NOTE 8. FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

Our determination of fair value measurements is based on the assumptions that market participants would use in pricing the asset or liability. At September 30, 2017, the Company’s convertible debt (see Note 7) and certain derivative instruments were the only financial instruments measured in the financial statements at fair value on a recurring basis. Nonrecurring fair value measurements were utilized in the determination of the fair value of acquired properties in 2017 and 2016 (see Notes 3 and 4), in the accounting for the Company’s equity transactions that occurred in March 2016 and 2017 (see Note 10), and in the valuation of the stock-based compensation grants (see Note 12) and impaired hotels during the three and nine months ended September 30, 2017 and 2016.

Derivative Instruments

Currently, the Company uses derivatives, such as interest rate swaps and caps, to manage its interest rate risk. The fair value of interest rate positions is determined using the standard market methodology of netting discounted expected future cash receipts and payments. Variable interest rates used in the calculation of projected receipts and payments on the positions are based on expectations of future interest rates derived from observable market interest rate curves and volatilities. Derivatives expose the Company to credit risk in the event of non-performance by the counterparties under the terms of the agreements. The Company believes it minimizes this credit risk by transacting with major creditworthy financial institutions. These interest rate positions at September 30, 2017 and December 31, 2016 are as follows:

Associated debt

Type

Terms

Effective date

Maturity date

Notional amount at September 30, 2017

Notional amount at December 31, 2016

Credit facility

Cap

Caps 30-day LIBOR at 2.50%

03/2017

03/2019

50,000

Huntington

Swap

Swaps 30-day LIBOR + 2.25% for fixed rate of 4.13% cancellable at Company's option anytime after 11/01/2018 without penalty

11/2015

11/2020

7,361

Latitude

Cap

Caps 30-day LIBOR at 1.0%

03/016

06/2017

11,124

Additionally, prior to the execution of the Exchange Agreement (see Note 10) on March 16, 2016, which extinguished the instrument, the Company was required to bifurcate and include on the consolidated balance sheet at fair value the embedded conversion option in the 6.25% Series C Cumulative Convertible Preferred Stock (“Series C Preferred Stock”) due to the presence of an antidilution provision that required an adjustment in the common stock conversion price should subsequent issuances of the Company’s common stock be issued below the instrument’s original common stock conversion price.

Similarly, at December 31, 2015, prior to the execution of the Exchange Agreement, the terms of the common stock warrants issued to the holders of the Series C Preferred Stock also included an antidilution provision that required a reduction in the warrant’s exercise price should the conversion price of the Series C Preferred Stock be adjusted due to its antidilution provisions. Accordingly, the warrants did not qualify for equity classification, and, as a result, the fair value of the warrants was shown as a derivative liability on the consolidated balance sheet. With the execution of the Exchange Agreement, this provision of these warrants was effectively eliminated and the conversion price was locked permanently. Following this modification of terms, the warrants qualified for equity classification and were reclassified to additional paid-in capital at their fair value of $611 on the date of the modification.

The fair value of these derivative liabilities recognized in connection with the Series C Preferred Stock were determined using the Monte Carlo simulation method. The Monte Carlo simulation method is a generally accepted statistical method used to generate a defined number of stock price paths in order to develop a reasonable estimate of the range of future expected stock prices of the Company and its peer group and minimize standard error and is considered a Level 3 fair value measurement.

Included in the Series E Preferred Stock issued on March 1, 2017 is a redemption right that allows the Company to redeem up to a total of 490,250 shares of Series E Preferred Stock for specific percentages of its liquidation preference (see Note 10). This option requires bifurcation and was determined to be an asset with a fair value on the date of issuance of $150 using a trinomial lattice-based model, considered a Level 3 fair value measurement.

All derivatives recognized by the Company are reported as either derivative assets or liabilities on the consolidated balance sheets and are adjusted to their fair value at each reporting date. All gains and losses on derivative instruments are included in net gain on derivatives and convertible debt and with the exception of realized gains and losses related to the interest rate instruments, which are included in interest expense on the consolidated statements of operations. Net gains of $2 and $71 for the three months ended September 30, 2017 and 2016, respectively, and $139 and $6,529 for the nine months ended September 30, 2017 and 2016, respectively, were recognized related to derivative instruments.

Recurring Fair Value Measurements

The following tables provide the fair value of the Company’s financial assets and (liabilities) carried at fair value and measured on a recurring basis:


	Fair value at
	September 30, 2017		Level 1		Level 2		Level 3
Interest rate derivatives	$	3	$	-	$	3	$	-
Series E Preferred embedded redemption option		337		-		-		337
Convertible debt		(1,038)		-		-		(1,038)
Total	$	(698)	$	-	$	3	$	(701)


	Fair value at
	December 31, 2016		Level 1		Level 2		Level 3
Interest rate derivatives	$	(8)	$	-	$	(8)	$	-
Convertible debt		(1,315)		-		-		(1,315)
Total	$	(1,323)	$	-	$	(8)	$	(1,315)

There were no transfers between levels during the three or nine months ended September 30, 2017 or 2016.

The following tables present a reconciliation of the beginning and ending balances of items measured at fair value on a recurring basis that use significant unobservable inputs (Level 3) and the related gains and losses recorded in the consolidated statements of operations during the periods:


	Three months ended September 30,
	2017						2016
	Series E Preferred embedded redemption option		Convertible debt		Total		Convertible debt
Fair value, beginning of period	$	333	$	(1,050)	$	(717)	$	(1,191)
Net gains (losses) recognized in earnings		4		12		16		(45)
Purchase and issuances		-		-		-		-
Sales and settlements		-		-		-		-
Gross transfers into Level 3		-		-		-		-
Gross transfers out of Level 3		-		-		-		-
Fair value, end of period	$	337	$	(1,038)	$	(701)	$	(1,236)
						-
Total unrealized gains (losses) during the period included in earnings related to instruments held at end of period	$	4	$	12	$	16	$	(45)


	Nine months ended September 30,
		2017						2016
	Series E Preferred embedded redemption option		Convertible debt		Total		Series C Preferred embedded derivative		RES warrant derivative		Convertible debt		Total
Fair value, beginning of period	$	-	$	(1,315)	$	(1,315)	$	(6,271)	$	(2,411)	$	-	$	(8,682)
Net gains (losses) recognized in earnings		187		277		464		4,848		1,800		(224)		6,424
Purchase and issuances		150		-		150		-		-		(1,012)		(1,012)
Sales and settlements		-		-		-		1,423		-		-		1,423
Gross transfers into Level 3		-		-		-		-		-		-		-
Gross transfers out of Level 3		-		-		-		-		611 (1)		-		611
Fair value, end of period	$	337	$	(1,038)	$	(701)	$	-	$	-	$	(1,236)	$	(1,236)

Total unrealized gains (losses) during the period included in earnings related to instruments held at end of period	$	187	$	277	$	464	$	-	$	-	$	(224)	$	(224)

(1)

RES warrants were permanently reclassified to additional paid-in capital as discussed above.

Fair Value of Long-Term Debt

The Company estimates the fair value of its fixed rate debt by discounting the future cash flows of each instrument at estimated market rates or credit spreads consistent with the maturity of debt obligations with similar credit risks. Credit spreads take into consideration general market conditions and maturity. The inputs utilized in estimating the fair value of debt are classified in Level 2 of the fair value hierarchy. Both the carrying value and estimated fair value of the Company’s long-term debt are presented net of deferred financing costs in the table below:


	Carrying value as of				Estimated fair value as of
	September 30, 2017		December 31, 2016		September 30, 2017		December 31, 2016
Held for use	$	118,387	$	47,918	$	118,441	$	48,034
Held for sale		7,289		14,802		7,289		15,186
Total	$	125,676	$	62,720	$	125,730	$	63,220

Impaired Hotel Properties

In the performance of impairment analysis for both held for sale and held for use properties, fair value is determined with the assistance of independent real estate brokers and through the use of operating results and revenue multiples based on the Company’s experience with hotel sales as well as available industry information. For held for sale properties, estimated selling costs are based on our experience with similar asset sales. These are considered Level 3 measurements. The amount of impairment and recovery of previously recorded impairment recognized in the three and nine months ended September 30, 2017 and 2016 is shown in the tables below:


	Three months ended September 30,
	2017			2016
	Number of hotels		Impairment (loss) recovery	Number of hotels		Impairment (loss) recovery
Continuing Operations:
Held for sale hotels:
Impairment loss	2	$	(895)	-	$	-
Sold hotels:
Impairment loss	-		-	3		(343)
Impairment recovery	2		47	-		-
Total net impairment loss:	4	$	(848)	3	$	(343)


	Nine months ended September 30,
	2017			2016
	Number of hotels		Impairment (loss) recovery	Number of hotels		Impairment (loss) recovery
Continuing Operations:
Held for sale hotels:
Impairment loss	2	$	(895)	-	$	-
Sold hotels:
Impairment loss	2		(783)	3		(1,257)
Impairment recovery	2		80	-		-
Total net impairment loss:	6	$	(1,598)	3	$	(1,257)