11. Commitments and Contingencies

Management Agreements

Management agreements with the Company’s third-party hotel managers require the Company to pay between 1.75% and 3.5% of total revenue of the managed hotels to the third-party managers each month as a basic management fee. 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 basic management fees, net of key money incentives received from third-party hotel managers, along with incentive management fees incurred by the Company during the three and nine months ended September 30, 2017 and 2016 were included in other property-level expenses on the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Basic management fees	$	8,432	$	8,510	$	25,269	$	25,130
Incentive management fees		1,172		1,541		5,525		4,735
Total basic and incentive management fees	$	9,604	$	10,051	$	30,794	$	29,865

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 fees incurred by the Company during the three and nine months ended September 30, 2017 and 2016 were included in franchise costs on the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Franchise assessments (1)	$	6,839	$	6,666	$	19,941	$	19,546
Franchise royalties		2,592		2,742		7,426		7,856
Total franchise costs	$	9,431	$	9,408	$	27,367	$	27,402

(1)

Includes advertising, reservation and frequent guest club assessments.

Renovation and Construction Commitments

At September 30, 2017, the Company had various contracts outstanding with third parties in connection with the renovation and repositioning of certain of its hotel properties. The remaining commitments under these contracts at September 30, 2017 totaled $54.2 million.

Capital Leases

The Hyatt Centric 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.

During the third quarter of 2017, the Company corrected an immaterial error by reclassifying the Courtyard by Marriott Los Angeles ground lease from an operating lease to a capital lease due to the lease containing a future bargain purchase right option. Upon examination of this future purchase right option, the Company determined that the economic disincentive for continuing to lease the property will be so significant that the Company will likely exercise the option. The Company assessed the cumulative impact of this error on the affected financial statement line items (capital lease assets, capital lease liability, ground lease expense and interest expense) in its previously reported 2016 and 2017 financial statements pursuant to the guidance in ASC 250 Accounting Changes and Error Corrections ("ASC 250") and SEC Staff Accounting Bulletin ("SAB") No. 99 Materiality. The assessment concluded that the error was not material, individually or in the aggregate, to either the current or any prior period consolidated financial statements. As such, in accordance with ASC 250 (SAB No. 108, Considering Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), the $4.5 million cumulative adjustment to reclassify the ground lease from an operating lease to a capital lease was recognized in the current period as an increase to interest expense, with no revision to prior periods.

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


	September 30,		December 31,
	2017		2016
	(unaudited)
Gross capital lease asset - buildings and improvements	$	58,799	$	58,799
Gross capital lease asset - land		6,605		—
Gross capital lease assets		65,404		58,799
Accumulated depreciation		(7,840)		(6,738)
Net capital lease assets	$	57,564	$	52,061

Future minimum lease payments under the Company’s capital leases together with the present value of the net minimum lease payments as of September 30, 2017 are as follows (in thousands):


2017	$	2,357
2018		2,357
2019		2,357
2020		2,365
2021		2,453
Thereafter		139,287
Total minimum lease payments (1)		151,176
Less: Amount representing interest (2)		(124,419)
Present value of net minimum lease payments (3)	$	26,757

(1)

Minimum lease payments do not include percentage rent which may be paid under the Hyatt Centric Chicago Magnificent Mile building lease on the basis of 4.0% of the hotel’s gross room revenues over a certain threshold. Under the Hyatt Chicago Magnificent Mile’s building lease, $20,000 and $36,000 in percentage rent was due during the three and nine months ended September 30, 2017 and 2016, respectively.

(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 sheet as of September 30, 2017 as a current obligation of $1,000, which is included in accounts payable and accrued expenses, and as a long-term obligation of $26.8 million, which is 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 nine months ended September 30, 2017 and 2016 was included in property tax, ground lease and insurance on the Company’s consolidated statements of operations and comprehensive income as follows (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Minimum rent, including straight-line adjustments	$	2,124	$	2,251	$	6,804	$	6,857
Percentage rent (1)		1,901		2,802		5,241		7,327
Total	$	4,025	$	5,053	$	12,045	$	14,184

(1)

Several of the Company’s hotels pay percentage rent, which is calculated on operating revenues above certain thresholds.

