Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

At May 1, 2003, there were 42,785,856 outstanding shares of common stock, no par value, of the registrant.

Table of Contents

APPLE HOSPITALITY TWO, INC.

FORM 10-Q

INDEX

-2-

Table of Contents

-3-

Table of Contents

PART I.     FINANCIAL INFORMATION

Item 1     Financial Statements (Unaudited)

Apple Hospitality Two, Inc.
Consolidated Balance Sheets (Unaudited)

See notes to consolidated financial statements.

-4-

Table of Contents

Apple Hospitality Two, Inc.
Consolidated Statement of Operations (Unaudited)

See notes to consolidated financial statements.

-5-

Table of Contents

APPLE HOSPITALITY TWO, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (Unaudited)

See notes to consolidated financial statements.

-6-

Table of Contents

APPLE HOSPITALITY TWO, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See notes to consolidated financial statements.

-7-

Table of Contents

Notes to Consolidated Financial Statements

Note 1

General Information and Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information required by generally accepted accounting principles.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  These unaudited financials should be read in conjunction with the Company’s audited consolidated financial statements.

Organization

Apple Hospitality Two, Inc. (the “Company”), a Virginia corporation, was formed on January 17, 2001, with the first investor closing on May 1, 2001.  The Company merged with Apple Suites, Inc. on January 31, 2003 and balances are reflected accordingly.  The consolidated financial statements include the accounts of the Company and its subsidiaries.  All significant intercompany transactions and balances have been eliminated upon consolidation. 

The REIT Modernization Act, effective January 1, 2001, permits real estate investment trusts (“REIT”) to establish taxable businesses to conduct certain previously disallowed business activities. The Company has formed a wholly-owned taxable REIT subsidiary, Apple Hospitality Management, Inc., and has leased all of its hotels to Apple Hospitality Management, Inc. or its subsidiaries (collectively, the “Lessee”).

Stock Incentive Plans

The Company elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related Interpretations in accounting for its employee stock options. As discussed in Note 5, the alternative fair value accounting provided for under FASB Statement No. 123, “Accounting for Stock-Based Compensation,” (“FASB 123”) requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company’s stock options equals the market price of the underlying stock on the date of grant and other criteria are met, no compensation expense is recognized.

Compensation expense related to issuance of 202,500 Series B convertible preferred shares to Mr. Knight was recognized at such time when the number of shares to be issued for conversion of the Series B shares could be reasonably estimated and the Merger, which triggered the conversion of the Series B shares to shares was probable. The expense was measured as the difference between the fair value of the shares for which the Series B convertible preferred shares were converted and the amounts paid for the Series B convertible preferred shares.

The issuance of the Series B convertible preferred shares to other individuals not employed by the company is accounted for under FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Expense related to the issuance of the Series B convertible preferred shares was determined based on fair value of the Series B convertible preferred shares at grant date in excess of amounts paid by these individuals. Since the number of common shares to which the Series B convertible preferred shares could be converted was not known at grant date and ultimate convertibility to common shares is only allowed through a defined triggering event, the fair value of the Series B convertible preferred shares were remeasured and not recorded as expense until the Merger with Apple Suites triggered the conversion of the Series B convertible preferred shares.

Stock compensation expense included in the Statement of Operations for the period ended March 31, 2003 was $10,176,000, attributable to the conversion of all 240,000 B shares to common stock. The amount of stock compensation expense that would have been recognized had the fair value method prescribed under SFAS No. 123 been applied is also $10,176,000, as Merger triggered the conversion of the Class B convertible preferred shares and under a known conversion ratio. No stock compensation expense was recorded during the first quarter of 2002, nor would any have been recorded during the same period had the fair value method prescribed by FASB 123 been applied.

-8-

Table of Contents

Earnings Per Common Share

Basic earnings per common share is computed based upon the weighted average number of shares outstanding during the year. Diluted earnings per share is calculated after giving effect to all potential common shares that were dilutive and outstanding for the year. During 2002 Series B preferred convertible shares were not included in basic and diluted earnings per common share calculations, as their conversion to common stock was not considered probable during those periods.  Series C preferred convertible stock is included in basic and diluted earnings per common share as they are considered common stock equivalents.

Income Taxes

The Company is operated as, and will annually elect to be taxed as a REIT under Sections 856 to 860 of the Internal Revenue Code.  Earnings and profits, which will determine the taxability of distributions to shareholders, will differ from income reported for financial reporting purposes primarily due to the differences for federal income tax purposes in the estimated useful lives used to compute depreciation. 

The Lessee, as a taxable REIT subsidiary of the Company, is subject to federal and state income taxes.  The Lessee has a taxable loss during the three months ended March 31, 2003 and 2002. No benefit has been recorded since realization of such benefit is not probable.

Use of Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates.

Reclassifications

Certain reclassifications have been made to amounts in prior years’ financial statements to conform to current year presentation.

Note 2

Investment in Hotels

At March 31, 2003, the Company owned sixty-six hotels.  Ten of the hotels (the “Crestline Portfolio” or “Res III Portfolio”) were acquired by the Company in September 2001 from Crestline Capital Corporation and certain of its subsidiaries.  Fifteen of the Company’s hotels (the “Res I Portfolio”) were acquired effective February 22, 2002, and twenty-three (the “Res II Portfolio”) were acquired effective August 28, 2002.  An additional hotel in Redmond, Washington was acquired effective January 3, 2003.  Seventeen hotels were acquired in connection with the acquisition of Apple Suites, Inc on January 31, 2003.

