $                 $             

Proceeds to us (before expenses)(1)(2)

   $                 $             

Proceeds to selling stockholders (before expenses)(2)

   $                 $             

(1) No underwriting discount will be applicable to the shares of common stock that we sell directly to Marriott.
(2) Includes 0.75% of the gross offering proceeds to us, or $         in the aggregate, payable by us to Citigroup Capital Markets Inc. and Friedman, Billings, Ramsey & Co., Inc. for financial advisory services. The selling stockholders have also agreed to pay Citigroup Capital Markets, Inc. and Friedman, Billings, Ramsey & Co., Inc. a fee equal to 0.75% of the gross offering proceeds to the selling stockholders.

 

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

We expect to deliver the shares of common stock on or about                     , 2005.

 

The underwriters may purchase up to an additional              shares of common stock from us at the public offering price, less the underwriting discount, within 30 days after the date of this prospectus solely to cover over-allotments, if any.

 

CitigroupFriedman Billings Ramsey

 

The date of this prospectus is                     , 2005


Table of Contents

TABLE OF CONTENTS

 

     Page

SUMMARY

   1

Our Company

   1

Our Competitive Strengths

   2

Risk Factors

   2

Our Business Objective and Strategies

   4

Hotel Industry

   5

Our Initial Hotel Properties

   6

Our Acquisition Properties

   8

Our Structure

   10

Hotel Industry Segments

   11

Our Principal Office

   11

Our Tax Status

   11

Restrictions on Ownership of Our Stock

   12

Our Distribution Policy

   13

Registration Rights and Lock-Up Agreements

   13

Selling Stockholders

   14

THE OFFERING

   15

SUMMARY SELECTED FINANCIAL AND OPERATING DATA

   16

RISK FACTORS

   20

Risks Related to Our Business, Growth Strategy and Investment Sourcing Relationship with Marriott

   20

Risks Related to the Hotel Industry

   30

General Risks Related to the Real Estate Industry

   35

Risks Related to Our Organization and Structure

   36

Risks Related to this Offering

   41

FORWARD LOOKING STATEMENTS

   43

MARKET DATA

   44

USE OF PROCEEDS

   45

DIVIDEND POLICY AND DISTRIBUTIONS

   46

CAPITALIZATION

   49

DILUTION

   50

Net Tangible Book Value

   50

Dilution After This Offering

   50

Differences Between New and Existing Stockholders in Number of Shares of Common Stock and Amount Paid

   50

SELECTED FINANCIAL AND OPERATING DATA

   51

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   56

Overview

   56

Industry Trends and Outlook

   57
     Page

Key Indicators of Financial Condition and Operating Performance

   57

Critical Accounting Policies and Estimates

   58

Other Recent Accounting Pronouncement

   59

Results of Operations

   60

Liquidity and Capital Resources

   63

Off-Balance Sheet Arrangements

   66

Outstanding Debt

   66

Financing Strategy

   67

Contractual Obligations

   68

Cash Distribution Policy

   68

Inflation

   69

Seasonality

   69

Geographic Concentration

   69

Tax and Depreciation

   69

Qualitative Disclosures about Market Risk

   69

HOTEL INDUSTRY

   70

OUR BUSINESS

   74

Our Company

   74

Our Competitive Strengths

   74

Our Business Objective and Strategies

   77

Hotel Industry Segments

   78

Environmental Matters

   78

Competition

   79

Employees

   80

Legal Proceedings

   80

Regulation

   80

Insurance

   81

OUR PROPERTIES

   82

Our Initial Hotel Properties

   82

Mortgage Debt

   93

Taxes on Proposed Capital Improvements

   94

Our Acquisition Properties

   95

OUR PRINCIPAL AGREEMENTS

   103

The Information Acquisition Agreement

   103

Our Hotel Management Agreements

   103

Our TRS Leases

   110

Our Ground Lease Agreements

   112

MANAGEMENT

   115

Our Directors and Senior Executive Officers

   115

Corporate Governance Profile

   117

Board of Directors and Committees

   118

Audit Committee

   118

Nominating and Corporate Governance Committee

   118

Compensation Committee

   119

Compensation Committee Interlocks and Insider Participation

   119

Code of Business Conduct and Ethics

   119

 

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     Page

Conflicts of Interest

   120

Vacancies on our Board of Directors

   120

Compensation of Directors

   120

Executive Compensation

   121

Employment Agreements

   121

Annual Incentive Bonus Policy

   122

401(k) Plan

   123

Equity Incentive Plan

   123

Liability, Exculpation and Indemnification

   124

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   126

Transactions with Marriott

   126

Arrangements with our Senior Executive Officers and Certain Directors

   128

INVESTMENT POLICIES AND POLICIES WITH RESPECT TO CERTAIN ACTIVITIES

   130

Investments in Real Estate or Interests in Real Estate

   130

Investments in Mortgages, Structured Financings and Other Lending Policies

   130

Investments in Securities of or Interests in Persons Primarily Engaged in Real Estate Activities and Other Issuers

   130

Dispositions

   131

Financing Policies

   131

Equity Capital Policies

   131

FORMATION OF OUR COMPANY

   133

INSTITUTIONAL TRADING OF OUR COMMON STOCK

   134

PRINCIPAL STOCKHOLDERS

   135

SELLING STOCKHOLDERS

   137

REGISTRATION RIGHTS AGREEMENT

   138

LOCK-UP AGREEMENTS

   140

DESCRIPTION OF CAPITAL STOCK AND CERTAIN MATERIAL PROVISIONS OF MARYLAND LAW, OUR CHARTER AND BYLAWS

   142

General

   142

Common Stock

   142

Preferred Stock

   142

Power to Issue Additional Shares of Common Stock and Preferred Stock

   143

Restrictions on Ownership and Transfer

   143

Transfer Agent and Registrar

   145

Certain Provisions of Maryland Law and of Our Charter and Bylaws

   146
     Page

DESCRIPTION OF THE PARTNERSHIP AGREEMENT OF DIAMONDROCK HOSPITALITY LIMITED PARTNERSHIP

   149

Management of the Operating Partnership

   149

Removal of the General Partners; Transfer of the General Partner’s Interest

   149

Amendments of the Partnership Agreement

   149

Redemption Rights

   150

Issuance of Additional Units, Common Stock or Convertible Securities

   150

Tax Matters

   151

Extraordinary Transactions

   151

Term

   151

Exculpation and Indemnification of the General Partner

   151

SHARES ELIGIBLE FOR FUTURE SALE

   152

General

   152

Rule 144

   153

Rule 701

   153

Redemption Rights

   153

FEDERAL INCOME TAX CONSIDERATIONS

   154

Taxation of the Company

   154

Qualification as a REIT

   156

Qualified REIT Subsidiaries and Disregarded Entities

   161

Taxation of the Operating Partnership

   161

Investments in Taxable REIT Subsidiaries

   162

Taxation of U.S. Stockholders Holding Common Stock

   163

Unrelated Business Taxable Income

   165

Information Reporting Requirements and Backup Withholding Tax

   165

Taxation of Non-U.S. Stockholders Holding Common Stock

   166

State, Local, and Foreign Tax

   168

ERISA CONSIDERATIONS

   169

UNDERWRITING

   171

LEGAL MATTERS

   176

EXPERTS

   176

WHERE YOU CAN FIND MORE INFORMATION

   177

REPORTS TO STOCKHOLDERS

   178

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

   F-1

 

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SUMMARY

 

The following summary highlights information contained elsewhere in this prospectus. You should read the entire prospectus, including “Risk Factors” and our historical and pro forma financial statements appearing elsewhere in this prospectus, before investing in our common stock. References in this prospectus to “we,” “our,” “us” and “our company” refer to DiamondRock Hospitality Company, including, as the context requires, DiamondRock Hospitality Limited Partnership, our operating partnership, as well as our other direct and indirect subsidiaries, including our existing taxable REIT subsidiary, Bloodstone TRS, Inc. References to “Marriott” are to Marriott International, Inc., including, as the context requires, its subsidiaries. References to “RevPAR” are to revenue per available room, which is the product of average daily rate, which we refer to as “ADR,” and occupancy, and is a key performance indicator for the hotel industry. Unless otherwise indicated, the information contained in this prospectus assumes that (i) the underwriters’ over-allotment option is not exercised and (ii) the common stock to be sold in this offering is sold at $11.50 per share, which is the midpoint of the range of prices indicated on the front cover of this prospectus.

 

Our Company

 

We are a self-advised real estate company that owns, acquires and invests in upper upscale and upscale hotel properties located primarily in North America. To a lesser extent, we may invest, on a selective basis, in premium limited-service and extended-stay hotel properties in urban locations.

 

Our senior management team has extensive experience and a broad network of relationships in the hotel industry, which we believe provides us with ongoing access to hotel property investment opportunities and enables us to quickly identify and consummate acquisitions. We began operations in July 2004 when we completed a private placement of our common stock. Since our July 2004 private placement, we have acquired seven hotels, comprising 2,357 rooms, located in the following markets: New York City (2 hotels), Washington D.C., Los Angeles, Salt Lake City, Northern California and Lexington, Kentucky for purchase prices aggregating approximately $368.0 million.

 

We have an investment sourcing relationship with Marriott, a leading worldwide hotel brand, franchise and management company. Marriott has agreed to provide us, subject to certain limitations, with a “first look” at hotel property acquisition and investment opportunities known to Marriott. This investment sourcing relationship with Marriott has already facilitated the acquisition of five of our initial seven hotel properties. We believe that our ability to implement our business strategies is greatly enhanced by the continuing source of additional acquisition opportunities generated by this relationship, as many of the properties Marriott brings to our attention are offered to us through “off-market” transactions, meaning that they are not made generally available to other hospitality companies. However, neither we nor Marriott have entered into a binding agreement or commitment setting forth the terms of this investment sourcing relationship. As a result, our investment sourcing relationship may be modified or terminated at any time by either party.

 

We intend to use Marriott as our preferred, but not exclusive, hotel management company for our hotel properties and expect to benefit from Marriott’s strong brands and its excellent hotel management services. Marriott-branded hotels have an extensive record of generating premiums in RevPAR over competitive brands. Each of our initial hotel properties operates under a recognized Marriott brand, including Marriott®, Renaissance Hotels and Resorts® and Courtyard by Marriott®. In connection with our July 2004 private placement, Marriott purchased 3.0 million shares, which represents 13.8% of our outstanding common stock (including unvested restricted stock). In addition, concurrently with the completion of this offering, we are selling directly to Marriott shares of our common stock at the initial public offering price in an amount equal to the lesser of $15.0 million or that number of shares which, when combined with Marriott’s existing holdings, will represent a 9.8% ownership interest in our company upon completion of this offering.

 


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Our Competitive Strengths

 

We believe we distinguish ourselves from other owners, acquirors and investors in hotel properties through our competitive strengths, which include:

 

    Experienced Management Team.    We believe the extensive hotel industry experience of our senior management team will enable us to effectively implement our business strategies. Our senior management team of William W. McCarten, John L. Williams, Mark W. Brugger, Michael D. Schecter and Sean M. Mahoney has extensive experience in lodging, real estate and related service industries, including hotel asset management, acquisitions, mergers, dispositions, development, redevelopment and financing. Collectively, they have been involved in hotel transactions aggregating several billion dollars and over 100,000 hotel rooms.

 

    Marriott Investment Sourcing Relationship.    Our investment sourcing relationship with Marriott provides us, subject to certain limitations, with a “first look” at hotel property acquisition and investment opportunities known to Marriott. Our senior management team currently meets with senior representatives of Marriott approximately every two weeks to discuss, among other things, potential hotel property investment opportunities known to Marriott. As a result of Marriott’s extensive network, relationships and knowledge of hotel property investment opportunities, we believe we have preferred access to a unique source of hotel property investment opportunities, many of which may not be available to other hospitality companies. Since our formation in 2004, Marriott has provided us access to more than $1.9 billion of off-market acquisition opportunities. Our relationship with Marriott has facilitated the acquisition of five of our initial seven hotel properties, including the Marriott Griffin Gate Resort and the Lodge at Sonoma Renaissance Resort & Spa, both of which we acquired directly from Marriott.

 

    Proven Acquisition Capability.    Our senior management team has established a broad network of hotel industry contacts and relationships, including relationships with hotel owners, financiers, operators, commercial real estate brokers and other key industry participants. These industry relationships have provided us with another valuable source of potential hotel property investment opportunities. We believe that our ability to quickly identify, negotiate, finance and consummate acquisitions has positioned us as a preferred buyer of hotel properties.

 

    Growth-Oriented Capital Structure.    Upon completion of, and application of the net proceeds from, this offering and the closing of the acquisitions that we consider probable as of the date of this prospectus, we will have approximately $300.1 million in secured financing, representing an initial leverage ratio of approximately 39.3% of our pro forma total investments as of March 25, 2005, including projected capital improvements. In addition, we have a commitment from Wachovia Bank, National Association, for a three-year, $75.0 million senior secured revolving credit facility, which may be expanded to $250.0 million, at our election, subject to approval by Wachovia Bank, National Association, to fund additional acquisitions and renovations and for general working capital and other corporate purposes. We maintain a target leverage ratio of 45% to 55% of total enterprise value.

 

Risk Factors

 

See “Risk Factors” beginning on page 20 for certain risk factors relevant to an investment in our common stock, including, among others:

 

    We were formed in May 2004 and commenced operations in July 2004 and have a limited operating history.

 

    Our management has no prior experience operating a REIT and limited experience operating a public company and therefore may have difficulty in successfully and profitably operating our business.

 

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    We cannot assure you that we will qualify, or remain qualified, as a REIT.

 

    If we are unable to complete the acquisitions of the hotel properties we have under contract in a timely fashion or at all, we will have no designated use for substantially all of the net proceeds of this offering and may experience delays in locating and securing attractive alternative investments. These delays could result in our future operating results not meeting expectations and adversely affect our ability to make distributions to our stockholders.

 

    All of our initial hotel properties are managed by Marriott. As a result, our success is dependent in part on the continued success of Marriott and its brands.

 

    Failure of the hotel industry to continue to improve may adversely affect our ability to execute our business strategies, which, in turn, would adversely affect our ability to make distributions to our stockholders.

 

    We face competition for the acquisition of hotels and we may not be successful in identifying or completing hotel acquisitions that meet our criteria, which may impede our growth.

 

    Our investment sourcing relationship with Marriott is non-exclusive and based on a non-binding understanding that may be changed or terminated at any time, which could adversely affect our ability to execute our business strategies, which in turn, would adversely affect our ability to make distributions to our stockholders.

 

    In order to maintain our investment sourcing relationship with Marriott, Marriott may encourage us to enter into transactions or hotel management agreements that are not in our best interests.

 

    We rely on hotel management companies, including Marriott, to operate our hotel properties under the terms of hotel management agreements. Even if we believe our hotel properties are being operated inefficiently or in a manner that does not result in satisfactory RevPAR and operating profits, we may not have sufficient rights under our hotel management agreements to enable us to force the hotel management company to change its method of operation of our hotel properties.

 

    Our hotel management agreements require us to bear the operating risks of our hotel properties. Our operating risks include decreased hotel revenues and increased operating expenses. Any decreases in hotel revenues or increases in operating expenses may have a material adverse impact on our earnings and cash flow.

 

    Upon completion of this offering, application of the net offering proceeds and the closing of the probable acquisitions, we will have approximately $300.1 million in debt outstanding. Future debt service obligations may adversely affect our operating results, require us to liquidate our properties, jeopardize our tax status as a REIT or limit our ability to make distributions to our stockholders. Additionally, if we were to default on our secured debt in the future, the loss of any property securing the debt would harm our ability to satisfy other financial obligations.

 

    We acquired interests in three of our current properties and the golf course associated with a fourth property by acquiring a leasehold interest in the property on which the building is located, and we may acquire additional properties in the future through the purchase of hotels subject to ground leases. As lessee under ground leases, we are exposed to the risk of losing the property, or a portion of the property, upon termination, or an earlier breach by us, of the ground lease.

 

    Our hotel properties are and will continue to be subject to various operating risks common to the hotel industry. Competition for acquisitions, the seasonality of the hotel industry, our investment concentration in a particular segment of the real estate industry and the need for capital expenditures could harm our future operating results and adversely affect our ability to make distributions to our stockholders.

 

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    The events of September 11, 2001, recent economic trends, the military action in Afghanistan and Iraq and the possibility of future terrorist acts and military action have adversely affected the hotel industry generally, and similar future events could adversely affect the industry in the future.

 

    Uninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to our stockholders.

 

    Because real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties in our portfolio in response to changing economic, financial and investment conditions may be limited. In addition, because our hotel management agreements contain restrictions on our ability to dispose of our hotel properties, are typically long-term and do not terminate in the event of a sale, our ability to sell our hotel properties may be further limited.

 

    Provisions of our charter and bylaws may limit the ability of a third party to acquire control of our company, which may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests.

 

    If we fail to qualify for or lose our status as a REIT, we would be subject to federal income tax on our taxable income, reducing amounts available for distribution to our stockholders.

 

    As a REIT, we generally are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to our stockholders. In the event of future downturns in our operating results and financial performance or the need for unanticipated capital improvements to our hotel properties, we may be unable to declare or pay distributions to our stockholders.

 

    The number of shares of common stock available for future sale may have an adverse effect on the market price of our common stock.

 

Our Business Objective and Strategies

 

Our principal business objective is to maximize stockholder value through a combination of dividends, growth in funds from operations and increases in net asset value. We believe that we can create long-term value in our hotel properties by taking advantage of individual market recovery opportunities and aggressive asset management and repositioning, which may include: (i) re-branding, (ii) capital renovation and/or (iii) changing hotel management. In order to achieve our business objective, we intend to pursue the following strategies:

 

    Disciplined Acquisition of Hotel Properties.    We will seek to create value by acquiring upper upscale and upscale hotel properties in geographically diverse locations, and to a lesser extent, premium limited service and extended stay hotels in urban locations, in accordance with our disciplined acquisition strategy. Our focus is on acquiring undermanaged or undercapitalized hotel properties at prices below replacement cost and that are located in markets where we expect demand growth will outpace new supply.

 

    Aggressive Asset Management.    We intend to aggressively manage our hotel properties by continuing to employ value-added strategies (such as re-branding, renovating, or changing management) designed to increase the operating results and value of our hotel property investments. We currently plan to invest approximately $33.5 million in 2005 and 2006 to renovate our initial hotels, including $27.0 million in capital that has been pre-funded into various escrow accounts. We do not operate our hotel properties, but we have structured, and intend to continue to structure, our hotel management agreements to allow us to closely monitor the performance of our hotels and to ensure, among other things, that our third-party managers: (i) implement an approved business and marketing plan, (ii) implement a disciplined capital expenditure program and (iii) establish and prudently spend appropriate furniture, fixtures and equipment reserves.

 

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    Opportunistic Hotel Repositioning.    We intend to seek opportunities to acquire hotel properties that will benefit from repositioning, including re-branding, renovating or changing management to increase the operating results and value of our hotel property investments. We believe our investment sourcing relationship with Marriott will yield many of these opportunities.

 

Hotel Industry

 

We believe the hotel industry, as a whole, is continuing to recover from a pronounced downturn that occurred over the three-year period from 2001-2003. This recovery has been, and we expect it to continue to be, primarily driven by increased demand for hotel rooms. According to Smith Travel Research, demand for hotel rooms, measured by total rooms sold, increased by 0.3% in 2002, 1.5% in 2003 and 4.7% in 2004 and is projected to increase by 4.0% in 2005. By comparison, hotel room supply grew by 1.6% in 2002, 1.2% in 2003 and 1.0% in 2004 and is projected to increase by 1.2% in 2005 as compared to its past 15-year historical annual average of 2.1%.

 

We expect that sustained growth in demand will result in continued improvement of hotel industry fundamentals. According to Smith Travel Research:

 

    occupancy increased by 3.7% in 2004 and is projected to increase by 2.8% in 2005;

 

    ADR increased by 4.0% in 2004 and is projected to increase by 4.2% in 2005; and

 

    RevPAR increased by 7.8% in 2004 and is projected to increase by 7.1% in 2005.

 

LOGO

 

We expect that our hotel properties will be well-positioned to benefit from this recovery in hotel industry fundamentals.

 

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Our Initial Hotel Properties

 

The following table sets forth certain operating information for each of our initial hotels. This information includes periods prior to our acquisition of these hotels:

 

Property


  

Location


   Month/Year
Acquired


   Number of
Rooms(1)


   Average
Occupancy(2)


    ADR(2)

   RevPAR(2)

Courtyard Manhattan/

Midtown East

   New York, New York    11/04    307    89.2 %   $ 199.43    $ 177.85

Torrance Marriott

   Los Angeles County, California    1/05    487    77.4       99.63      77.16

Salt Lake City Marriott

Downtown

   Salt Lake City, Utah    12/04    510    67.9       115.51      78.49

Marriott Griffin Gate

Resort

   Lexington, Kentucky    12/04    408    68.0       110.11      74.90

Bethesda Marriott Suites

   Bethesda, Maryland    12/04    274    74.6       153.73      114.73

Courtyard Manhattan/

Fifth Avenue

   New York, New York    12/04    189    89.3       140.96      125.88
The Lodge at Sonoma Renaissance Resort & Spa    Sonoma, California    10/04    182    65.1       187.34      122.03
              
                   
TOTAL/WEIGHTED AVERAGES         2,357    75.0 %   $ 136.21    $ 102.11
              
                   

(1) As of December 31, 2004.
(2) For the fiscal year ended December 31, 2004.

 

 

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The following table sets forth information regarding our investment in each of our initial hotels:

 

Property


  Location

  Year
Opened


  Number
of
Rooms(1)


  Purchase
Price(2)


  Pre-Funded
Capital
Improvement
Escrows(3)


  Projected
Additional
Capital
Improvements(4)


  Total
Projected
Investment(5)


  Total
Projected
Investment
Per Room


Courtyard Manhattan/ Midtown East   New York,
New York
  1998   307   $ 74,318,000   $ 4,539,000   $ —     $ 78,857,000   $ 256,863
Torrance Marriott   Los
Angeles
County,
California
  1985   487     62,002,000     10,000,000     —       72,002,000     147,848
Salt Lake City Marriott Downtown   Salt Lake
City, Utah
  1981   510     49,584,000     3,761,000     500,000     53,845,000     105,578
Marriott Griffin Gate Resort   Lexington,
Kentucky
  1981   408     46,887,000     2,955,000     —       49,842,000     122,162
Bethesda Marriott Suites   Bethesda,
Maryland
  1990   274     41,062,000     830,000     4,000,000     45,892,000     167,489
Courtyard Manhattan/ Fifth Avenue   New York,
New York
  1990   189     35,623,000     4,117,000     2,000,000     41,740,000     220,847
The Lodge at Sonoma Renaissance Resort & Spa   Sonoma,
California
  2001   182     31,545,000     800,000     —       32,345,000     177,720
           
 

 

 

 

     

TOTALS/WEIGHTED AVERAGE

  2,357   $ 341,021,000   $ 27,002,000   $ 6,500,000   $ 374,523,000   $ 158,898
           
 

 

 

 

     

(1) As of December 31, 2004.
(2) Purchase price includes, for each hotel property, all amounts paid to the seller, assumed debt and amounts paid for working capital plus costs paid with respect to third-party professional fees in connection with our purchase, but it does not include costs related to mortgage debt used by us to finance the purchase of the hotel property or escrow accounts established for the pre-funded capital improvements.
(3) Pre-funded capital improvements are amounts pre-funded into various escrow accounts.
(4) Represents projected additional capital improvements scheduled to occur over the near term that have not been pre-funded into an escrow account.
(5) Total projected investment, for each hotel property, is the sum of the purchase price, pre-funded capital improvements and projected additional capital improvements.

 

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Table of Contents

Our Acquisition Properties

 

Acquisitions Under Contract.    We intend to use a portion of the net proceeds from this offering to acquire and invest in additional hotel properties. As of the date of this prospectus, we have five hotels under contract that we consider to be “probable” acquisitions. The hotels have an aggregate purchase price, including pre-funded capital improvement escrows, of approximately $382.7 million. We are acquiring the Marriott Los Angeles Airport, the Marriott Atlanta Alpharetta, the Frenchman’s Reef & Morning Star Marriott Beach Resort and the Renaissance Worthington as a package for a purchase price of approximately $319.5 million, and we sometimes refer to these hotels collectively in this prospectus as the “Capital Hotel Investment Portfolio.” We are also acquiring the Vail Marriott Mountain Resort & Spa for approximately $63.2 million. The following table sets forth information regarding those hotels:

 

Property


  

Location


   Number of
Rooms(1)


   Average
Occupancy(2)


    ADR(2)

   RevPAR(2)

Renaissance Worthington

   Fort Worth, Texas    504    73.0 %   $ 138.55    $ 101.15

Marriott Atlanta Alpharetta

   Atlanta, Georgia    316    59.9       121.20      72.59
Frenchman’s Reef &
Morning Star Marriott
Beach Resort
   St. Thomas, U.S. Virgin Islands    504    71.5       188.49      134.73
Marriott Los Angeles
Airport
   Los Angeles, California    1,004    79.1       96.50      76.30
Vail Marriott Mountain
Resort & Spa
   Vail, Colorado    347    60.0       162.52      97.59
         
                   

TOTAL/WEIGHTED AVERAGES

   2,675    71.8 %   $ 131.54    $ 94.39
         
                   

(1) As of December 31, 2004.
(2) For the fiscal year ended December 31, 2004.

 

Property


 

Location


  Year
Opened/
Renovated


  Number
of
Rooms(1)


  Purchase
Price(2)


  Pre-Funded
Capital
Improvement
Escrows(3)


  Projected
Additional
Capital
Improvements(4)


  Total
Projected
Investment(5)


  Total
Projected
Investment
Per Room


Renaissance Worthington   Fort Worth,
Texas
  1981   504   $ 78,876,000   $ 1,254,000   $ —     $ 80,130,000   $ 158,988
Marriott Atlanta Alpharetta   Atlanta,
Georgia
  2000   316     39,638,000     1,096,000     —       40,734,000     128,905
Frenchman’s Reef & Morning Star Marriott Beach Resort   St. Thomas, U.S. Virgin Islands   1973/
1984
  504     94,555,000     695,000     3,039,000     98,289,000     195,018
Marriott Los Angeles Airport   Los Angeles, California   1973   1,004     95,755,000     7,604,000     2,357,000     105,716,000     105,295
Vail Marriott Mountain Resort & Spa   Vail, Colorado   1983/1992   347     63,248,000     —       —       63,248,000     182,271
           
 

 

 

 

     
TOTALS/WEIGHTED AVERAGE   2,675   $ 372,072,000   $ 10,649,000   $ 5,396,000   $ 388,117,000   $ 145,090
           
 

 

 

 

     

(1) As of and for the fiscal year ended December 31, 2004.
(2)

Purchase price includes, for each hotel property, all amounts paid to the seller, assumed debt and amounts paid for working capital plus

 

8


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costs paid with respect to third-party professional fees in connection with our purchase, but it does not include costs related to mortgage debt used by us to finance the purchase of the hotel property or escrow accounts established for the pre-funded capital improvements.

(3) Pre-funded capital improvements are amounts pre-funded into various escrow accounts.
(4) Represents projected additional capital improvements scheduled to occur over the near term that will not be pre-funded into an escrow account.
(5) Total projected investment, for each hotel property, is the sum of the purchase price, pre-funded capital improvements and projected additional capital improvements.

 

We cannot assure you that we will acquire any of these properties because each proposed acquisition is subject to a variety of factors, including the satisfaction of closing conditions, such as the receipt of third-party consents and approvals and, with respect to the Capital Hotel Investment Portfolio, the simultaneous closing of the acquisition of each of the four hotels in this portfolio. We anticipate that the closings of the acquisition of these properties will occur on or before                     , 2005, which is after the date of the expected closing of this offering. Our inability to complete any of these acquisitions within our anticipated time frames, or at all, may harm our financial condition, results of operations, cash flow and our ability to make distributions to our stockholders.

 

In addition, we have deposited an aggregate of $9 million with the sellers of these five hotels and may deposit an additional aggregate of $5 million in order to exercise certain options to extend the closing date of the acquisitions. Currently, we expect that we will exercise these options and deposit the additional amounts. We will forfeit the respective deposits if the applicable acquisitions do not close, unless such failure to close is a result of the failure of the seller to satisfy its obligations or fulfill certain conditions precedent to closing under the applicable purchase and sale agreement.

