INTERSTATE HOTELS & RESORTS INC 10-K 2008
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For Fiscal Year Ended December 31, 2007
Commission File Number 1-14331
4501 North Fairfax Drive, Ste 500
Arlington, VA 22203
This Form 10-K can be accessed at no charge through above Web site.
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes þ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No
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 for which the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o 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 registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to the Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). o Yes þ No
The aggregate market value of common stock held by non-affiliates of the registrant was $112,573,643 (based on the closing sale price of $5.22 on June 29, 2007 as reported by the New York Stock Exchange). For this computation, the registrant has excluded the market value of all shares of its common stock reported as beneficially owned by executive officers and directors of the registrant; such exclusion shall not be deemed to constitute an admission that such person is an affiliate of the registrant. The number of shares of common stock outstanding at February 27, 2008 was 31,702,017.
Portions of the registrants definitive proxy statement relating to the Registrants 2007 Annual Meeting of Stockholders are incorporated by reference into Part III. We expect to file our proxy statement on or about April 21, 2008.
We are a leading hotel real estate investor and the nations largest independent operator, as measured by number of rooms under management and gross annual revenues of the managed portfolio. We have two reportable operating segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable segment, corporate housing, was disposed of on January 26, 2007, with the sale of BridgeStreet Corporate Housing Worldwide, Inc. and its affiliated subsidiaries, which we refer to as BridgeStreet. Each segment is reviewed and evaluated by the companys senior management. For financial information about each segment, see Note 10 to our consolidated financial statements.
Our hotel ownership segment includes our wholly-owned hotels and our minority interest, joint venture investments in hotel properties. Hotel ownership allows us to participate in the potential asset appreciation of the hotel properties, and as of December 31, 2007, we owned seven hotels and held non-controlling equity interests in 17 joint ventures, which own or hold ownership interests in 22 of our managed properties. We manage all of the properties that are part of our hotel ownership segment.
In our hotel management segment, we generate revenues from fees we receive for managing a portfolio of upscale, full-service and premium, select-service hospitality properties. We also generate revenues by providing specialized ancillary services in the hotel, resort, conference center and golf markets, which include insurance and risk management placed through a licensed broker, purchasing and project management, information technology and telecommunications, and centralized accounting functions.
As of December 31, 2007, we and our affiliates managed 191 hotel properties with 42,620 rooms and five ancillary service centers (which consist of a convention center, conference center, spa facility and two laundry centers), in 36 states, the District of Columbia, Russia, Mexico, Canada, Belgium and Ireland. Our portfolio of managed properties is diversified by location/market, franchise and brand affiliations, and ownership group. We manage hotels represented by nearly 30 franchise and brand affiliations in addition to managing 15 independent hotels. Our managed hotels are owned by more than 60 different ownership groups, including individual investors, institutional investors, investment funds, such as Cornerstone Real Estate, private equity firms, such as The Blackstone Group, and public real estate investment trusts, or REITs, such as Sunstone Hotel Investors, Inc.
In this report, we use the terms we, our, us, Interstate and the Company to refer to Interstate Hotels & Resorts, Inc. We were formed on August 3, 1998, as MeriStar Hotels & Resorts, Inc., when we were spun off by CapStar Hotel Company, which then changed its name to MeriStar Hospitality Corporation, which we refer to as MeriStar. We then became the lessee and primary manager of all of MeriStars hotels at the time of the spin-off. On January 1, 2001, in connection with the implementation of new REIT tax laws that permit subsidiaries of a REIT to lease the real estate it owns, we assigned the leases on each of the properties we were leasing from MeriStar to taxable REIT subsidiaries of MeriStar and entered into management contracts with those subsidiaries for each of the hotels owned by MeriStar.
On July 31, 2002, we merged with Interstate Hotels Corporation, which we refer to as Old Interstate, and were renamed Interstate Hotels & Resorts, Inc. The transaction was a stock-for-stock merger of Old Interstate into us, in which Old Interstate stockholders received 4.6 shares of our common stock for each equivalent share of Old Interstate. Our stockholders continued to own the same number of shares in new Interstate following the merger. Immediately after the merger, we effected a one-for-five reverse split of our common stock. The merger was accounted for as a reverse acquisition, with Old Interstate as the accounting acquirer, and us as the surviving company for legal purposes under our new name of Interstate Hotels & Resorts, Inc.
Throughout 2007, we focused on the execution of our business strategy by continuing to build a portfolio of quality management contracts and investing in hotels through joint ventures and selective whole-ownership. With the disposition of our corporate housing business, management was able to focus solely on the hotel industry. We
believe this strategic focus will enhance our overall long-term growth by allowing us to deploy all of our resources and expertise to our core area of operations. Our overall strategy to grow our core business in the hotel industry is to recruit and maintain a high quality management team, follow a disciplined investment philosophy, and provide best in class service to our customers and owner groups. We believe this strategy will, in turn, provide strong long-term growth opportunities for our stockholders.
In 2005, we began our expansion into hotel real estate with our purchase of the 331-room Hilton Concord, located in the East Bay area of San Francisco, California and the 195-room Hilton Durham, near Duke University, both of which are full-service hotels. In 2006, we purchased the 131-room Hilton Garden Inn Baton Rouge, a select-service hotel in Louisiana and the 308-room Hilton Arlington, a full-service hotel in Texas. In 2007, we acquired the 297-room Hilton Houston Westchase, the 495-room Westin Atlanta Airport and the 288-room Sheraton Columbia in Maryland, all full-service hotels.
We believe making investments in hotels through joint ventures and selective whole-ownership is a key component to our strategic growth. As of December 31, 2007, we owned six full-service hotels and one select-service hotel, and held non-controlling equity interests in 17 joint ventures, 12 of which own 22 hotels located throughout the United States and Mexico. As of December 31, 2007, we held investments in two joint ventures currently developing five hotels, one joint venture which manages three hotels in Mexico. We also have made investments in two joint ventures which as of February 27, 2008, had purchased 26 hotel properties.
The following table provides information relating to our joint venture investments as of December 31, 2007:
Early in 2008, two of our joint ventures acquired a total of 26 hotel properties. One of the joint ventures owns four full-service properties, three of which we previously managed. The second joint venture owns 22 select-service properties, which are additions to our portfolio of managed properties and offer a strong opportunity for growth through strategic repositioning with minimal renovation or transition costs.
In February 2008, we realized the successful completion of a joint venture investment cycle when our joint venture that owned the Doral Tesoro Hotel & Golf Club, located in Dallas, Texas, sold the hotel. We expect to recognize a gain in excess of $2.0 million related to the sale. Proceeds from the sale of the hotel will be redeployed through additional investment opportunities during 2008. This transaction highlights the upside and success we believe exists through our joint venture investments which range from 10% to 50%. These strategic partnerships and investments enable us to secure longer term management contracts, further align our interests in the hotels that we manage with those of the majority owners and provide us the opportunity to participate in the potential asset appreciation of these properties. We pursue whole-ownership opportunities when we believe our knowledge of the hotel, or the market in which it operates, will allow us to significantly increase the current value of the hotel. We accomplish this by making prudent capital improvements to the hotel and implementing our management strategies.
Our plan is to continue to expand our portfolio of real estate investments through the selective whole and joint venture ownership opportunities of hotels, resorts and conference centers. Our joint venture investment strategy is designed, in part, to secure additional full-service and select-service management contracts. We attempt to identify properties that are promising acquisition candidates located in markets with economic, demographic and supply dynamics favorable to hotel owners. Through our vast network of industry contacts, coupled with our due diligence process, we seek to select those acquisition targets where we believe that selected capital improvements and focused management will increase the propertys ability to attract key demand segments, demonstrate better financial performance, and increase long-term value. In order to evaluate the relative merits of each investment opportunity,
senior management and individual operations teams create detailed plans covering all areas of renovation and planned operation. These plans serve as the basis for our expansion decisions and guide subsequent renovation and operating plans.
We seek to invest in properties that meet the following market and hotel criteria:
We expect that our reputation as a leading hotel and hospitality manager combined with our relationships throughout the lodging industry will continue to provide us with a competitive advantage in identifying, evaluating and investing in hotels that meet our criteria. We have a record of successfully managing the renovation and repositioning of hotels in situations with varying levels of service, room rates and market types. We plan to continue to manage such renovation and repositioning programs as we invest in hotels, resorts and conference centers.
We believe we can maximize the value of our hotel portfolio through aggressive asset management. We continue to evaluate key performance indicators against established benchmarks and historical performance to ensure that an appropriate level of assistance is provided to our managers to maximize opportunities and value for each of our owned and managed owned assets. Areas of focus include enhancing revenue management for rooms, food and beverage and other services, reducing operating and overhead expenses and identifying operating efficiencies
through the benchmarking process, all of which improve the long-term profitability of the hotel. We also continuously focus on the guest satisfaction measurement process to ensure that we maintain a balance of profitability and guest satisfaction, further enhancing the long-term asset value of our portfolio.
Our asset management and development professionals work closely with our managers in overseeing capital expenditure budgets to ensure that our hotels are in good physical condition, highly competitive in the market and compliant with brand standards. We also work with our managers to ensure that renewal and replacement expenditures are efficiently spent to maximize the profitability of the hotel. In addition, we pursue opportunities to enhance asset value by completing selective capital improvements outside the scope of the typical renewal and replacement capital expenditures. These capital improvements may include converting under-utilized space to alternative uses, building additional guest rooms, recreational facilities, meeting space or exhibit halls, and installing energy management systems and increasing energy efficiency wherever possible. When appropriate, we also consider the complete repositioning of a hotel in a given market, which often includes a complete renovation of guest rooms, meeting rooms and public space modifications, and can also include a change in brand and name.
Our portfolio of managed properties is diversified by location/market, franchise and brand affiliations, and ownership group. The hotels managed by us and our affiliates are primarily located throughout the United States, including most major metropolitan areas and rapidly growing secondary cities. We and our affiliates also manage eleven international hotels, including five in Russia, three in Mexico and one each in Canada, Belgium and Ireland. In addition to geographic and market diversity, our managed hotels represent nearly 30 nationally and internationally recognized brand names including Marriott, Hilton, Sheraton, Westin, Renaissance, Radisson, Doubletree, Embassy Suites, Wyndham, and Hampton Inn, as well as 15 independent hotels. Our managed hotels are owned by more than 60 different ownership groups, including individual investors, institutional investors, investment funds, such as Cornerstone Real Estate, private equity firms, such as The Blackstone Group, and public real estate investment trusts, or REITS, such as Sunstone Hotel Investors, Inc.
We manage properties and provide related management services primarily within the upscale and mid-priced full-service sectors and the premium select-service sector. We believe the combination of these sectors provides us with a balanced mix of managed assets. The two sectors attract a wide variety of potential customers, including both business and leisure travelers. Our size, as the largest independent manager of hotels in the nation, allows us to provide systems and services to owners on a broad scale, capitalizing on the extensive experience of our corporate operations, sales and support personnel. We believe our independence from any one brand provides us the opportunity to be more flexible operationally and to have our interests more closely aligned with those of the owners of the hotels for which we manage.
Our principal operating objectives in our hotel management segment are to generate higher revenue per available room, or RevPAR, control costs and increase the net operating income of the hotels we manage, while providing our guests with high-quality service and value. We believe that skilled management is the most critical element in maximizing revenue and cash flow in hotel properties. Our senior hotel management team has successfully managed hotels in all sectors of the lodging industry. We attribute our management success to our ability to analyze each hotel as a unique property and to identify specific opportunities for RevPAR growth, as well as cash flow growth, available at each hotel. The challenging operating cycles that the hospitality industry encounters make our breadth and depth of experience and application of sound strategies even more valuable to the owners of the hotels we manage.
Our corporate office associates implement financing and investment activities and provide services to support and monitor our on-site hotel operations and executives. Each of our disciplines, including hotel operations, sales and marketing, human resources, food and beverage, technical services, information technology, development, risk management, legal and corporate finance, is staffed by an experienced team with significant expertise in their respective area. These departments support the hotel executives in their day-to-day activities by providing online, real-time financial reporting and review; accounting and budgeting services; sales and revenue management; cost controls; property management tools and other resources that we create, maintain and deliver efficiently and effectively using our centralized corporate office resources.
Key elements of our management programs include the following:
The following chart summarizes information on the national franchise affiliations of the properties we and our affiliates managed as of December 31, 2007:
We previously provided short and long-term corporate housing leases and apartment management within 15 major markets in the United States, as well as internationally in London and Paris, through the BridgeStreet® brand name in the extended corporate stay industry. On January 26, 2007, we sold BridgeStreet to an affiliate of Sorrento Asset Management, an Ireland-based company, for approximately $42.4 million. We redeployed the proceeds from this sale into investments in hotel real estate through wholly-owned acquisitions and joint ventures.
The operations of our corporate housing segment are reported as discontinued operations in our consolidated statement of operations for all periods presented, and the assets and liabilities are presented as held for sale on our consolidated balance sheet as of December 31, 2006.
MeriStar/Blackstone On February 21, 2006, MeriStar announced that it had entered into a definitive agreement to be acquired by The Blackstone Group. The acquisition closed in May 2006. Our management agreements for the 44 hotels Blackstone acquired remained in place after the transaction, although 35 hotels have since been sold, as of February 27, 2008. The total base management fee for each of the hotels we manage for Blackstone is 2.5% of total hotel revenue, however with incentive fees, we have the potential to earn up to 4% of total revenues. As of February 27, 2008, we continued to manage nine properties for Blackstone. Of the 35 properties which we no longer manage for Blackstone, we have individually acquired four properties, entered into joint ventures to acquire partial ownership of seven properties and retained the management contracts with the new owners for an additional two properties. The total management fees related to all MeriStar/Blackstone properties accounted for $8.6 million, or 13.4%, of management fees in 2007 and $20.3 million, or 27.0%, of management fees in 2006 (which included $3.2 million of business interruption proceeds from lost management fees that we received associated with eight MeriStar properties that were damaged or closed due to hurricanes in 2004).
Under the master management agreement that we entered into in 2004 with MeriStar (which has been assumed by Blackstone), we are entitled to a termination fee due to a sale of the property. The termination fees are calculated as the discounted future cash flows under the management agreement through the end of the initial contract term. Similar provisions are also in place in the event the hotel is sold during one of the renewal periods. The termination fees are paid over 48 months or as a discounted one-time payment. MeriStar/Blackstone may terminate management agreements each year, representing up to 600 rooms, with the election of a one-time termination fee payment equal to 18 months of management fees. MeriStar/Blackstone has the right to terminate a management agreement, free of any termination fees, if we make an investment in a hotel that is in the competitive set of any MeriStar/Blackstone hotel (provided that the termination request occurs between 12 and 18 months following the date of our investment). Additionally, Blackstone may also offset any unpaid termination fees due to us with future management fees earned from any new management agreement we would enter into with Blackstone. The remaining life under the master management agreement is approximately three years.
During August 2006, we entered into an amendment to our master fee agreement with Blackstone. The amendment allowed Blackstone to transition three properties from management by us without the sale of the property. In exchange, we received the right to preclude Blackstone from substituting any future management agreements given to us to reduce or offset its currently payable termination fees for hotels that had been sold as of August 2006. The amendment removed all contingencies related to the receipt of the agreed upon termination fee payments due from Blackstone. As a result, we recognized, on a present value basis, the $15.1 million of termination fees due to us as of the date of the amendment. During 2007 and 2006, we recognized $7.2 million and $24.3 million, respectively, in termination fees related to hotels sold by either Blackstone or MeriStar during their respective period of ownership.