-9-

Table of Contents

Investment in hotels consisted of the following:

Acquisition of Apple Suites, Inc.

The Company entered into a merger agreement with Apple Suites, Inc. (“Apple Suites”) on October 23, 2002. Effective January 31, 2003, Apple Suites merged with and into Hospitality Acquisition Company, the Company’s wholly-owned subsidiary.  Apple Suites owned, either directly or through its subsidiaries, a total of 17 upper-end extended-stay hotels throughout the United States, which comprised a total of 1,922 suites, and all of which are operated as part of the Homewood Suites® by Hilton® franchise system.  Mr. Glade M. Knight, Chairman and Chief Executive Officer of the Company was also the Chairman and Chief Executive Officer of Apple Suites, Inc.

Pursuant to the merger, each Apple Suites common share, issued and outstanding immediately prior to the effective time of the merger, was converted into the right to receive either: (i) one Unit of the Company, consisting of one common share of the Company and one Series A preferred share of the Company; or (ii) if the holder of an Apple Suites common share elected, $10.00 in cash per share, subject to a limit on the total amount of cash to be paid in the merger. As a result of the merger, holders of Apple Suites common shares received a total of 10,883,544 Units of the Company and approximately $17.8 million in cash. The Company funded the cash portion of the Merger consideration with available cash, and the Company assumed Apple Suites’ liability and paid certain merger costs.

In connection with acquisition of Apple Suites, Company shareholders were paid a special distribution of $0.497 per share, totaling approximately $15 million.

In connection with the acquisition of Apple Suites, Inc., the Company paid total consideration of $185 million, including assumption of liabilities and transaction costs.  Apple Suites assets and liabilities were recorded at fair value and no goodwill was recorded in convection with the transaction.  The fair value of assets acquired and liabilities assumed were as follows:

Also, in connection with this transaction, the Company terminated its advisory contract with Apple Suites Advisors, Inc. (“ASA”) and became self advised with all employees of ASA becoming employees

-10-

Table of Contents

of the Company. To implement the termination of the advisory agreement, the Company purchased ASA.  The Company acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement. Mr. Knight received a cash payment of $2 million and a non-interest-bearing promissory note, due four years after the merger, in a principal amount of $4.48 million.  The Company recognized an expense of $5,400,000 million related to this transaction in the first quarter of 2003.  Also in connection with the Company’s merger and the termination of the advisory agreement with ASA, the Company’s outstanding Series B convertible preferred shares were exchanged for 1,272,000 newly created Series C convertible preferred shares which have the same voting and dividend rights as if they had already been converted into 1,272,000 common shares (see Note 4).  In connection with this transaction, the Company recognized expense of $10,152,000 in the consolidated statement of operations during the first quarter of 2003.

Other Acquisition

Effective January 3, 2003, the Company acquired a Residence Inn® by Marriott® hotel in Redmond, Washington, which contains 180 suites and was in operation when acquired.  The hotel offers one and two room suites with the amenities generally offered by upscale extended-stay hotels.  It is located in a developed area near Seattle, Washington.

The gross purchase price for the hotel was $32,550,000.  This amount was satisfied at closing by cash payments and other adjustments in the approximate amount of $12,550,000 and the assumption of existing secured debt with an outstanding principal balance of $20,004,280.

AHT Redmond, Inc., which was formed to acquire the hotel, has assumed existing debt secured by the hotel.  The lender is Wells Fargo Bank Minnesota, National Association, as Trustee for the registered holders of GMAC Commercial Mortgage Securities, Inc., Mortgage Pass Through Certificates, Series 2002-C3, as serviced by GMAC Commercial Mortgage Corporation.

Note 3

Notes Payable

AHT Redmond

The principal balance of the assumed debt as of the closing date was approximately $20,000,000.  The debt is evidenced by a 8.375% promissory note, dated November 28, 2000, in the original principal amount of $20,500,000.  The promissory note provides for a maturity date of December 1, 2025.  The Company made a fair value adjustment to the debt of $1.64 million which marks the debt to 7.4%.

Apple Suites Merger

In connection with the Company’s merger with Apple Suites, the Company assumed $76 million of secured notes.  The notes bear an average fixed rate of interest of 8.4% per annum and are secured by 14 hotels.  The notes are payable in monthly installments, including principal and interest.  The Company made a fair value adjustment to the debt of $1.58 million which marks the debt to 7.4%.

The aggregate amounts of principal payable under all of the Company’s promissory notes, for the five years subsequent to March 31, 2003 are as follows:

-11-

Table of Contents

Note 4

Shareholders’ Equity

The issuance of the Series B convertible preferred shares to other individuals not employed by the Company is accounted for under FASB Statement No. 123, “Accounting for Stock-Based Compensation.” 

In January 2003, the shareholders of Apple Hospitality Two, Inc. (“Hospitality”) and Apple Suites, Inc. approved the acquisition of Apple Suites, Inc. by Apple Hospitality Two, Inc.  In connection with this transaction, all of the Hospitality 240,000 Series B convertible preferred shares converted to 1,272,000 Series C convertible preferred shares of the Company.  Expense related to the issuance of the Series B convertible preferred shares was determined based on fair value of the Series B convertible preferred shares at grant date in excess of amounts paid by these individuals.  The fair value was determined to be $8 at the date of the merger and was accordingly expensed under merger expense in the first quarter.