 

Letters of Intent.    In addition to the properties set forth above that we have under contract and that we consider probable, as of the date of this prospectus, we have          additional properties under non-binding letters of intent. The properties under these letters of intent have an aggregate acquisition cost of approximately $         million. We also cannot assure you that we will acquire any of the properties under these letters of intent because the letters of intent are non-binding and each of these transactions is subject to a variety of factors including: (i) the willingness of the current property owner to proceed with a transaction; (ii) our completion of satisfactory due diligence; (iii) the negotiation and execution of a mutually acceptable binding definitive purchase agreement and hotel management agreement (or assumption of an existing hotel management agreement); and (iv) the satisfaction of closing conditions, including the receipt of third-party consents and approvals.

 

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Table of Contents

Our Structure

 

We were formed as a Maryland corporation in May 2004. We conduct our business through a traditional umbrella partnership REIT, or UPREIT, in which our hotel properties are owned by our operating partnership, DiamondRock Hospitality Limited Partnership, limited partnerships, limited liability companies or other subsidiaries of our operating partnership. We are the sole general partner of our operating partnership and currently own, either directly or indirectly, all of the limited partnership units of our operating partnership. In the future, we may issue limited partnership units to third parties from time to time in connection with acquisitions of hotel properties. In order for the income from our hotel property investments to constitute “rents from real properties” for purposes of the gross income test required for REIT qualification, the income we earn cannot be derived from the operation of any of our hotels. Therefore, we lease each of our hotel properties to a wholly-owned subsidiary of Bloodstone TRS, Inc., our existing taxable REIT subsidiary, or TRS. We refer to these subsidiaries as our TRS lessees. We may form additional TRSs and TRS lessees in the future.

 

The following chart shows our corporate structure following the completion of this offering:

 

LOGO

 

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Table of Contents

Hotel Industry Segments

 

References to “upper upscale” and “upscale” are to hotels classified in those categories by Smith Travel Research, Inc. Smith Travel Research, Inc. classifies the hotel industry into the following chain scales, as determined by each brand’s annual average system-wide daily rates: luxury, upper upscale, upscale, midscale with food and beverage, midscale without food and beverage, and economy. The category of “upper upscale” includes hotels such as Embassy Suites Hotels, Hilton, Hyatt, Marriott and Sheraton; the category of “upscale” includes hotels such as Courtyard by Marriott, SpringHill Suites by Marriott, Crowne Plaza, Hawthorn Suites, Hilton Garden Inn, Radisson and Residence Inn by Marriott. ‘‘Extended-stay” hotels are hotels generally designed to accommodate guests staying more than six nights and typically provide rooms with fully equipped kitchens, entertainment systems, office spaces with computer and telephone lines and access to fitness centers and other amenities. “Limited-service” hotels target budget-conscious travelers and therefore have fewer amenities, such as in-house food and beverage facilities.

 

Our Principal Office

 

We have entered into a lease with an affiliate of Boston Properties, Inc. for the lease of office space located at Democracy Center, 6903 Rockledge Drive, Bethesda, MD 20817, which is across the street from Marriott’s corporate headquarters. Until we occupy our new office space, we will continue to sublease office space from Marriott located at its headquarters at 10400 Fernwood Road, Bethesda, MD 20817. Our telephone number is 301-380-7100. Our Internet address is http://www.drhc.com. The information on our website does not constitute a part of this prospectus.

 

Our Tax Status

 

We did not elect REIT tax status for our first taxable year ended December 31, 2004 but operated as a taxable C corporation for 2004. We intend to elect to be taxed as a REIT for federal income tax purposes for our taxable year ending on December 31, 2005 and for subsequent taxable years. If we qualify for taxation as a REIT, we generally will not be subject to federal income tax on that portion of our ordinary income or net capital gain that is currently distributed to our stockholders. Our ability to qualify as a REIT will depend upon our satisfaction of various operational and organizational requirements, including requirements related to the nature of our assets, the sources of our income, the diversity of our stock ownership and the distributions to our stockholders, including a requirement that we distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to our stockholders. If we fail to qualify as a REIT, we will be subject to federal income tax at regular corporate rates (up to 35%) as well as state and local taxes. Even if we qualify as a REIT, we may be subject to some federal, state, local and foreign taxes on our income and property. Our existing taxable REIT subsidiary, Bloodstone TRS, Inc., owner of our TRS lessees, is fully subject to corporate income tax as a C corporation on its earnings and the earnings of our TRS lessees.

 

In order to qualify as a REIT, our income must come primarily from “rents from real property,” mortgage interest and real estate gains. Qualifying “rents from real property” include rents from interests in real property, certain charges for services customarily rendered in connection with the rental of real property, and a limited amount of rent attributable to personal property that is leased under, or in connection with, a lease of real property. However, operating revenues from a hotel property are not qualifying “rents from real property.” Therefore, we generally must lease our hotel properties to another party from whom we will derive rent income that will qualify as “rents from real property” under the REIT rules. Accordingly, we generally will lease each of our hotels to a taxable TRS lessee. Each TRS lessee will pay rent to us that generally should qualify as “rents from real property,” provided that an “eligible independent contractor” operates and manages each hotel property on behalf of the TRS lessee. We expect that each of our hotel properties will be managed by an “eligible independent contractor.” The income remaining in our TRS lessees from the payment of rent to us, management fees, operating expenses and other costs will be subject to corporate tax.

 

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Table of Contents

Restrictions on Ownership of Our Stock

 

Our charter generally prohibits any stockholder from beneficially owning more than 9.8% of our common stock or of the value of the aggregate outstanding shares of our capital stock, except that certain “look-through entities,” such as mutual funds, may beneficially own up to 15% of our common stock or of the value of the aggregate outstanding shares of our capital stock. Our bylaws provide that, notwithstanding any other provision of our charter or the bylaws, our board of directors will exempt any person from the ownership limitation, provided that:

 

    such person shall not beneficially own shares of capital stock that would cause an “individual” (within the meaning of Section 542(a)(2) of the Internal Revenue Code, but not including a “qualified trust” (as defined in Code Section 856(h)(3)(E)) subject to the look-through rule of Code Section 856(h)(3)(A)(i)) to beneficially own (i) shares of capital stock in excess of 9.8% in value of the aggregate of the outstanding shares of our capital stock or (ii) shares of common stock in excess of 9.8% (in value or in number of shares, whichever is more restrictive) of the aggregate of the outstanding shares of our common stock;

 

    the board of directors obtains such representations and undertakings from such person as are reasonably necessary to ascertain that such person’s ownership of such shares of capital stock will not now or in the future jeopardize our ability to qualify as a REIT under the Code; and

 

    such person agrees that any violation or attempted violation of any of the foregoing restrictions or any such other restrictions that may be imposed by our board of directors will result in the automatic transfer of the shares of stock causing such violation to a trust.

 

Any amendment, alteration or repeal of this provision of our bylaws shall be valid only if approved by the affirmative vote of a majority of votes cast by stockholders entitled to vote generally in the election of directors. In addition, our charter also prohibits any person from:

 

    owning shares of our capital stock if such ownership would result in our being “closely held” within the meaning of Section 856(h) of the Code;

 

    transferring shares of our capital stock if such transfer would result in our capital stock being owned by fewer than 100 persons;

 

    owning shares of our capital stock if such ownership would cause any of our income that would otherwise qualify as rents from real property to fail to qualify as such, including as a result of any of our hotel management companies’ failing to qualify as “eligible independent contractors” under the REIT rules; and

 

    owning shares of our capital stock if such ownership would result in our failing to qualify as a REIT for federal income tax purposes.

 

In addition, our charter limits equity participation by “benefit plan investors” to less than 25% in the aggregate so that such participation in any class of our capital stock by such “benefit plan investors” will not be deemed “significant.” Additionally, our charter limits the ability of any stockholder to sell or transfer shares of our capital stock if such sale or transfer would result in ownership of such class of capital stock by “benefit plan investors” being “significant.” For such purposes, the terms “benefit plan investors” and “significant” are determined by reference to certain regulations promulgated by the U.S. Department of Labor. At the time shares of our common stock become “publicly-offered securities,” this 25% limitation will no longer be applicable to the shares of common stock, and we anticipate that our common stock will qualify as “publicly-offered securities” following this offering. Following this offering, “benefit plan investors” will not be permitted to own any class of our capital stock that does not qualify as “publicly-offered securities.”

 

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Table of Contents

Our Distribution Policy

 

We intend to generally distribute to our stockholders each year on a regular quarterly basis sufficient amounts of our REIT taxable income so as to avoid paying corporate income tax and excise tax on our earnings (other than the earnings of our taxable REIT subsidiary and TRS lessees, which are subject to tax at regular corporate rates) and to qualify for the tax benefits afforded to REITs under the Code. In order to qualify as a REIT under the Code, we generally must make distributions to our stockholders each year in an amount equal to at least:

 

    90% of our REIT taxable income determined without regard to the dividends paid deduction, plus

 

    90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code, minus

 

    any excess non-cash income.

 

We intend to pay a quarterly distribution of $0.1725 per share to our stockholders commencing with the third quarter of 2005 (which begins on June 18, 2005). On an annualized basis, this distribution would be $0.69 per share, representing an annualized distribution rate of approximately 6.0% based on the midpoint of the initial public offering price range of $11.50 per share. We also intend to distribute our non-REIT earnings and profits, which we currently estimate to be approximately $2.3 million, to eliminate any 2004 non-REIT earnings and profits, regardless of our 2005 REIT taxable income.

 

The actual amount and timing of distributions, however, will be at the discretion of our board of directors and will depend upon our actual results of operations and a number of other factors deemed relevant by our board of directors. Our cash available for distribution may be less than 90% of our REIT taxable income, in which case we could be required to either sell assets or borrow funds to make distributions. Distributions to our stockholders generally will be taxable to our stockholders as ordinary income; however, because a significant portion of our investment will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distribution may constitute a tax-free return of capital rather than taxable dividend income to stockholders.

 

Registration Rights and Lock-Up Agreements

 

Registration Rights Agreement.    Pursuant to a registration rights agreement among us, our operating partnership, Friedman, Billings, Ramsey & Co., Inc. and certain holders of our common stock, entered into on July 7, 2004, which we refer to as the registration rights agreement, we were required, among other things, to file with the SEC by April 7, 2005 a resale shelf registration statement registering all of the shares of common stock purchased or placed by Friedman, Billings, Ramsey & Co., Inc. in our July 2004 private placement that are not being sold in this offering and all of the 3,000,000 shares of common stock purchased by Marriott. The resale shelf registration statement was filed on April 4, 2005. We are required, under the registration rights agreement, to use our commercially reasonable efforts to cause the resale shelf registration statement to become effective under the Securities Act as promptly as practicable, not to exceed six months, after the filing (subject to certain extensions) and to maintain the resale shelf registration statement continuously effective under the Securities Act for a specified period.

 

Lock-up Agreements.    Our senior executive officers and directors and Marriott have entered into lock-up agreements that prohibit them from selling, pledging, transferring or otherwise disposing of our common stock or securities convertible into our common stock for a period of 180 days after the date of this prospectus. In addition, in accordance with the registration rights agreement, subject to specified exceptions, holders of shares of common stock sold in our July 2004 private placement have agreed not to offer, pledge, sell or otherwise dispose of any of shares of our common stock or securities convertible into our common stock that they have acquired prior to the date of this prospectus, and are not selling in this offering, for 60 days following the effective date of the registration statement of which this prospectus is a part. Citigroup Global Markets, Inc. and

 

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Table of Contents

Friedman, Billings, Ramsey & Co., Inc., on behalf of the underwriters, may, in their discretion, release all or any portion of the common stock subject to the lock-up agreements with our directors and officers at any time without notice or stockholder approval, in which case, our other stockholders would also be released from the restrictions pursuant to the registration rights agreement.

 

Selling Stockholders

 

Pursuant to, and subject to the terms and conditions of, the registration rights agreement, persons who purchased our common stock in connection with our July 2004 private placement and their transferees have the right to sell their common stock in this offering. We are including 815,000 shares of our common stock in this offering to be sold by three selling stockholders. None of the selling stockholders is an officer or director of our company, and Marriott is not a selling stockholder.

 

 

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Table of Contents

THE OFFERING

 

Common stock offered by us(1)

26,087,000 shares

 

Common stock offered by selling stockholders(2)

815,000 shares

 

Common stock concurrently sold by us directly to Marriott(2)

1,304,348 shares

 

Common stock to be outstanding upon completion of this offering(1)(3)

48,237,600 shares

 

Use of proceeds

The net proceeds to us from the sale of our common stock offered by this prospectus, and the concurrent direct sale of common stock to Marriott, after deducting the underwriting discount and the estimated offering expenses payable by us, will be approximately $277.6 million if the underwriters’ over-allotment option is not exercised, or approximately $317.3 million if the underwriters’ over-allotment option is exercised in full. We will not receive any of the proceeds from the sale of common stock by the selling stockholders.

 

We intend to use the net proceeds from this offering as follows:

 

    approximately $207.1 million to fund a portion of the purchase of the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa;

 

    approximately $64.0 million to repay existing indebtedness; and

 

    approximately $6.5 million to renovate our initial hotels.

 

 

Pending these uses, we intend to invest the net offering proceeds in interest-bearing, short-term marketable investment securities or money-market accounts that are consistent with our intention to qualify as a REIT.

 

Proposed New York Stock Exchange symbol

DRH

 


(1) Excludes 3,717,398 shares of common stock that may be issued by us upon exercise of the underwriters’ over-allotment option.
(2) We are selling directly to Marriott shares of our common stock at the initial public offering price in an amount equal to the lesser of $15.0 million or that number of shares which, when combined with Marriott’s existing holdings, will represent a 9.8% interest in our company upon completion of this offering.
(3) Includes 20,000 unrestricted shares of our common stock issued to our independent directors, 700,500 restricted shares of our common stock issued to our executive officers and other employees pursuant to our equity incentive plan and 430,000 shares issued to our executive officers, employees and directors in conjunction with this offering. Excludes 869,500 shares available for future issuance under our equity incentive plan.

 

15


Table of Contents

SUMMARY SELECTED FINANCIAL AND OPERATING DATA

 

We present in this prospectus certain historical and pro forma financial data. We also present certain operational data and non-U.S. generally accepted accounting principles, or GAAP, financial measures on a historical and pro forma basis.

 

The summary historical financial information as of December 31, 2004, and the period from May 6, 2004 (inception) to December 31, 2004, has been derived from our historical financial statements audited by KPMG LLP, independent registered public accounting firm, whose report with respect to such financial information is included elsewhere in this prospectus. The summary historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements as of December 31, 2004 and for the period from May 6, 2004 (inception) to December 31, 2004, and the related notes. The unaudited summary historical financial information as of March 25, 2005, and the fiscal quarter ended March 25, 2005, has been derived from our historical financial statements. The unaudited summary historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the unaudited consolidated financial statements as of March 25, 2005 and for the fiscal quarter ended March 25, 2005, and the related notes.

 

The unaudited pro forma consolidated balance sheet data as of March 25, 2005 is presented as if:

 

    the completion of this offering and application of the net proceeds,

 

    the probable acquisitions of the Vail Marriott Mountain Resort & Spa and the Capital Hotel Investment Portfolio, and

 

    the repayment of mortgage debt related to the Torrance Marriott and The Lodge at Sonoma Renaissance Resort & Spa

 

had occurred on March 25, 2005.

 

The unaudited pro forma consolidated statement of operations and other data for the fiscal quarter ended March 25, 2005, the fiscal year ended December 31, 2004 and the fiscal quarter ended March 26, 2004 are presented as if:

 

    the completion of this offering and application of the net proceeds,

 

    the acquisition of our initial seven hotels,

 

    the probable acquisitions of the Vail Marriott Mountain Resort & Spa and the Capital Hotel Investment Portfolio,

 

    our July 2004 private placement,

 

    our REIT election, and

 

    the repayment of mortgage debt related to the Torrance Marriott and The Lodge at Sonoma Renaissance Resort & Spa

 

had occurred on the first day of the periods presented.

 

These adjustments are also discussed in detail under “Unaudited Pro Forma Financial Data.” The pro forma information is not necessarily indicative of what our actual financial position or results of operations would have been as of the dates or for the periods indicated, nor does it purport to represent our future financial position or results of operations.

 

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Table of Contents

We present the following two non-GAAP financial measures throughout this prospectus that we believe are useful to investors as key measures of our operating performance: (1) earnings before interest expense, taxes, depreciation and amortization, or EBITDA; and (2) funds from operations, or FFO. These financial measures are discussed further under “Selected Financial and Operating Data.”

 

Amounts presented in accordance with our definitions of EBITDA and FFO may not be comparable to similar measures disclosed by other companies, as not all companies calculate these non-GAAP measures in the same manner. EBITDA and FFO should not be considered as an alternative measure of our net income (loss), operating performance, cash flow or liquidity. EBITDA and FFO may include funds that may not be used for our discretionary use due to functional requirements to conserve funds for capital expenditures, property acquisitions and other commitments or uncertainties. Although we believe that EBITDA and FFO can enhance your understanding of our results of operations, these non-GAAP financial measures, when viewed individually, are not necessarily better indicators of any trend as compared to GAAP measures such as net income (loss) or cash flow from operations. In this section and under “Selected Financial and Operating Data,” we include a quantitative reconciliation of EBITDA and FFO to the most directly comparable GAAP financial performance measure, which is net income (loss).

 

    Historical

    Pro Forma (unaudited)

 
    Fiscal
Quarter Ended
March 25, 2005


   

Period from
May 6, 2004 to

December 31, 2004


    Fiscal
Quarter Ended
March 25, 2005


    Fiscal
Quarter Ended
March 26, 2004


 

Fiscal

Year Ended
December 31, 2004


 
    (unaudited)                        

Statement of operations data:

                                     

Total revenues

  $ 26,348,781     $ 7,073,864     $ 74,892,425     $ 68,789,804   $ 280,196,120  

Operating costs and expenses:

                                     

Hotel operating expenses

    22,581,368       6,166,890       53,995,443       52,068,737     221,154,017  

Corporate expenses

    2,009,430       4,114,165       2,096,130       2,096,130     8,384,457  

Depreciation and amortization

    4,362,146       1,053,283       7,319,284       7,018,433     30,113,061  
   


 


 


 

 


Total operating expenses

    28,952,944       11,334,338       63,410,857       61,183,300     259,651,535  

Operating (loss)/income

    (2,604,163 )     (4,260,474 )     11,481,568       7,606,504     20,544,585  

Interest and other income

    (276,778 )     (1,333,837 )     (276,778 )     —       (1,333,837 )

Interest expense

    2,854,269       773,101       3,772,552       3,888,712     16,753,487  
   


 


 


 

 


(Loss)/income before income taxes

    (5,181,654 )     (3,699,738 )     7,985,794       3,717,792     5,124,935  

Income tax (provision)/benefit

    (79,857 )     1,582,113       (2,669,593 )     453,232     7,052,188  
   


 


 


 

 


Net (loss)/income

  $ (5,261,511 )   $ (2,117,625 )   $ 5,316,201     $ 4,171,024   $ 12,177,123  
   


 


 


 

 


FFO(1)

  $ (899,365 )   $ (1,064,342 )   $ 12,635,485     $ 11,189,457   $ 42,290,184  
   


 


 


 

 


EBITDA(2)(3)

  $ 2,034,761     $ (1,873,354 )   $ 19,077,630     $ 14,624,937   $ 51,991,483  
   


 


 


 

 


    Historical

    Pro Forma

           
   

As of

March 25, 2005


   

As of

December 31, 2004


   

As of

March 25, 2005


           

Balance sheet data:

    (unaudited)               (unaudited)                

Property and equipment, net

  $ 346,166,810     $ 285,642,439     $ 715,267,810                

Cash and cash equivalents

    43,804,058       76,983,107       20,661,798                

Total assets

    431,795,162       391,691,179       784,518,728                

Total debt

    224,094,249       180,771,810       300,094,249                

Total other liabilities

    16,826,161       15,331,951       16,826,161                

Stockholders’ equity

    190,874,752       195,587,418       467,598,318                

 

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    Historical

    Pro Forma

 
    Fiscal
Quarter Ended
March 25, 2005


   

Period from
May 6, 2004 to

December 31, 2004


    Fiscal
Quarter Ended
March 25, 2005


    Fiscal
Quarter Ended
March 26, 2004


   

Fiscal

Year Ended
December 31, 2004


 

Statistical data:

                                       

Number of hotels

    7       6       12       12       12  

Number of rooms

    2,357       1,870       5,032       5,032       5,032  

Occupancy

    69.7 %     67.8 %     74.9 %     73.2 %     73.3 %

ADR

  $ 137.21     $ 184.22     $ 158.50     $ 145.94     $ 133.78  

RevPAR

  $ 95.58     $ 124.99     $ 118.66     $ 106.81     $ 98.00  
 
  (1) Funds from operations (FFO), as defined by the National Association of Real Estate Investment Trusts (NAREIT), is net income (loss) (determined in accordance with GAAP), excluding gains (losses) from sales of property, plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures (which are calculated to reflect FFO on the same basis). The calculation of FFO may vary from entity to entity, thus our presentation of FFO may not be comparable to other similarly titled measures of other reporting companies. FFO is not intended to represent cash flows for the period. FFO has not been presented as an alternative to operating income, but as an indicator of operating performance, and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP.

 

    FFO is a supplemental industry-wide measure of REIT operating performance, the definition of which was first proposed by NAREIT in 1991 (and clarified in 1995, 1999 and 2002). Since the introduction of the definition by NAREIT, the term has come to be widely used by REITs. Historical GAAP cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical GAAP cost accounting to be insufficient by themselves. Accordingly, we believe FFO (combined with our primary GAAP presentations) help improve our stockholders’ ability to understand our operating performance. We only use FFO as a supplemental measure of operating performance. The following is a reconciliation between net income (loss) and FFO:

 

    Historical

    Pro Forma

   

Fiscal Quarter

Ended

March 25, 2005


   

Period from
May 6, 2004

to

December 31, 2004


   

Fiscal Quarter

Ended

March 25, 2005


  

Fiscal Quarter

Ended

March 26, 2004


  

Fiscal

Year Ended
December 31, 2004


Net (loss)/income

  $ (5,261,511 )   $ (2,117,625 )   $ 5,316,201    $ 4,171,024    $ 12,177,123

Depreciation and amortization

    4,362,146       1,053,283       7,319,284      7,018,433      30,113,061
   


 


 

  

  

FFO

  $ (899,365 )   $ (1,064,342 )   $ 12,635,485    $ 11,189,457    $ 42,290,184
   


 


 

  

  

 

  (2) EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization. We believe it is a useful financial performance measure for us and for our stockholders and is a complement to net income and other financial performance measures provided in accordance with GAAP. We use EBITDA to measure the financial performance of our operating hotels because it excludes expenses such as depreciation and amortization, taxes and interest expense, which are not indicative of operating performance. By excluding interest expense, EBITDA measures our financial performance irrespective of our capital structure or how we finance our properties and operations. By excluding depreciation and amortization expense, which can vary from hotel to hotel based on a variety of factors unrelated to the hotels’ financial performance, we can more accurately assess the financial performance of our hotels. Under GAAP, hotel properties are recorded at historical cost at the time of acquisition and are depreciated on a straight line basis. By excluding depreciation and amortization, we believe EBITDA provides a basis for measuring the financial performance of hotels unrelated to historical cost. However, because EBITDA excludes depreciation and amortization, it does not measure the capital we require to maintain or preserve our fixed assets. In addition, because EBITDA does not reflect interest expense, it does not take into account the total amount of interest we pay on outstanding debt nor does it show trends in interest costs due to changes in our borrowings or changes in interest rates. EBITDA, as calculated by us, may not be comparable to EBITDA reported by other companies that do not define EBITDA exactly as we define the term. Because we use EBITDA to evaluate our financial performance, we reconcile it to net income (loss) which is the most comparable financial measure calculated and presented in accordance with GAAP. EBITDA does not represent cash generated from operating activities determined in accordance with GAAP, and should not be considered as an alternative to operating income or net income determined in accordance with GAAP as an indicator of performance or as an alternative to cash flows from operating activities as an indicator of liquidity. The following is a reconciliation between net income (loss) and EBITDA:

 

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    Historical

    Pro Forma

 
   

Fiscal Quarter

Ended

March 25, 2005


   

Period from
May 6, 2004

to

December 31, 2004


   

Fiscal Quarter

Ended

March 25, 2005


  

Fiscal Quarter

Ended

March 26, 2004


   

Fiscal

Year Ended
December 31, 2004


 

Net loss

  $ (5,261,511 )   $ (2,117,625 )   $ 5,316,201    $ 4,171,024     $ 12,177,123  

Interest expense

    2,854,269       773,101       3,772,552      3,888,712       16,753,487  

Income tax expense/(benefit)

    79,857       (1,582,113 )     2,669,593      (453,232 )     (7,052,188 )

Depreciation and amortization

    4,362,146       1,053,283       7,319,284      7,018,433       30,113,061  
   


 


 

  


 


EBITDA

  $ 2,034,761     $ (1,873,354 )   $ 19,077,630    $ 14,624,937     $ 51,991,483  
   


 


 

  


 


 

  (3) The fiscal year ended December 31, 2004 and the fiscal quarter ended March 25, 2005 pro forma EBITDA includes the impact of approximately $6.9 million and $1.6 million, respectively, of non-cash straight-line ground rent expense recorded for the Bethesda Marriott Suites, the Marriott Griffin Gate Resort golf course and Courtyard Manhattan/Fifth Avenue ground leases.

 

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RISK FACTORS

 

An investment in our common stock involves a number of risks. The risks described below represent the material risks you should carefully consider before making an investment decision. These risks may materially and adversely affect our business, liquidity, financial condition and results of operations, in which case the value of our common stock could decline significantly and you could lose all or a part of your investment. The risk factors described below are not the only risks that may affect us. Some statements in this prospectus, including statements in the following risk factors, constitute forward looking statements. Please refer to the section entitled “Forward Looking Statements.”

 

Risks Related to Our Business, Growth Strategy and Investment Sourcing Relationship with Marriott

 

We were formed in May 2004 and commenced operations in July 2004 and have a limited operating history.

 

We have only recently been organized and commenced operations and, as a result, we have a limited operating history. We are subject to the risks generally associated with the formation of any new business, including unproven business models, untested plans, uncertain market acceptance and competition with established businesses. Consequently, it may be difficult for you to evaluate our historical performance.

 

Our management has no prior experience operating a REIT and limited experience operating a public company and therefore may have difficulty in successfully and profitably operating our business.

 

Prior to joining our company, our management had no experience operating a REIT and limited experience operating a public company. As a result, we cannot assure you that we will be able to successfully operate as a REIT or execute our business strategies as a public company and you should be especially cautious in drawing conclusions about the ability of our management team to execute our business plan.

 

We cannot assure you that we will qualify, or remain qualified, as a REIT.

 

We currently plan to elect to be taxed as a REIT for our taxable year ending December 31, 2005 and subsequent taxable years, and we expect to qualify as a REIT for such taxable year and future taxable years, but we cannot assure you that we will qualify, or will remain qualified, as a REIT. If we fail to qualify as a REIT for federal income tax purposes, all of our earnings will be subject to federal income taxation, which will reduce the amount of cash available for distribution to our stockholders.

 

If we are unable to complete the acquisitions of the hotel properties we have under contract in a timely fashion or at all, we will have no designated use for substantially all of the net proceeds of this offering and may experience delays in locating and securing attractive alternative investments, which would result in a reduction of the amount of cash available to our stockholders.

 

We intend to use substantially all of the net proceeds from this offering to acquire five hotel properties that we have under contract that we consider to be “probable” acquisitions. We anticipate that the closings of the acquisitions of these properties will occur on or before                 , 2005, which is after the date of the expected closing of this offering. However, we cannot assure you that we will acquire any of these properties because each proposed acquisition is subject to a variety of factors, including the satisfaction of closing conditions, including the receipt of third-party consents and approvals (including, with respect to each of the properties comprising the Capital Hotel Investment Portfolio, the consent of Marriott as hotel property manager, and with respect to the Vail Marriott Mountain Resort & Spa, our entering into a franchise agreement with Marriott). With respect to the Capital Hotel Investment Portfolio, we must acquire all four hotel properties if we acquire any of the properties. As a result, we may be less inclined to terminate a purchase and sale agreement with regard to a particular hotel property in the portfolio.

