DiamondRock Hospitality Company
Annual Report 2005

Plain-text annual report

2 0 0 5 A N N U A L R E P O R T DiamondRock Hospitality is a lodging dedicated real estate investment trust that invests in premium hotels. The Company enjoys a unique sourcing relationship with Marriott International. t h e d i am o n d r o c k h o s p i ta l i t y p o r t f o l i o b u s i n e s s h o t e l s marriott atlanta alpharetta, georgia bethesda marriott suites, maryland los angeles airport marriott, california r e s o r t s a n d c o n f e r e n c e c e n t e r s torrance marriott, california frenchman’s reef & morning star marriott beach resort, united states virgin islands marriott griffin gate resort, kentucky DiamondRock has a portfolio of high quality assets with excellent geographic diversity.The hotels are predominately located in markets with high barriers to entry such as New York City and Los Angeles.The portfolio falls into three categories: Business Hotels; Resorts and Conference Centers; and Urban Select Service.We believe that a well diversified portfolio will produce superior risk adjusted returns. Many attractive acquisition opportunities are available to us through our exclusive “first look” with Marriott International and the extensive network of industry relation- ships of our management team, which has sourced half of our hotels. orlando airport marriott, florida renaissance worthington, texas salt lake city marriott downtown, utah the lodge at sonoma, a renaissance resort and spa, california oak brook hills marriott resort, illinois vail marriott mountain resort & spa, colorado u r b a n s e l e c t s e rv i c e courtyard by marriott manhattan/fifth avenue, new york courtyard by marriott manhattan/midtown east, new york springhill suites atlanta buckhead, georgia William W. McCarten [right] Chairman & Chief Executive Officer John L.Williams [left] President & Chief Operating Officer ........................... [LEFT] The Vail Marriott Mountain Resort & Spa was acquired in an off-market transaction.This resort is adjacent to one of the top ski experiences in the United States. To our shareholders: S H A R E H O L D E R L E T T E R ........................... We have accomplished much since forming DiamondRock Hospitality Company less than two years ago.We have successfully completed two capital raises, including our May 2005 initial public offering, and have assembled a portfolio of fifteen high quality hotels with an aggregate investment of over $900 million. Benefiting from a terrific market for lodging and real estate, we are pleased to report that we accomplished all of our major strategic objectives in 2005: ◆ Successfully completed our initial public offering ◆ Prudently acquired high quality hotels —more than doubling our asset base ◆ Implemented value-added strategies through aggressive asset management ◆ Delivered strong growth in hotel operations ◆ Created an efficient capital structure and strong balance sheet By accomplishing these objectives, DiamondRock is poised to continue to generate strong shareholder returns. INITIAL PUBLIC OFFERING: A SUCCESS In May 2005, DiamondRock completed our oversubscribed initial public offering, selling almost 30 million shares at $10.50 per share resulting in net proceeds of $288.4 million.The total 2005 annualized return to those investors is approximately 30%.This return includes dividends declared in 2005, which represents a very competitive annualized yield of 5.8% based on the year-end stock price. DISCIPLINED ACQUIRER OF HOTELS: DOUBLING THE COMPANY Over the past year DiamondRock has been an active acquirer of premium hotels.We believe that it is an excellent time to acquire hotels because the lodg- ing cycle has several years of strong growth ahead.We successfully targeted upper upscale hotels in high barrier-to- entry markets.This execution was made possible by DiamondRock’s unique sourcing advantages and management’s industry experience. DiamondRock enjoys an exclusive sourcing arrange- ment with one of the leading lodging companies in the world, Marriott International. Marriott provides us a “first look” at certain acquisition oppor- tunities.This arrangement facilitated the acquisition of half of the hotels in our portfolio. DiamondRock also has the advantage of a very experienced man- agement team with some of the best relationships in the hospitality industry. Utilizing a disciplined, but comprehen- sive acquisition strategy, DiamondRock was able to acquire nine high quality hotels in 2005 for a total projected investment in excess of $600 million. Our portfolio is located in prime mar- kets such as New York, Los Angeles, Chicago and Vail.The overall quality and potential of these hotels have exceeded our original expectations. AGGRESSIVE ASSET MANAGEMENT: VALUE-ADD STRATEGIES Many of our hotels present opportunities to increase profits through aggressive asset management—including the imple- mentation of value-add strategies such as brand conversion, capital improvement plans or market repositioning. For example, early in 2005 we converted an independently branded hotel in Midtown Manhattan to a Marriott brand, which contributed to a 31% increase in revenues. Moreover, the profits at this hotel more than doubled from 2004. Thoughtful capital investment in our hotels provides the Company with another outstanding opportunity to increase returns. Among our portfolio of fifteen hotels, management has iden- tified approximately $84 million of opportunities to profitably invest capital. These opportunities range from rooms renovations (Courtyard Manhattan/ Midtown East, Los Angeles Airport Marriott, Bethesda Marriott Suites) to a total renovation and repositioning of the hotel (Torrance Marriott and the Oak Brook Hills Marriott Resort). Each capital project is carefully considered and executed to minimize disruption and maximize long-term returns. D IAMONDR OCK HOSPITALITY 20 05 ANNUAL REPORT 3 Our efficient, conservative capital structure and strong balance sheet have positioned DiamondRock for future growth. ........................... [LEFT] The Lodge at Sonoma Renaissance Resort & Spa was acquired from Marriott International at a substantial discount to original construction cost.The hotel experienced impressive RevPAR growth of 17.7% during 2005. [BELOW] The interior of the Vail Marriott Mountain Resort & Spa provides a warm and luxurious guest experience. STRONG OPERATING RESULTS: THE PROOF The culmination of our efforts and confirmation of our business strategy is best evidenced in the operating results of the portfolio. For the full-year, the port- folio of hotels generated above-market growth—including growth in the key lodging metric of revenue per available room or RevPAR. While industry RevPAR increased 8% 1, DiamondRock’s portfolio of hotels enjoyed double digit RevPAR growth in 2005.These dynamic operating results are attributable to the high quality of our hotels, strong industry fundamentals and the realization of our value-added strategies. EFFICIENT CAPITAL STRUCTURE: READY FOR GROWTH DiamondRock has a strong balance sheet and an efficient capital structure. As of the end of 2005, the Company’s debt-to-enterprise value ratio was only 41%. DiamondRock’s debt structure has benefited from today’s historically low interest rates. More than 90% of the Company’s debt is fixed rate and has a weighted average interest rate of only 5.6% and a weighted average maturity of more than 8 years. Our efficient capital structure positions us for growth and allows us to pay a meaningful and well-covered dividend. OUTLOOK: A BRIGHT 2006 We expect a strong 2006. Lodging industry fundamentals remain excellent: supply appears to be contained by high construction costs and alternative uses (i.e. condominium conversions); and demand is growing with increased business travel and pricing power has returned — allowing hotels to push rates in all segments. On the acquisition front, the market to acquire quality hotels remains very competitive.Through our unique advan- tages such as the “first look” arrangement with Marriott International and manage- ment’s longstanding contacts in the industry, we remain confident that we will uncover attractive acquisitions that meet our underwriting criteria. On March 7, 2006, we announced an agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile for $306 million. Situated on one of the very best locations in Chicago, this outstanding property will provide DiamondRock with a great convention hotel in one of the top convention markets in the country. Overall, we believe that general market conditions for lodging will remain robust and that our portfolio will continue to generate outsized returns because of its high quality, often irreplaceable locations, premium brand- ing and our value-add asset management strategies. William W. McCarten Chairman & Chief Executive Officer John L.Williams President & Chief Operating Officer 1 Based on Smith Travel Report for hotels in the United States. D IAMONDR OCK HOSPITALITY 20 05 ANNUAL REPORT 5 We aggressively manage our hotels by employing value- added strategies designed to increase the operating results and the net asset value of our hotels. The Courtyard Manhattan / Fifth Avenue enjoyed record performance driven by our decision to convert the hotel from an inde- pendent brand to a premium national brand. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ⌧⌧ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 OR "" TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 001-32514 DIAMONDROCK HOSPITALITY COMPANY (Exact Name of Registrant as Specified in Its Charter) Maryland (State or Other Jurisdiction of Incorporation or Organization) 20-1180098 (I.R.S. Employer Identification Number) 6903 Rockledge Drive, Suite 800 Bethesda, Maryland (Address of Principal Executive Offices) 20817 (Zip Code) Registrant’s telephone number, including area code: (240) 744-1150 Title of Each Class Common Stock, $.01 par value Name of Exchange On Which Registered New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes " No ⌧ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes " No ⌧ Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No " Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ⌧ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer " Accelerated filer " Non-accelerated filer ⌧ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes " No ⌧ As of March 6, 2006 there were 50,819,864 shares of common stock outstanding. Proxy Statement for the registrant’s 2006 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2005, is incorporated by reference in Part III herein. Documents Incorporated by Reference DIAMONDROCK HOSPITALITY COMPANY INDEX PART I Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1B. Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 2. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 3. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 4. PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Item 6. Item 7. Purchases of Equity Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 7a. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Item 9. Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PART III Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 11. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Item 13. Item 14. Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal Accounting Fees and Services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 15. Exhibits and Financial Statement Schedules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 PART IV Page 3 12 28 29 43 43 44 45 48 66 66 67 67 67 67 67 67 67 67 68 2 SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believes,” “project,” “expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the Item 1A “Risk Factors” of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Item 1. Business Overview PART I We are a self-advised real estate company. We are committed to maximizing shareholder value through investing in premium full-service hotels and, to a lesser extent, premium urban select-service hotels. We will own sixteen hotels comprising 7,311 rooms upon completion of our recently announced hotel acquisition in downtown Chicago. These hotels have an aggregate projected investment of approximately $1.3 billion and are geographically diversified across major markets in the United States. We differentiate ourselves through our: • Proven acquisition capability; • Aggressive asset management; • Conservative capital structure; and • Experienced senior management team. Proven Acquisition Capability Since we completed our first acquisition in October 2004, we have acquired, or have under contract to acquire, sixteen premium hotels. We have acquired eleven of these hotels in off-market transactions, meaning that they were not made generally available to other companies. We intend to make additional acquisitions that meet our stringent underwriting criteria. Consistent with this strategy, on March 1, 2006, we signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile at a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments. We believe that the current environment presents an excellent opportunity to acquire hotels based on our view that lodging industry fundamentals are currently strong and will remain strong for some time to come. Generally, we invest in hotels that we believe are priced below replacement costs and are located in markets with attractive growth prospects and high barriers to entry. We are focused on acquiring premium full-service hotels located throughout North America and, to a lesser extent, premium select-service hotels in urban locations. 3 We believe we have a competitive advantage in acquiring hotels through our unique investment sourcing relationship with Marriott, a leading worldwide hotel brand, franchise and management company. Our investment sourcing relationship with Marriott provides us, subject to certain limitations, with a “first look” at hotel acquisition and investment opportunities known to Marriott. As a result of Marriott’s extensive network, relationships and knowledge, we have preferred access to a unique source of hotel investment opportunities, many of which may not be available to other hospitality companies. Since our formation in May 2004, Marriott has provided us with access to several billion dollars of off-market acquisition opportunities. Our relationship with Marriott has facilitated the acquisition of eight of our hotels, including the Marriott Griffin Gate Resort and The Lodge at Sonoma, a Renaissance Resort & Spa, both of which we acquired directly from Marriott. Aggressive Asset Management We believe that we are able to create significant value in our portfolio by utilizing our management’s extensive experience and our innovative asset management strategies. Our senior management team has established a broad network of hotel industry contacts and relationships, including relationships with hotel owners, financiers, operators, project managers and contractors and other key industry participants. In particular, we believe that we are unique in having a senior management team, most of whom worked for many years at Marriott, with very deep knowledge of Marriott’s organization and processes, which gives us insight in how best to work with Marriott to deliver superior returns at our hotels. Our philosophy is to negotiate management agreements that give us the right to exert significant influence (but not day-to-day control) over the management of our properties, annual budgets and all capital expenditures, and then to use those rights to continually monitor and improve the performance of our properties. We cooperatively partner with the managers of our hotels in an attempt to increase operating results and long-term asset values at our hotels. In addition to working directly with the personnel at our hotels, our senior management team also has long-standing professional relationships with our hotel managers’ senior executives and we work directly with these senior executives to improve the performance of our portfolio. We believe we can create significant value in our portfolio through innovative asset management strategies such as rebranding, renovating or repositioning. We are committed to regularly evaluating our portfolio to determine if we can employ these value-added strategies at our hotels. We have rebranded two of our properties, including one in which we converted an independently branded hotel to a Marriott brand, which contributed to a 31% increase in revenues and significantly increased operating margins at the hotel in 2005 compared to pro forma 2004. We also have budgeted to spend approximately $84 million in 2006 on identified value-added capital investment opportunities at our existing hotels. The opportunities range from room renovation (Courtyard Manhattan/Midtown East, Los Angeles Airport Marriott, Bethesda Marriott Suites) to a total renovation and repositioning of the hotel (Torrance Marriott and the Oak Brook Hills Marriott Resort). In connection with our planned renovations and repositionings, our senior management team and our asset managers are individually committed to completing these renovations on time, on budget and with a minimal disruption at our hotels. We are optimistic that, when completed, these renovations will enable us to achieve higher rates and greater demand for our hotels. Conservative Capital Structure We are committed to maintaining a conservative capital structure with prudent aggregate leverage primarily comprised of long-term fixed-rate debt. However, we maintain the flexibility to modify these strategies if we believe fundamental changes have occurred in the capital markets. 4 As of December 31, 2005, more than 90% of our debt carried fixed interest rates, with a weighted- average interest rate of 5.6%, and a weighted-average maturity date in excess of 8 years. As of December 31, 2005, we had $428.4 million of debt outstanding, representing a debt-to-enterprise value ratio of 41%, which is calculated as our market capitalization plus net debt. We currently have a target debt-to-enterprise value ratio of 45% to 55%. We prefer a relatively simple but efficient capital structure. We have not invested in joint ventures and have not issued any operating partnership units or preferred stock. We endeavor to structure our hotel acquisitions so that they will not overly complicate our capital structure; however, we will consider a more complex transaction if we believe that the projected returns to our stockholders will significantly exceed the returns that would otherwise be available. Experienced Management Team The extensive hotel industry experience of our senior management team enables us to effectively implement our business strategies. Our senior management team of William W. McCarten, John L. Williams, Mark W. Brugger, Michael D. Schecter and Sean M. Mahoney has extensive experience in lodging, real estate and related service industries, including hotel asset management, acquisitions, mergers, dispositions, development, redevelopment and financing. Collectively, they have been involved in hotel transactions aggregating several billion dollars. In particular, our senior executive officers have the following experience: • Mr. McCarten had over twenty-five years’ experience with the Marriott organization. Over the course of his career with Marriott and its related entities, he served in a variety of positions, including Chief Executive Officer of HMSHost Corporation (formerly Host Marriott Services Corporation) and Executive Vice President and Operating Group President of Host Marriott Corporation, each a publicly traded company. Mr. McCarten oversaw the spin-off of HMSHost Corporation through its merger with Autogrill S.P.A. Mr. McCarten serves as our Chairman and Chief Executive Officer. • Mr. Williams has over twenty-five years’ experience with Marriott and recently served as Executive Vice President of North American Hotel Development for Marriott, where he had primary responsibility for the acquisition and development of full-service hotel projects involving Marriott Hotels & Resorts, Renaissance Hotels & Resorts and The Ritz-Carlton. He has extensive experience in acquiring, repositioning, developing and redeveloping hotels. Mr. Williams serves as our President and Chief Operating Officer. • Mr. Brugger has over a decade of experience in real estate and finance. He recently served as a Vice President -Project Finance with Marriott as well as Chief Executive Officer of a non-lodging Marriott subsidiary with over $300 million in annual revenues. His experience includes structured finance transactions totaling in excess of $2 billion as well as the acquisition, disposition and financing of investment properties. Mr. Brugger serves as our Executive Vice President, Chief Financial Officer and Treasurer. • Mr. Schecter has over fifteen years’ experience practicing law, including six years with Marriott. He has led and successfully completed a wide array of transactions in the hotel industry, including mergers and acquisitions, dispositions, joint ventures, and financings. Mr. Schecter serves as our General Counsel and Secretary. • Mr. Mahoney has twelve years’ experience as a certified public accountant. He most recently served as a senior manager with Ernst & Young LLP. He has extensive experience with clients in the real estate and hotel industries. Mr. Mahoney serves as our Chief Accounting Officer and Corporate Controller. 5 Our Company We commenced operations in July of 2004 when we completed a private placement of 21,000,000 shares of our common stock resulting in net proceeds of $196.3 million. We completed our initial public offering on June 1, 2005, issuing an additional 29,785,764 shares of common stock (including the underwriters’ purchase of the over-allotment option for 3,698,764 shares) at a price of $10.50 per share, resulting in net proceeds of approximately $288.4 million. As of December 31, 2005, we owned fifteen hotels, comprising 6,119 rooms, located in the following markets: Atlanta, Georgia (2); Fort Worth, Texas; Lexington, Kentucky; Los Angeles, California (2 hotels); New York, New York (2 hotels); Northern California; Oak Brook, Illinois; Orlando, Florida; Salt Lake City, Utah; Washington D.C.; St. Thomas, U.S. Virgin Islands; and Vail, Colorado. Recent Developments Chicago Marriott. On March 1, 2006, we signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile for a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments (or approximately $257,000 per room), including the assumption of $220 million of floating-rate debt. We made a $5 million non-refundable deposit upon entering into the purchase agreement. The acquisition is scheduled to close on March 15, 2006; however, we have the right to delay the closing for 30 days upon making an additional $5 million non-refundable deposit. We intend to refinance the existing floating-rate loan with a fixed-rate loan issued by Wachovia Bank, National Association. The principal amount of the refinanced loan will be determined based on market conditions at the time of the refinancing and is expected to be between $170 million and $220 million. The new loan will be a limited recourse loan secured by a mortgage on the property. We will finance the remainder of the purchase price through a portion of the net proceeds from an equity offering. We expect to borrow up to $100 million through a short-term floating-rate loan arranged by Wachovia Bank, National Association, which we will repay with a portion of the net proceeds of the equity offering. We believe this hotel has an excellent location on North Michigan Avenue in Chicago’s famed shopping and entertainment district, the Magnificent Mile. The hotel is predominantly marketed to groups and individual business travelers who are seeking a premium full-service hotel located in the heart of this well-known district. According to the sellers’ records, last year, over half of the rooms sold at the hotel were sold to corporate and association groups and roughly a quarter were sold to individual corporate travelers. The hotel has 60,000 square feet of flexible meeting space. We believe that supply and demand dynamics are very favorable in Chicago. For example, the number of hotel rooms added to downtown Chicago over the past five years has been very limited, averaging just over 1% per year. In addition, Chicago is a compelling location for conventions and other city-wide events and over the next few years should benefit from the displacement of conventions caused by Hurricane Katrina. We also believe that this hotel is an irreplaceable asset as the land acquisition and construction cost of building a new large hotel in downtown Chicago would be prohibitive. We cannot assure you that we will acquire the Chicago Marriott because the completion of the proposed acquisition is subject to a variety of conditions. Refinancing of Courtyard Manhattan/Fifth Avenue. We have a commitment from Lehman Brothers Bank to refinance the mortgage loan on the Courtyard Manhattan/Fifth Avenue that will mature in January 2007. Pursuant to this commitment, we expect to refinance the $23 million existing floating-rate loan with a $51 million fixed-rate loan that matures in 10 years. At the closing of the refinancing, the interest rate on the loan will be set based on the then current 10-year swap rate plus 90 basis points. We expect that the new fixed-rate loan will require principal repayments based on a 30-year amortization 6 schedule following the first five years of payments of interest only. We expect to close on this refinancing early in the second quarter of 2006. Increased dividend. On February 28, 2006, our board of directors declared an increase in the quarterly dividend for the first quarter of 2006. On April 11, 2006, a cash dividend of $0.18 per share will be paid to stockholders of record as of March 24, 2006. Our Relationship with Marriott Investment Sourcing Relationship We have an investment