HOST MARRIOTT, LP FORM 10-K

 


 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

x    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934

 

OR

 

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Year Ended December 31, 2002

    

    Commission File No. 0-25087

 

HOST MARRIOTT, L.P.

(Exact Name of Registrant as Specified in its Charter)

 

Delaware

 

52-2095412

(State of Incorporation)

 

(I.R.S. Employer Identification Number)

 

6903 Rockledge Drive, Suite 1500, Bethesda, Maryland

 

20817

(Address of Principal Executive Offices)

 

(Zip Code)

 

(240) 744-1000

(Registrant’s Telephone Number, Including Area Code)

 

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

 

Title of each class


Units of limited partnership interest (292,155,055 units outstanding as of March 28, 2003)

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  x

 

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

 

Document Incorporated by Reference

(None)

 



FORWARD-LOOKING STATEMENTS

 

This annual report on Form 10-K and the information incorporated by reference herein include forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. We identify forward-looking statements in this annual report and the information incorporated by reference herein by using words or phrases such as “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may be”, “objective”, “plan”, “predict”, “project” and “will be” and similar words or phrases, or the negative thereof.

 

These forward-looking statements are subject to numerous assumptions, risks and uncertainties. Factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by us in those statements include, among others, the following:

 

    national and local economic and business conditions, including the continuing effect of the war in Iraq and potential terrorist activity on travel, that will affect, among other things, demand for products and services at our hotels and other properties, the level of room rates and occupancy that can be achieved by such properties and the availability and terms of financing and our liquidity;

 

    our ability to maintain properties in a first-class manner, including meeting capital expenditure requirements;

 

    our ability to compete effectively in areas such as access, location, quality of accommodations and room rate;

 

    our ability to acquire or develop additional properties and the risk that potential acquisitions or developments may not perform in accordance with expectations;

 

    our degree of leverage which may affect our ability to obtain financing in the future;

 

    the reduction in our operating flexibility resulting from restrictive covenants in our debt agreements, including the risk of default that could occur;

 

    changes in travel patterns, taxes and government regulations that influence or determine wages, prices, construction procedures and costs;

 

    government approvals, actions and initiatives, including the need for compliance with environmental and safety requirements, and changes in laws and regulations or the interpretation thereof;

 

    the effects of tax legislative action, including specified provisions of the Work Incentives Improvement Act of 1999 as enacted on December 17, 1999 (we refer to this as the “REIT Modernization Act”);

 

    the ability of our sole general partner, Host Marriott Corporation, to continue to satisfy complex rules in order for it to maintain its status as a REIT for federal income tax purposes, our ability to satisfy the rules to maintain our status as a partnership for federal income tax purposes, the ability of certain of our subsidiaries to maintain their status as taxable REIT subsidiaries for federal income tax purposes, and our ability and the ability of our subsidiaries to operate effectively within the limitations imposed by these rules;

 

    the effect of any rating agency downgrades on the cost and availability of new debt financings;

 

    the relatively fixed nature of our property-level operating costs and expenses;

 

    our ability to recover fully under our existing insurance for terrorist acts and our ability to maintain adequate or full replacement cost “all-risk” property insurance on our properties; and

 

    other factors discussed below under the heading “Risk Factors” and in other filings with the Securities and Exchange Commission, or SEC.

 

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Although we believe the expectations reflected in our forward-looking statements are based upon reasonable assumptions, we can give no assurance that we will attain these expectations or that any deviations will not be material. Except as otherwise required by the federal securities laws, we disclaim any obligation or undertaking to publicly release any updates or revisions to any forward-looking statement contained in this annual report on Form 10-K and the information incorporated by reference herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

Items 1 & 2.    Business and Properties

 

Introduction

 

We are a Delaware limited partnership, operating through an umbrella partnership structure with Host Marriott Corporation, a Maryland corporation, or Host REIT, as the sole general partner. As of March 1, 2003, we owned 122 hotels representing approximately 59,000 rooms located throughout North America. Our hotels are operated under brand names that are among the most respected and widely recognized in the lodging industry—including Marriott, Ritz-Carlton, Four Seasons, Hilton, Hyatt and Swissôtel.

 

Our primary business objective is to provide superior total returns to our unitholders through a combination of earnings, distributions and appreciation in asset value by focusing on aggressive asset management, disciplined capital allocation and sound financial management.

 

We were formed in connection with Host REIT’s efforts to convert its hotel ownership business to qualify as a real estate investment trust, or “REIT,” for federal income tax purposes. As part of this conversion, which we refer to as the REIT conversion, on December 29, 1998, Host Marriott Corporation and various of its subsidiaries contributed substantially all of their assets to us and we assumed substantially all of their liabilities. The hotel ownership business formerly conducted by Host Marriott Corporation and its subsidiaries is conducted by and through us and our subsidiaries, and Host Marriott Corporation was merged with and into Host REIT. Host REIT owns approximately 90% of Host Marriott, L.P., as of March 1, 2003.

 

In this report, we refer to ourselves as “Host Marriott, L.P.,” the “operating partnership,” or “Host LP,” to our sole general partner (excluding its subsidiaries) as “Host REIT” and its predecessor, Host Marriott Corporation, a Delaware corporation, as “HMC.”

 

The address of our principal executive office is 6903 Rockledge Drive, Suite 1500, Bethesda, Maryland, 20817. Our phone number is 240-744-1000.

 

We make available free of charge, on or through Host REIT’s Internet website (www.hostmarriott.com), as soon as reasonably practicable after they are electronically filed or furnished to the SEC, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.

 

The Lodging Industry

 

The lodging industry in the United States consists of both private and public entities, which operate in an extremely diversified market under a variety of brand names. Competition in the industry is based primarily on the level of service, quality of accommodations, location and room rates. In order to cater to a wide variety of tastes and needs, the lodging industry is broadly divided into six segments: luxury, upper-upscale, upscale, midscale (with and without food and beverage service) and economy. Most of our hotels operate in urban markets either as luxury properties under such brand names as Ritz-Carlton and Four Seasons or as upper-upscale properties under such brand names as Marriott, Hilton, Hyatt, and Swissôtel. Although the competitive position of each of our hotels varies by market, we believe that they compare favorably to the hotels with which they compete in their respective markets.

 

2


 

A common measure used by the industry to evaluate the operations of a hotel is “room revenue per available room,” or “RevPAR,” which is defined as the product of the average daily room rate charged and the average daily occupancy achieved. RevPAR does not include food and beverage or other ancillary revenues, such as parking, telephone or other guest services generated by the property.

 

The operating environment for the lodging industry has been, and continues to be, difficult, primarily due to a weak economy. As a result, for the past two years industry RevPAR has declined. According to Smith Travel Research, RevPAR for hotels operating in the upper-upscale segment decreased 3% for the year ended December 31, 2002 over the prior year. This decline is attributable to a decrease in average daily rates of 4% and an increase in occupancy of one percentage point. Our hotels in the luxury and upper-upscale segments decreased 5.1% for that period as a result of an increase in occupancy of less than one percentage point and a decrease in average room rate of 5.9%. We believe that our hotel operations will continue to decline until the economy shows steady improvement and business travel increases. We also believe our hotels will experience a decline in RevPAR in the first and second quarters of 2003 with full year RevPAR comparable to 2002 levels or down modestly.

 

Supply and demand growth in the lodging industry and the segments in which we operate may be influenced by a number of factors, including growth of the economy, interest rates, unique local considerations and the relatively long lead time required to develop urban, convention and resort hotels. Properties in the upper-upscale segment of the lodging industry benefited from a favorable imbalance between supply and demand during the early 1990’s, driven in part by low construction levels and high gross domestic product, or GDP growth. From 1998 through 2000, supply moderately outpaced demand, which caused slight declines in occupancy rates; however, the impact of the occupancy decline was mitigated by increases in the average daily rate during the period. In 2001 and 2002, demand decreased substantially primarily due to terrorist acts and the economic downturn, which more recently has been exacerbated by the continuing concern over the war in Iraq and the possibility of further terrorist acts. We expect the rate of supply growth to continue to decrease for at least the next two years due to the limited availability of development financing for new construction. Additionally, we believe that demand will remain below historical levels during the first half of 2003, but may begin to grow during the second half of 2003, if the economy strengthens.

 

Business Strategy

 

Our primary business objective is to provide superior total returns to our unitholders through a combination of distributions, appreciation in net asset value per unit, and growth in earnings. In order to achieve this objective we seek to:

 

    maximize the value of our existing portfolio through aggressive asset management, by working with the managers of our hotels to continue to reduce operating costs and increase revenues and by completing selective capital improvements designed to improve operations and profitability;

 

    maintain a capital structure and liquidity profile that is appropriate given the operating characteristics of the assets we own;

 

    acquire upper-upscale and luxury full-service hotels if market conditions permit, including hotels operated by leading management companies. In the past we have completed our acquisitions through various structures, including transactions involving portfolios, single assets and through joint ventures; and

 

    opportunistically dispose of non-core assets, such as older assets with significant capital needs, assets that are at a competitive risk given potential new supply or assets in slower-growth markets.

 

We believe we are well-qualified to pursue our asset management and acquisition and disposition strategies. Our management team has extensive experience in acquiring and financing lodging properties and believes that its industry knowledge, relationships and access to market information provide a competitive advantage with

 

3


respect to identifying, evaluating and acquiring lodging properties and that this competitive advantage carries over to the work we do to improve and maintain the quality of our assets. These efforts include maximizing the value of our existing portfolio by directing our managers to reduce operating costs and to increase revenues at our hotels, monitoring property and brand performance; pursuing expansion and repositioning opportunities, overseeing capital expenditure budgets and forecasts, assessing return on investment capital expenditure opportunities, and analyzing competitive supply conditions in each of our markets.

 

Our acquisition strategy focuses on hotels operating as upper-upscale and luxury full-service hotels. We continue to believe there will be opportunities to acquire hotels in these segments at attractive multiples of cash flow and at discounts to replacement cost. Our acquisition strategy continues to focus on:

 

    properties with unique locations in markets with high barriers for entry for prospective competitors, including hotels located in urban, airport and resort and convention locations;

 

    properties operated under premium brand names, such as Marriott, Ritz-Carlton, Four Seasons, Hilton, Hyatt and Westin;

 

    larger hotels that are consistent with our portfolio objectives and require a significant investment, which narrows the competition for these acquisitions; and

 

    underperforming hotels whose operations can be enhanced by conversion to high quality brands and/or by upgrading or adding to the existing facilities.

 

Our acquisition efforts since 1998 have been limited by the lack of suitable targets that complement our portfolio, increased price competition and capital limitations due to weak equity markets. Consequently, our activity has been primarily focused on acquiring the interests of limited or joint venture partners, consolidating our ownership of assets already included in our portfolio and as described in “Operating Structure,” purchasing the lessee interests, which were created as part of the REIT conversion. We are particularly interested in exploring acquisitions that can be accomplished, at least in part, through the issuance of operating partnership units, thereby resulting in an overall improvement in our credit profile. We expect that the currently difficult refinancing market may ultimately cause some owners to sell properties; however, the timing of these potential sales is uncertain.

 

In addition to acquiring and maintaining superior assets, a key part of our strategy is to engage the leading hotel management companies such as Marriott, Ritz-Carlton, Hyatt, Four Seasons, Hilton and Starwood to operate our properties. As of March 1, 2003, 102 of our 122 properties were managed by subsidiaries of Marriott International, Inc., as Marriott or Ritz-Carlton brand hotels and an additional seven hotels are part of Marriott International’s full-service hotel system through franchise agreements. Our remaining hotels are represented by other nationally recognized brands such as Four Seasons, Hyatt and Hilton. In general, we believe that these premium brands have consistently outperformed other brands in the industry.

 

Operating Structure

 

The REIT Reorganization.    Host REIT manages all aspects of our business through its Board of Directors and our executive officers who are also officers of Host REIT. This includes decisions with respect to sale and purchase of hotels, the investment in these hotels and the financing of our assets. Together with Host REIT, we continue, in an UPREIT structure, the full-service hotel ownership business formerly conducted by HMC and its subsidiaries.

 

4


 

LOGO

 

During 1998, HMC reorganized its business and contributed their hotels and certain other assets so that they were owned by us and our subsidiaries. As a result of this reorganization, Host REIT became our sole general partner. For each share of Host REIT common stock, we have issued one unit of operating partnership interest, or OP Unit to Host REIT. When distinguishing between ourselves and Host REIT, the primary difference is the approximate 10% of the partnership interests of Host LP not held by Host REIT as of December 31, 2002.

 

We and our Subsidiaries.    We are a Delaware limited partnership. All of our assets are owned by us or our subsidiaries, all of which are general or limited partnerships or limited liability companies. The OP Units owned by holders other than Host REIT are redeemable at the option of the holders, generally within one year after the date of issuance of the holder’s OP Units. Upon redemption of an OP Unit, a holder may receive cash from us in an amount equal to the market value of one share of Host REIT common stock. Host REIT has the right, however, to acquire any OP Unit offered for redemption directly from the holder in exchange for one share of Host REIT common stock, instead of a cash redemption by us. Due to certain tax laws restricting REITs from deriving revenues directly from the operations of hotels, as part of the REIT conversion, the hotel properties were leased by us and our subsidiaries to third party lessees. In turn, these third party lessees assumed or entered into agreements with Marriott International and the other operators of our hotels to conduct the day-to-day management of the hotels. At the time of the REIT conversion, substantially all of our hotels were leased to Crestline Capital Corporation and its subsidiaries, or Crestline. As a result of tax law changes applying to REITs, substantially all of our hotels are currently leased to a wholly-owned taxable REIT subsidiary of ours, which is discussed below.

 

The REIT Modernization Act, which was enacted in December 1999, amended the Federal tax laws to permit REITs, effective January 1, 2001, to lease hotels to a corporation that qualifies as a taxable REIT subsidiary and to own all the voting stock of such a subsidiary. Unlike other subsidiaries of a REIT, the earnings of a taxable REIT subsidiary are subject to normal corporate level federal and state income taxes.

 

5


 

On January 1, 2001, one of our wholly owned taxable REIT subsidiaries, HMT Lessee LLC, acquired from Crestline the equity interests in the lessees of 112 of our hotels and the leasehold interests in four of our other hotels for $208 million in cash. In connection with that transaction, during the fourth quarter of 2000, we recorded a $207 million non-recurring, pre-tax loss related to the termination of the leases for financial reporting purposes. In addition, we recorded an $82 million tax benefit which is reflected as a deferred tax asset because, for income tax purposes, the transaction was recorded as an acquisition of leasehold interests that will be amortized over the remaining term of the leases.

 

During June 2001, HMT Lessee LLC acquired our remaining four leases held by third parties. In the first of these transactions, we acquired the lease for the San Diego Marriott Hotel and Marina by purchasing the lessee equity interest from Crestline for $4.5 million. We acquired the leases for the remaining three hotels which we did not already own, the San Diego Marriott Mission Valley, the Minneapolis Marriott Southwest, and the Albany Marriott in connection with the acquisition from Wyndham International, Inc. of their minority limited partnership interests in five partnerships holding seven of our Marriott branded hotels.

 

The acquisition of the leases through our taxable REIT subsidiary positioned us to better control our portfolio of hotels. Further, because we consolidate the taxable REIT subsidiary, our results of operations reflect the revenues and expenses generated by our hotels as well as taxes paid by the taxable REIT subsidiary.

 

All but one of our hotels are operated by third party hotel operators pursuant to long term hotel management agreements. Our arrangements with our hotel managers are discussed elsewhere in this “Business and Properties” section.

 

Lodging Property Portfolio

 

Overview.    Our lodging portfolio, as of March 1, 2003, consisted of 122 upper-upscale and luxury full-service hotels containing approximately 59,000 rooms.

 

The following chart details our portfolio by brand as of March 1, 2003:

 

Brand


  

Number of Hotels


  

Rooms


Marriott

  

99

  

49,542

Ritz-Carlton

  

10

  

3,831

Hyatt

  

4

  

2,217

Swissôtel

  

4

  

1,993

Four Seasons

  

2

  

608

Other brands

  

3

  

686

    
  
    

122

  

58,877

    
  

 

Our portfolio is geographically diversified with hotels in most of the major metropolitan areas in 28 states, Washington, D.C., Toronto and Calgary, Canada and Mexico City, Mexico. Our locations include central business districts of major cities, near airports and resort/convention locations where large-scale development opportunities are limited. These hotels, because of their locations, typically benefit from significant barriers to entry by competitors. Historically, our properties in urban, resort and convention locations have had higher RevPAR results than similar properties in suburban locations. These properties contributed 69% of our EBITDA during 2002. Our hotels have an average of approximately 483 rooms per hotel. Thirteen of our hotels have more than 750 rooms. Our hotels typically include meeting and banquet facilities, a variety of restaurants and lounges, swimming pools, gift shops and parking facilities, which enable them to serve business, leisure and group travelers. The average age of our properties is eighteen years, although many of the properties have had substantial renovations or major additions.

 

6


 

To maintain the overall quality of our lodging properties we assess annually the need for refurbishments and capital improvements. Typically, refurbishments occur at intervals of approximately seven years, based on an annual review of the condition of each property. The management agreements for the majority of our properties require us to escrow 5% of hotel sales and, on average, we spend approximately $200 to $250 million annually on these refurbishments and capital improvements. These expenditures do not include investments such as the construction of the spa at The Ritz-Carlton, Naples in 2001 or the 500-room tower added at the Orlando World Center Marriott in 2000. We will occasionally spend less than these amounts. For example, in 2002, we reduced our capital expenditures based on our assessment of the operating environment and to preserve capital. During this period, our capital expenditures have been focused on property maintenance and improvements designed to maintain appropriate levels of quality. As a result of the commitment we have historically made to maintaining our assets, we believe that the reductions in capital expenditures during the last two years have not adversely affected the long-term value of our portfolio. For 2003, we anticipate spending approximately $240 million on refurbishments and capital improvements, though these expenditures will depend on our results of operations. As the industry recovers, we plan to continue our strategy of pursuing capital expenditure projects designed to enhance the value of our hotels.

 

Acquisitions.    During 2002, we acquired 80% of the outstanding minority interests in the partnership that owns the San Diego Marriott Hotel and Marina (which increased our ownership in that partnership to 90%). We acquired these additional interests in exchange for 1.1 million shares of Host REIT common stock and 6.9 million OP Units. In addition, we completed the acquisition of the 1,139-room Boston Marriott Copley Place on June 14, 2002 for $214 million, which included the assumption of $97 million in mortgage debt. During 2001, we acquired the outstanding minority interests in seven of our Marriott-branded hotels from Wyndham International for $60 million.

 

We have not acquired hotels outside of the United States in recent years due to the difficulty in identifying opportunities which meet our return criteria. However, we intend to continue to evaluate acquisition opportunities in international locations, and will pursue these only when we believe they will offer satisfactory returns after adjustments for currency and country-related risks.

 

Dispositions.    We continue to evaluate the sale of hotels or other assets that do not fit our long-term strategy or otherwise fail to meet our ongoing investment criteria, such as hotels located in slower growth markets, hotels that require significant future capital improvements or hotels that are at a competitive risk given potential new supply. We may reinvest the net proceeds from property sales into hotels that are more consistent with our portfolio, or in a manner consistent with our investment strategy. Among the alternatives we may consider in this regard are the repayment of debt and open market purchases of Host REIT’s common stock, OP Units or Host REIT’s convertible redeemable preferred securities. In addition, under the terms of our credit facility and our senior notes indenture, to the extent not otherwise invested in a manner consistent with the terms of these agreements, we are required to use the net proceeds from asset dispositions (during a twelve month period) once the net proceeds are in excess of 1% of our total assets to permanently repay amounts outstanding, if any, under our credit facility, and thereafter, to tender for our senior notes at par. The following table summarizes our dispositions from January 1, 2001 through March 1, 2003 (in millions, except number of rooms):

 

Property


  

Year of Disposition


  

Location


  

Rooms


    

Total

Consideration


    

Pre-tax

Gain (Loss)

on Disposal


 

Ontario Airport Marriott

  

2003

  

Ontario, CA

  

299

    

$

26

    

$

 

St. Louis Marriott Pavilion(1)

  

2002

  

St. Louis, MO

  

672

    

 

    

 

22

 

Vail Marriott Mountain Resort

  

2001

  

Vail, CO

  

349

    

 

50

    

 

15

 

Pittsburgh City Center Marriott

  

2001

  

Pittsburgh, PA

  

402

    

 

15

    

 

(3

)


(1)   St. Louis Marriott Pavilion hotel is included in discontinued operations in the accompanying consolidated financial statements.

 

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Development Projects.      During 2002 and 2001, we completed the development of the 295-room Ritz-Carlton, Naples Golf Resort and completed the addition of two spas to existing properties.

 

In January 2002, we opened The Ritz-Carlton, Naples Golf Resort, which is located approximately three miles from our existing Ritz-Carlton, Naples beachfront hotel. The Naples Golf Resort had a development cost of approximately $75 million and includes 15,000 square-feet of meeting space, four food and beverage outlets, and full access to the Tiburon Golf Club, a 36-hole Greg Norman designed golf complex, which borders the hotel. We own 49% of the partnership which owns Tiburon Golf Club, and invested an additional $3 million in 2002 to complete an additional nine holes for the 36-hole golf course. The newly created golf resort and a 50,000 square-foot beachfront spa facility, which opened in April 2001 at a cost of approximately $25 million, operate in concert with the 463-room Ritz-Carlton, Naples beachfront hotel. Further, given the close proximity of the properties, we expect to benefit from cost efficiencies and the ability to capture larger groups than could be accommodated at either of the individual hotels. In June 2001, we completed the 20,000 square foot oceanfront spa at the Marriott Harbor Beach Resort in Fort Lauderdale, Florida at a cost of $8 million. We believe that the spa should increase revenues of this property, which includes 30,000 square feet of meeting space, through increased appeal to business and leisure travelers.

 

Portfolio Performance.    Set forth below is information about the performance of our hotel properties, including for our comparable hotels (as defined below). This information includes unaudited hotel operating profit and operating profit margin for our comparable properties. Comparable hotel operating profit is a non-GAAP financial measure within the meaning of applicable SEC rules. We believe that the comparable hotel-level results help us and our investors evaluate the recurring operating performance of our properties in similar environments, including in comparisons with other REITs and hotel owners. While these measures are based on accounting principles generally accepted in the United States of America, costs such as depreciation, corporate expenses and other non-recurring revenues and expenses have been incurred and are not reflected in this presentation. As a result, the comparable hotel-level results do not represent total revenues or operating profit.

 

Further, results of operations for our hotels that are both managed and operated under the Marriott brand name report results on a 52 or 53-week fiscal year, which ends on the Friday closest to December 31. In 2002, these hotels reported 53 weeks of operations compared to 52 weeks for 2001. Our consolidated financial statements have been adjusted to reflect the results of operations for these properties on a calendar year basis. However, in reporting our hotel operating statistics (average room rates, occupancy, RevPAR and the Schedule of Comparable Hotel-Level Results), the results of the Marriott managed and branded hotels reflect 53 weeks in 2002 compared to 52 weeks in 2001.

 

We define our comparable hotels as properties that are owned or leased, directly or indirectly, by us and for which we reported operating results throughout 2002 and 2001. We exclude from our operating results hotels that have been acquired or sold during those periods, or that have had substantial property damage or that have undergone large scale capital projects. We also exclude rental income from non-hotel properties and the results of our leased limited service hotels.