 

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We also intend to enter into two first mortgage loans aggregating $140.0 million with Wachovia Bank, National Association in order to fund a portion of the purchase price for the Capital Hotel Investment Portfolio. The mortgage loans will be secured by first mortgage liens on the Marriott Los Angeles Airport and the Renaissance Worthington. We cannot assure you that we will obtain these mortgage loans. If we do not obtain these mortgage loans, we will have insufficient financing to acquire the Capital Hotel Investment Portfolio.

 

If we do not complete these acquisitions within our anticipated time frame or at all, we may experience delays in locating and securing attractive alternative investments. These delays would result in our future operating results not meeting expectations and adversely affect our ability to make distributions to our stockholders. If we are unable to complete the purchase of the hotel properties that we have under contract, we will have no specific designated use for a substantial portion of the net proceeds from this offering and investors will be unable to evaluate in advance the manner in which we invest the net proceeds or the economic merits of the properties we may ultimately acquire with the net proceeds.

 

If we do not complete the acquisitions of the hotel properties that we have under contract, we will have incurred substantial expenses without our stockholders realizing the expected benefits.

 

If we are unable to complete the acquisition of these properties, we may lose substantial deposits that we have provided to the sellers. We have deposited an aggregate of $9 million with the sellers of the five hotels that we consider probable acquisitions as of the date of this prospectus and may deposit an additional aggregate of $5 million in order to exercise certain options to extend the closing date of the acquisitions. Currently, we expect that we will exercise these options and deposit the additional amounts. We will forfeit the respective deposits if the applicable acquisitions do not close, unless such failure to close is a result of the failure of the respective seller to satisfy its obligations or fulfill certain conditions precedent to closing under the applicable purchase and sale agreements. We have also incurred approximately $     million in due diligence legal and accounting expenses in connection with these acquisitions and may incur additional due diligence legal and accounting expenses prior to their acquisition.

 

Because our senior executive officers will have broad discretion to invest the net proceeds of this offering, they may make investments for which the returns are substantially below expectations or which result in net operating losses.

 

Because we intend to use substantially all of the net proceeds of this offering to acquire properties under contract, if we are not successful in acquiring these properties, our senior executive officers will have broad discretion, within the investment criteria established by our board of directors, to invest the net proceeds of this offering and to determine the timing of these investments. This discretion could result in investments that may not yield returns consistent with your expectations or which may result in net operating losses.

 

Our remedies will be limited if the sellers default and fail to perform their obligations under the contracts for the acquisition of the hotel properties we have under contract.

 

In the event that the sellers of the acquisition properties fail to perform their obligations under the contracts, we will have limited remedies. For example, in certain specified circumstances, if the sellers default, we would have the right to seek specific performance or alternatively, in the case of the Capital Hotel Investment Portfolio, liquidated damages, under the terms of the applicable contracts. However, in seeking specific performance, we would face considerable delays in completing these acquisitions, if at all. Pursuing specific performance would also prevent or delay us from seeking attractive alternative investments in which to invest the net proceeds from this offering. Even if we were successful in an action to recover liquidated damages, we cannot assure you that the sellers would have sufficient funds to pay these damages. Therefore, we are more likely to decide to terminate the agreement in the event of certain seller defaults. In that case, our remedies would be limited to the

 

21


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return of our deposits (assuming our exercise of extension options, approximately $9.0 million, in the case of the Capital Hotel Investment Portfolio, and approximately $4.0 million, in the case of the Vail Marriott Mountain Resort & Spa), and the payment, in each case, of our reasonable, third-party costs and expenses incurred in connection with the agreements, not to exceed $500,000 in the aggregate, in the case of the Capital Hotel Investment Portfolio, and $300,000, in the case of the Vail Marriott Mountain Resort & Spa.

 

Our estimated initial cash available for distributions will not be sufficient to make distributions to our stockholders at expected levels in the event that we do not complete the acquisition of the hotel properties that we have under contract.

 

Our estimated initial annual distribution to our stockholders represents 99.4% of our estimated cash available for distribution for the twelve months ended March 25, 2005. We will be unable to pay this estimated initial annual distribution to our stockholders out of cash available for distribution as calculated under “Dividend Policy and Distributions” in the event that we do not complete the acquisition of the hotel properties that we have under contract within our anticipated timeframe or at all. If sufficient cash is not available for distribution from our operations, we may have to fund distributions from working capital, borrow to provide funds for distributions or reduce the amount of distributions. Our use of debt to fund distributions will decrease the cash available for distributions to our stockholders.

 

Failure of the hotel industry to continue to improve may adversely affect our ability to execute our business strategies, which, in turn, would adversely affect our ability to make distributions to our stockholders.

 

Our business strategy is focused in the hotel industry, and we cannot assure you that hotel industry fundamentals will continue to improve. Economic slowdown and world events outside our control, such as terrorism, have adversely affected the hotel industry in the recent past and if these events reoccur, may adversely affect the industry in the future. In the event conditions in the hotel industry do not continue to improve as we expect, our ability to execute our business strategies will be adversely affected, which, in turn, would adversely affect our ability to make distributions to our stockholders.

 

Most of our hotels are upper upscale and upscale hotels; the upper upscale segments of the hotel market are highly competitive and generally subject to greater volatility than other segments of the market, which could harm our profitability.

 

The upper upscale and upscale segments of the hotel business are highly competitive. Our hotels compete on the basis of location, room rates and quality, service levels, reputation and reservation systems, among many other factors. There are many competitors in our hotel chain scale segments, and many of these competitors have substantially greater marketing and financial resources than we have. This competition could reduce occupancy levels and rental revenue at our hotels, which would harm our operations. Also, over-building in the hotel industry may increase the number of rooms available and may decrease the average occupancy and room rates at our hotels. In addition, in periods of weak demand, profitability is negatively affected by the relatively high fixed costs of operating upper upscale and upscale hotels when compared to other classes of hotels.

 

We are experiencing and expect to continue to experience rapid growth and may not be able to adapt our management and operational systems to integrate the hotel properties we expect to invest in and reposition without unanticipated disruption or expense.

 

Since we commenced operations in July 2004, we have experienced rapid growth, acquiring seven hotels containing an aggregate of 2,357 rooms and have developed our business strategies based on the expectation of continued rapid growth. We cannot assure you that we will be able to adapt our management, administrative, accounting and operational systems, or hire and retain qualified operational staff to integrate and manage our investment in or repositioning of any hotel properties. Our failure to successfully integrate and manage

 

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acquisitions could have a material adverse effect on our financial condition and results of operations and our ability to make distributions to our stockholders.

 

We face competition for the acquisition of hotels and we may not be successful in identifying or completing hotel acquisitions that meet our criteria, which may impede our growth.

 

One component of our business strategy is expansion through acquisitions, and we may not be successful in identifying or completing acquisitions that are consistent with our strategy. We compete with institutional pension funds, private equity investors, REITs, hotel companies and others who are engaged in the acquisition of hotels. This competition for hotel investments may increase the price we pay for hotels and these competitors may succeed in acquiring those hotels that we seek to acquire. Furthermore, our potential acquisition targets may find our competitors to be more attractive suitors because they may have greater marketing and financial resources, may be willing to pay more or may have a more compatible operating philosophy. In addition, the number of entities competing for suitable hotels may increase in the future, which would increase demand for these hotels and the prices we must pay to acquire them. If we pay higher prices for hotels, our returns on investment and profitability may be reduced. Also, future acquisitions of hotels or hotel companies may not yield the returns we expect and may result in stockholder dilution.

 

Our success depends in part on the success of Marriott.

 

All of our current hotel properties are managed by Marriott. As a result, our success is dependent in part on the continued success of Marriott and its brands. If market recognition or the positive perception of these Marriott brands is reduced or compromised, the goodwill associated with Marriott branded hotels may be adversely affected and the results of operations of our hotel properties managed by Marriott may be adversely affected. Similarly, if Marriott experiences a general decline in its business, no longer has access to high quality investment opportunities or experiences a reduction in its access to hotel investment opportunities, our business strategies could be adversely affected.

 

Our investment sourcing relationship with Marriott is non-exclusive and based on a non-binding understanding that may be changed or terminated at any time, which could adversely affect our ability to execute our business strategies, which in turn, would adversely affect our ability to make distributions to our stockholders.

 

Our investment sourcing relationship with Marriott is non-exclusive and based on a non-binding understanding that creates limited legal obligations. Both parties are free to terminate or attempt to change our investment sourcing relationship at any time, without notice or explanation. While Marriott intends to provide us a “first look” at hotel investment opportunities known to Marriott that are consistent with our stated business strategies, it will not provide us with opportunities where it is contractually or ethically prohibited from doing so, or where Marriott believes it would be damaging to existing Marriott relationships. The only limited legal obligation that will arise from this understanding is that we and Marriott have agreed for a two-year period beginning on July 1, 2004 not to enter into certain strategic agreements with other third parties. While we retain the right to utilize any hotel brand and any hotel management company, we believe that our utilization of brands or hotel management companies other than Marriott could adversely affect our investment sourcing relationship with Marriott. Termination of, or an adverse change in, our investment sourcing relationship with Marriott may limit our sources of acquisition and investment opportunities and therefore adversely affect our ability to execute our business strategies. Our inability to execute our business strategies would adversely affect our ability to make distributions to our stockholders.

 

Our investment sourcing relationship with Marriott may not result in the acquisition of any future hotel properties.

 

We believe that access to information about hotel property investment opportunities known to Marriott will provide us with a competitive advantage by providing us with knowledge about a potential investment

 

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opportunity before it has been widely marketed. Therefore, while we expect that this competitive advantage will lead to favorable investments by us, we cannot assure you that this “first look” will result in the acquisition of any future hotel properties or provide us with a competitive advantage. Additionally, as a result of our investment sourcing relationship with Marriott, we may not be aware, or in a position to take advantage, of favorable investment opportunities known to other hotel operators.

 

Marriott may encourage us to enter into transactions or hotel management agreements that are favorable to Marriott.

 

Pursuant to our investment sourcing relationship with Marriott, we have pursued and intend to continue to pursue, hotel property investment opportunities referred to us by Marriott, and we intend to utilize Marriott as our preferred hotel management company. It is possible that in connection with a particular hotel property acquisition or hotel management agreement, Marriott will encourage us to enter into an acquisition or hotel management agreement with terms that are more favorable to Marriott than we might otherwise agree to with a third party. In order to maintain our investment sourcing relationship with Marriott, we may not seek the most advantageous terms with Marriott with regard to a particular acquisition or hotel management agreement as we might otherwise seek with third parties.

 

Our success depends in part on maintaining good relations with Marriott.

 

Our senior executive officers are familiar with the Marriott management, strategy and processes but do not have significant experience with other brand companies or hotel management companies. Over the last several years, Marriott has been involved in contractual and other disputes with owners of the hotel properties it manages. Although we currently maintain good relations with Marriott, we cannot assure you that disputes between us and Marriott regarding the management of our properties or the services it provides to us will not arise. Should our relationship with Marriott deteriorate, we believe that one of our competitive advantages could be eliminated. In particular, we may be denied access to information about which hotel properties may be available for sale and how such hotel properties may be repositioned. As a result, we would seek to grow by investing in hotel properties that are being competitively pursued in the marketplace, which may result in our paying higher prices for assets or being denied access to otherwise attractive hotel investment opportunities.

 

Our objectives may conflict from time to time with the objectives of Marriott, which conflict may adversely impact the operation and profitability of a hotel property.

 

Marriott and its affiliates own, operate or franchise properties other than our hotel properties, including properties that directly compete with our hotel properties. Therefore, Marriott may have short-term or long-term goals and objectives that conflict with our own, including with respect to the brands under which our hotel properties operate. These differences may be significant and may include the remaining term of any hotel management agreement, trade area restrictions with respect to competition by Marriott or its affiliates or differing policies, procedures or practices. As a result of these potentially differing objectives, Marriott may present to us, and we may invest in, hotel investment opportunities, and enter into management agreements, that are less favorable to us than other alternatives. These differing objectives could result in a deterioration in our relationship with Marriott and may adversely affect our ability to execute our business strategies, which in turn, would adversely affect our ability to make distributions to our stockholders.

 

Our results of operations are highly dependent on the management of our hotel properties by third-party hotel management companies.

 

In order to qualify as a REIT, we cannot operate our hotel properties or participate in the decisions that affect the daily operations of our hotel properties. Our TRS lessees may not operate these hotel properties and, therefore, they must enter into third-party hotel management agreements with one or more eligible independent contractors (including Marriott). Thus, third-party hotel management companies that enter into management contracts with our TRS lessees will control the daily operations of our hotel properties.

 

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Under the terms of the hotel management agreements that we have entered into with Marriott (or its affiliates), or will enter into in the future with Marriott or other third-party hotel management companies, our ability to participate in operating decisions regarding our hotel properties will be limited. We currently rely and will continue to rely on these hotel management companies to adequately operate our hotel properties under the terms of the hotel management agreements. We do not have the authority to require any hotel property to be operated in a particular manner or to govern any particular aspect of its operations (for instance, setting room rates). Thus, even if we believe our hotel properties are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, ADRs and operating profits, we may not have sufficient rights under our hotel management agreements to enable us to force the hotel management company to change its method of operation. We can only seek redress if a hotel management company violates the terms of the applicable hotel management agreement with the TRS lessee, and then only to the extent of the remedies provided for under the terms of the hotel management agreement. Our current hotel management agreements are generally non-terminable, subject to certain exceptions for cause (see “Our Principal Agreements—Our Hotel Management Agreements”), and in the event that we need to replace any of our hotel management companies pursuant to termination for cause, we may experience significant disruptions at the affected properties, which may adversely affect our ability to make distributions to our stockholders.

 

Our current hotel management agreements contain certain restrictions against the sale of a hotel property to certain parties, which may affect the value of our hotel properties.

 

The hotel management agreements that we have entered into with Marriott (and those we expect to enter into in the future) contain provisions restricting our ability to dispose of our hotel properties to certain parties, which, in turn, may have an adverse affect on the value of our hotel properties. Marriott’s hotel management agreements generally prohibit the sale of a hotel property to:

 

    certain competitors of Marriott;

 

    purchasers who are insufficiently capitalized; or

 

    purchasers who might jeopardize certain liquor or gaming licenses.

 

Our mortgage agreements and ground leases contain certain provisions that may limit our ability to sell our hotel properties.

 

In order to assign or transfer our rights and obligations under certain of our mortgage agreements, we generally must:

 

    obtain the consent of the lender;

 

    pay a fee equal to a fixed percentage of the outstanding loan balance; and

 

    pay any costs incurred by the lender in connection with any such assignment or transfer.

 

Additionally, our ground lease agreements with respect to Bethesda Marriott Suites and Salt Lake City Marriott Downtown require consent of the lessor for assignment or transfer. These provisions of our mortgage agreements and ground leases may limit our ability to sell our hotel properties which, in turn, could adversely impact the price realized from any such sale.

 

Our current hotel management agreements contain provisions requiring us to pay certain fees to the property manager even if the hotel property is not profitable, which may adversely affect our ability to sell the hotel property.

 

The hotel management agreements that we have entered into with Marriott (and those we expect to enter into in the future) contain provisions that require us to pay substantial base management fees to Marriott irrespective of whether the hotels are profitable and incentive management fees that represent a substantial

 

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portion of the net operating income from the particular hotel property. As a result, because our hotel properties would have to be sold subject to the applicable hotel management agreement, these fee payment provisions may deter some potential purchasers and could adversely impact the price realized from any such sale.

 

Our current hotel management agreements are generally long term, which may adversely affect our ability to sell the hotel property.

 

Our current hotel management agreements that we have entered into with Marriott contain initial terms ranging from twenty to forty years and certain agreements have renewal periods, at Marriott’s option, of ten to forty-five years. Because our hotel properties would have to be sold subject to the applicable hotel management agreement, the term length of a hotel management agreement may deter some potential purchasers and could adversely impact the price realized from any such sale.

 

Our TRS lessee structure subjects us to the risk of increased operating expenses.

 

Our hotel management agreements require us to bear the operating risks of our hotel properties. Our operating risks include not only changes in hotel revenues and changes in our TRS lessees’ ability to pay the rent due under the leases, but also increased operating expenses, including, among other things:

 

    wage and benefit costs;

 

    repair and maintenance expenses;

 

    energy costs;

 

    property taxes;

 

    insurance costs; and

 

    other operating expenses.

 

Any decreases in hotel revenues or increases in operating expenses could have a materially adverse effect on our earnings and cash flow.

 

Our ability to make distributions to our stockholders is subject to fluctuations in our financial performance, operating results and capital improvement requirements.

 

As a REIT, we generally will be required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to our stockholders. In the event of future downturns in our operating results and financial performance or unanticipated capital improvements to our hotel properties, we may be unable to declare or pay distributions to our stockholders. The timing and amount of distributions are in the sole discretion of our board of directors, which will consider, among other factors, our actual results of operations, debt service requirements, capital expenditure requirements for our properties and our operating expenses. We may not generate sufficient cash in order to fund distributions to our stockholders.

 

Among the factors which could adversely affect our results of operations and our distributions to stockholders are reduced net operating profits or operating losses, increased debt service requirements and capital expenditures at our hotel properties. Among the factors which could reduce our net operating profits are decreases in hotel property revenues and increases in hotel property operating expenses. Hotel property revenue can decrease for a number of reasons, including increased competition from a new supply of rooms and decreased demand for rooms. These factors can reduce both occupancy and room rates at our hotel properties.

 

If we were to default on our secured debt in the future, the loss of any property securing the debt would harm our ability to satisfy other obligations.

 

We expect that a substantial portion of our debt (including the three-year, $75.0 million senior secured revolving credit facility we intend to enter into with Wachovia Bank, National Association) will be secured by

 

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first mortgage deeds of trust on our properties. Although our existing secured debt documents do not contain cross-default provisions, using our properties as collateral increases our risk of property losses because defaults on indebtedness secured by properties may result in foreclosure actions initiated by lenders and ultimately our loss of the property that secures any loans for which we are in default. For tax purposes, a foreclosure on any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure but would not receive any cash proceeds. As a result, we may be required to identify and utilize other sources of cash for distributions to our stockholders. If this occurs, our financial condition, cash flow and ability to satisfy our other debt obligations or ability to pay dividends may be adversely affected.

 

Future debt service obligations could adversely affect our operating results, may require us to liquidate our properties, may jeopardize our tax status as a REIT and limit our ability to make distributions to our stockholders.

 

Assuming the application of a portion of our net proceeds from this offering to repay approximately $64.0 million of mortgage debt and the acquisition of the hotel properties currently under contract as described in “Use of Proceeds,” we will have approximately $300.1 million in outstanding debt, which will represent approximately 39.3% of our aggregate property investment and repositioning costs. We currently maintain a policy that limits our total debt level to no more than 60% of our aggregate property investment and repositioning costs. Our board of directors, however, may change or eliminate this debt limit, and/or the policy itself, at any time without the approval of our stockholders. In the future, we and our subsidiaries may be able to incur substantial additional debt, including secured debt. Incurring such debt could subject us to many risks, including the risks that:

 

    our cash flow from operations will be insufficient to make required payments of principal and interest;

 

    we may be more vulnerable to adverse economic and industry conditions;

 

    we may be required to dedicate a substantial portion of our cash flow from operations to the repayment of our debt, thereby reducing the cash available for distribution to our stockholders, funds available for operations and capital expenditures, future investment opportunities or other purposes;

 

    the terms of any refinancing may not be as favorable as the terms of the debt being refinanced; and

 

    the use of leverage could adversely affect our stock price and the ability to make distributions to our stockholders.

 

If we violate covenants in our future indebtedness agreements, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on favorable terms, if at all.

 

If we obtain debt in the future and do not have sufficient funds to repay our debt at maturity, it may be necessary to refinance this debt through additional debt financing, private or public offerings of debt securities, or additional equity financings. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancings, increases in interest expense could adversely affect our cash flow, and, consequently, our cash available for distribution to our stockholders. If we are unable to refinance our debt on acceptable terms, we may be forced to dispose of our hotel properties on disadvantageous terms, potentially resulting in losses adversely affecting cash flow from operating activities. In addition, we may place mortgages on our hotel properties to secure our line of credit or other debt. To the extent we cannot meet these debt service obligations, we risk losing some or all of those properties to foreclosure. Additionally, our debt covenants could impair our planned strategies and, if violated, result in a default of our debt obligations.

 

Higher interest rates could increase debt service requirements on our floating rate debt and could reduce the amounts available for distribution to our stockholders, as well as reduce funds available for our operations, future investment opportunities or other purposes. We may obtain in the future one or more forms of interest rate

 

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protection—in the form of swap agreements, interest rate cap contracts or similar agreements—to “hedge” against the possible negative effects of interest rate fluctuations. However, we cannot assure you that any hedging will adequately mitigate the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations. In addition, we may be subject to risks of default by hedging counter-parties. Adverse economic conditions could also cause the terms on which we borrow to be unfavorable.

 

Our existing indebtedness contains, and we expect our future indebtedness will contain, financial covenants that could limit our operations and our ability to make distributions to our stockholders.

 

We intend to enter into a three-year, $75.0 million senior secured revolving credit facility with Wachovia Bank, National Association. Under the terms of the senior secured revolving credit facility, we may elect to increase the amount of the facility to $250.0 million, subject to approval of Wachovia Bank, National Association. We also intend to enter into two mortgage loans aggregating $140.0 million with Wachovia Bank, National Association to fund a portion of the purchase price for the Capital Hotel Investment Portfolio. The mortgage loans will be secured by first mortgage liens on the Marriott Los Angeles Airport and the Renaissance Worthington. Our existing indebtedness contains, and we expect our future indebtedness and new mortgage loans will contain, financial and operating covenants, including net worth requirements, fixed charge coverage and debt ratios and other limitations which will restrict our ability to make distributions or other payments to our stockholders (other than those required by the Code), sell all or substantially all of our assets and engage in mergers, consolidations and certain acquisitions. Failure to meet our financial covenants could result from, among other things, changes in our results of operations, the incurrence of debt or changes in general economic conditions. Advances under our senior secured revolving credit facility will be subject to borrowing base requirements based on the hotels securing the facility. These covenants may restrict our ability to engage in transactions that we believe would otherwise be in the best interests of our stockholders. Failure to comply with any of the covenants in our senior secured revolving credit facility could result in a default under one or more of our debt instruments. This could cause one or more of our lenders to accelerate the timing of payments and could harm our business, operations, financial condition or liquidity. Although we have a commitment letter for such facility, we may be unable to close on the facility based on the terms described in this prospectus or at all. We also cannot assure you that we will obtain the mortgage loans. If we do not obtain the mortgage loans, we will have insufficient financing to acquire the Capital Hotel Investment Portfolio.

 

We may be unable to acquire any of the hotel properties that we have under non-binding letters of intent, which could adversely affect our future operating results and our ability to make distributions to our stockholders.

 

As of the date of this prospectus, we have          additional properties under non-binding letters of intent having an aggregate acquisition cost of approximately $         million. We also cannot assure you that we will acquire any of the properties under these letters of intent because the letters of intent are non-binding and each of these transactions is subject to a variety of factors including: (i) the willingness of the current property owner to proceed with a transaction, (ii) our completion of satisfactory due diligence, (iii) the negotiation and execution of a mutually acceptable binding definitive purchase agreement and hotel management agreement (or assumption of an existing hotel management agreement) and (iv) the satisfaction of closing conditions, including the receipt of third-party consents and approvals. Accordingly, we cannot assure you that we will be in a position to acquire any of the properties under non-binding letters of intent following this offering. If we are unsuccessful in completing the acquisition of additional hotel properties in the future, our future operating results will not meet expectations and our ability to make distributions to our stockholders will be adversely affected.

 

Our ownership of properties through ground leases exposes us to the loss of such properties upon breach or termination of the ground leases.

 

We acquired interests in three of our current hotel properties and the golf course associated with a fourth property by acquiring a leasehold interest in land underlying the property; a portion of the land underlying the

 

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Renaissance Worthington is subject to ground leases; and we may acquire additional hotel properties in the future through the purchase of hotel properties subject to ground leases. As lessee under ground leases, we would be exposed to the possibility of losing the hotel property, or a portion of the hotel property, upon termination, or an earlier breach by us, of the ground lease.

 

Potential payment of a fund withdrawal liability under Section 4201 of ERISA would have a material adverse effect on our results of operations.

 

On March 31, 2005, the New York Hotel Trades Council and Hotel Association of New York City, Inc. Pension Fund (the “Fund”) sent us a Notice of Demand for Payment of Withdrawal Liability under Section 4202 of ERISA, with regard to our acquisition of the Courtyard Manhattan/Fifth Avenue and the related transfer of management of the hotel to Marriott. The Fund assessed a withdrawal liability of $484,242 under Section 4201 of ERISA. If we decide to pay the amount assessed, or if it were determined that we must pay such amount, such payment would have a material adverse effect on our cash flow and results of operations.

 

Joint venture investments could be adversely affected by our lack of sole decision-making authority, our reliance on co-venturer’s financial condition and disputes between us and our co-venturers.

 

We may co-invest in the future with third parties through partnerships, joint ventures or other entities, acquiring non-controlling interests in or sharing responsibility for managing the affairs of a property, partnership, joint venture or other entity. In this event, we would not be in a position to exercise sole decision-making authority regarding the property, partnership, joint venture or other entity. Investments in partnerships, joint ventures, or other entities may, under certain circumstances, involve risks not present were a third party not involved, including the possibility that partners or co-venturers might become bankrupt, fail to fund their share of required capital contributions, make dubious business decisions or block or delay necessary decisions. Partners or co-venturers may have economic or other business interests or goals which are inconsistent with our business interests or goals, and may be in a position to take actions contrary to our policies or objectives. Such investments may also have the potential risk of impasses on decisions, such as a sale, because neither we nor the partner or co-venturer would have full control over the partnership or joint venture. Disputes between us and partners or co-venturers may result in litigation or arbitration that would increase our expenses and prevent our officers and/or directors from focusing their time and effort on our business. Consequently, actions by, or disputes with, partners or co-venturers might result in subjecting properties owned by the partnership or joint venture to additional risk. In addition, we may in certain circumstances be liable for the actions of our third-party partners or co-venturers.

 

Our success depends on key personnel whose continued service is not guaranteed.

 

We depend on the efforts and expertise of our senior executive officers to manage our day-to-day operations and strategic business direction. The loss of any of their services could have an adverse effect on our operations.

 

We have entered into an agreement with each of our senior executive officers that provides each of them benefits in the event his employment is terminated by us without cause, by him for good reason, or under certain circumstances following a change of control of our company.

 

We have entered into an agreement with each of our senior executive officers, except Mr. Mahoney, that provides each of them with severance benefits if his employment is terminated by us without cause, by him for good reason, or with respect to all our senior executive officers, under certain circumstances following a change of control of our company. Certain of these benefits and the related tax indemnity could prevent or deter a change of control of our company that might involve a premium price for our common stock or otherwise be in the best interests of our stockholders.

 

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A portion of our revenues may be attributable to operations outside of the United States, which will subject us to different legal, monetary and political risks, as well as currency exchange risks, and may cause unpredictability in a significant source of our cash flows that could adversely affect our ability to make distributions to our stockholders.

 

We may acquire selective hotel properties outside of the United States, although we do not expect our international assets to exceed 10% of our total assets. International investments and operations generally are subject to various political and other risks that are different from and in addition to risks in U.S. investments, including:

 

    the enactment of laws prohibiting or restricting the foreign ownership of property;

 

    laws restricting us from removing profits earned from activities within the foreign country to the United States, including the payment of distributions, i.e., nationalization of assets located within a country;

 

    variations in the currency exchange rates, mostly arising from revenues made in local currencies;

 

    change in the availability, cost and terms of mortgage funds resulting from varying national economic policies;

 

    changes in real estate and other tax rates and other operating expenses in particular countries; and

 

    more stringent environmental laws or changes in such laws.

