12. Commitments and Contingencies

Management Agreements

Management agreements with the Company’s third-party hotel managers require the Company to pay between 2.0% and 3.5% of total revenue of the managed hotels to the third-party managers each month as a basic management fee. Total basic management fees incurred by the Company during the three and six months ended June 30, 2014 and 2013 were included in the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):



	Three Months Ended		Three Months Ended		Six Months Ended		Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Continuing operations — property general and administrative expense, and corporate overhead expense	$	8,268	$	6,463	$	14,981	$	11,818
Discontinued operations		—		—		—		65
	$	8,268	$	6,463	$	14,981	$	11,883

In addition to basic management fees, provided that certain operating thresholds are met, the Company may also be required to pay incentive management fees to certain of its third-party managers. Total incentive management fees incurred by the Company during the three and six months ended June 30, 2014 and 2013 were included in the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):

Three Months Ended

Six Months Ended

June 30, 2014

June 30, 2013

June 30, 2014

June 30, 2013

(unaudited)

Continuing operations — property general and administrative expense

926

682

1,958

1,486

License and Franchise Agreements

The Company has entered into license and franchise agreements related to certain of its hotel properties. The license and franchise agreements require the Company to, among other things, pay monthly fees that are calculated based on specified percentages of certain revenues. The license and franchise agreements generally contain specific standards for, and restrictions and limitations on, the operation and maintenance of the hotels which are established by the franchisors to maintain uniformity in the system created by each such franchisor. Such standards generally regulate the appearance of the hotel, quality and type of goods and services offered, signage and protection of trademarks. Compliance with such standards may from time to time require the Company to make significant expenditures for capital improvements.

Total license and franchise costs incurred by the Company during the three and six months ended June 30, 2014 and 2013 were included in the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):



	Three Months Ended		Three Months Ended		Six Months Ended		Six Months Ended
	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Continuing operations — franchise costs	$	10,261	$	8,771	$	18,338	$	15,249
Discontinued operations		—		—		—		73
	$	10,261	$	8,771	$	18,338	$	15,322

Total license and franchise costs included royalties of $3.1 million and $2.9 million incurred by the Company during the three months ended June 30, 2014 and 2013, respectively. During the six months ended June 30, 2014 and 2013, total license and franchise costs included royalties of $5.6 million and $5.0 million, respectively. The remaining costs included advertising, reservation and priority club assessments.

Renovation and Construction Commitments

At June 30, 2014, the Company had various contracts outstanding with third parties in connection with the renovation of certain of its hotel properties aimed at maintaining the appearance and quality of its hotels. The remaining commitments under these contracts at June 30, 2014 totaled $49.2 million.

Capital Leases

The Hyatt Chicago Magnificent Mile is subject to a building lease which expires in December 2097. Upon acquisition of the hotel in June 2012, the Company evaluated the terms of the lease agreement and determined the lease to be a capital lease pursuant to the Leases Topic of the FASB ASC.

The Company leases certain printers and copiers which leases have been determined to be capital leases pursuant to the Leases Topic of the FASB ASC. All of the leases expire in December 2014.

Assets under capital lease were included in investment in hotel properties, net on the Company’s consolidated balance sheets as follows (in thousands):



	June 30,		December 31,
	2014		2013
	(unaudited)
Buildings and improvements	$	58,799	$	58,799
Furniture, fixtures and equipment		104		104
		58,903		58,903
Accumulated depreciation		(3,099)		(2,356)
	$	55,804	$	56,547

Future minimum lease payments under capital leases together with the present value of the net minimum lease payments as of June 30, 2014 are as follows (in thousands):



2014	$	1,432
2015		1,403
2016		1,403
2017		1,403
2018		1,403
Thereafter		110,115
Total minimum lease payments (1)		117,159
Less: Amount representing interest (2)		(101,553)
Present value of net minimum lease payments (3)	$	15,606

(1)

Minimum lease payments do not include percentage rent which may be paid under the Hyatt Chicago Magnificent Mile building lease on the basis of 4.0% of the hotel’s gross room revenues over a certain threshold. No percentage rent was due for the three and six months ended June 30, 2014 and 2013.

(2)

Interest includes the amount necessary to reduce net minimum lease payments to present value calculated at the Company’s incremental borrowing rate at lease inception.

(3)

The present value of net minimum lease payments are presented on the Company’s consolidated balance sheets as current obligations of $30,000 and $35,000 as of June 30, 2014 and December 31, 2013, respectively, and as long term obligations of $15.6 million as of both June 30, 2014 and December 31, 2013. The current obligations are included in accounts payable and accrued expenses, and the long-term obligations are included in capital lease obligations, less current portion.

Ground, Building and Air Leases

Total rent expense incurred pursuant to ground, building and air lease agreements for the three and six months ended June 30, 2014 and 2013 was included in the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):

Three Months Ended

Six Months Ended

June 30, 2014

June 30, 2013

June 30, 2014

June 30, 2013

(unaudited)

Continuing operations — property tax, ground lease and insurance

4,511

4,355

8,967

8,586

Prior to the Company’s June 2014 acquisition of the land underlying the Fairmont Newport Beach, the land was leased to the Company by a third party. The Company’s acquisition of the land reduced its ground lease expense by $0.1 million during both the three and six months ended June 30, 2014.

Rent expense incurred pursuant to leases on the corporate facility totaled $0.1 million for both the three months ended June 30, 2014 and 2013, and $0.2 million for both the six months ended June 30, 2014 and 2013, and was included in corporate overhead expense.

Concentration of Risk

The concentration of the Company’s hotels in California, New York, Illinois, Massachusetts and the greater Washington DC area exposes the Company’s business to economic conditions, competition and real and personal property tax rates unique to these locales. As of June 30, 2014, the Company’s 29 hotels were concentrated in California, New York, Illinois, Massachusetts and the greater Washington DC area as follows:



									Greater
									Washington DC
	California		New York		Illinois		Massachusetts		Area
	(unaudited)		(unaudited)		(unaudited)		(unaudited)		(unaudited)
Number of hotels	9		3		3		3		3
Percentage of total rooms	32	%	9	%	8	%	14	%	13	%
Percentage of total revenue for the six months ended June 30, 2014	34	%	12	%	6	%	14	%	13	%

Other

In accordance with the Contingencies Topic of the FASB ASC, which requires a liability be recorded based on the Company’s estimate of the probable cost of the resolution of a contingency, the Company accrued $0.3 million when it sold the Rochester Portfolio related to potential future costs for certain capital expenditures at one of the hotels in the Rochester Portfolio. During the second quarter of 2014, the Company determined that its total costs for these capital expenditures may range from $2.0 million to $3.0 million. As such, the Company accrued an additional $1.8 million during the second quarter of 2014 in accordance with the Contingencies Topic of the FASB ASC, which is included in discontinued operations for the three and six months ended June 30, 2014, bringing the total amount accrued for this contingency to $2.1 million as of June 30, 2014.

The Company has provided customary unsecured environmental indemnities to certain lenders. The Company has performed due diligence on the potential environmental risks, including obtaining an independent environmental review from outside environmental consultants. These indemnities obligate the Company to reimburse the indemnified parties for damages related to certain environmental matters. There is no term or damage limitation on these indemnities; however, if an environmental matter arises, the Company could have recourse against other previous owners or a claim against its environmental insurance policies.

At June 30, 2014, the Company had $0.8 million of outstanding irrevocable letters of credit to guaranty the Company’s financial obligations related to workers’ compensation insurance programs from prior policy years. The beneficiaries of these letters of credit may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation. No draws have been made through June 30, 2014.