The newly created Hospitality Series C convertible preferred shares were issued in exchange for Hospitality Series B convertible preferred shares.  Mr. Knight would have otherwise been entitled to receive 1,073,000 Hospitality units upon conversion of his Hospitality Series B convertible preferred shares in connection with the termination of Hospitality’s advisory agreement with Apple Suites Advisors and Hospitality’s property acquisition/distribution agreement with Apple Suites Realty.  The new Hospitality Series C convertible preferred shares will have a liquidation preference comparable to the Hospitality Series B convertible preferred shares, in that holders of Hospitality Series C convertible preferred shares will receive no payments in a liquidation for their Series C convertible preferred shares until holders of Hospitality units are paid in full for their Hospitality Series A preferred shares.  The Hospitality Series C convertible preferred shares will also have the some voting rights and rights to receive dividend distributions as if they had already been converted to Hospitality common shares.

Note 5

Management Agreements

Residence Inn Hotels

The Company’s forty-nine Residence Inn hotels are subject to management agreements under which Residence Inn by Marriott, Inc. (the “Manager”) manages the hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years. The agreements generally provide for payment of base management fees, which are calculated annually and are generally 3% of sales, and incentive management fees, which are generally equal to 15% to 20% of

-12-

Table of Contents

operating profit (as defined in the management agreements) over a priority return (as defined in the management agreements) to us.  Total incentive management fees may not exceed 20% of cumulative operating profit, or 20% of current year operating profit.  Incentive management fees are currently payable only if and to the extent there is sufficient cash flow from the hotels after consideration of qualifying debt service and after consideration to a priority return on investment, including property improvements.  Amounts not currently payable are deferred and are payable in future years only if and to the extent there is sufficient cash flow from future operations or upon sale or refinancing of the hotels after consideration to a priority return to us (as defined in the management agreements), which is generally 12%.  In the event of early termination of the management agreements, the Manager will receive additional fees based on the unexpired term and expected future base and incentive management fees. The Company has the option to terminate the management agreements if specified performance thresholds are not satisfied.

Incentive fees are payable on a portfolio by portfolio basis.  The Company has three portfolios of Residence Inn hotels with separate incentive management agreements which are subject to this calculation. The Company records incentive management fee exposure when it is considered probable that these fees will be paid.  The Company has recorded the full amount of deferred incentive management fees on the Res III portfolio.  The Company has not recorded any deferred incentive management fees for the Res I and Res II portfolios. 

The Company has acquired its Residence Inn hotels in three separate transactions, (“Res I” – purchased February 2002, “Res II” – purchased August 28, 2002, and “Res III” – purchased September 2001).  In the Res I and Res II purchases, the Company assumed the amended and restated management agreements in effect with the Manager by the prior owner and the Company assumed deferred incentive management fees totaling $6.7 million and $7.0 million, respectively, at the date of the respective acquisitions.  Additionally, the Company assumed the cost basis of $187 and $243 million for Res I and Res II, respectively, and the holding period of the prior owner for purposes of calculating the priority returns upon sale of the properties.  The Company paid approximately $132 and $161 million for Res I and Res II, respectively. 

The following table summarizes deferred incentive management fees (“DIMF”) under the Residence Inn management agreements (dollars in millions).

Pursuant to the terms of the management agreements, the Manager also furnishes the hotels with certain chain services which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Chain services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries on a fair and equitable basis. In addition, the Company’s hotels

-13-

Table of Contents

participate in the Marriott Rewards® program. The cost of this program is charged to all hotels in the Marriott International hotel system.

The Lessees are obligated to provide the Manager with sufficient funds, generally 5% of revenue, to cover the cost of replacements and renewals to the hotels’ property and improvements. Under certain circumstances, the Lessees will be required to establish escrow accounts for such purposes under terms outlined in the agreements. To the extent the Lessees are not required to fund such amounts into escrow accounts, the Lessees remain liable to make such fundings in the future. The Lessees are obligated under these management agreements to fund FF&E requirements in excess of amounts placed in restricted cash accounts, which as of December 31 had aggregate balances of $18.6 million and $20.1 million.

Homewood Suites Hotels

The Company’s seventeen Homewood Suites hotels are managed by Promus Hotels, Inc. (“Promus”), a wholly owned subsidiary of Hilton Hotels Corporation (“Hilton”) under the terms of a management agreement, as part of the Homewood Suites® by Hilton franchise.

The Company is obligated to pay the costs of real estate and personal property taxes, property insurance and maintenance of the hotels.  The Company is committed under management agreements to fund up to 5% of gross revenues for capital expenditures to include periodic replacement or refurbishment of furniture, fixtures, and equipment.  At March 31, 2003 and 2002, Promus held $3,008 and $324,737, respectively, for these capital improvement reserves.  In addition, in accordance with the franchise agreements, at March 31, 2003 and 2002, $54,762 and $443,101, respectively, were held for the Property Improvement Plan with a financial institution and treated as restricted cash.

Promus manages day-to-day operations of the Homewood Suites hotels.  For the hotels acquired prior to 2001, Promus charges fees equal to 4% of total revenue for this function.  For two of the hotels acquired in 2001, Promus charges a base management fee of 2% of total revenue and an incentive management fee calculated on the basis of operating profit of the hotels.  No incentive management fees were earned in 2003 or 2002.  For the other two hotels acquired in 2001, Promus charges 2% of total revenues for the first twelve months, 3% of total revenues for the second twelve months and 4% of total revenues thereafter.  Promus also charges a fee of 4% of suite revenue for franchise licenses to operate as a Homewood Suites® by Hilton® hotel and to participate in its reservation system.  Total expenses for these services were $881,573 and $1,342,226 for the first three months of 2003 and 2002, respectively.  These expenses are included in the hotel operating expenses mentioned above.

