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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

For the transition period from                              to                             

Commission File Number 34-0-22164

RFS HOTEL INVESTORS, INC.
(Exact name of Registrant as specified in its Charter)

Securities registered pursuant to Section 12(b) of the Act: None

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

Common Stock $0.01 par value
(Title of Class)

New York Stock Exchange
(Name of Market)

        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 and (2) has been subject to such filing requirements for the past 90 days.    ý Yes    oNo

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

        The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $382,732,967 based on the last sale price in the New York Stock Exchange for such stock on March 14, 2002.

        The number of shares of the Registrant's Common Stock outstanding was 26,395,377 as of March 14, 2002.

Documents Incorporated by Reference
Portions of the Proxy Statement for the 2001 Annual Meeting of Shareholders are incorporated into Part I and Part III.

PART I

Item 1. Business

        RFS Hotel Investors, Inc. ("RFS" or the "Company") is a self-administered hotel real estate investment trust ("REIT") headquartered in Memphis, Tennessee. The Company has grown from owning seven hotels with 1,118 rooms in five states at the time of the Company's initial public offering in August 1993 to owning interests in 58 hotels with approximately 8,400 rooms in 24 states at December 31, 2001. Many of the Company's hotels are located in attractive metropolitan areas or rapidly growing secondary markets and are well located within these markets. All but two of the Company's hotels are operated under franchises from nationally recognized franchisors such as Marriott International, Inc., Hilton Hotels Corporation, Starwood Hotels & Resorts, Inc. and Six Continents PLC. For the year ended December 31, 2001, the Company generated approximately 93% of the Company's earnings before interest, taxes, depreciation and amortization ("EBITDA"), as defined herein, from hotels operating under nationally recognized brands from these franchisors.

        RFS is the sole general partner of RFS Partnership, L.P. (the "Partnership") and, at December 31, 2001, owned an approximately 91% interest in the Partnership. RFS, the Partnership, and their subsidiaries are herein referred to collectively, as the "Company". Substantially all of the Company's business activities are conducted through the Partnership. For the year ended December 31, 2001, the Company generated revenues of $221.9 million and EBITDA of $81.8 million.

        In 2001, the Company received 42% of its EBITDA from full service hotels, 33% from extended stay hotels and 25% from limited service hotels. The Company received 65% of its EBITDA in five states (California (37%), Florida (10%), Texas (7%), Michigan (6%) and Illinois (5%)).

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        The following summarizes additional information for the 58 hotels owned at December 31, 2001:

(1)

Does not include EBITDA of $92 from the Hampton Inn in Plano, Texas that was sold in February, 2001 and EBITDA of $303 from the Comfort Inn in Farmington Hills, Michigan that was sold in May, 2001.

        The following summarizes the number of hotels owned for the periods presented:

        At December 31, 2001, the Company leased five hotels to two third-party lessees. Fifty-one hotels are managed by Flagstone Hospitality Management LLC ("Flagstone") and the remaining seven hotels are managed by four other third-party management companies.

Termination of Leases and Related Agreements with Hilton

        Under the REIT Modernization Act (the "RMA") that became effective January 1, 2001, the Company is permitted to lease its hotels to wholly-owned taxable REIT subsidiaries of the Company ("TRS Lessees"), provided that the TRS Lessees engage a third-party management company to manage the hotels. Effective January 1, 2001, the Company terminated its operating leases, management contracts and related ancillary agreements with a wholly-owned subsidiary of Hilton Hotels Corporation ("Hilton") for approximately $65.5 million. This transaction represents the

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cancellation of executory contracts that extended through 2012 and substantially all of the termination payment was recorded as an expense on January 1, 2001. The cancellation of these agreements entitles the TRS Lessees to retain the operating profits from hotels, which previously accrued to Hilton under these contracts and in the opinion of management, gives the Company the following advantages over its prior third-party structure:

•

more control over the daily operations of these hotels;



•

benefits from any cost efficiencies or ancillary revenues generated at these hotels;



•

these hotels are not encumbered by long-term third-party leases;



•

favorable management agreements; and



•

financial statements that more clearly depict the Company's hotel operations.

All of the hotels continue to operate under the same franchise affiliation as prior to the contract termination.

        Effective January 1, 2001, the TRS Lessees entered into new management contracts with Flagstone. Flagstone is a recently formed company owned by MeriStar Hotels & Resorts, Inc., a leading independent hotel management company.

        In connection with the termination of the leases and related agreements, the Company redeemed 973,684 shares of its Series A Preferred Stock owned by a subsidiary of Hilton for $13 million, which resulted in a gain on redemption of $5.1 million that was included in net income available to common shareholders in the first quarter of 2001.

        The aggregate $73 million of payments to Hilton ($60 million lease termination expense plus $13 million to repurchase the Series A Preferred Stock, plus related expenses), were financed by:

•

the sale of two hotels in 2000 for approximately $25 million;



•

net proceeds from the sale of a new issue of non-convertible mandatorily redeemable preferred stock (the "Series B Preferred Stock") for $25 million (before fees and expenses); and



•

borrowings under the Company's line of credit.

