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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

  For the fiscal year ended December 31, 2003

  For the transition period from              to             

Commission File Number 000-49748

APPLE HOSPITALITY TWO, INC.

(Exact name of registrant as specified in its charter)

(804) 344-8121

(Registrant’s telephone number, including area code)

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

None

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

Units (Each Unit is equal to one common share, no par value, and one Series A preferred share)

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

Indicate by check mark if disclosure of deliquent filers pursuant to Item 405 of Regulation S-K (5229.405 of this chapter) is not continued herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  ¨    No  x

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

Based upon the price at which the common equity for Apple Hospitality Two, Inc’s best efforts offering was last sold through June 30, 2003., the aggregate market value of the voting common equity held by non-affiliates of the registrant on such date was a total of $387,068,722. The Company does not have any non-voting common equity.

On December 31, 2003, there were approximately 40,644,638 common shares outstanding.

APPLE HOSPITALITY TWO, INC.

FORM 10-K

INDEX

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PART I

This Annual 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 this Annual 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.

Item 1. Business

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., structured as a tax-fee merger, on January 31, 2003 and results of Apple Suites operations are included in the Company’s results from February 1, 2003. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company transactions and balances have been eliminated upon consolidation.

The Company is a real estate investment trust. 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 wholly-owned taxable REIT subsidiaries (collectively, the “Lessee”), which lease all of the Company’s hotels from wholly-owned qualified REIT subsidiaries. The hotels are operated and managed by affiliates of either Marriott or Hilton under hotel management agreements.

Website Access

The address of the company’s Internet website is www.applehospitality.com. The company makes available through its Internet website its annual report on Form 10-K, quarterly reports on From 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 as soon as reasonably practicable after the company electronically files such material with, or furnishes it to, the SEC.

Growth Strategies

The Company’s primary objective is to enhance shareholder value by increasing cash from operations and cash available for distributions. The Company’s focus is on maximizing the internal growth of the Company’s portfolio by selecting properties that have strong cash flow growth potential.

The Company seeks to increase operating cash flow and enhance its value through internal growth, renovations and acquisitions. The Company’s internal growth strategy is to utilize its asset management expertise to improve the quality of the Company’s hotels by renovating, redeveloping and thereby improving hotel revenue and operational performance.

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The Company believes that its planned future renovation and redevelopment activities will increase revenue per available room (“REVPAR”) growth at the Company’s hotels, thereby increasing lease revenue. The Company is committed to fund a percentage of gross revenue per month for certain capital expenditures for periodic replacement or refurbishment of furniture, fixtures and equipment. The Company has approximately $16.5 million held in escrow for future furniture, fixture and equipment purchases at December 31, 2003. During 2003, the Company began a major renovation program for its hotels to enhance revenue per available room. This program will continue in 2004. Total capital expenditures in the program were approximately $40 million and included thirteen hotels. Renovations of twelve additional hotels are planned for 2004.

The Company continuously monitors its portfolios and will, where appropriate, selectively acquire or dispose of properties based on specific market conditions.

Financing

Substantially all of the Company’s hotels are encumbered by mortgage debt. The Company’s bylaws require board of director approval for debt above certain levels. Debt levels are reviewed quarterly by the board to ensure reasonableness in relation to the Company’s assets.

Competition

The Company believes that the hotel industry is highly competitive. Each of the Company’s hotels is located in a developed area that includes other hotels and competes for guests primarily with other extended-stay hotels in its immediate vicinity and secondarily with other hotels in its geographic market. An increase in the number of competitive hotels in a particular area could have a material adverse effect on the occupancy, average daily rate (“ADR”) and revenue per available room (“REVPAR”) of the Company’s hotels in that area. The Company believes that brand recognition, location, price and quality (of both the hotel and the services provided) are the principal competitive factors affecting its hotels.