See Risk Factors Risk Factors Related to Our Business Our management agreements may be terminated or not renewed under various circumstances, including if the properties to which they relate are sold or otherwise disposed of by their owners, which may have a material impact on our results of operations and A large percentage of our managed properties are owned by a small group of owners, which could result in the loss of multiple management agreements in a short period.
Relationships with Other Significant Owners In October 2004, we entered into a stock purchase agreement with Sunstone Hotel Investors, which we refer to as Sunstone REIT, to acquire Sunstone Hotel Properties, which we refer to as Sunstone, a hotel management company. In connection with the acquisition, Sunstone entered into new management contracts with respect to 52 hotels and two ancillary service centers previously managed by Sunstone, 50 of which were owned by Sunstone REIT and its affiliates. The management agreements have an initial term of 20 years, with two extensions of five years each. As of December 31, 2007, our Sunstone subsidiary managed 29 hotels and two ancillary service centers, which accounted for 7,796 rooms, or 18.3% of our total managed rooms. Management fees related to all Sunstone properties managed during 2007 were $9.2 million, or 14.5%, of total management fees. Management fees for all Sunstone properties managed in 2006 were $10.0 million, or 13.3%, of total management fees. Under the termination provisions of our management agreements with Sunstone REIT we would be entitled to receive a termination fee if a contract is terminated prior to October 2010.
As of December 31, 2007, we managed five hotels in Moscow for a single owner, two of which were additions in 2007. The management agreements for these five properties expire between 2022 and 2024. These hotels accounted for $12.6 million, or 19.8%, of total management fees in 2007 and $9.6 million, or 12.7%, of total management fees in 2006.
As of December 31, 2007, we managed 38 hotels owned by Equity Inns, Inc., which accounted for 4,847, or 11.4% of total managed rooms. The total management fees related to all Equity Inns, Inc. properties accounted for $3.8 million, or 5.9%, of total management fees in 2007 and $3.9 million, or 5.2%, of total management fees in 2006.
As of December 31, 2007, we managed eight hotels for three separate independent owners which accounted for 4,197, or 9.8%, of total managed rooms. These properties accounted for $9.8 million, or 15.3%, of total management fees in 2007, and $6.8 million, or 9.1%, of total management fees in 2006.
We employ a flexible branding strategy based on each particular managed hotels market environment and other unique characteristics. Accordingly, a majority of our managed properties operate under various national trade names pursuant to licensing arrangements with national franchisors.
Generally, the third-party owners of our managed hotels, rather than us, are parties to the franchise agreements permitting the use of the trade names under which the hotels are operated. We are a party, however, to certain franchise agreements with Starwood Hotels & Resorts Worldwide, Inc. and Hilton Hotels Corporation, for the hotels we wholly-own. In the case where we are not the owner of the hotels, the hotel owners are required to reimburse us for all costs incurred in connection with these franchise agreements. Our franchise agreements which allow us to use these trade names expire at varying times, generally ranging from 2009 to 2027. We have registered with the United States Patent and Trademark Office the trademarks Colony® and Doral®, which we utilize in connection with managing hotels. We do not believe that the loss or expiration of any or all of our trademarks would have a material adverse effect on our business. The registrations for our marks expire at varying times, generally ranging from 2008 to 2015.
A number of states regulate the licensing of hospitality properties and restaurants, including liquor licensing, by requiring registration, disclosure statements and compliance with specific standards of conduct. We believe that we are substantially in compliance with these requirements. Managers of hospitality properties are also subject to laws governing their relationship with employees, including minimum wage requirements, overtime, working conditions and work permit requirements. Compliance with, or changes in, these laws could reduce the revenue and profitability of our properties and could otherwise adversely affect our operations.
We and our affiliates currently manage 11 international properties and have signed two additional management contracts for international properties that will commence operations in the second half of 2008. There are risks inherent in conducting business internationally. These include: employment laws and practices in foreign countries; tax laws in foreign countries, which may provide for tax rates that exceed those of the U.S. and which may provide that our foreign earnings are subject to withholding requirements or other restrictions; unexpected changes in regulatory requirements or monetary policy; and other potentially adverse tax consequences.
Under the Americans with Disabilities Act, all public accommodations are required to meet certain requirements related to access and use by disabled persons. These requirements became effective in 1992. Although significant amounts of capital have been and continue to be invested by our owners in federally required upgrades to our managed hotel properties, a determination that we or our owners are not in compliance with the Americans with Disabilities Act could result in a judicial order requiring compliance, imposition of fines or an award of damages to private litigants. We or our owners are likely to incur additional costs of complying with the Americans with Disabilities Act. However, those costs are not expected to have a material adverse effect on our results of operations or financial condition.
Under various federal, state and local and foreign environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be liable for noncompliance with applicable environmental, health and safety requirements and for the costs of investigation, monitoring, removal or remediation of hazardous or toxic substances. These laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. The presence of those hazardous or toxic substances on a property could also result in personal injury or property damage or similar claims by private parties. In addition, the presence of contamination, or the failure to report, investigate or properly remediate contaminated property, may adversely affect the operation of the property or the owners ability to sell or rent the property or to borrow using the property as collateral. Persons who arrange for the disposal or treatment of hazardous or toxic substances may also be liable for the costs of removal or remediation of those substances at the disposal or treatment facility, whether or not that facility is or ever was owned or operated by that person. The operation and removal of underground storage
tanks are also regulated by federal and state laws. In connection with the ownership and operation of hotels, the operators, such as us, or the owners of those properties, could be held liable for the costs of remedial action for regulated substances and storage tanks and related claims. Environmental laws and common law principles could also be used to impose liability for releases of hazardous materials, including asbestos-containing materials, into the environment, and third parties may seek recovery from owners or operators of real properties for personal injury associated with exposure to released asbestos-containing materials or other hazardous materials. We are not currently aware of any potential material exposure as a result of any environmental claims.
All of the hotels that we own and the majority of the hotels we manage have undergone Phase I environmental site assessments, which generally provide a non-intrusive physical inspection and database search, but not soil or groundwater analyses, by a qualified independent environmental consultant. The purpose of a Phase I assessment is to identify potential sources of contamination for which the hotel owner or others may be responsible. The Phase I assessments have not revealed, nor are we aware of, any environmental liability or compliance concerns that we believe would have a material adverse effect on our results of operations or financial condition. Nevertheless, it is possible that these environmental site assessments may not have revealed all environmental liabilities or compliance concerns, or that material environmental liabilities or compliance concerns exist of which we are currently unaware.
In addition, a significant number of the hotels that we own or manage have been inspected to determine the presence of asbestos. Federal, state and local environmental laws, ordinances and regulations require containment, abatement or removal of asbestos-containing materials and govern emissions of and exposure to asbestos fibers in the air. Asbestos-containing materials are present in various building materials such as sprayed-on ceiling treatments, roofing materials or floor tiles at some of the hotels. Operations and maintenance programs for maintaining asbestos-containing materials have been or are in the process of being designed and implemented, or the asbestos-containing materials have been scheduled to be or have been abated at these hotels at which we are aware that asbestos-containing materials are present. We are not currently aware of any potential material exposure as a result of any asbestos-related claims for our owned hotels and we are indemnified by our hotel owners for any related claims under our management agreements.
We have also detected the presence of mold at one of our owned hotels and are evaluating the impact and will take the appropriate measures to remediate. Many of the costs associated with remediation of mold may be excluded from coverage under our property and general liability policies, in which event we would be required to use our own funds to remediate. Further, in the event moisture infiltration and resulting mold is pervasive, we may not be able to rent rooms at that hotel, which could result in a loss of revenue. Liabilities resulting from moisture infiltration and the presence of, or exposure to mold, could have a future material adverse effect on our business, financial condition, results of operations and ability to make distributions to our stockholders.
Furthermore, various court decisions have established that third parties may recover damages for injury caused by property contamination or exposure to hazardous substances such as asbestos, lead paint or black mold. In recent years, concern about indoor exposure to mold has been increasing as such exposure has been alleged to have a variety of adverse effects on health. As a result, there has been an increasing number of lawsuits against owners and managers of real property relating to the presence of mold. Damages related to the presence of mold are generally excluded from our insurance coverage. Should an uninsured loss arise against us, we would be required to use our own funds to resolve the issue, which could have an adverse impact on our results of operations or financial condition.
Although we sold BridgeStreet in January 2007, we may be required to indemnify the purchaser to the extent our policies, during the time we owned it, are found not to have been in compliance with local laws. As a former lessee of accommodations through our corporate housing segment, we believed our employees were either outside the purview of, exempt from or in compliance with, laws in the jurisdictions in which we operated, requiring real estate brokers to hold licenses. There however, can be no assurance that our position in any jurisdiction would be upheld if challenged.
We compete primarily in the following segments of the lodging industry: the upscale and mid-priced sectors of the full-service segment and the select-service segment and resorts. Other full and select-service hotels and resorts compete with our properties in each geographic market in which our properties are located. Competition in the lodging industry is based on a number of factors, most notably convenience of location, brand affiliation, price, range of services and guest amenities or accommodations offered and quality of customer service and overall product.
In addition, we compete for hotel management contracts against numerous competitors, many of which have more financial resources than us. These competitors include the management arms of some of the major hotel brands as well as independent, non-brand- affiliated hotel managers. See Risk Factors Risk Factors Related to Our Business We face significant competition in the lodging industry and in the acquisition of real estate properties.
As of December 31, 2007, we employed approximately 19,700 associates, of whom approximately 17,200 were compensated on an hourly basis. We are reimbursed by the hotel owners for wages, benefits and other employee related costs directly related to employees at their respective hotels. Some of the employees at 22 of our hotels are represented by labor unions. We believe that labor relations with our employees are generally good.
Generally, hotel revenues are greater in the second and third calendar quarters than in the first and fourth calendar quarters. Hotels in tourist destinations generate greater revenue during tourist season than other times of the year. Seasonal variations in revenue at the hotels we own or manage will cause quarterly fluctuations in revenues.
We will make available, free of charge, access to our Annual Report on Form 10-K, Proxy Statement, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such reports are electronically filed with or furnished to the SEC through our home page at www.ihrco.com.
You should carefully consider the risk factors set forth below as well as the other information contained in this Annual Report on Form 10-K in connection with evaluating us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business, results of operations or financial condition. Certain statements in Risk Factors are forward-looking statements. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements for additional information about our business, results of operations and financial condition.
Risk Factors Related to Our Business
We encounter industry risks related to operating, managing and owning hotels that could cause our results of operations to suffer.
Various factors could adversely affect our ability to generate hotel revenues for our owned properties and management fees for our managed properties, which are based on hotel revenues. Our business is subject to all of the operating risks inherent in the lodging industry. These risks include, but are not limited to, the following:
We encounter industry-related and other risks related to our investments in and ownership of hotels and other real estate that could adversely impact its value to us.
In addition to the operating risks described above, with respect to hotels and real estate where we hold an ownership interest, we have the following additional risks:
Most of these factors are beyond our control. As our company expands through the acquisition and/or development of real estate, the magnitude of these risks may increase. Any of these factors could have a material and adverse impact on the value of our assets or on the revenues that can be generated from those assets. In addition, due to the level of fixed costs required to operate upscale and select-service hotels, significant expenditures necessary for the operation of these properties generally cannot be reduced when circumstances cause a reduction in revenue. Therefore, if our properties do not generate revenue sufficient to meet operating expenses, including debt service and capital expenditures, our income will be adversely affected. In addition, as we increase our ownership of hotels, we will be more subject to volatility in our overall revenues, cash flows from operations and net income, as our portfolio of owned hotels is currently less diversified across markets and asset classes than our portfolio of managed hotels, and the revenues, cash from operations and net income associated with a single owned hotel will generally be substantially greater than the same from a single managed hotel.
Changes in ownership of managed hotels could adversely affect the retention of our existing hotel management agreements.
Increased hotel values in recent years have resulted in an increased rate of disposition by the owners of hotels we manage, which has led to the loss of management contracts. The loss of associated management contracts could have an adverse effect on our revenues to the extent we do not replace lost management contracts with new ones. An economic slowdown may lead to an increased risk of bankruptcy by owners of hotels and/or foreclosures on the hotel properties, which may inhibit our ability to collect fees under our management agreements or may lead to their termination.
A large percentage of our managed properties are owned by a small group of owners, which could result in the loss of multiple management agreements in a short period.
A significant portion of our managed properties and management fees are derived from seven owners. This group of owners represents 92, or 48.2%, of our managed properties and 22,453, or 52.7%, of our managed rooms as of December 31, 2007. These seven owners also accounted for 69.0% of our base and incentive management fees in 2007. Our portfolio of managed properties could be adversely impacted if any of these owners were acquired by another entity, sold their portfolio or entered into a property disposition plan. In addition to lost revenues, the termination of management agreements could result in the impairment of intangible assets and goodwill. See Our management agreements may be terminated or not renewed under various circumstances, including if the properties to which they relate are sold or otherwise disposed of by their owners, which may have a material impact on our results of operations.
If our revenues are negatively affected by one or more particular risks, our owned hotels operating margins could suffer.
We report operating revenues and expenses from our owned hotels; therefore, we are susceptible to changes in operating revenues and are subject to the risk of fluctuating hotel operating margins at those hotels. Hotel operating expenses include, but are not limited to, wage and benefit costs, energy costs, supplies, repair and maintenance expenses, utilities, insurance and other operating expenses. These operating expenses can be difficult to predict, resulting in unpredictability in our operating margins. Also, due to the level of fixed costs required to operate full-service hotels, we are limited in our ability to reduce significant expenditures when circumstances cause a reduction in revenue.
Our management agreements may be terminated or not renewed under various circumstances, including if the properties to which they relate are sold or otherwise disposed of by their owners, which may have a material impact on our results of operations.
If the owner of a property we manage disposes of the property, or under certain management agreements, if specified performance standards at the hotel are not met, the owner may cease our management of the property.
Similarly, if an owner of properties we manage is acquired, the subsequent owner may have the right to terminate our management agreements. Although the management agreements with two of our most significant owners (Blackstone and Sunstone REIT) contain termination fee provisions, our management agreements with other owners generally have limited or no termination fees payable to us if a hotel is sold and the agreement is terminated. The termination of management contracts as a result of hotel dispositions or other factors could therefore have an adverse effect on our revenues. In addition, hotel owners may choose to allow our management agreements to expire. As of December 31, 2007, approximately 69 of our management agreements had current terms scheduled to expire within two years. In addition, for certain of our owners, we do not have the right to assign a management contract to an unrelated third party without prior written consent of the relevant hotel owner. A change in control of our Company would require the consent of these owners.
The termination of management contracts may result in the write-off of management contract intangible assets and require an evaluation for potential impairment of our goodwill. The write-off of management contract intangible assets or the impairment of goodwill could have a material adverse effect on our statement of operations and earnings per share.
A high percentage of the hotels we manage are upscale hotels so we may be particularly susceptible to an economic downturn, which could have a material adverse effect on our results of operation and financial condition.