Competitive Strengths

        The Company believes that it is distinguished by the following competitive strengths:

        Diversified Asset Base.    The Company's hotel portfolio is diversified by brand, geography and market segment. The Company's hotels are operated under leading brands including Sheraton, Residence Inn by Marriott, Hilton, Doubletree, Holiday Inn, Hampton Inn, and Homewood Suites by Hilton. The Company owns hotels in 24 states. For the year ended December 31, 2001, the Company generated 37% of its EBITDA in California, 10% in Florida, 7% in Texas, 6% in Michigan, 5% in Illinois and 35% in 19 other states, and the Company generated 42% of its EBITDA from full service hotels, 33% from extended stay hotels and 25% from limited service hotels. No single hotel accounted for more than 6% of the Company's EBITDA for the year ended December 31, 2001.

        Conservative Balance Sheet.    The Company believes there is a competitive advantage in limiting the use of leverage and preserving a conservative capital structure. The Company is committed to maintaining financial flexibility, which the Company believes may allow it to pursue selective acquisitions and attractive renovation, rebranding and redevelopment opportunities. As part of this commitment, the Company's board of directors presently has a policy limiting the amount of total debt the Company will incur to an amount not in excess of 45% of its investment in hotel properties, at cost. Furthermore, management's long-term compensation is based, in part, on maintaining leverage

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below this target ratio. At December 31, 2001, the Company's ratio of total debt to investment in hotel properties, at cost, as defined, was 38%. Additionally, the Company's ratios of debt to EBITDA and EBITDA to interest expense for the year ended December 31, 2001 were 3.7x and 3.3x, respectively.

        Disciplined Capital Rationing.    The Company is committed to a selective acquisition strategy which entails acquiring properties only if they meet at least one of the Company's specific criteria and can be purchased at reasonable multiples to historical cash flow. As a result, the Company has achieved significant returns on investments on the Company's hotel properties. For the years ended December 31, 2001, 2000, and 1999, the un-leveraged return on investment for our comparable hotels was 11.3%, 13.4%, and 12.8%, respectively. Based upon the Company's 38% to 40% leverage and its 7.44% to 7.9% average borrowing costs in those years, the Company's leveraged return on investment was 13.4%, 16.8%, and 16.4%, respectively.

        Favorable Corporate Structure.    As a result of the REIT Modernization Act, effective January 1, 2001, the Company was able to terminate its operating leases and management contracts with subsidiaries of Hilton, and establish the TRS Lessees, which currently lease 53 of our hotels. This TRS structure enables us to directly oversee the management of these hotels without an intermediate third-party lessee. The new TRS structure also allows the Company to retain the operating profits from the hotels in the TRS lessee structure and provides the Company with the following advantages when compared to the Company's prior third-party lessee structure:

•

more control over the daily operations of these hotels;



•

benefits from cost efficiencies or ancillary revenues generated at these hotels;



•

benefits from hotels no longer being encumbered by long-term third-party leases;



•

favorable management agreements; and



•

financial statements that more clearly depict the Company's hotel operations.

        Experienced Senior Management.    The senior management team is comprised of three executive officers with complementary skills and extensive experience in the hotel industry and various other areas of real estate. Bob Solmson, the Company's Chairman of the Board and Chief Executive Officer, founded RFS in 1993 and has been actively involved in the real estate and hotel businesses since 1974. Randy Churchey, the Company's President and Chief Operating Officer since November 1999, previously served as the Chief Financial Officer for FelCor Lodging Trust Incorporated and prior to that held various positions with Coopers & Lybrand, L.L.P. Kevin Luebbers, the Company's Executive Vice President and Chief Financial Officer, joined RFS in July 2000 from Hilton Hotels Corporation, where he most recently served as Senior Vice President of Planning and Investment Analysis.

Business Strategy

        The principal features of the Company's business strategy are outlined below:

        Actively Manage the Portfolio of Assets.    The Company seeks to increase operating cash flows through aggressive asset management. The Company applies its asset management and investing expertise to the renovation, redevelopment and rebranding of its existing hotels and the maintenance of strong strategic relationships with its brand owners and managers. Over the past four fiscal years, the Company has spent approximately $86 million upgrading, renovating and redeveloping existing hotels in order to enhance their competitive position and improve cash flow. Recent examples of this strategy include:

•

an $11 million renovation and conversion of the 234-room San Francisco Fisherman's Wharf hotel from a Ramada Plaza to a Hilton;



•

a $4.5 million, 40-room addition to the Beverly Heritage hotel in Milpitas, California;



•

the conversion of the Sunnyvale, California hotel from a Four Points by Sheraton to a Sheraton; and



•

the renovation and conversion of the Clayton, Missouri hotel from a Holiday Inn to a Sheraton.

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        Maintain Strong Brand Affiliations.    All but two of the Company's hotels operate under franchises from national hotel brands. Franchised hotels typically have higher levels of occupancy and average daily rates than non-franchised hotels due to access to the national reservation systems and marketing provided by these franchisors. For the year ended December 31, 2001, the Company generated 93% of its EBITDA from hotels under franchise by four of the largest and most well-respected hotel franchisors: Marriott (Residence Inn, Courtyard by Marriott, TownePlace Suites by Marriott), Hilton (Hilton, Doubletree, Hampton Inn, Homewood Suites by Hilton), Starwood (Sheraton and Four Points by Sheraton) and Six Continents (Holiday Inn and Holiday Inn Express).