Hotel Operating Performance

The Company owned 49 Residence Inn^® by Marriott^® hotels, consisting of 5,947 suites, and 17 Homewood Suites^® by Hilton^® hotels (acquired on January 31, 2003), consisting of 1,922 suites at December 31, 2003, and 48 Residence Inn^® by Marriott^® hotels, consisting of 5,767 suites at December 31, 2002. Suite revenues for these hotels totaled $189,599,903 for the year ended December 31, 2003, and $102,895,689 for the year ended December 31, 2002. For those same periods, the hotels achieved average occupancy of 74% and 78%, ADR of $91 and $92 and REVPAR of $67 and $71, respectively.

Property Taxes and Insurance

The Company maintains real estate tax escrows, funded from gross revenues of the hotels, which are used to pay the costs of real estate and personal property taxes for certain properties and portfolios. Property insurance is also funded from gross revenues. Taxes, insurance and other expenses incurred by the Company totaled $12,762,914 for the year ended December 31, 2003 and $6,578,038 for the year ended December 31, 2002.

Maintenance

The hotels have an ongoing need for renovation and refurbishment. Under various hotel management agreements, the Company has agreed to fund expenditures for periodic repairs, replacement or refurbishment of furniture, fixtures and equipment for the hotels in an amount equal to a certain percentage of gross revenues. In addition, other capital improvement projects are directly funded by the Company.

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Employees

During 2003, all employees involved in the day-to-day operation of the Company’s hotels were employed by the management companies engaged pursuant to the hotel management agreements. Persons working at the corporate headquarters on the Company’s behalf were employees of Apple Suites Advisors, Inc. (“ASA”) until January 31, 2003, at which time those persons became employees of Apple Hospitality Two, Inc. At December 31, 2003, the Company had 18 employees.

Environmental Matters

In connection with each of the Company’s hotel acquisitions, the Company obtains a Phase I Environmental Report and such additional environmental reports and surveys as are necessitated by such preliminary report. Based on such reports, the Company is not aware of any environmental situations requiring remediation at its properties, which have not been or are not currently being remediated as necessary. No material remediation costs have or are expected to occur.

Property Acquisitions

During fiscal year 2003, the Company acquired the following:

On January 17, 2003, the Company acquired, through a subsidiary, the Residence Inn Redmond extended-stay hotel in Redmond, Washington. (The Residence Inn^® and Marriott^® trademarks are the property of Marriott International, Inc. or one of its affiliates). For prorated rent and other accounting purposes, the effective date of the acquisition is treated as January 3, 2003, but closing on the acquisition did not occur until January 17, 2003.

Effective on January 31, 2003, Apple Suites, Inc., a Virginia corporation (“Suites”), merged (the “Merger”) with and into Hospitality Acquisition Company, a Virginia corporation and a subsidiary of Apple Hospitality Two, Inc. (“Hospitality”). 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.

For further information about these acquisitions, refer to the Company’s discussion of the Merger under the “Recent Acquisitions” section of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 2. Properties

As of December 31, 2003, the Company owned 49 Residence Inn^® by Marriott^® hotels comprised of 5,947 suites and 17 Homewood Suites^® by Hilton hotels comprised of 1,922 suites. The hotels are located in various states. The following table includes the location of each hotel, the date of construction, the date acquired, encumbrances, initial acquisition cost, gross carrying value and the number of suites of each hotel.

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Real Estate and Accumulated Depreciation

As of December 31, 2003

(Dollars in thousands)

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Investment in hotels at December 31, 2003, consisted of the following:

For additional information about the Company’s properties, refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 3. Legal Proceedings

The Company is not presently subject to any material litigation nor, to its knowledge, is any litigation threatened against the Company or any of its properties, other than routine actions arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on the Company’s business or financial condition or results of operations.

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

None.

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PART II

Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters

Common Shares

The Company’s Registration Statement on Form S-11 (File No. 333-77055) was declared effective by the Securities and Exchange Commission on May 1, 2001, and on that date the Company commenced an initial best efforts offering of 20.1 million Units. On May 29, 2002, the initial offering closed. The Company’s Registration Statement on Form S-11 (File No. 333-101194) was declared effective by the Securities and Exchange Commission on May 2, 2002, and on that date the Company commenced its second best efforts offering of 10 million Units. On November 26, 2002, the second offering closed. The managing underwriter was David Lerner Associates, Inc. and all of the Units were sold for the Company’s account. A Unit consists of one common share and one Series A preferred share. The Series A preferred shares have no voting rights, no distribution rights, and no conversion rights. In addition, the Series A preferred shares are not separately tradable from the common shares to which they relate. The only right associated with each Series A preferred share is a priority distribution upon the sale of the Company’s assets. The priority distribution will be equal to $10.00 per Series A preferred share, and no more, before any distribution will be made to the holders of any other shares. Upon that distribution, the Series A preferred shares will have no other distribution rights.