Note 6

Related Parties

Prior to January 31, 2003, the Company was externally-advised and had contracted with ASA to advise and provide day to day management services to the Company.  In accordance with the contract, the Company paid ASA a fee equal to .1% to .25% of total equity contributions received by the Company in addition to certain reimbursable expenses.  During the first quarter of 2003, ASA earned $62,500 under this agreement and was not reimbursed any expenses.  During the first quarter of 2002, ASA earned $163,831 under this agreement

Concurrent with the Company’s merger with Apple Suites on January 31, 2003, the Company terminated its advisory contract with ASA and became self-advised.  To implement the termination of the advisory agreement, the Company purchased ASA.  The Company acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement.

-14-

Table of Contents

Mr. Knight received a cash payment of  $2 million and a non-interest-bearing promissory note, due four years after the merger, in a principal amount of $4.48 million.  The Company recognized an expense of $5,400,000 related to this transaction in the first quarter of 2003.  Also in connection with the Company’s merger and the termination of the advisory agreement with ASA, the Company’s outstanding Series B convertible preferred shares were exchanged for 1,272,000 newly created Series C convertible preferred shares which have the same voting and dividend rights as if they had already been converted into 1,272,000 common shares (see note 2). 

As of December 31, 2002, we had contracted with Apple Suites Realty Group, Inc. (“ASRG”) to provide brokerage services for the acquisition and disposition of our real estate assets. In accordance with the contract, ASRG is paid a fee of 2% of the gross purchase price of any acquisitions or gross sale price of any dispositions of real estate investments, subject to certain conditions. For the quarter and year ended March 31, 2003 and December 31, 2002, ASRG earned $644,000 and $5,866,784, respectively, under this agreement. ASRG is owned by Mr. Glade M. Knight, our Chairman. Concurrent with our merger with Apple Suites on January 31, 2003, our agreement with ASRG was terminated.

In addition, each Apple Suites Class B convertible share owned by Mr. Knight and two other individuals, issued and outstanding immediately prior to the effective time of the merger, was converted into a Unit. As a result, holders of Apple Suites Class B received 480,000 common shares of Apple Suites. The 400,000 Apple Suites common shares converted into 480,000 Units of the Company.  Apple Suites will recognize expense of approximately $3.8 million in its Income Statement in the first quarter of 2003 related to this conversion.

Note 7

Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share in accordance with FAS 128:

-15-

Table of Contents

Note 8

Pro Forma Information

The following pro forma information for the quarters ended March 31, 2003 and 2002 is presented as if the acquisition of Apple Suites, Inc. as well as the Res I and Res II portfolio and Redmond acquisition, occurred on January 1, 2002.  The pro forma information does not purport to represent what the Company’s results of operations would actually have been if such transactions, in fact, had occurred on January 1, 2002, nor does it purport to represent the results of operations for future periods.

The pro forma information reflects adjustments for actual revenues and expenses of the 38 hotels acquired in 2002 for the respective period in 2002 prior to acquisition by the Company.  Net income has been adjusted as follows:  (1) expense related to the issuance of Series C preferred convertible stock and expense related to the termination of the advisory contract have been eliminated since they are directly attributable to the Apple Suites acquisition and are not expected to have on-going impact; (2) depreciation has been adjusted based on the Company’s basis in the hotels; (3) advisory expenses have been adjusted based on the Company’s contractual arrangements; (4) interest expense has been adjusted to reflect the acquisition as of January 1, 2002; (5) common stock raised during 2002 to purchase these hotels has been adjusted to reflect issuances as of January 1, 2002, including issuance of Series C preferred convertible stock.

Note 9

Industry Segments

The Company owns extended-stay hotel properties throughout the United States that generate rental and other property related income.  The Company separately evaluates the performance of each of its hotel properties.  However, because each of the hotel properties has similar economic characteristics, facilities, and services, the properties have been aggregated into a single segment.  All segment disclosure is included in or can be derived from the Company’s consolidated financial statements.

Note 10

Subsequent Events

In April 2003, the Board of Directors of the Company declared and distributed to its shareholders dividends in the amount of $10.7 million ($0.25 per share). 

-16-

Table of Contents

Item 2      Management’s Discussion and Analysis of Financial Condition and Results of Operations

This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Such Statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.  Such factors include the ability of the Company to implement its acquisition strategy and operating strategy; the Company’s ability to manage planned growth; changes in economic cycles and competition within the extended-stay hotel industry.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore there can be no assurance that such statements included in the quarterly report will prove to be accurate.  In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the results or conditions described in such statements or the objectives and plans of the Company will be achieved.  In addition, the Company’s qualification as a real estate investment trust involves the application of highly technical and complex provisions of the Internal Revenue Code.  Readers should carefully review the Company’s financial statements and the notes thereto, as well as the risk factors described in the Company’s filings with the Securities and Exchange Commission.

General

We are a real estate investment trust (“REIT”) that owns upper-end, extended-stay hotels.  We were formed on January 17, 2001, with the first investor closing commencing on May 1, 2001.

Hotels Owned

We own sixty-six hotels, with a total of 7,869 suites. 