        Make Selective Acquisitions.    Over the past several years, the Company believed that acquisition prices were not attractive by historical standards and generally offered cash returns below the Company's cost of capital; as a result, the Company reduced its acquisition activity. The Company believes that the current acquisition environment may become more favorable because an increasing number of owners are seeking liquidity events and many potential buyers are focused on integrating past acquisitions and reducing debt levels. The Company intends to pursue its acquisition strategy by focusing its acquisition activities primarily on individual 200 to 500-room hotels with the potential for attractive returns and which meet one or more of the following criteria:

•

under-performing, upscale, full service hotels in strong markets (i.e., urban or highly developed suburban markets) which may benefit from rebranding or redevelopment;



•

national brand hotels in the upscale, full service segment which may benefit from overflow traffic from a nearby larger, convention hotel of the same brand; and



•

hotels in promising geographic locations where RFS is currently under-represented.

        Divest Non-Core Properties.    The Company continues to modify its portfolio by selectively divesting hotels that are not consistent with its long-term investment objectives, particularly limited service hotels located in smaller markets. The Company intends to continue to selectively divest hotels that:

•

may offer limited earnings growth;



•

may suffer adverse changes in their local markets; or



•

may not offer attractive returns on required additional capital investments.

        Over the past four years, the Company has sold 10 non-core properties for approximately $61.9 million.

Recent Developments

        On February 20, 2002, the Company completed the sale of 1.15 million shares of common stock, including shares that were issued upon the exercise of the underwriter's over-allotment option. Net proceeds of approximately $14.2 million from the sale of the common stock were used to reduce the outstanding balance on the line of credit.

        On February 26, 2002, the Company sold $125 million of senior notes. The senior notes are unsecured and guaranteed by the Company and certain of its subsidiaries. The Company has or is expected to use the net proceeds to retire the 1996 CMBS mortgage debt ($58.2 million outstanding at December 31, 2001), pay the prepayment penalty on the 1996 CMBS mortgage debt of approximately $6.5 million, terminate the two outstanding interest rate swap agreements for approximately $3.2 million, with the balance used to reduce outstanding borrowings under the line of credit. As a result of the prepayment of the 1996 CMBS debt, the Company will also expense as an extraordinary item $1.4 million in unamortized debt costs.

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Financing

        The Company believes there is a competitive advantage in limiting the use of leverage and preserving a conservative capital structure. The Company is committed to maintaining financial flexibility, which the Company believes may allow it to pursue selective acquisitions and attractive renovation, rebranding and redevelopment opportunities. As part of this commitment, the Company's board of directors presently has a policy limiting the amount of total debt the Company will incur to an amount not in excess of 45% of its investment in hotel properties, at cost. Furthermore, management's long-term compensation is based, in part, on maintaining leverage below this target ratio. At December 31, 2001, the company's ratio of total debt to investment in hotel properties, at cost, as defined, was 38%. Additionally, the Company's ratios of debt to EBITDA and EBITDA to interest expense for the year ended December 31, 2001 were 3.7x and 3.3x, respectively.

        The interest rate on the $140 million Line of Credit that matures in July 2004 ranges from 150 basis points to 250 basis points above LIBOR, depending on the Company's ratio of total debt to its investment in hotel properties (as defined). The interest rate on the variable contracts of the Line of Credit outstanding at December 31, 2001 was 4.03%, calculated as the LIBOR interest rate of 2.03% plus 200 basis points. The Line of Credit is collateralized by first priority mortgages on 24 hotels that restrict the transfer, pledge or other hypothecation of the hotels (collectively, the "Collateral Pool"). The Company may obtain a release of the pledge of any hotel in the Collateral Pool if the Company provides a substitute hotel or reduces the total availability under the Line of Credit. Borrowings under the Line of Credit are limited to the Borrowing Base Value, which was $111.4 million at December 31, 2001. The Line of Credit contains various covenants including the maintenance of a minimum net worth, minimum debt and interest coverage ratios, and total indebtedness and liability limitations. The Company was in compliance with these covenants at December 31, 2001.

        The Company participates in two interest rate swap agreements. One of the interest rate swap agreements is for a notional amount of $30 million maturing in July 2003. Under this interest rate swap agreement, the Company receives payments based on the one month LIBOR rate of 2.14% and pays a fixed rate of 4.775% at December 31, 2001. In addition, the Company participates in a second interest rate swap agreement for a notional amount of $40 million maturing in July 2003. Under the second interest rate swap agreement, the Company receives payments based on the one-month LIBOR rate of 2.14% and pays a fixed rate of 6.535% at December 31, 2001.

        The differences to be paid or received by the Company under the terms of the interest rate swap agreements are accrued as interest rates change and recognized as an adjustment to interest expense by the Company pursuant to the terms of the agreements and have a corresponding effect on its future cash flows. Agreements such as these contain a credit risk that the counterparties may be unable to meet the terms of the agreement. The Company minimizes that risk by evaluating the creditworthiness of its counterparties, which is limited to major banks and financial institutions, and does not anticipate non-performance by the counterparties. Net receipts (payments) under the interest rate swap agreements were $(1.3) million and $0.1 million for the years ended December 31, 2001 and 2000.