There is currently no established public market in which the Company’s common shares are traded.

On December 31, 2003, there were 11,435 beneficial shareholders of the Company’s common shares.

Distributions of $54,243,300 were paid to the shareholders during 2003. Distributions were paid in an amount of $1.50 per share for the year ended December 31, 2003. The $1.50 per share includes a special dividend of $.50 associated with the Company’s merger with Apple Suites, Inc. In 2002, the Company paid distributions at an annual rate of $1.00 per share. The timing and amounts of distributions to shareholders are within the discretion of the Company’s Board of Directors. Future distributions will depend on the Company’s results of operations, cash flow from operations, economic conditions and other factors such as working capital and capital expenditure requirements, as well as requirements under federal income tax provisions for qualification as a REIT.

Non-Employee Directors Stock Option Plan and Incentive Plan

The Company’s board of directors has adopted and the Company’s shareholders have approved a Non-Employee Directors Stock Option Plan and an Incentive Plan. The options issued under each plan convert to Units. Each Unit is equal to one common share and one Series A Preferred share of the Company. As of December 31, 2003, there were 121,820 options outstanding.

Distribution Policy

To maintain its REIT status the Company is required to distribute at least 90% of its ordinary income. All distributions are at the discretion of the Company’s board of directors. Since inception of the Company, it has paid a quarterly dividend of $.25 per share, excluding a one-time dividend associated with the Apple Suites, Inc. merger. As a result of the Company’s 2003 results from operations and renovation program, the Company will reevaluate its dividend policy in 2004.

Series C Convertible Preferred Shares Dividend and Distribution Rights

The holders of the Company’s Series C convertible preferred shares will be entitled to receive, on an as converted basis, the same distributions as declared for the holders of the Company’s common shares, except for distributions in liquidation. If the Company liquidates the Company’s assets or dissolves entirely and the Company’s assets are sufficient to pay the distribution rights of the Series A preferred shares in full, the remaining assets will first be used to pay $10.00 per share to the holders of the Series C convertible

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preferred shares, on an as converted basis. Then, any remaining assets will be distributed pro rata to the holders of common shares and the holders of Series C convertible preferred shares, on an as converted basis.

Conversion

The Series C convertible preferred shares will be convertible into Units upon and for 180 days following the occurrence of either of the following events: (1) the Company transfers substantially all of the Company’s assets, stock or business as a going concern, whether through exchange, merger, consolidation, lease, share exchange or otherwise, other than a sale of assets in liquidation, dissolution or winding up of the Company’s business; or (2) the Company lists the Company’s Units on a national securities exchange or quotation system or in any established market. Upon the occurrence of either triggering event, each Series C convertible preferred share will be convertible into one unit, subject to adjustment to reflect stock dividends on, or split, subdivision or combination of, the Company’s common shares.

Voting Rights

The holders of Series C convertible preferred shares are entitled to vote on all matters submitted to a vote of shareholders as if they were converted into the Company’s common shares, except as otherwise provided by law. The holders of the Company’s common shares and the holders of Series C convertible preferred shares, on an as converted basis, have exclusive voting power with respect to the election of directors, except as provided with respect to any other class or series of shares. There is no cumulative voting in the election of directors. Therefore the holders of a majority of the outstanding common shares and Series C convertible preferred shares, on an as converted basis, are able to elect all of the directors then standing for election and the holders of the remaining common shares and Series C convertible preferred shares are not able to elect any directors.

