Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

 

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

FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2013

-OR-

 

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

For the transition period from                 to                

Commission file number 001-36190

 

 

Extended Stay America, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   46-3140312

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

Commission file number 001-36191

 

 

ESH Hospitality, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   27-3559821

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

11525 N. Community House Road, Suite 100

Charlotte, North Carolina 28277

(Address of principal executive offices, including zip code)

(980) 345-1600

(Registrants’ telephone number, including area code)

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

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $0.01 per share, of Extended

Stay America, Inc. and Class B Common Stock, par value

$0.01 per share, of ESH Hospitality, Inc., which are

attached and trade together as a Paired Share.

  New York Stock Exchange

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

 

None   None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Extended Stay America, Inc.    Yes  ¨    No  x
ESH Hospitality, Inc.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

Extended Stay America, Inc.    Yes  ¨    No  x
ESH Hospitality, Inc.    Yes  ¨    No  x

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.

 

Extended Stay America, Inc.    Yes  x    No  ¨
ESH Hospitality, Inc.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Extended Stay America, Inc.    Yes  x    No  ¨
ESH Hospitality, Inc.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K

 

Extended Stay America, Inc.    x   
ESH Hospitality, Inc.    x   

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Extended Stay America, Inc.    Large accelerated filer ¨    Accelerated filer  ¨
  

Non-accelerated filer x

(Do not check if a smaller reporting company)

   Smaller reporting company  ¨
ESH Hospitality, Inc.    Large accelerated filer ¨    Accelerated filer  ¨
  

Non-accelerated filer  x

(Do not check if a smaller reporting company)

   Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Extended Stay America, Inc.    Yes  ¨    No  x
ESH Hospitality, Inc.    Yes  ¨    No  x

As of June 28, 2013, the last business day of the registrants’ most recently completed second quarter, the registrants’ Paired Shares were not publicly traded. The registrants’ Paired Shares began trading on the New York Stock Exchange on November 13, 2013. As of March 10, 2014, the aggregate value of the registrants’ Paired Shares held by non-affiliates was approximately $900.9 million, based on the number of shares held by non-affiliates as of March 10, 2014 and the closing price of the registrants’ Paired Shares on the New York Stock Exchange on March 10, 2014.

Indicate by check mark whether the registrants have filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.    Yes  x    No  ¨

As of March 10, 2014, Extended Stay America, Inc. had 204,787,500 shares of common stock outstanding and ESH Hospitality, Inc. had 204,787,500 shares of Class B common stock and 250,295,833 shares of Class A common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statements relating to the 2014 Annual Meetings of Shareholders are incorporated by reference into Part III of this combined annual report on Form 10-K.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
ABOUT THIS COMBINED ANNUAL REPORT      ii   
CERTAIN DEFINED TERMS      iv   
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS      iv   
PART I   
Item 1.    Business      1   
Item 1A.    Risk Factors      6   
Item 1B.    Unresolved Staff Comments      29   
Item 2.    Properties      29   
Item 3.    Legal Proceedings      30   
Item 4.    Mine Safety Disclosures      30   
PART II    
Item 5.    Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      30   
Item 6.    Selected Financial Data      34   
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      41   
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk      74   
Item 8.    Financial Statements and Supplementary Data      75   
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      153   
Item 9A.    Controls and Procedures      153   
Item 9B.    Other Information      153   
PART III   
Item 10.    Directors, Executive Officers and Corporate Governance      154   
Item 11.    Executive Compensation      154   
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      154   
Item 13.    Certain Relationships and Related Transactions, and Director Independence      155   
Item 14.    Principal Accounting Fees and Services      155   
PART IV   
Item 15.    Exhibits, Financial Statement Schedules      155   

 

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ABOUT THIS COMBINED ANNUAL REPORT

This combined annual report on Form 10-K is filed by Extended Stay America, Inc., a Delaware corporation (the “Corporation”), and its controlled subsidiary, ESH Hospitality, Inc., a Delaware corporation (“ESH REIT”). Both the Corporation and ESH REIT have securities that have been registered under the Securities Act of 1933, as amended (the “Securities Act”), which are publicly traded and listed on the New York Stock Exchange (the “NYSE”) as Paired Shares (as defined below). As further discussed below, unless otherwise indicated or the context requires, the terms the “Company,” “Extended Stay,” “Extended Stay America,” “we,” “our” and “us” refer to the Corporation, ESH REIT and their subsidiaries considered as a single enterprise.

We believe combining the annual reports on Form 10-K of the Corporation and ESH REIT into this single report results in the following benefits:

 

    Enhances investors’ understanding of the Corporation and ESH REIT by enabling investors, whose ownership of Paired Shares gives them an ownership interest in our hotel properties through ESH REIT and in the operation of our business through the Corporation, to view the business as a whole.

 

    Eliminates duplicative and potentially confusing disclosure and provides a more streamlined presentation, since a substantial amount of our disclosure applies to the Corporation and ESH REIT.

 

    Creates time and cost efficiencies through the preparation of one combined report instead of two separate reports.

On November 18, 2013, the Corporation and ESH REIT completed their initial public offering (the “Offering”) of Paired Shares. Prior to the Offering, we completed the Pre-IPO Transactions (as defined in “Business—Our Recent Operating History—The Pre-IPO Transactions”), which restructured and reorganized the existing business. Unless otherwise indicated or the context requires:

 

    Company. Subsequent to the Pre-IPO Transactions, the term “Company” refers to the Corporation, ESH REIT and their subsidiaries considered as a single enterprise. For the period from October 8, 2010 (the “Acquisition Date”) through the Pre-IPO Transactions, the term “Company” refers to ESH REIT, ESH Strategies (as defined below), HVM (as defined below) and their subsidiaries considered as a single enterprise.

 

    Corporation. The term “Corporation” refers to Extended Stay America, Inc., a Delaware corporation, and its subsidiaries (excluding ESH REIT and its subsidiaries), which include the Operating Lessees (as defined below), ESH Strategies (as defined below) and ESA Management (as defined below). The Corporation controls ESH REIT through its ownership of ESH REIT’s Class A common stock, which represents approximately 55% of the outstanding common stock of ESH REIT.

 

    ESH REIT. Subsequent to the Pre-IPO Transactions, the term “ESH REIT” refers to ESH Hospitality, Inc., a Delaware corporation that has elected to be taxed as a REIT, and its subsidiaries. For the period from the Acquisition Date through the Pre-IPO Transactions, the term “ESH REIT” refers to ESH Hospitality LLC, a Delaware limited liability company that elected to be taxed as a REIT, its subsidiaries, which prior to the Pre-IPO Transactions, included three taxable REIT subsidiaries (the “Operating Lessees”) and HVM (as defined below), a consolidated variable interest entity. ESH REIT is a majority-owned subsidiary of the Corporation. For the period from the Acquisition Date through the Pre-IPO Transactions, ESH REIT was indirectly owned by the Sponsors (as defined below).

 

    ESH Strategies. The term “ESH Strategies” refers to ESH Hospitality Strategies LLC, a Delaware limited liability company, and its subsidiaries. ESH Strategies owns the intellectual property related to our business and is a wholly-owned subsidiary of the Corporation. For the period from the Acquisition Date through to the Pre-IPO Transactions, ESH Strategies was owned by the Sponsors (as defined below).

 

    ESA Management and HVM. The term “ESA Management” refers to ESA Management LLC, a Delaware limited liability company, and its subsidiaries. ESA Management manages the leased hotel properties on behalf of the Operating Lessees, and is a wholly-owned subsidiary of the Corporation. ESH REIT leases its hotel properties to the Operating Lessees. For the period from the Acquisition Date through the Pre-IPO Transactions, the Operating Lessees engaged HVM LLC (“HVM”) as an eligible independent contractor within the meaning of Section 856(d)(9) of the Internal Revenue Code of 1986, as amended (the “Code”), to manage the leased hotel properties on behalf of the Operating Lessees.

 

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    Company Predecessor. The term “Company Predecessor” refers to substantially all of the assets and operations of Homestead Village LLC that were auctioned off by the former debtors of Homestead Village LLC in its Chapter 11 reorganization, which were acquired by ESH REIT and ESH Strategies, collectively, on the Acquisition Date. The acquisition was accounted for as a business combination in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 805, “Business Combinations.”

 

    ESH REIT Predecessor. The term “ESH REIT Predecessor” refers to the portion of the assets and operations of Homestead Village LLC acquired by ESH REIT on the Acquisition Date. The acquisition was accounted for as a business combination in accordance with FASB ASC 805, “Business Combinations.”

 

    Paired Shares. The term “Paired Shares” means the shares of common stock, par value $0.01 per share, of the Corporation together with the shares of Class B common stock, par value $0.01 per share, of ESH REIT, which are attached and trade as a single unit.

 

    Sponsors. The term “Sponsors” collectively refers to Centerbridge Partners, L.P., Paulson & Co. Inc. and the Blackstone Group, L.P. and their affiliates.

See “Business—Our Corporate Structure” for a simplified structure chart reflecting our current corporate structure.

For ease of presentation:

 

    When we refer to our ownership of hotel properties, we are referring to the hotel properties owned by subsidiaries of ESH REIT.

 

    When we refer to the management and operation of our hotel properties, we are referring to the management of hotel properties by ESA Management, which is owned by the Corporation, subsequent to the Pre-IPO Transactions, and the management of hotel properties by HVM prior to the Pre-IPO Transactions.

 

    When we refer to our brands, we are referring to intellectual property related to our business owned by ESH Strategies.

 

    When we refer to our management team, our executives or officers, we are referring to the management team (and executives and officers) of the Corporation and ESH REIT. Prior to the Pre-IPO Transactions, when we refer to our management team, our executives or officers, we are referring to HVM’s management team (and executives and officers).

To help investors understand the differences between the Company and ESH REIT, this combined annual report on Form 10-K presents the following sections or portions of sections for each of the Company and ESH REIT (where applicable):

 

    Part II Item 5 – Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

    Part II Item 6 – Selected Financial Data

 

    Part II Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

    Part II Item 7A – Quantitative and Qualitative Disclosures About Market Risk

 

    Part II Item 8 – Financial Statements and Supplementary Data

As required by FASB ASC 810, “Consolidations,” due to the Corporation’s controlling financial interest in ESH REIT, the Corporation is required to consolidate ESH REIT’s financial position, results of operations, comprehensive income and cash flows with those of the Corporation. As such, selected financial data, management’s discussion and analysis of financial condition and results of operations and financial statements are presented herein for each of the Company, on a consolidated and combined basis, and ESH REIT. The Corporation’s stand-alone financial condition and related information is discussed herein where applicable.

This report also includes separate Part II Item 9A – Controls and Procedures sections and separate Exhibit 31 and 32 certifications for each of the Corporation and ESH REIT in order to establish that the Chief Executive Officer and the Chief Financial Officer of the Corporation and the Chief Executive Officer and the Chief Financial Officer of ESH REIT have made the requisite certifications and that the Corporation and ESH REIT are compliant with Rule 13a-15 or Rule 15d-15 of the Securities Exchange Act of 1934 and 18 U.S.C. §1350.

 

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CERTAIN DEFINED TERMS

The following are definitions of certain key lodging operating metrics used in this combined annual report on Form 10-K:

“ADR” or “average daily rate” means hotel room revenues divided by total number of rooms sold in a given period.

“Extended stay market” means the market of hotels with a fully equipped kitchenette in each guest room, which accept reservations and do not require a lease, as defined by The Highland Group.

“Hotel operating profit” means the sum of room and other hotel revenues less hotel operating expenses (excluding loss on disposal of assets) and “hotel operating margin” means the ratio of hotel operating profit divided by the sum of room and other hotel revenues.

“Mid-price extended stay segment” means the segment of the extended stay market that generally operates at a daily rate between $45 and $95, as defined by The Highland Group.

“Occupancy” or “occupancy rate” means the total number of rooms sold in a given period divided by the total number of rooms available at a hotel or group of hotels.

“RevPAR” or “revenue per available room” means the product of average daily room rate multiplied by the average daily occupancy achieved for a hotel or group of hotels in a given period. RevPAR does not include other ancillary revenues, such as food and beverage revenues or parking, telephone or other guest service revenues generated by a hotel.

The following terms when used in connection with our company-wide initiatives to renovate and make improvements to our hotel properties have the following meanings in this combined annual report on Form 10-K (in all cases, unless the context otherwise requires or where otherwise indicated):

“Hotel renovations” or “Platinum renovation package” refer to upgrades that typically include remodeling of common areas, new paint, carpet, signage, tile or vinyl flooring and counters in bathrooms and kitchens, as well as the refurbishment of furniture, replacement of aged mattresses and installation of new flat screen televisions, artwork, lighting and bedspreads.

“Post-Renovation Period” means the twelve-month period starting the month after the completion of the Ramp-Up Period.

“Pre-Renovation Period” means the twelve-month period ending the month prior to the commencement of renovations.

“Ramp-Up Period” means, typically, the additional three-month period for a renovated hotel to return to occupancy levels approximating Pre-Renovation Period levels following the Renovation Period.

“Renovation Period” means the approximately three-month period it takes to complete a Platinum hotel renovation, during which the hotel experiences temporary disruption and weakened performance.

“Room refreshes” or “Silver refresh package” refer to upgrades that typically include the replacement of aged mattresses and installation of new flat screen televisions, lighting, bedspreads and signage.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This combined annual report on Form 10-K contains “forward-looking statements” within the meaning of the federal securities laws. All statements other than statements of historical facts included in this combined annual report on Form 10-K may be forward-looking. Statements herein regarding our ongoing hotel reinvestment program, our ability to meet our debt service obligations, our future capital expenditures, our distribution or dividend strategy, our plans, objectives, goals, beliefs, business strategies, future events, business conditions, results of operations, financial position and our business outlook, business trends and other information referred to under “Business,” “Risk Factors,” “Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities—Distribution Policies” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements.

 

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When used in this combined annual report on Form 10-K, the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “will,” “look forward to” and variations of such words or similar expressions are intended to identify forward-looking statements. The forward-looking statements are not historical facts, and are based upon our current expectations, beliefs, estimates and projections, and various assumptions, many of which, by their nature, are inherently uncertain and beyond our control. Our expectations, beliefs, estimates and projections are expressed in good faith and we believe there is a reasonable basis for them. However, there can be no assurance that management’s expectations, beliefs, estimates and projections will result or be achieved and actual results may vary materially from what is expressed in or indicated by the forward-looking statements.

There are a number of risks, uncertainties and other important factors, many of which are beyond our control, that could cause our actual results to differ materially from the forward-looking statements contained in this combined annual report on Form 10-K. Such risks, uncertainties and other important factors include, but are not limited to:

 

    changes in U.S. general and local economic activity and the impact of these changes on consumer demand for lodging and related services in general and for extended stay lodging in particular;

 

    levels of spending in the business, travel and leisure industries, as well as consumer confidence;

 

    increased competition and the over-building of hotels in our markets;

 

    incidents or adverse publicity concerning our hotels or other extended stay hotels;

 

    our ability to implement our business strategies profitably;

 

    declines in occupancy and average daily rate;

 

    our ability to retain the services of certain members of our management;

 

    the ability of ESH REIT to qualify, and remain qualified, as a REIT under the Code;

 

    actual or constructive ownership (including deemed ownership by virtue of certain attribution provisions under the Code) of Paired Shares by investors who we do not control may cause ESH REIT to fail to meet the REIT income tests;

 

    the availability of capital for renovations and future acquisitions;

 

    the high fixed cost of hotel operations;

 

    the seasonal and cyclical nature of the real estate and lodging businesses;

 

    interruptions in transportation systems, which may result in reduced business or leisure travel;

 

    events beyond our control, such as war, terrorist attacks, travel-related health concerns and natural disasters;

 

    changes in distribution arrangements, such as through internet travel intermediaries;

 

    our ability to keep pace with improvements in technology utilized for reservations systems and other operating systems;

 

    decreases in brand loyalty due to increasing use of internet reservation channels;

 

    fluctuations in the supply and demand for hotel rooms;

 

    changes in the tastes and preferences of our customers;

 

    our ability to integrate and successfully operate any hotel properties acquired in the future and the risks associated with these hotel properties;

 

    changes in federal, state or local tax law, including legislative, administrative, regulatory or other actions affecting REITs or changes in interpretations thereof or increased taxes resulting from tax audits;

 

    the cost of compliance with and liabilities under environmental, health and safety laws;

 

    changes in real estate and zoning laws and increases in real property tax rates;

 

    increases in interest rates and operating costs;

 

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    our substantial indebtedness;

 

    inadequate insurance coverage;

 

    adverse litigation judgments or settlements; and

 

    our status as a “controlled company.”

There may be other factors that may cause our actual results to differ materially from the forward-looking statements, including factors disclosed in this combined annual report on Form 10-K. You should evaluate all forward-looking statements made in this combined annual report on Form 10-K in the context of these risks and uncertainties.

We caution you that the risks, uncertainties and other factors referenced above may not contain all of the risks, uncertainties and other factors that are important to you. In addition, we cannot assure you that we will realize the results, benefits or developments that we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our business in the way expected. We undertake no obligation to publicly update or revise any forward-looking statements to reflect subsequent events or circumstances, except as required by law.

 

 

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PART I

 

Item 1. Business

Our Company

We are the largest owner/operator of company-branded hotels in North America. Our business operates in the extended stay lodging industry, and we own and operate 684 hotel properties comprising approximately 76,200 rooms located in 44 states across the United States and in Canada. We own and operate 632 of our hotels under the core brand, Extended Stay America, which serves the mid-price extended stay segment, and accounts for approximately half of the segment by number of rooms in the United States. In addition, we own and operate three Extended Stay Canada hotels and 49 hotels in the economy extended stay segment under the Crossland Economy Studios and Hometown Inn brands. For the year ended December 31, 2013, the Company had revenues of approximately $1.1 billion, Adjusted EBITDA of approximately $518.6 million and net income of approximately $82.7 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures—The Company” for a definition of Adjusted EBITDA and a reconciliation of net income to Adjusted EBITDA.

Our extended stay hotels are designed to provide an affordable and attractive alternative to traditional lodging or apartment accommodations and are targeted toward self-sufficient, value-conscious guests. Our hotels feature fully-furnished rooms with in-room kitchens, complimentary grab-and-go breakfast, free WiFi, flat screen TVs and limited housekeeping service, which is typically provided on a weekly basis. Our guests include business travelers, professionals on temporary work or training assignments, persons relocating, temporarily displaced or purchasing a home and anyone else in need of temporary housing. These guests generally rent accommodations on a weekly or longer term basis.

In 2013, our average length of stay was approximately 26 days, our occupancy was 74.2% and our hotels generated property-level hotel operating margins greater than 50%.

We were founded in January 1995 as a developer, owner and operator of extended stay hotels. Following a period focused primarily on new development, we became a consolidator of hotel properties by selectively acquiring extended stay companies and hotels, ultimately creating the largest mid-price extended stay company in the United States. We were acquired out of bankruptcy by the Sponsors on October 8, 2010. We now operate an extended stay hospitality platform with approximately 10,000 employees and are led by a management team with extensive public company experience in hospitality, consumer retail and service businesses.

Our Recent Operating History

Prior to the Offering, we restructured and reorganized our then-existing business through a series of transactions (collectively, as described more fully below, the “Pre-IPO Transactions”). We believe that our business is now more operationally efficient because all of the assets, operations and management of our business, other than ownership of the hotel properties, is housed in one entity. Ownership of Paired Shares gives investors an ownership interest in our hotel properties through ESH REIT and in the operation of our business through the Corporation. The structure permits us to retain some, though not all, of the REIT benefits of our prior structure (i.e., while ESH REIT continues to be taxed as a REIT for U.S. federal income tax purposes, all distributions paid by ESH REIT to the Corporation are subject to corporate level tax, effectively eliminating a majority of the tax benefit of REIT status for the consolidated and combined Company taken as a whole).

The Corporation

Extended Stay America, Inc. was incorporated in Delaware on July 8, 2013. The Corporation manages and operates the 684 hotels owned by ESH REIT. The hotel properties are managed by ESA Management, a wholly-owned subsidiary of the Corporation, pursuant to management agreements with the operating lessees, and operated by the Operating Lessees, wholly-owned subsidiaries of the Corporation, pursuant to leases with ESH REIT. The substantial majority of the hotels are operated under the core brand, Extended Stay America. A wholly-owned subsidiary of the Corporation owns the brands related to our business.

 

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ESH REIT

ESH Hospitality, Inc. was formed as a limited liability in Delaware on September 16, 2010 and was converted to a corporation on November 5, 2013. ESH REIT has elected to be taxed as a REIT. ESH REIT owns the Company’s 684 hotels, which are managed and operated by subsidiaries of the Corporation as described in the preceding paragraph.

The Pre-IPO Transactions

The Corporation was formed for the purpose of effecting the Pre-IPO Transactions. Prior to the Pre-IPO Transactions, ESH Hospitality Holdings LLC, a Delaware limited liability company (“Holdings”), owned all of ESH REIT’s then-outstanding common units. Prior to the Pre-IPO Transactions, the Sponsors owned an approximate 99% interest in Holdings and the remaining interests were owned by certain members of the board of managers of Holdings and employees of HVM. Prior to the Pre-IPO Transactions, the Operating Lessees were each taxable REIT subsidiaries that leased the hotel properties from ESH REIT pursuant to operating leases. HVM was an eligible independent contractor, within the meaning of Section 856(d)(9) of the Code, that managed the hotel properties pursuant to management agreements with the Operating Lessees. Subsidiaries of ESH Strategies owned the trademarks and licensed their use to the Operating Lessees pursuant to trademark license agreements.

Through the Pre-IPO Transactions, the existing business was restructured and reorganized such that Holdings was liquidated and substantially all of the common stock of ESH REIT was distributed to the Sponsors; the Operating Lessees, ESH Strategies and the assets and obligations of HVM were transferred to the Corporation; the shareholders of ESH REIT transferred to the Corporation all of the Class A common stock of ESH REIT; and 100% of the common stock of the Corporation and all of the Class B common stock of ESH REIT were paired, forming the Paired Shares.

The Corporation, through its direct wholly-owned subsidiaries, now leases the hotel properties from ESH REIT, owns the trademarks related to the business and self-manages the hotel properties. In addition, the Corporation owns all of the Class A common stock of ESH REIT, which represents approximately 55% of the outstanding shares of common stock of ESH REIT. The Corporation used the majority of the proceeds it received in the Offering to purchase a sufficient number of additional shares of Class A common stock of ESH REIT to ensure that, upon the completion of the Offering, the Class A common stock of ESH REIT owned by the Corporation represented approximately 55% of the outstanding common stock of ESH REIT.

Our Brands

We own and operate substantially all of our hotels under the core Extended Stay America brand and during 2013 completed a rebranding program to consolidate the remaining hotels that were operated under the former brand portfolio of Homestead Studio Suites, Studio Plus and Extended Stay Deluxe under this single brand. Our Extended Stay America-branded hotels feature:

 

    In-room kitchens;

 

    Free WiFi;

 

    Free grab-and-go breakfast;

 

    Flat screen TVs with premium cable channels;

 

    On-site guest laundry; and

 

    Unlimited local phone service.

We own and operate 632 Extended Stay America hotels with approximately 69,600 rooms in the United States and three hotels with 500 rooms in Canada under the Extended Stay Canada brand. Additionally, we continue to own and operate 47 hotels with approximately 5,900 rooms under the Crossland Economy Studios brand and two hotels with 265 rooms under the Hometown Inn brand. Crossland and Hometown Inn operate in a lower price tier than Extended Stay America-branded hotels, offering fewer amenities and smaller room sizes and primarily appeal to guests with longer duration stays.

 

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Our Corporate Structure

The chart below summarizes our corporate structure as of the date of this combined annual report on Form 10-K.

 

LOGO

 

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Our Industry

U.S. Lodging Industry

The lodging industry is a significant part of the U.S. economy, generating over $122.3 billion of room revenues in 2013 and comprising approximately 4.9 million hotel rooms as of December 31, 2013, according to STR, Inc. Lodging industry performance is generally tied to both macro-economic and micro-economic trends in the United States and, similar to other industries, experiences both positive and negative operating cycles. Since the 2008 to 2009 recession, demand in the U.S. lodging industry has begun to recover while supply growth has remained at historically low rates. According to PricewaterhouseCoopers (“PwC”), room supply grew 0.7% in 2013 and is expected to grow 1.0% in 2014, which is still well below historical annual supply growth of 1.7% over the last 15 years. RevPAR has grown in the U.S. lodging industry for each year starting in 2010 and according to PwC, RevPAR for the overall U.S. lodging industry grew 5.4% in 2013 and is expected to grow 6.0% in 2014.

U.S. Extended Stay Segment

Extended stay hotels represent a growing segment within the U.S. lodging industry with approximately 360,925 rooms that generated approximately $7.9 billion of revenues for the year ended December 31, 2013, according to The Highland Group. The extended stay segment tends to follow the cyclicality of the overall lodging industry.

Extended stay hotels are further differentiated by price point into economy, mid-price and upscale segments. Our business is focused primarily on the mid-price extended stay segment, which comprised approximately 39% of the supply of extended stay rooms in 2013. RevPAR growth for the mid-price extended stay segment has outpaced the U.S. lodging industry as a whole since 2009 as well as the economy and upscale extended stay segments. The mid-price extended stay segment rebounded from an industry trough with RevPAR growth of 33.4% between 2009 and 2013, which was higher than the overall U.S. lodging industry as well as the economy and upscale extended stay segments, each of which grew at 28.2%, 21.5% and 22.2%, respectively, for the same period.

Seasonality

The lodging industry is seasonal in nature. Based upon the operating history of our hotels, we believe that our business is not as seasonal in nature as the overall lodging industry. However, our revenues are generally lower during the first and fourth quarters of each calendar year as is typical in the U.S. lodging industry. Because many of our expenses are fixed and do not fluctuate with changes in revenues, declines in revenues can cause disproportionate fluctuations or decreases in our quarterly earnings and cash flows during these periods.

Cyclicality

The lodging industry is cyclical and its fundamental performance tends to follow the general economy, albeit on a lagged basis. There is a history of increases and decreases in demand for hotel rooms, in occupancy levels and in rates realized by owners of hotels through economic cycles. Variability of results through some of the cycles in the past has been more severe due to changes in the supply of hotel rooms in given markets or in given categories of hotels. The combination of changes in economic conditions and in the supply of hotel rooms can result in significant volatility in results of operations for owners of hotel properties. The costs of running a hotel tend to be more fixed than variable. Because of this, in an environment of either increasing or decreasing revenues, the rate of change in earnings will be greater than the rate of change in revenues. See “Risk Factors—The lodging industry, including the extended stay segment, is cyclical and a worsening of general economic conditions or low levels of economic growth could materially adversely affect our business, financial condition, results of operations and our ability to pay dividends to our shareholders.”

Competition

We operate in a highly competitive industry. Competition in the lodging industry is based on a number of factors, including room rates, quality of accommodations, service levels, convenience of location, reputation, reservation systems, name recognition and the supply and availability of lodging in local markets, including short-term lease apartments and limited service hotels. Competitors may include new participants in the lodging industry generally and participants in other segments of the lodging industry that may enter the extended stay segment. They may also include existing participants in the extended stay segment that may increase their

 

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product offerings to include facilities in the budget, economy or mid-price segments. We also compete for travelers with hotels outside the extended stay segment as well as serviced apartments. Competition is for both quality locations to build new facilities and for guests to fill and pay for those facilities. We also face competition from third-party internet travel intermediaries, such as Priceline.com, Expedia.com and Travelocity.com, and specialized intermediaries that locate and reserve hotel rooms for corporate lodgers. See “Risk Factors—Risks Related to the Lodging Industry—We operate in a highly competitive industry.”

Employees

We employ approximately 10,000 employees. Approximately 9,500 of these employees are property-level employees, comprised of approximately 3,200 full time employees and approximately 6,300 part time employees. None of our employees are represented by unions or covered by collective bargaining agreements. We consider our relations with our employees to be good.

Sales, Marketing and Reservations

Our sales team is made up of approximately 115 sales professionals focused on growing our business with key accounts, building relationships with new customers and coaching our property operation teams on local sales. We are organized regionally, or by account, and our team focuses on the following customers: major Fortune 500 companies; small and medium sized businesses; travel agencies; relocation and staffing consultants; and medical, technology, government and educational organizations. Approximately 40% of our revenue in 2013 was derived from accounts managed by this team. Our upgraded brand and amenity offering now allows our sales force to target a broader corporate customer base. We believe further penetration of corporate accounts will yield a more profitable customer base.

We seek to maximize revenue in each hotel through our revenue management team, made up of approximately 35 associates. They are responsible for determining prices and managing the availability of room inventory to different channels and customer segments. Historically, we had very limited staffing and focus on this area. Beginning in 2012, we significantly expanded our staffing and investment in revenue management. We have centralized our approach and developed several analytical tools to inform pricing and inventory decisions. We believe we have an opportunity to further improve the team’s effectiveness and efficiency by deploying an automated revenue management system.

Our marketing strategy is focused on growing awareness of our brands and demand for our hotels through a combination of media channels, including TV, print and radio, public relations and email marketing. We also put a significant emphasis on our internet activity, buying search engine placement, internet display advertising and other media to drive traffic to our website. We maintain a customer database and use it for targeted marketing activity. Additionally, we have introduced marketing in new channels, such as TV and radio, in part to support our consolidation under a single brand.

We use a central reservation system to provide access to our hotel inventory through a wide variety of channels—property-direct, our central call center, our desktop and mobile websites, travel agency global distribution systems and our wholesale and online distribution booking partners. We outsource our reservation system, our call center and management of our website. For the year ended December 31, 2013, approximately 60% of our revenue was derived from property-direct reservations, approximately 8% was derived from our central call center, approximately 17% was derived from our own proprietary website, approximately 6% was derived from online booking partners and approximately 9% was derived from global distribution systems. We believe we also have an opportunity to increase the power and reach of our distribution network by enhanced connections with additional agency, merchant and wholesale partners.

Environmental Matters

Our hotel properties are subject to various federal, state and local environmental laws that impose liability for contamination. Under these laws, governmental entities have the authority to require us, as the current or former owner of the property, to perform or pay for the clean-up of contamination (including hazardous substances, waste or petroleum products) at or emanating from the property and to pay for natural resource damage arising from contamination. These laws often impose liability without regard to whether the owner or operator knew of or caused the contamination. Such liability can be joint and several, so that each covered person can be responsible for all of the costs involved, even if more than one person may have been responsible for the contamination. We can also be liable to private parties for costs of remediation, personal injury and death and/or property damage resulting from contamination at or emanating from our hotel properties. Moreover, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property on favorable terms or at all. Furthermore, persons who sent waste to a waste disposal facility, such as a landfill or an incinerator, may be liable for costs associated with cleanup of that facility.

        Recent Phase I environmental assessments have been obtained for each of our hotel properties. The Phase I environmental assessments were intended to identify potential contamination, but did not include any invasive sampling procedures, such as soil or ground water sampling. The Phase I environmental assessments identified a number of known or potential environmental conditions associated with historic uses of the hotel properties or adjacent properties. However, the Phase I environmental assessments did not identify any environmental liability that we believe would have a material adverse effect on our business, assets, results of operations or liquidity. It is possible that these environmental assessments did not reveal all potential environmental liabilities, such as the presence of former underground tanks for the storage of petroleum-based or waste products, that could create a potential for release of hazardous substances. In addition, it is possible that environmental liabilities have arisen since the assessments were completed. No assurances can be given that (i) future regulatory requirements will not impose any material environmental liability, or (ii) the current environmental condition of our hotel properties will not be affected by the condition of properties in the vicinity of our hotel properties (such as the presence of leaking underground storage tanks) or by third parties unrelated to us.

We have obtained environmental insurance with respect to each of our hotel properties, subject to limits, deductibles and exclusions customarily carried for similar properties. We believe that the environmental insurance policies are appropriate and adequate given the relative risk of loss, the cost of the coverage and industry practice; however, our environmental insurance coverage may not be sufficient to fully cover our losses.

In addition, our hotels (including our real property, operations and equipment) are subject to various federal, state and local environmental, health and safety regulatory requirements that address a wide variety of issues, including, but not limited to, the use, management and disposal of hazardous substances and wastes, air emissions, discharges of waste materials (such as refuge or sewage), the registration, maintenance and operation of our boilers and storage tanks, asbestos, and lead-based paint. Some of our hotels also routinely handle and use hazardous or regulated substances and wastes as part of their operations, which are subject to regulation (for example, swimming pool chemicals or biological waste). Our hotels incur costs to comply with these environmental, health and safety laws and regulations, and if these regulatory requirements are not met or become more stringent in the future, or unforeseen events result in the discharge of dangerous or toxic substances at our hotel properties, we could be subject to increased costs of compliance, fines and penalties for non-compliance, and material liability from third parties for harm to the environment, damage to real property or personal injury and death. We are aware of no past or present environmental liability for non-compliance with environmental, health and safety laws and regulations that we believe would have a material adverse effect on our business, assets or results of operations.

Certain hotels we currently own or those we acquire in the future contain, may contain, or may have contained asbestos-contaminating material (“ACM”). Environmental, health and safety laws require that ACM be properly managed and maintained, and include requirements to undertake special precautions, such as removal or abatement, if ACM would be disturbed during maintenance, renovation or demolition of a building. These laws regarding ACM may impose fines and penalties on building owners, employers and operators for failure to comply with these requirements or expose us to third-party liability. We are not presently aware of any ACM at our hotel properties that would result in a material adverse effect on our business, assets or results of operations.

 

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In addition, when excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our hotel properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property. In addition, the presence of significant mold could expose us to liability from our guests, employees and others if property damage or health concerns arise. We are not presently aware of any indoor air quality issues at our hotel properties that would result in a material adverse effect on our business, assets or results of operations.

Regulation

A number of states and local governments regulate the licensing of hotels by requiring registration, disclosure statements and compliance with specific standards of conduct. We believe that each of our hotels has the necessary permits and approvals to operate its respective business, and we intend to continue to obtain these permits and approvals for any new hotels. We are also subject to laws governing our relationship with our employees, including minimum wage requirements, overtime, working conditions and work permit requirements. An increase in the minimum wage rate, employee benefit costs or other costs associated with employees could materially adversely affect our business. There are frequently proposals under consideration, at the federal and state levels, to increase the minimum wage.

Under the American with Disabilities Act of 1990 (the “ADA”), all public accommodations are required to meet certain federal requirements related to access and use by disabled persons. We attempt to satisfy ADA requirements in the designs for our hotels, but we cannot assure you that we will not be subjected to a material ADA claim. If that were to happen, we could be ordered to spend substantial sums to achieve compliance, fines could be imposed against us, and we could be required to pay damage awards to private litigants. The ADA and other regulatory initiatives could materially adversely affect our business as well as the lodging industry in general.

Insurance

We currently have the types and amounts of insurance coverage that we consider appropriate for a company in our business. While we believe that our insurance coverage is adequate, our business, results of operations and financial condition could be materially adversely affected if we were held liable for amounts exceeding the limits of our insurance coverage or for claims outside the scope of our insurance coverage.

Available Information

Our website address is www.extendedstay.com. Our combined annual reports on Form 10-K, combined quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are available free of charge through our website under “Investor Relations,” as soon as reasonably practicable after the electronic filing of these reports is made with the Securities and Exchange Commission (“SEC”). The information contained on, or that can be accessed through, our website, is expressly not incorporated by reference in this combined annual report on Form 10-K.

 

Item 1A. Risk Factors

You should carefully consider the following risks as well as the other information included in this combined annual report on Form 10-K. Any of the following risks could materially and adversely affect our business, financial condition or results of operations and our ability to pay dividends to our shareholders.

Risks Related to the Lodging Industry

We operate in a highly competitive industry.