 

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Schedule of Comparable Hotel-Level Results(1)

(unaudited, in millions, except hotel statistics)

 

    

2002


    

2001


 

Number of hotels

  

 

118

 

  

 

118

 

Number of rooms

  

 

56,327

 

  

 

56,327

 

Percent change in Comparable RevPAR

  

 

(5.1

)%

        

Comparable hotel operating profit margin

  

 

24.2

%

  

 

26.0

%

Percent change in comparable operating profit

  

 

(9.6

)%

        

Sales

                 

Room

  

$

2,082

 

  

$

2,160

 

Food and beverage

  

 

1,118

 

  

 

1,114

 

Other

  

 

248

 

  

 

282

 

    


  


Hotel sales

  

 

3,448

 

  

 

3,556

 

    


  


Expenses

                 

Room

  

 

512

 

  

 

520

 

Food and beverage

  

 

819

 

  

 

821

 

Other

  

 

144

 

  

 

147

 

Management fees, ground rent and other costs

  

 

1,138

 

  

 

1,144

 

    


  


Hotel expenses

  

 

2,613

 

  

 

2,632

 

    


  


Comparable Hotel Operating Profit

  

 

835

 

  

 

924

 

Business interruption insurance proceeds, net(2)

  

 

17

 

  

 

—  

 

Non-comparable hotel results, net

  

 

31

 

  

 

30

 

Office building and limited service properties, net

  

 

4

 

  

 

9

 

Depreciation expense

  

 

(372

)

  

 

(374

)

Corporate and other expenses

  

 

(49

)

  

 

(51

)

Lease repurchase expense

  

 

—  

 

  

 

(5

)

    


  


Operating Profit

  

$

466

 

  

$

533

 

    


  



(1)   We consider 118 of our hotels to be comparable properties for the periods presented. The five non-comparable properties that we currently own for the periods presented are the New York Financial Center Marriott (substantially damaged in the September 11, 2001 terrorist attacks), the Boston Marriott Copley Place (acquired in June 2002), The Ritz-Carlton, Naples Golf Resort (opened January 2002), JW Marriott Mexico City and the Mexico City Airport Marriott (we did not consolidate these two properties until we acquired Rockledge Hotel Properties, Inc. in April 2001).
(2)   Represents the $17 million of business interruption insurance proceeds, net of certain operating expenses, we have recognized for the Marriott World Trade Center, which was destroyed September 11, 2001 and the New York Marriott Financial Center which was also damaged in the terrorist attack.

 

The chart below sets forth performance information for our comparable properties as of December 31, 2002:

 

    

2002


    

2001


 

Comparable Hotels

                 

Number of properties

  

 

118

 

  

 

118

 

Number of rooms

  

 

56,327

 

  

 

56,327

 

Average daily rate

  

$

142.17

 

  

$

151.16

 

Occupancy percentage

  

 

70.4

%

  

 

69.8

%

RevPAR

  

$

100.12

 

  

$

105.45

 

RevPAR % change

  

 

(5.1

)%

        

 

9


 

The chart below presents performance information for our entire portfolio of hotels as of December 31, 2002:

 

    

2002


    

2001


    

2000


 

All Properties

                          

Number of properties

  

 

123

 

  

 

122

 

  

 

122

 

Number of rooms

  

 

59,176

 

  

 

58,385

 

  

 

58,370

 

Average daily rate

  

$

143.19

 

  

$

151.68

 

  

$

158.24

 

Occupancy percentage

  

 

70.4

%

  

 

69.9

%

  

 

77.6

%

RevPAR

  

$

100.74

 

  

$

105.96

 

  

$

122.72

 

RevPAR % change

  

 

(4.9

)%

  

 

(13.7

)%

        

 

The following tables set forth performance information by geographic region for 2002 and 2001 for our comparable properties as well as the total portfolio:

 

      

As of

December 31, 2002


 

Year Ended

December 31, 2002


 

Year Ended

December 31, 2001


  

Percent Change in RevPAR


 
      

No. of

Properties


  

No. of

Rooms


 

Average

Daily Rate


    

Average

Occupancy

Percentages


   

RevPAR


 

Average Daily Rate


    

Average

Occupancy

Percentages


    

RevPAR


  

Comparable Properties     by Region

                                                             

Atlanta

    

15

  

6,563

 

$

138.70

    

66.4

%

 

$

92.03

 

$

150.80

    

65.0

%

  

$

98.02

  

(6.1

)%

DC Metro

    

13

  

4,998

 

 

139.70

    

69.9

 

 

 

97.59

 

 

150.67

    

67.9

 

  

 

102.26

  

(4.6

)

Florida

    

13

  

7,582

 

 

150.26

    

70.1

 

 

 

105.38

 

 

158.34

    

69.4

 

  

 

109.88

  

(4.1

)

International

    

4

  

1,641

 

 

97.57

    

70.9

 

 

 

69.15

 

 

102.04

    

71.8

 

  

 

73.28

  

(5.6

)

Mid-Atlantic

    

9

  

6,222

 

 

186.41

    

76.7

 

 

 

143.05

 

 

189.43

    

77.5

 

  

 

146.77

  

(2.5

)

Mountain

    

8

  

3,313

 

 

107.89

    

64.1

 

 

 

69.19

 

 

110.02

    

66.2

 

  

 

72.79

  

(5.0

)

New England

    

6

  

2,277

 

 

129.97

    

69.3

 

 

 

90.02

 

 

144.62

    

66.2

 

  

 

95.78

  

(6.0

)

North Central

    

15

  

5,395

 

 

120.89

    

67.8

 

 

 

82.00

 

 

131.20

    

66.9

 

  

 

87.80

  

(6.6

)

Pacific

    

23

  

11,822

 

 

149.43

    

69.3

 

 

 

103.63

 

 

163.96

    

68.9

 

  

 

112.98

  

(8.3

)

South Central

    

12

  

6,514

 

 

128.62

    

76.8

 

 

 

98.79

 

 

132.32

    

75.5

 

  

 

99.91

  

(1.1

)

      
  
                                                 

All regions

    

118

  

56,327

 

 

142.17

    

70.4

 

 

 

100.12

 

 

151.16

    

69.8

 

  

 

105.45

  

(5.1

)

      
  
                                                 

 

      

As of

December 31, 2002


 

Year Ended

December 31, 2002


  

Year Ended

December 31, 2001 (1)


  

Percent Change in RevPAR


 
      

No. of

Properties


  

No. of

Rooms


 

Average

Daily Rate


    

Average

Occupancy

Percentages


    

RevPAR


  

Average Daily Rate


    

Average

Occupancy

Percentages


    

RevPAR


  

All Properties by     Region

                                                               

Atlanta

    

15

  

6,563

 

$

138.70

    

66.4

%

  

$

92.03

  

$

150.80

    

65.0

%

  

$

98.02

  

(6.1

)%

DC Metro

    

13

  

4,998

 

 

139.70

    

69.9

 

  

 

97.59

  

 

150.67

    

67.9

 

  

 

102.26

  

(4.6

)

Florida

    

14

  

7,877

 

 

152.53

    

69.3

 

  

 

105.76

  

 

158.34

    

69.4

 

  

 

109.88

  

(3.8

)

International

    

6

  

2,552

 

 

110.03

    

71.0

 

  

 

78.09

  

 

113.34

    

70.7

 

  

 

80.18

  

(2.6

)

Mid-Atlantic

    

10

  

6,726

 

 

186.47

    

76.5

 

  

 

142.70

  

 

189.76

    

77.5

 

  

 

147.06

  

(3.0

)

Mountain

    

8

  

3,313

 

 

107.87

    

64.1

 

  

 

69.17

  

 

113.03

    

65.8

 

  

 

74.35

  

(7.0

)

New England

    

7

  

3,416

 

 

142.27

    

70.0

 

  

 

99.65

  

 

144.62

    

66.2

 

  

 

95.78

  

4.0

 

North Central

    

15

  

5,395

 

 

120.89

    

67.8

 

  

 

82.00

  

 

131.20

    

66.9

 

  

 

87.80

  

(6.6

)

Pacific

    

23

  

11,822

 

 

149.43

    

69.3

 

  

 

103.63

  

 

163.96

    

68.9

 

  

 

112.98

  

(8.3

)

South Central

    

12

  

6,514

 

 

128.47

    

76.5

 

  

 

98.32

  

 

130.81

    

74.9

 

  

 

97.97

  

0.4

 

      
  
                                                   

All regions

    

123

  

59,176

 

 

143.19

    

70.4

 

  

 

100.74

  

 

151.68

    

69.9

 

  

 

105.96

  

(4.9

)

      
  
                                                   

(1)   For 2001, the results of operations represent 125 hotels with 59,954 rooms.

 

10


 

We believe that the location and high quality of our hotels, combined with internationally recognized premium brands, has allowed us to maintain RevPAR and average daily rate premiums relative to our competition. While competition is specific to individual markets, and may include hotels from multiple segments of the lodging industry, generally we define our competition as hotels operated under brands in the upper-upscale and luxury full-service segments. These hotels include the Ritz-Carlton, Marriott, Four Seasons, Fairmont, Doubletree, Inter-Continental, Hyatt, Hilton, Renaissance, Embassy Suites, Sheraton, Swissôtel, W Hotel, Westin and Wyndham brand properties. Based on data provided by Smith Travel Research, occupancy at our comparable properties was approximately 5 percentage points higher for both 2002 and 2001. Average daily rate was also higher by approximately 6% and 8%, respectively, for the same periods resulting in our comparable RevPAR premium of approximately 14% and 16% for the years 2002 and 2001, respectively, as compared with similar hotels in the upper-upscale segment.

 

The economic trends affecting the travel and hotel industries and the overall economy will be a major factor in determining the rate of growth in our hotel revenues. In the current environment, our managers have actively adjusted the mix of business at our properties, increasing the percentage of room nights from group and discounted business travelers in reaction to the decline in premium business travelers. The current booking cycle for reservations remains much shorter than historical cycles, and therefore, predictions for the volume and mix of business in 2003 are difficult to forecast. For the year ended December 31, 2002, as a percentage of total rooms sold, transient business comprised approximately 55%, a decrease of 3% since 2000. Demand in the corporate and premium business traveler segments, which represent the segments with the highest average room rate, declined 40% in that same period. This decline in demand was partially offset by additional group and contract business, which comprised approximately 45% of total rooms sold in 2002. Additionally, the ability of our managers to curb operating costs while continuing to maintain service and maintenance levels at our hotels will have a material impact on our future operating profit growth.

 

Foreign Operations.    We currently own four Canadian and two Mexican properties containing a total of 2,552 rooms. During 2002 and 2001, 97% of our total revenues were attributed to sales within the United States and the remaining 3% of our total revenues were attributed to these properties. During 2000, 98% of our total revenues were attributed to sales within the United States and the remaining 2% was attributed to our foreign properties.

 

Competition.    Competition is often specific to individual markets and includes hotels operated under brands in the upper-upscale and luxury full-service segments. In addition, many management contracts do not have restrictions on the ability of management companies to convert, franchise or develop other hotel properties in our markets. As a result, we often compete with our managers such as Marriott International, which may own or invest in hotels that compete with our hotels.

 

We believe, however, that our properties will enjoy competitive advantages associated with their operations under the Marriott, Ritz-Carlton, Four Seasons, Hilton and Hyatt hotel brand systems. The national marketing programs and reservation systems of these brands combined with the strong management systems and expertise they provide should enable our properties to continue to perform favorably in terms of both occupancy and room rates. Each of our managers maintains national reservation systems with reservation agents that have the current status of the rooms available and rates from the properties. Host REIT’s website permits users to connect to the Marriott, Ritz-Carlton, Four Seasons, Hilton and Hyatt reservation systems to reserve rooms at our hotels. In addition, repeat guest business is enhanced by guest rewards programs offered by Marriott, Hilton and Hyatt.

 

Seasonality.    Our hotel sales have traditionally experienced moderate seasonality, which varies based on the individual hotel property and the region. Additionally, hotel revenues in the fourth quarter reflect sixteen weeks of results compared to twelve weeks for each of the first three quarters of the fiscal year. During 2000, the

 

11


hotel sales were not recorded in our revenues, as most of our hotels were leased to third parties; however, hotel sales were used to calculate rental income. Hotel sales by quarter for the years 2000 through 2002 for our lodging properties are as follows:

 

Year


  

First Quarter


    

Second Quarter


    

Third Quarter


    

Fourth Quarter


 

2000

  

21

%

  

25

%

  

22

%

  

32

%

2001

  

23

 

  

26

 

  

23

 

  

28

(1)

2002

  

21

 

  

25

 

  

21

 

  

33

 

    

  

  

  

Average

  

22

 

  

25

 

  

22

 

  

31

 

    

  

  

  


(1)   The fourth quarter results for 2001 were significantly affected by the terrorist attacks on September 11, 2001.

 

12


Hotel Properties.    The following table sets forth the location and number of rooms of our 122 hotels as of March 1, 2003. Each hotel is operated as a Marriott brand hotel unless otherwise indicated by its name.

 

 

 

 

Location


  

Rooms


Arizona

    

Mountain Shadows Resort

  

337

Scottsdale Suites

  

251

The Ritz-Carlton, Phoenix

  

281

California

    

Coronado Island Resort(1)

  

300

Costa Mesa Suites

  

253

Desert Springs Resort and Spa

  

884

Fullerton(1)

  

224

Hyatt Regency, Burlingame

  

793

Manhattan Beach(1)

  

385

Marina Beach(1)

  

370

Newport Beach

  

586

Newport Beach Suites

  

254

Sacramento Host Airport

  

89

San Diego Hotel and Marina(1)(2)

  

1,356

San Diego Mission Valley(2)

  

350

San Francisco Airport

  

684

San Francisco Fisherman’s Wharf

  

285

San Francisco Moscone Center(1)

  

1,498

San Ramon(1)

  

368

Santa Clara(1)

  

755

The Ritz-Carlton, Marina del Rey(1)

  

304

The Ritz-Carlton, San Francisco

  

336

Torrance

  

487

Colorado

    

Denver Southeast(1)

  

590

Denver Tech Center

  

628

Denver West(1)

  

305

Connecticut

    

Hartford/Farmington

  

381

Hartford/Rocky Hill(1)

  

251

Florida

    

Fort Lauderdale Marina

  

579

Harbor Beach Resort(1)(2)

  

637

Jacksonville(1)

  

256

Miami Airport(1)

  

772

Miami Biscayne Bay(1)

  

601

Orlando World Center Resort

  

2,000

Palm Beach Gardens

  

279

Singer Island Hilton

  

223

Tampa Airport(1)

  

296

Tampa Waterside

  

717

Tampa Westshore(1)

  

310

The Ritz-Carlton, Amelia Island

  

449

The Ritz-Carlton, Naples

  

463

The Ritz-Carlton, Naples Golf Resort

  

295

Georgia

    

Atlanta Marquis

  

1,675

Atlanta Midtown Suites(1)

  

254

Atlanta Norcross

  

222

Atlanta Northwest

  

401

Atlanta Perimeter(1)

  

400

Four Seasons, Atlanta

  

244

Grand Hyatt, Atlanta

  

438

JW Marriott Hotel at Lenox(1)

  

371

 

Location


  

Rooms


Georgia (continued)

    

Swissôtel, Atlanta

  

365

The Ritz-Carlton, Atlanta

  

444

The Ritz-Carlton, Buckhead

  

553

Illinois

    

Chicago/Deerfield Suites

  

248

Chicago/Downers Grove Suites

  

254

Chicago/Downtown Courtyard

  

337

Chicago O’Hare

  

681

Chicago O’Hare Suites(1)

  

256

Swissôtel, Chicago

  

632

Indiana

    

South Bend(1)

  

298

Louisiana

    

New Orleans

  

1,290

Maryland

    

Bethesda(1)

  

407

Gaithersburg/Washingtonian Center

  

284

Massachusetts

    

Boston/Newton

  

430

Boston Marriott Copley Place

  

1,139

Hyatt Regency, Cambridge

  

469

Swissôtel, Boston

  

501

Michigan

    

The Ritz-Carlton, Dearborn

  

308

Detroit Livonia

  

224

Detroit Romulus

  

246

Detroit Southfield

  

226

Minnesota

    

Minneapolis City Center

  

583

Minneapolis Southwest(2)

  

321

Missouri

    

Kansas City Airport(1)

  

382

New Hampshire

    

Nashua

  

245

New Jersey

    

Hanover

  

353

Newark Airport(1)

  

591

Park Ridge(1)

  

289

New Mexico

    

Albuquerque(1)

  

411

New York

    

Albany(2)

  

359

New York Financial Center

  

504

New York Marquis(1)

  

1,944

Swissôtel, The Drake

  

495

North Carolina

    

Charlotte Executive Park

  

297

Greensboro/Highpoint(1)

  

299

Raleigh Crabtree Valley

  

375

Research Triangle Park

  

225

Ohio

    

Dayton

  

399

Oklahoma

    

Oklahoma City

  

354

Oklahoma City Waterford

  

197

 

13


 

Location


  

Rooms


Oregon

    

Portland

  

503

Pennsylvania

    

Four Seasons, Philadelphia

  

364

Philadelphia Convention Center (2)

  

1,408

Philadelphia Airport(1)

  

419

Tennessee

    

Memphis

  

404

Texas

    

Dallas/Fort Worth Airport

  

491

Dallas Quorum(1)

  

548

Houston Airport(1)

  

565

Houston Medical Center(1)

  

386

JW Marriott Houston

  

514

Plaza San Antonio(1)

  

252

San Antonio Rivercenter(1)

  

1,001

San Antonio Riverwalk(1)

  

512

Utah

    

Salt Lake City(1)

  

510

Virginia

    

Dulles Airport(1)

  

368

Fairview Park

  

395

 

Location


  

Rooms


Virginia (continued)

    

Hyatt Regency, Reston

  

517

Key Bridge(1)

  

586

Norfolk Waterside(1)

  

405

Pentagon City Residence Inn

  

299

The Ritz-Carlton, Tysons Corner(1)

  

398

Washington Dulles Suites

  

253

Westfields

  

335

Williamsburg

  

295

Washington

    

Seattle SeaTac Airport

  

459

Washington, DC

    

Washington Metro Center

  

456

Canada

    

Calgary

  

384

Toronto Airport(2)

  

424

Toronto Eaton Center(1)

  

459

Toronto Delta Meadowvale

  

374

Mexico

    

JW Marriott, Mexico City (2)

  

312

Mexico City Airport (2)

  

599

    

TOTAL

  

58,877

    

 

 


(1) The land on which this hotel is built is leased under one or more long-term lease agreements.

(2) This property is not wholly owned by the operating partnership.

 

Other Real Estate Investments

 

In addition to our 122 full-service hotels, we maintain investments in joint ventures or partnerships that in the aggregate own three full-service hotels, 120 limited service hotels and other investments, the operations of which we do not consolidate. During 2002, our equity in earnings of affiliates from these investments was less than 1% of our total revenues. Typically, we manage our investments and conduct business through a combination of general and limited partnership and limited liability company interests. As of December 31, 2002, the combined balance sheets of these investments included approximately $1.3 billion in assets and $1.0 billion in debt, principally first mortgages on hotel properties. All of the debt of these entities is non-recourse to us and our subsidiaries. We consolidate entities (in the absence of other factors determining control) when we own over 50% of the voting shares of another company or, in the case of partnership investments, when we own a majority of the general partnership interest. The control factors we consider include the ability of minority shareholders or other partners to participate in or block management decisions.

 

For a more detailed discussion of our other real estate investments, including a summary of the outstanding debt balances of our affiliates, see “Management’s Discussion and Analysis of Results of Operations and Financial Condition—Investments in Affiliates” and Note 4 to the Consolidated Financial Statements—“Investments in Affiliates.”

 

Environmental and Regulatory Matters

 

Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be liable for the costs of removal or remediation of hazardous or toxic substances on, under or in such property. These laws may impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. In addition, certain environmental laws and common law principles could be used to impose liability for release of asbestos-containing materials, and third parties may seek recovery from owners or operators of real properties for personal

 

14


injury associated with exposure to released asbestos-containing materials. Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require corrective or other expenditures. In connection with our current or prior ownership or operation of hotels, we may be potentially liable for various environmental costs or liabilities. Although we are currently not aware of any material environmental claims pending or threatened against us, we can offer no assurance that a material environmental claim will not be asserted against us in the future.

 

Material Agreements

 

Our hotels are managed and operated by third parties pursuant to management agreements with our lessee subsidiaries. The initial term of our management agreements is generally 15 to 20 years with multiple renewal terms. Our management agreements with our operators typically have terms described below.

 

    General.    Under each management agreement, the manager provides complete management services to the applicable lessee.

 

    Operational services.    The managers have sole responsibility and exclusive authority for all activities necessary for the day-to-day operation of the hotels, including establishing all room rates, processing reservations, procuring inventories, supplies and services, providing periodic inspection and consultation visits to the hotels by the managers’ technical and operational experts and promoting and publicizing of the hotels. The manager receives compensation in the form of a base management fee and an incentive management fee, typically calculated as percentages of gross revenues and operating profits, respectively. Typically, the incentive management fee is paid only after the owner has received a priority return.

 

    Executive supervision and management services.    The managers provide all managerial and other employees for the hotels, review the operation and maintenance of the hotels, prepare reports, budgets and projections, provide other administrative and accounting support services to the hotel, such as planning and policy services, financial planning, divisional financial services, risk planning services, product planning and development, employee planning, corporate executive management, legislative and governmental representation and certain in-house legal services and protect trademarks, trade-names and service marks. The manager also provides a national reservations system.

 

    Chain services.    The management agreements require the manager to furnish chain services that are usually furnished on a central basis. Such services include: (1) the development and operation of computer systems and reservation services, (2) regional management and administrative services, regional marketing and sales services, regional training services, manpower development and relocation costs of regional personnel and (3) such additional central or regional services as may from time to time be more efficiently performed on a regional or group level. Costs and expenses incurred by the manager in providing such services are allocated among all hotels managed by the manager or its affiliates.

 

    Working capital and fixed asset supplies.    Our management agreements typically require us to maintain working capital for each hotel and to fund the cost of fixed asset supplies such as linen and other similar items. We are also responsible for providing funds to meet the cash needs for the hotel operations of the hotels if at any time the funds available from hotel operations are insufficient to meet the financial requirements of the hotels.

 

   

Furniture, Fixtures and Equipment replacements.    The management agreements generally provide that once each year the manager will prepare a list of furniture, fixtures and equipment to be acquired and certain routine repairs to be performed in the next year and an estimate of the funds that are necessary therefore, subject to our review or approval. Under the agreement, we are required to provide to the manager all necessary furniture, fixtures and equipment for the operation of the hotels (including funding any required furniture, fixtures and equipment replacements). For purposes of funding the furniture, fixtures and equipment replacements, a specified percentage of the gross revenues of the hotel is deposited by the manager in an escrow account (typically 5%). However, for 80 of our hotels, we have

 

15


 

entered into an agreement with Marriott International to allow us to fund such expenditures directly as incurred from one account which we control subject to maintaining a minimum balance of the greater of $29 million, or 30% of total annual contributions, rather than escrowing funds at accounts at each hotel.

 

    Building alterations, improvements and renewals.    The management agreements require the manager to prepare an annual estimate of the expenditures necessary for major repairs, alterations, improvements, renewals and replacements to the structural, mechanical, electrical, heating, ventilating, air conditioning, plumbing and vertical transportation elements of each hotel. In addition to the foregoing, the management agreements generally provide that the manager may propose such changes, alterations and improvements to the hotel as are required, in the manager’s reasonable judgment, to keep the hotel in a competitive, efficient and economical operating condition.

 

    Sale of the hotel.    Most of the management agreements limit our ability to sell, lease or otherwise transfer the hotels unless the transferee is not a competitor of the manager, and unless the transferee assumes the related management agreements and meets specified other conditions.