 

In addition, currency devaluations and unfavorable changes in international monetary and tax policies could have a material adverse effect on our profitability and financing plans, as could other changes in the international regulatory climate and international economic conditions. Liabilities arising from differing legal, monetary and political risks as well as currency fluctuations could adversely affect our financial condition, operating results and our ability to make distributions to our stockholders. In addition, the requirements for qualifying as a REIT limit our ability to earn gains, as determined for federal income tax purposes, attributable to changes in currency exchange rates. These limitations may significantly limit our ability to invest outside of the United States or impair our ability to qualify as a REIT.

 

Any properties we invest in outside of the United States may be subject to foreign taxes.

 

In the future, we may invest in hotel properties in foreign countries. Those foreign countries will impose taxes on our hotel properties and our operations within their jurisdictions. To the extent possible, we will structure our investments and activities to minimize our foreign tax liability, but we will likely incur foreign taxes with respect to non-U.S. properties. Moreover, the requirements for qualification as a REIT may preclude us from always using the structure that minimizes our foreign tax liability. Furthermore, because we are a REIT, we and our stockholders will derive little or no benefit from the foreign tax credits arising from the foreign taxes we pay. As a result, foreign taxes we pay will reduce our income and available cash flow from our foreign hotel properties, which, in turn, could reduce our ability to make distributions to our stockholders.

 

Risks Related to the Hotel Industry

 

Our ability to make distributions to our stockholders may be affected by factors unique to the hotel industry.

 

Operating Risks.    Our hotel properties are and will continue to be subject to various operating risks common to the hotel industry, many of which are beyond our control, including:

 

    competition from other hotel properties that may be located in our markets, some of which may have greater marketing and financial resources than us;

 

    an over-supply or over-building of hotel properties in our markets, which could adversely affect occupancy rates and revenues at our properties;

 

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    dependence on business and commercial travelers and tourism;

 

    increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists;

 

    increases in operating costs due to inflation and other factors that may not be offset by increased room rates;

 

    necessity for periodic capital reinvestment to repair and upgrade our hotel properties;

 

    changes in interest rates and in the availability, cost and terms of debt financing;

 

    changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;

 

    adverse effects of a downturn in the hotel industry; and

 

    risks generally associated with the ownership of hotel properties and real estate, as we discuss in detail below.

 

These factors could reduce the net operating profits of our TRS lessees, which in turn could adversely affect our ability to make distributions to our stockholders.

 

Competition for Acquisitions.    We compete for hotel investment opportunities with competitors that may have a different appetite for risk than we do or have substantially greater financial resources than we do. This competition may generally limit the number of suitable investment opportunities offered to us and may also increase the bargaining power of property owners seeking to sell to us, making it more difficult for us to acquire new hotel properties on attractive terms.

 

Seasonality of Hotel Industry.    Some hotel properties that we have acquired or may acquire in the future have business that is seasonal in nature. This seasonality can be expected to cause quarterly fluctuations in our revenues. Our quarterly earnings may be adversely affected by factors outside our control, including weather conditions and poor economic factors. As a result, we may have to enter into short-term borrowings in certain quarters in order to offset these fluctuations in revenues and to make distributions to our stockholders.

 

Investment Concentration in Single Industry.    Our entire business is related to the hotel industry. Therefore, a downturn in the hotel industry, in general, will have a material adverse effect on our hotels’ revenues and the net operating profits of our TRS lessees and amounts available for distribution to our stockholders.

 

Capital Expenditures.    Our hotel properties have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. These capital improvements may give rise to the following risks:

 

    construction cost overruns and delays;

 

    a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms;

 

    uncertainties as to market demand or a loss of market demand after capital improvements have begun; and

 

    disputes with franchisors/managers regarding compliance with relevant management/franchise agreements.

 

The costs of these capital improvements could adversely affect our financial condition and amounts available for distribution to our stockholders.

 

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The development of hotel properties is subject to timing, budgeting and other risks that may adversely affect our operating results and our ability to make distributions to stockholders.

 

We may selectively engage in new developments of hotel properties as market conditions warrant. Developing hotel properties involves a number of risks, including risks associated with:

 

    construction delays or cost overruns that may increase project costs;

 

    receipt of zoning, occupancy and other required governmental permits and authorizations;

 

    development costs incurred for projects that are not pursued to completion;

 

    acts of God such as earthquakes, hurricanes, floods or fires that could adversely impact a project;

 

    ability to raise capital; and

 

    governmental restrictions on the nature or size of a project.

 

We cannot assure you that any development project will be completed on time or within budget. Our inability to complete a project on time or within budget may adversely affect our operating results and our ability to make distributions to our stockholders.

 

The hotel industry is capital intensive and our inability to obtain financing could limit our growth.

 

Our hotel properties require periodic capital expenditures and renovations to remain competitive and the acquisition of additional hotel properties requires significant capital expenditures. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we generally must distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to maintain our REIT tax status. As a result, our ability to fund capital expenditures, or investments through retained earnings, is very limited. Consequently, we will rely upon the availability of debt or equity capital to fund our investments and capital improvements, but these sources of funds may not be available on favorable terms and conditions. Neither our charter nor our bylaws limits the amount of debt that we can incur; however, we may not be able to obtain additional equity or debt financing on favorable terms, if at all.

 

The events of September 11, 2001, recent economic trends, the military action in Afghanistan and Iraq and the possibility of future terrorist acts and military action have adversely affected the hotel industry generally, and similar future events could adversely affect the industry in the future.

 

Before September 11, 2001, hotel owners and operators had begun experiencing declining RevPAR, as a result of the slowing U.S. economy. The terrorist attacks of September 11, 2001 and the after-effects (including the possibility of more terror attacks in the United States and abroad), combined with economic trends and the U.S.-led military action in Afghanistan and Iraq, substantially reduced business and leisure travel and hotel industry RevPAR generally. If the economy once again declines or there is a future terrorist attack in the United States, our business may be materially and adversely affected. We cannot predict the extent to which these factors will directly or indirectly impact your investment in our common stock, the hotel industry or our operating results in the future. Declining RevPAR at hotels that we acquire would reduce our net income and restrict our ability to fund capital improvements at our hotels and our ability to make distributions to stockholders necessary to maintain our status as a REIT. Additional terrorist attacks, acts of war or similar events could have further material adverse effects on the markets on which shares of our common stock will trade, the hotel industry at large and our operations in particular.

 

Potential future outbreaks of contagious diseases could have a material adverse effect on our revenues and results of operations due to decreased travel, especially in areas significantly affected by the disease.

 

In 2003, the outbreak of Severe Acute Respiratory Syndrome, or SARS, drastically decreased travel in areas significantly affected by the disease. Potential future outbreaks of SARS or other contagious diseases could

 

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adversely impact travel to areas where we have hotel properties, which could have a material adverse effect on our revenues or results of operations.

 

We place significant reliance on technology.

 

The hotel industry continues to demand the use of sophisticated technology and systems including technology utilized for property management, procurement, reservation systems, customer loyalty programs, distribution and guest amenities. These technologies can be expected to require refinements and there is the risk that advanced new technologies will be introduced. If various systems and technologies become outdated or new technology is required, we may not be able to replace outdated technology or introduce or achieve expected benefits from new technology as quickly as our competition, within budgeted costs for such technology or at all, which in turn may have an adverse effect on our revenues and results of operations.

 

We may be adversely affected by increased use of business-related technology which may reduce the need for business-related travel.

 

The increased use of teleconference and video-conference technology by businesses could result in decreased business travel as companies increase the use of technologies that allow multiple parties from different locations to participate at meetings without traveling to a centralized meeting location. To the extent that such technologies play an increased role in day-to-day business and the necessity for business-related travel decreases, demand for hotel properties may decrease and our profitability may be adversely affected.

 

Uninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to our stockholders.

 

We have acquired and intend to maintain comprehensive insurance on each of our hotel properties, including liability, terrorism, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel property owners. We cannot assure you that such coverage will be available at reasonable rates. Various types of catastrophic losses, like earthquakes and floods and losses from foreign terrorist activities such as those on September 11, 2001 or losses from domestic terrorist activities such as the Oklahoma City bombing may not be insurable or may not be insurable on reasonable economic terms. Future lenders may require such insurance and our failure to obtain such insurance could constitute a default under loan agreements. Depending on our access to capital, liquidity and the value of the properties securing the affected loan in relation to the balance of the loan, a default could have a material adverse effect on our results of operations and ability to obtain future financing.

 

In the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel property, as well as the anticipated future revenue from that particular hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position with regard to the damaged or destroyed property.

 

Noncompliance with governmental regulations could adversely affect our operating results.

 

Environmental Matters

 

Our hotel properties are and will be subject to various federal, state and local environmental laws. Under these laws, courts and government agencies may have the authority to require us, as owner of a contaminated property, to clean up the property, even if we did not know of or were not responsible for the contamination.

 

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These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property. Under the environmental laws, courts and government agencies also have the authority to require that a person who sent waste to a waste disposal facility, such as a landfill or an incinerator, pay for the clean-up of that facility if it becomes contaminated and threatens human health or the environment. A person that arranges for the disposal or treatment, or transports for disposal or treatment, a hazardous substance at a property owned by another person may be liable for the costs of removal or remediation of hazardous substances released into the environment at that property.

 

Furthermore, various court decisions have established that third parties may recover damages for injury caused by property contamination. For instance, a person exposed to asbestos while staying in a hotel may seek to recover damages if he or she suffers injury from the asbestos. Lastly, some of these environmental laws restrict the use of a property or place conditions on various activities. For example, certain laws require a business using chemicals (such as swimming pool chemicals at a hotel property) to manage them carefully and to notify local officials that the chemicals are being used.

 

We could be responsible for the costs associated with a contaminated property. The costs to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could adversely affect the funds available for distribution to our stockholders. We cannot assure you that future laws or regulations will not impose material environmental liabilities or that the current environmental condition of our hotel properties will not be affected by the condition of the properties in the vicinity of our hotel properties (such as the presence of leaking underground storage tanks) or by third parties unrelated to us.

 

We may face liability regardless of:

 

    our knowledge of the contamination;

 

    the timing of the contamination;

 

    the cause of the contamination; or

 

    the party responsible for the contamination of the property.

 

The current owner and manager of the Frenchman’s Reef & Morning Star Marriott Beach Resort property is currently working with the Virgin Islands Department of Planning and Natural Resources in St. Thomas, Virgin Islands to clean up twenty-one 55-gallon drums of both hazardous and non-hazardous waste, as well as remediate contamination caused by a leak associated with two 15,000 gallon diesel fuel underground storage tanks at that property. The cost of both efforts is estimated to range up to $400,000. Should more aggressive remediation be required or if fines are imposed, our costs could increase, and the costs could be material. Also, we will have no recourse against the seller of this property for any of the environmental liabilities at this property prior to our acquisition of the property. Material environmental liabilities could negatively affect our cash flow and results of operations.

 

Although we have taken and will take commercially reasonable steps to assess the condition of our properties, there may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest. In addition, we are obligated to indemnify our lenders for any liability they may incur in connection with a contaminated property.

 

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The presence of hazardous substances on a property may adversely affect our ability to sell the property and could cause us to incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to pay dividends to our stockholders.

 

Americans with Disabilities Act and Other Changes in Governmental Rules and Regulations

 

Under the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or private litigants winning damages. If we are required to make substantial modifications to our hotel properties, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to make distributions to our stockholders could be adversely affected.

 

General Risks Related to the Real Estate Industry

 

Illiquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition.

 

Because real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties or investments in our portfolio in response to changing economic, financial and investment conditions may be limited. In addition, because all of our hotel management agreements contain restrictions on our ability to dispose of our hotel properties, are typically long-term and do not terminate in the event of a sale, our ability to sell hotel properties may be further limited. The real estate market is affected by many factors that are beyond our control, including:

 

    adverse changes in international, national, regional and local economic and market conditions;

 

    changes in interest rates and in the availability, cost and terms of debt financing;

 

    changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;

 

    the ongoing need for capital improvements, particularly in older structures;

 

    changes in operating expenses; and

 

    civil unrest, acts of God, including earthquakes, floods and other natural disasters and acts of war or terrorism, including the consequences of terrorist acts such as those that occurred on September 11, 2001, which may result in uninsured losses.

 

We may decide to sell our hotel properties in the future. We cannot predict whether we will be able to sell any hotel property or investment for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property or loan.

 

We may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that hotel property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that hotel property. These facts and any others that would impede our ability to respond to adverse changes in the performance of our hotel properties could have a material adverse effect on our operating results and financial condition, as well as our ability to make distributions to stockholders.

 

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Increases in our property taxes could adversely affect our ability to make distributions to our stockholders.

 

Each of our hotel properties is subject to real and personal property taxes. These taxes on our hotel properties may increase as tax rates change and as the properties are assessed or reassessed by taxing authorities. If property taxes increase, our ability to make distributions to our stockholders could be adversely affected.

 

Our hotel properties may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.

 

When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of mold to which our hotel guests or employees could be exposed at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, exposure to mold by our guests or employees, management company employees or others could expose us to liability if property damage or health concerns arise.

 

Risks Related to Our Organization and Structure

 

Our failure to qualify as a REIT under the federal tax laws will result in adverse tax consequences.

 

The federal income tax laws governing REITs are complex.

 

We intend to operate in a manner that will qualify us as a REIT under the federal income tax laws beginning January 1, 2005. The REIT qualification requirements are extremely complex, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Accordingly, we cannot be certain that we will be successful in operating so that we can qualify as a REIT. At any time, new laws, interpretations, or court decisions may change the federal tax laws or the federal income tax consequences of our qualification as a REIT. We have not applied for or obtained a ruling from the Internal Revenue Service that we will qualify as a REIT.

 

Failure to qualify as a REIT would subject us to federal income tax.

 

If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax on our taxable income. We might need to borrow money or sell assets in order to pay any such tax. If we cease to be a REIT, we no longer would be required to distribute most of our taxable income to our stockholders. Unless we were entitled to relief under certain federal income tax laws, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT.

 

Failure to make required distributions would subject us to tax.

 

In order to qualify as a REIT, we generally are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to our stockholders. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws. As a result, for example, of differences between cash flow and the accrual of income and expenses for tax purposes, or of nondeductible expenditures, our REIT taxable income in any given year could exceed our cash available for distribution. In addition, to the extent we may retain earnings of our TRS lessees in those subsidiaries, such amount of cash would not be available for

 

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distribution to our stockholders to satisfy the 90% distribution requirement. Accordingly, we may be required to borrow money or sell assets to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement and to avoid federal corporate income tax and the 4% nondeductible excise tax in a particular year.

 

The formation of our TRS lessees increases our overall tax liability.

 

Bloodstone TRS, Inc. and our TRS lessees, and any other of our domestic TRSs, are subject to federal and state income tax on their taxable income, which in the case of our TRS lessees currently consists and generally will continue to consist of revenues from the hotel properties leased by our TRS lessees plus, in certain cases, key money payments (amounts paid to us by a hotel management company in exchange for the right to manage a hotel property we acquire), net of the operating expenses for such properties and rent payments to us. Accordingly, although our ownership of Bloodstone TRS, Inc. and our TRS lessees allows us to participate in the operating income from our hotel properties in addition to receiving rent, that operating income is fully subject to income tax. Such taxes could be substantial. The after-tax net income of our TRS lessees or other TRSs is available for distribution to us.

 

We incur a 100% excise tax on transactions with Bloodstone TRS, Inc. and our TRS lessees or other TRSs that are not conducted on an arm’s-length basis. For example, to the extent that the rent paid by one of our TRS lessees exceeds an arm’s-length rental amount, such amount potentially is subject to the excise tax. We intend that all transactions between us and our TRS lessees will continue to be conducted on an arm’s-length basis and, therefore, that the rent paid by our TRS lessees to us will not be subject to the excise tax.

 

Consequences of our operating as a C corporation for 2004.

 

As a C corporation, for our first taxable year ended December 31, 2004, we incurred federal and state income taxes of approximately $0.9 million. In addition, because we were a C corporation for our taxable year ended December 31, 2004, we generally will be subject to a corporate-level tax on a taxable disposition of any appreciated asset we hold as of the effective date of our REIT election which is expected to be January 1, 2005, which tax could reduce the amount that we could otherwise distribute to our stockholders. Specifically, if we dispose of a built-in-gain asset in a taxable transaction prior to the tenth anniversary of the effective date of our REIT election, we would be subject to tax at the highest regular corporate rate (currently 35%) on the lesser of the gain recognized and the asset’s built-in-gain.

 

In addition, to qualify as a REIT, we may not have, at the end of any taxable year, any undistributed earnings and profits accumulated in any non-REIT taxable year. Our non-REIT earnings and profits will include any earnings and profits we accumulated before the effective date of our REIT election. For our first taxable year ended December 31, 2004, we had approximately $2.3 million of non-REIT earnings and profits. We intend to distribute these earnings and profits, which we currently estimate will be approximately $2.3 million, to eliminate any 2004 non-REIT earnings and profits, regardless of our 2005 REIT taxable income. We expect that this earnings and profits distribution will be declared in the last quarter of 2005 and paid in 2005. Moreover, we intend to distribute (and avoid tax on) our 2005 REIT taxable income.

 

We could lose our REIT status if Marriott or another hotel management company with which we enter into hotel management agreements fails to qualify as an “eligible independent contractor” under the Code.

 

The hotel properties leased by our TRS lessees must be operated by an “eligible independent contractor” as defined in the Code in order for the rental income from our TRS lessees to qualify as rents from real property under the applicable REIT income tests. In order to qualify as an eligible independent contractor, a hotel management company must satisfy certain requirements, including that the hotel management company may not own, directly or indirectly, more than 35% of our stock and not more than 35% of the hotel management company may be owned, directly or indirectly, by one or more persons owning 35% or more of our stock. For

 

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purposes of determining whether these ownership limits are satisfied, actual ownership as well as constructive ownership under the rules of Section 318 of the Code (with certain modifications) is taken into account. Each of our TRS lessees has hired and we anticipate will continue to hire a hotel management company that we expect to qualify as an eligible independent contractor to manage and operate the hotel properties leased by our TRS lessee, and Marriott intends to qualify as an eligible independent contractor. However, constructive ownership under Section 318 of the Code resulting, for example, from relationships between Marriott or another hotel management company and any of our stockholders could impact Marriott’s or such other hotel management company’s ability to satisfy the applicable ownership limits. Discovery of any such relationship could disqualify Marriott or another hotel management company as an eligible independent contractor, which could in turn cause us to fail to qualify as a REIT. If we fail to qualify for or lose our status as a REIT, we would be subject to federal income tax on our taxable income. See “Federal Income Tax Considerations.” In addition, in such event, the hotel management agreements that we expect to enter into with Marriott may not be terminable, thereby making it impossible to avoid such disqualification. Consistent with hotel management agreements already in place with Marriott, we do not expect that our hotel management agreements with Marriott will provide us with protection from such an occurrence.

 

Plans should consider ERISA risks of investing in our common stock.

 

ERISA and Section 4975 of the Code prohibit certain transactions that involve (i) certain pension, profit-sharing, employee benefit, or retirement plans or individual retirement accounts and (ii) any person who is a “party in interest” or “disqualified person” with respect to such plan. Consequently, the fiduciary of a plan contemplating an investment in our common stock should consider whether our company, any other person associated with the issuance of our common stock or any affiliate of the foregoing is or may become a “party in interest” or “disqualified person” with respect to the plan and, if so, whether an exemption from such prohibited transaction rules is applicable. If a fiduciary of a plan engages in certain transactions with a “party in interest” or “disqualified person” for which no prohibited transaction exemption is available, the parties to the transaction could be subject to excise taxes and other penalties. See “ERISA Considerations.”

 

We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our common stock.

 

At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. Any of those new laws or interpretations may take effect retroactively and could adversely affect us or our stockholders.

 

Provisions of our charter may limit the ability of a third party to acquire control of our company.

 

Our charter provides that no person may beneficially own more than 9.8% of our common stock or of the value of the aggregate outstanding shares of our capital stock, except certain “look-through entities,” such as mutual funds, which may beneficially own up to 15% of our common stock or of the value of the aggregate outstanding shares of our capital stock. Our board of directors has waived this ownership limitation for Marriott Hotel Services, Inc. and certain institutional investors in the past. Our bylaws provide that, notwithstanding any other provision of our charter or the bylaws, our board of directors will exempt any person from the ownership limitation, provided that:

 

    such person shall not beneficially own shares of capital stock that would cause an “individual” (within the meaning of Section 542(a)(2) of the Internal Revenue Code, but not including a “qualified trust” (as defined in Code Section 856(h)(3)(E)) subject to the look-through rule of Code Section 856(h)(3)(A)(i)) to beneficially own (i) shares of capital stock in excess of 9.8% in value of the aggregate of the outstanding shares of our capital stock or (ii) shares of common stock in excess of 9.8% (in value or in number of shares, whichever is more restrictive) of the aggregate of the outstanding shares of our common stock;

 

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    the board of directors obtains such representations and undertakings from such person as are reasonably necessary to ascertain that such person’s ownership of such shares of capital stock will not now or in the future jeopardize our ability to qualify as a REIT under the Code; and

 

    such person agrees that any violation or attempted violation of any of the foregoing restrictions or any such other restrictions that may be imposed by our board of directors will result in the automatic transfer of the shares of stock causing such violation to a trust.

 

Any amendment, alteration or repeal of this provision of our bylaws shall be valid only if approved by the affirmative vote of a majority of votes cast by stockholders entitled to vote generally in the election of directors.

 

These ownership limitations may prevent an acquisition of control of our company by a third party without our board of directors’ approval, even if our stockholders believe the change of control is in their best interests. Our charter authorizes our board of directors to issue up to 100,000,000 shares of common stock and up to 10,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Furthermore, our board of directors may, without any action by the stockholders, amend our charter from time to time to increase or decrease the aggregate number of shares of stock of any class or series that we have authority to issue. Issuances of additional shares of stock may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests.

 

Certain advance notice provisions of our bylaws may limit the ability of a third party to acquire control of our company.

 

Our bylaws provide that (a) with respect to an annual meeting of stockholders, nominations of persons for election to the board of directors and the proposal of business to be considered by stockholders may be made only (i) pursuant to our notice of the meeting, (ii) by the board of directors or (iii) by a stockholder who is entitled to vote at the meeting and has complied with the advance notice procedures set forth in the bylaws and (b) with respect to special meetings of stockholders, only the business specified in our notice of meeting may be brought before the meeting of stockholders and nominations of persons for election to the board of directors may be made only (i) pursuant to our notice of the meeting, (ii) by the board of directors or (iii) provided that the board of directors has determined that directors shall be elected at such meeting, by a stockholder who is entitled to vote at the meeting and has complied with the advance notice provisions set forth in the bylaws. These advance notice provisions may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests.

 

Provisions of Maryland law may limit the ability of a third party to acquire control of our company.

 

Certain provisions of the Maryland General Corporation Law, or the MGCL, may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interests, including:

 

    “business combination” provisions that, subject to certain limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter impose special appraisal rights and special stockholder voting requirements on these combinations; and

 

   

“control share” provisions that provide that “control shares” of our company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition”

 

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(defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.

 

We have opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL, by resolution of our board of directors and by amendment to our bylaws, and in the case of the control share provisions of the MGCL, pursuant to a provision in our bylaws. However, our board of directors may amend, alter or repeal the resolution to opt in to the business combination provisions of the MGCL, provided that, in accordance with our bylaws, such amendment, alteration or repeal of the resolution is approved, at a meeting duly called, by the affirmative vote of a majority of votes cast by stockholders entitled to vote generally for directors and the affirmative vote of a majority of continuing directors. Our directors may also, by amendment to our bylaws, opt in to the control share provisions of the MGCL in the future, provided that, in accordance with our bylaws, such decision to opt in is approved, at a meeting duly called, by the affirmative vote of a majority of votes cast by a majority stockholders entitled to vote generally for directors and the affirmative vote of a majority of continuing directors.

 

Additionally, Title 3, Subtitle 8 of the MGCL permits our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to take certain actions that may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests.

 

Our ownership limitations may restrict or prevent you from engaging in certain transfers of our common stock.

 

In order to maintain our REIT qualification, among other requirements, no more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal income tax laws to include various kinds of entities) during the last half of any taxable year (other than the first year for which a REIT election is made). In addition, the REIT rules generally prohibit a manager of one of our hotel properties from owning, directly or indirectly, more than 35% of our stock and a person who holds 35% or more of our stock from also holding, directly or indirectly, more than 35% of any such hotel management company. To qualify for and preserve REIT status, our charter contains an aggregate share ownership limit and a common share ownership limit. Generally, any shares of our stock owned by affiliated owners will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit.

 

If anyone transfers or owns shares in a way that would violate the aggregate share ownership limit or the common share ownership limit (unless such ownership limits have been waived by our board of directors), or prevent us from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or our continued qualification as a REIT, then we will consider the initial intended transfer or ownership to be null and void from the outset. The intended transferee or owner of those shares will be deemed never to have owned the shares. Anyone who acquires or owns shares in violation of the aggregate share ownership limit, the common share ownership limit (unless such ownership limits have been waived by our board of directors) or the other restrictions on transfer or ownership in our charter bears the risk of a financial loss when the shares are redeemed or sold if the market price of our stock falls between the date of purchase and the date of redemption or sale.

 

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.

 

To qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. In order to meet these tests, we may be required to forego

 

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attractive business or investment opportunities. Thus, compliance with the REIT requirements may hinder our ability to operate solely to maximize profits.

 

The ability of our board of directors to revoke our REIT status without stockholder approval may cause adverse consequences to our stockholders.

 

Our charter provides that our board of directors may revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. If we cease to be a REIT, we would become subject to federal income tax on our taxable income and would no longer be required to distribute most of our taxable income to our stockholders, which may have adverse consequences on our total return to our stockholders.

 

Risks Related to this Offering

 

We cannot assure you that a public market for our common stock will develop.

 

Prior to this offering, there has not been a public market for our common stock and, even though we intend to apply to list the shares of our common stock on the NYSE, we cannot assure you that an active trading market for the shares of common stock offered hereby will develop or, if developed, that any such market will be sustained. In the absence of an active public trading market, an investor may be unable to liquidate an investment in our common stock. The initial public offering price has been determined by us and the underwriters. We cannot assure you that the price at which the shares of common stock will sell in the public market after the closing of this offering will not be lower than the price at which they are sold by the underwriters.

 

The market price of our equity securities may vary substantially.

 

The trading prices of equity securities issued by REITs have historically been affected by changes in market interest rates. One of the factors that may influence the price of our common stock or preferred stock in public trading markets is the annual yield from distributions on our common stock or preferred stock as compared to yields on other financial instruments. An increase in market interest rates, or a decrease in our distributions to stockholders, may lead prospective purchasers of our stock to demand a higher annual yield, which could reduce the market price of our equity securities.

 

Other factors that could affect the market price of our equity securities include the following:

 

    actual or anticipated variations in our quarterly results of operations;

 

    changes in market valuations of companies in the hotel or real estate industries;

 

    changes in expectations of future financial performance or changes in estimates of securities analysts;

 

    fluctuations in stock market prices and volumes;

 

    issuances of common stock or other securities in the future;

 

    the addition or departure of key personnel; and

 

    announcements by us or our competitors of acquisitions, investments or strategic alliances.

 

The number of shares available for future sale could cause our share price to decline.

 

Upon the completion of this offering, we will have 48,237,600 shares of common stock outstanding. We cannot predict whether future issuances of shares of our common stock or the availability of shares for resale in the open market will decrease the market price of our common stock. Sales of substantial numbers of shares of our common stock in the public market, or the perception that such sales might occur, could adversely affect the

 

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market price of our common stock. In addition, under registration rights agreements, we have granted holders of the 20,850,000 shares of our common stock issued in our July 2004 private placement, including 3,000,000 shares purchased by Marriott directly from us, the right to have their shares registered for resale under the Securities Act. If any or all of these holders sell a large number of securities in the public market, the sale could reduce the trading price of our common stock and could impede our ability to raise capital in the future. We also may issue from time to time additional common stock or units of our operating partnership in connection with the acquisition of properties and we may grant additional demand or piggyback registration rights in connection with these issuances. Sales of substantial amounts of common stock or the perception that these sales could occur may adversely effect the prevailing market price for our common stock. In addition, the sale of these shares could impair our ability to raise capital through a sale of additional equity securities.

 

The exercise of the underwriter’s over-allotment option, any future redemption of our operating partnership units for common stock, portfolio or business acquisitions and other issuances of our common stock could have an adverse effect on the market price of our common stock. In addition, future issuances of our common stock may be dilutive to existing stockholders.

