Service Properties Trust (SVC) 2012 Q2 法說會逐字稿

Good day, and welcome to the Hospitality Properties Trust second-quarter 2012 financial results conference call. This call is being recorded. At this time for opening remarks and introductions I would like to turn the wall over to the Senior Manager of IR, Ms. Carlynn Finn. Please go ahead, Ms. Finn.

Thank you, and good afternoon. Joining me on today's call are John Murray, President, and Mark Kleifges, Chief Financial Officer. John and Mark will make a short presentation, which will be followed by a question-and-answer session. The recording and retransmission of today's conference call is strictly prohibited without prior written consent of HPT.

Before we begin today's call, I would like to read our Safe Harbor statements. Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and other securities laws. These forward-looking statements are based on HPT's present beliefs and expectations as of today, August 7, 2012. The Company undertakes no obligation to revise or publicly release the result of any revisions to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission, or SEC.

In addition, this call may contain non-GAAP financial measures, including normalized funds from operations or normalized FFO. A reconciliation of normalized FFO and EBITDA to net income, as well as components to calculate AFFO, CAD or FAD, are available in our supplemental package found in the Investor Relations section of the Company's website. Actual results may differ materially from those projected in these forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q to be filed with the SEC, and in our Q2 supplemental operating and financial data found on our website at www.HPTReit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. Now, I would like to turn the call over to John Murray.

Thank you, Carlynn. Good afternoon. Welcome to our second-quarter 2012 earnings call. Today, HPT reported second-quarter normalized FFO of $0.75 per share. Focusing first on our travel center investments, this morning, TA reported improved quarterly results with second-quarter 2012 net income of $29.9 million compared to net income of $21.8 million in the 2011 second quarter, a 36.8% increase. TA's second-quarter performance at HPT's 185 travel centers included continued strong pull-down fuel margins on slightly reduced fuel volumes, and increases in non-fuel sales and gross margin. Property rental rent coverage for HPT's travel centers was approximately 2.1 times for the quarter.

Turning to HPT's hotel investments, second-quarter RevPAR increased 0.9% at our comparable 288 hotels. RevPAR increased 1.5% at our 290 hotels, including the two recently-acquired Royal Sonesta Hotels. The result of a 3.7 percentage point decrease in average occupancy to 72.6%, offset by a 6.7% increase in average daily rate to $102.42. During the quarter, we had 72 hotels under renovation for all or part of the period, including hotels in our Marriott number 1, Marriott 234, IHT, Hyatt, and Radisson portfolios. The impact of these renovations, primary from reduced occupancies because rooms were out of service, was significant as RevPAR was up 4.6% quarter-over-quarter for non-renovation hotels, but was down 9% at comparable renovation properties.

GOP margins at the 218 non-renovation hotels increased 90 basis points. Importantly, we have credit support from each of these operators in the form of guarantees and security deposits. Accordingly, even during this period of significant renovations and impacted operations, HPT will continue to receive its priority returns and rents from these portfolios. Average daily rate growth for our 290 hotels was 6.7% in the second quarter of 2012, an increase in each hotel portfolio, and for 16 of our 17 brands this quarter compared to last year, as our operators continue to manage debt mix and push rates during peak travel periods. Despite the unsteady macroeconomic environment, and excluding renovation hotels we have seen continued steady RevPAR improvement in 2012 as we did in 2011. However, the impact of renovations, some renovation delays and post renovation ramp-up continues to weigh on hotel performance. This will continue throughout 2012 and 2013. Nonetheless, we are pleased with the operating performance of the 35 hotels that completed renovations in 2011, with RevPAR up 8.6% and GOP margin up 310 basis points at these hotels in the second quarter of 2012 versus 2011.