The lodging industry is highly competitive. We compete with traditional hotels and lodging facilities (including limited service hotels), other purpose built extended stay hotels (including those owned and operated by major hospitality chains with well-established and recognized brands and individually-owned extended stay hotels) and alternative lodging (including serviced apartments). We expect that competition within the mid-price and economy segments of the extended stay lodging market will continue as we face increased competition from third-party internet travel intermediaries, such as Priceline.com, Expedia.com and Travelocity.com, and specialized intermediaries that locate and reserve hotel rooms for corporate lodgers. We compete based on a number of factors, including room rates, quality of accommodations, service levels, convenience of location, reputation, reservation systems, brand recognition and supply and availability of alternative lodging. See “Business—Competition.” To maintain our rates,

 

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we may face pressure to offer increased services and amenities at our hotel properties, comparable to those offered at traditional hotels, which could increase our operating costs and reduce our profitability. We do not expect to increase our rates to match our competitors, and a number of our competitors have a significant number of individuals participating in their guest loyalty programs, which may enable them to attract more customers and more effectively retain such customers. Our competitors may also have greater financial and marketing resources than we do, which could allow them to reduce their rates, offer greater convenience, services or amenities, build new hotels in direct competition with our existing hotels, improve their properties, expand and improve their marketing efforts, all of which could have a material adverse effect on our business, financial condition and results of operations.

The lodging industry, including the extended stay segment, is cyclical and a worsening of general economic conditions or low levels of economic growth could materially adversely affect our business, financial condition, results of operations and our ability to pay dividends to our shareholders.

The performance of the lodging industry, including the extended stay segment, is closely linked to the performance of the general economy and is sensitive to business and personal discretionary spending levels. Declines in corporate budgets and spending and consumer demand due to adverse general economic conditions, risks affecting or reducing travel patterns, lower consumer confidence and high unemployment or adverse political conditions can lower the revenues and profitability of our hotels.

Changes in consumer demand and general business cycles can subject, and have subjected, our revenues to significant volatility. The majority of our expenses are relatively fixed. These fixed expenses include labor costs, interest, rent, property taxes, insurance and utilities, all of which may increase at a greater rate than our revenues. The expenses of owning and operating hotels are not significantly reduced when circumstances such as market and economic factors and competition cause a reduction in revenues. Where cost-cutting efforts are insufficient to offset declines in revenues, we could experience a material decline in margins and reduced operating cash flows or losses. If we are unable to decrease our expenses significantly or rapidly when demand for our hotels decreases, the decline in our revenues could have a materially adverse effect on our net operating cash flows and profitability. This effect can be especially pronounced during periods of economic contraction or slow economic growth, such as the recent economic recession.

In addition to general economic conditions, new hotel room supply is an important factor that can affect the lodging industry’s performance and overbuilding has the potential to further exacerbate the negative effect of an economic downturn or precipitate a cycle turn. Room rates and occupancy, and thus RevPAR, tend to increase when demand growth exceeds supply growth. Decline in hotel room demand, or a continued growth in hotel room supply, could result in revenues that are substantially below expectations or result in losses, which could have a material adverse effect on our business, financial condition, results of operations and our ability to pay dividends to our shareholders. See “Business—Our Industry” for a description of increases in hotel room supply.

The extended stay segment has tended to follow the overall cyclicality of the lodging industry. In periods of declining demand, competition for guests may result in more reliance on longer-term guests, who generally pay lower rates than shorter-term guests, which could reduce revenues and margins. Equally, in periods of increasing demand, a transition to shorter-term guests paying higher rates might result in increased hotel expenses for amenities considered necessary to attract those guests, such as daily rather than weekly housekeeping, potentially reducing margins.

Uncertainty regarding the rate and pace of recovery from the recent economic downturn and the impact any such recovery may have on the lodging industry makes it difficult to predict future profitability levels. A slowing of the current economic recovery or new economic weakness could materially adversely affect our revenues and profitability.

We are subject to the operating risks common to the lodging industry.

Changes in general and local economic and market conditions and other factors beyond our control as well as the business, financial, operating and other risks common to the lodging industry and inherent to the ownership of hotels could materially adversely affect demand for lodging products and services. This includes demand for rooms at hotel properties that we own, operate or acquire. These factors include:

 

    changes in the relative mix of extended stay brands in various industry price categories;

 

    over-building of hotels in our markets;

 

    changes in the desirability of particular geographic locations, lodging preferences and travel patterns of customers;

 

    increases in customer price sensitivity, making it more difficult to achieve planned ADR increases;

 

    dependence on corporate and commercial travelers and on tourism;

 

    decreased corporate budgets and spending and cancellations, deferrals or renegotiations of group business;

 

    high levels of unemployment and depressed housing prices;

 

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    increases in operating costs due to inflation and other factors that may not be offset by increased room rates;

 

    increases in the cost, or the lack of availability, of capital to operate, maintain and renovate our hotel properties;

 

    potential increases in labor costs, including as a result of increases to federal and state minimum wage levels, unionization of the labor force and increasing health care insurance expense;

 

    changes in taxes and governmental regulations that influence or set wages, prices, interest rates or construction and maintenance procedures and costs;

 

    the costs and administrative burdens associated with compliance with applicable laws and regulations; and

 

    events beyond our control that may disproportionately affect the travel industry, such as war, terrorist attacks, travel-related health concerns, transportation and fuel prices, interruptions in transportation systems, travel-related accidents, fires, natural disasters and severe weather.

These factors can adversely affect, and from time to time have materially adversely affected, individual hotel properties, particular regions or business as a whole. How we manage any one or more of these factors, or any crisis, could limit or reduce demand and the rates we are able to charge for rooms or services, which could materially adversely affect our operating results and growth. These factors may be exacerbated by the relatively illiquid nature of our real estate holdings, which will limit our ability to vary our portfolio in response to changes in economic and other conditions.

Our revenues are subject to seasonal fluctuations.

The lodging industry is seasonal in nature. Our occupancy rates and revenues generally are lower than average during the first and fourth quarter of each calendar year. Quarterly variations in revenues at our hotel properties could materially adversely affect our near-term operating revenues and cash flows, which in turn could have a material adverse effect on our business, financial condition and results of operations.

Risks Related to Our Business

If we fail to implement our business strategies, our business, financial condition and results of operations could be materially adversely affected.

Our financial performance and success depend in large part on our ability to successfully implement our business strategies. See “Business—Our Business Strategy.” We cannot assure you that we will be able to successfully implement our business strategies, realize any benefit from our strategies or be able to continue improving our results of operations. We may spend significant amounts in connection with our business strategies, which would result in increased costs but may not result in increased revenues or improved results of operations.

Implementation of our business strategies could be affected by a number of factors beyond our control, such as increased competition, legal and regulatory developments, general economic conditions or an increase in operating costs. Any failure to successfully implement our business strategies could materially adversely affect our business, financial condition and results of operations. We may, in addition, decide to alter or discontinue certain aspects of our business strategies at any time.

Our capital expenditures may not result in our expected improvements in our business.

We are executing a phased capital investment program across our portfolio in order to seek to drive incremental market share gains. This program is dedicated to seeking increased revenue through our Platinum renovation and Silver refresh programs to upgrade 633, or approximately 93%, of our hotels. Capital investments with respect to in-process or completed phases of our hotel reinvestment program are expected to total approximately $365.8 million, of which approximately $322.9 has been spent as of December 31, 2013. During 2014, we expect to spend in excess of $75.0 million on current and future phases of our reinvestment program. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Capital Expenditures.”

The realization of returns on our investments in line with our expectations is dependent on a number of factors, including, but not limited to, general economic conditions, events beyond our control, whether our assumptions in making the investment were correct and changes in the factors underlying our investment decision, such as changes in the tastes and preferences of our customers. We can provide no assurance that we will continue to see returns on our previous capital expenditure investments, that we will realize our expected returns on our current investments, or any returns at all, or that our future investments will result in our expected returns on investments, returns that are consistent with our prior returns on capital expenditure investments, or any returns at all. Growth that we do realize as a result of our capital expenditures is expected to stabilize over time. A failure to realize our expected returns on our investments in our hotel properties could materially adversely affect our business, financial condition and results of operations.

 

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Access to capital, timing, budgeting and other risks associated with the ongoing need for capital expenditures at our hotel properties could materially adversely affect our financial condition and limit our ability to compete effectively and pay dividends to our shareholders.

The lodging industry is a capital intensive business that requires significant capital expenditures to own and operate hotel properties. In addition, we must maintain, renovate and improve our hotel properties in order to remain competitive, maintain the value and brand standards of our hotel properties and comply with applicable laws and regulations.

Maintenance, renovations and improvements to our hotel properties create an ongoing need for cash and, to the extent we cannot fund expenditures from cash generated by operations, funds must be borrowed or otherwise obtained. We also intend to pay regular dividends, which means we may not retain cash for future capital expenditures. Access to the capital that we need to renovate and maintain our existing hotel properties and to acquire new hotel properties is critical to the continued growth of our business and our revenues. The availability of capital or the conditions under which we can obtain capital can have a significant impact on the overall level, cost and pace of future renovation or development and therefore the ability to grow our revenues. As of December 31, 2013, we had total indebtedness of approximately $2.9 billion. Our substantial indebtedness may impair our ability to borrow additional amounts. Our ability to access additional capital could also be limited by the terms of our indebtedness and any future indebtedness, which restrict or will restrict our ability to incur debt under certain circumstances. In particular, the 2012 Mortgage Loan and the 2012 Mezzanine Loans prohibit any further encumbrances on the collateral securing that indebtedness, which is comprised of substantially all of our hotels. In the past, reduced investments in our properties resulted in declining performance of our business.

Additionally, our ongoing operational requirements and capital expenditures subject us to the following risks:

 

    potential environmental problems, such as the need to remove or abate asbestos-containing materials;

 

    design defects, construction cost overruns (including labor and materials) and delays;

 

    difficulty obtaining zoning, occupancy and other required permits or authorizations;

 

    the possibility that revenues will be reduced temporarily while rooms offered are out of service due to capital improvement projects; and

 

    a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available on affordable terms or at all.

If the cost of funding renovations or enhancements exceeds budgeted amounts, and/or the time period for renovation is longer than initially anticipated, our profits could be reduced. If we are forced to spend larger amounts of cash from operations than anticipated to operate, maintain or renovate existing hotel properties, then our ability to use cash for other purposes, including paying dividends to our shareholders or the potential acquisition of hotel properties, could be limited and our profits could be reduced. Similarly, if we cannot access the capital we need to fund our operations or implement our business strategies, we may need to postpone or cancel planned maintenance, renovations or improvements plans, which could impair our ability to compete effectively and harm our business, financial condition and results of operations.

 

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We are exposed to the risks resulting from real estate ownership, which could increase our costs, reduce our profitability and limit our ability to respond to market conditions.

Our principal assets consist of real property. Our real estate ownership subjects us to additional risks not applicable to those competitors in the lodging industry that only manage or franchise hotel properties, including:

 

    the illiquid nature of real estate, which may limit our ability to promptly sell one or more hotels in our portfolio in response to changing financial conditions;

 

    adverse changes in economic and market conditions;

 

    real estate, insurance, zoning, tax, environmental and eminent domain laws, including the condemnation of our properties;

 

    fluctuations in real estate values or potential impairments in the value of our assets;

 

    the ongoing need for capital improvements and expenditures to maintain, renovate or upgrade hotel properties;

 

    risks associated with mortgage debt, including the possibility of default, fluctuating interest rate levels and the availability of replacement financing;

 

    risks associated with the possibility that expense increases will outpace revenue increases and that in the event of an economic downturn, the high proportion of fixed expenses among our costs will make it difficult to reduce our expenses to the extent required to offset declining revenues;

 

    changes in laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance; and

 

    events beyond our control, such as war, terrorist attacks and force majeure events, including earthquakes, tornados, hurricanes, fires or floods.

Economic and other conditions may materially adversely affect the valuation of our hotel properties resulting in impairment charges that could have a material adverse effect on our business, results of operations and earnings.

We hold goodwill, intangible assets and a significant amount of long-lived assets. We evaluate our tangible and intangible assets annually for impairment, or more frequently based on various triggers, including when a property has current or projected operating losses or when other material trends, contingencies or changes in circumstances indicate that a triggering event has occurred, such that an asset’s value may not be recoverable. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies.” During times of economic distress, declining demand and declining earnings often result in declining asset values. As a result, we have incurred and we may in the future incur impairment charges, which in the future could be material and adversely affect our results of operations and earnings.

We have a significant amount of debt and the agreements governing our indebtedness place, and any future indebtedness may place, restrictions on us, reducing operational flexibility and creating default risks.

We have a significant amount of debt. As of December 31, 2013, we had total indebtedness of approximately $2.9 billion and the Company had a debt-to-equity ratio of 2.2x. In the future, subject to compliance with the covenants included in our indebtedness, we may incur additional indebtedness and intercompany indebtedness, to finance future hotel acquisitions, renovation and improvement activities and for other corporate purposes. A substantial level of indebtedness could have a material adverse effect on our business, results of operations and financial condition because it could, among other things:

 

    require us to dedicate a substantial portion of our cash flows to make principal and interest payments on indebtedness, thereby reducing our cash flows available to fund working capital, capital expenditures and other general corporate purposes, including our ability to pay cash dividends to our shareholders;

 

    increase our vulnerability to general adverse economic and industry conditions and limit our flexibility in planning for, or reacting to, changes in our business and our industry;

 

    limit our ability to borrow additional funds or refinance indebtedness on favorable terms or at all to expand our business or ease liquidity constraints; and

 

    place us at a competitive disadvantage relative to competitors that have less indebtedness or greater resources.

 

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We cannot assure you that our business will generate sufficient cash flows to enable us to pay our indebtedness, fund our other liquidity needs or pay dividends to our shareholders. If we are unable to meet our debt service obligations, our indebtedness will prevent us from paying cash dividends with respect to our stock. In such case, in order to satisfy the REIT distribution requirements imposed by the Code, ESH REIT may distribute taxable stock dividends to its shareholders in the form of additional shares of its stock.

If we fail to generate sufficient cash flows to meet our debt service obligations, we expect that we will need to refinance all or a portion of our debt on or before maturity. We cannot assure you that we will be able to refinance any of our debt on attractive terms on or before maturity, commercially reasonable terms or at all, particularly because of our substantial levels of debt and because of restrictions on debt prepayment and additional debt incurrence contained in the agreements governing our existing debt. Our future results of operations and our ability to service, extend or refinance our indebtedness will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control.

In addition, the agreements governing our indebtedness contain covenants that place restrictions on us. These covenants may restrict, among other activities, our ability to:

 

    merge, consolidate or transfer all or substantially all of our assets;

 

    sell, transfer, pledge or encumber our stock or the ownership interests of our subsidiaries;

 

    incur additional debt;

 

    enter into, terminate or modify leases for our hotel properties;

 

    make certain expenditures, including capital expenditures;

 

    pay dividends on or repurchase our capital stock; and

 

    enter into certain transactions with affiliates.

In addition, the occurrence of (i) an Event of Default under any of the 2012 Mortgage Loan or the 2012 Mezzanine Loans, (ii) a Debt Yield Trigger Event (a Debt Yield, as defined in the 2012 Mortgage Loan, of less than 9.0%) or (iii) a Guarantor Bankruptcy Event would result in a Cash Trap Event, as defined in the 2012 Mortgage Loan. During the period of a Cash Trap Event, any excess cash flow, after all monthly requirements are fully funded (including the payment of budgeted management fees and operating expenses), would be held by the loan service agent as additional collateral for the 2012 Mortgage Loan, which would prevent ESH REIT from making cash dividends.

The occurrence of a Debt Yield Trigger Event (a Debt Yield, as defined in the Corporation revolving credit facility, of less than 11.5%, increasing to 12.0% on and after November 18, 2014, as of the last day of any calendar month), a Default or an Event of Default (each as defined in the Corporation revolving credit facility) would require the Corporation to prepay advances existing under the Corporation revolving credit facility and cash collateralize outstanding letters of credit. The Corporation may cure a Trigger Event by (a) repaying advances and cash collateralizing outstanding letters of credit and (b) maintaining the threshold Debt Yield level for three consecutive months following the month in which the Trigger Event occurred. During a Trigger Event, a Default or an Event of Default, the Corporation is restricted from making cash dividends. As of December 31, 2013, the Company’s Debt Yield was 16.8% and a Cash Trap Event was not in effect under any of its debt agreements.

The occurrence of a Debt Yield Trigger Event, (a Debt Yield, as defined in the ESH REIT revolving credit facility, of less than 11.0%, increasing to 11.5% on and after November 18, 2014, as of the last day of any calendar month), a Default or an Event of Default (each as defined in the ESH REIT revolving credit facility) would require ESH REIT to prepay advances existing under ESH REIT revolving credit facility and cash collateralize outstanding letters of credit. ESH REIT may cure a Trigger Event by (a) repaying advances and cash collateralizing outstanding letters of credit and (b) maintaining the threshold Debt Yield level for three consecutive months following the month in which the Trigger Event occurred. During a Trigger Event, a Default or an Event of Default, ESH REIT is restricted from making cash dividends (subject to certain exceptions to be agreed). As of December 31, 2013, ESH REIT’s Debt Yield was 16.9% and a Cash Trap Event was not in effect under any of its debt agreements.

These covenants could impair our ability to grow our business, take advantage of attractive business opportunities, successfully compete or pay dividends. For a description of the covenants imposed by the agreements governing our indebtedness, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Description of Certain Indebtedness.” Our ability to comply with the financial and other restrictive covenants may be affected by events beyond our control, including general economic, financial and industry conditions. A breach of any of the covenants under any of the agreements governing our

 

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indebtedness could result in an event of default. Cross-default provisions in the debt agreements could cause an event of default under one debt agreement to trigger an event of default under other debt agreements. Upon the occurrence of an event of default under any of our debt agreements, the lenders could elect to declare all outstanding debt under such agreements to be immediately due and payable. If we are unable to repay or refinance the accelerated debt, the lenders could proceed against any assets pledged to secure that debt, which could include the foreclosure on some or all of the hotel properties securing such indebtedness. Furthermore, the agreements governing any future indebtedness will likely contain covenants that place restrictions on us.

Mortgage and mezzanine debt obligations expose us to the possibility of foreclosure, which could result in the loss of any hotel property subject to mortgage or mezzanine debt.

The 2012 Mortgage Loan is secured by mortgages on 680 of our 684 hotel properties and related assets. Several mezzanine loans are secured by pledges of direct and indirect equity in the 2012 Mortgage Loan obligors. Incurring mortgage and other secured debt obligations increases our risk of property losses because defaults on secured indebtedness may result in foreclosure actions initiated by lenders and ultimately our loss of the hotel properties or other properties securing such loans. If such obligors were in default under a mortgage loan or mezzanine loan, we could lose some or all of the hotel properties securing, directly or indirectly, such loan to foreclosure. For tax purposes, a foreclosure of our hotel properties would be treated as a sale of the hotel for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the hotel, it would recognize taxable income on foreclosure, but would not receive any cash proceeds, which could hinder ESH REIT’s ability to meet the REIT distribution requirements imposed by the Code. ESH REIT may assume or incur new mortgage indebtedness on hotel properties that it acquires in the future. Any default under any one of ESH REIT’s mortgage debt obligations may increase its risk of default on its other indebtedness.

Our business depends on the quality and reputation of our brands, and any deterioration in the quality or reputation of our brands or the lodging industry could materially adversely affect our market share, reputation, business, financial condition and results of operations.

Our brands and our reputation are among our most important assets. We have consolidated the substantial majority of our hotels under the Extended Stay America brand. Our ability to attract and retain guests depends, in part, upon the external perceptions of Extended Stay America and Crossland Economy Studios, the quality of our hotels and services and our corporate and management integrity. An incident involving the potential safety or security of our guests or employees, or negative publicity regarding safety or security at our competitors’ properties or in respect of our third-party vendors and the industry, and any media coverage resulting therefrom, may harm our brands and our reputation, cause a loss of consumer confidence in Extended Stay America and the industry, and materially adversely affect our results of operations. The considerable expansion in the use of social media and online review sites over recent years has compounded the potential scope and speed of any negative publicity that could be generated by such incidents, whether or not the description of any events by social media is accurate. Adverse incidents have occurred in the past and may occur in the future.

In addition, we believe that the Corporation’s trademarks and other intellectual property are fundamental to the reputation of our brands. The Corporation develops, maintains, licenses and polices a substantial portfolio of trademarks and other intellectual property rights. To the extent necessary, the Corporation enforces its intellectual property rights to protect the value of its trademarks, our development activities, to protect our good name, to promote its brand name recognition, to enhance our competitiveness and to otherwise support our business goals and objectives. The Corporation relies on trademark laws to protect its proprietary rights. Monitoring for unauthorized use of the Corporation’s intellectual property is difficult. Litigation may be necessary to enforce the Corporation’s intellectual property rights or to determine the validity and scope of the proprietary rights of others. Litigation of this type could result in substantial costs and diversion of resources, may result in counterclaims or other claims against the Corporation and could significantly harm our results of operations. From time to time, the Corporation applies to have certain trademarks registered. There is no guarantee that such trademark registrations will be granted. We cannot assure you that all of the steps the Corporation has taken to protect its trademarks will be adequate to prevent imitation of its trademarks by others. The unauthorized reproduction of the Corporation’s trademarks could diminish the value of our brands and their market acceptance, competitive advantages or goodwill, which could materially adversely affect our business and financial condition.

We could incur significant costs related to government regulation and litigation over environmental, health and safety matters.

Our hotel properties are subject to various federal, state and local environmental laws that impose liability for contamination. Under these laws, governmental entities have the authority to require us, as the current or former owner of the property, to perform or pay for the clean-up of contamination (including hazardous substances, waste or petroleum products) at or emanating from the property and to pay for natural resource damage arising from contamination. These laws often impose liability without regard to whether the owner or operator knew of or caused the contamination. Such liability can be joint and several, so that each covered person can be responsible for all of the costs involved, even if more than one person may have been responsible for the contamination. We can also be liable to private parties for costs of remediation, personal injury and death and/or property damage resulting from

 

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contamination at or emanating from our hotel properties. Moreover, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property on favorable terms or at all. Furthermore, persons who sent waste to a waste disposal facility, such as a landfill or an incinerator, may be liable for costs associated with cleanup of that facility.

In addition, our hotels (including our real property, operations and equipment) are subject to various federal, state and local environmental, health and safety regulatory requirements that address a wide variety of issues, including, but not limited to, the use, management and disposal of hazardous substances and wastes, air emissions, discharges of waste materials (such as refuge or sewage), the registration, maintenance and operation of our boilers and storage tanks, asbestos and lead-based paint. Some of our hotels also routinely handle and use hazardous or regulated substances and wastes as part of their operations, which are subject to regulation (for example, swimming pool chemicals or biological waste). Our hotels incur costs to comply with these environmental, health and safety laws and regulations and if these regulatory requirements are not met or become more stringent in the future or unforeseen events result in the discharge of dangerous or toxic substances at our hotel properties, we could be subject to increased costs of compliance, fines and penalties for non-compliance and material liability from third parties for harm to the environment, damage to real property or personal injury and death.

In particular, certain hotels we currently own or those we acquire in the future contain, may contain, or may have contained, ACM. Environmental, health and safety laws require that ACM be properly managed and maintained, and include requirements to undertake special precautions, such as removal or abatement, if ACM would be disturbed during maintenance, renovation or demolition of a building. These laws regarding ACM may impose fines and penalties on building owners, employers and operators for failure to comply with these requirements or expose us to third-party liability.

We may be liable for indemnification or similar payments relating to the Company Predecessor in accordance with the Fifth Amended Plan of Reorganization (the “Plan”), the bankruptcy court’s order confirming the Plan (the “Confirmation Order”), and under certain agreements providing for indemnification in connection with the Company Predecessor.

We may be liable for indemnification or similar payments relating to the Company Predecessor. Under its constitutive documents, other agreements or applicable law, the Company Predecessor had obligations to defend, indemnify, reimburse, exculpate, advance fees and expenses, or limit the liabilities of certain officers and employees for certain matters relating to the Company Predecessor (the “Predecessor Indemnification Obligations”). Under the Plan and the Confirmation Order, we retained Predecessor Indemnification Obligations to those officers and employees who were officers and employees both prior to and after the effective date of the Plan. We may, therefore, face liabilities with respect to such Predecessor Indemnification Obligations. In addition, we may face liabilities arising from a separate agreement providing for Predecessor Indemnification Obligations to a former officer. Currently, certain claims remain outstanding against several of our former officers and employees in litigation brought on behalf of the Litigation Trust, which could trigger our Predecessor Indemnification Obligations, and new claims may arise in the future against those we have agreed to indemnify. While we believe the likelihood that we will be required to fund any material Predecessor Indemnification Obligations is remote and we are unable to quantify the potential exposure for which we may have to provide indemnification in the future, to the extent that we are required to fund any Predecessor Indemnification Obligations, our results of operations and our liquidity and capital resources could be materially and adversely affected.

The geographic concentration of our portfolio may make us particularly susceptible to adverse economic developments in those geographic areas in which we operate a substantial portion of our hotels.

The concentration of our hotel properties in a particular geographic area may materially impact our operating results if that area is impacted by negative economic developments. As of December 31, 2013, 13.5% of our rooms were in California, 10.3% of our rooms were in Texas, 7.9% of our rooms were in Florida and 5.2% of our rooms were in Illinois. We are particularly susceptible to adverse economic or other conditions in these markets (such as periods of economic slowdown or recession, business layoffs or downsizing, industry slowdowns, relocations of businesses, increases in real estate and other taxes and the cost of complying with governmental regulations or increased regulation), as well as to natural disasters or terrorist events that occur in these markets. Our business, financial condition and results of operations would be materially adversely affected by any significant adverse developments in any of those markets. Our operations may also be materially adversely affected if competing hotels are built in these markets. Furthermore, submarkets within any of these markets may be dependent on the economic performance of a limited number of industries which drive those markets.

 

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We may seek to expand through acquisitions of other companies and hotel properties, and we may also seek to diversify through franchising; these activities may be unsuccessful or divert our management’s attention.

We intend to consider strategic and complementary acquisitions of other companies and hotel properties. In many cases, we will be competing for these opportunities with third parties that may have substantially greater financial resources than we do. Acquisitions of companies or hotel properties are subject to risks that could affect our business, including risks related to:

 

    failing to consummate acquisitions after incurring significant transaction costs;

 

    issuing shares of stock that could dilute the interests of our existing shareholders;

 

    spending cash and incurring debt;

 

    contributing hotel properties or related assets to ventures that could result in recognition of losses;

 

    assuming unknown and contingent liabilities; or

 

    creating additional expenses.

We cannot assure you that we will be able to successfully identify opportunities or complete transactions on commercially reasonable terms or at all, or that we will actually realize any anticipated benefits from such acquisitions. There may be high barriers to entry, including restrictive zoning laws, limited availability of hotel properties and higher costs of land, in many key markets and scarcity of available acquisition, development and investment opportunities in desirable locations. Similarly, we cannot assure you that we will be able to obtain financing for acquisitions on attractive terms or at all, or that the ability to obtain financing will not be restricted by the terms of our indebtedness or any future indebtedness. In addition, the pairing arrangement may prevent our use of common tax-free acquisition structures, which may increase the cost and difficulty of acquiring other businesses and hotel properties and inhibit our ability to expand through acquisitions.

The success of any such acquisition will also depend, in part, on our ability to integrate the acquisition with our existing operations. We may experience difficulty with integrating acquired companies, hotel properties or other assets, including difficulties relating to:

 

    acquiring hotel properties with undisclosed defects in design or construction or requiring unanticipated capital improvements;

 

    entering new markets;

 

    coordinating sales, distribution and marketing functions;

 

    integrating information technology systems; and

 

    preserving the important licensing, distribution, marketing, customer, labor and other relationships of the acquired assets.

We own and operate all of the hotel properties associated with our brands. In the future, we may seek to realize the benefits of franchising and franchise certain of our hotel properties pursuant to agreements with third-party franchisees. We currently do not have experience operating a significant franchising business and expect that the development and implementation of any franchise system will likely require significant expenditures and could divert management’s attention from other business concerns, each of which could have a material adverse effect on our business, financial condition and results of operations. The viability of any franchising business will depend on our ability to establish and maintain good relationships with franchisees. If we enter the franchising business, we may be exposed to additional risks, including, but not limited to, the financial condition and access to capital of franchisees, reputational harm due to the action of franchisees and litigation as a result of disagreements with franchisees. At this time we cannot guarantee that we will seek to expand or diversify our business through franchising in the near future.

In addition, any such acquisition or franchising activity could demand significant attention from our management that would otherwise be available for our regular operations, which could have a material adverse effect on our business.

An increase in the use of third-party internet intermediaries to book online hotel reservations could materially adversely affect our business, financial condition and results of operations.

Some of the rooms at our hotels are booked through third-party internet travel intermediaries and other online travel service providers. These intermediaries primarily focus on leisure travel and also provide offerings for corporate travel and group meetings. Intermediaries use a variety of aggressive online marketing methods to attract customers, including the purchase, by certain companies, of trademarked online keywords such as “Extended Stay” from internet search engines to steer customers toward their websites. These intermediaries hope that consumers will eventually develop brand loyalties to their reservation system rather than to our brands. Accordingly, our business, financial condition and results of operations could be harmed if travel intermediaries succeed in significantly shifting loyalties from our brands to their reservation systems and diverting bookings away from our website or through their fees increasing the overall cost of internet bookings for our hotels.

 

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A failure by our intermediaries to attract or retain their customer bases could lower demand for hotel rooms and, in turn, reduce our revenues. Additionally, if bookings by these third-party intermediaries increase, these intermediaries may be able to obtain higher commissions or other significant contract concessions from us, increasing the overall cost of these third-party distribution channels. Some of our distribution agreements with these companies are not exclusive, have a short term, are terminable at will or are subject to early termination provisions. The loss of distributors, increased distribution costs or the renewal of distribution agreements on significantly less favorable terms could adversely impact our business.

We are reliant upon technology and the disruption or malfunction in our information technology systems could materially adversely affect our business.

The lodging industry depends upon the use of sophisticated information technology and systems, including those utilized for reservations, property management, procurement and operation of our administrative systems. For example, we depend on our central reservation system, which allows bookings of hotel rooms directly, via telephone through our call centers, by travel agents, online through our website and through our online reservation partners. We operate third-party systems, making us reliant on third-party service providers, data communication networks and software upgrades, maintenance and support. Many of our information technology systems are outdated and require substantial upgrading. These technologies are costly and are expected to require refinements that may cause disruptions to many of our key information and technology systems. If we are unable to replace or introduce information technology and other systems as quickly as our competitors or within budgeted costs or schedules, or if we are unable to achieve the intended benefits of any new information technology or other systems, our results of operations could be adversely affected and our ability to compete effectively could be diminished.

Further, we have from time to time experienced disruptions of these systems, and disruptions of the operation of these systems as a result of failures related to our internal or our service provider systems and support may occur in the future. Information technology systems that we rely upon are also vulnerable to damage or interruption from:

 

    events beyond our control, such as war, terrorist attacks and force majeure events, including earthquakes, tornados, hurricanes, fires or floods;

 

    power losses, computer systems failures, internet and telecommunications or data network failures, service provider negligence, improper operation by or supervision of employees, user error, physical and electronic losses of data and similar events; and

 

    computer viruses, cyber attacks, penetration by individuals seeking to disrupt operations or misappropriate information and other breaches of security.

The occurrence of any of these problems at any of our information technology facilities, any of our call centers or any third party service providers could cause interruptions or delays in our business or loss of data, or render us unable to process reservations. In addition, if our information technology systems are unable to provide the information communications capacity that we need, or if our information technology systems suffer problems caused by installing system enhancements, we could experience similar failures or interruptions. If our information technology systems fail and our redundant systems or disaster recovery plans are not adequate to address such failures, or if our property and business interruption insurance does not sufficiently compensate us for any losses that we may incur, our revenues and profits could be reduced and the reputation of our brands and our business could be harmed.

Cyber risk and the failure to maintain the integrity of internal or customer data could result in faulty business decisions and harm our reputation or subject us to costs, fines or lawsuits, or limit our ability to accept credit cards.

Our businesses require the collection, transmission and retention of large volumes of internal and customer data, including credit card numbers and other personally identifiable information of our customers, in various information technology systems that we maintain and in those maintained by third parties with whom we contract to provide services. We and our service providers also maintain personally identifiable information about our employees. The integrity and protection of that customer, employee and company data is critical to us. If that data is inaccurate or incomplete, we could make faulty decisions. Further, our customers and employees have a high expectation that we and our service providers will adequately protect their personal information. The information, security and privacy requirements imposed by governmental regulation are increasingly demanding. Our systems may not be able to satisfy these changing requirements and customer and employee expectations, or may require significant additional investments or time in order to do so. Efforts to hack or breach security measures, failures of systems or software to operate as designed or intended, viruses, operator error or inadvertent releases of data all threaten our and our service provider’s information systems and records. Our reliance on computer, internet-based and mobile systems and communications and the frequency and sophistication of efforts by hackers to gain unauthorized access to such systems have increased significantly in recent years. A breach

 

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in the security of our information technology systems or those of our service providers could lead to an interruption in the operation of our systems, resulting in operational inefficiencies and a loss of profits. Additionally, a significant theft, loss or misappropriation of, or access to, customers’ or other proprietary data or other breach of our information technology systems could result in fines, legal claims or legal proceedings, including regulatory investigations and actions, or liability for failure to comply with privacy and information security laws, which could disrupt our operations, damage our reputation and expose us to claims from customers, financial institutions, regulators, payment card associations, employees and other persons, any of which could have a material adverse effect on our financial condition and results of operations.

In addition, we are subject to the Payment Card Industry Data Security Standard (the “PCI DSS”), a set of requirements administered by the Payment Card Industry Security Standards Council, an independent body created by the major credit card brands, and designed to ensure that companies handling credit card information maintain a secure environment. We are not currently in compliance with the PCI DSS and accordingly have been subject to monthly penalties imposed by VISA. We expect to come into compliance in the next three months; however, there can be no assurance that we will successfully do so. If we fail to achieve PCI DSS compliance, we could become subject to substantially increased penalties or lose our ability to accept credit card payments. As approximately 81.0% of our room revenue for the year ended December 31, 2013 was paid by credit card, loss of the ability to accept credit cards for payment would likely create a significant disruption to our operations, could reduce our occupancy levels and could have a material adverse effect on our business, financial condition and results of operations.

Changes in privacy laws could adversely affect our ability to market our products effectively.

We rely on a variety of direct marketing techniques, including telemarketing, email, marketing and postal mailings. Any future restrictions in laws such as the Telemarketing Sales Rule, CAN-SPAM Act and various state laws or new federal laws regarding marketing and solicitation or data protection laws that govern these activities could adversely affect the continuing effectiveness of telemarketing, email and postal mailing techniques and could force changes in our marketing strategies. If this occurs, we may not be able to develop adequate alternative marketing strategies, which could impact the amount and timing of our revenues. We also obtain access to potential customers from travel service providers and other companies with whom we have substantial relationships and market to some individuals on these lists directly or by including our marketing message in the other company’s marketing materials. If access to these lists was prohibited or otherwise restricted, our ability to develop new customers and introduce them to our products could be materially impaired.

We are exposed to a variety of risks associated with safety, security and crisis management.

There is a constant need to protect the safety and security of our guests, employees and assets against natural and man-made threats. These include but are not limited to exceptional events such as extreme weather, civil or political unrest, violence and terrorism, serious and organized crime, fraud, employee dishonesty, cyber crime, fire and day-to-day accidents, incidents and petty crime, which impact the guest or employee experience, could cause loss of life, sickness or injury and result in compensation claims, fines from regulatory bodies, litigation and impact our reputation. Serious incidents or a combination of events could escalate into a crisis, which if managed poorly could further expose our brands to reputational damage, which could have a material adverse effect on our business, financial condition and results of operations.