 

Lock-up agreements may not limit the number of shares of common stock sold into the market.

 

Our executive officers and directors and Marriott have entered into lock-up agreements that prohibit them from selling, pledging, transferring or otherwise disposing of our common stock or securities convertible into our common stock for a period of 180 days after the date of this prospectus. Subject to specified exceptions, certain of our directors and senior executive officers and Marriott also have entered into lock-up agreements in connection with our July 2004 private placement that prohibit them from selling, pledging, transferring or otherwise disposing of our common stock or securities convertible into our common stock for 180 days after the effective date of the resale shelf registration statement that we are required to file pursuant to the registration rights agreement. In addition, in accordance with the registration rights agreement, subject to specified exceptions, holders of shares of common stock sold in our July 2004 private placement have agreed not to offer, pledge, sell or otherwise dispose of any of shares of our common stock or securities convertible into our common stock that they have acquired prior to the date of this prospectus, and are not selling in this offering, for 60 days following the effective date of the registration statement of which this prospectus is a part. Citigroup Global Markets, Inc. and Friedman, Billings, Ramsey & Co., Inc., on behalf of the underwriters, may, in their discretion, release all or any portion of the common stock subject to the lock-up agreements with our directors and officers at any time without notice or stockholder approval, in which case, our other stockholders would also be released from the restrictions pursuant to the registration rights agreement. If the restrictions under the lock-up agreements and the registration rights agreement are waived or terminated, up to approximately 22,731,848 shares of common stock will be available for sale into the market, subject only to applicable securities rules and regulations, which could reduce the market price for our common stock.

 

Investors in this offering will experience immediate dilution in the book value per share.

 

The initial public offering price of our common stock is substantially higher than what our net tangible book value per share will be immediately after this offering. Purchasers of our common stock in this offering will incur immediate dilution of approximately $1.81 in net tangible book value per share of our common stock, based on the midpoint of the price range for the shares to be sold in this offering.

 

We cannot assure you that we will be able to make distributions to our stockholders in the future.

 

We intend to make annual distributions on a regular quarterly basis in sufficient amounts so as to avoid paying corporate income tax and excise tax on our earnings (other than the earnings of our taxable REIT subsidiary and TRS lessees, which are subject to tax at regular corporate rates). This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Code. However, our ability to pay distributions may be adversely affected by the risk factors described in this prospectus. All distributions are made

 

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at the discretion of our board of directors and will depend upon our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. We cannot assure you that we will be able to pay distributions in the future. In addition, some of our distributions may include a return of capital.

 

An increase in market interest rates may have an adverse effect on the market price of our common stock.

 

One of the factors that investors may consider in deciding whether to buy or sell our common stock is our dividend rate as a percentage of the market price of our common stock, relative to market interest rates. If market interest rates increase, prospective investors may desire a higher dividend or interest rate on our common stock or seek securities paying higher dividends or interest. The market price of our common stock likely will be strongly affected by the earnings and return that we derive from our investments and income with respect to our properties and our related distributions to stockholders, and not from the market value or underlying appraised value of the properties or investments themselves. As a result, interest rate fluctuations and capital market conditions can affect the market price of our common stock. For instance, if interest rates rise without an increase in our dividend rate, the market price of our common stock could decrease because potential investors may require a higher dividend yield on our common stock as market rates on interest-bearing securities, such as bonds, rise. In addition, rising interest rates would result in increased interest expense on our variable rate debt, thereby adversely affecting cash flow and our ability to service our indebtedness and pay dividends.

 

Future offerings of debt securities or preferred stock, which would be senior to our common stock upon liquidation and for the purposes of distributions, may cause the market price of our common stock to decline.

 

In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock. We will be able to issue additional shares of common stock or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which our securities may be listed or traded. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to preemptive rights or other protections against dilution. Preferred stock and debt, if issued, could have a preference on liquidating distributions or a preference on dividend or interest payments that could limit our ability to make a distribution to the holders of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock and diluting their interest.

 

FORWARD LOOKING STATEMENTS

 

We make statements in this prospectus that are forward-looking statements within the meaning of the federal securities laws. In particular, statements pertaining to our capital resources, portfolio performance and results of operations contain forward-looking statements. Likewise, our pro forma financial statements and all of our statements regarding anticipated growth in our funds from operations and anticipated market conditions, demographics and results of operations are forward-looking statements. You can identify forward-looking statements by the use of forward-looking terminology such as “believe,” “expect,” “may,” “will,” “should,” “seek,” “approximately,” “intend,” “plan,” “pro forma,” “estimate” or “anticipate” or the negative of these words and phrases or similar words or phrases which are predictions of or indicate future events or trends and which do not relate solely to historical matters. You can also identify forward-looking statements by discussions of strategy, plans, market statistics, or intentions.

 

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Forward-looking statements involve numerous risks and uncertainties and you should not rely on them as predictions of future events. Forward-looking statements depend on assumptions, data or methods which may be incorrect or imprecise and we may not be able to realize them. We do not guarantee that the transactions and events described will happen as described (or that they will happen at all). The following factors, among others, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements:

 

    the factors discussed in this prospectus, including without limitation those set forth under the sections titled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Our Business,” “Hotel Industry” and “Our Properties”;

 

    difficulties in completing acquisitions;

 

    our failure to obtain necessary outside financing;

 

    adverse economic or real estate developments in our markets;

 

    general economic conditions;

 

    the degree and nature of our competition;

 

    increased interest rates and operating costs;

 

    difficulties in identifying properties to acquire;

 

    availability of and our ability to retain qualified personnel;

 

    our failure to qualify or maintain our status as a REIT;

 

    changes in our business or investment strategy;

 

    availability, terms and deployment of capital;

 

    general volatility of the capital markets and the market price of our common stock;

 

    environmental uncertainties and risks related to natural disasters;

 

    changes in foreign currency exchange rates; and

 

    changes in real estate and zoning laws and increases in real property tax rates.

 

While forward-looking statements reflect our good faith beliefs, they are not guarantees of future performance. You should carefully consider this risk when you make an investment decision concerning our common stock. We disclaim any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, of new information, data or methods, future events or other changes. For a further discussion of these and other factors that could impact our future results, performance or transactions, see the section above entitled “Risk Factors.”

 

MARKET DATA

 

Market data and forecasts used in this prospectus have been obtained from independent industry sources as well as from research reports prepared for other purposes, including market information compiled by Smith Travel Research, Inc. which, among other things, provides research reports and forecasts on the performance of the hotel and travel industry. We have not independently verified the data obtained from these sources. Forecasts and other forward-looking information obtained from these sources are subject to the same qualifications and the additional uncertainties regarding the other forward-looking statements in this prospectus.

 

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USE OF PROCEEDS

 

We will issue 26,087,000 shares of our common stock if the underwriters’ over-allotment option is not exercised and 29,804,397 shares of our common stock if the underwriters’ over-allotment option is exercised in full. In addition, concurrently with the completion of this offering, we are selling directly to Marriott shares of our common stock at the initial public offering price in an amount equal to the lesser of $15.0 million or that number of shares which, when combined with Marriott’s existing holdings, will represent a 9.8% ownership interest in our company upon completion of this offering.

 

After deducting the underwriting discount and commissions and estimated expenses of this offering, we expect net proceeds from this offering, including the shares sold directly to Marriott, of approximately $277.6 million if the underwriters’ over-allotment option is not exercised, or approximately $317.3 million if the underwriters’ over-allotment option is exercised in full. We will not receive any of the proceeds from the sale of shares of common stock by the selling stockholders.

 

We will contribute the net proceeds to our operating partnership. Our operating partnership intends to use the net proceeds received from us as follows:

 

    approximately $207.1 million to fund a portion of the purchase of the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa (we intend to enter into two mortgage loans aggregating $140.0 million, which loans will be secured by first mortgage liens on the Marriott Los Angeles Airport and Renaissance Worthington hotels);

 

    approximately $64.0 million to repay the following indebtedness at the time this indebtedness becomes prepayable without penalty;

 

    approximately $20.0 million of debt that bears interest at LIBOR plus 2.40%, which may be prepaid without penalty in October 2005 and matures in November 2006, incurred in connection with the acquisition of The Lodge at Sonoma Renaissance Resort & Spa;

 

    approximately $44.0 million of senior and subordinated debt that bears interest at LIBOR plus 2.50%, which may be prepaid without penalty in July 2005 and matures in January 2007, incurred in connection with the acquisition of Torrance Marriott; and

 

    approximately $6.5 million to complete the planned renovations of our initial hotels.

 

 

Pending these uses, we intend to invest the net proceeds in interest-bearing, short-term investment grade securities or money-market accounts that are consistent with our intention to qualify as a REIT. Such investments may include, for example, government and government agency certificates, interest-bearing bank deposits and mortgage loan participation.

 

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DIVIDEND POLICY AND DISTRIBUTIONS

 

We have not declared or paid any dividends on our common stock since our inception in May 2004. We intend to generally distribute to our stockholders each year on a regular quarterly basis sufficient amounts of our REIT taxable income so as to avoid paying corporate income tax and excise tax on our earnings (other than the earnings of our taxable REIT subsidiary and TRS lessees, which are all subject to tax at regular corporate rates) and to qualify for the tax benefits afforded to REITs under the Code. In order to qualify as a REIT under the Code, we generally must make distributions to our stockholders each year in an amount equal to at least:

 

    90% of our REIT taxable income determined without regard to the dividends paid deduction, plus;

 

    90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code, minus;

 

    any excess non-cash income.

 

See “Federal Income Tax Considerations.”

 

In our first taxable year ended December 31, 2004, we had approximately $2.3 million of non-REIT earnings and profits. In order to qualify as a REIT, we may not have, at the end of any taxable year, any undistributed earnings and profits accumulated in any non-REIT taxable year. We therefore intend to distribute these earnings and profits, which we currently estimate will be approximately $2.3 million, to eliminate any 2004 non-REIT earnings and profits, regardless of our 2005 REIT taxable income. We expect that this earnings and profits distribution will be declared in the last quarter of 2005 and paid in 2005. Moreover, we intend to distribute (and avoid tax on) our 2005 REIT taxable income.

 

We intend to pay a quarterly distribution of $0.1725 per share to our stockholders commencing with the third quarter of 2005 (which begins on June 18, 2005). On an annualized basis, this distribution would be $0.69 per share, representing an annualized distribution rate of approximately 6.0% based on the midpoint of the initial public offering price range of $11.50 per share.

 

The actual amount, timing and frequency of our distributions will be at the discretion of, and authorized by, our board of directors and will depend on our actual results of operations and a number of other factors, including:

 

    the timing of our investment of the net proceeds of this offering;

 

    the rent received from our TRS lessees;

 

    our debt service requirements;

 

    capital expenditure requirements for our hotel properties;

 

    unforeseen expenditures at our hotel properties;

 

    our taxable income and the taxable income of our TRS lessees;

 

    the annual distribution requirement under the REIT provisions of the Code;

 

    our operating expenses and the operating expenses of our TRS lessees; and

 

    other factors that our board of directors may deem relevant.

 

In addition, our ability to make distributions to our stockholders will depend, in part, upon the amount of distributions we receive from our operating partnership, DiamondRock Hospitality Limited Partnership, which will depend upon the amount of lease payments received from our TRS lessees, and, in turn, upon the management of our hotel properties by third party hotel management companies, who will be engaged to operate our hotels. There are no legal, operational or other restrictions that currently prevent our TRS lessees from making distributions to our operating partnership and our operating partnership from making a distribution to us.

 

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To the extent not inconsistent with maintaining our REIT status, we may retain earnings of our TRS lessees in those subsidiaries, and such amount of cash would not be available to satisfy the 90% distribution requirement. If our cash available for distribution to our stockholders is less than 90% of our REIT taxable income, we could be required to sell assets or borrow funds to make distributions. Dividend distributions to our stockholders will generally be taxable to our stockholders as ordinary income to the extent of our current or accumulated earnings and profits. Because a significant portion of our investments are equity ownership interests in hotel properties, which results in depreciation and non-cash changes against our income, a portion of our distributions may constitute a tax-free return of capital. Finally, we cannot assure you that we will have cash available for distributions to our stockholders.

 

The following table sets forth calculations relating to intended initial distributions based on our pro forma financial data, and we cannot assure you that the intended initial distributions will be made or sustained. The calculations are being made solely for the purpose of illustrating the initial distribution and are not necessarily intended to be a basis for determining future distributions. The calculations include the following material assumptions:

 

    income and cash flows from operations for the twelve months ended December 31, 2004 will be substantially the same for the twelve months ending March 25, 2005, with the exception of additional corporate expenses not permitted to be included as a pro forma adjustment for the twelve months ended December 31, 2004 and increases in contractual ground rent for the twelve months ending December 31, 2005;

 

    cash flows used in investing activities will be the contractually committed and planned amounts for the twelve months ending December 31, 2005; and

 

    cash flows used in financing activities will be the contractually committed amounts for the twelve months ending December 31, 2005.

 

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These calculations do not assume any changes to our operations or any acquisitions or dispositions, which would affect our operating results and cash flows, or changes in our outstanding common stock. We cannot assure you that our actual results will be as indicated in the calculations below. All dollar amounts are in thousands.

 

 

Pro forma for the twelve months ended March 25, 2005:

        

Pro forma net income for the year ended December 31, 2004

   $ 12,177,123  

Add: Pro forma net income for the fiscal quarter ended March 25, 2005

     5,316,201  

Less: Pro forma net income for the fiscal quarter ended March 26, 2004

     4,171,024  
    


Pro forma net income for the twelve months ended March 25, 2005

     13,322,300  

Add: Depreciation and amortization

     30,433,912  

Add: Non-cash straight line ground rent expense

     6,890,239  

Add: Non-cash amortization of restricted stock

     2,440,417  

Add: Amortization of deferred financing costs

     384,519  

Add: Non-cash adjustment to interest rate caps

     25,656  

Less: Amortization of deferred key money

     (158,333 )

Less: Amortization of debt premium

     (163,992 )

Less: Amortization of unfavorable lease provision

     (138,200 )

Less: Non-cash income tax benefit

     (3,929,363 )

Less: Increase in contractual ground rent

     (20,333 )

Less: Additional corporate expenses not permitted to be included as a pro forma adjustment

     (330,000 )
    


Adjusted cash flows from operations for the twelve months ended March 25, 2005

     48,756,822  

Cash flows used in investing activities

     (12,164,733 )

Cash flows used in financing activities—scheduled principal payments on debt payable

     (3,113,034 )
    


Cash available for distribution

   $ 33,479,055  

Intended initial distribution(1)

   $ 33,283,944  
    


Ratio of intended initial distribution to cash available for distribution

     99.4 %
    



(1) Represents the aggregate amount of the intended annual distribution multiplied by the 48,237,600 shares of common stock that will be outstanding upon completion of this offering. Excludes 3,717,398 shares of common stock that may be issued by us upon exercise of the underwriters’ over-allotment option.

 

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CAPITALIZATION

 

The following table sets forth:

 

    our actual capitalization as of March 25, 2005; and

 

    our pro forma capitalization, as adjusted to give effect to (i) the probable acquisitions of the Vail Marriott Mountain Resort & Spa and the Capital Hotel Investment Portfolio and the incurrence of debt to finance these acquisitions; (ii) the repayment of the mortgage debt on the Lodge of Sonoma Renaissance Resort and Spa and the Torrance Marriott; and (iii) the sale of our common stock in this offering, excluding shares of common stock that may be issued by us upon exercise of the underwriters’ over-allotment option at an assumed public offering price of $11.50 per share, and the application of the net proceeds as described in “Use of Proceeds.”

 

     As of March 25, 2005

 
     Actual

     Pro Forma

 

Cash

   $ 43,804,058      $ 20,661,798  
    


  


Total debt(1)

     224,094,249        300,094,249  

Stockholders’ equity

                 

Preferred stock, $.01 par value per share, 10,000,000 shares authorized, no shares issued and outstanding

     —          —    

Common stock, $.01 par value per share, 100,000,000 shares authorized, 21,020,100 shares issued and outstanding; 47,107,100 shares issued and outstanding, as adjusted after this offering(2)

     210,201        471,071  

Additional paid-in capital

     198,043,687        475,333,282  

Accumulated deficit

     (7,379,136 )      (8,206,035 )
    


  


Total stockholders’ equity

     190,874,752        467,598,318  
    


  


Total capitalization

   $ 414,969,001      $ 767,692,567  
    


  



(1) Excludes the senior secured revolving credit facility we intend to enter into following this offering. For a description of our senior secured revolving credit facility, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”
(2) Excludes 3,717,398 shares of common stock that may be issued by us upon exercise of the underwriters’ over-allotment option and 869,500 shares of common stock available for future awards under our equity incentive plan.

 

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DILUTION

 

Net Tangible Book Value

 

At March 25, 2005, we had a combined net tangible book value of approximately $190.9 million, or $8.79 per share ($8.45 per share giving effect to the grants of restricted shares). Net tangible book value per share represents the amount of our total tangible assets less total liabilities, divided by the number of shares of our common stock outstanding.

 

Dilution After This Offering

 

Purchasers of our common stock will experience an immediate dilution of the net tangible book value of our common stock from the initial public offering price. Dilution in net tangible book value per share represents the difference between the amount per share paid by purchasers of common stock in this offering and the net tangible book value per share of common stock immediately after this offering and the application of the estimated net offering proceeds. After giving effect to the sale of the shares of our common stock offered by us under this prospectus at an assumed initial public offering price of $11.50 per share and the deduction of underwriting discounts and estimated offering expenses, our pro forma net tangible book value at March 25, 2005 would have been $467.6 million, or approximately $9.69 per share of our common stock. This amount represents an immediate increase in net tangible book value of $0.61 per share to our existing stockholders and an immediate dilution in pro forma net tangible book value of $1.81 per share from an assumed public offering price of $11.50 per share of our common stock to new investors. The following table illustrates this per share dilution:

 

Assumed initial public offering price per share

   $ 11.50

Pro forma net tangible book value per share at March 25, 2005(1)

     8.79

Increase in pro forma net tangible book value per share attributable to this offering(2)

     0.90
    

Pro forma net tangible book value per share after this offering(3)

   $ 9.69
    

Dilution in pro forma net tangible book value per share to new investors(4)

   $ 1.81
    


(1) Net tangible book value per share of common stock is determined by dividing net tangible book value at March 25, 2005 by the number of shares of common stock outstanding prior to this offering.
(2) After deducting underwriting discounts, commissions and other expenses of this offering.
(3) Based on the pro forma net tangible book value attributable to common stockholders of approximately $467.6 million divided by the sum of shares of our common stock to be outstanding after giving effect to this offering.
(4) Dilution is determined by subtracting (i) pro forma net tangible book value per share of our common stock after giving effect to this offering and the application of the net proceeds from (ii) the initial public offering price per share paid by a new investor in this offering.

 

Differences Between New and Existing Stockholders in Number of Shares of Common Stock and Amount Paid

 

The table below summarizes, as of March 25, 2005, on the pro forma basis discussed above, the differences between the number of shares of common stock purchased from us, the total consideration and average price per share paid by existing stockholders and by the new investors purchasing common stock in this offering. We used an assumed initial public offering price of $11.50 per share, and we have not deducted estimated underwriting discounts and commissions and estimated offering expenses in our calculations.

 

     Shares Issued

   

Cash/Tangible

Book Value


     Number

   Percentage

    Amount

   Percentage

    Per Share

Existing stockholders

   21,720,600    45.0 %   190,874,752    40.8 %   $ 8.79

New investors in this offering

   26,517,000    55.0 %   276,723,566    59.2 %   $ 10.44
    
  

 
  

     

Total

   48,237,600    100.0 %   467,598,318    100.0 %      
    
  

 
  

     

 

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SELECTED FINANCIAL AND OPERATING DATA

 

We present in this prospectus certain historical and pro forma financial data. We also present certain operational data and non-GAAP financial measures on a historical and pro forma basis.

 

The selected historical financial information as of December 31, 2004, and the period from May 6, 2004 (inception) to December 31, 2004, has been derived from our historical financial statements audited by KPMG LLP, independent registered public accounting firm, whose report with respect to such financial information is included elsewhere in this prospectus. The selected historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the consolidated financial statements as of December 31, 2004 and for the period from May 6, 2004 (inception) to December 31, 2004, and the related notes. The unaudited summary historical financial information as of March 25, 2005, and the fiscal quarter ended March 25, 2005, has been derived from our historical financial statements. The unaudited summary historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the unaudited consolidated financial statements as of March 25, 2005 and for the fiscal quarter ended March 25, 2005, and the related notes.

 

The unaudited pro forma consolidated balance sheet data as of March 25, 2005 is presented as if:

 

    the completion of this offering and application of the net proceeds,

 

    the probable acquisitions of the Vail Marriott Mountain Resort & Spa and the Capital Hotel Investment Portfolio, and

 

    the repayment of mortgage debt related to the Torrance Marriott and The Lodge at Sonoma Renaissance Resort & Spa

 

had occurred on March 25, 2005.

 

The unaudited pro forma consolidated statement of operations and other data for the fiscal quarter ended March 25, 2005, the fiscal year ended December 31, 2004 and the fiscal quarter ended March 26, 2004 are presented as if:

 

    the completion of this offering and application of the net proceeds,

 

    the acquisition of our initial seven hotels,

 

    the probable acquisitions of the Vail Marriott Mountain Resort & Spa and the Capital Hotel Investment Portfolio,

 

    our July 2004 private placement,

 

    our REIT election, and

 

    the repayment of mortgage debt related to the Torrance Marriott and The Lodge at Sonoma Renaissance Resort & Spa

 

had occurred on the first day of the periods presented.

 

These adjustments are also discussed in detail under “Unaudited Pro Forma Financial Data.” The pro forma information is not necessarily indicative of what our actual financial position or results of operations would have been as of the dates or for the periods indicated, nor does it purport to represent our future financial position or results of operations.

 

We present the following two non-GAAP financial measures throughout this prospectus that we believe are useful to investors as key measures of our operating performance: (1) EBITDA; and (2) FFO.

 

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EBITDA represents net income (loss) excluding: (1) interest expense; (2) provision for income taxes, including income taxes applicable to sale of assets; and (3) depreciation and amortization. We believe EBITDA is useful to an investor in evaluating our operating performance because it helps investors evaluate and compare the results of our operations from period to period by removing the impact of our capital structure (primarily interest expense) and our asset base (primarily depreciation and amortization) from our operating results. We also use EBITDA as one measure in determining the value of hotel acquisitions and dispositions.

 

We compute FFO in accordance with standards established by NAREIT, which defines FFO as net income (loss) (determined in accordance with GAAP), excluding gains (losses) from sales of property, plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures (which are calculated to reflect FFO on the same basis). We believe that the presentation of FFO provides useful information to investors regarding our operating performance because it is a measure of our operations without regard to specified non-cash items, such as real estate depreciation and amortization and gain or loss on sale of assets. We also use FFO as one measure in determining our results after taking into account the impact of our capital structure.

 

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We caution investors that amounts presented in accordance with our definitions of EBITDA and FFO may not be comparable to similar measures disclosed by other companies, since not all companies calculate these non-GAAP measures in the same manner. EBITDA and FFO should not be considered as an alternative measure of our net income (loss), operating performance, cash flow or liquidity. EBITDA and FFO may include funds that may not be available for our discretionary use due to functional requirements to conserve funds for capital expenditures and property acquisitions and other commitments and uncertainties. Although we believe that EBITDA and FFO can enhance your understanding of our results of operations, these non-GAAP financial measures, when viewed individually, are not necessarily better indicators of any trend as compared to GAAP measures such as net income (loss) or cash flow from operations. In addition, you should be aware that adverse economic and market conditions may harm our cash flow. Under “Summary Historical and Pro Forma Financial and Operating Data” and this section, as required, we include a quantitative reconciliation of EBITDA and FFO to the most directly comparable GAAP financial performance measure, which is net income (loss).

 

    Historical

    Pro Forma (unaudited)

 
    Fiscal
Quarter Ended
March 25, 2005


   

Period from
May 6,
2004 to

December 31, 2004


    Fiscal
Quarter Ended
March 25, 2005


    Fiscal
Quarter Ended
March 26, 2004


 

Fiscal

Year Ended
December 31, 2004


 
    (unaudited)                        

Statement of operations data:

                                     

Revenues:

                                     

Rooms

  $ 18,668,351     $ 5,137,370     $ 50,338,052     $ 45,915,460   $ 181,032,365  

Food and beverage

    6,414,097       1,507,960       20,519,668       18,850,038     82,436,425  

Other

    1,266,333       428,534       4,034,705       4,024,306     16,727,330  
   


 


 


 

 


Total revenues

    26,348,781       7,073,864       74,892,425       68,789,804     280,196,120  
   


 


 


 

 


Operating costs and expenses:

                                     

Rooms

    4,987,281       1,455,380       11,796,923       11,275,524     45,355,215  

Food and beverage

    5,081,237       1,266,827       15,080,888       14,347,912     61,364,514  

Other

    12,512,850       3,444,683       27,117,632       26,445,301     114,434,288  

Corporate expenses

    2,009,430       4,114,165       2,096,130       2,096,130     8,384,457  

Depreciation and amortization

    4,362,146       1,053,283       7,319,284       7,018,433     30,113,061  
   


 


 


 

 


Total operating expenses

    28,952,944       11,334,338       63,410,857       61,183,300     259,651,535  
   


 


 


 

 


Operating (loss)/income

    (2,604,163 )     (4,260,474 )     11,481,568       7,606,504     20,544,585  

Interest and other income

    (276,778 )     (1,333,837 )     (276,778 )     —       (1,333,837 )

Interest expense

    2,854,269       773,101       3,772,552       3,888,712     16,753,487  
   


 


 


 

 


(Loss)/income before income taxes

    (5,181,654 )     (3,699,738 )     7,985,794       3,717,792     5,124,935  

Income tax (provision)/benefit

    (79,857 )     1,582,113       (2,669,593 )     453,232     7,052,188  
   


 


 


 

 


Net (loss)/income

  $ (5,261,511 )   $ (2,117,625 )   $ 5,316,201     $ 4,171,024   $ 12,177,123  
   


 


 


 

 


FFO(1)

  $ (899,365 )   $ (1,064,342 )   $ 12,635,485     $ 11,189,457   $ 42,290,184  
   


 


 


 

 


EBITDA(2)(3)

  $ 2,034,761     $ (1,873,354 )   $ 19,077,630     $ 14,624,937   $ 51,991,483  
   


 


 


 

 


 

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     Historical

   Pro Forma

         
     As of March 25,
2005


  

As of

December 31,

2004


   As of March 25,
2005


         
     (unaudited)         (unaudited)          

Balance sheet data:

                              

Property and equipment, net

   $ 346,166,810    $ 285,642,439    $ 715,267,810          

Cash and cash equivalents

     43,804,058      76,983,107      20,661,798          

Total assets

     431,795,162      391,691,179      784,518,728          

Total debt

     224,094,249      180,771,810      300,094,249          

Total other liabilities

     16,826,161      15,331,951      16,826,161          

Shareholders’ equity

     190,874,752      195,587,418      467,598,318          
     Historical

    Pro Forma

 
     Fiscal
Quarter Ended
March 25, 2005


   

Period from
May 6, 2004 to

December 31, 2004


    Fiscal
Quarter Ended
March 25, 2005


    Fiscal
Quarter Ended
March 26, 2004


   

Fiscal

Year Ended
December 31, 2004


 

Statistical data:

                                        

Number of hotels

     7       6       12       12       12  

Number of rooms

     2,357       1,870       5,032       5,032       5,032  

Occupancy

     69.7 %     67.8 %     74.9 %     73.2 %     73.3 %

ADR

   $ 137.21     $ 184.22     $ 158.50     $ 145.94     $ 133.78  

RevPAR

   $ 95.58     $ 124.99     $ 118.66     $ 106.81     $ 98.00  

  (1) FFO, as defined by NAREIT, is net income (loss) (determined in accordance with GAAP, excluding gains (losses) from sales of property, plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures (which are calculated to reflect FFO on the same basis). The calculation of FFO may vary from entity to entity, thus our presentation of FFO may not be comparable to other similarly titled measures of other reporting companies. FFO is not intended to represent cash flows for the period. FFO has not been presented as an alternative to operating income, but as an indicator of operating performance, and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP.