There is optimism about the ongoing lodging recovery in the US as a result of constrained supply growth, steady demand and increases in average day rate and GOP margins. However, sluggish economic growth at home and continued economic weakness in Europe and Asia continues to create uncertainty about the sustainability of this recovery. Most of our managers are taking a more conservative view now than they did earlier this year, and their full year 2012 RevPAR expectations now range from 3.5% to 7.5% with an average around 4%, down from the 5% to 8% range they previously forecast, because of the extended renovations and projected post-renovation ramp-up timing in the current economic environment. We told you last quarter that second-quarter FFO would be flat because of renovation activity. There will continue to be renovations in the third and fourth quarters, but the pace will slow compared to this Washington and the first quarter of 2012. We expect 29 hotels will be under renovation during all or parts of the third quarter and about 20 in the fourth quarter. Renovation activity is expected to pick up again in the first quarter of 2013. We have tried to schedule as many renovation projects as possible for periods where they may create the least disruption to hotel performance. Nonetheless, there will be projects underway in each quarter and it will partially offset growth from properties not under renovation.

Part of our strategy in acquiring the two Sonesta hotels and establishing an affiliated relationship with Sonesta was to improve our growth opportunities. During the second quarter, HPT and Sonesta converted four hotels from our IHT portfolio in Hilton Head, Baltimore, Burlington, Massachusetts, and Philadelphia to Sonesta brands. Since the end of the second quarter, we have rebranded an additional seven hotels from IHT to Sonesta brands, and by the end of August, we expect to convert six IHG-branded hotels to Sonesta and two Marriott Residence Inns to Sonesta ES Suites. Renovations are planned at all of these hotels, which will occur in 2013 and 2014. We plan to sell two hotels, which are going to be rebranded to Sonesta ES Suites, to entities affiliated with Sonesta, and we are currently evaluating possible acquisitions to continue to grow the Sonesta relationship. The Sonesta relationship is not our only growth opportunity. Last week, we closed on the new management agreement we announced in May with Wyndham Hotels and Resorts whereby Wyndham converted 15 Candlewood Suites and one Staybridge Suites Hotel to Wyndham's Hawthorne Suites brand. Wyndham also converted four Crowne Plazas to Wyndham hotels. We are currently evaluating other possible acquisition opportunities with Wyndham, and plan to grow in portfolio.

On July 13, we sold the St. Louis Airport Marriott for $29.25 million. Taking into account the above conversions, planned conversions, the St. Louis sale, the planned sale of two Staybridge Suites and ignoring new potential acquisitions, going forward HPT's portfolio will be made up of 122 Marriott-managed hotels, 91 hotels managed by IHG, 22 hotels managed by Hyatt, 21 hotels managed by Sonesta, 20 hotels managed by Wyndham, and 11 hotels managed by Carlson. As we have discussed, we are in the process of returning each of these hotels to like-new condition during the present ongoing renovation process, and expect the long-term performance of our hotels to remain strong. I will now turn the presentation over to Mark to provide further detail on our financial results.

Thanks, John. First, let's review the second-quarter operating results for our hotel properties. As John discussed, we had 72 properties or about 25% of our hotels under renovation for all or part of the second quarter. As would be expected, this level of renovation activity had a negative impact on the operating results of our hotel portfolio, with revenue growth at our 288 comparable hotels up less than 1% versus the prior-year quarter. Results were more favorable at our 216 hotels not under renovation during the second quarter, with revenues at these hotels up $8.8 million or 3.7% quarter-over-quarter. Our strongest performing portfolio was our Marriott Number 1 portfolio with a revenue increase of 7.6%, while revenue for our IHG portfolio, which had 44 properties under renovation for the quarter, declined 1.6% quarter-over-quarter. Renovation activity also took its toll on hotel profitability, with gross operating profit for our comparable hotels down approximately $700,000, or about 0.5% quarter-over-quarter and GOP margin percentage down 54 basis points to 38.8%.