Our hotel properties may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem.

When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold at any of our hotel properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property. In addition, the presence of significant mold could expose us to liability from our guests, employees and others if property damage or health concerns arise.

Compliance with the laws and regulations that apply to our hotel properties could materially adversely affect our ability to make future acquisitions or renovations, result in significant costs or delays and adversely affect our business strategies.

Our hotels are subject to various local laws and regulatory requirements that address our ability to obtain licenses for our operations. In particular, we are subject to permitting and licensing requirements, which can restrict the use of our hotel properties and increase the cost of acquisition, renovation and operation of our hotels. In addition, federal and state laws and regulations, including laws such as the ADA, impose further restrictions on our operations. Under the ADA, all public accommodations must meet federal requirements related to access and use by disabled persons. We may be subject to audits or investigations of all of our hotels to determine our compliance. Some of our hotels may not be fully compliant with the ADA. If one or more of the hotels in our portfolio is not in compliance with the ADA or any other regulatory requirements, we may be required to incur additional costs to bring the

 

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property into compliance and we might be required to pay damages or governmental fines. In addition, the obligation to make readily achievable accommodations is an ongoing one. Existing requirements may change and future requirements may require us to make significant unanticipated capital expenditures that could materially adversely affect our business, financial condition, liquidity, results of operations and cash flows.

Hospitality companies have been the target of class actions and other lawsuits alleging violations of federal and state law and other claims, and we may be subject to legal claims.

Our operating income and profits may be reduced by legal or governmental proceedings brought by or on behalf of our employees, customers or other third parties. In recent years, a number of hospitality companies have been subject to lawsuits, including class action lawsuits, alleging violations of federal and state law regarding workplace and employment matters, discrimination and other alleged violations of law. A number of these lawsuits have resulted in the payment of substantial damages by the defendants. Similar lawsuits have been instituted against us from time to time, and we cannot assure you that we will not incur substantial damages and expenses resulting from lawsuits of this type or other claims, which could have a material adverse effect on our business, financial condition and results of operations.

Changes in federal, state, local or foreign tax regulation or disputes with tax authorities could materially adversely affect our business, financial condition and profitability by increasing our tax costs.

The determination of our provision for income taxes and other tax liabilities requires estimations and significant judgments and there are many transactions and calculations where the ultimate tax determination is uncertain. We are subject to taxation at the federal, state or provincial and local levels in the United States and Canada. Our future tax rates could be materially adversely affected by changes in composition of earnings in jurisdictions with differing tax rates, changes in the valuation of our deferred tax assets and liabilities and substantive changes to tax rules and the application thereof by United States federal, state, local and foreign governments, all of which could result in materially higher corporate taxes than would be incurred under existing tax law or interpretation and could adversely affect our profitability. Further, our determination of our tax liability is always subject to audit and review by applicable domestic and foreign tax authorities. Any adverse outcome of any such audit or review could have an adverse effect on our business and reduce our profits to the extent potential tax liabilities exceed our reserves, and the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made.

In addition, the recent economic downturn has reduced tax revenues for United States federal, state and local governments and as a result tax authorities have increased their efforts to raise revenues through changes in tax laws and audits. Increased efforts by tax authorities to raise revenues through changes in tax laws and audits could materially increase our effective tax rate.

Increases in ESH REIT’s property taxes could materially adversely affect our profitability and ability to pay dividends to our shareholders.

Hotel properties are subject to real and personal property taxes. These taxes may increase as tax rates change and as ESH REIT’s hotel properties are assessed or reassessed by taxing authorities. In particular, ESH REIT’s property taxes could increase following acquisitions as acquired properties are reassessed. In recent periods, state and local governments have been seeking to increase property taxes. If property taxes increase, our business, financial condition, results of operations and ESH REIT’s ability to make distributions to its shareholders could be materially adversely affected.

Our insurance may not fully compensate us for damage to or losses involving our hotel properties.

We maintain comprehensive insurance on each of our hotel properties, including liability, fire and extended coverage, in the types and amounts we believe are adequate and customary in our industry. Nevertheless, there are some types of losses, generally of a catastrophic nature, such as hurricanes, earthquakes, fires, floods, terrorist acts or liabilities that result from breaches in the security of our information technology systems, that may be uninsurable or too expensive to justify obtaining insurance. Additionally, market forces beyond our control could limit the scope of insurance coverage that we can obtain or restrict our ability to obtain insurance coverage at reasonable rates. As a result, we may not be successful in obtaining insurance without increases in cost or decreases in coverage levels. We use our discretion in determining amounts, coverage limits and deductibility provisions of insurance, with a view to obtaining appropriate insurance on our hotel properties at a reasonable cost and on suitable terms. In the event of significant damage or loss, our insurance coverage may not be sufficient to cover the full current market value or replacement value of our investment in a property, and in some cases could result in certain losses being totally uninsured. In addition, inflation, changes in building codes and zoning ordinances, environmental considerations and other factors might make it impossible or impractical to use insurance proceeds to replace or repair a property that has been damaged or destroyed. Under these and other circumstances, insurance proceeds may not be adequate to restore our economic position with respect to a damaged or destroyed property. Accordingly, ESH REIT could lose some or all of the capital it has invested in a property, as well as the anticipated future revenue from the property, and ESH REIT could remain obligated for guarantees, debt or other financial obligations of the property. Our debt instruments, consisting of

 

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Mortgage Loans secured by our hotel properties, Mezzanine Loans and the revolving credit facilities of the Corporation and ESH REIT, contain customary covenants requiring us to maintain insurance. Although we believe that we currently maintain sufficient insurance coverage to satisfy these obligations, there is no assurance that in the future we will be able to procure coverage at a reasonable cost. In addition, there can be no assurance that the lenders under these instruments will not take the position that we do not have sufficient insurance coverage and therefore is in breach of these debt instruments allowing the lenders to declare an event of default and accelerate repayment of debt.

We are dependent upon our ability to attract and retain key officers and other highly qualified personnel.

Our success and our ability to implement our business strategies will depend in large part upon the efforts and skills of our senior management and our ability to attract and retain key officers and other highly qualified personnel. Competition for such personnel is intense. There can be no assurance that we will continue to be successful in attracting and retaining qualified personnel. If we lose or suffer an extended interruption in the services of one or more of our key officers, our business, financial condition and results of operations could be materially adversely affected. Accordingly, there can be no assurance that our senior management will be able to successfully execute and implement our business and operating strategies.

We have a new management team that does not have experience in the extended stay segment.

During the past several years we have substantially changed our management team. Our chief executive officer started in February 2012, our chief financial officer started in July 2011 and our chief operating officer started in September 2013, and each had no extended stay hotel industry experience prior to joining Extended Stay. It is important to our success that the new members of the management team quickly understand the extended stay hotel industry. If they are unable to do so, our business, financial conditions and results of operations could be materially adversely affected.

Labor shortages could restrict our ability to operate our hotels or implement our business strategies or result in increased labor costs that could reduce our profitability.

Our success depends in large part on our ability to attract, retain, train, manage and engage our employees. Our hotels are staffed 24 hours a day, seven days a week by thousands of employees around the country. If we are unable to attract, retain, train, manage and engage skilled employees, our ability to manage and staff our hotel properties adequately could be impaired, which could reduce customer satisfaction and harm our reputation. Staffing shortages could also hinder our ability to implement our business strategy. Because payroll costs are a major component of the operating expenses at our hotel properties, a shortage of skilled labor could also require higher wages that would increase our labor costs, which could reduce our profitability and limit our ability to pay dividends to shareholders. In addition, increases in minimum wage rates could result in significantly increased costs for us and result in reduced margins and profitability.

Attempts by labor organizations to organize groups of our employees or changes in labor laws could disrupt our operations, increase our labor costs or interfere with the ability of our management to focus on implementing our business strategies.

We may become subject to collective bargaining agreements, similar agreements or regulations enforced by governmental entities in the future. Changes in the federal regulatory scheme could make it easier for unions to organize groups of our employees. If relationships with our employees or other field personnel become adverse, our hotel properties could experience labor disruptions such as strikes, lockouts and public demonstrations. Additionally, if such changes take effect, our employees or other field personnel could be subject to organizational efforts, which could potentially lead to disruptions or require our management’s time to address unionization issues. Labor regulation could also lead to higher wage and benefit costs, changes in work rules that raise operating expenses and legal costs, and limit our ability to take cost saving measures during economic downturns. These or similar agreements, legislation or changes in regulations could disrupt our operations, hinder our ability to cross-train and cross-promote our employees due to prescribed work rules and job classifications, reduce our profitability or interfere with the ability of our management to focus on executing our business and operating strategies.

Adverse judgments or settlements resulting from legal proceedings in which we may be involved in the normal course of our business could reduce our profitability or limit our ability to operate our business.

In the normal course of our business, we are often involved in various legal proceedings. We cannot predict with certainty the cost of defense, the cost of prosecution or the ultimate outcome of these legal proceedings. Additionally, we could become the subject of future claims by third parties, including guests who use our hotels, our employees, our shareholders or regulators. Any significant adverse determinations, judgments or settlements could reduce our profitability and could materially adversely affect our business, financial condition and results of operations or limit our ability to operate our business. Further, we may incur costs related to claims for which we have appropriate third party indemnity, but such third parties fail to fulfill their contractual obligations. See “Legal Proceedings.”

 

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Risks Related to ESH REIT and its Status as a REIT

Failure of ESH REIT to qualify as a REIT or remain qualified as a REIT would cause it to be taxed as a regular C corporation, which would expose it to substantial tax liability and could substantially reduce the amount of cash available to pay dividends to its shareholders.

ESH REIT elected to be taxed as a REIT for U.S. federal income tax purposes effective as of October 7, 2010. We believe ESH REIT has been organized and operated in such a manner so as to qualify as a REIT and ESH REIT currently intends to continue to operate as a REIT. However, qualification as a REIT involves the application of highly technical and complex provisions of the Code, for which only a limited number of judicial and administrative interpretations exist. The complexity of these provisions is greater in the case of a REIT that owns hotels and leases them to a corporation with which a portion of its stock is paired. As a result, ESH REIT is likely to encounter a greater number of interpretive issues under the REIT qualification rules, and more such issues which lack clear guidance, than are other REITs. Even an inadvertent or technical mistake could jeopardize ESH REIT’s REIT qualification.

In connection with the Offering, the Company received an opinion that ESH REIT should have qualified as a REIT as of that time. We believe ESH REIT has operated in conformity with the requirements to qualify as a REIT since that date, and that ESH REIT continues to satisfy the structural requirements to maintain its REIT status. One of the requirements unique to our structure is that, in order for ESH REIT to qualify as a REIT, no shareholder may actually or constructively own 10 percent or more of the value of shares of ESH REIT or the Corporation. While we do not monitor share ownership for purposes of this test, in the event that a shareholder crosses the 10-percent threshold, we believe that the excess share provisions of the ESH REIT and Corporation charters should be triggered to reduce the relevant shareholder’s ownership and insulate the Company from risk with respect to this issue.

If ESH REIT failed to qualify as a REIT in any taxable year, and no available relief provision applied, it would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates, and distributions to holders of its stock would not be deductible by it in computing its taxable income. ESH REIT may also be subject to additional state and local taxes if it fails to qualify as a REIT. Any such corporate tax liability could be substantial and would reduce the amount of cash available for investment, debt service and distribution to holders of its stock, which in turn could have a material adverse effect on the value and market price of the Shares. To the extent that distributions to shareholders by ESH REIT have been made on the belief that ESH REIT qualified as a REIT, ESH REIT might be required to borrow funds or to liquidate certain of its investments to pay the applicable tax. If, for any reason, ESH REIT failed to qualify as a REIT and it was not entitled to relief under certain Code provisions, it would be subject to a material tax liability and unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify, which could materially adversely affect our business and operating strategies and the market value of the Shares.

Failure to qualify as a REIT could result from a number of factors, including, without limitation:

 

    the leases of ESH REIT’s hotels to the Corporation are not respected as true leases for U.S. federal income tax purposes;

 

    rents received from the Corporation are treated as rents received from a “related party tenant”;

 

    ESH REIT is not respected as an entity separate from the Corporation or the REIT qualification tests are applied to ESH REIT on a combined basis with the Corporation; or

 

    failure to satisfy the REIT distribution requirements due to restrictions under ESH REIT’s indebtedness.

In addition, if ESH REIT fails to qualify as a REIT, it will no longer be required to make distributions as a condition to REIT qualification and all of its distributions to holders of its common stock, after payment of corporate level tax as noted above, would be taxable as regular C corporation dividends to the extent of ESH REIT’s current and accumulated earnings and profits. Thus, if ESH REIT failed to qualify as a REIT, dividends paid to ESH REIT’s shareholders currently taxed as individuals would be qualified dividend income, currently taxed at preferential rates, and ESH REIT’s shareholders currently taxed as corporations (including the Corporation) would be entitled to the dividends received deduction with respect to such dividends, subject in each case to applicable limitations under the Code. As a result of all these factors, ESH REIT’s failure to qualify as a REIT could impair our business and operating strategies and materially adversely affect the market price of the Shares.

If rents received by ESH REIT from the Corporation are treated as rent received from a “related party tenant,” ESH REIT will fail to qualify as a REIT.

To qualify as “rents from real property” for purposes of the two gross income tests applicable to REITs, ESH REIT must not own, actually or constructively (by virtue of certain attribution provisions of the Code), 10% or more (by vote or value) of the stock of any corporate lessee or 10% or more of the assets or net profits of any non-corporate lessee (a “related party tenant”). The Corporation will be treated as a related party tenant for purposes of the gross income tests if ESH REIT owns, actually or constructively (by virtue of certain attribution provisions of the Code), 10% or more of the stock (by vote or value) of the Corporation. The Corporation does not believe that it is a related party tenant of ESH REIT.

 

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However, events beyond our knowledge or control could result in a shareholder, including an investor in the Sponsors, owning or being deemed to own 10% or more of the paired common stock. The ownership attribution rules that apply for purposes of the 10% threshold are complex and may cause the outstanding shares owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, for instance, the acquisition of less than 10% of the outstanding paired common stock (or the acquisition of an interest in an entity which owns paired common stock) by an individual or entity could cause that individual or entity to be treated as owning in excess of 10% of ESH REIT. In addition, a person may be treated as owning 10% or more of the value of stock of ESH REIT by virtue of owning an interest in an entity other than a Sponsor-managed fund that owns an interest in ESH REIT. Although ESH REIT intends to make timely annual demands of certain shareholders of record to disclose the beneficial owners of Shares issued in their name, as required by the Treasury Regulations, monitoring actual or constructive ownership of the Shares, including by investors in the Sponsors, on a continuous basis is not feasible. The charters of the Corporation and ESH REIT contain restrictions on the amount of shares of stock of either entity so that no person can own, actually or constructively (by virtue of certain attribution provisions of the Code), more than 9.8% of the outstanding shares of any class or series of stock of either ESH REIT or the Corporation. The Class A common stock of ESH REIT and the 125 shares of preferred stock of ESH REIT are not subject to the 9.8% ownership limitation under the charter of ESH REIT. However, given the breadth of the Code’s constructive ownership rules and the fact that it is not feasible for ESH REIT and the Corporation to continuously monitor actual and constructive ownership of paired common stock, there can be no assurance that such restrictions will be effective in preventing any person from actually or constructively acquiring 9.8% or more of the outstanding shares of any class or series of stock of the Corporation or ESH REIT. If the Corporation were treated as a “related party tenant” of ESH REIT, ESH REIT would not be able to satisfy either of the two gross income tests applicable to REITs and would fail to qualify for REIT status. If ESH REIT failed to qualify as a REIT and it was not entitled to relief under certain Code provisions, it would be subject to a material tax liability and unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify. In addition, it is unlikely ESH REIT would avail itself of certain relief provisions under the Code customarily available to a REIT that has failed to satisfy a REIT requirement but wants to retain its REIT status. If a REIT fails to satisfy either of the two gross income requirements, such relief provisions require payment of a punitive tax in an amount equal to 100% of the estimated profits of the REIT attributable to the amount of gross income by which the REIT failed the gross income tests. Since substantially all ESH REIT’s gross income will be rent paid pursuant to the operating leases with the Corporation, a substantial part of ESH REIT’s total profits could become subject to such 100% tax under such relief provisions of the Code if this rent failed to qualify under the two gross income tests. In that event, ESH REIT would not likely pursue any of the relief provisions available to REITs under certain provisions of the Code.

Our structure has been infrequently utilized by public companies and has not been employed by a public company since a similar structure was employed by a public company in 2006, and the IRS could challenge ESH REIT’s qualification as a REIT.

Our structure has been infrequently utilized by public companies and has not been employed by a public company since a similar structure was employed by a public company in 2006, and there is little guidance on the tax treatment of a paired share arrangement. Section 269B of the Code provides that the determination of whether an entity qualifies as a REIT must be made on a combined basis if the entity is “stapled” to another entity. ESH REIT and the Corporation will be considered “stapled entities” if more than 50% of the value of the beneficial ownership of shares of ESH REIT is paired with the shares of the Corporation. We believe that the value of the Class B common stock does not represent more than 50% of the value of all of the shares of stock of ESH REIT and, accordingly, that ESH REIT and the Corporation are not “stapled entities” for purposes of Section 269B of the Code. If ESH REIT failed to qualify as a REIT under this rule and it was not entitled to relief under certain Code provisions, it would be subject to a material tax liability and unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify. Additionally, the IRS could challenge the REIT status of ESH REIT on the basis that the Class B common stock is not freely transferrable. Such assertion, if successful, would result in the loss of ESH REIT’s REIT status. If ESH REIT failed to qualify as a REIT under this rule and it was not entitled to relief under certain Code provisions, it would be subject to a material tax liability and unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify. Finally, the IRS could also assert that the Corporation should be treated as owning all of the common stock of ESH REIT. If upheld, such an assertion would effectively eliminate the benefit of REIT status for ESH REIT. No advance ruling has been or will be sought from the IRS regarding ESH REIT’s qualification as a REIT or any other matter discussed in this prospectus.

The ownership limits that apply to REITs, as prescribed by the Code and by ESH REIT’s charter, may inhibit market activity in the Shares and restrict our business combination opportunities.

In order for ESH REIT to qualify to be taxed as a REIT, not more than 50% in value of the outstanding shares of its stock may be owned, beneficially or constructively, by five or fewer individuals, as defined in the Code to include certain entities, at any time during the last half of each taxable year after the first year for which it elected to qualify to be taxed as a REIT. Subject to certain exceptions, ESH REIT’s charter authorizes its board of directors to take such actions as are necessary and desirable to preserve its qualification to be taxed as a REIT. ESH REIT’s charter also provides that, unless exempted by the board of directors, no person may

 

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own more than 9.8% of the outstanding shares of any class or series of its stock. The constructive ownership rules are complex and may cause shares of stock owned directly or constructively (by virtue of certain attribution provisions of the Code) by a group of related individuals or entities to be constructively owned by one individual or entity. These ownership limits could delay or prevent a transaction or a change in control of us that might involve a premium price for Shares or otherwise be in the best interests of our shareholders.

If ESH REIT’s leases with the Corporation are not respected as true leases for U.S. federal income tax purposes, ESH REIT would fail to qualify as a REIT.

To qualify as a REIT, ESH REIT is required to satisfy two gross income tests, pursuant to which specified percentages of its gross income must be passive income, such as rent. For the rent paid pursuant to the operating leases with the Corporation, which should comprise substantially all of ESH REIT’s gross income, to constitute qualifying rental income for purposes of the gross income tests, the leases must be respected as true leases for U.S. federal income tax purposes and must not be treated as service contracts, joint ventures or some other type of arrangement. ESH REIT has structured the leases, and intends to structure any future leases, so that the leases will be respected as true leases for U.S. federal income tax purposes, but there can be no assurance that the IRS will not challenge this treatment or that a court would not sustain such a challenge. If the leases were not respected as true leases for U.S. federal income tax purposes, ESH REIT would not be able to satisfy either of the two gross income tests applicable to REITs and would fail to qualify for REIT status. If ESH REIT failed to qualify as a REIT and it was not entitled to relief under certain Code provisions, it would be subject to a material tax liability and unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify.

If rents received by ESH REIT from the Corporation do not reflect arm’s-length terms, the IRS could seek to recharacterize the rents.

The rates of rent payable by the Corporation to ESH REIT under the operating leases are intended to reflect arm’s-length terms. However, transfer pricing is an inherently subjective matter, and the IRS could, under Section 482 of the Code, assert that the rates of rent between the Corporation and ESH REIT do not reflect arm’s-length terms. If the IRS was successful in asserting that the rates of rent were not on arm’s-length terms, it could adversely impact our REIT qualification or our effective tax rate and tax liability.

Our principal Operating Lessee recently received a notice that it will be subject to an audit by the Internal Revenue Service.

On February 10, 2014, we received notice that the Company’s principal Operating Lessee will be subject to an audit by the Internal Revenue Service (the “IRS”) with respect to its 2011 taxable year, during which it was a taxable REIT subsidiary of ESH REIT. We note that the IRS has conducted audits of other lodging REITs and their taxable REIT subsidiaries, and in at least three cases has focused on the transfer pricing aspects of the hotel leases between the REIT and its taxable REIT subsidiaries. In two of those cases, the IRS found the terms of the leases not to be on arm’s-length terms and proposed adjustments in connection with the audits. We believe our rent provisions reflect arm’s-length terms. However, there can be no assurances that the IRS will agree, and the outcome of the anticipated audit and its impact on the Company cannot be predicted at this time.

ESH REIT has a limited operating history as a publicly traded REIT and may not be successful in operating as a publicly traded REIT, which may adversely affect its ability to make distributions to its shareholders.

ESH REIT has a limited operating history as a publicly traded REIT. The REIT rules and regulations are highly technical and complex. ESH REIT cannot assure you that its management team’s past experience will be sufficient to successfully operate ESH REIT as a publicly traded REIT, implement appropriate operating and investment policies and comply with Code or Treasury Regulations that are applicable to it. Failure to comply with the income, asset and other requirements imposed by the REIT rules and regulations could prevent ESH REIT from qualifying as a REIT and could force it to pay unexpected taxes and penalties, which may adversely affect its ability to make distributions to its shareholders.

Even if ESH REIT continues to qualify as a REIT, it may face other tax liabilities that could reduce our cash flows.

Even if ESH REIT continues to qualify for taxation as a REIT, it may be subject to certain U.S. federal, state and local taxes on its income and assets including, but not limited to, taxes on any undistributed income and property and transfer taxes. In order to maintain its status as a REIT, each year ESH REIT must distribute to holders of its common stock at least 90% of its REIT taxable income, determined before the deductions for dividends paid and excluding any net capital gain. To the extent that ESH REIT satisfies this distribution requirement, but distributes less than 100% of its taxable income and net capital gain, it will be subject to U.S. federal corporate income tax on its undistributed REIT taxable income and net capital gain. In addition, ESH REIT will be subject to a 4% nondeductible excise tax if the actual amount that it pays out to holders of its common stock in a calendar year is less than a minimum amount specified under the Code. ESH REIT generally expects to distribute approximately 95% of its REIT taxable income. Thus, ESH REIT will be subject to U.S. federal corporate income tax on its undistributed REIT taxable income and net capital gain and may be subject to U.S. federal excise tax. Any of these taxes would decrease cash available for distributions to holders of its common stock, and lower distributions of cash could adversely affect the market price of the Shares.

The REIT distribution requirements could materially adversely affect ESH REIT’s liquidity and may force ESH REIT to borrow funds or sell assets during unfavorable market conditions or make taxable distributions of its capital stock.

In order to meet the REIT distribution requirements and avoid the payment of income and excise taxes, ESH REIT may need to borrow funds on a short-term basis or sell assets, even if the then-prevailing market conditions are not favorable for these borrowings or sales. ESH REIT’s cash flows may be insufficient to fund required REIT distributions as a result of differences in timing between the actual receipt of income and the recognition of income for U.S. federal income tax purposes, or the effect of non-deductible capital expenditures, the creation of reserves or required debt service obligations or amortization payments. The insufficiency of ESH REIT’s cash flows to cover its distribution requirements could have a material adverse effect on its ability to incur additional indebtedness or sell equity securities in order to fund distributions required to maintain its qualification as a REIT.

 

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ESH REIT may from time to time make distributions to its shareholders in the form of its taxable stock dividends, which could result in shareholders incurring tax liability without receiving sufficient cash to pay such tax.

Although it has no current intention to do so, ESH REIT may in the future distribute taxable stock dividends to its shareholders in the form of additional shares of its stock. ESH REIT might distribute additional shares of its Class A common stock, shares of Class B common stock and/or shares of its preferred stock to the Corporation and/or shares of its Class B common stock to the holders of its Class B common stock. Taxable shareholders receiving such dividends will be required to include the full amount of the dividend as ordinary income to the extent of ESH REIT’s current and accumulated earnings and profits for U.S. federal income tax purposes. As a result, shareholders may be required to pay income taxes with respect to such dividends in excess of the cash dividends received. If a U.S. shareholder sells ESH REIT common or preferred shares that it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of the Shares at the time of the sale. Furthermore, with respect to certain non-U.S. shareholders, ESH REIT may be required to withhold U.S. federal income tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in its common stock.

Dividends paid by REITs do not qualify for the reduced tax rates available for some dividends.

Certain dividends known as qualified dividends payable to U.S. shareholders that are individuals, trusts or estates currently are subject to the same tax rates as long-term capital gains, which are significantly lower than the maximum rates for ordinary income. Dividends paid by REITs, however, generally are not eligible for such reduced rates. Although these rules do not adversely affect the taxation of REITs, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs and the Shares.

Applicable REIT laws may restrict certain business activities and increase our overall tax liability.

As a REIT, ESH REIT is subject to various restrictions on the types of income it can earn, assets it can own and activities in which it can engage. Business activities that could be impacted by applicable REIT laws include, but are not limited to, activities such as developing alternative uses of real estate, including the development and/or sale of hotel properties. Due to these restrictions, we anticipate that we will conduct certain business activities, including those mentioned above, through the Corporation. The Corporation is taxable as a regular C corporation and is subject to U.S. federal, state, local and, if applicable, foreign taxation on its taxable income. To qualify as a REIT, ESH REIT must satisfy certain asset, income, organizational, distribution, shareholder ownership and other requirements on an ongoing basis. In order to meet these tests, ESH REIT may be required to forego investments it might otherwise make. Thus, ESH REIT’s compliance with the REIT requirements may hinder our business and operating strategies, financial condition and results of operations.

Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.

The REIT provisions of the Code substantially limit ESH REIT’s ability to hedge its assets and liabilities. Any income from a hedging transaction that ESH REIT enters into primarily to manage risk of currency fluctuations or to manage risk of interest rate changes with respect to borrowings made or to be made to acquire or carry real estate assets does not constitute “gross income” for purposes of the 75% or 95% gross income tests that apply to REITs, provided that certain identification requirements are met. To the extent that ESH REIT enters into other types of hedging transactions or fails to properly identify such transaction as a hedge, the income is likely to be treated as non-qualifying income for purposes of both of the gross income tests. As a result of these rules, ESH REIT may be required to limit its use of advantageous hedging techniques or implement those hedges through a TRS. This could increase the cost of ESH REIT’s hedging activities because its TRS may be subject to tax on gains or expose ESH REIT to greater risks associated with changes in interest rates than it would otherwise choose to bear. In addition, losses in a TRS will generally not provide any tax benefit, except that such losses could theoretically be carried back or forward against past or future taxable income in the TRS.

The application of FIRPTA to non-U.S. holders of Class B common stock of ESH REIT is not clear.

A non-U.S. person disposing of a U.S. real property interest (“USRPI”), including shares of a U.S. corporation whose assets consist principally of USRPIs, is generally subject to tax under the Foreign Investment in Real Property Tax Act (“FIRPTA”), on the gain recognized on the disposition, in which case they would also be required to file U.S. tax returns with respect to such gain. FIRPTA does not apply, however, to the disposition of stock in a REIT if the REIT is a “domestically controlled REIT.” We intend to take the position that ESH REIT is a domestically controlled REIT under the Code. However, there can be no assurance that the IRS will not challenge this treatment or that a court would not sustain such a challenge. If ESH REIT were to fail to qualify as a “domestically controlled REIT,” gains realized by a non-U.S. holder on a sale of Class B common stock would be subject to tax under FIRPTA unless the Class B common stock was regularly traded on an established securities market (such as the NYSE) and the

 

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non-U.S. holder did not at any time during a specified testing period directly or indirectly own more than 5% of the value of the outstanding Class B common stock. While there is no authority addressing whether a component of a paired interest will be considered to be regularly traded on an established securities market by virtue of the paired interest being considered to be regularly traded on an established securities market, we intend to take the position that the Class B common stock of ESH REIT is traded on an established securities market following the Offering.

Non-U.S. holders of Class B common stock of ESH REIT may be subject to tax under FIRPTA on distributions.

Non-U.S. holders of Class B common stock may incur tax on distributions that are attributable to gain from a sale or exchange of a USRPI by ESH REIT under FIRPTA. A USRPI includes certain interests in real property and stock in corporations at least 50% of whose assets consist of USRPIs. Under FIRPTA, a non-U.S. shareholder is taxed on distributions attributable to gain from sales of USRPIs as if such gain were effectively connected with a U.S. trade or business of the non-U.S. shareholder, in which case they would also be required to file U.S. tax returns with respect to such gains. A non-U.S. shareholder thus would be taxed on such a distribution at the normal capital gains rates applicable to U.S. shareholders, subject to applicable alternative minimum tax and a special alternative minimum tax in the case of a nonresident alien individual. A non-U.S. corporate shareholder not entitled to treaty relief or exemption also may be subject to the 30% branch profits tax on such a distribution.

If the Class B common stock is regularly traded on an established securities market located in the United States, capital gain distributions on the Class B common stock that are attributable to ESH REIT’s sale of real property will be treated as ordinary dividends rather than as gain from the sale of a USRPI as long as the non-U.S. shareholder did not own more than 5% of the Class B common stock at any time during the one-year period preceding the distribution. As a result, non-U.S. shareholders generally will be subject to withholding tax on such capital gain distributions in the same manner as they are subject to withholding tax on ordinary dividends. As noted above, we intend to take the position that the Class B common stock will be regularly traded on an established securities market located in the United States following the Offering. If the Class B common stock is not considered to be regularly traded on an established securities market located in the United States or the non-U.S. shareholder owned more than 5% of the Class B common stock at any time during the one-year period preceding the distribution, capital gain distributions that are attributable to ESH REIT’s sale of real property would be subject to tax under FIRPTA, as described in the preceding paragraph. In such case, ESH REIT must withhold 35% of any distribution that ESH REIT could designate as a capital gain dividend. A non-U.S. shareholder may receive a credit against its tax liability for the amount ESH REIT withholds. Moreover, if a non-U.S. shareholder disposes of ESH REIT common stock during the 30-day period preceding a dividend payment, and such non-U.S. shareholder (or a person related to such non-U.S. shareholder) acquires or enters into a contract or option to acquire the Class B common stock within 61 days of the first day of the 30-day period described above, and any portion of such dividend payment would, but for the disposition, be treated as a USRPI capital gain to such non-U.S. shareholder, then such non-U.S. shareholder shall be treated as having USRPI capital gain in an amount that, but for the disposition, would have been treated as USRPI capital gain.

Risks Related to the Corporation

The Corporation is subject to tax at regular corporate rates.

The Corporation is subject to U.S. federal income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates, and distributions to holders of Corporation common stock are not deductible by it in computing its taxable income. In calculating its taxable income, the Corporation must include as income any dividends received from ESH REIT. Distributions to holders of Corporation common stock are taxable as dividends to the extent of current and accumulated earnings and profits. Dividends paid by the Corporation to noncorporate U.S. shareholders that constitute qualified dividend income will be taxable to the shareholder at the preferential rates applicable to long-term capital gains provided the shareholder meets certain holding period requirements. Distributions in excess of the Corporation’s current and accumulated earnings and profits would generally be considered a return of capital for U.S. federal income tax purposes to the extent of the holder’s adjusted tax basis in their shares. A return of capital is not taxable, but it has the effect of reducing the holder’s adjusted tax basis in their shares. If distributions exceed the adjusted tax basis of a holder’s shares, they will be treated as gain from the sale or exchange of such stock.

The application of FIRPTA could adversely affect non-U.S. holders of the Paired Shares.

The Corporation is expected to be a United States real property holding corporation under the Code. As a result, under FIRPTA, certain non-U.S. holders of Corporation common stock may be subject to U.S. federal income tax on gain from the disposition of such stock, in which case they would also be required to file U.S. tax returns with respect to such gain. Whether these FIRPTA provisions apply depends on the amount of Corporation common stock that such non-U.S. holder holds and whether, at the time they dispose of their shares, Corporation common stock is regularly traded on an established securities market (such as the NYSE) within the meaning of the applicable Treasury Regulations. While there is no authority addressing whether a component of a paired interest will be considered to be traded on an established securities market by virtue of the paired interest being considered to be traded on an established securities market, we intend to take the position that the common stock of the Corporation is traded on an established securities market. So long as the Corporation common stock is regularly traded as noted above, only a non-U.S. holder who has held,

 

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actually or constructively, more than 5% of the Corporation’s common stock at any time during the applicable testing period may be subject to U.S. federal income tax on the disposition of such common stock under FIRPTA. In addition, a separate valuation of the Class B common stock of ESH REIT and common stock of the Corporation may not be available. As a result, the portion of any gain on the disposition of a Paired Share that is attributable to shares of common stock of the Corporation, and subject to FIRPTA, may be difficult to determine.

If ESH REIT was to lose its REIT status, it could materially adversely affect the Corporation, and therefore materially adversely affect the Company.

The Corporation will receive a substantial portion of its income in the form of distributions from ESH REIT. If ESH REIT was not treated as a REIT, it would be subject to U.S. federal income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates, and distributions to holders of its stock, including the Corporation, would not be deductible by it in computing its taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to holders of its stock, including the Corporation, and would likely reduce the value of the ESH REIT Class A common stock held by the Corporation, which in turn could have a material adverse effect on the value of the Corporation’s common stock. See “—Risks Related to ESH REIT and its Status as a REIT.”

Risks Related to the Paired Shares

If our stock price fluctuates, you could lose a significant part of your investment.

The market price of the Paired Shares may be influenced by many factors including:

 

    announcements of new hotels or services or significant price reductions by us or our competitors;

 

    changes in tax law or interpretations thereof;

 

    the failure of securities analysts to cover the Paired Shares or changes in analysts’ financial estimates;

 

    variations in quarterly results of operations;

 

    default on our indebtedness or foreclosure of our hotel properties;

 

    economic, legal and regulatory factors unrelated to our performance;

 

    increased competition;

 

    future sales of the Paired Shares or the perception that such sales may occur;

 

    investor perceptions of us and the lodging industry;

 

    events beyond our control, such as war, terrorist attacks, travel-related health concerns, transportation and fuel prices, travel-related accidents, natural disasters and severe weather; and

 

    the other factors listed in this “Risk Factors” section.

As a result of these factors, investors in Paired Shares may not be able to resell their Paired Shares at or above their purchase price. In addition, our stock price may be volatile. The stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of companies like us. Accordingly, these broad market and industry factors may significantly reduce the market price of the Paired Shares, regardless of our operating performance.

Certain of our shareholders each beneficially own a substantial amount of the Paired Shares and have substantial control over us and their interests may conflict with or differ from your interests as a shareholder.