Changes in Securities and Use of Proceeds

In connection with the merger with Apple Suites, the Company’s advisory agreement and the advisory agreement of Apple Suites with ASA was terminated. No further advisory fees are due under those agreements. In addition, the property acquisition/distribution agreements that the companies had with ASRG also was terminated. As a result of the Merger, the 240,000 Class B convertible preferred shares of Apple Suites held by Glade M. Knight and two business associates converted into 480,000 common shares of Apple Suites, which subsequently converted into 480,000 Units. Mr. Knight and the other holders of the Company’s Series B convertible preferred shares of Apple Hospitality Two exchanged their Series B convertible preferred shares for 1,272,000 newly created Series C convertible preferred shares.

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Item 6.

SELECTED FINANCIAL DATA

(in thousands, except per share data)

The following table sets forth selected financial data for the year ended December 31, 2003, December 31, 2002, and for the period January 17, 2001, through December 31, 2001, that has been derived from the Company’s audited financial statements and notes thereto. This data should be read in conjunction with Item 7, Management’s Discussion and Analysis of Financial Conditions and Results of Operations, and Item 15(a), the Consolidated Financial Statements and Notes thereto, appearing elsewhere in this Annual Report on Form 10-K.

(a) Funds from operations (FFO) is defined as net income (computed in accordance with generally accepted accounting principles - GAAP) excluding gains and losses from sales of depreciable property, plus depreciation, amortization and certain start-up costs. Additionally, the Company has excluded merger related costs as it believes modified FFO is a better measure of the Company’s performance. The merger costs are not anticipated to be recurring and were a result of the Company’s merger with Apple Suites. The company considers modified FFO in evaluating property acquisitions and its operating performance and believes that modified FFO should be considered along with, but not as an alternative to, net income and cash flows as a measure of the Company’s activities in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs.

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

This annual 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 this annual 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.

Overview

The Company is a real estate investment trust (“REIT”) that owns upscale, extended-stay hotels. The Company was formed on January 17, 2001, with the first investor closing commencing on May 1, 2001. The Company owns 66 hotels within different markets in the United States. The performance of the Company’s hotels can be influenced by many factors, including local hotel competition, local and national economic conditions and the performance of the individual managers assigned to our hotels. In evaluating financial condition and operating performance, the Company focuses on revenue measurements such as occupancy, average daily rate and revenue per available room and expenses such as hotel operating expenses, general and administrative expenses and other expenses described below.

During 2003, the Company’s results were impacted by two significant events. First, the lodging industry as a whole continued to experience a decline in occupancy and rates due to general economic conditions. Second, the Company began a major renovation project for many of its hotels. Accordingly, the Company’s financial performance was lower than prior years. Since there can be no assurance that economic conditions will improve, and since the Company will continue its renovation project in 2004, there can be no assurance that operating results will improve in 2004. However, due to the positive impact of the completed renovations and positive economic conditions in early 2004, the Company does believe there will be improvement in its results in 2004.

Hotels Owned

The Company owns 66 hotels, with a total of 7,869 suites. Of the Company’s 66 hotels, we own 49 Residence Inn^® by Marriott^® properties consisting of 5,947 suites, and 17 Homewood Suites^® by Hilton consisting of 1,922 suites.

The Company acquired its first 10 hotels in September 2001. 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:

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Fifteen of the Company’s hotels were acquired in February 2002. 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:

Twenty-three of the Company’s hotels were acquired in August 2002. 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:

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Seventeen of the Company’s hotels were acquired as a result of the merger with Apple Suites, Inc. (“Apple Suites”) 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 the Homewood Suites^® by Hilton franchise system:

Effective January 3, 2003, the company acquired a hotel in Redmond, Washington which has 180 suites and is operated as part of the Residence Inn^® by Marriott^® franchise system.

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Management Agreements

The Company’s Residence Inn hotels are subject to management agreements under which Residence Inn^® by Marriott^®, Inc. (the “Manager”) manages the hotels and provides access to the Company to Marriott’s intellectual property and proprietary sales and reservation system, 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 a percentage of sales, incentive management fees over a priority return (as defined in the management agreements), system fees, marketing fees and chain services. Incentive fees are payable only to the extent of cash flow from the properties as described in the management agreement on a portfolio basis. The Company has three portfolios of multiple hotels and one other hotel with separate incentive management agreements which are subject to this calculation. The Company records deferred 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. Total expenses for 2003 and 2002 paid to Residence Inn were $12.3 million and $8.9 million, respectively. Additionally, these agreements have termination provisions for the Company if certain operating results are not achieved.