Excluding hotels under renovation during the quarter, gross operating profit increased $5.9 million, or 6.5%. The GOP margin percentage increased 102 basis points to 38.9% at our comparable hotels. Performance this quarter was strong at our Carlson portfolio and Marriott Number 1 portfolio, which each had one hotel under renovation during the quarter, with 16.4% and 12.7% increases respectively in gross operating profit and 250 and 224 basis point increases respectively in GOP margin percentage. Despite the negative impact of renovation activities on hotel revenues and gross operating profit, cash flow available to pay our minimum rents and returns for our comparable hotels increased $12.5 million, or 15.6% quarter-over-quarter. This increase was a result of the temporary deferral of the requirement that our managers make FF&E reserve contributions for our IHG and Marriott 234 agreements and the improved operating performance of our Marriott Number 1 and Carlson portfolios this quarter.

Turning to coverage of our minimum returns in rents for the 2012 second quarter, our Marriott 234 and IHG portfolios had coverage of 1.08 and 1 times respectively. Coverage from the Marriott portfolio benefited from the second-quarter contract amendment which included a provision to defer the requirement to fund FF&E escrows retroactive to the beginning of 2012. During the second quarter, after giving effect to this change in FF&E reserve requirements, the amount available under the Marriott 234 guarantee was replenished by $6.5 million, resulting in a remaining balance of $30.5 million at June 30. During the quarter, we also replenished the IHG security deposit by the $1.5 million of cash flow, in excess of our minimum returns for the quarter, resulting in an available security deposit of $41.1 million at the end of the quarter. At quarter-end all other payments due under our hotel operating agreements were current. Information regarding all of our security deposit and guarantee balances at quarter end will be included in our Form 10-Q, which will be filed tomorrow.

Turning to our travel center portfolio, performance continued to improve this quarter with property level EBITDAR at our 185 centers, up $11.6 million, or 12% versus 2011 second quarter. Fuel volumes for the second quarter were down slightly from the prior year, but per-gallon fuel margins increased this quarter resulting in an 11% increase in fuel gross margin compared to the 2011 quarter. Non-fuel revenue and gross margin increased 4.1% and 2.2% respectively quarter-over-quarter. Property-level rent coverage improved from the 2011 second quarter, and was 2.11 times for our TA centers and 2.08 times for our Petro centers. Earlier today, TA reported second quarter 2012 corporate-level EBITDAR of $94.1 million, a 13.5% increase from the 2011 second quarter. TA's EBITDAR covering the total cash rents at the corporate level was very strong at 1.74 times for the second quarter. On a trailing 12-month basis, the coverage was strong at 1.36 times.

Turning to HPT's operating results for the second quarter, this morning we recorded normalized FFO of $93 million, or $0.75 per share. This compares to second-quarter 2011 normalized FFO of $110.2 million, or $0.89 per share. The majority of the decline in normalized FFO in the 2011 quarter is due to the temporary elimination of FF&E escrow funding requirements for the Marriott 234 and IHG portfolios, which had the effect of reducing HPT's 2012 normalized FFO by $14.3 million, or approximately $0.12 per share from the 2011 quarter. But more importantly, did not reduce HPT's cash flow from operations or cash available for distribution. EBITDA was $139.9 million in the second quarter, and our EBITDA to total fixed charges coverage ratio for the quarter remained strong at 3.2 times. In May, HPT paid a common dividend of $0.45 per share. Our normalized FFO payout ratio was approximately 60% for the 2012 second quarter.

Before opening the call to questions, I would like to provide an update on where HPT stands at the end of the second quarter, with its capital funding commitments. We have agreed to fund up to $145 million for renovations to the 68 hotels in our Marriott 234 agreement. As of the end of the quarter, we have funded $45.2 million. We expect to fund an additional $38.8 million in 2012 and the remainder in 2013. We have also agreed fund up to $290 million for renovations to 91 hotels in our InterContinental agreement. As of the end of the quarter, we have funded $126.8 million. We expect to fund an additional $123.8 million in 2012, and the remainder in 2013.