Approximately 80% of the rooms we manage are in hotels that are classified as upscale or upper-upscale hotels. These hotels generally command higher room rates. However, in an economic downturn, these hotels may be more susceptible to a decrease in revenues, as compared to hotels in other categories that have lower room rates. This characteristic results from hotels in this segment generally targeting business and high-end leisure travelers. In periods of economic difficulties, business and leisure travelers may seek to reduce travel costs by limiting trips or seeking to reduce costs on their trips. Adverse changes in economic conditions could have a material adverse effect on our results of operations and financial condition.
Acts of terrorism, the threat of terrorism, the ongoing war against terrorism and other factors have impacted and will continue to impact the hotel industry and all hotel companies results of operations.
The threat of terrorism could have a negative impact on hotel operations, causing lower than expected performance, particularly in weak economic cycles. The threat of terrorism could cause a significant decrease in hotel occupancy and average daily rates and result in disruptions in business and leisure travel patterns due to concerns about travel safety. Future outbreaks of hostilities could have a material negative effect on air travel and on our business. In addition, increased security measures at airports or in major metropolitan areas may also cause disruptions to our operations.
The uncertainty associated with incidents and threats and the possibility of future attacks may hamper business and leisure travel patterns in the future. In addition, potential future outbreaks of contagious diseases and similar disruptive events could have a material adverse effect on our revenues and results of operations due to decreased travel and occupancy, especially in areas affected by such events.
We are dependent on the owners of the hotel properties we manage to fund operational expenditures related to those properties, and if such funds are untimely or not paid, we are required to bear the cost.
We incur significant expenditures related to the management of hotel properties, including salary and other benefit related costs and business and employee related insurance costs for which we are reimbursed by the hotel owners. In the normal course of business, we make every effort to pay these costs only after receiving payment from an owner for such costs. However, to the extent an owner would not be able to reimburse these costs, due to a sudden and unexpected insolvency situation or otherwise, we would be required to pay these costs directly until such time as we could make other arrangements. Although we would make every effort to eliminate these costs prior to the point at which an owner could not reimburse us and we would continue to pursue payment through all available legal means, our results of operations could be adversely affected if we were forced to bear those costs.
If we are unable to identify additional appropriate real estate acquisition or development opportunities and to arrange the financing necessary to complete these acquisitions or developments, our continued growth could be impaired.
We continually evaluate potential real estate development and acquisition opportunities. Any future acquisitions or developments will be financed through a combination of internally generated funds, additional bank borrowings from existing or new credit facilities or mortgages, public offerings or private placements of equity or debt securities. The nature of any future financing will depend on factors such as the size of the particular acquisition or development and our capital structure at the time of a project. We may not be able to identify appropriate new acquisition or development opportunities and necessary financing may not be available on suitable terms, if at all.
An important part of our growth strategy will be the investment in, and acquisition of, hotels. Continued industry consolidation and competition for acquisitions could adversely affect our growth prospects going forward. We will compete for hotel and other investment opportunities with other companies, some of which may have greater financial or other resources than we have. Competitors may have a lower cost of capital and may be able to pay higher prices or assume greater risks than would be prudent for us to pay or assume. If we are unable to make real estate investments and acquisitions, our continued growth could be impaired.
Development activities that involve our co-investment with third parties may further increase completion risk or result in disputes that could increase project costs or impair project operations. Partnerships, joint ventures and other business structures involving our co-investment with third parties generally include some form of shared control over the operations of the business and create additional risks, including the possibility that other investors in such ventures could become bankrupt or otherwise lack the financial resources to meet their obligations, or could have or develop business interests, policies or objectives that are inconsistent with ours. Although we actively seek to minimize such risks before investing in partnerships, joint ventures or similar structures, actions by another investor may present additional risks of project delay, increased project costs, or operational difficulties following project completion.
We face significant competition in the lodging industry and in the acquisition of real estate properties.
There is no single competitor or small number of competitors that are dominant either in the hotel management or lodging business. We operate in areas that attract numerous competitors, some of which may have substantially greater resources than we or the owners of the properties that we manage have, including Marriott International, Inc., Starwood Hotel & Resorts Worldwide, Inc. and Hilton Hotels Corporation, among others. Competition in the lodging industry is based generally on location, brand affiliation, room availability, room rates, range and quality of services and guest amenities offered. New or existing competitors could lower rates; offer greater conveniences, services or amenities; or significantly expand, improve or introduce new facilities in markets in which we compete. Any of these factors could adversely affect operations and the number of suitable business opportunities. In addition, we compete for hotel management contracts against numerous other companies, many of which may have greater financial resources than we have. These competitors include the management divisions of the major hotel brands as well as independent, non-brand affiliated hotel managers.
We expect to acquire additional hotel properties from time to time. The acquisition of properties involves risks, including the risk that the acquired property will not perform as anticipated and the risk that any actual costs for rehabilitating, repositioning, renovating and improving identified in the pre-acquisition process will exceed estimates. There is, and it is expected that there will continue to be, significant competition for acquisitions that meet our investment criteria as well as risks associated with obtaining financing for acquisition activities. The continuing consolidation in the hotel industry may also reduce the availability of opportunities for us to acquire hotels. Our failure to make such acquisitions could have a material adverse effect on our ability to carry out our growth strategy.
In addition to acquiring hotels and resorts directly, we have invested and expect to continue to invest in joint ventures. Joint ventures often have shared control over the operation of the joint venture assets. Consequently, actions by a partner may subject hotels and resorts owned by the joint venture to additional risk. As we generally
maintain a minority ownership interest in our joint ventures, we are usually unable to take action without the approval of our joint venture partners. Alternatively, our joint venture partners could take actions binding on the joint venture without our consent.
The illiquidity of real estate investments and the lack of alternative uses of hotel properties could significantly limit 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, the ability to promptly sell one or more properties in response to changing economic, financial and investment conditions is limited. 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. In addition, hotel properties may not readily be converted to alternative uses if they were to become unprofitable due to competition, age of improvements, decreased demand or other factors. The conversion of a hotel to alternative uses would also generally require substantial capital expenditures. We may be required to expend funds to correct defects or to make improvements before a property can be sold. We may not have funds available to correct those defects or to make those improvements and as a result our ability to sell the property would be limited. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could significantly harm our financial condition and results of operations.
Failure to maintain adequate insurance levels or failure to be reimbursed by our hotel owners for property level insurance coverage or losses could result in significant expenditures.
We maintain insurance coverage at the hotels we manage and are the named insured on the workers compensation, general liability, and employment practices insurance policies. We are reimbursed by the hotel owners for the cost of these insurance policies as per our management contracts. We place insurance policies with insurers that are A.M. Bests rated A or better. We look to maintain adequate coverage to minimize our overall risk exposure. There are losses that may not be covered by these policies and in some cases we may, after reviewing the risks, accept a level of risk on a per claim basis in order to maintain adequate insurance at appropriate premiums. We would be indemnified for these losses assuming the owner is accessible and has the financial ability to compensate us. Losses incurred under these policies may not be reported or settled for several years after the original date of loss. If the insurance company becomes insolvent, we will pursue payment from the hotel owner but may not be successful. We would be liable for any amounts we do not collect from an owner and those amounts could be significant.
We also maintain health and welfare benefit programs for our associates at the hotels we manage. These programs include securing fully insured contracts and administrative services with various carriers for short term disability, medical and dental insurance coverage. We have decided to retain a portion of the risk with respect to certain programs based on our belief that we have a sufficient risk pool to stabilize claim projections, appropriate claims controls and limited overall risk. Regarding the short term disability and dental programs, overall benefit payments are considered low, resulting in overall limited risk exposure. With regard to the medical program, we purchase reinsurance on a specific claim basis so that overall risk is limited on a per occurrence basis. Premiums for the funding of the risk retention programs are determined by outside consultants, including Hewitt Associates, after carefully reviewing past claim patterns, the population of those we insure both geographically and demographically, as well as other factors to determine a reasonable level of risk. However, to the extent we experience significant losses that are not reimbursed by the hotel owners and exceed our reserves, those losses could have a material adverse effect on our results of operations.
Uninsured and underinsured losses could adversely affect our financial condition, results of operations and our ability to make distributions to our stockholders.
Various types of catastrophic losses, such as losses due to wars, terrorist acts, earthquakes, floods, hurricanes, pollution, contagious diseases, such as the avian flu and Severe Acute Respiratory Syndrome (SARS), or environmental matters, generally are either uninsurable or not economically insurable, or may be subject to insurance coverage limitations, such as large deductibles or co-payments. In the event of a catastrophic loss, our
insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a property, as well as the anticipated future revenue from the property. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. In the event of a significant loss that is covered by insurance, our deductible may be high and, as a consequence, it could materially adversely affect our financial condition. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position in the damaged or destroyed property.
Large scale terrorist attacks and hurricanes could result in an increase in premiums and reductions in insurance coverage, especially for terrorism and catastrophic risks such as wind, flood and earthquakes. If we are unable to maintain cost-effective insurance that meets the requirements of our lenders and franchisors, or if we are unable to amend or obtain waivers of those requirements, it could have a material adverse effect on our business.
We invest in a single industry and are therefore very susceptible to economic fluctuations specific to that industry.
Our current strategy is to acquire interests only in hospitality and lodging. As a result, we are subject to the risks inherent in investing in a single industry. The effects on cash available for distribution resulting from a downturn in the hotel industry may be more pronounced than if we had diversified our investments.
Our international operations expose us to additional risks, which, if we fail to manage them adequately, may adversely impact our results of operations.
Our management fees earned from hotels located outside of the United States were 21.0%, 13.7% and 11.5% of total management fees for 2007, 2006 and 2005, respectively. At December 31, 2007, we and our affiliates managed 11 international properties, an increase from the four international properties we managed at the end of 2006. In July 2007, we entered into two separate joint ventures to own and operate hotels in Mexico. We own 15% of one of the joint ventures, which owns three resort properties in Mexico, and we own 50% of the other joint venture, which manages those three hotels and serves to identify other management opportunities in Mexico and Latin America. We expect to begin managing our sixth and seventh hotels in Moscow in 2008. We will also continue to actively pursue additional international opportunities. We have also formed in 2008, a joint venture management company (of which we hold a 50% interest) that will begin seeking management opportunities in India. Simultaneous with the formation of this management company, we also invested in a related private real estate fund that will seek opportunities to purchase and/or develop hotels in India.
As we continue to grow our international presence, we are subject to various risks. These risks include tax, environmental zoning, employment laws, repatriation of money, liquor license, exposure to currency fluctuations, managing potential difficulties in enforcing contractual obligations and intellectual property rights, other laws in the countries in which we operate, and the effects of potential and actual international terrorism and hostilities. We are particularly sensitive to any factors that may influence international travel. In addition, we cannot be certain of the effect that changing political and economic conditions could have on our international hotel operations and on our ability to collect on loans to third-party owners overseas. Furthermore, the success of our international operations depends on our ability to attract and retain qualified management personnel who are familiar not only with our business and industry but also with the local commercial practices and economic environment.
As a U.S. company operating internationally, we may be subject to inconsistencies between U.S. law and the laws of an international jurisdiction. If taxation authorities in the countries in which we operate interpret our tax position in a manner that is materially different than our assumptions, our tax liabilities could increase which could materially adversely impact our financial results. Tax laws in foreign countries may provide for tax rates that exceed those of the U.S. which may provide that our foreign earnings are subject to withholding requirements or other restrictions. In addition, sales and international jurisdictions typically are made in local currencies, which subject us to risks
associated with currency fluctuations. Currency devaluations and unfavorable changes in international monetary and tax policies could have a material adverse effect on our profitability and financing plans, as could other changes in the international regulatory climate and international economic conditions.
Third-party hotel owners are not required to use the ancillary services we provide, which reduces the revenue we would otherwise receive from them.
In addition to traditional hotel management services, we offer to third-party hotel owners several ancillary services such as purchasing, project management, self-insurance programs and risk management, information technology and telecommunication services, and centralized accounting services. We expect to derive a portion of our revenues from these services. Our management contracts do not obligate third-party hotel owners to utilize these services, and the failure of hotel owners to utilize these services could adversely affect our overall revenues.
We are the brand franchisee of record for the hotels we own and for some of the hotels we have interests in or manage. In addition, with respect to hotels for which we are not the franchisee, we may sign a manager acknowledgment agreement with the franchisor that details some of our rights and obligations with respect to the hotel and references the hotels franchise agreement. The franchise agreements generally contain specific standards for, and restrictions and limitations on, the operation and maintenance of a hotel in order to maintain uniformity within the franchisors system. Those limitations may conflict with our philosophy of creating specific business plans tailored to each hotel and to each market. Standards are often subject to change over time, at the discretion of the franchisor, and may restrict a franchisees ability to make improvements or modifications to a hotel without the consent of the franchisor. In addition, compliance with standards could require a hotel owner to incur significant expenses or capital expenditures. Action or inaction by us or by the owner of a hotel we manage could result in a breach of standards or other terms and conditions of the franchise agreements and could result in the loss or cancellation of a franchise license.
Loss of franchise licenses without replacement would likely have an adverse effect on hotel revenues which could result in adverse affects to our overall revenues. In connection with terminating or changing the franchise affiliation of a hotel, the owner of the hotel may be required to incur significant expenses or capital expenditures. Moreover, the loss of a franchise license could have a material adverse effect upon the operation or the underlying value of the hotel covered by the franchise due to the loss of associated name recognition, marketing support and centralized reservation systems provided by the franchisor. Franchise agreements covering the hotels we manage expire or terminate, without specified renewal rights, at various times and have differing remaining terms. As a condition to renewal, these franchise agreements frequently contemplate a renewal application process. This process may require an owner to make substantial capital improvements to a hotel. Although the management agreements generally require owners to make capital improvements to maintain the quality of a property, we are not able to directly control the timing or amount of those expenditures.
Some of the franchise agreements under which we operate and manage hotels restrict the franchisees ability to own or operate another hotel within a specified territory or with regard to specific hotels. These limitations, if found to apply to us, may limit our ability to acquire new management agreements and potentially impair our continued growth.
Union contracts for hotel employees in several major markets will be up for renewal between 2008 and 2010. Although under the terms of the management contracts the employees at our managed hotels are paid by the hotel owners, they are our employees. In addition, we have a significant number of employees working at our owned hotels. The failure to timely renegotiate the contracts that are expiring could result in labor disruptions, which could adversely affect our revenues and profitability. Labor costs could also escalate beyond our expectations and could have a material adverse effect on our operating margins.
In addition, there are ongoing attempts to unionize at some of those hotels that we own and/or manage which are not currently unionized. To the extent any of our non-unionized properties become unionized, our labor costs would most likely increase and have an adverse effect on our operating margins at our owned hotels.
Under various federal, state, local and foreign environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be liable for noncompliance with applicable environmental and health and safety requirements for the costs of investigation, monitoring, removal or remediation of hazardous or toxic substances. These laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. The presence of these hazardous or toxic substances on a property could also result in personal injury or property damage or similar claims by private parties. In addition, the presence of contamination or the failure to report, investigate or properly remediate contaminated property, may adversely affect the operation of the property or the owners ability to sell or rent the property or to borrow using the property as collateral. Persons who arrange for the disposal or treatment of hazardous or toxic substances may also be liable for the costs of removal or remediation of those substances at the disposal or treatment facility, whether or not that facility is or ever was owned or operated by that person. The operation and removal of underground storage tanks are also regulated by federal and state laws. In connection with the ownership and operation of hotels, the operators, such as us or the owners of those properties could be held liable for the costs of remedial action for regulated substances and storage tanks and related claims.