 

     FFO is a supplemental industry-wide measure of REIT operating performance, the definition of which was first proposed by NAREIT in 1991 (and clarified in 1995, 1999 and 2002). Since the introduction of the definition by NAREIT, the term has come to be widely used by REITs. Historical GAAP cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical GAAP cost accounting to be insufficient by themselves. Accordingly, we believe FFO (combined with our primary GAAP presentations) help improve our stockholders’ ability to understand our operating performance. We only use FFO as a supplemental measure of operating performance. The following is a reconciliation between net income (loss) and FFO:

 

     Historical

     Pro Forma

    

Fiscal Quarter
Ended

March 25, 2005


    

Period from

May 6, 2004

to December 31,
2004


    

Fiscal Quarter
Ended

March 25, 2005


   Fiscal Quarter
Ended
March 26, 2004


  

Fiscal

Year Ended
December 31,

2004


Net (loss)/income

   $ (5,261,511 )    $ (2,117,625 )    $ 5,316,201    $ 4,171,024    $ 12,177,123

Depreciation and amortization

     4,362,146        1,053,283        7,319,284      7,018,433      30,113,061
    


  


  

  

  

FFO

   $ (899,365 )    $ (1,064,342 )    $ 12,635,485    $ 11,189,457    $ 42,290,184
    


  


  

  

  

 

  (2)

EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization. We believe it is a useful financial performance measure for us and for our stockholders and is a complement to net income and other financial performance measures provided in accordance with GAAP. We use EBITDA to measure the financial performance of our operating hotels because it excludes expenses such as depreciation and amortization, taxes and interest expense, which are not indicative of operating performance. By excluding interest expense, EBITDA measures our financial performance irrespective of our capital structure or how we finance our properties and operations. By excluding depreciation and amortization expense, which can vary from hotel to hotel based on a variety of factors unrelated to the hotels’ financial performance, we can more accurately assess the financial performance of our hotels. Under GAAP, hotel properties are recorded at historical cost at the time of acquisition and are depreciated on a straight line basis. By excluding depreciation and amortization, we believe EBITDA provides a basis for measuring the financial performance of hotels unrelated to historical cost. However, because EBITDA excludes depreciation and

 

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amortization, it does not measure the capital we require to maintain or preserve our fixed assets. In addition, because EBITDA does not reflect interest expense, it does not take into account the total amount of interest we pay on outstanding debt nor does it show trends in interest costs due to changes in our borrowings or changes in interest rates. EBITDA, as calculated by us, may not be comparable to EBITDA reported by other companies that do not define EBITDA exactly as we define the term. Because we use EBITDA to evaluate our financial performance, we reconcile it to net income (loss) which is the most comparable financial measure calculated and presented in accordance with GAAP. EBITDA does not represent cash generated from operating activities determined in accordance with GAAP, and should not be considered as an alternative to operating income or net income determined in accordance with GAAP as an indicator of performance or as an alternative to cash flows from operating activities as an indicator of liquidity. The following is a reconciliation between net income (loss) and EBITDA:

 

    Historical

    Pro Forma

 
    Fiscal
Quarter Ended
March 25,
2005


   

Period from

May 6, 2004 to

December 31,
2004


   

Fiscal

Quarter Ended

March 25,
2005


  Fiscal
Quarter Ended
March 26,
2004


   

Fiscal

Year Ended
December 31,

2004


 

Net (loss)/income

  $ (5,261,511 )   $ (2,117,625 )   $ 5,316,201   $ 4,171,024     $ 12,177,123  

Interest expense

    2,854,269       773,101       3,772,552     3,888,712       16,753,487  

Income tax expense/(benefit)

    79,857       (1,582,113 )     2,669,593     (453,232 )     (7,052,188 )

Depreciation and amortization

    4,362,146       1,053,283       7,319,284     7,018,433       30,113,061  
   


 


 

 


 


EBITDA

  $ 2,034,761     $ (1,873,354 )   $ 19,077,630   $ 14,624,937     $ 51,991,483  
   


 


 

 


 


 

  (3) The fiscal year ended December 31, 2004 and the fiscal quarter ended March 25, 2005 pro forma EBITDA includes the impact of approximately $6.9 million and $1.6 million, respectively, of non-cash straight-line ground rent expense recorded for the Bethesda Marriott Suites, the Marriott Griffin Gate Resort golf course and Courtyard Manhattan/Fifth Avenue ground leases.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

We were recently formed and did not commence revenue generating operations until July 2004. Please see “Risk Factors—Risks Related to Our Business, Growth Strategy and Investment Sourcing Relationship With Marriott” for a discussion of risks relating to our limited operating history. The following discussion should be read in conjunction with our audited financial statements and the related notes thereto included elsewhere in this prospectus.

 

Overview

 

We are a real estate hospitality company that owns, acquires and invests in upper upscale and upscale hotel properties located primarily in North America. To a lesser extent, we may invest, on a selective basis, in limited service and extended stay hotel properties in urban locations. We began operations in July 2004 when we completed a private placement of our common stock to certain institutional and accredited investors in which net proceeds of approximately $196.3 million were raised.

 

Our principal business objective is to maximize stockholder value through a combination of dividends, growth in funds from operations and increases in net asset value. We believe that we can create long-term value in the hotel properties we acquire by taking advantage of individual market recovery opportunities, aggressive asset management and repositioning. We currently plan to invest approximately $33.5 million in 2005 and 2006 to renovate our initial hotels, including one hotel that has been re-branded.

 

Since our July 2004 private placement, we have acquired the following seven hotel properties, comprising 2,357 rooms: Courtyard Manhattan/Midtown East in New York, New York; Torrance Marriott in Los Angeles, California; Salt Lake City Marriott Downtown in Salt Lake City, Utah; Marriott Griffin Gate Resort in Lexington, Kentucky; Bethesda Marriott Suites in Bethesda, Maryland; Courtyard Manhattan/Fifth Avenue in New York, New York; and The Lodge at Sonoma Renaissance Resort & Spa, in Northern California.

 

We conduct substantially all of our operations through DiamondRock Hospitality Limited Partnership, our operating partnership. We are the sole general partner of our operating partnership and as a result we control the operating partnership. At present, we own 100% of the partnership units either directly or through our wholly-owned subsidiary, DiamondRock Hospitality, LLC, although, in the future, we may issue limited partnership units to third parties in exchange for capital or in exchange for interests in hotel properties from time to time. We also may issue limited partnership units to management as a substitute for restricted stock grants or other equity-based compensation. Sellers of hotel properties that receive limited partnership units of our operating partnership in exchange for their ownership interest in those properties may be able to defer recognition of any taxable gain that would be recognized in a cash sale until such time as their limited partnership units are redeemed or we sell the contributed properties. Upon a limited partner’s election to have us redeem its units, we may redeem them, at our election, either for cash or shares of our common stock on a one-for-one basis, subject to any lock-up or other restrictions that may exist. Whenever we issue stock, we will be obligated to contribute any net proceeds we receive from such issuance to our operating partnership and our operating partnership will, in turn, be obligated to issue an equivalent number of limited partnership units to us. Our operating partnership will distribute the income it generates from its operations to us to the extent not payable to other limited partners. In turn, we expect to distribute a substantial majority of the amounts we receive from our operating partnership to our stockholders in the form of quarterly cash distributions.

 

We intend to elect to be treated as a self-advised REIT, effective January 1, 2005. For us to qualify as a REIT, we cannot operate our hotel properties. Therefore, our operating partnership and its subsidiaries lease our hotel properties to our TRS lessees, who in turn must engage one or more eligible independent contractors to manage our hotel properties. The leases generally provide for a fixed annual base rent plus percentage rent and certain other additional charges. We have entered into hotel management agreements with Marriott for all of our

 

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current seven hotel properties. Our TRS lessees are consolidated into our financial statements for accounting purposes. However, because both our operating partnership and our TRS lessees are controlled by us, our principal source of funds on a consolidated basis come from the operations of our hotels properties. The earnings of our TRS lessees are subject to federal and state income tax similar to the tax assessed on other C corporations; such tax reduces our funds from operations and the cash available for distribution to our stockholders.

 

The discussion below relates to the results of operations of the hotel properties that we currently own. The historical financial statements presented herein were prepared in accordance with GAAP. Following the completion of this offering, we expect to use the proceeds of this offering as described in “Use of Proceeds.” Therefore, the discussion below should not be read as being indicative of any future operating results of our company.

 

Industry Trends and Outlook

 

We believe the hotel industry, as a whole, is continuing to recover from a pronounced downturn that occurred over the three-year period from 2001-2003. This recovery has been, and we expect it to continue to be, primarily driven by increased demand for hotel rooms as compared to increases in hotel room supply. According to Smith Travel Research, Inc., demand for hotel rooms, measured by total rooms sold, increased by 0.3% in 2002, 1.5% in 2003 and 4.7% in 2004 and is projected to increase by 4.0% in 2005. By comparison, hotel room supply grew by 1.6% in 2002, 1.2% in 2003 and 1.0% in 2004 and is projected to increase by 1.2% in 2005 as compared to its past 15-year historical annual average of 2.1%. As a result, we expect that sustained growth in demand and lower growth in supply will result in continued improvement of hotel industry fundamentals. Specifically, according to Smith Travel Research, Inc.:

 

    occupancy increased 3.7% in 2004 and is projected to increase by 2.8% in 2005;

 

    average daily rate, or ADR, increased by 4% in 2004 and is projected to increase by 4.2% in 2005; and

 

    RevPAR increased by 7.8% in 2004 and is projected to increase by 7.1% in 2005.

 

While we believe the trends in room demand and growth supply will result in continued improvement in hotel industry fundamentals, we cannot assure you that these trends will continue. The trends discussed above may not continue for any number of reasons, including an economic slowdown and world events outside of our control, such as terrorism. In the past, these events have adversely affected the hotel industry and if these events reoccur, they may adversely affect the industry in the future.

 

Key Indicators of Financial Condition and Operating Performance

 

We use a variety of operating and other information to evaluate the financial condition and operating performance of our business. These key indicators include financial information that is prepared in accordance with GAAP, as well as other financial information that is not prepared in accordance with GAAP. In addition, we use other information that may not be financial in nature, including statistical information and comparative data. We use this information to measure the performance of individual hotel properties, groups of hotel properties and/or our business as a whole. We periodically compare historical information to our internal budgets as well as industry-wide information. These key indicators include:

 

    occupancy percentage;

 

    ADR;

 

    RevPAR;

 

    EBITDA; and

 

    FFO.

 

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Occupancy, ADR and RevPAR are commonly used measures within the hotel industry to evaluate operating performance. ADR and RevPAR include only room revenue. Room revenue comprised approximately 73% of our total revenues for the fiscal year ended December 31, 2004, and is dictated by demand, as measured by occupancy percentage, pricing, as measured by ADR, and our available supply of hotel rooms. RevPAR, which is calculated as the product of ADR and occupancy percentage, is another important statistic for monitoring operating performance at the individual hotel level and across our business as a whole. We evaluate individual hotel RevPAR performance on an absolute basis with comparisons to budget and prior periods, as well as on a company-wide and regional basis.

 

Our ADR, occupancy percentage and RevPAR performance may be impacted by macroeconomic factors such as regional and local employment growth, personal income and corporate earnings, office vacancy rates and business relocation decisions, airport and other business and leisure travel, new hotel construction and the pricing strategies of competitors. In addition, our ADR, occupancy percentage and RevPAR performance is dependent on the continued success of Marriott and its brands.

 

We also use EBITDA and FFO as measures of the financial performance of our business. EBITDA and FFO are supplemental financial measures, and are not defined by GAAP. EBITDA and FFO, as calculated by us, may not be comparable to EBITDA and FFO reported by other companies that do not define EBITDA and FFO exactly as we define those terms. EBITDA and FFO do not represent cash generated from operating activities determined in accordance with GAAP, and should not be considered as alternatives to operating income or net income determined in accordance with GAAP, as indicators of performance or as alternatives to cash flows from operating activities as indicators of liquidity. See “Selected Financial and Operating Data” for further discussion of our use of EBITDA and FFO and reconciliations to net income.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements include the accounts of DiamondRock Hospitality Company and all consolidated subsidiaries. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. While we do not believe the reported amounts would be materially different, application of these policies involves the exercise of judgment and the use of assumptions as to future uncertainties and, as a result, actual results could differ materially from these estimates. We evaluate our estimates and judgments, including those related to the impairment of long-lived assets, on an ongoing basis. We base our estimates on experience and on various other assumptions that are believed to be reasonable under the circumstances. All of our significant accounting policies are disclosed in the notes to our consolidated financial statements. The following represent certain critical accounting policies that require us to exercise our business judgment or make significant estimates:

 

Investment in Hotel Properties.    Investments in hotel properties are stated at acquisition cost and allocated to land, property and equipment and identifiable intangible assets at fair value in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Property and equipment are recorded at fair value based on analyses, including current replacement cost for similar capacity and allocated to buildings, improvements, furniture, fixtures and equipment based on analysis performed by management and appraisals received from independent third parties. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15 to 40 years for buildings and land improvements and one to ten years for furniture and equipment. Identifiable intangible assets are typically related to contracts, including ground lease agreements and hotel management agreements, which are recorded at fair value. Above-market and below-market contract values are based on the present value of the difference between contractual amounts to be paid pursuant to the contracts acquired and our estimate of the fair market contract rates for corresponding contracts. Contracts acquired that are at market do not have significant value. We typically enter into a new hotel management agreement based on market terms at the time of acquisition. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates

 

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of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired.

 

We review our investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the investments in hotel properties may not be recoverable. Events or circumstances that may cause us to perform a review include, but are not limited to, adverse changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of an investment in a hotel property exceed the hotel’s carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying value to the estimated fair market value is recorded and an impairment loss recognized.

 

Revenue Recognition.    Hotel revenues, including room, golf, food and beverage, and other hotel revenues, are recognized as the related services are provided.

 

Stock-based Compensation.    We account for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation, as amended. For restricted stock awards, we record unearned compensation equal to the number of shares awarded multiplied by the average price of our common stock on the date of the award. Unearned compensation is amortized using the straight-line method over the period in which the restrictions lapse (i.e., vesting period). For unrestricted stock awards, we record compensation expense on the date of the award equal to the number of shares awarded multiplied by the average price of our common stock on the date of the award, less the purchase price for the stock, if any.

 

Accounting for Key Money.    Marriott has contributed to us certain amounts, which we refer to as key money, in exchange for the right to manage certain of our hotel properties. We defer key money received from a hotel manager in conjunction with entering into a long-term hotel management agreement and amortize the amount received against management fees over the term of the management agreement.

 

Other Recent Accounting Pronouncement

 

On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, or “SFAS 123(R).” SFAS 123(R) replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. The FASB has concluded that companies could adopt the new standard in one of two ways: either the modified prospective transition method or the modified retrospective transition method. Using the modified prospective transition method, a company would recognize share-based employee compensation cost from the beginning of the fiscal period in which the recognition provisions are first applied as if the fair-value-based accounting method had been used to account for all employee awards granted, modified, or settled after the effective date and to any awards that were not fully vested as of the effective date. Using the modified retrospective method, a company would recognize employee compensation cost for periods presented prior to the adoption of the proposed standard in accordance with the original provisions of SFAS No. 123; that is, an entity would recognize employee compensation cost in the amounts reported in the pro forma disclosures provided in accordance with SFAS No. 123. For periods after the date of adoption of the standard, the modified prospective transition method described above would be applied. SFAS 123(R) becomes effective for public companies with their first fiscal year that begins after June 15, 2005. For non-public companies, the standard becomes effective for their first fiscal year beginning after December 15, 2005. We currently utilize the fair value approach for accounting for stock compensation, and therefore expect that the impact on our financial condition and results of operations of adopting SFAS 123(R) is expected to be minimal.

 

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Results of Operations

 

May 6, 2004 (inception) through December 31, 2004

 

We were formed on May 6, 2004, began operations in July 2004 and acquired our first hotel property in October 2004. We completed our private placement of common stock in July 2004 and received proceeds, net of offering costs and fees, of approximately $196.3 million. Stockholders’ equity at December 31, 2004 was approximately $195.6 million. Our GAAP loss before income taxes, for the period from inception through December 31, 2004 was $3.7 million.

 

Revenue.    We had total revenues of $7.1 million for the period from May 6, 2004 to December 31, 2004. Revenue consists primarily of the room, food and beverage and other revenues from The Lodge at Sonoma and the Courtyard Midtown East for the periods subsequent to our acquisition dates of October 27, 2004 and November 19, 2004, respectively. Revenues are also included for the post acquisition period for our other four acquisitions, completed during the last two weeks of 2004. The average occupancy of our hotels was 67.8% for the periods subsequent to acquisition. The hotels collectively achieved an ADR of $184.22 and RevPAR of $124.99, respectively, for the periods subsequent to acquisition. Our full year 2004 pro forma revenues, assuming we acquired the initial seven hotels, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2004, were $280.2 million and pro forma RevPAR was $98.00.

 

Hotel operating expenses.    Our hotel operating expenses totaled $6.2 million for the period from May 6, 2004 to December 31, 2004. Hotel operating expenses consist primarily of operating expenses of The Lodge at Sonoma and the Courtyard Midtown East for the periods subsequent to our acquisition dates of October 27, 2004 and November 19, 2004, respectively. Operating expenses are also included for the post acquisition period of our other four 2004 acquisitions, which were completed during the last two weeks of 2004. Our 2004 pro forma hotel operating expenses, assuming we acquired the initial seven hotels, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2004, are $221.2 million. Our 2004 pro forma hotel operating expenses include annual straight-line ground rent relating to three of our initial hotels of $8.2 million, which consists of $6.9 million of non-cash ground rent expense and $1.3 million of cash expense in annual contractual ground rent.

 

Depreciation and amortization expense.    Our depreciation and amortization expense totaled $1.1 million for the period from May 6, 2004 to December 31, 2004. Depreciation and amortization is recorded on our hotels for the periods subsequent to acquisition. Depreciable lives of hotel furniture, fixtures and equipment are estimated as the time period between the acquisition date and the date that the hotel furniture, fixtures and equipment will be replaced. The furniture, fixtures and equipment depreciable lives are less than one year for the Courtyard Midtown East, the Courtyard Fifth Avenue and the Bethesda Marriott Suites since these hotels will undergo significant renovations in 2006. Our 2004 pro forma depreciation expense, assuming we acquired the initial seven hotels, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2004, is $30.1 million, which reflects the use of actual depreciation lives assigned to the assets in purchase accounting.

 

Corporate expenses.    Our corporate expenses totaled $4.1 million for the period from May 6, 2004 to December 31, 2004. Corporate expenses principally consist of employee related costs, including base payroll, bonus and restricted stock. Corporate expenses also include organizational costs, professional fees and directors’ fees. Our 2004 pro forma corporate expenses are $8.4 million. The pro forma 2004 corporate expenses include our budgeted corporate expenses with the exception of the impact of share grants that will be awarded to the executive officers at the completion of this offering due to the one time impact of these awards and certain budgeted corporate expenses that do not meet the pro forma criteria under Article 11 of Regulation S-X under the Securities Act of 1933, as amended. The pro forma corporate expenses consist of $3.7 million of employee payroll, bonus and other compensation, $2.4 million of restricted stock expense, $753,000 of professional fees, $378,000 of directors’ fees, $367,000 of office and equipment rent, $313,000 of insurance costs, $251,000 of shareholder fees and $190,000 of other corporate expenses.

 

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Interest expense.    Our interest expense totaled $773,101 for the period from May 6, 2004 to December 31, 2004. Interest expense relates to the mortgage debt incurred in connection with our acquisitions. Our mortgage debt on two of our hotels bears interest at variable rates based on LIBOR. The interest rates as of December 31, 2004 on these two mortgage loans were 4.74% and 5.04%, respectively. The mortgage debt on our other four hotels bears interest at fixed rates ranging from 5.11% to 7.69% per year. Our 2004 pro forma interest expense, assuming we acquired the initial seven hotels, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2004, is $16.8 million.

 

Income taxes.     We recorded an income tax benefit of $1.6 million for the period from May 6, 2004 to December 31, 2004. The 2004 current tax liability of $879,717 is the result of temporary differences primarily resulting from deferred key money, capitalized pre-opening costs, restricted stock expense, straight-line ground rent, depreciation and other items that will result in 2004 taxable income. A significant portion of the deferred tax assets recorded in 2004 was expensed in the first quarter of 2005 in connection with our REIT election.

 

Fiscal Quarter Ended March 25, 2005

 

We own seven hotel properties as of March 25, 2005. Our total assets were $431.8 million as of March 25, 2005. Total liabilities were $240.9 million as of March 25, 2005, including $224.1 million of debt. Stockholders’ equity was approximately $190.9 million as of March 25, 2005. Our net loss for the fiscal quarter ended March 25, 2005 was $5.3 million.

 

Revenue.    We had total revenues of $26.3 million for the fiscal quarter ended March 25, 2005. Revenue consists primarily of the room, food and beverage and other revenues from the initial seven hotels. The average occupancy of our hotels was 69.7% for the fiscal quarter ended March 25, 2005. The hotels collectively achieved an ADR of $137.21 and RevPAR of $95.58 during the fiscal quarter ended March 25, 2005. The RevPAR of the initial seven hotels increased 11.8% from the comparable period in 2004. The fiscal quarter ended March 25, 2005 pro forma revenues, assuming we acquired the Torrance Marriott, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2005, were $74.9 million and pro forma RevPAR was $118.66.

 

Hotel operating expenses.    Our hotel operating expenses totaled $22.6 million for the fiscal quarter ended March 25, 2005. Hotel operating expenses consist primarily of operating expenses of the initial seven hotels, including approximately $1.6 million of non-cash straight line ground rent expense. Our pro forma hotel operating expenses for the fiscal quarter ended March 25, 2005, assuming we acquired the Torrance Marriott, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2005, were $54 million. Our pro forma hotel operating expenses for the fiscal quarter ended March 25, 2005 include straight-line ground rent relating to three of our initial hotels of $1.9 million, which consists of $1.6 million of non-cash ground rent expense and $291,200 of cash expense in contractual ground rent.

 

Depreciation and amortization expense.    Our depreciation and amortization expense totaled $4.4 million for the fiscal quarter ended March 25, 2005. Depreciation and amortization is recorded on our hotels for the periods subsequent to acquisition. Depreciable lives of hotel furniture, fixtures and equipment are estimated as the time period between the acquisition date and the date that the hotel furniture, fixtures and equipment will be replaced. The furniture, fixtures and equipment depreciable lives are less than one year for the Courtyard Midtown East, the Courtyard Fifth Avenue and the Bethesda Marriott Suites since these hotels will undergo significant renovations. Our pro forma depreciation expense for the fiscal quarter ended March 25, 2005, assuming we acquired the Torrance Marriott, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2005, was $7.3 million, which reflects the use of actual depreciation lives assigned to the assets in purchase accounting.

 

Corporate expenses.    Our corporate expenses totaled $2.0 million for the fiscal quarter ended March 25, 2005. Corporate expenses principally consist of employee related costs, including base payroll, bonus and restricted stock. Corporate expenses also include organizational costs, professional fees and directors’ fees. Our pro forma corporate expenses for the fiscal quarter ended March 25, 2005 are $2.1 million. The pro forma

 

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corporate expenses include our budgeted corporate expenses with the exception of the impact of share grants that will be awarded to the executive officers at the completion of the offering due to the one time impact of these awards and certain budgeted corporate expenses that do not meet the pro forma criteria under Article 11 of Regulation S-X under the Securities Act of 1933, as amended. The pro forma corporate expenses consist of $923,000 of employee payroll, bonus and other compensation, $610,000 of restricted stock expense, $188,000 of professional fees, $95,000 of directors’ fees, $92,000 of office and equipment rent, $78,000 of insurance costs, $63,000 of shareholder fees and $48,000 of other corporate expenses.

 

Interest expense.    Our interest expense totaled $2.9 million for the fiscal quarter ended March 25, 2005. Interest expense relates to the mortgage debt related to the initial seven hotels. Our mortgage debt on three of our hotels bears interest at variable rates based on LIBOR. The interest rates as of March 25, 2005 on these three mortgage loans ranged between 5.15% and 5.58%. The mortgage debt on the other four initial hotels bears interest at fixed rates ranging from 5.11% to 7.69% per year. Our pro forma interest expense for the fiscal quarter ended March 25, 2005, assuming we acquired the Torrance Marriott, the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa on January 1, 2005, was $3.8 million.

 

Income taxes.    We recorded a provision for income taxes of $79,857 for the fiscal quarter ended March 25, 2005. We recorded an income statement charge of $1.4 million to reverse a portion of the deferred tax assets recorded in 2004 in connection with our REIT election. This charge was offset by an income tax benefit of $1.3 million recorded in our TRS for the fiscal quarter ended March 25, 2005.

 

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Pro Forma Quarterly Financial Information

 

The following table presents certain quarterly pro forma financial information:

 

    

Fiscal Quarter
Ended

March 26,
2004


   

Fiscal Quarter
Ended

June 18,

2004


   

Fiscal Quarter
Ended

September 10,
2004


    Fiscal Quarter
Ended
December 31,
2004


    Fiscal Year
Ended
December 31,
2004


 

REVENUES

                                        

Rooms

   $ 45,915,460     $ 41,970,622     $ 39,891,134     $ 53,255,149     $ 181,032,365  

Food and beverage

     18,850,038       20,733,311       17,514,643       25,338,433       82,436,425  

Other

     4,024,306       4,667,767       4,384,483       3,650,774       16,727,330  
    


 


 


 


 


Total revenues

     68,789,804       67,371,700       61,790,260       82,244,356       280,196,120  

OPERATING EXPENSES

                                        

Rooms.

     11,275,524       10,774,139       11,070,296       12,235,256       45,355,215  

Food and beverage

     14,347,912       14,639,361       13,574,886       18,802,355       61,364,514  

Management fees and other hotel expenses.

     26,445,301       27,598,342       26,056,180       34,334,465       114,434,288  

Depreciation and amortization.

     7,018,433       7,018,433       7,018,433       9,057,762       30,113,061  

Corporate expenses

     2,096,130       2,096,130       2,096,130       2,096,067       8,384,457  
    


 


 


 


 


Total operating expenses

     61,183,300       62,126,405       59,815,925       76,525,905       259,651,535  
    


 


 


 


 


OPERATING PROFIT

     7,606,504       5,245,295       1,974,335       5,718,451       20,544,585  

OTHER EXPENSES (INCOME)

                                        

Interest income.

     —         —         —         (1,333,837 )     (1,333,837 )

Interest expense

     3,888,712       3,888,712       3,888,712       5,087,351       16,753,487  
    


 


 


 


 


Total other expenses (income)

     (3,888,712 )     3,888,712       3,888,712       3,753,514       15,419,650  

INCOME (LOSS) BEFORE INCOME TAXES

     3,717,792       1,356,583       (1,914,377 )     1,964,937       5,124,935  

Income tax provision

     (453,232 )     (1,980,413 )     (3,514,598 )     (1,103,945 )     (7,052,188 )
    


 


 


 


 


NET INCOME (LOSS)

   $ 4,171,024     $ 3,336,996     $ 1,600,221     $ 3,068,882     $ 12,177,123  
    


 


 


 


 


EBITDA

   $ 14,624,937     $ 12,263,728     $ 8,992,768     $ 16,110,050     $ 51,991,483  
    


 


 


 


 


FFO

   $ 11,189,457     $ 10,355,429     $ 8,618,654     $ 12,126,644     $ 42,290,184  
    


 


 


 


 


 

Liquidity and Capital Resources

 

Our short-term liquidity requirements consist primarily of funds necessary to fund future distributions to our stockholders to maintain our REIT status as well as to pay for operating expenses and other expenditures directly associated with our hotel properties, including:

 

    recurring maintenance and capital expenditures necessary to maintain our hotel properties properly; and

 

    interest expense and scheduled principal payments on outstanding indebtedness.

 

We expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under our anticipated secured revolving credit facility.

 

Our long-term liquidity requirements consist primarily of funds necessary to pay for the costs of acquiring additional hotel properties, renovations, expansions and other non-recurring capital expenditures that need to be made periodically to our hotel properties, scheduled debt payments and making distributions to our stockholders.