sourcing relationship with Marriott, a leading worldwide hotel brand, franchise and management company. Marriott has agreed to provide us, subject to certain limitations, with a “first look” at hotel acquisition and investment opportunities known to Marriott. We believe that our ability to implement our business strategies is greatly enhanced by the continuing source of additional acquisition opportunities generated by this relationship, as many of the properties Marriott brings to our attention are offered to us through “off-market” transactions, meaning that they are not made generally available to other real estate investment companies. However, we have not entered into a binding agreement or commitment setting forth all of the terms of this investment sourcing relationship. As a result, our investment sourcing relationship may be modified or terminated at any time by either party. Since our formation in 2004, Marriott has provided us with access to several billion dollars of off- market acquisition opportunities and our sourcing relationship has facilitated the acquisition of eight of our hotels, including the Marriott Griffin Gate Resort and The Lodge at Sonoma, a Renaissance Resort & Spa, each of which we acquired directly from Marriott. Our senior management team regularly meets with senior representatives of Marriott to explore how to further our investment sourcing relationship in order to maximize the value of the relationship to both parties. To date, both companies have worked proactively to convert appropriate opportunities into hotel investments made by us and managed by Marriott. Except where contractually or ethically prohibited, or where Marriott believes it would be damaging to existing Marriott relationships, Marriott provides us a “first look” at potential hotel investment opportunities known to Marriott that are consistent with our stated business strategy. These hotel investment opportunities are those situations where Marriott believes that it may have a significant influence on a potential sale. We believe we are Marriott’s preferred purchaser of full-service as well as urban select-service and urban extended-stay hotels in the United States, Canada and Mexico. Whether the “first look” opportunity develops further will depend upon the circumstances of each investment. In order to continue to develop this relationship, except where contractually or ethically prohibited, we intend to provide Marriott with a “first look” at all hotel management opportunities that become known to us. Neither we nor Marriott have entered into a binding agreement or commitment setting forth all of the terms of this relationship. Our investment sourcing relationship may be modified or terminated at any time by either party. We retain the right to utilize any property brand and any hotel management company. We believe that should we pursue any such opportunity, it will not affect our investment sourcing relationship with Marriott, so long as such an opportunity does not interfere with Marriott’s objectives for our investment sourcing relationship. On the other hand, Marriott has numerous longstanding relationships with other potential property owners and we understand that Marriott may work with other owners on any potential transaction. Marriott’s only binding commitment with regard to this investment sourcing relationship is that until June 30, 2006, it will not enter into any written agreement or series of written agreements granting any third party the right to receive information from Marriott concerning opportunities to purchase full- service, urban select-service or urban extended-stay hotels in the United States, or in any region thereof, 7 prior to such opportunities being presented to us. Our only binding commitment with regard to this relationship is that until June 30, 2006, we will not enter into a written agreement or series of written agreements granting any third party the right to receive information from us concerning potential opportunities to provide hotel management services for full-service, urban select-service or urban extended-stay hotels in the United States, or in any region thereof, prior to such opportunity being presented to Marriott. However, for any particular hotel, we are under no obligation to use Marriott as our hotel management company and we may invest in hotels that do not operate under one of Marriott’s brands. We intend to permit this written agreement to expire on June 30, 2006, however, we intend to continue and to expand, the very successful unwritten investment sourcing relationship with Marriott and we believe that our relationship is solid and continues to achieve the objectives of both parties. Key Money and Yield Support Marriott has contributed to us certain amounts in exchange for the right to manage hotels we have acquired. We refer to these amounts as “Key Money.” Marriott has provided us with Key Money of approximately $10.5 million in the aggregate in connection with our acquisitions of the Courtyard Manhattan/Midtown East ($2.5 million), the Courtyard Manhattan/Fifth Avenue ($1 million), the Torrance Marriott ($3 million), the Oak Brook Hills Marriott Resort ($2.5 million), the SpringHill Suites Atlanta Buckhead ($0.5 million) and the Orlando Airport Marriott ($1 million). The $3.5 million in Key Money payments received from Marriott in connection with our acquisitions of the Courtyard Manhattan/Fifth Avenue and Courtyard Manhattan/Midtown East are not recoverable by Marriott. The $7 million in Key Money contributed by Marriott in connection with our acquisitions of the Torrance Marriott, the Oak Brook Hills Marriott Resort, the SpringHill Suites Atlanta Buckhead and the Orlando Airport Marriott is recoverable subject to a 10% reduction per year in the event that the applicable management agreement with Marriott terminates within 10 years and such termination is not a result of a default by Marriott. In addition, Marriott has provided us with operating cash flow guarantees for certain hotels and will fund shortfalls of actual hotel operating income compared to a negotiated target net operating income. We refer to these guarantees as “Yield Support.” Marriott provided us with Yield Support for the Oak Brook Hills Marriott Resort for fiscal years 2006 and 2007. The guarantee provides that Marriott will fund actual hotel operating income shortfalls during fiscal years 2006 and 2007. The total guarantee obligation of Marriott is capped at $2.5 million. The SpringHill Suites Atlanta Buckhead also has Yield Support for each of fiscal years 2006 and 2007, which will reduce base management fees. The annual Yield Support is capped at $0.1 million for each of fiscal year 2006 and 2007, respectively. The Orlando Airport Marriott has Yield Support for fiscal year 2006, which is capped at $1 million. Hotel Management We intend to use Marriott as our preferred, but not exclusive, hotel management company for our hotels and expect to benefit from Marriott’s strong brands and its excellent hotel management services. Marriott-branded hotels have an extensive record of generating premiums in RevPAR over competitive brands. Each of our hotels operates under a recognized Marriott brand, including Marriott®, Renaissance Hotels and Resorts®, SpringHill Suites® and Courtyard by Marriott®. Investment in DiamondRock In connection with our July 2004 private placement, Marriott purchased 3 million shares of common stock at the same purchase price as all other investors in our private placement. That purchase represented 13.8% of our outstanding common stock following our private placement. In connection with our initial public offering, Marriott purchased 1,428,571 shares of our common stock at the same purchase price as all other investors. As of December 31, 2005 Marriott owned 8.6% of our outstanding common stock. 8 Our Corporate Structure We conduct our business through a traditional umbrella partnership REIT, or UPREIT, in which our hotels are owned by subsidiaries of our operating partnership, DiamondRock Hospitality Limited Partnership. We are the sole general partner of our operating partnership and currently own, either directly or indirectly, all of the limited partnership units of our operating partnership. In order for the income from our hotel investments to constitute “rents from real properties” for purposes of the gross income test required for REIT qualification, we must lease each of our hotels to a wholly-owned subsidiary of our taxable REIT subsidiary, or TRS, or an unrelated third party. However, we may structure our properties which are not subject to U.S. federal income tax differently from the structures we use for our U.S. properties. For example, the Frenchman’s Reef & Morning Star Marriott Beach Resort is held by a United States Virgin Islands corporation which we have elected to be a TRS. The following chart shows our corporate structure as of the date of this report: DiamondRock Hospitality Company 100% (direct and indirect) DiamondRock Hospitality Limited Partnership (our operating partnership) 100% Bloodstone TRS, Inc. (our taxable REIT subsidiary) 100% Subsidiaries Owning Hotels 100% Subsidiaries Leasing Hotels (our TRS Leasees) Leases Management Agreements Hotel Management Companies, including Marriott International, Inc. or one or more wholly owned subsidiaries of Marriott Environmental Matters Under various federal, state and local environmental laws and regulations, a current or previous owner, operator or tenant of real estate may be required to investigate and clean up hazardous or toxic substances or petroleum product releases or threats of releases at such property and may be held liable to a government entity or to third parties for property damage and for investigation, clean-up and monitoring costs incurred by such parties in connection with the actual or threatened contamination. These laws 9 typically impose clean-up responsibility and liability without regard to fault, or whether or not the owner, operator or tenant knew of or caused the presence of the contamination. The liability under these laws may be joint and several for the full amount of the investigation, clean-up and monitoring costs incurred or to be incurred or actions to be undertaken, although a party held jointly and severally liable may obtain contributions from other identified, solvent, responsible parties of their fair share toward these costs. These costs may be substantial and can exceed the value of the property. The presence of contamination, or the failure to properly remediate contamination, on a property may adversely affect the ability of the owner, operator or tenant to sell or rent that property or to borrow funds using such property as collateral and may adversely impact our investment in that property. Federal regulations require building owners and those exercising control over a building’s management to identify and warn, via signs and labels, of potential hazards posed by workplace exposure to installed asbestos-containing materials and potential asbestos-containing materials in their building. The regulations also set forth employee training, record keeping and due diligence requirements pertaining to asbestos-containing materials and potential asbestos-containing materials. Significant fines can be assessed for violation of these regulations. Building owners and those exercising control over a building’s management may be subject to an increased risk of personal injury lawsuits by workers and others exposed to asbestos-containing materials and potential asbestos-containing materials as a result of these regulations. The regulations may affect the value of a building containing asbestos-containing materials and potential asbestos-containing materials in which we have invested. Federal, state and local laws and regulations also govern the removal, encapsulation, disturbance, handling and disposal of asbestos- containing materials and potential asbestos-containing materials when such materials are in poor condition or in the event of construction, remodeling, renovation or demolition of a building. Such laws may impose liability for improper handling or a release to the environment of asbestos-containing materials and potentially asbestos-containing materials and may provide for fines to, and for third parties to seek recovery from, owners or operators of real estate facilities for personal injury or improper work exposure associated with asbestos-containing materials and potential asbestos-containing materials. Prior to closing any property acquisition, we obtain Phase I environmental assessments in order to attempt to identify potential environmental concerns at the properties. These assessments are carried out in accordance with an appropriate level of due diligence and will generally include a physical site inspection, a review of relevant federal, state and local environmental and health agency database records, one or more interviews with appropriate site-related personnel, review of the property’s chain of title and review of historic aerial photographs and other information on past uses of the property. We may also conduct limited subsurface investigations and test for substances of concern where the results of the Phase I environmental assessments or other information indicates possible contamination or where our consultants recommend such procedures. We cannot assure you that these assessments will discover every environmental condition that may be present on a property. Competition The hotel industry is highly competitive and our hotels are subject to competition from other hotels for guests. Competition is based on a number of factors, including convenience of location, brand affiliation, price, range of services, guest amenities, and quality of customer service. Competition is specific to the individual markets in which our properties are located and will include competition from existing and new hotels operated under brands in the full-service, select-service and extended-stay segments. We believe that properties flagged with a Marriott brand will enjoy the competitive advantages associated with their operations under such brand. Marriott’s centralized reservation systems and national advertising, marketing and promotional services combined with the strong management expertise they provide enable our properties to perform favorably in terms of both occupancy and room rates. Marriott Rewards® generates repeat guest business that might otherwise go to competing hotels. Increased competition may have a material adverse effect on occupancy, ADR and RevPAR or may require us to make capital 10 improvements that we otherwise would not undertake, which may result in decreases in the profitability of our hotels. We face competition for the acquisition of and investment in hotels from institutional pension funds, private equity investors, REITs, hotel companies and others who are engaged in the acquisition of hotels. Some of these competitors have substantially greater financial and operational resources than we have and may have greater knowledge of the markets in which we seek to invest. This competition may reduce the number of suitable investment opportunities offered to us and increase the cost of acquiring our targeted hotel investments. Although we expect that our investment sourcing relationship with Marriott will continue to provide us with a continuing source of investment opportunities, Marriott is under no binding commitment to provide us with any such opportunities or continue that relationship. Employees We currently employ 14 full-time employees. We believe that our relations with our employees are good. None of our employees is a member of any union; however, the employees of Marriott working at the Courtyard Manhattan/Fifth Avenue hotel are currently represented by a labor union and are subject to a collective bargaining agreement. Legal Proceedings We are not involved in any material litigation nor, to our knowledge, is any material litigation pending or threatened against us, other than routine litigation arising out of the ordinary course of business or which is expected to be covered by insurance and not expected to harm our business, financial condition or results of operations. Regulation Our properties must comply with Title III of the Americans with Disabilities Act, or ADA, to the extent that such properties are “public accommodations” as defined by the ADA. The ADA may require removal of structural barriers to access by persons with disabilities in certain public areas of our properties where such removal is readily achievable. We believe that our properties are in substantial compliance with the ADA and that we will not be required to make substantial capital expenditures to address the requirements of the ADA. However, noncompliance with the ADA could result in imposition of fines or an award of damages to private litigants. The obligation to make readily achievable accommodations is an ongoing one, and we will continue to assess our properties and to make alterations as appropriate in this respect. Insurance We carry comprehensive liability, fire, extended coverage, earthquake, business interruption and rental loss insurance covering all of the properties in our portfolio under a blanket policy, which is up for renewal on April 1, 2006. In addition, we carry earthquake and terrorism insurance on our properties in an amount and with deductibles, which we believe are commercially reasonable. We do not carry insurance for generally uninsured losses such as loss from riots, war or acts of God. Certain of the properties in our portfolio are located in areas known to be seismically active or subject to hurricanes and we have appropriate insurance for those risks, although they are subject to higher deductibles than ordinary property insurance. Most of our hotel management agreements generally provide that we are responsible for obtaining and maintaining property insurance, business interruption insurance, flood insurance, earthquake insurance (if the hotel is located in an “earthquake prone zone” as determined by the U.S. Geological Survey) and other customary types of insurance related to hotels and the manager is responsible for obtaining general liability insurance, workers’ compensation and employer’s liability insurance. 11 Item 1A. Risk Factors The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that it may currently deem immaterial also may impair its business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be adversely affected. Risks Related to Our Business and Operations We are a relatively young company and are subject to all of the risks associated with being at an early stage of development. We commenced operations in July 2004 and, as a result, have a limited operating history. We have experienced rapid growth in our short history and have developed our business strategies based on the expectation of continued rapid growth. We cannot assure you that we will be able to adapt our management, administrative, accounting and operational systems, or hire and retain qualified operational staff to integrate and manage our investment in our hotels. Our failure to successfully integrate and manage acquisitions could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our management has limited experience operating a REIT and a public company and therefore may have difficulty in profitably operating our business. Prior to joining our company, our senior management team had no experience operating a REIT and limited experience operating a public company. As a result, we cannot assure you that we will be able to continue to successfully operate as a REIT or execute our business strategies as a public company. You should be cautious in drawing conclusions about the ability of our senior management team to execute our business plan. Our inability to execute our business plan could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our business model, especially our concentration in premium full-service hotels, can be highly volatile. We own hotels, a very different asset class from many other REITs. A typical office REIT, for example, has long-term leases with third party tenants, which provides a relatively stable long-term stream of revenue. Our TRS, on the other hand, does not enter into a lease with a hotel manager. Instead, our TRS engages the hotel manager pursuant to a management agreement and pays the manager a fee for managing the hotel. The TRS receives all the operating profit or losses at the hotel. Moreover, virtually all hotel guests stay at the hotel for only a few nights, so the rate and occupancy at each of our hotels changes every day. As a result, we may have highly volatile earnings. In addition to fluctuations related to our business model, our hotels are and will continue to be subject to various long-term operating risks common to the hotel industry, many of which are beyond our control, including: • competition from other hotels that may be located in our markets, some of which may have greater marketing and financial resources than us; • an over-supply or over-building of hotels in our markets, which could adversely affect occupancy rates and revenues at our properties; • dependence on business and commercial travelers and tourism, both of which vary with consumer and business perceptions as to the strength of the general economy; • increases in energy costs and other expenses affecting travel, which may affect travel patterns and reduce the number of business and commercial travelers and tourists; 12 • increases in operating costs due to inflation and other factors that may not be offset by increased room rates; and • changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance. In addition, our hotels are mostly in the premium full-service segment of the hotel business that tends to have the best operating results in a strong economy and the worst results in a weak economy. In periods of weak demand, profitability is negatively affected by the relatively high fixed costs of operating premium full-service hotels when compared to other classes of hotels. The occurrence of any of the foregoing factors could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our hotels are subject to significant competition. Currently, the supply and demand in the markets where our hotels are located is in balance and, with few exceptions, the markets are very competitive. However, historically, a material increase in the supply of new hotel rooms to a market can quickly destabilize that market and existing hotels have experienced rapidly decreasing RevPAR and profitability. If such over-building occurs in one or more of our major markets, we may experience a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. In the event of natural disasters, terrorist attacks, significant military actions, outbreaks of contagious diseases or other events for which we may not have adequate insurance, our operations may suffer. One of our major hotels, Frenchman’s Reef & Morning Star Marriott Beach Resort, is located on the side of a cliff facing the ocean in the United States Virgin Islands, which is in the so-called “hurricane belt” in the Caribbean. The hotel was partially destroyed by a hurricane in the mid-1990’s and since then has been damaged by subsequent hurricanes. In addition, three of our hotels, the Los Angeles Airport Marriott, the Torrance Marriott and The Lodge at Sonoma, a Renaissance Resort & Spa, are located in areas that are seismically active. Finally, four of our hotels are located in metropolitan markets that have been, or may in the future be, targets of actual or threatened terrorist attacks, including New York City and Los Angeles. These hotels are each material to our financial results. Frenchman’s Reef & Morning Star Marriott Beach Resort, Los Angeles Airport Marriott, the Torrance Marriott, Courtyard Manhattan/Midtown East and Courtyard Manhattan/Fifth Avenue constituted 8.6%, 11.2%, 9.1%, 10.4% and 5.0% of our revenues in 2005, respectively. Additionally, even in the absence of direct physical damage to our hotels, the occurrence of any natural disasters, terrorist attacks, significant military actions, outbreaks of contagious diseases, such as SARS or the avian bird flu, or other casualty events affecting the United States, will likely have a material adverse effect on business and commercial travelers and tourists, the economy generally and the hotel and tourism industries in particular. While we cannot predict the impact of the occurrence of any of these events, such impact could result in a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. We have acquired and intend to maintain comprehensive insurance on each of our hotels, including liability, terrorism, fire and extended coverage, of the type and amount we believe are customarily obtained for or by hotel owners. We cannot assure you that such coverage will be available at reasonable rates or with reasonable deductibles. For example, Frenchman’s Reef & Morning Star Marriott Beach Resort has a high deductible if it is damaged due to a wind storm. Various types of catastrophic losses, like earthquakes, floods, losses from foreign terrorist activities such as those on September 11, 2001, or losses from domestic terrorist activities such as the Oklahoma City bombing may not be insurable or are generally not insured because of economic infeasibility, legal restrictions or the policies of insurers. Future lenders may require such insurance and our failure to obtain such insurance could constitute a default under loan agreements. 