All of the hotels that we own and the majority of the hotels we manage have undergone Phase I environmental site assessments, which generally provide a non-intrusive physical inspection and database search, but not soil or groundwater analyses, by a qualified independent environmental consultant. The purpose of a Phase I assessment is to identify potential sources of contamination for which the hotel owner may be responsible. The Phase I assessments have not revealed, nor are we aware of, any environmental liability or compliance concerns that we believe would have a material adverse effect on our results of operations or financial condition. Nevertheless, it is possible that these environmental site assessments did not reveal all environmental liabilities or compliance concerns or that material environmental liabilities or compliance concerns exist of which we are currently unaware.
In addition, a significant number of the hotels we own or manage have been inspected to determine the presence of asbestos. Federal, state and local environmental laws, ordinances and regulations also require abatement or removal of asbestos-containing materials and govern emissions of and exposure to asbestos fibers in the air. Asbestos-containing materials are present in various building materials such as sprayed-on ceiling treatments, roofing materials or floor tiles at some of the hotels. Operations and maintenance programs for maintaining asbestos-containing materials have been or are in the process of being designed and implemented, or the asbestos-containing materials have been scheduled to be or have been abated, at those hotels at which we are aware that asbestos-containing materials are present. Any liability resulting from non-compliance or other claims relating to environmental matters could have a material adverse effect on our results of operations or financial condition.
We have also detected the presence of mold at one of our owned hotels and are evaluating the impact and will take the appropriate measures to remediate the situation. Many of the costs associated with remediation of mold may be excluded from coverage under our property and general liability policies, in which event we would be required to use our own funds to remediate. Further, in the event moisture infiltration and resulting mold is pervasive, we may not be able to rent rooms at that hotel, which could result in a loss of revenue. Liabilities resulting from moisture infiltration and the presence of or exposure to mold could have a future material adverse effect on our business, financial condition, results of operations and ability to make distributions to our stockholders.
Furthermore, various court decisions have established that third parties may recover damages for injury caused by property contamination or exposure to hazardous substances such as asbestos, lead paint or black mold. In recent years, concern about indoor exposure to mold has been increasing as such exposure has been alleged to have a variety of adverse effects on health. As a result, there has been an increasing number of lawsuits against owners and managers of real property relating to the presence of mold. Damages related to the presence of mold are generally excluded from our insurance coverage. Should an uninsured loss arise against us at one of our owned hotels, we
would be required to use our own funds to resolve the issue, which could have an adverse impact on our results of operations or financial condition.
Aspects of hotel, resort, conference center, and restaurant operations are subject to governmental regulation, and changes in regulations may have significant adverse effects on our business.
A number of states regulate various aspects of hotels, resorts, conference centers and restaurants, including liquor licensing, by requiring registration, disclosure statements and compliance with specific standards of conduct and timely filing of certain sales use or property tax forms, which could result in additional tax payments and fines. Managers of hotels are also subject to employment laws, including minimum wage requirements, overtime, working conditions and work permit requirements. Compliance with, or changes in, these laws could reduce the revenue and profitability of hotels and could otherwise adversely affect our results of operations or financial condition. As an agent for hotels we may be liable for noncompliance.
Under the Americans with Disabilities Act, or ADA, all public accommodations in the United States are required to meet federal requirements related to access and use by disabled persons. These requirements became effective in 1992. A determination that the hotels we own are not in compliance with the ADA could result in a judicial order requiring compliance, imposition of fines or an award of damages to private litigants.
Generally, hotel revenues are greater in the second and third calendar quarters than in the first and fourth calendar quarters, although hotels in tourist destinations generate greater revenue during tourist season than other times of the year. Seasonal variations in revenue at the hotels we own or manage will cause quarterly fluctuations in revenues. Events beyond our control, such as extreme weather conditions, economic factors, geopolitical conflicts, actual or potential terrorist attacks, and other considerations affecting travel may also adversely affect our earnings.
Failure to maintain the integrity of internal or customer data could result in faulty business decisions and damage to our reputation, subjecting us to costs, fines or lawsuits.
Our businesses require collection and retention of large volumes of internal and customer data, including credit card numbers and other personally identifiable information of our customers as they are entered into, processed by, summarized by, and reported by our various information systems. We also maintain personally identifiable information about our employees. The integrity and protection of that customer, employee, and company data is critical to us. If that data is not accurate or complete we could make faulty decisions. Our customers also have a high expectation that we will adequately protect their personal information, and the regulatory environment surrounding information security and privacy is increasingly demanding, both in the United States and other international jurisdictions in which we operate. A significant theft, loss or fraudulent use of customer, employee or company data could adversely impact our reputation and could result in remedial and other expenses, fines and litigation.
If the material weakness in our internal control over financial reporting that we have identified is not remedied, it could result in a material misstatement in our financial statements not being prevented or detected in a timely manner, could adversely affect investor confidence in the accuracy and completeness of our financial statements, and could have an adverse effect on the trading price of our common stock.
Through, in part, the documentation, testing and assessment of our internal control over financial reporting pursuant to the rules promulgated by the SEC under Section 404 of the Sarbanes-Oxley Act of 2002 and Item 308 of Regulation S-K, management has concluded that we did not maintain effective controls over a change in accounting for the impairment of intangible assets related to terminated management contracts. Management has determined that this control deficiency represented a material weakness as of December 31, 2007. This material weakness and our remediation plans are described further in Item 9A Controls and Procedures in this Annual Report on Form 10-K.
Prior to the remediation of this material weakness in 2008, there remains risk that the controls on which we currently rely will fail to be sufficiently effective, which could result in a material misstatement of our financial position or results of operations and require a restatement of our financial statements. In addition, even if we are successful in
strengthening our controls and procedures, such controls and procedures may not be adequate to prevent or identify irregularities or facilitate the fair presentation of our financial statements or SEC reporting. Any material weakness or the unsuccessful remediation thereof could have a material adverse effect on reported results of operations and financial condition, as well as impair our ability to meet our quarterly and annual reporting requirements in a timely manner.
Our ability to maintain our competitive position will depend, to a significant extent, on the efforts and ability of our senior management. Our ability to attract and retain highly qualified personnel is critical to our operations. Competition for personnel is intense, and we may not be successful in attracting and retaining our personnel. Our inability to attract and retain highly qualified personnel may adversely affect our results of operations and financial condition.
Risk Factors Related to Our Capital Structure
Restrictions imposed by our debt agreements may limit our ability to execute our business strategy and increase the risk of default under our debt obligations.
Our amended and restated senior secured credit facility, which we entered into in March 2007 (as amended from time to time, which we refer to as the Credit Facility), and our mortgages contain restrictive covenants. These restrictions include requirements to maintain financial ratios, which may significantly limit our ability to, among other things:
A significant decline in our operations could reduce our cash from operations and cause us to be in default under other covenants in our debt agreements. A default would leave us unable to access our Credit Facility, and we depend on our Credit Facility to supply the necessary liquidity to continue or to implement new operations and execute on our business strategy.
We will, in the future, be required to repay, refinance or negotiate an extension of the maturity of our debt agreements. Our ability to complete the necessary repayments, refinancings or extensions is subject to a number of conditions, many of which are beyond our control. For example, if there were a disruption in the lodging or financial markets as a result of the occurrence of one of the risks identified above under Risk Factors Related to Our Business or any other event, we might be unable to access the financial markets. Failure to complete the necessary repayments, refinancings or extensions of our agreements would have a material adverse effect on us.
Our leverage could have a material adverse effect on our ability to satisfy our obligations under our indebtedness and place other limitations on the conduct of our business.
As of December 31, 2007, we had total indebtedness of $211.7 million. Our level of indebtedness has important consequences. It currently requires us to dedicate a portion of our cash flow from operations to payments of principal and interest on our indebtedness, which reduces the availability of our cash flow to fund working capital, capital expenditures and our business strategy. Additionally, it could:
In addition, despite our current indebtedness levels, we may still be able to incur substantially more debt. This could further exacerbate the risks associated with our leverage.
As of December 31, 2007, we had a deficit in working capital of $12.8 million. A continued deficit in working capital may require us to make additional borrowings to pay our current obligations. Such borrowings would serve to reduce amounts available to us for pursuit of our business strategy of growing through securing additional management contracts and acquiring additional hotel, resort and conference center properties.
Credit rating services assign a rating to us based on their perception of our ability to service debt. Our current long-term ratings are B1 Negative and B/Stable/- from Moodys and S&P, respectively. Fluctuations in our operating performance or changes in the amount of our debt may result in a change to our rating. A negative change in our ratings could increase the cost of, or prevent us from making future financings.
Impairments of assets or goodwill may increase the risk of default under our debt obligations and have an adverse effect on our stock price.
We are required to evaluate our assets, including goodwill, annually or upon certain trigger events in order to ascertain that the historical carrying value is not less than the fair market value of the asset. Should we determine that an assets carrying value is less than its fair market value, the asset would be considered impaired, and we would recognize a write-down of the asset to its current fair value.
Our current debt covenants require us to maintain certain ratios, including a minimum net worth. To the extent an impairment would reduce our asset base, we could fall below that net worth and fail that test. If we are unable to obtain a waiver or amendment to the covenant, the resulting default could adversely affect our liquidity.
In addition, because the impairment of long-lived assets or goodwill would be recorded as an operating expense, such a write-down would negatively affect our net income and earnings per share, which could have a negative impact on our stock price.
Our stockholder rights plan and the anti-takeover defense provisions of our charter documents may deter potential acquirers and depress our stock price.
Under our stockholder rights plan, holders of our common stock hold one preferred share purchase right for each outstanding share of common stock they hold, exercisable under defined circumstances involving a potential change of control. The preferred share purchase rights have the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by our Board of Directors. Those provisions could have a material adverse effect on the premium that potential acquirers might be willing to pay in an acquisition or that investors might be willing to pay in the future for shares of our common stock.
Provisions of Delaware law and of our charter and bylaws may have the effect of discouraging a third party from making an acquisition proposal for us. These provisions could delay, defer or prevent a transaction or a change in control of us under circumstances that could otherwise give the holders of our common stock the opportunity to
realize a premium over the then-prevailing market price of our common stock. These provisions include the following:
There are currently no unresolved staff comments.
Our corporate headquarters are located in Arlington, Virginia. In 2007, we established our first international office in Moscow, Russia to capitalize on the potential growth in the international markets. In addition, we also maintain corporate offices in Irving, Texas and San Clemente, California.
Our hotel management segment includes the operations related to our managed properties, our purchasing, construction and design subsidiary and our subsidiary that provides self insurance programs. As of December 31, 2007, we owned and/or managed hotels in 36 states, the District of Columbia, Russia, Mexico, Canada, Belgium and Ireland. The following table sets forth operating information with respect to the properties we owned and managed as of December 31,:
Our hotel ownership segment consists of our wholly-owned hotels and joint venture investments. As of December 31, 2007 we wholly-owned seven hotels. The following table details our seven wholly-owned hotels as of December 31, 2007. These properties have also been included in the table above.
For information on our properties held through joint ventures, see Business Hotel Ownership.
In the normal course of business activities, various lawsuits, claims and proceedings have been or may be instituted or asserted against us. Based on currently available facts, we believe that the disposition of matters pending or asserted will not have a material adverse effect on our consolidated financial position, results of operations or liquidity.
We did not submit any matters to a vote of security holders during the fourth quarter of 2007.
Our common stock is listed on the NYSE under the ticker-symbol IHR. As of February 27, 2008, there were 31,702,017 shares of our common stock were listed and outstanding, held by approximately 2,979 record holders.
The following table lists, for the fiscal quarters indicated, the range of high and low closing prices per share of our common stock in U.S. dollars, as reported on the NYSE Composite Transaction Tape.
We have not paid any cash dividends on our common stock, and we do not anticipate that we will do so in the foreseeable future. We intend to retain earnings, if any, to provide funds for the continued growth and development of our business. Any determination to pay cash dividends in the future will be at the discretion of the Board of Directors and will be dependent upon lender approval as well as our results of operations, financial condition, contractual restrictions and other factors deemed relevant by the Board of Directors.
Set forth in the following tables are summary historical consolidated financial and other data as of and for each of the last five fiscal years.
Selected Financial and Other Data
(Dollars in Thousands, Except Per Share Data)
Managements Discussion and Analysis of Financial Condition and Results of Operations is intended to help the reader understand Interstate, our operations and our present business environment. MD&A is provided as a supplement to and should be read in conjunction with our consolidated financial statements and the accompanying notes. MD&A is organized into the following sections:
As previously disclosed in our Current Report on Form 8-K dated February 27, 2008, on February 26, 2008, our Audit Committee determined, after discussions with management, that our previously-issued financial statements as of and for the quarters ended March 31, 2007, June 30, 2007 and September 30, 2007 should no longer be relied upon because of errors in our calculation of intangible asset impairment charges that resulted from the termination of certain hotel management contracts. As a result, we have restated our unaudited condensed consolidated financial data for the periods affected by the errors, as set forth in Note 19 Quarterly Financial Data (Unaudited) to the financial statements contained in this Annual Report on Form 10-K. The correct method of calculation of intangible asset impairment charges with respect to terminated hotel management contracts has been used in the preparation of the financial statements set forth in this Annual Report on Form 10-K.
We are a leading hotel real estate investor and the nations largest independent operator, measured by number of rooms under management and gross annual revenues of the managed portfolio. We have two reportable operating segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable segment, corporate housing, was disposed of on January 26, 2007 with the sale of BridgeStreet, our corporate housing subsidiary. The results of this segment are reported as discontinued operations in our consolidated financial statements for all periods presented.
As of December 31, 2007, we own seven hotels with 2,045 rooms and held non-controlling joint venture equity interests in 17 joint ventures, which hold ownership interests in 22 of our managed properties.
As of December 31, 2007, we and our affiliates managed 191 hotel properties with 42,620 rooms and five ancillary service centers, in 36 states, the District of Columbia, Russia, Mexico, Canada, Belgium and Ireland. Our portfolio of managed properties is diversified by location/market, franchise and brand affiliations, and ownership group. We manage hotels represented by nearly 30 franchise and brand affiliations in addition to operating 15 independent hotels. Our managed hotels are owned by more than 60 different ownership groups.
Our revenues consist primarily of the following (percentages do not include other revenue from managed properties):
Our operating expenses consist primarily of the following (percentages do not include other expenses from managed properties):
We had a successful year in 2007 as a result of the operating performance at our owned and managed properties as well as the continued execution of our growth strategy of diversifying our earnings base through both wholly owned and joint venture real estate ownership. The Company has redefined itself over the past two years as we have moved from being primarily a management company to one with various sources of income. We have executed on our plan to expand and stabilize our income generating activities through acquisitions of strategic hospitality properties. In 2007, a significant portion of our operations were derived from longer-term real estate ownership, with our hotel management segment contributing the balance of our income. We expect this trend to continue in 2008 as a result of our acquisitions in 2007 being reflected in operations for a full year and our investment in an additional international joint venture in the first quarter of 2008.