 

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We expect to meet our long-term liquidity requirements through various sources of capital including the cash we will have available upon completion of this offering, cash provided by operations, and borrowings, as well as through the issuances of additional equity or debt securities. Our ability to incur additional debt is dependent upon a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, general market conditions for REITs and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time, but the capital markets may not be consistently available to us on terms that are attractive, or at all. We believe that our existing cash and cash equivalents, together with the net proceeds from this offering, cash flow from operations and borrowings, will be sufficient to acquire the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa, to fund the $33.5 million of renovation costs in 2005 and 2006 for our initial hotels and to fund our cash requirements during the next twelve months.

 

In addition, we intend to utilize various types of debt to finance a portion of the costs of acquiring additional hotel properties. We expect this debt will include long-term, fixed-rate, mortgage loans, variable-rate term loans, and secured revolving lines of credit. We intend to enter into approximately $82.6 million in first mortgage debt in connection with our acquisition of the Marriott Los Angeles Airport hotel and approximately $57.4 million of first mortgage debt in connection with our acquisition of the Renaissance Worthington hotel.

 

Our Credit Facility

 

We intend to enter into a senior secured revolving credit facility with Wachovia Bank, National Association. We expect that:

 

    our operating partnership will be the borrower under the credit facility and that the credit facility will be guaranteed by certain of the operating partnership’s existing and future subsidiaries, including those subsidiaries which hold the hotels securing the revolving credit facility; and

 

    the credit facility will have a term of three years, subject to a one-year extension.

 

    the credit facility will be available for general corporate purposes, including the following:

 

    funding of acquisitions;

 

    repayment of debt;

 

    working capital needs; or

 

    any other payments deemed necessary or desirable by management and approved by the lender.

 

    the credit facility will be subject to the following financial covenants:

 

    a maximum leverage ratio (total indebtedness to total asset value, each as defined in the facility) of 0.75 to 1.00 of tangible net worth, which maximum ratio shall decrease to 0.70 to 1.00 during months 13 through 24 of the facility and 0.65 to 1.00 during months 25 through 36;

 

    a minimum ratio of adjusted EBITDA to fixed charges (each as defined in the facility) of 1.50 to 1.00;

 

    maximum REIT dividend payouts of 100% of cash available for distribution during any four-quarter period (subject to dividend payments to preserve our REIT status); and

 

    a maximum of 50% of our total indebtedness outstanding in un-hedged floating rate debt.

 

The senior secured revolving credit facility will contain customary provisions regarding events of default, including, among others, the failure to pay principal and interest when due, failure to comply with covenants and bankruptcy or insolvency in excess of $10 million of total asset value (as defined in the facility) with respect to us, our subsidiaries that are guarantors under the facility and certain other of our subsidiaries. In addition, the facility will contain provisions for cross-default on payment defaults on principal aggregating $10 million.

 

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The senior secured revolving credit facility will initially be secured by first priority mortgage liens on specific hotel properties to be approved by the agent and the lenders under the facility in their sole and absolute discretion, which we refer to in this prospectus as the “collateral package.” We currently expect that the Torrance Marriott and the Frenchman’s Reef & Morning Star Marriott Beach Resort will be the two hotel properties comprising the collateral package. The amount borrowed under the facility may not exceed the lesser of (i) 65% of the appraised value of the hotels in the collateral package or (ii) 65% of the aggregate cost of each hotel in the collateral package plus the acquisition capital budget of each hotel in the collateral package. We must maintain a ratio of net operating income (less certain specified fees of the hotels in the collateral package) to minimum debt service under the facility of 1.40 to 1.00. Minimum debt service shall be the actual amounts outstanding under the facility based on a 25-year amortization and an interest rate equal to the greater of (i) 7.0% or (ii) the then-current yield for a ten-year U.S. Treasury note plus 1.75%.

 

We may add hotels to the collateral package only if the applicable hotel is:

 

    a full service, select service or extended stay hotel;

 

    operated by managers and subject to management agreements acceptable to the agent and a specified number of lenders under the credit facility (Marriott is deemed an approved third-party manager under the facility);

 

    free of all material structural and title defects;

 

    free from environmentally hazardous materials, as verified by a Phase I environmental assessment; and

 

    wholly-owned by us on a fee simple basis (ground leases covering the property are permissible).

 

The lenders’ commitment under the revolving credit facility will terminate on the third anniversary of the facility, subject to a one-year extension, which requires the payment of a facility extension fee on the commitment amount. All borrowings under the revolving credit facility are subject to the satisfaction of customary conditions, including the absence of a default and accuracy of representations and warranties.

 

We will have the ability to prepay advances under the facility in whole or in part at any time without penalty, subject to reimbursement of the lender’s breakage and redeployment costs in the case of prepayment of LIBOR borrowings. We may irrevocably cancel, in whole or in part, unutilized portions of any commitment under the facility in excess of outstanding loans and the stated amount of all letters of credit.

 

Borrowings under the facility will be subject to an interest rate equal to either, at our option, a fluctuating rate equal to a base rate or a periodic fixed rate equal to one-, two-, three- or six-month LIBOR, plus, in each case, an applicable margin based upon our leverage. The applicable margin will be an annual percentage rate that ranges from 0.75% to 1.25% for base rate loans and 1.45% to 1.95% for LIBOR loans. We expect to pay a yearly fee (payable quarterly in arrears) to the lenders under the facility of 0.35% on the unused portion of the facility and a 0.15% fee of the face amount of each letter of credit payable upon the issuance of each such letter of credit. We will pay an annual letter of credit fee (based on the face amount of each outstanding letter of credit) equal to the then-applicable LIBOR margin.

 

As we have not yet entered into a definitive agreement with respect to the credit facility, the final terms may materially differ from those described in this prospectus.

 

Any indebtedness we incur will likely be subject to continuing covenants, and we will likely be required to make continuing representations and warranties in connection with that debt. These debt covenants will likely restrict certain of our subsidiaries’ ability to distribute funds to us and our ability to make distributions to our stockholders. Moreover, some or all of our debt may be secured by some or all of our assets. If we default in the payment of interest or principal on any of our debt, breach any representation or warranty in connection with any borrowing or violate any covenant in any loan document, the lender may accelerate the maturity of the debt,

 

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requiring us to immediately repay all outstanding principal and accrued interest. If we are unable to make the payment, our lender could foreclose on any assets that are pledged as collateral to the lender. The lender could also sue us or force us into bankruptcy. Any of these events would likely have a material adverse effect on the value of an investment in our common stock.

 

In order to qualify as a REIT and to avoid corporate-level tax on the income we distribute to our stockholders, we generally are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, on an annual basis. Therefore, once the total net proceeds of this offering and our July 2004 private placement are substantially fully invested, we intend to raise additional capital in order to grow our business and invest in additional hotel properties. However, there is no assurance that we will be able to borrow funds or raise additional equity capital on terms acceptable to us, if at all. For additional information regarding our distribution policies and requirements, see “Dividend Policy and Distributions.”

 

Off-Balance Sheet Arrangements

 

We lease the land underlying the Bethesda Marriott Suites and the Courtyard Manhattan/Fifth Avenue pursuant to ground leases that provide for ground lease rental payments that are stipulated in the ground leases and increase in pre-established amounts over the remaining terms of the leases. We lease the land underlying the Salt Lake City Marriott Downtown pursuant to a ground lease that provides for ground lease payments that are calculated based on a percentage of gross revenues. We record the future minimum ground rent payments on the Bethesda Marriott Suites and the Courtyard Manhattan/Fifth Avenue on a straight-line basis as required by accounting principles generally accepted in the United States. We also lease the ground under the Marriott Griffin Gate Resort golf course and the ground under a portion of the Salt Lake City Marriott Downtown ballroom not covered by the main ground lease underlying the hotel.

 

Outstanding Debt

 

After application of a portion of the net proceeds from this offering to repay approximately $64 million of mortgage debt as described in “Use of Proceeds,” we expect to have approximately $300.1 million of outstanding debt. The following table sets forth, as of March 25, 2005, our debt obligations on our initial hotel properties.

 

Property


   Principal
Balance


    Prepayment
Penalties


   Interest Rate

  Maturity
Date


  

Amortization
Provisions


Courtyard Manhattan/Midtown East

   $ 44,778,987     No(1)    5.195%   12/09    25 years

Torrance Marriott

     44,000,000 (2)   No(3)    LIBOR(11)
+ 2.50%
  1/07(8)    Interest Only

Salt Lake City Marriott Downtown

     38,814,632     Yes(1)    5.50%   12/14    20 years(10)

Marriott Griffin Gate Resort

     30,893,000     Yes(4)    5.11%   1/10    25 years

Bethesda Marriott Suites

     19,700,758     Yes(5)    7.69%   2/23    25 years

Courtyard Manhattan/Fifth Avenue

     23,000,000     No(6)    LIBOR(11)
+ 2.70%
  1/07(8)    Interest Only

The Lodge at Sonoma Renaissance

    Resort & Spa

     20,000,000     No(7)    LIBOR(11)
+ 2.40%
  11/06(9)    Interest Only
    


                 

Total:

   $ 221,187,377                    
    


                 

(1) The debt may not be prepaid until three months prior to the maturity date of the mortgage loan (the “Prepayment Release Date”). For Salt Lake City Marriott Downtown, we may prepay the loan on or after the Prepayment Release Date without payment of fees. However, we must pay to the lender, simultaneously with such prepayment, the interest that would have accrued on the outstanding principal balance of the loan at the regular interest rate through the end of the interest period in which such prepayment occurs.
(2) Includes $35,000,000 senior debt secured by a first mortgage and $9,000,000 subordinated debt.
(3) The debt may be prepaid at par at any time except during the period from July 13, 2005 to January 13, 2006. We intend to repay the debt with the proceeds of this offering.

 

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(4) We may not prepay the loan without the express written consent of the lender, and we have no right to prepay the debt until October 2009. Notwithstanding the foregoing, if the lender accepts prepayment of the debt prior to October 2009, we must pay a penalty equal to the greater of (i) 1% of the outstanding principal and (ii) the present value, as of the prepayment calculation date, of a series of monthly payments over the remaining term of the loan, each equal to the amount of interest that would be due on the portion of the loan being prepaid, assuming an annual interest rate of 5.11% over the discounted reinvestment yield, as such term is defined in the agreement.
(5) The debt may be prepaid. If it is prepaid prior to August 2012, it is subject to a prepayment fee equal to the greater of i) one percent of the outstanding principal amount or ii) a yield maintenance premium determined as set forth in the Deed of Trust.
(6) The debt may be prepaid at par as of December 2005.
(7) The debt may be prepaid at par at any time except during certain days each month as specified in the applicable loan agreement. We intend to repay the debt with the proceeds of this offering.
(8) The debt allows for three one-year extensions provided that certain conditions are met.
(9) The debt allows for one 12-month extension provided that certain conditions are met.
(10) There is an accelerated amortization provision based on a predetermined formula of available cash flow.
(11) We have entered into an interest rate cap agreement on this debt. Breakage fees may be payable if the debt is repaid.

 

The following table sets forth certain terms with respect to the first mortgage debt that we intend to enter into with Wachovia Bank, National Association in connection with the acquisitions of the Marriott Los Angeles Airport and Renaissance Worthington hotels:

 

 

Property


   Principal
Balance


   Prepayment
Penalties


  Interest Rate

  Term

   Amortization
Provisions


Marriott Los Angeles Airport

   $ 82,600,000    No(1)   not less than 5.35%(2)   10 years    30 years(3)

Renaissance Worthington

     57,400,000    No(1)   not less than 5.35%(2)   10 years    30 years(3)
    

                 

Total:

   $ 140,000,000                  
    

                 

(1) Prepayment of the debt is not permitted until the earlier of (i) two years after securitization (the lender intends to sell all or a portion of the debt through one or more public offerings) or (ii) four years from the closing date. Thereafter, we may pay a defeasance deposit in lieu of a prepayment of the debt. Prepayment in full will be permitted at par on the last three payment dates before the maturity date.
(2) The interest rate shall equal the sum of (a) 0.60%, (b) the 10-year mid-market swap spread and (c) the yield-to-maturity for the 10-year Treasury bond. In no event, however, shall the interest rate be less than 5.35%.
(3) The debt has a four-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule.

 

Financing Strategy

 

We currently maintain a policy that limits our total debt level to no more than 60% of our aggregate property investment and repositioning costs, with a target leverage ratio of 45% to 55% of total enterprise value. Our board of directors, however, may change or eliminate this debt limit, and/or the policy itself, at any time, without the approval of our stockholders. Upon completion of this offering, we will have a debt ratio of approximately 39.3% of our pro forma property investment and repositioning costs as of March 25, 2005.

 

Going forward, we will consider a number of factors when evaluating our level of indebtedness and making financial decisions, including, among others, the following:

 

    the interest rate of the proposed financing;

 

    prepayment penalties and restrictions on refinancing;

 

    the purchase price of properties we acquire with debt financing;

 

    our long-term objectives with respect to the financing;

 

    our target investment returns;

 

    the ability of particular properties, and our company as a whole, to generate cash flow sufficient to cover expected debt service payments;

 

    overall level of consolidated indebtedness;

 

    timing of debt and lease maturities;

 

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    provisions that require recourse and cross-collateralization;

 

    corporate credit ratios, including debt service coverage, debt to total market capitalization and debt to undepreciated assets; and

 

    the overall ratio of fixed and variable-rate debt.

 

Beyond our anticipated secured revolving credit facility, we intend to use other financing methods as necessary, including obtaining from banks, institutional investors or other lenders, financings through property mortgages, bridge loans, letters of credit, and other arrangements, any of which may be unsecured or may be secured by mortgages or other interests in our investments. In addition, we may issue publicly or privately placed debt instruments. When possible and desirable, we will seek to replace short-term sources of capital with long-term financing.

 

Our indebtedness may be recourse, non-recourse or cross-collateralized and may be fixed rate or variable rate. If the indebtedness is non-recourse, the collateral will be limited to the particular properties to which the indebtedness relates. In addition, we may invest in properties subject to existing loans secured by mortgages or similar liens on the properties, or may refinance properties acquired on a leveraged basis. We may use the proceeds from any borrowings to refinance existing indebtedness, to refinance investments, for general working capital or for other purposes when we deem it advisable.

 

Contractual Obligations

 

The following table outlines the timing of payment requirements related to our consolidated mortgage debt and other commitments as of December 31, 2004.

 

     Payments due by period

     Total

  

Less than

1 year


  

1 to 3

years


  

4 to 5

years


  

After 5

years


Long-Term Debt Obligations

   $ 177,827,573    $ 3,113,034    $ 49,699,211    $ 47,579,899    $ 77,435,429

Operating Lease Obligations—Ground Leases

   $ 608,071,048    $ 1,260,432    $ 2,648,853    $ 2,941,491    $ 601,220,272

Office Space

   $ 87,000    $ 87,000    $ —      $ —      $ —  

 

We intend to fund the acquisition of the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa through approximately $207.1 million of the net proceeds of this offering, $140.0 million of the proceeds from the two first mortgage loans described above and approximately $29.6 million of available cash.

 

Cash Distribution Policy

 

We operated as a taxable C Corporation during our first taxable year ended December 31, 2004. We will elect to be taxed as a REIT under the Code for the taxable year ending on December 31, 2005 and subsequent taxable years. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we generally distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, to our stockholders. It is our current intention to comply with these requirements, elect REIT status and maintain such status going forward. As a REIT, we generally will not be subject to corporate federal, state or local income taxes on taxable income we distribute to our stockholders (although the taxable income of Bloodstone TRS, Inc., our TRS lessees and other TRSs generally will be subject to regular corporate tax). If we fail to qualify as a REIT in any taxable year, we will be subject to federal, state and local income taxes at regular corporate rates and we may not be able to qualify as a REIT for four subsequent tax years. Even if we qualify for federal taxation as a REIT, we may be subject to certain state and local taxes on our income and property and to federal income and excise taxes on our undistributed taxable income. See “Dividend Policy and Distributions.”

 

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Inflation

 

Operators of hotel properties, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our hotel management companies to raise room rates.

 

Seasonality

 

The operations of hotel properties historically have been seasonal depending on location and, accordingly, we expect some seasonality in our business.

 

Geographic Concentration

 

Our hotel properties are located in the following markets: New York City (2 hotels), Washington D.C., Los Angeles, Salt Lake City, Northern California and Lexington, Kentucky.

 

Tax and Depreciation

 

The following table reflects certain real estate tax information for our initial properties:

 

Property


  

Federal
Tax Basis

(In thousands)


   Property
Tax Rate
2004
Estimate(1)


   

Real Estate
Tax 2004
Estimate

(In thousands)


   Depreciation
Method


   Tax
Depreciation
Life (Years)


   Annual
Depreciation
Percent (%)


 

Courtyard

Manhattan/Midtown

East

   $ 71,144    1.5 %   $ 1,052    Straight-Line    39    2.564 %

Torrance Marriott

     51,504    1.4       711    Straight-Line    39    2.564  

Salt Lake City Marriott

Downtown

     45,292    1.4       645    Straight-Line    39    2.564  

Marriott Griffin Gate

Resort

     41,297    0.8       325    Straight-Line    39    2.564  

Bethesda Marriott

Suites

     46,271    1.1       517    Straight-Line    39    2.564  

Courtyard

Manhattan/Fifth

Avenue

     33,779    2.4       798    Straight-Line    39    2.564  

The Lodge at Sonoma

Renaissance Resort &

Spa

     27,410    1.2       335    Straight-Line    39    2.564  

(1) Per $1,000 of assessed value.

 

Qualitative Disclosures about Market Risk

 

Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. In pursuing our business strategies, the primary market risk to which we are currently exposed, and which we expect to be exposed to in the future, is interest rate risk. Some of our outstanding debt has a variable interest rate. We use interest rate caps to manage our interest rate risks relating to our variable rate debt. Our total outstanding debt at March 25, 2005 was approximately $224.1 million, of which approximately $87 million or 38.8% was variable rate debt. If market rates of interest on our variable debt were to increase by 1.0%, or approximately 100 basis points, the increase in interest expense on our variable debt would decrease future earnings and cash flows by approximately $870,000 annually. On the other hand, if market rates of interest on our variable rate were to decrease by one percentage point, or approximately 100 basis points, the decrease in interest expense on our variable rate debt would increase future earnings and cash flow by approximately $870,000. As of March 25, 2005, the fair value of the fixed rate debt is equal to the book value.

 

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HOTEL INDUSTRY

 

Hotel Industry Recovery.    We believe that the U.S. hotel industry is continuing to recover from the severe effects of an economic slowdown and reduction in travel following the terrorist attacks of September 11, 2001, which led to declines in room rates as hotels competed more aggressively for fewer guests. As a result, hotel industry RevPAR and operating performance declined substantially in the period 2001 to 2003.

 

General economic and local market conditions affect the levels of business and leisure travel, which in turn affect hotel demand and, therefore, operating performance. Along with hotel demand, new hotel room supply is another important factor affecting the hotel industry’s performance. Room rates, occupancy and RevPAR typically increase when demand growth exceeds supply growth. According to Smith Travel Research, Inc., demand for hotel rooms recently increased while growth in the supply of new hotel rooms slowed and is expected to remain at historically low levels for the next several years.

 

Attractive Environment for Acquisitions.    We believe that the current environment presents the opportunity to acquire hotel properties at an attractive time in the hotel industry cycle and participate in improved hotel industry fundamentals. As economic conditions continue to improve, we expect a number of hotel properties with attractive values will be sold over the near-term. Unlike the last industry downturn in the early 1990’s, current hotel owners generally have not been compelled to sell their hotels at distressed prices. In the most recent downturn, hotel properties generally were more conservatively leveraged and hotel owners therefore were able to comply with their debt service obligations despite the cash flow reductions caused by the economic and industry slowdown. While the hotel industry is now recovering from the general economic decline of the previous few years, we believe that a significant number of hotel owners are motivated to sell their hotel properties for a number of reasons. Some owners are restructuring their portfolios by selling some hotels in order to restore service levels and accelerate maintenance and capital expenditures to capitalize on recovering demand levels and increase potential revenue streams at their remaining hotels. Other owners have been forced to hold their assets longer than planned during the market downturn and are seeking to sell into the first rising market in several years.

 

Because the market appears to accept the notion of broad hotel market recovery, sellers are demanding and receiving relatively high multiples of trailing earnings for their hotels. We believe that, even at such relatively high valuations, hotel industry performance indicators will generally continue to improve, providing the opportunity for future increases in revenues and profits.

 

Favorable Long-Term Demand Fundamentals.    As shown in the chart below, hotel room demand has historically been highly correlated with GDP growth. From 1988 to 2000, demand for hotel rooms grew at an average annual rate of approximately 2.6%, in line with the 3.3% average annual growth rate in GDP during the same period. However, a declining economy and the terrorist attacks of September 11, 2001 led to sharp declines in travel activities in 2001. Beginning in 2002, hotel room demand and GDP showed signs of improvement. Hotel room demand increased by 0.3% in 2002 and 1.5% in 2003, while GDP increased by 1.9% in 2002 and 3.0% in 2003. In 2004, the general economic and hotel room demand recovery continued, as hotel room demand increased by 4.7% and GDP increased by 4.4%. It is projected that hotel room demand will grow by 4.0% in 2005.

 

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LOGO

 

We expect that sustained growth in demand will result in continued improvement of hotel industry fundamentals. According to Smith Travel Research:

 

    occupancy increased by 3.7% in 2004 and is projected to increase by 2.8% in 2005; and

 

    ADR increased by 4.0% in 2004 and is projected to increase by 4.2% in 2005.

 

Favorable Supply Fundamentals.    Historically, periods of weak hotel industry performance have been followed by a decrease in the growth of new hotel supply as availability of new development capital declines. Although improving operating fundamentals encourage new construction, development may require up to several years to complete. As a result, supply growth typically lags behind a hotel industry recovery. As shown in the graph below, new hotel room supply growth averaged 2.6% annually from 1988 to 2000, which is an average growth rate that is approximately equal to the average growth rate for demand over the same period of time, but since 2001, hotel room supply increased by only 1.6% in 2002, 1.2% in 2003 and 1.0% in 2004. New hotel room supply is projected to grow by 1.2% in 2005, as compared to its past 15-year historical annual average of 2.1%. We expect that if new supply remains constrained in 2005 and beyond, even moderate increases in demand should translate into further increases in hotel revenues and profitability.

 

 

LOGO

 

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Improving RevPAR.    RevPAR is generally higher in periods when room demand exceeds new supply growth. In 2001 and 2002, hotel room demand declined significantly below new room supply, resulting in RevPAR declines of 6.9% in 2001 and 2.7% in 2002. The aggregate percentage decline over this two-year period substantially surpassed the aggregate percentage decline for the 1990-91 period, previously considered one of the worst periods in the modern history of the U.S. hotel industry. We believe the industry is recovering in a pattern similar to that following the post-1991 decline. In 2003, hotel room demand stabilized and RevPAR increased 0.4%. In 2004, hotel demand increased significantly, leading to a significant increase in RevPAR of 7.8%, and RevPAR growth of 7.1% is projected for 2005.

 

LOGO

 

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Improving Margins.    The hotel industry has operated more efficiently over the past decade, notwithstanding the significant industry downturn of 2001-2003. Periods of strong RevPAR growth tend to be characterized by increases in gross operating margin, or GOP margins, while periods of slower RevPAR growth or periods of RevPAR decline tend to be characterized by GOP margin decreases. For example, from 2000 through 2003, GOP margins declined from 40.9% to 35.0% as RevPAR declined by an average of 3.1% annually. We believe that as economic conditions continue to improve, our hotel occupancy rates will increase, making it possible for us to increase daily rates and thereby increase our RevPAR and operating margins.

 

LOGO

 

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OUR BUSINESS

 

Our Company

 

We are a self-advised real estate company that owns, acquires and invests in upper upscale and upscale hotel properties located primarily in North America. To a lesser extent, we may invest, on a selective basis, in premium limited-service and extended-stay hotel properties in urban locations.

 

We began operations in July 2004 when we completed a private placement of our common stock.

 

Our Competitive Strengths

 

We believe we distinguish ourselves from other owners, acquirors and investors in hotel properties through our competitive strengths, which provide us with a competitive advantage over our competitors in implementing our strategies. Our competitive strengths include:

 

Experienced Management Team.    We believe the extensive hotel industry experience of our senior management team will enable us to effectively implement our business strategies. Our senior management team of William W. McCarten, John L. Williams, Mark W. Brugger, Michael D. Schecter and Sean M. Mahoney has extensive experience in lodging, real estate and related service industries, including hotel asset management, acquisitions, mergers, dispositions, development, redevelopment and financing. Collectively, they have been involved in hotel transactions aggregating several billion dollars and over 100,000 hotel rooms. In particular, our senior executive officers have the following experience:

 

    Mr. McCarten had over twenty-five years experience with the Marriott organization. Over the course of his career with Marriott and its related entities, he served in a variety of positions, including Chief Executive Officer of HMSHost Corporation (formerly Host Marriott Services Corporation) and Executive Vice President and Operating Group President of Host Marriott Corporation, each a publicly traded company. Mr. McCarten oversaw the spin-off of HMSHost Corporation through its merger with Autogrill S.P.A. The common stock of HMSHost Corporation initially traded at $6.25 per share in 1995 and HMSHost Corporation was subsequently purchased by Autogrill, S.P.A. in 1999 for $15.75 per share (a 152% return). Mr. McCarten serves as our Chairman and Chief Executive Officer.

 

    Mr. Williams had over twenty-five years experience with Marriott and recently served as Executive Vice President of North American Hotel Development for Marriott, where he had primary responsibility for the acquisition and development of full-service hotel projects involving Marriott Hotels & Resorts, Renaissance Hotels & Resorts and The Ritz-Carlton. He has extensive experience in acquiring, repositioning, developing and redeveloping hotels. Mr. Williams serves as our President and Chief Operating Officer.

 

    Mr. Brugger has over a decade of experience in real estate and finance. He recently served as the Vice President Project Finance with Marriott as well as Chief Executive Officer of a non-lodging Marriott subsidiary with over $300 million in annual revenues. His experience includes structured finance transactions totaling in excess of $2 billion as well as the acquisition, disposition and financing of investment properties. Mr. Brugger serves as our Executive Vice President, Chief Financial Officer and Treasurer.

 

    Mr. Schecter has fifteen years experience practicing law, including six years with Marriott. He has led and successfully completed a wide array of transactions in the hotel industry, including mergers and acquisitions, dispositions, joint ventures, and financings. Mr. Schecter serves as our General Counsel and Secretary.

 

    Mr. Mahoney has over eleven years experience as a certified public accountant. He most recently served as a senior manager with Ernst & Young LLP. He has extensive experience with clients in the real estate and hotel industries. Mr. Mahoney serves as our Chief Accounting Officer and Corporate Controller.

 

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Marriott Investment Sourcing Relationship.    Our investment sourcing relationship with Marriott provides us, subject to certain limitations, with a “first look” at hotel property acquisition and investment opportunities known to Marriott. As a result of Marriott’s extensive network, relationships and knowledge of hotel property investment opportunities, we believe we have preferred access to a unique source of hotel property investment opportunities, many of which may not be available to other hospitality companies.

 

We regularly explore with Marriott how to further our investment sourcing relationship in order to maximize the value of the relationship to both parties. To date, both companies have worked proactively to convert appropriate opportunities into hotel property investments made by us and managed by Marriott. Our senior management team currently meets with senior representatives of Marriott approximately every two weeks to discuss, among other things, potential hotel property investment opportunities known to Marriott that are consistent with our stated business strategy.

 

Since our formation in 2004, Marriott has provided us with access to more than $1.9 billion of off-market acquisition opportunities. Marriott has contributed to us certain amounts in exchange for the right to manage hotel properties we have acquired. We refer to these amounts as “key money.” Marriott has provided us with key money of approximately $6.5 million in the aggregate in connection with our acquisitions of the Courtyard Manhattan/Midtown East ($2.5 million), the Courtyard Manhattan/Fifth Avenue ($1.0 million) and the Torrance Marriott ($3.0 million). In connection with our acquisitions of the Courtyard Manhattan/Midtown East and The Lodge at Sonoma Renaissance Resort & Spa, Marriott also contributed $800,000 and $400,000, respectively, to the hotels’ furniture, fixtures and equipment reserves. The $1.0 million in key money payments received from Marriott in connection with our acquisition of the Courtyard Manhattan/Fifth Avenue is recoverable in the event that we have not completed certain renovations by January 22, 2006 and Marriott terminates the management agreement in accordance with certain provisions of the management agreement. The $3.0 million in key money contributed by Marriott in connection with our acquisition of the Torrance Marriott is recoverable, subject to a 10% reduction per year through 2014, in the event that the management agreement with Marriott terminates within 10 years and such termination is not a result of a default by Marriott. Our relationship with Marriott has facilitated the acquisition of five of our initial seven hotel properties, including the Marriott Griffin Gate Resort and the Lodge at Sonoma Renaissance Resort & Spa, each of which we acquired directly from Marriott. We believe that we will continue to benefit from this relationship.