13 Depending on our access to capital, liquidity and the value of the properties securing the affected loan in relation to the balance of the loan, a default could have a material adverse effect on our results of operations and ability to obtain future financing. In the event of a substantial loss, our insurance coverage may not be sufficient to cover the full current market value or replacement cost of our lost investment. Should an uninsured loss or a loss in excess of insured limits occur, we could lose all or a portion of the capital we have invested in a hotel, as well as the anticipated future revenue from that particular hotel. In that event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property. Inflation, changes in building codes and ordinances, environmental considerations and other factors might also keep us from using insurance proceeds to replace or renovate a hotel after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position with regard to the damaged or destroyed property. With or without insurance, damage to any of our hotels, or to the hotel industry generally, due to fire, hurricane, earthquake, terrorism, outbreaks such as avian bird flu or other man-made or natural disasters or casualty events could materially and adversely affect our business, financial condition, results of operations and our ability to make distributions to our stockholders. The hotel industry is capital intensive and we are subject to risks associated with our ongoing need for renovations and capital improvements as well as financing for such expenditures. In order to remain competitive, our hotels have an ongoing need for renovations and other capital improvements, including replacements, from time to time, of furniture, fixtures and equipment. These capital improvements may give rise to the following risks: • construction cost overruns and delays; • a possible shortage of available cash to fund capital improvements and the related possibility that financing for these capital improvements may not be available to us on affordable terms; • disruptions in the operations of the hotel as well as in demand for the hotel while capital improvements are underway; and • disputes with franchisors/hotel managers regarding compliance with relevant management/franchise agreements. The costs of these capital improvements could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. In addition, we may not be able to fund capital improvements or acquisitions solely from cash provided from our operating activities because we generally must distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to maintain our REIT tax status. As a result, our ability to fund capital expenditures, or investments through retained earnings, is very limited. Consequently, we will rely upon the availability of debt or equity capital to fund our investments and capital improvements, but these sources of funds may not be available on favorable terms and conditions. Neither our charter nor our bylaws limits the amount of debt that we can incur; however, we may not be able to obtain additional equity or debt financing on favorable terms, if at all. If we do not complete the acquisition of the Chicago Marriott, we will have incurred substantial expenses without our stockholders realizing the expected benefits. If we are unable to complete the acquisition of the Chicago Marriott, we may lose substantial deposits that we have provided to sellers. We have deposited with an escrow agent a $5 million non-refundable deposit. We may exercise our option to extend the closing date of the acquisition, in which case we will deposit an additional $5 million non-refundable deposit. We will forfeit these deposits if the acquisition 14 does not close, unless such failure to close is a result of the failure of the seller to satisfy its obligations or fulfill certain conditions precedent to closing under the purchase agreement. We cannot assure you that we will acquire the Chicago Marriott because the proposed acquisition is subject to a variety of factors, including the satisfaction of closing conditions. Our inability to complete this acquisition within our anticipated timeframe, or at all, will cause us to forfeit our non-refundable deposit. We have also incurred several hundred thousand dollars in due diligence, legal and accounting expenses in connection with this acquisition and may incur additional due diligence, legal and accounting expenses prior to closing. Our hotel portfolio is not diverse by brand or manager and there are risks associated with using Marriott’s brands on all of our hotels and having Marriott manage most of our hotels. Our success depends in part on the success of Marriott. All of our current hotels utilize brands owned by Marriott. As a result, our success is dependent in part on the continued success of Marriott and its brands. If market recognition or the positive perception of these Marriott brands is reduced or compromised, the goodwill associated with Marriott branded hotels may be adversely affected and the results of operations of our hotels may be adversely affected. As a result, we could experience a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our success depends in part on maintaining good relations with Marriott. Due to the differences in how each company earns its money, which company is responsible for operating losses and capital expenditures, and tensions between an individual hotel and the brand standards of a large chain, there are natural conflicts between an owner of a hotel and a brand company, such as Marriott. Over the last several years, Marriott has been involved in contractual and other disputes with owners of the hotels it manages. Although we currently maintain good relations with Marriott, we cannot assure you that disputes between us and Marriott regarding the management of our properties will not arise. Should our relationship with Marriott deteriorate, we believe that two of our competitive advantages (namely our ability to work with senior executives at Marriott to improve the asset management of our hotels and our investment sourcing relationship) could be eliminated, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our results of operations are highly dependent on the management of our hotel properties by third-party hotel management companies, including Marriott. In order to qualify as a REIT, we cannot operate our hotel properties or participate in the decisions that affect the daily operations of our hotel properties. Our TRS lessees may not operate these hotel properties and, therefore, they must enter into third-party hotel management agreements with one or more eligible independent contractors (including Marriott). Thus, third-party hotel management companies that enter into management contracts with our TRS lessees will control the daily operations of our hotel properties. Under the terms of the hotel management agreements that we have entered into with Marriott (or its affiliates), or that will enter into in the future with Marriott or other third-party hotel management companies, our ability to participate in operating decisions regarding our hotel properties is limited. We currently rely, and will continue to rely, on these hotel management companies to adequately operate our hotel properties under the terms of the hotel management agreements. We do not have the authority to require any hotel property to be operated in a particular manner or to govern any particular aspect of its operations (for instance, setting room rates). Thus, even if we believe our hotel properties are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, ADRs and 15 operating profits, we may not have sufficient rights under our hotel management agreements to enable us to force the hotel management company to change its method of operation. We can only seek redress if a hotel management company violates the terms of the applicable hotel management agreement with the TRS lessee, and then only to the extent of the remedies provided for under the terms of the hotel management agreement. Our current management agreements are generally non-terminable, subject to certain exceptions for cause (see “Our Principal Agreements—Our Hotel Management Agreements”), and in the event that we need to replace any of our hotel management companies pursuant to termination for cause, we may experience significant disruptions at the affected properties, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. There are risks associated with the Marriott investment sourcing relationship. Our investment sourcing relationship with Marriott is non-exclusive and based on a non-binding understanding that may be changed or terminated at any time, which could adversely affect our ability to execute our business strategies, which in turn, would adversely affect our ability to make distributions to our stockholders. Our investment sourcing relationship with Marriott is non-exclusive and based on a non-binding understanding. Both parties are free to terminate or attempt to change our investment sourcing relationship at any time. While Marriott intends to provide us a “first look” at hotel investment opportunities known to Marriott that are consistent with our stated business strategies, it will not provide us with opportunities where it is contractually or ethically prohibited from doing so, or where Marriott believes it would be damaging to existing Marriott relationships. Termination of, or an adverse change in, our investment sourcing relationship with Marriott may limit our sources of acquisition and investment opportunities and therefore adversely affect our ability to execute our business strategies. We believe that access to information about hotel investment opportunities known to Marriott gives us a competitive advantage by providing us with knowledge about a potential investment opportunity before it has been widely marketed. Therefore, while we expect that this competitive advantage will lead to favorable investments, we cannot assure you that this “first look” will result in the acquisition of any future hotels or provide us with a competitive advantage. Marriott may encourage us to enter into transactions or hotel management agreements that are not favorable to us. Pursuant to our investment sourcing relationship with Marriott, we have pursued and intend to continue to pursue, hotel investment opportunities referred to us by Marriott, and we intend to work with Marriott as our preferred hotel management company. Marriott is paid a fee based on gross revenues at the hotels while we only benefit from operating profits at a hotel. It is possible that Marriott will encourage us to acquire a hotel which generates significant gross revenues, but little or no operating profits. Marriott may also have short-term or long-term goals and objectives that conflict with our own, including the terms of the agreements under which our hotels are managed. These differences may be significant and may include the fees payable to Marriott, the term of any hotel management agreement, trade area restrictions with respect to competition by Marriott or its affiliates or differing policies, procedures or practices. As a result of these potentially differing objectives, Marriott may present to us, and we may invest in, hotel investment opportunities, and enter into management agreements, that are less favorable to us than other alternatives. If we do enter into below market management agreements, our returns on invested capital and operating results will suffer. These differing objectives could result in deterioration in our relationship with Marriott and may adversely affect our ability to execute our business strategies, which in turn, would have a material adverse 16 effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our ownership of properties through ground leases exposes us to the risk that we may have a difficulty financing such properties, may sell such properties for a lower price or may lose such properties upon breach or termination of the ground leases. We acquired interests in three hotels (Bethesda Marriott Suites, Courtyard Manhattan/Fifth Avenue and the Salt Lake City Marriott Downtown), the parking lot associated with another hotel (Renaissance Worthington) and two golf courses associated with two additional hotels (Marriott Griffin Gate Resort and Oak Brook Hills Marriott Resort) by acquiring a leasehold interest in land underlying the property. We may acquire additional hotels in the future through the purchase of hotels subject to ground leases. In the past, from time to time, secured lenders have been unwilling to lend, or otherwise charged higher interest rates, for loans secured by a leasehold mortgage compared to loans secured by a fee simple mortgage. In addition, at any given time, investors may be disinterested in buying properties subject to a ground lease and may pay a lower price for such properties than for a comparable property in fee simple or they may not purchase such properties at any prices, so we may find that we will have a difficult time selling a property subject to a ground lease or may receive less proceeds from such sale. Finally, as lessee under ground leases, we are exposed to the possibility of losing the hotel, or a portion of the hotel, upon termination, or an earlier breach by us, of the ground lease, which could result in a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Our existing indebtedness contains financial covenants that could limit our operations and our ability to make distributions to our stockholders. Our existing indebtedness contains financial and operating covenants, such as net worth requirements, fixed charge coverage, debt ratios and other limitations which will restrict our ability to make distributions or other payments to our stockholders, sell all or substantially all of our assets and engage in mergers, consolidations and certain acquisitions. In addition, our existing indebtedness contains restrictions (including cash management provisions) that may under circumstances specified in the loan agreements prohibit our subsidiaries that own our hotels from making distributions or paying dividends, repaying loans to us or other subsidiaries or transferring any of their assets to us or another subsidiary. Failure to meet our financial covenants could result from, among other things, changes in our results of operations, the incurrence of debt or changes in general economic conditions. These covenants may restrict our ability to engage in transactions that we believe would otherwise be in the best interests of our stockholders. This could cause one or more of our lenders to accelerate the timing of payments and could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. There is refinancing risk associated with our debt. Our typical debt contains limited principal amortization, therefore the vast majority of the principal must be repaid at the maturity of the loan in a so-called “balloon payment.” At the maturity of these loans, assuming we do not have sufficient funds to repay the debt, we will need to refinance this debt. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancings, increases in interest expense will adversely affect our cash flow, and, consequently, our cash available for distribution to our stockholders. If we are unable to refinance our debt on acceptable terms, we may be forced to dispose of our hotels on disadvantageous terms, potentially resulting in losses that could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Higher interest rates could increase debt service requirements on our floating-rate debt and could reduce the amounts available for distribution to our stockholders, as well as reduce funds available from 17 our operations, future investment opportunities or other purposes. We may obtain in the future one or more forms of interest rate protection—in the form of swap agreements, interest rate cap contracts or similar agreements—to “hedge” against the possible negative effects of interest rate fluctuations. However, we cannot assure you that any hedging will adequately mitigate the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations. In addition, we may be subject to risks of default by hedging counter-parties. Adverse economic conditions could also cause the terms on which we borrow to be unfavorable. If we default on our secured debt in the future, the lenders may foreclose on our hotels. All of our indebtedness for borrowed money, except our credit facility, is secured by single property first mortgages on the applicable property. Our credit facility is secured by a mortgage on the Torrance Marriott and the Vail Marriott Mountain Resort & Spa and by certain pledges of our equity interests in certain of our subsidiary entities that own our properties. Should we default on any of the loans, the lender will be able to foreclose on the property pledged to the relevant lender under that loan. In addition to losing the property, a foreclosure may result in recognition of taxable income. Under the Code, a foreclosure would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure even though we did not receive any cash proceeds. As a result, we may be required to identify and utilize other sources of cash for distributions to our stockholders. If this occurs, our financial condition, cash flow and ability to satisfy our other debt obligations or ability to pay dividends may be adversely affected. Due to restrictions in our hotel management agreements, mortgage agreements and ground leases, we may not be able to sell our hotels at the highest possible price (or at all). Our current hotel management agreements are long-term and contain certain restrictions on selling our hotels, which may affect the value of our hotels. The hotel management agreements that we have entered into with Marriott (and those we expect to enter into in the future) contain provisions restricting our ability to dispose of our hotels which, in turn, may have an adverse affect on the value of our hotels. Marriott’s hotel management agreements generally prohibit the sale of a hotel to: • certain competitors of Marriott; • purchasers who are insufficiently capitalized; or • purchasers who might jeopardize certain liquor or gaming licenses. In addition, there are rights of first refusal in the hotel management agreement for the Salt Lake City Marriott Downtown and in both the franchise agreement and management agreement for the Vail Marriott Mountain Resort & Spa. These rights of first refusal might discourage certain purchasers from expending resources to conduct due diligence and making an offer to purchase these hotels from us, thus resulting in a lower sales price. Finally, our current hotel management agreements contain initial terms ranging from fifteen to forty years and certain agreements have renewal periods, exercisable at the option of the property manager, of ten to forty-five years. Because our hotels would have to be sold subject to the applicable hotel management agreement, the term length of a hotel management agreement may deter some potential purchasers and could adversely impact the price realized from any such sale. To the extent we receive less sale proceeds, we could experience a material adverse effect on our business financial conditions, results of operations and our ability to make distributions to stockholders. 18 Our mortgage agreements contain certain provisions that may limit our ability to sell our hotels. In order to assign or transfer our rights and obligations under certain of our mortgage agreements, we generally must: • obtain the consent of the lender; • pay a fee equal to a fixed percentage of the outstanding loan balance; and • pay any costs incurred by the lender in connection with any such assignment or transfer. These provisions of our mortgage agreements may limit our ability to sell our hotels which, in turn, could adversely impact the price realized from any such sale. To the extent we receive less sale proceeds, we could experience a material adverse effect on our business financial conditions, results of operations and our ability to make distributions to stockholders. Our ground leases contain certain provisions that may limit our ability to sell our hotels. Our ground lease agreements with respect to Bethesda Marriott Suites and Salt Lake City Marriott Downtown require the consent of the lessor for assignment or transfer. These provisions of our ground leases may limit our ability to sell our hotels which, in turn, could adversely impact the price realized from any such sale. In addition, at any given time, investors may be disinterested in buying properties subject to a ground lease and may pay a lower price for such properties than for a comparable property in fee simple or they may not purchase such properties at any price. Accordingly, we may find it difficult to sell a property subject to a ground lease or may receive less proceeds from any such sale. To the extent we receive less sale proceeds, we could experience a material adverse effect on our business financial conditions, results of operations and our ability to make distributions to stockholders. We face competition for the acquisition of hotels and we may not be successful in identifying or completing hotel acquisitions that meet our criteria, which may impede our growth. One component of our business strategy is expansion through acquisitions, and we may not be successful in identifying or completing acquisitions that are consistent with our strategy. We compete with institutional pension funds, private equity investors, REITs, hotel companies and others who are engaged in the acquisition of hotels. This competition for hotel investments may increase the price we pay for hotels and these competitors may succeed in acquiring those hotels that we seek to acquire. Furthermore, our potential acquisition targets may find our competitors to be more attractive suitors because they may have greater financial resources, may be willing to pay more or may have a more compatible operating philosophy. In addition, the number of entities competing for suitable hotels may increase in the future, which would increase demand for these hotels and the prices we must pay to acquire them. If we pay higher prices for hotels, our returns on investment and profitability may be reduced. Also, future acquisitions of hotels or hotel companies may not yield the returns we expect and may result in stockholder dilution. Our success depends on senior executive officers whose continued service is not guaranteed. We depend on the efforts and expertise of our senior executive officers to manage our day-to-day operations and strategic business direction. The loss of any of their services could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Noncompliance with governmental regulations could adversely affect our operating results. Environmental matters. Our hotels are, and the hotels we acquire in the future will be, subject to various federal, state and local environmental laws. Under these laws, courts and government agencies may have the authority to 19 require us, as owner of a contaminated property, to clean up the property, even if we did not know of or were not responsible for the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property. Under the environmental laws, courts and government agencies also have the authority to require that a person who sent waste to a waste disposal facility, such as a landfill or an incinerator, pay for the clean-up of that facility if it becomes contaminated and threatens human health or the environment. A person that arranges for the disposal or treatment, or transports for disposal or treatment, a hazardous substance at a property owned by another person may be liable for the costs of removal or remediation of hazardous substances released into the environment at that property. Furthermore, various court decisions have established that third parties may recover damages for injury caused by property contamination. For instance, a person exposed to asbestos while staying in a hotel may seek to recover damages if he or she suffers injury from the asbestos. Lastly, some of these environmental laws restrict the use of a property or place conditions on various activities. For example, certain laws require a business using chemicals (such as swimming pool chemicals at a hotel) to manage them carefully and to notify local officials that the chemicals are being used. We could be responsible for the costs associated with a contaminated property. The costs to clean up a contaminated property, to defend against a claim, or to comply with environmental laws could be material and could adversely affect the funds available for distribution to our stockholders. We cannot assure you that future laws or regulations will not impose material environmental liabilities or that the current environmental condition of our hotels will not be affected by the condition of the properties in the vicinity of our hotels (such as the presence of leaking underground storage tanks) or by third parties unrelated to us. We may face liability regardless of: • our knowledge of the contamination; • the timing of the contamination; • the cause of the contamination; or • the party responsible for the contamination of the property. Although we have taken and will take commercially reasonable steps to assess the condition of our properties, there may be unknown environmental problems associated with our properties. If environmental contamination exists on our properties, we could become subject to strict, joint and several liability for the contamination by virtue of our ownership interest. In addition, we are obligated to indemnify our lenders for any liability they may incur in connection with a contaminated property. The presence of hazardous substances or petroleum contamination on a property may adversely affect our ability to sell the property and could cause us to incur substantial remediation costs. The discovery of environmental liabilities attached to our properties could have a material adverse effect on our results of operations and financial condition and our ability to pay dividends to our stockholders. 