        The fair value of the interest rate swap agreements are estimated based on quotes from the market makers of these instruments and represents the estimated amounts the Company would expect to receive or pay to terminate the agreements. Credit and market risk exposures are limited to the net interest differentials. The estimated unrealized net loss on these instruments was approximately $3.2 million and $0.8 million at December 31, 2001 and 2000.

        The Company's other borrowings are nonrecourse to the Company and contain provisions allowing for the substitution of collateral (except for the 1996 CMBS debt which matures in two tranches in August 2008 and November 2011), upon satisfaction of certain conditions, after the respective loans have been outstanding for approximately four years. Most of the mortgage borrowings are repayable and subject to various prepayment penalties, yield maintenance, or defeasance obligations. At

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December 31, 2001 and 2000, approximately 96% of RFS' debt is fixed at an average interest rate of 7.7%.

        On January 2, 2001, the Company issued 250 thousand shares of non-convertible mandatorily redeemable Series B Preferred Stock for $25 million before fees and expenses of approximately $1 million. Holders of the Series B Preferred Stock are entitled to receive quarterly cash dividends at an annual rate of 12.5% of the liquidation preference of the shares. If not repaid, beginning January 1, 2006, the dividend rate increases 2.0% per annum up to a maximum rate of 20.5%. The Company may redeem shares of the Series B Preferred Stock in whole but not in part, on or after December 31, 2003 at the stated value of $25 million. If the shares are redeemed before December 31, 2003, the redemption price is at varying premiums over the liquidation preference. The shares are mandatorily redeemable upon a change of control, dissolution or winding up of the Company or on the Company's failure to qualify as a REIT.

        The Company believes that it maintains a conservative dividend policy. Based on 2001 results the Company's dividend payout ratio was approximately 68% (dividends divided by funds from operations) and the dividend coverage ratio was 1.5x (funds from operations divided by dividends).

Competition

        Substantially all of the Hotels are located in developed areas that include other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, ADR and RevPar of the Hotels. New, competing hotels may be opened in the Company's markets, which could materially and adversely affect hotel operations.

Employees

        At December 31, 2001, the Company had a total of 23 employees. Robert M. Solmson, (age 54), Chairman of the Board and Chief Executive Officer, Randy L. Churchey, (age 41), President and Chief Operating Officer, Kevin M. Luebbers, (age 35), Executive Vice President and Chief Financial Officer, and Craig Hofer (age 42), Vice President and Chief Information Officer each have employment agreements with the Company. Information with respect to these employment agreements is incorporated by reference to the Company's Proxy Statement.

        All persons employed in the day-to-day operations of the hotels are employees of the management companies engaged to operate the hotels and are not the Company's employees.

Tax Status

        The Company has operated and intends to continue to operate so as to qualify as a REIT under the federal income tax laws. Qualification as a REIT involves the application of highly technical and complex rules for which there are only limited judicial or administrative interpretations. There are no controlling authorities that deal specifically with many tax issues affecting a REIT that owns hotel properties. The determination of various factual matters and circumstances not entirely within our control may affect our ability to qualify as a REIT.

        New regulations, administrative interpretations or court decisions could adversely affect the Company's qualification as a REIT or the federal income tax consequences of such qualification. If RFS were to fail to qualify as a REIT in any taxable year, it would not be allowed a deduction for distributions to shareholders in computing our taxable income. It also would be subject to federal income tax (including any applicable alternative minimum tax) on taxable income at regular corporate rates. Unless entitled to relief under certain Code provisions, the Company also would be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost. As a result, the cash available for distribution to shareholders would be reduced for each of the

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years involved. Although the Company currently intends to operate in a manner designed to qualify as a REIT, it is possible that future economic, market, legal, tax or other considerations may cause the Board of Directors, with the consent of a majority of the shareholders, to revoke the REIT election.

        Under the RMA, commencing January 1, 2001, the Company may now own up to 100% of the stock of one or more taxable REIT subsidiaries ("TRS"). A TRS is a taxable corporation that may lease hotels under certain circumstances, provide services to the Company, and perform activities unrelated to the Company's tenants, such as third-party management, development, and other independent business activities. Overall, no more than 20% of the value of the Company's assets may consist of securities of one or more TRSs.

        Under the RMA, a TRS is permitted to lease hotels from the Company as long as the hotels are operated on behalf of the TRS by a third-party hotel manager who satisfies the following requirements:

•

such manager is, or is related to a person who is, actively engaged in the trade or business of operating "qualified lodging facilities" for any person unrelated to the Company and its TRS;



•

such manager does not own, directly or indirectly, more than 35% of RFS's stock;



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no more than 35% of such manager is owned, directly or indirectly, by one or more persons owning 35% or more of RFS's stock; and



•

the Company does not directly or indirectly derive any income from such manager.

        The RMA limits the deductibility of interest paid or accrued by a TRS to the Company to assure that the TRS is subject to an appropriate level of corporate taxation. The RMA also imposes a 100% excise tax on transactions between a TRS and the Company or its tenants that are not conducted on an arm's-length basis.