We have also agreed to fund up to $75 million for renovations to the 20 hotels in our new Wyndham agreement. As of the end of the quarter, we have funded $430,000. We expect to fund an additional $25 million in 2012, and the remainder in 2013. We are currently working with Sonesta to develop renovation budgets for the 19 hotels that have been or will be converted to Sonesta brands. Our preliminary estimate is that we will fund between $130 million and $150 million for these renovations. We expect to fund $10 million in 2012, with the remainder taking place in 2013 and 2014. We also expect to fund up to $93 million for improvements to our travel centers in 2012. As of the end of the quarter, we have funded $18 million.

With respect to our balance sheet and liquidity, at quarter end we had cash of approximately $25 million, which excludes $47.5 million of cash escrowed for improvements to our hotels, and had no amounts outstanding on our $750 million revolving credit facility. As of today, we have approximately $75 million of cash on hand and $750 million of borrowing capacity under our credit facility, available to fund our remaining capital commitments and future acquisitions. In closing, we remain optimistic about the prospect of continued improvement in the operating results at our travel centers, as well as the positive impact our extensive renovation program will have on the long-term performance of our hotels. Operator, we can open it up for questions.

(Operator Instructions)

We have a question from Jeffrey Donnelly from Wells Fargo. Please go ahead.

John, can you just talk a little bit more in specific about the renovations? I am just trying to get a sense for, I guess, how invasive and disruptive they have been and what we can expect from sort of a before and after potential. Are these largely lobby renovations? Are they guest room renovations? Give us a sense of how many rooms have been going in and out of service?

To the last part first. I don't have a number handy on the rooms count in and out. The renovations have been extensive. They have been complete room renovations in almost all of the hotels, and lobby renovations as well. So in the Courtyards, they are refreshing lobby. Marriott's new lobby concept for Courtyard. There is a new gatehouse design for Residence Inns we have been upgrading to, as well as upgrading the rooms. In the Candlewood Hotels, it's been rooms. Some kitchen renovations, including cabinetry and bathroom renovations. In the Staybridge Suites, it's been rooms and kitchen renovations. So it's been a very substantial renovation in each of the hotels.

And what's your expectation, I guess? How are you thinking about, to measure their success or failure post renovation? Are you looking for them to recover their lost occupancy and some degree of rate in the 12 months that follows? How should we set our expectations for that?

Yes. The hotels have -- as rooms have been out of service, they have been trying to hold rates at pretty good levels. In the extended stay hotels, which many of these hotels are, they have been focused more on short-term stays during the renovation process because you probably will never see a customer back again if they had to stay for three months, all of which was during a renovation period. But the expectation after is that we will regain the occupancy that we lost.

We were lucky in that we've traditionally run somewhere between a 15% and 20% premium in the industry in terms of our occupancy levels. Even though we have lost occupancy during this process, we are still running at a premium. So we are optimistic that we will regain occupancy once the renovations are complete, and the hotels are in a much-improved condition. And we're also optimistic we will be able to charge higher rates as a result of the improved condition and more competitive nature of the properties. I guess I would point out in the -- particularly with the extended stay hotels, it does take some time to rebuild that base of longer term stays, which are the more profitable stays in an extended stay hotel. But, if you're planning to be working on a project or involved in training or otherwise staying at an extended stay hotel for a month or three months or a year, there is a lot of planning and advance planning that goes into selecting what hotel you're going to stay at. And as a result, it takes a little bit more time to build that base of business.

So, we are not expecting that as soon as we finish the punch list, we're going to jump right back in the first month to 2007 levels. But we are expecting that there will be a steady increase back towards that level of performance. And I guess the other thing is just that any salesperson who is competing with our hotels, if they're any good, has been calling on as many customers as they can saying, do you really want to stay at that hotel? It's scheduled for a renovation soon. You know, it's going to be in renovation during the period you want to have your meeting or you want to have your stay or your event. And so, there's market pressure that you have to sell against once you complete the renovation, too. So we are expecting performance to come back. But it won't be immediate.