Affiliates of Centerbridge, Paulson and Blackstone each beneficially own approximately 27.2% of the Paired Shares, with no individual entity owning, actually or constructively, more than 9.8% as provided in the respective charters of the Corporation and ESH REIT, and we are a “controlled company” within the meaning of the NYSE rules and ESH REIT is controlled by virtue of its ownership by the Corporation, regardless of the Sponsors’ ownership. In addition, four directors of the Corporation and three directors of ESH REIT were designated by the Sponsors pursuant to the shareholders agreement between the Corporation, ESH REIT and the Sponsors. Further, the Sponsors are entitled to consent rights on specified matters pursuant to the shareholders agreement. As a result, the Sponsors are able to exert a significant degree of influence or actual control over our management and affairs and over matters requiring shareholder approval, including the election of directors, a merger, consolidation or sale of all or substantially all of our assets and other significant business or corporate transactions. These shareholders may have interests that are different from yours and

 

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may vote in a way with which you disagree and which may be adverse to your interests. In addition, this concentration of ownership could have the effect of delaying or preventing a change in control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could cause the market price of the Paired Shares to decline or prevent our shareholders from realizing a premium over the market price for their Paired Shares.

Additionally, each of the Sponsors is in the business of making investments in companies and may acquire and hold, and in a few instances have acquired and held, interests in businesses that compete directly or indirectly with us. One or more of the Sponsors may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. The Corporation’s and ESH REIT’s charters provide that none of the Sponsors, any of their affiliates or any director who is not employed by us (including any non-employee director who serves as one of our officers in both his director and officer capacities) or his or her affiliates have any duty to refrain from engaging, directly or indirectly, in the same business activities or similar business activities or lines of business in which we operate.

As restrictions on resale end or if the Sponsors exercise their registration rights, a significant number of Paired Shares could become eligible for resale. As a result, the market price of our stock could decline if the Sponsors sell their Paired Shares or are perceived by the market as intending to sell them. See “—Future sales or the possibility of future sales of a substantial amount of the Paired Shares may depress the price of the Paired Shares.”

Future sales or the possibility of future sales of a substantial amount of the Paired Shares may depress the price of the Paired Shares.

Future sales or the availability for sale of substantial amounts of the Paired Shares in the public market could adversely affect the prevailing market price of the Paired Shares and could impair our ability to raise capital through future sales of equity securities.

The charters of the Corporation and ESH REIT authorize us to issue 3,500,000,000 Paired Shares, of which 204,787,500 Paired Shares are outstanding as of March 10, 2014. 32,487,500 Paired Shares were sold in our initial public offering, which are freely transferable without restriction or further registration under the Securities Act of 1933, as amended (the “Securities Act”). The remaining 172,300,000 Paired Shares, including the Paired Shares owned by the Sponsors and our executive officers and directors, are restricted from immediate resale under the federal securities laws and the lock-up agreements between the Sponsors, our executive officers and directors and the underwriters, but may be sold in the near future. Following the expiration of the applicable lock-up period, all these Paired Shares will be eligible for resale under Rule 144 or Rule 701 of the Securities Act, subject to volume limitations and applicable holding period requirements. In addition, the Sponsors have the ability to cause us to register the resale of their Paired Shares.

We may issue Paired Shares or other securities from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of Paired Shares, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be substantial. We may also grant registration rights covering those Paired Shares or other securities in connection with any such acquisitions and investments.

We have also filed a registration statement on Form S-8 covering 8,000,000 Paired Shares in connection with our employee benefit plans.

We cannot predict the size of future issuances of the Paired Shares or the effect, if any, that future issuances and sales of the Paired Shares will have on the market price of the Paired Shares. Sales of substantial amounts of the Paired Shares (including Paired Shares issued in connection with an acquisition), or the perception that such sales could occur, may adversely affect prevailing market prices for the Paired Shares.

Under our equity incentive plans, the granting entity will need to compensate the non-granting entity for the issuance of its component share of the Paired Shares.

The Extended Stay America, Inc. 2013 Long-Term Incentive Plan (“Corporation 2013 LTIP”) and the ESH Hospitality, Inc. 2013 Long-Term Incentive Plan (“ESH REIT 2013 LTIP,” each a “2013 LTIP”) contemplate grants of Paired Shares to employees, officers and directors of the Corporation and ESH REIT (each a “Granting Entity”), as applicable. Each Granting Entity makes awards to eligible participants under its respective 2013 LTIP in respect of Paired Shares, subject to the non-Granting Entity’s approval of the terms of each award made under the Granting Entity’s 2013 LTIP, and the non-Granting Entity’s agreement to issue its component of the Paired Share (i.e., with respect to the Corporation, a share of common stock, and with respect to ESH REIT, a share of Class B common stock) to the grantee at the time of delivery of its component of the Paired Share.

 

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The Granting Entity will compensate the non-Granting Entity generally in cash for its issuance of its component of the Paired Share for the fair market value at the time of issuance. In some cases, the applicable Granting Entity may have to pay more for a share of the non-Granting Entity than it would have otherwise paid at the time of grant as the result of an increase in the value of a Paired Share between the time of grant and the time of exercise or settlement. In addition, the Corporation may need to acquire additional shares of Class A common stock of ESH REIT at the time of issuance of the shares of Class B common stock of ESH REIT in order to maintain its 55% interest in ESH REIT.

Under the 2013 LTIPs, a grant of RSUs results in the recognition of total compensation expense equal to the grant date fair value of such grant. Compensation expense related to a grant is recognized on a straight-line basis over the requisite service period of each grant. As it relates to the Company’s financial statements, with respect to grants issued to directors of ESH REIT, such compensation expense is recognized on a mark-to-market basis each period rather than on a straight-line basis.

If securities analysts do not publish research or reports about Extended Stay, or if they issue unfavorable commentary about us or our industry or downgrade the Paired Shares, the price of the Paired Shares could decline.

The trading market for the Paired Shares depends in part on the research and reports that third-party securities analysts publish about Extended Stay and the lodging industry. One or more analysts could downgrade the Paired Shares or issue other negative commentary about Extended Stay or our industry. In addition, we may be unable or slow to maintain and attract additional research coverage. Alternatively, if one or more of these analysts cease coverage of Extended Stay, we could lose visibility in the market. As a result of one or more of these factors, the trading price of the Paired Shares could decline.

Delaware law and our organizational documents may impede or discourage a takeover, which could deprive our shareholders of the opportunity to receive a premium for their shares.

The Corporation and ESH REIT are Delaware corporations, and the anti-takeover provisions of Delaware law impose various impediments to the ability of a third party to acquire control of us, even if a change of control would be beneficial to our existing shareholders. In addition, provisions of the Corporation’s and ESH REIT’s charters and bylaws may make it more difficult for, or prevent a third party from, acquiring control of us without the approval of our boards of directors. These provisions include, among others:

 

    the ability of our boards of directors to designate one or more series of preferred stock and issue shares of preferred stock without shareholder approval;

 

    actions by shareholders may not be taken by written consent, except that any action required or permitted to be taken by our shareholders may be effected by written consent until such time as the Sponsors cease to own 50% or more of the outstanding Paired Shares;

 

    the sole power of a majority of the boards of directors to fix the number of directors;

 

    advance notice requirements for nominating directors or introducing other business to be conducted at shareholder meetings, provided that such notice will not be applicable to the Sponsors so long as they own at least 50% of the outstanding Paired Shares; and

 

    the limited ability of shareholders to call special meetings while the Sponsors own at least 50% of the outstanding Paired Shares;

 

    the affirmative supermajority vote of our shareholders to amend anti-takeover provisions in our charters and bylaws.

The foregoing factors, as well as the significant ownership of Paired Shares by the Sponsors, and certain covenant restrictions under our indebtedness could impede a merger, takeover or other business combination or discourage a potential investor from making a tender offer for the Paired Shares, which, under certain circumstances, could reduce the market price of the Paired Shares.

The Corporation and ESH REIT may each issue shares of preferred stock in the future, which could make it difficult for another company to acquire us or could otherwise adversely affect holders of the Paired Shares, which could depress the price of the Paired Shares.

        The Corporation has 21,202 shares of 8.0% voting preferred stock outstanding. ESH REIT has 125 shares of 12.5% preferred stock outstanding. The Corporation’s charter authorizes the Corporation to issue up to 350,000,000 shares of one or more additional series of preferred stock. ESH REIT’s charter authorizes ESH REIT to issue up to 350,000,000 shares of one or more additional series of preferred stock. The boards of directors of the Corporation and ESH REIT will have the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by shareholders. Preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of the Paired Shares. The potential issuance of preferred stock may delay or prevent a change in control of us, discouraging bids for the Paired Shares at a premium over the market price and adversely affect the market price and the voting and other rights of the holders of the Paired Shares.

 

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ESH REIT may be subject to adverse legislative or regulatory tax changes that could adversely affect the market price of the Paired Shares.

At any time, the U.S. federal income tax laws governing REITs or the administrative interpretations of those laws may be amended. We cannot predict when or if any new U.S. federal income tax law, regulation, or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation, or interpretation may take effect retroactively. ESH REIT, the Corporation and holders of Class B common stock could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation, which could effectively eliminate our structure, and in turn, adversely affect the market price of the Paired Shares.

There is a possibility that there will be amendments to or elimination of the pairing arrangement, which may, in turn, impact ESH REIT’s status as a REIT.

Each share of common stock of the Corporation is attached to and trades together with the Class B common stock of ESH REIT. Under the Corporation’s and ESH REIT’s charters, each of the respective board of directors may modify or eliminate this pairing arrangement without the consent of its respective shareholders at any time if that board of directors no longer deems it in the best interests of the Corporation or ESH REIT, as the case may be, for their shares to continue to be attached and trade together. At this time, neither board has determined the circumstances under which the pairing arrangement would be terminated. However, circumstances that the respective board might consider in making such a determination may include, for example, the enactment of legislation that would significantly reduce or eliminate the benefits of our current structure. With respect to such determination, the respective board must fulfill at all times its respective fiduciary duties and, therefore, it is not possible to predict at this time the future circumstances under which the respective board would terminate the pairing arrangement. In addition, holders of Paired Shares have the option, by the vote of a majority of the Paired Shares then outstanding, to eliminate the pairing arrangement in accordance with the respective charters of the Corporation and ESH REIT. The pairing arrangement will be automatically terminated upon bankruptcy of either of the Corporation or ESH REIT.

The Corporation and ESH REIT each have the right, at their option and without the consent of the holders of the Paired Shares, to acquire shares of Class B common stock of ESH REIT from the holders of such shares in exchange for cash, securities of the Corporation or ESH REIT, as the case may be, and/or any other property with a fair market value, as determined by a valuation firm or investment bank, at least equal to the fair market value of the Class B common stock of ESH REIT being exchanged. The Corporation and ESH REIT each have the right, at their option and without the consent of the holders of the Paired Shares, to acquire shares of the Corporation’s common stock from the holders of such shares in exchange for cash, securities of the Corporation or ESH REIT, as the case may be, and/or any other property with a fair market value, as determined by a valuation firm or investment bank, at least equal to the fair market value of the Corporation’s common stock being exchanged. Holders of the Paired Shares could be subject to U.S. federal income tax on the exchange of shares of Class B common stock of ESH REIT or shares of common stock of the Corporation and may not receive cash to pay the tax from the Corporation or ESH REIT.

After any such acquisition, shares of the Corporation’s common stock may be paired with shares of Class B common stock of ESH REIT in a different proportion, but such shares will continue to be attached and trade together. Further, the Corporation’s charter and ESH REIT’s charter allow the respective boards of directors of the Corporation and ESH REIT to, in their sole discretion, issue unpaired shares of their capital stock. Trading in unpaired shares of the Corporation or ESH REIT may reduce the liquidity or value of the Paired Shares. The Class A common stock of ESH REIT owned by the Corporation is also freely transferable and if transferred, the transferee will hold unpaired shares of common stock of ESH REIT.

ESH REIT’s board of directors could terminate its status as a REIT, subjecting ESH REIT’s taxable income to U.S. federal income taxation, which would increase its liabilities for taxes.

Under ESH REIT’s charter, its board of directors may terminate its REIT status, without the consent of its shareholders, at any time if the board no longer deems it in the best interests of ESH REIT to continue to qualify under the Code as a REIT, subject to the Sponsors’ consent rights pursuant to the shareholders agreement between the Corporation, ESH REIT and the Sponsors. ESH REIT’s board of directors has not yet determined the circumstances under which ESH REIT’s status as a REIT would be terminated. However, circumstances that the board may consider in making such a determination may include, for example:

 

    the enactment of new legislation that would significantly reduce or eliminate the benefits of being a REIT or having a paired share arrangement; or

 

    ESH REIT no longer being able to satisfy the REIT requirements.

 

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With respect to this determination, ESH REIT’s board must fulfill at all times its fiduciary duties and, therefore, it is not possible to predict at this time the future circumstances under which the board would terminate ESH REIT’s status as a REIT.

If ESH REIT’s status as REIT is terminated, its taxable income will be subject to U.S. federal income taxation (including any applicable alternative minimum tax) at regular corporate rates. If ESH REIT’s status was terminated and it was not entitled to relief under certain Code provisions, it would be unable to elect REIT status for the four taxable years following the year during which it ceased to so qualify.

We are exposed to risks relating to evaluations of our internal controls required by Section 404 of the Sarbanes-Oxley Act.

We are in the process of evaluating our internal controls systems to allow management to report on, and our independent auditors to audit, our internal controls over financial reporting. We will be performing the system and process evaluation and testing (and any necessary remediation) required to comply with the management certification and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, and will be required to comply with Section 404 in full (including an auditor attestation on management’s internal controls report) in our combined annual report on Form 10-K for the year ending December 31, 2014 (subject to any change in applicable SEC rules). Furthermore, upon completion of this process, we may identify control deficiencies of varying degrees of severity under applicable SEC and Public Company Accounting Oversight Board (“PCAOB”) rules and regulations that remain unremediated. As a public company, we will be required to report, among other things, control deficiencies that constitute a “material weakness” or changes in internal controls that, or that are reasonably likely to, materially affect internal controls over financial reporting. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A “significant deficiency” is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of our financial reporting.

If we fail to implement the requirements of Section 404 in a timely manner, regulatory authorities such as the SEC or the PCAOB might subject us to sanctions or investigation. If we do not implement improvements to our disclosure controls and procedures or to our internal controls in an effective or timely manner, our independent registered public accounting firm may not be able to certify as to the effectiveness of our internal controls over financial reporting pursuant to an audit of our controls. This may subject us to adverse regulatory consequences or a loss of confidence in the reliability of our financial statements. We could also suffer a loss of confidence in the reliability of our financial statements if we or our independent registered public accounting firm reports a material weakness in our internal controls, if we do not develop and maintain effective controls and procedures or if we are otherwise unable to deliver timely and reliable financial information. Any loss of confidence in the reliability of our financial statements or other negative reaction to our failure to develop timely or adequate disclosure controls and procedures or internal controls could result in a decline in the price of the Paired Shares. In addition, if we fail to remedy any material weakness, our financial statements may be inaccurate, we may face restricted access to the capital markets and the trading price of the Paired Shares may be adversely affected. In connection with the audits of our 2013 and 2012 financial statements, our management and auditors identified “significant deficiencies.”

The requirements of being a public company, including compliance with the reporting requirements of the Exchange Act and the requirements of the Sarbanes-Oxley Act and the NYSE, may strain our resources, increase our costs and divert management’s attention, and we may be unable to comply with these requirements in a timely or cost-effective manner.

As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the corporate governance standards of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, and the NYSE. These requirements place a strain on our management, systems and resources. The Exchange Act requires us to file annual, quarterly and current reports with respect to our business and financial condition within specified time periods and to prepare proxy statements with respect to the annual meetings of shareholders of the Corporation and ESH REIT. The Sarbanes-Oxley Act requires that we maintain effective disclosure controls and procedures and internal controls over financial reporting. The NYSE requires that we comply with various corporate governance requirements. To maintain and improve the effectiveness of our disclosure controls and procedures and internal controls over financial reporting and comply with the Exchange Act and NYSE requirements, significant resources and management oversight are required. This may divert management’s attention from other business concerns and lead to significant costs associated with compliance, which could have a material adverse effect on us and the price of the Paired Shares. Advocacy efforts by shareholders and third parties may also prompt even more changes in governance and reporting requirements. We cannot predict or estimate the amount of additional costs we may incur or the timing of these costs.

 

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We are a “controlled company” within the meaning of the NYSE rules and, as a result, qualify for, and rely on, exemptions from certain corporate governance requirements.

A company of which more than 50% of the voting power is held by an individual, a group or another company is a “controlled company” within the meaning of the NYSE rules and may elect not to comply with certain corporate governance requirements of the NYSE, including:

 

    the requirement that a majority of the boards of directors of the Corporation and ESH REIT consist of independent directors;

 

    the requirement that each of the Corporation and ESH REIT have a nominating/corporate governance committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; and

 

    the requirement that each of the Corporation and ESH REIT have a compensation committee that is composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities.

We rely on all of the exemptions listed above. Accordingly, you will not have the same protections afforded to shareholders of companies that are subject to all of the corporate governance requirements of the NYSE.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

As of December 31, 2013, we owned and operated 684 hotels. The average age of our hotel properties at December 31, 2013 was 14.9 years. We are under long-term ground leases at four of our hotel properties with initial terms terminating at various dates between 2016 and 2096 with most leases including multiple renewal options for generally five or 10 year periods. Other than the four ground leases described above, all remaining hotel properties and grounds are fully owned. The following table shows certain information regarding those hotels.

 

State/Country

  

Hotels

  

Number of Rooms

  

% of Total Rooms

California

   85    10,310    13.5%

Texas

   69    7,817    10.3%

Florida

   54    6,017    7.9%

Illinois

   34    3,932    5.2%

North Carolina

   33    3,421    4.5%

Virginia

   30    3,291    4.3%

Georgia

   30    3,248    4.3%

Ohio

   30    2,878    3.8%

Washington

   23    2,690    3.5%

Arizona

   19    2,229    2.9%

New Jersey

   19    2,224    2.9%

Michigan

   19    2,114    2.8%

Colorado

   17    2,095    2.8%

Maryland

   19    2,063    2.7%

Tennessee

   19    2,015    2.6%

Missouri

   16    1,724    2.3%

Pennsylvania

   16    1,713    2.2%

Massachusetts

   13    1,434    1.9%

New York

   11    1,323    1.7%

Indiana

   13    1,228    1.6%

South Carolina

   11    1,102    1.4%

Minnesota

   10    1,043    1.4%

Oregon

   7    898    1.2%

Kentucky

   10    892    1.2%

Louisiana

   7    791    1.0%

Kansas

   7    767    1.0%

Alabama

   7    692    0.9%

Wisconsin

   6    664    0.9%

Nevada

   5    652    0.9%

 

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State/Country

  

Hotels

  

Number of Rooms

  

% of Total Rooms

Utah

   5    622    0.8%

Connecticut

   5    570    0.7%

Canada

   3    500    0.7%

Oklahoma

   5    474    0.6%

New Mexico

   4    459    0.6%

Alaska

   4    420    0.6%

Rhode Island

   4    403    0.5%

Arkansas

   3    305    0.4%

Mississippi

   3    273    0.4%

Montana

   2    208    0.3%

Iowa

   2    190    0.2%

Delaware

   1    142    0.2%

Idaho

   1    107    0.1%

New Hampshire

   1    101    0.1%

Maine

   1    92    0.1%

Nebraska

   1    86    0.1%
  

 

  

 

  

 

Total

   684    76,219    100.0%
  

 

  

 

  

 

We lease our corporate headquarters in Charlotte, North Carolina. The initial lease term expires in August 2021 with two additional five year renewal terms. Our offices are sufficient to meet our present needs, and we do not anticipate any difficulty in securing additional office space, as needed, on terms acceptable to us.

 

Item 3. Legal Proceedings

We are from time to time subject to various claims and lawsuits incidental to our business. In the opinion of management, these claims and suits, individually or in the aggregate, will not have a material adverse effect on the Company’s consolidated and combined financial statements, results of operations or liquidity or on ESH REIT’s consolidated financial statements, results of operations or liquidity.

 

Item 4. Mine Safety Disclosures

None.

PART II

 

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

Market Information

The Paired Shares are listed on the NYSE under the symbol “STAY” and commenced trading on November 13, 2013. Below is a summary of the high and low prices of our Paired Shares for the quarterly period since the date of our initial public offering:

 

2013

   High      Low  

Fourth Quarter (from November 13, 2013, date of initial trading)

   $ 26.26       $ 20.00   

The Class A common stock of ESH REIT is held by the Corporation and has never been publicly traded.

Holders of Record

As of March 10, 2014, there were 117 holders of record of the Paired Shares and the Corporation was the only holder of ESH REIT’s Class A common stock. Because many of our Paired Shares are held by brokers and other institutions on behalf of shareholders, we are unable to estimate the total number of beneficial owners represented by these record holders.

 

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Distribution Policies

We intend to make distributions of $0.15 per Paired Share per quarter. We intend to maintain our distribution rate unless our consolidated and combined results of operations, net income, Adjusted EBITDA, liquidity, cash flows, financial condition or prospects, economic conditions or other factors differ materially from the assumptions used in projecting our intended distribution rate. We intend to make our expected distributions in respect of the Class B common stock of ESH REIT. In the event distributions in respect of the Class B common stock of ESH REIT are not sufficient to meet our expected distributions, the expected distributions may be completed through distributions in respect of the common stock of the Corporation using funds distributed to the Corporation as distributions on the Class A common stock of ESH REIT, after allowance for tax, if any, on those funds.

The Corporation’s and ESH REIT’s boards of directors are independent of one another and owe separate fiduciary duties to the Corporation and ESH REIT. Each board of directors will separately determine the form, timing and amount of any distributions to be paid by the respective entities for any period. For a description of the Corporation’s distribution policy, please see “—Corporation Distribution Policy” and for ESH REIT’s distribution policy, see “—ESH REIT Distribution Policy.”

Corporation Distribution Policy

The Corporation’s board of directors has not declared any distributions on the Corporation’s common stock and currently has no intention to do so, except as described above. The payment of any distributions will be at the discretion of the Corporation’s board of directors. Any such distributions will be made subject to the Corporation’s compliance with applicable law and will depend on, among other things, the receipt by the Corporation of dividends from ESH REIT in respect of the Class A common stock, the Corporation’s results of operations and financial condition, level of indebtedness, capital requirements, capital contributions to ESH REIT, contractual restrictions, restrictions in any existing or future debt agreements of the Corporation or ESH REIT and in any preferred stock and other factors that the Corporation’s board of directors may deem relevant.

The Corporation’s ability to pay dividends will depend on its receipt of cash dividends from ESH REIT, which may further restrict its ability to pay distributions. In particular, ESH REIT’s ability to pay distributions is restricted by the terms of its indebtedness. In cases in which the terms of any of the Corporation’s or ESH REIT’s existing or future indebtedness prohibits the payment of cash dividends, ESH REIT may declare and pay taxable stock dividends to maintain its REIT status. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Description of Certain Indebtedness” for a description of the restrictions on the Corporation’s and ESH REIT’s ability to pay distributions.

ESH REIT Distribution Policy

ESH REIT intends to make regular quarterly cash distributions to its shareholders (including the Corporation), as more fully described below. To qualify as a REIT, ESH REIT must distribute annually to its shareholders an amount at least equal to:

 

    90% of its REIT taxable income, computed without regard to the deduction for dividends paid and excluding any net capital gain; plus

 

    90% of the excess of its net income, if any, from foreclosure property over the tax imposed on such income by the Code; less

 

    the sum of certain items of non-cash income that exceeds a percentage of ESH REIT’s income.

ESH REIT will be subject to income tax on its taxable income that is not distributed and to an excise tax to the extent that certain percentages of its taxable income are not distributed by specified dates. ESH REIT generally expects to distribute approximately 95% of its REIT taxable income. ESH REIT will be subject to U.S. federal corporate income tax on its undistributed REIT taxable income and net capital gain and may be subject to U.S. federal excise tax. Taxable income as computed for purposes of the forgoing tax rules will not necessarily correspond to ESH REIT’s income before income taxes as determined under accounting principles generally accepted in the United States (“GAAP”) for financial reporting purposes.

 

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On February 26, 2014, the board of directors of ESH REIT declared a pro rata cash distribution of $0.08 per share for the fourth quarter of 2013 on its Class A common stock and Class B common stock with respect to the period commencing upon the completion of the Offering and ending on December 31, 2013, based on our intended distribution rate of $0.15 per Paired Share for a full quarter. The dividend is payable on March 26, 2014, to shareholders of record as of March 12, 2014.

The timing and frequency of ESH REIT’s distributions will be authorized by ESH REIT’s board of directors, in its sole discretion, and declared based on a variety of factors, including:

 

    actual consolidated results of operations;

 

    ESH REIT’s debt service requirements;

 

    capital expenditure requirements for its hotel properties;

 

    ESH REIT’s taxable income;

 

    the annual distribution requirement under the REIT provisions of the Code;

 

    contractual restrictions;

 

    restrictions in any current or future debt agreements and in any preferred stock;

 

    ESH REIT’s operating expenses; and

 

    other factors that ESH REIT’s board of directors may deem relevant.

Class A common stock and Class B common stock are entitled to any common stock dividends that ESH REIT’s board of directors may declare. Each share of Class A and Class B common stock will be entitled to the same amount of dividends per share, except that, in cases in which the terms of any of ESH REIT’s existing or future indebtedness prohibits the payment of cash dividends, ESH REIT may declare and pay taxable stock dividends in respect of the Class A common stock that differ from dividends paid in respect of the Class B common stock in order to maintain its REIT status. Approximately 55% of ESH REIT’s dividends will be paid to the Corporation on account of the Class A common stock.

ESH REIT’s ability to pay distributions is restricted by the terms of its indebtedness. In cases in which the terms of any of ESH REIT’s existing or future indebtedness prohibits the payment of cash dividends, ESH REIT may declare and pay taxable stock dividends in order to maintain its REIT status. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Description of Certain Indebtedness” for a description of the restrictions on ESH REIT’s ability to pay distributions. In cases where ESH REIT distributes additional shares of its Class B common stock to the holders of its Class B common stock, the Corporation may correspondingly distribute a number of additional shares of its common stock, which together with the shares of Class B common stock distributed by ESH REIT will form Paired Shares.

Stock Performance Graph

The following graph compares the total shareholder return on the Paired Shares to the cumulative total returns of the Standard and Poor’s 500 Stock Index (“S&P 500”) and the Standard and Poor’s 500 Hotel Index (“S&P Hotel Index”) for the period from November 13, 2013, the date on which our Paired Shares commenced trading on the NYSE, through December 31, 2013. The graph assumes an initial investment of $100 on November 13, 2013 in the Paired Shares and in each of the indices and also assumes the reinvestment of dividends where applicable. The results shown in the graph below are not necessarily indicative of future performance.

 

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LOGO

This performance graph shall and related information shall not be deemed “soliciting material” or to be “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any future filing under the Securities Act or Exchange Act, except to the extent that we specifically incorporate it by reference into such filing.

Recent Sales of Unregistered Securities

On November 6, 2013, the Corporation issued 100 shares of common stock to Holdings and the holders of the ownership interests of ESH REIT’s predecessor, ESH Hospitality LLC, for consideration of $100. The issuance of these shares of common stock was made pursuant to an exemption provided by Section 4(a)(2) of the Securities Act. At the time of the issuance of such shares, the Corporation was owned and controlled by employees of the Sponsors.

On November 11, 2013, ESH REIT issued 39,706,944 shares of Class A common stock to the Corporation in consideration of a note issued to ESH REIT by the Corporation in the principal amount of $357,314,750.50. On November 18, 2013, the Corporation paid to ESH REIT $357,586,999.53, including $272,249.03 of accrued interest, in satisfaction of the note described in the preceding sentence. The issuance of these shares of Class A common stock was made pursuant to an exemption provided by Section 4(a)(2) of the Securities Act. At the time of issuance of such shares, the Corporation and ESH REIT were commonly controlled and owned.

On November 12, 2013, the Corporation issued 172,199,900 shares of common stock to its existing shareholders in consideration of the shareholders’ contribution to the Corporation of 210,466,667 shares of Class A common stock of ESH REIT. The issuance of these shares of common stock was made pursuant to an exemption provided by Section 4(a)(2) of the Securities Act. All of the recipients of the shares were existing shareholders of the Corporation.

Also on November 12, 2013, ESH REIT issued 122,222 shares of Class A common stock to the Corporation in consideration of a note issued to ESH REIT in the principal amount of $1,099,851.03. On November 18, 2013, the Corporation paid to ESH REIT $1,100,569.33, including $718.30 of accrued interest, in satisfaction of the note described in the preceding sentence. The issuance of these shares of Class A common stock was made pursuant to an exemption provided by Section 4(a)(2) of the Securities Act. At the time of issuance of such shares, the Corporation and ESH REIT were commonly controlled and owned.

Use of Proceeds from Registered Securities

        On November 18, 2013, the Corporation and ESH REIT completed an initial public offering of 32,487,500 Paired Shares for cash consideration of $20.00 per Paired Share, each Paired Share consisting of one share of common stock, par value $0.01 per share, of the Corporation, that is attached to and trades as a single unit with one share of Class B common stock, par value $0.01 per share, of ESH REIT. The Offering included 4,237,500 Paired Shares purchased by the underwriters in connection with the exercise in full of their option to purchase additional Paired Shares. The Paired Shares sold in the Offering were registered under the Securities Act pursuant to the Corporation and ESH REIT’s Registration Statement on Form S-1 (File No. 333-190052), which was declared effective by the SEC on November 12, 2013. The Offering raised gross proceeds to the Corporation and ESH REIT of approximately $649.8 million, and net proceeds to the Corporation and ESH REIT of approximately $602.2 million after deducting underwriting discounts, commissions and other transaction costs. The Offering proceeds were divided among the Corporation and ESH REIT based on their relative valuations. The Corporation used the majority of the proceeds it received to purchase shares of Class A common stock of ESH REIT to maintain its ownership of approximately 55% of the outstanding common stock of ESH REIT. ESH REIT used its proceeds from the Offering, including proceeds received pursuant to the sale of Class A common stock to the Corporation, in addition to cash on hand, to repay approximately $331.0 million of its Mezzanine A Loan, approximately $218.5 million of its Mezzanine B Loan and approximately $165.5 million of its Mezzanine C Loan.

Deutsche Bank Securities, Goldman, Sachs & Co., J.P. Morgan, Citigroup, BofA Merrill Lynch, Barclays, Morgan Stanley and Macquarie Capital acted as joint book-running managers for the Offering. Blackstone Capital Markets, Baird, Houlihan Lokey and Stifel acted as co-managers for the Offering.

Purchase of Equity Securities by the Issuer and Affiliated Purchasers

None.

 

33


Table of Contents

Item 6. Selected Financial Data

Selected Historical Financial and Other Data—The Company

The selected historical consolidated and combined financial data of the Company for the years ended December 31, 2013, 2012 and 2011 and as of December 31, 2013 and 2012 have been derived from the audited consolidated and combined financial statements of the Company included elsewhere in this combined annual report on Form 10-K. The selected historical consolidated and combined financial data of the Company for the period from October 8, 2010 through December 31, 2010 and as of December 31, 2011 and 2010 have been derived from the audited consolidated and combined financial statements of the Company not included elsewhere in this combined annual report on Form 10-K. The selected historical consolidated and combined financial data of the Company Predecessor for the period from January 1, 2010 through October 7, 2010 and the year ended December 31, 2009 and as of December 31, 2009 have been derived from the audited consolidated and combined financial statements of the Company Predecessor not included elsewhere in this combined annual report on Form 10-K. The following information should be read in conjunction with, and is qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the historical audited consolidated and combined financial statements and related notes and other financial information included herein.

On October 8, 2010, the Company acquired substantially all of the businesses, assets and operations of the Company Predecessor that were auctioned off by the former debtors of the Company Predecessor, which was in Chapter 11 reorganization. The Company succeeded principally all of the assets and operations of the Company Predecessor. As a result, the historical consolidated and combined financial results of the Company are presented alongside those of the Company Predecessor herein. The acquisition was accounted for as a business combination in accordance with FASB ASC 805, “Business Combinations.” Certain financial information of the Company is not comparable to that of the Company Predecessor. This information includes, but may not be limited to, depreciation and amortization expense, restructuring and acquisition transaction expenses, interest expense, income tax expense and reorganization gain, net.

 

     Company      Company Predecessor  

(Dollars in millions, other than

ADR and RevPAR)

   Year
Ended
December 31,
2013
     Year
Ended
December 31,
2012
     Year
Ended
December 31,
2011
     Period
from
October 8,
2010
through
December 31,
2010
     Period
from
January 1,
2010
through
October 7,
2010
     Year
Ended
December 31,
2009
 

Statement of operations data:

                 

Room revenues

   $ 1,114.0       $ 984.3       $ 913.0       $ 188.7       $ 659.9       $ 818.4   

Other hotel revenues

     17.8         16.9         18.7         4.1         13.2         15.0   

Management fees, license fees and other revenues

     1.0         10.3         11.0         2.6         7.5         0.3   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

     1,132.8         1,011.5         942.7         195.4         680.6         833.7   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Hotel operating expenses

     540.6         493.6         463.4         101.8         351.3         440.8   

General and administrative expenses

     108.3         88.5         75.0         17.6         66.9         84.1   

Depreciation and amortization

     168.1         129.9         120.4         27.0         290.6         378.9   

Managed property payroll expenses

     0.7         6.6         6.4         1.5         4.8         —     

Restructuring expenses

     0.6         5.8         10.5         —           —           —     

Acquisition transaction expenses

     0.2         1.7         0.6         21.5         —           —     

Impairment of long-lived assets

     3.3         1.4         —           —           44.6         27.6   

Office building operating expenses

     —          —           1.0         0.2         0.8         —     

 

34


Table of Contents
     Company     Company Predecessor  

(Dollars in millions, other than per share data,

ADR and RevPAR)

   Year
Ended
December 31,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Loss on lease termination

     —          —          —          —          —          12.1   

Allowance for receivables from affiliates

     —          —          —          —          —          19.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     821.8        727.5        677.3        169.6        759.0        963.1   

Other income

     1.1        0.3        0.2        0.2        1.3        —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     312.1        284.3        265.6        26.0        (77.1     (129.4

Interest expense

     234.6        257.7        212.5        49.6        —          297.2   

Adequate protection payments in lieu of interest

     —          —          —          —          167.0        —     

Loss on derivative instruments

     —          —          —          —          —          0.4   

Interest income

     0.2        0.3        0.6        —          —          0.2   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before reorganization gain (loss) and income taxes

     77.7        26.9        53.7        (23.6     (244.1     (426.8

Reorganization gain (loss), net

     —          —          —          —          3,430.5        (41.4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income tax (benefit) expense

     77.7        26.9        53.7        (23.6     3,186.4        (468.2

Income tax (benefit) expense

     (5.0     4.6        7.1        (1.5     (120.4     929.9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

     82.7        22.3        46.6        (22.1     3,306.8        (1,398.1

Net loss (income) attributable to noncontrolling interests

     3.5        (1.6     (1.0     (0.4     (1,517.3     1,309.4   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) attributable to common shareholders or members

   $ 86.2      $ 20.7      $ 45.6      $ (22.5   $ 1,789.5      $ (88.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share-basic

   $ 0.49      $ 0.12      $ 0.27      $ (0.13   $ 10.66      $ (0.53
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share-diluted

   $ 0.49      $ 0.12      $ 0.26      $ (0.13   $ 10.66      $ (0.53
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other financial data:

            

Cash flows provided by (used in):

            

Operating activities

   $ 311.3      $ 201.1      $ 180.6      $ 15.6      $ 106.6      $ 39.0   

Investing activities

     (165.3     (223.8     (43.4     (3,920.0     (41.7     39.2   

Financing activities

     (189.0     27.6        (50.1     3,914.5        (1.6     (21.7

Capital expenditures

     (172.5     (271.5     (106.1     (11.6     (38.0     (32.4

EBITDA(a)

     480.2        414.2        386.0        53.0        3,644.0        207.7   

Adjusted EBITDA(a)

     518.6        434.9        409.8        74.8        260.7        289.3   

Hotel operating profit(b)

     594.1        508.5        468.9        91.0        324.4        393. 1   

Hotel operating margin(b)

     52.5     50.8     50.3     47.2     48.2     47.2

 

35


Table of Contents
     Company     Company Predecessor  

(Dollars in millions, other than

ADR and RevPAR)

   Year
Ended
December 31,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Operating data:

            

Rooms (at period end)

     76,219        75,928        73,657        73,657        73,657        73,795   

Average occupancy rate

     74.2     73.3     75.1     72.3     75.9     65.8

ADR

   $ 54.15      $ 49.77      $ 45.20      $ 42.10      $ 42.07      $ 44.74   

RevPAR

   $ 40.18      $ 36.46      $ 33.96      $ 30.44      $ 31.93      $ 29.44   

 

     Company      Company
Predecessor
 

(Dollars in millions)

   December 31,
2013
     December 31,
2012
     December 31,
2011
     December 31,
2010
     December 31,
2009
 

Balance sheet data:

              

Cash and cash equivalents(1)

   $ 60.5       $ 103.6       $ 98.6       $ 11.4       $ 79.5   

Restricted cash

     47.3         61.6         236.7         253.2         0.2   

Property and equipment, net

     4,127.3         4,110.6         3,844.1         3,860.6         6,346.0   

Total assets

     4,449.7         4,491.7         4,357.3         4,351.6         6,536.1   

Mortgage loans payable

     2,519.8         2,525.7         1,980.2         2,004.3         4,108.3   

Mezzanine loans payable

     365.0         1,080.0         700.0         700.0         3,295.5   

Other debt

     41.2         —           —           —           —     

Total liabilities

     3,108.5         3,738.9         2,805.9         2,824.1         8,466.4   

Total consolidated and combined equity (deficit)(1)

     1,341.2         752.8         1,551.4         1,527.5         (1,930.3

Total liabilities and consolidated and combined equity

   $ 4,449.7       $ 4,491.7       $ 4,357.3       $ 4,351.6       $ 6,536.1   

 

(1) In February 2014, ESH REIT declared a REIT dividend with respect to the fourth quarter of 2013 of $0.08 per share payable to holders of record of ESH REIT Class A common stock and Class B common stock as of March 12, 2014, or approximately $36.4 million.