 

    Service marks.    During the term of the management agreements, the service mark, symbols and logos currently used by the manager may be used in the operation of the hotel. Any right to use the service marks, logo and symbols and related trademarks at a hotel will terminate with respect to that hotel upon termination of the management agreement with respect to such hotel.

 

    Termination fee.    Most of the management agreements provide that if the management agreement is terminated prior to its full term due to casualty, condemnation or the sale of the hotel, the manager may be eligible to receive a termination fee, except in the case of its failing to meet certain financial performance criteria.

 

Employees

 

On March 1, 2003, we had 189 employees, including approximately 13 employees at the Sacramento Host Airport hotel, who are covered by a collective bargaining agreement that is subject to review and renewal on a regular basis. We believe that we and our managers generally have good relations with labor unions at our hotels. We and our managers have not experienced any material business interruptions as a result of labor disputes.

 

RISK FACTORS

 

Prospective investors should carefully consider, among other factors, the material risks described below.

 

Financial Risks

 

We depend on external sources of capital for future growth and we may be unable to access capital when necessary.    As with REITs, but unlike corporations generally, our ability to reduce our debt and finance our growth largely must be funded by external sources of capital because Host Marriott generally is required to distribute to its shareholders at least 90% of its taxable income in order to qualify as a REIT, including taxable income Host Marriott recognizes for tax purposes but with regard to which Host Marriott does not receive corresponding cash. Our ability to access the external capital we require could be hampered by a number of factors many of which are outside of our control, including, without limitation, declining general market conditions, unfavorable market perception of our growth potential, decreases in our current and estimated future earnings, excessive cash distributions or decreases in the market price of Host Marriott common stock. In addition, our ability to access additional capital may also be limited by the terms of our existing indebtedness, which, among other things, restricts our incurrence of debt and the payment of distributions. The occurrence of any of these above-mentioned factors, individually or in combination, could prevent us from being able to obtain the external capital we require on terms that are acceptable to us or at all and the failure to obtain necessary external capital could materially adversely affect our future growth.

 

16


 

We have substantial leverage.    We have a significant amount of indebtedness, which could have important consequences. It currently requires us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, which reduces the availability of our cash flow to fund working capital, capital expenditures, expansion efforts, distributions to our unitholders and other general purposes. Additionally, it could:

 

    limit our ability to undertake refinancings of our debt or obtain financing for expenditures, acquisitions, development or other expenditures on terms and conditions acceptable to us; or

 

    affect adversely our ability to compete effectively or operate successfully under adverse economic conditions.

 

If our cash flow and working capital were not sufficient to fund our expenditures or service our indebtedness, we would have to raise additional funds through:

 

    the sale of our OP Units, which would normally be funded by the sale of Host REIT stock;

 

    the incurrence of additional permitted indebtedness; or

 

    the sale of our assets.

 

We cannot assure you that any of these sources of funds would be available to us or, if available, would be on terms that we would find acceptable or in amounts sufficient for us to meet our obligations or fulfill our business objectives.

 

Our future cash distributions to our partners and to Host REIT for its dividends on preferred and common stock may be limited by the terms of our indebtedness and, in addition, our ability to make distributions on our common OP Units may be further limited by the terms of our preferred OP Units.    In order for Host REIT to maintain its status as a REIT, it is currently required to distribute to its stockholders at least 90% of its taxable income. Our UPREIT structure requires us to make distributions to our OP unitholders, including Host REIT, whenever Host REIT makes a distribution that satisfies the distribution requirements under the REIT laws. Under the terms of our credit facility and our senior notes indenture, distributions from us to Host REIT, which it depends upon in order to obtain the cash necessary to pay dividends to its common and preferred stockholders, are permitted only to the extent that, at the time of the distributions, we can satisfy certain financial covenant tests and meet other requirements. For example, to make distributions to Host REIT, we must in general have a consolidated coverage ratio (measuring the pro forma ratio of our consolidated EBITDA to our consolidated cash interest expense) of 2.0 to 1.0 or greater. In addition, the aggregate amount of all of our debt, not including our convertible debt obligation to Host REIT, must be less than or equal to 65% of our total assets plus accumulated depreciation. If we fail to meet these requirements, we will only be able to make cash distributions to Host REIT, subject to compliance with certain other requirements, in the amounts required to maintain its qualification as a REIT. As of the beginning of the third quarter of 2002, we have had a consolidated coverage ratio of less than 2.0 to 1.0. Therefore, we will be able to make distributions to Host REIT and our other OP unitholders only to the extent that we have taxable income and are required to make distributions to enable Host REIT to maintain its status as a REIT. Accordingly, we expect to continue to be prohibited from making distributions on our common OP Units beyond the level necessary to maintain Host REIT’s status as a REIT until our coverage ratio is at or above the 2.0 to 1.0 coverage ratio.

 

Under the terms of each of our class A, class B and class C cumulative redeemable preferred OP Units, we are not permitted to make distributions on our common OP Units unless cumulative distributions have been paid (or funds for payment have been set aside for payment) on each such class of preferred OP Units. Therefore, our ability to make distributions on our common OP Units is subject to our having previously paid all cumulative distributions accrued on our outstanding classes of preferred OP Units. Since the issuance of each of our classes of preferred OP Units, all distributions on our preferred OP Units have been paid when due and there are no distributions accrued for prior quarters through 2002. Our ability to pay distributions on our preferred and common OP Units is limited by our convertible debt obligation to Host REIT.

 

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As of December 31, 2002 we remained under the 2.0 to 1.0 EBITDA-to-cash interest coverage ratio under the senior notes indenture. As a result, distributions on both common and preferred OP Units were restricted to the minimum amount of distributions required to maintain Host Marriott’s REIT status. Required distributions to Host REIT for 2002 were satisfied in part by payment of distributions on the preferred OP Units in 2002. We believe that the remaining 2002 distribution requirement to enable Host REIT to satisfy its remaining 2002 distribution requirement should largely be satisfied by the payment of distributions expected to be declared on preferred OP Units in the first, second and third quarters of 2003. We may, however, also need to make a nominal distribution to common OP unitholders in 2003 to satisfy any remaining 2002 distribution requirement to enable Host REIT to satisfy its remaining 2002 distribution requirement. The payment of any additional distributions on either common or preferred OP Units will depend on 2003 operating performance and its impact on Host REIT’s taxable income and whether our EBITDA-to-cash interest ratio is below 2.0 to 1.0 coverage for fiscal year 2003. We cannot provide assurance that we will experience improvement in our operations sufficient to reinstate a distribution on our common OP Units or that we will continue to pay distributions on our preferred OP Units.

 

Rating Agency downgrades may increase our cost of capital.    Certain of our debt, including our senior notes, are rated by independent rating agencies, such as Moody’s and Standard & Poor’s. These rating agencies may elect to downgrade their ratings on our debt at any time. As a result of continuing weak economic conditions, the lodging industry experienced a significant decline in business in 2002. Revenues at our hotels decreased during 2002 compared to 2001, and we currently expect that revenues will continue to decrease for at least the first half of 2003, when compared to revenues for the same period in 2002. As a result of the deterioration in our operations, one of the rating agencies downgraded their rating on our senior debt on February 13, 2003. The other rating agency affirmed our rating, but if our operating results continue to decline, they will be more likely to downgrade their rating on our debt. These downgrades negatively affect our access to the capital markets.

 

The terms of our debt place restrictions on us and our subsidiaries, reducing operational flexibility and creating default risks.    There are no restrictions in our organizational documents that limit the amount of indebtedness that we may incur. The documents governing the terms of our senior notes and credit facility contain covenants that place restrictions on us and our subsidiaries. The terms of our debt put limitation on the following activities:

 

    acquisitions, mergers and consolidations;

 

    the incurrence of additional debt;

 

    the creation of liens;

 

    proceeds from the sale of assets;

 

    capital expenditures;

 

    repurchase of limited partner interests;

 

    the payment of distributions; and

 

    transactions with affiliates.

 

In addition, certain covenants in our credit facility and the senior notes indenture require us and our subsidiaries, as a condition to engaging in certain activities, to meet financial performance tests. These restrictive covenants, together with other restrictive covenants in the documents governing our other debt (including our mortgage debt), reduce our flexibility in conducting our operations and limit our ability to engage in activities that may be in our long-term interest. In addition, certain covenants in our credit facility and the senior notes indenture require us to meet financial performance tests at all times without regard to the activities in which we engage. Our failure to comply with these restrictive covenants could result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our debt or a significant increase in the interest rates on our debt, either of which could adversely affect our ability to maintain adequate liquidity.

 

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We are currently in compliance with the terms and restrictive covenants of our credit facility, but if operations do not improve, we may fail to comply with certain of the terms of our credit facility. While we expect to modify the terms of our credit facility to provide for less stringent financial covenants, there can be no assurance that we will be successful in making such modification on terms that are acceptable to us. If we are unable to modify the terms of the credit facility to provide for less stringent financial covenants or to obtain alternative sources of capital on terms acceptable to us, our liquidity will be adversely affected.

 

Our mortgage debt contains provisions that may reduce our liquidity.    Certain of our mortgage debt requires that, to the extent cash flow from the hotels which secure such debt drops below stated levels, we escrow cash flow after the payment of debt service until operations improve above the stated levels. In some cases, the escrowed amount may be applied to the outstanding balance of the mortgage debt. Such provisions were triggered under two of our mortgage facilities which are secured by twelve of our properties. As a result, approximately $17 million of cash has been escrowed as of December 31, 2002. There can be no assurance that these properties will achieve the minimum cash flow levels required to trigger a release of the escrowed funds. The amounts required to be escrowed may be material and may negatively affect our liquidity by limiting our access to cash flow after debt service from these mortgaged properties.

 

Certain financial covenants under the documents governing our indebtedness limit our ability to engage in activities that may be in our long-term best interest.    Under the terms of our credit facility and the senior notes indenture, we and our subsidiaries are generally prohibited from incurring additional indebtedness unless, at the time of such incurrence, we would satisfy the requirements set forth therein, including the consolidated coverage ratio as discussed above. As a result of the effects on our business of the continuing weak economic environment, our consolidated coverage ratio calculated beginning in the third quarter of 2002 continues to be less than 2.0 to 1.0. Because our consolidated coverage ratio is below this level, the terms of our indebtedness prohibits us from incurring indebtedness other than the incurrence of amounts specifically permitted to be incurred, such as borrowings under our credit facility and the incurrence of debt in connection with refinancings. Our failure to maintain a consolidated coverage ratio that is equal to or greater than 2.0 to 1.0 also limits our ability to reinstate the payment of distributions on our common OP Units as described in “Risk Factors—Financial Risks—Our future cash distributions to our partners and to Host REIT for its dividends on preferred and common stock may be limited by the terms of our indebtedness and, in addition, our ability to make distributions on our common OP Units may be further limited by the terms of our preferred OP Units.” The restriction imposed by this covenant may limit our ability to engage in activities that may be in our long-term interest.

 

Risks of Operation

 

Our revenues and the value of our properties are subject to conditions affecting the lodging industry. The lodging industry has experienced a difficult period, and operations have generally been declining for the past two years. The decline has resulted in a decline in RevPAR and declining profit margins. The decline is due to a number of factors including a weak economy and apprehension over further terrorist activity in the United States and the war in Iraq, all of which have changed the travel patterns of both business and leisure travelers. It is not clear whether these changes are permanent or whether they will continue to evolve creating new opportunities or difficulties for the industry. Based on the uncertain state of the economy, we have forecasted that RevPAR will be comparable to 2002 levels or down modestly. Our forecast is affected and can change based on the following items:

 

    changes in the national, regional and local economic climate;

 

    reduced demand and increased operating costs and other conditions resulting from terrorist attacks;

 

    changes in business and pleasure travel patterns;

 

    local market conditions such as an oversupply of hotel rooms or a reduction in lodging demand;

 

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    the attractiveness of our hotels to consumers and competition from comparable hotels;

 

    the quality, philosophy and performance of the managers of our hotels;

 

    changes in room rates and increases in operating costs due to inflation and other factors; and

 

    unionization.

 

There can be no assurance that the current weak economic conditions will not continue for an extended period of time or that if such conditions do continue, they will not further affect our operations. To the extent that such conditions were to persist, our assets may not generate income sufficient to pay our expenses and we may be unable to service our debt and maintain our properties.

 

In addition, thirty of our hotels and assets related thereto are subject to various mortgages in an aggregate amount of approximately $2.3 billion. Although the debt is generally non-recourse to us, if these hotels do not produce adequate cash flow to service the debt secured by such mortgages, the mortgage lenders could foreclose on these assets. If the cash flow from these properties were not sufficient to provide us with an adequate return, we may opt to allow such foreclosure rather than make the necessary mortgage payments with funds from other sources. However, our senior notes indenture and credit facility contain cross default provisions, which depending upon the amount of secured debt defaulted on, could cause a cross default under both of these agreements. For this and other reasons, we cannot assure you that permitting any such foreclosure would not adversely affect our long-term business prospects.

 

Our expenses may not decrease if our revenue drops.    Certain expenses associated with owning and operating hotels are fixed and do not necessarily decrease when circumstances such as market factors and competition cause a reduction in income from the property. Because of current weak economic conditions, particularly in the lodging industry, we have been working with our managers to reduce the operating costs of our hotels. While we have achieved reductions in operating costs as a result of these efforts, further cost reductions could be difficult to achieve if operating levels continue to decline. Some of the cost reduction efforts undertaken may eventually need to be reversed even if operations remain at reduced levels. Regardless of these efforts to reduce costs, our expenses will be affected by inflationary increases, and in the case of certain costs, such as wages, benefits and insurance, may exceed the rate of inflation in 2003, and our managers may be unable to offset these increased expenses with higher room rates. Any of our efforts to reduce operating costs or failure to make scheduled capital expenditures could adversely affect the growth of our business and the value of our hotel properties.

 

Our revenues may be affected by increased use of reservation systems based on the Internet.    Although a majority of the rooms sold on the Internet are sold through websites maintained by our managers, a growing number of rooms are sold through independent Internet sites. Typically, these independent Internet sites purchase rooms at a negotiated discount from participating properties, which could result in lower average room rates compared to the room rates that the manager may have obtained. While we do not believe that price is the only factor considered when choosing our properties, if the discount or the amount of rooms sold using the Internet were to increase significantly our results of operations could be adversely affected.

 

Our ground lease payments may increase faster than the revenues we receive on the hotels situated on the leased properties.    As of March 1, 2003, 44 of our hotels are subject to ground leases (including the New York World Trade Center Marriott hotel ground lease which is still in effect). These ground leases generally require increases in ground rent payments every five years. Our ability to service our debt could be adversely affected to the extent that our revenues do not increase at the same or a greater rate than the increases in rental payments under the ground leases. In addition, if we were to sell a hotel encumbered by a ground lease, the buyer would have to assume the ground lease, which may result in a lower sales price. Moreover, to the extent that such ground leases are not renewed at their expiration, our revenues could be adversely affected.

 

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We do not control our hotel operations and we are dependent on the managers of our hotels.    Because federal income tax laws restrict REITs and their subsidiaries from operating a hotel, we do not manage our hotels. Instead, we retain third-party managers to manage our hotels pursuant to management agreements. Our income from the hotels may be adversely affected if our managers fail to provide quality services and amenities or if they fail to maintain a quality brand name. While our wholly owned taxable REIT subsidiaries lease substantially all of our full-service properties and monitor the hotel managers’ performance, we have limited specific recourse under our management agreements if we believe that the hotel managers are not performing adequately. In addition, from time to time, we have had, and continue to have, differences with the managers of our hotels over their performance and compliance with the terms of our management agreements. We generally resolve issues with our managers through discussions and negotiations. However, if we are unable to reach satisfactory results through discussions and negotiations, we may choose to litigate such a dispute. Failure by our hotel managers to fully perform the duties agreed to in our management agreements could adversely affect our results of operations.

 

Our relationship with Marriott International may result in conflicts of interest.    Marriott International, a public hotel management company, and its affiliates, manages or franchises 109 of our 122 hotels as of March 1, 2003. In addition, Marriott International manages, and in some cases owns or is invested in, hotels that compete with our hotels. As a result, Marriott International has in the past made and may in the future make decisions regarding competing lodging facilities that are not or would not be in our best interests.

Prior to the departure of J. W. Marriott, Jr. from Host Marriott’s (our general partner) Board of Directors at the end of his term in May of 2002, and Richard E. Marriott’s resignation from the board of Marriott International in May of 2002, Richard E. Marriott was our Chairman of the Board and a director of Marriott International and his brother, J. W. Marriott, Jr., was a member of our general partner’s Board of Directors and served as a director and executive officer of Marriott International. As a result, both individuals had potential conflicts of interest as our general partner’s directors when making decisions regarding Marriott International. J. W. Marriott, Jr. and Richard E. Marriott beneficially owned, as determined for securities law purposes, as of February 28, 2003, approximately 12.4% and 12.7%, respectively, of the outstanding shares of common stock of Marriott International. Our general partner’s Board of Directors followed its policies and procedures intended to limit the involvement of J. W. Marriott, Jr. and Richard E. Marriott in conflict situations, including requiring them to abstain from voting as directors in matters that presented a conflict between the companies.

 

Our management agreements could impair the sale or financing of our hotels.    Under the terms of our management agreements, we generally may not sell, lease or otherwise transfer the hotels unless the transferee is not a competitor of the manager and the transferee assumes the related management agreements and meets specified other conditions. Our ability to finance or sell any of the properties, depending upon the structure of such transactions, may require the manager’s consent. If the manager does not consent, we would be prohibited from taking actions in our best interest without breaching the management agreement.

 

The acquisition contracts relating to some hotels limit our ability to sell or refinance those hotels.    For reasons relating to tax considerations of the former and current owners of approximately 18 of our full-service hotels, we agreed to restrictions on selling the hotels or repaying or refinancing the mortgage debt on those hotels for varying periods depending on the hotel, substantially all of which will expire by 2008. We anticipate that, in specified circumstances, we may agree to similar restrictions in connection with future hotel acquisitions. As a result, even if it were in our best interests to sell these hotels or refinance the mortgage debt on such hotels, it may be difficult or costly to do so during their respective lock-out periods.

 

We may be unable to sell properties because real estate investments are illiquid.    Real estate investments generally cannot be sold quickly. We may not be able to vary our portfolio promptly in response to economic or other conditions. The inability to respond promptly to changes in the performance of our investments could adversely affect our financial condition and our ability to service our debt. In addition, there

 

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are limitations under the federal tax laws applicable to REITs and agreements that we have entered into when we acquired some of our properties that may limit our ability to recognize the full economic benefit from a sale of our assets.

 

We depend on our key personnel.    We depend on the efforts of our executive officers and other key personnel. While we believe that we could find replacements for these key personnel, the loss of their services could have a significant adverse effect on our operations. None of our key personnel have employment agreements.

 

Litigation judgments or settlements could have a material adverse effect on our financial condition. We are a party to various lawsuits, including lawsuits relating to our conversion into a REIT. While we and the other defendants to such lawsuits believe all of the lawsuits in which we are a defendant are without merit and we are vigorously defending against such claims, we can give no assurance as to the outcome of any of the lawsuits. If any of the lawsuits were to be determined adversely to us or a settlement involving a payment of a material sum of money were to occur, there could be a material adverse effect on our financial condition.

 

We may acquire hotel properties through joint ventures with third parties that could result in conflicts.    Instead of purchasing hotel properties directly, we may invest as a co-venturer. Joint venturers often share control over the operation of the joint venture assets. For example, we entered into a joint venture with Marriott International that owns two limited partnerships holding, in the aggregate, 120 Courtyard by Marriott hotels. Subsidiaries of Marriott International manage these Courtyard by Marriott hotels and other subsidiaries of Marriott International serve as ground lessors and mezzanine lender to the partnerships. Actions by a co-venturer could subject the assets to additional risk, including:

 

    our co-venturer in an investment might have economic or business interests or goals that are inconsistent with our, or the joint venture’s, interests or goals;

 

    our co-venturer may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives; or

 

    our co-venturer could go bankrupt, leaving us liable for its share of joint venture liabilities.

 

Although we generally will seek to maintain sufficient control of any joint venture to permit our objectives to be achieved, we might not be able to take action without the approval of our joint venture partners. Also, our joint venture partners could take actions binding on the joint venture without our consent. For further discussion of the risks associated with entering into a joint venture with Marriott International, “Risk Factors—Risks of Operation—Our relationship with Marriott International may result in conflicts of interest.”

 

Environmental problems are possible and can be costly.    We believe that our properties are in compliance in all material respects with applicable environmental laws. Unidentified environmental liabilities could arise, however, and could have a material adverse effect on our financial condition and performance. Federal, state and local laws and regulations relating to the protection of the environment may require a current or previous owner or operator of real estate to investigate and clean up hazardous or toxic substances or petroleum product releases at the property. The owner or operator may have to pay a governmental entity or third parties for property damage and for investigation and clean-up costs incurred by the parties in connection with the contamination. These laws typically impose clean-up responsibility and liability without regard to whether the owner or operator knew of or caused the presence of the contaminants. Even if more than one person may have been responsible for the contamination, each person covered by the environmental laws may be held responsible for all of the clean-up costs incurred. In addition, third parties may sue the owner or operator of a site for damages and costs resulting from environmental contamination emanating from that site. Environmental laws also govern the presence, maintenance and removal of asbestos. These laws require that owners or operators of buildings containing asbestos properly manage and maintain the asbestos, that they notify and train those who may come into contact with asbestos and that they undertake special precautions, including removal or other abatement, if asbestos would be disturbed during renovation or demolition of a building. These laws may impose

 

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fines and penalties on building owners or operators who fail to comply with these requirements and may allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos fibers.

 

Compliance with other government regulations can be costly.    Our hotels are subject to various other forms of regulation, including Title III of the Americans with Disabilities Act, building codes and regulations pertaining to fire safety. Compliance with those laws and regulations could require substantial capital expenditures. These regulations may be changed from time to time, or new regulations adopted, resulting in additional costs of compliance, including potential litigation. Any increased costs could have a material adverse effect on our business, financial condition or results of operations.

 

Future terrorist attacks could adversely affect us.    Previous terrorist attacks have adversely affected the travel and hospitality industries, including the full-service hotel industry. The impact which these terrorist attacks have had, or could have on our business in particular and the United States economy, the global economy and global financial markets in general is indeterminable. It is possible that these factors could have a material adverse effect on our business, our ability to finance our business, our ability to insure our properties (see “Risk Factors—Risks of Operation—We may not be able to recover fully under our existing terrorism insurance for losses caused by some types of terrorist acts, and recently enacted federal terrorism legislation does not ensure that we will be able to obtain terrorism insurance in adequate amounts or at acceptable premium levels in the future.”) and on our financial condition and results of operations as a whole.

 

Some potential losses are not covered by insurance.    We carry comprehensive insurance coverage for general liability, property, business interruption and other risks with respect to all of our hotels and other properties. These policies offer coverage features and insured limits that we believe are customary for similar type properties. Generally, our “all-risk” property policies provide that coverage is available on a per occurrence basis and that, for each occurrence, there is an overall limit as well as various sub-limits on the amount of insurance proceeds we can receive. Sub-limits exist for certain types of claims such as service interruption, abatement, expediting costs or landscaping replacement, and the dollar amounts of these sub-limits are significantly lower than the dollar amounts of the overall coverage limit. Our property policies also provide that all of the claims from each of our properties resulting from a particular insurable event, must be combined together for purposes of evaluating whether the aggregate limits and sub-limits contained in our policies have been exceeded and, in the case of our Marriott-managed hotels, any such claims will also be combined with the claims of other owners of Marriott-managed hotels for the same purpose. That means that, if an insurable event occurs that affects more than one of our hotels, or, in the case of Marriott-managed hotels, affects Marriott-managed hotels owned by others, the claims from each affected hotel will be added together to determine whether the aggregate limit or sub-limits, depending on the type of claim, have been reached and each affected hotel will only receive a proportional share of the amount of insurance proceeds provided for under the policy. We may incur losses in excess of insured limits and, as a result, we may be even less likely to receive sufficient coverage for risks that affect multiple properties such as earthquakes or certain types of terrorism.