And just a housekeeping question or two. Do you have the Marriott and IHG, I guess, home security deposit balances as of today rather than quarter-end? I was just curious where they might be at.

Let me see if I have that with me, Jeff. I just don't think I brought it.

Maybe while you're looking I will ask John, I saw in your notes that RMR purchased two of the hotels. Just to be clear, that's not one of the other [par marshalated] REITs? That's the advisor. And why did RMR step into that position?

That's a good question. As you know, there are REIT requirements that -- to be a qualified. It's a technical answer -- I apologize in advance. The REIT requirements that to be a qualified third-party manager you have to manage for -- Sonesta has to manage for other parties besides just HPT. And when we acquired Sonesta, and today, we believe that Sonesta easily met those requirements because they manage a number of hotels. Five or six hotels in the Middle East and Egypt and Qatar, and they manage a hotel in Coconut Grove that's not owned by HPT. However, the business in Egypt is very fragile. The situation there, I think everybody knows, is not very good. So to be sure that we weren't going to run into any technical issues with IRS requirements, a couple of other entities were set up and they bought two of the least well-performing Staybridge Hotels that we had in our portfolio. And those will be owned by affiliates of RMR and managed by Sonesta, and ensures compliance with that technical requirement.

Thanks, guys.

Jeff, getting back to you on your question about the Marriott guaranteeing the IHG security deposit, as of today the Marriott guarantee has increased, since quarter-end, from $30.5 million to $31.8 million available. And the IHG security deposit has increased from $40.1 million to $41.9 million at August 7.

Great. Thank you.

And our next question comes from Dan Donlan with Janney. Please go ahead.

Just real quick. Mark, could you kind of explain what's going on with Marriott 2, 3, and 4? You I think you had to have some rent come in or Marriott had to replenish some of the rent, but then you saw the security deposit go up or guarantee go up. Could you kind of explain kind of what went on there?

Are you talking about the $6 million-plus replenishment of the guarantee during the quarter?

Right. Why was it replenished if it was $2.4 million less than the minimum rent? Maybe I'm reading that wrong.

No, no. Let me see if I can explain it in a simple way because, obviously, there was somewhat complex waterfalls behind that contract. To start with, during the quarter, we entered into an amendment to that contract with Marriott that eliminated the need for them to escrow FF&E reserves. And that amendment was retroactive back to the beginning of the year. So during the second quarter, we not only did not record any income from FF&E escrows from the Marriott 234 agreement, but we reversed the income that we had recognized in the first quarter.

Now, when you eliminate the FF&E reserve, what that does, if you think about our typical cash waterfall, its hotel revenues, less operating expenses, less the FF&E reserve, and then what's left goes towards payment of our minimum return. So if you eliminate the FF&E reserve, that increases the amount of cash that's available to pay our minimum return. And because the Marriott guarantee is capped at the 90% of our minimum return, that increasing cash flow, we only get up to 90%. But if we had retained all the excess cash flow, we would have been over 90%. So we gave some of the cash back to Marriott, which was used to replenish the guarantee. If you want to talk about that offline, I can walk you through the actual numbers.

Okay. I mean, that actually made sense. I've got it. Okay. And then has all the properties that you are going to convert to Sonesta, has that been decided, or is there still potential for some of the Marriott, IHG, or any other remaining hotels to be converted to Sonesta?

There are no other hotels in our portfolio other than the ones we have already identified that will be converted.

Okay. And I guess looking out to maybe a normalized number, what percentage of your minimum rents or call it hotel EBITDA do you think will be associated with Sonesta?

I think it's around 6%.

Okay. That's pretty small. And then what -- on the $130 million to $150 million that you are looking to spend on the Sonesta hotels, what is that on a per key basis, if you have that?