 

(a) EBITDA and Adjusted EBITDA. Earnings before interest expense, net, income taxes, depreciation and amortization (“EBITDA”) is a commonly used measure in many industries. We adjust EBITDA when evaluating our performance because we believe that the adjustment for certain items, such as restructuring and acquisition transaction expenses, impairment charges related to long-lived assets, bankruptcy-related gains and expenses, non-cash equity-based compensation and other items not indicative of ongoing operating performance, provides useful supplemental information to investors regarding our ongoing operating performance. We believe that EBITDA and Adjusted EBITDA provide useful information to investors regarding our results of operations that help us and our investors evaluate the ongoing operating performance of our hotels and facilitate comparisons between us and other lodging companies, hotel owners and capital-intensive companies.

EBITDA and Adjusted EBITDA, as presented, may not be comparable to measures calculated by other companies. This information should not be considered as an alternative to net income, net income per share, cash flow from operations or any other operating performance measure calculated in accordance with GAAP. Cash expenditures for various real estate or hotel assets such as capital expenditures, interest expense and other items have been and will continue to be incurred and are not reflected in EBITDA or Adjusted EBITDA. Management compensates for these limitations by separately considering the impact of these excluded items to the extent they are material to operating decisions or assessments of operating performance. Our historical consolidated and combined statements of operations and cash flows include interest expense, capital expenditures and other excluded items, all of which should be considered when evaluating our performance, in addition to our non-GAAP financial measures. Additionally, EBITDA and Adjusted EBITDA should not solely be considered as a measure of our liquidity or indicative of funds available to fund our cash needs, including our ability to pay dividends. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures—The Company—EBITDA and Adjusted EBITDA.”

 

36


Table of Contents

The following table provides a reconciliation of net income (loss) to EBITDA and Adjusted EBITDA for the years ended December 31, 2013, 2012 and 2011, the period from October 8, 2010 through December 31, 2010, the period from January 1, 2010 through October 7, 2010 and the year ended December 31, 2009 (in millions):

 

     Company     Company Predecessor  
     Year
Ended
December 31,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Net income (loss)

   $ 82.7      $ 22.3      $ 46.6      $ (22.1   $ 3,306.8      $ (1,398.1

Interest expense, net

     234.4        257.4        211.9        49.6        167. 0        297.0   

Income tax (benefit) expense

     (5.0     4.6        7.1        (1.5     (120.4     929.9   

Depreciation and amortization

     168.1        129.9        120.4        27.0        290.6        378.9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

EBITDA

     480.2        414.2        386.0        53.0        3,644.0        207.7   

Restructuring expenses

     0.6        5.8        10.5        —          —          —     

Acquisition transaction expenses

     0.2        1.7        0.6        21.5        —          —     

Impairment of long-lived assets

     3.3        1.4        —          —          44.6        27.6   

Bankruptcy-related (gain) expense, net

     —          —          —          —          (3,430.5     41.4   

Non-cash equity-based compensation

     20.2        4.4        4.7        0.3        —          —     

Other expenses

     14.1 (1)      7.4 (2)      8.0 (3)      —          2.6  (4)      12.6 (5) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ 518.6      $ 434.9      $ 409.8      $ 74.8      $ 260.7      $ 289.3   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

  (1) For the year ended December 31, 2013, includes costs related to preparations for our initial public offering, consisting primarily of the Pre-IPO Transactions, of $11.2 million and loss on disposal of assets of $2.9 million.
  (2) For the year ended December 31, 2012, includes costs related to preparations for our initial public offering, consisting primarily of the Pre-IPO Transactions, of $1.6 million, consulting fees related to implementation of our new strategic initiatives, including services related to pricing and yield management projects, of $4.9 million and loss on disposal of assets of $0.9 million.
  (3) For the year ended December 31, 2011, includes consulting fees related to implementation of our new strategic initiatives, including services related to pricing and yield management projects, of $7.4 million and loss on disposal of assets of $0.6 million.
  (4) For the period from January 1, 2010 through October 7, 2010, includes loss on disposal of assets of $2.6 million.
  (5) For the year ended December 31, 2009, includes loss on capital lease termination of $12.1 million and loss on disposal of assets of $0.5 million.

 

(b) Hotel Operating Profit and Hotel Operating Margin. Hotel operating profit and hotel operating margin measure owned hotel-level operating results prior to debt service, depreciation and amortization and general and administrative expenses and are supplemental measures of aggregate hotel-level profitability. Both measures are used by us to evaluate the operating profitability of our hotels. We define hotel operating profit as the sum of room and other hotel revenues less hotel operating expenses (excluding loss on disposal of assets) and hotel operating margin as the ratio of hotel operating profit divided by the sum of room and other hotel revenues. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures—The Company—Hotel Operating Profit and Hotel Operating Margin.”

The following table provides a reconciliation of our room revenues, other hotel revenues and hotel operating expenses (excluding loss on disposal of assets) to hotel operating profit and hotel operating margin for the years ended December 31, 2013, 2012 and 2011, the period from October 8, 2010 through December 31, 2010, the period from January 1, 2010 through October 7, 2010 and the year ended December 31, 2009 (in millions):

 

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Table of Contents
     Company     Company Predecessor  
     Year
Ended
December 31,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Room revenues

   $ 1,114.0     $ 984.3      $ 913.0      $ 188.7      $ 659.9      $ 818.4   

Other hotel revenues

     17.8        16.9        18.7        4.1        13.2        15.0   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total hotel revenues

     1,131.8        1,001.2        931.7        192.8        673.1        833.4   

Hotel operating expenses

     537.7 (1)      492.7 (2)      462.8 (3)      101.8        348.7 (4)      440.3 (5) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Hotel operating profit

   $ 594.1      $ 508.5      $ 468.9      $ 91.0      $ 324.4      $ 393.1   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Hotel operating margin

     52.5     50.8     50.3     47.2     48.2     47.2
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

  (1) For the year ended December 31, 2013, excludes loss on disposal of assets of $2.9 million.
  (2) For the year ended December 31, 2012, excludes loss on disposal of assets of $0.9 million.
  (3) For the year ended December 31, 2011, excludes loss on disposal of assets of $0.6 million.
  (4) For the period from January 1, 2010 through October 7, 2010, excludes loss on disposal of assets of $2.6 million.
  (5) For the year ended December 31, 2009, excludes loss on disposal of assets of $0.5 million.

Selected Historical Financial and Other Data—ESH REIT

The selected historical consolidated financial data of ESH REIT for the years ended December 31, 2013, 2012 and 2011 and as of December 31, 2013 and 2012 have been derived from the audited consolidated financial statements of ESH REIT included elsewhere in this combined annual report on Form 10-K. The selected historical consolidated financial data of ESH REIT for the period from October 8, 2010 through December 31, 2010 and as of December 31, 2011 have been derived from the audited consolidated financial statements of ESH REIT not included elsewhere in this combined annual report on Form 10-K. The selected historical consolidated financial data for ESH REIT as of December 31, 2010 has been derived from the unaudited consolidated statements of ESH REIT not included elsewhere in this combined annual report on Form 10-K. The selected historical combined financial data of ESH REIT Predecessor for the period from January 1, 2010 through October 7, 2010 and for the year ended December 31, 2009 and as of December 31, 2009 have been derived from the unaudited combined financial statements of ESH REIT Predecessor not included elsewhere in this combined annual report on Form 10-K. The following information should be read in conjunction with, and is qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the historical audited consolidated financial statements and related notes and other financial information included herein.

The historical combined financial statements of ESH REIT Predecessor were prepared by combining the financial results of the entities that owned the hotel properties and the assets and operating companies of the Company Predecessor, other than those acquired by ESH Strategies, and represent the assets and entities consolidated in the financial statements of ESH REIT after the Acquisition Date. Certain financial information of ESH REIT Predecessor is not comparable to that of ESH REIT. This information includes, but may not be limited to, depreciation and amortization expense, restructuring and acquisition transaction expenses, interest expense, income tax expense and reorganization gain, net.

 

38


Table of Contents
     ESH REIT     ESH REIT Predecessor  

(Dollars in millions)

   Year
Ended
December 31,
2013
     Year
Ended
December 31,
2012
     Year
Ended
December 31,
2011
     Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Statement of operations data:

               

Rental revenues

   $ 71.9       $ —         $ —         $ —        $ —        $ —     

Hotel room revenues

     984.0         984.3         913.0         188.7        659.9        818.4   

Other hotel revenues

     15.6         16.9         18.7         4.1        13.2        15.0   

Management fees and other revenues

     1.0         10.3         11.2         2.6        7.3        0.3   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total revenues

     1,072.5         1,011.5         942.9         195.4        680.4        833.7   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Hotel operating expenses

     478.7         493.6         463.4         101.8        351.3        440.8   

General and administrative expenses

     86.8         87.8         72.4         17.5        66.9        83.9   

Depreciation and amortization

     167.2         129.9         120.4         27.0        290.6        378.9   

Managed property payroll expenses

     0.6         6.6         6.4         1.5        4.8        —     

Trademark license fees

     3.0         3.0         2.8         0.6        0.7        0.8   

Restructuring expenses

     0.6         5.8         10.5         —          —          —     

Acquisition transaction expenses

     0.2         1.7         0.6         21.5        —          —     

Impairment of long—lived assets

     3.3         1.4         —           —          11.1        22.3   

Office building operating expenses

     —           —           1.0         0.2        0.8        —     

Loss on lease termination

     —           —           —           —          —          12.1   

Allowance for receivables from affiliates

     —           —           —           —          —          19.6   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total operating expenses

     740.4         729.8         677.5         170.1        726.2        958.4   

Other income

     1.1         0.4         0.2         0.2        1.4        —     
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     333.2         282.1         265.6         25.5        (44.4     (124.7

Interest expense

     234.2         257.7         212.5         49.6        —          297.3   

Adequate protection payments in lieu of interest

     —           —           —           —          167.1        —     

Loss on derivative instruments

     —           —           —           —          —          0.5   

Interest income

     0.6         0.3         0.6         —          0.1        0.1   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Income (loss) before reorganization gain (loss) and income taxes

     99.6         24.7         53.7         (24.1     (211.4     (422.4

 

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Table of Contents
     ESH REIT     ESH REIT Predecessor  

(Dollars in millions, other than per share data)

   Year
Ended
December 31,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Period
from
October 8,
2010
through
December 31,
2010
    Period
from
January 1,
2010
through
October 7,
2010
    Year
Ended
December 31,
2009
 

Reorganization gain (loss), net

     —          —          —          —          3,430.5        (41.4

Income (loss) before income tax (benefit) expense

     99.6        24.7        53.7        (24.1     3,219.1        (463.8

Income tax (benefit) expense

     (0.9     4.6        7.1        (1.5     (120.4     929.9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

     100.5        20.1        46.6        (22.6     3,339.5        (1,393.7

Net (income) loss attributable to noncontrolling interests

     (0.8     (1.6     (1.1     (0.4     (1,545.5     1,306.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) attributable to shareholders or members

   $ 99.7      $ 18.5      $ 45.5      $ (23.0   $ 1,794.0      $ (87.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share:

            

Class A-Basic

   $ 0.26      $ 0.05      $ 0.12      $ (0.06   $ 4.81      $ (0.23
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Class A-Diluted

   $ 0.26      $ 0.05      $ 0.12      $ (0.06   $ 4.81      $ (0.23
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Class B-Basic

   $ 0.26      $ 0.05      $ 0.12      $ (0.06   $ 4.81      $ (0.23
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Class B-Diluted

   $ 0.25      $ 0.05      $ 0.12      $ (0.06   $ 4.81      $ (0.23
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other financial data:

            

Cash flows provided by (used in):

            

Operating activities

   $ 295.2      $ 194.2      $ 180.5      $ 15.7      $ 106.0      $ 56.9   

Investing activities

     (164.1     (223.8     (43.4     (3,909.5     (41.7     20.5   

Financing activities

     (215.7     34.3        (50.1     3,903.9        (1.6     (21.7

Capital expenditures

     (171.9     (271.5     (106.1     (11.6     (38.0     (32.4

 

     ESH REIT      ESH REIT 
Predecessor
 

(Dollars in millions)

   December 31,
2013
     December 31,
2012
     December 31,
2011
     December 31,
2010
     December 31,
2009
 

Balance sheet data:

              

Cash and cash equivalents(1)

   $ 18.6       $ 103.3       $ 98.5       $ 11.4       $ 77.9   

Restricted cash

     45.9         61.6         236.7         253.2         0.2   

Property and equipment, net

     4,119.9         4,110.6         3,844.1         3,860.6         6,346.0   

Total assets

     4,328.3         4,487.4         4,346.7         4,341.1         6,490.5   

Mortgage loans payable

     2,519.8         2,525.7         1,980.2         2,004.3         4,108.3   

Mezzanine loans payable

     365.0         1,080.0         700.0         700.0         3,295.5   

Revolving credit facility

     20.0         —           —           —           —     

 

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Table of Contents
     ESH REIT      ESH REIT 
Predecessor
 

(Dollars in millions)

   December 31,
2013
     December 31,
2012
     December 31,
2011
     December 31,
2010
     December 31,
2009
 

Total liabilities

     3,000.8         3,741.2         2,806.5         2,824.6         8,466.4   

Total consolidated and combined equity (deficit)(1)

     1,327.5         746.2         1,540.2         1,516.5         (1,975.9

Total liabilities and consolidated and combined equity

   $ 4,328.3       $ 4,487.4       $ 4,346.7       $ 4,341.1       $ 6,490.5   

 

(1) In February 2014, ESH REIT declared a REIT dividend with respect to the fourth quarter of 2013 of $0.08 per share payable to holders of record of ESH REIT Class A common stock and Class B common stock as of March 12, 2014, or approximately $36.4 million.

EBITDA, Adjusted EBITDA, hotel operating profit and hotel operating margin are not meaningful or useful measures for ESH REIT on a stand-alone basis due to the fact that a Paired Share represents an investment in the Company, as a single enterprise, which is reflected in the consolidated and combined Company results; therefore, we believe these performance measures are meaningful for the Company only.

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

The following discussion should be read in conjunction with “Business-Our Recent Operating History-The Pre-IPO Transactions,” “Selected Historical Financial and Other Data” and:

 

    the consolidated and combined financial statements and related notes of the Company included in Item 8 of this combined annual report on Form 10-K; and

 

    the consolidated financial statements and related notes of ESH REIT included in Item 8 of this combined annual report on Form 10-K.

We have presented below separate “Results of Operations” for each of the Company and ESH REIT. Where appropriate, the following discussion includes analysis of the effects of the Pre-IPO Transactions and the Offering. Portions of the following discussion reflect the changes in our structure resulting from the Pre-IPO Transactions. Prior to the Pre-IPO Transactions, the Operating Lessees, which were wholly-owned subsidiaries of ESH REIT, leased the hotel properties from ESH REIT pursuant to operating leases. HVM, an eligible independent contractor (within the meaning of Section 856(d)(9) of the Internal Revenue Code of 1986, as amended (the “Code”)), managed the hotel properties pursuant to management agreements with the Operating Lessees. ESH Strategies owned the trademarks and licensed their use to the Operating Lessees pursuant to trademark license agreements. The Pre-IPO Transactions restructured and reorganized the existing business and legal entities such that the Operating Lessees, ESH Strategies and the assets and obligations of HVM were transferred to the Corporation. Additionally, our assets and operations, other than ownership of our real estate assets (which continue to be owned by ESH REIT), are held by the Corporation and operated as an integrated enterprise. Subsequent to the Pre-IPO Transactions, the Corporation owns all of the Class A common stock of ESH REIT, representing approximately 55% of the outstanding common stock of ESH REIT.

The following discussion may contain forward-looking statements about our market, analysis, future trends, the demand for our services and other future results, among other topics. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed in “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” Those sections expressly qualify any subsequent oral and written forward-looking statements attributable to us or persons acting on our behalf.

Overview

We are the largest owner/operator of company-branded hotels in North America. Our business operates in the extended stay lodging industry, and as of December 31, 2013, we own and operate 684 hotel properties comprising approximately 76,200 rooms located in 44 states across the United States and in Canada. We own and operate 632 of our hotels under the core brand, Extended Stay America, which serves the mid-price extended stay segment, and accounts for approximately half of the segment by number of rooms in the United States. In addition, we own and operate three Extended Stay Canada hotels, 47 hotels in the economy extended stay segment under the Crossland Economy Studios brand and two hotels in the economy extended stay segment under the Hometown Inn brand. On December 31, 2013, we completed the acquisition of two hotels which, through the date of acquisition, we previously managed. Effective January 1, 2014, the operations of these hotels will be included in the operating results of our consolidated portfolio.

 

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Our extended stay hotels are designed to provide an affordable and attractive alternative to traditional lodging or apartment accommodations and are targeted toward self-sufficient, value-conscious guests. Our hotels feature fully-furnished rooms with in-room kitchens, complimentary grab-and-go breakfast, free WiFi, flat screen TVs and limited housekeeping service, which is typically provided on a weekly basis. Our guests include business travelers, professionals on temporary work or training assignments, persons relocating, temporarily displaced or purchasing a home and anyone else in need of temporary housing. These guests generally rent accommodations on a weekly or longer term basis.

Key Metrics Evaluated by Management

We evaluate the performance of our business through the use of certain non-GAAP financial measures. “GAAP” refers to generally accepted accounting principles in the United States. Each of these non-GAAP financial measures should be considered as supplemental measures to GAAP performance measures such as total revenues, net income, net income per share and cash flow provided by operating activities. We provide a more detailed discussion of certain of these non-GAAP financial measures, how management uses such measures to evaluate our financial condition and operating performance, a discussion of certain limitations of such measures and a reconciliation of such measures to the nearest GAAP measures under “—Non-GAAP Financial Measures-The Company.”

Average daily rate (“ADR”) is a commonly used measure within the lodging industry to evaluate hotel financial performance. ADR represents hotel room revenues divided by total number of rooms sold in a given period. ADR measures average room price attained by a hotel or group of hotels, and ADR trends provide useful information concerning pricing policies and the nature of the customer base of a hotel or group of hotels. Changes in room rates have an impact on overall revenues and profitability.

Occupancy is a commonly used measure within the lodging industry to evaluate hotel financial performance. Occupancy represents the total number of rooms sold in a given period divided by the total number of rooms available at a hotel or group of hotels. Occupancy measures the utilization of our hotels’ available capacity. Management uses occupancy to gauge demand at a specific hotel or group of hotels in a given period. Occupancy levels also help us determine achievable ADR levels as demand for hotel rooms increases or decreases.

Revenue per available room (“RevPAR”) is a commonly used measure within the lodging industry to evaluate hotel financial performance. RevPAR is defined as the product of the average daily room rate charged and the average daily occupancy achieved for a hotel or group of hotels in a given period. RevPAR does not include other ancillary revenues, such as food and beverage revenues or parking, telephone or other guest service revenues generated by a hotel. Although RevPAR does not include these other hotel revenues, it generally is considered a key indicator of core revenues for many hotels. For the year ended December 31, 2013, room revenues represented approximately 98.3% of our total revenues.

RevPAR changes that are driven predominately by occupancy have different implications on incremental hotel operating profit than do changes that are driven predominately by ADR. For example, increases in occupancy at a hotel would lead to increases in room revenues and other hotel revenues, as well as incremental operating costs (including housekeeping services, utilities and room amenity costs). RevPAR increases due to higher room rates, however, would generally not result in additional operational room-related costs, with the exception of those charged or incurred as a percentage of revenue, such as credit card fees. As a result, changes in RevPAR driven by increases or decreases in ADR generally have a greater effect on operating profitability than changes in RevPAR driven by occupancy levels. Due to seasonality in our business, we review RevPAR by comparing current periods to the same periods in prior years.

Additional non-GAAP financial measures include:

 

    EBITDA and Adjusted EBITDA. Earnings before interest expense, net, income taxes, depreciation and amortization (“EBITDA”) is a commonly used measure in many industries. We adjust EBITDA when evaluating our performance because we believe that the adjustment for certain items, such as restructuring and acquisition transaction expenses, impairment charges related to long-lived assets, non-cash equity-based compensation and other items not indicative of ongoing operating performance, provides useful supplemental information to investors regarding our ongoing operating performance. We believe that EBITDA and Adjusted EBITDA provide useful information to investors regarding our results of operations that help us and our investors evaluate the ongoing operating performance of our hotels and facilitate comparisons between us and other lodging companies, hotel owners and capital-intensive companies.

 

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    Hotel Operating Profit and Hotel Operating Margin. Hotel operating profit and hotel operating margin measure hotel-level operating results prior to debt service, depreciation and amortization and general and administrative expenses and are supplemental measures of aggregate hotel-level profitability. Both measures are used by us to evaluate the operating profitability of our hotels. We define hotel operating profit as the sum of room and other hotel revenues less hotel operating expenses (excluding loss on disposal of assets) and hotel operating margin as the ratio of hotel operating profit divided by the sum of room and other hotel revenues.

Understanding Our Results of Operations – The Company

Revenues and Expenses. The Company’s revenues are derived primarily from the operation of our owned hotels. Hotel operating expenses account for the largest portion of the Company’s operating expenses and reflect the expenses of our owned hotels. The following table presents the components of the Company’s revenues as a percentage of our total revenues for the year ended December 31, 2013:

 

     Percentage of
2013

Revenues

•      Room revenues. Room revenues are driven primarily by ADR and occupancy. Pricing policy, as well as the customer mix of a hotel, is a significant driver of ADR. Due to our high occupancy levels, our current focus is on increasing RevPAR by increasing ADR.

 

For the year ended December 31, 2013, we experienced RevPAR growth of approximately 10.2% due to the collective impact of our hotel reinvestment program, upgraded operational practices, investments in marketing and brand awareness and focus on service excellence. We believe our continued focus on these initiatives will drive continued RevPAR growth at or above the level of our competitive set for at least 2014.

   98.3%

•      Other hotel revenues. Other hotel revenues include ancillary revenues such as laundry revenues, additional housekeeping fees and pet charges. Occupancy and the customer mix of a hotel, as well as the number of guests that have long-term stays, are the key drivers of other hotel revenues.

   1.6%

•      Management fees, license fees and other revenues. Management fees, license fees and other revenues represent total gross fees earned from our two managed hotels, which we acquired on December 31, 2013, as well as the reimbursement of payroll expenses incurred on behalf of these managed hotels. Revenue of the managed hotels is the principal driver of management fees and license fees and occupancy of the managed hotels is one of the principal drivers of the reimbursement of payroll expenses. Due to the business and entity restructuring that occurred in connection with the Pre-IPO Transactions and our acquisition of the two managed hotels, we expect to have no management fees, license fees and other revenues in 2014.

   0.1%

The following table presents the components of the Company’s operating expenses as a percentage of our total operating expenses for the year ended December 31, 2013:

 

     Percentage of
2013 
Operating
Expenses

•      Hotel operating expenses. Hotel operating expenses include all expenses associated with operating our owned hotels. These costs, although primarily fixed in nature, do have some variable components. Those that are relatively fixed include payroll, real property taxes and insurance. Occupancy is a key driver of expenses that have a high degree of variability such as room supplies, repair and maintenance and utilities. Other variable expenses include internet advertising costs, hotel reservation services and travel agent commissions.

   65.8%

 

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Table of Contents

We experienced an increase in hotel operating expenses of approximately $46.9 million for the year ended December 31, 2013, driven in part by enhancements to our product and service offering, including complimentary grab-and-go breakfast and free in-room WiFi. As a result, in 2013 we saw hotel operating expenses increase at a rate greater than we would expect to be typical in future periods.

  

•     General and administrative expenses. General and administrative expenses include expenses associated with corporate overhead. These costs consist primarily of compensation expense of our corporate staff, professional fees, including consulting, audit, tax and legal fees and global brand marketing expense.

     13.2 %

•     Depreciation and amortization. Depreciation and amortization is a non-cash charge that relates primarily to the acquisition and related usage of hotels and other property and equipment.

     20.4 %

•     Managed property payroll expenses. Managed property payroll expenses include all payroll expenses related to the hotel staff of our two managed hotels, which we acquired on December 31, 2013. We are fully reimbursed for these costs as stipulated in the respective management agreements. The reimbursement of these costs is included as a component of management fees, license fees and other revenues. We expect to have no managed property payroll expenses in 2014.

     0.1 %

•     Restructuring expenses. Restructuring expenses are costs associated with an anticipated business combination or one-time termination benefits and employee relocation costs. During 2013, we initiated an operations restructuring which changed certain aspects of our property staffing model. For these programs, expenses included employee relocation, recruitment, separation payments and other costs.

     0.1 %

•     Acquisition transaction expenses. Acquisition transaction expenses are legal, professional and other such fees directly related to the acquisition of hotels.

     0.0 %

•     Impairment of long-lived assets. Impairment of long-lived assets is a non-cash charge recognized when events and circumstances indicate that the carrying value of an asset may not be recoverable.

     0.4 %

Understanding Our Results of Operations – ESH REIT

Revenues and Expenses. Prior to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflected room and other hotel revenues, as rental revenues and expenses with respect to the operating leases between ESH REIT and its previously owned subsidiaries, the Operating Lessees, eliminated in consolidation and the Operating Lessee’s results of operations were owned by ESH REIT. Further, ESH REIT’s consolidated results of operations reflected all hotel operating expenses. Subsequent to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflect ESH REIT’s sole source of revenue, rental revenues earned under its operating leases, which are no longer eliminated in consolidation due to the fact that ESH REIT no longer owns the Operating Lessees. Also, ESH REIT’s consolidated results of operations reflect only those hotel operating expenses directly related to ownership of the hotels, such as real estate taxes and insurance expense, and do not include hotel operating expenses incurred by the Operating Lessees.

Prior to the Pre-IPO Transactions, HVM managed the hotel properties pursuant to management agreements with the Operating Lessees. ESH REIT held a variable interest in HVM and consolidated the financial position, results of operations, comprehensive income and cash flows of HVM, including the management fees earned by HVM pursuant to the management agreements. Subsequent to the Pre-IPO Transactions, ESA Management, a wholly-owned subsidiary of the Corporation, manages the hotel properties.

The following table presents the components of ESH REIT’s revenues as a percentage of ESH REIT’s total revenues for the year ended December 31, 2013:

 

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Table of Contents
     Percentage of
2013 
Revenues

•      Rental revenues. Rental revenues represent the revenues generated from leasing the hotel properties to the Operating Lessees. Rental revenues consist of fixed minimum rental payments plus specified percentages of hotel room revenues earned by the Operating Lessees over designated hotel room revenue thresholds.

 

For the period from January 1, 2013 through the Pre-IPO Transactions, ESH REIT owned the Operating Lessees; therefore, rental revenues earned were eliminated in consolidation. Subsequent to the Pre-IPO Transactions, rental revenues earned are no longer eliminated. For 2014 and beyond, rental revenues will be the sole source of ESH REIT’s consolidated revenue.

   6.7%

•      Hotel room revenues. Room revenues are driven primarily by ADR and occupancy. Pricing policy, as well as the customer mix of a hotel, is a significant driver of ADR.

  

For the period from January 1, 2013 through the Pre-IPO Transactions, ESH REIT owned the Operating Lessees; therefore, hotel room revenues were included in ESH REIT’s consolidated results of operations. Subsequent to the Pre-IPO Transactions, ESH REIT no longer owns the Operating Lessees and hotel room revenues are no longer included in ESH REIT’s consolidated results of operations. For 2014 and beyond, ESH REIT’s consolidated operating results will reflect no hotel room revenues, only lease rental revenues.

   91.7%

•      Other hotel revenues. Other hotel revenues include ancillary revenues such as laundry revenues, additional housekeeping fees and pet charges.

 

For the period from January 1, 2013 through the Pre-IPO Transactions, ESH REIT owned the Operating Lessees; therefore, other hotel revenues were included in ESH REIT’s consolidated results of operations. Subsequent to the Pre-IPO Transactions, ESH REIT no longer owns the Operating Lessees and the other hotel revenues are no longer included in ESH REIT’s consolidated results of operations. For 2014 and beyond, ESH REIT’s consolidated operating results will reflect no other hotel revenues, only lease rental revenues.

   1.5%

•      Management fees and other revenues. Management fees and other revenues represent total gross fees earned from two managed hotels, which were acquired on December 31, 2013, as well as the reimbursement of payroll expenses incurred on behalf of these managed hotels.

 

For the period from January 1, 2013 through the Pre-IPO Transactions, ESH REIT held a variable interest in and consolidated HVM; therefore, management fees for our managed hotels were included in ESH REIT’s consolidated results of operations. Subsequent to the Pre-IPO Transactions, management fees are no longer included in ESH REIT’s consolidated results of operations. For 2014 and beyond, ESH REIT’s consolidated operating results will reflect no management fees, only lease rental revenues.

   0.1%

The following table presents the components of ESH REIT’s operating expenses as a percentage of ESH REIT’s total operating expenses for the year ended December 31, 2013:

 

     Percentage of
2013 
Operating
Expenses

•      Hotel operating expenses. Prior to the Pre-IPO Transactions, hotel operating expenses included all expenses associated with operating our owned hotels. These costs, although primarily fixed in nature, did have some variable components. Those that were relatively fixed included payroll, real property taxes and insurance. Occupancy is a key driver of expenses that have a high degree of variability such as room supplies, repair and maintenance and utilities. Other variable expenses included internet advertising costs, hotel reservation services and travel agent commissions.

 

Subsequent to the Pre-IPO Transactions, hotel operating expenses include only those expenses directly related to ownership of the hotels, such as real estate taxes and insurance expenses.

   64.7%

 

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Table of Contents

•     General and administrative expenses. Prior to the Pre-IPO Transactions, since ESH REIT consolidated the results of operations of HVM, a variable interest entity, general and administrative expenses included expenses associated with all corporate overhead. These costs consisted primarily of compensation expense of our corporate staff, professional fees, including consulting, audit, tax and legal fees and global brand marketing expense.

 

Subsequent to the Pre-IPO Transactions, ESH REIT neither owns nor consolidates the management entity, ESA Management; therefore, general and administrative expenses include only those overhead expenses incurred directly by ESH REIT and administrative service costs paid to ESA Management.

     11.7 %

•     Depreciation and amortization. Depreciation and amortization is a non-cash charge that relates primarily to the acquisition and related usage of hotels and other property and equipment.

     22.6 %

•     Managed property payroll expenses. Prior to the Pre-IPO Transactions, since ESH REIT consolidated the results of HVM, a variable interest entity, managed property payroll expenses included all payroll expenses related to the hotel staff of two managed hotels, which we acquired on December 31, 2013. HVM was fully reimbursed for these costs as stipulated in the respective management agreements. The reimbursement of these costs was included as a component of management fees and other revenues.

 

Subsequent to the Pre-IPO Transactions, ESH REIT neither owns nor consolidates the management entity, ESA Management. For 2014 and beyond, ESH REIT’s consolidated operating results will reflect no hotel operating expenses.

     0.1 %

•     Trademark license fees. Prior to the Pre-IPO Transactions, ESH REIT owned the Operating Lessees, which paid fees to ESH Strategies for the use of their trademark licenses. Trademark license fees directly correlated with hotel room revenues at the hotel properties. Subsequent to the Pre-IPO Transactions, ESH REIT no longer owns the Operating Lessees. For 2014 and beyond, ESH REIT’s consolidated results of operations will reflect no trademark license fees.

     0.4

•     Restructuring expenses. Restructuring expenses are costs associated with an anticipated business combination or one-time termination benefits and employee relocation costs. For these programs, expenses included employee relocation, recruitment, separation payments and other costs.

     0.1

•     Acquisition transaction expenses. Acquisition transaction expenses are legal, professional and other such fees directly related to the acquisition of hotels.

     0.0

•     Impairment of long-lived assets. Impairment of long-lived assets is a non-cash charge recognized when events and circumstances indicate that the carrying value of an asset may not be recoverable.

     0.4 %

Results of Operations

Results of Operations discusses each of the Company’s consolidated and combined financial statements and ESH REIT’s consolidated financial statements, each of which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and costs and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those relating to property and equipment, goodwill, income taxes, equity-based compensation, revenue recognition, consolidation policies and contingencies. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions and conditions.

For the period from the Pre-IPO Transactions through December 31, 2013, the consolidated and combined financial statements of the Company include the financial position, results of operations, comprehensive income, changes in equity and cash flows of the Corporation and its subsidiaries, including the Operating Lessees, ESH Strategies, ESA Management and ESH REIT. Third party equity interests in ESH REIT, which consist of the Class B common stock of ESH REIT and represent approximately 45% of ESH REIT’s total common equity, are not owned by the Company and therefore are presented as noncontrolling interests.

 

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For the periods prior to the Pre-IPO Transactions, the consolidated and combined financial statements of the Company include the financial position, results of operations, comprehensive income, changes in equity and cash flows of the Company’s predecessor, which includes ESH REIT’s predecessor, ESH Hospitality LLC, ESH Strategies and HVM. Third party equity interests in HVM, which represented all of HVM’s equity, were not owned by the Company’s predecessor and therefore are presented as noncontrolling interests. ESH REIT and ESH Strategies became a consolidated group by the time of the completion of the Offering. Since the Pre-IPO Transactions, which resulted in these entities becoming a consolidated group, were accounted for at historical cost, the Company’s predecessor financial information combines ESH REIT’s predecessor financial information with that of ESH Strategies.