 

In addition, there are other risks such as war, certain forms of terrorism such as nuclear, biological or chemical terrorism and some environmental hazards that may be deemed to fall completely outside the general coverage limits of our policies or may be uninsurable or may be too expensive to justify insuring against. If any such risk were to materialize and materially adversely affect one or more of our properties, we would likely not be able to recover our losses.

 

We may also encounter challenges with an insurance provider regarding whether it will pay a particular claim that we believe to be covered under our policy. Should a loss in excess of insured limits or an uninsured loss occur or should we be unsuccessful in obtaining coverage from an insurance carrier, 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 hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property.

 

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We may not be able to recover fully under our existing terrorism insurance for losses caused by some types of terrorist acts, and recently enacted federal terrorism legislation does not ensure that we will be able to obtain terrorism insurance in adequate amounts or at acceptable premium levels in the future.    On September 11, 2001, terrorist attacks on the World Trade Center Towers in New York City resulted in the destruction of our New York World Trade Center Marriott hotel and caused considerable damage to our New York Marriott Financial Center hotel. Although we had both property and business interruption insurance with a major insurer from whom we expect to receive proceeds to cover a substantial portion of the losses at both hotels, we cannot currently determine the amount or timing of those payments. Under the terms of the New York World Trade Center Marriott ground lease, any proceeds from the property portion of the hotel claim are required to be placed in an insurance trust for the exclusive purpose of rebuilding the hotel. As of March 1, 2003, we had received business interruption and property advances from our insurers in an aggregate amount of $41 million, approximately $6 million of which was for property insurance proceeds relating to the two hotels. If the amount of such insurance proceeds is substantially less than our actual losses or if the payments are substantially delayed, it could have a material adverse effect on our business.

 

In addition, as a result of the September 11, 2001 terrorist attacks, most insurers ceased to offer terrorism coverage in conjunction with “all-risk” property policies (described below), and the main source of property terrorism coverage became separate “standalone” terrorism insurance policies offering limited coverage amounts with high premium levels. We have procured such standalone terrorism coverage, which is subject to annual aggregate limits which fall below the full replacement cost of certain high value properties, and with more limited coverage than the all-risk program shared among various hotels. On November 26, 2002, the Federal Terrorism Risk Insurance Act of 2002 (TRIA) required all-risk and liability insurers who had excluded or limited terrorism coverage to remove the exclusion in exchange for requiring insureds to pay an additional premium for the coverage within a specified time period. Because our liability policies generally offered terrorism coverage, TRIA mainly impacts our all-risk insurance.

 

We, through Marriott International and our broker for certain of our non-Marriott International properties, decided to purchase the additional terrorism coverage under TRIA and are currently in the process of obtaining the insurance. This terrorism coverage, compared to standalone coverage, offers the higher limits and more comprehensive coverage associated with our all-risk programs. However, as noted above, the all-risk program also has limitations such as per occurrence limits and sublimits which might have to be shared proportionally across participating hotels under certain loss scenarios. All-risk insurers also only have to provide TRIA-related coverage for “certified” acts of terrorism—namely those which are committed on behalf of non-United States persons or interests. Further, we do not have full replacement coverage at all of our properties for acts of terrorism committed on behalf of United States persons or interests, as our coverage for such incidents is limited to the standalone program and its aggregate limits and to its provisions for sharing coverage with other owners who experience a loss. In addition, property damage related to war and to nuclear incidents is excluded under our standalone terrorism policies. The policy also excludes coverage for chemical and biological incidents, and it is unclear whether these incidents would be covered under our other standalone policies. The availability of any such coverage under TRIA is currently unclear as government and insurance industry experts continue to analyze the language and intent of the legislation and we continue to review the language of our all-risk policies. In addition, TRIA terminates on December 31, 2005, and there is no guarantee that the terrorism coverage that it mandates will be readily available or affordable thereafter. As a result of the above, there remains considerable uncertainty regarding the extent and adequacy of terrorism coverage that will be available to protect our interests in the event of future terrorist attacks that impact our properties.

 

We may be unable to satisfy the insurance requirements of our lenders given the changes in the insurance industry after the terrorist attacks of September 11, 2001.    We are required to maintain adequate or full replacement cost “all-risk” property insurance on properties that are subject to mortgage agreements. In the months following the terrorist attacks of September 11, 2001, our policies in effect during the time of the terrorist attacks expired, and thereafter, we completed renewals of the all-risk property insurance policies for all of our hotels. As discussed above, we also procured standalone coverage for terrorism, but not at levels which

 

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provided full replacement value at all of our properties with loans. The existence of additional terrorism coverage since the passage of TRIA should satisfy many of these lenders. However, as discussed above, this coverage also has limitations.

 

In addition, certain of our mortgage debt agreements require us to maintain property insurance provided by carriers maintaining certain minimum ratings from Standard & Poor’s, A.M. Best or other rating agencies. We do not currently satisfy a minimum Standard & Poor’s insurer rating requirement of AA for six of our properties subject to approximately $481 million of mortgage debt. We also do not currently satisfy the minimum Standard & Poor’s insurer rating requirement of AA- for one of the properties within a mortgage backed securities portfolio subject to approximately $609 million in mortgage debt. Following a downgrade in September of 2002, our main carrier for these properties possesses a Standard & Poor’s rating of A+. We have notified the appropriate lenders of this situation, and all have either waived the minimum carrier rating requirement, or provided written assurances that they are satisfied with the makeup of our pool of insurers. Additionally, for five of our properties subject to approximately $711 million of mortgage debt, our insurance does not meet the requirement that all property insurance carriers maintain a minimum A.M. Best rating of A-X. For one of the properties, the main carrier does not satisfy the financial strength requirement under the loan. For the other four properties, several of the companies making up our pool of insurers do not satisfy the minimum A.M. Best rating with respect to market capitalization. All of the affected lenders have been notified, and they have waived the requirement or provided written assurances that they are satisfied with our insurance.

 

While we do not expect any of the lenders to take action in response to these deficiencies, we cannot provide assurances that each of our lenders will continue to be satisfied with our insurance coverage, or with the rating levels of our carriers, or that our carriers will not be downgraded further. If any of these lenders become dissatisfied with our insurance coverage or the ratings of our insurance carriers, they may on our behalf, elect to procure additional property insurance coverage that meets their ratings requirements. The cost of such additional property insurance coverage would be borne by the property or properties securing the loans. Also, the premiums associated with such coverage may be considerably higher than those associated with our current coverage.

 

Risks relating to redemption of OP Units

 

A holder who redeems OP Units may have adverse tax effects.    A holder of OP Units who redeems OP Units will be treated for tax purposes as having sold the OP Units. The sale will be taxable and the holder will be treated as realizing an amount equal to the sum of the value of the common stock or cash the holder receives plus the amount of operating partnership nonrecourse liabilities allocable to the redeemed OP Units. It is possible that the amount of gain the holder recognizes could exceed the value of the common stock the holder receives. It is even possible that the tax liability resulting from this gain could exceed the value of the common stock or cash the holder receives.

 

If a holder of OP Units redeems OP Units, the original receipt of the OP Units may be subject to tax. If a holder of OP Units redeems OP Units, particularly within two years of receiving them, there is a risk that the original receipt of the OP Units may be treated as a taxable sale under the “disguised sale” rules of the Internal Revenue Code. Subject to several exceptions, the tax law generally provides that a partner’s contribution of property to a partnership and a simultaneous or subsequent transfer of money or other consideration from the partnership to the partner will be presumed to be a taxable sale. In particular, if money or other consideration is transferred by a partnership to a partner within two years of the partner’s contribution of property, the transactions are presumed to be a taxable sale of the contributed property unless the facts and circumstances clearly establish that the transfers are not a sale. On the other hand, if two years have passed between the original contribution of property and the transfer of money or other consideration, the transactions will not be presumed to be a taxable sale unless the facts and circumstances clearly establish that they should be.

 

Differences between an investment in shares of common stock and OP Units may affect redeeming holders of OP Units.    If a holder of OP Units elects to redeem OP Units, we will determine whether the holder receives cash or shares of our common stock in exchange for the OP Units. Although an investment in shares of

 

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Host REIT’s common stock is substantially similar to an investment in OP Units, there are some differences between ownership of OP Units and ownership of common stock. These differences include form of organization, management structure, voting rights, liquidity and federal income taxation, some of which may be material to investors.

 

There are possible differing fiduciary duties of Host REIT, as the general partner, and the Board of Directors of Host REIT.    Host REIT, as the general partner of the operating partnership, and the Board of Directors of Host REIT, respectively, owe fiduciary duties to their constituent owners. Although some courts have interpreted the fiduciary duties of the Board of Directors in the same way as the duties of a general partner in a limited partnership, it is unclear whether, or to what extent, there are differences in such fiduciary duties. It is possible that the fiduciary duties of the directors of Host REIT to the shareholders may be less than those of Host REIT, as the general partner of the operating partnership, to the holders of OP Units.

 

We expect to make distributions to Host REIT even when we cannot otherwise make restricted payments under the senior notes indenture and the credit facility.    Even though we expect generally to be prohibited from making restricted payments under the senior notes indenture, based upon our estimates of taxable income for 2002, we expect to be able to make distributions to Host REIT under the senior notes indenture and the credit facility.

 

Under the senior notes indenture, we are only allowed to make restricted payments if, at the time we make such a restricted payment, we are able to incur at least $1.00 of indebtedness under the “Limitation on Incurrence of Indebtedness and Issuance of Disqualified Stock” covenant. If our consolidated coverage ratio becomes less than 2.0 to 1.0, which did occur beginning in the third quarter of 2002, we will not be able to incur $1.00 of additional indebtedness and, thus, will not be able to make any restricted payments until we comply with the covenant.

 

Even when we are unable to make restricted payments during the period that our consolidated coverage ratio is less than 2.0 to 1.0, the senior notes indenture permits us to make permitted REIT distributions, which are any distributions (1) to Host REIT that are necessary to maintain Host REIT’s status as a REIT under the Internal Revenue Code or to satisfy the distributions required to be made by reason of Host REIT’s making of the election provided for in Notice 88-19 (or Treasury regulations issued pursuant thereto) if the aggregate principal amount of all of our outstanding indebtedness (other than our convertible debt obligations to Host REIT) and that of our restricted subsidiaries, on a consolidated basis, at such time is less than 80% of Adjusted Total Assets (as defined in the indenture) and (2) to certain other holders of our partnership units where such distribution is required as a result of, or a condition to, the payment of distributions to Host REIT.

 

We intend, during the period that we are unable to make restricted payments under the senior notes indenture and under similar restrictions under the credit facility, to continue our practice of distributing quarterly, based on our current estimates of taxable income for any year, an amount of our available cash sufficient to enable Host REIT to pay quarterly dividends on its preferred stock (and, to the extent permitted under the credit facility, on its common stock) in an amount necessary to satisfy the requirements applicable to REITs under the Internal Revenue Code. In the event that we make distributions to Host REIT to enable it to pay dividends in amounts in excess of those necessary for Host REIT to maintain its status as a REIT, we will be in default under the senior notes indenture. See—“Our future cash distributions to our partners and to Host REIT for its dividend on preferred and common stock may be limited by the terms of our indebtedness and, in addition, our ability to make distributions on our common OP Units may be limited by the terms of our preferred OP Units.”

 

Risks of Ownership of Host REIT Common Stock

 

There are limitations on the ability of investors to acquire Host REIT common stock and to effect a change in control.    The charter and bylaws of Host REIT, our partnership agreement, Host REIT’s shareholder rights plan, the Maryland General Corporation Law and certain contracts contain a number of provisions that

 

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could delay, defer or prevent a transaction or a change in control of us that might involve a premium price for Host REIT’s shareholders or otherwise be in their best interests, including the following:

 

    Ownership limit.    The 9.8% ownership limit described under “Risk Factors—Risks of Ownership of Host REIT Common Stock—There are possible adverse consequences of limits on ownership of Host REIT common stock” may have the effect of precluding a change in control of us by a third party without the consent of Host REIT’s Board of Directors, even if the change in control would be in the interests of Host REIT’s shareholders, and even if the change in control would not reasonably jeopardize Host REIT’s REIT status.

 

    Staggered board.    Host REIT’s Board of Directors consists of seven director positions, but Host REIT’s charter provides that the number of directors may be increased or decreased according to Host REIT’s bylaws, provided that the total number of directors is not less than three nor more than 13. Pursuant to Host REIT’s bylaws, the number of directors will be fixed by Host REIT’s Board of Directors within the limits set forth in Host REIT’s charter. Host REIT’s Board of Directors is divided into three classes of directors. Directors for each class are chosen for a three-year term when the term of the current class expires. The staggered terms for directors may affect Host REIT’s shareholders’ ability to effect a change in control of Host REIT, even if a change in control would be in the interests of Host REIT’s shareholders.

 

    Removal of Board of Directors.    Host REIT’s charter provides that, except for any directors who may be elected by holders of a class or series of shares of capital stock other than Host REIT common stock, directors may be removed only for cause and only by the affirmative vote of shareholders holding at least two-thirds of Host REIT’s outstanding shares entitled to be cast for the election of directors. Vacancies on the Board of Directors may be filled by the concurring vote of a majority of the remaining directors and, in the case of a vacancy resulting from the removal of a director by the shareholders, by at least two-thirds of all the votes entitled to be cast in the election of directors.

 

    Preferred shares; classification or reclassification of unissued shares of capital stock without shareholder approval.    Host REIT’s charter provides that the total number of shares of stock of all classes which Host REIT has authority to issue is 800,000,000, initially consisting of 750,000,000 shares of common stock and 50,000,000 shares of preferred stock, of which 14,140,000 shares of preferred stock were issued and outstanding as of December 31, 2002. Host REIT’s Board of Directors has the authority, without a vote of shareholders, to classify or reclassify any unissued shares of stock, including common stock, into preferred stock, or vice versa, and to establish the preferences and rights of any preferred or other class or series of shares to be issued. The issuance of preferred shares or other shares having special preferences or rights could delay or prevent a change in control even if a change in control would be in the interests of Host REIT’s shareholders. Because Host REIT’s Board of Directors has the power to establish the preferences and rights of additional classes or series of shares without a shareholder vote, Host REIT’s Board of Directors may give the holders of any class or series preferences, powers and rights, including voting rights, senior to the rights of holders of Host REIT common stock.

 

    Consent rights of the limited partners.    Under our partnership agreement, Host REIT generally will be able to merge or consolidate with another entity with the consent of partners holding percentage interests that are more than 50% of the aggregate percentage interests of the outstanding limited partnership interests entitled to vote on the merger or consolidation, including any limited partnership interests held by Host REIT, as long as the holders of limited partnership interests either receive or have the right to receive the same consideration as Host REIT’s shareholders. Host REIT, as holder of a majority of the limited partnership interests, would be able to control the vote. Under Host REIT’s charter, holders of at least two-thirds of Host REIT’s outstanding shares of common stock generally must approve the merger or consolidation.

 

   

Maryland business combination law.    Under the Maryland General Corporation Law, specified “business combinations,” including specified issuances of equity securities, between a Maryland corporation and any person who owns 10% or more of the voting power of the corporation’s then

 

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outstanding shares, or an “interested shareholder,” or an affiliate of the interested shareholder are prohibited for five years after the most recent date in which the interested shareholder becomes an interested shareholder. Thereafter, any of these specified business combinations must be approved by 80% of the outstanding voting shares, and by two-thirds of the voting shares other than voting shares held by an interested shareholder unless, among other conditions, the corporation’s common shareholders receive a minimum price, as defined in the Maryland General Corporation Law, for their shares and the consideration is received in cash or in the same form as previously paid by the interested shareholder. Host REIT is subject to the Maryland business combination statute.

 

    Maryland control share acquisition law.    Under the Maryland General Corporation Law, “control shares” acquired in a “control share acquisition” have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter, excluding shares owned by the acquiror and by officers or directors who are employees of the corporation. “Control shares” are voting shares which, if aggregated with all other voting shares previously acquired by the acquiror or over which the acquiror is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquiror to exercise voting power in electing directors within one of the following ranges of voting power: (1) one-fifth or more but less than one-third, (2) one-third or more but less than a majority or (3) a majority or more of the voting power. Control shares do not include shares the acquiring person is then entitled to vote as a result of having previously obtained shareholder approval. A “control share acquisition” means the acquisition of control shares, subject to specified exceptions. Host REIT is subject to these control share provisions of Maryland law.

 

    Merger, consolidation, share exchange and transfer of our assets.    Pursuant to Host REIT’s charter, subject to the terms of any outstanding class or series of capital stock, Host REIT can merge with or into another entity, consolidate with one or more other entities, participate in a share exchange or transfer its assets within the meaning of the Maryland General Corporation Law if approved (1) by Host REIT’s Board of Directors in the manner provided in the Maryland General Corporation Law and (2) by Host REIT’s shareholders holding two-thirds of all the votes entitled to be cast on the matter, except that any merger of Host REIT with or into a trust organized for the purpose of changing its form of organization from a corporation to a trust requires only the approval of Host REIT’s shareholders holding a majority of all votes entitled to be cast on the merger. Under the Maryland General Corporation Law, specified mergers may be approved without a vote of shareholders and a share exchange is only required to be approved by a Maryland corporation by its Board of Directors. Host REIT’s voluntary dissolution also would require approval of shareholders holding two-thirds of all the votes entitled to be cast on the matter.

 

    Amendments to Host REIT’s charter and bylaws.    Host REIT’s charter contains provisions relating to restrictions on transferability of Host REIT common stock, the classified Board of Directors, fixing the size of Host REIT’s Board of Directors within the range set forth in Host REIT’s charter, removal of directors and the filling of vacancies, all of which may be amended only by a resolution adopted by the Board of Directors and approved by Host REIT’s shareholders holding two-thirds of the votes entitled to be cast on the matter. As permitted under the Maryland General Corporation Law, Host REIT’s charter and bylaws provide that directors have the exclusive right to amend Host REIT’s bylaws. Amendments of this provision of Host REIT’s charter also would require action of Host REIT’s Board of Directors and approval by shareholders holding two-thirds of all the votes entitled to be cast on the matter.

 

   

Shareholder rights plan.    Host REIT adopted a shareholder rights plan which provides, among other things, that when specified events occur, Host REIT’s shareholders will be entitled to purchase from Host REIT a newly created series of junior preferred shares, subject to Host REIT’s ownership limit described below. The preferred share purchase rights are triggered by the earlier to occur of (1) ten days after the date of a public announcement that a person or group acting in concert has acquired, or obtained the right to acquire, beneficial ownership of 20% or more of Host REIT’s outstanding shares of common stock or (2) ten business days after the commencement of or announcement of an intention to make a tender offer or exchange offer, the consummation of which would result in the acquiring persons becoming the

 

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beneficial owner of 20% or more of Host REIT’s outstanding common stock. The preferred share purchase rights would cause substantial dilution to a person or group that attempts to acquire Host REIT on terms not approved by Host REIT’s Board of Directors.

 

There are possible adverse consequences of limits on ownership of Host REIT common stock.    To maintain its qualification as a REIT for federal income tax purposes, not more than 50% in value of Host REIT’s outstanding shares of capital stock may be owned, directly or indirectly, by five or fewer individuals, as defined in the Internal Revenue Code to include some entities. In addition, a person who owns, directly or by attribution, 10% or more of an interest in a tenant of Host REIT, or a tenant of any partnership in which Host REIT is a partner, cannot own, directly or by attribution, 10% or more of Host REIT shares without jeopardizing Host REIT’s qualification as a REIT. Primarily to facilitate maintenance of Host REIT’s qualification as a REIT for federal income tax purposes, the ownership limit under Host REIT’s charter prohibits ownership, directly or by virtue of the attribution provisions of the Internal Revenue Code, by any person or persons acting as a group, of more than 9.8% of the issued and outstanding shares of Host REIT common stock, subject to an exception for shares of Host REIT common stock held prior to our conversion into a REIT (referred to as the “REIT conversion”) so long as the holder would not own more than 9.9% in value of Host REIT’s outstanding shares after the REIT conversion, and prohibits ownership, directly or by virtue of the attribution provisions of the Internal Revenue Code, by any person, or persons acting as a group, of more than 9.8% of the issued and outstanding shares of any class or series of Host REIT’s preferred shares. Together, these limitations are referred to as the “ownership limit”. Host REIT’s Board of Directors, in its sole and absolute discretion, may waive or modify the ownership limit with respect to one or more persons who would not be treated as “individuals” for purposes of the Internal Revenue Code if the Board of Directors is satisfied, based upon information required to be provided by the party seeking the waiver and, if it determines necessary or advisable, upon an opinion of counsel satisfactory to Host REIT’s Board of Directors, that ownership in excess of this limit will not cause a person who is an individual to be treated as owning shares in excess of the ownership limit, applying the applicable constructive ownership rules, and will not otherwise jeopardize Host REIT’s status as a REIT for federal income tax purposes (for example, by causing any of Host REIT’s tenants to be considered a “related party tenant” for purposes of the REIT qualification rules). Common stock acquired or held in violation of the ownership limit will be transferred automatically to a trust for the benefit of a designated charitable beneficiary, and the person who acquired the common stock in violation of the ownership limit will not be entitled to any distributions thereon, to vote those shares of common stock or to receive any proceeds from the subsequent sale of the common stock in excess of the lesser of the price paid for the common stock or the amount realized from the sale. A transfer of shares of Host REIT common stock to a person who, as a result of the transfer, violates the ownership limit may be void under certain circumstances, and, in any event, would deny that person any of the economic benefits of owning shares of Host REIT common stock in excess of the ownership limit. The ownership limit may have the effect of delaying, deferring or preventing a change in control and, therefore, could adversely affect the shareholders’ ability to realize a premium over the then-prevailing market price for Host REIT common stock in connection with such transaction.

 

Federal Income Tax Risks

 

Our obligations to Host REIT potentially may increase our indebtedness or cause us to liquidate investments on adverse terms.    To continue to qualify as a REIT, Host REIT is required to distribute to its shareholders with respect to each year at least 90% of its taxable income, excluding net capital gain. In addition, Host REIT will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions made by it with respect to the calendar year are less than the sum of 85% of its ordinary income and 95% of its capital gain net income for that year and any undistributed taxable income from prior periods less excess distributions from prior years. Host REIT intends to make distributions to its shareholders to comply with the distribution requirement and to avoid the nondeductible excise tax and will rely for this purpose on distributions from us. Host REIT’s sole source of cash to make these distributions is from its partnership interest in us. Our partnership agreement requires us to distribute to our partners an amount of our available cash sufficient to enable Host REIT to pay shareholder dividends that will satisfy the requirements applicable under the Internal Revenue Code to

 

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REITs and to avoid any federal income or excise tax liability for Host REIT. There are differences in timing between our recognition of taxable income and our receipt of cash available for distribution due to, among other things, the seasonality of the lodging industry and the fact that some taxable income will be “phantom” income (which is taxable income that is not matched by cash flow or EBITDA to us) attributable to our deferred tax liabilities arising from certain transactions entered into by Host REIT in years prior to the conversion of Host Marriott to a REIT. These differences could require us to arrange for short-term, or possibly long-term, borrowings or to issue additional equity to enable us to meet this distribution requirement to Host REIT. In addition, because the REIT distribution requirements prevent Host REIT from retaining earnings, we effectively are prohibited from retaining earnings as well. Accordingly, we will generally be required to refinance debt that matures with additional debt or equity. We cannot assure you that any of the sources of funds described herein, if available at all, would be sufficient to meet the distribution obligations of Host REIT, in which case we may be required to liquidate investments on adverse terms in order to satisfy such obligations of Host REIT.