20 Americans with Disabilities Act and other changes in governmental rules and regulations. Under the Americans with Disabilities Act of 1990, or the ADA, all public accommodations must meet various federal requirements related to access and use by disabled persons. Compliance with the ADA’s requirements could require removal of access barriers, and non-compliance could result in the U.S. government imposing fines or private litigants winning damages. If we are required to make substantial modifications to our hotels, whether to comply with the ADA or other changes in governmental rules and regulations, our financial condition, results of operations and ability to make distributions to our stockholders could be adversely affected. Our hotel properties may contain or develop harmful mold, which could lead to liability for adverse health effects and costs of remediating the problem. When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Concern about indoor exposure to mold has been increasing, as exposure to mold may cause a variety of adverse health effects and symptoms, including allergic reactions. As a result, the presence of mold to which our hotel guests or employees could be exposed at any of our properties could require us to undertake a costly remediation program to contain or remove the mold from the affected property, which would reduce our cash available for distribution. In addition, exposure to mold by our guests or employees, management company employees or others could expose us to liability if property damage or adverse health concerns arise. If the hotel market declines, it may adversely affect our ability to execute our business strategies, which, in turn, would adversely affect our ability to make distributions to our stockholders. Our business strategy is focused in the hotel industry, and we cannot assure you that hotel industry fundamentals will not decline from current conditions. Economic slowdown and world events outside our control, such as natural disasters and terrorism, have adversely affected the hotel industry in the recent past and a reoccurrence of these events may adversely affect the industry in the future. In the event of a decline in the hotel market, our ability to execute our business strategies will be adversely affected, which, in turn, would have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Future debt service obligations may adversely affect our operating results, require us to liquidate our properties, jeopardize our tax status as a REIT and limit our ability to make distributions to our stockholders. We currently maintain a target debt-to-enterprise value ratio of 45% to 55%. Enterprise value is calculated as market capitalization plus net debt. Our board of directors, however, may change or eliminate this target leverage ratio at any time without the approval of our stockholders. In the future, we and our subsidiaries may be able to incur substantial additional debt, including secured debt. Incurring such debt could subject us to many risks, including the risks that: • our cash flow from operations will be insufficient to make required payments of principal and interest; • we may be more vulnerable to adverse economic and industry conditions; • we may be required to dedicate a substantial portion of our cash flow from operations to the repayment of our debt, thereby reducing the cash available for distribution to our stockholders, funds available for operations and capital expenditures, future investment opportunities or other purposes; 21 • the terms of any refinancing may not be as favorable as the terms of the debt being refinanced; and • the use of leverage could adversely affect our stock price and the ability to make distributions to our stockholders. If we violate covenants in our future indebtedness agreements, we could be required to repay all or a portion of our indebtedness before maturity at a time when we might be unable to arrange financing for such repayment on favorable terms, if at all. If we obtain debt in the future and do not have sufficient funds to repay our debt at maturity, it may be necessary to refinance this debt through additional debt financing, private or public offerings of debt securities, or additional equity financings. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on refinancings, increases in interest expense could adversely affect our cash flow, and, consequently, our cash available for distribution to our stockholders. If we are unable to refinance our debt on acceptable terms, we may be forced to dispose of our hotel properties on disadvantageous terms, potentially resulting in losses adversely affecting cash flow from operating activities. In addition, we may place mortgages on our hotel properties to secure our line of credit or other debt. To the extent we cannot meet these debt service obligations, we risk losing some or all of those properties to foreclosure. Additionally, our debt covenants could impair our planned strategies and, if violated, result in a default of our debt obligations. Higher interest rates could increase debt service requirements on our floating rate debt and could reduce the amounts available for distribution to our stockholders, as well as reduce funds available for our operations, future investment opportunities or other purposes. We may obtain in the future one or more forms of interest rate protection—in the form of swap agreements, interest rate cap contracts or similar agreements—to “hedge” against the possible negative effects of interest rate fluctuations. However, we cannot assure you that any hedging will adequately mitigate the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations. In addition, we may be subject to risks of default by hedging counter-parties. Adverse economic conditions could also cause the terms on which we borrow to be unfavorable. Illiquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties and harm our financial condition. Because real estate investments are relatively illiquid, our ability to promptly sell one or more hotel properties or investments in our portfolio in response to changing economic, financial and investment conditions may be limited. The real estate market is affected by many factors that are beyond our control, including: • adverse changes in international, national, regional and local economic and market conditions; • changes in interest rates and in the availability, cost and terms of debt financing; • changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances; • the ongoing need for capital improvements, particularly in older structures; • changes in operating expenses; and • civil unrest, acts of God, including earthquakes, floods and other natural disasters and acts of war or terrorism, including the consequences of terrorist acts such as those that occurred on September 11, 2001, which may result in uninsured losses. We may decide to sell our hotel properties in the future. We cannot predict whether we will be able to sell any hotel property or investment for the price or on the terms set by us, or whether any price or other 22 terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a hotel property or loan. We may be required to expend funds to correct defects or to make improvements before a hotel property can be sold. We cannot assure you that we will have funds available to correct those defects or to make those improvements. In acquiring a hotel property, we may agree to lock-out provisions that materially restrict us from selling that hotel property for a period of time or impose other restrictions, such as a limitation on the amount of debt that can be placed or repaid on that hotel property. These facts and any others that would impede our ability to respond to adverse changes in the performance of our hotel properties could have a material adverse effect on our operating results and financial condition, as well as our ability to make distributions to stockholders. A portion of our revenues may be attributable to operations outside of the United States, which will subject us to different legal, monetary and political risks, as well as currency exchange risks, and may cause unpredictability in a significant source of our cash flows that could adversely affect our ability to make distributions to our stockholders. We may acquire selective hotel properties outside of the United States. International investments and operations generally are subject to various political and other risks that are different from and in addition to risks in U.S. investments, including: • the enactment of laws prohibiting or restricting the foreign ownership of property; • laws restricting us from removing profits earned from activities within the foreign country to the United States, including the payment of distributions, i.e., nationalization of assets located within a country; • variations in the currency exchange rates, mostly arising from revenues made in local currencies; • change in the availability, cost and terms of mortgage funds resulting from varying national economic policies; • changes in real estate and other tax rates and other operating expenses in particular countries; and • more stringent environmental laws or changes in such laws. In addition, currency devaluations and unfavorable changes in international monetary and tax policies could have a material adverse effect on our profitability and financing plans, as could other changes in the international regulatory climate and international economic conditions. Liabilities arising from differing legal, monetary and political risks as well as currency fluctuations could adversely affect our financial condition, operating results and our ability to make distributions to our stockholders. In addition, the requirements for qualifying as a REIT limit our ability to earn gains, as determined for federal income tax purposes, attributable to changes in currency exchange rates. These limitations may significantly limit our ability to invest outside of the United States or impair our ability to qualify as a REIT. Any properties we invest in outside of the United States may be subject to foreign taxes. We may invest in additional hotel properties located outside the United States. Jurisdictions outside the United States will generally impose taxes on our hotel properties and our operations within their jurisdictions. To the extent possible, we will structure our investments and activities to minimize our foreign tax liability, but we will likely incur foreign taxes with respect to non-U.S. properties. Moreover, the requirements for qualification as a REIT may preclude us from always using the structure that minimizes our foreign tax liability. Furthermore, as a REIT, we and our stockholders will derive little or no benefit from the foreign tax credits arising from the foreign taxes we pay. As a result, foreign taxes we pay will reduce our income and available cash flow from our foreign hotel properties, which, in turn, could have a 23 material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Seasonality of the hotel business can be expected to cause quarterly fluctuations in our earnings. The hotel industry is seasonal in nature. Generally, our earnings are higher in the third and fourth quarters. As a result, we may have to enter into short-term borrowings in our first and second quarters in order to offset these fluctuations in earnings and to make distributions to our stockholders. We cannot assure you that we will qualify, or remain qualified, as a REIT. Risks Related to Our Status as a REIT We will elect, and believe we are qualified, to be taxed as a REIT for our taxable year ended December 31, 2005, and we expect to continue to qualify as a REIT for future taxable years, but we cannot assure you that we have qualified, or will remain qualified, as a REIT. The REIT qualification requirements are extremely complex and official interpretations of the federal income tax laws governing qualification as a REIT are limited. Certain aspects of our REIT qualification are beyond our control. For example, we will fail to qualify as a REIT if one of our hotel managers acquires directly or constructively more than 35% of our stock. Accordingly, we cannot be certain that we will be successful in operating so that we can remain qualified as a REIT. At any time, new laws, interpretations, or court decisions may change the federal tax laws or the federal income tax consequences of our qualification as a REIT. Moreover, our charter provides that our board of directors may revoke or otherwise terminate our REIT election, without the approval of our stockholders, if it determines that it is no longer in our best interest to continue to qualify as a REIT. If we fail to qualify as a REIT and do not qualify for certain statutory relief provisions, or otherwise cease to be a REIT, we will be subject to federal income tax on our taxable income. We might need to borrow money or sell assets in order to pay any such tax. Unless we were entitled to relief under certain federal income tax laws, we could not re-elect REIT status until the fifth calendar year after the year in which we failed to qualify as a REIT. Maintaining our REIT qualification contains certain restrictions and drawbacks. Complying with REIT requirements may cause us to forego otherwise attractive opportunities. To remain qualified as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. In order to meet these tests, we may be required to forego attractive business or investment opportunities. For example, we may not lease to our TRS any hotel which contains gaming. Thus, compliance with the REIT requirements may hinder our ability to operate solely to maximize profits. Our results of operations are highly dependent on the management of our hotels by third-party hotel management companies. In order to remain qualified as a REIT, we cannot operate our hotels or participate in the decisions that affect the daily operations of our hotels. Our TRS lessees must therefore enter into third-party hotel management agreements with one or more eligible independent contractors (including Marriott). Under the terms of the hotel management agreements that we have entered into with Marriott (or its affiliates), or will enter into in the future with Marriott or other third-party hotel management companies, 24 our ability to participate in operating decisions regarding our hotels will be limited. We currently rely and will continue to rely on these hotel management companies to adequately operate our hotels under the terms of the hotel management agreements. We do not have the authority to require any hotel to be operated in a particular manner or to govern any particular aspect of its operations (for instance, setting room rates). Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, ADRs and operating profits, we may not have sufficient rights under our hotel management agreements to enable us to force the hotel management company to change its method of operation. We can only seek redress if a hotel management company violates the terms of the applicable hotel management agreement with the TRS lessee, and then only to the extent of the remedies provided for under the terms of the hotel management agreement. Our current management agreements are generally non-terminable, subject to certain exceptions for cause, and in the event that we need to replace any of our hotel management companies pursuant to termination for cause, we may experience significant disruptions at the affected properties, which may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our stockholders. Failure to make required distributions would subject us to tax. In order to remain qualified as a REIT, we generally are required to distribute at least 90% of our REIT taxable income, determined without regard to the dividends paid deduction, each year to our stockholders. To the extent that we satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws. As a result, for example, of differences between cash flow and the accrual of income and expenses for tax purposes, or of nondeductible expenditures, our REIT taxable income in any given year could exceed our cash available for distribution. Accordingly, we may be required to borrow money or sell assets to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement and to avoid federal corporate income tax and the 4% nondeductible excise tax in a particular year. The formation of our TRSs and TRS lessees increases our overall tax liability. Bloodstone TRS, Inc. and any other of our domestic TRSs are subject to federal and state income tax on their taxable income. The taxable income of our TRS lessees is included in the taxable income of Bloodstone TRS, Inc. and currently consists and generally will continue to consist of revenues from the hotels leased by our TRS lessees plus, in certain cases, Key Money payments (amounts paid to us by a hotel management company in exchange for the right to manage a hotel we acquire), net of the operating expenses for such properties and rent payments to us. Such taxes could be substantial. Our non-U.S. TRSs also may be subject to tax in jurisdictions where they operate. We incur a 100% excise tax on transactions with our TRSs that are not conducted on an arms-length basis. For example, to the extent that the rent paid by one of our TRS lessees exceeds an arms-length rental amount, such amount potentially is subject to the excise tax. While we believe we structure all of our leases on an arms-length basis, upon an audit, the IRS might disagree with our conclusion. You may be restricted from transferring our common stock. In order to maintain our REIT qualification, among other requirements, no more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (as defined in the federal income tax laws to include various kinds of entities) during the last half of any taxable year (other than the first year for which a REIT election is made). In addition, the REIT rules generally prohibit a 25 manager of one of our hotels from owning, directly or indirectly, more than 35% of our stock and a person who holds 35% or more of our stock from also holding, directly or indirectly, more than 35% of any such hotel management company. To qualify for and preserve REIT status, our charter contains an aggregate share ownership limit and a common share ownership limit. Generally, any shares of our stock owned by affiliated owners will be added together for purposes of the aggregate share ownership limit, and any shares of common stock owned by affiliated owners will be added together for purposes of the common share ownership limit. If anyone transfers or owns shares in a way that would violate the aggregate share ownership limit or the common share ownership limit (unless such ownership limits have been waived by our board of directors), or prevent us from continuing to qualify as a REIT under the federal income tax laws, those shares instead will be transferred to a trust for the benefit of a charitable beneficiary and will be either redeemed by us or sold to a person whose ownership of the shares will not violate the aggregate share ownership limit or the common share ownership limit. If this transfer to a trust fails to prevent such a violation or our continued qualification as a REIT, then we will consider the initial intended transfer or ownership to be null and void from the outset. The intended transferee or owner of those shares will be deemed never to have owned the shares. Anyone who acquires or owns shares in violation of the aggregate share ownership limit, the common share ownership limit (unless such ownership limits have been waived by our board of directors) or the other restrictions on transfer or ownership in our charter bears the risk of a financial loss when the shares are redeemed or sold if the market price of our stock falls between the date of purchase and the date of redemption or sale. Risks Related to Our Organization and Structure Provisions of our charter may limit the ability of a third party to acquire control of our company. Our charter provides that no person may beneficially own more than 9.8% of our common stock or of the value of the aggregate outstanding shares of our capital stock, except certain “look-through entities,” such as mutual funds, which may beneficially own up to 15% of our common stock or of the value of the aggregate outstanding shares of our capital stock. Our board of directors has waived this ownership limitation for Marriott Hotel Services, Inc. and certain institutional investors in the past. Our bylaws waive this ownership limitation for certain other classes of investors. These ownership limitations may prevent an acquisition of control of our company by a third party without our board of directors’ approval, even if our stockholders believe the change of control is in their best interests. Our charter also authorizes our board of directors to issue up to 100,000,000 shares of common stock and up to 10,000,000 shares of preferred stock, to classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares. Furthermore, our board of directors may, without any action by the stockholders, amend our charter from time to time to increase or decrease the aggregate number of shares of stock of any class or series that we have authority to issue. Issuances of additional shares of stock may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests. Certain advance notice provisions of our bylaws may limit the ability of a third party to acquire control of our company. Our bylaws provide that (a) with respect to an annual meeting of stockholders, nominations of persons for election to our board of directors and the proposal of business to be considered by stockholders may be made only (i) pursuant to our notice of the meeting, (ii) by the board of directors or (iii) by a stockholder who is entitled to vote at the meeting and has complied with the advance notice procedures set forth in the bylaws and (b) with respect to special meetings of stockholders, only the business specified in our notice of 26 meeting may be brought before the meeting of stockholders and nominations of persons for election to the board of directors may be made only (i) pursuant to our notice of the meeting, (ii) by the board of directors or (iii) provided that the board of directors has determined that directors shall be elected at such meeting, by a stockholder who is entitled to vote at the meeting and has complied with the advance notice provisions set forth in the bylaws. These advance notice provisions may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests. Provisions of Maryland law may limit the ability of a third party to acquire control of our company. The Maryland General Corporation Law, or the MGCL, has certain restrictions on a “business combination” and “control share acquisition” which we have opted out of. If an affirmative majority of votes cast by a majority of stockholders entitled to vote approve it, our board of directors may opt in to such provisions of the MGCL. If we opt in, and the shareholders approve it, these provisions may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interests. Additionally, Title 3, Subtitle 8 of the MGCL permits our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to take certain actions that may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders’ best interests. We have entered into an agreement with each of our senior executive officers that provides each of them benefits in the event his employment is terminated by us without cause, by him for good reason, or under certain circumstances following a change of control of our company. We have entered into an agreement with each of our senior executive officers that provides each of them with severance benefits if his employment is terminated under certain circumstances following a change of control of our company. Certain of these benefits and the related tax indemnity could prevent or deter a change of control of our company that might involve a premium price for our common stock or otherwise be in the best interests of our stockholders. Risk of future dilution. As hotel acquisition opportunities arise from time to time, we may issue additional shares of common stock or preferred stock to raise the capital necessary to finance the hotel acquisitions or may issue common stock or preferred stock or partnership units, which are redeemable on a one-to-one basis for our common stock, to acquire hotels. Such issuances could result in dilution of shareholders’ equity. Future offerings of debt securities or preferred stock, which would be senior to our common stock upon liquidation and for the purpose of distributions, may cause the market price of our common stock to decline. In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock. We will be able to issue additional shares of common stock or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which our securities may be listed or traded. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to 27 preemptive rights or other protections against dilution. Preferred stock and debt, if issued, could have a preference on liquidating distributions or a preference on dividend or interest payments that could limit our ability to make a distribution to the holders of our common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock and diluting their interest. Item 1B. Unresolved Staff Comments None. 28 Item 2. Our Properties Overview The following table sets forth certain operating information for each of our hotels for the year ended December 31, 2005. This information includes periods prior to our acquisition of these hotels unless otherwise indicated: Location Number of Rooms Average Occupancy (%) ADR ($) RevPAR ($) % Change from 2004 RevPAR(4) Los Angeles, California Salt Lake City, Utah 1,004 510 77.0% $ 101.99 118.68 71.4 $ 78.52 84.76 2.9% 8.0 Property Los Angeles Airport Marriott. . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . Frenchman’s Reef & MorningStar Marriott Beach Resort . . . . . . . . . . . . . . . . . . . . . . Renaissance Worthington. . . . . . . . . Torrance Marriott. . . . . . . . . . . . . . . Orlando Airport St. Thomas, U.S. Virgin Islands Fort Worth, Texas Los Angeles County, California Marriott (1) . . . . . . . . . . . . . . . . . . Orlando, Florida Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . Lexington, Kentucky Oak Brook Hills Marriott Resort (2) . . . . . . . . . . . . . . . . . . . Oak Brook, Illinois Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . . . . . . . Vail, Colorado Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . Atlanta, Georgia Courtyard Manhattan/Midtown East . . . . . . . . . . . . . . . . . . . . . . . . New York, New York Bethesda Marriott Suites . . . . . . . . . SpringHill Suites Atlanta Bethesda, Maryland Buckhead (3). . . . . . . . . . . . . . . . . Atlanta, Georgia Courtyard Manhattan/Fifth Avenue. New York, New York The Lodge at Sonoma, a Renaissance Resort & Spa. . . . . . . . . . . . . . . . . TOTAL/WEIGHTED AVERAGE . Sonoma, California (1) We acquired the hotel on December 16, 2005. 504 504 487 486 408 384 346 318 307 274 220 185 182 6,119 78.5 76.9 80.9 78.1 63.8 51.0 58.7 60.6 87.9 77.4 65.8 84.5 200.18 151.48 103.23 157.06 116.45 83.49 103.46 80.79 122.22 78.00 121.85 62.13 192.06 112.66 132.60 80.42 230.52 160.38 103.19 212.87 202.52 124.13 67.92 179.83 16.6 15.1 8.2 9.1 4.1 3.7 4.9 10.8 13.9 8.2 N/A 42.6 70.4 204.03 72.9% $ 141.95 143.65 $ 103.47 17.7 10.7% (2) We acquired the hotel on July 29, 2005. The hotel was immediately converted to the Oak Brook Hills Marriott Resort. (3) The hotel was newly built and commenced operations on July 1, 2005. Hotel statistics are presented for our ownership period which commenced on July 22, 2005. (4) The % change from 2004 RevPAR excludes the SpringHill Suites Atlanta Buckhead. The hotel was newly built in 2005 and there are no comparable statistics for 2004. 29 The following table sets forth information regarding our investment in each of our hotels: Location Year Opened Number of Rooms (1) Total Investment (1) 2006 Budgeted Capital Expenditures (2) Total Projected Investment (3) Total Projected Investment Per Room Los Angeles, CA 1973 1,004 $ 114,681,000 $ 18,073,000 $ 132,754,000 $ 132,225 Salt Lake City, UT 1981 510 51,123,000 3,703,000 54,826,000 107,502 St. Thomas, USVI 1973/1984 504 504 487 486 408 76,106,000 10,860,000 86,966,000 172,552 80,811,000 2,853,000 83,664,000 166,000 67,421,000 7,625,000 75,046,000 154,099 71,154,000 12,235,000 83,389,000 171,582 49,779,000 1,933,000 51,712,000 126,745 1981 1985 1983 1981 1987 384 66,165,000 11,483,000 77,648,000 202,208 1983/2002 2000 1998 1990 346 318 307 274 65,259,000 3,665,000 68,924,000 199,202 38,833,000 284,000 39,117,000 123,009 75,382,000 2,667,000 78,049,000 254,231 42,185,000 5,831,000 48,016,000 175,241 2005 220 34,341,000 40,000 34,381,000 156,277 1990 185 41,832,000 2,575,000 44,407,000 240,038 2001 182 6,119 32,430,000 $ 907,502,000 486,000 $ 84,313,000 32,916,000 $ 991,815,000 180,857 $ 162,088 Property Los Angeles Airport Marriott . . . . . . Salt Lake City Marriott Downtown . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . Renaissance Worthington . . . Fort Worth, TX Torrance Marriott . . . . . . Los Angeles County, CA Orlando Airport Marriott . . . . . . Orlando, FL Marriott Griffin Gate Resort . . . Lexington, KY Oak Brook Hills Marriott Resort . . . . . . . Oak Brook, IL Vail Marriott Mountain Resort & Spa . . Vail, CO Marriott Atlanta Alpharetta . . . . Atlanta, GA Courtyard Manhattan/Midt own East. . . . . . New York, NY Bethesda Marriott Suites . . . . . . . . SpringHill Suites Bethesda, MD Atlanta Buckhead . . . . . Atlanta, GA Courtyard Manhattan/Fifth Avenue. . . . . . . New York, NY The Lodge at Sonoma, a Renaissance Resort & Spa . . Sonoma, CA Total . . . . . . . . . . (1) As of December 31, 2005. (2) 2006 budgeted capital expenditures represents capital expenditures regardless of whether they will be paid for through an escrow account or owner funding. (3) Total projected investments for each hotel is the gross book value of the hotel as of December 31, 2005 plus 2006 budgeted capital expenditures. Recent Developments Chicago Marriott. On March 1, 2006, we signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile for a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments (or approximately $257,000 per room), including the assumption of $220 million of floating-rate debt. We made a $5 million non-refundable deposit upon entering into the purchase agreement. The acquisition is scheduled to close on March 15, 2006; however, we have the right to delay the closing for 30 days upon making an additional $5 million non-refundable deposit. We intend to refinance the existing floating-rate 30 loan with a fixed-rate loan issued by Wachovia Bank, National Association. The principal amount of the refinanced loan will be determined based on market conditions at the time of the refinancing and is expected to be between $170 million and $220 million. The new loan will be a limited recourse loan secured by a mortgage on the property. We will finance the remainder of the purchase price through a portion of the net proceeds from an equity offering. We expect to borrow up to $100 million through a short-term floating-rate loan arranged by Wachovia Bank, National Association, which we will repay with a portion of the net proceeds of the equity offering. We believe this hotel has an excellent location on North Michigan Avenue in Chicago’s famed shopping and entertainment district, the Magnificent Mile. The hotel is predominantly marketed to groups and individual business travelers who are seeking a premium full-service hotel located in the heart of this well-known district. According to the sellers’ records, last year, over half of the rooms sold at the hotel were sold to corporate and association groups and roughly a quarter were sold to individual corporate travelers. The hotel has 60,000 square feet of flexible meeting space. We believe that supply and demand dynamics are very favorable in Chicago. For example, the number of hotel rooms added to downtown Chicago over the past five years has been very limited, averaging just over 1% per year. In addition, Chicago is a compelling location for conventions and other city-wide events and over the next few years should benefit from the displacement of conventions caused by Hurricane Katrina. We also believe that this hotel is an irreplaceable asset as the land acquisition and construction cost of building a new large hotel in downtown Chicago would be prohibitive. We cannot assure you that we will acquire the Chicago Marriott because the completion of the proposed acquisition is subject to a variety of conditions. Refinancing of Courtyard Manhattan/Fifth Avenue. We have a commitment from Lehman Brothers Bank to refinance the mortgage loan on the Courtyard Manhattan/Fifth Avenue that will mature in January 2007. Pursuant to this commitment, we expect to refinance the $23 million existing floating-rate loan with a $51 million fixed-rate loan that matures in 10 years. At the closing of the refinancing, the interest rate on the loan will be set based on the then current 10-year swap rate plus 90 basis points. We expect that the new fixed-rate loan will require principal repayments based on a 30-year amortization schedule following the first five years of payments of interest only. We expect to close on this refinancing early in the second quarter of 2006. Our Hotels Los Angeles Airport Marriott The Los Angeles Airport Marriott has 1,004 guestrooms, including 19 suites, and approximately 55,000 square feet of meeting space. The hotel attracts both business and leisure travelers due to its convenient location minutes from Los Angeles International Airport (LAX), the fourth busiest airport in the world. The property attracts large groups due to its significant amount of meeting space, guestrooms and parking spaces. The hotel was built in 1973 and the most recent material renovation occurred in 1999. We are presently planning a major renovation of the rooms (replacing soft goods and case goods), bathrooms and corridors in 2006. We own a fee simple interest in the hotel. Salt Lake City Marriott Downtown The Salt Lake City Marriott Downtown has 510 guestrooms, including 6 suites, and approximately 22,300 square feet of meeting space. The hotel is located in downtown Salt Lake City across from the Salt 31 Palace Convention Center near Temple Square. Demand for the hotel is generated primarily by the Convention Center, the Church of Jesus Christ of Latter-Day Saints, the University of Utah, government offices and nearby ski destinations. The hotel is connected to Crossroads Plaza Mall, which is expected to undergo a major reconstruction as part of a redevelopment that is expected to include the construction of up to 900 residential units. We believe the hotel will also benefit from the planned establishment by the Church of Jesus Christ of Latter-Day Saints of a major university, with enrollment of up to 10,000 students, near the hotel. While we believe that the Salt Lake City market has good growth prospects over the next few years, it currently is characterized by over-supply, leading to intense rate competition and lower RevPAR. The hotel was built in 1981 and, immediately prior to the 2002 Salt Lake Olympic games, the prior owner made significant capital improvements, including the replacement of soft goods in the guestrooms and a refurbishment of the lobby, ballroom and public space. We hold ground lease interests in the hotel and the extension that connects the hotel to Crossroads Plaza Mall. The term of the ground lease for the hotel runs through 2056, inclusive of five ten-year renewal options. The term of the ground lease for the extension of the hotel (containing approximately 1,078 square feet) runs through 2017, inclusive of the one remaining ten-year renewal option. Frenchman’s Reef & Morning Star Marriott Beach Resort The Frenchman’s Reef & Morning Star Marriott Beach Resort was recently voted “best resort hotel and best resort hotel with a view” by readers of Caribbean Travel & Life. It is a 17-acre resort hotel located in St. Thomas, U.S. Virgin Islands. The hotel is located on a cliff overlooking Charlotte Amalie Bay and the Caribbean Sea. The hotel has 504 guestrooms, including 27 suites, and approximately 60,000 square feet of meeting space. The hotel caters primarily to tourists, but also attracts group business travelers. The Frenchman’s Reef section of the resort was built in 1973 and the Morning Star section of the resort was built in 1984. Following severe damage from a hurricane, the entire resort was substantially rebuilt in 1996 as part of a $60 million capital improvement. We own a fee simple interest in the hotel. Renaissance Worthington The Renaissance Worthington is Fort Worth’s only AAA Four Diamond hotel. It has 504 guestrooms, including 30 suites, and approximately 57,000 total square feet of meeting space. The hotel is located in downtown Fort Worth in Sundance Square, a sixteen-block retail area. It is also near Fort Worth’s Convention Center, which hosts a wide range of events, including conventions, conferences, sporting events, concerts and trade and consumer shows. The hotel was opened in 1981 and underwent $4 million in renovations in 2002 and 2003. While the hotel does not currently face significant competition from its competitors, the City of Fort Worth has announced that it will heavily subsidize the construction of a new hotel to be managed by Omni to be built next to the convention center. We expect that hotel to become the Renaissance Worthington’s primary competitor in the market. The Omni is scheduled to open in 2008. We acquired a fee simple interest in the hotel. A portion of the land under the parking garage (consisting of 0.28 acres of the entire 3.46 acre site) is subject to three co-terminous ground leases. Each of the ground leases extends to July 31, 2022 and provides for three successive renewal options of 15 years each. The ground leases provide for adjustments to the fixed ground rent payments every ten years during the term. 32 Torrance Marriott The Torrance Marriott has 487 guestrooms, including 11 suites, and approximately 23,000 square feet of indoor and outdoor meeting space. The hotel is located in Los Angeles County in Torrance, California, a major automotive center. Three major Japanese automobile manufacturers, Honda, Nissan and Toyota, have their U.S. headquarters in the Torrance area and generate significant demand for the hotel. It is also adjacent to the Del Amo Fashion Center mall, one of the largest malls in America. The hotel benefits from the fact that hotel room supply growth in Los Angeles has remained at relatively low levels, averaging only 0.62 percent per year between 1992 and 2003. The hotel was completed in 1985. We have developed an intensive capital improvement and repositioning plan for this hotel and plan to replace the guestroom soft goods, renovate the lobby, food and beverage outlets and meeting space, and convert the gift shop to a Starbucks outlet. We also see an opportunity to introduce new concepts for two of the property’s food and beverage outlets. We believe that our repositioning plan will allow this hotel to improve guest satisfaction, entice more group business, improve local catering sales and command higher rates. We own a fee simple interest in the hotel. Orlando Airport Marriott The Orlando Airport Marriott has 486 guestrooms, including 14 suites, and approximately 26,000 square feet of meeting space. The hotel has a resort-like setting yet is well-located in a successful commercial office park five minutes from the Orlando International Airport. The hotel serves predominantly business transient guests as well as small and mid-size groups that enjoy the hotel’s amenities as well as its proximity to the highly efficient and well run airport. We believe that the long-term trends at this hotel are very favorable as new hotel construction in the Orlando Airport sub-market is minimal while the airport is one of the fastest growing airports in the country. The hotel was built in 1983. We have developed an extensive renovation plan for this hotel, which we believe will help position the hotel to capture higher-rated corporate transient business. We have also begun to implement a complete re-segmentation of the customer base of the hotel by replacing the large, low-rated airline crew segment with higher-rated transient and group business. We own a fee simple interest in the hotel. Marriott Griffin Gate Resort Marriott Griffin Gate Resort is a 163-acre regional resort located north of downtown Lexington, Kentucky. The resort has 408 guestrooms, including 21 suites as well as 13,000 square feet of meeting space. The resort contains three distinct components: the seven story main hotel and public areas, the Griffin Gate Golf Club, with the Rees Jones-designed 18-hole golf course, and The Mansion (which was originally constructed in 1854 and was Lexington’s first AAA 4-Diamond restaurant). The hotel is near all the area’s major corporate office parks and regional facilities of a number of major companies such as IBM, Toyota, Lexel Corporation and Lexmark International. The hotel also is located in proximity to downtown Lexington, the University of Kentucky, the historic Keeneland Horse Track and the Kentucky Horse Park. The hotel was originally opened in 1981. In 2003, the prior owner, Marriott International, initiated a major renovation and repositioning of the resort, with an approximate $10 million capital improvement plan. We completed the renovation plan in 2005. The renovation included a complete guestroom and guestroom corridor renovation, as well as a renovation of the exterior façade. We also significantly renovated the public space at the hotel. 33 We own a fee simple interest in the hotel, The Mansion, and most of the Griffin Gate Golf Club. However, there is a ground lease interest under approximately 54 acres of the golf course. The ground lease runs through 2033 (inclusive of four five-year renewal options), and contains a buyout right beginning at the end of the term in 2013 and at the end of each five-year renewal term thereafter. We are the sub- sublessee under another minor ground lease of land adjacent to the golf course, with a term expiring in 2020. Oak Brook Hills Marriott Resort In July 2005, we acquired the Oak Brook Hills Resort & Conference Center, replaced the existing manager with an affiliate of Marriott and re-branded the hotel as the Oak Brook Hills Marriott Resort. The resort has 384 guestrooms, including 37 suites. The hotel markets itself to national and regional conferences by providing over 40,000 square feet of meeting space at a hotel with a championship golf course that is convenient to both O’Hare and Chicago Midway airports and is near downtown Chicago. The resort is located in Oak Brook, Illinois. The hotel was built in 1987. We have begun an extensive renovation at the resort which we intend to complete during 2006. We will renovate the public space, meeting rooms, food and beverage outlets and guest rooms. The hotel is located on approximately 18 acres that we own in fee simple. The hotel is adjacent to an 18 hole, approximately 110 acre, championship golf course that we lease pursuant to a ground lease which has approximately 40 years remaining, including renewal terms. Rent for the entire initial term of the ground lease has been paid in full. Vail Marriott Mountain Resort & Spa The Vail Marriott Mountain Resort & Spa is located at the base of Vail Mountain in Vail, Colorado. The hotel has 346 guestrooms, including 61 suites, and approximately 21,000 square feet of meeting space. The hotel is approximately 150 yards from the Eagle Bahn Express Gondola, which transports guests to the top of Vail Mountain, the largest single ski mountain in North America, with over 5,289 acres of skiable terrain. The hotel is located in Lions Head Village, the center of which is currently undergoing a massive renovation to create a new European-inspired plaza which will include luxury condominiums and a small 36 room hotel, as well as equipment rentals, ski storage, lockers, ski and snowboard school, shopping and après ski restaurant and bar; dining and shopping opportunities; and a winter ice-skating plaza and entertainment venues. Vail Resorts is scheduling the renovation to be completed before the 2007-2008 season. In total, more than a billion dollars is being invested in the redevelopment of the town of Vail over the next few years and we are optimistic that this investment will increase the value of our hotel. The hotel opened in 1983 and underwent a luxurious renovation of the public space, guest rooms and corridors in 2002. We are currently planning on completing the renovation, of the meeting space and pre- function space over the next year. We own a fee simple interest in the hotel. Marriott Atlanta Alpharetta The Marriott Atlanta Alpharetta is located in the city of Alpharetta, Georgia, approximately 22 miles north of Atlanta. Alpharetta is located in North Fulton County, a rapidly growing, very affluent county, which is characterized by being the national or regional headquarters of a number of large corporations and it contains a large network of small and mid-sized companies supporting these corporations. The hotel is located in the Windward Office Park near several major corporations, including ADP, AT&T, McKesson, Siemens, Nortel and IBM. The hotel provides all of the amenities that are desired by business 34 guests and is one of the few full-service hotels in a market predominately characterized by chain-affiliated select-service hotels. The hotel opened in 2000 and is in excellent condition. The hotel includes 318 guestrooms and 9,000 square feet of meeting space. We own a fee simple interest in the hotel. Courtyard Manhattan/Midtown East The Courtyard Manhattan/Midtown East is located in Manhattan’s East Side, on Third Avenue between 52nd and 53rd Streets. The hotel has 307 guestrooms and 1,500 square feet of meeting space. Prior to 1998, the building was used as an office building, but then was completely renovated and opened in 1998 as a Courtyard by Marriott. We will complete a complete guestroom and public space renovation in the first quarter of 2006. We also intend to add four new guestrooms as part of this renovation. We intend to target the higher end of the market as a result of many of these improvements. We hold a fee simple interest in a commercial condominium unit, which includes a 47.725% undivided interest in the common elements in the 866 Third Avenue Condominium; the rest of the condominium is owned predominately (48.2%) by the building’s other major occupant, Memorial Sloan-Kettering. The hotel occupies the lobby area on the 1st floor, all of the 12th-30th floors and its pro rata share of the condominium’s common elements. Bethesda Marriott Suites Bethesda Marriott Suites is located in the Rock Spring Corporate Office Park near downtown Bethesda, Maryland, with convenient access to Washington, D.C.’s Beltway (I-495) and the I-270 Technology Corridor. Rock Spring Corporate Office Park contains several million feet of office space and includes companies such as Marriott and Lockheed Martin Corp., as well as the National Institute of Health. The hotel contains 274 guestrooms, all of which are suites, and 4,300 square feet of total meeting space. The hotel was built in 1990. We are currently completing the refurbishment of guestrooms, to reposition the hotel for higher-rated business. We hold a ground lease interest in the property. The current term of the ground lease will expire in 2087. SpringHill Suites Atlanta Buckhead The SpringHill Suites Atlanta Buckhead is located in the heart of the Buckhead submarket of Atlanta, Georgia. Buckhead is one of the country’s largest urban mixed-use development areas, combining major office, retail, hotel, restaurant/entertainment and high-rise residential development within its commercial core area. The hotel is newly constructed and first opened for business in July 2005. We purchased the hotel upon opening from the developer of the hotel. We own a fee simple interest in this 220-room all-suite hotel. The hotel also has 2,000 square feet of meeting space. Courtyard Manhattan/Fifth Avenue The Courtyard Manhattan/Fifth Avenue is located on 40th Street, just off of Fifth Avenue in Midtown Manhattan, across the street from the New York Public Library. The hotel is situated in a convenient 35 tourist and business location. It is within walking distance from Times Square, Broadway theaters, Grand Central Station, Rockefeller Center and the Empire State Building. The hotel opened in 1990 as a Journey’s End-branded hotel and has since changed brands a number of times. The prior owner of the hotel invested $3.7 million in 1999 to refurbish the hotel and convert it to a Clarion brand pursuant to a five-year agreement. Upon the end of that agreement, the hotel operated under the name Hotel 5A, a non-franchised brand. We believe the hotel’s lack of strong brand affiliation adversely impacted operating results. In 2004, the previous owner engaged a national brokerage firm to market the hotel for sale and, through our senior management team’s relationship with the broker, we learned about the opportunity to purchase this hotel before it was broadly marketed. Between the time we learned of the opportunity to purchase the hotel and the bid date, we informed Marriott of this opportunity, and Marriott agreed to work with us on an exclusive basis to determine if the hotel was physically suitable to be converted to a Courtyard by Marriott hotel brand. The hotel was operating at a significant discount to the comparably located Courtyard Manhattan/Midtown East, located at 366 Third Avenue. The ADR at the hotel in 2004 was $58 lower than that of the Courtyard Manhattan/Midtown East in 2004. Prior to the bid date, we worked with Marriott to develop a significant rebranding, renovation and repositioning plan to convert the hotel to a Courtyard by Marriott and take advantage of the hotel’s excellent location and the strength of the Marriott brand. Marriott provided $1 million of Key Money to enter into a long-term hotel management agreement with Marriott. We submitted a bid, won the bid process and acquired the hotel in December 2004, and the hotel was re-branded as a Courtyard by Marriott in January 2005. We are completing significant capital improvements in 2005 and 2006 in connection with the re- branding, renovation and repositioning plan. The capital improvement plan included a complete soft goods renovation of the guestrooms, purchasing new furniture and bedding for the guestrooms, renovation of the bathrooms with granite vanity tops, installation of a new exercise facility, construction of a boardroom meeting space and modifications to make the hotel more accommodating to persons with disabilities. We hold a ground lease interest in the hotel. The term of the ground lease expires in 2085, inclusive of one 49-year extension. The hotel includes 185 guestrooms. The Lodge at Sonoma, a Renaissance Resort & Spa The Lodge at Sonoma, a Renaissance Resort & Spa, is located in the heart of the Sonoma Valley wine country, 45 miles from San Francisco, in the town of Sonoma, California. Numerous wineries are located within a short driving distance from the resort. The area is served by the Sacramento, Oakland and San Francisco airports. The resort is readily accessible by a variety of local, county, and state highways, including Highway 101. Leisure demand is generated by Sonoma Valley and Napa Valley wine country attractions. Group and business demand is primarily generated from companies located in San Francisco and the surrounding Bay Area, and some ancillary demand is generated from the local wine industry. We own a fee simple interest in the hotel, which is comprised of the main two-story Lodge building, including 76 guestrooms and 18 separate cottage buildings, containing the remaining 102 guestrooms and 4 suites. The Raindance Spa is located in a separate two-story building at the rear of the cottages. The hotel also has 22,000 square feet of meeting and banquet space. 