Cautionary Factors That May Affect Future Results

        This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements containing the words "believes", "anticipates", "expects" and words of similar import. Such forward-looking statements relate to future events, the future financial performance of the Company, and involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward looking statements. Readers should specifically consider the various factors identified in this report and in any other documents filed by the Company with the Securities and Exchange Commission that could cause actual results to differ. The Company disclaims any obligation to update any such factors or to publicly announce the result of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

Risks Related to the Company and the Conduct of Business

The events of September 11, 2001, as well as the U.S. economic recession, have adversely impacted the hotel industry generally, and the Company has experienced an adverse effect on its results of operations and financial condition. These trends may continue to impact the Company into the foreseeable future.

        Prior to September 11, 2001, the Company's hotels had begun experiencing declining RevPAR as a result of the slowing economy, particularly the Company's hotels in San Francisco and Silicon Valley. The terrorist attacks of September 11, 2001 and the effects of the economic recession have led to a substantial reduction in business and leisure travel throughout the United States and industry RevPAR generally. RevPAR at the Company's hotels specifically has declined substantially since September 11. While RevPAR at the Company's hotels has improved from the depressed levels in the weeks following

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the events of September 11, RevPAR at the Company's hotels remains below pre-September 11 levels and may remain at such depressed levels. The Company cannot predict the extent to which the events of September 11 will continue to directly or indirectly impact the hotel industry or the Company's operating results in the future. Continued lower RevPAR at the Company's hotels could have an adverse effect on its results of operations and financial condition, including the Company's ability to remain in compliance with debt covenants, fund capital improvements and renovations at its hotels and the ability to make dividend payments necessary to maintain the REIT tax status. Additional terrorist attacks could have further material adverse effects on the hotel industry and the Company's operations.

New TRS lessee structure subjects the Company to the risk of increased hotel operating expenses.

        Prior to January 1, 2001, substantially all of the Company's hotels were leased to third-parties under leases providing for the payment of rent based, in part, on revenues from the Company's hotels. Accordingly, operating risks were essentially limited to changes in hotel revenues and to the lessees' ability to pay the rent due under the leases. In addition to the ownership expenses previously borne by the Company, the Company is now subject to the risks of increased hotel operating expenses for the 53 hotels now in the Company's TRS lessee structure, including but not limited to:

•

wage and benefit costs;



•

repair and maintenance expenses;



•

energy costs, which have increased significantly in recent months, especially at the California hotels;



•

the costs of liability insurance; and



•

other operating expenses.

        Increases in these operating expenses can have a significant adverse impact on the Company's earnings and cash flow.

Uninsured and underinsured losses might have an adverse effect on the Company's financial condition.

        The Company maintains comprehensive insurance on each of its hotels, including liability, fire and extended coverage, of the type and amount the Company believes is customarily obtained for or by hotel owners. All 10 of the Company's hotels in California are located in areas that are subject to earthquake activity. These hotels are located in areas of high seismic risk and some were constructed under building codes which were less stringent with regard to earthquake related requirements. An earthquake could render significant damage to the hotels. Additionally, areas in Florida, where seven of the company's hotels are located, may experience hurricane or high-wind activity. The Company has earthquake insurance policies on its hotels in California and wind insurance policies on certain of its hotels located in Florida. However, various types of catastrophic losses, like earthquakes and floods may not be fully insurable or may not be economically insurable. With respect to the hotels in California, in addition to the applicable deductibles under the earthquake insurance policies, the Company is self-insured for the first $5 million per earthquake. Property insurance, which the Company believes currently insures against losses resulting from a terrorist attack, is subject to renewal in July 2002. Upon renewal, the Company does not know whether its property insurance will protect against losses resulting from a terrorist attack. The Company believes that such losses may not be economically insurable. In the event of a substantial loss, insurance coverage may not be able to cover the full current market value or replacement cost of the Company's lost investment. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also affect the Company's ability to replace or renovate a hotel after it has been damaged or destroyed.

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Hotel concentration in certain states, particularly California, subjects the Company to operating risks.

        For the year ended December 31, 2001, approximately 65% of the Company's EBITDA came from its hotels located in California (37%), Florida (10%), Texas (7%), Michigan (6%) and Illinois (5%). Adverse events in these areas, such as economic recessions or natural disasters, could cause a loss of revenues from these hotels, which could have a greater adverse effect on the Company as a result of its concentration of assets in these areas. The Company's geographic concentration also exposes it to risks of oversupply and competition in its principal markets. Each of the Company's hotels competes with other hotels in its market area. A number of additional hotel rooms will continue to be built in the markets in which the Company's hotels are located, which could result in too many hotel rooms in those regions. Significant increases in the supply of hotel rooms without corresponding increases in demand can have a severe adverse effect on the Company's business, financial condition and results of operations.

        The San Francisco Bay Area has recently suffered an economic downturn related to the decline in the technology and Internet related markets which populated this area. In particular, revenues at the Company's four hotels in Silicon Valley and two hotels in San Francisco have been adversely impacted by the slowing economy and by recent job reductions in the technology and Internet sectors. For the year ended December 31, 2001, the Company received approximately 37% of its EBITDA from hotels in portions of California, including Silicon Valley (18%), Los Angeles (7%), San Francisco (5%), San Diego (4%) and Sacramento (3%). As a result of the events of September 11 and the continued economic recession in the fourth quarter of 2001, while the Company's entire hotel portfolio was adversely impacted, the six San Francisco Bay Area hotels were particularly affected. The six San Francisco Bay Area hotels' RevPAR declined 42.7% in the fourth quarter of 2001. The remaining four California hotels' RevPAR declined 2.3% and the entire portfolio RevPAR, excluding our six San Francisco Bay Area hotels, declined 6.9% in the fourth quarter of 2001.