For the period from the Pre-IPO Transactions through December 31, 2013, the consolidated financial statements of ESH REIT include the financial position, results of operations, comprehensive income, changes in equity and cash flows of ESH REIT and its subsidiaries.

For the periods prior to the Pre-IPO Transactions, the consolidated financial statements of ESH REIT include the financial position, results of operations, comprehensive income, changes in equity and cash flows of ESH REIT’s predecessor, ESH Hospitality LLC, and its subsidiaries, which included the Operating Lessees. Third party equity interests in HVM, a consolidated variable interest entity, which represented all of HVM’s equity, were not owned by ESH REIT and therefore are presented as noncontrolling interests.

Results of Operations – The Company

Comparison of Years Ended December 31, 2013 and December 31, 2012

As of December 31, 2013, we owned and operated 684 hotels consisting of approximately 76,200 rooms. As of December 31, 2012, we owned 682 hotels consisting of approximately 75,900 rooms. In the third quarter of 2011, we began renovating our hotels which, during the years ended December 31, 2013 and 2012, reduced the total number of rooms in service. Further, on December 13, 2012, we acquired 17 hotels from HFI Acquisitions Company LLC (“HFI”) and on December 31, 2013, we acquired two hotels from LVP Acquisition Corporation (“LVP”). Effective January 1, 2014, the results of operations of the two acquired hotels will be included in the Company’s consolidated and combined results of operations.

The following table presents our consolidated and combined results of operations for the years ended December 31, 2013 and 2012, including the amount and percentage change in these results between the periods (in thousands):

 

    

Year Ended

December 31,

    

Year Ended

December 31,

              
     2013      2012      Change ($)     Change (%)  

Revenues:

          

Room revenues

   $ 1,113,956       $ 984,273       $ 129,683        13.2

Other hotel revenues

     17,787         16,898         889        5.3

Management fees, license fees and other revenues

     1,075         10,291         (9,216 )     (89.6 )%
  

 

 

    

 

 

    

 

 

   

Total revenues

     1,132,818         1,011,462         121,356        12.0
  

 

 

    

 

 

    

 

 

   

Operating expenses:

          

Hotel operating expenses

     540,551         493,635         46,916        9.5

General and administrative expenses

     108,325         88,543         19,782        22.3

Depreciation and amortization

     168,053         129,938         38,115        29.3

Managed property payroll expenses

     728         6,600         (5,872 )     (89.0 )%

 

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Restructuring expenses

     605        5,763        (5,158 )     (89.5 )%

Acquisition transaction expenses

     235        1,675       (1,440     (86.0 )%

Impairment of long-lived assets

     3,330        1,420       1,910        134.5
  

 

 

   

 

 

   

 

 

   

Total operating expenses

     821,827        727,574        94,253        13.0

Other income

     1,134        384        750        195.3
  

 

 

   

 

 

   

 

 

   

Income from operations

     312,125        284,272        27,853        9.8

Interest expense

     234,593        257,656        (23,063 )     (9.0 )%

Interest income

     (134 )     (307 )     173        (56.4 )%
  

 

 

   

 

 

   

 

 

   

Income before income tax (benefit) expense

     77,666        26,923        50,743        188.5

Income tax (benefit) expense

     (4,990     4,642        (9,632 )     207.5
  

 

 

   

 

 

   

 

 

   

Net income

     82,656        22,281        60,375        271.0

Net loss (income) attributable to noncontrolling interests

     3,575        (1,549     5,124        (330.8 )% 
  

 

 

   

 

 

   

 

 

   

Net income attributable to common shareholders or members

   $ 86,231      $ 20,732      $ 65,499        315.9
  

 

 

   

 

 

   

 

 

   

The following table presents key operating metrics, including occupancy, ADR and RevPAR, for our owned hotels for the years ended December 31, 2013 and 2012, respectively:

 

     Year Ended
December 31,
    Year Ended
December 31,
       
     2013     2012     Change (%)  

Number of hotel properties (1)

     684       682        0.3 %

Number of rooms (1)

     76,219       75,928        0.4 %

Occupancy

     74.2 %     73.3 %     1.2 %

ADR

   $ 54.15     $ 49.77        8.8 %

RevPAR

   $ 40.18      $ 36.46        10.2 %

 

(1) On December 31, 2013, we acquired two hotel properties consisting of 291 rooms; results of operations of the acquired hotels will be included in our consolidated and combined results of operations effective January 1, 2014.

Room revenues. Room revenues increased by approximately $129.7 million, or 13.2%, to approximately $1,114.0 million for the year ended December 31, 2013 compared to approximately $984.3 million for the year ended December 31, 2012. Excluding room revenues of approximately $30.1 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $1.3 million for the period from December 13, 2012 through December 31, 2012, the increase in room revenues of approximately $100.9 million was due to a 8.9% increase in ADR and a 1.5% increase in occupancy, resulting in a 10.4% increase in RevPAR, which was primarily a result of our hotel reinvestment program, operating and service initiatives and more consistent pricing and discount policies.

 

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Other hotel revenues. Other hotel revenues remained relatively consistent, increasing by approximately $0.9 million, or 5.3%, to approximately $17.8 million for the year ended December 31, 2013 compared to approximately $16.9 million for the year ended December 31, 2012.

Management fees, license fees and other revenues. Management fees, license fees and other revenues decreased by approximately $9.2 million, or 89.6%, to approximately $1.1 million for the year ended December 31, 2013 compared to approximately $10.3 million for the year ended December 31, 2012. Management fees and license fees from managed hotel properties directly correlate with room revenues at those hotel properties and totaled approximately $0.4 million and $2.9 million for the years ended December 31, 2013 and 2012, respectively. The reimbursement of payroll expenses incurred on behalf of the managed hotel properties totaled approximately $0.7 million and $6.6 million for the years ended December 31, 2013 and 2012, respectively. These decreases were due to the fact that the 17 HFI hotels acquired in December 2012 were managed by us during the year ended December 31, 2012, but were owned by us during the year ended December 31, 2013. We expect to have no management fees, license fees and other revenues in 2014.

Hotel operating expenses. Hotel operating expenses increased by approximately $46.9 million, or 9.5%, to approximately $540.6 million for the year ended December 31, 2013 compared to approximately $493.6 million for the year ended December 31, 2012. Excluding hotel operating expenses of approximately $15.9 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $0.7 million for the period from December 13, 2012 through December 31, 2012, the increase in hotel operating expenses of approximately $31.8 million was partly driven by an increase of approximately $8.7 million due to the offering of complimentary grab-and-go breakfast at substantially all of our hotels during the year ended December 31, 2013 as compared to a smaller percentage of our hotels during the year ended December 31, 2012. Also, the increase was related to increases in hotel staff payroll expense, reservations expense, real estate taxes, marketing expense due to our increased focus on internet advertising and utility expenses for the year ended December 31, 2013 compared to the year ended December 31, 2012.

Hotel operating margin increased to 52.5% for the year ended December 31, 2013 compared to 50.8% for the year ended December 31, 2012. The increase in hotel operating margin was primarily related to our increase in ADR. Total hotel revenues increased by approximately $130.6 million for the year ended December 31, 2013 compared to the year ended December 31, 2012, while hotel operating profit increased by approximately $85.6 million for the same period, which represents an operating margin flow-through, defined as the change in hotel operating profit divided by the change in total room and other hotel revenues, of approximately 65.6%.

General and administrative expenses. General and administrative expenses increased by approximately $19.8 million, or 22.3%, to approximately $108.3 million for the year ended December 31, 2013, compared to approximately $88.5 million for the year ended December 31, 2012. This increase was driven by a $15.8 million increase in stock compensation expense, approximately $14.6 million of which related to the modification of the vesting schedules of awards outstanding prior to the Pre-IPO Transactions, as well as $6.0 million in legal fees during the year ended December 31, 2013, both of which are related to our initial public offering. In 2014, the Company expects to incur approximately $5.0 million in public company transition costs.

Depreciation and amortization. Depreciation and amortization increased by approximately $38.1 million, or 29.3%, to approximately $168.1 million for the year ended December 31, 2013 compared to approximately $129.9 million for the year ended December 31, 2012. Excluding depreciation expense of approximately $5.8 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $0.3 million for the period from December 13, 2012 through December 31, 2012, the increase of approximately $32.7 million in depreciation and amortization was primarily due to an increase in investment in hotel assets as a result of our ongoing hotel reinvestment program.

Managed property payroll expenses. Managed property payroll expenses decreased by approximately $5.9 million, or 89.0%, to approximately $0.7 million for the year ended December 31, 2013 compared to approximately $6.6 million for the year ended December 31, 2012. This decrease is due to the fact that the 17 HFI hotels acquired in December 2012 were managed by us during the year ended December 31, 2012, but were owned by us during the year ended December 31, 2013. We expect to have no managed property payroll expenses in 2014.

Restructuring expenses. During the year ended December 31, 2013, we initiated an operations restructuring which changed certain aspects of our property staffing model, for which we incurred costs of approximately $0.6 million. During the year ended December 31, 2011, we initiated a corporate restructuring that we completed during the year ended December 31, 2012, which included, among other things, the relocation of the corporate headquarters to Charlotte, North Carolina, for which we incurred costs of approximately $5.8 million, approximately $2.0 million of which was a non-cash charge related to executive separation payments during the year ended December 31, 2012. For these restructuring programs, expenses included employee relocation, recruitment and separation payments and other costs. As of December 31, 2013, all costs associated with both of these programs had been incurred.

 

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Acquisition transaction expenses. During the year ended December 31, 2013, we incurred acquisition transaction costs of approximately $0.2 million related to our acquisition of assets of the 17 HFI hotels and the two LVP hotels. During the year ended December 31, 2012, we incurred acquisition transaction costs of approximately $1.7 million related to our acquisition of assets of the 17 HFI hotels.

Impairment of long-lived assets. Asset impairments are recorded as required based on an evaluation of property and equipment and intangible assets for impairment. We recognized an impairment charge of approximately $3.3 million related to property and equipment during the year ended December 31, 2013 and approximately $1.4 million during the year ended December 31, 2012.

Interest expense. Interest expense decreased by approximately $23.1 million, or 9.0%, to approximately $234.6 million for the year ended December 31, 2013 compared to approximately $257.7 million for the year ended December 31, 2012. The decrease is due to a decrease in debt extinguishment and other costs of approximately $18.1 million as well as a net decrease in contractual interest expense and amortization of deferred financing costs of $5.0 million.

Subsequent to the Offering, the Corporation entered into the Corporation revolving credit facility and ESH REIT repaid $715.0 million of its outstanding mezzanine loans, terminated the Extended Stay LLC revolving credit facility and entered into the ESH REIT revolving credit facility, which resulted in debt extinguishment and other costs of approximately $27.1 million, composed of prepayment penalties of approximately 13.4 million, the write-off of unamortized deferred financing costs of approximately $11.7 million and other costs of approximately $2.0 million. In November 2012, ESH REIT refinanced its then-outstanding mortgage and mezzanine loans, which resulted in debt extinguishment and other costs of approximately $45.1 million, composed of prepayment penalties of approximately $10.5 million, the write-off of unamortized deferred financing costs of approximately $34.4 million and other costs of approximately $0.2 million. As a result of the debt refinancing in 2012, ESH REIT’s total debt increased by approximately $945.1 million and its weighted-average interest rate decreased by approximately 2.0%. This resulted in a net decrease in contractual interest expense and amortization of deferred financing costs of approximately $5.0 million. The partial prepayment of mezzanine loan principal subsequent to the Offering further reduced the Company’s weighted average interest rate, which was approximately 4.4% as of December 31, 2013. In 2014, the Company expects to incur approximately $148.0 million in interest expense, including the amortization of deferred financing costs, substantially all of which will be incurred at ESH REIT.

Income tax (benefit) expense. Our effective income tax rate decreased by 23.6% to (6.4)% for the year ended December 31, 2013 compared to 17.2% for the year ended December 31, 2012, primarily due to an income tax benefit of approximately $6.6 million related to the recognition of a deferred tax asset associated with the change in ESH REIT’s expected distribution policy. Taxable income associated with the Pre-IPO Transactions was exempt from federal tax, as it was generally earned by ESH REIT. The Company’s effective tax rate is lower than the federal statutory rate of 35% due to ESH REIT’s status as a REIT under the provisions of the Code during these periods and the fact that prior to the Pre-IPO Transactions, the income of HVM and ESH Strategies was not taxed at the corporate level due to their limited liability company status.

In 2014, the Company’s taxable income will include the taxable income of its wholly-owned subsidiaries, ESA Management, ESH Strategies and the Operating Lessees, and will also include dividend income related to its ownership of the shares of Class A common stock of ESH REIT, which represents approximately 55% of the outstanding common stock of ESH REIT. Beginning in 2014, ESH REIT expects to distribute 95% of its taxable income and therefore will incur federal and state income tax on the taxable income not distributed. Changes in ESH REIT’s currently contemplated distribution policy may impact income tax expense in 2014 and beyond, which may include the consideration of the realizability of ESH REIT’s deferred tax asset and the potential establishment of a valuation allowance thereon. As a result of the changes associated with the Pre-IPO Transactions and the revised ESH REIT distribution policy, the Company expects its effective tax rate in 2014 to be in the range of 23% to 24%.

Comparison of Years Ended December 31, 2012 and December 31, 2011

As of December 31, 2011, we owned and operated 665 hotels consisting of approximately 73,700 rooms and managed 19 hotels consisting of approximately 2,600 rooms. On December 13, 2012, we acquired the 17 HFI hotels, which HVM previously managed. Therefore, as of December 31, 2012, we owned and operated 682 hotels consisting of approximately 75,900 rooms and managed two hotels consisting of approximately 290 rooms. In the third quarter of 2011, we began renovating our hotels which, during the third and fourth quarters of 2011 and the year ended December 31, 2012, reduced the total number of rooms in service.

 

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The following table presents our results of operations for the years ended December 31, 2012 and 2011, including the amount and percentage change in these results between the periods (in thousands):

 

     Year Ended
December 31,
2012
    Year Ended
December 31,
2011
    Change ($)     Change (%)  

Revenues:

        

Room revenues

   $ 984,273      $ 912,988      $ 71,285        7.8

Other hotel revenues

     16,898        18,693        (1,795 )     (9.6 )%

Management fees, license fees and other revenues

     10,291        11,047        (756 )     (6.8 )%
  

 

 

   

 

 

   

 

 

   

Total revenues

     1,011,462        942,728        68,734        7.3

Operating expenses:

        

Hotel operating expenses

     493,635        463,369        30,266        6.5

General and administrative expenses

     88,543        75,041        13,502        18.0

Depreciation and amortization

     129,938        120,438        9,500        7.9

Managed property payroll expenses

     6,600        6,409        191        3.0

Restructuring expenses

     5,763        10,491        (4,728 )     (45.1 )%

Acquisition transaction expenses

     1,675        593        1,082        182.5

Impairment of long-lived assets

     1,420        —         1,420        n/a   

Office building operating expenses

     —         1,010        (1,010 )     n/a   
  

 

 

   

 

 

   

 

 

   

Total operating expenses

     727,574        677,351        50,223        7.4

Other income

     384        232        152        65.5
  

 

 

   

 

 

   

 

 

   

Income from operations

     284,272        265,609        18,663        7.0

Interest expense

     257,656        212,474        45,182        21.3

Interest income

     (307 )     (550 )     243        (44.2 )%
  

 

 

   

 

 

   

 

 

   

Income before income taxes

     26,923        53,685        (26,762 )     (49.9 )%

Income tax expense

     4,642        7,050        (2,408 )     (34.2 )%
  

 

 

   

 

 

   

 

 

   

Net income

     22,281        46,635        (24,354 )     (52.2 )%

Net income attributable to noncontrolling interests

     (1,549 )     (1,062 )     (487 )     45.9
  

 

 

   

 

 

   

 

 

   

Net income attributable to members

   $ 20,732      $ 45,573      $ (24,841 )     (54.5 )%
  

 

 

   

 

 

   

 

 

   

The following table presents key operating metrics, including occupancy, ADR and RevPAR, for our owned hotels for the years ended December 31, 2012 and 2011, respectively:

 

     Year Ended
December 31,
2012
    Year Ended
December 31,
2011
    Change (%)  

Number of hotel properties(1)

     682        665        2.6

Number of rooms(1)

     75,928        73,657        3.1

Occupancy

     73.3 %     75.1 %     (2.4 )%

ADR

   $ 49.77      $ 45.20        10.1

RevPAR

   $ 36.46      $ 33.96        7.4

 

(1) Difference in number of hotel properties and rooms between periods is due to acquisition of the 17 HFI hotels on December 13, 2012.

Room revenues. Room revenues increased by approximately $71.3 million, or 7.8%, to approximately $984.3 million for the year ended December 31, 2012 compared to approximately $913.0 million for the year ended December 31, 2011. The increase in room revenues was due to a 10.1% increase in ADR, which was primarily a result of operating initiatives related to our pricing policy and consistency with respect to room discounts across our portfolio, offset by a 2.4% decrease in occupancy, which was primarily due to guest displacement associated with our hotel renovations, resulting in a 7.4% increase in RevPAR.

Other hotel revenues. Other hotel revenues decreased by approximately $1.8 million, or 9.6%, to approximately $16.9 million for the year ended December 31, 2012 compared to approximately $18.7 million for the year ended December 31, 2011. The decrease in other hotel revenues was primarily due to a decrease in internet access fees as a result of the offering of free basic WiFi in all of our rooms with an option to purchase upgraded WiFi at all of our hotels beginning in January 2012.

        Management fees, license fees and other revenues. Management fees, license fees and other revenues decreased by approximately $0.8 million, or 6.8%, to approximately $10.3 million for the year ended December 31, 2012 compared to approximately $11.0 million for the year ended December 31, 2011. Management fees and license fees from managed hotel properties directly correlate with room revenues at those hotel properties and remained consistent at approximately $2.9 million for the years ended December 31, 2012 and 2011. The reimbursement of payroll expenses incurred on behalf of the managed hotel properties increased by approximately $0.2 million, or 3.0%, to approximately $6.6 million for the year ended December 31, 2012 compared to approximately $6.4 million for the year ended December 31, 2011. Offsetting these increases, other revenues during the year ended December 31, 2011 consisted of revenues from the lease of the unoccupied portion of our corporate office building of approximately $1.7 million, which was sold on December 29, 2011.

 

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Hotel operating expenses. Hotel operating expenses increased by approximately $30.3 million, or 6.5%, to approximately $493.6 million for the year ended December 31, 2012 compared to approximately $463.4 million for the year ended December 31, 2011. The increase in hotel operating expenses was mainly driven by increases in hotel staff payroll expense of approximately $10.7 million. Also, the increase was related to higher marketing expense of approximately $7.6 million due to an increased focus on internet advertising. Additionally, there was an increase in real estate taxes of approximately $2.8 million and an increase in travel agent reservations and commissions of approximately $2.4 million. The remaining increase was primarily due to the offering of complimentary grab-and-go breakfast at the majority of our hotels during the year ended December 31, 2012 as compared to a limited number of hotels during the year ended December 31, 2011.

Hotel operating margin increased to 50.8% for the year ended December 31, 2012 compared to 50.3% for the year ended December 31, 2011. The increase in hotel operating margin was primarily related to our increase in ADR while maintaining approximately the same level of occupancy. Total hotel revenues increased by approximately $69.5 million for the year ended December 31, 2012 compared to the year ended December 31, 2011, while hotel operating profit increased by approximately $39.5 million for the same period, which represents an operating margin flow-through, defined as the change in hotel operating profit divided by the change in total room and other hotel revenues, of approximately 56.8%, which reflects, in part, the impact of spending during the period for our hotel reinvestment program.

General and administrative expenses. General and administrative expenses increased by approximately $13.5 million, or 18.0%, to approximately $88.5 million for the year ended December 31, 2012 compared to approximately $75.0 million for the year ended December 31, 2011. This increase was driven by global brand marketing costs of approximately $10.0 million primarily as a result of the introduction of television advertising during the year ended December 31, 2012. Also, the increase was partially related to approximately $4.3 million of compensation expense due to the enhancement of the number and depth of senior management positions in connection with our corporate restructuring as well as approximately $1.6 million related to preparation for our initial public offering. Partially offsetting these increases was a decrease of approximately $2.4 million related to consulting fees associated with the implementation of our strategic initiatives.

Depreciation and amortization. Depreciation and amortization increased by approximately $9.5 million, or 7.9%, to approximately $129.9 million for the year ended December 31, 2012 compared to approximately $120.4 million for the year ended December 31, 2011. The increase in depreciation and amortization is the result of the increase in investment in hotel assets as a result of our ongoing hotel reinvestment program.

Managed property payroll expenses. Managed property payroll expenses increased by approximately $0.2 million, or 3.0%, to approximately $6.6 million for the year ended December 31, 2012 compared to approximately $6.4 million for the year ended December 31, 2011.

Restructuring expenses. During the year ended December 31, 2011, we initiated a corporate restructuring that we completed during the year ended December 31, 2012, which included, among other things, the relocation of the corporate headquarters to Charlotte, North Carolina, for which we incurred costs of approximately $5.8 million, approximately $2.0 million of which was a non-cash charge related to executive separation payments and approximately $10.5 million, approximately $1.6 million of which was a non-cash charge related to a loss on the sale of our former corporate office building, during the years ended December 31, 2012 and 2011, respectively.

Acquisition transaction expenses. During the year ended December 31, 2012, we incurred acquisition transaction costs of approximately $1.7 million related to our acquisition of assets of the 17 HFI hotels. During the year ended December 31, 2011, we incurred acquisition transaction costs of approximately $0.6 million related to our acquisition of substantially all of the Company Predecessor’s businesses, assets and operations in October 2010.

Impairment of long-lived assets. Asset impairments are recorded as required based on an evaluation of property and equipment and intangible assets for impairment. During the year ended December 31, 2012, we recognized an impairment charge of approximately $1.4 million related to property and equipment. During the year ended December 31, 2011, no impairment charges were recognized.

Office building operating expenses. During the year ended December 31, 2011, we owned our former corporate office building and leased the unoccupied portion of the building to third-party tenants. We sold the office building on December 29, 2011; thus, we incurred no office building operating expenses for the year ended December 31, 2012 compared to approximately $1.0 million for the year ended December 31, 2011.

 

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Interest expense. Interest expense increased by approximately $45.2 million, or 21.3%, to approximately $257.7 million for the year ended December 31, 2012 compared to approximately $212.5 million for the year ended December 31, 2011. In connection with ESH REIT’s November 2012 debt refinancing, ESH REIT incurred debt extinguishment and other costs of approximately $45.1 million, which are included as a component of interest expense. As a result of the refinancing in 2012, ESH REIT’s total debt increased by approximately $945.1 million and its weighted-average interest rate decreased by approximately 2.0%. This resulted in a net increase in contractual interest expense and amortization of deferred financing costs of approximately $0.1 million.

Income tax expense. Our effective income tax rate increased by 4.1% to 17.2% for the year ended December 31, 2012 compared to 13.1% for the year ended December 31, 2011, primarily due to the impact of ESH REIT’s November 2012 debt refinancing, as prepayment penalties and other charges generated almost no income tax benefit because they occurred at ESH REIT. These rates are lower than the federal statutory rate of 35% primarily due to ESH REIT’s status as a REIT under the provisions of the Code.

Results of Operations—ESH REIT

Comparison of Years Ended December 31, 2013 and December 31, 2012

ESH REIT owns all of our 684 hotel properties. For the periods through the Pre-IPO Transactions, the consolidated results of operations of ESH REIT include the results of operations of ESH REIT’s predecessor, ESH Hospitality LLC, and its subsidiaries, which included the Operating Lessees. Additionally, for periods through the Pre-IPO transactions, ESH REIT’s consolidated results of operations include the results of operations of HVM, a consolidated variable interest entity. Third party equity interests in HVM, which represented all of HVM’s equity, were not owned by ESH REIT and therefore are presented as noncontrolling interests.

For the period from the Pre-IPO Transactions through December 31, 2013, the consolidated results of operations of ESH REIT include the results of operations of ESH REIT and its subsidiaries, which do not include the Operating Lessees. Further, the results of operations of ESA Management, which now performs the management and administrative services previously performed by HVM, are not consolidated within ESH REIT’s results, as ESA Management is owned by the Corporation.

ESH REIT’s consolidated results of operations subsequent to the Pre-IPO Transactions, as well as in 2014 and beyond, will present consolidated operating results in a manner which reflects ESH REIT’s legal structure and the entity-related changes that were a result of the Pre-IPO Transactions. For example:

 

    Prior to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflected room and other hotel revenues, as lease rental income and expense with respect to the operating leases between ESH REIT and its previously owned, consolidated subsidiaries, the Operating Lessees, respectively, eliminated in consolidation and the Operating Lessee’s results of operations were owned by ESH REIT. Subsequent to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflect ESH REIT’s sole source of revenue, lease rental income earned under its operating leases, which are no longer eliminated in consolidation due to the fact that ESH REIT no longer owns the Operating Lessees. ESH REIT is no longer entitled to the Operating Lessees’ hotel room and other hotel revenues.

 

    Prior to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflected all hotel operating expenses, whether such costs were incurred by ESH REIT (i.e., real estate taxes and insurance, which are directly related to the ownership of the hotels) or by the Operating Lessees (i.e., utilities, hotel property payroll, marketing and repair and maintenance expense, which the Operating Lessees incur as prescribed by the operating leases). Subsequent to the Pre-IPO Transactions, ESH REIT’s consolidated results of operations reflect only those hotel operating expenses that are incurred directly by ESH REIT.

 

    Prior to the Pre-IPO Transactions, since ESH REIT consolidated the results of operations of HVM, administrative service costs paid to HVM eliminated in consolidation. Subsequent to the Pre-IPO Transactions, such costs do not eliminate in consolidation and are reflected as a component of general and administrative expenses.

 

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As of December 31, 2013, ESH REIT owned 684 hotels consisting of approximately 76,200 rooms. As of December 31, 2012, ESH REIT owned 682 hotels consisting of approximately 75,900 rooms. In the third quarter of 2011, ESH REIT began renovating its hotels which, during the years ended December 31, 2013 and 2012, reduced the total number of rooms in service. Further, on December 13, 2012, ESH REIT acquired the 17 HFI hotels and on December 31, 2013, ESH REIT acquired the two LVP hotels. Effective January 1, 2014, the rental revenue and applicable hotel operating expenses of the two acquired hotels will be included in ESH REIT’s consolidated results of operations.

The following table presents ESH REIT’s consolidated results of operations for the years ended December 31, 2013 and 2012, including the amount and percentage change in these results between the periods (in thousands):

 

     Year Ended     Year Ended              
     December 31,     December 31,              
     2013     2012     Change ($)     Change (%)  

Revenues:

        

Rental revenues

   $ 71,900      $ —        $ 71,900        n/a   

Hotel room revenues

     983,950        984,273        (323     0.0 %

Other hotel revenues

     15,576        16,898        (1,322     (7.8 )%

Management fees and other revenues

     1,113        10,346        (9,233     (89.2 )%
  

 

 

   

 

 

   

 

 

   

Total revenues

     1,072,539        1,011,517        61,022        6.0 %
  

 

 

   

 

 

   

 

 

   

Operating expenses:

        

Hotel operating expenses

     478,727        493,635        (14,908     (3.0 )%

General and administrative expenses

     86,676        87,807        (1,131     (1.3 )%

Depreciation and amortization

     167,185        129,938        37,247        28.7 %

Managed property payroll expenses

     639        6,600        (5,961     (90.3 )%

Trademark license fees

     2,998        3,004        (6     (0.2 )%

Restructuring expenses

     605        5,763        (5,158     (89.5 )%

Acquisition transaction expenses

     235        1,675        (1,440     (86.0 )%

Impairment of long-lived assets

     3,330        1,420       1,910        134.5 %
  

 

 

   

 

 

   

 

 

   

Total operating expenses

     740,395        729,842        10,553        1.4 %

Other income

     1,075        384        691        179.9 %
  

 

 

   

 

 

   

 

 

   

Income from operations

     333,219        282,059        51,160        18.1 %

Interest expense

     234,258        257,656        (23,398     (9.1 )%

Interest income

     (629     (307     (322     104.9 %
  

 

 

   

 

 

   

 

 

   

Income before income tax (benefit) expense

     99,590        24,710        74,880        303.0 %

Income tax (benefit) expense

     (876     4,642        (5,518     118.9 %
  

 

 

   

 

 

   

 

 

   

Net income

     100,466        20,068        80,398        400.6 %

Net income attributable to noncontrolling interests

     (730     (1,549     819        (52.9 )%
  

 

 

   

 

 

   

 

 

   

Net income attributable to shareholders or members

   $ 99,736      $ 18,519      $ 81,217        438.6 %
  

 

 

   

 

 

   

 

 

   

Rental revenues. Consolidated rental revenues were approximately $71.9 million for the year ended December 31, 2013 compared to $0 for the year ended December 31, 2012. For the period from January 1, 2013 through the Pre-IPO Transactions, the consolidated results of operations of ESH REIT included the results of operations of the Operating Lessees. Therefore, during that

 

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period, ESH REIT’s rental revenues, as well as the Operating Lessee’s rental expenses, were eliminated in consolidation. For the period from the Pre-IPO Transactions through December 31, 2013, the consolidated results of operations of ESH REIT did not include the results of operations of the Operating Lessees. Therefore, during that period, rental revenues were not eliminated in consolidation. Rental revenues consist of fixed minimum rental payments plus specified percentages of hotel revenues earned by the Operating Lessees over designated thresholds.

Hotel room revenues. In connection with the Pre-IPO Transactions, ESH REIT transferred the Operating Lessees to the Corporation; therefore, ESH REIT’s consolidated results of operations for the year ended December 31, 2013 include results of operations of the Operating Lessees for the period from January 1, 2013 through the Pre-IPO Transactions. ESH REIT’s consolidated results of operations for the year ended December 31, 2012 include the results of operations of the Operating Lessees for the full year.

Hotel room revenues decreased by approximately $0.3 million, to approximately $984.0 million for the year ended December 31, 2013 compared to approximately $984.3 million for the year ended December 31, 2013. Excluding room revenues of approximately $26.3 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $1.3 million for the period from December 13, 2012 through December 31, 2012, room revenues decreased by approximately $25.3 million. The decrease was due to the fact that for the year ended December 31, 2013, subsequent to the Pre-IPO Transactions, room revenues do not include the room revenues of the Operating Lessees. The decrease, therefore, is a result of the inclusion of slightly greater than ten months of Operating Lessee room revenues in the year ended December 31, 2013 as compared with the inclusion of a full year of Operating Lessee room revenues in the year ended December 31, 2012.

Other hotel revenues. Other hotel revenues decreased by approximately $1.3 million, or 7.8%, to approximately $15.6 million for the year ended December 31, 2013 compared to approximately $16.9 million for the year ended December 31, 2012. Excluding other hotel revenues of approximately $0.3 million related to the 17 HFI hotels for the year ended December 31, 2013 and $0 for the period from December 13, 2012 through December 31, 2012, other hotel revenues decreased by approximately $1.6 million. The decrease was a result of the inclusion of other hotel revenues related to the Operating Lessees for the period from January 1, 2013 through the Pre-IPO Transactions in the year ended December 31, 2013 as compared with the inclusion of other hotel revenues related to the Operating Lessees for the full year ended December 31, 2012.

Management fees and other revenues. A subsidiary of the Corporation acquired all of the assets and assumed all of the liabilities of HVM in connection with the Pre-IPO Transactions; therefore, ESH REIT’s consolidated results of operations for the year ended December 31, 2013 include results of operations of HVM for the period from January 1, 2013 through the Pre-IPO Transactions. ESH REIT’s consolidated results of operations for the year ended December 31, 2012 include the results of operations for HVM for the full year.

Management fees and other revenues decreased by approximately $9.2 million, or 89.2%, to approximately $1.1 million for the year ended December 31, 2013 compared to approximately $10.3 million for the year ended December 31, 2012. Management fees from managed hotel properties totaled approximately $0.5 million and $2.9 million for the years ended December 31, 2013 and 2012, respectively. The reimbursement of payroll expenses incurred on behalf of the managed hotel properties totaled approximately $0.6 million and $6.6 million for the years ended December 31, 2013 and 2012, respectively. These decreases were due to the fact that the 17 HFI hotels acquired in December 2012 were managed by HVM during most of the year ended December 31, 2012, but were owned by ESH REIT during the year ended December 31, 2013. For the period from the Pre-IPO Transactions through December 31, 2013, the consolidated results of operations of ESH REIT do not include the results of operations of the management entity.

Hotel operating expenses. In connection with the Pre-IPO Transactions, ESH REIT transferred the Operating Lessees to the Corporation; therefore, ESH REIT’s consolidated results of operations for the year ended December 31, 2013 include results of operations of the Operating Lessees for the period from January 1, 2013 through the Pre-IPO Transactions. ESH REIT’s consolidated results of operations for the year ended December 31, 2012 include the results of operations of the Operating Lessees for the full year.

Hotel operating expenses decreased by approximately $14.9 million, or 3.0%, to approximately $478.7 million for the year ended December 31, 2013 compared to approximately $493.6 million for the year ended December 31, 2012. Excluding hotel operating expenses of approximately $13.4 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $0.7 million for the period from December 13, 2012 through December 31, 2012, hotel operating expenses decreased by approximately $27.6 million. This decrease is due to the fact that for the year ended December 31, 2013, subsequent to the Pre-IPO Transactions, hotel operating expenses include only those hotel operating expenses directly related to ownership of the hotels, such as

 

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real estate taxes and insurance expense, and do not include hotel operating expenses incurred by the Operating Lessees. The decrease, therefore, was a result of the inclusion of slightly greater than ten months of Operating Lessee hotel operating expenses in the year ended December 31, 2013 as compared with the inclusion of a full year of Operating Lessee hotel operating expenses in the year ended December 31, 2012.

Subsequent to the Pre-IPO Transactions, hotel operating margin is not a relevant operating measure for ESH REIT as its sole source of consolidated revenue is rental revenue generated from leasing the hotel properties to the Operating Lessees, and its hotel operating expenses represent only a portion of the hotels’ total operating expenses, specifically those related to the ownership of, but not the operation of, the hotel properties.

General and administrative expenses. General and administrative expenses decreased by approximately $1.1 million, or 1.3%, to approximately $86.7 million for the year ended December 31, 2013, compared to approximately $87.8 million for the year ended December 31, 2012. The overall decrease is due to a decrease in consulting expenses of approximately $4.3 million related to the implementation of new strategic initiatives, including services related to pricing and yield management projects, as well as a decrease in payroll related expenses of approximately $3.2 million for the period from the Pre-IPO Transactions through December 31, 2013, during which the management entity was not consolidated with or by ESH REIT. Offsetting these decreases, there was an increase of approximately $9.0 million in public company transaction and transition costs as a result of the Offering completed in November 2013.

In 2014, ESH REIT’s general and administrative expenses are expected to include payroll and related expenses of ESH REIT employees, professional fees, including legal, audit and tax fees, board of directors fees, directors and officers insurance and other public company costs. In addition, ESH REIT will incur costs under its services agreement with ESA Management for certain overhead services performed on ESH REIT’s behalf. The services relate to shared executive management (including the Chief Executive Officer, the Chief Financial Officer and the Chief Legal Officer), accounting, financial analysis, training and technology. These costs are expected to include payroll and other costs related to shared officers and executives, as well as shared payroll and other costs related to finance and accounting personnel.

Depreciation and amortization. Depreciation and amortization increased by approximately $37.2 million, or 28.7%, to approximately $167.2 million for the year ended December 31, 2013 compared to approximately $129.9 million for the year ended December 31, 2012. Excluding depreciation expense of approximately $5.8 million related to the 17 HFI hotels for the year ended December 31, 2013 and approximately $0.3 million for the period from December 13, 2012 through December 31, 2012, the increase of approximately $31.8 million in depreciation and amortization was primarily due to an increase in investment in hotel assets as a result of our ongoing hotel reinvestment program.