 

Except where contractually or ethically prohibited, or where Marriott believes it would be damaging to existing Marriott relationships, Marriott provides us a “first look” at hotel property investment opportunities known to Marriott that are consistent with our stated business strategy. These hotel property investment opportunities are those upon which Marriott believes that it may have a significant influence on a potential sale. We believe we are Marriott’s preferred purchaser of full-service as well as urban select-service and urban extended-stay hotels in the United States, Canada and Mexico. We believe that Marriott currently views “first look” as meaning Marriott will approach us first and give us an opportunity to work with Marriott in connection with an investment. Whether the “first look” opportunity develops further will depend upon the circumstances of each investment. In order to continue to develop this relationship, except where contractually or ethically prohibited, we intend to provide Marriott with a “first look” at all hotel management opportunities that become known to us.

 

Neither we nor Marriott have entered into a binding agreement or commitment setting forth the terms of this investment sourcing relationship. Our investment sourcing relationship may be modified or terminated at any time by either party. We retain the right to utilize any property brand and any hotel management company. We believe that should we pursue any such opportunity, it will not affect our investment sourcing relationship with Marriott, so long as such an opportunity does not interfere with Marriott’s objectives for our investment sourcing relationship. On the other hand, Marriott has numerous longstanding relationships with other potential property owners and we understand that Marriott may work with other owners on any potential transaction.

 

Marriott’s only binding commitment with regard to this investment sourcing relationship is that until June 30, 2006, it will not enter into any written agreement or series of written agreements granting any third

 

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party the right to receive information from Marriott concerning opportunities to purchase full-service, urban select-service or urban extended-stay hotels in the United States, or in any region thereof, prior to such opportunities being presented to us. Our only binding commitment with regard to this relationship is that until June 30, 2006, we will not enter into a written agreement or series of written agreements granting any third party the right to receive information from us concerning potential opportunities to provide hotel management services for full-service, urban select-service or urban extended-stay hotels in the United States, or in any region thereof, prior to such opportunity being presented to Marriott. However, for any particular hotel, we are under no obligation to use Marriott as our hotel management company and we may invest in hotel properties that do not operate under one of Marriott’s brands.

 

Pursuant to this investment sourcing relationship, we have pursued, and intend to continue to pursue, hotel property investment opportunities referred to us by Marriott and we intend to continue to utilize Marriott as our preferred hotel management company. We believe that this strategy will benefit our stockholders because we believe that Marriott’s strong brands and excellent hotel management services have an extensive track record of providing its owners with a RevPAR premium over competitive brands.

 

The chart below shows RevPAR indices for selected Marriott brands for 2004 as of September 2004. The RevPAR index for any given hotel measures the level of RevPAR achieved by that hotel relative to its competitors in a specific market. For example, a hotel with a RevPAR index of 105 indicates that, on average, that hotel achieves 5% higher RevPAR than its competitors in that specific market.

 

The chart below is based on data provided by Smith Travel Research, Inc., based on specifications set by Marriott. For each market where there is a Marriott branded hotel, Marriott applies its knowledge of the market to determine a set of competitors. Marriott considers a variety of factors, some of which are subjective, to determine the competitors. Marriott then instructs Smith Travel Research, Inc. to provide Marriott with the RevPAR data for the specified competitive set. The RevPAR index for an entire brand is calculated by comparing the aggregate RevPAR for all hotels in the brand versus the aggregate RevPAR for all hotels in that brand’s competitive sets.

 

LOGO

 

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Proven Acquisition Capability.    Our senior management team has established a broad network of hotel industry contacts and relationships, including relationships with hotel owners, financiers, operators, commercial real estate brokers and other key industry participants. These industry relationships have provided us with a valuable source of potential hotel property investment opportunities. Since our July 2004 private placement, we have acquired the following seven hotel properties, comprising 2,357 rooms:

 

    Courtyard Manhattan/Midtown East in New York, New York, acquired in November 2004 for approximately $74.3 million (sourced by Marriott and purchased from a private partnership);

 

    Torrance Marriott in Los Angeles, California, acquired in January 2005 for approximately $62.0 million (sourced by a broker and purchased from a public REIT);

 

    Salt Lake City Marriott Downtown in Salt Lake City, Utah, acquired in December 2004 for approximately $49.6 million (sourced by a broker and purchased from a public REIT);

 

    Marriott Griffin Gate Resort in Lexington, Kentucky, acquired in December 2004 for approximately $46.9 million (sourced by and purchased from Marriott);

 

    Bethesda Marriott Suites in Bethesda, Maryland, acquired in December 2004 for approximately $41.1 million (sourced by a broker and purchased from a private partnership);

 

    Courtyard Manhattan/Fifth Avenue in New York, New York, acquired in December 2004 for approximately $35.6 million (sourced by a broker and purchased from an institutional investment fund); and

 

    The Lodge at Sonoma Renaissance Resort & Spa in Northern California, acquired in October 2004 for approximately $31.5 million (sourced by and purchased from Marriott).

 

We have also entered into contracts for the purchase of the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa, comprising an aggregate of 2,675 rooms, for approximately $382.7 million.

 

We believe that our ability to quickly identify, negotiate, finance and consummate acquisitions has positioned us as a preferred buyer of hotel properties.

 

Growth-Oriented Capital Structure.    Upon completion of, and application of the net proceeds from, this offering and the closing of the acquisitions of the Capital Hotel Investment Portfolio and the Vail Marriott Mountain Resort & Spa, we will have approximately $300.1 million in secured financing, representing an initial leverage ratio of approximately 39.3% of our pro forma total investments as of March 25, 2005, including projected capital improvements. In addition, we intend to enter into a three-year, $75.0 million senior secured revolving credit facility with Wachovia Bank, National Association, which may be expanded to $250.0 million at our election, subject to approval by Wachovia Bank, National Association, to fund additional acquisitions and renovations and for general working capital and other corporate purposes. We maintain a target leverage ratio of 45% to 55% of total enterprise value.

 

Our Business Objective and Strategies

 

Our principal business objective is to maximize stockholder value through a combination of dividends, growth in funds from operations and increases in net asset value. In order to achieve this objective, our key strategies are as follows:

 

    disciplined acquisition of hotel properties;

 

    aggressive asset management; and

 

    opportunistic hotel repositioning.

 

Disciplined Acquisition of Hotel Properties.    We will seek to create value by acquiring upper upscale and upscale hotel properties in geographically diverse locations, and to a lesser extent, premium limited service and

 

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extended stay hotels in urban locations, in accordance with our disciplined acquisition strategy. Our focus is on acquiring undermanaged or undercapitalized hotel properties at prices below replacement cost and that are located in markets where we expect demand growth will outpace new supply.

 

Aggressive Asset Management.    We intend to aggressively manage our hotel properties by continuing to employ value-added strategies (such as re-branding, renovating, or changing management) designed to increase the operating results and value of our hotel property investments. We will conduct improvements to certain of our initial properties designed to enhance the overall experience of hotel guests and increase RevPAR and asset value. For example, in certain hotels, we are planning the addition of new furniture and bedding, installation of granite vanities in bathrooms, and introduction of new concepts for food and beverage outlets, such as the conversion of a gift shop to a Starbuck’s outlet. We currently plan to invest approximately $33.5 million in 2005 and 2006 to renovate our initial hotels, including $27.0 million in capital that has been pre-funded into various escrow accounts.

 

We do not operate our hotel properties, but we have structured, and intend to continue to structure, our hotel management agreements to allow us to closely monitor the performance of our hotels and to ensure, among other things, that our third-party managers: (i) implement an approved business and marketing plan, (ii) implement a disciplined capital expenditure program and (iii) establish and prudently spend appropriate furniture, fixtures and equipment reserves.

 

Capitalizing on Repositioning Opportunities.    We intend to seek opportunities to acquire hotel properties that will benefit from repositioning, including re-branding, renovating or changing management to increase the operating results and value of our hotel property investments. In this regard, we believe our investment sourcing relationship with Marriott will yield many of these opportunities.

 

Hotel Industry Segments

 

Smith Travel Research, Inc. classifies the hotel industry into the following chain scales, as determined by each brand’s average system-wide daily rates: luxury, upper upscale, upscale, midscale with food and beverage, midscale without food and beverage, and economy. The category of “upper upscale” includes hotels such as Doubletree, Embassy Suites Hotels, Hilton, Hyatt, Marriott and Sheraton; the category of “upscale” includes hotels such as Courtyard by Marriott, Crowne Plaza, Hawthorn Suites, Hilton Garden Inn, Radisson, Residence Inn by Marriott and Wyndham; and the category of “midscale” includes hotels such as Four Points—Sheraton, Holiday Inn, Holiday Inn Express and Holiday Inn Select.

 

“Extended-stay” hotels are hotels generally designed to accommodate guests staying more than six nights and typically provide rooms with fully equipped kitchens, entertainment systems, office spaces with computer and telephone lines, access to fitness centers and other amenities. “Limited-service” hotels target budget-conscious travelers and therefore have fewer amenities, such as in-house food and beverage facilities.

 

Environmental Matters

 

Under various federal, state and local environmental laws and regulations, a current or previous owner, operator or tenant of real estate may be required to investigate and clean up hazardous or toxic substances or petroleum product releases or threats of releases at such property and may be held liable to a government entity or to third parties for property damage and for investigation, clean-up and monitoring costs incurred by such parties in connection with the actual or threatened contamination. These laws typically impose clean-up responsibility and liability without regard to fault, or whether or not the owner, operator or tenant knew of or caused the presence of the contamination. The liability under these laws may be joint and several for the full amount of the investigation, clean-up and monitoring costs incurred or to be incurred or actions to be undertaken, although a party held jointly and severally liable may obtain contributions from other identified, solvent, responsible parties of their fair share toward these costs. These costs may be substantial and can exceed the value

 

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of the property. The presence of contamination, or the failure to properly remediate contamination, on a property may adversely affect the ability of the owner, operator or tenant to sell or rent that property or to borrow funds using such property as collateral and may adversely impact our investment in that property.

 

Federal regulations require building owners and those exercising control over a building’s management to identify and warn, via signs and labels, of potential hazards posed by workplace exposure to installed asbestos-containing materials and potential asbestos-containing materials in their building. The regulations also set forth employee training, record keeping and due diligence requirements pertaining to asbestos-containing materials and potential asbestos-containing materials. Significant fines can be assessed for violation of these regulations. Building owners and those exercising control over a building’s management may be subject to an increased risk of personal injury lawsuits by workers and others exposed to asbestos-containing materials and potential asbestos-containing materials as a result of these regulations. The regulations may affect the value of a building containing asbestos-containing materials and potential asbestos-containing materials in which we have invested. Federal, state and local laws and regulations also govern the removal, encapsulation, disturbance, handling and disposal of asbestos-containing materials and potential asbestos-containing materials when such materials are in poor condition or in the event of construction, remodeling, renovation or demolition of a building. Such laws may impose liability for improper handling or a release to the environment of asbestos-containing materials and potentially asbestos-containing materials and may provide for fines to, and for third parties to seek recovery from, owners or operators of real estate facilities for personal injury or improper work exposure associated with asbestos-containing materials and potential asbestos-containing materials.

 

Prior to closing any property acquisition, we obtain Phase I environmental assessments in order to attempt to identify potential environmental concerns at the properties. These assessments are carried out in accordance with an appropriate level of due diligence and will generally include a physical site inspection, a review of relevant federal, state and local environmental and health agency database records, one or more interviews with appropriate site-related personnel, review of the property’s chain of title and review of historic aerial photographs and other information on past uses of the property. We may also conduct limited subsurface investigations and test for substances of concern where the results of the Phase I environmental assessments or other information indicates possible contamination or where our consultants recommend such procedures. We cannot assure you that these assessments will discover every environmental condition that may be present on a property.

 

The 2002 Phase I of the Frenchmans’ Reef Marriott Beach Resort property in St. Thomas, Virgin Islands identified two environmental issues that are currently still being resolved. First, twenty-one 55-gallon drums containing both hazardous and non-hazardous wastes were identified on the property. While there was no associated soil staining, fines may be imposed by the Virgin Islands Department of Planning and Natural Resources, or VIDPNR, for labeling issues and improper disposal. The estimated cost of clean up in 2002 was $2,000 to $3,000. Second, two 15,000 gallon diesel fuel underground storage tanks, or USTs, were reported to have leaked in 1984. While the leak was fixed in 1984 and the tanks were removed in 1997, cleanup of the spill to date has been limited. Accordingly, the official closure approval of the USTs is still under review by VIDPNR. The estimated cost of clean up, not including potential fines, if any, is estimated to range up to $400,000. Also, we will have no recourse against the seller of this property for any of the environmental liabilities at this property prior to our acquisition of the property.

 

Competition

 

We encounter strong competition for investments in hotel properties. The hotel industry is highly competitive and our hotel properties are subject to competition from other hotels for guests. Competition is based on a number of factors, including convenience of location, brand affiliation, price, range of services, guest amenities, and quality of customer service. Competition is specific to the individual markets in which our properties are located and will include competition from existing and new hotels operated under brands in the full-service, select-service and extended-stay segments. We believe that properties flagged with a Marriott brand will enjoy the competitive advantages associated with their operations under such brand. Marriott’s centralized

 

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reservation systems and national advertising, marketing and promotional services combined with the strong management expertise they provide should enable our properties to perform favorably in terms of both occupancy and room rates. We also believe that Marriott Rewards® will generate repeat guest business that might otherwise go to competing hotels. Increased competition would have a material adverse effect on occupancy, ADR and RevPAR or may require us to make capital improvements that we otherwise would not undertake, which may result in decreases in the profitability of our hotel properties.

 

We face competition for the acquisition of and investment in hotel properties from institutional pension funds, private equity investors, REITs, hotel companies and others who are engaged in the acquisition of hotels. Some of these entities have substantially greater financial and operational resources than we have and may have greater knowledge of the markets in which we seek to invest. This competition may reduce the number of suitable investment opportunities offered to us and increase the cost of acquiring our targeted hotel property investments. Although we expect that our investment sourcing relationship with Marriott will continue to provide us with a continuing source of investment opportunities, Marriott is under no binding commitment to provide us with any such opportunities, as described under “Our Business—Our Investment Sourcing Relationship With Marriott.”

 

Employees

 

We currently employ nine full-time employees. We anticipate hiring a number of additional full-time employees following the completion of this offering. We believe that our relations with our employees are good. None of our employees is a member of any union; however, the employees of Marriott working at our Courtyard Manhattan/Fifth Avenue hotel are currently represented by a labor union and are subject to a collective bargaining agreement.

 

Legal Proceedings

 

We are not involved in any material litigation nor, to our knowledge, is any material litigation pending or threatened against us, other than routine litigation arising out of the ordinary course of business or which is expected to be covered by insurance and not expected to harm our business, financial condition or results of operations.

 

On March 31, 2005, the New York Hotel Trades Council and Hotel Association of New York City, Inc. Pension Fund, or Fund, sent us a Notice of Demand for Payment of Withdrawal Liability under Section 4202 of ERISA, with regard to our acquisition of the Courtyard Manhattan/Fifth Avenue and the related transfer of management of the hotel to Marriott. The Fund assessed a withdrawal liability of $484,242 under Section 4201 of ERISA. We believe that the acquisition of the Courtyard Manhattan/Fifth Avenue did not constitute or give rise to a partial or complete withdrawal from the Fund and have requested that the Fund rescind the Notice of Demand for Payment of Withdrawal Liability. We are currently unable to assess whether the Fund will rescind the notice.

 

Regulation

 

Our properties must comply with Title III of the Americans with Disabilities Act, or ADA, to the extent that such properties are “public accommodations” as defined by the ADA. The ADA may require removal of structural barriers to access by persons with disabilities in certain public areas of our properties where such removal is readily achievable. We believe that our properties are in substantial compliance with the ADA and that we will not be required to make substantial capital expenditures to address the requirements of the ADA. However, noncompliance with the ADA could result in imposition of fines or an award of damages to private litigants. The obligation to make readily achievable accommodations is an ongoing one, and we will continue to assess our properties and to make alterations as appropriate in this respect.

 

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Insurance

 

We carry comprehensive liability, fire, extended coverage, earthquake, business interruption and rental loss insurance covering all of the properties in our portfolio under a blanket policy. We do not carry insurance for generally uninsured losses such as loss from riots, war or acts of God. In addition, we carry earthquake and terrorism insurance on our properties in an amount and with deductibles which we believe are commercially reasonable. Certain of the properties in our portfolio are located in areas known to be seismically active. See “Risk Factors—Risks Related to the Hotel Industry—Uninsured and underinsured losses could adversely affect our operating results and our ability to make distributions to our stockholders.”

 

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OUR PROPERTIES

 

Our Initial Hotel Properties

 

We own seven hotel properties. All of these hotel properties are currently managed by Marriott. We believe that each of these properties is adequately covered by insurance. The following table sets forth certain operating information for each of our initial hotels. This information includes periods prior to our acquisition of these hotels:

 

Property


  

Location


   Month
Acquired


   Number of
Rooms(1)


   Average
Occupancy(2)


    ADR(2)

   RevPAR(2)

Courtyard Manhattan/

Midtown East

   New York, New York    11/04    307    89.2 %   $ 199.43    $ 177.85

Torrance Marriott

   Los Angeles County, California    1/05    487    77.4       99.63      77.16

Salt Lake City Marriott

Downtown

   Salt Lake City, Utah    12/04    510    67.9       115.51      78.49

Marriott Griffin Gate

Resort

   Lexington, Kentucky    12/04    408    68.0       110.11      74.90

Bethesda Marriott Suites

   Bethesda, Maryland    12/04    274    74.6       153.73      114.73

Courtyard Manhattan/

Fifth Avenue

   New York, New York    12/04    189    89.3       140.96      125.88
The Lodge at Sonoma Renaissance Resort & Spa    Sonoma, California    10/04    182    65.1       187.34      122.03
              
                   
TOTAL/WEIGHTED AVERAGES         2,357    75.0 %   $ 136.21    $ 102.11
              
                   

(1) As of December 31, 2004.
(2) For the fiscal year ended December 31, 2004.

The following table sets forth information regarding our investment in each of our initial hotels:

 

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Property


  Location

  Year
Opened


  Number
of
Rooms(1)


  Purchase
Price(2)


  Pre-Funded
Capital
Improvement
Escrows(3)


  Projected
Additional
Capital
Improvements(4)


  Total
Projected
Investment(5)


  Total
Projected
Investment
Per Room


Courtyard Manhattan/ Midtown East   New York,
New York
  1998   307   $ 74,318,000   $ 4,539,000   $ —     $ 78,857,000   $ 256,863
Torrance Marriott   Los
Angeles
County,
California
  1985   487     62,002,000     10,000,000     —       72,002,000     147,848
Salt Lake City Marriott Downtown   Salt Lake
City, Utah
  1981   510     49,584,000     3,761,000     500,000     53,845,000     105,578
Marriott Griffin Gate Resort   Lexington,
Kentucky
  1981   408     46,887,000     2,955,000     —       49,842,000     122,162
Bethesda Marriott Suites   Bethesda,
Maryland
  1990   274     41,062,000     830,000     4,000,000     45,892,000     167,489
Courtyard Manhattan/ Fifth Avenue   New York,
New York
  1990   189     35,623,000     4,117,000     2,000,000     41,740,000     220,847
The Lodge at Sonoma Renaissance Resort & Spa   Sonoma,
California
  2001   182     31,545,000     800,000     —       32,345,000     177,720
           
 

 

 

 

     

TOTALS/WEIGHTED AVERAGE

  2,357   $ 341,021,000   $ 27,002,000   $ 6,500,000   $ 374,523,000   $ 158,898
           
 

 

 

 

     

(1) As of December 31, 2004.
(2) Purchase price includes, for each hotel property, all amounts paid to the seller, assumed debt and amounts paid for working capital plus costs paid with respect to third-party professional fees in connection with our purchase, but it does not include costs related to mortgage debt used by us to finance the purchase of the hotel property or escrow accounts established for the pre-funded capital improvements.
(3) Pre-funded capital improvements are amounts already funded into various escrow accounts and include furniture, fixtures and equipment reserves and lender-required reserves.
(4) Represents projected capital improvements scheduled to occur over the near term that have not been pre-funded into an escrow account.
(5) Total projected investment, for each hotel property, is the sum of the purchase price, pre-funded capital improvements and projected capital improvements.

 

Courtyard Manhattan/Midtown East

 

Location and Demand Generators:    The Courtyard Manhattan/Midtown East is located in Manhattan’s East Side, on Third Avenue between 52nd and 53rd Streets. Demand for the hotel is generated by nearby financial services and other firms located in Midtown Manhattan.

 

The Property:    We hold a fee simple interest in a commercial condominium unit, which includes a 47.725% undivided interest in the common elements in the 866 Third Avenue Condominium; the rest of the condominium is owned predominately (48.2%) by the building’s other major occupant, Memorial Sloan-Kettering. The hotel contains 307 guestrooms and occupies the lobby area on the 1st floor, all of the 12th-30th floors and its pro rata share of the condominium’s common elements. The hotel was converted from office use and had its grand opening in 1998 as a Courtyard by Marriott.

 

In 1998, the prior owners entered into a long-term management agreement with Marriott to have the hotel managed and operated as a Courtyard. Following the post-9/11 downturn in the New York City hotel market, the prior owners filed a Chapter 11 bankruptcy case in October 2003 with the intention of rejecting the Marriott hotel management agreement and converting the hotel into residential condominium units. After substantial litigation with Marriott, the owners and Marriott agreed to resolve their disputes by selling the hotel to Marriott. In November 2004, the bankruptcy court confirmed the proposed plan, which provided, among other things, for the

 

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sale of the hotel to Marriott for $75 million. During this time and prior to signing the purchase and sale agreement, Marriott worked exclusively with us to determine our level of interest in acquiring the hotel. As a result of these discussions, on the day of the real estate closing, Marriott assigned the purchase and sale agreement to us and we took title to the hotel directly from the prior owners. In addition, Marriott also contributed to us $2.5 million of non-recoverable key money in return for our agreement to enter into a new, long-term management agreement.

 

We believe that the hotel will benefit from continued improvement in the New York City hotel market.

 

We have budgeted $4.3 million for a complete guestroom and public space renovation in 2005, or $14,134 per room. We intend to target the higher end of the market as a result of many of these improvements. We believe that the improving hotel market in New York City and the planned capital improvements will position this hotel to take advantage of its location and continuing improvement in the hotel industry.

 

Additional property highlights include:

 

Guestrooms:

 

    307 guestrooms, including 8 suites, 182 king rooms and 117 double/double rooms. The guestrooms average 366 square feet in size.

 

Meeting Space:

 

    3 meeting rooms; 1,500 square feet of total meeting space.

 

Food and Beverage:

 

    East Side Café, with 82 seats.

 

    East Side Lounge, with 22 seats.

 

Other Amenities:

 

    Fitness Center.

 

Competition:    Competitor hotels include The Doubletree, The Crowne Plaza at the United Nations, The Roosevelt and Radisson. We compete with these hotels based on a number of factors, including location, brand, price, service and amenities, as well as property condition. New York City is a highly competitive hotel market that has historically been fairly volatile, reflecting the overall business climate in New York City. Several hotels have recently been, or are being, converted into residential condominium units, reducing the supply of upper-upscale hotel rooms in New York City.

 

Operating and Occupancy Information

 

    Fiscal Year

    First Fiscal Quarter

 
    2000

    2001

    2002

    2003

    2004

    2004

    2005

 

Room Revenue

  $ 20,742,000     $ 16,513,000     $ 16,099,000     $ 14,898,000     $ 19,874,000     $ 3,524,230     $ 4,048,187  

ADR

  $ 204.37     $ 176.31     $ 168.79     $ 161.66     $ 199.43     $ 162.62     $ 184.82  

Occupancy %

    91.0 %     83.8 %     83.7 %     82.5 %     89.2 %     84.0 %     84.9 %

RevPAR

  $ 185.98     $ 147.77     $ 141.35     $ 133.32     $ 177.85     $ 136.66     $ 156.98  

 

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Torrance Marriott

 

Location and Demand Generators:    The Torrance Marriott is located adjacent to the Del Amo Fashion Center mall, one of the largest malls in America, approximately ten miles from Los Angeles International Airport and less than two miles from the Pacific Ocean in the South Bay area of Los Angeles County. The hotel benefits from the fact that hotel room supply growth in Los Angeles has remained at relatively low levels, averaging only 0.62 percent per year between 1992 and 2003.

 

Torrance is a major automotive center. Three major Japanese automobile manufacturers, Honda, Nissan and Toyota, have their U.S. headquarters in the Torrance area and generate significant demand for the hotel. The hotel is also expected to benefit from the extensive renovation and expansion of the Del Amo Fashion Center mall, which was purchased by the Mills Corporation in 2003.

 

The Property:    We own a fee simple interest in the hotel. The hotel was completed in 1985 and includes 487 guestrooms, including 11 suites, within a 17-story building. The property includes over 700 parking spaces in a three-story parking deck adjacent to the hotel.

 

At the time of our acquisition, the hotel was managed by Marriott and owned by Host Marriott Corporation, or Host, which had the right to sell the hotel subject to a Marriott franchise agreement and terminate the Marriott management agreement. Marriott provided us with $3.0 million in key money as an inducement to enter into a long-term management agreement. The $3.0 million in key money is recoverable by Marriott, subject to a 10% reduction per year through 2014, in the event that the management agreement with Marriott terminates within 10 years and such termination is not a result of a default by Marriott. We successfully negotiated with Host to purchase both the Salt Lake City Marriott Downtown and the Torrance Marriott for a combined purchase price. We believe the Marriott key money was essential in our ability to win the bid for the two hotels because it allowed us to increase our bid for the properties.

 

We have developed an intensive capital improvement and repositioning plan for this hotel and plan to spend $10 million in 2005 and 2006, or almost $20,534 per room, to replace the guestroom softgoods, renovate the lobby, food and beverage outlets and meeting space, and convert the gift shop to a Starbuck’s outlet. We also see an opportunity to introduce new concepts for two of the property’s food and beverage outlets. We believe that our repositioning plan will allow this hotel to improve guest satisfaction, entice more group business, improve local catering sales and command higher rates.

 

Additional property highlights include:

 

Guestrooms:

 

    487 guestrooms, including 11 suites, 260 king rooms and 216 double/double rooms.

 

Meeting Space:

 

    Approximately 23,000 total square feet of indoor and outdoor meeting space;

 

    10,080 square foot Grand Ballroom and 19 meeting rooms; and

 

    7,000 square foot outdoor meeting pavilion.

 

Food and Beverage:

 

    Garden Court Restaurant;

 

    Pitcher’s Sports Bar; and

 

    Lobby Lounge.

 

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Other Amenities:

 

    Indoor/Outdoor Pool;

 

    Children’s Pool;

 

    Fitness Center;

 

    Jacuzzi;

 

    Car Rental Desk; and

 

    Barber/Beauty Shop.

 

Competition:    Competitor hotels include The Crowne Plaza Redondo Beach, Hilton Torrance, Hilton Carson Civic Plaza and Marriott Manhattan Beach. We compete with these hotels based on a number of factors, including location, brand, price, service and amenities, as well as property condition. The Torrance hotel market has been highly competitive, with the Redondo Beach Crowne Plaza and the Hilton Torrance being the primary competitors.

 

Operating and Occupancy Information

 

     Fiscal Year

    First Fiscal Quarter

 
     2000

    2001

    2002

    2003

    2004

    2004

    2005

 

Room Revenue

   $ 16,469,000     $ 15,837,000     $ 13,691,000     $ 13,171,000     $ 13,678,000     $ 3,108,958     $ 3,551,689  

ADR

   $ 107.49     $ 107.71     $ 91.69     $