The following table summarizes the locations of and number of suites at these ten hotels (collectively, the “Crestline Portfolio”), all of which operate as part of the Residence Inn® by Marriott® franchise system:

Fifteen of our hotels were acquired effective February 22, 2002, in a transaction described below under “Recent Acquisition-Res I Portfolio.”  The following table summarizes the location of and number of suites at these fifteen hotels (the “Res I Portfolio”), all of which operate as part of the Residence Inn® by Marriott® franchise system:

-17-

Table of Contents

Twenty-three of our hotels were acquired in August 2002, in a transaction described below. The following table summarizes the location of and number of suites at these twenty-three hotels (the “Res II Portfolio”), all of which operate as part of the Residence Inn® by Marriott® franchise system:

Seventeen of our hotels were acquired as a result of the merger with Apple Suites, Inc. on January 31, 2003. The following table summarizes the location of and number of suites at these seventeen hotels, all of which are operated as part of Homewood Suites® by Hilton® franchise system:

Effective January 3, 2003, the company acquired one hotel. The following table summarizes the location

-18-

Table of Contents

of and number of suites at this hotel, which is operated as part of the Residence Inn® by Marriott® franchise system.

Management Agreements

Our Residence Inn hotels are subject to management agreements under which Residence Inn® by Marriott®, Inc. (the “Manager”) manages the Company’s hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years.  The agreements generally provide for payment of base management fees, which are calculated annually and are generally 3% of sales, and incentive management fees, which are generally equal to 15% to 20% of operating profit (as defined in the management agreements) over a priority return (as defined in the management agreements) to the Company.  Incentive fees are payable only to the extent of cash flow from the properties as described in the management agreement on a portfolio basis.  We have three portfolios of multiple hotels and one other hotel with separate incentive management agreements which are subject to this calculation.  We record incentive management fee exposure when it is considered probable that these fees will be paid.  See “Expenses” under Results of Operations below for further discussion.

Promus manages day-to-day operations of our Homewood Suites hotels.  For the hotels acquired prior to 2001, Promus charges fees equal to 4% of total revenue for this function.  For two of the hotels acquired in 2001, Promus charges a base management fee of 2% of total revenue and an incentive management fee calculated on the basis of operating profit of the hotels.  No incentive management fees were earned in 2002.  For the two other hotels acquired in 2001, Promus charges 2% of total revenues for the first twelve months, 3% of total revenues for the second twelve months and 4% or total revenues thereafter.  Promus also charges a fee of 4% of suite revenue for franchise licenses to operate as a Homewood Suites® by Hilton® and to participate in its reservation system.  Total expenses for franchise fees, management fees, advertising expenses and other reimbursable services were $881,573 and $1,342,226 for the first three months of 2003 and 2002, respectively.  These expenses are included in the hotel operating expenses mentioned below.

Recent Acquisitions

Recent Acquisition – Res I Portfolio

During the first quarter of 2002, we acquired, through subsidiaries, Marriott Residence Inn Limited Partnership, which owns fifteen (15) extended-stay hotels.  For simplicity, this entity will be referred to as the “Res I Partnership.”  Although the acquisition was conducted through a merger in which our subsidiaries acquired the Res I Partnership, the purpose and result was acquisition of the hotels.  Each hotel operates as part of the Residence Inn® by Marriott® franchise system.

The gross purchase price for the acquisition was approximately $133.4 million. The purchase price, as adjusted at closing, was paid through a combination of transactions. In November 2001, we made a deposit of $35 million, which was applied toward the purchase price at closing.  In addition, we made a cash payment of approximately $7 million at closing. To satisfy the remainder of the purchase price, we received a credit at closing equal to the unpaid balance of existing loans, which were secured by the hotels. These secured loans have been subsequently refinanced and are an obligation of the Res I Partnership.  Further details about the refinance are provided under “Notes Payable” section below and

-19-

Table of Contents

in Note 3 of the “Notes to Financial Statements” in Item 1.  We also used the proceeds of our offerings to pay 2% of the total gross purchase price, which equals $2,667,052, as a commission to ASRG.

Recent Acquisition – Res II Portfolio

On August 28, 2002, we acquired, through subsidiaries, Marriott Residence Inn II Limited Partnership, which has direct or indirect ownership of 23 extended-stay hotels.  For simplicity, this entity will be referred to as the “Res II Partnership.”  Although the acquisition was conducted through a merger in which our subsidiaries acquired the Res II Partnership, the purpose and result was our acquisition of the hotels.  Each hotel operates as part of the Residence Inn® by Marriott® franchise system. 

The purchase price for the acquisition was approximately $136 million, net of cash acquired of $24 million.  The purchase price, as subject to certain adjustments at closing, was satisfied through a combination of transactions.  They included the assumption of the existing loan in the approximate amount of $132 million (representing outstanding principal and interest as of August 31, 2002), which is secured by the hotels owned directly by the Res II Partnership, together with a cash payment for the net balance of the purchase price (after credit for a deposit of $3 million, with interest, and certain other cash balances).  The source for the cash payment was our second offering of Units, plus funds raised in our initial offering, which ended as of May 29, 2002.  We also used the proceeds of our Offerings to pay 2% of the total base purchase price, which equals $3,199,732, as a commission to ASRG.

The secured loan continues to be an obligation of the Res II Partnership.  Further details about the secured loans are provided under the “Notes Payable” section below and in Note 3 to “Notes to the Financial Statements” in Item 1 above.