Hotel Ownership In 2007, we continued to expand and stabilize our income generating activities through our acquisitions of strategic hospitality properties. During the year, we acquired three full-service hotels with 1,080 rooms for a total acquisition price of $176.3 million. In addition, we contributed a total of $17.1 million in 2007 to either new or existing joint ventures. Our joint venture investments at year-end also include five properties currently
under development. Early in 2008, two of our joint ventures closed on the purchases of a four property portfolio and a 22 property portfolio. In addition, we also continue to expand our international presence through a 50-50 joint venture partnership with JHM Hotels, one of the nations largest independent hotel owners and developers, to operate and selectively invest in hotels in India. We committed to fund $0.5 million towards the working capital of this joint venture. Concurrently with the creation of our the joint venture, we committed to invest $6.25 million in a real estate investment fund dedicated solely to the investment of hotels in India. This fund has, in turn, committed to let our Indian management joint venture have the first opportunity to manage the hotels in which the fund invests.
In addition to increasing our owned hotel portfolio, we also continued to focus on efficiency and performance at our managed hotels. Our portfolio of seven wholly-owned hotels performed very well, with a RevPAR increase of 5.5%. The total operating income from our owned hotels was $13.3 million in 2007 compared to $4.7 million in 2006, an increase of 183%.
The hotels we acquired in 2007, all of which were purchased from affiliates of Blackstone, were as follows:
An important part of our ownership strategy is investing capital to upgrade our hotels, as it allows us to reposition the hotel and create value. Aside from the comprehensive renovation programs at our hotels purchased in 2007, we also expect to invest approximately $7 million on strategic capital improvements at our four other wholly-owned properties. We also have renovation programs at 11 hotels owned by our joint ventures. Our portion of the cost that we expect to fund toward these programs in 2008 is approximately $1.7 million. With the completion of these enhancement programs in 2008, we expect to see significant operating growth in 2009 for these hotels. Due to the magnitude of the renovations at the Westin Atlanta Airport and Sheraton Columbia, there will be some renovation displacement in 2008, however we will continue to manage the process to minimize any disruption to our guests.
In addition to wholly owned acquisitions, we also continued to identify joint venture investment opportunities during 2007 and throughout the early part of 2008. Our joint venture investments in hotels are designed to enable us to secure longer term management contracts, further align our interests in the hotels that we manage with owners, as well as provide us the opportunity to participate in the potential asset appreciation of these properties.
The significant joint venture activity in 2007 and early 2008 related to the following investments:
three-property portfolio of Tesoro® resorts located in Cabo San Lucas, Manzanillo and Ixtapa, Mexico. The joint venture plans to invest $10.0 million for comprehensive renovations and improvements at all three resort properties in 2008, of which our share is equal to $1.5 million. We also invested $0.5 million for a 50% interest in a separate joint venture with Steadfast to manage hotels. The new management joint venture, which is intended as a platform for further growth in Mexico, assumed management of the three-property portfolio of Tesoro® resorts upon its formation. This was our first international joint venture.
Our joint venture with FFC Capital Corporation acquired a portfolio of 22 properties located throughout the Midwest in Illinois, Iowa, Michigan, Minnesota, Wisconsin and Texas. We invested $1.7 million for a 10% equity interest in the portfolio of hotels. Upon closing, all 22 properties, representing 2,397 rooms, were converted to various Wyndham Worldwide brands. The properties are located along major interstates and proximate to major commercial and leisure demand generators.
True North Tesoro Property Partners, L.P., in which we hold a 15.9% equity interest, sold the Doral Tesoro Hotel & Golf Club located near Dallas, Texas. We expect to recognize a gain in excess of $2.0 million related to the sale.
We continued our international expansion by forming a 50-50 joint venture partnership with JHM Hotels to operate and selectively invest in hotels in India. We committed to fund $0.5 million towards the working capital of the joint venture. The joint venture, named JHM/Interstate Hotels India (JHM/Interstate), will serve as our platform for all hospitality-related activities in India, primarily focusing on securing management agreements on existing and to-be-built hotels. JHM/Interstate is establishing an office in New Delhi, India. Concurrently with the formation of our management platform in India, we and our partners each committed to invest $6.25 million each for a total of $12.5 million in the Duet Hotel Investment Fund, a U.K.-based, real estate investment fund dedicated solely to the investment of hotels in India. Duet has raised approximately $175 million in equity, with anticipated total equity contributions in excess of $200 million. Duets mission to develop approximately 25 hotels in India in the three- and four-star categories, targeted at business travelers and located in secondary and tertiary cities, as well as satellite townships outside major urban centers. The fund has committed to give JHM/Interstate the first opportunity to manage the hotels in which it invests.
We have also been active in investing in joint ventures focused on new development. Throughout 2007, we contributed an additional $1.7 million to IHR Greenbuck Hotel Venture, LLC, one of our joint ventures in which we hold a 15% equity interest that will build approximately five aloft® hotels over the next several years, with the potential for additional development opportunities. Intended to be similar to the W Hotel® brand, aloft® is the new premium select-service hotel brand being introduced by Starwood Hotels & Resorts Worldwide, Inc. Our joint venture partner is responsible for site selection, construction and development and management. We will operate the hotels following completion of construction. The joint venture has signed long-term franchise agreements for the first two properties. Construction commenced on the first property located in Rancho Cucamonga, Californa in January 2007, while the second location in Cool Springs, Tennessee broke ground in August 2007. The property in
Rancho Cucamonga is expected to open in May 2008, while the property in Cool Springs is expected to open in September 2008.
In August 2007, we entered a partnership with Premier Properties USA to build three hotels. We will operate all three properties upon the completion of construction and own a 15% equity interest in the partnership.
Hotel Management Although the number of hotel properties we manage decreased during 2007, the operating performance of our managed properties continued to improve year over year. RevPAR increased $8.28, or 9.1%, in 2007, compared to 2006. Incentive fees, which are tied directly to the operating performance of the hotels we manage, were $21.3 million in 2007, an increase of $3.8 million, or 22.0%, compared to the prior year.
We continued to realize the effects of the significant number of hotel purchase and sale transactions in the real estate market, which reduced the number of properties we manage. We ceased managing a total of 60 hotels during 2007, which included the loss of 17 properties owned by Blackstone that we ceased managing. Of the 25 properties sold by Blackstone during 2007, we acquired whole ownership of three properties, entered into joint ventures to acquire partial ownership of three properties and retained the management contracts with the new owners for an additional two. Additionally, CNL Hotels & Resorts, Inc. disposed of 22 properties through two portfolio dispositions, five of which we continue to manage. Sunstone REIT also disposed of eight non-core hotels during 2007.
In summary, the management fees earned for the 63 management contracts terminated in 2007 were as follows (in thousands):
While our property count has significantly declined over the past two years, it has begun to stabilize. In the fourth quarter of 2007, our property count increased by a net seven properties, our first quarterly increase in the past 11 quarters. We expect this trend to continue through the first quarter of 2008. Throughout 2007, we partially offset the loss of 12,763 rooms related to the 60 lost management contracts with the addition of 28 management contracts, totaling 5,180 rooms. These additions include seven international management contracts totaling 1,727 rooms, which demonstrates our focus and ability to expand our international presence. Also, the merger of Equity Inns, Inc. was also completed in October 2007 and we continue to manage this portfolio of 38 hotels, which have 4,847 rooms and accounted for $3.7 million of management fees in 2007.
Although we lost a net of 32 management contracts during 2007, our impairment analysis of goodwill related to our hotel management reporting unit continued to indicate that the carrying value of goodwill was not impaired. This result is primarily due to the increase in our operating income from our portfolio of managed hotels as we, and the hotel industry as a whole, continue to have strong year-over-year results. In addition, we have an active pipeline of new management contracts that were signed in 2007 or expected to be signed in 2008 and 2009. Our goodwill analysis was based on future cash flow projections. These projections were based on assumptions made by management, which we believe to be reasonable.
Sale of BridgeStreet Corporate Housing In January 2007, we sold BridgeStreet, our corporate housing subsidiary, for approximately $42.4 million, resulting in a pre-tax gain on sale of $20.5 million.
Industry Overview The lodging industry, of which we are a part, is subject to both national and international extraordinary events. Over the past several years we have continued to be impacted by events including the ongoing war on terrorism, the potential outbreak and epidemic of infectious disease, natural disasters, the continuing change in the strength and performance of regional and global economies and high levels of hotel acquisitions activity by private equity investors and other acquirers of real estate.
According to Smith Travel Research, in 2006 and 2007, the significant growth that the lodging industry experienced in 2004 and 2005 began to decelerate. RevPAR growth was 5.7% and 7.8% in 2007 and 2006, respectively. Room demand increased by only 1.2% in 2007 (against a room supply increase of 1.4%), up from a 0.5% room demand increase in 2006 (against a room supply increase of 0.2%). The growth in the industry is forecasted to continue in future years, albeit at a slower pace than recently experienced. The potential slowdown due to the uncertainty in the economic conditions and the presidential election will have a greater impact on lower priced segments. Overall industry RevPAR is projected to grow an additional 4.4% in 2008. As occupancy is projected to decrease 0.8% in 2008, nearly all of the growth will be driven by an increase in ADR of 5.2%. Overall industry room demand and room supply are both projected to grow by 1.4% and 2.2% in 2008, respectively.
Financial Targets, Growth Strategy and Operating Strategy Over the past five years, with the increased transaction activity in the hotel real estate market, we began to see an immediate need for maintaining a diversified revenue base. In 2006, with Blackstones acquisition of MeriStar, the single largest owner in our management portfolio at the time, the need for diversity became increasingly apparent. In 2006, we continued to implement a plan developed by management in 2005 to expand, diversify and stabilize our revenue sources through an emphasis on increasing our management portfolio base and investing in hotel real estate through wholly-owned acquisitions and joint ventures. In 2007, we took significant steps toward our vision of diversifying our revenue sources and increasing shareholder value by recycling assets through new opportunities that we believe will provide a more stable long term platform and a greater level of return.
In January 2007, we sold BridgeStreet for approximately $42.4 million. We immediately began redeploying the proceeds from this sale into investments in hotel real estate through both whole-ownership acquisitions and joint ventures. The impact of our investment activity has been significant, as evidenced by the increase in lodging revenues in 2007 of $46.3 million, or 166%, compared to 2006. Additionally, in 2007 we increased our investment in joint ventures by a net $16.5 million, to $27.6 million as of the end of 2007.
Management contract attrition continued to challenge us in 2007 as it had in 2006. A net loss of management contracts resulted in a decrease in management fee revenue in 2007 from 2006 (excluding termination fees) of $11.6 million, or 15.4%. After a steady decline in our management contract portfolio, precipitated by a strong real estate market and a greater number of real estate transactions that took place over the past two years. We began, in the third quarter of 2007, to see a stabilization of our portfolio and, in the fourth quarter, realized a net increase of seven management contracts, our first increase in eleven quarters. This increase continued into 2008 as we added a net additional increase of 29 contracts in January and February.
Looking forward to 2008, our growth strategy will continue to focus on expansion through three diverse, yet interrelated areas of our business. First, to continue as a leader in the hotel management industry, it is imperative that we continue to build our core business by securing additional management contracts for quality properties. We expect that our development pipeline will continue to produce new management opportunities in 2008.
In addition to our continued pursuit of management opportunities within the United States, we continue to seek additional growth through a focus on international management opportunities. During 2007, we and our affiliates commenced management at seven new international properties in four countries, bringing our total international presence to 11 managed properties in five countries. Furthermore, we have signed agreements to commence management in 2008 of two additional properties in Russia, bringing our total presence to seven managed properties in that country alone. In addition, we opened a regional office in Moscow to capitalize on our expected growth in the international markets. In the first quarter of 2008, we continued our international expansion forming a 50-50 joint venture partnership with JHM Hotels to operate and invest in hotels in India. The joint venture will serve as our platform for expansion for all hospitality related activities in India.
Second, we will continue to remain focused on establishing strategic partnerships and developing new opportunities through additional investments in joint ventures. These investments, in which our ownership interest is typically between 10% and 20%, provide not only the opportunity to secure new management agreements, but also the opportunity to participate in the equity and real estate appreciation of the lodging asset. In 2008, two of our joint ventures, previously formed in 2007, closed on two separate transactions, acquiring a four hotel portfolio and a 22 hotel portfolio in addition to the formation of, and our investment in, the joint venture with JHM Hotels. As of March 1, 2008, we hold minority ownership interests in 52 hotel properties currently operating or currently under development, through 17 real estate partnerships and limited liability companies. We continue to seek and acquire ownership interests in upscale, full-service hotels, select-service hotels, conference centers and resorts where we believe an opportunity exists to create and increase value through market recovery, strategic repositioning and our operating expertise.
Third, we will continue to identify promising whole-ownership acquisition candidates located in markets with favorable economic, demographic and supply dynamics. We will select these acquisition opportunities, when and if our capital resources allow, and we believe selected capital improvements and focused management will increase the propertys ability to attract key demand segments, demonstrate better financial performance, and increase long-term value. See Liquidity, Capital Resources and Financial Position.
In addition to our expansion strategies we will continue to implement our operating strategy and emphasize organic growth for the owners of the properties we manage, building on our success in the past three years. At our hotel properties, we have continued to emphasize our dedication to service, through a commitment to guest satisfaction surveys, improved training of hotel employees and specialists who focus on improving the operations of designated brands under our management. Based upon the operating results and feedback received at our managed properties, we have seen tangible evidence that this commitment to superior service has produced positive results. We will also continue to rely on our ability to identify specific opportunities to enhance growth at each hotel in order to generate higher RevPAR, net operating income and overall return for our owners. In all of our business segments, we will continue to rely on the experience of our senior management team, which have successfully managed hotels in all sectors of the lodging industry. By continuing to execute on our focused growth and operating strategies in 2008, we anticipate that we can continue to build a more consistent and long-term stream of income which will provide for increased value for our shareholders.
Opportunities, Challenges and Risks During the past three years, we have purchased seven hotels and have planned or completed comprehensive renovations to each of these properties to reposition them as benchmarks in their respective markets. We expect these renovations to require a total cash outlay of approximately $35 million during 2008. Upon the completion of the comprehensive renovation programs in 2008, we believe all of our wholly owned properties will be well positioned to generate greater RevPAR and capitalize on the markets in which they operate. We believe we have the required capital resources available to fund the projected cash outlays under these renovation projects, but the ability of these hotels to continue to operate and generate an acceptable return on our investment will depend, to a large extent, on our ability to avoid any potential delays and complete the renovations on time and on budget.
Our current debt agreements include restrictions which could prevent us from raising additional capital needed to take advantage of desired acquisition and investment opportunities. Given the current lending environment, our access to additional funding may be limited. Currently, we see no immediate need to obtain additional capital to fund our operational and growth strategies under our 2008 operating projections. However, should a need arise for us to obtain additional capital funding for growth opportunities, our ability, or inability to do so, may require the restructuring of certain debt and the amendment of certain covenants. Our ability and willingness to accept market terms may significantly affect our ability to obtain additional capital funding. Also, an increase in our cost of capital may cause us to delay, restructure or not commence future investments, which could limit our ability to grow our business. In addition, the market value of our common stock could make financing through an equity offering a less attractive option. See Liquidity, Capital Resources and Financial Position.
Our ability to achieve our expected financial results through the implementation of our growth and operating strategies could be affected by various challenges and risks which include overall domestic and international economic factors, including industry-related factors and other factors which are more specific to us, all of which are discussed in more detail in the Risk Factors section. Our continued growth strategy through hotel ownership
provides us with more direct exposure to specific hospitality and lodging economic risk, including but not limited to reductions in demand. We could also be affected by continued industry consolidation and competition, which may limit the amount and nature of opportunities for us to consider.