There's 3,300 keys.

Okay.

You can do the math.

No problem. And then I guess just lastly kind of on, moving to Sonesta, from Marriott and IHG branded hotels, how are you mitigating the loss from the loyalty programs in the brand systems? It would seem to me that an extended stay product, if you are staying a month, you'd want to be able to get the points from Hilton and Marriott. So how are you guys looking to mitigate that loss from not having a loyalty program? Are you building in a loyally program with Sonesta? Any thoughts there would be helpful.

Yes. There is a few components to that. I guess the first thing is that the -- as you would expect, Marriott and IHG and the other major brands don't deliver those loyalty points and systems at no cost. So when the -- while there is an expected drop-off when those are taken out of the equation, there is a substantial cost component that also comes out. So that's part of the mitigation. Part of the mitigation is by working hard on guest relations and customer service and delivering good product through the renovation process that we're embarked upon. And then the third component, as you mentioned, is Sonesta has their own reservation system and is working on developing their own guest affinity program. And over time as their recognition improves in the marketplace, and as their service levels are high, and their product quality is high, we expect that guests will develop a preference for Sonesta hotels equal to some of the other major brands.

Okay. Thank you very much.

And our next question comes from Wes Golladay from RBC Capital Markets. Please go ahead.

Quick question. You mentioned possible additional acquisitions with Wyndham. Would these be one-off assets, maybe a portfolio or relatively newer hotels, older hotels that might need renovation? What are we looking at here?

Obviously, on almost every acquisition opportunity you look at there is confidentiality agreements involved. So I can only answer that in a vague way. But we have looked at very large portfolio acquisitions with Wyndham this year, even involving brands. And we've looked at several different one-off transactions where we would add existing hotels that are in key markets and reasonably well performing, but where we think by putting the Wyndham brand on the property we can improve and perhaps spending money on capital, can improve performance. We can take those new hotels and add them to the existing Wyndham portfolio we have. It's been a combination. We have a pretty open dialogue and a fairly healthy pipeline.

And would you say that pipeline is better now versus the last time we talked on the call?

The last time we talked we didn't a Wyndham deal yet.

Oh, shoot. But the pipeline.

Yes, the pipeline has been very full and active. We have been bidding on a number of different marketed transactions for large portfolios and individual hotels. We have been bidding and developing leads outside the brokerage community's marketing process. But I am not sure that I can say we have ever been busier on an acquisitions front than we are today. It's a very active pipeline.

And on the capital market front, what is the plan for all the renovations? You know, let some of it go on the line and once it hits a certain threshold would you tap the debt markets, preferred market, possibly the equity. How do you plan on financing the whole 2013?

Yes. Well, to date we don't have anything out on the line today and about $75 million of cash. So it's going to be a little while before we have enough on the line to where we have enough to actually access the capital markets. We're probably going to end the year with $220 million out on the line. And at that point, we'd have we'd be getting close to the size of a raise where we could access the capital markets. And I would think debt would probably be the way we'd go to clean that out.

Okay. So you have like a sweet spot, maybe $250 million, $300 million and then clean it out?

Yes.

Thanks a lot.

And our next question comes from Ryan Meliker with MLV. Please go ahead.

Just a couple quick questions. First of all, I'm sorry if I missed it, but you had said in your opening -- in your opening remarks that your managers were averaging about 4% RevPAR growth for the year. Is that after renovation or before renovation?

That's factoring in the renovations.

That's factoring in the renovations. So, I mean, correct me if I'm wrong, but given that factoring in the renovations you were only up 0.4% year to date, that basically implies close to 8% RevPAR growth, inclusive of renovation and tacked back in. Is that correct?

We are expecting the performance will pick up once the hotels are renovated. That's correct. And then we expect to see both some pick-up in occupancy and improvement rate. The mix of properties is some are coming -- some are prepping to go into renovations, some are being renovated and some are coming out of renovations. So when the exact timing is, whether they all hit their numbers exactly as they project, we're hopeful.