Managed property payroll expenses. Managed property payroll expenses decreased by approximately $6.0 million, or 90.3%, to approximately $0.6 million for the year ended December 31, 2013 compared to approximately $6.6 million for the year ended December 31, 2012. This decrease is due to the fact that the 17 HFI hotels acquired in December 2012 were managed by HVM during the year ended December 31, 2012, but were owned by us during the year ended December 31, 2013. Subsequent to the Pre-IPO Transactions, the management entity is not consolidated with or by ESH REIT; therefore, in future periods, there will be no managed property payroll expenses.

Trademark license fees. Trademark license fees remained consistent at $3.0 million for the years ended December 31, 2013 and 2012. Prior to the Pre-IPO Transactions, ESH REIT owned the Operating Lessees, which pay fees to ESH Strategies for the use of their trademark licenses. Trademark license fees are directly correlated with hotel room revenues at the hotel properties. Subsequent to the Pre-IPO Transactions, ESH REIT no longer owns the Operating Lessees. For 2014 and beyond, ESH REIT’s consolidated results of operations will reflect no trademark license fees.

Restructuring expenses. During the year ended December 31, 2013 and prior to the Pre-IPO Transactions, HVM, a consolidated variable interest entity, initiated an operations restructuring, which changed certain aspects of its property staffing model, and incurred costs of approximately $0.6 million. During the year ended December 31, 2011, HVM initiated a corporate restructuring that was completed during the year ended December 31, 2012, which included, among other things, the relocation of the corporate headquarters to Charlotte, North Carolina, and incurred costs of approximately $5.8 million, approximately $2.0 million of which was a non-cash charge related to executive separation payments during the year ended December 31, 2012. For these restructuring programs, expenses included employee relocation, recruitment and separation payments and other costs. As of the Pre-IPO Transactions, all costs associated with both of these programs had been incurred.

Acquisition transaction expenses. During the year ended December 31, 2013, we incurred acquisition transaction costs of approximately $0.2 million related to ESH REIT’s acquisition of assets of the 17 HFI hotels and the two LVP hotels. During the year ended December 31, 2012, ESH REIT incurred acquisition transaction costs of approximately $1.7 million related to its acquisition of assets of the 17 HFI hotels.

 

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Impairment of long-lived assets. Asset impairments are recorded as required based on an evaluation of property and equipment and intangible assets for impairment. We recognized an impairment charge of approximately $3.3 million related to property and equipment during the year ended December 31, 2013 and approximately $1.4 million during the year ended December 31, 2012.

Interest expense. Interest expense decreased by approximately $23.4 million, or 9.1%, to approximately $234.3 million for the year ended December 31, 2013 compared to approximately $257.7 million for the year ended December 31, 2012. The decrease is due to a decrease in debt extinguishment and other costs of approximately $18.2 million as well as a net decrease in contractual interest expense and amortization of deferred financing costs of $5.2 million.

Subsequent to the Offering, ESH REIT repaid $715.0 million of its mezzanine loans, terminated the Extended Stay LLC revolving credit facility and entered into the ESH REIT revolving credit facility, which resulted in debt extinguishment and other related costs of approximately $26.9 million, composed of prepayment penalties of approximately $13.4 million, the write-off of unamortized deferred financing costs of approximately $11.7 million and other costs of approximately $1.8 million. In November 2012, ESH REIT refinanced its then-outstanding mortgage and mezzanine loans, which resulted in debt extinguishment and other costs of approximately $45.1 million, composed of prepayment penalties of approximately $10.5 million, the write-off of unamortized deferred financing costs of approximately $34.4 million and other costs of approximately $0.2 million. As a result of the debt refinancing in 2012, ESH REIT’s total debt increased by approximately $945.1 million and its weighted-average interest rate decreased by approximately 2.0%. This resulted in a net decrease in contractual interest expense and amortization of deferred financing costs of approximately $5.2 million. The partial prepayment of mezzanine loan principal subsequent to the Offering further reduced ESH REIT’s weighted average interest rate, which was approximately 4.4% as of December 31, 2013. In 2014, ESH REIT expects to incur approximately $148.0 million in interest expense, including the amortization of deferred financing costs.

Income tax expense. ESH REIT’s effective income tax rate decreased by 19.7% to (0.9)% for the year ended December 31, 2013 compared to 18.8% for the year ended December 31, 2012, primarily due to an income tax benefit of approximately $6.6 million related to the recognition of a net deferred tax asset associated with the change in ESH REIT’s expected distribution policy. ESH REIT’s effective tax rate is lower than the federal statutory rate of 35% due to its status as a REIT under the provisions of the Code during these periods and the fact that prior to the Pre-IPO Transactions, the income of HVM was not taxed at the corporate level due to its limited liability company tax status.

While ESH REIT has historically distributed 100% of its taxable income, beginning in 2014, it intends to distribute approximately 95% of its taxable income. Accordingly, ESH REIT will be subject to income taxes on approximately 5% of its taxable income. As a result, deferred tax balances have been adjusted during the year to reflect the fact that an estimated 5% of ESH REIT’s future taxable income will be subject to tax. This change in distribution policy resulted in the recognition of a deferred tax asset during 2013 of approximately $7.8 million related to ESH REIT’S net operating loss carryforwards that existed as of December 31, 2012. In addition, net deferred tax liabilities of approximately $1.2 million were recorded during 2013 related to temporary differences that are now expected to be included in taxable income in the future. Changes in ESH REIT’s currently contemplated distribution policy may impact income tax expense in 2014 and beyond, which may include the consideration of the realizability of ESH REIT’s deferred tax asset and the potential establishment of a valuation allowance thereon.

Comparison of Years Ended December 31, 2012 and December 31, 2011

As of December 31, 2011, ESH REIT and its subsidiaries owned and operated 665 hotels consisting of approximately 73,700 rooms and managed 19 hotels consisting of approximately 2,600 rooms. On December 13, 2012, ESH REIT acquired the 17 HFI hotels, which HVM previously managed. Therefore, as of December 31, 2012, ESH REIT and its subsidiaries owned and operated 682 hotels consisting of approximately 75,900 rooms and managed two hotels consisting of approximately 290 rooms. In the third quarter of 2011, we began renovating our hotels which, during the third and fourth quarters of 2011 and all of 2012, reduced the total number of rooms in service.

The following table presents ESH REIT’s and its subsidiaries’ results of operations for the years ended December 31, 2012 and 2011 including the amount and percentage change in these results between the periods (in thousands):

 

     Year Ended
December 31,
2012
     Year Ended
December 31,
2011
     Change ($)     Change (%)  

Revenues:

          

Room revenues

   $ 984,273       $ 912,988       $ 71,285        7.8

Other hotel revenues

     16,898         18,693         (1,795 )     (9.6 )%

Management fees and other revenues

     10,346         11,172         (826 )     (7.4 )%
  

 

 

    

 

 

    

 

 

   

Total revenues

     1,011,517         942,853         68,664        7.3

Operating expenses:

          

Hotel operating expenses

     493,635         463,369         30,266        6.5

General and administrative expenses

     87,807         72,413         15,394        21.3

Depreciation and amortization

     129,938         120,438         9,500        7.9

 

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Managed property payroll expenses

     6,600        6,409        191        3.0 %

Trademark license fees

     3,004        2,795        209        7.5

Restructuring expenses

     5,763        10,491        (4,728 )     (45.1 )%

Acquisition transaction expenses

     1,675        593        1,082        182.5

Impairment of long-lived assets

     1,420        —         1,420        n/a   

Office building operating expenses

     —         1,010        (1,010 )     n/a   
  

 

 

   

 

 

   

 

 

   

Total operating expenses

     729,842        677,518        52,324        7.7

Other income

     384        232        152        65.5
  

 

 

   

 

 

   

 

 

   

Income from operations

     282,059        265,567        16,492        6.2

Interest expense

     257,656        212,474        45,182        21.3

Interest income

     (307 )     (550 )     243        (44.2 )%
  

 

 

   

 

 

   

 

 

   

Income before income taxes

     24,710        53,643        (28,933 )     (53.9 )%

Income tax expense

     4,642        7,050        (2,408 )     (34.2 )%
  

 

 

   

 

 

   

 

 

   

Net income

     20,068        46,593        (26,525 )     (56.9 )%

Net income attributable to noncontrolling interests

     (1,549 )     (1,062 )     (487 )     45.9
  

 

 

   

 

 

   

 

 

   

Net income attributable to members

   $ 18,519      $ 45,531      $ (27,012 )     (59.3 )%
  

 

 

   

 

 

   

 

 

   

Room revenues. Room revenues increased by approximately $71.3 million, or 7.8%, to approximately $984.3 million for the year ended December 31, 2012 compared to approximately $913.0 million for the year ended December 31, 2011. The increase in room revenues was due to a 10.1% increase in ADR, which was primarily a result of operating initiatives related to pricing policy and consistency with respect to room discounts across our portfolio, offset by a 2.4% decrease in occupancy, which was primarily due to guest displacement associated with our hotel renovations, resulting in a 7.4% increase in RevPAR.

Other hotel revenues. Other hotel revenues decreased by approximately $1.8 million, or 9.6%, to approximately $16.9 million for the year ended December 31, 2012 compared to approximately $18.7 million for the year ended December 31, 2011. The decrease in other hotel revenues was primarily due to a decrease in internet access fees as a result of the offering of free basic WiFi in all of our rooms with an option to purchase upgraded WiFi at all of our hotels beginning in January 2012.

Management fees and other revenues. Management fees and other revenues decreased by approximately $0.8 million, or 7.4%, to approximately $10.3 million for the year ended December 31, 2012 compared to approximately $11.2 million for the year ended December 31, 2011. Fees from managed hotel properties and ESH Strategies remained consistent at approximately $3.0 million for the years ended December 31, 2012 and 2011 and were primarily driven by fees from managed hotel properties, which directly correlate with room revenues at those hotel properties. The reimbursement of payroll expenses incurred on behalf of the managed hotel properties increased by approximately $0.2 million, or 3.0%, to approximately $6.6 million for the year ended December 31, 2012 compared to approximately $6.4 million for the year ended December 31, 2011. Offsetting these increases, other revenues during the year ended December 31, 2011 consisted of revenues from the lease of the unoccupied portion of our corporate office building of approximately $1.7 million, which was sold on December 29, 2011.

Hotel operating expenses. Hotel operating expenses increased by approximately $30.3 million, or 6.5%, to approximately $493.6 million for the year ended December 31, 2012 compared to approximately $463.4 million for the year ended December 31, 2011. The increase in hotel operating expenses was mainly driven by increases in hotel staff payroll expense of approximately $10.7 million. Also, the increase was related to higher marketing expense of approximately $7.6 million due to an increased focus on internet advertising. Additionally, there was an increase in real estate taxes of approximately $2.8 million and an increase in travel agent reservations and commissions of approximately $2.4 million. The remaining increase was primarily due to the offering of complimentary grab-and-go breakfast at the majority of our hotels during the year ended December 31, 2012 as compared to a limited number of hotels during the year ended December 31, 2011.

Hotel operating margin increased to 50.8% for the year ended December 31, 2012 compared to 50.3% for the year ended December 31, 2011. The increase in hotel operating margin was primarily related to our increase in ADR while maintaining approximately the same level of occupancy. Total hotel revenues increased by approximately $69.5 million for the year ended December 31, 2012 compared to the year ended December 31, 2011, while hotel operating profit increased by approximately $39.5 million for the same period, which represents an operating margin flow-through, defined as the change in hotel operating profit divided by the change in total room and other hotel revenues, of approximately 56.8%, which reflects, in part the impact of spending during the period for our hotel reinvestment program.

General and administrative expenses. General and administrative expenses increased by approximately $15.4 million, or 21.3%, to approximately $87.8 million for the year ended December 31, 2012 compared to approximately $72.4 million for the year ended December 31, 2011. This increase was driven by global brand marketing costs of approximately $10.0 million primarily as a result of the introduction of television advertising during the year ended December 31, 2012. Also, the increase was partially related to approximately $4.3 million of compensation expense due to the enhancement of the number and depth of senior management positions in connection with our corporate restructuring as well as approximately $1.6 million related to preparation for our initial public offering. Partially offsetting these increases was a decrease of approximately $0.5 million related to consulting fees associated with the implementation of our strategic initiatives.

 

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Depreciation and amortization. Depreciation and amortization increased by approximately $9.5 million, or 7.9%, to approximately $129.9 million for the year ended December 31, 2012 compared to approximately $120.4 million for the year ended December 31, 2011. The increase in depreciation and amortization is the result of the increase in investment in hotel assets as a result of our ongoing hotel reinvestment program.

Managed property payroll expenses. Managed property payroll expenses increased by approximately $0.2 million, or 3.0%, to approximately $6.6 million for the year ended December 31, 2012 compared to approximately $6.4 million for the year ended December 31, 2011.

Trademark license fees. Trademark license fees increased by approximately $0.2 million, or 7.5%, to approximately $3.0 million for the year ended December 31, 2012 compared to approximately $2.8 million for the year ended December 31, 2011. Trademark license fees directly correlate with room revenues.

Restructuring expenses. During the year ended December 31, 2011, we initiated a corporate restructuring that we completed during the year ended December 31, 2012, which included, among other things, the relocation of the corporate headquarters to Charlotte, North Carolina, for which we incurred costs of approximately $5.8 million, approximately $2.0 million of which was a non-cash charge related to executive separation payments, and approximately $10.5 million, approximately $1.6 million of which was a non-cash charge related to a loss on the sale of our former corporate office building, during the years ended December 31, 2012 and 2011, respectively.

Acquisition transaction expenses. During the year ended December 31, 2012, we incurred acquisition transaction costs of approximately $1.7 million related to our acquisition of assets of the 17 HFI hotels. During the year ended December 31, 2011, we incurred acquisition transaction costs of approximately $0.6 million related to our acquisition of substantially all of ESH REIT Predecessor’s businesses, assets and operations in October 2010.

Impairment of long-lived assets. Asset impairments are recorded as required based on an evaluation of property and equipment and intangible assets for impairment. During the year ended December 31, 2012, we recognized an impairment charge of approximately $1.4 million related to property and equipment. During the year ended December 31, 2011, no impairment charges were recognized.

Office building operating expenses. During the year ended December 31, 2011, we owned our former corporate office building and leased the unoccupied portion of the building to third-party tenants. We sold the office building on December 29, 2011; thus, we incurred no office building operating expenses for the year ended December 31, 2012 compared to approximately $1.0 million for the year ended December 31, 2011.

Interest expense. Interest expense increased by approximately $45.2 million, or 21.3%, to approximately $257.7 million for the year ended December 31, 2012 compared to approximately $212.5 million for the year ended December 31, 2011. In connection with our November 2012 debt refinancing, we incurred debt extinguishment and other costs of approximately $45.1 million which are included as a component of interest expense. As a result of the refinancing, our total debt increased by approximately $945.1 million and our weighted-average interest rate decreased by approximately 2.0%. This resulted in a net increase in contractual interest expense and amortization of deferred financing costs of approximately $0.1 million.

Income tax expense. ESH REIT’s effective income tax rate increased by 5.7% to 18.8% for the year ended December 31, 2012 compared to 13.1% for the year ended December 31, 2011, primarily due to the impact of ESH REIT’s November 2012 debt refinancing, as prepayment penalties and other charges generated almost no income tax benefit due to our REIT status. These rates are lower than the federal statutory rate of 35% primarily due to ESH REIT’s status as a REIT under the provisions of the Code.

Non-GAAP Financial Measures – The Company

EBITDA and Adjusted EBITDA

EBITDA is defined as net income excluding: (1) interest expense, net; (2) income tax expense (benefit); and (3) depreciation and amortization. EBITDA is a commonly used measure of performance in many industries. We believe that EBITDA provides useful information to investors regarding our operating performance as it helps us and investors evaluate the ongoing performance of our hotels after removing the impact of our capital structure, primarily interest expense, and our asset base, primarily depreciation and amortization. We believe that the use of EBITDA facilitates comparisons between us and other lodging companies, hotel owners and capital-intensive companies. Additionally, EBITDA is a measure that is widely used by management in our annual budgeting and compensation planning processes.

 

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We use Adjusted EBITDA when evaluating our performance because we believe the adjustment for certain additional items, described below, provides useful supplemental information to investors regarding our ongoing hotel operating performance and that the presentation of Adjusted EBITDA, when combined with the GAAP presentation of net income, net income per share and cash flow provided by operating activities, is beneficial to the overall understanding of our ongoing operating performance. We adjust EBITDA for the following items and refer to this measure as Adjusted EBITDA:

 

    Restructuring expenses—We exclude restructuring expenses that include employee separation payments and other restructuring costs.

 

    Acquisition transaction expenses—Transaction related expenses associated with the acquisition of hotels are expensed when incurred. We exclude the effect of these costs because we believe they are not reflective of ongoing or future operating performance.

 

    Impairment of long-lived assets—We exclude the effect of impairment losses recorded on property and equipment and intangible assets, as we believe that including them in Adjusted EBITDA is not consistent with reflecting the ongoing operating performance of our hotels.

 

    Non-cash equity-based compensation—We exclude non-cash charges related to the amortization of equity-based compensation awards to employees and directors.

 

    Other expenses (income) —We exclude the effect of other costs or income that we do not consider reflective of our ongoing or future operating performance, including: costs related to preparations for our initial public offering and public company transition fees; consulting fees related to the implementation of our new strategic initiatives, including services related to pricing and yield management projects and the loss on disposal of assets.

EBITDA and Adjusted EBITDA, as presented, may not be comparable to measures calculated by other companies. This information should not be considered as an alternative to net income, net income per share, cash flow from operations or any other operating performance measure calculated in accordance with GAAP. Cash expenditures for various real estate or hotel assets such as capital expenditures, interest expense and other items have been and will continue to be incurred and are not reflected in EBITDA or Adjusted EBITDA. Management compensates for these limitations by separately considering the impact of these excluded items to the extent they are material to operating decisions or assessments of operating performance. Our consolidated and combined statements of operations and cash flows include interest expense, net, capital expenditures and other excluded items, all of which should be considered when evaluating our performance, in addition to our non-GAAP financial measures. Additionally, EBITDA and Adjusted EBITDA should not solely be considered as a measure of our liquidity or indicative of funds available to fund our cash needs, including our ability to pay dividends.

EBITDA and Adjusted EBITDA are not meaningful or useful measures for ESH REIT on a stand-alone basis due to the fact that a Paired Share represents an investment in the Company, as a single enterprise, which is reflected in the consolidated and combined Company results; therefore, we believe these performance measures are meaningful for the Company only. The following table provides a reconciliation of our net income to EBITDA and Adjusted EBITDA for the Company for the years ended December 31, 2013, 2012 and 2011 (in thousands):

 

    

Year Ended

December 31,

   

Year Ended

December 31,

   

Year Ended

December 31,

 
     2013     2012     2011  

Net income

   $ 82,656      $ 22,281      $ 46,635   

Interest expense, net

     234,459        257,349        211,924   

Income tax (benefit) expense

     (4,990     4,642        7,050   

Depreciation and amortization

     168,053        129,938        120,438   
  

 

 

   

 

 

   

 

 

 

EBITDA

     480,178        414,210        386,047   

Restructuring expenses

     605        5,763        10,491   

Acquisition transaction expenses

     235        1,675        593   

Impairment of long-lived assets

     3,330        1,420        —     

Non-cash equity-based compensation

     20,168        4,409        4,730   

Other expenses

     14,094 (1)     7,431 (2)     8,003 (3) 
  

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ 518,610      $ 434,908      $ 409,864   
  

 

 

   

 

 

   

 

 

 

 

(1) For the year ended December 31, 2013, includes costs related to preparations for our initial public offering, consisting primarily of the Pre-IPO Transactions, of $11.2 million and loss on disposal of assets of $2.9 million.
(2) For the year ended December 31, 2012, includes costs related to preparations for our initial public offering, consisting primarily of the Pre-IPO Transactions, of $1.6 million, consulting fees related to implementation of our new strategic initiatives, including services related to pricing and yield management projects, of $4.9 million and loss on disposal of assets of $0.9 million.
(3) For the year ended December 31, 2011, includes costs related to implementation of our new strategic initiatives, including services related to pricing and yield management projects, of $7.4 million and loss on disposal of assets of $0.6 million.

 

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Hotel Operating Profit and Hotel Operating Margin

Hotel operating profit and hotel operating margin measure owned hotel-level operating results prior to debt service, depreciation and amortization and general and administrative expenses and are supplemental measures of aggregate hotel-level profitability. Both measures are used by us to evaluate the operating profitability of our hotels. We define hotel operating profit as the sum of room and other hotel revenues less hotel operating expenses (excluding loss on disposal of assets) and hotel operating margin as the ratio of hotel operating profit divided by the sum of room and other hotel revenues.

Hotel operating profit and hotel operating margin are not meaningful or useful measures for ESH REIT on a stand-alone basis due to the fact that a Paired Share represents an investment in the Company, as a single enterprise, which is reflected in the consolidated and combined Company results; therefore, we believe these performance measures of are meaningful for the Company only. The following table provides a reconciliation of room revenues, other hotel revenues and hotel operating expenses to hotel operating profit and hotel operating margin for the Company for the years ended December 31, 2013, 2012 and 2011 (in thousands).

 

    

Year Ended

December 31,

   

Year Ended

December 31,

   

Year Ended

December 31,

 
     2013     2012     2011  

Room revenues

   $ 1,113,956      $ 984,273      $ 912,988   

Other hotel revenues

     17,787        16,898        18,693   
  

 

 

   

 

 

   

 

 

 

Total hotel revenues

     1,131,743        1,001,171        931,681   

Hotel operating expenses

     537,661 (1)       492,722 (2)       462,726 (3) 
  

 

 

   

 

 

   

 

 

 

Hotel operating profit

   $ 594,082      $ 508,449      $ 468,955   
  

 

 

   

 

 

   

 

 

 

Hotel operating margin

     52.5 %     50.8 %     50.3
  

 

 

   

 

 

   

 

 

 

 

(1) For the year ended December 31, 2013, excludes loss on disposal of assets of $2.9 million.
(2) For the year ended December 31, 2012, excludes loss on disposal of assets of $0.9 million.
(3) For the year ended December 31, 2011, excludes loss on disposal of assets of $0.6 million.

 

Inflation

We do not believe that inflation had a material effect on our business during the years ended December 31, 2013, 2012 or 2011. Although we believe that increases in the rate of inflation will generally result in comparable increases in hotel room rates, severe inflation could contribute to a slowing of the national economy. Such a slowdown could result in a reduction in room rates and fewer room reservations, negatively impacting our revenues and net income.

 

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Liquidity and Capital Resources

Company Overview

On a consolidated and combined basis, we have historically generated significant cash flow from our operations and have financed our ongoing business primarily with existing cash and cash flow generated from operations. We generated cash flow from operations of approximately $311.3 million for the year ended December 31, 2013. Our current liquidity requirements consist primarily of funds necessary to pay for operating expenses directly associated with our hotels, recurring maintenance and capital expenditures necessary to maintain our hotels, general and administrative expenses, interest expense, scheduled principal payments on ESH REIT’s outstanding indebtedness and required ESH REIT dividend payments. In addition to recurring maintenance and capital expenditures necessary to maintain our hotels, we are also performing and expect to continue to perform renovations to our hotels. See “—Capital Expenditures—Hotel Reinvestment Program.” We expect to fund this program from a combination of cash on hand, cash flow from operations and/or borrowings under our revolving credit facilities, as needed.

Assuming we exercise our options to extend the maturity for certain ESH REIT mortgage debt that is scheduled to mature in December 2014 for up to three consecutive one-year periods, which options are subject to limited conditions, our long-term liquidity requirements will include funds for principal payments on ESH REIT’s mortgage and mezzanine loans maturing between December 2017 and December 2019. The December 2014 and 2015 extension conditions include providing an adequate extension notice period, the extension or renewal of our interest rate cap and having none of the borrowing entities be in default, as defined. The 2016 extension conditions include the conditions for the 2014 and 2015 extensions, as well as the requirement of a specified minimum debt yield. Other long-term liquidity requirements may include the need to obtain funds to expand our hotel reinvestment program and to acquire additional hotels. We expect to meet our long-term liquidity requirements through various sources of capital, including future debt or equity financings by the Corporation or ESH REIT, existing working capital and cash flow from operations. However, there are a number of factors that may have a material adverse effect on our ability to access these capital sources, including the current and future state of overall equity and credit markets, our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by lenders, general market conditions for the lodging industry, our operating performance and liquidity and market perceptions about us. The success of our business strategy will depend, in part, on our ability to access these various capital sources. There can be no assurance that we will be able to raise any such financing on terms acceptable to us or at all.

The Company had cash and cash equivalents of approximately $60.5 million and restricted cash of approximately $47.3 million at December 31, 2013. Based upon the current level of operations, management believes that our cash flow from operations, together with our significant cash balances, available borrowings under our revolving credit facilities (as described in “—Our Indebtedness”) and our capacity for additional borrowings will be adequate to meet our anticipated funding requirements and business objectives for the foreseeable future. We intend to regularly review our capital structure and at any time may refinance or repay existing indebtedness, incur new indebtedness or issue equity securities.

Although there is not a material difference in the liquidity and capital resource requirements of the Corporation and ESH REIT for the periods presented herein, we separately review the liquidity and capital resource requirements for each of the Corporation and ESH REIT.

The Corporation

The Corporation’s primary source of liquidity will be the dividend income it expects to receive in respect of its ownership of approximately 55% of the common stock of ESH REIT. Other sources of liquidity include income from the operations of the Operating Lessees, ESA Management and ESH Strategies. The Corporation’s cash flow from operations is adequate to meet all of its funding requirements. Market pricing terms were recently negotiated in our operating leases, management agreements and trademark and license agreements.

 

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We anticipate that the Corporation will accumulate cash and expect that over time it will return cash to ESH REIT in order to fund the renovation, acquisition or construction of new hotels, the repayment of debt and for other corporate purposes. The Corporation may transfer cash to ESH REIT through the purchase of additional shares of Class A common stock, which would increase its ownership of ESH REIT and reduce the Company’s overall tax efficiency. The Corporation may also lend funds to ESH REIT through the execution of an unsecured intercompany credit facility. The covenants of any such unsecured intercompany credit facility would be expected to be customary for similar debt securities in light of then-prevailing market conditions. In accordance with restrictions under the ESH REIT revolving credit facility, any such credit facility would have an aggregate principal amount of no more than $200 million, a maturity date which may not be earlier than 91 days after the ESH REIT revolving credit facility maturity date (as such date may be extended) and be junior in right of payment to the ESH REIT revolving credit facility pursuant to a subordination agreement to be entered into. The entering into an unsecured intercompany credit facility and the terms of such credit facility are subject to a number of factors, and we cannot assure that we will enter into an intercompany credit facility at all. Additionally, the Corporation may pay dividends on its common stock to meet all or a portion of our expected dividend rate on our Paired Shares.

The Corporation’s board of directors has not declared any distributions on the Corporation’s common stock and currently has no intention to do so, except as described in “Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities—Distribution Policies.” The payment of any future distributions will be at the discretion of the Corporation’s board of directors. Any such distributions will be made subject to the Corporation’s compliance with applicable law, and will depend on, among other things, the receipt by the Corporation of dividends from ESH REIT in respect of the Class A common stock, the Corporation’s results of operations and financial condition, level of indebtedness, capital requirements, contractual restrictions, restrictions in any existing and future debt agreements of the Corporation and ESH REIT and in any preferred stock and other factors that the Corporation’s board of directors may deem relevant.

Based upon the current level of operations, management believes that the Corporation’s cash position, cash flow from operations and available borrowings under the Corporation revolving credit facility will be adequate to meet all of the Corporation’s funding requirements and business objectives for the foreseeable future.

ESH REIT

Subsequent to the Pre-IPO Transactions, ESH REIT’s primary source of liquidity is lease rental income it receives from the Operating Lessees. ESH REIT’s primary use of liquidity is the payment of its fixed costs of ownership of the hotel properties, including interest expense, scheduled principal payments on its outstanding indebtedness, real estate taxes, insurance expense and capital expenditures, including those capital expenditures related to our hotel reinvestment program. In order to qualify and maintain its status as a REIT, ESH REIT must distribute annually to its shareholders an amount at least equal to:

 

    90% of its REIT taxable income, computed without regard to the deduction for dividends paid and excluding any net capital gain; plus

 

    90% of the excess of its net income, if any, from foreclosure property over the tax imposed on such income by the Code; less

 

    the sum of certain items of non-cash income that exceeds a percentage of ESH REIT’s income.

ESH REIT will be subject to income tax on its taxable income that is not distributed and to an excise tax to the extent that certain percentages of its taxable income are not distributed by specified dates. ESH REIT generally expects to distribute approximately 95% of its REIT taxable income and net capital gain and may be subject to U.S. federal excise tax.

We intend to make distributions of $0.15 per Paired Share per quarter, which we intend to make in respect of the Class B common stock of ESH REIT. In the event distributions in respect of the Class B common stock of ESH REIT are not sufficient to meet our expected distributions, the expected distributions may be completed through distributions in respect of the common stock of the Corporation using funds distributed to the Corporation in respect of the Class A common stock of ESH REIT, after allowance for tax, if any, on those funds.

On February 26, 2014, the board of directors of ESH REIT declared a pro rata cash distribution of $0.08 per share for the fourth quarter of 2013 on its Class A common stock and Class B common stock with respect to the period commencing upon completion of the Offering and ending on December 31, 2013, based on our intended distribution rate of $0.15 per Paired Share for a full quarter. The dividend is payable on March 26, 2014 to shareholders of record as of March 12, 2014. See “Market for Registrants’ Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities—Distribution Policies” for a description of our distribution policies.

Due to REIT distribution requirements, ESH REIT has historically not accumulated significant amounts of cash and is not expected to do so in the future. As a result, we expect that ESH REIT will need to refinance all or a portion of its debt, including the 2012 Mortgage Loans and Mezzanine Loans, on or before maturity. We cannot assure you that ESH REIT will be able to refinance any of its debt on attractive terms on or before maturity, on commercially reasonable terms or at all.

 

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Based upon the current level of operations, management believes that ESH REIT’s cash position, cash flow from operations and available borrowings under the ESH REIT revolving credit facility will be adequate to meet all of ESH REIT’s funding requirements and business objectives for the foreseeable future.

Sources and Uses of Cash – The Company

The following cash flow information is provided for the Company, as there was no meaningful difference for ESH REIT on a stand-alone basis for the periods presented below.

Comparison of Years Ended December 31, 2013 and December 31, 2012

We had unrestricted cash and cash equivalents of approximately $60.5 million and $103.6 million at December 31, 2013 and 2012, respectively.

 

    

Year Ended

December 31,

   

Year Ended

December 31,

       
(in thousands)    2013     2012     Change  

Cash provided by (used in):

      

Operating activities

   $ 311,313      $ 201,110      $ 110,203   

Investing activities

     (165,259     (223,842     58,583   

Financing activities

     (188,977     27,594        (216,571

Effects of changes in exchange rate on cash and cash equivalents

     (202     136        (338
  

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

   $ (43,125   $ 4,998      $ (48,123
  

 

 

   

 

 

   

 

 

 

Cash Flows provided by Operating Activities

Cash flows provided by operating activities totaled approximately $311.3 million for the year ended December 31, 2013 compared to approximately $201.1 million for the year ended December 31, 2012, an increase of approximately $110.2 million. Cash flow from operations was positively impacted during the year ended December 31, 2013 by additional cash generated through improved operating performance of our hotels, specifically a 10.2% increase in RevPAR. Additionally, cash flows provided by operations increased as a result of the timing of interest payments associated with ESH REIT’s mortgage and mezzanine loans.

Cash Flows used in Investing Activities

Cash flows used in investing activities totaled approximately $165.3 million for the year ended December 31, 2013, of which approximately $172.5 million related to the purchases of property and equipment and approximately $16.4 million was related to the acquisition of the two LVP hotels, offset by approximately $14.3 million related to reimbursements from loan escrow accounts and approximately $7.8 million of collateral on insurance reserves. For the year ended December 31, 2012, cash used in investing activities was approximately $223.8 million.

Cash Flows (used in) provided by Financing Activities

Cash flows used in financing activities totaled approximately $189.0 million for the year ended December 31, 2013 and consisted primarily of principal payments on ESH REIT’s 2012 Mezzanine Loans of $715.0 million and distributions to our Sponsors of approximately $78.4 million, offset by the sale of equity as a result of the Offering of approximately $602.2 million. Cash flows provided by financing activities totaled approximately $27.6 million for the year ended December 31, 2012 and included $3,600.0 million generated by new borrowings from ESH REIT’s 2012 Mortgage and Mezzanine Loans, partially offset by the repayment of approximately $2,674.5 million related to ESH REIT’s 2010 Mortgage and Mezzanine Loans, approximately $832.9 million of distributions to our Sponsors and approximately $64.6 million related to the payment of the deferred financing and other costs.

 

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Comparison of Years Ended December 31, 2012 and December 31, 2011

We had unrestricted cash and cash equivalents of approximately $103.6 million and $98.6 million at December 31, 2012 and 2011, respectively.

 

(in thousands)    Year Ended
December 31,
2012
    Year Ended
December 31,
2011
    Change  

Cash provided by (used in):

      

Operating activities

   $ 201,110      $ 180,605      $ 20,505   

Investing activities

     (223,842 )     (43,389 )     (180,453 )

Financing activities

     27,594        (50,074 )     77,668   

Effects of changes in exchange rate on cash and cash equivalents

     136        71        65   
  

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

   $ 4,998      $ 87,213      $ (82,215 )
  

 

 

   

 

 

   

 

 

 

Cash Flows provided by Operating Activities

Cash flows provided by operating activities totaled approximately $201.1 million for the year ended December 31, 2012 compared to approximately $180.6 million for the year ended December 31, 2011, an increase of approximately $20.5 million. Cash flows from operations were positively impacted during the year ended December 31, 2012 by additional cash generated by the improved operating performance of our hotels, specifically a 10.1% increase in ADR, offset by a 2.4% decrease in occupancy, which resulted in increased RevPAR of approximately 7.4%.

Cash Flows used in Investing Activities

Cash flows used in investing activities totaled approximately $223.8 million for the year ended December 31, 2012, of which approximately $128.3 million was related to the acquisition of the 17 HFI hotels and approximately $271.5 million related to the purchases of property and equipment, offset by approximately $175.2 million related to reimbursements from loan escrow accounts, and proceeds from litigation and insurance settlements of approximately $0.8 million. For the year ended December 31, 2011, cash used in investing activities was approximately $43.4 million. Cash flows used in investing activities increased approximately $180.5 million from the year ended December 31, 2011 primarily due to the fact that the Company invested more with respect to its hotel reinvestment program than in 2011, and due to the acquisition of the 17 HFI hotels in December 2012.

Cash Flows provided by (used in) Financing Activities

Cash flows provided by financing activities totaled approximately $27.6 million for the year ended December 31, 2012, which included $3,600.0 million generated by new borrowings from the 2012 Mortgage and Mezzanine Loans, partially offset by the repayment of approximately $2,674.5 million related to the 2010 Mortgage and Mezzanine Loans, approximately $832.9 million in distributions to our Sponsors and approximately $64.6 million related to the payment of deferred financing and other costs. Cash flows used in financing activities totaled approximately $50.1 million for the year ended December 31, 2011, which primarily consisted of approximately $24.1 million related to principal payments on ESH REIT’s mortgage loans and approximately $26.1 million of distributions to our Sponsors.