36 Our Hotel Management Agreements We are a party to hotel management agreements with Marriott for fourteen of the fifteen properties owned as of December 31, 2005. The fifteenth hotel, the Vail Marriott Mountain Resort & Spa, is managed by an affiliate of Vail Resorts and is under a long-term franchise agreement with Marriott. Marriott is responsible for (i) the hiring of certain executive level employees, subject to certain veto rights, (ii) training and supervising the managers and employees required to operate the properties and (iii) purchasing supplies, for which we generally will reimburse Marriott. Marriott provides centralized reservation systems, national advertising, marketing and promotional services, as well as various accounting and data processing services. Marriott also prepares and implements annual operations budgets subject to our review and approval. Each of our management agreements limits our ability to sell, lease or otherwise transfer the hotels unless the transferee (i) is not a competitor of the manager, (ii) assumes the related management agreements and (iii) meets specified other conditions. Term The following table sets forth the effective date, initial term and number of renewal terms under the respective hotel management agreements for each of our hotels. Generally, the term of the hotel management agreements generally automatically renew for a negotiated number of consecutive periods upon the expiration of the initial term unless the property manager gives notice to us of its election not to renew the hotel management agreement. The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Midtown East. . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . Courtyard Manhattan/Fifth Avenue . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . Date of Agreement Initial Term Number of Renewal Terms 10/2004 11/2004 12/2001 01/2005 12/2004 12/2004 1/2005 9/2000 9/2000 9/2000 9/2000 6/2005 7/2005 7/2005 11/2005 20 years 30 years 30 years 30 years 20 years 21 years 40 years 30 years 30 years 30 years 30 years 15½ years 30 years 30 years 30 years One ten-year period Two ten-year periods Three fifteen-year periods None One ten-year period Two ten-year periods None Two ten-year periods Two ten-year periods Two ten-year periods Two ten-year periods None Two ten-year periods None None Amounts Payable under our Hotel Management Agreements Under our current hotel management agreements, the property manager receives a base management fee and, if certain financial thresholds are met or exceeded, an incentive management fee. The base management fee is generally payable as a percentage of gross hotel revenues for each fiscal year. The incentive management fee is generally based on hotel operating profits and is typically equal to between 20% and 25% of hotel operating profits but the fee only applies to that portion of hotel operating profits above a negotiated return on our invested capital. We refer to this excess of operating profits over a return on our invested capital as “available cash flow.” 37 The following table sets forth the base management fee and incentive management fee, generally due and payable each fiscal year, for each of our properties: Courtyard Manhattan/Midtown East. . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Fifth Avenue . . . . . . . . . . . . . . . . . . . The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) As a percentage of gross revenues. Base Management Fee(1) 5% 3% 3% 3% 3% 5%(8) 3% 3% 3% 3% 3% 3% 5%(11) 3% 3% Incentive Management Fee(2) 25%(3) 20%(4) Not more than 20%(5) 20%(6) 50%(7) 25%(9) 20%(10) 25%(12) 25%(13) 25%(14) 25%(15) 20%(16) 25%(17) 20% or 30%(18) 20% or 25%(19) (2) Based on a percentage of hotel operating profits above a negotiated return on our investment capital as more fully described in the following footnotes. (3) Calculated as a percentage of operating profits in excess of 10.75% of the sum of (i) $73.7 million and (ii) the amount of certain capital expenditures. (4) Calculated as a percentage of operating profits in excess of the sum of (i) $7.5 million and (ii) 10.75% of certain capital expenditures. (5) The incentive management fee is equal to the available cash flow for each fiscal year, subject to a cap of 20% of operating profit for such fiscal year. Commencing with the fiscal year 2002, the operating profit with respect to each fiscal year is reduced by an amount equal to 10.75% of all material capital expenditures funded by the TRS lessee; provided that the material capital expenditures are included in the calculation of the incentive management fee with respect to the fiscal year or fiscal years during which such expenditures occurred (on a pro rata basis). (6) Calculated as a percentage of operating profits in excess of the sum of (i) $5.5 million and (ii) 10.75% of certain capital expenditures. (7) Calculated as a percentage of operating profits in excess of the sum of (i) the payment of certain loan procurement costs, (ii) 10.75% of certain capital expenditures, (iii) an agreed-upon return on certain expenditures and (iv) the value of certain amounts paid into a reserve account established for the replacement, renewal and addition of certain hotel goods. (8) The base management fee will be equal to 5.5% of gross revenues for fiscal years 2010 through 2014 and 6% for fiscal year 2015 and thereafter until the expiration of the agreement. Also, beginning in 2007, the base management fee may increase to 5.5% at the beginning of the next fiscal year if operating profits equal or exceed $4.7 million, and beginning in 2011, the base management fee may increase to 6.0% at the beginning of the next fiscal year if operating profits equal or exceed $5.0 million. (9) Calculated as a percentage of operating profits in excess of 12% of the sum of (i) $38.8 million and (ii) the amount of certain capital expenditures, less 5% of the total real estate tax bill (for as long as the hotel is leased to a party other than the manager). (10) Calculated as a percentage of operating profits in excess of the sum of (i) $3.6 million and (ii) 10.75% of capital expenditures. (11) The base management fee will be equal to 6% of gross revenues for fiscal years 2008 through 2016 and 6.5% of gross revenues thereafter. In the event that the property’s operating profit is below certain thresholds in 2006 and 2007, the base management fee may be reduced by up to $100,000 per year. In addition, in the event that the hotel’s operating profit is above certain thresholds starting in 2008, the base management fee will be increased to 6.5% and if the hotel’s operating profit is above an additional threshold starting in 2012, the base management fee will be increased to 7.0% 38 (12) Calculated as a percentage of operating profits in excess of the sum of (i) $4.1 million and (ii) 10.75% of certain capital expenditures. (13) Calculated as a percentage of operating profits in excess of the sum of (i) $8.4 million and (ii) 10.75% of certain capital expenditures. (14) Calculated as a percentage of operating profits in excess of the sum of (i) $9.4 million and (ii) 10.75% of certain capital expenditures. (15) Calculated as a percentage of operating profits in excess of the sum of (i) $7.6 million and (ii) 10.75% of certain capital expenditures. (16) Calculated as a percentage of operating profits in excess of 11% of our invested capital. The incentive management fee rises to 25% if the hotel achieves operating profits in excess of 15% of our invested capital. (17) Calculated as a percentage of operating profits in excess of the sum of (i) $4.1 million and (ii) 12% of certain capital expenditures and pre-conversion expenses. (18) Calculated as a percentage of operating profits in excess of the sum of (i) $8.1 million and (ii) 10.75% of certain capital expenditures. The percentage of operating profits is 20% except from 2011 through 2025 when it is 30%. (19) Calculated as a percentage of operating profits in excess of 10.75% of our acquisition costs plus certain capital expenditures. We estimate that the threshold will be approximately $9 million. The percentage of operating profits is 20% except from 2011 through 2025 when it is 25%. We paid $8,107,902 and $260,724 of management fees during the year ended December 31, 2005 and the period from May 6, 2004 (inception) to December 31, 2004. The management fees for the year ended December 31, 2005 consisted of $634,000 of incentive management fees and $7,473,902 of base management fees. All management fees earned during the period from May 6, 2004 (inception) to December 31, 2004 were base management fees. Chicago Marriott Management Agreement In connection with our probable acquisition of the Chicago Marriott, we expect to assume a hotel management agreement, dated November 28, 1989, with Marriott as the hotel manager. The initial term expires in December 2008 and is automatically extended for five additional periods of 10 years each. Under this hotel management agreement, Marriott receives a base management fee of 3% of gross revenue as well as an incentive management fee of 20% of hotel operating profits. Unlike all of our other management agreements, the incentive management fee is calculated on the entire operating profit as there is no “owners priority” and the incentive management fee does not deduct base management fees from the calculation of hotel operating profits. This agreement may be terminated by Marriott upon the expiration of the initial term or any renewal term upon eighteen months written notice. This agreement may not be terminated by us and does not provide for any performance termination right. Our Ground Lease Agreements Three of our hotels are subject to ground lease agreements that cover all of the land underlying the respective hotel: • The Bethesda Marriott Suites hotel is subject to a ground lease that runs until 2087. There are no renewal options. • The Courtyard Manhattan/Fifth Avenue is subject to a ground lease that runs until 2085, inclusive of one 49-year renewal option. • The Salt Lake City Marriott Downtown is subject to two ground leases: one ground lease covers the land under the hotel and the other ground lease covers the portion of the hotel that extends into the Crossroads Plaza Mall. The term of the ground lease covering the land under the hotel runs through 2056, inclusive of our renewal options, and the term of the ground lease covering the extension runs through 2017, inclusive of the remaining ten-year renewal option. 39 In addition, part of one of the parking garages adjacent to one of our hotels is subject to a ground lease agreement: • A portion of the parking garage relating to the Renaissance Worthington is subject to three ground leases that cover, contiguously with each other, approximately one-fourth of the land on which the parking garage is constructed. Each of the ground leases has a term that runs through July 2067, inclusive of the three 15-year renewal options. Finally, two of the golf courses adjacent to two of our hotels are subject to ground lease agreements: • The golf course which is part of the Marriott Griffin Gate Resort is subject to a ground lease covering approximately 54 acres. The ground lease runs through 2033, inclusive of our renewal options. We have the right, beginning in 2013 and upon the expiration of any 5-year renewal term, to purchase the property covered by such ground lease for an amount ranging from $27,500 to $37,500 per acre, depending on which renewal term has expired. The ground lease also grants us the right to purchase the leased property upon a third party offer to purchase such property on the same terms and conditions as the third party offer. We are also the sub-sublessee under another minor ground lease of land adjacent to the golf course, with a term expiring in 2020. • The golf course which is part of the Oak Brook Hills Marriott Resort is subject to a ground lease covering approximately 110 acres. The ground lease runs through 2045 including renewal options. These ground leases generally require us to make rental payments (including a percentage of gross receipts as percentage rent with respect to the Courtyard Manhattan/Fifth Avenue ground lease) and payments for all, or in the case of the ground leases covering the Salt Lake City Marriott Downtown extension and a portion of the Marriott Griffin Gate Resort golf course, our tenant’s share of, charges, costs, expenses, assessments and liabilities, including real property taxes and utilities. Furthermore, these ground leases generally require us to obtain and maintain insurance covering the subject property. 40 The following table reflects the annual base rents of our ground leases: Property Term(1) Annual Rent Ground leases under hotels Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Fifth Avenue(3) (4). . . . . . . . . Through 10/87 $390,015(2) 10/97 – 9/07 10/07 – 9/17 10/17 – 9/27 10/27 – 9/37 10/37 – 9/47 10/47 – 9/57 10/57 – 9/67 10/67 – 9/77 10/77 – 9/85 800,000 906,000 1,132,812 1,416,015 1,770,019 2,212,524 2,765,655 3,457,069 4,321,336 Salt Lake City Marriott Downtown (Ground Lease for Hotel) . . . . . . . . . . . . . . . . . . . . . Through 12/56 Greater of $132,000 or 2.6% of annual gross room sales (Ground Lease for Extension) . . . . . . . . . . . . . . . . . . . Ground leases under parking garage Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . . . Ground leases under golf course Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . Through 12/07 1/08 – 12/12 1/13 – 12/17 Through 7/12 8/12 – 7/22 8/22 – 7/37 8/37 – 7/52 8/52 – 7/67 9/03 – 8/08 9/08 – 8/13 9/13 – 8/18 9/18 – 8/23 9/23 – 8/28 9/28 – 8/33 Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . 10/85 – 9/25 (1) These terms assume our exercise of all renewal options. (2) Represents rent for the year ended December 31, 2005. Rent will increase annually by 5.5%. 9,343 10,277 11,305 36,613 40,400 46,081 51,764 57,444 90,750 99,825 109,800 120,750 132,750 147,000 1(5) (3) The ground lease term is 49 years. We have the right to renew the ground lease for an additional 49 year term on the same terms then applicable to the ground lease. (4) The total annual rent includes the fixed rent noted in the table plus a percentage rent equal to 5% of gross receipts for each lease year, but only to the extent that 5% of gross receipts exceeds the minimum fixed rent in such lease year. (5) We have the right to extend the term of this lease for two consecutive renewal terms of ten years each with rent at then market value. Subject to certain limitations, an assignment of the ground leases covering the Courtyard Manhattan/Fifth Avenue and a portion of the Marriott Griffin Gate Resort golf course and the Oak Brook Hills Marriott Resort golf course do not require the consent of the ground lessor. With respect to the 41 ground leases covering the Salt Lake City Marriott Downtown hotel and extension and Bethesda Marriott Suites, any proposed assignment of our leasehold interest as ground lessee under the ground lease requires the consent of the applicable ground lessor. As a result, we may not be able to sell, assign, transfer or convey our ground lessee’s interest in any such property in the future absent the consent of the ground lessor, even if such transaction may be in the best interests of our stockholders. Mortgage Debt As of December 31, 2005, we had approximately $416.4 million of outstanding mortgage debt. The following table sets forth our mortgage debt obligations on our hotels. Property Bethesda Marriott Suites . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . . . . . Marriott Griffin Gate Principal Balance $ 19,305,400 Prepayment Penalties Yes(1) 62,500,000 No(2) Resort . . . . . . . . . . . . . . . . 30,442,250 Yes(4) Los Angeles Airport Marriott . . . . . . . . . . . . . . 82,600,000 No(2) Courtyard Manhattan/ Interest Rate 7.69% 5.44% 5.11% 5.30% Maturity Date 2/23 Amortization Provisions 25 years 8/15 30 years(3) 1/10 25 years 7/15 Interest Only Fifth Avenue . . . . . . . . . . 23,000,000 No(5) LIBOR + 2.70%(6) 1/07(7) Interest Only Courtyard Manhattan/ Midtown East. . . . . . . . . . Orlando Airport Marriott . Salt Lake City Marriott 44,130,896 59,000,000 No(8) No(2) Downtown . . . . . . . . . . . . Renaissance Worthington . Total . . . . . . . . . . . . . . . . . . . 38,016,189 57,400,000 $ 416,394,735 Yes(8) No(2) 5.195% 5.68% 5.50% 5.40% 12/09 12/15 12/14 7/15 25 years 30 years (9) 20 years(10) 30 years(11) (1) The debt may be prepaid. If it is prepaid prior to August 2012, it is subject to a prepayment fee equal to the greater of (i) one percent of the outstanding principal amount or (ii) a yield maintenance premium determined as set forth in the Deed of Trust. (2) Prepayment of the debt on the Los Angeles Airport Marriott, Renaissance Worthington and Orlando Airport Marriott is not permitted until the earlier of (i) two years after securitization (the lender intends to sell all or a portion of the debt through one or more public offerings) or (ii) four years from the closing date. Thereafter, we may pay a defeasance deposit in lieu of a prepayment of the debt. Prepayment in full will be permitted at par on the last three payment dates before the maturity date. For the loan secured by the mortgage on Frenchman’s Reef & Morning Star Marriott Beach Resort, we may release the lien of mortgage through a defeasance deposit at any time after the earlier of (i) two years after securitization or (ii) thirty months after the closing date of the loan. (3) The debt has a three-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. (4) We may not prepay the loan without the express written consent of the lender, and we have no right to prepay the debt until October 2009. Notwithstanding the foregoing, if the lender accepts prepayment of the debt prior to October 2009, we must pay a penalty equal to the greater of (i) 1% of the outstanding principal and (ii) the present value, as of the prepayment calculation date, of a series of monthly payments over the remaining term of the loan, each equal to the amount of interest that would be due on the portion of the loan being prepaid, assuming an annual interest rate of 5.11% over the discounted reinvestment yield, as such term is defined in the agreement. (5) The debt may be prepaid at par. (6) We have entered into an interest rate cap agreement on this debt. Breakage fees may be payable if the debt is repaid. (7) The debt allows for three one-year extensions provided that certain conditions are met. 42 (8) The debt may not be prepaid until three months prior to the maturity date of the mortgage loan (the “Prepayment Release Date”). For Salt Lake City Marriott Downtown, we may prepay the loan on or after the Prepayment Release Date without payment of fees. However, we must pay to the lender, simultaneously with such prepayment, the interest that would have accrued on the outstanding principal balance of the loan at the regular interest rate through the end of the interest period in which such prepayment occurs. (9) The debt has a five-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. (10) There is an accelerated amortization provision based on a predetermined formula of available cash flow. (11) The debt has a four-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. Item 3. Legal Proceedings We are not involved in any material litigation nor, to our knowledge, is any material litigation threatened against us. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2005. 43 Item 5. Market for our common stock and related stockholder matters Market Information PART II Our common stock trades on the New York Stock Exchange under the symbol “DRH”. The following table sets forth, for the indicated period, the high and low closing prices for the common stock, as reported on the New York Stock Exchange: Price Range High Low Year Ended December 31, 2005 First Quarter (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second Quarter (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . N/A $11.73 $12.62 $12.00 N/A $10.50 $11.14 $10.84 Year Ended December 31, 2006 First Quarter (through March 6, 2006). . . . . . . . . . . . . . . . . $13.52 $11.85 (1) Our common stock commenced trading on the New York Stock Exchange on May 26, 2005. The closing price of our common stock on the New York Stock Exchange on March 6, 2006 was $13.40 per share. In order to maintain our qualification as a REIT, we must make distributions to our stockholders each year in an amount equal to at least: • 90% of our REIT taxable income determined without regard to the dividends paid deduction, plus; • 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the U.S. Internal Revenue Code of 12986, as amended (the “Code”), minus; • Any excess non-cash income. During the second fiscal quarter of 2005 our board of directors declared a cash dividend of $0.0326 per share of our common stock. The dividend was paid on June 28, 2005 to stockholders of record as of June 17, 2005. During the third fiscal quarter of 2005 our board of directors declared a cash dividend of $0.1725 per share of our common stock. The dividend was paid on September 27, 2005 to stockholders of record as of September 9, 2005. During the fourth fiscal quarter of 2005 our board of directors declared a cash divided of $0.1725 per share of our common stock. The dividend was paid on January 17, 2006 to stockholders on record as of December 30, 2005. As of March 6, 2006, there were 18 record holders of our common stock. In order to comply with certain requirements related to our qualification as a REIT, our charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.8% of the outstanding common shares. 44 Equity compensation plan information. The following table sets forth information regarding securities authorized for issuance under our equity compensation plan, the 2004 Stock Option and Incentive Plan, as of December 31, 2005. Under our 2004 Stock Option and Incentive Plan, we have only issued shares of restricted stock or deferred stock units. We have not issued any options to purchase shares of DiamondRock Hospitality Company’s common stock and do not intend to issue any such options in 2006. See Note 5 on page F-12 for a complete description of the 2004 Stock Option and Incentive Plan. Equity Compensation Plan Information Number of securities to be issued upon exercise of outstanding options, warrants and rights (a) Weighted-average exercise price of outstanding options, warrants and rights (b) Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c) 1,170,333 — 1,170,333 N/A N/A N/A 829,667 — 829,667 Plan category Equity compensation plans approved by security holders. . . . . . . . . . . . . . . . Equity compensation plans not approved by security holders. . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 6. Selected Financial Data The selected historical financial information as of and for the year ended December 31, 2005, and as of December 31, 2004 and the period from May 6, 2004 (inception) to December 31, 2004, has been derived from our audited historical financial statements. The selected historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements as of and for the year ended December 31, 2005 and as of December 31, 2004 and for the period from May 6, 2004 (inception) to December 31, 2004, and the related notes contained elsewhere in this Form 10-K. We present the following two non-GAAP financial measures that we believe are useful to investors as key measures of our operating performance: (1) EBITDA; and (2) FFO. We caution investors that amounts presented in accordance with our definitions of EBITDA and FFO may not be comparable to similar measures disclosed by other companies, since not all companies calculate these non-GAAP measures in the same manner. EBITDA and FFO should not be considered as an alternative measure of our net income (loss), operating performance, cash flow or liquidity. EBITDA and FFO may include funds that may not be available for our discretionary use due to functional requirements to conserve funds for capital expenditures and property acquisitions and other commitments and uncertainties. Although we believe that EBITDA and FFO can enhance your understanding of our results of operations, these non- GAAP financial measures, when viewed individually, are not necessarily better indicators of any trend as compared to GAAP measures such as net income (loss) or cash flow from operations. In addition, you should be aware that adverse economic and market conditions may harm our cash flow. Under this section, as required, we include a quantitative reconciliation of EBITDA and FFO to the most directly comparable GAAP financial performance measure, which is net income (loss). 