 

Adverse consequences would apply if we failed to qualify as a partnership.    We believe that we qualify to be treated as a partnership for federal income tax purposes. As a partnership, we are not subject to federal income tax on our income. Instead, each of our partners is required to pay tax on its allocable share of our income. No assurance can be provided, however, that the Internal Revenue Service, or IRS, will not challenge our status as a partnership for federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating us as a corporation for tax purposes, we would be subject to federal, state and local, and foreign corporate income tax, which would reduce significantly the amount of cash available for debt service and for distribution to our partners, including Host REIT. In addition, our classification as a corporation would cause some of our partners, including Host REIT, to recognize gain at least equal to such partner’s “negative capital account,” and possibly more, depending upon the circumstances. Finally, Host REIT would fail to meet the income tests and certain of the asset tests applicable to REITs and, accordingly, would cease to qualify as a REIT. If Host REIT fails to qualify as a REIT or we fail to qualify as a partnership, such failure would cause an event of default under our credit facility, which in turn would constitute an event of default under our outstanding debt securities.

 

Adverse consequences would apply if Host REIT failed to qualify as a REIT.    We believe that Host REIT has been organized and has operated in such a manner so as to qualify as a REIT under the Internal Revenue Code, commencing with the taxable year beginning January 1, 1999, and Host REIT currently intends to continue to operate as a REIT during future years. No assurance can be provided, however, that Host REIT qualifies as a REIT or that new legislation, treasury regulations, administrative interpretations or court decisions will not significantly change the tax laws with respect to Host REIT’s qualification as a REIT or the Federal income tax consequences of such qualification. If Host REIT fails to qualify as a REIT, it would be subject to federal and state income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates. In addition, unless entitled to statutory relief, Host REIT would not qualify as a REIT for the four taxable years following the year which REIT qualification is lost. The additional tax burden on Host REIT would significantly reduce the cash available for distribution to its shareholders, and Host REIT would no longer be required to make any distributions to its shareholders. Host REIT’s failure to qualify as a REIT could reduce materially the value of its common stock and would cause any distributions to its shareholders that otherwise would have been subject to tax as capital gain dividends to be taxable as ordinary income to the extent of its current and accumulated earnings and profits, or E&P. However, subject to limitations under the Internal Revenue Code, corporate distributes may be eligible for the dividends received deduction with respect to its distributions. Host REIT’s failure to qualify as a REIT also would cause an event of default under our credit facility that could lead to an acceleration of the amounts due under the credit facility, which, in turn, would constitute an event of default under our outstanding debt securities.

 

Host REIT will be disqualified as a REIT at least for taxable year 1999 if it failed to distribute all of its E&P attributable to its non-REIT taxable years.    In order to qualify as a REIT, Host REIT cannot have at the end of any taxable year any undistributed E&P that is attributable to one of its non-REIT taxable years. A REIT has until the close of its first taxable year as a REIT in which it has non-REIT E&P to distribute its

 

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accumulated E&P. Host REIT was required to have distributed this E&P prior to the end of 1999, the first taxable year for which its REIT election was effective. If Host REIT failed to do this, it will be disqualified as a REIT at least for taxable year 1999. We believe that distributions of non-REIT E&P that Host REIT made were sufficient to distribute all of the non-REIT E&P as of December 31, 1999, but we cannot provide assurance that it met this requirement.

 

If our leases are not respected as true leases for Federal income tax purposes, Host REIT would fail to qualify as a REIT.    To qualify as a REIT, Host REIT must satisfy two gross income tests, under which specified percentages of its gross income must be passive income, like rent. For the rent paid pursuant to the leases, which constitutes substantially all of our gross income, to qualify for purposes of the gross income tests, the leases must be respected as true leases for Federal income tax purposes and not be treated as service contracts, joint ventures or some other type of arrangement. In addition, the lessees must not be regarded as related party tenant, as defined in the Internal Revenue Code. We believe that the leases will be respected as true leases for Federal income tax purposes. There can be no assurance, however, that the IRS will agree with this view. We also believe that Crestline, the lessee of substantially all of our full-service hotels prior to January 1, 2001, was not a related party tenant and, as a result of changes in the tax laws effective January 1, 2001, HMT Lessee will not be treated as a related party tenant so long as it qualifies as a taxable REIT subsidiary. If the leases were not respected as true leases for Federal income tax purposes or if the lessees were regarded as related party tenants, Host REIT would not be able to satisfy either of the two gross income tests applicable to REITs and Host REIT would lose its REIT status.

 

If HMT Lessee fails to qualify as a taxable REIT subsidiary, Host REIT would fail to qualify as a REIT.    For Host REIT’s taxable years beginning on and after January 1, 2001, as a result of REIT tax law changes under the specific provisions of the REIT Modernization Act, Host REIT is permitted to lease the hotels to our subsidiary that is taxable as a corporation and that elects to be treated as a taxable REIT subsidiary. Accordingly, HMT Lessee has directly or indirectly acquired all the full-service hotel leasehold interests from third parties. So long as HMT Lessee and other affiliated lessees qualify as taxable REIT subsidiaries of ours, they will not be treated as related party tenants. We believe that HMT Lessee qualifies to be treated as a taxable REIT subsidiary for Federal income tax purposes. We cannot assure you, however, that the IRS will not challenge its status as a taxable REIT subsidiary for Federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in disqualifying HMT Lessee from treatment as a taxable REIT subsidiary, Host REIT would fail to meet the asset tests applicable to REITs and substantially all of its income would fail to qualify for the gross income tests and, accordingly, Host REIT would cease to qualify as a REIT.

 

Despite Host REIT’s REIT status, it remains subject to various taxes, including substantial deferred and contingent tax liabilities.    Notwithstanding Host REIT’s status as a REIT, it is subject, through its ownership interest, to certain federal, state, local and foreign taxes on its income and property. In addition, Host REIT will be required to pay Federal income tax at the highest regular corporate rate upon its share of any “built-in gain” recognized as a result of any sale before January 1, 2009, by us and our non-corporate subsidiaries of assets, including the hotels, in which interests were acquired by us from our predecessor and its subsidiaries as part of the REIT conversion. Built-in gain is the amount by which an asset’s fair market value exceeded our adjusted basis in the asset on January 1, 1999, the first day of Host REIT’s first taxable year as a REIT. The total amount of gain on which Host REIT would be subject to corporate income tax if the assets that it held at the time of the REIT conversion were sold in a taxable transaction prior to January 1, 2009 would be material to us. In addition, at the time of the REIT conversion, Host REIT expected that it or Rockledge Hotel Properties, Inc. or Fernwood Hotel Assets, Inc., or Rockledge and Fernwood, respectively, (each of which is a taxable corporation in which we owned a 95% nonvoting interest and, as of April, 2001, acquired 100% of the voting interests and each of which elected to be a taxable REIT subsidiary effective January 1, 2001) likely would recognize substantial built-in gain and deferred tax liabilities in the next ten years without any corresponding receipt of cash by Host REIT or us. Host REIT may have to pay certain state income taxes because not all states treat REITs the same as they are treated for Federal income tax purposes. Host REIT may also have to pay certain

 

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foreign taxes to the extent it owns assets or conducts operations in foreign jurisdictions. We are obligated under our partnership agreement to pay all such taxes (and any related interest and penalties) incurred by Host REIT, as well as any liabilities that the IRS or tax authorities successfully may assert against Host REIT for corporate income taxes for taxable years prior to the time Host REIT qualified as a REIT. Our taxable REIT subsidiaries, including Rockledge, Fernwood and HMT Lessee, are taxable as corporations and will pay federal, state and local income tax on their net income at the applicable corporate rates, and foreign taxes to the extent they own assets or conduct operations in foreign jurisdictions.

 

As a REIT, Host REIT is subject to limitations on its ownership of debt and equity securities.    Subject to the exceptions discussed in this paragraph, a REIT is prohibited from owning securities in any one issuer to the extent that the value of those securities exceeds 5% of the value of the REIT’s total assets, or the securities owned by the REIT represent more than 10% of the issuer’s outstanding voting securities or more than 10% of the value of the issuer’s outstanding securities. A REIT is permitted to own securities of a subsidiary in an amount that exceeds the 5% value test and the 10% vote or value test if the subsidiary elects to be a taxable REIT subsidiary which is taxable as a corporation. However, a REIT may not own securities of taxable REIT subsidiaries that represent in the aggregate more than 20% of the value of the REIT’s total assets.

 

Our taxable REIT subsidiaries are subject to special rules that may result in increased taxes.    Several Internal Revenue Code provisions ensure that a taxable REIT subsidiary is subject to an appropriate level of federal income taxation. For example, a taxable REIT subsidiary is limited in its ability to deduct interest payments made to an affiliated REIT. In addition, the REIT has to pay a 100% penalty tax on some payments that it receives if the economic arrangements between the REIT and the taxable REIT subsidiary are not comparable to similar arrangements between unrelated parties.

 

We may be required to pay a penalty tax upon the sale of a hotel.    The Federal income tax provisions applicable to REITs provide that any gain realized by a REIT on the sale of property held as inventory or other property held primarily for sale to customers in the ordinary course of business is treated as income from a “prohibited transaction” that is subject to a 100% penalty tax. Under existing law, whether property, including hotels, is held as inventory or primarily for sale to customers in the ordinary course of business is a question of fact that depends upon all of the facts and circumstances with respect to the particular transaction. We intend that we and our subsidiaries will hold the hotels for investment with a view to long-term appreciation, to engage in the business of acquiring and owning hotels and to make occasional sales of hotels as are consistent with our investment objectives. We cannot assure you, however, that the IRS might not contend that one or more of these sales is subject to the 100% penalty tax.

 

Item 3.    Legal Proceedings

 

We believe all of the lawsuits in which we are a defendant, including the following lawsuits, are without merit and we intend to defend vigorously against such claims; however, no assurance can be given as to the outcome of any of the lawsuits.

 

Marriott Hotel Properties II Limited Partnership (MHP II).    Limited partners of MHP II filed putative class action lawsuits in Palm Beach County Circuit Court on May 10, 1996, Leonard Rosenblum, as Trustee of the Sylvia Bernice Rosenblum Trust, et. Al. v. Marriott MHP Two Corporation, et. Al., Case No. CL-96-4087-AD, and, in the Delaware Court of Chancery on April 24, 1996, Cary W. Salter, Jr., et. Al. v. MHP II Acquisition Corp., et. Al., respectively, against Host REIT and certain of its affiliates alleging that the defendants violated their fiduciary duties and engaged in fraud and coercion in connection with the 1996 tender offer for MHP II units and our acquisition of MHP II during the REIT conversion.

 

In the Florida case, the defendants removed the case to the United States District Court for the Southern District of Florida and, after hearings on various procedural motions, the District Court remanded the case to state court on July 25, 1998.

 

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In the Delaware case, the Delaware Court of Chancery initially granted the plaintiffs’ motion to voluntarily dismiss the case with the proviso that the plaintiffs could refile in the aforementioned action in federal court in Florida. After the District Court’s remand of the Florida action back to Florida state court, two of the three original Delaware plaintiffs asked the Court of Chancery to reconsider its order granting their voluntary dismissal. The Court of Chancery refused to allow the plaintiffs to join the Florida action and, instead, reinstated the Delaware case, now styled In Re Marriott Hotel Properties II Limited Partnership Unitholders Litigation, Consolidated Civil Action No. 14961. On January 29, 1999, Cary W. Salter, one of the original plaintiffs, alone filed an Amended Consolidated Class Action Complaint in the Delaware action. On January 24, 2000, the Delaware Court of Chancery issued a memorandum opinion in which the court dismissed all but one of the plaintiff’s claims, which remaining claim concerns the adequacy of disclosure during the initial tender offer. On October 22, 2001, we entered into a settlement agreement with respect to the two above-referenced cases. At a fairness hearing held on February 22, 2002, the Florida court gave final approval to the settlement. The Court of Chancery subsequently dismissed the Delaware case.

 

A subsequent lawsuit, Accelerated High Yield Growth Fund, Ltd., et al. v. HMC Hotel Properties II Limited Partnership, et. Al., C.A. No. 18254NC, was filed on August 23, 2000 in the Delaware Court of Chancery by the MacKenzie Patterson group of funds, one of the three original Delaware plaintiffs, against Host REIT and certain of its affiliates alleging breach of contract, fraud and coercion in connection with the acquisition of MHP II during the 1998 REIT conversion. The plaintiffs allege that our acquisition of MHP II by merger in connection with the REIT conversion violated the partnership agreement and that our subsidiary acting as the general partner of MHP II breached its fiduciary duties by allowing the merger to occur. The settlement referenced above resolves all claims of MHP II’s limited partners against Host REIT and its affiliates with the exception of the claims of the MacKenzie Patterson group. The MacKenzie Patterson group elected to opt out of the settlement class with respect to its 28 limited partner units. Discovery is proceeding in this case.

 

Mutual Benefit Chicago Marriott Suite Hotel Partners, L.P. (“O’Hare Suites”).    On October 5, 2000, Joseph S. Roth and Robert M. Niedelman, limited partners in O’Hare Suites, filed a putative class action lawsuit, Joseph S. Roth, et al., v. MOHS Corporation, et al., Case No. 00CH14500, in the Circuit Court of Cook County, Illinois, Chancery Division, against Host REIT, Host LP, Marriott International, and MOHS Corporation, a subsidiary of Host LP and a former general partner of O’Hare Suites. The plaintiffs allege that an improper calculation of the hotel manager’s incentive management fees resulted in inappropriate payments in 1997 and 1998, and, consequently, in an inadequate appraised value for their limited partner units in connection with the acquisition of O’Hare Suites during the REIT conversion. The plaintiffs are seeking damages of approximately $13 million. We are currently seeking a denial of class certification and we intend to challenge the adequacy of the proposed class representatives.

 

Item 4.    Submission of matters to a vote of security holders

 

None

 

 

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PART II

 

Item 5.    Market for our common OP Units and related unitholder matters

 

There is no established public trading market for our OP Units and transfers of OP Units are restricted by the terms of our partnership agreements. We have not declared any distributions on our common OP Units during 2002, or for the fourth quarter of 2001. We did pay distributions for the three quarters of 2001 on our OP Units totaling $0.78 per unit. See “Management Discussion and Analysis of Results of Operations and Financial Condition—Overview.”

 

Under the terms of our senior notes indenture and the credit facility, our ability to pay distributions and make other payments is dependent on our ability to satisfy certain financial requirements, including an EBITDA-to-cash interest coverage ratio of at least 2.0 to 1.0. Since the beginning of the third quarter of 2002, we have not met this EBITDA-to-cash interest coverage ratio. As a result, we are permitted to declare and pay distributions on common and preferred OP Units only to the extent necessary such that Host REIT is permitted to declare and pay dividends to the extent necessary to maintain its status as a REIT. See “Risk Factors—Financial Risks—Our future cash distributions to our partners and to Host REIT for its dividends on preferred and common stock may be limited by the terms of our indebtedness and, in addition, our ability to make distributions on our common OP Units may be further limited by the terms of our preferred OP Units.”

 

The number of holders of record of our OP Units on March 7, 2003 was 2,585. The number of outstanding OP Units as of March 7, 2003 was 292,141,196, of which 264,587,577 were owned by Host REIT.

 

Issuances of Unregistered Securities.

 

Unless stated otherwise, we acquired interests in partnerships owning hotel properties in connection with each of the following issuances of unregistered securities.

 

In April 2002, we acquired an interest in the partnership that owns the San Diego Marriott Hotel and Marina through the issuance of 6.9 million OP Units to minority partners in exchange for their partnership interests. The OP Units issued are redeemable for the cash equivalent of a share of Host REIT’s common stock or, at Host REIT’s option, shares of its common stock.

 

In March 2001, Host REIT issued 5,980,000 shares of Class C cumulative redeemable preferred stock, the proceeds of which were used to purchase 5,980,000 units of Class C cumulative redeemable preferred OP Units. Distributions on the preferred OP Units are payable quarterly in arrears at the rate of 10% per year. The issuance of the preferred OP Units was made in reliance on an exemption from the registration requirements for the Securities Act pursuant to section 4(2).

 

34


 

Item 6.    Selected Financial Data

 

The following table presents certain selected historical financial data of us and our predecessor, which has been derived from audited consolidated financial statements for the five years ended December 31, 2002.

 

The historical information contained in the following table for our 2002, 2001 and 1998 operations primarily represents gross hotel-level revenues and expenses of our properties. During 1999 and 2000, we owned the hotels but leased them to third-party lessees and, accordingly, during these periods our historical revenues primarily represent rental income generated by our leases. For a comparison of hotel level sales for fiscal years 2000 and 2001, please see the tables presenting comparable periods in our “Managements Discussion and Analysis of Results of Operations and Financial Condition—Results of Operations.”

 

    

Fiscal Year


    

2002


    

2001


  

2000


  

1999


  

1998(1)(2)


    

(in millions, except per share data)

Income Statement Data:

                                    

Revenues(3)

  

$

3,680

 

  

$

3,767

  

$

1,407

  

$

1,303

  

$

3,450

Income (loss) from continuing operations(4)

  

 

(32

)

  

 

62

  

 

205

  

 

257

  

 

195

Income (loss) before extraordinary items

  

 

(25

)

  

 

59

  

 

203

  

 

256

  

 

195

Net income (loss)(5)

  

 

(19

)

  

 

57

  

 

207

  

 

285

  

 

47

Net income (loss) available to common unitholders

  

 

(54

)

  

 

25

  

 

187

  

 

279

  

 

47

Basic earnings (loss) per common unit:

                                    

Income (loss) from continuing operations

  

 

(.23

)

  

 

.11

  

 

.65

  

 

.86

  

 

.90

Income (loss) before extraordinary items

  

 

(.21

)

  

 

.10

  

 

.64

  

 

.86

  

 

.90

Net income (loss)

  

 

(.19

)

  

 

.09

  

 

.66

  

 

.96

  

 

.22

Diluted earnings (loss) per common unit:

                                    

Income (loss) from continuing operations

  

 

(.23

)

  

 

.11

  

 

.64

  

 

.84

  

 

.85

Income (loss) before extraordinary items

  

 

(.21

)

  

 

.10

  

 

.63

  

 

.83

  

 

.85

Net income (loss)

  

 

(.19

)

  

 

.09

  

 

.65

  

 

.93

  

 

.27

Cash distributions per common unit

  

 

—  

 

  

 

.78

  

 

.91

  

 

.84

  

 

1.00

Balance Sheet Data:

                                    

Total assets

  

$

8,311

 

  

$

8,334

  

$

8,391

  

$

8,196

  

$

8,262

Debt

  

 

6,130

 

  

 

6,094

  

 

5,814

  

 

5,583

  

 

5,698


(1)   In 1998, we changed our fiscal year end to December 31 for both financial and tax reporting requirements. Previously, our fiscal year ended on the Friday nearest to December 31. As a result of this change, the results of operations for 15 hotels not managed by Marriott International were adjusted in 1998 to include 13 months of operations (December 1997 through December 1998). The additional month of operations in 1998 increased our revenues by $44 million.
(2)   The historical financial data for fiscal year 1998 reflect as discontinued operations our senior living business that we disposed of in the spin-off of Crestline as part of the REIT conversion.
(3)   Historical revenues for 2000 and 1999 primarily represent rental income generated by our leases, primarily with Crestline. Revenues in 1998 represent gross hotel sales because our leases were not in effect until January 1, 1999. Effective January 1, 2001, we acquired ownership of the leasehold interests in 116 of our full-service hotels from Crestline. Accordingly, our results of operations for 2001 and 2002 reflect this acquisition by presenting hotel level revenues rather than rental income. Beginning with the third quarter of 2001, hotel level revenues were recorded as a result of the acquisition of four additional leasehold interests.
(4)   In accordance with SFAS No. 144, which was effective beginning in fiscal year 2002, we reported the operations of the St. Louis Marriott Pavilion hotel as discontinued operations in conjunction with the transfer of the hotel to the lender in January 2002. As required by this statement, all prior periods have been restated to reflect the operations of the hotel as discontinued operations.
(5)   Our extraordinary gains and losses primarily are the result of early extinguishment of debt and the write-off of deferred financing fees for all periods presented.

 

35


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

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and the other financial information included elsewhere in this report. This discussion includes forward-looking statements about our business and operations. Our actual results could differ materially from those currently anticipated and expressed in such forward-looking statements and as a result of the factors we describe under “Risk Factors” and elsewhere in this report.

 

Overview

 

Host Marriott, L.P., a Delaware limited partnership, operating through an umbrella partnership structure with Host REIT as the sole general partner, is the owner of 122 hotel properties, which operate primarily in the luxury and upper-upscale hotel segments. Host REIT operates as a self-managed and self-administered REIT with its operations conducted solely through us and our subsidiaries. As of December 31, 2002, Host REIT owned approximately 90% of our outstanding OP Units. As of January 2003, the National Association of Real Estate Investment Trusts ranks Host REIT as the largest lodging REIT.

 

Our hotels are operated under brand names that are among the most respected and widely recognized in the lodging industry—including Marriott, Ritz-Carlton, Four Seasons, Hilton and Hyatt. Our properties are located in central business districts of major cities, near airports and in resort/convention locations. Our portfolio depends on revenue from large and small group business, business travel, as well as leisure and discount travelers. The target profile of our portfolio includes upper-upscale and luxury properties in hard to duplicate locations that may allow us to maintain room rate and occupancy premiums over our competitors. We seek to maximize the value of our portfolio through aggressive asset management, by directing the managers of our hotels to reduce operating costs and increase revenues and by completing selective capital improvements.

 

Our hotel sales traditionally experienced moderate seasonality. Additionally, hotel revenues in the fourth quarter typically reflect a greater proportion of our annual revenues than each of the prior quarters because our fourth quarter reflects sixteen weeks of results compared to twelve weeks for the first three quarters of the fiscal year. See “Business and Properties—Seasonality.”

 

Our results of operations primarily represent hotel level sales, which are room, food and beverage and other ancillary income such as telephone, parking and other guest services. Operating expenses consist of the costs to provide these services as well as depreciation, management fees, real and personal property taxes, ground rent, equipment rent, property insurance, income taxes of our consolidated taxable REIT subsidiaries and other costs.

 

The operating environment during 2002 presented many challenges and was influenced significantly by reduced airline travel, weak economic conditions and general international unrest as a result of the threat of further terrorist activity and the potential for war in the Middle East. As a result, the lodging industry and our company experienced significant declines in revenues and operating profits because of reduced demand and rising operating expenses, including increased insurance costs. We expect these conditions to persist into 2003. We are expecting RevPAR in 2003 to be generally comparable to 2002 levels or modestly lower, though RevPAR is likely to decline in the first half of 2003. We also expect continuing pressure on operating margins as we expect that certain important components of our operating costs, such as wages, benefits and insurance, will increase at a rate greater than estimated inflation in 2003. Thus, operating profits and margins for 2003 will likely be below 2002 levels, especially if economic conditions do not improve.

