Eagle Hospitality Properties Trust (EHP)

 
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Eagle Hospitality Properties Trust 10-K 2007
Form 10-K
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-K

 


ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the year ended December 31, 2006

Commission file number: 001-32279

EAGLE HOSPITALITY PROPERTIES TRUST, INC.

(Exact name of registrant specified in its charter)

 


 

Maryland   55-0862656
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)

100 E. RiverCenter Blvd., Suite 480, Covington, KY

(Address of principal executive office)

41011

(Zip Code)

(859) 581-5900

(Registrant’s telephone number, including area code)

 


Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class   Name of Each Exchange on
Which Registered
8 1/4% Series A Cumulative Redeemable
Preferred Stock, $.01 par value
  New York Stock Exchange
Common Stock, $.01 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  ¨        Accelerated Filer  x        Non-Accelerated Filer  ¨

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K.  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in rule 12b-2 of the Securities Exchange Act).    Yes  ¨    No  x

The Company has only one class of common stock, par value $0.01 per share. The aggregate market value of the shares of common stock held by non-affiliates (based upon the closing sale price of $9.18 on the New York Stock Exchange) on December 31, 2006 was approximately $153.9 million. There were 17,753,496 shares of common stock outstanding as of February 1, 2007.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement in connection with its Annual Meeting of Stockholders to be held May 1, 2007, are incorporated by reference in Part III, Items 10, 11, 12, 13 and 14 of the Form 10-K.

 



Table of Contents

EAGLE HOSPITALITY PROPERTIES TRUST, INC.

ANNUAL REPORT FOR THE YEAR ENDED DECEMBER 31, 2006

TABLE OF CONTENTS

 

          Page

PART I

     

Item 1.

  

Business

   4

Item 1A.

  

Risk Factors

   11

Item 1B.

  

Unresolved Staff Comments

   20

Item 2.

  

Properties

   20

Item 3.

  

Legal Proceedings

   22

Item 4.

  

Submission of Matters to a Vote of Security Holders

   22

PART II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   23

Item 6.

  

Selected Financial Data

   26

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   30

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   39

Item 8.

  

Financial Statements and Supplementary Data

   40

Item 9.

  

Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

   40

Item 9A.

  

Controls and Procedures

   40

Item 9B.

  

Other Information

   41

PART III

     

Item 10.

  

Directors, Executive Officers and Corporate Governance of the Registrant

   42

Item 11.

  

Executive Compensation

   42

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   42

Item 13.

  

Certain Relationships and Related Transactions

   42

Item 14.

  

Principal Accountant Fees and Services

   42

PART IV

     

Item 15.

  

Exhibits and Financial Statements Schedule

   43

 

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Forward-Looking Statements

We make forward-looking statements throughout this Form 10-K and documents incorporated herein by reference that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans, and objectives. Statements regarding the following subjects are forward-looking by their nature:

 

  ·  

our business and investment strategy;

 

  ·  

our projected operating results;

 

  ·  

completion of any pending transactions;

 

  ·  

our ability to obtain future financing arrangements;

 

  ·  

our understanding of our competition;

 

  ·  

market trends;

 

  ·  

projected capital expenditures, and

 

  ·  

the impact of technology on our operations and business.

The forward-looking statements are based on our beliefs, assumptions, and expectations of our future performance taking into account all information currently available to us. These beliefs, assumptions, and expectations can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity, and results of operations may vary materially from those expressed in our forward-looking statements. You should carefully consider this risk when you make an investment decision concerning our common stock. Additionally, the following factors could cause actual results to vary from our forward-looking statements:

 

  ·  

the factors discussed in this Form 10-K, including those set forth under the sections titled “Risk Factors,” “Management’s Discussion and Analysis of Financial Conditions and Results of Operations,” “Business,” and “Properties;”

 

  ·  

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

 

  ·  

changes in our business or investment strategy;

 

  ·  

availability, terms, and deployment of capital;

 

  ·  

availability of qualified personnel;

 

  ·  

changes in our industry and the market in which we operate, interest rates, or the general economy; and

 

  ·  

the degree and nature of our competition.

When we use the words “will likely result,” “may,” “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend,” or similar expressions, we intend to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. We are not obligated to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

 

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Item 1. Business

Our Company

Eagle Hospitality Properties Trust, Inc. (the “Company”) is a self-advised real estate investment trust (“REIT”) formed to pursue investment opportunities in the full-service and all-suites hotel industry. The Company commenced its operations effective as of October 1, 2004 when it completed its initial public offering (“IPO”) and acquired a 100% interest in eight hotels and a 49% interest in one other hotel (Embassy Suites Cincinnati–RiverCenter), all of which were previously owned or controlled by Corporex Companies LLC (“Corporex”). Because we had the right and obligation to acquire the remaining 51% interest in the entity that owned the Embassy Suites Cincinnati-RiverCenter from William P. Butler, the Company’s Chairman, no later than January 31, 2006 in exchange for 427,485 operating partnership units, the assets, liabilities and operations of such entity are included in our consolidated financial statements in accordance with the provisions in Financial Interpretation 46(R). The remaining 51% in this hotel was acquired on December 5, 2005 for 427,485 operating partnership units.

Our operating partnership, EHP Operating Partnership, L.P. (“EHP OP”) was organized as a limited partnership under the laws of the state of Maryland. The Company is the sole general partner of and owns approximately 74% of the limited partnership units in EHP OP. Limited partners (including certain of our officers and directors) own the remaining operating partnership units. After one year from the date the units are issued, limited partners may generally redeem each unit for the cash value of one share of our common stock or, at our sole option, one share of common stock.

EHP TRS Holding Co, Inc (“EHP TRS”), our taxable REIT subsidiary, was incorporated as a Maryland corporation. Except for our Embassy Suites Hotel and Casino San Juan, each of our hotel properties is leased to a wholly owned subsidiary of EHP TRS, which engages hotel management companies to manage and operate the hotels under management contracts. Under applicable REIT tax rules, neither we nor our operating partnership can directly undertake the daily management activities of our hotels. Therefore, our principal source of funds will be dependent on EHP TRS’s ability to generate cash flow from the operation of the hotels. EHP TRS is subject to income taxes at regular corporate rates on its taxable income.

The IPO consisted of the sale of 16,770,833 shares of common stock sold to the public at a price of $9.75 per share. The IPO generated net proceeds of approximately $149.3 million. In addition, 208,332 shares of common stock were issued to Corporex in connection with a strategic alliance entered into with Corporex and certain affiliates of Corporex granting us, among other things, an exclusive right of refusal to pursue certain investment opportunities identified by them in the future during the term of the agreement. 146,540 shares of common stock were issued to affiliates of Corporex in connection with the acquisition of two of our initial hotels. In addition, 5,566,352 operating partnership units were issued to Corporex and affiliates in connection with the acquisition of seven of our initial hotels. These operating partnership units are redeemable for the cash value of one share of our common stock or, at our sole option, one share of common stock. We also agreed to make earn-out payments totaling in the aggregate up to 833,333 additional operating partnership units, which will be payable over a three-year period to the original contributors of the Embassy Suites Hotel Columbus/Dublin, the Embassy Suites Hotel Cleveland/Rockside and the Embassy Suites Hotel Denver International Airport only if certain operating measurements are achieved on any trailing 12-month basis within three years from the contribution. At September 30, 2005, the Embassy Suites Hotel Denver International Airport achieved the required measurements and in accordance with the earn-out terms of the original acquisition agreement 250,000 additional operating partnership units were issued to the former owners of this hotel on December 5, 2005. At June 30, 2006, the Embassy Suites Hotel Columbus/Dublin achieved the required measurements and in accordance with the earn-out terms of the original acquisition agreement 83,333 additional operating partnership units were issued to the former owners of this hotel on July 24, 2006.

 

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On June 13, 2005, the Company issued 4,000,000 shares of 8 1/4% Cumulative Redeemable Series A Preferred Stock. The net proceeds of this issuance was $96.5 million. The proceeds were used to purchase hotel properties and for general corporate and working capital purposes.

As of February 1, 2007, we owned thirteen hotels, all of which are located in the United States. We currently have no foreign operations, and all of our hotels are full-service and all-suites hotels.

We maintain a website at www.eaglehospitality.com. On our website, we make available free-of-charge all of the documents that we file or furnish with the Securities and Exchange Commission as soon as reasonably practical. In addition, our Code of Business Conduct and Ethics and our Corporate Governance Guidelines are also available free-of-charge on our website.

All reports filed with the Securities and Exchange Commission may also be read and copied at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549. Further information regarding the operation of the public reference room may be obtained by calling 1-800-SEC-0330. In addition, all of our filed reports can be obtained at the SEC’s website at www.sec.gov.

Hotel Acquisitions

In addition to the nine hotels acquired in conjunction with the initial public offering in 2004, we acquired the following hotels in 2005 and 2006:

 

  ·  

the 270-room Embassy Suites Hotel Phoenix-Scottsdale for a net purchase price of $33.1 million on February 22, 2005;

 

  ·  

the 351-room Hilton Glendale in Glendale, California for a net purchase price of $77.5 million on June 23, 2005; and

 

  ·  

the 299-room Embassy Suites Hotel and Casino San Juan in San Juan, Puerto Rico for a net purchase price of $60.2 million on June 28, 2005.

 

  ·  

the 273-room Embassy Suites Boston at Logan International Airport in Boston, Massachusetts for a net purchase price of $53.4 million on July 21, 2006.

Each of these hotels fit into our defined acquisition strategy of acquiring upper-upscale hotels in high-barrier-to-entry urban and select resort locations. These acquisitions also helped us achieve the goal of diversifying our portfolio and reducing the reliance on our Midwest hotels.

Our Strategy

Our goal is to generate strong risk-adjusted returns on invested capital for our stockholders by consistently paying attractive dividends and achieving long-term appreciation in full-service, all-suites and boutique hotel investments. The Company seeks to fund a substantial percentage of new investments with capital “recycled” from the disposition of owned assets. Assets may be disposed of when potential acquisitions present themselves offering higher returns on the capital employed than the assets currently owned by the Company.

Internal Growth

Embedded Growth Within Our Portfolio of Full-Service and All-Suites Hotels.    Our portfolio is comprised of thirteen full-service and all-suites hotels encompassing 3,516 rooms all flagged by nationally recognized premier brands, including Embassy Suites Hotels, Marriott, Hyatt and Hilton. We believe that a number of our existing hotels present an opportunity for growth through aggressive asset management, property repositioning and capital improvements. During 2006, we continued extensive renovations at five of our hotels (Embassy Suites Tampa-Airport/Westshore, Hyatt Regency Rochester, Embassy Suites Hotel Phoenix-Scottsdale, Hilton Glendale and Embassy Suites Hotel and Casino San Juan).

 

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External Growth

We intend to be patient and highly selective in pursuing acquisition opportunities. We employ a disciplined methodology to identify and evaluate possible acquisition opportunities that maximize the returns on capital employed. Specifically, our acquisition strategy focuses on acquiring upper-upscale hotels in high-barrier-to-entry urban and select resort locations that also provide the benefit of geographic diversification within our portfolio.

Additional factors considered are those that are important indicators of future operating performance, such as:

 

  ·  

macroeconomic trends;

 

  ·  

hotel capital market environment;

 

  ·  

domestic and international travel patterns;

 

  ·  

geographic, economic and political barriers to entry;

 

  ·  

individual market economic and socioeconomic trends;

 

  ·  

local infrastructure to support growth;

 

  ·  

asset age and quality;

 

  ·  

potential and existing competition in the specific marketplace; and

 

  ·  

availability of premier brands in a given market.

Continued Focus on Full-Service and All-Suites Hotels with Premier Brands.    We pursue opportunities to acquire full-service and all-suites hotels under premier brands in geographically diversified primary, secondary and resort markets in the United States. We identify hotel acquisition opportunities that meet our quality and investment criteria. In addition, we may identify hotel acquisitions with a view to renovate and reposition a hotel, in which we reflag a hotel with a more competitive brand, or through selected development projects. Because our hotels operate in the full-service sector of the lodging industry, which generally has more operating leverage than limited service hotels, reduction in gross revenues generally has a magnifying downward effect on net operating income. Alternatively, when gross revenues increase, which we have experienced recently as lodging industry fundamentals improve, net operating income typically grows at a faster rate than revenue. We believe that this dynamic, which is often referred to in the industry as “profit flow-through,” impacts full service hotels more than limited service hotels. Because of profit flow-through, we believe that this targeted sector of the industry provides the best relative risk-adjusted returns for our stockholders.

Leverage our REIT Structure in Seeking Investment Opportunities.    We believe the value of our REIT structure, which provides us access to broad sources of capital but precludes us from operating hotels, provides us a competitive advantage over many real estate operators for new investment opportunities. We believe that we will be viewed by capable and experienced hotel operators as an attractive owner because we can provide professional, financially strong ownership and potentially allow the operators to continue to manage their hotels following our acquisition of them. These opportunities may arise, for example, when hotel operators consider the sale of one or more of their hotels, have impending financial maturities that create burdensome capital requirements or have financial sponsor buyout opportunities.

Management Expertise

Asset Management Expertise Supplements Our Hotel Managers.    We believe that we can enhance our financial performance through expert asset management. The incentive management fee compensation structure under our management agreements enables us to ensure that our third-party managers implement a disciplined capital maintenance program and a strategic marketing budget and operating plan.

 

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Senior Officers and Directors with Significant Experience and Ownership Stake.    Our team has significant experience in the areas of hotel operations, development, acquisition and financing. Our management’s strategy over the years has been driven by an in-depth knowledge and understanding of lodging industry fundamentals, identifying key industry trends, leveraging relationships with market-leading operators and franchisors, driving property level performance through active asset management and capital improvement programs and prudently financing investments to enhance investor value. As a result of the completion of the IPO, our senior officers and directors own approximately 20% of our outstanding common stock on a fully-diluted basis, which serves to align their economic interests with those of our shareholders.

Our Distribution Policy

In order to qualify as a REIT, we must generally make annual distributions to our stockholders of at least 90% of our REIT taxable income (which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). Distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our dividend policy will not change in the future. Our ability to pay distributions to our stockholders will depend, in part, upon our receipt of distributions from our operating partnership, which may depend upon receipt of lease payments with respect to our properties from the wholly-owned subsidiary of our operating partnership, EHP TRS, and, in turn, upon the management of our properties by our property managers. Distributions to our stockholders will generally be taxable to our stockholders as ordinary income. However, since a portion of our investments consist of equity ownership interests in hotels, which result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, we may maintain accumulated earnings of EHP TRS in that entity.

Our charter allows us to issue preferred stock with a preference on distributions. The partnership agreement of our operating partnership allows the operating partnership to issue units with a preference on distributions. The dividend preference according to the rights and preferences of our 8 1/4% Series A Cumulative Redeemable Preferred Stock and units could limit our ability to make a dividend distribution to our common stockholders.

Hotel Renovations

As part of the positioning of our hotels we feel that it is important to have a regular program of capital improvements, which helps to maintain and enhance the competitiveness of our hotels and maximizes the potential for earnings growth. During the year ended December 31, 2006, the Company invested approximately $10.7 million in completed or ongoing capital improvements at our hotels. We anticipate investing approximately $13.5-$16.5 million in additional capital improvements during 2007.

Our Competition

The hotel industry is highly competitive. Each of our hotels is located in a developed area that includes other hotel properties. Hence, our hotels compete for guests with other full-service or limited-service hotels in the immediate vicinity and, secondarily, with hotels in its geographic market. The future occupancy, average daily rate (“ADR”), and room revenue per available room (“RevPAR”) of any hotel could be materially and adversely affected by an increase in the number or quality of the competitive hotel properties in its market area. We believe that brand recognition, location, quality of the hotel and the services provided, and price are the principal competitive factors affecting our hotels.

Our Employees

At February 1, 2007, we had 12 full-time employees. The employees perform directly or through our operating partnership various acquisition, development, redevelopment, asset management and corporate

 

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management functions. All persons employed in the day-to-day operation of our hotels are employees of the management companies (or their affiliates) engaged by our lessees, and are not our employees.

Environmental Matters

Our hotel properties are subject to various federal, state and local environmental laws. Under these laws, courts and government agencies 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 did not cause the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of clean-up, 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 transports for disposal or treatment a hazardous substance at a property owned by another may be liable for the costs of removal or remediation of hazardous substances released into the environment at that property.

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

We have reviewed Phase I ESAs that were previously prepared for our hotels. Even though the Phase I ESA review did not reveal any material environmental contamination, with the exception of the Embassy Suites Boston, that might have a material adverse effect on our business, assets, results of operations or liquidity, we may have material environmental liabilities of which we are unaware. These Phase I ESAs do not necessarily protect us from CERCLA liabilities. The Phase I ESAs may not identify all potential environmental liabilities.

The Embassy Suites Boston, which we purchased on July 21, 2006, was originally constructed by a prior owner on a site with known environmental contamination. In connection with the acquisition, we hired an environmental engineer to review the original work and received certification from the original environmental engineer that all work was completed per the requirements of the Massachusetts Department of Environmental Protection Agency. A series of reports with the final report dated July 2003 indicates that proper remedial efforts had been undertaken during the development of the hotel and that no additional actions were required to be taken. However, no assurances can be provided that we will not be required to undertake remedial efforts in the future to address unknown environmental problems at this hotel or any of our other hotels. Any such expenses would reduce our net operating income and adversely affect our cash available for distributions.

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 can make no assurances that (1) future laws or regulations will not impose material environmental liabilities or (2) 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.

Further, 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

 

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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 significant mold at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property.

Insurance

We will maintain insurance on all of our hotels with insurance companies that are licensed to underwrite the type of insurance being issued in the jurisdiction in which such insurance policy will be delivered, including the following (subject, in some instances, to prior approval by our lenders):

 

  ·  

Insurance on the hotel, including contents, against loss or damage by fire, lightning and all other risks covered by usual standard, extended coverage endorsements with deductible limits in an amount not less than 100% of the replacement cost;

 

  ·  

Insurance against loss or damage from explosion of boilers, pressure vessels, pressure pipes and sprinklers installed in the hotel;

 

  ·  

Insurance on the hotel, including contents, against loss or damage by earth movement with deductible limits approved by our TRS in an amount reasonably determined by the TRS consistent with local market conditions;

 

  ·  

Business interruption insurance;

 

  ·  

Worker’s compensation and employer’s liability insurance;

 

  ·  

Terrorism insurance;

 

  ·  

Fidelity bonds in amounts and with deductible limits approved by our TRS;

 

  ·  

Comprehensive general public liability insurance;

 

  ·  

Crime insurance and errors and omissions insurance insuring our TRS against intentional or negligent acts or omissions with such carriers and under such policies as may be requested and approved by the TRS; and

 

  ·  

Such other insurance as is deemed advisable for protection against claims, liabilities or losses arising out of or connected with the operation of the hotel.

Insurance premiums and any costs or expenses with respect to such insurance (including deductibles for claims) are treated as deductions in determining operating profit.

Compliance with NYSE Corporate Governance Related Listing Standards

Each year, the chief executive officer of each company listed on the New York Stock Exchange must certify to the NYSE that he or she is not aware of any violation by the company of NYSE corporate governance listing standards as of the date of certification, qualifying the certification to the extent necessary. Last year, on May 30, 2006, the Company’s chief executive officer timely submitted the required certification, without qualification, to the NYSE.

In addition, NYSE listing standards obligate each NYSE-listed company to disclose that the Company filed with the SEC, as an exhibit to the company’s most recently filed Annual Report on Form 10-K, the certification regarding the quality of the company’s public disclosure required by Section 302 of the Sarbanes-Oxley Act of 2002. Attached as an exhibit to this Annual Report on Form 10-K is such certificate, and this Form 10-K and the certificate have been filed with the SEC.

 

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Our Franchise Licenses

We believe that the public’s perception of quality associated with a franchisor is an important feature in the operation of a hotel. Franchisors provide a variety of benefits for franchisees, which include national advertising, publicity, and other marketing programs designed to increase brand awareness, training of personnel, continuous review of quality standards, and centralized reservation systems. As of February 1, 2007, the Company operated thirteen hotels under the following franchise licenses:

Embassy Suites, a registered trademark of Hilton Hospitality, Inc.

Hilton Hotels, a registered trademark of Hilton Hospitality, Inc.

Hyatt Regency, a registered trademark of Hyatt Corporation

Marriott, a trademark of Marriott International, Inc.

We anticipate that most of the additional hotels we acquire will be operated under franchise licenses as well.

Our management companies must operate each hotel pursuant to the terms of the related franchise agreement, and must use their best efforts to maintain the right to operate each hotel as such. In the event of termination of a particular franchise agreement, our management companies must operate the effected hotels under such other franchise agreement, if any, as we enter into or obtain as franchisee.

The franchise licenses generally specify certain management, operational, recordkeeping, accounting, reporting, and marketing standards and procedures with which the franchisee must comply, including requirements related to:

 

  ·  

training of operational personnel;

 

  ·  

safety;

 

  ·  

maintaining specified insurance;

 

  ·  

the types of services and products ancillary to guest room services that may be provided;

 

  ·  

display of signage; and

 

  ·  

the type, quality, and age of furniture, fixtures, and equipment included in guest rooms, lobbies, and other common areas.

