5. Fair Value Measurements and Interest Rate Derivatives

Fair Value Measurements

As of December 31, 2017 and 2016, 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 Measurements and Disclosures 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.

As of December 31, 2017 and 2016, the only financial instruments that the Company measures at fair value on recurring bases 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.

In the aftermath of Hurricane Harvey, combined with continued operational declines due to weakness in the Houston market, and in accordance with the Property, Plant and Equipment Topic of the FASB ASC, the Company identified indicators of impairment and reviewed both of its Houston hotels for possible impairment. Using Level 3 measurements, including each hotel’s undiscounted cash flow, which took into account each hotel’s expected cash flow from operations, anticipated holding period and estimated proceeds from disposition, the Company determined that neither hotel’s carrying value was fully recoverable. As such, during 2017, the Company recorded a total impairment charge of $40.1 million, including $31.0 million for the Hilton North Houston and $9.1 million for the Marriott Houston, which is included in impairment loss on the Company’s consolidated statements of operations for the year ended December 31, 2017.

The following table presents the Company’s assets measured at fair value on a recurring and nonrecurring basis at December 31, 2017 and 2016 (in thousands):


			Fair Value Measurements at Reporting Date
	Total		Level 1		Level 2		Level 3
December 31, 2017:
Houston hotels, net (1)	$	34,473	$	—	$	—	$	34,473
Interest rate cap derivatives		4		—		4		—
Interest rate swap derivatives		3,390		—		3,390		—
Life insurance policy (2)		645		—		645		—
Total assets measured at fair value at December 31, 2017	$	38,512	$	—	$	4,039	$	34,473

December 31, 2016:
Interest rate cap derivative	$	—	$	—	$	—	$	—
Interest rate swap derivatives		1,749		—		1,749		—
Life insurance policy (2)		861		—		861		—
Total assets measured at fair value at December 31, 2016	$	2,610	$	—	$	2,610	$	—

(1)

Includes the total fair market value of the Houston hotels, net of accumulated depreciation. The hotels are included in investment in hotel properties, net on the accompanying consolidated balance sheets.

(2)

Includes the split life insurance policy for a former Company associate. 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 basis at December 31, 2017 and 2016 (in thousands):


			Fair Value Measurements at Reporting Date
	Total		Level 1		Level 2		Level 3
December 31, 2017:
Retirement benefit agreement (1)	$	645	$	—	$	645	$	—
Total liabilities measured at fair value at December 31, 2017	$	645	$	—	$	645	$	—

December 31, 2016:
Retirement benefit agreement (1)	$	861	$	—	$	861	$	—
Total liabilities measured at fair value at December 31, 2016	$	861	$	—	$	861	$	—

(1)

Includes the retirement benefit agreement for a former Company associate. The agreement calls for the balance of the retirement benefit agreement 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 $1.4 million through December 31, 2017, 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 in the accompanying consolidated balance sheets.

Interest Rate Derivatives

The Company’s interest rate derivatives consisted of the following at December 31, 2017 and 2016 (in thousands):


									Estimated Fair Value Asset
		Strike / Capped			Effective	Maturity	Notional		December 31,
Hedged Debt	Type	Rate		Index	Date	Date	Amount		2017		2016
Hilton San Diego Bayfront (1)	Cap	4.250	%	1-Month LIBOR	April 15, 2015	May 1, 2017	$	N/A	$	N/A	$	—
Hilton San Diego Bayfront (1)	Cap	4.250	%	1-Month LIBOR	May 1, 2017	May 1, 2019	$	109,681		—		N/A
Hilton San Diego Bayfront (1)	Cap	6.000	%	1-Month LIBOR	November 10, 2017	December 9, 2020	$	220,000		4		N/A
$85.0 million term loan (2)	Swap	3.391	%	1-Month LIBOR	October 29, 2015	September 2, 2022	$	85,000		2,010		1,336
$100.0 million term loan (3)	Swap	3.653	%	1-Month LIBOR	January 29, 2016	January 31, 2023	$	100,000		1,380		413
									$	3,394	$	1,749

(1)

In March 2017, the Company purchased a new interest rate cap agreement for $19,000 related to the existing loan secured by the Hilton San Diego Bayfront. The new agreement, whose terms were substantially the same as the terms under the expiring cap agreement, effectively replaced the expiring agreement on May 1, 2017. In November 2017, the Company refinanced the existing loan secured by the Hilton San Diego Bayfront (see Note 7). Coterminous with the loan refinance, the Company purchased a new interest rate cap agreement for $0.1 million, with a strike rate of 6.0% and an expiration date in December 2020. The fair values of the Hilton San Diego Bayfront cap agreements are included in other assets, net on the accompanying consolidated balance sheets as of both December 31, 2017 and 2016.

(2)

The fair value of the $85.0 million term loan swap agreement is included in other assets, net on the accompanying consolidated balance sheets as of both December 31, 2017 and 2016. The 1-month LIBOR rate was swapped to a fixed rate of 1.591%.

(3)

The fair value of the $100.0 million term loan swap agreement is included in other assets, net on the accompanying consolidated balance sheets as of both December 31, 2017 and 2016. The 1-month LIBOR rate was swapped to a fixed rate of 1.853%.

Noncash changes in the fair values of the Company’s interest rate derivatives resulted in decreases to interest expense for the years ended December 31, 2017, 2016 and 2015 as follows (in thousands):


	2017		2016		2015
Noncash interest on derivatives	$	(1,520)	$	(1,426)	$	(309)

Fair Value of Debt

As of December 31, 2017 and 2016, 77.8% and 76.2%, respectively, of the Company’s outstanding debt had fixed interest rates, including the effects of interest rate swap agreements. The Company uses Level 3 measurements to estimate the fair value of its debt by discounting the future cash flows of each instrument at estimated market rates. The Company’s principal balances and fair market values of its consolidated debt as of December 31, 2017 and 2016 were as follows (in thousands):


	December 31, 2017				December 31, 2016
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Debt	$	990,402	$	997,922	$	935,944	$	930,665