Promus Hotels, Inc. (“Promus”), a wholly-owned subsidiary of Hilton, manages day-to-day operations of the Company’s Homewood Suites hotels. Promus charges fees for this function, which are calculated as a percentage of revenue. Incentive management fees are calculated, for certain properties, on the basis of operating profit of the hotels. No incentive management fees were earned in 2003. Promus also charges a fee, calculated as a percentage 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 approximately $7.6 million for the year ended December 31, 2003. These expenses are included in the hotel operating expenses mentioned below.

Acquisitions During 2003

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 that was formed to acquire the hotel, has assumed existing debt secured by the hotel. The lender is The 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.

Apple Suites, Inc.

On 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 upscale 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 the Company’s 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,

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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, 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 11,361,000 (valued at $8 per share for accounting purposes) Units and approximately $17.8 million in cash, and the Company assumed Apple Suites’ liabilities and paid certain merger costs. The Company funded the cash portion of the Merger consideration with available cash. Apple Suites assets and liabilities were recorded at fair value and no goodwill or intangible assets were recorded in connection with the transaction.

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, 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 has recognized an expense related to this transaction of $5.5 million through December 31, 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 year ended December 31, 2003.

Related Party Transactions

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

Prior to January 31, 2003, the Company had contracted with ASRG to provide brokerage services for the acquisition and disposition of the Company’s real estate assets. In accordance with the contract, ASRG was 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 years ended December 31, 2003 and 2002, ASRG earned $651,000 and $5,866,784, respectively, under this agreement. ASRG was owned by Mr. Glade M. Knight, the Company’s Chairman. Concurrent with the Company’s merger with Apple Suites on January 31, 2003, the Company’s agreement with ASRG was terminated.

The Company 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, the Company paid ASA a fee equal to 0.1% to 0.25% of total equity contributions the Company received in addition to certain reimbursable expenses. For the years ended December 31, 2003 and 2002, ASA earned $62,500 and $568,170, respectively, under this agreement. Concurrent with the Company’s merger with Apple Suites on January 31, 2003, the advisory agreement with ASA was terminated and no further advisory fees were due under that agreement. 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. Also in connection with the 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.

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The Company has an advisory agreement with Apple Hospitality Five Advisors, Inc., whereas the Company receives advisory fee revenue equal to 0.1% to 0.25% of total equity contributions received by Apple Hospitality Five, Inc., plus certain reimbursable expenses in exchange for Company personnel performing advisory and real estate acquisition due diligence for Apple Hospitality Five, Inc. The Company received advisory fee revenue in the amount of $296,435 under this agreement during the year ended December 31, 2003.

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 the Merger with it. (Refer to the “Acquisition of Apple Suites, Inc.” section above for further information about the merger with Apple Suites), and Mr. Knight is Chairman, President and Chief Executive Officer of Apple Hospitality Five, Inc.

Results of Operations for Years 2003 and 2002

The Company’s operating results were impacted by two significant events during 2003. First the lodging industry as a whole experienced a decline due to an overall decline in economic conditions throughout the United States. As reflected in the analysis below, Apple’s results were impacted by this overall industry decline. Second, the Company began a major renovation effort for 13 of its hotels during 2003. As a result periodically throughout the renovation process rooms at the individual hotels were taken out of service in order to perform the renovation, thus reducing the operating results for that hotel. The Company plans to continue its renovation efforts during 2004 with an additional 12 hotels scheduled for renovation in 2004.