Capital Expenditures

We maintain each of our hotels in good repair and condition and in conformity with applicable laws and regulations. The cost of all improvements and significant alterations are generally made with cash flows from operations. During the years ended December 31, 2013, 2012 and 2011, we incurred capital expenditures of approximately $172.5 million, $271.5 million and $106.1 million, respectively. These capital expenditures were primarily made as a result of our hotel reinvestment program that began in the third quarter of 2011, which remains ongoing, as well as the acquisition of the assets of the two LVP hotels on December 31, 2013 and the acquisition of the assets of the 17 HFI hotels on December 12, 2012. Funding for future capital expenditures is expected to be provided primarily from cash flow from operations or, to the extent necessary, the Corporation’s or ESH REIT’s revolving credit facilities. In 2014, we expect to incur capital expenditures between $150.0 million and $170.0 million, consisting of hotel renovations, information technology-related projects and maintenance capital expenditures.

Hotel Reinvestment Program

        Since the third quarter of 2011, we have been performing significant hotel renovations and room refreshes and have been executing a phased capital investment program across our portfolio in order to seek to drive incremental market share gains. This program is dedicated to seeking revenues through our Platinum renovation and Silver refresh programs to upgrade 633, or approximately 93%, of our hotels. We have developed a methodology for selecting specific hotels for our reinvestment program by evaluating potential returns based on multiple market and property specific variables. We created two levels of investment: the more extensive Platinum renovation package and the more limited Silver refresh package. Prior to executing either package at a hotel, management determines whether, in its view, the selected level of capital investment is likely to result in incremental revenues and profits and achieve a return on investment that would meet our return criteria.

 

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A Platinum renovation generally requires approximately $1.0 million in spend per hotel. Platinum renovations typically include remodeling of common areas, new paint, carpet, signage, tile or vinyl flooring and counters in bathrooms and kitchens, as well as the refurbishment of furniture, replacement of aged mattresses and installation of new flat screen televisions, artwork, lighting and bedspreads. A Silver refresh generally requires approximately $150,000 in spend per hotel. Silver refreshes typically include the replacement of aged mattresses and installation of new flat screen televisions, lighting, bedspreads and signage.

In order to incorporate the results of previous investments into our decision making process, we have undertaken the reinvestment program in phases. As of December 31, 2013, we have completed Platinum renovations at 230 hotels and are in the process of implementing Platinum renovations at 92 additional hotels. Furthermore, we have completed Silver refreshes at 311 additional hotels, none of which are currently slated for a Platinum upgrade, but we expect to decide to upgrade some of them in the future. Given the more extensive nature of a Platinum renovation, a longer ramp-up time is expected in order to reach stabilization at post-renovation performance levels for Platinum renovations than for Silver refreshes.

The following table summarizes our projects that have been completed or are in process as of December 31, 2013:

 

Scope of Work

   Number of
Hotels
    Expected
Timing
     Total Expected
Cost
(in millions)
     Total Expected
Remaining
Cost
(in millions)
     Cumulative Costs
Incurred
through
December 31,
2013
(in millions)
 

Hotel renovation (Platinum)

     322 (1)      Q3 2011– Q1 2014       $ 318.5       $ 42.9       $ 275.6   

Room refresh (Silver)

     311        Q4 2011– Q3 2013         47.3         —           47.3   
  

 

 

      

 

 

    

 

 

    

 

 

 

Total

     633         $ 365.8       $ 42.9       $ 322.9   
  

 

 

      

 

 

    

 

 

    

 

 

 

 

(1) Includes 22 hotels that were part of our initial pilot program.

We are executing a phased capital investment program across our portfolio in order to drive incremental market share gains.

We believe that our capital investments are driving incremental market share at our renovated properties. We evaluate our hotel reinvestment program by calculating the ADR, occupancy, RevPAR and RevPAR Index(2) performance of our renovated hotels. In general, it takes approximately three months to complete a Platinum hotel renovation (period from commencement to completion of renovations, the “Renovation Period”), during which we experience temporary disruption and weakened performance at the hotel. Following the Renovation Period, it typically takes an additional three months for the hotel to return to occupancy levels approximating Pre-Renovation Period levels (such three-month period, the “Ramp-Up Period”). In order to better analyze the improvements associated with our investments, we have developed a methodology that adjusts for the impact of the temporary disruption associated with both the Renovation and Ramp-Up Periods. In particular, we compare the performance over a twelve-month period starting the month after the completion of the Ramp-Up Period (the “Post-Renovation Period”) to the performance over a twelve-month period ending the month prior to the commencement of the renovations (the “Pre-Renovation Period”). As of December 31, 2013, we owned 82 hotels for which we had results for the Post-Renovation Period. These hotels demonstrated RevPAR growth of 18.2% and RevPAR Index growth of 10.6% in the Post-Renovation Period as compared to the Pre-Renovation Period. Furthermore, the majority of the growth was achieved through increases in ADR, which grew 21.7% over the time period. While we attribute this growth primarily to our capital reinvestment program, we also believe that this improvement has benefited from the implementation of our other initiatives including our re-branding, increased marketing and service initiatives. Although we have already begun to realize the benefits of these initiatives, we expect that a significant amount of the return from our capital investments will be realized in the future. In addition, we believe we will have further opportunities to expand our hotel reinvestment program as we upgrade additional hotels.

 

(2) “RevPAR Index” is stated as a percentage and is calculated for a hotel by comparing the hotel’s RevPAR to the aggregate RevPAR of a group of competing hotels generally in the same market. RevPAR Index is a weighted average of the individual property results. We subscribe to STR, Inc. (f/k/a “Smith Travel Research, Inc.”) (“STR”), an independent, third party service, which collects and compiles the data used to calculate RevPAR Index. We select the competing hotels included in the RevPAR Index, subject to STR’s guidelines. STR, Inc. does not endorse Extended Stay America, Inc. or any other company, and STR data should not be viewed as investment advice or as a recommendation to take a particular course of action.

 

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The following table shows a summary of results of the 82 hotels for which we had results for the Post-Renovation Period as of December 31, 2013:

 

     Pre-Renovation
Period
    Post-Renovation
Period
    Post-Renovation
Change (%)
 

Occupancy

     73.4     71.4     (2.7 )% 

ADR

   $ 54.65      $ 66.52        21.7

RevPAR

   $ 40.15      $ 47.45        18.2

RevPAR Index

     85.7        94.8        10.6

Beyond capital expenditures associated with customary renovation cycles, we will consider additional renovation capital expenditures that we believe will provide an attractive return on investment. We will continue to evaluate the opportunity to upgrade hotels that have received a room refresh by spending additional capital expenditures to provide a hotel renovation. In addition to the approximately $42.9 million of expected costs remaining for our current 92 hotel renovations, we expect to spend in excess of an additional $30.0 million on further renovation phases during 2014.

Rebranding

We spent approximately $9.4 million and $10.0 million on rebranding during the years ended December 31, 2013 and 2012, respectively. Costs associated with rebranding are recorded as general and administrative expenses.

Our Indebtedness

Corporation Revolving Credit Facility

The Corporation entered into a revolving credit facility on November 18, 2013. The Corporation revolving credit facility permits borrowings up to $75.0 million by the Corporation until November 18, 2014, at which time the borrowing availability under the facility will be reduced to $50.0 million. The facility provides for the issuance of up to $50.0 million of letters of credit as well as borrowings on same day notice, referred to as swingline loans, in an amount up to $20.0 million. Borrowings under the facility bear interest at a rate equal to an adjusted LIBOR rate or a base rate determined by reference to the highest of (1) the prime lending rate, (2) the overnight federal funds rate plus 0.5% or (3) the one-month adjusted LIBOR rate plus 1.0%, plus an applicable margin of 2.75% for base rate loans and 3.75% for LIBOR loans. There is no scheduled amortization under the facility; the principal amount outstanding is due and payable in full at maturity, November 18, 2016, subject to a one-year extension option.

As of December 31, 2013, the outstanding balance drawn on the Corporation revolving credit facility was $0 and the amount of borrowing capacity under the Corporation revolving credit facility was $50.1 million, reduced from $75.0 million due to $24.9 million of letters of credit outstanding.

In addition to paying interest on any outstanding principal under the Corporation revolving credit facility, the Corporation is required to pay a commitment fee in respect of unutilized commitments. If 50.0% or more of the facility is drawn, the commitment fee is 0.175%, while if less than 50.0% of the facility is drawn, such fee is 0.35%. The Corporation is also required to pay customary letters of credit fees and agency fees.

If at any time outstanding loans, unreimbursed letter of credit drawings and undrawn letters of credit under the Corporation revolving credit facility exceed the lenders’ commitments at such time, the Corporation will be required to repay outstanding loans or cash collateralize letters of credit at 105% in an aggregate amount equal to such excess, with no reduction of the commitment amount.

The Corporation’s obligations under the Corporation revolving credit facility is guaranteed by its existing and future direct and indirect domestic subsidiaries (with certain exceptions, including, but not limited to, ESH REIT and its subsidiaries and certain other entities that may not provide guarantees pursuant to the 2012 Mortgage Loan and 2012 Mezzanine Loans). The Corporation revolving credit facility is secured by a first-priority security interest in substantially all of the assets of the Corporation and the guarantors under the facility (with certain exceptions).

The Corporation revolving credit facility contains a number of covenants that, among other things and subject to certain exceptions, restrict the Corporation’s ability and the ability of its subsidiaries (other than, with certain exceptions, ESH REIT and its subsidiaries) to incur additional indebtedness, pay dividends and make other restricted payments, engage in transactions with the Corporation’s affiliates, sell all or substantially all of their assets, merge and create liens. The Corporation revolving credit facility also contains certain customary affirmative covenants and events of default.

        If any loans or obligations are outstanding during any fiscal quarter, the Corporation revolving credit facility requires that the Consolidated Leverage Ratio, calculated as of the end of such fiscal quarter, be less than or equal to 9.0 to 1.0 for fiscal quarters ended on or before December 31, 2015 and 8.75 to 1.0 for fiscal quarters ended on or after January 1, 2016. Further, if loans or obligations are outstanding during any calendar month, the Corporation revolving credit facility requires that the Debt Yield not be less than 9.0% as at the last day of such calendar month.

In order to avoid a Trigger Event, as defined, the Corporation revolving credit facility requires a Debt Yield, as defined, of at least 11.5% during the first year of the facility, increasing to 12.0% on and after November 18, 2014. The occurrence of a Trigger Event would require the Corporation to repay the outstanding facility balance and would restrict its ability to make additional borrowings. As of December 31, 2013, the Debt Yield was 16.8% and no Trigger Event had occurred.

Corporation Mandatorily Redeemable Preferred Stock

The Corporation has authorized 350.0 million shares of preferred stock, par value $0.01 per share, of which 21,202 shares of mandatorily redeemable voting preferred stock were issued and outstanding as of December 31, 2013. Dividends on the preferred shares are payable quarterly in arrears at a rate of 8.0% per year. With respect to dividend, distribution and liquidation rights, the 8.0% voting preferred stock ranks senior to the Corporation’s common stock. Holders of the 8.0% voting preferred stock are generally entitled to one vote for each share and will vote together with the Corporation common stock as a single class on all matters that the Corporation’s common shareholders are entitled to vote upon. On or after November 15, 2018, a holder of the 8.0% voting preferred stock has the right to require the Corporation to redeem in cash the 8.0% voting preferred stock at $1,000 per share plus any accumulated but unpaid dividends. On November 15, 2020, the Corporation shall mandatorily redeem all of the 8.0% voting preferred stock at $1,000 per share plus any accumulated but unpaid dividends.

ESH REIT Mortgage Loans

        2012 Mortgage Loan—On November 30, 2012, ESA P Portfolio LLC, ESA P Portfolio MD Borrower LLC, ESA Canada Properties Borrower LLC, ESH/TN Properties LLC (each a subsidiary of ESH REIT and collectively, the “Mortgage Borrower”) entered into an approximately $2.52 billion mortgage loan comprised of three components (the “2012 Mortgage Loan”), which is governed by that certain Loan Agreement, dated as of November 30, 2012, by and among the Mortgage Borrower, certain affiliates of the Mortgage Borrower, JPMorgan Chase Bank, National Association, German American Capital Corporation, Citigroup Global Markets Realty Corp., Bank of America, N.A. and Goldman Sachs Mortgage Company (as amended, the “MLA”). Component A is comprised of five subcomponents, each with varying floating interest rates and a collective weighted average interest rate of LIBOR plus approximately 2.1% and a total balance of $349.8 million and a maturity date of December 1, 2014, with three one-year extension options. Components B and C have fixed interest rates of approximately 3.4% and 4.1% and total balances of $350.0 million and $1,820.0 million and maturity dates of December 1, 2017 and December 1, 2019, respectively.

 

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As of December 31, 2013, the outstanding balance on the 2012 Mortgage Loan was $2,519.8 million. The 2012 Mortgage Loan requires interest-only payments of approximately $7.8 million due on the first day of each calendar month. Each component of the 2012 Mortgage Loan has amounts that are freely prepayable. The below table shows freely prepayable amounts and prepayment penalties under the 2012 Mortgage Loan.

 

     Mortgage Loan ($ in millions)
     Component A     Component B   Component C
     Freely
Prepayable
     Prepayment
Penalty(1)
    Freely
Prepayable
     Prepayment
Penalty(1)(2)
  Freely
Prepayable
     Prepayment Penalty(1)(2)

Prior to January 2, 2014

   $ 52.5         3.0 %   $ 157.5       N/A (3)   $ 157.5       N/A (3)

January 2, 2014 to July 1, 2014

     52.5         1.0 %     157.5       Greater of 1.0% or

Yield Maintenance

    157.5       Greater of 1.0 % or
Yield Maintenance

July 2, 2014 to January 1, 2015

     349.8         0.0 %     157.5       Greater of 1.0 % or
Yield Maintenance
    157.5       Greater of 1.0 % or
Yield Maintenance

January 2, 2015 to July 1, 2015

     349.8         0.0 %     350.0       0.0%     157.5       Greater of 1.0 % or
Yield Maintenance

July 2, 2015 to January 1, 2016

     349.8         0.0 %     350.0       0.0%     157.5       Greater of 1.0 % or
Yield Maintenance

After January 2, 2016

     349.8         0.0 %     350.0       0.0%     1,820.0       0.0%

 

(1) Prepayment penalty applies to the amount in excess of freely prepayable amounts.
(2) Yield Maintenance, calculated as set forth in the 2012 Mortgage Loan, means the excess of (i) the sum of the present values of the scheduled payments of interest and principal to be made with respect to the portion of the Component being prepaid (in excess of the freely payable portion) over (ii) the principal amount of the Component being prepaid (in excess of the freely prepayable portion).
(3) Voluntary prepayment in excess of the freely payable amount not permitted prior to January 2, 2014.

Substantially all of ESH REIT’s hotel properties (680 of the 684 hotel properties) serve as collateral for the 2012 Mortgage Loan.

On November 18, 2013, the Corporation assumed the obligations of the guarantor under a customary recourse carveout guaranty pursuant to which the Corporation guaranteed (a) under certain limited circumstances, losses related to the 2012 Mortgage Loan plus enforcement costs incurred by the lenders, and (b) under certain other limited circumstances, repayment of the 2012 Mortgage Loan up to an aggregate liability under this clause (b) of $252.0 million plus enforcement costs.

In connection with the 2012 Mortgage Loan, the Loan Parties (as defined in the MLA) made certain representations, warranties and covenants customary in mortgage loan transactions, including, without limitation, regarding the ownership and operation of the hotels and standard special purpose bankruptcy remote entity provisions that are provided in order to make certain that each loan party (and certain specified affiliates) will maintain a prescribed level of separateness to forestall a substantive consolidation of such entities in the event of a bankruptcy action.

The occurrence of an Event of Default, a Mezzanine Loan Event of Default, a Debt Yield Trigger Event (a Debt Yield, as defined, of less than 9.0%) or a Guarantor Bankruptcy Event triggers a Cash Trap Event, as defined. During the period of a Cash Trap Event, any excess cash flow, after all monthly requirements (including the payment of management fees and operating expenses) are fully funded, is held by the loan service agent as additional collateral for the 2012 Mortgage Loan. As of December 31, 2013 and December 31, 2012, no notice of a Cash Trap Event having been triggered had been received as the Mortgage Borrower’s Debt Yield was 17.0% and 11.9%, respectively.

A right of contribution agreement provides that if any funds of the Corporation are needed and used to service ESH REIT’s obligations under the 2012 Mortgage Loan or the 2012 Mezzanine Loans, such as in the case of a Cash Trap Event, ESH REIT shall be obligated to reimburse the Corporation, with interest, for the amount of any such funds that were applied for this purpose as soon as permitted under the 2012 Mortgage Loan and 2012 Mezzanine Loans. Interest shall accrue on ESH REIT’s reimbursement obligation at the relevant applicable federal rate as determined under Section 1274(d) of the Code. In lieu of cash payment, the Corporation may elect, at its option, to receive payment in the form of additional shares of Class A common stock of ESH REIT of an equivalent value.

The 2012 Mortgage Loan is subject to certain customary events of default under the Loan Documents (as defined in the MLA, hereinafter, the “Mortgage Loan Documents”).

        Upon the occurrence of an Event of Default, as defined, Lender, as defined, may, among other things, take the following actions: (i) accelerate the maturity date of the 2012 Mortgage Loan, (ii) foreclose on any or all of the mortgages securing the mortgage loan or (iii) apply amounts on deposit in the reserve accounts to pay the debt service on the 2012 Mortgage Loan.

ESH REIT Mezzanine Loans

2012 Mezzanine Loans—On November 30, 2012, Mezzanine A Borrower, Mezzanine B Borrower and Mezzanine C Borrower (as defined in the MLA, each a subsidiary of ESH REIT, and collectively, the “Mezzanine Borrowers”) entered into three mezzanine loans totaling approximately $1.08 billion (the “2012 Mezzanine Loans”).

On November 26, 2013, ESH REIT repaid $270.0 million of the 2012 Mezzanine Loans. Repayment consisted of $125.0 million of the 2012 Mezzanine A Loan, $82.5 million of the 2012 Mezzanine B Loan and $62.5 million of the 2012 Mezzanine C Loan. On December 27, 2013, ESH REIT repaid $445.0 million of the 2012 Mezzanine Loans. Repayment consisted of approximately $206.0 million of the 2012 Mezzanine A Loan, approximately $136.0 million of the 2012 Mezzanine B Loan and approximately $103.0 million of the 2012 Mezzanine C Loan. ESH

 

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REIT incurred approximately $25.2 million of debt extinguishment and other costs in connection with these prepayments, composed of prepayment penalties of approximately $13.4 million, the write-off of unamortized deferred financing costs of approximately $10.9 million and other costs of approximately $0.9 million. Debt extinguishment costs are included as a component of interest expense in the Company’s and ESH REIT’s consolidated statements of operations for the year ended December 31, 2013.

As of December 31, 2013, the Mezzanine A Loan had a fixed interest rate per annum of approximately 8.3%, a total balance of approximately $169.0 million and a maturity date of December 1, 2019; the Mezzanine B Loan had a fixed interest rate per annum of approximately 9.6%, a total balance of approximately $111.5 million and a maturity date of December 1, 2019; and the Mezzanine C Loan had a fixed interest rate per annum of approximately 11.5%, a total balance of approximately $84.5 million and a maturity date of December 1, 2019.

As of December 31, 2013, interest-only payments for the 2012 Mezzanine Loans total approximately $2.9 million and are due on the first day of each calendar month. Each of the 2012 Mezzanine Loans are subject to similar cash management account requirements and loan covenants generally as described above for the 2012 Mortgage Loan. The terms of the 2012 Mezzanine Loans track, in all material respects, those set forth in the 2012 Mortgage Loan Documents with the exception of typical distinctions made between mortgage loans and mezzanine loans. The relationships vis-à-vis each of the three 2012 Mezzanine Loans and the 2012 Mortgage Loan are governed by the terms of the intercreditor agreement. These include such rights of Mezzanine Lenders (as defined in the MLA) to cure defaults under the Mortgage Loan Documents and the ability to acquire all or part of the outstanding mezzanine and/or mortgage loans during the continuance of an Event of Default under the 2012 Mezzanine Loans. Certain investment funds of the Sponsors were the holders of $37.2 million of the 2012 Mezzanine Loans as of December 31, 2013.

Amounts outstanding under each of the 2012 Mezzanine Loans are prepayable. Prior to June 1, 2014, amounts prepaid incur a prepayment penalty of 3.0%. Between June 2, 2014 and December 1, 2014, amounts prepaid incur a prepayment penalty of 1.0%. After December 1, 2014, no prepayment penalty exists.

Any voluntary prepayment by a Mezzanine Borrower creates an obligation of the other Mezzanine Borrowers to make corresponding pro rata prepayments on their respective Mezzanine Loans. On November 18, 2013, the Corporation assumed the obligations of the guarantor under a customary recourse carveout guaranty pursuant to which the Corporation guaranteed (a) under certain limited circumstances, losses related to the 2012 Mezzanine Loans plus enforcement costs incurred by the mezzanine lenders and (b) under certain other limited circumstances, repayment of the 2012 Mezzanine Loans up to an aggregate liability under this clause (b) of $108.0 million plus enforcement costs.

The 2012 Mezzanine Loans are subject to certain customary events of default under the Mezzanine Loan Documents. Upon the occurrence of an Event of Default under the 2012 Mezzanine Loans, the applicable Mezzanine Lender may, among other things, take the following actions: (i) accelerate the maturity date of the applicable 2012 Mezzanine Loan or (ii) exercise all the rights and remedies of a secured party under the Uniform Commercial Code, as adopted and enacted by the state or states where any of the Mezzanine Collateral (as defined in the MLA) is located, against the Mezzanine Borrowers and the Mezzanine Collateral.

ESH REIT Revolving Credit Facility

ESH REIT entered into a revolving credit facility on November 18, 2013. The ESH REIT revolving credit facility permits borrowings up to $250.0 million by ESH REIT. Subject to the satisfaction of certain criteria, ESH REIT will be able to request to increase the facility to an amount up to $350.0 million. The facility provides for the issuance of up to $50.0 million of letters of credit as well as borrowings on same-day notice, referred to as swingline loans, in an amount up to $20.0 million. Borrowings under the facility bear interest at a rate equal to an adjusted LIBOR rate or a base rate determined by reference to the highest of (1) the prime lending rate, (2) the overnight federal funds rate plus 0.5% or (3) the one-month adjusted LIBOR rate plus 1.0%, plus an applicable margin of 2.00% for base rate loans and 3.00% for LIBOR loans. There is no scheduled amortization under the facility; the principal amount is due and payable on November 18, 2016.

As of December 31, 2013, the outstanding balance drawn on the ESH REIT revolving credit facility was $20.0 million and the amount of borrowing capacity under the ESH REIT revolving credit facility was $230.0 million.

In addition to paying interest on any outstanding principal under the ESH REIT revolving credit facility, ESH REIT is required to pay a commitment fee in respect of unutilized commitments. If 50.0% or more of the facility is drawn, the commitment fee is 0.175%, while if less than 50.0% of the facility is drawn, such fee will be 0.35%. ESH REIT is also required to pay customary letters of credit fees and agency fees.

If at any time outstanding loans, unreimbursed letter of credit drawings and undrawn letters of credit under the ESH REIT revolving credit facility exceed the lenders’ commitments at such time, ESH REIT will be required to repay outstanding loans or cash collateralize letters of credit at 105% in an aggregate amount equal to such excess, with no reduction of the commitment amount.

        ESH REIT’s obligations under the ESH REIT revolving credit facility is guaranteed by its existing and future direct and indirect domestic subsidiaries (with certain exceptions, including certain entities that may not provide guarantees pursuant to the 2012 Mortgage Loan and 2012 Mezzanine Loans). The ESH REIT revolving credit facility is secured by a first-priority security interest in substantially all of the assets of ESH REIT and the guarantors under the facility (with certain exceptions, including certain entities that may not be pledged of pursuant to the 2012 Mortgage Loan and 2012 Mezzanine Loans).

The ESH REIT revolving credit facility contains a number of covenants that, among other things and subject to certain exceptions, restrict ESH REIT’s ability and the ability of its subsidiaries to incur additional indebtedness, pay dividends and make other restricted payments, engage in transactions with ESH REIT’s affiliates, sell all or substantially all of their assets, merge and create liens. The ESH REIT revolving credit facility also contains certain customary affirmative covenants and events of default.

If any loans or obligations are outstanding during any fiscal quarter, the ESH REIT revolving credit facility requires that the Consolidated Leverage Ratio, calculated as of the end of such fiscal quarter, be less than or equal to 9.25 to 1.0 for fiscal quarters ended on or before December 31, 2015 and 9.00 to 1.0 for fiscal quarters ended on or after January 1, 2016. Further, if loans or obligations are outstanding during any calendar month, the ESH REIT revolving credit facility requires that the Debt Yield not be less than 9.0% as of the last day of such calendar month.

In order to avoid a Trigger Event, as defined, the ESH REIT revolving credit facility requires a Debt Yield, as defined, of at least 11.0% during the first year of the facility, increasing to 11.5% on and after November 18, 2014. The occurrence of a Trigger Event would require ESH REIT to repay the outstanding facility balance and would restrict its ability to make additional borrowings. As of December 31, 2013, the Debt Yield was 16.9% and no Trigger Event had occurred.

Extended Stay LLC Revolving Credit Facility

On November 30, 2012, Extended Stay LLC, a subsidiary of ESH REIT, entered into a revolving credit facility of $100.0 million. The Extended Stay LLC revolving credit facility terminated on November 18, 2013, in connection with the Offering.

Contractual Obligations

The following table summarizes our contractual obligations as of December 31, 2013:

 

     Payments Due by Period  
(Dollars in thousands)    Total      2014     2015      2016      2017      2018      Thereafter  

Mortgage loans

   $ 2,519,843       $ 349,843 (3)    $ —         $ —         $ 350,000       $ —         $ 1,820,000   

Mezzanine loans

     365,000         —          —           —           —           —           365,000   

Reedemable preferred stock

     21,202         —          —           —           —           —           21,202   

Revolving credit facility

     20,000         —          —           20,000         —           —           —     

Interest payments on outstanding debt obligations (1)

     713,538         127,263        122,405         122,718         121,772         109,690         109,690   

Operating lease obligations

     99,769         2,224        2,309         2,366         2,428         2,491         87,951   

Purchase obligations (2)

     10,600         10,600        —           —           —           —           —     

Other commitments (4)

     5,682         272        292         299         299         299         4,221   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 3,755,634       $ 490,202      $ 125,006       $ 145,383       $ 474,499       $ 112,480       $ 2,408,064   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Floating rate interest calculated using the one-month LIBOR at December 31, 2013.
(2) Our purchase obligations consist of commitments for hotel capital expenditures.
(3) The 2012 Mortgage Loan Component A December 2014 maturity is subject to three one-year extensions.
(4) The Company has a commitment to make quarterly payments in lieu of taxes to the owner of the land on which one of the properties is located. The initial term of the agreement terminates in 2031.

Off-Balance Sheet Arrangements

Neither the Corporation nor ESH REIT have off balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

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Critical Accounting Policies

Our discussion and analysis of our historical financial condition and results of operations is based on the Company’s historical consolidated and combined financial statements and ESH REIT’s historical consolidated financial statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual amounts may differ significantly from these estimates and assumptions.

We have provided a summary of significant accounting policies in the notes to the Company’s historical consolidated and combined financial statements and ESH REIT’s historical consolidated financial statements, each included elsewhere in this combined annual report on Form 10-K. We have set forth below those accounting policies that we believe require material subjective or complex judgments and have the most significant impact on the Company’s and ESH REIT’s financial condition and results of operations. We evaluate estimates, assumptions and judgments on an ongoing basis, based on information that is then available to us, our experience and various matters that we believe are reasonable and appropriate for consideration under the circumstances.

Investment in Property and Equipment

Property and equipment additions are recorded at cost. Major improvements that extend the life or utility of property or equipment are capitalized and depreciated over a period equal to the shorter of the life of the improvement or the estimated remaining useful life of the asset. Ordinary repairs and maintenance are charged to expense as incurred. Depreciation and amortization are recorded on a straight-line basis over estimated useful lives, which range from 1 to 49 years.

Management assesses whether there has been impairment of the value of property and equipment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of property and equipment is measured by a comparison of the carrying amount of a hotel property to the estimated future undiscounted cash flows expected to be generated by the hotel property. Impairment is recognized when estimated future undiscounted cash flows, including estimated proceeds from disposition, are less than the carrying value of the hotel property. We use internally developed undiscounted cash flow models that include the following assumptions, among others: projections of revenues, expenses and related cash flows based on assumed long-term growth rates, demand trends and expected future capital expenditures. We base these assumptions on our historical data and experience, third-party appraisals, industry projections, micro and macro general economic condition projections and our expectations. The estimation of future undiscounted cash flows is inherently uncertain and relies upon assumptions regarding current and future economic and market conditions. If such conditions change, then an adjustment reducing the carrying value of the hotel property could occur in the future period in which conditions change.

To the extent that a hotel property is impaired, the excess carrying amount of the hotel property over its estimated fair value is charged to operating earnings. Fair value is determined based upon the discounted cash flows of the hotel property, quoted market prices or independent appraisals, as considered necessary. We use internally developed discounted cash flow models that include assumptions similar to those used in our undiscounted cash flow models, as well as assumptions related to estimated discount rates.

Income Taxes

Subsequent to the Pre-IPO Transactions, the Corporation’s taxable income includes the taxable income of its wholly-owned subsidiaries, ESA Management, ESH Strategies and the Operating Lessees, and, beginning in 2014, will include dividend income related to its approximately 55% ownership of ESH REIT. Prior to the Pre-IPO Transactions, all of ESH REIT’s distributions were made to its owners and ESH REIT generally incurred no federal income tax. However, as a result of the Pre-IPO Transactions, including the contribution of ESH REIT’s Class A common stock to the Corporation, approximately 55% of ESH REIT’s future distributions will be subject to corporate income tax.

The Company recognizes deferred tax assets and liabilities using the asset and liability method, under which deferred tax assets and liabilities are calculated based upon the temporary differences between the financial statement and income tax bases of assets and liabilities using currently enacted tax rates. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized in future periods. The realization of deferred tax assets, net of any valuation allowance, is primarily dependent on estimated future taxable income. A change in the estimate of future taxable income may require an addition to, or a reduction of, the valuation allowance.

 

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ESH REIT has elected to be taxed and expects to continue to qualify as a REIT under the provisions of the Code. A REIT is generally not subject to federal income tax on its separately filed federal tax return as long as the REIT complies with various requirements to maintain its status, including the distribution of at least 90% of its taxable income, excluding capital gains. During 2013, consistent with prior years, ESH REIT distributed 100% or more of its taxable income and therefore incurred no federal income tax. Beginning in 2014, ESH REIT intends to distribute 95% of its taxable income and therefore will incur federal and state income tax on the taxable income not distributed. As a result, deferred tax balances were adjusted in 2013 to reflect the fact that an estimated 5% of ESH REIT’s future taxable income will be subject to tax. This change in policy resulted in the recognition of a deferred tax asset during 2013 of approximately $7.8 million related to net operating loss carryforwards that existed as of December 31, 2012. In addition, net deferred tax liabilities of approximately $1.2 million were recorded during 2013 related to temporary differences that are expected to be included in taxable income in the future. Additionally, ESH REIT may be subject to certain state and local income taxes where REIT status is not recognized.

Prior to the Pre-IPO Transactions, the Operating Lessees, which were subsidiaries of ESH REIT, elected to be treated as taxable REIT subsidiaries. As such, the Operating Lessees were generally subject to federal, state, local and/or foreign income taxes on their separate tax returns. The Operating Lessees recognized deferred tax assets and liabilities using the asset and liability method. Also prior to the Pre-IPO Transactions, ESH Strategies’ and HVM’s operating results were reportable by their members, or members of their ultimate parent. Thus, income taxes were not recognized for these entities in the Company’s historical consolidated and combined financial statements or in ESH REIT’s historical consolidated financial statements. ESH Strategies and HVM were also subject to state and local taxes in certain jurisdictions.

Equity-Based Compensation

The Corporation and ESH REIT each maintain a Long-Term Incentive Plan (“LTIP”) under which the Corporation and ESH REIT may issue awards to eligible employees or directors consisting of restricted stock awards, restricted stock units or other share-based awards. The Corporation and ESH REIT recognize costs resulting from equity-based awards over their vesting periods. The Corporation and ESH REIT classify equity-based awards granted in exchange for employee services as either equity awards or as liability awards. The classification of restricted stock awards or restricted stock units either as an equity award or a liability award is based upon cash settlement options. Equity awards are measured based on their fair value on the date of grant. Liability awards are re-measured to fair value each reporting period. The value of all equity-based awards, less estimated forfeitures, is recognized over the period during which an employee or director is required to provide services in exchange for the award – the requisite service period (usually the vesting period). No compensation cost is recognized for awards for which employees or directors do not render the requisite services. Costs related to equity classified awards issued by ESH REIT are re-measured to fair value each period in the Company’s consolidated and combined financial statements due to the fact that ESH REIT employees and directors are not employees or directors of the Corporation. The fair value of equity-based awards on the date of grant is based on the closing price of a Paired Share on the date of grant.

For awards granted under the Corporation LTIP, ESH REIT will receive compensation from the Corporation generally in cash for its issuance of its component of the Paired Share for the fair market value at the time of issuance. In some cases, the Corporation may have to pay more for a share of the ESH REIT Class B common stock than it would have otherwise paid at the time of grant as the result of an increase in the value of a Paired Share between the time of grant and the time of exercise or settlement. This would result in no additional compensation expense. In addition, for awards granted under the ESH REIT LTIP, ESH REIT will compensate the Corporation generally in cash for its issuance of its component of the Paired Share for the fair market value at the time of issuance. In some cases, ESH REIT may have to pay more for a share of the Corporation common stock than it would have otherwise paid at the time of grant as the result of an increase in the value of a Paired Share between the time of grant and the time of exercise or settlement.

Prior to the Pre-IPO Transactions, HVM maintained a management incentive plan, which provided for HVM employees and members of the boards of managers of ESH Hospitality Holdings, LLC (“Holdings”) and ESH Strategies Holdings, LLC (“Strategies Holdings”) awards of restricted limited liability company interests (“Profit Units”) in Holdings and Strategies Holdings. The fair value of equity-based awards on the date of grant was estimated using the Black-Scholes Merton model, using various assumptions regarding (a) the expected holding period, (b) the risk-free rate of return, (c) expected dividend yield on the underlying units, (d) the expected volatility in the fair value of the Company’s equity, and (e) a discount for lack of marketability, and was calculated based on the grant agreement terms, which included thresholds for internal rate of return and recovery of Holdings’ and Strategies Holdings’ members’ initial equity investments.

 

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The expected holding period represented the period of time that the Profit Units were expected to be outstanding. The units were assumed to remain outstanding until ESH REIT and ESH Strategies experienced a change in control of ownership or an initial public offering. The risk-free rate of return for periods approximating the expected holding period of the units was based on the U.S. constant maturity treasuries yield in effect at the grant date. A dividend yield was assumed based on the ESH REIT and ESH Strategies’ historical dividend rates. Because our equity was privately held and was not traded in an active market, we used the historical volatility of the share values of publicly traded companies within similar industries as a surrogate for the expected volatility of ESH REIT’s and ESH Strategies’ equity. The discount for lack of marketability was calculated for each expected holding period using a put-option Black-Scholes Merton model. The key assumptions used for the period from January 1, 2013 through the Pre-IPO Transactions and the years ended December 31, 2012 and 2011 were as follows:

 

     Period from
January 1, 2013
through the
Pre-IPO
Transactions
    Year Ended
December 31,
2012
    Year Ended
December 31,
2011
 

Expected holding period

     0.25 years        3 years        2 – 4 years   

Risk–free rate of return

     0.2     0.4     0.3% – 0.6%   

Expected dividend yield

     0.0     0.0     0.9%   

Expected volatility

     30.0     55.0