A significant portion of our managed properties and management fees are derived from seven owners. This group of owners represents 92, or 48.2%, of our managed properties as of December 31, 2007, and 69.0% of our base and incentive management fees for the year ended December 31, 2007. If these owners sell their hotels, enter into a property disposition plan, or are acquired, as we have seen with MeriStar in 2006 and CNL in 2007, we may be at risk of losing a large percentage of our management contracts and related revenues. We would be entitled to receive approximately $9.3 million in termination fees assuming the twelve remaining Blackstone properties were terminated on January 1, 2008 in addition to approximately $16.5 million due from properties terminated prior to December 31, 2007. If the remaining 29 management contracts with Sunstone REIT were terminated as of January 1, 2008, we would be entitled to approximately $9.0 million in termination fees. For the majority of our other owners, termination fees would not be significant.
The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. Application of these policies involves the exercise of judgment and the use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on experience, industry data and various other assumptions that are believed to be reasonable under the circumstances. Our significant accounting policies are disclosed in the notes to our consolidated financial statements. We believe that the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results as they require our most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has discussed the selection of these critical accounting policies and the effect of estimates with the Audit Committee of our Board of Directors.
We earn revenue from hotel management contracts and related services and operations of our wholly owned hotels. Generally, revenues are recognized when services have been rendered. Given the nature of our business, revenue recognition practices do not contain estimates that materially affect results of operations. Revenues related to our corporate housing segment, which was sold in January 2007, are included as part of discontinued operations. The following is a description of the composition of our revenues:
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, whenever events or changes in circumstances indicate that the carrying values of long-lived assets (which consist of our owned hotels and intangible assets with determinable useful lives) may not be recoverable, we perform separate analyses to determine the recoverability of the related assets carrying value. These events or circumstances may include, but are not limited to; projected cash flows which are significantly less than the most recent historical cash flows; a significant loss of management contracts without the realistic expectation of a replacement; and economic events which could cause significant adverse changes and uncertainty in business and leisure travel patterns.
When evaluating long-lived assets for potential impairment, we make estimates of the undiscounted cash flows from the expected future operations of the asset. If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment calculation compares the carrying value of the asset to the assets estimated fair value, which may be based on estimated discounted future cash flows. We recognize an impairment loss if the amount of the assets carrying value exceeds the assets estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset becomes its new cost basis.
Our impairment evaluations contain uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting useful lives for the assets and selecting the discount rate that reflects the risk inherent in future cash flows. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to evaluate long-lived asset impairment losses. However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and asset fair values, we may be exposed to losses that could be material.
We allocate the purchase price of hotels based on the fair value of the acquired real estate, building, furniture fixture and equipment, liabilities assumed and identified intangible assets. The purchase price represents cash and other assets exchanged or liabilities assumed. The estimates of fair value used to allocate the purchase price is based upon appraisals and valuations performed by management and independent third parties. Property and equipment are carried at cost and are depreciated using the straight-line method over the expected useful lives of the assets (generally 40 years for buildings, seven years for furniture, fixtures and equipment, and three years for computer equipment). Renovations and replacements that improve or extend the life of an asset are capitalized and depreciated over its expected useful life. Our assessments of the fair value allocated and expected useful life of assets acquired are subjective. A change in our estimates will affect depreciation expense and net income.
For properties acquired from Blackstone that we managed prior to the purchase, we were entitled to termination fees pursuant to the preexisting management agreements for those properties. Under Emerging Issues Task Force Issue 04-1, Accounting for Preexisting Relationships between the Parties to a Business Combination (EITF 04-1), the settlement of the preexisting management agreements (including the payment of the termination fees) requires accounting separate from the acquisition of the properties. Under EITF 04-1, the effective settlement of a management agreement with respect to an acquired property is required to be measured at the lesser of (x) the amount by which the agreement is favorable or unfavorable from our perspective when compared to pricing for current market transactions for the same or similar management agreements and, (y) the stated settlement provisions that are unfavorable to the seller. Therefore, in connection with the purchase of a hotel being managed by us, we will evaluate the terms of the contract and record the lesser amount, if any, as income from the settlement of the management contract and a corresponding increase in the recorded purchase price.
We evaluate goodwill to assess potential impairments on an annual basis, or more frequently if events or other circumstances indicate that the carrying value of goodwill may not be recoverable. We evaluate the fair value of goodwill at the reporting unit level and make that determination based upon future cash flow projections. Assumptions used in these projections, such as forecasted growth rates, cost of capital and multiples to determine the terminal value of the reporting units, are consistent with internal projections and operating plans. We record an impairment loss when the implied fair value of the goodwill assigned to the reporting unit is less than the carrying
value of the reporting unit, including goodwill. In the fourth quarter of 2007, we completed our annual impairment testing of goodwill and determined there was no impairment.
We determine fair value using widely accepted valuation techniques, which contain uncertainties because they require management to make assumptions and to apply judgment to estimate industry economic factors and the profitability of future business strategies. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economic conditions, as well as future expectations. We have not made any material changes in our impairment loss assessment methodology during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to test for goodwill impairment losses. However, if actual results are not consistent with our estimates and assumptions, we may be exposed to an impairment charge that could be material.
We make certain estimates and judgments in determining our income tax expense, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets for financial statement purposes. Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities. The tax rates used to determine deferred tax assets or liabilities are the enacted tax rates in effect for the year in which the differences are expected to reverse. Realization of certain deferred tax assets is dependent upon generating sufficient taxable income prior to the expiration of the carryforward periods. A valuation allowance is required to be established against deferred tax assets unless we determine that it is more likely than not that we will ultimately realize the tax benefit associated with a deferred tax asset.
At December 31, 2007, we have a valuation allowance of $20.6 million to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. This is an allowance against some, but not all, of our recorded deferred tax assets. The valuation allowance we recorded includes the effect of the limitations on our deferred tax assets arising from net operating loss carryforwards. The utilization of our net operating loss carryforwards will be limited by the provisions of the Internal Revenue Code. We have considered estimated future taxable income and prudent and feasible ongoing tax planning strategies in assessing the need for a valuation allowance. Our estimates of taxable income require us to make assumptions about various factors that affect our operating results, such as economic conditions, consumer demand, competition and other factors. Our actual results may differ from these estimates. Based on actual results or a revision in future estimates, we may determine that we are not able to realize additional portions of our net deferred tax assets in the future; if that occurred, we would record a charge to the income tax provision in that period.
Depreciation expense is based on the estimated useful lives of our assets, which are generally the following: buildings and improvements, 40 years or less; furniture and fixtures, five to seven years; computer equipment, three years; and software, five years. If an owned hotel is undergoing a significant renovation, we will shorten the useful lives of the assets affected by the renovation to a period which corresponds to the renovation period.
Amortization expense for our intangible assets is based on the estimated useful life of the underlying future benefit of the intangible asset. The lives of our intangible assets are based upon the length of their related management contracts. These lives are determined at the onset of the management contract. However, as certain circumstances arise, such as a disposition plan by the owner, the estimated future benefit of the contract may change. At the end of 2006, we revised the remaining useful life of our management contracts with Blackstone from approximately 19 years to four years based upon their rate of dispositions.
While management believes its estimates are reasonable, a change in circumstances could require us to revise the estimated useful lives related to our property and equipment and intangible assets. If we revised the useful lives of these assets, we could be exposed to material changes in the depreciation and amortization expense which we record.
Judgment is required with respect to the consolidation of our joint venture investments in the evaluation of financial interests and control, including the assessment of the adequacy of the equity invested in the joint venture, the
proportionality of financial interests and voting interests, as well as the importance of rights and privileges of the joint venture partners based on voting rights. Currently, we have investments in joint ventures that own, operate or develop hotel properties, which we record using the equity or cost method of accounting. We are not the primary beneficiary in any variable interest entities. We do not guarantee debt held by the joint ventures and the debt is non-recourse to us. While we do not believe we are required to consolidate any of our current joint ventures, if we were required to do so, then all of the results of operations and the assets and liabilities would be included in our financial statements.
Results of Operations
Statistics related to our wholly-owned properties and managed hotel properties include:
Hotels under management decreased by a net of 32 properties as of December 31, 2007 compared to December 31, 2006, due to the following:
Hotels under management decreased by a net of 63 properties as of December 31, 2006 compared to December 31, 2005, due to the following:
The operating statistics related to our owned hotels on a same store basis(2) were as follows:
The operating statistics related to our managed hotels on a same store basis(3) were as follows:
The significant components of total revenue were as follows (in thousands):
The composition of our management and termination fees by significant owner groups was as follows (in thousands):
Other Revenue from Managed Properties
The significant components of undistributed operating expenses were as follows (in thousands):
Administrative and General
Depreciation and Amortization
Restructuring and Severance Expenses
Asset Impairment and Write-offs
The significant components of other income and expenses, were as follows (in thousands):
Interest Expense, net of interest income
Equity in Earnings of Affiliates
Gain on Sale of Investments and Extinguishment of Debt
Income Tax Expense
Income from Discontinued Operations, net of Tax
Key metrics related to our liquidity, capital resources and financial position are as follows (in thousands):
The decrease in cash provided by operating activities of $37.6 million from 2006 to 2007 was primarily driven by the decrease in management fees, termination fees and other revenue (primarily accounting fees) of $30.9 million. These revenues all decreased due to the net loss of properties under management over the course of 2007 and 2006. In 2007, we also had an increase in G&A expense of $6.4 million and an increase in interest expense of $5.2 million due to our additional ownership of hotel properties. In addition, the net change in our assets and liabilities resulted in a cash outflow of $1.2 million in 2007, while in 2006, those changes resulted in a cash inflow of $10.8 million. These decreases were offset by an increase in operating income from our owned hotels of $14.5 million, primarily due to our acquisition of three additional hotels in 2007 and the full year effect of our two acquisitions in 2006.
The increase in cash provided by operating activities of $33.5 million from 2005 to 2006 was primarily driven by the significant increases in income from operations of $24.6 million. This increase was primarily due to the increase in termination fees of $18.7 million, business interruption proceeds of $3.2 million and stronger operating results at the hotels with an increase in incentive fees of $3.1 million. Income from operations also included an increase in non-cash expenses related to asset impairments and write-offs of $7.6 million in 2006.
The major components of the increase in cash used in investing activities from 2006 to 2007 were:
The major components of the increase in cash used in investing activities from 2005 to 2006 were:
Cash provided by financing activities increased $121.4 million in 2007 compared to 2006. In 2007, we borrowed an additional $127.4 million, net of repayments/extinguishments, to fund the acquisition of three properties, while in 2006, our long-term debt balance remained flat compared to 2005. We spent $3.3 million in 2007 in connection with the refinancing of our long-term debt. We received $2.8 million of additional proceeds in 2006 from the issuance of common stock related to the exercise of stock options.
Cash provided by financing activities increased $7.3 million in 2006 compared to 2005. In 2006, and 2005, we borrowed approximately the same amount of total long-term debt that we repaid, resulting in no substantial net effect on cash from financing activities. The revolving loan under our credit facility had a balance of $20.1 million at the end of 2005 and was repaid in full by the end of 2006 as cash from operations increased year over year. The change in financing activities was due to additional financing fees of $4.0 million incurred in 2005 in connection with the refinancing of our long-term debt. These cash outflows were offset by the $2.8 million in additional proceeds from the issuance of common stock during 2006 compared to 2005, related to the exercise of stock options.
Liquidity Requirements Our known short-term liquidity requirements consist primarily of funds necessary to pay for operating expenses and other expenditures, including: corporate expenses, payroll and related benefits, legal costs, and other costs associated with the management of hotels, interest and scheduled principal payments on our outstanding indebtedness and capital expenditures, which include renovations and maintenance at our owned hotels.
Our long-term liquidity requirements consist primarily of funds necessary to pay for scheduled debt maturities, capital improvements at our owned hotels and costs associated with potential acquisitions. In March 2007, we entered into a new, senior secured credit facility, as amended from time to time, which we refer to as the Credit Facility. The Credit Facility matures in March 2010 and consists of a $115.0 million term loan and an $85.0 million revolver. As of December 31, 2007, we had $45.0 million available under our revolver. We also have two non-recourse mortgage loans for $24.7 million and $32.8 million, which mature in November 2009 and February 2010, respectively.
We have historically satisfied our short-term liquidity requirements through cash provided by our operations and borrowings from our Credit Facility. Our borrowings under our Credit Facility are subject to certain restrictions under the Credit Facility agreement. Additionally, we must maintain compliance with our financial covenants, including an acceptable degree of leverage, value of unencumbered assets and interest coverage ratios, in order to continue to have funds available to borrow under our Credit Facility. We continually monitor our operating and cash flow models in order to forecast our compliance with the financial covenants. As of December 31, 2007 we were in compliance with all financial covenants.
Our short-term liquidity could be influenced by various factors including changes in lodging demand due to seasonality or a slowdown in the overall economy and RevPAR declines. During the past three years, we have invested in the ownership of multiple lodging properties through joint venture partnerships and the whole ownership acquisition of seven hotels. This degree of ownership elevates our level of sensitivity to RevPAR fluctuations, declines in the real estate market and the overall economy in general, which could have a significant impact on our earnings and cash flows. Additional factors include increased operating costs, interest rate changes, natural disasters and non-specific operational risks.
We have historically satisfied our long-term liquidity requirements through various sources of capital, including cash provided by operations, bank credit facilities, long-term mortgage indebtedness and the issuance of equity. We believe that these sources of capital will continue to be available to us in the future to fund our long-term liquidity requirements. Nevertheless, there are certain factors that may have a material adverse effect on our access to these capital sources. Our ability to incur additional debt is dependent upon a number of factors, including our degree of leverage, the value of our unencumbered assets (if any), our public debt ratings and borrowing restrictions imposed by existing lenders. As of December 31, 2007, our long-term ratings were B1 Negative and B/Stable/- from Moodys and S&P, respectively.
Our continued ability to raise funds through the issuance of equity securities is dependent upon, among other things, overall general market conditions, market valuation of our equity and perceptions about our Company. We will continue to analyze which sources of capital are most advantageous to us at any particular point in time, but equity and debt financing may not be consistently available to us on terms that are financially viable or at all.
Expectations for 2008 During 2008, we expect to fund our operations and growth strategy through cash from operations, cash on hand and borrowings from our Credit Facility. Additionally, in early 2008, we are seeking to enter into a $30.0 million non-recourse mortgage for the Sheraton Columbia, the proceeds of which we will use to repay our borrowings under the Credit Facility. We will also seek to have the right to borrow up to an additional $5.0 million as needed towards the completion of an estimated $12 million comprehensive renovation plan which commenced in early 2008. We expect that our $18.0 million comprehensive renovation plan at the Westin Atlanta Airport, which began in 2007 and has an estimated cost of $15 million to complete, will be funded by cash on hand or borrowings against our Credit Facility. We also expect to spend approximately $8 million on renovations at our other wholly owned hotels and approximately $1.7 million for our share of renovations at 11 of our joint venture hotels in 2008.