Recent Acquisition – Redmond, Washington

Effective January 3, 2003, the Company acquired a Residence Inn ® by Marriott ® hotel in Redmond, Washington, which contains 180 suites and was in operation when acquired.  The hotel offers one and two room suites with the amenities generally offered by upscale extended-stay hotels.  It is located in a developed area near Seattle, Washington.

The gross purchase price for the hotel was $32,550,000.  This amount was satisfied at closing by cash payments and other adjustments in the approximate amount of $12,550,000 and the assumption of existing secured debt.

AHT Redmond, Inc., a subsidiary of the Company that was formed to acquire the hotel, has assumed existing debt secured by the hotel.  The lender is Wells Fargo Bank Minnesota, National Association, as Trustee for the registered holders of GMAC Commercial Mortgage Securities, Inc., Mortgage Pass Through Certificates, Series 2002-C3, as serviced by GMAC Commercial Mortgage Corporation.

The principal balance of the assumed debt as of the closing date was approximately $20,000,000, which bore interest at 8.375%.  The debt is evidenced by a promissory note, dated November 28, 2000, in the original principal amount of $20,500,000.  The promissory note provides for a maturity date of December 1, 2025.

Acquisition of Apple Suites, Inc.

We also entered into a merger agreement with Apple Suites on October 23, 2002. Effective January 31, 2003, Apple Suites merged with and into Hospitality Acquisition Company, our wholly-owned subsidiary.  Apple Suites owned, either directly or through its subsidiaries, a total of 17 upper-end

-20-

Table of Contents

extended-stay hotels throughout the United States, which comprised a total of 1,922 suites, and all of which are operated as part of the Homewood Suites® by Hilton® franchise system. The merger did not change the management positions Mr. Glade M. Knight held with us prior to the merger nor did our boards of directors change as a result of the merger.

Pursuant to the merger, each Apple Suites common share, issued and outstanding immediately prior to the effective date of the merger, was converted into the right to receive either: (i) one Unit of the Company, consisting of one common share of the Company and one Series A preferred share of the Company; or (ii) if the holder of a Apple Suites common share elected, $10.00 in cash, subject to a limit on the total amount of cash to be paid in the merger. As a result of the merger, holders of Apple Suites common shares received a total of 10,883,544 Units and approximately $17.8 million in cash, and the Company assumed Apple Suites’ liability and paid certain merger costs. We funded the cash portion of the merger consideration with available cash. 

Also in connection with this transaction, the Company terminated its advisory contract with ASA and became self-advised. To implement the termination of the advisory agreement, we purchased ASA.  We acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement. Mr. Knight received a cash payment of $2 million and a non-interest-bearing promissory note, due four years after the merger, in a principal amount of $4.48 million.  The Company will recognize an expense related to this transaction of $5.4 million in the first quarter of 2003.

In addition, 1,272,000 newly created Series C convertible preferred shares were issued in exchange for outstanding Series B convertible preferred shares.  Holders of Series B convertible preferred shares would have otherwise been entitled to receive 1,272,000 Units upon conversion of their Series B convertible preferred shares in connection with the termination of the advisory agreement with ASA and termination of the brokerage service agreement with ASRG.  The new Series C convertible preferred shares have a liquidation preference comparable to the Series B convertible preferred shares, in that holders of Series C convertible preferred shares receive no payments in a liquidation for their Series C convertible preferred shares until holders of Units are paid in full for their Series A preferred shares. The Series C convertible preferred shares have the same voting rights and rights to receive dividend distributions as if they had already been converted to common shares.  The company recognized expense related to this transaction of $10,152,000 during the first quarter of 2003.

In addition, each Apple Suites Class B convertible share owned by Mr. Knight and two other individuals, issued and outstanding immediately prior to the effective time of the merger, was converted into a Unit. As a result, holders of Apple Suites Class B convertible shares received a total of 480,000 Units in the Merger.  Apple Suites will recognize expense of approximately $3.8 million in its Income Statement in the first quarter of 2003 related to this conversion.

Related Party Transactions

We have significant transactions with related parties.  These transactions cannot be construed to be arm’s length and the results of our operations could be different if these transactions were conducted with non-related parties.

Prior to January 31, 2003, we had contracted with ASRG to provide brokerage services for the acquisition and disposition of our real estate assets. In accordance with the contract, ASRG is paid a fee of 2% of the gross purchase price of any acquisitions or gross sale price of any dispositions of real estate investments, subject to certain conditions. For the year ended December 31, 2002, ASRG earned

-21-

Table of Contents

$5,866,784 under this agreement. During the first quarter of 2003, ASRG earned $644,000 under this contract. ASRG is owned by Mr. Glade M. Knight, our Chairman. Concurrent with our merger with Apple Suites on January 31, 2003, our agreement with ASRG was terminated.

As of December 31, 2002, we had contracted with ASA to advise and provide us day-to-day management services and due diligence services on acquisitions.  In accordance with the contract, we paid ASA a fee equal to 0.1% to 0.25% of total equity contributions we received in addition to certain reimbursable expenses. For the quarter ended March 31, 2003 and year ended December 31, 2002 through December 31, 2001, ASA earned $62,500 and $568,170, respectively, under this agreement. Concurrent with our merger with Apple Suites on January 31, 2003, our advisory agreement with ASA was terminated and no further advisory fees were due under that agreement. To implement the termination of the advisory agreement, we purchased ASA.  We acquired all of Mr. Glade M. Knight’s stock in ASA instead of paying a $6.48 million termination fee due ASA under the advisory agreement. Mr. Knight received a cash payment of $2 million and a non-interest-bearing promissory note, due four years after the merger, in a principal amount of $4.48 million.  Also in connection with our merger and the termination of the advisory agreement with ASA, our outstanding Series B convertible preferred shares were exchanged for 1,272,000 newly created Series C convertible preferred shares which have the same voting and dividend rights as if they had already been converted into 1,272,000 common shares. 