 

We have a significant fixed-cost component and expenses associated with owning and operating hotels, which do not necessarily decrease when circumstances such as market factors cause a reduction in revenue for the property. As a result, changes in RevPAR can result in a greater percentage change in our earnings and cash flows. In response to the decline in the operations of our hotels in 2002 and 2001, we have been working with our hotel managers to achieve cost reductions at the properties, and we believe that these efforts have slowed the

 

36


decrease in our operating margins. Although some of these cost savings may not be permanent, we believe that we have achieved some meaningful long-term efficiencies. In the future, margin improvement will generally be dependent upon revenue growth as additional cost reductions may be difficult to obtain and, as noted above, we expect that certain of our costs will increase at a rate greater than inflation in 2003.

 

As of December 31, 2002, we were under the 2.0 to 1.0 EBITDA-to-cash interest coverage ratio required under the senior notes indenture. As a result, distributions on both common and preferred OP Units were restricted to the minimum amount of distributions required for Host REIT to maintain REIT status. Required distributions for 2002 were satisfied in part by payment of distributions on the preferred OP Units in 2002. We believe that the remaining 2002 distribution requirement should largely be satisfied by the payment of distributions expected to be declared on preferred OP Units in the first, second and third quarters of 2003. We may, however, also need to pay a nominal common OP Unit distribution in 2003 to the extent necessary to satisfy any remaining 2002 distribution requirement. The payment of any additional distribution on either common or preferred OP Units will depend on 2003 operating performance and its impact on taxable income and whether our EBITDA-to-cash interest coverage ratio is at least 2.0 to 1.0 coverage for 2003.

 

Results of Operations

 

Beginning January 1, 2001, we reported gross property level sales from the majority of our hotels, and our expenses included all property level costs including depreciation, management fees, real and personal property taxes, ground rent, equipment rent, property insurance and other costs. Our revenues for 2000 represent rental income on leases of our hotels. Expenses during 2000 represent specific owner costs, including real estate and property taxes, property insurance and ground and equipment rent. As a result, our 2002 and 2001 results are not comparable to the historical reported amounts for 2000.

 

2002 Compared to 2001

 

Revenues.    Hotel sales declined $50 million, or 1.4%, to approximately $3,579 million for 2002 from $3,629 million in 2001. The $50 million decrease in hotel sales for 2002 primarily reflects the decrease in RevPAR for our properties of 4.9% to $100.74. While the decrease in RevPAR is due in part to the reduction in business and leisure travel, it is also the result of the change in business mix at our properties. Transient business, which includes the corporate and premium business segments, which generally pay the highest average room rates has decreased by over 3% since 2000 as a percentage of room sales. Our managers have partially offset this decline with additional group and contract business and other segments that have lower average room rates. As a result, while occupancy has increased slightly, the average room rate has declined significantly. We believe these trends will continue to affect our operations until the economy strengthens and business travel increases.

 

Rental income decreased $35 million, or 25.7%, to $101 million for 2002 from $136 million in 2001. Rental income for 2002 and 2001 includes: 1) lease income from our limited service hotel leases of $71 million and $77 million, respectively, 2) lease income from full-service hotel leases of $24 million and $53 million, respectively, and 3) office space rental income of $6 million for both years. We repurchased the lessee entities with respect to four of the remaining five full-service hotels leased to third parties effective June 16, 2001 and terminated those leases for financial reporting purposes. As a result, we currently record rental income with respect to only one full-service hotel.

 

Operating Costs and Expenses.    Operating costs and expenses decreased $20 million, or .6%, to $3,214 million in 2002 compared to 2001. This decrease is primarily the result of our efforts and those of our managers to control operating costs at the hotels and the overall decline in occupancy. However, overall our comparable hotel operating profit margin decreased 1.8 percentage points. Rental expense during 2002 and 2001 for our limited service hotel leases was $70 million and $71 million, respectively, and office space expense was $3 million for both periods. These expenses are included in other property-level expenses on the consolidated

 

37


statements of operations. As previously discussed, we believe that operating margins will likely decline in 2003 as a result of total costs increasing at a rate greater than total revenues. In particular, we expect that costs such as wages, benefits and insurance will increase at a rate greater than inflation.

 

Corporate Expenses.    Corporate expenses decreased by $2 million, or 6.3%, to $30 million in 2002 compared to 2001. The decrease in expenses was principally due to a decrease in stock-based compensation.

 

Host REIT has stock-based compensation plans under which it may award to participating employees options to purchase shares of Host REIT’s common stock, Host REIT’s deferred shares of Host REIT common stock or restricted shares of Host REIT common stock as well as an employee stock purchase plan. The restricted shares issued to certain officers and key executives vest over a three-year period in annual installments based on continued employment and the attainment of performance criteria established by Host REIT’s Compensation Policy Committee. These shares are subject to market adjustments that result in compensation expense (benefit) on a quarterly basis. As a result of the decline in Host REIT’s stock price and our operations in 2002, certain performance thresholds were not met, and a portion of these shares previously granted were forfeited, resulting in the reversal of expense previously recognized and a reduction in 2002 overall expenses.

 

Minority Interest Expense.    For 2002 and 2001, we recognized minority interest expense of $8 million and $16 million, respectively. The variance in minority interest expense is due to the decrease in our results of operations as described above.

 

Discontinued Operations.    During January 2002, we transferred the St. Louis Marriott Pavilion to the mortgage lender in a non-cash transaction. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which we adopted January 1, 2002, we classified the hotel’s operating results as discontinued operations in all periods presented. As a result, at December 31, 2002 and 2001, we recorded income, net of taxes, of $7 million and a loss of $3 million, respectively, as discontinued operations.

 

Extraordinary Gain.    During 2002, we recorded an extraordinary gain, net of tax, of $6 million, representing the extinguishment of debt on the St. Louis Marriott Pavilion. During 2001, we recorded an extraordinary loss, net of tax, of $2 million representing the write-off of deferred financing costs and certain fees paid to our lender in connection with renegotiations of the credit facility, as well as the refinancing of the mortgage debt on our Canadian properties.

 

2001 Compared to 2000

 

Revenues.    As discussed above, our revenues and operating profit for 2001 are not comparable to 2000, due to our acquisition of the lessee entities by our wholly owned taxable REIT subsidiary. The table below presents gross hotel sales for the years ended December 31, 2001 and 2000. For 2000, gross hotel sales were used as the basis for calculating rental income. The data is presented in order to facilitate an investor’s understanding and comparative analysis of the operations of our properties and does not represent our revenues for these periods.

 

    

Year Ended


    

December 31, 2001


  

December 31, 2000


    

(in millions)

Hotel sales

             

Rooms

  

$

2,550

  

$

2,877

Food and beverage

  

 

1,173

  

 

1,309

Other

  

 

306

  

 

323

    

  

Total hotel sales

  

$

4,029

  

$

4,509

    

  

 

The $480 million decrease in hotel sales for 2001 primarily reflects the decrease in RevPAR for our properties of 13.7% to $105.96. Room sales also declined as a result of the loss of sales from the New York

 

38


Marriott World Trade Center and the New York Marriott Financial Center due to the terrorist acts of September 11, 2001. The declines were partially offset by incremental revenues provided by the 500-room expansion at the Orlando Marriott, which was placed in service in June 2000, and the addition of three hotels as a result of our consolidation of Rockledge Hotel Properties, Inc. (“Rockledge”) and Fernwood Hotel Assets, Inc. (“Fernwood”) as of March 24, 2001.

 

The decline in RevPAR during 2001 was generally due to a decrease in occupancy of 7.7 percentage points and a 4.1% decrease in room rates for the year. As a result of decreased hotel sales, we directed our managers to implement cost cutting measures and revenue enhancement programs at the property level during the second quarter in order to stabilize operating profit margins. These measures included increasing labor efficiency, particularly at the managerial level and in the food and beverage area at the hotels, reducing discretionary expenses in rooms, food and beverage, and repairs and maintenance and reducing energy consumption. While we believe these measures were moderately successful profit margins on our portfolio of hotels still decreased 3.0 percentage points for 2001.

 

Corporate Expenses.      Corporate expenses decreased by $10 million, or 24%, as a result of corporate cost cutting during 2001 and a decrease of $6 million in compensation expense related to Host REIT’s employee stock plans.

 

Lease Repurchase Expense.    In connection with the definitive agreement with Crestline in November 2000 for the purchase of the leasehold interests with respect to 116 hotels, we recorded a nonrecurring loss provision of $207 million. In 2001, as a result of the purchase of four additional leasehold interests, we recognized a loss of $5 million.

 

Minority Interest Expense.    For 2001 and 2000, we recognized minority interest expense of $16 million and $27 million, respectively. The variance is primarily due to the decrease in our results of operations as described above.

 

Equity in Earnings of Affiliates.    Equity in earnings of affiliates decreased $24 million, or 89%, to $3 million for 2001. The decrease is principally due to the acquisition and consolidation of two subsidiaries on March 24, 2001.

 

Provision for Income Taxes.    For the year ended December 31, 2001, we recorded an income tax provision of $9 million, a change of $107 million, from the $98 million income tax benefit in 2000. The change is primarily due to the $82 million benefit taken during 2000 due to the recognition of the income tax asset as a result of the purchase of the leasehold interests with respect to 116 hotels. Also, during 2001 and 2000, we favorably resolved certain tax matters and recognized $16 million and $32 million, respectively, related thereto as a benefit to our tax provision.

 

Liquidity and Capital Resources

 

Our principal sources of cash are cash from operations, the sale of assets, borrowings under our credit facility and our ability to obtain additional financing through various financial markets. Our principal uses of cash are for payments of debt, capital expenditures, asset acquisitions, operating costs, corporate expenses and distributions to our OP Unit holders. We believe our sources of cash will be sufficient to meet our current liquidity needs.

 

As of December 31, 2002, we had $361 million of cash and cash equivalents, which was an increase of $9 million over our December 31, 2001 balance. In addition, we have $133 million of restricted cash as a result of lender and management agreement restrictions. Additionally, approximately $171 million of our available cash and cash equivalents is held by our wholly-owned taxable REIT subsidiaries. The distribution of this cash to us could, under certain circumstances, increase our current or future income tax expense and/or the amounts Host REIT is required to distribute to maintain its status as a REIT.

 

39


 

On July 25, 2002, we completed the renegotiation of the management and other agreements on 102 of our Marriott and Ritz-Carlton branded hotels, providing us with expanded approval rights over operating and capital budgets. In addition to these modifications, we expanded the pool of hotels subject to an existing agreement that allows us to sell assets unencumbered by a Marriott management agreement without the payment of termination fees. The revised pool includes 46 assets, 75% (measured by EBITDA) of which may be sold over approximately a ten-year or greater period (and 22.5% (measured by EBITDA) of which may be sold unencumbered by the Marriott brand). These changes were effective as of December 29, 2001. We have also completed the renegotiation of the management agreements on our four Swissôtel management contracts, and have the ability to terminate two management agreements immediately and the remaining two over the next five years. We believe that the modifications to the Swissôtel agreements together with our revised agreements with Marriott International will enhance our ability to dispose of our non-core assets more efficiently.

 

As part of the renegotiation with Marriott International, we also reduced the amount of working capital required and expanded an existing agreement that allowed us to fund furniture, fixtures and equipment expenditures as incurred from one account that we control rather than depositing funds into individual escrow accounts for each hotel. As a result, an additional $125 million in cash became available for our general use effective July 25, 2002. At that time, approximately $75 million of funds returned to us were previously held in furniture, fixtures and equipment escrows to fund capital expenditures. While we continue to be obligated to fund capital expenditures as such expenditures are approved by us, this modification has enabled us to use the available funds for general corporate purposes.

 

We will continue to maintain higher than normal cash balances in 2003 because we believe that the war in Iraq could adversely affect the economy and in particular the lodging industry, which would result in further decline in our operations. We believe that increased operating performance levels, specifically increased levels of business travel demand, would signal an opportunity to lower our cash balances through debt prepayments or asset acquisitions. While we currently have $300 million of availability under our credit facility and have no amounts outstanding thereunder, our forecast of operations indicates that we may fail to meet certain maintenance covenants for the credit facility during the second quarter of 2003. As a result, we expect to modify our financial covenants in the credit facility.

 

Approximately $116 million of our mortgage debt matures, and $102 million of regularly scheduled amortization on our mortgage debt occurs, prior to 2005. We have no other significant refinancing requirements until 2005.

 

We remain interested in pursuing single asset and portfolio acquisitions and have discussed the possibility of these transactions with several interested parties. We believe there will be opportunities over the next several years to acquire assets that are consistent with our target profile of upper-upscale and luxury properties in hard to duplicate urban, convention and resort locations. However, we cannot be certain as to the size or timing of acquisition opportunities or of our ability to obtain transaction financing.

 

We will continue to pursue opportunities to dispose of non-core assets that are not consistent with our portfolio strategy. During 2003, we expect to continue to have discussions with potential buyers for certain of our non-core hotels. We believe that, if consummated, sales of non-core properties transactions could result in net proceeds of between $100 million to $250 million. We intend to use the proceeds from dispositions to repay debt, though we could also elect to invest in our current portfolio or to acquire additional hotels. However, there can be no assurance that these dispositions will occur.

 

Cash provided by Operations.    During 2002, our cash provided by operations increased by $91 million when compared to 2001. The increase over the prior year is partly due to an agreement we negotiated with Marriott International under which $50 million in cash became available to us because of a reduction in working capital requirements under our revised management agreements and the use of $208 million of operating cash in 2001 for the purchase of the lessee interests previously leased to Crestline. The overall increase in cash provided by operations was partially offset by the declining operating results at the hotels during 2002.

 

40


 

Cash used in Investing Activities.    Based on our assessment of the current operating environment and to conserve capital, we continued our disciplined approach to capital expenditures during 2002. As a result, renewal and replacement capital expenditures at our properties have decreased by approximately $60 million, or 29%, when compared to the same period in 2001. Despite these decreases, we have focused on property maintenance and selected improvements designed to maintain appropriate levels of quality. As a result of the changes in our agreements with Marriott International, approximately $75 million of funds previously held in escrow accounts for capital expenditures at certain properties has been returned to us. On June 14, 2002, we acquired the Boston Marriott Copley Place in Boston, Massachusetts for a purchase price of $214 million, which included the assumption of $97 million of mortgage debt.

 

We completed the sale of the Ontario Airport Marriott on January 24, 2003 for $26 million to the Westbrook Fund IV Acquisitions, LLC. We used the proceeds of this sale to retire certain of our debt.

 

The following table summarizes significant investing activities which were completed during the first quarter of 2003 and for the years 2002 and 2001 (in millions):

 

Transaction Date


  

Description of Transaction


    

Sale/

(Investment)

Price


 

January 2003

  

Sale of Ontario Airport Marriott

    

$

26

 

June 2002

  

Purchase of the 1,139-room Boston Marriott Copley Place

    

 

(214

)

January 2002

  

Development of the 295-room Golf Lodge at The Ritz-Carlton, Naples

    

 

(75

)

December 2001

  

Sale of Vail Marriott Mountain Resort and the Pittsburgh City Center Marriott

    

 

65

 

June 2001

  

Addition of a spa facility at the Marriott Harbor Beach Resort

    

 

(8

)

June 2001

  

Purchase of minority ownership interest(1)

    

 

(60

)

April 2001

  

Addition of a spa facility at The Ritz-Carlton, Naples

    

 

(25

)

March 2001

  

Purchase of 100% of the voting interest in Rockledge and Fernwood(2)

    

 

(2

)


(1)   The limited partner interests relate to seven full-service hotels.
(2)   The voting interests were previously held by the Host Marriott Statutory Employee/Charitable Trust. Prior to the acquisition, we held a 95% non-voting interest in each company. As a result of the acquisition we consolidated three full-service hotels, one of which was transferred to the lender in 2002.

 

Cash used in Financing Activities.    During 2002, the cash used in financing activities primarily consisted of principal repayments on debt of $63 million and preferred OP Unit distributions of $35 million. On December 20, 2002, the Board of Directors of Host REIT declared a quarterly cash distribution of $0.625 per unit for each class of preferred OP Units, which was paid on January 15, 2003 to unitholders of record on December 31, 2002. We did not declare a distribution on our common OP Units during 2002.

 

We are aware that certain of our outstanding senior notes are currently trading at a discount to their respective face amounts. To reduce future cash interest payments, as well as future amounts due at maturity or upon redemption, we may from time to time purchase senior notes for cash through open market purchases, privately negotiated transactions or by conducting a tender offer. Host REIT’s Board of Directors has authorized the repurchase of up to $150 million of our senior notes from the proceeds of any dispositions. Repurchases of debt, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. During March 2003, we purchased $8 million of our 9.25% senior notes at par.

 

41


 

The following table summarizes significant financing activity, except for the credit facility, payment of distributions and non-cash equity transactions (all of which are discussed below), during the first quarter of 2003 and for the years 2002 and 2001 (in millions):

 

Transaction Date


  

Description of Transaction


    

Transaction amount


 

March 2003

  

Retired a portion of 9.25% senior notes due in 2007

    

$

(8

)

January 2003

  

Partial prepayment of The Ritz-Carlton, Naples and Buckhead mortgage

    

 

(17

)

September 2002

  

Retired 9.5% senior notes due in 2005(1)

    

 

(13

)

January 2002

  

Purchase of interest rate cap(2)

    

 

(3

)

December 2001

  

Issuance of Series H senior notes(3)

    

 

450

 

October 2001

  

Retired San Antonio Marriott Riverwalk mortgage loan

    

 

(17

)

August 2001

  

Proceeds from the Canadian mortgage loan(4)

    

 

97

 

August 2001

  

Retired The Ritz-Carlton, Amelia Island mortgage loan(4)

    

 

(88

)

March 2001

  

Issuance of Class C cumulative redeemable preferred OP Units(5)

    

 

143

 


(1)   We retired the remaining $13 million of these senior notes at approximately 101% of par. We recorded a nominal loss on the retirement.
(2)   This agreement caps the floating interest rate at 14% for the swap agreement for the Series I senior notes.
(3)   Proceeds from the Series H senior notes were used to repay the outstanding balance on the credit facility. Additionally, we entered into an interest rate swap agreement with regards to this principal balance, as discussed below. These notes were exchanged in June 2002 for Series I senior notes on a one-for-one basis and are substantially identical to the Series H senior notes and are freely transferable by the holders.
(4)   A Canadian subsidiary entered into a financing agreement pursuant to which it borrowed $97 million. The Calgary Marriott, Toronto Airport Marriott, Toronto Marriott Eaton Centre and Toronto Delta Meadowvale hotels serve as collateral. The proceeds from this financing were used to refinance existing indebtedness on these hotels, as well as to repay the $88 million mortgage note on The Ritz-Carlton, Amelia Island hotel.
(5)   On March 27, 2001, we issued approximately 6.0 million units of 10% Class C cumulative redeemable preferred OP Units for net proceeds of $143 million. Holders of the Class C Preferred OP Units are entitled to receive cumulative cash distributions at a rate of 10% per year of the $25 per unit liquidation preference.

 

Debt.    As of December 31, 2002, our total consolidated debt was approximately $6.1 billion. We have $136 million in principal amortization and debt maturities due during 2003 and $2.4 billion in principal amortization and debt maturities due over the next five years. The weighted average interest rate of all our debt is approximately 7.8% and our current average maturity is 7.0 years. Additionally, 91% of our debt has a fixed rate of interest as of December 31, 2002. Over time, we expect to increase the proportion of floating rate debt in our capital structure to 20% to 25% of our total debt, although there can be no assurances that we will be able to achieve this result on terms acceptable to us. In December 2001, in order to take advantage of low, short-term interest rates, we entered into an interest rate swap agreement (described in “Derivative Instruments”) to convert the fixed rate of the Series H senior notes, which were subsequently exchanged into Series I senior notes, to a floating rate. In January 2002, we entered into a separate cap arrangement to limit our exposure to interest rate increases on this floating rate swap (described in “Derivative Instruments”). We continue to evaluate our mix of fixed rate and floating rate debt and, to the extent we deem it appropriate, we may enter into additional interest rate swap agreements related to some of our fixed rate debt.

 

In March 2003, we purchased $8 million of 9.25% senior notes due in 2007 at par, and we immediately retired the notes. On January 30, 2003, we prepaid $17 million of mortgage debt related to two of our Ritz-Carlton properties. On September 16, 2002, we called $13 million of 9.5% senior notes due in May 2005 at 101% of par. We immediately retired the notes and recorded an extraordinary loss of $150,000 on the early retirement of the debt, which is presented in the statement of operations, net of $6 million extraordinary gain on extinguishment of debt related to the transfer of the St. Louis Marriott Pavilion to the lender.

 

42


 

On June 6, 2002, we entered into a credit facility that provides an aggregate revolving loan commitment amount of up to $400 million ($300 million of which is available currently, with the balance becoming available to the extent that our leverage ratio meets a specified level.) The credit facility has an initial three-year term with an option to extend for an additional year if certain conditions are met. Interest on borrowings under the credit facility will be calculated based on a spread over LIBOR ranging from 2.50% to 3.75%. The rate will vary based on our leverage ratio. We are required to pay a quarterly commitment fee that will vary based on the amount of unused capacity under the credit facility. Currently, the commitment fee is .55% on an annual basis for available capacity and .10% on additional capacity. As of March 1, 2003, we have not drawn on the credit facility.

 

In addition to the customary affirmative and negative covenants and restrictions, the credit facility contains covenants that require us to maintain leverage ratios below specified levels as well as interest, fixed charges and unsecured interest coverage ratios above specified levels. While we are currently in compliance with these maintenance covenants, our current forecasts indicate that we may fail to meet certain of these ratios during the second quarter of 2003. As a result, we expect to modify the financial covenants in our credit facility. We do not have any amounts outstanding under the credit facility in advance of seeking a modification and we believe that this will facilitate us in reaching an agreement with our lenders with regard to such a modification. There can be no assurances, however, that we will, in fact, reach such an agreement. In addition, any additional covenants could have an impact on our ability to conduct our operations.

 

Under the terms of the senior notes indenture and the credit facility, our ability to incur indebtedness is subject to restrictions and the satisfaction of various conditions, including an EBITDA-to-cash interest coverage ratio of at least 2.0 to 1.0. Beginning in the third quarter of 2002, we have not met this interest coverage ratio incurrence test. As a result, our ability to incur indebtedness is limited to indebtedness specifically permitted under the credit facility and the senior notes indenture, such as borrowings under the credit facility and borrowings in connection with a refinancing of existing debt. Our failure to meet this interest coverage ratio also restricts our ability to pay distributions on our common and preferred OP Units, except to the extent necessary to Host REIT to maintain its status as a REIT. We are currently considering several options to improve our interest coverage. These options could include, among others, retiring existing debt, swapping certain of our fixed interest rate debt for lower floating interest rate debt or acquiring properties with low or no indebtedness. There can be no assurance that these options will be available to us, or if available, that these options would be economically justifiable to implement.

 

We have approximately $3.2 billion of senior notes outstanding that are currently rated by Moody’s and Standard & Poor’s. As a result of the significantly reduced operating levels which followed the September 11, 2001 terrorist attacks and the economic slowdown, the ratings on these senior notes and the senior notes issued by many other lodging companies were downgraded and placed on negative credit watch. On February 13, 2003, Standard and Poor’s downgraded its rating on our senior debt from BB- to B+. At the same time, Standard & Poor’s also downgraded its rating on Host REIT’s preferred stock from B- to CCC+. The other rating agency affirmed our rating, but if operating results continue to decline, they will be more likely to downgrade their rating on our debt. While we have no significant senior note maturities until 2005, if operations were to decline further, or if our credit ratios do not otherwise improve, our senior notes could be downgraded further. If we were unable to subsequently improve our credit ratings, our cost to issue additional senior notes, to refinance this debt as it comes due or to issue additional preferred OP Units would likely increase.

 

All of our mortgage debt is recourse solely to specific assets except for fraud, misapplication of funds and other customary recourse provisions. We have thirty assets that are secured by mortgage debt. Twelve of these assets are secured by mortgage debt that contains restrictive covenants that require the mortgage servicer or lender to retain and hold in escrow the cash flow after debt service when it declines below specified operating levels. The impact of these covenants is discussed below.

 

Eight of our hotel properties secure a $609 million mortgage loan that is the sole asset of a trust that issued commercial mortgage pass-though certificates, which we refer to as the CMBS Loan. These hotels securing the

 

43


CMBS Loan are the New York Marriott Marquis, the San Francisco Airport Hyatt Regency, the Cambridge Hyatt Regency, the Reston Hyatt Regency, and the Swissôtels in Boston, New York, Atlanta and Chicago, which we refer to as the CMBS Portfolio. The CMBS Loan contains a provision that requires the mortgage servicer to retain the excess cash from the CMBS Portfolio after payment of debt service if net cash flow after payment of taxes, insurance, ground rent and reserves for furniture, fixtures and equipment for the trailing twelve months declines below $96 million. Annual debt service is approximately $64 million. As a result of the effect on operations of the September 11, 2001 terrorist attacks and the economic slowdown, this provision was triggered beginning in the third quarter of 2002 and will remain in effect until the CMBS Portfolio generates the necessary minimum cash flow for two consecutive quarters, at which point, the cash that has been escrowed will be returned to us. As of December 31, 2002, approximately $10 million of cash has been escrowed. Additional amounts will be escrowed, and these amounts may be significant. There can be no assurance that the CMBS Portfolio will reach the minimum cash flow for the required period of time so that the cash will be released.

 

On July 12, 2002, we modified the terms of the mortgage debt secured by our four Canadian properties. Under the terms of this modification, we have agreed to escrow the excess cash flow from these hotels on a retroactive basis effective December 29, 2001. To the extent that cash flow available for debt service for the twelve months ended March 28, 2003 is insufficient to achieve a specified debt-service coverage level, some or all of the escrowed excess cash flow will be applied to the outstanding balance of this debt. Thereafter, excess cash flow will continue to be applied to the outstanding balance to the extent necessary to achieve the specified level of debt service coverage. As of December 31, 2002, approximately $7 million of cash is escrowed in connection with this provision. The majority of the balance will be applied to the outstanding balance of the indebtedness and that the balance of the escrow will be released to us. Thereafter, we do not expect to be required to apply additional amounts of excess cash flow to the outstanding balance of the debt. However, if actual results fall short of the current forecast, additional amounts may be escrowed, which would result in additional principal repayments being made.

 

Derivative Instruments.    Historically, our debt has primarily been fixed rate including all of our previous series of senior notes. We have increased the amount of our exposure to variable rate instruments with the issuance of our Series H senior notes, which were subsequently exchanged into Series I senior notes, by using a derivative product. On December 20, 2001, we entered into an interest rate swap agreement, maturing in January 2007. Under the swap, we receive fixed-rate payments at 9.5% and pay floating-rate payments based on one-month LIBOR plus 4.5% on a $450 million notional amount. On January 4, 2002, in a separate agreement with a different counterparty, we purchased an interest rate cap for $3 million with the same notional amount which caps the floating interest rate at 14%.

 

Our Canadian subsidiaries entered into financing agreements pursuant to which they borrowed $96.6 million due August 2006 at a variable rate of LIBOR plus 2.75%. Since the mortgage loan on these Canadian properties is denominated in U.S. Dollars and the functional currency of the Canadian subsidiary is the Canadian Dollar, we purchased derivative instruments for hedging of the foreign currency investment. Additionally, we purchased a separate interest rate cap relating to $48.3 million of the debt for approximately $400,000, which effectively capped the interest rate at 10.75%. See Item 7a. “Quantitative and Qualitative Disclosure about Market Risk,” for additional information on these derivative instruments.

 

Lease Obligations

 

HPT Leases.    Prior to 1997, we divested certain limited-service hotel properties through the sale and leaseback of 53 Courtyard by Marriott properties and 18 Residence Inn properties to Hospitality Properties Trust, or HPT. As part of the REIT conversion, the Courtyard and Residence Inn properties were subleased to subsidiaries of Crestline. The properties are managed by Marriott International under long-term management agreements. Rent payable by Crestline under the non-cancelable subleases consists of the minimum rent payable under the HPT leases plus an additional percentage rent based upon sales levels and is guaranteed by Crestline up to a maximum amount of $30 million.

 

44


 

Other Lease Activities.    Additionally, we have lease and sublease activity relating to HMC’s former restaurant operations for which we remain either directly or contingently liable. As of December 31, 2002, the expected sublease rental income for the restaurant operations exceeded our lease liability. For a more detailed discussion of our lease obligations, see Note 9 to the consolidated financial statements.

 

Contractual Obligations

 

The table below summarizes our obligations for principal payments on our debt and future minimum lease payments on our operating and capital leases (in millions):

 

    

Payments due by period


    

Total


  

Less

than 1 year


  

1-3 years


  

3-5 years


  

More

than 5 years


Long-Term Debt Obligations(1)

  

$

6,117

  

$

136

  

$

642

  

$

1,645

  

$

3,694

Capital Lease Obligations(2)

  

 

16

  

 

5

  

 

10

  

 

1

  

 

—  

Operating Lease Obligations(3)

  

 

2,030

  

 

110

  

 

208

  

 

195

  

 

1,517

    

  

  

  

  

Total

  

$

8,163

  

$

251

  

$

860

  

$

1,841

  

$

5,211

    

  

  

  

  


(1)   The amounts shown include amortization of principal and debt maturities on our debt as well as discounts of $6 million on our senior notes. The amounts do not include $16 million of capital lease liabilities.
(2)   Future minimum lease payments have not been reduced by aggregate minimum sublease rentals from restaurants of $3 million, payable to us under non-cancelable subleases. The lease payments also include interest payable of $3 million.
(3)   Future minimum lease payments have not been reduced by aggregate minimum sublease rentals from restaurants and HPT subleases of $36 million and $657 million, respectively, payable to us under non-cancelable subleases.

 

Investments in Affiliates

 

We own certain investments which we do not consolidate and, accordingly, are accounted for under the equity method of accounting in accordance with our accounting policies as described in Note 1 to the consolidated financial statements. We have included the table below and the following discussion to provide investors with additional information on these investments. Investments in affiliates consist of the following as of December 31, 2002:

 

      

Ownership

Interests


    

Investment


  

Debt


  

Assets


             

(in millions)

    

CBM Joint Venture LLC

    

50

%

  

$

76

  

$

911

  

120 Courtyard hotels

JWDC Limited Partnership

    

55

%

  

 

37

  

 

95

  

JW Marriott, Washington, D.C.

Tiburon Golf Ventures, L.P.

    

49

%

  

 

20

  

 

—  

  

36-hole golf course

             

  

    

Total

           

$

133

  

$

1,006

    
             

  

    

 

One of our wholly-owned taxable REIT subsidiaries continues to own a 50% interest in a joint venture with Marriott International that owns, through two limited partnerships, 120 Courtyard by Marriott properties totaling approximately 17,550 rooms. The joint venture, CBM Joint Venture LLC, had approximately $911 million of debt at December 31, 2002. This debt is comprised of first mortgage loans secured by the properties owned by the two partnerships, senior notes secured by the ownership interest in one partnership and mezzanine debt with a face amount of $200 million. Amortization for the mortgage debt was approximately $30 million for the year ended December 31, 2002. The mezzanine debt is an obligation of the joint venture and was provided by an affiliate of Marriott International. All of the debt is non-recourse to, and not guaranteed by, us or any of our subsidiaries.

 

45


 

RevPAR at the Courtyard hotels declined 9.9% in 2002. Based on our current forecasts for 2003, we expect that these hotels will generate sufficient cash flow from operations to fund the respective debt service obligations of the two partnerships. However, because of seasonality issues, one of the partnerships is expected to make use of a senior note debt service reserve, as well as certain rights to require repayment to the partnership of certain expenses previously paid and subordination provisions for current payments in its ground leases and management agreements. In addition, we anticipate that the joint venture will defer interest payments on the mezzanine debt at least until the second half of 2003. Deferral of the interest payments due on the mezzanine debt is not a default. To the extent deferred, unpaid balances are added to principal and earn interest at 13%. As of December 31, 2002, the partnerships and the joint venture maintained aggregate cash balances of approximately $23 million.

 

We currently have a non-controlling investment in a partnership that owns the JW Marriott hotel in Washington, D.C. The partnership, JWDC Limited Partnership, is the borrower under a $95.3 million mortgage loan that matures in December 2003. The mortgage is secured by the hotel and is non-recourse to us. Between January 15, 2003 and June 30, 2003, we have the option to purchase the 44.4% limited partner interest of one of the partners for the fair value of the interest (approximately $3 million). We also have the option to purchase our co-general partner’s 1% general partner interest for the lesser of $375,000 or fair value of the interest in the second quarter of 2003. Absent other circumstances, we intend to exercise these rights and will begin to consolidate the partnership, at which time we will repay or refinance the mortgage loan.

 

We currently have a 49% interest in Tiburon Golf Ventures, L.P., which owns the 36-hole Greg Norman-designed golf course surrounding The Ritz-Carlton, Naples Golf Resort.

 

We own minority interests in two partnerships. One owns the Budapest Marriott, and the other owns the Des Moines Marriott. We also own minority preferred shares in STSN, Inc., a technology service provider company. As a result of operating losses at these investments, we wrote the carrying value down to zero prior to January 1, 2000. Further, we have not received any distributions from these investments. We do not have any guarantees or commitments in relation to any of these interests. We do incur immaterial expenses related to these investments. If we are able to dispose of these investments, we will recognize a gain in an amount equal to the proceeds received.

 

During the second and third quarters of 2002, we sold our 1% general partner interests in the Marriott Residence Inn Limited Partnership and Marriott Residence Inn II Limited Partnership, which owned 15 and 23 Residence Inn properties, respectively.

 

For a more detailed discussion of our other real estate investments, which includes a summary of the outstanding debt balances of our affiliates, see Note 4 to the consolidated financial statements.

 

Guarantees

 

We have certain guarantees, which consist of commitments we have made to third parties for leases or debt, that are not on our books due to various dispositions, spin-offs and contractual arrangements, but that we have agreed to pay in the event of certain circumstances including default by an unrelated party. We consider the likelihood of any material payments under these guarantees to be remote. The guarantees are listed below:

 

    We remain contingently liable for leases on certain divested non-lodging properties. These primarily represent divested restaurants that were sold subject to our guarantee of rental payments. The amount is approximately $48 million as of December 31, 2002.

 

   

In connection with the sale of the El Paso Marriott hotel in 1999, we provided a guarantee to the City of El Paso in the event the purchaser, Columbia Sussex, defaults on bonds supported by the cash flows from the hotel. However, the purchaser also provided a standby letter of credit, a corporate guaranty and has been making sinking fund deposits, all of which would serve as collateral to the extent our

 

46


 

guarantee was called. Our guarantee supports the $14 million of bonds outstanding as of December 31, 2002. We have elected to exercise our right under the guarantee to require Columbia Sussex to retire the bonds prior to June 14, 2003. We are obligated to pay a 1%, or $140,000, prepayment penalty in connection with the early retirement of this debt at the time of such retirement.

 

    We are obligated under the partnership agreement (and various tax-sharing agreements with former affiliated entities) to pay all taxes (federal, state, local and foreign—including any related interest and penalties) incurred by us, as well as any liabilities that the IRS successfully may assert against us and under certain circumstances against former affiliated entities. As the potential liability is based in part on a finding by a specific taxing authority, these amounts cannot be estimated at this time.

 

    In 1997, we owned Leisure Park Venture Limited Partnership, which owns and operates a senior living facility. We spun-off the partnership as part of Crestline in the REIT conversion, but we remain obligated under a guarantee of interest and principal with regard to $14.7 million of municipal bonds issued by the New Jersey Economic Development Authority through their maturity in 2027. However, to the extent we are required to make any payments under the guarantee, we have been indemnified by Crestline, who is indemnified by the subsequent purchaser of the facility.

 

Insurance

 

Insurance Recovery and Revenue Recognition for the Terrorist Acts.    We are working closely with our insurance companies to resolve our claims related to the destruction of the Marriott World Trade Center and the damage to the New York Marriott Financial Center, including negotiating insurance payments for property damage, as well as business interruption. At the same time, we are working with the Port Authority of New York and New Jersey, or Port Authority, and the Lower Manhattan Development Corporation to determine how the World Trade Center site in New York will be redeveloped, though we anticipate that it will be several years before these issues are resolved. In accordance with accounting rules, we wrote off the $129 million net book value of the World Trade Center hotel in the fourth quarter of 2001 and recorded a corresponding receivable for property insurance proceeds due to us under the terms of our insurance contract.

 

Our property insurance policy covering the Marriott World Trade Center provides payment of full replacement costs to rebuild the hotel. We are required to rebuild the hotel under the terms of our ground lease with the Port Authority and are currently developing an estimate of the replacement cost of the hotel. Should the plan developed for the World Trade Center site not include a hotel, we have two options under our insurance policy: first would be to apply the replacement cost to acquiring or constructing a hotel at another location; second would be to accept a lesser amount as defined in the insurance policy and not be required to apply that amount toward the acquisition or development of a hotel. We have received minimal insurance proceeds for property damage at the Marriott World Trade Center and, to the extent that we receive additional funds, they will be held in escrow by a trustee until there is a final resolution on rebuilding.

 

We reopened the New York Marriott Financial Center on January 7, 2002. We have received a total of approximately $6 million in insurance proceeds for property damage to this hotel, which have been used to pay for building repairs.

 

We expect to continue to receive business interruption proceeds for what we believe our operating results would have been at the Marriott World Trade Center absent the terrorist attacks, although the timing of the receipt of some of these proceeds cannot be determined with certainty.

 

Since September 11, 2001, we have received $35 million in business interruption insurance with respect to the two hotels. These proceeds have been offset by $12.1 million of operating expenses for the same period, primarily representing net operating losses at the New York Marriott Financial Center, ground lease payments at the Marriott World Trade Center and severance and other payroll costs. As a result of the resolution of certain contingencies related to a portion of the insurance recoveries, we were able to recognize approximately

 

47


$17 million of income associated with business interruption insurance on these two properties during 2002, which is recorded in other hotel sales on the consolidated statements of operations.

 

Insurance Coverage.    Certain of our lenders require us to obtain adequate or full replacement cost “all-risk” property insurance through insurers that maintain certain ratings from Standard & Poor’s, A.M. Best or other rating agencies. During the annual renewal of our property insurance policies, which was completed during the second quarter of 2002, our managers and/or brokers purchased the property insurance program that was commercially reasonable and available at that time. However, we were unable to obtain full and complete terrorism insurance coverage for all types of terrorist attacks, although the passage of the Terrorism Risk Insurance Act of 2002 significantly improved the levels and breadth of coverage available. Further, certain of our insurance carriers did not meet lender rating requirements at the time of the renewal. As a result of the terrorist attacks of September 11, 2001, the economic downturn and the potential for additional terrorist attacks, one of our major carriers on the Marriott International property program was downgraded by the rating agencies, thereby exacerbating the rating non-compliance issue. We have notified our lenders and they have waived the requirement or provided written assurances that they are satisfied with our insurance regarding compliance with these covenants, although the lenders have reserved the right to enforce coverage and rating requirements. If we are required to obtain new or additional insurance, or if the lenders or servicers exercise their rights to purchase such coverage on our behalf and charge us for it, it is likely that the premiums will be higher and the increase in cost could be material. For further discussion see “Risk Factors—Risks of Operations—We may be unable to satisfy the insurance requirements of our lenders given the changes in the insurance industry after the terrorist attacks of September 11, 2001.

 

Insurance Coverage on Mexican Properties.    We carry comprehensive insurance coverage for general liability, property, business interruption and other risks with respect to all of our hotels and other properties. These policies offer coverage features and insured limits that we believe are customary for similar type properties. One of our properties, the Mexico City Marriott Airport hotel has experienced a measurable amount of settlement during the past several years. While settlement of buildings in the region of Mexico City where the hotel is located is common and widespread, our hotel has shown different degrees of settlement in different parts of the building. While we have commenced remediation activities at this hotel, there can be no assurance that such remediation will successfully correct the uneven settlement. If we are unable to correct the uneven settlement to the satisfaction of our insurers, any resulting property loss or loss of ability to use the hotel may not be covered by insurance. The net book value of the hotel was $35 million at December 31, 2002.

 

FFO and EBITDA

 

Set forth below are two non-GAAP financial measures that we use and that we believe are useful to investors: Comparative Funds From Operations (or FFO) Available to Common Stockholders, which we refer to as Comparative FFO, and Earnings Before Interest Expense, Taxes, Depreciation and Amortization and other non-cash items, or EBITDA. Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminish predictably over time. Since real estate values instead have historically risen or fallen with market conditions, most industry investors have considered presentation of operating results for real estate companies that use historical cost accounting to be misleading or uninformative. The National Association of Real Estate Investment Trusts, or NAREIT, adopted the definition of Funds From Operations, or FFO, in order to promote an industry-wide standard measure of REIT operating performance that would not have certain drawbacks associated with net income under accounting principles generally accepted in the United States of America, or GAAP. Management believes that the presentation of Comparative FFO (defined below) provides useful information to investors regarding our financial condition and results of operations because it is a measure of our ability to service debt, fund capital expenditures and expand our business.

 

However, Comparative FFO and EBITDA as presented may not be comparable to amounts calculated by other companies. This information should not be considered as an alternative to net income, operating profit, cash from operations, or any other operating performance measure prescribed by GAAP. Cash expenditures for

 

48


various long-term assets, interest expense (for EBITDA purposes only) and other items have been and will be incurred and are not reflected in the EBITDA and Comparative FFO presentations.

 

Comparative FFO.    NAREIT defines FFO as net income (computed in accordance with GAAP) excluding gains (or losses) from sales of real estate and real estate-related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Comparative FFO consists of FFO adjusted for significant non-recurring items such as the repurchase of the leasehold interests in 2000 and 2001 and tax refunds in 2002. We also adjust FFO to reflect the payment of our preferred distributions as these funds are not available to common OP unitholders, which is consistent with the calculation of net income available to common shareholders under GAAP.

 

EBITDA.    Management believes that the presentation of EBITDA provides useful information to investors regarding our financial condition and results of operations because EBITDA is useful for evaluating our capacity to incur and service debt, fund capital expenditures and to expand our business. Specifically, our lenders and rating agencies believe that EBITDA is a better measure of unleveraged cash flow that can be isolated by asset and is utilized to determine our ability to service debt. Restrictive covenants in our senior notes indenture and our credit facility each contain incurrence ratios based on EBITDA. Management also uses EBITDA as one measure in determining the value of acquisitions and dispositions.

 

As a result of the decline in operations, EBITDA decreased $84 million, or 8.9%, to $863 million in 2002 from $947 million in 2001. Comparative FFO available to common shareholders also decreased $90 million, or 21.4%, to $330 million in 2002 over 2001. The following is a reconciliation of income from continuing operations to EBITDA and Comparative FFO (in millions):

 

      

Year Ended


 
      

December 31,

2002


      

December 31,

2001


 

Income (loss) from continuing operations

    

$

(32

)

    

$

62

 

EBITDA from discontinued operations

    

 

 

    

 

3

 

Interest expense

    

 

500

 

    

 

491

 

Depreciation and amortization

    

 

372

 

    

 

374

 

Minority interest expense

    

 

8

 

    

 

16

 

Income taxes

    

 

6

 

    

 

9

 

Lease repurchase expense

    

 

 

    

 

5

 

Equity in (earnings) losses of affiliates

    

 

9

 

    

 

(3

)

Other changes, net

    

 

 

    

 

(10

)

      


    


EBITDA of Host LP

    

 

863

 

    

 

947

 

Interest expense

    

 

(500

)

    

 

(491

)

Distributions on preferred OP Units

    

 

(35

)

    

 

(32

)

Income taxes

    

 

(6

)

    

 

(9

)

Partnership adjustments and other

    

 

 

    

 

13

 

Adjustments for discontinued operations

    

 

 

    

 

(2

)

Tax benefit of lease repurchase(1)

    

 

12

 

    

 

10

 

Tax effect of nonrecurring items(2)

    

 

(4

)

    

 

(16

)

      


    


Comparative Funds From Operations of Host LP available to common unitholders

    

$

330

 

    

$

420

 

      


    



(1)   This adjustment reflects the realization of the income tax benefit from the purchase of 120 leasehold interests at year-end 2000 and June 2001.
(2)   Comparative FFO is adjusted to reflect the effect of non-recurring items in the current period tax provision/(benefit), including the resolution of prior year tax matters and other items.

 

49


 

Our interest coverage, defined as EBITDA divided by cash interest expense, was 1.8 times, 2.0 times and 2.4 times for 2002, 2001 and 2000, respectively. The ratio of earnings to fixed charges and preferred OP Unit distributions was 1.1 to 1.0 and 1.2 to 1.0, in 2001 and 2000, respectively. In 2002, we had a deficiency of earnings to fixed charges and preferred OP Unit distributions of $34 million, primarily due to depreciation expense. In accordance with Securities and Exchange Commission regulations, the ratio is calculated as the sum of pre-tax income from continuing operations before adjustments for minority interest and income (loss) from equity investments plus amortization of capitalized interest, distributions from equity investments and fixed charges less capitalized interest and distributions on preferred OP Units divided by fixed charges which is the sum of interest expensed and capitalized, and preferred units and the estimate of interest within rental expense. See Exhibit 12.1.

 

Inflation.    Our properties have been impacted by inflation through its effect on increasing costs. Unlike other real estate, hotels have the ability to set rent (room rates) levels on a daily basis, so the impact of higher inflation often can be passed on to customers. However, the current weak economic environment has resulted in a decline in demand and has restricted our managers’ ability to raise room rates to offset rising costs.

 

Critical Accounting Policies.    Our consolidated financial statements include accounts of the company and all consolidated subsidiaries. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. While we do not believe the reported amounts would be materially different, application of these policies involves the exercise of judgment and the use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. All of our significant accounting policies are disclosed in Note 1 to our consolidated financial statements. The following represent certain critical accounting policies that require the use of business judgment or significant estimates to be made:

 

    Determination of Fair Value of Long-lived Assets.    The determination of the fair value or impairment of assets is based on a number of assumptions including results of future operations and expected cash flows. Judgment is required for determining the growth rate of these properties, the need for capital expenditures, as well as specific market and economic conditions. Additionally, the timing of this determination can be affected by the classification of these assets as held-for-sale.

 

    Depreciation and Amortization Expense.    Depreciation expense is based on the estimated useful life of our assets. Amortization expense for leasehold improvements is the shorter of the lease term or the estimated useful life of the related assets. The life of the assets are based on a number of assumptions, including cost and timing of capital expenditures to maintain and refurbish the assets, as well as specific market and economic conditions. While management believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income or the gain or loss on the sale of any of the assets.

 

    Incentive Management Fees.    Incentive management fees due to managers are accrued when earned, whether or not paid, based on stated formulas in management agreements. However, judgment can be required during interim reporting periods as a result of the change in allocation ratios at specified times or upon the occurrence of certain events. Fees earned on a full year basis are not affected because the management fees are determined annually; however, there can be variation among the quarters which may affect reported results.

 

    Consolidation policies.    Judgment is required with respect to the consolidation of partnership and joint venture entities in the evaluation of control, including assessment of the importance of rights and privileges of the partners based on voting rights, as well as financial interests that are not controllable through voting interests. Currently, we have investments in entities that in the aggregate own 123 hotel properties and other investments which we record using the equity method of accounting. The debt on these investments is non-recourse to the company and the effect of their operations on our results of operations is not material. For further detail on our unconsolidated entities see Note 4 to our consolidated financial statements.

 

50


 

New Accounting Standards.    In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” This interpretation requires an existing unconsolidated variable interest entity to be consolidated by their primary beneficiary if the entity does not effectively disperse risk among all parties involved or if other parties do not have significant capital to finance activities without subordinated financial support from the primary beneficiary. The primary beneficiary is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity. This interpretation is effective immediately for variable interest entities created after January 31, 2003 and no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003 for interests in variable interest entities that were acquired prior to February 1, 2003. Absent other circumstances, we believe that this interpretation will require us to consolidate the JWDC Limited Partnership, which owns the JW Marriott hotel in Washington, D.C., during 2003. For more detail on our ownership interest in the JWDC Limited Partnership, see Note 4 to our consolidated financial statements.

 

In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FASB Interpretation No. 34. This interpretation outlines disclosure requirements in a guarantor’s financial statements relating to any obligations under guarantees for which it may have potential risk or liability, as well as clarifies a guarantor’s requirement to recognize a liability for the fair value, at the inception of the guarantee, of an obligation under that guarantee. The initial recognition and measurement provisions of this interpretation are effective for guarantees issued or modified after December 31, 2002 and the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. As of March 1, 2003, we have not provided any guarantees that would require recognition as liabilities under this interpretation. We have disclosed guarantees in accordance with this interpretation in this report on Form 10-K.

 

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The standard requires the recognition of costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. We do not expect the statement to have a significant impact on our financial position or operating results.

 

In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” The provisions of this standard, which primarily relate to the rescission of Statement 4, eliminate the requirement that gains and losses from the extinguishment of debt be classified as extraordinary items unless it can be considered unusual in nature and infrequent in occurrence. These provisions are effective in fiscal years beginning after May 15, 2002. We will implement the provisions of SFAS No. 145 beginning in fiscal year 2003. At the time of implementation, we will reclassify any gains or losses from debt extinguishments in prior periods as income (loss) from operations. We do not expect the statement to have a significant impact on our financial position or operating results.

 

In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” which replaces SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets” to determine when a long-lived asset should be classified as held for sale, among other things. Those criteria specify that the asset must be available for immediate sale in its present condition, subject only to terms that are usual and customary for sales of such assets, and the sale of the asset must be probable, and its transfer expected to qualify for recognition as a completed sale, within one year. This Statement is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 requires that for dispositions after the Statement’s effective date, gains and losses from the dispositions of investment properties and the properties’ historical operating results will be treated as discontinued operations, and therefore, be classified separately from income from continuing operations. Prior period operating results of disposed assets previously included in

 

51


continuing operations must be reclassified as discontinued operations for all periods presented, although net income is not affected. As a result of the transfer of the St. Louis Marriott Pavilion to the mortgage lender in 2002, we have restated the statement of operations for all periods presented to reflect the operations of the property as discontinued operations (See Note 12 to our consolidated financial statements). We do not expect the statement to have a significant impact on our financial position or operating results.

 

Change in Accounting for Stock Options

 

At December 31, 2002, Host REIT has two stock-based employee compensation plans, which are described more fully in Note 10 to our consolidated financial statements. Prior to 2002, Host REIT accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No stock-based employee compensation cost relating to the employee stock option plan is reflected in 2001 and 2000 net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In addition, no stock-based employee compensation cost relating to the employee stock purchase plan is reflected in 2001 and 2000 net income as the plan was considered non-compensatory under APB 25. Effective January 1, 2002, Host REIT adopted the fair value recognition provisions of the Financial Accounting Standards Board’s SFAS No. 123, “Accounting for Stock-Based Compensation,” prospectively to all employee awards granted, modified or settled after January 1, 2002. Awards under its employee stock option plan generally vest over four years. Therefore, the cost related to stock-based employee compensation included in the determination of net income for 2002 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123. The adoption of SFAS No. 123 did not change the calculation of stock-based employee compensation costs for shares granted under our deferred stock and restricted stock plans.

 

Item 7a.    Quantitative and Qualitative Disclosures about Market Risk

 

Interest Rate Sensitivity

 

The table below provides information about our derivative financial instruments and other financial instruments that are sensitive to changes in interest rates, including interest rate swaps and debt obligations. For debt obligations, the table presents scheduled maturities and related weighted average interest rates by expected maturity dates. For interest rate swaps, the table presents notional amounts and weighted average interest rates by expected (contractual) maturity dates. Weighted average interest rates are based on implied forward rates in the yield curve as of December 31, 2002. Notional amounts are used to calculate the contractual payments to be exchanged under the contract. Weighted average variable rates are presented in U.S. dollar equivalents, which is the company’s reporting currency.

 

    

Expected Maturity Date


    

2003


    

2004


    

2005


    

2006


    

2007


    

There-  

after


    

Total


  

Fair

Value


    

($ in millions)

Liabilities

                                                                   

Debt:

                                                                   

Fixed Rate

  

$

135

 

  

$

81

 

  

$

558

 

  

$

647

 

  

$

906

 

  

$

3,707

 

  

$

6,034

  

$

5,992

Average interest rate

  

 

8.1

%

  

 

8.1

%

  

 

8.1

%

  

 

8.0

%

  

 

7.9

%

  

 

7.8

%

             

Variable Rate

                                                                   

Canadian mortgage

  

$

1

 

  

$

1

 

  

$

2

 

  

$

92

 

  

$

 

  

$

 

  

 

96

  

 

102

Average interest rate

  

 

4.5

%

  

 

5.8

%

  

 

6.7

%

  

 

7.3

%

  

 

%

  

 

%

             
                                                          

  

Total Debt

                                                        

$

6,130

  

$

6,094

Interest Rate Derivatives

                                                                   

Interest Rate Swaps

                                                                   

Fixed to Variable

  

$

 

  

$

 

  

$

 

  

$

 

  

$

450

 

  

$

 

  

$

450

  

$

40

Average pay rate

  

 

6.2

%

  

 

7.6

%

  

 

8.4

%

  

 

9.0

%

  

 

9.6

%

  

 

%

             

Average receive rate

  

 

9.5

%

  

 

9.5

%

  

 

9.5

%

  

 

9.5

%

  

 

9.5

%

  

 

%

             

 

52


 

Under SFAS 133, “Accounting for Derivatives and Hedging Activities,” as it relates to our derivative products, we have entered into an interest rate swap that is designated as a fair value hedge and is treated as a hedge for tax purposes. Since the requirements for hedge accounting have been met, the swap is recorded at fair value on the balance sheet with changes in the fair value recorded to the carrying value of the Series I senior notes. Additionally, the amounts paid or received under the swap agreement will be recognized over the life of the agreement as an adjustment to interest expense. This interest rate swap agreement converted our payment obligations on the $450 million amount from a fixed rate to a floating rate based on one-month LIBOR plus 4.5%. A change in the LIBOR rate of 100 basis points will result in $4.5 million increase or decrease in our annual interest expense.

 

On January 4, 2002, in a separate agreement with a different counterparty, we purchased, for approximately $3 million, an interest rate cap with the same notional amount ($450 million) which caps the floating interest rate at 14% on the swap agreement for the Series I debt. In August 2001, we purchased an interest rate cap as part of our refinancing of $96.6 million of debt on our Canadian properties. The interest rate cap was purchased for approximately $0.4 million and is based on a notional amount ($48.3 million) which caps the floating interest rate at 10.75%. Under SFAS 133, the caps do not qualify for hedge accounting, and, therefore, will be marked to market and the gains and losses from changes in the market value of the caps will be recorded in other income or expense in the current period.

 

As of December 31, 2002, approximately 90% of our debt bears interest at fixed rates. This debt structure largely mitigates the impact of changes in the rate of inflation on future interest costs. We have some financial instruments that are sensitive to changes in interest rates, including our credit facility. The interest rate on our credit facility is based on a spread over LIBOR, ranging from 2.5% to 3.75%. There were no amounts outstanding on our credit facility at December 31, 2002. The weighted average interest rate for our credit facility was 5.5% for the year ended December 31, 2002. The weighted average interest rate for the prior credit facility was 4.4% for the year ended December 31, 2001. The prior credit facility was repaid in full in December 2001 with the net proceeds from the offering of the Series H senior notes, which were subsequently exchanged for Series I senior notes, and a portion of the proceeds from the sale of two properties.

 

Exchange Rate Sensitivity

 

The table below summarizes information on instruments and transactions that are sensitive to foreign currency exchange rates, including foreign currency forward exchange agreements. For foreign currency forward exchange agreements, the table presents the notional amounts and weighted average exchange rates by expected (contractual) maturity dates. These notional amounts generally are used to calculate the contractual payments to be exchanged under the contract.

 

    

Expected Maturity Date


    

2003


  

2004


  

2005


  

2006


  

2007


  

There-

after


  

Total


  

Fair

Value


Anticipated Transactions and Related Derivatives

                                                       

Foreign Currency Forward

                                                       

Exchange Agreements Contract Amount, in millions

  

$

8.3

  

$

8.9

  

$

9.2

  

$

97.0

  

$

  —

  

$

  —

  

$

123.4

  

$

127.2

Average Contractual Exchange Rate

  

 

1.56

  

 

1.56

  

 

1.57

  

 

1.57

  

 

  

 

             

 

On August 30, 2001, our Canadian subsidiaries entered into a mortgage loan pursuant to which they borrowed $96.6 million (denominated in U.S. dollars) at a variable rate of LIBOR plus 2.75%. The Calgary Marriott, Toronto Airport Marriott, Toronto Marriott Eaton Centre, and Toronto Delta Meadowvale hotels serve as collateral for this financing. In addition, since the mortgage loan on these Canadian properties is denominated

 

53


in U.S. Dollars and the functional currency of the Canadian subsidiaries is the Canadian Dollar, the subsidiaries entered into currency forward contracts to hedge the currency exposure of converting Canadian dollars to U.S. dollars on a monthly basis to cover debt service payments. This swap has been designated as a cash flow hedge of the debt service payments, and the forward contracts are recorded at fair value on the balance sheet with offsetting changes recorded in accumulated other comprehensive income. The fair value of the forward contracts is recorded each period. The weighted average interest rate for this mortgage loan was 4.6% and 5.5%, respectively, for the years ended December 31, 2002 and 2001. The fair value of the forward contracts was $3.8 million and $1.5 million, respectively, at December 31, 2002 and 2001.

 

Item 8.    Financial Statements and Supplementary Data

 

The following financial information is included on the pages indicated:

 

Host Marriott, L.P.

 

    

Page


Independent Auditor’s Report

  

55

Consolidated Balance Sheets as of December 31, 2002 and 2001

  

56

Consolidated Statements of Operations for the Years Ended December 31, 2002, 2001 and 2000

  

57

Consolidated Statements of Partners’ Capital and Comprehensive Income for the Years Ended December 31, 2002, 2001 and 2000

  

58

Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000

  

59

Notes to Consolidated Financial Statements

  

61

 

54


INDEPENDENT AUDITORS’ REPORT

 

The Partners

Host Marriott, L.P.:

 

We have audited the accompanying consolidated balance sheets of Host Marriott, L.P. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, partners’ capital and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the consolidated financial statements, we have also audited the financial statement Schedule III as listed in the index as Item 15(a)(ii). These consolidated financial statements and the financial statement schedule are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 Host Marriott, L.P. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule referred to above, 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.

 

As discussed in note 1, the Partnership adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets in 2002.

 

KPMG LLP

 

McLean, Virginia

February 24, 2003

 

55


HOST MARRIOTT, L.P. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

December 31, 2002 and 2001

 

    

2002


    

2001


 
    

(in millions)

 

ASSETS

                 

Property and equipment, net

  

$

7,031

 

  

$

6,999

 

Notes and other receivables (including amounts due from affiliates of $6 million and $6 million, respectively)

  

 

53

 

  

 

54

 

Due from managers

  

 

82

 

  

 

141

 

Investments in affiliates

  

 

133

 

  

 

142

 

Other assets

  

 

518

 

  

 

532

 

Restricted cash

  

 

133

 

  

 

114

 

Cash and cash equivalents

  

 

361

 

  

 

352

 

    


  


    

$

8,311

 

  

$

8,334

 

    


  


LIABILITIES AND PARTNERS’ CAPITAL

                 

Debt

                 

Senior notes

  

$

3,247

 

  

$

3,235

 

Mortgage debt

  

 

2,289

 

  

 

2,261

 

Convertible debt obligation to Host Marriott Corporation

  

 

492

 

  

 

492

 

Other

  

 

102

 

  

 

106

 

    


  


    

 

6,130

 

  

 

6,094

 

Accounts payable and accrued expenses

  

 

118

 

  

 

121

 

Other liabilities

  

 

252

 

  

 

320

 

    


  


Total liabilities

  

 

6,500

 

  

 

6,535

 

    


  


Minority interest

  

 

92

 

  

 

108

 

Limited partnership interests of third parties at redemption value (representing 27.7 million units and 21.6 million units at December 31, 2002 and 2001, respectively)

  

 

245

 

  

 

194

 

Partners’ capital

                 

General partner

  

 

1

 

  

 

1

 

Cumulative redeemable preferred limited partner

  

 

339

 

  

 

339

 

Limited partner

  

 

1,136

 

  

 

1,162

 

Accumulated other comprehensive loss

  

 

(2

)

  

 

(5

)

    


  


Total partners’ capital

  

 

1,474

 

  

 

1,497

 

    


  


    

$

8,311

 

  

$

8,334

 

    


  


 

See Notes to Consolidated Financial Statements.

 

56


HOST MARRIOTT, L.P. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

Years Ended December 31, 2002 and 2001 and 2000

(in millions, except per common unit amounts)

 

    

2002


    

2001


    

2000


 

REVENUES

                          

Rooms

  

$

2,167

 

  

$

2,222

 

  

$

 

Food and beverage

  

 

1,146

 

  

 

1,125

 

  

 

 

Other

  

 

266

 

  

 

282

 

  

 

 

    


  


  


Total hotel sales

  

 

3,579

 

  

 

3,629

 

  

 

 

Rental income

  

 

101

 

  

 

136

 

  

 

1,398

 

Other income

  

 

 

  

 

2

 

  

 

9

 

    


  


  


Total revenues

  

 

3,680

 

  

 

3,767

 

  

 

1,407

 

    


  


  


OPERATING COSTS AND EXPENSES

                          

Rooms

  

 

533

 

  

 

541

 

  

 

 

Food and beverage

  

 

847

 

  

 

843

 

  

 

 

Hotel departmental expenses

  

 

951

 

  

 

945

 

  

 

 

Management fees

  

 

161

 

  

 

177

 

  

 

 

Other property-level expenses

  

 

301

 

  

 

298

 

  

 

276

 

Depreciation and amortization

  

 

372

 

  

 

374

 

  

 

331

 

Corporate expenses

  

 

30

 

  

 

32

 

  

 

42

 

Lease repurchase expense

  

 

 

  

 

5

 

  

 

207

 

Other expenses

  

 

19

 

  

 

19

 

  

 

24

 

    


  


  


OPERATING PROFIT

  

 

466

 

  

 

533

 

  

 

527

 

Minority interest expense

  

 

(8

)

  

 

(16

)

  

 

(27

)

Interest income

  

 

20

 

  

 

36

 

  

 

40

 

Interest expense

  

 

(500

)

  

 

(491

)

  

 

(466

)

Net gains on property transactions

  

 

5

 

  

 

6

 

  

 

6

 

Equity in earnings (losses) of affiliates

  

 

(9

)

  

 

3

 

  

 

27

 

    


  


  


INCOME (LOSS) BEFORE INCOME TAXES

  

 

(26

)

  

 

71

 

  

 

107

 

Benefit from (provision for) income taxes

  

 

(6

)

  

 

(9

)

  

 

98

 

    


  


  


INCOME (LOSS) FROM CONTINUING OPERATIONS

  

 

(32

)

  

 

62

 

  

 

205

 

Income (loss) from discontinued operations

  

 

7

 

  

 

(3

)

  

 

(2

)

    


  


  


INCOME (LOSS) BEFORE EXTRAORDINARY ITEM

  

 

(25

)

  

 

59

 

  

 

203

 

Extraordinary gain (loss) on the extinguishment of debt

  

 

6

 

  

 

(2

)

  

 

4

 

    


  


  


NET INCOME (LOSS)

  

 

(19

)

  

 

57

 

  

 

207

 

Less: Distributions on preferred units

  

 

(35

)

  

 

(32

)

  

 

(20

)

    


  


  


NET INCOME (LOSS) AVAILABLE TO COMMON UNITHOLDERS

  

$

(54

)

  

$

25

 

  

$

187

 

    


  


  


BASIC EARNINGS (LOSS) PER COMMON UNIT:

                          

Continuing operations

  

$

(.23

)

  

$

.11

 

  

$

.65

 

Discontinued operations

  

 

.02

 

  

 

(.01

)

  

 

(.01

)

Extraordinary gain (loss)

  

 

.02

 

  

 

(.01

)

  

 

.02

 

    


  


  


BASIC EARNINGS (LOSS) PER COMMON UNIT

  

$

(.19

)

  

$

.09

 

  

$

.66

 

    


  


  


DILUTED EARNINGS PER (LOSS) COMMON UNIT:

                          

Continuing operations

  

$

(.23

)

  

$

.11

 

  

$

.64

 

Discontinued operations

  

 

.02

 

  

 

(.01

)

  

 

(.01

)

Extraordinary gain (loss)

  

 

.02

 

  

 

(.01

)

  

 

.02

 

    


  


  


DILUTED EARNINGS (LOSS) PER COMMON UNIT

  

$

(.19

)

  

$

.09

 

  

$

.65

 

    


  


  


 

See Notes to Consolidated Financial Statements.

 

57


HOST MARRIOTT, L.P. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF PARTNERS’ CAPITAL

AND COMPREHENSIVE INCOME

 

Years Ended December 31, 2002, 2001 and 2000

(in millions)

 

Class A, B and C Preferred

Units

Outstanding


  

Common

OP Units

Outstanding


        

Preferred

Limited

Partner


 

General

Partner


 

Limited

Partner


      

Accumulated

Other

Comprehensive

Income (Loss)


      

Comprehensive

Income (Loss)


 

8.1

  

219.7

 

 

Balance, December 31, 1999

  

$

196

 

$

1

 

$

1,122

 

    

$

2

 

          

  

—  

 

 

Net income

  

 

—  

 

 

—  

 

 

207  

 

    

 

 

    

$

207

 

  

—  

 

 

Other comprehensive income (loss):

                                          
          

Foreign currency translation adjustment

  

 

—  

 

 

—  

 

 

—  

 

    

 

(2

)

    

 

(2

)

          

Unrealized gain on HM Services common stock to net income

  

 

—  

 

 

—  

 

 

—  

 

    

 

(1

)

    

 

(1

)

                                                 


  

—  

 

 

Comprehensive income

                                    

$

204

 

                                                 


  

3.3

 

 

Units issued to Host Marriott for the comprehensive stock and employee stock purchase plans

  

 

—  

 

 

—  

 

 

15

 

    

 

—  

 

          

  

0.7

 

 

Redemptions of limited partnership interests

  

 

—  

 

 

—  

 

 

(3

)

    

 

—  

 

          

  

—  

 

 

Distributions on OP Units

  

 

—  

 

 

—  

 

 

(259

)

    

 

—  

 

          

  

—  

 

 

Distributions on Preferred Limited Partner Unit

  

 

—  

 

 

—  

 

 

(21

)

    

 

—  

 

          

  

(4.9

)

 

Repurchases of OP Units

  

 

—  

 

 

—  

 

 

(44

)

    

 

—  

 

          

  

—  

 

 

Market adjustment to record Preferred OP Units and OP Units of third parties at redemption value

  

 

—  

 

 

—  

 

 

(291

)

    

 

—  

 

          

8.1

  

218.8

 

 

Balance, December 31, 2000

  

 

196

 

 

1

 

 

726

 

    

 

(1

)

          

  

—  

 

 

Net income

  

 

—  

 

 

—  

 

 

57

 

    

 

—  

 

    

$

57

 

  

—  

 

 

Other comprehensive income (loss):

                                          
          

Foreign currency translation adjustment

  

 

—  

 

 

—  

 

 

—  

 

    

 

(3

)

    

 

(3

)

          

Unrealized gain on HM Services common stock to net income

  

 

—  

 

 

—  

 

 

—  

 

    

 

(1

)

    

 

(1

)

                                                 


  

—  

 

 

Comprehensive income

                                    

$

53

 

                                                 


  

0.5

 

 

Units issued to Host Marriott for the comprehensive stock and employee stock purchase plans

  

 

—  

 

 

—  

 

 

5

 

    

 

—  

 

          

  

42.1

 

 

Redemptions of limited partnership interests

  

 

—  

 

 

—  

 

 

547

 

    

 

—  

 

          

  

—  

 

 

Distributions on OP Units

  

 

—  

 

 

—  

 

 

(222

)

    

 

—  

 

          

  

—  

 

 

Distributions on Preferred Limited Partner Units

  

 

—  

 

 

—  

 

 

(32

)

    

 

—  

 

          

6.0

  

—  

 

 

Issuance of Preferred OP Units

  

 

143

 

 

—  

 

 

—  

 

    

 

—  

 

          

  

—  

 

 

Market adjustment to record Preferred OP Units and OP Units of third parties at redemption value

  

 

—  

 

 

—  

 

 

81

 

    

 

—  

 

          

14.1

  

261.4

 

 

Balance, December 31, 2001

  

 

339

 

 

1

 

 

1,162

 

    

 

(5

)

          

  

—  

 

 

Net income (loss)

  

 

—  

 

 

—  

 

 

(19

)

    

 

—  

 

    

$

(19

)

  

—  

 

 

Other comprehensive income (loss):

                                          
          

Foreign currency translation adjustment

  

 

—  

 

 

—  

 

 

—  

 

    

 

4

 

    

 

4

 

          

Unrealized gain on HM Services common stock to net income

  

 

—  

 

 

—  

 

 

—  

 

    

 

(1

)

    

 

(1

)

                                                 


  

—  

 

 

Comprehensive income

                                    

$

(16

)

                                                 


  

0.5

 

 

Units issued to Host Marriott for the comprehensive stock and employee stock purchase plans

  

 

—  

 

 

—  

 

 

8

 

    

 

—  

 

          

  

1.8

 

 

Redemptions of limited partnership interests of third parties

  

 

—  

 

 

—  

 

 

13

 

    

 

—  

 

          

  

—  

 

 

Distributions on Preferred Limited Partner Units

  

 

—  

 

 

—  

 

 

(35

)

    

 

—  

 

          

  

—  

 

 

Market adjustment to record Preferred OP Units and OP Units of third parties at redemption value

  

 

—  

 

 

—  

 

 

7

 

    

 

—  

 

          

14.1

  

263.7

 

 

Balance, December 31, 2002

  

$

339

 

$

1

 

$

1,136

 

    

$

(2

)

          

 

See Notes to Consolidated Financial Statements.

 

58


HOST MARRIOTT, L.P. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years Ended December 31, 2002, 2001 and 2000

 

 

    

2002


    

2001


    

2000


 
    

(in millions)

 

OPERATING ACTIVITIES

                          

Net income (loss)

  

$

(19

)

  

$

57

 

  

$

207