We will continue to focus on our growth strategy of primarily minority investments in hotels through the formation of strategic joint venture partnerships. We will also continue to selectively evaluate whole-ownership opportunities in 2008. However, opportunities will be considered along with other factors including but not limited to expected returns on investment, current capital structure and other potential investments. Additionally, we expect to use additional cash flows from operations to pay required debt service, income taxes and make planned capital purchases, exclusive of the renovation programs mentioned above for our wholly-owned hotels which include regular capital expenditures for maintenance. We expect to continue to seek minority interest ownership in real estate though joint ventures during 2008. We expect to fund these investments through cash from operations or borrowings under our Credit Facility. We also continue to evaluate investment opportunities to acquire hotel management businesses and management contracts which may require cash. If none of these investments become available, we will pay down debt and/or invest in short-term securities with excess cash flow until those investments become available.
Our ability to incur additional debt is dependent upon a number of factors, including our degree of leverage, the value of our unencumbered assets (if any), our public debt ratings and borrowing restrictions imposed by existing lenders. Given the current lending environment, our access to additional funding may be limited. In consideration of our current working capital, projected operations and current capital structure, we do not foresee a need to seek additional capital to fund our operational and growth strategies in 2008. Should a need arise for us to obtain additional capital funding for growth opportunities, we will first access the available funds under our Credit Facility. In consideration of our covenants, we would expect no limitations in accessing the full balance under our Credit Facility to fund growth operations. If we are required to obtain additional funds in excess of our current Credit Facility, our ability or inability to do so, may require the restructuring of certain debt and the amendment of certain covenants. Our ability and willingness to accept certain terms may significantly affect our ability to obtain additional capital funding. Also, an increase in our cost of capital may cause us to delay, restructure or not commence future investments, which could limit our ability to grow our business.
Senior Credit Facility In March 2007, we closed on our new $125.0 million Credit Facility, which replaced our previous $108.0 million credit facility. The new Credit Facility consisted of a $65.0 million term loan and a $60.0 million revolving loan. Upon entering into the new Credit Facility, we borrowed $65.0 million under the term loan and used a portion of those proceeds to pay off the remaining obligations under the previous credit facility. In connection with the purchase of the Westin Atlanta Airport in May 2007, we amended the new Credit Facility. The amendment increased our total borrowing capacity to $200.0 million, consisting of a $115.0 term loan and a $85.0 million revolving line of credit. We utilized the additional $50.0 million of borrowings under our term loan to purchase the Westin Atlanta Airport. As of December 31, 2007, $45.0 million of capacity was available to us for borrowing under our revolver. In addition, we have the ability to increase the revolving Credit Facility and/or term loan by up to $75.0 million, in the aggregate, by and after seeking additional commitments from lenders and
amending certain of our covenants. Under the amended Credit Facility, we are required to make quarterly payments on the term loan of approximately $0.3 million.
The actual interest rates on both the revolving loan and term loan depend on the results of certain financial tests. As of December 31, 2007, based on those financial tests, borrowings under the term loan and the revolving loan bore interest at the 30-day LIBOR rate plus 275 basis points (a rate of 7.6% per annum). We incurred interest expense of $7.9 million, $5.8 million and $6.1 million on the senior credit facilities for the twelve months ended December 31, 2007, 2006 and 2005, respectively. In January 2008, we entered into an interest rate collar for a notional amount of $110 million. The interest rate collar consists of an interest rate cap at 4.0% and an interest rate floor at 2.47% on the 30-day LIBOR rate.
The debt under the Credit Facility is guaranteed by certain of our wholly-owned subsidiaries and collateralized by pledges of ownership interests, owned hospitality properties, and other collateral that was not previously prohibited from being pledged by any of our existing contracts or agreements. The Credit Facility contains covenants that include maintenance of certain financial ratios at the end of each quarter, compliance reporting requirements and other customary restrictions. As of December 31, 2007, we were in compliance with all of these covenants.
Mortgage Debt The following table summarizes our mortgage debt as of December 31, 2007:
We incurred mortgage interest expense of $4.1 million, $1.8 million and $1.0 million for the twelve months ended December 31, 2007, 2006 and 2005, respectively. Based on the terms of these mortgage loans, a prepayment cannot be made during the first year after it has been entered. After one year, a penalty of 1% is assessed on any prepayments. The penalty is reduced ratably over the course of the second year. There is no penalty for prepayments made in the third year.
Shelf Registration Statement In August 2004, we filed a Form S-3 shelf registration statement registering up to $150.0 million of debt securities, preferred stock, common stock and warrants. The registration statement also registered approximately 6.2 million shares of our common stock held by CGLH Partners I, LP and CGLH Partners II, LP, which are beneficially owned by certain of our directors. Of these shares, at least 4.3 million shares have already been sold by affiliates of the CGLH partnership in the open market. Affiliates of the CGLH Partnerships have the right to include any of their remaining 1.9 million shares they may still hold in the shelf registration statement pursuant to a registration rights agreement they executed with us at the time of our July 2002 merger with Interstate Hotels Corporation.
Contractual Obligations and Off-Balance Sheet Arrangements The following table summarizes our contractual obligations at December 31, 2007, and the effect that those obligations are expected to have on our liquidity and cash flows in future periods (in thousands):
We also have the following commitments and off-balance sheet arrangements currently outstanding:
During 2005, the prior carrier presented invoices to us and other policy holders related to dividends previously granted to us and other policy holders with respect to the prior policies. Based on this information, we have determined that the amount is probable and estimable and have therefore recorded the liability. In September 2005, we invoiced the prior carrier for premium refunds due to us on previous policies. The initial premiums on these policies were calculated based on estimated employee payroll expenses and gross hotel revenues. Due to the September 11th terrorist attacks and the resulting substantial decline in business and leisure travel in the months that followed, we reduced hotel level headcount and payroll. The estimated premiums billed were significantly overstated and as a result, we are owed refunds on the premiums paid. The amount of our receivable exceeds the dividend amounts claimed by the prior carrier. We have reserved the amount of the excess given the financial condition of the carrier. We believe that we hold the legal right of offset in regard to this receivable and payable with the prior insurance carrier. Accordingly, there was no effect on the statement of operations in 2005, 2006, or 2007. We will aggressively pursue collection of our receivable and do not expect to pay any amounts to the prior carrier prior to reaching an agreement with them regarding the contractual amounts due to us. To the extent we do not collect sufficiently on our receivable and pay amounts that we have been invoiced, we will vigorously attempt to recover any additional amounts from our owners.
The SEC encourages companies to disclose forward-looking information so that investors can better understand a companys future prospects and make informed investment decisions. In this Annual Report on Form 10-K and the information incorporated by reference herein, we make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements anticipating future growth in revenues, net income and cash flow. Any statements in this document about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as will likely result, expect, believe, will continue, anticipate, estimate, intend, plan, projection, would and outlook and other similar terms and phrases. Accordingly, these statements involve estimates, assumptions and uncertainties that are not yet determinable and could cause actual results to differ materially from those expressed in the statements. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this Annual Report on Form 10-K and the documents incorporated by reference herein. In addition to the risks related to our business, the factors that may cause actual results to differ materially from those described in the forward-looking statements include, among others, the following:
These factors and the risk factors referred to above could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made or incorporated by reference in this Annual Report on Form 10-K. You should not place undue reliance on any of these forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made and we do not undertake to update any forward-looking statement or statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
We are exposed to market risk in the form of changes in interest rates and foreign currency exchange rate fluctuation. In certain instances, we attempt to reduce volatility in earnings and cash flow associated with interest rate and foreign exchange rate risks by entering into derivative arrangements intended to provide hedges against a portion of the associated risks. We continue to have exposure to such risks to the extent that they are not hedged.
Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. As of December 31, 2007, all of our debt is at variable rates based on current LIBOR rates. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity, Capital Resources and Financial Position Long-Term Debt for more information regarding our long-term debt.
In an effort to manage interest rate risk covering our outstanding debt, we have entered into various interest rate cap agreements. In February 2005, we entered into a $19.0 million, three-year interest rate cap agreement in connection with the mortgage loan on the Hilton Concord hotel. At our option, we cancelled this interest rate cap upon repayment in full of the Hilton Concord mortgage note in April 2007. In March 2005, we entered into a $55.0 million, three-year interest rate cap agreement related to our Credit Facility. The interest rate agreement caps the 30-day LIBOR at 5.75% matured on January 14, 2008. On January 11, 2008, we entered into an interest rate collar agreement for a notional amount of $110 million. The interest rate collar consists of an interest rate cap at 4.0% and an interest rate floor at 2.47% on the 30-day LIBOR rate. We receive the difference of the cap rate and
30-day LIBOR should LIBOR exceed the cap rate. We pay the difference of the floor rate and 30-day LIBOR should LIBOR fall below the floor rate. The interest rate collar became effective January 14, 2008, with monthly settlement dates on the last day of each month beginning January 31, 2008, and maturing January 31, 2010.
In October 2006, we entered into a $24.7 million, three-year interest rate cap agreement in conjunction with our mortgage loan associated with the purchase of the Hilton Arlington. The interest rate agreement caps the 30-day LIBOR at 7.25% and is scheduled to mature on November 19, 2009. In February 2007, we entered into a $32.8 million interest rate cap agreement in conjunction with our mortgage loan associated with the purchase of the Hilton Houston Westchase. The agreement caps the 30-day LIBOR at 7.25% and is scheduled to mature in February 2010. At December 31, 2007, the total fair value of these interest rate cap agreements was approximately $11,100. The change in fair value for these interest rate cap agreements is recognized in the consolidated statement of operations.
The 30-day LIBOR rate, upon which our debt and interest rate cap agreements are based, decreased from 5.3% per annum as of December 31, 2006, to 5.0% per annum as of December 31, 2007. Giving effect to our interest rate hedging activities, a 1.0% change in the 30-day LIBOR would have changed our interest expense by approximately $1.5 million, $0.9 million and $0.9 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Our international operations are subject to foreign exchange rate fluctuations. To date, our only foreign currency exposure are management and incentive fees related to our managed properties in Russia, which are denominated and paid in Rubles. Most of our foreign operations have been largely self-contained or U.S. dollar-denominated and as such, we have not been exposed to material foreign exchange risk. Therefore, to date, we have not entered into any currency contracts or other derivative financial instruments. We continue to monitor and evaluate our current and future exposure to foreign currency fluctuation and risk in determining future derivative arrangements.
We derived approximately 8.6%, 7.4% and 8.8% of our revenues, excluding reimbursed expenses, from services performed outside of the United States for the years ended December 31, 2007, 2006 and 2005, respectively. Our foreign currency translation gains and (losses) of approximately $0.1 million, $1.1 million and $(0.5) million for the years ended December 31, 2007, 2006 and 2005, respectively, are included in accumulated other comprehensive income (loss) in our statement of operations.
The following Consolidated Financial Statements are filed as part of this Annual Report of Form 10-K:
The Board of Directors and Stockholders
Interstate Hotels & Resorts, Inc.:
We have audited the accompanying consolidated balance sheets of Interstate Hotels & Resorts, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive income (loss), stockholders equity, and cash flows for each of the years in the three-year period ended December 31, 2007. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule III as listed in the index at item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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 provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Interstate Hotels & Resorts, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Interstate Hotels & Resorts, Inc. and subsidiaries internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 17, 2008, expressed an adverse opinion on the effectiveness of the Companys internal control over financial reporting.
March 17, 2008
The Board of Directors and Stockholders
Interstate Hotels & Resorts, Inc.:
We have audited the internal control over financial reporting as of December 31, 2007 for Interstate Hotels & Resorts, Inc. and subsidiaries (the Company), based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys 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 the effectiveness of the Companys 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys 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 companys 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 companys 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.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the companys annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in Managements Report on Internal Control Over Financial Reporting. The Company did not have effective policies and procedures designed either to evaluate or review changes in accounting principles in accordance with U.S. generally accepted accounting principles.
In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, Interstate Hotels & Resorts, Inc. and subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Interstate Hotels & Resorts, Inc. and subsidiaries. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 consolidated financial statements, and this report does not affect our report dated March 17, 2008 which expressed an unqualified opinion on those consolidated financial statements.
March 17, 2008
INTERSTATE HOTELS & RESORTS, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
INTERSTATE HOTELS & RESORTS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(In thousands, except per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
INTERSTATE HOTELS & RESORTS,
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
The accompanying notes are an integral part of the consolidated financial statements.
INTERSTATE HOTELS & RESORTS, INC
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of the consolidated financial statements.
INTERSTATE HOTELS & RESORTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except share and per share amounts)
We are a leading hotel real estate investor and the nations largest independent operator, as measured by number of rooms under management and gross annual revenues of the managed portfolio. We have two reportable operating segments: hotel ownership (through whole-ownership and joint ventures) and hotel management. A third reportable operating segment, corporate housing, was disposed of on January 26, 2007 with the sale of BridgeStreet Corporate Housing Worldwide, Inc. and its affiliated subsidiaries, which we refer to as BridgeStreet. Each segment is reviewed and evaluated by the companys senior management. For financial information about each segment, see Note 10, Segment Information.
Our hotel ownership segment includes our wholly-owned hotels and our minority interest, joint venture investments in hotel properties. Hotel ownership allows us to participate in the potential asset appreciation of the hotel properties, and as of December 31, 2007, we owned seven hotels and held non-controlling equity interests in 17 joint ventures, which own or hold ownership interests in 22 of our managed properties. We manage all of the properties within our hotel ownership segment.
We manage a portfolio of hospitality properties and provide related services in the hotel, resort and conference center markets. Our portfolio is diversified by location/market, franchise and brand affiliations. The related services provided include insurance and risk management, purchasing and capital project management, information technology and telecommunications and centralized accounting. As of December 31, 2007, we and our affiliates managed 191 hotel properties with 42,620 rooms and five ancillary service centers (which consist of a convention center, conference center, spa facility and two laundry centers), in 36 states, the District of Columbia, Russia, Mexico, Canada, Belgium and Ireland.
Our corporate housing division was disposed of on January 26, 2007, with the sale of BridgeStreet. It provided apartment rentals for both individuals and corporations with a need for temporary housing as an alternative to long-term apartment rentals or prolonged hotel stays. The assets and liabilities of our corporate housing division are presented as held for sale in our consolidated balance sheets as of December 31, 2006 and as discontinued operations in our consolidated statement of operations and cash flows for all periods presented in this report.
Our subsidiary operating partnership, Interstate Operating Company, L.P, indirectly holds substantially all of our assets. We are the sole general partner of that operating partnership. Certain independent third parties and we are limited partners of the partnership. The interests of those third parties are reflected in minority interests on our consolidated balance sheet. The partnership agreement gives the general partner full control over the business and affairs of the partnership. We own more than 99% of the subsidiary operating partnership.
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These statements include our accounts and the accounts of all of our majority owned subsidiaries. If we determine that we hold an interest in a variable interest entity (VIE) within the meaning of Financial Accounting Standards Board, or FASB, Interpretation No. 46(R), Consolidation of Variable Interest Entities (FIN 46(R)) and that our variable interest will absorb a majority of the entities expected losses, or receive a majority of the expected returns, or both to the extent they occur, then we will consolidate the entity.
If the entity does not meet the definition of a VIE, we evaluate our voting interest and other indicators of control. We consolidate entities when we own over 50% of the voting shares of a company or the majority of the general partner interest of a partnership, assuming the absence of other factors determining control. Other control factors we consider include the ability of minority owners to participate in or block management decisions. Emerging Issues Task Force 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights, (EITF 04-05) addresses the issue
of what rights held by the limited partner(s) preclude consolidation in circumstances in which the sole general partner would otherwise consolidate the limited partnership in accordance with U.S. GAAP. We are not the sole general partner in any of our joint ventures, nor are we the controlling general partner for the one joint venture which involves multiple general partners. We are not the primary beneficiary or controlling investor in any of these joint ventures, however we exert significant influence as the manager of the underlying assets and therefore account for our interests using the equity method of accounting.