Mr. Knight also serves as the Chairman and Chief Executive Officer of Cornerstone Realty Income Trust, Inc., an apartment REIT.  Mr. Knight was Chairman and Chief Executive Officer of Apple Suites prior to our merger with it.  (Refer to the “Acquisition of Apple Suites, Inc.” section above for further information about the merger with Apple Suites). 

Results of Operations

Revenues

Our principal source of revenue is hotel suite revenue.  For the quarter ended March 31, 2003 and 2002, we had suite revenue and other revenue of $41,768,938 and $11,873,486, and $1,675,698 and $477,030, respectively.  The increase in revenues is attributable to the acquisitions of 56 hotels since March 31, 2002.  For those same periods, the hotels achieved average occupancy of 74% and 73%, ADR, of $92 and $95 and REVPAR, of $68 and $69, respectively.  ADR, or average daily rate, is calculated as room revenue divided by number of rooms sold, and REVPAR, or revenue per available room, is calculated as occupancy multiplied by ADR.

For the quarter ended March 31, 2003 and 2002, respectively, the Company had interest income of $336,500 and $202,938, respectively.  Interest income represents excess cash, invested in short term money market instruments.

Expenses

Interest expense was $6,129,150 and $1,094,587, for the quarter ended March 31, 2003 and 2002 respectively.  Interest expense for the quarter ended March 31, 2003, represents interest on the 8.08%, $53 million promissory note assumed in conjunction with the Crestline acquisition, interest expense on the 8.6%, interest expense on the refinance of the Res I Partnership acquisition debt in the amount of $83 million at a fixed interest rate of 7.4%, and interest expense on the 8.85%, $130 million promissory note assumed in conjunction with the Res II Partnership acquisition and interest expense on the $20 million Redmond acquisition at 8.375% and Apple Suites debt of $76 million at 8.4%.  Interest for the quarter ended March 31, 2002 only represented the Crestline mortgage. 

-22-

Table of Contents

Depreciation expense for the quarter ended March 31, 2003 and March 31, 2002 was $3,566,842 and $1,070,758, respectively.  Depreciation expense for 2003 represents expense of our 66 hotels and related personal property, and expense for 2002 represents expense of the 10 hotels and related personal property.

Taxes, insurance and other expense for the quarters ended March 31, 2003 and 2002 was $2,616,102 or 6% of our suite revenue and $787,890 or 7% of our suite revenue, respectively. 

General and administrative expenses for the quarter ended March 31, 2003 and 2002 were $523,303 or 1.2% of our suite revenue and $273,442 or 2.3% of our suite revenue, respectively. This percentage decreased as our asset base grew during 2002. 

Hotel operating expenses totaled $10,505,864 or 25% of our suite revenue and $2,610,056 or 22% of our suite revenue for the quarter ended March 31, 2003 and 2002, respectively.  The reduction of REVPAR has increased hotel operating expenses on a % basis due to fixed costs associated with operating a hotel.

Residence Inn Hotels

Our Residence Inn hotels are subject to management agreements under which the Manager manages our hotels, generally for an initial term of 15 to 20 years with renewal terms at the option of the Manager of up to an additional 50 years. The agreements generally provide for payment of base management fees, which are calculated annually and are generally 3% of sales, and incentive management fees, which are generally equal to 15% to 20% of operating profit (as defined in the management agreements) over a priority return (as defined in the management agreements) to us.  Total incentive management fees may not exceed 20% of cumulative operating profit, or 20% of current year operating profit.  Incentive management fees are currently payable only if and to the extent there is sufficient cash flow from the hotels after consideration of qualifying debt service and after consideration to a priority return on investment, including property improvements.  Amounts not currently payable are deferred and are payable in future years only if and to the extent there is sufficient cash flow from future operations or upon sale or refinancing of the hotels after consideration to a priority return to us (as defined in the management agreements), which is generally 12%.  In the event of early termination of the management agreements, the Manager will receive additional fees based on the unexpired term and expected future base and incentive management fees. We have the option to terminate the management agreements if specified performance thresholds are not satisfied.

Incentive fees are payable on a portfolio by portfolio basis for Residence Inn properties.  We have three portfolios of multiple hotels and one other hotel with separate management agreements which are subject to this calculation. We record incentive management fee exposure when it is considered probable that these fees will be paid.  We have recorded the full amount of deferred incentive management fees on the Res III portfolio and Redmond hotel.  We have not recorded any deferred incentive management fees for the Res I and Res II portfolios. 

We have acquired our Residence Inn hotels in separate transactions, (“Res I” – purchased February 2002, “Res II” – purchased August 28, 2002, and “Res III” – purchased September 2001).  In the Res I and Res II purchases, we assumed the amended and restated management agreements in effect with the Manager by the prior owner and we assumed deferred incentive management fees totaling $6.7 million and $7.0 million, respectively, at the date of the respective acquisitions.  Additionally, we assumed the cost basis of $187 and $243 million for Res I and Res II, respectively, and the holding period of the prior owner for purposes of calculating the priority returns upon sale of the properties.  We paid approximately $132 and $161 million for Res I and Res II, respectively. 