        Also, California faced an energy crisis during 2001 that significantly increased energy costs at the 10 California hotels, although the impact was somewhat offset through the Company's ability to collect energy surcharges in California. While this energy crisis appears to be resolved, if California experiences another energy crisis, and the Company cannot adequately pass its increased costs to customers through energy surcharges or otherwise, or the state's economy, particularly Northern California, continues to experience decreasing occupancy rates, RevPAR, average daily rate ("ADR") or other industry fundamentals, it could have a material adverse effect on the Company's business, financial condition and results of operation.

Reliance on third-party management companies to operate the Company's hotels and a change in these management companies may be costly and disruptive to the Company's operations.

        Under the REIT Modernization Act, in order for us to continue to qualify as a REIT, the Company's hotels must be managed by third-parties. Under the terms of the management agreements, the Company's ability to participate in operating decisions regarding the hotels is limited. Flagstone Hospitality Management and four other unrelated third-parties currently manage all of the Company's hotels. These property managers presently control the daily operations of the hotels. The Company depends on these managers to adequately operate its hotels as provided in the management agreements. Even if the company believes that its hotels are not being managed efficiently or in a manner that results in satisfactory occupancy rates, RevPAR or ADR, the Company may not be able to force the management company to change the way it operates the Company's hotels in a timely manner. Additionally, in the event that the Company needs to replace any of its management companies, particularly Flagstone, which manages 51 of the 58 hotels, the Company may experience significant disruptions at its hotels and in its operations generally and decreased occupancy. Flagstone is a recently formed company with a limited operating history. Furthermore, because the Company must have third-party managers to maintain its REIT status, it may be forced to enter into new management

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agreements on terms that the Company believes are unfavorable or less favorable than the terms of the Company's current agreements. Any of the foregoing, may result in a material adverse effect on the Company's business, financial condition and results of operations.

Compliance with requirements of franchise agreements.

        Most of the Company's hotels are operated under a franchise license. Each license agreement requires that the licensed hotel be maintained and operated in accordance with certain standards and requires the Company to pay a variety of franchise related fees to the franchisors. The franchisors also may require substantial improvements to the Company's hotels, for which the Company would be responsible, as a condition to the renewal or continuation of these franchise licenses.

        If a franchise license terminates due to the Company's failure to make required improvements or to otherwise comply with its terms, the Company may be liable to the franchisor for a termination payment. These termination payments would vary by franchise agreement and by hotel. Although the Company has never had a franchise agreement terminated by a franchisor, the loss of a substantial number of franchise licenses and the related termination payments could have a material adverse effect on its business, financial condition and results of operations.

The Company may not be able to successfully implement its selective acquisition and disposition strategy or fully realize the benefit of its strategy.

        One of the Company's key strategies includes the acquisition of attractive hotel properties. However, the Company competes for hotel acquisitions with entities that have substantially greater financial and other resources and a lower cost of capital than RFS. These entities generally may be able to accept more risk than the Company can manage wisely and may be able to pay higher acquisition prices than the Company is willing to pay. This competition may generally limit the number of suitable investment opportunities offered to RFS. This competition may also increase the bargaining power of property owners seeking to sell to RFS, making it more difficult for the Company to acquire new properties on attractive terms. Furthermore, in recent years, the Company believes that acquisition prices were not attractive by historical standards and the Company reduced its acquisition activity accordingly. While the Company believes that the hotel acquisition market has recently become more favorable, there can be no assurance that a sufficient number of attractive properties, both in terms of price and quality, will be available for acquisition or that the Company will ultimately be able to acquire those hotel properties on favorable terms.

        Additionally, the Company's strategy includes continually shifting its portfolio by selectively divesting limited service hotels which are not consistent with the Company's long-term investment horizon, particularly those in smaller markets. As with acquisitions, the Company faces competition for buyers of its hotel properties. Other sellers of hotels may have the financial resources to dispose of their hotels on unfavorable terms that the Company would be unable to accept. If the Company cannot find buyers for its non-core properties, it will not be able to implement its divestiture strategy.

        In the event that the Company cannot fully execute its acquisition and divestiture strategy or realize the benefits therefrom, it may not be able to grow its business, EBITDA or cash flow.

The Company may be unable to adequately finance or fully realize the anticipated benefits of its renovations.

        As part of the Company's internal growth strategy, it regularly renovates, redevelops and, in certain cases, re-brands its hotels. In addition, the franchisors require the Company to make periodic capital improvements as a condition to keeping the franchise licenses. During 2000 and 2001, the Company spent approximately $32.6 million and $18.0 million, respectively, on capital improvements to its hotels. The Company expects to spend approximately $9.0 million on capital improvements to its

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hotels in 2002. The Company's current indebtedness, as well as the notes, will restrict its ability to finance proposed capital expenditures, which may cause the Company to delay, alter materially or abandon planned capital improvements and renovations. In addition to the difficulties with financing these projects discussed above, renovations also give rise to the following risks:

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possible environmental problems;



•

construction cost overruns and delays;



•

uncertainties as to market demand or a loss of market demand after renovations have begun; and



•

displacement of room revenues due to rooms being out of order.

        If the completion of renovation projects is significantly delayed, operating results could be adversely affected. In addition, no assurance can be given that recently completed and ongoing improvements will achieve the results anticipated when the Company made the decision to invest in the improvements.

Risks Related to the Hotel Industry

The Company is subject to the risks of hotel operations.

        The Company has invested only in hotel-related assets, and its hotels are subject to all of the risks common to the hotel industry. These risks could adversely affect hotel occupancy and the rates that can be charged for hotel rooms as well as hotel operating expenses, and generally include:

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competition from other hotels;



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increases in supply of hotel rooms that exceed increases in demand;



•

increases in energy costs and other travel expenses that reduce business and leisure travel;



•

adverse effects of declines in general and local economic activity;



•

adverse effects of a downturn in the hotel industry; and



•

risks generally associated with the ownership of hotels and real estate, as discussed below.

A continued industry fundamental downturn could adversely affect results of operations.

        According to Smith Travel Research, for all U.S. hotels, room supply in 2001 increased 2.4% while demand decreased by 3.4% and this trend may continue for the immediate future. Additionally, industry RevPAR in 2001 decreased 6.9% as compared to the same period in 2000, and is expected to decrease slightly in 2002.

        If the Company is unable to sustain appropriate levels of RevPAR, its operating margins may deteriorate, and it may be unable to execute its business plan, including the selective acquisition of hotel properties. In addition, if this downward trend continues, the Company may be unable to continue to meet its debt service obligations as they become due or to obtain necessary additional financing.

Seasonality of the hotel business can be expected to cause quarterly fluctuations in revenues.

        The hotel industry is seasonal in nature. Generally, occupancy rates and hotel revenues are greater in the second and third quarters than in the first and fourth quarters. This seasonality can be expected to cause quarterly fluctuations in revenues. Quarterly financial results also may be adversely affected by factors outside the Company's control, including weather conditions and poor economic factors. As a

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result, the Company may have to enter into short-term borrowing in the first and fourth quarters in order to offset these fluctuations in revenues and to make distributions to its shareholders.

The Company will also encounter risks that may adversely affect real estate ownership in general.

        The Company's investments in hotels are subject to the numerous risks generally associated with owning real estate, including among others:

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adverse changes in general or local economic or real estate market conditions;



•

changes in zoning laws;



•

changes in traffic patterns and neighborhood characteristics;



•

increases in assessed valuation and tax rates;



•

increases in the cost of property insurance;



•

governmental regulations and fiscal policies;



•

the potential for uninsured or underinsured property losses;



•

the impact of environmental laws and regulations; and



•

other circumstances beyond our control.

        Moreover, real estate investments are relatively illiquid, and the Company may not be able to vary its portfolio in response to changes in economic and other conditions.

Compliance with environmental laws may adversely affect the Company's financial condition.

        The Company's hotel properties are subject to various federal, state and local environmental laws. Under these laws, courts and government agencies have the authority to require the owner of a contaminated property to clean up the property, even if the owner did not know of or was not responsible for the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, contamination can affect the value of a property and, therefore, an owner's ability to borrow funds using the property as collateral. Under the environmental laws, courts and government agencies also have the authority to require that a person who sent waste to a waste disposal facility, like a landfill or an incinerator, pay for the clean-up of that facility if it becomes contaminated and threatens human health or the environment. Furthermore, decisions by courts have established that third-parties may recover damages for injury caused by property contamination. For instance, a person exposed to asbestos while staying in a hotel may seek to recover damages if he suffers injury from the asbestos.

        The Company could be responsible for the costs discussed above, if one or more of its properties are found to be contaminated. The costs to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could affect the funds available for distribution to our shareholders. To determine whether any costs of this nature may be incurred, the Company commissioned Phase I environmental site assessments, or ESAs, before it acquired hotels. These studies typically include a review of historical information and a site visit but not soil or groundwater testing. The Company obtained the ESAs to help identify whether it might be responsible for cleanup costs or other environmental liabilities. The ESAs on the Company's hotels did not reveal any environmental conditions that are likely to have a material adverse effect on the Company's business, assets, results of operations or liquidity. However, ESAs do not always identify all potential problems or environmental liabilities. Consequently, the Company may have material environmental liabilities of which it is unaware.

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        The Phase I ESA for the Hampton Inn—Airport in Indianapolis, indicated that the hotel disposes of approximately 10% of its solid waste at a facility that is a state Superfund site. Such a site may be subject to investigation and remediation under the federal and state Superfund laws, and persons that sent hazardous substances to the site may be jointly and severally liable for the costs of the work. The Phase I ESA report states that solid waste from the Indianapolis hotel was disposed into a domestic waste cell of the facility. A state official informed the engineering firm conducting the Phase I ESA that this domestic waste cell is segregated by a containment structure and is adjacent to, but not part of, the Superfund site. The Phase I audit did not indicate that the Indianapolis hotel has arranged for the disposal of any hazardous substances at this facility. If the Indianapolis hotel in fact arranged for such disposal, however, it could be found liable for at least a part of any response costs.

Compliance with the Americans with Disabilities Act may adversely affect our financial condition.

        Under the Americans with Disabilities Act of 1990, all public accommodations, including hotels, are required to meet certain federal requirements for access and use by disabled persons. The Company believes that its hotels substantially comply with the requirement of the Americans with Disabilities Act. However, a determination that the hotels are not in compliance with that Act could result in liability for both governmental fines and damages to private parties. If the Company were required to make unanticipated major modifications to the hotels to comply with the requirements of the Americans with Disabilities Act, it could adversely affect the Company's ability to pay its obligations.

Risks Related to RFS's Qualification as a REIT Under U.S. Tax Laws

The federal income tax laws governing REITs are complex.

        RFS has operated and intends to continue to operate in a manner that is intended to qualify it as a REIT under the federal income tax laws. The REIT qualification requirements are extremely complicated, however, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Accordingly, RFS cannot be certain that it has been or will continue to be successful in operating so as to qualify as a REIT. At any time, new laws, interpretations, or court decisions may change the federal tax laws or the federal income tax consequences of qualification as a REIT.

Failure to make required distributions would subject RFS to tax.

        In order to qualify as a REIT, each year RFS must pay out to its shareholders at least 90% of its taxable income, other than any net capital gain. To the extent that RFS satisfies the distribution requirement, but distributes less than 100% of its taxable income, RFS will be subject to federal corporate income tax on its undistributed taxable income. In addition, RFS will be subject to a 4% nondeductible excise tax if the actual amount that it pays out to its shareholders in a calendar year is less than a minimum amount specified under federal tax laws. RFS's only source of funds to make such distributions comes from distributions that it receives from the Partnership. Accordingly, RFS may be required to borrow money or sell assets to make distributions sufficient to enable it to pay out enough of its taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year. This risk may be intensified because the Company's current indebtedness restricts its ability to borrow money and sell assets, even if necessary to make distributions to maintain RFS's REIT status.

Failure to qualify as a REIT would subject RFS to federal income tax.

        If RFS fails to qualify as a REIT in any taxable year, RFS would be subject to federal income tax on its taxable income. RFS might need to borrow money or sell hotels in order to pay any such tax. If RFS ceases to be a REIT, RFS no longer would be required to distribute most of its taxable income to

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its shareholders. Unless RFS's failure to qualify as a REIT were excused under federal income tax laws, it could not re-elect REIT status until the fifth calendar year following the year in which it failed to qualify.

The formation of the TRS Lessees will increase the Company's overall tax liability.

        Effective January 1, 2001, RFS formed the TRS Lessees, which currently lease 53 of our hotels. The TRS Lessees are subject to federal and state income tax on their taxable income, which consists of the revenues from the hotels leased by the TRS Lessees net of the operating expenses for such hotels and rent payments. Accordingly, although the formation of the TRS Lessees allows the Company to participate in the operating income from the hotels in addition to receiving rent, that operating income is fully subject to income tax. The Company does not expect to pay any material state or federal income taxes in the next several years. The after-tax net income of the TRS Lessees is available for distribution to the shareholders as dividends.

Ownership Limitation

        In order for the Company to maintain its status as a REIT, no more than 50% in value of its outstanding stock may be owned (actually or constructively under the applicable tax rules) by five or fewer persons during the last half of any taxable year. The Company's Charter prohibits, subject to certain exceptions, any person from owning more than 9.9% (determined in accordance with the Internal Revenue Code and the Securities Exchange Act of 1934, as amended) of the number of outstanding shares of any class of its capital stock. The Company's Charter also prohibits any transfer of its capital stock that would result in a violation of the 9.9% ownership limit, reduce the number of stockholders below 100 or otherwise result in the Company failing to qualify as a REIT. Any attempted transfer in violation of the Charter prohibitions will be void and the intended transferee will not acquire any right in the shares resulting in such violation. The Company has the right to take any lawful action that it believes necessary or advisable to ensure compliance with these ownership and transfer restrictions and to preserve its status as a REIT, including refusing to recognize any transfer of capital stock in violation of its Charter.

        If a person holds or attempts to acquire shares in excess of the Company's ownership and transfer restrictions, these shares will be immediately designated as "shares-in-trust" and transferred automatically and by operation of law, in trust, to a trustee designated by the Company. The trustee will have the right to receive all distributions on, to vote and to sell these shares. The holder of the excess shares will have no right or interest in these shares, except the right (under certain circumstances) to receive the lesser of: (i) the proceeds of any sale of these shares by the trustee to a permitted owner and (ii) the amount paid for these shares (or the market value of these shares, determined in accordance with the Charter, if the shares were received by gift, bequest or otherwise without payment). Accordingly, the record owner of any shares designated as shares-in-trust would suffer a financial loss if the price at which these shares are sold to a permitted owner is less than the price paid for these shares.

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Item 2. Properties

        The following sets forth information regarding the Company's hotels as of, and for the year ended December 31, 2001. Pursuant to management agreements between the TRS Lessees and Flagstone, Flagstone manages 51 of the Company's 58 hotels. As indicated below, the remaining seven hotels are leased to or managed by other hotel management companies.

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