We own 100% of seven hotel properties, the operations of which are consolidated in our financial statements. We eliminate all intercompany balances and transactions.
We have reclassified certain immaterial amounts in the prior years consolidated balance sheets within current assets to conform to the current-year presentation. These classifications have no effect on net income.
Preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on our best knowledge of current events and actions we may undertake in the future. Actual results may ultimately differ from those estimates, although management does not believe such estimates would materially affect the financial statements in any individual year. Estimates are used in accounting for, among other things, the impairment of long-lived assets, the impairment of goodwill, income taxes and useful lives for depreciation and amortization.
We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Our insurance captive subsidiary holds short-term liquid investments. We have classified all short-term investments as available-for-sale. The value of unrealized gains and losses on these securities, if any, are reported as accumulated other comprehensive income, which is a separate component of stockholders equity. The value of our short term investments was $1.4 million and $1.3 million as of December 31, 2007 and 2006, respectively. We periodically evaluate whether any declines in the fair value of these investments are other than temporary. If management determines that a decline in fair value is other than temporary, the carrying value of the investment will be reduced to the current fair value of the investment and we will recognize a charge in the consolidated statements of income equal to the amount of the carrying value reduction. The average underlying maturities of these investments range from six months to three years. Despite the long-term nature of the securities stated contractual maturities, these funds can be readily liquidated within a short period of time; therefore, these securities have been classified as short-term and included in prepaid expenses and other current assets.
Restricted cash primarily consists of cash reserves statutorily required to be held by our captive insurance subsidiary for insurance we provide to our managed hotels; escrows required related to property improvement plans at wholly-owned hotels; and working capital from our owners to purchase goods for renovation projects that our purchasing subsidiary oversees.
We provide an allowance for doubtful accounts when we determine it is more likely than not a specific accounts receivable will not be collected and provide a general reserve for the population of our accounts that we believe may become uncollectible based on current business conditions. Our allowance for doubtful accounts was $1.9 million and $1.4 million as of December 31, 2007 and 2006, respectively.
In January 2007, we were retained as manager for two properties owned by Capstar Hotel Company, LLC (New Capstar), a newly formed real estate investment company founded by Paul Whetsell, our current Chairman of the Board. As of December 31, 2007, balances related to New Capstar have been included within Due from related parties on our consolidated balance sheet and Management fees related parties on our consolidated statement of operations.
In May 2006, The Blackstone Group, which we refer to as Blackstone, acquired MeriStar Hospitality Corporation, which we refer to as MeriStar. MeriStar had previously been considered a related party, as our Chairman of the Board, Paul Whetsell, was also the CEO of MeriStar. Mr. Whetsell did not become part of the Blackstone management team, and we do not consider Blackstone to be a related party. As such, the line items due from related parties on our consolidated balance sheet and management fees related parties on our consolidated statement of operations do not include any amounts associated with Blackstone at December 31, 2007 and for the period from May 2, 2006 through December 31, 2006, although fees received from Meristar prior to May 2, 2006 continue to be included in Management fees related parties. See Note 13, Related-Party Transactions for further information on these related party transactions.
Our managed properties for which we also hold a joint venture ownership interest continue to be presented as related parties. See Note 3, Investments in Joint Ventures for further information on these related party amounts.
We provide the benefit of a non-qualified deferred compensation plan for certain employees, allowing them to make deferrals upon which we will match up to certain thresholds defined in the plan. The investments in the plan, which consist primarily of mutual funds, are classified as available for sale. They are recorded at fair value with corresponding unrealized gains or losses reported as accumulated other comprehensive income, which is a separate component of stockholders equity. These unrealized gains and losses serve to increase or decrease the corresponding deferred compensation obligation, which is paid to the employees when they terminate employment with us or reach the required age for distribution.
Property and equipment are recorded at cost and depreciated over their estimated useful lives. Costs directly related to an acquisition are capitalized in accordance with SFAS 141. All internal costs related to the pursuit of an acquisition are expensed as incurred. All third-party costs capitalized in connection with the pursuit of an unsuccessful acquisition are expensed at the time the pursuit is abandoned. Repairs and maintenance costs that do not improve service potential or extend economic life are expensed as incurred.
Depreciation expense is recorded using the straight-line method over the assets estimated useful lives, which generally have the following ranges: buildings and improvements, 40 years or less; furniture and fixtures, five to seven years; computer equipment, three years; and software, five years. Leasehold improvements are depreciated over the shorter of the lease terms or the estimated useful lives of the improvements.
Whenever events or changes in circumstances indicate that the carrying values of property and equipment may be impaired, we perform an analysis to determine the recoverability of the assets carrying value. We make estimates of the undiscounted cash flows from the expected future operations of the asset. If the analysis indicates that the carrying value is not recoverable from future cash flows, the asset is written down to estimated fair value and an impairment loss is recognized.
We account for the majority of our joint venture investments in limited partnerships and limited liability companies using the equity method of accounting when we own more than a minimal investment. We currently employ the cost method on one of our joint venture ownership interests. At December 31, 2007, our ownership interest in these joint ventures ranged from 10% to 50%. We periodically assess the recoverability of our equity method and cost method investments. If an identified event or change in circumstances requires an impairment evaluation, we assess the fair value based on accepted valuation methodologies, including discounted cash flows, estimates of sales proceeds and external appraisals, as appropriate. If an investment is considered to be impaired and the decline is other than temporary, we will recognize an impairment of the investment to its fair value. Cash distributions from joint venture investments are presented as an operating activity on our statement of cash flows when it is a return on investment and as an investing activity on our statement of cash flows when it is a return of investment. See Note 3, Investments in Joint Ventures for additional information on our equity investments.
We have notes receivable, which are generally issued in connection with obtaining a management contract, due from various hotel owners. As of December 31, 2007, we had ten notes receivable outstanding, for a total of
$5.0 million, net of allowance. We review notes receivable for potential impairment when events or changes in circumstances indicate that the carrying value may not be recoverable.
Goodwill represents the excess of the cost to acquire a business over the estimated fair value of the net identifiable assets of that business. We estimate the fair value of goodwill to assess potential impairments on an annual basis, or during the year if an event or other circumstances indicate that we may not be able to recover the carrying value amount of the asset. We evaluate the fair value of goodwill at the reporting unit level and make that determination based upon internal projections of expected future cash flows and operating plans. We record an impairment loss when the implied fair value of the goodwill assigned to the reporting unit is less than the carrying value of that reporting unit, including goodwill.
Our intangible assets consist of costs incurred to obtain management contracts, franchise agreements, and deferred financing fees. The cost of intangible assets is amortized to reflect the pattern of economic benefits consumed, principally on a straight-line basis over the estimated periods benefited. Management contract and franchise agreement costs are amortized over the life of the related management contract, unless circumstances indicate that the useful life is a shorter period. We currently amortize these costs over periods ranging from one to 20 years. Deferred financing fees consist of costs incurred in connection with obtaining various loans and are amortized to interest expense over the life of the underlying loan using a method which approximates the effective interest method.
Costs incurred to obtain a management contract may include payments to an owner as an incentive. These amounts are also capitalized as an intangible asset; however, they are amortized against management fee revenue over the life of the management contract using the straight-line method.
We test intangible assets with definite lives for impairment whenever events or changes in circumstances indicate that the carrying values may not be recoverable. For intangible assets related to management contracts, this may occur when we are notified by an owner that we will no longer be managing a specific property or when a multiple property owner indicates their intent to dispose of a portion or all of their portfolio. We make estimates of the undiscounted cash flows from the expected future operations related to the asset. If the analysis indicates that the carrying value is not recoverable from future cash flows, the asset is written down to estimated fair value and an impairment loss is recognized. When a management contract is terminated, we write-off the entire value of the intangible asset related to the terminated management contract as of the date of termination.
Assets/Liabilities Held for Sale and Discontinued Operations
Assets and liabilities are classified as held for sale when they meet the criteria of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. We believe this criteria includes reclassifying an asset or business segment as held for sale when management, having the authority to do so, has initiated an effort to dispose of the asset or business segment. Assets and liabilities held for sale consist of the assets and liabilities that will be disposed of with the sale of our corporate housing subsidiary in January 2007. Included as assets held for sale are net accounts receivable, prepaid expenses, net fixed assets and goodwill. Included as liabilities held for sale are accounts payable and accrued expenses.
We present the results of operations of an entity as discontinued operations when the operations and cash flows of the entity have been, or will be, eliminated from our ongoing operations and the entity will not have any significant continuing involvement in our operations. Discontinued operations include the operating results of our corporate housing subsidiary for the years ended December 31, 2007, 2006 and 2005 and also the operating results of the Residence Inn Pittsburgh, which was sold in September 2005, for the year ended December 31, 2005.
Minority interest represents the percentage of our subsidiary operating partnership, Interstate Operating Company, L.P., which is owned by third parties. Net income of the subsidiary is allocated to minority interests based on their weighted average ownership percentages during the period. At December 31, 2007 and 2006, the redemption value of the outstanding operating partnership units was $0.2 million and $0.7 million, respectively.
We earn revenue from our owned hotels and hotel management and related sources. We recognize revenue from our owned hotels from rooms, food and beverage, and other operating departments as earned at the close of each business day. In addition, we collect sales, occupancy and other similar taxes at our owned hotels that we remit to the taxing authority, which we present on a net basis (excluded from revenue) on our statement of operations. Our hotel management segment earns fees from base and incentive management fees, termination fees, receivables from third-party owners of hotel properties and fees for other related services we provide, primarily centralized accounting and purchasing. We recognize base fees and fees for other services as revenue when earned in accordance with the individual management contracts. Base management fees are calculated based on a percentage of the total revenue at the property. We record incentive fees in the period in which they are earned. As most of our contracts have annual incentive fee targets, we typically record incentive fees on these contracts in the last month of the annual contract period when all contingencies have been met. We record termination fees as revenue when all contingencies related to the termination fees have been removed.
These amounts represent expenses incurred in managing the hotel properties for which we are contractually reimbursed by the hotel owner and generally include salary and employee benefits for our employees working in the properties and certain other insurance costs.
We are involved in various legal proceedings and tax matters. Due to their nature, such legal proceedings and tax matters involve inherent uncertainties including, but not limited to, court rulings, negotiations between affected parties and governmental actions. We assess the probability of loss for such contingencies and accrue a liability and/or disclose the relevant circumstances, as appropriate. See Note 15, Commitments and Contingencies for additional information.
On January 1, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS 109. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The cumulative effect of applying the provisions of FIN 48 are reported as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that fiscal year. See Note 18, Income Taxes for additional information.
We have accounted for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (SFAS 109). The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities to reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The realization of total deferred tax assets is contingent upon the generation of future taxable income. Valuation allowances are provided to reduce such deferred tax assets to amounts more likely than not to be ultimately realized.
On January 1, 2006, we adopted SFAS No. 123 (revised 2004), Share Based Payment (SFAS 123R) using the modified prospective method. We have previously and will continue to use the Black-Scholes pricing model to estimate the value of stock options granted to employees. The adoption of SFAS 123R did not have a material impact on our results of operations or financial position as all of our unvested stock-based awards as of December 31, 2005 had previously been accounted for under the fair value method of accounting. See Note 14, Stock-Based Compensation, for additional information.
We maintain the results of operations for our Russian office in the local currency and translate these results using the average exchange rates during the period. We translate the assets and liabilities to U.S. dollars using the exchange
rate in effect at the balance sheet date. We reflect the resulting translation adjustments in stockholders equity as a cumulative foreign currency translation adjustment, a component of accumulated other comprehensive (loss) income, net of tax. To date, our only foreign currency exposure related to our management contracts are for management and incentive fees related to our properties in Russia and Belgium, which are denominated and paid in Rubles and Euros, respectively. Most of our foreign operations have been largely self-contained or U.S. dollar-denominated and as such, we have not been exposed to material foreign exchange risk.
We have entered into three interest rate cap agreements, which are considered derivative instruments, in order to manage our interest rate exposure. Our interest rate risk management objective is to limit the impact of interest rate changes on our earnings and cash flows. We record these agreements at fair value as either assets or liabilities. Amounts paid or received under these agreements are recognized over the life of the agreements as adjustments to interest expense. If the requirements for hedge accounting are met, gains and losses from changes in the fair value of the agreements are recorded as a component of accumulated other comprehensive (loss) income, net of tax. Otherwise, we recognize changes in the fair value of the agreements in the consolidated statement of operations. We do not enter into derivative financial instruments for trading or speculative purposes and monitor the financial stability and credit standing of our counterparties.
The Company considers the recorded cost of its financial assets and liabilities which consist primarily of cash and cash equivalents, accounts receivable, marketable securities, notes receivable, and accounts payable to approximate fair values of the respective assets and liabilities as of December 31, 2007 and 2006, as they are primarily short-term in nature. Our long-term debt is primarily variable rate, which is adjusted quarterly, and therefore, approximated fair value as of December 31, 2007 and 2006.
We compute basic earnings per share by dividing net income by the weighted-average number of shares outstanding. Dilutive earnings per share include the diluted effect of outstanding stock-based compensation awards and minority interests that have the option to convert their limited partnership interests to common stock. No effect is presented for anti-dilutive securities.
We participate in various vendor rebate and allowance arrangements as a manager of hotel properties. There are three types of programs common in the hotel industry that are sometimes referred to as rebates or allowances, including unrestricted rebates, marketing (restricted) rebates and sponsorships. The primary business purpose of these arrangements is to secure favorable pricing for our hotel owners for various products and services or enhance resources for promotional campaigns co-sponsored by certain vendors. More specifically, unrestricted rebates are funds returned to the buyer, generally based upon volumes or quantities of goods purchased. Marketing (restricted) allowances are funds allocated by vendor agreements for certain marketing or other joint promotional initiatives. Sponsorships are funds paid by vendors, generally used by the vendor to gain exposure at meetings and events, which are accounted for as a reduction of the cost of the event.
Unrestricted rebates are refunded back to the properties or applied towards training programs for the properties. We account for marketing and sponsorship allowances as adjustments of the prices of the vendors products and services. Vendor rebates received for unrestricted and marketing allowances are recorded as accrued expenses on our consolidated balance sheets until utilized.
In September 2006, FASB Statement No. 157, Fair Value Measurements (SFAS 157) was issued. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of the adoption of this statement.
In December 2007, FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements (SFAS 160) was issued. SFAS 160 establishes a single method of accounting for changes in a parents ownership interest in a subsidiary that does not result in deconsolidation. The statement also requires expanded disclosures in
the consolidated financial statements that clearly identify and distinguish between the interests of the parents owners and the interest of the noncontrolling owners of the subsidiary. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of the adoption of this statement.
In December 2007, FASB Statement No. 141(R), Business Combinations (SFAS 141(R)) was issued. SFAS 141(R) replaces SFAS 141, Business Combinations, however, it retains the fundamental requirements in SFAS 141. SFAS 141(R) defines the acquirer and the date of the combination for each business acquisition. SFAS 141(R), should be applied prospectively to business combinations for which the acquisition dates are on or after the start of the year beginning on or after December 15, 2008.
Our investments in and advances to our joint ventures consist of the following (in thousands, except number of hotels):