Risk Management and Use of Derivative Financial Instruments

9 Months Ended

Sep. 30, 2013

Risk Management and Use of Derivative Financial Instruments

Risk Management and Use of Derivative Financial Instruments

Note 7. Risk Management and Use of Derivative Financial Instruments

Portfolio Concentration Risk

At September 30, 2013, we were exposed to concentrations within the brands under which we operate our hotels and within the geographic areas in which we have invested to date. We operate in the domestic U.S. market only. For the nine months ended September 30, 2013, 69.5% of our revenue was generated from seven hotels located in California, Tennessee and Louisiana. At September 30, 2013, 79.3% of our Net investments in hotels was comprised ofsevenhotels located in California, New York, Tennessee and North Carolina.

Risk Management

In the normal course of our ongoing business operations, we encounter economic risk. There are two main components of economic risk that impact us: interest rate risk and market risk. We are primarily subject to interest rate risk on our interest-bearing assets and liabilities. Market risk includes changes in the value of our properties and related loans.

Use of Derivative Financial Instruments

When we use derivative instruments, it is generally to reduce our exposure to fluctuations in interest rates. We have not entered, and do not plan to enter into, financial instruments for trading or speculative purposes. In addition to derivative instruments that we entered into on our own behalf, we may also be a party to derivative instruments that are embedded in other contracts, which are considered to be derivative instruments. The primary risks related to our use of derivative instruments include default by a counterparty to a hedging arrangement on its obligation and a downgrade in the credit quality of a counterparty to such an extent that our ability to sell or assign our side of the hedging transaction is impaired. While we seek to mitigate these risks by entering into hedging arrangements with counterparties that are large financial institutions that we deem to be creditworthy, it is possible that our hedging transactions, which are intended to limit losses, could adversely affect our earnings. Furthermore, if we terminate a hedging arrangement, we may be obligated to pay certain costs, such as transaction or breakage fees. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities.

We measure derivative instruments at fair value and record them as assets or liabilities, depending on our rights or obligations under the applicable derivative contract. Derivatives that are not designated as hedges must be adjusted to fair value through earnings. For a derivative designated and that qualified as a cash flow hedge, the effective portion of the change in fair value of the derivative is recognized in Other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of the derivative's change in fair value is immediately recognized in earnings.

The following table sets forth certain information regarding our derivative instruments on our Consolidated Hotels (in thousands):

Derivatives Designated		Asset Derivatives Fair Value at				Liability Derivatives Fair Value at
as Hedging Instruments	Balance Sheet Location	September 30, 2013		December 31, 2012		September 30, 2013		December 31, 2012
Interest rate swaps	Other assets	$	505		-	$	-	$	-
Interest rate swaps	Accounts payable, accrued expenses and other liabilities		-		-		(710)		(410)
		$	505	$	-	$	(710)	$	(410)

All derivative transactions with an individual counterparty are governed by a master International Swap and Derivatives Association agreement, which can be considered as a master netting arrangement; however, we report all our derivative instruments on a gross basis on the balance sheet. At bothSeptember 30, 2013 and December 31, 2012, no cash collateral has been posted nor received for any of our derivative positions.

During the three and nine months ended September 30, 2013,we recognized losses of $1.9million and $1.0 million, respectively, in Other comprehensive income on derivatives in connection with our interest rate swaps. During both the three and nine months ended September 30, 2012,we recognized a loss of less than $0.1 million in Other comprehensive income on derivatives in connection with our interest rate swap.

During the three and nine months ended September 30, 2013, we reclassified losses of $0.3million and $0.5million, respectively, from Other comprehensive income on derivatives into interest expense in connection with our interest rate swaps. During both the three and nine months ended September 30, 2012, we reclassified losses of less than $0.1 million from Other comprehensive income on derivatives into interest expense in connection with our interest rate swaps. Additionally, during the nine months ended September 30, 2012, we recognized unrealized losses of $0.1 million related to an interest rate swap prior to its designation as a hedge.

Interest Rate Swaps and Caps

We are exposed to the impact of interest rate changes primarily through our borrowing activities. To limit this exposure, we attempt to obtain mortgage financing on a long-term, fixed-rate basis. However, from time to time, we or our investment partners may obtain variable-rate non-recourse mortgage loans and, as a result, may enter into interest rate swap agreements or interest rate cap agreements with counterparties. Interest rate swaps, which effectively convert the variable-rate debt service obligations of the loan to a fixed rate, are agreements in which one party exchanges a stream of interest payments for a counterparty's stream of cash flow over a specific period. The notional, or face, amount on which the swaps are based is not exchanged. An interest rate cap limits the effective borrowing rate of variable-rate debt obligations while allowing participants to share in downward shifts in interest rates. Our objective in using these derivatives is to limit our exposure to interest rate movements.

The interest rate swaps that we had outstanding on our Consolidated Hotel investmentsat September 30, 2013were designated as cash flow hedges and are summarized as follows (dollars in thousands):

		Notional		Effective	Effective	Expiration	Fair Value at
Instrument	Type	Amount		Interest Rate	Date	Date	September 30, 2013
1-Month LIBOR	“Rollercoaster” swap	$	9,750	5.0%	5/2012	5/2015	$	(104)
1-Month LIBOR	“Pay-fixed” swap		51,500	4.6%	12/2012	12/2017		505
1-Month LIBOR	“Pay-fixed” swap		19,350	4.1%	3/2013	3/2017		(9)
1-Month LIBOR	“Pay-fixed” swap		44,000	4.1%	7/2013	7/2018		(597)
							$	(205)

Amounts reported in Other comprehensive income related to interest rate swaps will be reclassified to interest expense as interest payments are made on our variable-rate debt. At September 30, 2013, we estimated that an additional $1.1 million, inclusive of amounts attributable to noncontrolling interests of $0.5 million, will be reclassified as interest expense during the next 12 months related to our interest rate swaps.

Some of the agreements we have with our derivative counterparties contain certain credit contingent provisions that could result in a declaration of default against us regarding our derivative obligations if we either default or are capable of being declared in default on certain of our indebtedness. At September 30, 2013, we had not been declared in default on any of our derivative obligations. The estimated fair value of our derivatives that were in a net liability position was $0.8 million and $0.4 million at September 30, 2013 and December 31, 2012, respectively, which included accrued interest and any adjustment for nonperformance risk. If we had breached any ofthese provisions at eitherSeptember 30, 2013or December 31, 2012, we could have been required to settle our obligations under these agreements at theiraggregate termination value of $0.8 million and $0.5 million, respectively.

The derivative instruments that our Unconsolidated Hotel investments had outstanding at September 30, 2013 are summarized as follows (in thousands):

	Ownership
	Interest at		Notional			Effective	Expiration	Fair Value at
Description	September 30, 2013	Type	Amount		Cap Rate	Date	Date	September 30, 2013
1-Month LIBOR	57.0%	Interest rate cap		35,000	1.0%	10/2012	10/2015	$	47
1-Month LIBOR	80.4%	“Pay-fixed” swap		33,000	N/A	8/2013	8/2018		(596)
								$	(549)