Rent expense incurred pursuant to a lease on the corporate facility totaled $0.1 million for both the three months ended September 30, 2017 and 2016, and $0.2 million for both the nine months ended September 30, 2017 and 2016, and is included in corporate overhead expense.

Concentration of Risk

The concentration of the Company’s hotels in California, Hawaii, Illinois, Massachusetts, the greater Washington DC area, Louisiana and Florida exposes the Company’s business to economic and severe weather conditions, competition and real and personal property tax rates unique to these locales. As of September 30, 2017, 21 of the Company’s 27 hotels were geographically concentrated as follows:


				Trailing 12-Month
		Percentage of		Total
	Number of Hotels	Total Rooms		Consolidated Revenue
	(unaudited)	(unaudited)		(unaudited)
California	7	29	%	34	%
Hawaii	1	4	%	7	%
Illinois	3	9	%	7	%
Massachusetts	3	15	%	16	%
Greater Washington DC area	3	14	%	13	%
Louisiana	2	6	%	4	%
Florida	2	7	%	7	%

Hurricanes Harvey and Irma

During the third quarter of 2017, four of the Company’s 27 hotels were impacted to varying degrees by Hurricanes Harvey and Irma: the Hilton North Houston; the Marriott Houston; the Oceans Edge Hotel & Marina; and the Renaissance Orlando at SeaWorld®. In August 2017, Hurricane Harvey attained Category 4 intensity as it made landfall in the Eastern and Southern United States, inflicting widespread damage in Texas, among other areas. The Company’s Houston hotels remained open during Hurricane Harvey; however, they both sustained wind-driven rain infiltration and water damage within some of the guestrooms, meeting space and public areas. In September 2017, Hurricane Irma attained Category 4 intensity as it made landfall in Florida, inflicting widespread damage, particularly in the Florida Keys, in which the Company’s Oceans Edge Hotel & Marina is located. The hotel closed on September 7, 2017, following a mandatory evacuation order, and partially reopened on September 27, 2017. The property sustained limited damage as a result of Hurricane Irma, and the hotel was able to reopen all guestrooms on October 19, 2017. Finally, the Renaissance Orlando at SeaWorld® hotel in Orlando, Florida remained open and operational during Hurricane Irma and sustained minimal damage.

The Company maintains customary property, casualty, environmental, flood and business interruption insurance at all of its hotels, the coverage of which is subject to certain limitations including higher deductibles in the event of a named storm. The Company is evaluating its ability to submit claims at each of the Houston hotels for portions of the restoration expense incurred. For the Houston hotels, the Company accrued combined hurricane-related restoration expense of $0.9 million as of September 30, 2017, which is included in repairs and maintenance expense in the accompanying consolidated statements of operations for the three and nine months ended September 30, 2017. The deductibles related to property damage at the Oceans Edge Hotel & Marina are structured on a building by building basis, none of which sustained enough damage to exceed their deductibles. At September 30, 2017, the Company accrued hurricane-related restoration expense of $0.7 million for the Oceans Edge Hotel & Marina, along with $0.1 million for the Renaissance Orlando at SeaWorld®, both of which are included in repairs and maintenance expense in the accompanying consolidated statements of operations for the three and nine months ended September 30, 2017. Should the Company incur additional hurricane-related costs in the future at any of these four hotels, additional expense will be recognized as they are incurred.

In addition, the Company expects to file a claim under its business interruption insurance policy for business profits lost at the Oceans Edge Hotel & Marina as a result of the damage suffered by Hurricane Irma. Once the claim is settled with the Company’s insurance carriers, the payments, if any, will be recorded in the period or periods in which they are received.

Other

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 September 30, 2017, the Company had $0.5 million of outstanding irrevocable letters of credit to guarantee 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 September 30, 2017.

The Company is subject to various claims, lawsuits and legal proceedings, including routine litigation arising in the ordinary course of business, regarding the operation of its hotels and Company matters. While it is not possible to ascertain the ultimate outcome of such matters, the Company believes that the aggregate amount of such liabilities, if any, in excess of amounts covered by insurance will not have a material adverse impact on its financial condition or results of operations. The outcome of claims, lawsuits and legal proceedings brought against the Company, however, is subject to significant uncertainties.