Revenues

The Company’s principal source of revenue is hotel suite revenue. For the years ended December 31, 2003 and 2002, the Company had suite revenue and other revenue of $189,599,903 and $6,205,954 and $102,895,689 and $3,324,115, respectively. The increase in revenues is attributable to the acquisition of the Redmond hotel; the Company’s merger with Apple Suites, Inc; and the revenues associated with a full year of operations for the Company’s other hotel properties. For the years ended December 31, 2003 and 2002, the hotels achieved average occupancy of 74% and 78%, ADR of $91 and $92 and REVPAR of $67 and $71, 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. The decrease in occupancy, ADR and REVPAR for the years ended December 31, 2003 is related to the Company’s major renovation program at its hotel properties and a general industry decline due to economic conditions throughout the U.S. During the renovations program, suites are taken out of service while renovations are completed. The Company estimates approximately 54,000 room nights were out of service in 2003.

For the year ended December 31, 2003 and 2002, the Company had interest income of $840,681 and $1,292,925, respectively. Interest income represents earnings on excess cash, invested in short term money market instruments.

Expenses

The Company’s hotel operating expenses totaled $49,999,662 or 26% of suite revenue and $24,816,733 or 24% of suite revenue for the year ended December 31, 2003 and 2002, respectively. The reduction of REVPAR has increased hotel operating expenses on a percentage of revenue basis due primarily to lower ADR and to fixed costs associated with operating a hotel.

The Company’s general and administrative expenses for the year ended December 31, 2003 and 2002 were $1,948,134 or 1% of suite revenue and $1,943,257 or 2% of suite revenue, respectively. This percentage decreased as the Company’s asset base grew during 2003.

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Taxes, insurance and other expense for the year ended December 31, 2003 and 2002 was $12,762,914 or 7% of suite revenue and $6,578,038 or 6% of suite revenue, respectively.

Depreciation expense for the year ended December 31, 2003 and 2002 was $19,264,109 and $7,561,545, respectively. Depreciation expense for 2003 represents expense of the Company’s 66 hotels and related personal property, as well as a full year of renovations; and expense for 2002 represents expense of 48 hotels and related personal property owned at December 31, 2002. The Company’s capital expenditures increased from $6.8 million in 2002 to $48.6 million in 2003, as part of a major renovation program.

Interest expense was $25,545,677 and $13,402,143 for the year ended December 31, 2003 and 2002 respectively. Interest expense for the year ended December 31, 2003, represents interest on the 8.08%, $53 million promissory note assumed in conjunction with the Crestline acquisition, 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%, interest expense on the 8.85%, $130 million promissory note assumed in conjunction with the Res II Partnership acquisition, interest expense on the $20 million Redmond acquisition at 8.375% and Apple Suites debt of $76 million at and average rate of 8.4%. Interest expense also includes approximately $2.5 million in amortization of the Company’s fair value adjustment, and amortization of the premium on the Company’s note payable to Glade M. Knight, as discussed under Related Party Transactions above. Interest for the year ended December 31, 2002 represented the Crestline mortgage, Res I mortgages, and Res II mortgages, as well as an adjustment for early extinguishment of debt related to the Res I mortgage.

The Company incurred approximately $15.9 million in expenses in 2003 related to the Apple Suites merger. The expenses include approximately $10.2 million associated with the conversion of the series B convertible preferred shares to series C convertible shares and $5.5 million associated with the termination of the advisory agreement with ASA.

During the year ended December 31, 2003, the Company capitalized interest of $1.6 million related to suites out of service for renovations. No interest was capitalized in 2002.

Residence Inn Hotels

The Company’s 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 a percentage of sales, incentive management fees over a priority return (as defined in the management agreements), system fees, marketing fees and chain services. 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. System fees, marketing fees and chain services are based primarily on revenue and compensate Marriott for the use of their intellectual property, reservation and accounting systems and corporate personnel. Total fees paid in 2003 and 2002 were $12.3 million and $8.9 million, respectively.

Incentive fees are payable on a portfolio by portfolio basis for Residence Inn properties. The Company has three portfolios of multiple hotels and one other hotel with separate 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 and Redmond hotel. The Company has not recorded any deferred incentive management fees for the Res I and Res II portfolios.

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The Company acquired its 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, the Company assumed the amended and restated management agreements in effect with the Manager by the prior owner and 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 million 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 $133 million and $160 million for Res I and Res II, respectively.

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.