-23-

Table of Contents

The following table summarizes deferred incentive management fees (“DIMF”) under these management agreements (dollars in millions).

No amounts of DIMF were recorded upon the acquisition of Res I and Res II as the fair value of these amounts were not readily determinable and payment was not considered probable.

Pursuant to the terms of the management agreements, the Manager also furnishes the hotels with certain chain services which are generally provided on a central or regional basis to all hotels in the Marriott International hotel system. Chain services include central training, advertising and promotion, a national reservation system, computerized payroll and accounting services, and such additional services as needed which may be more efficiently performed on a centralized basis. Costs and expenses incurred in providing such services are allocated among all domestic hotels managed, owned or leased by Marriott International or its subsidiaries on a fair and equitable basis. In addition, our hotels participate in the Marriott Rewards program. The cost of this program is charged to all hotels in the Marriott International hotel system.

The lessees are obligated to provide the Manager with sufficient funds, generally 5% of revenue, to cover the cost of replacements and renewals to the hotels’ property and improvements. Under certain circumstances, the lessees will be required to establish escrow accounts for such purposes under terms outlined in the agreements. To the extent the lessees are not required to fund such amounts into escrow accounts, the lessees remain liable to make such fundings in the future. The lessees are obligated under these management agreements to fund FF&E requirements in excess of amounts placed in restricted cash accounts, which was $9,338,464 and $7,350,048, respectively, at March 31, 2003 and December 31, 2002.

In addition to management fees, we also pay each hotels’ pro rata share of the Manager’s actual costs and expenses incurred in providing certain chain services on a central or regional basis to all the hotels operated by the Manager or other Marriott affiliate.  Chain services include central training and development; computerized payroll and accounting services; and such additional central or regional services performed on a centralized basis.  For the quarters ended March 31, 2003 and 2002, respectively, the Company had incurred $705,794 and $199,419 in chain services.

The management agreements also provide for payments of costs associated with certain system-wide advertising, promotional and public relations materials and programs and the operational costs of reservation systems.  Each hotel pays two and one-half percent (2.5%) of suite revenues to this marketing fund.  For the quarters ended March 31, 2003 and 2002, respectively, the Company incurred $2,987,751 and $630,963 in marketing fees.

-24-

Table of Contents

Homewood Suites Hotels

The Company’s seventeen Homewood Suites hotels are managed by Promus Hotels, Inc. (“Promus”), a wholly owned subsidiary of Hilton Hotels Corporation (“Hilton”) under the terms of a management agreement, as part of the Homewood Suites® by Hilton® franchise.

The Company is obligated to pay the costs of real estate and personal property taxes, property insurance and maintenance of the hotels.  The Company is committed under management agreements to fund up to 5% of gross revenues for capital expenditures to include periodic replacement or refurbishment of furniture, fixtures, and equipment At March 31, 2003 and 2002, Promus held $3,008 and $324,737, respectively, for these capital improvement reserves. In addition, in accordance with the franchise agreements, at March 31, 2003 and 2002, $54,762 and $443,101, respectively, were held for the Property Improvement Plan with a financial institution and treated as restricted cash.

Promus manages day-to-day operations of the Homewood Suites hotels.  For the hotels acquired prior to 2001, Promus charges fees equal to 4% of total revenue for this function.  For two of the hotels acquired in 2001, Promus charges a base management fee of 2% of total revenue and an incentive management fee calculated on the basis of operating profit of the hotels.  No incentive management fees were earned in 2003 or 2002.  For the other two hotels acquired in 2001, Promus charges 2% of total revenues for the first twelve months, 3% of total revenues for the second twelve months and 4% of total revenues thereafter.  Promus also charges a fee of 4% of suite revenue for franchise licenses to operate as a Homewood Suites® by Hilton® hotel and to participate in its reservation system.  Total expenses for these services were $881,573 and $1,342,226 for the first three months of 2003 and 2002, respectively.  These expenses are included in the hotel operating expenses mentioned above.

Liquidity and Capital Resources

Cash and cash equivalents

Cash and cash equivalents totaled $66,416,917 at March 31, 2003 and $125,521,805 at December 31, 2002.  We plan to use this cash for future acquisition costs, renovations, distributions to shareholders, debt service and to fund general corporate expenses.

Equity

From the initial closing under our first offering, and through our second offering and through the period ended December 31, 2002, we sold 30,157,931 Units (3,157,895 units at $9.50 per Unit and 27,000,036 Units at $10 per Unit) to our investors, including Units sold through the reinvestment of distributions.  The total gross proceeds from the Units sold were $300,000,360 which netted us $268,131,348 after the payment of selling commissions and other offering costs. 

Notes Payable

AHT Redmond

The principal balance of the assumed debt as of the closing date was approximately $20,000,000.  The debt is evidenced by a 8.375% promissory note, dated November 28, 2000, in the original principal amount of $20,500,000.  The promissory note provides for a maturity date of December 1, 2025.

Apple Suites Portfolio

In connection with the Company’s merger with Apple Suites, the Company assumed $76 million of secured notes.  The notes bear an average fixed rate of interest of 8.4% per annum and are secured by 14 hotels.  The loan is payable in monthly installments, including principal and interest.

-25-

Table of Contents

Total Notes Payable

The aggregate amounts of principal payable under all of the Company’s promissory notes, for the five years subsequent to March 31, 2003 are as follows: