UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended March 31, 2017

 

SOTHERLY HOTELS INC.

(Exact name of registrant as specified in its charter)

 

 

 

SOTHERLY HOTELS LP

(Exact name of registrant as specified in its charter)

 

 

 

410 West Francis Street

Williamsburg, Virginia 23185

(757) 229-5648

(Address and Telephone Number of Principal Executive Offices)

 

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.

Sotherly Hotels Inc.    Yes  ☒    No  ☐     Sotherly Hotels LP    Yes  ☒    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 (section 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.)

Sotherly Hotels Inc.    Yes  ☒    No  ☐     Sotherly Hotels LP    Yes  ☒    No  ☐

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

Sotherly Hotels Inc.

 

Sotherly Hotels LP

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

Sotherly Hotels Inc.    Yes  ☐    No  ☒ Sotherly Hotels LP    Yes  ☐    No  ☒

 

As of May 8, 2017, there were 13,798,051 shares of Sotherly Hotels Inc.’s common stock issued and outstanding.  

 

 

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EXPLANATORY NOTE

We refer to Sotherly Hotels Inc. as the “Company,” Sotherly Hotels LP as the “Operating Partnership,” the Company’s common stock as “Common Stock,” the Company’s preferred stock as “Preferred Stock,” and the Operating Partnership’s preferred interest as the “Preferred Interest.”  References to “we” and “our” mean the Company, its Operating Partnership and its subsidiaries and predecessors, collectively, unless the context otherwise requires or where otherwise indicated.

The Company conducts virtually all of its activities through the Operating Partnership and is its sole general partner. The partnership agreement provides that the Operating Partnership will assume and pay when due, or reimburse the Company for payment of, all costs and expenses relating to the ownership and operations of, or for the benefit of, the Operating Partnership. The partnership agreement further provides that all expenses of the Company are deemed to be incurred for the benefit of the Operating Partnership.

This report combines the Quarterly Reports on Form 10-Q for the period ended March 31, 2017 of the Company and the Operating Partnership. We believe combining the quarterly reports into this single report results in the following benefits:

To help investors understand the significant differences between the Company and the Operating Partnership, this report presents the following separate sections for each of the Company and the Operating Partnership:

 

 

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SOTHERLY HOTELS INC.

SOTHERLY HOTELS LP

INDEX

 

 

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PART I

 

 

SOTHERLY HOTELS INC.

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS INC.

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS LP

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS LP

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS LP

CONSOLIDATED STATEMENT OF CHANGES IN PARTNERS’ CAPITAL

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

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SOTHERLY HOTELS LP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

 

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SOTHERLY HOTELS INC.

SOTHERLY HOTELS LP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

 

1. Organization and Description of Business

Sotherly Hotels Inc., (the “Company”), is a self-managed and self-administered lodging real estate investment trust (“REIT”) that was incorporated in Maryland on August 20, 2004 to own full-service, primarily upscale and upper-upscale hotels located in primary and secondary markets in the mid-Atlantic and southern United States.  Currently, the Company is focused on the acquisition, renovation, upbranding and repositioning of upscale to upper-upscale full-service hotels in the southern United States.  The Company’s portfolio consists of investments in eleven hotel properties, comprising 2,838 rooms, and the hotel commercial condominium unit of the Hyde Resort & Residences condominium hotel.  All of the Company’s hotels, except for the Georgian Terrace, The Whitehall and the Hyde Resort & Residences, operate under the Hilton, Crowne Plaza, DoubleTree, and Sheraton brands.

The Company commenced operations on December 21, 2004 when it completed its initial public offering and thereafter consummated the acquisition of six hotel properties (the “initial properties”). Substantially all of the Company’s assets are held by, and all of its operations are conducted through, Sotherly Hotels LP, (the “Operating Partnership”).  

Pursuant to the terms of the Amended and Restated Agreement of Limited Partnership (the “Partnership Agreement”) of the Operating Partnership, the Company, as general partner, is not entitled to compensation for its services to the Operating Partnership.  The Company, as general partner, conducts substantially all of its operations through the Operating Partnership and the Company’s administrative expenses are the obligations of the Operating Partnership.  Additionally, the Company is entitled to reimbursement for any expenditure incurred by it on the Operating Partnership’s behalf.

For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which, at March 31, 2017, was approximately 89.1% owned by the Company, and its subsidiaries, lease the hotels to direct and indirect subsidiaries of MHI Hospitality TRS Holding, Inc., MHI Hospitality TRS, LLC and certain of its subsidiaries, (collectively, “MHI TRS”), each of which is a wholly-owned subsidiary of the Operating Partnership. MHI TRS then engages an eligible independent hotel management company, MHI Hotels Services, LLC, which does business as Chesapeake Hospitality (“Chesapeake Hospitality”), to operate the hotels under a management contract. MHI TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

All references in this report to “we”, “us” and “our” refer to the Company, its Operating Partnership and its subsidiaries and predecessors, collectively, unless the context otherwise requires or where otherwise indicated.

Significant transactions occurring during the current and prior fiscal year include the following:

On March 21, 2016, we entered into an agreement with the existing lender to extend the maturity of the mortgage on The Whitehall until November 2017.

On June 27, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Savannah DeSoto with MONY Life Insurance Company.  The mortgage term is ten years maturing July 1, 2026, subject to certain criteria. The mortgage bears a fixed interest rate of 4.25%.  The mortgage amortizes on a 25-year schedule after a 1-year interest-only period. The Company used the proceeds to repay the existing first mortgage on the Hilton Savannah DeSoto and to pay closing costs, and will use the balance of the proceeds to fund ongoing renovations at the hotel and for general corporate purposes.

On June 30, 2016, we entered into a loan agreement and other loan documents, including a guaranty of payment by the Operating Partnership, to secure a $19.0 million mortgage on the Crowne Plaza Tampa Westshore with Fifth Third Bank.  The mortgage term has an initial term of three years, and may be extended for two additional periods of one year each, subject to certain conditions. The mortgage bears a floating interest rate of the 30-day LIBOR plus 3.75%, subject to a floor rate of 3.75%.  The mortgage amortizes on a 25-year schedule.  The Company used the proceeds to repay the existing first mortgage on the Crowne Plaza Tampa Westshore and to pay closing costs, and will use the balance of the proceeds for general corporate purposes.

On August 23, 2016, the Company sold 1,610,000 shares of 8% Series B Cumulative Redeemable Perpetual Preferred stock, for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred units.

On September 30, 2016, the Operating Partnership redeemed the entire $27.6 million aggregate principal amount of its outstanding 8% Notes.

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On October 12, 2016, we entered into a loan agreement to secure a $20.5 million mortgage on The Whitehall with the International Bank of Commerce.  Pursuant to the loan documents, the loan provides initial proceeds of $15.0 million, with an additional $5.5 million available upon the satisfaction of certain conditions, has a term of five years, bears a floating interest rate of the one month LIBOR plus 3.5%, subject to a floor rate of 4.0%, amortizes on an 18-year schedule after a 2-year interest only period, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP.

On November 3, 2016, we entered into a loan agreement to refinance the mortgage on the Sheraton Louisville Riverside with Symetra Life Insurance Company.  Pursuant to the loan documents, the loan provides proceeds of $12.0 million, has a maturity date of December 1, 2026, bears a fixed interest rate of 4.27% for the first 5 years of the loan with an option for the lender to reset that rate after 5 years, amortizes on a 25-year schedule, is subject to prepayment fees, and is guaranteed by Sotherly Hotels LP up to 50% of the unpaid principal balance, interest, and other amounts owed.

On November 3, 2016, we entered into a loan agreement to modify and extend the mortgage on the Crowne Plaza Hampton Marina with TowneBank.  Pursuant to the amended loan documents, the loan continues to bear a fixed interest rate of 5.00%, has a maturity date of November 1, 2019, and beginning on December 1, 2016 requires monthly principal payments of $15,367 plus interest.

On December 1, 2016, we entered into a promissory note and other loan documents to secure a $35.0 million mortgage on the Hilton Wilmington Riverside with MONY Life Insurance Company.  Pursuant to the loan documents, the loan: provides initial proceeds of $30.0 million, with an additional $5.0 million available upon the satisfaction of certain conditions. The mortgage term is ten years maturing November 30, 2026, subject to certain criteria. The mortgage bears a fixed interest rate of 4.25%.  The mortgage amortizes on a 25-year schedule after a 1-year interest-only period. The Company used the proceeds to repay the existing first mortgage on the Hilton Wilmington Riverside and to pay closing costs, and will use the balance of the proceeds to fund ongoing renovations at the hotel and for general corporate purposes.

On December 2, 2016, the Company’s board of directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management.  Through December 31, 2016 the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.  The Company did not repurchase any shares under the stock repurchase program during the three months ended March 31, 2017.  The Company used available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the board of directors.

The Company’s board of directors adopted an Employee Stock Ownership Plan (“ESOP”) as of November 29, 2016, effective January 1, 2016.  The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees.  The ESOP is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock. From January 3, 2017 to February 28, 2017 the ESOP purchased 682,500 shares of common stock for approximately $4.9 million.

Coincident with the execution of the loan from the Company to the ESOP, the Operating Partnership committed to fund a loan to the Company to allow the Company to loan funds to the ESOP, for the purpose as stated above.

On January 30, 2017, we closed on the purchase of the commercial condominium unit of the Hyde Resort & Residences, a 400-unit condominium hotel located in the Hollywood, Florida market, for an aggregated price of approximately $4.8 million from 4111 South Ocean Drive, LLC. In connection with the closing of the transaction, the Company entered into a lease agreement for the 400-space parking garage and meeting rooms associated with the condominium hotel, agreements relating to the operation and management of the hotel condominium association and a condominium unit rental program, and a pre-opening services agreement whereby the seller paid the Company a fee of approximately $0.8 million for certain pre-opening related preparations.

On February 7, 2017, we closed on the sale of the Crowne Plaza Hampton Marina to Marina Hotels, LLC for an approximate price of $5.6 million.

 

 

2. Summary of Significant Accounting Policies

Basis of Presentation – The consolidated financial statements of the Company presented herein include all of the accounts of Sotherly Hotels Inc., the Operating Partnership, MHI TRS and subsidiaries. All significant inter-company balances and transactions have been eliminated.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

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The consolidated financial statements of the Operating Partnership presented herein include all of the accounts of Sotherly Hotels LP, MHI TRS and subsidiaries. All significant inter-company balances and transactions have been eliminated, with the exception of the ESOP, which records a charge for salaries expense on allocated shares and their dividends. Additionally, all administrative expenses of the Company and those expenditures made by the Company on behalf of the Operating Partnership are reflected as the administrative expenses, expenditures and obligations thereto of the Operating Partnership, pursuant to the terms of the Partnership Agreement.

Investment in Hotel Properties – Investments in hotel properties include investments in operating properties which are recorded at acquisition cost and allocated to land, property and equipment and identifiable intangible assets. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation are removed from our accounts and any resulting gain or loss is included in the statements of operations. Expenditures under a renovation project which constitute additions or improvements that extend the life of the property are capitalized.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 7 to 39 years for buildings and building improvements and 3 to 10 years for furniture, fixtures and equipment. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the related assets.

We review our investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause a review include, but are not limited to, adverse permanent changes in the demand for lodging at the properties due to declining national or local economic conditions and/or new hotel construction in markets where the hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are found to be less than the carrying amount of the asset, an adjustment to reduce the carrying amount to the related hotel property’s estimated fair market value would be recorded and an impairment loss recognized.

Assets Held For Sale – We record assets as held for sale when management has committed to a plan to sell the assets, actively seeks a buyer for the assets, and the consummation of the sale is considered probable and is expected within one year.

Cash and Cash Equivalents – We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents.

Concentration of Credit Risk – We hold cash accounts at several institutions in excess of the Federal Deposit Insurance Corporation (the “FDIC”) protection limits of $250,000. Our exposure to credit loss in the event of the failure of these institutions is represented by the difference between the FDIC protection limit and the total amounts on deposit. Management monitors, on a regular basis, the financial condition of the financial institutions along with the balances there on deposit to minimize our potential risk.

Restricted Cash – Restricted cash includes real estate tax escrows, insurance escrows and reserves for replacements of furniture, fixtures and equipment pursuant to certain requirements in our various mortgage agreements.

Accounts Receivable – Accounts receivable consists primarily of hotel guest and banqueting receivables. Ongoing evaluations of collectability are performed and an allowance for potential credit losses is provided against the portion of accounts receivable that is estimated to be uncollectible.  

Inventories – Inventories, consisting primarily of food and beverages, are stated at the lower of cost or market, with cost determined on a method that approximates first-in, first-out basis.

Franchise License Fees – Fees expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The unamortized franchise fees as of March 31, 2017 and December 31, 2016 were $366,030 and $386,612, respectively. Amortization expense for the three month periods ended March 31, 2017 and 2016 totaled $31,452 and $15,131, respectively.

Deferred Financing and Offering Costs – Deferred financing costs are recorded at cost and consist of loan fees and other costs incurred in issuing debt and are reflected in mortgage loans, net on the consolidated balance sheets. Deferred offering costs are recorded at cost and consist of offering fees and other costs incurred in issuing equity and are reflected in prepaid expenses, inventory and other assets on the consolidated balance sheets. Amortization of deferred financing costs is computed using a method that approximates the effective interest method over the term of the related debt and is included in interest expense in the consolidated statements of operations.

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Our amortization of deferred offering costs occurs when one of our equity offerings is complete, whereby the costs are offset against the equity funds raised in the future and included in additional paid-in capital on the consolidated balance sheets, or if the offering expires and the offering costs exceed the funds raised in the offering then the excess will be included in corporate general and administrative expenses in the consolidated statements of operations.

Derivative Instruments – Our derivative instruments are reflected as assets or liabilities on the balance sheet and measured at fair value. Derivative instruments used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as an interest rate risk, are considered fair value hedges. Derivative instruments used to hedge exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. For a derivative instrument designated as a cash flow hedge, the change in fair value each period is reported in accumulated other comprehensive income in stockholders’ equity and partners’ capital to the extent the hedge is effective. For a derivative instrument designated as a fair value hedge, the change in fair value each period is reported in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. For a derivative instrument that does not qualify for hedge accounting or is not designated as a hedge, the change in fair value each period is reported in earnings.

We use derivative instruments to add stability to interest expense and to manage our exposure to interest-rate movements. To accomplish this objective, we primarily are using an interest rate cap which acts as a cash flow hedge and is not designated as a hedge.  We value our interest-rate cap at fair value, which we define as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). We also have used derivative instruments in the Company’s stock to obtain more favorable terms on our financing. We do not enter into contracts to purchase or sell derivative instruments for speculative trading purposes.

Fair Value Measurements –

We classify the inputs used to measure fair value into the following hierarchy:

We endeavor to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following table represents our interest rate cap, mortgage loans and unsecured notes measured at fair value and the basis for that measurement:

 

 

Noncontrolling Interest in Operating Partnership – Certain hotel properties were acquired, in part, by the Operating Partnership through the issuance of limited partnership units of the Operating Partnership. The noncontrolling interest in the Operating Partnership is: (i) increased or decreased by the limited partners’ pro-rata share of the Operating Partnership’s net income or net loss, respectively; (ii) decreased by distributions; (iii) decreased by redemption of partnership units for the Company’s common stock; and (iv) adjusted to equal the net equity of the Operating Partnership multiplied by the limited partners’ ownership percentage immediately after each issuance of units of the Operating Partnership and/or the Company’s common stock through an adjustment to additional paid-in

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capital. Net income or net loss is allocated to the noncontrolling interest in the Operating Partnership based on the weighted average percentage ownership throughout the period.

Revenue Recognition – Revenues from operations of the hotels and condominium hotel are recognized when the services are provided. Revenues consist of room sales, food and beverage sales, and other hotel department revenues, such as rental management fees, telephone, parking, gift shop sales and rentals from restaurant tenants, rooftop leases and gift shop operators. Revenues are reported net of occupancy and other taxes collected from customers and remitted to governmental authorities.

Lease Revenue – Several of our properties generate revenue from leasing commercial space adjacent to the hotel, the restaurant space within the hotel, apartment units and space on the roofs of our hotels for antennas and satellite dishes.  We account for the lease income as revenue from other operating departments within the statement of operations pursuant to the terms of each lease.  Lease revenue was approximately $0.5 million and $0.5 million, for the three months ended March 31, 2017 and 2016, respectively.

A schedule of minimum future lease payments receivable for the remaining nine and twelve-month lease periods is as follows:

 

 

Income Taxes – The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended. As a REIT, the Company generally will not be subject to federal income tax. MHI TRS, our wholly owned taxable REIT subsidiary which leases our hotels from subsidiaries of the Operating Partnership, is subject to federal and state income taxes.

We account for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  As of March 31, 2017, and December 31, 2016, deferred tax assets totaled approximately $6.8 million and $6.9 million, respectively, of which approximately $5.9 million and $6.0 million relate to net operating losses of our TRS Lessee.  A valuation allowance is required for deferred tax assets if, based on all available evidence, it is “more-likely-than-not” that all or a portion of the deferred tax asset will or will not be realized due to the inability to generate sufficient taxable income in certain financial statement periods.  The “more-likely-than-not” analysis means the likelihood of realization is greater than 50%, that we will or will not be able to fully utilize the deferred tax assets against future taxable income. The net amount of deferred tax assets that are recorded on the financial statements must reflect the tax benefits that are expected to be realized using these criteria.  We perform this analysis by evaluating future hotel revenues and expenses accounting for certain non-recurring costs and expenses during the current and prior two fiscal years as well as anticipated changes in the lease rental payments from the TRS Lessee to subsidiaries of the Operating Partnership. We have determined that it is more-likely-than-not that we will be able to fully utilize our deferred tax assets for future tax consequences, therefore no valuation allowance is required.  As of March 31, 2017 and December 31, 2016, we had no uncertain tax positions. Our policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. As of March 31, 2017, the tax years that remain subject to examination by the major tax jurisdictions to which the Company is subject generally include 2010 through 2016. In addition, as of March 31, 2017, the tax years that remain subject to examination by the major tax jurisdictions to which MHI TRS is subject generally include 2004 through 2016.

The Operating Partnership is generally not subject to federal and state income taxes as the unit holders of the Partnership are subject to tax on their respective shares of the Partnership’s taxable income.

Stock-based Compensation – The Company’s 2004 Long Term Incentive Plan (the “2004 Plan”) and its 2013 Long-Term Incentive Plan (the “2013 Plan”), which the Company’s stockholders approved in April 2013, permit the grant of stock options, restricted stock and performance share compensation awards to its employees for up to 350,000 and 750,000 shares of common stock, respectively. The Company believes that such awards better align the interests of its employees with those of its stockholders.

Under the 2004 Plan, the Company made stock awards totaling 337,438 shares, including 255,938 shares issued to certain executives and employees and 81,500 restricted shares issued to its independent directors. Of the 255,938 shares issued to certain of our executives and employees, all have vested except 6,000 shares issued to the Chief Financial Officer upon execution of his employment contract which will vest pro rata on the next anniversary of the effective date of his employment agreement. All of the 81,500 restricted shares issued to the Company’s independent directors have vested. The 2004 Plan was terminated in 2013.

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Under the 2013 Plan, the Company has made stock awards totaling 121,100 shares, including 74,600 non-restricted shares to certain executives and employees and 46,500 restricted shares issued to its independent directors.  All awards have vested except for 12,000 shares issued to the Company’s independent directors in February 2017, which will vest on December 31, 2017.  

Previously, under the 2004 Plan, and currently, under the 2013 Plan, the Company may issue a variety of performance-based stock awards, including nonqualified stock options. The value of the awards is charged to compensation expense on a straight-line basis over the vesting or service period based on the value of the award as determined by the Company’s stock price on the date of grant or issuance.  As of March 31, 2017, no performance-based stock awards have been granted. Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value method. Total compensation cost recognized under the 2013 Plan for the three months ended March 31, 2017 and 2016 was $94,140 and $196,742, respectively. The 2004 Plan was terminated in April 2013.

Additionally, the Company sponsors and maintains an ESOP and related trust for the benefit of its eligible employees. We reflect unearned ESOP shares as a reduction of stockholders’ equity.  Dividends on unearned ESOP shares, when paid, will be considered to be compensation expense. The Company recognizes compensation expense equal to the fair value of the Company’s ESOP shares during the periods in which they become committed to be released.  To the extent that the fair value of the Company’s ESOP shares differs from the cost of such shares, the differential is recognized as additional paid in capital.  Because the ESOP is internally leveraged through a loan from the Company to the ESOP, the loan receivable by the Company from the ESOP is not reported as an asset nor is the debt of the ESOP shown as a liability in the consolidated financial statements.

Advertising – Advertising costs were $65,010 and $74,063 for the three months ended March 31, 2017 and 2016, respectively. Advertising costs are expensed as incurred.

Involuntary Conversion of Assets – We record gains or losses on involuntary conversions of assets due to recovered insurance proceeds to the extent the undepreciated cost of a nonmonetary asset differs from the amount of monetary proceeds received. During the three-month period ending March 31, 2017, we recognized approximately a $1.0 million gain on involuntary conversion of assets which is reflected in the consolidated statements of operations.

Comprehensive Income – Comprehensive income as defined, includes all changes in equity during a period from non-owner sources. We do not have any items of comprehensive income other than net income.

Segment Information – We have determined that our business is conducted in one reportable segment: hotel ownership.

Use of Estimates – The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure 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 results could differ from those estimates.

 

Recent Accounting Pronouncements – In February 2017, the Financial Accounting Standards Board (“FASB”) issued ASU 2017-05, Other Income-Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20).  The FASB issued this update to clarify the scope of Subtopic 610-20, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets, and to add guidance for partial sales of nonfinancial assets. Subtopic 610-20, which was issued in May 2014 as a part of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), provides guidance for recognizing gains and losses from the transfer of nonfinancial assets in contracts with noncustomers. The amendments in this update also simplify GAAP by eliminating several accounting differences between transactions involving assets and transactions involving businesses in many transactions related to: a partial sale of real estate; a transfer of a nonfinancial asset within the scope of FASB ASC Topic 845, Nonmonetary Transactions; a contribution of a nonfinancial asset to form a joint venture; and a transfer of a nonfinancial asset to an equity method investee. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. We will adopt this ASU as of our quarter ending March 31, 2018.  We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash.  This ASU addresses the diversity within entities that have restricted cash or restricted cash equivalents and are required to present a statement of cash flows under Topic 230.  The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early application of this ASU is permitted for all entities. We will adopt this ASU as of our quarter ending March 31, 2018.  We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.  Current GAAP either is unclear or does not include specific guidance on the eight cash flow classification issues

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included in the amendments in this update. The amendments are an improvement to GAAP because they provide guidance for each of the eight issues, thereby reducing the current and potential future diversity in practice. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early application of this ASU is permitted for all entities. We will adopt this ASU as of our quarter ending March 31, 2018.  We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In May 2016, the FASB issued ASU No. 2016-12, “Revenue from Contracts with Customers – Narrow-Scope Improvements and Practical Expedients”. The amendments in this ASU provide clarification to certain core recognition principles related to ASU No. 2014-09 including collectability, sales tax presentation, noncash consideration, contract modifications and completed contracts at transition and disclosures no longer required if the full retrospective transition method is adopted.  The amendments do not change the core principle of the guidance.  We will adopt this ASU as of our quarter ending March 31, 2018.  We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In April 2016, the FASB issued ASU No. 2016-10, “Revenue from Contracts with Customers – Identifying Performance Obligations and Licensing”. This update clarifies guidance related to identifying performance obligations and licensing implementation contained in ASU No. 2014-09. The amendments do not change the core principle of the guidance.  We will adopt this ASU as of our quarter ending March 31, 2018.  We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The FASB issued this ASU to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet by lessees for those leases classified as operating leases under current GAAP and disclosing key information about leasing arrangements. The amendments in this ASU are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. Early application of this ASU is permitted for all entities. We do not expect this ASU to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

 

3. Acquisition of Hotel Property

Hyde Resort & Residences. On January 30, 2017, we acquired the hotel commercial condominium unit of the Hyde Resort & Residences condominium hotel, for an aggregate price including inventory and other assets of approximately $4.8 million. The allocation of the estimated purchase price based on fair values is as follows:

 

 

The results of operations of the hotel are included in our consolidated financial statements from the date of acquisition. The total revenue and net loss related to the acquisition for the period January 30, 2017 to March 31, 2017 are approximately $0.8 million and $10,614, respectively. There is no pro forma financial information, since this is a new operation without prior historical information.

 

4. Investment in Hotel Properties, Net and Investment in Hotel Properties Held for Sale, Net

Investment in hotel properties, net as of March 31, 2017 and December 31, 2016 consisted of the following:

 

 

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Investment in hotel properties held for sale, net as of March 31, 2017 and December 31, 2016 consisted of the following:

 

 

Investment in hotel properties held for sale, net represents the Crowne Plaza Hampton Marina property which was sold on February 7, 2017, for approximately $5.6 million.  After selling costs, mortgage loan payoff and associated fees we realized an approximate gain on the sale of assets of $0.1 million, as reflected in the consolidated statements of operations.

 

5. Debt

Mortgage Loans, Net. As of March 31, 2017 and December 31, 2016, we had approximately $279.3 million and approximately $282.7 million of outstanding mortgage debt, respectively. The following table sets forth our mortgage debt obligations on our hotels.

 

 

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We were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans, as of March 31, 2017.

Total future mortgage debt maturities, without respect to any extension of loan maturity, as of March 31, 2017 were as follows:

 

 

7.0% Unsecured Notes. On November 21, 2014, the Operating Partnership issued 7.0% senior unsecured notes in the aggregate amount of $25.3 million (the “7% Notes”). The indenture requires quarterly payments of interest and matures on November 15, 2019. The 7% Notes are callable after November 15, 2017 at 101% of face value.

 

 

6. Commitments and Contingencies

Ground, Building and Submerged Land Leases – We lease 2,086 square feet of commercial space next to the Hilton Savannah DeSoto for use as an office, retail or conference space, or for any related or ancillary purposes for the hotel and/or atrium space. In December 2007, we signed an amendment to the lease to include rights to the outdoor esplanade adjacent to the leased commercial space. The areas are leased under a six-year operating lease, which expired October 31, 2006 and has been renewed for the third of three optional five-year renewal periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for this operating lease for each of the three months ended March 31, 2017 and 2016 totaled $18,245.

We lease, as landlord, the entire fourteenth floor of the Savannah hotel property to The Chatham Club, Inc. under a ninety-nine year lease expiring July 31, 2086. This lease was assumed upon the purchase of the building under the terms and conditions agreed to by the previous owner of the property. No rental income is recognized under the terms of this lease as the original lump sum rent payment of $990 was received by the previous owner and not prorated over the life of the lease.

We lease a parking lot adjacent to the DoubleTree by Hilton Raleigh Brownstone-University in Raleigh, North Carolina. The land is leased under a second amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a 50-year operating lease, which expired August 31, 2016. We exercised a renewal option for the first of three additional ten-year periods expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. We hold an exclusive and irrevocable option to purchase the leased land at fair market value at August 1, 2018, or at the end of any 10-year renewal period, subject to the payment of an annual fee of $9,000, and other conditions. Rent expense for the three months ended March 31, 2017 and 2016, each totaled $23,871.

We lease land adjacent to the Crowne Plaza Tampa Westshore for use as parking under a five-year agreement with the Florida Department of Transportation that commenced in July 2009.  In May 2014, we extended the agreement for an additional five years.  The agreement expires in July 2019. The agreement requires annual payments of $2,432, plus tax, and may be renewed for an additional five years. Rent expense for the three months ended March 31, 2017 and 2016, each totaled $651.

We lease certain submerged land in the Saint Johns River in front of the Crowne Plaza Jacksonville Riverfront from the Board of Trustees of the Internal Improvement Trust Fund of the State of Florida. The submerged land was leased under a five-year operating lease requiring annual payments of $4,961, which expired September 18, 2012. A new operating lease was executed requiring annual payments of $6,020 and expires September 18, 2017. Rent expense for the three months ended March 31, 2017 and 2016, each totaled $1,505.

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We lease 5,216 square feet of commercial office space in Williamsburg, Virginia under an agreement, as amended, that commenced September 1, 2009 and expires August 31, 2018.  Rent expense for the three months ended March 31, 2017 and 2016 totaled $22,552 and $23,871.

We also lease certain furniture and equipment under financing arrangements expiring between August 2017 and March 2019.

A schedule of minimum future lease payments for the following nine and twelve-month periods is as follows:

 

 

Employment Agreements - The Company has entered into various employment contracts with employees that could result in obligations to the Company in the event of a change in control or termination without cause.

Management Agreements – As of March 31, 2017, each of our wholly-owned hotels and the rental program and condominium association of the Hyde Resort & Residences operated under a management agreement with Chesapeake Hospitality (see Note 9).  The management agreements expire between January 1, 2020 and January 30, 2022, and may be extended for up to two additional periods of five years each subject to the approval of both parties.  Each of the individual hotel management agreements may be terminated earlier than the stated term upon the sale of the hotel covered by the respective management agreement, in which case we may incur early termination fees.

Franchise Agreements – As of March 31, 2017, most of our hotels operated under franchise licenses from national hotel companies. Under the franchise agreements, we are required to pay a franchise fee generally between 2.5% and 5.0% of room revenues, plus additional fees for marketing, central reservation systems, and other franchisor programs and services that amount to between 2.5% and 6.0% of room revenues from the hotels. The franchise agreements expire between July 2017 and October 2030.   On April 12, 2016 we allowed the franchise agreement on the Crowne Plaza Houston Downtown to expire.  The property has been rebranded as The Whitehall.  Each of our franchise agreements provides for early termination fees in the event the agreement is terminated before the stated term.

Restricted Cash Reserves – Each month, we are required to escrow with the lenders on the Hilton Wilmington Riverside, the Hilton Savannah DeSoto, the DoubleTree by Hilton Raleigh Brownstone-University, the DoubleTree by Hilton Jacksonville Riverside, the Crowne Plaza Hollywood Beach Resort, and the Georgian Terrace an amount equal to one-twelfth (1/12) of the annual real estate taxes due for the properties. We are also required by several of our lenders to establish individual property improvement funds to cover the cost of replacing capital assets at our properties. Each month, those contributions equal 4.0% of gross revenues for the Hilton Wilmington Riverside, the Hilton Savannah DeSoto, DoubleTree by Hilton Raleigh Brownstone–University, the DoubleTree by Hilton Jacksonville Riverside, the Crowne Plaza Hollywood Beach Resort, The Whitehall, and the Georgian Terrace and equal 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport.

ESOP Purchase Commitment – The Company’s board of directors approved the ESOP on November 29, 2016.  The ESOP is a non-contributory defined contribution plan covering all employees of the Company.  The ESOP is a leveraged ESOP, meaning the contributed funds are loaned to the ESOP from the Company.  The Company entered into a loan agreement with the ESOP on December 29, 2016, pursuant to which the ESOP may borrow up to $5.0 million to purchase shares of the Company’s common stock on the open market.  Shares purchased by the ESOP are held in a suspense account for allocation among participants as contributions are made to the ESOP by the Company.  The share allocations will be accounted at fair value at the date of allocation.  As of March 31, 2017, the ESOP had purchased 682,500 shares of the Company’s common stock in the open market for approximately $4.9 million, which the ESOP borrowed from the Company pursuant to the loan agreement.  As of March 31, 2017, no participant allocations have been made.

Litigation –To our knowledge, we are not involved in any material litigation threatened against us. We are involved in routine litigation arising out of the ordinary course of business, all of which we expect to be covered by insurance and we believe it is not reasonably possible such matters will have a material adverse impact on our financial condition or results of operations or cash flows.

 

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7. Preferred Stock and Units

Preferred Stock and Units.

As of March 31, 2017, and December 31, 2016, there were 1,610,000 shares, respectively, of the Preferred Stock issued and outstanding.

The Company has increased its authorized shares of preferred stock to 11,000,000.  On August 23, 2016, the Company issued 1,610,000 shares, $0.01 par value per share, of its 8% Series B Cumulative Redeemable Perpetual Preferred Stock for net proceeds after all expenses of approximately $37.8 million, which it contributed to the Operating Partnership for an equivalent number of preferred partnership units. Holders of the Company’s preferred stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions.  The Company pays cumulative cash distributions on the preferred stock at a rate of 8.00% per annum of the $25.00 liquidation preference per share. The preferred stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of the Company or its affiliates.

The Company is the holder of the Operating Partnership’s preferred partnership units.  As of March 31, 2017, and December 31, 2016, there were 1,610,000 units of the preferred partnership units issued and outstanding, respectively.  

Preferred Unit Distributions – The Company is the holder of the Operating Partnership’s preferred partnership units, and is entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions.  The Operating Partnership pays cumulative cash dividends on the preferred partnership units at a rate of 8.00% per annum of the $25.00 liquidation preference per unit. For the quarters ended March 31, 2017 and 2016, the Operating Partnership declared and paid $0.50 and $0.00 per preferred unit, respectively.

 

 

8. Common Stock and Units

Common Stock – The Company is authorized to issue up to 49,000,000 shares of common stock, $0.01 par value per share. Each outstanding share of common stock entitles the holder to one vote on all matters submitted to a vote of stockholders.  Holders of the Company’s common stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions. On December 2, 2016, the Company’s board of directors authorized a stock repurchase program under which the Company may purchase up to $10.0 million of its outstanding common stock, par value $0.01 per share, at prevailing prices on the open market or in privately negotiated transactions, at the discretion of management.  The Company has and expects to continue to use available working capital to fund purchases under the stock repurchase program and intends to complete the repurchase program prior to December 31, 2017, unless extended by the board of directors.  Through December 31, 2016 the Company repurchased 481,100 shares of common stock for approximately $3.2 million and the repurchased shares have been returned to the status of authorized but unissued shares of common stock.  The Company did not repurchase any shares under the stock repurchase program during the three months ended March 31, 2017.  Between January 3, 2017 and February 28, 2017, the ESOP purchased 682,500 shares of the Company’s common stock for approximately $4.9 million.  All of the 682,500 ESOP shares are considered unearned ESOP shares at March 31, 2017 and are excluded from outstanding Company’s common stock on the consolidated balance sheets and the earnings per share calculations on the consolidated statements of operations.

The following is a schedule of issuances, since January 1, 2016, of the Company’s common stock:

On February 15, 2017, the Company was issued 12,000 units in the Operating Partnership and awarded 12,000 shares of restricted stock to its independent directors.

On February 2, 2016, the Company was issued 36,250 units in the Operating Partnership and awarded an aggregate of 22,000 shares of unrestricted stock to certain executives and employees as well as 12,000 shares of restricted stock and 2,250 shares of unrestricted stock to certain of its independent directors.

On February 1, 2016, two holders of units in the Operating Partnership redeemed 422,687 units for an equivalent number of shares of the Company’s common stock.

As of March 31, 2017 and December 31, 2016, the Company had 13,798,051 and 14,468,551 shares of common stock outstanding, respectively.

Operating Partnership Units – Holders of Operating Partnership units, other than the Company as general partner, have certain redemption rights, which enable them to cause the Operating Partnership to redeem their units in exchange for shares of the Company’s common stock on a one-for-one basis or, at the option of the Company, cash per unit equal to the average of the market price of the Company’s common stock for the 10 trading days immediately preceding the notice date of such redemption. The number

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of shares issuable upon exercise of the redemption rights will be adjusted upon the occurrence of stock splits, mergers, consolidations or similar pro-rata share transactions, which otherwise would have the effect of diluting the ownership interests of the limited partners or the stockholders of the Company.

There were no issuances or redemptions, since January 1, 2016, of units in the Operating Partnership other than the issuances of units in the Operating Partnership to the Company described above.

As of March 31, 2017 and December 31, 2016, the total number of Operating Partnership units outstanding was 16,258,691 and 16,246,691, respectively.

As of March 31, 2017 and December 31, 2016, the total number of outstanding Operating Partnership units not owned by the Company was 1,778,140 and 1,778,140, respectively, with a fair market value of approximately $11.4 million and $12.1 million, respectively, based on the price per share of the common stock on such respective dates.

 

 

9. Related Party Transactions

Chesapeake Hospitality. As of March 31, 2017, the members of Chesapeake Hospitality (a company that is majority-owned and controlled by the Company’s chairman and chief executive officer, the Company’s former chief financial officer, and two former members of the Company’s board of directors) owned 1,740,691 shares, approximately 12.0%, of the Company’s outstanding common stock as well as 870,271 Operating Partnership units. The following is a summary of the transactions between Chesapeake Hospitality and us:

Accounts Receivable – At March 31, 2017 and December 31, 2016, we were due $158,680 and $0, respectively, from Chesapeake Hospitality.

Management Agreements – As of March 31, 2017, each of our wholly-owned hotels and the Hyde Resort & Residences operated under various management agreements with Chesapeake Hospitality.  The management agreements expire between January 1, 2020 and January 30, 2022, and may be extended for up to two additional periods of five years each subject to the approval of both parties.  Each of the individual hotel management agreements may be terminated earlier than the stated term upon the sale of the hotel covered by the respective management agreement, in which case we may incur early termination fees.  We also have a master agreement with Chesapeake Hospitality that has a five-year term, but may be extended for such additional periods as long as an individual management agreement remains in effect.

The base management fees for The Whitehall and the Georgian Terrace were 2.00% through 2015, increased to 2.25% in 2016, and increased to 2.50% in 2017 and for each year thereafter.  The base management fee for the Crowne Plaza Hollywood Beach Resort was 2.00% from July 2015 through July 2016, increased to 2.25% in July 2016, and increases to 2.50% in July 2017 and each year thereafter.  The base management fee for the Hyde Resort & Residences is 2.00% from January 2017 through January 2018, increases to 2.25% in January 2018, and increases to 2.50% in January 2019 and for each year thereafter.  The base management fees for the remaining properties in the current portfolio are 2.65% through 2017 and decreases to 2.50% thereafter.  For new individual hotel management agreements, Chesapeake Hospitality will receive a base management fee of 2.00% of gross revenues for the first full year from the commencement date through the anniversary date, 2.25% of gross revenues the second full year, and 2.50% of gross revenues for every year thereafter.  The Company and Chesapeake Hospitality agreed to substitute the Hyde Resort & Residences for the Crowne Plaza Hampton Marina and there was no termination fee associated with the termination of the Crowne Plaza Hampton Marina management agreement.  Each management agreement sets an incentive management fee equal to 10% of the amount by which gross operating profit, as defined in the management agreement, for a given year exceeds the budgeted gross operating profit for such year; provided, however, that the incentive management fee payable in respect of any such year shall not exceed 0.25% of the gross revenues of the hotel included in such calculation.

Base management and administrative fees earned by Chesapeake Hospitality for our properties totaled $973,068 and $932,386 for the three months ended March 31, 2017 and 2016, respectively.  In addition, estimated incentive management fees of $26,293 and $13,698 were accrued for the three months ended March 31, 2017 and 2016, respectively.  

Employee Medical Benefits – We purchase employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of Chesapeake Hospitality for our employees as well as those employees that are employed by Chesapeake Hospitality that work exclusively for our hotel properties. Gross premiums for employee medical benefits paid by the Company (before offset of employee co-payments) were $1,267,936 and $1,326,154 for the three months ended March 31, 2017 and 2016, respectively.

Sotherly Foundation – During 2015, the Company loaned $180,000 to the Sotherly Foundation, a non-profit organization to benefit wounded American veterans living in communities near our hotels.  As of March 31, 2017, and December 31, 2016, the balance of the loan was $80,000, respectively.

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Loan Receivable - Affiliate – As of March 31, 2017, approximately $4.9 million was due the Operating Partnership for advances to the Company under a loan agreement dated December 29, 2016, as well as $19,926 in accrued interest.  The Company used the proceeds to make advances to the ESOP to purchase shares of the Company’s common stock.

Others. We employ Ashley S. Kirkland, the daughter of our Chief Executive Officer as a legal analyst and Robert E. Kirkland IV, her husband, as our compliance officer.  We also employ Andrew M. Sims Jr., the son of our Chief Executive Officer, as a manager. Compensation for the three months ended March 31, 2017 and 2016 totaled $91,277 and $85,521, respectively, for the three individuals.  

On February 1, 2016, one current member of the Company’s board of directors redeemed 322,687 units for an equivalent number of shares of the Company’s common stock, and one previous member of the board of directors redeemed 100,000 units for an equivalent number of shares of the Company’s common stock, pursuant to the terms of the partnership agreement.

During the three-month period ending March 31, 2017 and 2016, the Company reimbursed $48,859  and $28,802, respectively, to a partnership controlled by the Chief Executive Officer for business-related air travel pursuant to the Company’s travel reimbursement policy.

 

 

10. Retirement Plans

We maintain a 401(k) plan for qualified employees which is subject to “safe harbor” provisions and which requires that we match 100.0% of the first 3.0% of employee contributions and 50.0% of the next 2.0% of employee contributions. All employer matching funds vest immediately in accordance with the “safe harbor” provision.  Contributions to the plan totaled $24,238 and $29,231 for the three months ended March 31, 2017 and 2016, respectively.

The Company’s board of directors adopted an Employee Stock Ownership Plan (“ESOP”) on November 29, 2016, effective January 1, 2016.  The ESOP is a non-contributory defined contribution plan covering all employees of the Company. The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees.  The ESOP is a leveraged ESOP, meaning the contributed funds are loaned to the ESOP from the Company.  The Company entered into a loan agreement with the ESOP on December 29, 2016, pursuant to which the ESOP may borrow up to $5.0 million to purchase shares of the Company’s common stock on the open market, which serve as collateral for the loan.  As of December 31, 2016, the ESOP had not purchased any shares of the Company’s common stock and had not drawn funds under the loan agreement with the Company.  Shares purchased by the ESOP are held in a suspense account for allocation among participants.  As contributions are made into the ESOP by the Company they are reflected as unearned ESOP shares on the consolidated balance sheets of the Company.  The share allocations are accounted for at fair value on the date of allocation and there have been no share allocations that have been committed to be released as of March 31, 2017.  Between January 3, 2017 and February 28, 2017, the Company’s ESOP purchased 682,500 shares of the Company’s common stock for an approximate value of $4.9 million. The fair value of the shares held by the ESOP on March 31, 2017 and December 31, 2016, was approximately $4.6 million and $0, respectively.

 

11. Indirect Hotel Operating Expenses

Indirect hotel operating expenses consists of the following expenses incurred by the hotels:

 

 

 

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12. Income Taxes

The components of the income tax provision (benefit) for the three months ended March 31, 2017 and 2016 are as follows:

 

 

A reconciliation of the statutory federal income tax provision (benefit) to the Company’s income tax provision (benefit) is as follows:

 

 

As of March 31, 2017 and December 31, 2016, we had a net deferred tax asset of approximately $6.8 million and $6.9 million, respectively, of which, approximately $5.9 million and $6.0 million, respectively, are due to accumulated net operating losses of our TRS Lessee. These loss carryforwards will begin to expire in 2028 if not utilized by such time.  As of both March 31, 2017 and December 31, 2016, approximately $0.2 million of the net deferred tax asset is attributable to our share of start-up expenses related to the Crowne Plaza Hollywood Beach Resort, start-up expenses related to the opening of the Sheraton Louisville Riverside and the Crowne Plaza Tampa Westshore that were not deductible in the year incurred, but are being amortized over 15 years.  The remainder of the net deferred tax asset is attributable to year-to-year timing differences including accrued, but not deductible, employee performance awards, vacation and sick pay, bad debt allowance and depreciation.  

We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of March 31, 2017 and December 31, 2016, respectively. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance.  At March 31, 2017 and December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward of our TRS Lessee.  A number of factors played a critical role in this determination, including:

 

At March 31, 2017 and December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward.

 

 

13. Income Per Share and Per Unit

Income per Share. The limited partners’ outstanding limited partnership units in the Operating Partnership (which may be redeemed for common stock upon notice from the limited partners and following our election to redeem the units for stock rather than

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cash) have been excluded from the diluted earnings per share calculation as there would be no effect on the amounts since the limited partners’ share of income would also be added back to net income. The shares of Series B Preferred Stock are not convertible into or exchangeable for any other property or securities of the Company, except upon the occurrence of a change of control and have been excluded from the diluted earnings per share calculation as there would be no impact on the current controlling stockholders. The 682,500 non-committed, unearned ESOP shares reduce the number of issued and outstanding common shares and similarly reduce the weighted average number of common shares outstanding. The computation of basic and diluted income per share is presented below.

 

 

Income Per Unit – The computation of basic and diluted earnings per unit is presented below.

 

 

 

14. Subsequent Events

On April 11, 2017, we paid a quarterly dividend (distribution) of $0.10 per common share (and unit) to those stockholders (and unitholders of the Operating Partnership) of record on March 15, 2017.

On April 17, 2017, we paid a quarterly dividend of $0.50 per preferred share (and unit) to the preferred stockholders (and preferred unitholders of the Operating Partnership) of record as of March 31, 2017.

On April 24, 2017, we authorized payment of a quarterly dividend (distribution) of $0.105 per common share (and unit) to the stockholders (and unitholders of the Operating Partnership) of record as of June 15, 2017. The dividend (distribution) is to be paid on July 11, 2017.

On April 24, 2017, we authorized payment of a quarterly dividend of $0.50 per preferred share (and unit) to the preferred stockholders (and preferred unitholders of the Operating Partnership) of record as of June 30, 2017. The dividend is to be paid on July 17, 2017.

 

 

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Overview

Sotherly Hotels Inc. is a self-managed and self-administered lodging REIT incorporated in Maryland in August 2004 to pursue opportunities in the full-service, primarily upscale and upper-upscale segments of the hotel industry located in primary and secondary markets in the mid-Atlantic and southern United States.  Substantially all of the assets of Sotherly Hotels Inc. are held by, and all of its operations are conducted through, Sotherly Hotels LP, formerly MHI Hospitality, L.P. We commenced operations in December 2004 when we completed our initial public offering and thereafter consummated the acquisition of the initial properties.

Our hotel portfolio currently consists of eleven full-service, primarily upscale and upper-upscale hotels, comprising 2,838 rooms and the hotel commercial condominium unit of the Hyde Resort & Residences. All of our properties, except for the Georgian Terrace, The Whitehall and the Hyde Resort & Residences operate under well-known brands such as Hilton, Crowne Plaza, DoubleTree and Sheraton.   As of March 31, 2017, we owned the following hotel properties:

 

 

We conduct substantially all our business through our Operating Partnership.  We are the sole general partner of our Operating Partnership, and we own an approximate 89.1% interest in our Operating Partnership, as of the date of this filing, with the remaining interest being held by limited partners who were the contributors of our initial properties and related assets.

To qualify as a REIT, we cannot operate hotels. Therefore, our wholly-owned hotel properties are leased to our TRS Lessees, which are wholly owned subsidiaries of the Operating Partnership.  Our TRS Lessees then engage an eligible independent hotel management company to operate the hotels under a management agreement.  Our TRS Lessee has engaged Chesapeake Hospitality to manage our wholly-owned hotels.  Our TRS Lessees, and their parent, MHI Hospitality TRS Holding, Inc., are consolidated into our financial statements for accounting purposes.  The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.

Key Operating Metrics

In the hotel industry, room revenue is considered the most important category of revenue and drives other revenue categories such as food, beverage, catering, parking, and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:

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RevPAR changes that are primarily driven by changes in occupancy have different implications for overall revenues and profitability than changes that are driven primarily by changes in ADR. For example, an increase in occupancy at a hotel would lead to additional variable operating costs (such as housekeeping services, laundry, utilities, room supplies, franchise fees, management fees, credit card commissions and reservation expenses), but could also result in increased non-room revenue from the hotel’s restaurant, banquet or parking facilities. Changes in RevPAR that are primarily driven by changes in ADR typically have a greater impact on operating margins and profitability as they do not generate all of the additional variable operating costs associated with higher occupancy.

When calculating composite portfolio metrics, we include available rooms at the Hyde Resort & Residences that participate in our rental program and are not reserved for owner-occupancy.

We also use FFO, Adjusted FFO and Hotel EBITDA as a measure of our operating performance.  See “Non-GAAP Financial Measures.”

 

 

Results of Operations

 

The following tables illustrate the key operating metrics for the three months ended March 31, 2017 and 2016, respectively, for the Company’s wholly-owned properties (“actual” portfolio metrics), as well as the eleven wholly-owned properties in the portfolio that were under the Company’s control during the three months ended March 31, 2017 and the corresponding period in 2016 (“same-store” portfolio metrics). Accordingly, the same-store data does not reflect the performance of the Crowne Plaza Hampton Marina which was sold in February 2017, or our interest in the Hyde Resort & Residences which was acquired on January 30, 2017.  The composite portfolio metrics represent all of the Company’s wholly-owned properties and the participating condominium hotel rooms at the Hyde Resort & Residences during the three months ended March 31, 2017 and the corresponding period in 2016.

 

 

Comparison of the Three Months Ended March 31, 2017 to the Three Months Ended March 31, 2016

Revenue.  Total revenue for the three months ended March 31, 2017 increased approximately $0.9 million, or 2.3%, to approximately $38.7 million compared to total revenue of approximately $37.8 million for the three months ended March 31, 2016. The increase in revenue for the three months ended March 31, 2017 resulted mainly from the start of operations at the Hyde Resort & Residences, accounting for an increase of approximately $0.8 million for the period, offset by a decrease of approximately $0.6 million after the sale of our property in Hampton, Virginia.  The remaining net increase in revenues of approximately $0.7 million was reflected by increases at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; Houston, Texas and Atlanta, Georgia; and were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida and other revenue decreases at properties in Philadelphia, Pennsylvania and Jeffersonville, Indiana.

Room revenue increased approximately $0.1 million, or 0.2%, to approximately $27.4 million for the three months ended March 31, 2017 compared to room revenue of approximately $27.3 million for the three months ended March 31, 2016.  The increase in room revenue for the three months ended March 31, 2017 resulted mainly from favorable results of a 1.6% increase in occupancy, a 3.6% increase in ADR and a 5.3% increase in RevPAR, as compared to the same period in 2016. Additionally, increase in room

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revenues for the three months ended March 31, 2017 resulted from a net increase in room revenues of approximately $0.5 million by increases at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; Houston, Texas and Atlanta, Georgia; which were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida, as well as other revenue decreases at properties in Philadelphia, Pennsylvania and Jeffersonville, Indiana and were mostly offset by a decrease of approximately $0.4 million of room revenue after the sale of our property in Hampton, Virginia.  

Food and beverage revenues increased approximately $0.1 million, or 0.9%, to approximately $8.3 million for the three months ended March 31, 2017 compared to food and beverage revenues of approximately $8.2 million for the three months ended March 31, 2016.   The increase in food and beverage revenues for the three months ended March 31, 2017, resulted from increases in food and beverage revenues at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Philadelphia, Pennsylvania; Laurel, Maryland; Houston, Texas and Atlanta, Georgia, which were offset by decreases in revenue at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida and other revenue decreases at properties in Jacksonville, Florida; Tampa, Florida and Jeffersonville, Indiana and by a decrease of approximately $0.2 million of food and beverage revenues after the sale of our property in Hampton, Virginia.

Revenue from other operating departments increased approximately $0.8 million, or 34.2%, to approximately $3.0 million for the three months ended March 31, 2017 compared to revenue from other operating departments of approximately $2.2 million for the three months ended March 31, 2016.  The increase in revenue from other operating departments for the three months ended March 31, 2017 resulted mainly from the start of operations at the Hyde Resort & Residences, accounting for an increase of approximately $0.8 million for the period.

Hotel Operating Expenses.  Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses and management fees, were approximately $27.2 million for the three months ended March 31, 2017, a decrease of approximately $0.5 million, or 1.9%, compared to total hotel operating expenses of approximately $27.8 million for the three months ended March 31, 2016.  The decrease in hotel operating expenses for the three months ended March 31, 2017 was substantially related to a decrease in expenses of approximately $0.7 million after the sale of our property in Hampton, Virginia.  The remaining net increase in hotel operating expenses of approximately $0.2 million was reflected by increases in expenses at our properties in Wilmington, North Carolina; Raleigh, North Carolina; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; Houston, Texas and Atlanta, Georgia and an increase in expenses from the start of operations at the Hyde Resort & Residences, accounting for an increase in hotel operating expenses of approximately $1.4 million for the period, that were offset by decreases in hotel operating expenses of approximately $1.2 million at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida and decreases in expenses at our properties in Philadelphia, Pennsylvania and Jeffersonville, Indiana.

Rooms expense for the three months ended March 31, 2017 decreased approximately $0.4 million, or 5.6%, to approximately $6.7 million compared to rooms expense for the three months ended March 31, 2016 of approximately $7.1 million. The net decrease in rooms expense for the three months ended March 31, 2017 resulted from a decrease in expenses of approximately $0.2 million after the sale of our property in Hampton, Virginia. The remaining net decrease in rooms expenses of approximately $0.2 million was reflected by increases in expenses at our properties in Raleigh, North Carolina; Laurel, Maryland; Jacksonville, Florida; Tampa, Florida; Houston, Texas and Atlanta, Georgia that were offset by decreases in rooms expenses at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida and other rooms expense decreases at properties in Wilmington, North Carolina; Philadelphia, Pennsylvania and Jeffersonville, Indiana.

Food and beverage expenses for the three months ended March 31, 2017 decreased approximately $0.2 million, or 3.6%, to approximately $5.7 million compared to food and beverage expenses of approximately $5.9 million for the three months ended March 31, 2016. The decrease in food and beverage expenses for the three months ended March 31, 2017, resulted mainly by a decrease in expenses of approximately $0.2 million after the sale of our property in Hampton, Virginia.

Indirect expenses at our wholly-owned properties for the three months ended March 31, 2017 increased approximately $0.1 million, or 0.5%, to approximately $14.2 million compared to indirect expenses of approximately $14.1 million for the three months ended March 31, 2016.  The increase in indirect expenses for the three months ended March 31, 2017 resulted from the start of operations at the Hyde Resort & Residences, accounting for an increase in expenses of approximately $0.8 million for the period, which was offset by a decrease in expenses of approximately $0.3 million after the sale of our property in Hampton, Virginia. The remaining net decrease in indirect expenses of approximately $0.4 million was reflected by decreases in expenses at our properties impacted by renovation activities in Savannah, Georgia and Hollywood Beach, Florida of approximately $0.5 million which were offset by increases of expenses at our properties in Wilmington, North Carolina; Philadelphia, Pennsylvania; Raleigh, North Carolina; Laurel, Maryland; Tampa, Florida; Houston, Texas and Atlanta, Georgia that were offset by decreases in indirect expenses at our properties in Jacksonville, Florida; and Jeffersonville, Indiana.

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Depreciation and Amortization.  Depreciation and amortization expense for the three months ended March 31, 2017 increased approximately $0.4 million, or 10.7%, to $4.1 million compared to depreciation and amortization of approximately $3.7 million for the three months ended March 31, 2016.  The increase was mostly attributable to increases in the depreciation related to our properties being renovated in Savannah, Georgia and Hollywood Beach, Florida, accounting for increases of approximately $0.4 million for the period.

Corporate General and Administrative.  Corporate general and administrative expenses for the three months ended March 31, 2017 increased approximately $0.1 million, or 6.5% to approximately $1.7 million compared to corporate general and administrative expenses of approximately $1.6 million for the three months ended March 31, 2016.  The increase in corporate general and administrative expenses was mainly due to an increase in legal costs of approximately $0.2 million, being offset by a one-time reduction in tax penalties of approximately $0.1 million.

Interest Expense.  Interest expense for the three months ended March 31, 2017 decreased approximately $0.8 million, or 17.7%, to approximately $3.8 million compared to interest expense of approximately $4.6 million for the three months ended March 31, 2016.  The decrease in interest expense for the three months ended March 31, 2017, was substantially related to the reduction of the 8% unsecured notes in August 2016, with a decrease of approximately $0.5 million, compared to the three-month period ending March 31, 2016.  We also reduced our average interest rate to 4.71% for the three months ended March 31, 2017, compared to 5.24% for the three months ended March 31, 2016, resulting in the remaining reduction of approximately $0.3 million.

Unrealized Loss on Hedging Activities.  As of March 31, 2017, the fair market value of the interest rate cap is $17,651.  The unrealized loss on hedging activities during the three months ended March 31, 2017 and 2016, was $15,945 and $50,557, respectively.

Gain on Involuntary Conversion of Assets.  Gain on involuntary conversion of assets for the three months ended March 31, 2017 increased approximately $1.0 million to approximately $1.0 million compared to gain on involuntary conversion of assets of $0 for the three months ended March 31, 2016.  During October 2016, hurricane Matthew damaged real and personal property our Crowne Plaza Hampton Marina and Hilton Savannah DeSoto properties and we had a one-time involuntary conversion in the amount of approximately $1.0 million.

Income Taxes.  We had an income tax provision of approximately $0.2 million for the three months ended March 31, 2017 compared to an income tax benefit of approximately $0.4 million for the three months ended March 31, 2016.  The income tax provision is primarily derived from the operations of our TRS Lessees.  Our TRS Lessees realized an operating income for the three months ended March 31, 2017, compared to an operating loss for the three months ended March 31, 2016.

Net Income.  We realized net income for the three months ended March 31, 2017 of approximately $2.9 million compared to net income of approximately $0.5 million for the three months ended March 31, 2016 as a result of the operating results discussed above.

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Non-GAAP Financial Measures

We consider FFO, Adjusted FFO and Hotel EBITDA, all of which are non-GAAP financial measures, to be key supplemental measures of our performance and could be considered along with, not alternatives to, net income (loss) as a measure of our performance. These measures do not represent cash generated from operating activities determined by generally accepted accounting principles (“GAAP”) or amounts available for our discretionary use and should not be considered alternative measures of net income, cash flows from operations or any other operating performance measure prescribed by GAAP.

FFO and Adjusted FFO.  Industry analysts and investors use FFO as a supplemental operating performance measure of an equity REIT.  FFO is calculated in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”).  FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any noncontrolling interest from unconsolidated partnerships and joint ventures.  Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time.  Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself.

We consider FFO to be a useful measure of adjusted net income (loss) for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.

We further adjust FFO for certain additional items that are not in NAREIT’s definition of FFO, including changes in deferred income taxes, any unrealized gain (loss) on hedging instruments or warrant derivative, loan impairment losses, losses on early extinguishment of debt, aborted offering costs, loan modification fees, franchise termination costs, costs associated with the departure of executive officers, litigation settlement, over-assessed real estate taxes on appeal, change in control gains or losses and acquisition transaction costs. We exclude these items as we believe it allows for meaningful comparisons between periods and among other REITs and is more indicative than FFO of the on-going performance of our business and assets. Our calculation of Adjusted FFO may be different from similar measures calculated by other REITs.

The following is a reconciliation of net income to FFO and Adjusted FFO for the three months ended March 31, 2017 and 2016:

 

 

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Hotel EBITDA.  We define Hotel EBITDA as net income or loss excluding: (1) interest expense, (2) interest income, (3) income tax provision or benefit, (4) equity in the income or loss of equity investees, (5) unrealized gains and losses on derivative instruments not included in other comprehensive income, (6) gains and losses on disposal of assets, (7) realized gains and losses on investments, (8) impairment of long-lived assets or investments, (9) loss on early debt extinguishment, (10) gains or losses on change in control, (11) corporate general and administrative expense, (12) depreciation and amortization, (13) gains and losses on involuntary conversions of assets and (14) other operating revenue not related to our wholly-owned portfolio.  We believe this provides a more complete understanding of the operating results over which our wholly-owned hotels and its operators have direct control.  We believe Hotel EBITDA provides investors with supplemental information on the on-going operational performance of our hotels and the effectiveness of third-party management companies operating our business on a property-level basis.

Our calculation of Hotel EBITDA may be different from similar measures calculated by other REITs.

The following is a reconciliation of net income to Hotel EBITDA for the three months ended March 31, 2017 and 2016:

 

 

Sources and Uses of Cash

Operating Activities.  Our principal source of cash to meet our operating requirements, including distributions to unitholders and stockholders as well as debt service (excluding debt maturities), is the operations of our hotels.  Cash flow provided by operating activities for the three months ended March 31, 2017 was approximately $5.6 million.  We had a decrease in cash provided by operating activities for the three months ended March 31, 2017 of approximately $1.0 million, compared to the three months ended March 31, 2016.  The decrease is mainly attributable to a net decrease of changes in assets and liabilities of approximately $2.4 million, offset by an increase in net income of approximately $2.4 million, and a decrease of approximately $1.0 million in other adjustments to reconcile net income to net cash provided by operating activities.  We expect that cash on hand and the net cash provided by operations will be adequate to fund our continuing operations, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends (distributions) to the Company’s stockholders (and unitholders of the Operating Partnership) in accordance with federal income tax laws which require us to make annual distributions, as “qualifying distributions,” to the Company’s stockholders of at least 90% of its REIT taxable income (determined without regard to the dividends-paid deduction and by excluding its net capital gains, and reduced by certain non-cash items).

Investing Activities.  During the three months ended March 31, 2017, we used approximately $4.0 million to acquire our interest in the Hyde Resort and Residences, $6.3 million on capital expenditures, of which, approximately $0.7 million related to the routine replacement of furniture, fixtures and equipment and $5.6 million related to renovation of our properties in Wilmington, North Carolina, Savannah, Georgia and Hollywood Beach, Florida.  We also contributed approximately $1.8 million during the three months ended March 31, 2017 into reserves required by the lenders for ten of our hotels according to the provisions of their respective loan agreements.  During the three months ended March 31, 2017, we received reimbursements from those reserves of approximately $2.2 million for capital expenditures related to those properties.  The Operating Partnership loaned to the Company approximately $4.9 million for financing to the ESOP. We also received approximately $5.4 million for the sale of the Crowne Plaza Hampton Riverside.

Financing Activities. During the three months ended March 31, 2017, we used approximately $3.6 million for net mortgage payments, dividend and distribution payments of $2.4 million and the repurchase of common stock of the Company for approximately $1.1 million pursuant to the stock repurchase program. Additionally, the Company loaned approximately $4.9 million to the ESOP.

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Capital Expenditures

We anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at historical norms for our properties and the industry.  Historically, we have aimed to maintain overall capital expenditures, except for those required by our franchisors as a condition to a franchise license or license renewal, at 4.0% of gross revenue.  Below is a description of capital expenditures by property:

Given our desire to continue the renovation activities at our properties in Wilmington, North Carolina, Savannah, Georgia and Hollywood Beach, Florida, we aim to restrict all other capital expenditures at these hotels during the renovation period to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensor that is necessary to maintain our brand affiliation.  We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to these renovation activities to total 2.50% to 3.00% of gross revenues in 2017.

We expect a substantial portion of our capital expenditures for the recurring replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors.  Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels.  We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the DoubleTree by Hilton Raleigh Brownstone-University, The Whitehall, the DoubleTree by Hilton Jacksonville Riverfront, the Crowne Plaza Hollywood Beach Resort and the Georgian Terrace as well as 4.0% of room revenues for the DoubleTree by Hilton Philadelphia Airport on a monthly basis.

 

 

Liquidity and Capital Resources

As of March 31, 2017, we had total cash of approximately $26.4 million, of which approximately $21.7 million was in cash and cash equivalents and approximately $4.6 million was restricted for real estate taxes, insurance, capital improvement and certain other expenses, or otherwise restricted.  We expect that our cash on hand combined with our cash flow from the operations of our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, and monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of the indentures or mortgage debt).

 

Other than monthly mortgage loan principal payments, we do not have any debt obligations maturing until August 2018.  In August 2018, the mortgage on our DoubleTree by Hilton Raleigh Brownstone University matures at the amortized mortgage balance of approximately $14.5 million.  We have approximately $95.8 million in debt obligations maturing in 2019, including $25.3 million of the Operating Partnership’s 7% Notes and approximately $70.5 million in mortgage debt, including reductions for future monthly principal payments on the mortgages.

 

We intend to continue to invest in hotel properties as suitable opportunities arise. The success of our acquisition strategy depends, in part, on our ability to access additional capital through other sources. There can be no assurance that we will continue to make investments in properties that meet our investment criteria. Additionally, we may choose to dispose of certain hotels as a means to provide liquidity.

 

We expect to meet our liquidity requirements for hotel property acquisitions, property redevelopment, investments in new joint ventures and debt maturities, which include the repayment of the 7% Notes (which are callable after November 15, 2017) and the retirement of maturing mortgage debt, through net proceeds from additional issuances of common shares, additional issuances of preferred shares, issuances of units of limited partnership interest in our Operating Partnership, secured and unsecured borrowings, the selective disposition of non-core assets, and cash on hand.  From time to time and subject to market conditions, we may also seek to refinance mortgage debt prior to maturity where appropriate.  We remain committed to a flexible capital structure and strive to maintain prudent debt leverage.

 

 

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Financial Covenants

Mortgage Loans

Our mortgage loan agreements contain various financial covenants.  Failure to comply with these financial covenants could result from, among other things, changes in the local competitive environment, general economic conditions and disruption caused by renovation activity or major weather disturbances.

If we violate the financial covenants contained in these agreements, we may attempt to negotiate waivers of the violations or amend the terms of the applicable mortgage loan agreement with the lender; however, we can make no assurance that we would be successful in any such negotiation or that, if successful in obtaining waivers or amendments, such waivers or amendments would be on attractive terms.  Some mortgage loan agreements provide alternate cure provisions which may allow us to otherwise comply with the financial covenants by obtaining an appraisal of the hotel, prepaying a portion of the outstanding indebtedness or by providing cash collateral until such time as the financial covenants are met by the collateralized property without consideration of the cash collateral.  Alternate cure provisions which include prepaying a portion of the outstanding indebtedness or providing cash collateral may have a material impact on our liquidity.

If we are unable to negotiate a waiver or amendment or satisfy alternate cure provisions, if any, or unable to meet any alternate cure requirements and a default were to occur, we would possibly have to refinance the debt through additional debt financing, private or public offerings of debt securities, or additional equity financing.

Under the terms of our non-recourse secured mortgage loan agreements, failure to comply with the financial covenants in the loan agreement triggers cash flows from the property to be directed to the lender, which may limit our overall liquidity as that cash flow would not be available to us.

As of March 31, 2017, we were in compliance with all debt covenants, current on all loan payments and not otherwise in default under any of our mortgage loans.

Unsecured Notes

The indenture for the 7% Notes contains certain covenants and restrictions that require us to meet certain financial ratios.  We are not permitted to incur any Debt (other than intercompany Debt), as defined in the indenture, if, immediately after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, the ratio of the aggregate principal amount of all outstanding Debt to Adjusted Total Asset Value, as defined in the indenture, would be greater than 0.65 to 1.0.  In addition, we are not permitted to incur any Debt if the ratio of Stabilized Consolidated Income Available for Debt Service to Stabilized Consolidated Interest Expense, both as defined in the indenture, on the date on which such additional Debt is to be incurred, on a pro-forma basis, after giving effect to the incurrence of such Debt and to the application of the proceeds thereof, would be less than 1.50 to 1.0.

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These financial measures are not calculated in accordance with GAAP and are presented below for the sole purpose of evaluating our compliance with the key financial covenants as they were applicable at March 31, 2017 and December 31, 2016, respectively.

 

 

Dividend Policy

We intend to continue to declare quarterly distributions to our stockholders.  The amount of future common stock (and Operating Partnership unit) distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Internal Revenue Code’s annual distribution requirements and

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other factors, which the Company’s board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by the Company’s board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.

In January 2017, we increased the quarterly dividend (distribution) to $0.10 per common share (and unit).

In April 2017, we increased the quarterly dividend (distribution) to $0.105 per common share (and unit).

Off-Balance Sheet Arrangements

None.

Inflation

We generate revenues primarily from lease payments from our TRS Lessees and net income from the operations of our TRS Lessees. Therefore, we rely primarily on the performance of the individual properties and the ability of the management company to increase revenues and to keep pace with inflation.  Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation.  However, competitive pressures at some or all of our hotels may limit the ability of the management company to raise room rates.

Our expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.

Geographic Concentration and Seasonality

Our hotels are located in Florida, Georgia, Indiana, Maryland, North Carolina, Pennsylvania, and Texas.  As a result, we are particularly susceptible to adverse market conditions in these geographic areas, including industry downturns, relocation of businesses and any oversupply of hotel rooms or a reduction in lodging demand.  Adverse economic developments in the markets in which we have a concentration of hotels, or in any of the other markets in which we operate, or any increase in hotel supply or decrease in lodging demand resulting from the local, regional or national business climate, could materially and adversely affect us.

The operations of our hotel properties have historically been seasonal.  The months of April and May are traditionally strong, as is October.  The periods from mid-November through mid-February are traditionally slow with the exception of hotels located in certain markets, namely Florida and Texas, which experience significant room demand during this period.

Critical Accounting Policies

The critical accounting policies are described below.  We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.

Investment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and improvements and 3-10 years for furniture and equipment.  In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels acquired from third parties, which were contributed to us in connection with the Company’s initial public offering, are recorded at historical cost basis.  Noncontrolling interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value at the time of acquisition.

We review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable.  Events or circumstances that may cause us to perform our review include, but are not limited to, adverse permanent changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located.  When such conditions exist, management performs a recoverability analysis to determine if the estimated undiscounted future cash flows from operating activities and the estimated proceeds from the ultimate disposition of a hotel property exceed its carrying value.  If the estimated undiscounted future cash flows

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are found to be less than the carrying amount of a hotel property, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value would be recorded and an impairment loss is recognized.

There were no charges for impairment of hotel properties recorded for the three months ended March 31, 2017.

In performing the recoverability analysis, we project future operating cash flows based upon significant assumptions regarding growth rates, occupancy, room rates, economic trends, property-specific operating costs and future capital expenditures required to maintain the hotel in its current operating condition.  We also project cash flows from the eventual disposition of the hotel based upon various factors including property-specific capitalization rates, ratio of selling price to gross hotel revenues and the selling price per room.

Revenue Recognition.  Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.  Revenues are reported net of occupancy and other taxes collected from customers and remitted to governmental authorities. Receivables for amounts earned under various contracts are subject to audit.

Income Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of March 31, 2017 and December 31, 2016, respectively. We regularly evaluate the likelihood that our TRS Lessee will be able to realize its deferred tax assets and the continuing need for a valuation allowance.  At each of March 31, 2017 and December 31, 2016, we determined, based on all available positive and negative evidence, that it is more-likely-than-not that future taxable income will be available during the carryforward periods to absorb all of the consolidated federal and state net operating loss carryforward.  A number of factors played a critical role in this determination, including:

Should unanticipated adverse financial trends occur, or other negative evidence develop, a valuation allowance may be necessary in the future against some or all of our deferred tax assets.

Recent Accounting Pronouncements

For a summary of recently adopted and newly issued accounting pronouncements, please refer to the Recent Accounting Pronouncements section of Note 2, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.

Forward Looking Statements

Information included and incorporated by reference in this Form 10-Q may contain 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, and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our current strategies, expectations, and future plans are generally identified by our use of words, such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative, but the absence of these words does not necessarily mean that a statement is not forward-looking.  All statements regarding our expected financial position, business and financing plans are forward-looking statements. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to:

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Additional factors that could cause actual results to vary from our forward-looking statements are set forth under the section titled “Risk Factors” in our Annual Report on Form 10-K and subsequent reports filed with the Securities and Exchange Commission.

These risks and uncertainties should be considered in evaluating any forward-looking statement contained in this report or incorporated by reference herein.  All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document.  All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section.  We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report, except as required by law.  In addition, our past results are not necessarily indicative of our future results.

 

 

The effects of potential changes in interest rates are discussed below.  Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that could occur assuming hypothetical future movements in interest rates.  These disclosures are not precise indicators of expected future losses, but only indicators of reasonably possible losses.  As a result, actual future results may differ materially from those presented.  The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.

To meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates.  Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs.  From time to time we may enter into interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments.  We do not intend to hold or issue derivative contracts for trading or speculative purposes.

As of March 31, 2017, we had approximately $225.5 million of fixed-rate debt and approximately $80.8 million of variable-rate debt.  The weighted-average interest rate on the fixed-rate debt was 4.84%.  A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows.  Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR.  However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates.   Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $80.8 million, the balance at March 31, 2017, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.

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As of December 31, 2016, we had approximately $228.7 million of fixed-rate debt and approximately $81.1 million of variable-rate debt.  The weighted-average interest rate on the fixed-rate debt was 4.84%.  A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows.  Our variable-rate debt is exposed to changes in interest rates, specifically the changes in 1-month LIBOR.  However, to the extent that 1-month LIBOR does not exceed the 1-month LIBOR floor on the mortgage on the DoubleTree by Hilton Philadelphia Airport of 0.50%, a portion of our variable-rate debt would not be exposed to changes in interest rates.   Assuming that the aggregate amount outstanding on the mortgages on the Crowne Plaza Tampa Westshore, DoubleTree by Hilton Philadelphia Airport, DoubleTree by Hilton Jacksonville Riverfront and the mortgage on The Whitehall remains at approximately $81.1 million, the balance at December 31, 2016, the impact on our annual interest incurred and cash flows of a one percent increase in 1-month LIBOR would be approximately $0.8 million.

Sotherly Hotels Inc.

Disclosure Controls and Procedures

The Company’s management, under the supervision and participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of March 31, 2017. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2017, its disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in its reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels Inc. have been detected.

Changes in Internal Control over Financial Reporting

There was no change in Sotherly Hotels Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels Inc.’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels Inc.’s internal control over financial reporting.

Sotherly Hotels LP

Disclosure Controls and Procedures

The Operating Partnership’s management, under the supervision and participation of the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, has evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act), as of March 31, 2017. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2017, the disclosure controls and procedures were effective and designed to ensure that (i) information required to be disclosed in the reports filed under the Exchange Act is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and instructions, and (ii) information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

The Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of Sotherly Hotels Inc., as general partner, does not expect that the disclosure controls and procedures or the internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of the controls can provide absolute assurance that all control issues and instances of fraud, if any, within Sotherly Hotels LP have been detected.

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Changes in Internal Control over Financial Reporting

 There was no change in Sotherly Hotels LP’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during Sotherly Hotels LP’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, Sotherly Hotels LP’s internal control over financial reporting.

 

 

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PART II

 

 

We are not involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business. We believe that these routine legal proceedings, in the aggregate, are not material to our financial condition and results of operations.

 

 

There have been no material changes in our risk factors from those disclosed in our annual report on Form 10-K for the year ended December 31, 2016.

 

 

On January 30, 2017, the Company used a portion of the proceeds from its offering of Series B Preferred Stock to purchase the commercial condominium unit of the Hyde Resort & Residences, a condominium hotel located in the Hollywood, Florida market, for an aggregated price of approximately $4.8 million from 4111 South Ocean Drive, LLC.

From time to time, the Operating Partnership issues limited partnership units to the Company, as required by the Partnership Agreement, to mirror the capital structure of the Company to reflect additional issuances by the Company and to preserve equitable ownership ratios.

The Company’s board of directors adopted an Employee Stock Ownership Plan (“ESOP”) as of November 29, 2016, effective January 1, 2016.  The Company sponsors and maintains the ESOP and related trust for the benefit of its eligible employees.  The ESOP is funded by a loan from the Company, pursuant to which the ESOP may borrow up to $5,000,000 to purchase shares of the Company’s common stock.  Through March 31, 2017 the ESOP purchased the following amounts of common stock and the repurchased shares have been returned to the status of authorized but unissued shares of common stock:

 

 

Not applicable.

 

 

Not applicable.

 

 

Not applicable.

 

 

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The following exhibits are filed as part of this Form 10-Q:

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

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EXHIBIT INDEX

 

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