Sure.

Remains to be seen, obviously.

That makes sense. And then with regards to renovation impact in the back half of the year, you indicated that sounds like you're going to have a lighter CapEx implications in the back half of the year than the front half of the year. From what Mark just disclosed, it sounds like it's going to be over $250 million in CapEx back half of the year and year-to-date you are only at around $167 million. So help me understand why the higher degree of CapEx is going to have less implication on RevPAR.

Some of it has to do with the timing of when you actually pay the bills.

Sure. So it's really timing driven? It's not about what you're doing. Okay.

A lot of the FF&E, you put a 50% deposit on. But there is a fairly long lead time when that stuff shows up and is installed. So there is a lot of moving parts.

Sure. I figured as much. That's helpful. And then, just lastly, with regards to the Marriott Number 1, obviously you guys have indicated in the past that host is that's going to revert back from host to your TRS. Is the minimum guarantee guaranteed by Marriott, as the operator or by host? And then is there going to be any time of, I guess, security to that minimum guarantee given there is no deposit on that portfolio?

No. The credit support for that contract comes in the form of a security deposit put up by host.

Right.

There is no Marriott guarantee. When it converts back to us, there will be no credit support.

So there will be no credit support and no minimum guarantee. So it will be basically like a typical hotel like the rest of the REITs, in other words?

There is a minimum -- the contract is still a little different. The way the contract would work is there would be the cash waterfall that exists today would stay in place. So hotel operating expenses before management fee would be the first deduction. Then an FF&E reserve. Then our minimum after we get paid our minimum, Marriott would get its base management fee. Then there is, as I recall, a 50/50 split of residual cash flow after that.

So there is a minimum? You still have your minimum before Marriott gets their fee?

Yes.

And that doesn't change. It's more just if there is no credit support if the properties don't cover the minimum?

Correct.

Okay. Wonderful. That's helpful. Thank you very much.

(Operator Instructions)

Our next question comes from David Loeb from Baird. Please go ahead.

I want to clarify a couple things, just for starters for my own understanding. Mark, if we can go back to the debt raise question. Essentially, I guess I've had the question about the free cash flow and I want to make sure I'm looking at free cash flow the way you do. All of these capital investments are essentially into earning assets, correct? You're getting a percentage of every dollar you put in?

Correct. A minimum return or minimum rent depending on the contract as we make FF&E reserve fundings, as we call them. Our minimum rent or minimum return goes up anywhere from 9% to 10%. 8% to 10%. I'm sorry.

So when you look at free cash flow, do you even look at that as a factor in it? Or is that, rather, something you view as use of free cash flow?

We view it -- we and our Board view it as a use of free cash flow.

So if I am understanding the dynamics correctly, you are talking about going to the bond market, borrowing it depending on the term, 4%, 5% to fund the investments that are going to yield you 8% or 10%?

Correct.

Sounds like a pretty good deal. And then as you do that, I wanted to ask about the dividend. Given your Board is viewing free cash flow as being free cash flow before you choose to make new investments, as you make these new investments, increase the taxable income, is there upward pressure on the dividend over the next 6 months, 18 months, whatever?

From a tax standpoint?

Yes.

No. No, because depreciation comes into play, which is a great shelter of taxable income. So I don't think we'll -- I don't think that will be the reason that there's dividend pressure. I think as we get farther through the renovation process and as returns start to -- rent coverage and return coverage start to improve in our agreements, there will be more focus by the Board and management on increasing the dividend.

Okay. The reason I asked about that is because last year, 2011, 100% of your dividend was taxable income. It sounds like you're not necessarily bumping up against paying out 100%?

No. Without getting into a long technical discussion, you're correct. It was 100%. It will probably be 100% this year, but we'll be okay from a federal tax distribution standpoint.