Seasonality

Although our hotel property acquisitions made after the IPO have added to the geographical diversity of our portfolio, virtually all of our properties’ operations historically have shown a seasonal pattern. This seasonality pattern can be expected to cause fluctuations in our quarterly lease revenue under the percentage leases. We anticipate that our cash flow from the operation of the properties will be sufficient to enable us to make quarterly distributions to maintain our REIT status. To the extent that cash flow from operations is insufficient during any quarter due to temporary or seasonal fluctuations in lease revenue, we expect to utilize other cash on hand or borrowings to make required distributions. However, we cannot make any assurances that we will make distributions in the future.

 

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Item 1A. Risk Factors

An investment in our stock involves various risks. You should carefully consider the following risk factors in conjunction with the other information contained herein before purchasing our stock. The risks discussed herein can adversely affect our business, liquidity, operating results, and financial condition. This could cause the market price of our stock to decline and could cause you to lose all or part of your investment. The risk factors described below are not the only risks that may affect us. Additional risks and uncertainties not presently known to us also may adversely affect our business, liquidity, operating results, and financial condition.

Risks Related to Our Business

Interest rate increases may increase our interest expense.

As of December 31, 2006, approximately $89.7 million of our long-term debt, or 35%, was in variable interest rate loans. An increase in interest rates could increase the Company’s interest expense which in turn could negatively effect our earnings and ability to make shareholder distributions.

Conflicts of interest could result in our management acting other than in our stockholders’ best interest.

Conflicts of interest relating to Commonwealth Hotels, Inc. may lead to management decisions that are not in the stockholders’ best interest. The chairman of our board of directors, Mr. William P. Butler, serves as the chairman of the board of directors of Commonwealth. Mr. Butler owns 85% of Commonwealth. One of our directors, Mr. Thomas Banta, is also on Commonwealth’s board of directors and is employed by Corporex. Commonwealth manages nine of our hotels and may provide related services and continue to provide property management services, fee development services and occasional property identification services for third parties. Additionally, Mr. Butler, through his interests in Corporex and its affiliates, including Commonwealth, owns interests in or otherwise has an interest in the performance of several lodging properties that are not full-service and all-suites hotels and that are not owned or controlled by our operating partnership.

Mr. Butler’s ownership interest in and management obligations to Commonwealth and Mr. Banta’s relationships with Commonwealth and Corporex will present them with conflicts of interest in making management decisions related to the commercial arrangements between us and Commonwealth.

We have entered into 10-year management agreements with Commonwealth relating to nine of our hotels. Since Mr. Butler controls Commonwealth, the management agreements were not negotiated in arm’s length transactions. Each management agreement describes the terms of Commonwealth’s management of one of the hotels. Under certain circumstances, if we terminate a management agreement as to one of the hotels, we will be required to pay Commonwealth a potentially significant termination fee. As the majority owner of Commonwealth which would receive any development, management and management termination fees payable by us under the management agreements, Mr. Butler may influence our decisions to sell a hotel or acquire or develop a hotel when it is not in the best interests of our stockholders to do so.

Commonwealth will have a right of first refusal to manage all hotels that we acquire in the future, unless the acquisition opportunity was not known to us and has been brought to us by another pre-qualified management company or a majority of our independent directors decides in good faith for valid business reasons to use another management company. As a result of his ownership interest in and management obligations to Commonwealth, Mr. Butler’s relationship with Commonwealth may present a conflict of interest in our decision to sell a hotel or acquire or develop a hotel.

Holders of units in our operating partnership, including members of our management team, may suffer adverse tax consequences upon our sale or refinancing of certain properties. Therefore, holders of units, either directly or indirectly, including Messrs. Butler and Blackham, may have different objectives

 

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than holders of our common stock regarding the appropriate pricing and timing of a property’s sale or timing and amount of a property’s refinancing. These officers and directors of ours may influence us not to sell or refinance certain properties, even if such sale or refinancing might be financially advantageous to our stockholders, or to enter into tax-deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in our best interest.

Tax indemnification obligations, which apply in the event that we sell certain properties, could limit our operating flexibility.

If we dispose of any of our initial nine hotels (other than the Embassy Suites Hotel Tampa-Airport/Westshore and the Hyatt Regency Rochester), we would be obligated to indemnify the original contributors (including their permitted transferees and persons who are taxable on the income of a contributor or permitted transferee) against certain tax consequences of the sale. We have agreed to pay a contributor’s tax liability with respect to gain allocated to the contributor under Section 704(c) of the Internal Revenue Code if we dispose of a property contributed by the contributor in a taxable transaction during a “protected period,” which continues until the earlier of:

 

  ·  

10 years after the contribution of such property; and

 

  ·  

the date on which the contributor no longer owns, in the aggregate, at least 25% of the units we issued to the contributor at the time of its contribution of property to our operating partnership.

This tax indemnity will be equal to the amount of the federal and state income tax liability the contributor incurs with respect to the gain allocated to the contributor upon such sale. The terms of the contribution agreements also require us to gross up the tax indemnity payment for the amount of income taxes due as a result of the tax indemnity payment. While the tax indemnities do not contractually limit our ability to conduct our business in the way we desire, we are less likely to sell any of the contributed properties in a taxable transaction during the indemnity period. Instead, we would either hold the property for the entire indemnity period or seek to transfer the property in a tax-deferred like-kind exchange. In addition, a condemnation of one of our properties could trigger our tax indemnification obligations.

If we were to have sold in a taxable transaction all seven of the initial hotels contributed to us in exchange for operating partnership units immediately after the closing of the IPO, our estimated total tax indemnification obligation to our indemnified contributors, including the gross-up payment, would have ranged between $45 million and $75 million. In addition, under certain of the tax indemnification agreements, we have agreed to use commercially reasonable efforts during the protected period to make available to the contributors opportunities to guarantee liabilities of our operating partnership, which will allow the contributors to defer recognition of gain in connection with the contribution of these seven hotels.

Hotel franchise requirements could increase our operating costs and lower our net income.

We must comply with operating standards and terms and conditions imposed by the franchisors of the hotel brands under which our hotels, including any hotels we may acquire in the future, operate as well as any hotels we may acquire in the future. The franchisors periodically inspect their licensed hotels to confirm adherence to their operating standards. The failure of a hotel to maintain standards could result in the loss or cancellation of a franchise license. With respect to operational standards, we rely on our outside property managers to conform to such standards. The franchisors may also require us to make certain capital improvements to maintain the hotel in accordance with system standards, the costs of which can be substantial. It is possible that a franchisor could condition the continuation of a franchise on the completion of capital improvements that our management or board of directors determines are too expensive or otherwise not economically feasible in light of general economic conditions or the operating results or prospects of the affected hotel. In that event, our management or board of directors may elect to allow the franchise to lapse or be terminated, which could result in a change in branding or in the operation of the hotel as an independent, unbranded hotel.

 

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In addition, when the term of a franchise expires, the franchisor has no obligation to issue a new franchise. The loss of a franchise could significantly decrease the revenues at the hotel and reduce the underlying value of the affected hotel due to the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. The loss of a franchise could also reduce our cash available for distribution to stockholders.

Our returns depend on management of our hotels by third parties.

In order to qualify as a REIT, we cannot operate our hotel properties or participate in the decisions affecting the daily operations of our hotels. Our TRS may not operate the leased hotels and, therefore, it must enter into management agreements with eligible independent contractors that are not our subsidiaries or otherwise controlled by us to manage the hotels. Thus, independent hotel operators, under management agreements with our TRS, control the daily operations of our hotels.

Under the terms of the management agreements that we have with Commonwealth, Hyatt Corporation, Hilton Hotels Corporation and Prism Hotels our ability to participate in operating decisions regarding the hotels is limited. We will depend on these independent management companies to adequately operate our hotels on a daily basis as provided in the management agreements. Even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, ADR, and RevPAR, we may not be able to force the management company to change its method of operation of our hotels. We can only seek redress if a management company violates the terms of the applicable management agreement with the TRS, and then only to the extent of the remedies provided for under the terms of the management agreement, which in the case of nine of our hotels were not negotiated on an arm’s length basis. Additionally, in the event that we need to replace any of our management companies, we may be required by the terms of the management agreement to pay substantial termination fees and may experience significant disruptions at the affected hotels. Furthermore, since Commonwealth manages nine of our hotels, any disruption in our relationship could result in lower revenues or higher operating costs, either of which would result in lower net income.

Geographic concentration of our hotels makes our business vulnerable to economic downturns in Ohio, particularly in the Cincinnati metropolitan area.

Five of our hotels are located in Ohio and Kentucky, three of which are located in the Cincinnati metropolitan area. Although our external growth strategy is focused on geographically diversifying our asset base, economic and real estate conditions in Ohio, particularly in Cincinnati, will significantly affect our revenues and the value of our hotels for the foreseeable future. Business layoffs or downsizing, industry slowdowns, changing demographics and other similar factors may adversely affect the economic climate in Ohio. Any resulting oversupply or reduced demand for hotels in Ohio would therefore have a disproportionate negative impact on our revenues and limit our ability to make distributions to stockholders.

We may be unable to generate sufficient revenue from operations to pay our operating expenses and to pay distributions to our stockholders.

As a REIT, we are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction and by excluding net capital gain, each year to our stockholders. In the event of future downturns in our operating results and financial performance or unanticipated capital improvements to our hotels, including capital improvements which may be required by our franchisors, 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 financial performance, debt service obligations and debt covenant compliance and capital expenditure requirements. We cannot assure you that we will be able to generate sufficient cash to fund

 

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distributions. Furthermore, if our operating performance suffers, our cash available for distribution could be less than 90% of our REIT taxable income. In this event, we would either be required to borrow funds to pay the distribution or lose our REIT status.

Future debt service obligations could adversely affect our overall 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.

At December 31, 2006, we have $253.5 million in consolidated debt. We and our subsidiaries may be able to incur substantial additional debt, including secured debt, in the future. Incurring debt could subject us to many risks, including the risks that:

 

  ·  

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

 

  ·  

our debt may increase our vulnerability to adverse economic and industry conditions;

 

  ·  

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

 

  ·  

the terms of any refinancing will not be as favorable as the terms of the debt being refinanced.

If we violate covenants in our 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 attractive terms, if at all.

If we incur or 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 would lower our cash flow, and, consequently, 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 hotels on disadvantageous terms, potentially resulting in losses that reduce cash flow from operating activities. We may place additional mortgages on our hotels to secure a line of credit that we expect to obtain prior to the closing of the offering or other debt. To the extent we cannot meet our debt service obligations, we risk losing some or all of those hotels to foreclosure. Also, covenants applicable to our debt could impair our planned strategies and, if violated, result in a default of our debt obligations, which could cause us to seek protection under the bankruptcy laws and likely would result in a total loss of a stockholder’s investment.

Risks Related to Hotel Investments

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

Our hotel properties will require periodic capital expenditures and renovation to remain competitive. The lenders under some of our mortgage debt agreements require us to set aside varying amounts each year for capital improvements at our hotels. Acquisitions or development of additional hotel properties will require significant capital expenditures. We may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we must distribute at least 90% of our REIT taxable income each year to maintain our REIT tax status. Consequently, we will rely upon the availability of debt or equity capital to fund hotel acquisitions and improvements. As a result, our ability to fund capital expenditures, acquisitions or hotel development through retained earnings will be limited. Our ability to grow through acquisitions or development of hotels will be limited if we cannot obtain satisfactory debt or equity

 

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financing, which will depend on market conditions. Neither our charter nor our bylaws limits the amount of debt that we can incur. However, we cannot assure you that we will be able to obtain additional equity or debt financing or that we will be able to obtain such financing on favorable terms.

Uninsured and underinsured losses could reduce our net income and limit our ability to make distributions to our stockholders.

We intend to maintain comprehensive insurance on each of our hotels, including liability, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. There are no assurances that current coverage will continue to be available at reasonable rates. In addition, there are certain types of losses that management, such as flood or hurricane insurance, may decide not to insure against since the cost of insuring is not economical. The Company may suffer losses that exceed its insurance coverage, particularly to the extent any of our policies do not cover 100% of the replacement cost.

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 hotels in our portfolio in response to changing economic, financial and investment conditions is limited. The real estate market is affected by many factors that are beyond our control, including:

 

  ·  

adverse changes in national 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 and other ordinances and costs of compliance with laws and regulations;

 

  ·  

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

 

  ·  

changes in operating expenses; and

 

  ·  

civil unrest, terrorism, acts of war and natural disasters, including earthquakes and floods, which may result in uninsured and underinsured losses.

We may decide to sell our hotels in the future. We cannot predict whether we will be able to sell any property 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 property.

We may be required to expend funds to correct defects or to make improvements before a 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 property, we may agree to lock-out provisions that materially restrict us from selling that 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 property or an indemnification of adverse tax consequences to sellers. We have entered into such agreements with respect to seven of initial hotels with the contributors of those hotels. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could reduce our net income and limit our ability to pay distributions to stockholders.

The costs of compliance with or liabilities under environmental laws may harm our operating results.

Our hotels may be subject to environmental liabilities. An owner of real property can face liability for environmental contamination created by the presence or discharge of hazardous substances on the property. We may face liability regardless of:

 

  ·  

our knowledge of the contamination;

 

  ·  

the timing of the contamination;

 

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  ·  

the cause of the contamination; or

 

  ·  

the party responsible for the contamination of the property.

We have reviewed Phase I environmental reports for all of our hotels. Most of these Phase I environmental reports were conducted within the last eight years, though we have relied upon older Phase I environmental reports for some of our hotels. These Phase I environmental reports do not protect us as the purchaser of the properties from liabilities under the Comprehensive Environmental Response Compensation and Liability Act of 1980, or “CERCLA.” Although none of these Phase I environmental reports identified any material contamination at any of our hotels, with the exception of the Embassy Suites Boston, the Phase I environmental reports do not identify potential unknown material environmental liabilities.

The Embassy Suites Boston, which we purchased on July 21, 2006, was originally constructed by a prior owner on a site with known environmental contamination. In connection with the acquisition, we hired an environmental engineer to review the original work and received certification from the original environmental engineer that all work was completed per the requirements of the Massachusetts Department of Environmental Protection Agency. A series of reports with the final report dated July 2003 indicates that proper remedial efforts had been undertaken during the development of the hotel and that no additional actions were required to be taken. However, no assurances can be provided that we will not be required to undertake remedial efforts in the future to address unknown environmental problems at this hotel or any of our other hotels. Any such expenses would reduce our net operating income and adversely affect our cash available for distributions.

The presence of hazardous substances on a property may cause a decline in the value of that property and we may incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could increase our operating costs and limit our ability to pay distributions to stockholders.

Our hotels may unknowingly 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 significant mold 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, the presence of significant mold could expose us to liability from our guests, employees of ours or of our property managers and others if property damage or health concerns arise.

Actions by organized labor could increase our hotel management expenses.

Employees of third-party hotel management companies that we have contracts with to manage our hotels in certain locations have been approached by members of local organized labor constituencies. Potential labor activities at these hotels could increase the administrative, labor and legal expenses of the third-party hotel management companies managing these hotels. Any additional expenses related to potential union activities could in turn increase the reimbursements to the management companies pursuant to the terms of the contracts we have with those management companies. In addition, potential labor activities could cause the diversion of business to hotels that are not involved in similar labor activities resulting in the loss of group business in the affected cities. Any of these potential consequences to labor activities could result in lower revenues or higher operating costs, either of which would result in lower net income.

 

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Risks Related to Our Status as a REIT

If we do not qualify as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.

We operate so as to qualify as a REIT under the Internal Revenue Code. However, qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT status. If we fail to qualify as a REIT in any tax year, then:

 

  ·  

we would be taxed as a regular domestic corporation, which, among other things, means being unable to deduct distributions to stockholders in computing taxable income and being subject to federal income tax on our taxable income at regular corporate rates;

 

  ·  

any resulting tax liability could be substantial and would reduce the amount of cash available for distribution to stockholders; and

 

  ·  

unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and, thus, our cash available for distribution to stockholders would be reduced for each of the years during which we did not qualify as a REIT.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets. For example:

 

  ·  

We will be required to pay tax on undistributed REIT taxable income.

 

  ·  

We may be required to pay “alternative minimum tax” on our items of tax preference.

 

  ·  

If we have net income from the disposition of foreclosure property held primarily for sale to customers in the ordinary course of business or other non-qualifying income from foreclosure property, we must pay tax on that income at the highest corporate rate.

 

  ·  

If we sell a property in a “prohibited transaction,” our gain from the sale would be subject to a 100% penalty tax. A “prohibited transaction” would be a sale of property, other than a foreclosure property, held primarily for sale to customers in the ordinary course of business.

 

  ·  

Our TRS is a fully taxable corporation and will be required to pay federal and state taxes on its income, which will consist of the revenues from the hotels leased from the operating partnership, net of the operating expenses for such hotels and rent payments to us.

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. We may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of generating strong risk-adjusted returns on invested capital for our stockholders.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

To qualify as a REIT, we must also ensure that at the end of each calendar quarter at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment in securities (other than government securities and qualified real estate

 

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assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and no more than 20% of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries. If we fail to comply with these requirements at the end of any calendar quarter, we must correct such failure within 30 days after the end of the calendar quarter to avoid losing our REIT status and suffering adverse tax consequences. As a result, we may be required to liquidate otherwise attractive investments.

Complying with REIT requirements may force us to borrow to make distributions to stockholders.

As a REIT, we must distribute at least 90% of our annual REIT taxable income (determined without regard to the dividends paid deduction and excluding net capital gain) to our stockholders. To the extent that we satisfy the 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.

From time to time, we may generate taxable income greater than our net income for financial reporting purposes, or our taxable income may be greater than our cash flow available for distribution to stockholders. If we do not have other funds available in these situations, we could be required to borrow funds, sell investments at disadvantageous prices or find another alternative source of funds to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce the market price of our common stock.

Risk Factors Related to Our Corporate Structure

There are no assurances of our ability to make distributions in the future.

We intend to make quarterly distributions to our stockholders in amounts such that all or substantially all of our taxable income in each year, subject to certain adjustments, is distributed. This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. However, our ability to pay distributions may be adversely affected by the risk factors described herein. All distributions will be made 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. There are no assurances of our ability to pay distributions in the future. In addition, some of our distributions may include a return of capital.

Because provisions contained in Maryland law and our charter may have an anti-takeover effect, investors may be prevented from receiving a “control premium” for their shares.

Provisions contained in our charter and Maryland general corporation law may have effects that delay, defer or prevent a takeover attempt, which may prevent stockholders from receiving a “control premium” for their shares. For example, these provisions may defer or prevent tender offers for our common stock or purchases of large blocks of our common stock, thereby limiting the opportunities for our stockholders to receive a premium for their common stock over then-prevailing market prices. These provisions include the following:

 

  ·  

Ownership limit:    The ownership limit in our charter limits related investors, including, among other things, any voting group, from acquiring over 9.8% of our common stock without our permission.

 

  ·  

Preferred stock:    Our charter authorizes our board of directors to issue preferred stock in one or more classes and to establish the preferences and rights of any class of preferred stock issued.

 

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These actions can be taken without soliciting stockholder approval. The issuance of preferred stock could have the effect of delaying or preventing someone from taking control of us, even if a change in control were in our stockholders’ best interests.

Maryland statutory law provides that an act of a director relating to or affecting an acquisition or a potential acquisition of control of a corporation may not be subject to a higher duty or greater scrutiny than is applied to any other act of a director. Hence, directors of a Maryland corporation may not be required to act in takeover situations under the same standards as apply in Delaware and other corporate jurisdictions.

Preferred stock or future offerings of debt securities, which would be senior to our common stock upon liquidation, or equity securities, which would dilute our existing stockholders and may be senior to our common stock for the purposes of distributions, may cause the market price of our common stock to decline.

On June 13, 2005 we issued 4,000,000 shares of 8 1/4% Series A Cumulative Preferred stock. 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 additional classes of preferred stock or common stock. 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. Our preferred stock, could have a preference on liquidating distributions or a preference on dividend 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 offerings reducing the market price of our common stock and diluting their stock holdings in us.

Common stock eligible for future sale may cause our share price to decline.

We cannot predict the effect, if any, of future sales of common stock, or the availability of common stock for future sales, on the market price of our common stock. Sales of substantial amounts of common stock (including more than 6,000,000 shares of common stock issuable upon the conversion of operating partnership units), or the perception that these sales could occur, may adversely affect prevailing market prices for our common stock.

We also may issue from time to time additional shares of common stock or units of our operating partnership in connection with the acquisition of hotels, and we expect to grant demand or piggyback registration rights in connection with these issuances. Sales of substantial amounts of our common stock or the perception that these sales could occur may have the effect of putting downward pressure on the prevailing market price for our common stock or may impair our ability to raise capital through a sale of additional equity securities.

We depend on key personnel with long-standing business relationships, the loss of whom could threaten our ability to operate our business successfully.

Our future success depends, to a significant extent, upon the continued services of our management team. In particular, the lodging industry experience of Mr. Butler, our non-executive chairman, Mr. Blackham, our chief executive officer, Mr. Martz, our chief financial officer, Mr. Guernier, our senior vice-president acquisitions and the extent and nature of the relationships they have developed with hotel franchisors, operators and owners and hotel lending and other financial institutions are critically important to the success of our business. We do not maintain key person life insurance on any of our officers.

 

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Although these officers currently have employment agreements with us, we cannot assure you of the continued employment of all of our officers. The loss of services of one or more members of our corporate management team would limit our ability to acquire additional hotels and could result in increased operating costs.

The ability of our board of directors to change our major corporate policies may not be in your interest.

Our board of directors determines our major corporate policies, including our acquisition, financing, growth, operations and distribution policies. Our board may amend or revise these and other policies from time to time without the vote or consent of our stockholders.

Our Chairman and his affiliates beneficially own approximately 20% of our common stock on a fully diluted basis and exercise significant control over our company and may delay, defer or prevent us from taking actions that would be beneficial to our other stockholders.

William P. Butler, our Chairman, and his affiliates own approximately 20% of the outstanding shares of our common stock on a fully diluted basis. Accordingly, Mr. Butler may be able to exercise significant control over the outcome of substantially all matters required to be submitted to our stockholders for approval, including decisions relating to the election of our board of directors and the determination of our day-to-day corporate and management policies. In addition, Mr. Butler is able to exercise significant control over the outcome of any proposed merger or consolidation of our company, which would require the affirmative vote of the holders of a majority of the outstanding shares of our common stock. Mr. Butler’s ownership interest in our company may discourage third parties from seeking to acquire control of our company, which may cause the market price of our common stock to decline.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The following table sets forth information for each of our hotels owned as of December 31, 2006:

 

Hotel

 

Location

 

Hotel Managed by

  # of Rooms

Cincinnati Landmark Marriott

  Covington, KY   Commonwealth   321

Hilton Cincinnati Airport

  Florence, KY   Commonwealth   306

Hyatt Regency Rochester

  Rochester, NY   Hyatt Corporation   336

Chicago Marriott Southwest at Burr Ridge

  Burr Ridge, IL   Commonwealth   184

Embassy Suites Hotel Cincinnati-RiverCenter

  Covington, KY   Commonwealth   226

Embassy Suites Hotel Columbus/Dublin

  Dublin, OH   Commonwealth   284

Embassy Suites Hotel Cleveland/Rockside

  Independence, OH   Commonwealth   271

Embassy Suites Hotel Denver-International Airport

  Denver, CO   Commonwealth   174

Embassy Suites Hotel Tampa-Airport/Westshore

  Tampa, FL   Commonwealth   221

Embassy Suites Hotel Phoenix-Scottsdale

  Phoenix, AZ   Commonwealth   270

Hilton Glendale

  Glendale, CA   Hilton Hotels Corporation   351

Embassy Suites Hotel & Casino San Juan

  San Juan, PR   Hilton Hotels Corporation   299

Embassy Suites Hotel Boston at Logan International Airport

  Boston, MA   Prism Hotels   273
       

Total Rooms

      3,516
       

 

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We own these hotels in fee simple except for the Cincinnati Landmark Marriott and the Embassy Suites Hotel Cincinnati-RiverCenter, which are owned pursuant to air rights leases with the Commonwealth of Kentucky and the City of Covington, Kentucky that expire in 2150 and 2140 (including all extensions), respectively, the Hyatt Regency Rochester, which is owned pursuant to a ground lease with the County of Monroe Industrial Development Agency that expires in 2020, at which time we have the option to purchase the property for $1.00, and the Embassy Suites Boston at Logan International Airport, which is owned pursuant to a ground lease with Yebba Brothers LLC that expires in 2099.

On June 23, 2005, we acquired the Hilton Glendale in Glendale, California. The previous owner of the Hilton Glendale had a loan with the Glendale Redevelopment Agency (“GRA”). This loan had a participating feature in which the GRA would receive 1.5% of revenues above certain thresholds through 2018 and 2.0%, thereafter. The loan was paid off by the previous owner at the time we purchased the hotel and the intent was that the previous owner would enter into a cash buyout agreement of the participating feature of the loan with the GRA. This agreement was not finalized and in accordance with the hotel purchase agreement the previous owner refunded $2.5 million of the initial purchase price to us on April 13, 2006. As a buyout agreement was not reached we remain subject to the participating feature. We do not anticipate the participation payments to be of a material nature to our financial statements in the near term.

As of December 31, 2006, we owned thirteen hotels. The following table sets forth information regarding the material mortgages against the hotels (dollars in thousands):

 

Property

 

Name of Property-
Owning Entity

  Principal
Balance as of
December 31,
2006
 

Prepayment/
Defeasance

 

Interest Rate

 

Maturity
Date

 

Amortization
Provisions

Prudential Loan (Tranche A) (1)

 

N/A

  $ 57,163  

If paid 90 days before the loan matures then the greater of 1% outstanding principal balance or Yield Maintenance (2)

 

5.43%

 

March 5, 2010

 

$354 of monthly interest and principal. Balloon payment of $53,000 at maturity.

Prudential Loan (Tranche B) (1)

 

N/A

  $ 23,714  

No prepayment penalty after March 2007

 

1.75% + LIBOR

 

March 5, 2010

 

$145 of monthly interest and principal. Balloon payment of $22,000 at maturity.

Hilton Glendale

  EHP Glendale, LLC   $ 53,100   No defeasance permitted until July 2007; no penalty thereafter   5.21%  

July 7,

2012

  Monthly interest payments, Balloon payment of $53.100 at maturity

Embassy Suites
Hotel San Juan

 

EHP San Juan Suites, LLC

  $ 38,200  

No defeasance permitted until June 2007; no penalty thereafter

 

5.135%

 

September 7, 2012

 

Monthly interest payments until 4/1/08; thereafter $226 of monthly interest and principal payments. Balloon payment of $35,000.

Hyatt Rochester

  EHP Rochester Hotel, LLC   $ 15,328   Greater of 1% outstanding principal balance or Yield Maintenance (2)   7.28%   September1, 2008   Monthly payments of principal and interest of $130. Balloon payment of $14,592 at maturity.

(1) Prudential loans collateralize Cincinnati Marriott Landmark, Embassy Suites Hotel Tampa, and Embassy Suites Hotel Independence.
(2) Yield maintenance means a payment equal to the present value of the difference (if any) between the remaining schedule payments of principal and interest and the remaining payments of principal, assuming the U.S. Treasury interest rate applicable to the date of each remaining principal payment.

 

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In addition to the mortgage debt, the Company has an unsecured $110 million revolving line of credit that expires January 1, 2009. As of December 31, 2006, the Company had $66.0 million drawn on the line of credit. The interest rate on the loan is currently 2.50%, plus LIBOR, although the spread is variable depending upon certain financial metrics of the Company. Also, the Company has a loan for a shuttle van that matures in July, 2007. The ending principal balance as of December 31, 2006 was approximately $14,000. The monthly interest and principal payment is $2,016 with a fixed interest rate of 5.1%.

Participating Lease

The Embassy Suites Hotel & Casino San Juan is subject to a participating lease with a third party lessor. Under the terms of the lease we derive income from a base rent amount as well as participating rent based upon fixed percentages of revenue exceeding certain thresholds. We are currently evaluating the desirability of maintaining the current lease structure for this hotel. As part of this lease we are responsible for maintaining a reserve for capital improvements and payment for all capital improvements to the property. The lessee is responsible for the payment of all insurance and taxes on the property.

Ownership and Insurance

We own our hotels in fee simple except for the Cincinnati Landmark Marriott and the Embassy Suites Hotel Cincinnati-RiverCenter, which are owned pursuant to air rights leases with the Commonwealth of Kentucky and the City of Covington, Kentucky that expire in 2150 and 2140 (including all extensions), respectively, the Hyatt Regency Rochester, which is owned pursuant to a ground lease with the County of Monroe Industrial Development Agency that expires in 2020, at which time we will purchase the property for $1.00 and the Embassy Suites Boston at Logan International Airport, which is owned pursuant to a ground lease with Yebba Brothers LLC that expires in 2099. We believe that each of these properties is adequately covered by insurance. However, we have not obtained owners’ title policies with respect to every hotel and may incur liabilities as a result.

Item 3. Legal Proceedings

We are not involved in any material litigation nor, to our knowledge, is any material litigation threatened against us.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2006.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock is traded on the New York Stock Exchange under the symbol “EHP”. The following table sets forth for 2005 and 2006 the high and low closing sale prices for our common stock, as traded on that exchange and the cash distributions that occurred per share.

 

     High    Low    Distribution

First Quarter 2005

   $ 10.26    $ 8.97    $ 0.175

Second Quarter 2005

   $ 9.62    $ 8.76    $ 0.175

Third Quarter 2005

   $ 10.32    $ 9.27    $ 0.175

Fourth Quarter 2005

   $ 9.89    $ 7.42    $ 0.175

First Quarter 2006

   $ 10.08    $ 7.63    $ 0.175

Second Quarter 2006

   $ 9.99    $ 8.78    $ 0.175

Third Quarter 2006

   $ 9.71    $ 8.73    $ 0.175

Fourth Quarter 2006

   $ 9.99    $ 9.05    $ 0.175

* On January 16, 2007 a distribution of $0.175 per share was made to all common stockholders and operating partnership unit holders of record as of December 29, 2006.

 

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Stock Price Performance Graph

The following chart compares the cumulative total shareholder return, assuming that all dividends are reinvested, on the Company’s common stock with the cumulative total return of the S&P 500 Index and the cumulative total return of the NAREIT Equity REIT Index for the same period. The Stock price performance graph assumes an investment of $100 in Eagle and the two indices on October 1, 2004, the date of our initial public offering, through December 31, 2006.

LOGO

 

     10/1/04    12/31/04    12/31/05    12/31/06

Eagle

   $ 100.00    $ 100.49    $ 81.90    $ 106.08

NAREIT

   $ 100.00    $ 113.24    $ 127.02    $ 171.55

S&P 500

   $ 100.00    $ 107.11    $ 110.32    $ 125.35

Stockholder Information

As of February 1, 2007, we had approximately 5,200 record holders of our common stock. In order to comply with certain requirements related to our qualification as a REIT, our charter limits the number of common shares that may be owned by any single person or affiliated group to 9.8% of the outstanding common shares.

Dividend Information

During 2006, we paid $0.70 per common share in distributions. Approximately 20% of these distributions are a return of capital for tax purposes. These distributions occurred in January, April, July and October to our common shareholders and the operating partnership unit holders at $0.175 per distribution.

During 2006, we paid approximately $1.546875 per preferred share in distributions. The distributions are taxable as ordinary income and occurred in March, June and September at $0.515625 per distribution.

 

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The declaration of distributions by the Company is in the sole discretion of our Board of Directors and is influenced by the Company’s financial condition, liquidity, compliance with the REIT status and other relevant factors.

Equity Compensation Plans Information

The following table sets forth the information regarding our equity compensation plans as of December 31, 2006:

 

     Number of Securities
to be Issued Upon
Exercise of Outstanding
Options, Warrants,
and Rights
    Weighted-Average
Exercise Price of
Outstanding
Options, Warrants,
and Rights
   Number of Securities
Remaining Available
for Future Issuance

Equity compensation plans approved by security holders:

       

Restricted stock

   302,848 (1)   NA    608,832

Equity compensation plans not approved by security holders

   None     None    None

(1) Shares have been issued but only 117,665 have vested.

Sales of Unregistered Securities

On October 6, 2004, the Company issued 146,540 shares of common stock in a private offering pursuant to Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”) as partial consideration for the single-purpose entities that own two of our initial hotels. Each of the purchasers of the common stock was an accredited investor under Rule 501 of the Securities Act.

On October 6, 2004, the Company issued 208,332 shares of common stock to Corporex in a private offering pursuant to Section 4(2) of the Securities Act. The shares were issued to Corporex as consideration for entering into a strategic alliance agreement with us. Corporex was an accredited investor under Rule 501 of the Securities Act.

On October 6, 2004, the operating partnership issued an aggregate of 5,993,837 operating partnership units in a private offering pursuant to Section 4(2) of the Securities Act as partial consideration for the acquisition of seven our nine initial hotels. The operating partnership units were issued to the original contributors of seven of our hotels, each of whom was an accredited investor under Rule 501 of the Securities Act.

On December 5, 2005, the operating partnership issued 427,485 operating partnership units in a private offering pursuant to Section 4(2) of the Securities Act to CPX RiverCenter Development LLC, an entity that is beneficially owned by William P. Butler, our chairman, upon the exercise of its option to acquire the remaining 51% interest in the entity that owns the Embassy Suites Hotel Cincinnati-RiverCenter. As a result, we now own all of the interests in the entity that owns the Embassy Suites Hotel Cincinnati-RiverCenter. CPX RiverCenter Development LLC is an accredited investor under Rule 501 of the Securities Act.

On December 5, 2005, the operating partnership also issued an aggregate of 250,000 operating partnership units to the original contributors of the entity that owns the Embassy Suites Hotel Denver-International Airport in a private offering pursuant to Section 4(2) of the Securities Act. Each of the original contributors is an accredited investor under Rule 501 of the Securities Act. Such units were issued pursuant to the earn-out provisions of the original contribution agreement, which provided for the issuance of an aggregate of 250,000 units in the event that EBITDA (as defined in the agreement) at the Embassy

 

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Suites Hotel Denver-International Airport exceeded $2,815,459 for any 12-month trailing period prior to October 6, 2007. During the 12-month period ended September 30, 2005, EBITDA at the Embassy Suites Hotel Denver-International Airport exceeded $2,815,459.

On July 24, 2006, the operating partnership issued an aggregate of 83,333 operating partnership units to the original contributors of the entity that owns the Embassy Suites Hotel Columbus/Dublin in a private offering pursuant to Section 4(2) of the Securities Act. Each of the original contributors is an accredited investor under Rule 501 of the Securities Act. Such units were issued pursuant to the earn-out provisions of the original contribution agreement, which provided for the issuance of an aggregate of 83,333 units in the event that EBITDA (as defined in the agreement) at the Embassy Suites Hotel Columbus/Dublin exceeded $4,088,900 for any 12-month trailing period prior to October 6, 2007. During the 12-month period ended June 30, 2006, EBITDA at the Embassy Suites Hotel Columbus/Dublin exceeded $4,088,900.

After one year, limited partners may generally redeem each unit for the cash value of one share of our common stock or, at our sole option, one share of common stock.

Item 6. Selected Financial Data

The following table sets forth consolidated selected historical operating and financial data for the Company beginning with its commencement of operations on October 1, 2004. Prior to that time, this table includes the combined selected historical operating and financial data of certain affiliates of the Eagle Hospitality Group (the “Predecessor”).

The selected historical combined financial information as of December 31, 2003 and 2002 and for each of the two years in the period ended December 31, 2003 were derived from audited financial statements contained in the Company’s Registration Statement on Form S-11 (SEC File No. 333-115213). The unaudited historical combined financial statements include all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of such dates and for such periods under accounting principles generally accepted in the United States.

The information below should be read along with all other financial information and analysis presented elsewhere herein, including the sections captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated and combined financial statements and related notes thereto.

 

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Table of Contents

EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

 

    Company
2006
    Company
2005
    Company
&
Predecessor
2004
    Predecessor
2003
    Predecessor
2002
 

Operating Data:

         

Occupancy

    70.60 %     67.60 %     65.20 %     60.60 %     62.40 %

ADR

  $ 130.63     $ 118.30     $ 111.82     $ 112.68     $ 108.68  

RevPAR

  $ 92.23     $ 80.02     $ 72.86     $ 68.27     $ 67.77  

Statement of Operations data ($000’s) (1)

         

Revenues

  $ 150,983     $ 116,425     $ 82,298     $ 74,655     $ 69,820  

Hotel operating expenses, excluding depreciation, amortization and corporate overhead

    100,565       79,303       58,373       53,908       50,683  

Corporate overhead

    5,505       7,072       1,275       —         —    

Depreciation and amortization (2)

    17,889       14,013       9,285       9,518       8,563  
                                       

Operating profit

    27,024       16,037       13,365       11,229       10,574  

Interest income

    362       485       157       104       306  

Interest expense

    13,681       10,760       10,852       12,060       12,026  

Other income, net

    2       33       —         10       6  

Minority interest

    1,040       1,060       33       —         —    

Income tax (expense) benefit

    (1,331 )     2,758       —         —         —    
                                       

Net income (loss)

  $ 11,336     $ 7,493       $2,637       ($717 )     ($1,140 )

Distribution to preferred shareholders

    8,250       4,538       —         —         —    
                                       

Net income (loss) available to common shareholders

  $ 3,086     $ 2,955       $2,637       ($717 )     ($1,140 )
                                       

Statement of Cash Flows data ($000’s)

         

Net cash provided by operating activities

  $ 36,229     $ 27,306     $ 10,586     $ 8,737     $ 5,168  

Net cash used in investing activities

    (58,283 )     (184,171 )     (62,119 )     (1,920 )     (23,592 )

Net cash provided by (used in) financing activities

    17,175       149,832       70,444       (7,737 )     17,657  

Balance Sheet Data ($000’s)

         

Total Assets

  $ 461,726     $ 426,143     $ 252,384     $ 177,022     $ 185,372  

Total Debt

    253,519       211,427       130,765       196,124       200,553  

Total Liabilities

    276,773       229,258       138,192       202,223       206,220  

Total Minority Interest

    9,814       13,661       17,035       —         —    

Total Owners’ equity (deficit)

    175,139       183,224       97,157       (25,201 )     (20,848 )

Other Financial Data ($000’s):

         

EBITDA (3)

  $ 45,277     $ 30,568     $ 22,807     $ 20,861     $ 19,449  

FFO (4)

  $ 21,298     $ 17,477     $ 11,468     $ 7,916     $ 6,807  

SELECTED HISTORICAL FINANCIAL AND OTHER DATA

 

(1) The following hotels were added to the group during the period of January 1, 2002 through December 31, 2006:

 

Property

  

Opening/Acquisition Date

Embassy Suites Hotel Denver-International Airport

  

December 2002

Marriott Southwest at Burr Ridge

  

August 2004

Embassy Suites Hotel Phoenix-Scottsdale

  

February 2005

Hilton Glendale

  

June 2005

Embassy Suites Hotel & Casino San Juan

  

June 2005

Embassy Suites Boston at Logan International Airport

  

July 2006

 

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(2) Investments in hotel properties are stated at acquisition cost and allocated to property and equipment and identifiable intangible assets in accordance with Statement of Financial Accounting Standards No. 141. Property and equipment was recorded at current replacement value for similar capacity, and identifiable intangible assets were recorded at estimated fair value. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15-40 years for building and improvements and 3-10 years for furniture and equipment.

 

(3) EBITDA herein is defined as net income (loss) before interest expense, taxes, depreciation, amortization and minority interest. We believe EBITDA is a useful financial performance measure of adjusted earnings for us and for our stockholders and is a complement to net income and other financial performance measures provided in accordance with US generally accepted accounting principles (“GAAP”). We use EBITDA to measure the financial performance of our operating hotels because it excludes expenses such as depreciation, amortization, taxes, minority interest and interest expense, which are not indicative of operating performance. By excluding minority interest and 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 US 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 US GAAP. EBITDA does not represent net income (loss) and should not be considered as an alternative to operating income or net income determined in accordance with US GAAP. EBITDA does not represent cash flows from operating activities determined in accordance with US GAAP, and should not be considered as an indicator of performance or as an alternative to cash flows from operating activities as an indicator of liquidity. Below is a reconciliation of EBITDA to net (loss) income.

 

     Historical for the Years Ended December 31,  
     Company
2006
   Company
2005
    Company
&
Predecessor
2004
   Predecessor
2003
    Predecessor
2002
 

Reconciliation of EBITDA ($000’s)

            

Net income (loss)

   $ 11,336    $ 7,493       $2,637      ($717 )     ($1,140 )

Minority interest

     1,040      1,060       33      0       0  

Depreciation and amortization

     17,889      14,013       9,285      9,518       8,563  

Interest expense

     13,681      10,760       10,852      12,060       12,026  

Income tax expense (benefit)

     1,331      (2,758 )     —        —         —    
                                      

EBITDA

   $ 45,277    $ 30,568     $ 22,807    $ 20,861     $ 19,449  

 

(4)

Funds From Operations (“FFO”) is used by industry analysts and investors as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income (loss) determined in accordance with US GAAP, excluding extraordinary items as defined under US GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real

 

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estate asset depreciation and amortization, and after adjustment for any minority interest deriving from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with US GAAP 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 and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from US GAAP net income. Management believes that the use of FFO, combined with the required primary US GAAP presentations, has improved the understanding of operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure of adjusted earnings for reviewing comparative operating and financial performance (although FFO should be reviewed in conjunction with net income (loss), which remains the primary measure of performance) because FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, it may not be calculated in the same manner by other companies, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs. Below is a reconciliation of FFO to net (loss) income.

 

     Historical for the Years Ended December 31,  
     Company
2006
    Company
2005
    Company
&
Predecessor
2004
   Predecessor
2003
    Predecessor
2002
 

Reconciliation of FFO ($000’s)

           

Net income (loss) available to common shareholders

   $ 3,086     $ 2,955     $ 2,637      ($717 )   ($ 1,140 )

Minority interest

     1,040       1,060       33      —         —    

Depreciation and amortization

     17,174       13,495       8,798      8,633       7,947  

Gain on sale of assets

     (2 )     (33 )     —        —         —    
                                       

FFO

   $ 21,298     $ 17,477     $ 11,468    $ 7,916     $ 6,807  
                                       

Weighted average diluted shares outstanding

     23,527       23,142       22,911      —         —    

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our portfolio consists of thirteen full-service and all-suites hotels under the Embassy Suites Hotels, Marriott, Hilton and Hyatt brands.

In addition to the nine hotels acquired in conjunction with the initial public offering in 2004, the Company acquired the following hotels in 2005 and 2006:

 

  ·  

the 270-room Embassy Suites Hotel Phoenix-Scottsdale (“Embassy Phoenix”) for a net purchase price of $33.1 million on February 22, 2005;

 

  ·  

the 351-room Hilton Glendale in Glendale, California for a net purchase price of $77.5 million on June 23, 2005;

 

  ·  

the 299-room Embassy Suites Hotel and Casino San Juan (“Embassy Puerto Rico”) in San Juan, Puerto Rico for a net purchase price of $60.2 million on June 28, 2005; and

 

  ·  

the 273-room Embassy Suites Boston at Logan International Airport (“Embassy Boston”) in Boston, Massachusetts for a net price of $53.4 million on July 21, 2006.

According to an industry projection by PricewaterhouseCoopers (“PWC”) the lodging industry had room revenue per available room (“RevPAR”) increases of 8.0% in 2006 after having RevPAR increases of 8.5% in 2005. PWC projects that 85% of the RevPAR increase in 2006 is the result of increased rates. We had a total RevPAR increase of 15.3% in 2006 with almost 70% of the increase attributable to higher rates. As a result, the Company produced strong increases in funds from operations (“FFO”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”). The Company’s revenues are largely derived from hotel operating revenues, although we also have participating lease revenue in connection with the Embassy Suites Hotel and Casino San Juan.

For 2006, the Company had net income available to common shareholders of $3.1 million after minority interest, or $0.17 per diluted share. FFO was $21.3 million. RevPAR was $92.23. EBITDA was $45.3 million. We consider FFO, RevPAR and EBITDA to be key measures of the performance of our portfolio. RevPAR increased 15.3% compared to $80.02 in 2005. The RevPAR increase was driven by an approximately 10.4% increase in the Average Daily Rate (“ADR”). The largest RevPAR improvements at hotels that were owned by us for all of 2005 and 2006 were the Chicago Marriott Southwest at Burr Ridge (improvement of 32.9%, the result of a strong convention year in Chicago and an increasing presence by this hotel that opened in August 2004), the Embassy Suites Hotel Cleveland/Rockside (improvement of 17.9%, as a result of sales force obtaining increased group rates) and the Embassy Suites Denver International Airport (improvement of 11.6%, as a result of an aggressive strategy to drive ADR). In addition, the Embassy Suites Cincinnati–RiverCenter which faced a challenging year in 2005, largely the result of renovation-related displacement, showed a strong 8.3% RevPAR increase in 2006.

For us to qualify as a REIT, we cannot operate hotels. Therefore, with the exception of the Embassy Suites Hotel & Casino San Juan, our operating partnership and its subsidiaries lease our hotel properties to our TRS, which in turn engages eligible independent contractors to manage our hotels. The Embassy Suites Hotel & Casino San Juan is leased to an unaffiliated third-party lessee. That lessee has engaged Hilton Hotels Corporation to manage the hotel. Our TRS, which is a wholly owned subsidiary of our operating partnership, is consolidated into our financial statements for accounting purposes. Since both our operating partnership and our TRS are controlled by us, our principal source of funds on a consolidated basis is from the operations of our hotels. The earnings of our TRS are subject to taxation like other regular C-corporations.

 

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Results of Operations

In the hotel industry most categories of operating costs do not vary directly with the volume of sales, the exceptions, among others, being franchise, management and credit card fees, costs associated with food and beverages served and housekeeping services provided and travel agent commissions. Because of this operating leverage, changes in sales volume disproportionately impact operating results. Room revenue is the most important category of revenue and drives other revenue categories such as food and beverage and telephone. There are three key performance indicators used in the hotel industry to measure room sales:

 

  ·  

Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available;

 

  ·  

Average Daily Rate (ADR), which is total room revenue divided by the number of rooms sold; and

 

  ·  

RevPAR (room revenue per available room), which is the product of the occupancy percentage and ADR.

The following table illustrates the key performance indicators for the years ended December 31, 2006 (Company), 2005 (Company) and 2004 (Company and Predecessor) for our portfolio, which consists of the eight hotels that have been open and opened by the Company or Predecessor throughout the three years presented, plus the Chicago Marriott Southwest at Burr Ridge which opened in August 2004, the Embassy Suites Hotel Phoenix-Scottsdale which was purchased in February 2005, the Hilton Glendale which was purchased in June 2005, Embassy Suites Hotel & Casino San Juan which was purchased in June 2005 and the Embassy Suites Boston at Logan International Airport:

 

     Year Ended December 31,  
     2006     2005     2004  

Hotel Revenues ($000’s)

   $ 150,983     $ 116,425     $ 82,298  

RevPAR

     92.23       80.02       72.86  

Occupancy

     70.6 %     67.6 %     65.2 %

ADR

   $ 130.63     $ 118.30     $ 111.82  

We broadly group our guests into two sectors: transient and group. The transient sector includes the leisure, business or government traveler making individual room reservations. The group sector is composed of bookings for 10 or more rooms and includes leisure, business, government and convention and association travelers. The group leisure sector includes blocks for wedding parties, family reunions and other social gatherings. We offer our largest volume corporate customers a negotiated rate, and we refer to these customers as the group preferred business sector. We generally book the group sector at lower negotiated rates in order to maintain occupancy, but group events are often associated with higher food and beverage revenue.

Comparison of 2006 to 2005

Overview.    Increased ADR resulted in improving lodging industry fundamentals in 2006 (ADR accounted for 85% of the 2006 RevPAR increases according to projections by PWC). We also enjoyed strong ADR growth of 7.9% for our entire portfolio of owned hotels. This led to a total RevPAR increase of 10.6% for the portfolio. We continued our strategy of aggressive revenue management to drive the ADR increases by limiting group business during peak times in order to accommodate the higher rated leisure and business transient segments.

This ADR-focused strategy was successful as demand in 2006 surpassed the 2000 peak demand period and the supply of new hotel rooms was under 1% for 2006.

Revenues.    Total hotel operating revenues increased $34.6 million, or 29.7%, from $116.4 million in 2005 to $151.0 million in 2006. Of this increase, $21.6 million is the result of the 2006 and 2005

 

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acquisitions of the Embassy Suites Boston at Logan International Airport (“Embassy Boston”), Embassy Suites Hotel Phoenix-Scottsdale (“Embassy Phoenix”) and the Hilton Glendale. In 2006, we also saw an increase of $3.9 million in participating lease revenue from the Embassy Suites Hotel & Casino San Juan (“Embassy San Juan”), which we acquired in June 2005. The Chicago Marriott Southwest at Burr Ridge (“Marriott Burr Ridge”) which opened in August 2004 showed a revenue increase of $1.6 million in 2006. This is the result of a strong convention year in Chicago in 2006 and the increasing market penetration of the hotel. The Embassy Suites Hotel Columbus/Dublin (“Embassy Dublin”) showed a total revenue increase of $1.6 million, due to an improved business mix with increased transient business and food beverage revenue. The remaining hotels all showed revenue increases ranging from $0.3 million to $1.4 million due in large part to the increases in ADR.

Food and beverage revenues increased $6.2 million in 2006 as compared to 2005. Of this increase, $3.9 million is the result of the 2006 and 2005 acquisitions of the Embassy Boston, Embassy Phoenix and the Hilton Glendale. In addition, the Embassy Dublin and the Marriott Burr Ridge showed increases of $0.7 million and $0.3 million, respectively.

Operating Expenses.    Hotel operating expenses, including management fees, before depreciation and amortization increased by $21.3 million, or 26.9%, from $79.3 million in 2005 to $100.6 million in 2006. Of this amount, $15.7 million was the result of the hotels acquired in 2005 and 2006. The Embassy Suites Hotel Tampa-Airport/Westshore incurred increased property insurance of $0.2 million and increased real estate taxes of $0.1 million. The Marriott Burr Ridge saw real estate taxes decrease by $0.3 million as the result of a successful tax appeal. The remainder of the increased expenses were mostly seen in areas that have direct correlations to increased revenues, such as; food and beverage, front office, housekeeping, management fees, credit card fees, travel agent commissions and franchise fees.

Corporate General and Administrative Expense.    Corporate general and administrative expense decreased $1.6 million, or 22.5%, from $7.1 million in 2005 to $5.5 million in 2006. Virtually all of the decrease, or $1.5 million, was the result of the amortization in 2005 of the shares granted at the time of our IPO in conjunction with the Strategic Alliance Agreement with the Predecessor and its affiliates, these shares vested October 1, 2005. The remainder of the decrease was attributable to the decrease in audit-related expenses and insurance, largely offset, by increased expense for asset managers, other employee-related activities and higher director fees.

Depreciation and Amortization Expense.    Total depreciation and other amortization expense increased $3.9 million, or 27.9%, from $14.0 million in 2005 to $17.9 million in 2006. $3.7 million of the increased depreciation and amortization expense was related to the depreciation of fixed assets and amortization of franchise fees and loan costs related to our 2005 and 2006 acquisitions.

Net Operating Income.    Net operating income increased $11.0 million, or 68.8%, in 2006 from $16.0 million in 2005 to $27.0 million in 2006. $9.2 million of the increase was provided by the full-year effect of the 2005 Embassy Phoenix, Hilton Glendale and Embassy San Juan acquisitions. Also contributing was the improved operating performance demonstrated at the Marriott Burr Ridge and the decreased corporate general and administrative expense.

Interest Expense.    Total interest expense increased $2.9 million, or 26.9%, to $13.7 million in 2006 compared to $10.8 million in 2005. This increase is the result of the full-year impact of the borrowing related to the 2005 acquisitions, the July 21, 2006 acquisition of the Embassy Boston and the increased interest rates seen by the LIBOR-based variable rate debt.

Income Taxes.    As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its net income (loss) that does not relate to taxable REIT subsidiaries. However, EHP TRS Holding Co, Inc. is treated as a taxable REIT subsidiary for federal income tax purposes. In addition, the REIT and its subsidiaries will be subject to various state and local income taxes.

 

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The Company had a net tax expense of $1,331 and a net tax benefit of $2,758 respectively, for the periods ending December 31, 2006 and 2005.

 

     2006     2005  

Federal, state and local income tax expense

   $ (1,219 )   $ (565 )

Federal and state income tax benefit

     13       3,398  
                

Gross income tax (expense) benefit

     (1,206 )     2,833  

Valuation allowance

     (125 )     (75 )
                

Net income tax (expense) benefit

   $ (1,331 )   $ 2,758  
                

Net Income Available to Common Shareholders.    Our net income available to common shareholders increased $0.1 million, or 3.3%, from $3.0 million in 2005 to $3.1 million in 2006. This increase is the net result of the items discussed above, specifically the full-year effects of the 2005 hotel acquisitions and the improved profitability of the Marriott Burr Ridge, offset by the full-year of preferred dividend payments and income taxes.

Comparison of 2005 to 2004

Overview.    For the purposes of this comparison we have combined the results of the Company with those of the Predecessor for 2004, whereas, 2005 reflects only the results for the Company. In 2005, the hotel industry continued the recovery that began in 2004.

As a result of the strengthening seen in the industry in 2005, we focused our efforts on increasing the ADR for the entire portfolio and these efforts were rewarded with a 5.8% increase in ADR for 2005 as compared to 2004. This strategy proved to be successful in large part due to the increased demand outpacing the increased supply of new hotel rooms. Part of this strategy for increasing ADR included limiting group business during peak times in order to accommodate the higher rated leisure and business transient segments.

Revenues.    Total hotel operating revenues increased $34.1 million, or 41.4%, from $82.3 million in 2004 to $116.4 million in 2005. Of this increase, $20.8 million is the result of the 2005 acquisitions of the Embassy Suites Hotel Phoenix-Scottsdale (“Embassy Phoenix”) and the Hilton Glendale. In 2005, we also recognized $2.9 million in participating lease revenue from the Embassy Suites Hotel & Casino San Juan (“Embassy San Juan”). The Chicago Marriott Southwest at Burr Ridge (“Marriott Burr Ridge”) which opened in August 2004 showed a revenue increase of $5.1 million in 2005. This is the result of the typical growth cycle of a new hotel. The Hilton Cincinnati Airport produced a revenue increase of $1.5 million, the result of a 25.9% RevPAR increase much of which is attributable to the $3.7 million in capital improvements that occurred at the hotel during 2005. The remaining hotels all showed revenue increases ranging from $0.2 million to $1.1 million due in large part to the increases in ADR.

Of the $8.7 million in food and beverage revenues increase in 2005 as compared to 2004, $7.3 million of the increase incurred at the Marriott Burr Ridge ($1.7 million increase, largely the result of the maturation of the hotel), the Embassy Phoenix ($2.0 million, 2005 acquisition) and the Hilton Glendale ($3.6 million, 2005 acquisition). Of the remaining hotels, the Hilton Florence and the Cincinnati Marriott Landmark saw food and beverage increases of $0.3 million each in 2005.

Operating Expenses.    Hotel operating expenses before depreciation and amortization increased by $20.9 million, or 35.8%, from $58.4 million in 2004 to $79.3 million in 2005. Of this amount, $17.7 million was associated with the operation of the Marriott Burr Ridge which did not open until August, 2004 and the 2005 acquisitions, the Embassy Phoenix and Hilton Glendale. The other hotels saw net energy and insurance increases of $0.3 million and $0.1 million, respectively, in 2005 as compared to 2004. Also, our

 

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two Ohio hotels, the Embassy Suites Hotel Dublin and the Embassy Suites Hotel Independence, saw combined real estate tax increases of $0.3 million. The remainder of the increased expenses were mostly seen in food and beverage costs, front office and housekeeping.

Net Operating Income.    Net operating income increased $2.6 million, or 19.4%, in 2005 from $13.4 million in 2004 to $16.0 million in 2005. This increase is largely due to the acquisitions, the improved operating performance demonstrated at the Marriott Burr Ridge and the increased revenues seen at all of our hotels. Net operating income grew despite the full-year corporate expenses (the Predecessor had no corporate function), and inflationary pressures experienced in relation to housekeeping, front office and energy.

Corporate Expense and Stock-Based Compensation.    The Predecessor had no corporate function or stock-based compensation. As a result, these expenses for 2004 were only for the period from October 1, 2004 through December 31, 2004. The corporate expenses for 2005 increased $4.2 million, or six times, to $4.9 million in 2005 from $0.7 million for 2004. This increase was again due in part to the fact that these types of expenses were only present in the fourth quarter of 2004. In addition, in 2005 the Company incurred increased expenses typical of other companies in the first full year of existence, in particular for a public reporting entity, such as increases in: audit and tax expense, Board of Directors compensation, legal expense, investor relation expense and expenses related to broadened asset management.

The stock-based compensation, which began October 1, 2004, increased $1.5 million during 2005, from $0.6 million in 2004 to $2.1 million in 2005. The increase of $1.5 million, or 250%, was a combination of the $0.9 million of expense incurred for the shares granted in conjunction with the Strategic Alliance Agreement with the Predecessor and its affiliates, as well as the expense incurred for restricted stock grants to the employees, officers and directors of the Company.

Depreciation and Amortization Expense.    Total depreciation and other amortization expense increased $4.7 million, or 51%, from $9.3 million in 2004 to $14.0 million in 2005. $4.5 million of the increased depreciation and amortization expense was related to the 2005 acquisitions (Embassy Phoenix, Hilton Glendale and Embassy San Juan) depreciation of fixed assets and amortization of franchise fees and loan costs.

Interest Expense.    Total interest expense decreased $0.1 million to $10.8 million in 2005 compared to $10.9 million in 2004. The net decrease was the effect of a $75.4 million debt paydown in the fourth quarter of 2004 subsequent to the IPO and the refinancing debt at lower fixed rates. These reductions were offset by interest expense in connection with the debt secured by the 2005 acquisitions and the increased interest rates seen by the LIBOR-based variable rate debt.

Income Taxes.    As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its net income (loss) that does not relate to taxable REIT subsidiaries. However, EHP TRS Holding Co, Inc. is treated as a taxable REIT subsidiary for federal income tax purposes. In addition, the REIT and its subsidiaries will be subject to various state and local income taxes.

The Company had a net tax benefit of $2,758 and $0, respectively, for the periods ending December 31, 2005 and 2004.

 

     2005     2004  

State and local income tax expense

   $ (565 )   $ —    

Federal and state income tax benefit

     3,398       423  
                

Gross income tax benefit

     2,833       423  

Valuation allowance

     (75 )     (423 )
                

Net income tax benefit

   $ 2,758     $ —    
                

 

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Net Income Available to Common Shareholders.    Our net income available to common shareholders increased $0.4 million, or 15.4%, from $2.6 million in 2004 to $3.0 million in 2005. This increase is the net result of the items discussed above, offset by the $4.5 million in preferred dividends paid out in 2005 as a result of the 4,000,000 shares of 8 1/4% Series A Cumulative Redeemable Preferred Stock issued on June 13, 2005.

Liquidity and Capital Resources

Our principal source of funds to meet our cash requirements, including distributions to stockholders, is our share of the operating partnership’s cash flow. The operating partnership’s principal source of revenue is the cash flow provided by the hotel operations.

Cash flow from hotel operations is subject to all operating risks common to the hotel industry, including:

 

  ·  

Competition for guests from other hotels;

 

  ·  

Adverse effects of general and local economic conditions;

 

  ·  

Dependence on demand from business and leisure travelers, which may fluctuate and be seasonal;

 

  ·  

Increases in energy costs, airline fares, and other expenses related to travel, which may deter traveling;

 

  ·  

Increases in operating costs related to inflation and other factors, including wages, benefits, insurance, and energy;

 

  ·  

Overbuilding in the hotel industry, especially in particular markets; and

 

  ·  

Actual or threatened acts of terrorism and actions taken against terrorists, which often cause public concern about travel safety.

Recurring capital expenditures and debt service are the most significant short-term liquidity requirements. During the next 12 months, we expect capital expenditures will be funded by a combination of our replacement reserve accounts and our unsecured credit facility.

We expect to set aside 4% of future hotel revenues (5% with respect to the Hyatt Regency Rochester) in our replacement reserve accounts to fund capital expenditures for certain hotels. During 2006 we spent approximately $10.7 million in capital expenditures at our hotels.

The capital expenditures were incurred at the following hotels (millions):

 

Hyatt Rochester

   $ 2.4

Embassy San Juan

     2.1

Hilton Glendale

     2.1

Embassy Tampa

     2.1

Embassy Phoenix

     0.7

Embassy Boston

     0.3

Hilton Cincinnati Airport

     0.3

Landmark Marriott

     0.3

Embassy RiverCenter

     0.2

Embassy Dublin

     0.1

Embassy Denver

     0.1
      

Total

   $ 10.7
      

We fund our short-term liquidity requirements, including the short-term service of debt, through a combination of working capital, cash flows from operating activities and borrowings under our credit facility.

 

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Our long-term liquidity needs generally include the funding of future acquisition and development activity and the retirement of mortgage debt and amounts outstanding under our secured line of credit. We remain committed to maintaining a flexible capital structure. Accordingly, in addition to the sources described above with respect to our short-term liquidity, we expect to meet our long-term liquidity needs through a combination of some or all of the following:

 

  ·  

the issuance by the operating partnership of secured and unsecured debt securities;

 

  ·  

the issuance of additional shares of our common stock or preferred stock;

 

  ·  

the issuance of additional operating partnership units;

 

  ·  

the selective disposition of non-core assets; or the sale or contribution of some of our wholly owned properties, development projects and development land to strategic joint ventures to be formed with unrelated investors, which would have the net effect of generating additional capital through such sale or contributions.

We anticipate that our available cash and cash equivalents and cash flows from operating activities, with cash available from borrowings and other sources, will be adequate to meet our capital and liquidity needs in both the short and long term. However, if these sources of funds are insufficient or unavailable, our ability to satisfy cash payment obligations and make stockholder distributions may be adversely affected.

Off-Balance Sheet Arrangements

We currently have no off-balance sheet arrangements. For the period ended December 31, 2004 because we had the right and obligation to acquire the remaining 51% interest in the entity that owned the Embassy Suites Hotel Cincinnati–RiverCenter no later than January 31, 2006 in exchange for 427,485 operating partnership units, the assets, liabilities and operations of such entity were included in our consolidated financial statements as required by FIN 46(R). The Company exercised this right and acquired the remaining 51% of the hotel on December 5, 2005.

Distributions to Stockholders

We have elected to be taxed as a REIT commencing with our taxable year ended December 31, 2004. To maintain our status as a REIT, we are required to make annual distributions to our stockholders of at least 90% of our REIT taxable income (which is determined without regard to the dividends paid deduction and by excluding net capital gain and which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The amount, timing and frequency of distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future. Our ability to pay distributions to our stockholders will depend, in part, upon the management of our properties by our independent hotel managers. Distributions to our stockholders will generally be taxable to our stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS may retain any after-tax earnings.

Inflation

We rely entirely on the performance of our properties and the ability of the properties’ managers to increase revenues to keep pace with inflation. Hotel operators can generally increase room rates rather quickly, but competitive pressures may limit their ability to raise rates faster than inflation. Our general and administrative costs, such as real estate and personal property taxes, property and casualty insurance, and utilities, are also subject to inflationary pressures.

 

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Seasonality

Virtually all of our properties’ operations are subject to the peaks and valleys associated with seasonal occupancy. The seasonality pattern nevertheless can be expected to cause fluctuations in our revenue. We anticipate that our cash flow from the operation of the properties will be sufficient to enable us to make quarterly distributions to maintain our REIT status. To the extent that cash flow from operations is insufficient during any quarter due to temporary or seasonal fluctuations in revenue, we expect to utilize other cash on hand or borrowings to make required distributions. However, we cannot make any assurances that we will make distributions in the future.

Geographic Concentration

Three of our hotels are located in the Northern Kentucky/Greater Cincinnati, Ohio metropolitan area. Economic and real estate conditions in this area significantly affect our revenues. Business layoffs, downsizing, industry slowdowns, demographic changes and other similar factors may adversely affect the economic climate in this locale. Any resulting oversupply or reduced demand for hotels in the area would adversely affect revenues and net income.

Critical Accounting Policies

Our accounting policies are more fully described in the notes accompanying our consolidated financial statements. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. The Company believes that the following discussion addresses the Company’s most critical accounting policies, which are those that are most important to the portrayal of the Company’s financial condition and results of operations and require management’s most difficult, subjective, and complex judgments.

Consolidation Policy—The accompanying financial statements have been consolidated for all activities from inception (October 1, 2004) through December 31, 2006. Included in this consolidation are the Company’s operating entities (TRS), the limited liability companies that own the hotel properties and EHP OP. In accordance with FIN 46(R) also included in the consolidation are all activities and balances relating to the Embassy Suites Hotel Cincinnati–RiverCenter in which the Company owned a 49% interest until December 5, 2005, at which time the Company purchased the remaining 51% interest in this hotel. Under FIN 46(R) the Company was deemed to be the primary beneficiary of this variable interest entity prior to acquiring the remaining 51% because of the Company’s obligation to acquire the remaining interest of this hotel property for 427,485 operating units no later than January 31, 2006. The portion of the statements that reflects activities of the Predecessor, the periods prior to October 1, 2004, have been combined due to the common ownership of the entities. All significant intercompany accounts and transactions among the consolidated and combined entities have been eliminated in the consolidated and combined financial statements.

Revenue Recognition—Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. Participating lease revenue is recognized in accordance with lease terms. We generally consider accounts receivable to be fully collectible; however, there were an allowances for doubtful accounts of $105 and $34, respectively, at December 31, 2006 and 2005. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.

Investment in Hotel Properties—The nine initial hotel properties are stated at the Predecessor’s historical cost, plus an approximate $42.5 million minority interest partial step-up recorded upon formation of the

 

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Company on October 1, 2004, related to the acquisition of minority interest from unaffiliated parties related to seven of the initial properties. The hotel properties acquired subsequent to the initial nine hotel properties are stated at our cost. Improvements and additions which extend the life of the property are capitalized.

Impairment of Investment in Hotel Properties—Hotel properties are reviewed for impairment whenever events or changes in circumstances indicate the carrying values of the hotel properties may not be recoverable. The Company tests for impairment in several situations, including when current or projected cash flows are less than historical cash flows, when it becomes more likely than not that a hotel will be sold before the end of its previously estimated useful life, and when events or changes in circumstances indicate that a hotel’s net book value may not be recoverable. In the evaluation of the impairment of hotel properties, the Company makes many assumptions and estimates, including projected cash flows, holding period, expected useful life, future capital expenditures, and fair values, including consideration of capitalization rates, discount rates, and comparable selling prices. To date, no such impairment charges have been recognized. If an asset were deemed to be impaired, the Company would record an impairment charge for the amount the property’s net book value exceeds its fair value.

Depreciation and Amortization Expense—Depreciation expense is based on the estimated useful lives of the Company’s assets. Presently, investment in hotel properties, air rights, furniture, fixtures, and equipment are depreciated using the straight-line method over lives which range from 5 to 40 years. While the Company believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income (loss) or the gain or loss on the potential sale of any of the Company’s hotels. Amortization expense is related to franchise agreements with the various franchisors and is incurred ratably over the lives of the agreements. In addition, amortization expense is recognized for the costs relating to our mortgage and credit facilities. Again, these expenses are amortized ratably over the lives of the debt agreements. The Company incurred depreciation and amortization expense of $17.9 million, $14.0 million and $2.7 million for the years ended December 31, 2006 and 2005 and the period from October 1, 2004 through December 31, 2004, respectively. The Predecessor incurred depreciation and amortization expense of $6.6 million for the period of January 1, 2004 through September 30, 2004. Repairs and maintenance costs that do not extend the useful lives of the Company’s assets or enhance the utility of those assets are expensed as incurred. Our total capital expenditures for 2006 were $10.7 million. We anticipate spending $13-$16 million in capital expenditures during 2007.

Recent Accounting Pronouncements—

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year. We do not anticipate the adoption of this pronouncement to have a material effect on our consolidated financial statements.

In December 2004, the FASB issued Statement 123 (revised 2004) which establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, primarily on accounting for transactions in which an entity obtains employee services in share-based transactions. The FASB and SEC issued additional guidance and clarification to this Statement throughout 2005. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, with limited exceptions. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award—the requisite service period. Although the Company’s bylaws allow for the issuance of stock options, none have been issued to this point. The Company adopted this pronouncement as of January 1, 2006.

 

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Contractual Obligations and Commitments

As of December 31, 2006, the Company had the following contractual obligations pursuant to long-term borrowings, leases, purchase obligations not recognized in the financial statements, and all other liabilities reflected in the balance sheet (in thousands):

 

Contractual Obligations as of December 31,
2006
                        
          Payments Due by Period
     Total    Less than
1 year
   1-3
years
   3-5
years
   Thereafter

Long-term debt obligations

   $ 253,519    $ 1,696    $ 84,744    $ 78,715    $ 88,364

Operating lease obligations

     840      246      239      154      201

Capital lease obligations

     44      37      7      —        —  

Interest payment obligations

     63,133      17,811      27,761      12,485      5,076
                                  

Total

   $ 317,536    $ 19,790    $ 112,751    $ 91,354    $ 93,641
                                  

Also, the Company has employment agreements with its Senior Vice-President of Acquisitions, Chief Financial Officer and Chief Executive Officer. The agreements are for two years, three years and five years, respectively, expiring in May 2008, May 2008, and October 2009, respectively.

Subsequent Events

On January 29, 2007, Eagle Hospitality Properties Trust, Inc. issued a press release announcing that its Board of Directors has decided to explore strategic alternatives to enhance shareholder value, including a possible sale of the Company. As part of that process, the Board has formed a Special Committee, which has retained Morgan Stanley as financial advisor.

On January 16, 2007, the Company paid a cash dividend of $0.175 per share of common stock and operating partnership unit, for shareholders of record on December 29, 2006. The dividend was declared on December 1, 2006.

On January 2, 2007, the Company paid a cash dividend of $0.515625 per share of preferred stock, for shareholders of record on December 14, 2006. The dividend was declared on December 1, 2006.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.

As of December 31, 2006, we had outstanding approximately $89.7 million of variable-rate debt. The impact to our annual results of operations of a one-point change in interest rate on the outstanding balance of variable-rate debt as of December 31, 2006, would be approximately $0.9 million of interest expense. We also had approximately $163.8 million of 5.46% fixed-rate debt outstanding at December 31, 2006. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. We had no other outstanding debt as of December 31, 2006 nor did we have any outstanding interest rate hedge contracts.

The above amounts were determined based on the impact of hypothetical interest rates on our borrowing cost, and assume no changes in our capital structure. As the information presented above includes only those exposures that exist as of December 31, 2006, it does not consider those exposures or positions which could arise after that date. Hence, the information represented herein has limited predictive value. As a result, the ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the hedging strategies at the time, and the related interest rates.

 

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Item 8. Financial Statements and Supplementary Data

Index to Consolidated and Combined Financial Statements and Financial Statement Schedule

 

Management Report on Internal Control over Financial Reporting

   40

Report of Independent Registered Public Accounting Firm

   46

Report of Independent Registered Public Accounting Firm

   47

Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting

   48

Consolidated Balance Sheets as of December 31, 2006 and 2005

   49

Consolidated and Combined Statements of Income for the Years Ended December 31, 2006, 2005 and 2004

   50

Consolidated and Combined Statements of Stockholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004

   51

Consolidated and Combined Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004

   52

Notes to Consolidated and Combined Financial Statements

   53

Schedule III—Real Estate and Accumulated Depreciation

   71

Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

We have established disclosure controls and procedures to ensure that material information relating to us is timely communicated to the officers who certify our financial reports and to other members of our management and Board of Directors.

Based upon their evaluation as of December 31, 2006, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in our required SEC filings is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act. The Company’s internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external reporting purposes in accordance with generally accepted accounting principles in the United States.

Management, under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2006 was effective. All internal control systems, no matter how well designed, have inherent limitations. Because of

 

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the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Therefore, the Company’s internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation and presentation and may not prevent or detect misstatements.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report included herein, which expresses an unqualified opinion on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.

During the fourth quarter of 2006, there were no changes in our internal control over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, those controls.

Item 9B. Other Information

None.

 

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PART III

Item 10. Directors, Executive Officers and Corporate Governance of the Registrant

The required information is incorporated by reference to our Proxy Statement to be filed with respect to the Annual Meeting of Shareholders to be held on May 1, 2007.

Item 11. Executive Compensation

The required information is incorporated by reference to our Proxy Statement to be filed with respect to the Annual Meeting of Shareholders to be held on May 1, 2007.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The required information is incorporated by reference to our Proxy Statement to be filed with respect to the Annual Meeting of Shareholders to be held on May 1, 2007.

Item 13. Certain Relationships and Related Transactions

The required information is incorporated by reference from our Proxy Statement to be filed with respect to the Annual Meeting of Shareholders to be held on May 1, 2007.

Item 14. Principal Accountant Fees and Services

The required information is incorporated by reference to our Proxy Statement to be filed with respect to the Annual Meeting of Shareholders to be held on May 1, 2007.

 

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PART IV

Item 15. Exhibits, Financial Statement Schedules

 

  (a) Lists of Documents Filed as Part of this Report

 

  1. Consolidated and Combined Financial Statements, Consolidated Financial Statement Schedules and Report of Independent Registered Public Accounting Firms.

 

  2. Exhibits.

 

Ex.   

Description

  3         Articles of Amendment and Restatement (including all amendments or articles supplementary thereto), incorporated by reference to Exhibit 3 to the quarterly report on Form 10-Q for the period ended June 30, 2005.
  3.1      Bylaws, incorporated by reference to Exhibit 3.2 to the 2004 Registration Statement.
  4         Form of common stock certificate, incorporated herein by reference to Exhibit 4 to the 2004 Registration Statement.
10.1      Form of Agreement of Limited Partnership of EHP Operating Partnership, L.P., incorporated herein by reference to Exhibit 10.1 to the 2004 Registration Statement.
10.2      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Cincinnati Landmark Marriott), incorporated herein by reference to Exhibit 10.2 to the 2004 Registration Statement.
10.3      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Embassy Suites Hotel Denver-International Airport), incorporated herein by reference to Exhibit 10.3 to the 2004 Registration Statement.
10.4      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Embassy Suites Hotel Cincinnati-RiverCenter), incorporated herein by reference to Exhibit 10.4 to the 2004 Registration Statement.
10.5      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Hilton Cincinnati Airport), incorporated herein by reference to Exhibit 10.5 to the 2004 Registration Statement.
10.6      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Embassy Suites Hotel Cleveland/Rockside), incorporated herein by reference to Exhibit 10.6 to the 2004 Registration Statement.
10.7      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Embassy Suites Hotel Columbus/Dublin), incorporated herein by reference to Exhibit 10.7 to the 2004 Registration Statement.
10.8      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among EHP Operating Partnership, L. P. and the Grantors named therein (Chicago Marriott Southwest at Burr Ridge), incorporated herein by reference to Exhibit 10.8 to the 2004 Registration Statement.
10.9      Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among the Company, Rochester Downtown Hotel, Inc., Rochester Holding Corporation and KY Florida Hotels Investors, Inc. (Hyatt Regency Rochester), incorporated herein by reference to Exhibit 10.9 to the 2004 Registration Statement.
10.10    Omnibus Option Acquisition Agreement, dated as of May 4, 2004 by and among the Company, Tampa Westshore Hotel, Inc. and KY Florida Hotels Investors, Inc. (Embassy Suites Hotel Tampa-Airport/Westshore), incorporated herein by reference to Exhibit 10.10 to the 2004 Registration Statement.

 

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Ex.   

Description

10.11    Form of Employment Contract between Eagle Hospitality Properties Trust, Inc. and J. William Blackham, its chief executive officer, incorporated herein by reference to Exhibit 10.11 to the 2004 Registration Statement.*
10.12    2004 Long-Term Incentive Plan, incorporated herein by reference to Exhibit 10.12 to the 2004 Registration Statement.*
10.13    Form of Management Agreement between EHP TRS Holding Co., Inc. (or its wholly owned subsidiary) and Commonwealth Hotels, Inc., incorporated herein by reference to Exhibit 10.13 to the 2004 Registration Statement.
10.14    Form of Lease between EHP Operating Partnership, L.P. (or its wholly owned subsidiary) and EHP TRS Holding Co., Inc. (or its wholly owned subsidiary), incorporated herein by reference to Exhibit 10.14 to the 2004 Registration Statement.
10.15    Form of Nomination Rights Agreement between Eagle Hospitality Properties Trust, Inc. and Corporex Companies LLC, incorporated herein by reference to Exhibit 10.15 to the 2004 Registration Statement.
10.16    Form of Strategic Alliance Agreement among EHP Operating Partnership, L.P., Eagle Hospitality Properties Trust, Inc., Corporex Companies LLC and William P. Butler, incorporated herein by reference to Exhibit 10.16 to the 2004 Registration Statement.
10.17    Form of Non-Competition and Right of First Refusal Agreement among EHP Operating Partnership, L.P., Eagle Hospitality Properties Trust, Inc., Commonwealth Hotels, Inc., William P. Butler and Daniel T. Fay, incorporated herein by reference to Exhibit 10.17 to the 2004 Registration Statement.
10.18    Subscription Agreement dated May 5, 2004 between Eagle Hospitality Properties Trust, Inc. and Corporex Companies LLC, incorporated herein by reference to Exhibit 10.19 to the 2004 Registration Statement.
10.19    Form of Management Consulting and Advisory Agreement between Eagle Hospitality Properties Trust, Inc. and Corporex Companies LLC, incorporated herein by reference to Exhibit 10.20 to the 2004 Registration Statement.
10.20    Purchase Agreement dated as of December 29, 2004 between EHP Operating Partnership, L.P. and UP Stonecreek, Inc, incorporated herein by reference to Exhibit 10.21 to the annual report on Form 10-K filed March 28, 2005.
10.21    Form of Mortgage Note dated as of February 15, 2005 between subsidiaries of Eagle Hospitality Properties Trust, Inc. as borrowers, and The Prudential Insurance Company of America, as lender, incorporated herein by reference to Exhibit 10.22 to the annual report on Form 10-K filed March 28, 2005.
10.22    Deed of Trust, Assignment and Security Agreement dated as of February 22, 2005 among EHP Phoenix Suites, LLC, Phoenix Suites TRS, Inc. and U.S. Bank National Association, incorporated herein by reference to Exhibit 10.23 to the annual report on Form 10-K filed March 28, 2005.
10.23    Form of Employment Agreement between Eagle Hospitality Properties Trust, Inc. and Raymond D. Martz, incorporated by reference to Exhibit 10.4 to the quarterly report on Form 10-Q for the period ended March 31, 2005. *
10.24    Purchase Agreement dated as of May 11, 2005 between EHP Glendale, LLC and Hilton Glendale, L.P., as amended, incorporated herein by reference to Exhibit 10.1 to the quarterly report on Form 10-Q for the period ended June 30, 2005.

 

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Ex.   

Description

10.25    Agreement of Purchase and Sale dated as of April 28, 2005 between EHP Glendale, LLC and Hilton Glendale, L.P., as amended, incorporated herein by reference to Exhibit 10.2 to the quarterly report on Form 10-Q for the period ended June 30, 2005.
10.26    Loan Agreement dated as of July 7, 2005 between EHP Glendale, LLC and KeyBank National Association, incorporated herein by reference to Exhibit 10.4 to the quarterly report on Form 10-Q for the period ended June 30, 2005.
10.27    2005 Deferred Compensation Plan for Non-Employee Directors, incorporated herein by reference to Exhibit 10 to the current report on Form 8-K filed December 8, 2005.*
10.28    Credit Agreement dated as of December 21, 2005 between Eagle Hospitality Properties Trust, Inc. and U.S Bank, as the administrative agent, Key Bank, as the syndication agent and LaSalle Bank, as the documentation agent, incorporated herein by reference to Exhibit 10.28 of the annual report on Form 10-K filed March 7, 2006.
10.29    Employment Agreement of Brian Guernier dated May 22, 2006, incorporated herein by reference to Exhibit 10.1 of the current report on Form 8-K filed May 22, 2006.*
10.30    Amendment to amended and restated Senior Credit Agreement dated July 21, 2006, incorporated herein by reference to Exhibit 10.1 of the current report on Form 8-K filed July 28, 2006.
10.31    Purchase Agreement, dated as of June 15, 2006, by and among BPG/CGV Hotel Partners IX LLC and EHP Operating Partnership, L.P., incorporated herein by reference to Exhibit 10.2 to the quarterly report on Form 10-Q for the period ended September 30, 2006.
21         List of Subsidiaries
23.1      Consent of independent registered public accounting firm.
23.2      Consent of independent registered public accounting firm.
31.1     

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

31.2     

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

32.1     

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act

32.2     

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act


* Represents management contract or compensatory plan or arrangement.

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Eagle Hospitality Properties Trust, Inc.

We have audited the accompanying consolidated statements of operations and comprehensive income, owners’ equity, and cash flows for the period from October 1, 2004 (inception) to December 31, 2004, and the Predecessor’s combined statements of operations and comprehensive income, owner’s equity, and cash flows for the period from January 1, 2004 to September 30, 2004 of Eagle Hospitality Properties Trust, Inc. (a Maryland corporation) (the “Company”). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the Company’s consolidated results of operations and cash flows for the period from October 1, 2004 (inception) to December 31, 2004, and the Predecessor’s combined results of operations and cash flows for the period from January 1, 2004 to September 30, 2004, in conformity with accounting principles generally accepted in the United States of America.

/s/ Grant Thornton LLP

Cincinnati, Ohio

February 10, 2005

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of

Eagle Hospitality Properties Trust, Inc.

We have audited the accompanying consolidated balance sheets of Eagle Hospitality Properties Trust, Inc. (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, shareholders’ equity, and cash flows for the years then ended. Our audit also included the financial statement schedule listed in Item 8. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. The financial statements and schedule of the Company for the year ended December 31, 2004, were audited by other auditors whose report dated February 10, 2005, expressed an unqualified opinion on those statements and schedule.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provided a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements, taken as a whole, present fairly in all material respects, the information set forth therein.

As discussed in Note 3 to the consolidated financial statements in 2006 the Company changed its method of accounting for stock-based compensation.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 20, 2007, expressed an unqualified opinion thereon.

/s/    ERNST & YOUNG LLP

Chicago, Illinois

February 20, 2007

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of

Eagle Hospitality Properties Trust, Inc.

We have audited management’s assessment, included in the accompanying Management Report on Internal Control, that Eagle Hospitality Properties Trust, Inc. (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, shareholders’ equity, and cash flows for years then ended of the Company and our report dated February 20, 2007, expressed an unqualified opinion thereon.

/s/    ERNST & YOUNG LLP

Chicago, Illinois

February 20, 2007

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC.

CONSOLIDATED BALANCE SHEETS

AS OF DECEMBER 31, 2006 AND DECEMBER 31, 2005

($000’s omitted)

 

      December 31,
2006
    December 31,
2005
 
ASSETS     

Cash and cash equivalents

   $ 3,749     $ 8,628  

Restricted cash—real estate tax escrows

     465       1,623  

Restricted replacement reserves

     2,645       5,436  

Accounts receivable, net

     6,447       6,026  

Due from affiliates, net

     —         32  

Inventories

     624       620  

Deferred income taxes

     2,595       3,323  

Deferred franchise fees and loan fees, net

     2,883       3,517  

Prepaid expenses and other assets

     2,625       1,948  

Investment in hotel properties, net

     439,693       394,990  
                

Total assets

   $ 461,726     $ 426,143  
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

LIABILITIES:

    

Notes payable

   $ 253,519     $ 211,427  

Income tax payable

     474       565  

Accounts payable

     3,869       2,272  

Due to affiliates, net

     421       —    

Dividends and distributions payable

     6,220       4,135  

Accrued expenses

     10,371       8,761  

Advance deposits

     1,899       2,098  
                

Total liabilities

   $ 276,773     $ 229,258  
                

Minority interest

     9,814       13,661  

SHAREHOLDERS’ EQUITY

    

Preferred stock, $0.01 par value, 10,000,000 shares authorized, 8.25% Series A—4,000,000 issued and outstanding at December 31, 2006 and December 31, 2005

   $ 40     $ 40  

Common stock, $0.01 par value, 100,000,000 shares authorized, 17,753,496 and 17,382,385 shares issued and outstanding at December 31, 2006 and December 31, 2005, respectively

     177       174  

Additional paid-in capital

     196,400       196,847  

Deferred compensation

     —         (1,700 )

Accumulated other comprehensive income

     —         9  

(Dividends in excess of accumulated earnings)

     (21,478 )     (12,146 )
                

Total shareholders’ equity

   $ 175,139     $ 183,224  
                

Total liabilities and shareholders’ equity

   $ 461,726     $ 426,143  
                

See notes to consolidated financial statements

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME

(audited except the Predecessor period from January 1, 2004—September 30, 2004, 000’s Omitted)

 

   

Company

Year Ended

December 31, 2006

   

Company

Year Ended

December 31, 2005

   

Company

Period From

October 1, 2004 to

December 31, 2004

   

Predecessor

Period From

January 1, 2004 to

September 30, 2004

 

REVENUES:

       

Rooms department

  $ 103,240     $ 79,972     $ 14,619     $ 44,336  

Food and beverage department

    35,113       28,882       5,822       14,378  

Participating lease income

    6,853       2,940       —         —    

Other operating departments

    5,777       4,631       784       2,359  
                               

Total revenue

    150,983       116,425       21,225       61,073  
                               

EXPENSES:

       

Hotel expenses

    97,754       77,085       14,405       41,238  

Management fees—related party

    2,811       2,218       614       2,116  

Depreciation and amortization

    17,889       14,013       2,735       6,550  

Corporate general and administrative

    5,505       7,072       1,275       —    
                               

Total operating expenses

    123,959       100,388       19,029       49,904  
                               

NET OPERATING INCOME

    27,024       16,037       2,196       11,169  

Interest expense

    (13,681 )     (10,760 )     (2,099 )     (8,753 )

Interest income

    362       485       33       124  

Other income

    2       33       —         —    
                               

Income before minority interest and provision for income taxes

    13,707       5,795       130       2,540  
                               

Income tax (expense) benefit

    (1,331 )     2,758       —         —    

Minority interest expense

    (1,040 )     (1,060 )     (33 )  
                               

NET INCOME

  $ 11,336     $ 7,493     $ 97     $ 2,540  

Distributions to preferred shareholders

    (8,250 )     (4,538 )     —         —    
                               

Net income available to common shareholders

  $ 3,086     $ 2,955     $ 97     $ 2,540  

Unrealized (loss) gain on marketable securities

    (9 )     (13 )     22       19  

Effect of interest rate swap

    —         —         —         716  
                               

COMPREHENSIVE INCOME

  $ 3,077     $ 2,942     $ 119     $ 3,275  
                               

Basic income per share

  $ 0.17     $ 0.16     $ 0.01    

Diluted income per share

  $ 0.17     $ 0.16     $ —      

Weighted average basic shares outstanding

    17,552       17,127       16,917    

Weighted average diluted shares outstanding

    23,527       23,142       22,911    

See notes to consolidated and combined financial statements

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

FOR THE YEAR ENDED DECEMBER 31, 2006

($000’s Omitted)

 

    Preferred
Stock
  Common
Stock
  Additional
Paid-In Capital
    Deferred
Compensation
    Other
Comprehensive
Income (Loss)
   

Dividends

in Excess of
Accumulated
in Earnings

    Total  

Balance at January 1, 2003

  $ —     $ 37   $ (20,885 )   $ —       $ —       $ —       $ (20,848 )

Subscriptions Receivable

    —       —       225       —         —         —         225  

Contributions

    —       —       —         —         —         —         —    

Distributions

    —       —       —         —         —         (4,807 )     (4,807 )

Comprehensive income(loss)

    —       —       —         —         —         229       229  
                                                   

Balance at December 31, 2003

  $ —     $ 37   $ (20,660 )   $ —       $ —       $ (4,578 )   $ (25,201 )

Contributions

    —       —       11,264       —         —         —         11,264  

Distributions

    —       —       —         —         —         (2,852 )     (2,852 )

Comprehensive income(loss)

    —       —       —         —         —         3,275       3,275  
                                                   

Balance at September 30, 2004

  $ —     $ 37   $ (9,396 )   $ —       $ —       $ (4,155 )   $ (13,514 )

Formation Transactions on October 1, 2004:

             

Issuance of shares in connection with IPO:

    —       168     163,347       —         —         —         163,515  

Offering and pre-IPO expense

    —       —       (14,186 )     —         —         —         (14,186 )

Issuance of shares for initial properties

    —       1     1,427       —         —         —         1,428  

Establish minority interest

    —       —       (17,002 )     —         —         —         (17,002 )

Issuance of restricted shares

    —       5     4,296       (4,301 )     —         —         —    

Amortization of deferred compensation

    —       —         678       —         —         678  

Accumulated other comprehensive income

    —       —         —         22       —         22  

Issuance of operating units

    —       —       58,432       —         —         —         58,432  

Consideration given in excess of fair value, plus minority interest step-up

    —       —       (95,827 )     —         —         —         (95,827 )

Net Income

    —       —         —         —         97       97  
                                                   

Balance at December 31, 2004

  $ —     $ 174   $ 100,487     $ (3,623 )   $ 22     $ 97     $ 97,157  

Issuance of preferred shares

    40     —       96,416       —         —         —         96,456  

Common dividends paid, $0.70 per share

    —       —       —         —         —         (12,155 )     (12,155 )

Common dividends declared, $0.175 per share

    —       —       —         —         —         (3,043 )     (3,043 )

Preferred dividends paid, $1.134 per share

    —       —       —         —           (4,538 )     (4,538 )

Issuance of restricted shares

    —       —       221       (221 )     —         —         —    

Amortization of deferred compensation

    —       —       —         2,144       —         —         2,144  

Adjustment to opening balance sheet

    —       —       (277 )     —         —         —         (277 )

Unrealized loss on investments

    —       —       —         —         (13 )     —         (13 )

Net income

    —       —       —         —         —         7,493       7,493  
                                                   

Balance at December 31, 2005

  $ 40   $ 174   $ 196,847     $ (1,700 )   $ 9     $ (12,146 )   $ 183,224  

Common dividends paid, $0.70 per share

    —       —       —         —         —         (12,417 )     (12,417 )

Preferred dividends declared, $2.0625 per share

    —       —       —         —         —         (8,251 )     (8,251 )

Operating partnership unit redemption

    —       3     703       —         —         —         706  

Forfeiture of restricted stock

    —       —       (10 )     —         —         —         (10 )

Stock-based compensation

    —       —       560       —         —         —         560  

Reclass for FAS 123(R) adoption

    —       —       (1,700 )     1,700       —         —         —    

Unrealized loss on investments

    —       —       —         —         (9 )     —         (9 )

Net Income

    —       —       —         —         —         11,336       11,336  
                                                   

Balance at December 31, 2006

  $ 40   $ 177   $ 196,400     $ —       $ —       $ (21,478 )   $ 175,139  
                                                   

See notes to consolidated and combined financial statements

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS ($000s)

 

     The Company     The Company     The Company     Predecessor  
     Year Ended
December 31,
2006
    Year Ended
December 31,
2005
    Period from
October 1, 2004 to
December 31, 2004
    Period from
January 1, 2004 to
September 30, 2004
 

Cash flows from operating activities:

        

Net income

   $ 11,336     $ 7,493     $ 97     $ 2,540  

Adjustments to reconcile net income to net cash provided by operating activities:

        

Deferred income taxes

     728       (3,323 )     —         —    

Depreciation

     17,202       13,523       2,735       6,550  

Gain on sale of property and equipment

     (2 )     (33 )     —         —    

Amortization of deferred loan fees and franchise rights

     716       493       —         —    

Stock-based compensation

     560       2,144       678       —    

Minority interest

     1,040       1,060       33       —    

Changes in assets and liabilities:

        

Accounts receivables

     (181 )     (2,771 )     (1,990 )     (1,068 )

Inventory, prepaid expenses, and other assets

     (596 )     (637 )     (855 )     210  

Due to affiliates

     453       (1,120 )     799       136  

Accounts payable, accrued expenses and advance deposits

     4,973       10,477       (887 )     1,608  
                                

Net cash provided by operating activities

   $ 36,229     $ 27,306     $ 610     $ 9,976  

Cash flows from investing activities:

        

Acquisition of hotel properties

   $ (54,000 )   $ (173,264 )   $ (56,080 )   $ —    

Refund of portion of Hilton Glendale purchase price

     2,500       —         —         —    

Capital expenditures

     (10,725 )     (14,108 )     (1,237 )     (4,659 )

Proceeds from sale of assets

     2       33       —         —    

Restricted cash

     3,940       3,168       532       (675 )
                                

Net cash used in investing activities

   $ (58,283 )   $ (184,171 )   $ (56,785 )   $ (5,334 )

Cash flows from financing activities:

        

Proceeds from financing

   $ —       $ 195,200     $ —       $ 3,522  

Deferred loan costs paid

     —         (1,922 )     (1,242 )     (63 )

Debt principal payments

     (1,363 )     (113,692 )     (54,650 )     (2,296 )

Proceeds from initial public offering

     —         —         163,515       —    

Cost of initial public offering

     —         —         (14,186 )     —    

Proceeds from preferred stock offering

     —         100,000       —         —    

Cost of preferred stock offering

     —         (3,544 )     —         —    

Credit facility borrowings

     75,700       22,545       —         —    

Credit facility payments

     (32,245 )     —         —         —    

Proceeds from affiliate financing

     —         —         —         791  

Payment of related party loan

     —         (23,391 )     (21,549 )     (329 )

Payment on capital lease obligations

     (68 )     (64 )     (53 )     (164 )

Payments/Declarations of preferred stock dividends

     (8,250 )     (4,538 )     —         —    

Payments/Declarations of common stock dividends and distributions

     (16,599 )     (20,484 )     —         (2,852 )

Adjustments to opening balance sheet

     —         (278 )     —         —    
                                

Net cash provided by (used in) financing activities

   $ 17,175     $ 149,832     $ 71,835     $ (1,391 )
                                

Net (decrease) increase in cash and cash equivalents

   $ (4,879 )   $ (7,033 )   $ 15,660     $ 3,251  

Cash and cash equivalents, beginning of year

     8,628       15,661       1       1,199  
                                

Cash and cash equivalents, end of year

   $ 3,749     $ 8,628     $ 15,661     $ 4,450  
                                

See notes to consolidated and combined financial statements

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS

For the Years Ended December 31, 2006, 2005, and 2004

 

1. Organization and Description of Business

Eagle Hospitality Properties Trust, Inc. (the “Company”), a hotel investment company is a self-advised real estate investment trust (“REIT”), which commenced operations on October 1, 2004 when it completed its initial public offering (“IPO”) and concurrently consummated certain other formation transactions, including the acquisition of a 100% interest in eight hotels and a 49% interest in one other hotel, all of which were previously owned by Corporex Companies, LLC (“Corporex”). Because we had the right and obligation to acquire the remaining 51% interest in such entity from Corporex no later than January 31, 2006 in exchange for 427,485 operating partnership units, the assets, liabilities and operations of such entity are included in our consolidated financial statements. On December 5, 2005, the Company exercised this right and acquired the remaining 51% interest in this hotel property in exchange for 427,485 operating partnership units.

At September 30, 2005, the Embassy Suites Hotel Denver International Airport achieved the required measurements as outlined in the earn-out provisions of the original acquisition agreement and in accordance with the terms of the earn-out provisions 250,000 additional operating partnership units were issued to the former owners of this hotel on December 5, 2005.

At June 30, 2006, the Embassy Suites Hotel Columbus/Dublin Airport achieved the required measurements as outlined in the earn-out provisions of the original acquisition agreement and in accordance with the terms of the earn-out provisions 83,333 additional operating partnership units were issued to the former owners of this hotel on July 24, 2006.

Our operating partnership, EHP Operating Partnership, L.P. (“EHP OP”) was organized as a limited partnership under the laws of the state of Maryland. The Company is the sole general partner of and owns approximately 74% of the limited partnership units in our operating partnership. Limited partners (including certain of our officers and directors) own the remaining operating partnership units. After one year from the date partnership units are issued, partnership operating units may generally be redeemed for the cash value of one share of our common stock or, at our sole option, one share of common stock.

EHP TRS Holding Co, Inc. (“EHP TRS”), our taxable REIT subsidiary, was incorporated as a Maryland corporation. Except for the Embassy Suites Hotel and Casino San Juan, each of our hotel properties are leased to EHP TRS, which engages hotel management companies to manage and operate the hotels under management contracts. Under applicable REIT tax rules, neither we nor our operating partnership can directly undertake the daily management activities of our hotels. Therefore, our operating partnership and principal source of funds will be dependent on EHP TRS’s ability to generate cash flow from the operation of the hotels. EHP TRS will pay income taxes at regular corporate rates on its taxable income.

The IPO consisted of the sale of 16,770,833 shares of common stock (“initial shares”) to the public at a price of $9.75. This amount included 2,187,500 shares issued as the result of the underwriters’ over-allotment option. The IPO generated gross proceeds of approximately $163.5 million. The aggregate proceeds to the Company, net of underwriters’ discount and offering costs, was $149.3 million. In addition to the initial shares, 208,332 shares of restricted stock were issued to Corporex in connection with a strategic alliance entered into with Corporex and certain affiliated persons granting us, among other things, an exclusive right of refusal to pursue certain investment opportunities identified by them in the future during the term of the agreement. 232,868 shares of restricted stock were issued to the Company’s directors, officers, and other employees. 146,540 shares of common stock were issued to Corporex in

 

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NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

connection with the acquisition of certain hotels. In addition, 5,566,352 operating partnership units were issued to Corporex and affiliates as part of the compensation for the acquisition of the hotels.

The Predecessor as referred to throughout this document is defined as the collective ownership of the initial nine hotels, which have been combined in the 2004 presentation comparability. The nine hotels are the: Cincinnati Landmark Marriott, Hilton Cincinnati Airport, Hyatt Regency Rochester, Chicago Marriott Southwest at Burr Ridge, Embassy Suites Hotel Cincinnati–RiverCenter, Embassy Suites Hotel Columbus/Dublin, Embassy Suites Hotel Cleveland/Rockside, Embassy Suites Hotel Denver-International Airport and Embassy Suites Hotel Tampa-Westshore.

Concurrent with the Company’s formation, the Company utilized its net proceeds of $149.3 million to repay $65.5 million of indebtedness and paid an additional $56.1 million in cash related to the acquisition of certain initial properties, plus working capital, net of cash received. Hence, the Company had approximately $27.7 million in available cash immediately following its formation.

On June 13, 2005, the Company issued 4,000,000 shares of 8 1/4% Series A Cumulative Redeemable Preferred Stock, redeemable solely at our option beginning on June 13, 2010. The net proceeds of this issuance was $96.5 million. The proceeds were used to purchase hotel properties and for general corporate and working capital purposes.

In addition to the nine hotels acquired in conjunction with the initial public offering in 2004, the Company acquired the following hotels in 2005 and 2006:

 

  ·  

the 270-room Embassy Suites Hotel Phoenix-Scottsdale for a net purchase price of $33.1 million on February 22, 2005;

 

  ·  

the 351-room Hilton Glendale in Glendale, California for a net purchase price of $77.5 million on June 23, 2005;

 

  ·  

the 299-room Embassy Suites Hotel and Casino San Juan in San Juan, Puerto Rico for a net purchase price of $60.2 million on June 28, 2005; and

 

  ·  

the 273-room Embassy Suites Boston at Logan International Airport in Boston, Massachusetts for a net purchase price of $53.4 million on July 21, 2006.

As of December 31, 2006, we owned thirteen hotels all of which are located in the United States. We currently have no foreign operations, and all of our operations are within the hotel lodging industry.

 

2. Basis of Presentation

These consolidated financial statements presented herein include all of the accounts of the Company beginning with its commencement of operations on October 1, 2004. Prior to that time, this report includes the combined financial statements of the Predecessor.

On the consolidated and combined statements of cash flows for the period from October 1, 2004 to December 31, 2004, the Company reclassified deferred loan costs paid of $1.2 million from cash flow from operating activities to cash flow from financing activities and restricted cash of $0.5 million from cash flow from operating activities to cash flow from investing activities, resulting in a change in net cash used in operating activities of $0.1 million to net cash provided by operating activities of $0.6 million, a change in net cash flows used in investing activities from $57.3 million to net cash used in investing activities of $56.8 million, and a change in net cash provided by financing activities of $73.0 million to net cash provided by financing activities of $71.8 million.

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

3. Significant Accounting Policies Summary

Principles of Consolidation—The accompanying financial statements have been consolidated for all activities from inception (October 1, 2004) through December 31, 2006. Included in this consolidation are the Company’s operating entities (TRS), the limited liability companies that own the hotel properties and EHP Operating Partnership. In accordance with FIN 46(R) also included in the consolidation are all activities and balances relating to the Embassy Suites Hotel Cincinnati—RiverCenter in which the Company owned only a 49% interest until acquiring the remaining 51% on December 5, 2005 in exchange for 427,485 partnership units. Under FIN 46(R) the Company was deemed to have been the primary beneficiary of this variable interest entity prior to acquiring the remaining 51% because the Company was obligated to acquire the remaining 51% of this hotel property no later than January 31, 2006. The portion of the statements that reflects activities of the Predecessor, the periods prior to October 1, 2004, have been combined due to the common ownership of the entities. All significant intercompany accounts and transactions among the consolidated and combined entities have been eliminated in the consolidated and combined financial statements.

Revenue Recognition—Revenues include room, food, beverage, and other hotel revenues such as long-distance telephone service, laundry, and space rentals. These items are recorded as revenue as the services or products are provided to hotel guests. Participating lease revenue is recognized in accordance with lease terms.

Use of Estimates—The preparation of these consolidated and combined financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Investment in Hotel Properties—The nine initial hotel properties are stated at the Predecessor’s historical cost, plus an approximate $42.5 million minority interest partial step-up recorded upon formation of the Company on October 1, 2004, related to the acquisition of minority interest from unaffiliated parties related to seven of the initial properties. The hotel properties acquired subsequent to the initial nine hotel properties are stated at our cost. Improvements and additions which extend the life of the property are capitalized.

Impairment of Investment in Hotel Properties—Hotel properties are reviewed for impairment whenever events or changes in circumstances indicate the carrying values of the hotel properties may not be recoverable. The Company tests for impairment in several situations, including when current or projected cash flows are less than historical cash flows, when it becomes more likely than not that a hotel will be sold before the end of its previously estimated useful life, and when events or changes in circumstances indicate that a hotel’s net book value may not be recoverable. To date, no such impairment charges have been recognized. If an asset were deemed to be impaired, the Company would record an impairment charge for the amount the property’s net book value exceeds its fair value.

Depreciation and Amortization Expense—Depreciation expense is based on the estimated useful lives of the Company’s assets. Presently, investment in hotel properties, air rights, furniture, fixtures, and equipment are depreciated using the straight-line method over lives which range from 5 to 40 years. Amortization expense is related to franchise agreements with the various franchisors and is incurred ratably over the lives of the agreements. In addition, amortization expense is recognized for the costs relating to

 

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NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

our mortgage and credit facilities. These costs are amortized ratably over the lives of the debt agreements. The Company incurred depreciation and amortization expense of $17.9 million, $14.0 million and $2.7 million for the years ended December 31, 2006 and 2005 and the period from October 1, 2004 through December 31, 2004, respectively. The Predecessor incurred depreciation and amortization expense of $6.6 million for the period of January 1, 2004 through September 30, 2004. Repairs and maintenance costs that do not extend the useful lives of the Company’s assets or enhance the utility of those assets are expensed as incurred. We were required by our franchisors to make capital expenditures at the Our total capital expenditures for 2006 were $10.7 million.

Cash and Cash Equivalents—Cash and cash equivalents represent cash on hand and in banks and cash equivalents with maturities of less than 90 days from the date of purchase.

Restricted Cash—Restricted cash consists of cash held in escrow reserves required by franchisors and/or lenders that relate to the payment of capital expenditures, real estate taxes and insurance.

Accounts Receivable—Accounts receivable consists primarily of meeting and banquet room rental and hotel guest receivables. The Company generally does not require collateral. Ongoing credit evaluations are performed and an allowance for potential credit losses is provided against the portion of accounts receivable that is estimated to be uncollectible. There was an allowance for doubtful accounts receivable of $105 at December 31, 2006 and $34 at December 31, 2005.

Inventories—Inventories consist primarily of food and beverages, and are stated at the lower of cost or market value. Cost is generally determined using the first-in, first-out method.

Deferred Loan Fees, Net—Deferred loan fees are recorded at cost and amortized using the level yield which approximates the straight-line method over the terms of the related debt. The amount of deferred debt costs at December 31, 2006 and 2005 were carried at a cost of $3.0 million and $3.1 million, respectively. The accumulated amortization was $0.9 million and $0.4 million, respectively, as of December 31, 2006 and 2005.

Investments—Marketable securities are comprised primarily of mutual funds, stocks and stock funds carried at market value. In accordance with SFAS 115, the investments in marketable securities have been classified as available for sale. The recorded cost of investments which are considered to be available for sale is adjusted to fair market value. The difference between cost and fair value is classified as accumulated other comprehensive income in the equity section of the balance sheet. The cost of the marketable securities reflected in the accompanying consolidated and combined balance sheets at December 31, 2006 and 2005, is $0 and $0.3 million, respectively.

Advertising Costs—Advertising costs are expensed as incurred. For the years ended December 31, 2006 and 2005 and for the period from October 1, 2004 to December 31, 2004, the Company incurred advertising costs of approximately $10.7 million, $8.4 million and $1.5 million, respectively. For the period from January 1, 2004 to September 30, 2004 the Predecessor incurred advertising costs of approximately $4.3 million. Advertising costs are included in hotel expenses in the accompanying consolidated and combined statements of operations. We also pay advertising fees pursuant to the franchise agreements with Marriott and Hilton.

Hotel Expenses—Hotel expenses include hotel-level general and administrative fees, sales, advertising, and marketing expenses, repairs and maintenance expenses, franchise fees, utility costs, hotel labor costs, real estate taxes, franchise fees, costs of food and beverage, and insurance.

 

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NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

Deferred Franchise Fees—Deferred franchise fees at December 31, 2006 represents the cost of the franchise agreements associated with the Marriott, Hilton, and Embassy Suites hotels. These fees were carried at a cost of $0.9 million and $0.8 million at December 31, 2006 and 2005, respectively. The accumulated amortization at December 31, 2006 and 2005, respectively, was $0.1 million and $0.1 million. These agreements have varying remaining lives, from 2010 to 2026.

Income Taxes—As a REIT, the Company generally will not be subject to federal corporate income tax on that portion of its net income (loss) that does not relate to taxable REIT subsidiaries. However, EHP TRS Holding Co., Inc. is treated as a taxable REIT subsidiary for federal income tax purposes. In addition, the REIT and its subsidiaries are subject to various state and local income taxes.

Earnings (Loss) Per Share—Basic earnings (loss) per share is calculated by dividing net income (loss) available to common shareholders by the weighted average common shares outstanding during the period. Dilutive earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common shares were exercised or converted into common shares, whereby such exercise or conversion would result in lower (higher) earnings (loss) per share.

Stock-Based Compensation—In connection with the Company’s formation, the Company established the 2004 Long-Term Incentive Plan (the “Stock Plan”). The Company has issued a net total of 511,180 shares of restricted stock under the Stock Plan to its executives, directors, and certain employees of the Company, the Predecessor and its affiliates. The vesting periods for these shares range from one to five years. Such shares are charged to compensation expense on a straight-line basis over the vesting period based on the price on the date of issuance. For the years ending December 31, 2006 and 2005, the Company incurred total compensation expense of $0.6 million and $2.1 million, respectively, related to these restricted shares. For the period from inception through December 31, 2004, the Company recognized compensation expense of approximately $0.6 million related to these restricted shares. Under the Stock Plan, the Company may issue a variety of performance-based stock awards, including nonqualified stock options. At December 31, 2006, no performance-based stock awards have been issued other than the restricted stock discussed above. The amount of shares available for issuance under this plan increased by 46,168 shares on January 1, 2007, pursuant to the provisions of the plan. At December 31, 2006, the Company had approximately 608,832 remaining shares available for future issuance under the Stock Plan.

In December 2004, the FASB issued Statement 123 (revised 2004) which establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, primarily on accounting for transactions in which an entity obtains employee services in share-based transactions. The FASB and SEC issued additional guidance and clarification to this Statement throughout 2005. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, with limited exceptions. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award—the requisite period. Although the Company’s bylaws allow for the issuance of stock options, none have been issued to this point. The Company adopted this pronouncement as of January 1, 2006. The adoption of this pronouncement did not have a material effect on our consolidated financial statements.

2004 Long-Term Incentive Plan—The Stock Plan was adopted by the board of directors and approved by stockholders prior to the initial public offering. The purpose of the Stock Plan is to promote the Company’s success and enhance the value by linking the personal interests of participants to those of the stockholders, and by providing such persons with an incentive to achieve outstanding performance.

 

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NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

The Stock Plan authorizes the governance and compensation committee and the Company’s board of directors upon approval to grant awards to employees, officers, consultants (including, but not limited to, Corporex and its employees) and directors in the following forms:

 

  ·  

options to purchase shares of common stock, which may be incentive stock options or non-statutory stock options under the Internal Revenue Code;

 

  ·  

stock appreciation rights, which give the holder the right to receive the difference between the fair market value per share on the date of exercise over the grant price;

 

  ·  

performance awards, which are payable in cash or stock upon the attainment of certain performance goals;

 

  ·  

restricted stock and restricted stock units, which are subject to restrictions on transferability and other restrictions set by the board of directors; and

 

  ·  

other stock-based awards in the discretion of the board of directors, including outright stock grants.

The number of shares reserved and available for awards issued under the Stock Plan initially was 655,000 shares, plus an annual increase to be added on the last day of our fiscal year in each year, beginning in 2004, equal to the lesser of the following:

 

  ·  

a number of shares equal to 5.0% of any additional shares of common stock or operating partnership units issued after the closing initial public offering; or

 

  ·  

an amount determined by our board of directors or governance and compensation committee.

There were 302,848 shares of restricted stock issued under this plan at December 31, 2006.

Segments —The Company presently operates in one business segment within the hotel lodging industry: direct hotel investments. Direct hotel investments refers to owning hotels through either acquisition or new development. The Predecessor also only operated within the direct hotel investments segment.

Recent Accounting Pronouncements—

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year. We do not anticipate the adoption of this pronouncement to have a material effect on our consolidated financial statements.

 

4. Concentrations of Risk

All of the Company’s investments are concentrated in the hotel industry. The Company’s current investment strategy is to acquire or develop full service and full service all-suites hotels. At present, all of the Company’s hotels are located in the United States. Accordingly, adverse conditions in the U.S. hotel industry will have a material adverse effect on the Company’s operating and investment revenues and cash available for distribution to stockholders.

 

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Three of the Company’s hotels are located in the Northern Kentucky/Greater Cincinnati, Ohio metropolitan area. Economic and real estate conditions in the area significantly affect our revenues. Business layoffs, downsizing, industry slowdowns, demographic changes and other similar factors may adversely affect the economic climate in this locale. Any resulting oversupply or reduced demand for hotels in the area would adversely affect revenues and net income.

 

5. Investment in Hotel Properties

Investment in hotel properties consists of the following as of December 31, 2006 and 2005. All amounts are in thousands:

 

     December 31,  
     2006     2005  

Land and improvements

   $ 31,411     $ 31,337  

Buildings and leasehold rights

     397,316       349,559  

Furniture, fixtures, and equipment

     44,425       30,351  
                

Total property and equipment

     473,152       411,247  

Accumulated depreciation

     (33,459 )     (16,257 )
                

Investment in hotel properties, net

   $ 439,693     $ 394,990  

In connection with the Company’s formation, the Company recorded a minority interest partial step-up of approximately $42.5 million to the historical net carrying values of seven of its hotel properties as a result of the Company acquiring minority interest from unaffiliated parties.

 

6. Income Taxes

The Company has elected to be taxed as a REIT under the Internal Revenue Code. To qualify as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that the Company distributes at least 90% of the Company’s taxable income to the Company’s stockholders. The Company currently intends to adhere to these requirements and maintain the Company’s REIT status. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and may not qualify as a REIT for four subsequent taxable years. If the Company qualifies for taxation as a REIT, the Company may be subject to certain state and local taxes on the Company’s income as well as to federal income and excise taxes on the Company’s undistributed taxable income.

The Company had a net tax expense of $1,331 and a net tax benefit of $2,758, respectively, for the years ending December 31, 2006 and 2005.

 

     2006     2005  

Federal, state and local income tax expense

   $ (1,219 )   $ (565 )

Federal and state income tax benefit

     13       3,398  
                

Gross income tax (expense) benefit

     (1,206 )     2,833  

Valuation allowance

     (125 )     (75 )
                

Net income tax (expense) benefit

   $ (1,331 )   $ 2,758  
                

 

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EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

As of December 31, 2006, the Company had a net deferred tax asset of $2.6 million due to prior year losses by its taxable REIT subsidiary (“TRS”). Management believes that it is more likely than not that this deferred tax asset will be realized. There is a valuation allowance of $0.2 million for the state portion of this deferred asset because the realization is deemed to be less likely due to tax law changes.

The Company’s deferred tax assets and related valuation allowance consisted of the following for the years ending December 31, 2006 and 2005:

 

     2006     2005  

State deferred tax asset

   $ 357     $ 360  

Federal deferred tax asset

     2,438       3,038  
                

Gross deferred tax asset

     2,795       3,398  

Valuation allowance

     (200 )     (75 )
                

Net deferred tax asset

   $ 2,595     $ 3,323  
                

The Company had an income tax payable of $474 and $565, respectively as of December 31, 2006 and 2005.

 

     2006    2005

State and local income tax payable

   $ 474    $ 565

Federal income tax payable

     —        —  
             

Income tax payable

   $ 474    $ 565

The dividends paid to the holders of the preferred stock in 2006 are taxable as ordinary income and the dividends paid to the holders of common stock are deemed to be 80% taxable and 20% return of capital.

 

7. Minority Interest

Minority interest in the operating partnership represents the limited partners’ proportionate share of the equity in the operating partnership. Net income (loss) is allocated to minority interest based on limited partnership percentage ownership for the period. Upon formation of the Company on October 1, 2004, the Company issued 5,566,352 units of limited partnership interest to affiliates, plus another 427,485 partnership units were issued on December 5, 2005 in exchange for the remaining 51% of the Embassy Suites Hotel Cincinnati–RiverCenter. An additional 250,000 partnership units were issued to the former owners of the Embassy Suites Hotel Denver International Airport on December 5, 2005, in compliance with the earn-out provisions in the original purchase agreement. Also 83,333 partnership units were issued to the former owners of the Embassy Suites Hotel Columbus/Dublin on July 24, 2006, in compliance with the earn-out provisions in the original purchase agreement. During 2006, 326,111 partnership units were redeemed in exchange for an equal amount of shares of common stock. This total of 6,001,059 of partnership units represents an approximate minority interest ownership of 25%. After a one-year holding period from the date of issuance, partnership units may be redeemed for the cash value of one share of our common stock or, at our sole option, one share of common stock.

 

8. Related Party Transactions

Hotel Management Agreements—Nine of our hotels are subject to management agreements with Commonwealth Hotels, Inc. (“CHI”) and as such, the Company is obligated to pay monthly management fees equal to 2.50% of gross revenues in 2005, 2.75% in 2006, and 3.00% of gross revenues in 2007 and the years

 

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thereafter. These management agreements are for a term of ten years, with a renewal option for one additional five-year period at the option of CHI. If the Company terminates a management agreement on any of the properties prior to its expiration, due to sale of the property, the Company may be required to pay a substantial termination fee. The Company’s Chairman is the majority shareholder in Commonwealth Hotels, Inc. Management and incentive fees earned by Commonwealth for the years ending December 31, 2006 and 2005 and the period from October 1, 2004 and ending December 31, 2004 were $2.8 million, $2.2 million and $0.6 million, respectively. The management and incentive fees expensed by the Predecessor for the period ending September 30, 2004 were $2.1 million. At December 31, 2006 and 2005, respectively, the Company owed Commonwealth $0.3 million and $0.2 million in management fees payable.

General Partner Compensation—Under an agreement with the Predecessor, the general partner (CPXR, a wholly owned subsidiary of Corporex) of the partnership that owned the Embassy Suites Hotel Cincinnati-RiverCenter (“CPXR”) received compensation in the amount of 0.25% of the value of the assets of the partnership at the end of the calendar year. Compensation expensed under this agreement for the period ending September 30, 2004, was $60. The compensation to be paid under this agreement was cancelled effective September 30, 2004.

Strategic Alliance Agreement—The Company entered into a Strategic Alliance Agreement (“SAA”) at the time of its initial public offering with Corporex and affiliated parties. The SAA provides the Company with the right of first refusal for development opportunities with Corporex and affiliates, as well as a non-compete clause for markets in which we own or have an investment. The agreement expires October 1, 2014. Corporex received 208,332 shares of restricted common stock in conjunction with the SAA. The shares vested October 1, 2005. For the periods ending December 31, 2005 and 2004, the Company incurred approximately $1.5 million and $0.5 million, respectively, in expense as a result of the amortization of these shares.

Related Party Debt—The Company incurred interest expense for related party debt of $0.2 million and $0.3 million for the year ending December 31, 2005 and the period from October 1, 2004 through December 31, 2004, respectively. The Predecessor incurred interest expense for the related party debt of $0.7 million for the period ending September 30, 2004.

Transition Services—From October 1, 2004 through December 31, 2005, the Company agreed to make Mr. Blackham available to provide certain consulting and advisory transition services to Corporex in areas unrelated to our core business. The Company was compensated (in thousands) $10 per month for providing these services. In 2005 and 2004 the Company received $120 and $30, respectively, related to this agreement.

Leased Office Space—The Company’s headquarters are located in an office building that is owned by the Company’s Chairman and affiliates and the Company’s Chief Executive Officer. We entered into a lease for this office space subsequent to the offering at terms approximating the fair market value. We are obligated to pay $0.6 million in rent over a ten-year period, or on average, approximately (in thousands) $5 per month. In addition to the rent payments we will also be subject to a common area maintenance fee allocation related to this office space. During 2006 and 2005, we incurred approximately $0.1 million per year in rental and common area maintenance fees relating to this lease.

 

9. Commitments and Contingencies

Restricted Cash—Under certain existing loan agreements, the Company is obligated to escrow payments for insurance and real estate taxes. In addition, for provisions in management company agreements, or debt or loan agreements related to certain properties require the Company to escrow 4% of gross revenue for capital improvements.

 

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Franchise Fees—All of our hotels, except the Hyatt Regency Rochester, operate under franchise agreements. In conjunction with these franchise agreements the Company is obligated to pay the franchisors royalty fees between 4% and 6% of gross room revenue, and fees for marketing, reservations, and other related activities aggregating between 1% and 4% of gross room revenue. In addition, the Marriott hotels are obligated to pay between 2% and 3% for food and beverage revenues. Franchise fees are included in hotel expenses in the accompanying consolidated and combined statements of operations.

These franchise agreements expire beginning in 2010 through 2026. When the term of a franchise expires, the franchisor has no obligation to issue a new franchise. The loss of a franchise could have a material adverse effect on the operations or the underlying value of the affected hotel because of the loss of associated name recognition, marketing support, and centralized reservation systems provided by the franchisor. The loss of a franchise could also have a material adverse effect on cash available for distribution to stockholders. In addition, if the Company terminates a franchise prior to its expiration date, the Company would be required to pay a termination fee.

Hyatt Regency Rochester Management Agreement—The Hyatt Regency Rochester is managed under an agreement with the Hyatt Corporation that expires in 2022. Under the terms of this agreement the Hyatt Corporation receives a base management fee equal to 4% of the gross revenue of the hotel. Hyatt Corporation is also eligible to receive an incentive fee, payable in monthly installments, equal to the amount by which 20% of the profit for a fiscal year exceeds the base fee for that fiscal year. The Company paid incentive fees to Hyatt of $71, $61 and $0 for the years ended December 31, 2006 and 2005 and the period from October 1, 2004 to December 31, 2004, respectively. The Predecessor paid incentive fees to Hyatt of $32 for the period from January 1, 2004 to September 30, 2004.

Management Fees—All of our hotels, except the Hyatt Regency Rochester, the Hilton Glendale, the Embassy Suites Hotel Boston and the Embassy Suites Hotel and Casino San Juan, are subject to management agreements with Commonwealth (which is 85% owned by our Chairman, William P. Butler) and as such, the Company is obligated to pay monthly management fees equal to 2.50% of gross revenues in 2005, 2.75% in 2006, and 3.00% of gross revenues in 2007 and the years thereafter. Commonwealth is also eligible under certain conditions to receive incentive fees. These management agreements have ten-year terms, with a renewal option for one additional five-year period. If the Company terminates a management agreement on one of our properties prior to its expiration, due to sale of the property, the Company may be required to pay a substantial termination fee. The Company expensed $2.8 million, $2.2 million and $0.6 million under these agreements for the years ended December 31, 2006 and 2005 and for the period from October 1, 2004 through December 31, 2004, respectively. The Predecessor expensed $2.1 million for the period ending September 30, 2004. Included in these amounts expensed by the Company were incentive fees of $77, $16 and $0 for the years ended December 31, 2006 and 2005 and the period from October 1, 2004 to December 31, 2004, respectively. Incentive fees of $368 were expensed by the Predecessor for the period from January 1, 2004 to September 30, 2004 and were included in management fees.

Leases—The Embassy Suites Hotel Cincinnati–RiverCenter is subject to a lease agreement for hotel building “air rights” with the City of Covington, Kentucky. The hotel “air rights” lease agreement requires the payment of 5% of the amount by which room revenue exceeds $4.5 million in a twelve-month period. The rent year commences June of each year. The Company can elect to convert this rent year to a calendar year whereby the $4.5 million would be prorated for the first year calculation. The Company has not made this calendar year election. The “air rights” lease agreement expires in June 2015 and has five consecutive automatic renewal options of 25 years each unless the Company gives written notice to the City that it is not renewing the lease. The Company incurred rent expense (in thousands) of approximately $0.2 million,

 

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$0.2 million and $0.1 million for the years ended December 31, 2006 and 2005 and for the period from October 1, 2004 to December 31, 2004, respectively. Rent expense incurred by the Predecessor for the period ended September 30, 2004 was approximately $0.2 million.

The Cincinnati Landmark Marriott is subject to a lease agreement for hotel building “air rights” with The Commonwealth of Kentucky. The hotel “air rights” lease agreement requires no further payments for the entire term of the lease. The “air rights” lease expires on January 3, 2093, but may be extended to 2143.

The Hyatt Regency Rochester is owned pursuant to a ground lease with the County of Monroe Industrial Development Agency that expires in 2020, at which time we can purchase the property for $1.00.

The Embassy Suites Boston at Logan International Airport is owned pursuant to a ground lease with Yebba Brothers LLC that expires in 2099. The annual base lease payment is $0.6 million with an additional percentage rent feature that begins in 2009.

The Company has entered into other non-cancelable operating leases related to certain equipment and facilities. As of December 31, 2006, future minimum annual commitments for non-cancelable operating lease agreements are as follows (in thousands):

 

     Operating Leases

2007

   $ 246

2008

     150

2009

     89

2010

     82

2011

     72

Thereafter

     201
      

Total future minimum operating lease payments

   $ 840

Employment Agreements—The Company has entered into employment agreements with the Senior Vice President-Acquisitions, Chief Financial Officer and the Chief Executive Officer, which provide for minimum annual base salaries, other fringe benefits, and non-compete clauses as determined by the Company’s Board of Directors. The agreements have terms expiring May 2008, May 2008 and October 2009, respectively.

Litigation—We are not involved in any material litigation nor, to our knowledge, is any material litigation threatened against us.

Tax Indemnifications—Under the tax indemnification agreements, the Company has agreed to provide tax indemnification, which would range between $45 million and $75 million, to the original contributors against certain tax consequences of the sale. We have agreed to pay the contributor’s tax liability with respect to gain allocated to the contributor under Section 704(c) of the Internal Revenue Code if we dispose of a property contributed by the contributor in a taxable transaction during a “protected period”, which continues until the earlier of: a) October 1, 2014, or b) the date on which the contributor no longer owns, in the aggregate, at least 25% of the units we issued to the contributor at the time of its contribution of property to our operating partnership.

 

10. Fair Value of Financial Instruments

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, amounts due from or to affiliates, accounts payable, and accrued expenses approximate their fair values due to the short-term nature of these financial instruments.

 

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As of December 31, 2006 the carrying values of the variable rate notes payable, and capital leases payable approximate their fair values because the interest rates on these on these financial instruments are variable or approximate current interest rates charged on similar financial instruments. We believe that the book value of the $163.8 million of fixed rate debt, which has a weighted average interest rate of 5.46% at December 31, 2006, approximates the fair value of the debt.

Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

 

11. Supplemental Cash Flow Information

On March 8, 2006, our Board of Directors declared a dividend of $0.175 per common share and operating partnership unit. This dividend was paid on April 17, 2006 to holders of record as of March 31, 2006. The total amount of the dividends paid to holders of our common stock was $3.1 million and $1.0 million was paid to holders of operating partnership units.

On March 8, 2006, Eagle declared a quarterly dividend of $0.515625 per 8 1/4% Series A Cumulative Redeemable Preferred Share for the period ended March 31, 2006 to holders of record as of March 16, 2006. The total amount of dividends paid to holders of the preferred shares was $2.1 million and was paid on March 31, 2006.

On June 2, 2006, Eagle declared a dividend of $0.175 per common share and operating partnership unit. This dividend was paid on July 14, 2006, to holders of record as of June 30, 2006. The total amount of the dividends paid to holders of our common stock was $3.1 million and $1.0 million was paid to holders of operating partnership units.

On June 2, 2006, Eagle declared a quarterly dividend of $0.515625 per 8 1/4% Series A Cumulative Redeemable Preferred Share for the period ended June 30, 2006 to holders of record as of June 15, 2006. The total amount of dividends paid to holders of the preferred shares was $2.1 million and was paid on June 30, 2006.

On July 21, 2006, we completed the acquisition of the 273-room Embassy Suites Boston at Logan International Airport for $53.4 million. The hotel is subject to a 90-year ground lease. This hotel is managed by Prism Hotels & Resorts. The allocation of the purchase price is preliminary. This acquisition was funded via our $110 million unsecured credit facility, having an interest rate of 200 basis points over 30-day LIBOR. The credit facility was also amended to delay the phase-in of a stricter financial covenant to provide us with balance sheet flexibility during 2006 and the first quarter of 2007. Effective with this amendment, our senior unsecured credit facility now requires that the ratio of our total debt to total asset value as defined in the agreement not exceed 58% through December 31, 2006, 55% from the period January 1, 2007 through March 31, 2007 and 53% thereafter.

On September 1, 2006, Eagle declared a dividend of $0.175 per common share and operating partnership unit. This dividend was paid on October 16, 2006, to holders of record as of September 29, 2006. The total amount of the dividends paid to holders of our common stock was $3.1 million and $1.0 million was paid to holders of operating partnership units.

On September 1, 2006, Eagle declared a quarterly dividend of $0.515625 per 8 1/4% Series A Cumulative Redeemable Preferred Share for the period ended September 30, 2006 to holders of record as of September 14, 2006. The total amount of dividends paid to holders of the preferred shares was $2.1 million and was paid on September 29, 2006.

 

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On December 1, 2006, Eagle declared a dividend of $0.175 per common share and operating partnership unit. This dividend was paid on January 16, 2007, to holders of record as of December 29, 2006. The total amount of the dividends paid to holders of our common stock was $3.0 million and $1.1 million was paid to holders of operating partnership units. This dividend is in “Accrued expenses” on the December 31, 2006 Balance Sheet. For federal income tax purposes this dividend will be treated as a distribution that occurred in 2007.

On December 1, 2006, Eagle declared a quarterly dividend of $0.515625 per 8 1/4% Series A Cumulative Redeemable Preferred Share for the period ended December 31, 2006 to holders of record as of December 14, 2006. The total amount of dividends paid to holders of the preferred shares was $2.1 million and was paid on January 2, 2007. This dividend is in “Accrued expenses” on the December 31, 2006 Balance Sheet. For federal income tax purposes this dividend will be treated as a distribution that occurred in 2007.

For the year ended December 31, 2006, Eagle granted approximately (in thousands) 52 shares of restricted stock (weighted average grant price of $8.63 per share), valued at approximately $0.5 million, under its LTIP and cancelled approximately 6 shares of restricted stock (weighted average grant price of $9.03 per share) due to the employee resignations, valued at $0.1 million. For the year ended December 31, 2005, Eagle granted approximately (in thousands) 45 shares of restricted stock (weighted average grant price of $9.51 per share), valued at approximately $0.4 million, under the Stock Plan and cancelled approximately 22 shares of restricted stock (weighted average grant price of $9.75 per share) due to the employee resignations, valued at $0.2 million. For the period from October 1, 2004 through December 31, 2004, the Company issued approximately (in thousands) 441 shares of restricted stock, valued at $4.3 million. There were no cancellations during this period.

For the years ended December 31, 2006 and 2005 and the period from October 1, 2004 to December 31, 2004, interest paid by the Company was approximately $13.5 million (net of $0.4 million of capitalized interest), $10.2 million (net of $0.2 million of capitalized interest) and $3.3 million, respectively. For the period from January 1, 2004 to September 30, 2004, interest paid by the Predecessor was approximately $7.6 million.

During the period ended September 30, 2004, EHP Burr Ridge, LLC, the entity that owns the Marriott Burr Ridge hotel, was deemed to have been contributed to the Predecessor. The Predecessor assumed the $22.8 million basis in the hotel, $12.2 million in debt and equity of $11.3 million.

Total dividends paid to holders of common stock and operating partnership units for the years ended December 31, 2006 and 2005 were $16.6 million and $20.5 million, respectively. Total dividends paid to holders preferred stock for the years ended December 31, 2006 and 2005 were $8.3 million and $4.5 million, respectively.

There were no dividends paid by the Company for the period from October 1, 2004 through December 31, 2004. The Predecessor paid distributions of $2.9 million for the period ending September 30, 2004.

 

12. Segment Reporting

The Company presently operates in only one business segment within the hotel lodging industry: direct hotel investments. Direct hotel investments refers to owning hotels through either acquisition or new development.

The Predecessor also only operated within the direct hotel investments segment.

 

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13. Long Term Debt

Long-term debt consisted of the following as of December 31, 2006 and 2005 ($000’s).

LONG-TERM DEBT

 

     As of December 31,
     2006    2005

First mortgage with a $58.0 million, 5.43% fixed rate traunche and a $23.8 million, LIBOR plus 1.75% variable rate traunche. The loan has a combined balloon payment of $75.0 million due at maturity in March 2010. Monthly interest only payments until March 2006; thereafter, total monthly interest and principal payments of approximately $499. The fixed traunche has a prepayment penalty of the greater of 1% of the outstanding balance or Yield Maintenance (1) 90 days prior to maturity. The variable traunche can be prepaid at anytime after March 2007 with no penalty. This loan is collateralized by all of the real and personal property at the Cincinnati Marriott Landmark, the Embassy Suites Hotel Tampa and the Embassy Suites Hotel Independence.

     80,877      81,800

First mortgage with monthly interest only payments with a fixed interest rate of 5.21%. Balloon payment due at maturity in July 2012. Defeasance is not permitted prior to July 2007, but the loan can be retired without penalty thereafter. The loan is collateralized by a real and personal property at the Hilton Glendale Hotel.

     53,100      53,100

First mortgage with monthly interest only payments until April 2008, thereafter monthly interest and principal payment of $226. The loan has a fixed interest rate of 5.135%. Balloon payment of $35.0 million due at maturity in September 2012. Defeasance is not permitted prior to June 2007, but the loan can be retired without penalty thereafter. The loan is collateralized by a real and personal property at the Embassy Suites Hotel and Casino San Juan.

     38,200      38,200

First mortgage payable in monthly installments of $130 principal and interest fixed 7.28%; due September 2008 with a balloon payment of $14,592, collateralized by the Hyatt Regency Rochester. Prepayment penalty of greater of 1% of outstanding principal balance or Yield Maintenance. (1)

     15,328      15,746

Unsecured $110 million credit facility using six hotels as its borrowing base. Monthly interest only payments with a LIBOR-based variable interest rate. The variable spread at December 31, 2006, is 2.50% but varies based upon the Company’s leverage. Balloon payment of balance due at date of maturity, January 1, 2009. Under certain conditions, this credit facility can be increased to $200 million. This credit facility is not subject to prepayment penalties or limitations.

     66,000      22,544

$67 loan on a shuttle van at the Marriott Burr Ridge. Monthly principal and interest payments of $2. Fixed interest rate of 5.1%. Due July 2007. There is no prepayment penalty for this loan.

     14      37
             

Long-term Debt

   $ 253,519    $ 211,427
             

 

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(1) Yield maintenance means a payment equal to the present value of the difference (if any) between the remaining scheduled payments of principal and interest and the remaining payments of principal, assuming the U.S. Treasury interest rate applicable to the date of each remaining principal payment.

The long term debt described above matures as follows:

 

2007

   $ 1,696

2008

     82,626

2009

     2,118

2010

     77,853

2011

     862

Thereafter

     88,364
      
   $ 253,519
      

Restricted cash in the accompanying consolidated balance sheet consists primarily of escrow accounts required by the lenders and franchisors. The escrow reserves relate to the payment of capital expenditures, property insurance and real estate taxes.

Certain debt agreements have covenants that include maintaining a required debt service coverage ratio, maintaining furniture, fixtures and equipment reserves and levels of unrestricted liquidity by owners. Eagle was in compliance with all of these covenants as of December 31, 2006. As long as we are in compliance with these covenants, and the distributions are permitted by state law, there are no restrictions on the Eagle’s ability to make distributions to its stockholders.

 

14. Selected Quarterly Financial Data (unaudited)

Selected quarterly financial data for the Company for the years ended December 31, 2006, 2005 and 2004 are below:

 

     First
Quarter
    Second
Quarter
   Third
Quarter
   Fourth
Quarter
   Total

Total revenue

             

2006

   $ 35,158     $ 38,514    $ 38,245    $ 39,066    $ 150,983

2005

   $ 21,703     $ 28,768    $ 33,206    $ 32,748    $ 116,425
                                   

2004

   $ 18,590     $ 20,477    $ 22,006    $ 21,225    $ 82,298
                                   

Total operating expenses

             

2006

   $ 29,396     $ 30,245    $ 31,771    $ 32,547    $ 123,959

2005

   $ 20,280     $ 23,766    $ 28,605    $ 27,737    $ 100,388
                                   

2004

   $ 15,809     $ 16,019    $ 18,076    $ 19,029    $ 68,933
                                   

Operating income

             

2006

   $ 5,762     $ 8,269    $ 6,474    $ 6,519    $ 27,024

2005

   $ 1,423     $ 5,002    $ 4,601    $ 5,011    $ 16,037
                                   

2004

   $ 2,781     $ 4,458    $ 3,930    $ 2,196    $ 13,365
                                   

Net income available to common shareholders

             

2006

   $ 389     $ 2,101    $ 404    $ 192    $ 3,086

2005

   $ 645     $ 1,768    $ 227    $ 315    $ 2,955
                                   

2004

   $ (55 )   $ 1,609    $ 986    $ 97    $ 2,637
                                   

Diluted earnings per share

             

2006

   $ 0.02     $ 0.12    $ 0.02    $ 0.01    $ 0.17

2005

   $ 0.03     $ 0.10    $ 0.01    $ 0.02    $ 0.16
                                   

2004

   $ —       $ —      $ —      $ —      $ —  
                                   

 

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15. Subsequent Events

On January 29, 2007, Eagle Hospitality Properties Trust, Inc. issued a press release announcing that its Board of Directors has decided to explore strategic alternatives to enhance shareholder value, including a possible sale of the Company. As part of that process, the Board has formed a Special Committee, which has retained Morgan Stanley as financial advisor.

On January 16, 2007, the Company paid a cash dividend of $0.175 per share of common stock and operating partnership unit, for shareholders of record on December 29, 2006. The dividend was declared on December 1, 2006.

On January 2, 2007, the Company paid a cash dividend of $0.515625 per share of preferred stock, for shareholders of record on December 14, 2006. The dividend was declared on December 1, 2006.

 

16. Retirement Plans

The Company began a 401(k) plan for qualified employees on July 1, 2005. The plan is subject to “safe harbor” provisions which require that the Company match 100% of the first 3% of employee contributions and 50% of the next 2% of employee contributions. All Company matching funds vest immediately in accordance with the “safe harbor” provisions and all full time employees who have attained the age of 21 are eligible to participate in the plan the first day of the fiscal quarter after they begin their employment. Contributions to the plan for the years ending December 31, 2006 and 2005 were $50 and $14, respectively.

The Predecessor participated in a 401(k) plan for qualified employees. The Predecessor matched 50% of employee contributions up to a total match of 6% of employee’s wages. Contributions to the plan for the period ending September 30, 2004 were $102. All employees with at least one year of service and who attained the age of 21 were eligible. Employees vested automatically with respect to employee contributions. Vesting for employer contributions, based on years of service.

 

17. Business Combinations

Effective October 1, 2004, the Company acquired a 100% interest in eight hotels and a 49% percent interest in the Embassy Suites Cincinnati–RiverCenter, all of which were previously owned or controlled by Corporex. As we had the right and obligation to acquire the remaining 51% interest in the entity that owned the Embassy Suites Cincinnati-RiverCenter from William P. Butler, the Company’s Chairman, no later than January 31, 2006 in exchange for 427,485 operating partnership units, the assets, liabilities and operations of such entity were included in our consolidated financial statements in accordance with the provisions in Financial Interpretation 46(R). The Company exercised this right and acquired the remaining 51% interest in this hotel on December 5, 2005. The total consideration for the nine hotels, including the 427,485 operating partnership units issued for the 51% of the Embassy Suites Cincinnati–RiverCenter, was $317.7 million, plus $5.0 million of working capital, net of cash received.

In addition to the nine hotels acquired in conjunction with the initial public offering in 2004, we acquired the following hotels in 2005 and 2006:

 

  ·  

the 270-room Embassy Suites Hotel Phoenix-Scottsdale for a net purchase price of $33.1 million on February 22, 2005;

 

  ·  

the 351-room Hilton Glendale in Glendale, California for a net purchase price of $77.5 million on June 23, 2005;

 

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  ·  

the 299-room Embassy Suites Hotel and Casino San Juan in San Juan, Puerto Rico for a net purchase price of $60.2 million on June 28, 2005; and

 

  ·  

the 273-room Embassy Suites Boston at Logan International Airport in Boston, Massachusetts for a net purchase price of $53.4 million on July 21, 2006.

The following condensed pro forma financial information is presented as if the Embassy Suites Boston at Logan International Airport had been acquired as of January 1, 2005:

 

     For the year ended
December 31,
(unaudited)
 
     2006    2005  

Total revenues

   $ 161,179    $ 129,016  

Net income (loss) applicable to common shareholders

   $ 437    $ (202 )

Net income (loss) applicable to common shareholders per weighted average share basic and diluted

   $ 0.02    $ (0.01 )

Weighted average basic shares outstanding

     17,552      17,127  

Weighted average fully diluted shares outstanding

     23,527      23,142  

 

18. Hotel Expenses

Below is a listing of the significant hotel operating expenses, including the management fees for a related party for the Company for the years ended December 31, 2006 and 2005 and the combined amounts for the Company and Predecessor for the year ended December 31, 2004

 

Hotel Operating Expenses

   Company
2006
   Company
2005
   Company and
Predecessor
2004

Front office and housekeeping

   $ 24,686    $ 19,733    $ 14,631

Food and beverage

     23,156      18,300      12,940

General and administrative

     11,425      8,839      6,067

Marketing

     10,732      8,402      5,809

Property taxes

     5,826      5,153      3,606

Energy

     6,002      5,025      3,753

Other

     7,301      4,597      3,428

Repairs and maintenance

     4,938      4,004      2,950

Franchise fees

     3,688      3,032      2,459
                    

Hotel Operating Expense

   $ 97,754    $ 77,085    $ 55,643

Management fees—Related Party

     2,811      2,218      2,730
                    

Total Hotel Operating Expense

   $ 100,565    $ 79,303    $ 58,373
                    

 

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19. Earnings Per Common Share

The computation of basic and diluted earnings per common share is presented below:

 

     Year Ended
December 31,
2006
    Year Ended
December 31,
2005
    October 1, to
December 31,
2004

Numerator:

      

Net income available to common shareholders before dividends paid on unvested restricted shares

   $ 3,086     $ 2,955     $ 97

Dividends paid on unvested restricted shares

     (142 )     (265 )     —  
                      

Net income available to common shareholders after dividends paid on unvested restricted shares

     2,944       2,690       97

Portion of income allocable to minority interest

   $ 1,040     $ 1,060     $ 33
                      

Net income available to common shareholders and operating partnership unitholders after dividends paid on unvested restricted shares

   $ 3,984     $ 3,750     $ 130
                      

Denominator:

      

Weighted average number of common
shares—basic

     17,552,461       17,126,932       16,917,373

Dilutive effect of unvested restricted shares

     2,384       272       —  

Weighted average number of operating partnership units

     5,971,843       6,014,671       5,993,837
                      

Weighted average number of common shares and operating partnership units—diluted

     23,526,688       23,141,875       22,911,210
                      

Basic Earnings Per Common Share:

   $ 0.17     $ 0.16     $ 0.01
                      

Diluted Earnings Per Common Share:

   $ 0.17     $ 0.16     $ 0.00
                      

 

70


Table of Contents

EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

SCHEDULE III—REAL ESTATE AND ACCUMULATED DEPRECIATION

For the period ending December 31, 2006 (000’s)

 

        Initial Costs to Company   Cost Capitalized Subsequent to Acquisition

Description

  Encumbrances   Leasehold
Air Rights
  Land   Building and
Improvements,
etc.
  Land
Improvements
    Building and
Improvements,
etc.
    Carrying Costs at
Close of Period

Embassy Independence

  $ 22,646   $ —     $ 3,466   $ 25,113   $ 80     $ 5     $ 28,664

Embassy Dublin

    —       —       2,703     24,792     —         103       27,598

Embassy Denver

    —       —       1,631     19,943     —         853       22,427

Embassy Rivercenter

    —       —       —       8,829     6       1,023       9,858

Embassy Tampa

    18,602     —       1,403     19,192     —         2,738       23,333

Marriott RiverCenter

    39,629     6,100     —       41,096     —         21       47,217

Marriott Burr Ridge

    —       —       1,880     19,471     —         24       21,375

Hilton CVG

    —       —       1,088     8,909     (12 )     2,068       12,053

Hyatt Rochester

    15,328     —       1,612     21,472     —         792       23,876

Embassty Phoenix

    —       —       2,154     27,881     —         282       30,317

Hilton Glendale

    53,100     —       5,600     71,274     —         (1,896 )     74,978

Embassy San Juan

    38,200     —       9,800     48,757     —         —         58,557

Embassy Boston

    —       —       0     48,474     —         —         48,474
                                             

Totals

  $ 187,505   $ 6,100   $ 31,337   $ 385,203   $ 74     $ 6,013     $ 428,727
                                             

 

    Gross Amount at Which Carried at Close
of Period
             

Life on Which
Depreciation in
Latest Income
Statements
is Computed

Description

  Leasehold
Air Rights
  Land   Buildings and
Improvements
  Total   Accumulated
Depreciation
  Date of
Construction
  Date
Acquired
 

Embassy Independence

  $ —     $ 3,546   $ 25,118   $ 28,664   $ 1,465     October-04   Bldg & Impr. 5-40yrs

Embassy Dublin

    —       2,703     24,895     27,598     1,446     October-04   Bldg & Impr. 5-40yrs

Embassy Denver

    —       1,631     20,796     22,427     1,182     October-04   Bldg & Impr. 5-40yrs

Embassy Rivercenter

    —       6     9,852     9,858     619     October-04   Bldg & Impr. 5-40yrs

Embassy Tampa

    —       1,403     21,930     23,333     1,400     October-04   Bldg & Impr. 5-40yrs

Marriott RiverCenter

    6,100     —       41,117     47,217     2,409     October-04   Bldg & Impr. 5-40yrs

Marriott Burr Ridge

    —       1,880     19,495     21,375     1,138     October-04   Bldg & Impr. 5-40yrs

Hilton CVG

    —       1,076     10,977     12,053     792     October-04   Bldg & Impr. 5-40yrs

Hyatt Rochester

    —       1,612     22,264     23,876     1,289     October-04   Bldg & Impr. 5-40yrs

Embassty Phoenix

    —       2,154     28,163     30,317     1,387     February-05   Bldg & Impr. 5-40yrs

Hilton Glendale

    —       5,600     69,378     74,978     2,914     June-05   Bldg & Impr. 5-40yrs

Embassy San Juan

    —       9,800     48,757     58,557     1,979     June-05   Bldg & Impr. 5-40yrs

Embassy Boston

    —       —       48,474     48,474     622     July-06   Bldg & Impr. 5-40yrs
                                   

Totals

  $ 6,100   $ 31,411   $ 391,216   $ 428,727   $ 18,642      
                                   

 

71


Table of Contents

EAGLE HOSPITALITY PROPERTIES TRUST, INC. AND PREDECESSOR

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENT—(Continued)

 

SCHEDULE III—REAL ESTATE AND ACCUMULATED DEPRECIATION

Company for the periods ending December 31, 2006 and 2005 and the period from

October 1, 2004 (Inception) to December 31, 2004

Predecessor for period ending September 30, 2004

 

     Period ended
     The Company    The Predecessor
     December 31,
2005