5. Fair Value Measurements and Interest Rate Derivatives

Fair Value of Financial Instruments

As of September 30, 2016 and December 31, 2015, the carrying amount of certain financial instruments, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued expenses were representative of their fair values due to the short-term maturity of these instruments.

The Company follows the requirements of the Fair Value Measurement and Disclosure Topic of the FASB ASC, which establishes a framework for measuring fair value and disclosing fair value measurements by establishing a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:


Level 1	Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2	Inputs reflect quoted prices for identical assets or liabilities in markets that are not active; quoted prices for similar assets or liabilities in active markets; inputs other than quoted prices that are observable for the asset or the liability; or inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3	Unobservable inputs reflecting the Company’s own assumptions incorporated in valuation techniques used to determine fair value. These assumptions are required to be consistent with market participant assumptions that are reasonably available.

On an annual basis and periodically when indicators of impairment exist, the Company analyzes the carrying values of its hotel properties and other assets using Level 3 measurements, including a discounted cash flow analysis to estimate the fair value of its hotel properties and other assets taking into account each property’s expected cash flow from operations, holding period and estimated proceeds from the disposition of the property. The factors addressed in determining estimated proceeds from disposition include anticipated operating cash flow in the year of disposition and terminal capitalization rate. The Company did not identify any properties or other assets with indicators of impairment during either the three or nine months ended September 30, 2016 and 2015.

On an annual basis and periodically when indicators of impairment exist, the Company also analyzes the carrying value of its goodwill using Level 3 measurements, including a discounted cash flow analysis to estimate the fair value of its reporting units. As of both September 30, 2016 and December 31, 2015, the Company’s goodwill, which is included in other assets, net on the Company’s consolidated balance sheets, consists of $1.0 million associated with one of its hotels. The Company did not identify any indicator of goodwill impairment during either the three or nine months ended September 30, 2016 and 2015.

As of September 30, 2016 and December 31, 2015, the only financial instruments that the Company measures at fair value are its interest rate derivatives, along with a life insurance policy and a related retirement benefit agreement. In accordance with the Fair Value Measurement and Disclosure Topic of the FASB ASC, the Company estimates the fair value of its interest rate derivatives using Level 2 measurements based on quotes obtained from the counterparties, which are based upon the consideration that would be required to terminate the agreements. Both the life insurance policy and the related retirement benefit agreement, which are for a former Company associate, are valued using Level 2 measurements.

The following table presents the Company’s assets measured at fair value on a recurring and non-recurring basis at September 30, 2016 and December 31, 2015 (in thousands):


			Fair Value Measurements at Reporting Date
	Total		Level 1		Level 2		Level 3

September 30, 2016 (unaudited):
Interest rate cap derivatives	$	—	$	—	$	—	$	—
Life insurance policy (1)		857		—		857		—
Total assets measured at fair value at September 30, 2016	$	857	$	—	$	857	$	—
December 31, 2015:
Interest rate cap derivatives	$	1	$	—	$	1	$	—
Interest rate swap derivative		759		—		759		—
Life insurance policy (1)		964		—		964		—
Total assets measured at fair value at December 31, 2015	$	1,724	$	—	$	1,724	$	—

(1)

Includes the split life insurance policy for one of the Company’s former associates, which the Company values using Level 2 measurements. These amounts are included in other assets, net on the accompanying consolidated balance sheets, and will be used to reimburse the Company for payments made to the former associate from the related retirement benefit agreement, which is included in accrued payroll and employee benefits on the accompanying consolidated balance sheets.

The following table presents the Company’s liabilities measured at fair value on a recurring and non-recurring basis at September 30, 2016 and December 31, 2015 (in thousands):


			Fair Value Measurements at Reporting Date
	Total		Level 1		Level 2		Level 3

September 30, 2016 (unaudited):
Interest rate swap derivative	$	7,487	$	—	$	7,487	$	—
Retirement benefit agreement (1)		857		—		857		—
Total liabilities measured at fair value at September 30, 2016	$	8,344	$	—	$	8,344	$	—

December 31, 2015:
Interest rate swap derivative	$	437	$	—	$	437	$	—
Retirement benefit agreement (1)		964		—		964		—
Total liabilities measured at fair value at December 31, 2015	$	1,401	$	—	$	1,401	$	—

(1)

Includes the retirement benefit agreement for one of the Company’s former associates, which the Company values using Level 2 measurements. The agreement calls for the balance of the retirement benefit to be paid out to the former associate in ten annual installments, beginning in 2011. As such, the Company has paid the former associate a total of $1.2 million through September 30, 2016, which was reimbursed to the Company using funds from the related split life insurance policy noted above. These amounts are included in accrued payroll and employee benefits on the accompanying consolidated balance sheets.

Interest Rate Derivatives

The Company’s interest rate derivatives, which are not designated as effective cash flow hedges, consisted of the following at September 30, 2016 (unaudited) and December 31, 2015 (in thousands):


									Estimated Fair Value Asset (Liability)
		Strike / Capped			Effective	Maturity	Notional		September 30,		December 31,
Hedged Debt	Type	Rate		Index	Date	Date	Amount		2016		2015
Hilton San Diego Bayfront (1)	Cap	4.250	%	1-Month LIBOR	April 15, 2015	May 1, 2017	$	111,691	$	—	$	1
$85.0 million term loan (2)	Swap	3.391	%	1-Month LIBOR	October 29, 2015	September 2, 2022	$	85,000	$	(2,699)	$	759
$100.0 million term loan (2)	Swap	3.653	%	1-Month LIBOR	January 29, 2016	January 31, 2023	$	100,000	$	(4,788)	$	(437)
									$	(7,487)	$	323

(1)

The fair value of the Hilton San Diego Bayfront cap agreement is included in other assets, net on the accompanying consolidated balance sheets.

(2)

The fair values of both the $85.0 million term loan and the $100.0 million term loan swap agreements are included in other liabilities on the Company’s consolidated balance sheets. The 1-month LIBOR rate related to the $85.0 million term loan was swapped to a fixed rate of 1.591%. The 1-month LIBOR rate related to the $100.0 million term loan was swapped to a fixed rate of 1.853%.

Changes in the fair values of the Company’s interest rate derivatives resulted in (decreases) increases to interest expense for the three and nine months ended September 30, 2016 and 2015 as follows (in thousands):


	Three Months Ended		Three Months Ended		Nine Months Ended		Nine Months Ended
	September 30, 2016		September 30, 2015		September 30, 2016		September 30, 2015
(Gain) loss on derivatives, net	$	(1,374)	$	2	$	7,810	$	12

Fair Value of Debt

As of September 30, 2016 and December 31, 2015, 77.8% and 79.5%, respectively, of the Company’s outstanding debt had fixed interest rates, including the effects of interest rate swap agreements. The Company’s principal value of its consolidated debt totaled $1.0 billion and $1.1 billion as of September 30, 2016 and December 31, 2015, respectively. Using Level 3 measurements, the Company estimates that the fair market value of its debt totaled $1.0 billion and $1.1 billion as of September 30, 2016 and December 31, 2015, respectively.