Okay. And then back to the question about the change in the way you account for the Marriott agreement. Essentially, was there any cash flow change, or was it merely the way you are accounting for CapEx and the like?

Well, there's no impact on free cash flow to HPT or cash available for distribution. Think of it this way, is that we essentially get two payments from our managers related to our hotels. They pay us an FF&E reserve typically equal to 5% of revenues, and they distribute cash to us equal to that, and they distribute to us our minimum return. Both of those items are included in both net income and normalized FFO. When you get to cash flow from operating activities in the cash flow statement or cash available for distribution or FAD or whatever you want to call it, in the cash flow statement, we deduct that piece, that first payment related to the FF&E, we deduct that to get to cash flow from operations, because we are putting that cash into a restricted cash account. And in looking at CAD or determining cash available for distribution and evaluating our ability to pay a dividend or increase a dividend, we have always deducted the amounts escrowed for FF&E reserves. The point we're trying to make is that from a cash flow from operations or CAD standpoint, this change in FF&E escrow requirements had no impact on either.

So essentially the economics didn't change, but where it goes through the income statement changed. Is that correct?

The economics did change in the sense that the manner that we're not growing the escrow account. So think of it this way. If the Marriott escrow account isn't increasing while we are doing the renovations, we are going to have to fund -- make more FF&E or renovation fundings in our minimum return is going to go up as a result, a little higher.

That's improved economics, essentially?

Well, long term. You can look at it that way.

And in the short term, it takes a little bit of pressure off what would otherwise be a tight cash flow situation for our operators where they might be drawing on credit support more than they would prefer. So it's a balance.

Okay.

Like all of our agreements.

That makes sense. This is all very helpful. Last question. As you look at acquisitions, at what point do you feel like you will need to balance the additional borrowing with some additional common or preferred? And which of those do you think you would look towards?

Well, I think in terms of looking at your capital stack, I think I think we've got the right mix right now of preferred common and debt. Even if at the end of 2012 we fund the remaining, I think we've got about $270 million more of renovations we are going to fund this year. Our debt to total capitalization is still only going to be about 45%. So from a renovation standpoint, I don't think there is any need to raise equity. If we were to go out and do a significant acquisition or a significant number of acquisitions, we want to continue to run the Company, around that 45%, 40% to 50% debt to total book capitalization. So at some point there may be a need to raise common equity if we are successful on the acquisition front.

Great. Thank you very much.

And we have a follow-up question from Dan Donlan from Janney. Please go ahead.

I want to go back to the acquisitions real quick. In the past, you guys said you think you could still achieve your minimum rent structure on potential acquisitions. Is that still the case, or could you characterize maybe some of the opportunities in terms of the way they would be structured?

I think what you just said is still accurate. The transactions that we've been looking at have been within the construct of the typical HPT deal structure where we have a waterfall, as Mark described, where there is the operators bring in the revenues, pay the operating expenses, fund an FF&E reserve. There is a return paid to the owner, a management fee paid to the manager, and the returns are in the range of the deals that we have been recently doing or recently restructuring to, and they involve credit support and structure that we've had in the past.

That answers the question. I guess the other thing would be, are these going to be more full-service types of assets or limited service types of assets or a combination of both?

We've looked at both. We've looked at portfolios of select service hotels and individual urban properties in major markets. So when it's a one-off deal where we're adding to an existing portfolio, which I'd say the focus has been on -- most recently has been on the relationships that we have with Sonesta and with Wyndham. We have been looking at full-service hotels in the Sonesta case, for potential conversions for the ES suites brand and new Extended Stay brand.

Okay. Thank you.

And there are no further questions at this time. So I would like to turn the conference over to John Murray. Please go ahead.

Thank you all very much for joining us today. We look forward to speaking with you soon.

That concludes our conference today. Thank you for your participation and using AT&T Executive Teleconference. You may now disconnect.