45 Historical Year Ended December 31, 2005 Period from May 6, 2004 to December 31, 2004 Statement of operations data: Revenues: Rooms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 151,755,924 63,261,282 14,433,057 229,450,263 Operating costs and expenses: Rooms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other hotel expenses and management fees . . . . . . . . . . . . . . . . . . . Corporate expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss per share—basic and diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends declared per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FFO(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EBITDA(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,432,635 47,281,237 96,555,386 13,461,528 27,590,234 222,321,020 7,129,243 (1,548,635) 17,367,079 (8,689,201) 1,353,261 $ (7,335,940) (0.19) $ 0.38 $ $ 20,254,294 $ 36,268,112 $ 5,137,370 1,507,960 428,534 7,073,864 1,455,380 1,266,827 3,444,683 4,114,165 1,053,283 11,334,338 (4,260,474) (1,333,837) 773,101 (3,699,738) 1,582,113 $ (2,117,625) $ (0.12) — $ $ (1,064,342) $ (1,873,354) As of December 31, 2005 As of December 31, 2004 Balance sheet data: Property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 870,562,399 9,431,741 966,012,282 431,177,057 71,446,797 463,388,428 $ 285,642,439 76,983,107 391,691,179 180,771,810 15,331,951 195,587,418 (1) FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT’), is net income (loss) determined in accordance with GAAP, excluding gains (losses) from sales of property, plus real estate related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures (which are calculated to reflect FFO on the same basis). The calculation of FFO may vary from entity to entity, thus our presentation of FFO may not be comparable to other similarly titled measures of other reporting companies. FFO is not intended to represent cash flows for the period. FFO has not been presented as an alternative to operating income, but as an indicator of operating performance, and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. FFO is a supplemental industry-wide measure of REIT operating performance, the definition of which was first proposed by NAREIT in 1991 (and clarified in 1995, 1999 and 2002). Since the introduction of the definition by NAREIT, the term has come to be widely used by REITs. Historical GAAP cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use 46 historical GAAP cost accounting to be insufficient by themselves. Accordingly, we believe FFO (combined with our primary GAAP presentations) help improve our stockholders’ ability to understand our operating performance. We only use FFO as a supplemental measure of operating performance. The following is a reconciliation between net loss and FFO: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate related depreciation and amortization . . . . . . . . . . . . . . . . . . . FFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2005 Period from May 6, 2004 to December 31, 2004 $ (7,335,940) $ (2,117,625) 27,590,234 1,053,283 $ 20,254,294 $ (1,064,342) (2) EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization. We believe it is a useful financial performance measure for us and for our stockholders and is a complement to net income and other financial performance measures provided in accordance with GAAP. We use EBITDA to measure the financial performance of our operating hotels because it excludes expenses such as depreciation and amortization, taxes and interest expense, which are not indicative of operating performance. By excluding interest expense, EBITDA measures our financial performance irrespective of our capital structure or how we finance our properties and operations. By excluding depreciation and amortization expense, which can vary from hotel to hotel based on a variety of factors unrelated to the hotels’ financial performance, we can more accurately assess the financial performance of our hotels. Under GAAP, hotels are recorded at historical cost at the time of acquisition and are depreciated on a straight-line basis. By excluding depreciation and amortization, we believe EBITDA provides a basis for measuring the financial performance of hotels unrelated to historical cost. However, because EBITDA excludes depreciation and amortization, it does not measure the capital we require to maintain or preserve our fixed assets. In addition, because EBITDA does not reflect interest expense, it does not take into account the total amount of interest we pay on outstanding debt nor does it show trends in interest costs due to changes in our borrowings or changes in interest rates. EBITDA, as calculated by us, may not be comparable to EBITDA reported by other companies that do not define EBITDA exactly as we define the term. Because we use EBITDA to evaluate our financial performance, we reconcile it to net income (loss) which is the most comparable financial measure calculated and presented in accordance with GAAP. EBITDA does not represent cash generated from operating activities determined in accordance with GAAP, and should not be considered as an alternative to operating income or net income determined in accordance with GAAP as an indicator of performance or as an alternative to cash flows from operating activities as an indicator of liquidity. The following is a reconciliation between net income (loss) and EBITDA: $ Year Ended December 31, 2005 (7,335,940) 17,367,079 (1,353,261) 27,590,234 36,268,112 $ Period from May 6, 2004 to December 31, 2004 $ $ (2,117,625) 773,101 (1,582,113) 1,053,283 (1,873,354) Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EBITDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this prospectus. This discussion contains forward-looking statements about our business. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Forward- Looking Statements” and “Risk Factors” contained elsewhere in this prospectus. Overview We are a self-advised real estate company. We are committed to maximizing shareholder value through investing in premium full-service hotels and, to a lesser extent, premium urban select-service hotels. We will own sixteen hotels comprising 7,311 rooms upon completion of our recently announced hotel acquisition in downtown Chicago. These hotels have an aggregate projected investment of approximately $1.3 billion and are geographically diversified across major markets in the United States. We differentiate ourselves through our: • Proven acquisition capability; • Aggressive asset management; • Conservative capital structure; and • Experienced senior management team. Proven Acquisition Capability Since we completed our first acquisition in October 2004, we have acquired, or have under contract to acquire, sixteen premium hotels. We have acquired eleven of these hotels in off-market transactions, meaning that they were not made generally available to other companies. We intend to make additional acquisitions that meet our stringent underwriting criteria. Consistent with this strategy, on March 1, 2006, we signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile at a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments. We believe that the current environment presents an excellent opportunity to acquire hotels based on our view that lodging industry fundamentals are currently strong and will remain strong for some time to come. Generally, we invest in hotels that we believe are priced below replacement costs and are located in markets with attractive growth prospects and high barriers to entry. We are focused on acquiring premium full-service hotels located throughout North America and, to a lesser extent, premium select-service hotels in urban locations. We believe we have a competitive advantage in acquiring hotels through our unique investment sourcing relationship with Marriott, a leading worldwide hotel brand, franchise and management company. Our investment sourcing relationship with Marriott provides us, subject to certain limitations, with a “first look” at hotel acquisition and investment opportunities known to Marriott. As a result of Marriott’s extensive network, relationships and knowledge, we have preferred access to a unique source of hotel investment opportunities, many of which may not be available to other hospitality companies. Since our formation in May 2004, Marriott has provided us with access to several billion dollars of off-market acquisition opportunities. Our relationship with Marriott has facilitated the acquisition of eight of our hotels, including the Marriott Griffin Gate Resort and The Lodge at Sonoma, a Renaissance Resort & Spa, both of which we acquired directly from Marriott. 48 Aggressive Asset Management We believe that we are able to create significant value in our portfolio by utilizing our management’s extensive experience and our innovative asset management strategies. Our senior management team has established a broad network of hotel industry contacts and relationships, including relationships with hotel owners, financiers, operators, project managers and contractors and other key industry participants. In particular, we believe that we are unique in having a senior management team, most of whom worked for many years at Marriott, with very deep knowledge of Marriott’s organization and processes, which gives us insight in how best to work with Marriott to deliver superior returns at our hotels. Our philosophy is to negotiate management agreements that give us the right to exert significant influence (but not day-to-day control) over the management of our properties, annual budgets and all capital expenditures, and then to use those rights to continually monitor and improve the performance of our properties. We cooperatively partner with the managers of our hotels in an attempt to increase operating results and long-term asset values at our hotels. In addition to working directly with the personnel at our hotels, our senior management team also has long-standing professional relationships with our hotel managers’ senior executives and we work directly with these senior executives to improve the performance of our portfolio. We believe we can create significant value in our portfolio through innovative asset management strategies such as rebranding, renovating or repositioning. We are committed to regularly evaluating our portfolio to determine if we can employ these value-added strategies at our hotels. We have rebranded two of our properties, including one in which we converted an independently branded hotel to a Marriott brand, which contributed to a 31% increase in revenues and significantly increased operating margins at the hotel in 2005 compared to pro forma 2004. We also have budgeted to spend approximately $84 million in 2006 on identified value-added capital investment opportunities at our existing hotels. The opportunities range from room renovation (Courtyard Manhattan/Midtown East, Los Angeles Airport Marriott, Bethesda Marriott Suites) to a total renovation and repositioning of the hotel (Torrance Marriott and the Oak Brook Hills Marriott Resort). In connection with our planned renovations and repositionings, our senior management team and our asset managers are individually committed to completing these renovations on time, on budget and with a minimal disruption at our hotels. We are optimistic that, when completed, these renovations will enable us to achieve higher rates and greater demand for our hotels. Conservative Capital Structure We are committed to maintaining a conservative capital structure with prudent aggregate leverage primarily comprised of long-term fixed-rate debt. However, we maintain the flexibility to modify these strategies if we believe fundamental changes have occurred in the capital markets. As of December 31, 2005, more than 90% of our debt carried fixed interest rates, with a weighted- average interest rate of 5.6%, and a weighted-average maturity date in excess of 8 years. As of December 31, 2005, we had $428.4 million of debt outstanding, representing a debt-to-enterprise value ratio of 41%, which is calculated as our market capitalization plus net debt. We currently have a target debt-to-enterprise value ratio of 45% to 55%. We prefer a relatively simple but efficient capital structure. We have not invested in joint ventures and have not issued any operating partnership units or preferred stock. We endeavor to structure our hotel acquisitions so that they will not overly complicate our capital structure; however, we will consider a more complex transaction if we believe that the projected returns to our stockholders will significantly exceed the returns that would otherwise be available. 49 Experienced Senior Management Team The extensive hotel industry experience of our senior management team enables us to effectively implement our business strategies. Our senior management team of William W. McCarten, John L. Williams, Mark W. Brugger, Michael D. Schecter and Sean M. Mahoney has significant experience in lodging, real estate and related service industries, including hotel asset management, acquisitions, mergers, dispositions, development, redevelopment and financing. Collectively, they have been involved in hotel transactions aggregating several billion dollars. Key Indicators of Financial Condition and Operating Performance We use a variety of operating and other information to evaluate the financial condition and operating performance of our business. These key indicators include financial information that is prepared in accordance with GAAP, as well as other financial information that is not prepared in accordance with GAAP. In addition, we use other information that may not be financial in nature, including statistical information and comparative data. We use this information to measure the performance of individual hotels, groups of hotels and/or our business as a whole. We periodically compare historical information to our internal budgets as well as industry-wide information. These key indicators include: • Occupancy percentage; • ADR; • RevPAR; • EBITDA; and • FFO. Occupancy, ADR and RevPAR are commonly used measures within the hotel industry to evaluate operating performance. RevPAR, which is calculated as the product of ADR and occupancy percentage, is an important statistic for monitoring operating performance at the individual hotel level and across our business as a whole. We evaluate individual hotel RevPAR performance on an absolute basis with comparisons to budget and prior periods, as well as on a company-wide and regional basis. ADR and RevPAR include only room revenue. Room revenue comprised approximately 66% of our total revenues for the year ended December 31, 2005, and is dictated by demand, as measured by occupancy percentage, pricing, as measured by ADR, and our available supply of hotel rooms. Our ADR, occupancy percentage and RevPAR performance may be impacted by macroeconomic factors such as regional and local employment growth, personal income and corporate earnings, office vacancy rates and business relocation decisions, airport and other business and leisure travel, new hotel construction and the pricing strategies of competitors. In addition, our ADR, occupancy percentage and RevPAR performance is dependent on the continued success of Marriott and its brands. We also use EBITDA and FFO as measures of the financial performance of our business. See “Non- GAAP Financial Matters.” 50 Our Hotels As of December 31, 2005, we owned the following hotels: Property Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Location Los Angeles, California Salt Lake City, Utah Fort Worth, Texas St. Thomas, U.S. Virgin Islands Los Angeles County, California Beach Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Midtown East. . . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Fifth Avenue . . . . . . . . . . . . . . . . . . . . The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orlando, Florida Lexington, Kentucky Oak Brook, Illinois Vail, Colorado Atlanta, Georgia Bethesda, Maryland Atlanta, Georgia Sonoma, California New York, New York New York, New York Number of Rooms 1,004 510 504 504 487 486 408 384 346 318 307 274 220 185 182 6,119 Recent Developments Chicago Marriott. On March 1, 2006, we signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile for a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments (or approximately $257,000 per room), including the assumption of $220 million of floating-rate debt. We made a $5 million non-refundable deposit upon entering into the purchase agreement. The acquisition is scheduled to close on March 15, 2006; however, we have the right to delay the closing for 30 days upon making an additional $5 million non-refundable deposit. We intend to refinance the existing floating-rate loan with a fixed-rate loan issued by Wachovia Bank, National Association. The principal amount of the refinanced loan will be determined based on market conditions at the time of the refinancing and is expected to be between $170 million and $220 million. The new loan will be a limited recourse loan secured by a mortgage on the property. We will finance the remainder of the purchase price through a portion of the net proceeds from an equity offering. We expect to borrow up to $100 million through a short-term floating-rate loan arranged by Wachovia Bank, National Association, which we will repay with a portion of the net proceeds of the equity offering. We believe this hotel has an excellent location on North Michigan Avenue in Chicago’s famed shopping and entertainment district, the Magnificent Mile. The hotel is predominantly marketed to groups and individual business travelers who are seeking a premium full-service hotel located in the heart of this well-known district. According to the sellers’ records, last year, over half of the rooms sold at the hotel were sold to corporate and association groups and roughly a quarter were sold to individual corporate travelers. The hotel has 60,000 square feet of flexible meeting space. We believe that supply and demand dynamics are very favorable in Chicago. For example, the number of hotel rooms added to downtown Chicago over the past five years has been very limited, averaging just over 1% per year. In addition, Chicago is a compelling location for conventions and other city-wide events and over the next few years should benefit from the displacement of conventions caused by Hurricane Katrina. We also believe that this hotel is an irreplaceable asset as the land acquisition and construction cost of building a new large hotel in downtown Chicago would be prohibitive. 51 We cannot assure you that we will acquire the Chicago Marriott because the completion of the proposed acquisition is subject to a variety of conditions. Refinancing of Courtyard Manhattan/Fifth Avenue. We have a commitment from Lehman Brothers Bank to refinance the mortgage loan on the Courtyard Manhattan/Fifth Avenue that will mature in January 2007. Pursuant to this commitment, we expect to refinance the $23 million existing floating-rate loan with a $51 million fixed-rate loan that matures in 10 years. At the closing of the refinancing, the interest rate on the loan will be set based on the then current 10-year swap rate plus 90 basis points. We expect that the new fixed-rate loan will require principal repayments based on a 30-year amortization schedule following the first five years of payments of interest only. We expect to close on this refinancing early in the second quarter of 2006. Increased dividend. On February 28, 2006, our board of directors declared an increase in the quarterly dividend for the first quarter of 2006. On April 11, 2006, cash dividend of $0.18 per share will be paid to stockholders of record as of March 24, 2006. 2005 Highlights Significant highlights for the year ended December 31, 2005 are as follows: • Acquisitions. We acquired eight full-service hotels and one urban select-service hotel in 2005 for aggregate purchase prices of $623.2 million (including working capital and cash escrowed for future renovations). The eight full-service hotels that we acquired are: the Torrance Marriott (January 5, 2005); a portfolio of four full-service hotels: Renaissance Worthington, Marriott Atlanta Alpharetta, Frenchman’s Reef & Morning Star Marriott Beach Resort and Los Angeles Airport Marriott (June 23, 2005); the Vail Marriott Mountain Resort & Spa (June 24, 2005); Oak Brook Hills Resort & Conference Center (July 29, 2005); and the Orlando Airport Marriott (December 16, 2005). We also acquired the SpringHill Suites Atlanta Buckhead on July 22, 2005, an urban premium select-service hotel. • Initial Public Offering. We completed the initial public offering of our common stock on June 1, 2005. We sold 29,785,764 shares of common stock, including 3,698,764 shares of common stock exercised in the underwriters’ over-allotment, at the initial public offering price of $10.50 per share. The net proceeds to us, after deduction of offering costs, were $288.4 million. • Repaid Short-Term Floating-rate Debt. We repaid early the two year floating-rate debt incurred in connection with the acquisition of the Torrance Marriott on June 2, 2005 and the two year floating- rate debt incurred in connection with the acquisition of The Lodge at Sonoma, a Renaissance Resort & Spa, on June 16, 2005. • Dividends. Following our initial public offering, we began paying a cash dividend of $0.69 per share, on an annualized basis. We paid shareholders of record on June 17, 2005 a cash dividend of $0.0326 per share on June 28, 2005, we paid shareholders of record on September 9, 2005 a cash dividend of $0.1725 per share on September 27, 2005 and we paid shareholders of record on December 30, 2005 a cash dividend of $0.1725 per share on January 17, 2006. • Borrowed Long-Term Fixed-rate Debt. We incurred $261.5 million of long-term fixed-rate debt on four of our properties: the Los Angeles Airport Marriott, the Renaissance Worthington, the Frenchman’s Reef & Morning Star Marriott Beach Resort, and the Orlando Airport Marriott. All of the debt was secured by individual property, limited-recourse mortgages. • Credit Facility. We initiated our three-year $75 million senior secured revolving credit facility on July 8, 2005, which may be increased to $250 million subject to lender approval. We had $12 million drawn under our credit facility as of December 31, 2005. During January and February 2006, we drew an additional $16.0 million under the senior secured credit facility. 52 Results of Operations Year Ended December 31, 2005 As of December 31, 2005, we owned fifteen hotels. Our total assets were $966 million as of December 31, 2005. Total liabilities were $502.6 million as of December 31, 2005, including $431.2 million of debt. Shareholders’ equity was approximately $463.4 million as of December 31, 2005. Our net loss for the year ended December 31, 2005 was $7.3 million. We acquired nine of our fifteen hotels during the year ended December 31, 2005. Accordingly, the current period results are not comparable to the results for the corresponding period in 2004. Revenue. Our revenues totaled $229.5 million for the year ended December 31, 2005. Revenue consists primarily of the room, food and beverage and other revenues from our hotels. Revenues for the year ended December 31, 2005 consists of the following: Rooms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,755,924 63,261,282 14,433,057 $229,450,263 Individual hotel revenues for the year ended December 31, 2005 consisted of the following (in millions): Property Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan / Midtown East . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . . . . . . . . . . Renaissance Worthington. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan / Fifth Avenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Atlanta Alpharetta. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revenues $ 25.6 24.1 24.0 23.8 20.9 19.7 17.9 16.7 16.6 11.4 9.6 8.7 7.4 2.7 0.4 $229.5 The following pro forma key hotel operating statistics for our hotels for each of the years ended December 31, 2005 and 2004 excludes the SpringHill Suites Atlanta Buckhead due to the fact that this hotel was newly built and opened on July 1, 2005. The pro forma hotel operating statistics presented below include the results of operations of the hotels under previous ownership. Occupancy% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ADR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RevPAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2005 73.0% $142.54 $104.06 Year Ended December 31, 2004% Change 72.5% 0.5 percentage points $129.58 $ 93.99 10.0% 10.7% 53 The pro forma hotel operating statistics presented below include the results of operations of the hotels under previous ownership. Individual hotel RevPAR for the years ended December 31, 2005 and 2004 is as follows: Property Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan / Midtown East. . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/ Fifth Avenue . . . . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . . . . . . . . . . . The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . . . Total Excluding SpringHill Suites Atlanta Buckhead. . . . . . . . SpringHill Suites Atlanta Buckhead (1) . . . . . . . . . . . . . . . . . . . Total Including SpringHill Suites Atlanta Buckhead . . . . . . . . Year Ended December 31, 2005 $124.13 202.52 179.83 157.06 78.52 80.42 78.00 62.13 80.79 116.45 84.76 143.65 83.49 112.66 $104.06 $ 67.92 $103.47 Year Ended December 31, 2004 $114.74 177.85 126.09 134.73 76.30 72.59 74.94 59.93 74.06 101.15 78.49 122.03 77.16 107.42 $ 93.99 $ — $ 93.99 % Change from 2004 (2) 8.2% 13.9 42.6 16.6 2.9 10.8 4.1 3.7 9.1 15.1 8.0 17.7 8.2 4.9 10.7 N/A 10.7% (1) SpringHill Suites Atlanta Buckhead was newly built and commenced operations on July 1, 2005. There are no comparable statistics for 2004. (2) The % change from 2004 excludes the SpringHill Suites Atlanta Buckhead. The hotel was newly built in 2005 and there are no comparable statistics for 2004. Hotel operating expenses. Our hotel operating expenses totaled $181.3 million for the year ended December 31, 2005. Hotel operating expenses consist primarily of operating expenses of our hotels, including approximately $7.1 million of non-cash ground rent expense. The operating expenses for the year ended December 31, 2005 consist of the following (in millions): Rooms departmental expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage departmental expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other hotel expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Base management fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Incentive management fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ground rent—Contractual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ground rent—Non-cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 37.4 47.3 73.2 7.5 0.6 6.5 1.7 7.1 $181.3 Depreciation and amortization. Our depreciation and amortization expense totaled $27.6 million for the year ended December 31, 2005. Depreciation and amortization is recorded on our hotel buildings over 40 years for the periods subsequent to acquisition. Depreciable lives of hotel furniture, fixtures and equipment are estimated as the time period between the acquisition date and the date that the hotel furniture, fixtures and equipment will be replaced. We have assigned shorter depreciable lives of 1-2 years for the furniture, fixtures and equipment of the Courtyard Manhattan/Midtown East, the Courtyard 54 Manhattan/Fifth Avenue, the Bethesda Marriott Suites, the Marriott Atlanta Alpharetta, the Frenchman’s Reef & Morning Star Marriott Beach Resort, the Los Angeles Airport Marriott, the Oak Brook Hills Marriott Resort and the Orlando Airport Marriott since these hotels will undergo, and/or have undergone, significant renovations within two years of acquisition. Corporate expenses. Our corporate expenses totaled $13.5 million for the year ended December 31, 2005. Corporate expenses principally consist of employee related costs, including base payroll, bonus and restricted stock. Corporate expenses also include organizational costs, professional fees and directors’ fees. We recorded an expense of approximately $3.7 million during the year as a result of our commitment to issue, on the fifth anniversary of the initial public offering, 382,500 shares of common stock to our executive officers. Interest expense. Our interest expense totaled $17.4 million for the year ended December 31, 2005. This interest expense is related to mortgage debt incurred (or in one case assumed) in connection with our acquisition of our hotels ($15.8 million), amortization and write-off of deferred financing costs ($1.3 million) and interest and unused facility fees on our credit facility ($0.3 million). As of December 31, 2005, we have property-specific mortgage debt outstanding on nine of our hotels. On eight of the hotels, we have fixed-rate secured debt, which bears interest at rates ranging from 5.11% to 7.69% per year. On the ninth hotel, we have variable rate secured debt, the interest of which is based on LIBOR plus a spread. The interest rate as of December 31, 2005 on this mortgage loan was 7.075%. Our weighted-average interest rate as of December 31, 2005 was 5.60%. Amounts drawn under the credit facility bear interest at a variable rate that fluctuates based on the level of outstanding indebtedness in relation to the value of our assets from time to time. The weighted-average interest rate as of December 31, 2005 on the credit facility was 5.7575%. We had $12 million drawn on the credit facility as of December 31, 2005. During January and February 2006, we drew an additional $16 million under the credit facility. During the year, we repaid the mortgage debt on the Torrance Marriott ($44 million) and The Lodge at Sonoma, a Renaissance Resort & Spa ($20 million). In conjunction with the repayment of the mortgage on The Lodge at Sonoma, a Renaissance Resort & Spa, we incurred a prepayment penalty of approximately $50,000, which is classified as interest expense on the accompanying consolidated statements of operations. In conjunction with the repayment of these mortgages, we wrote off unamortized deferred financing fees of approximately $655,000, which is classified as interest expense on the accompanying consolidated statements of operations. Income taxes. We recorded a net benefit for income taxes of $1.4 million for the year ended December 31, 2005. We recorded an income statement charge of $1.4 million in the first quarter to reverse a portion of the deferred tax assets recorded in 2004 in connection with our REIT election. This charge was offset by an income tax benefit of $2.8 million recorded on the $7 million pre-tax loss of our TRS for the year ended December 31, 2005. May 6, 2004 (inception) through December 31, 2004 We were formed on May 6, 2004, began operations in July 2004 and acquired our first hotel in October 2004. We completed our private placement of common stock in July 2004 and received proceeds, net of offering costs and fees, of approximately $196.3 million. Stockholders’ equity at December 31, 2004 was approximately $195.6 million. Our GAAP loss before income taxes, for the period from inception (May 6, 2004) through December 31, 2004, was $3.7 million. Revenue. We had total revenues of $7.1 million for the period from May 6, 2004 to December 31, 2004. Revenue consists primarily of the room, food and beverage and other revenues from The Lodge at Sonoma, a Renaissance Resort & Spa, and the Courtyard Manhattan/Midtown East for the periods subsequent to our acquisition dates of October 27, 2004 and November 19, 2004, respectively. Revenues are also included for the post acquisition period for our other four acquisitions, completed during the last 55 two weeks of 2004. The average occupancy of our hotels was 67.9% for the periods subsequent to acquisition. The hotels collectively achieved an ADR of $184.22 and RevPAR of $125.02, respectively, for the periods subsequent to acquisition. Hotel operating expenses. Our hotel operating expenses totaled $6.2 million for the period from May 6, 2004 to December 31, 2004. Hotel operating expenses consist primarily of operating expenses of The Lodge at Sonoma, a Renaissance Resort & Spa, and the Courtyard Manhattan/Midtown East for the periods subsequent to our acquisition dates of October 27, 2004 and November 19, 2004, respectively. Operating expenses are also included for the post acquisition period of our other four 2004 acquisitions, which were completed during the last two weeks of 2004. Depreciation and amortization expense. Our depreciation and amortization expense totaled $1.1 million for the period from May 6, 2004 to December 31, 2004. Depreciation and amortization is recorded on our hotels for the periods subsequent to acquisition. Depreciable lives of hotel furniture, fixtures and equipment are estimated as the time period between the acquisition date and the date that the hotel furniture, fixtures and equipment will be replaced. The furniture, fixtures and equipment depreciable lives are less than one year for the Courtyard Manhattan/Midtown East, the Courtyard Manhattan/Fifth Avenue and the Bethesda Marriott Suites since these hotels were scheduled to undergo significant renovations in 2005 and 2006. Corporate expenses. Our corporate expenses totaled $4.1 million for the period from May 6, 2004 to December 31, 2004. Corporate expenses principally consist of employee related costs, including base salary, bonus and restricted stock. Corporate expenses also include organizational costs, professional fees and directors’ fees. Interest expense. Our interest expense totaled $0.8 million for the period from May 6, 2004 to December 31, 2004. Interest expense relates to the mortgage debt incurred in connection with our acquisitions. Our mortgage debt on two of our hotels bore interest at variable rates based on LIBOR. The interest rates as of December 31, 2004 on these two mortgage loans were 4.74% and 5.04%, respectively. The mortgage debt on our other four hotels bears interest at fixed rates ranging from 5.11% to 7.69% per annum. Income tax benefit. We recorded an income tax benefit of $1.6 million for the period from May 6, 2004 to December 31, 2004. The 2004 current tax liability of $0.9 million is the result of temporary differences primarily resulting from deferred Key Money, capitalized pre-opening costs, restricted stock expense, straight-line ground rent, depreciation and other items that will result in future taxable income. A significant portion of the deferred tax assets recorded in 2004 was expensed in the first quarter of 2005 in connection with our REIT election. Liquidity and Capital Resources Our short-term liquidity requirements consist primarily of funds necessary to fund future distributions to our stockholders to maintain our REIT status as well as to pay for operating expenses and other expenditures directly associated with our hotels, including maintenance and recurring capital expenditures as well as payments of interest and principal. We expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under our credit facility. Our long-term liquidity requirements consist primarily of funds necessary to pay for the costs of acquiring additional hotels, renovations, expansions and other capital expenditures that need to be made periodically to our hotels, scheduled debt payments and making distributions to our stockholders. We expect to meet our long-term liquidity requirements through various sources of capital, cash provided by operations, and borrowings, as well as through the issuances of additional equity or debt securities. Our 56 ability to incur additional debt is dependent upon a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by existing lenders. Our ability to raise funds through the issuance of debt and equity securities is dependent upon, among other things, general market conditions for REITs and market perceptions about us. Our Financing Strategy We are committed to maintaining a conservative capital structure with prudent aggregate leverage primarily comprised of long-term fixed-rate debt. However, we maintain the flexibility to modify these strategies if we believe fundamental changes have occurred in the capital markets. As of December 31, 2005, more than 90% of our debt carried fixed interest rates, with a weighted- average interest rate of 5.6%, and a weighted-average maturity date in excess of eight years. Moreover, as of December 31, 2005, we had $428.4 million of debt outstanding, representing a debt-to-enterprise value ratio of 41% which is calculated as our market capitalization plus net debt. We currently have a target debt-to-enterprise value ratio of 45% to 55%. In the current market, we have a strong bias for fixed-rate long-term limited recourse single property specific debt and when possible and desirable, we will seek to replace short-term sources of capital with long-term financing. In addition to property specific debt and our credit facility, we intend to use other financing methods as necessary, including obtaining from banks, institutional investors or other lenders, bridge loans, letters of credit, and other arrangements, any of which may be unsecured or may be secured by mortgages or other interests in our investments. In addition, we may issue publicly or privately placed debt instruments. We prefer a relatively simple but efficient capital structure. We have not invested in joint ventures and have not issued any operating partnership units or preferred stock. We endeavor to structure our hotel acquisitions so that they will not overly complicate our capital structure; however, we will consider a more complex transaction if we believe that the projected returns to our shareholders will significantly exceed the returns that would otherwise be available. Our Senior Secured Revolving Credit Facility On July 8, 2005, we entered into a three-year, $75 million senior secured revolving credit facility from Wachovia Bank, National Association, as administrative agent under the credit facility, and Citicorp North America, Inc. and Bank of America, N.A., as co-syndication agents under the credit facility. Our operating partnership is the borrower under the credit facility. The credit facility is guaranteed by substantially all of our material subsidiaries and is secured by first mortgages on certain of our qualifying properties, which make up the “borrowing base.” The Torrance Marriott and the Vail Marriott Mountain Resort & Spa are the two hotels currently comprising the borrowing base. We may add hotels to the borrowing base if certain conditions in the credit facility are met. We may extend the maturity date of the credit facility for an additional year upon the payment of applicable fees and the satisfaction of certain other conditions, such as the provision of adequate notice, our not defaulting on the terms of the credit facility and the truth of certain representations and warranties in all material respects at the time of extension. We also have the right to increase the amount of the credit facility to $250.0 million with the lenders’ approval. 57 Interest is paid on the periodic advances under the credit facility at varying rates, based upon either LIBOR or the applicable prime rate, plus an agreed upon additional margin amount. The interest rate depends upon our level of outstanding indebtedness in relation to the value of our assets from time to time, as follows: Prime rate margin. . . . . . . . . . . . . . . . . . . . . . LIBOR margin . . . . . . . . . . . . . . . . . . . . . . . . 70% or greater 1.25% 2.00% Leverage Ratio 65% to 70% 1.00% 1.75% less than 65% 0.75% 1.45% In addition to the interest payable on amounts outstanding under the credit facility, we are required to pay an amount equal to 0.35% of the unused portion of the credit facility. Our ability to borrow under the credit facility is dependent upon the size of the borrowing base. We will be permitted to borrow up to 65% of the lesser of (1) the appraised value of the borrowing base properties or (2) our cost of the borrowing base properties. Included in our cost of the borrowing base properties are renovation costs that we incur following the acquisition of the borrowing base properties. In addition, the net operating income generated by the borrowing base properties, as calculated by Wachovia Bank, National Association, must at all times be greater than 140% of the amount of implied debt service, which is an amount equal to the payment of principal and interest that we would have to pay if we had borrowed such amount under a conventional mortgage loans. Our current borrowing base assets permit us to draw the maximum amount under our credit facility. We had $12 million drawn on our credit facility as of December 31, 2005. In addition, we provided the Orlando Airport Marriott mortgage lender with an $11.4 million letter of credit secured by our credit facility as security for certain capital improvements of the Orlando Airport Marriott required under the mortgage debt. During January and February 2006, we drew an additional $16 million under the credit facility. Our senior secured credit facility contains various financial covenants. We complied with all of these covenants as of December 31, 2005. A summary of the most restrictive covenants, along with our corresponding value for each covenant, as of December 31, 2005, is as follows: Maximum leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minimum fixed charge coverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unhedged floating rate debt as a percentage of total indebtedness. . . . . . . . . . . Minimum implied debt service ratio for the borrowing base assets for the Value at December 31, 2005 45.6% 2.44x 2.8% Covenant 75% 1.5x 50% trailing twelve months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Limitation on our distributions to stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.40x 100% 7.66x 42.8% 2005 Mortgage Financings In connection with our acquisition of the Los Angeles Airport Marriott and the Renaissance Worthington, we incurred debt secured by property specific mortgages that aggregate $140 million. These borrowings consist of an $82.6 million mortgage on the Los Angeles Airport Marriott and a $57.4 million mortgage on the Renaissance Worthington. Each loan is secured by a first mortgage lien on the applicable hotel. Interest on each of the mortgages is fixed at a rate equal to 5.30%, in the case of the Los Angeles Airport Marriott mortgage debt, and at 5.40%, in the case of the Renaissance Worthington mortgage debt. Until August 11, 2009 with respect to the Renaissance Worthington loan, we will pay only interest. From and after August 11, 2009 with respect to the Renaissance Worthington loan, we will pay interest and 58 principal, with the amount of principal being determined based upon a 30-year amortization schedule. The Los Angeles Airport Marriott loan is interest only for the full term. For each loan, we will be obligated to repay all unpaid principal on July 11, 2015. On July 29, 2005, we entered into debt secured by a mortgage on the Frenchman’s Reef & Morning Star Marriott Beach Resort. The debt has a principal balance of $62.5 million, a term of 10 years, bears interest at 5.44%, and is interest only for the first three years and then amortizes on a 30-year schedule. In conjunction with the closing of the debt, the lender required $2.9 million of the loan proceeds to be set aside into a lender held escrow account to pre-fund certain capital improvements of the Frenchman’s Reef & Morning Star Marriott Beach Resort required under the mortgage debt. During the fourth quarter of 2005 the lender reduced the escrow requirement to $1.2 million. On December 15, 2005, we entered into mortgage debt in connection with the acquisition of the Orlando Airport Marriott. The mortgage debt has a principal balance of $59 million, a term of 10 years, bears interest at 5.68%, and is interest only for the first five years and then amortizes on a 30-year schedule. In conjunction with the closing of the mortgage debt, we provided the lender with an $11.4 million letter of credit secured by our credit facility as security for certain capital improvements of the Orlando Airport Marriott required under the mortgage debt. 2006 Proposed Financings We intend to refinance the $220 million floating-rate loan that we are assuming in connection with the acquisition of the Chicago Marriott with a fixed-rate loan issued by Wachovia Bank, National Association. The principal amount of the refinanced loan will be determined based on market conditions at the time of the refinancing and is expected to be between $170 million and $220 million. The new loan will be a limited recourse loan secured by a mortgage on the property. We will finance the remainder of the purchase price through a portion of the net proceeds from an equity offering. We expect to borrow up to $100 million through a short-term floating-rate loan arranged by Wachovia Bank, National Association, which we will repay with a portion of the net proceeds of the equity offering. Sources and Uses of Cash Our principal sources of cash are cash from operations, borrowing under mortgage financings, draws on our senior secured credit facility and the proceeds from our initial public offering. Our principal uses of cash are debt service, asset acquisitions, capital expenditures, operating costs, corporate expenses and dividends. Cash Provided by Operations. Our cash provided by operations was $19.8 million for the year ended December 31, 2005 which is the result of our net loss, adjusted for the impact of several non-cash charges, including $27.6 million of depreciation, $7.1 million of non-cash straight line ground rent, $1.3 million of amortization of deferred financing costs and loan repayment losses, and $6.3 million of stock grants, offset by working capital changes of $12.7 million and a $2.1 million non-cash income tax benefit. Our cash used in operations was $0.8 million for the period from May 6, 2004 to December 31, 2004 which is the result of our $2.1 million net loss, adjusted for the impact of several non-cash charges, including $1.1 million of depreciation, $1.4 million of stock grants and working capital changes of $0.3 million, offset by a $1.5 million non-cash income tax benefit. 59 Cash Used In Investing Activities. Our cash used in investing activities was $619.9 million and $275.1 million for the years ended December 31, 2005 and the period from May 6, 2004 to December 31, 2004, respectively. During the year ended December 31, 2005, we utilized $611.6 million of cash for the acquisition of the following hotels (in millions): Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Hotel Investments Portfolio (Los Angeles Airport Marriott, $ 61.5 Frenchman’s Reef & Morning Star Marriott Beach Resort, Marriott Atlanta Alpharetta, and Renaissance Worthington) . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315.2 63.7 65.7 34.1 71.4 $611.6 During the year ended December 31, 2005, we also incurred normal recurring capital expenditures at our other hotels of $18 million. In addition, we received $8 million of Key Money related to the Torrance Marriott ($3 million), the Courtyard Manhattan/Fifth Avenue ($1 million), the Oak Brook Hills Marriott Resort ($2.5 million), the SpringHill Suites Atlanta Buckhead ($0.5 million) and the Orlando Airport Marriott ($1 million). During the period from May 6, 2004 to December 31, 2004, we utilized $273.8 million to acquire our initial six hotels. During the period from May 6, 2004 to December 31, 2004, we also received $2.5 million of Key Money related to the Courtyard Manhattan/Midtown East and paid $3.3 million for pre-acquisition costs related to the acquisition of the Torrance Marriott. Cash Provided by Financing Activities. Approximately $532.5 million and $352.9 million of cash was provided by financing activities for the year ended December 31, 2005 and the period from May 6, 2004 to December 31, 2004, respectively. The cash provided by financing activities for the year ended December 31, 2005 primarily consists of $291.8 million of proceeds from the sale of 29.8 million shares of common stock in our initial public offering, offset by the $3.4 million of offering costs, $317.5 million of proceeds from mortgage debt of the Torrance Marriott ($44 million), the Los Angeles Marriott ($82.6 million), the Renaissance Worthington ($57.4 million), the Frenchman’s Reef Marriott & Morning Star Resort ($62.5 million), and the Orlando Airport Marriott ($59 million) and proceeds from $16 million of draws under the senior secured credit facility, net of $4 million of repayments under the facility. The cash provided by financing activities for the year ended December 31, 2005 was offset by the $56.9 million repayment of the secured debt incurred at the Lodge at Sonoma, a Renaissance Resort & Spa and the Torrance Marriott in June 2005, $2.8 million of financing costs paid during the year, $2.9 million of scheduled debt principal payments and $10.7 million of dividends. The cash provided by financing activities for the period from May 6, 2004 to December 31, 2004 primarily consists of $197.4 million of proceeds from the sale of 21 million shares of common stock in a private placement offering, offset by the $1 million of offering costs, $158 million of proceeds from mortgage debt of the Lodge at Sonoma, a Renaissance Resort & Spa ($20 million), the Marriott Griffin Gate Resort ($31 million), the Salt Lake City Marriott Downtown ($39 million), the Courtyard Manhattan/Fifth Avenue ($23 million) and the Courtyard Manhattan/Midtown East ($45 million). The cash provided by financing activities for the period from May 6, 2004 to December 31, 2004 was offset by $1.4 million of financing costs paid during the period and $0.1 million cash paid for interest rate caps. 60 The following table summarizes our significant financing activities since the beginning of 2005: Transaction Date January 13, 2005 . . . . . . . . . . . . . . . . June 1, 2005 . . . . . . . . . . . . . . . . . . . . June 2, 2005 . . . . . . . . . . . . . . . . . . . . June 16, 2005 . . . . . . . . . . . . . . . . . . . June 23, 2005 . . . . . . . . . . . . . . . . . . . June 28, 2005 . . . . . . . . . . . . . . . . . . . July 29, 2005 . . . . . . . . . . . . . . . . . . . . July 29, 2005 . . . . . . . . . . . . . . . . . . . . September 26, 2005. . . . . . . . . . . . . . September 27, 2005. . . . . . . . . . . . . . September 30, 2005. . . . . . . . . . . . . . January 25, 2006 . . . . . . . . . . . . . . . . January 27, 2006 . . . . . . . . . . . . . . . . February 28, 2006 . . . . . . . . . . . . . . . Dividend Policy Description of Transaction Proceeds from Torrance Marriott mortgage Proceeds from initial public offering, net of offering costs Repayment of Torrance Marriott mortgage, net Repayment of The Lodge at Sonoma mortgage Proceeds from LAX and Worthington mortgages Payment of second quarter dividends Proceeds from Frenchman’s Reef mortgage Draw under senior secured credit facility Draw under senior secured credit facility, net of $2 million repayment Payment of third quarter dividends Repayment of senior secured credit facility Draw under senior secured credit facility Payment of fourth quarter dividends Draw under senior secured credit facility Amount $ 44.0 million 288.6 million (36.9 million) (20.0 million) 140.0 million (1.8 million) 62.5 million 5.0 million 9.0 million (8.9 million) (2.0 million) 11.0 million (8.9 million) 5.0 million Generally, we intend to continue to distribute to our stockholders each year on a regular quarterly basis sufficient amounts of our REIT taxable income so as to avoid paying corporate income tax and excise tax on our earnings (other than the earnings of our TRS and TRS lessees, which are all subject to tax at regular corporate rates) and to qualify for the tax benefits afforded to REITs under the Code. In order to qualify as a REIT under the Code, we generally must make distributions to our stockholders each year in an amount equal to at least: • 90% of our REIT taxable income determined without regard to the dividends paid deduction, plus • 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code, minus • any excess non-cash income. During the second fiscal quarter of 2005 our board of directors declared a cash dividend of $0.0326 per share of our common stock. The dividend was paid on June 28, 2005 to stockholders of record as of June 17, 2005. During the third fiscal quarter of 2005 our board of directors declared a cash dividend of $0.1725 per share of our common stock. The dividend was paid on September 27, 2005 to stockholders of record as of September 9, 2005. During the fourth fiscal quarter of 2005 our board of directors declared a cash dividend of $0.1725 per share of our common stock. The dividend was paid on January 17, 2006 to stockholders on record as of December 30, 2005. On February 28, 2006 our board of directors declared an increase in the quarterly dividend for the first quarter of 2006. On April 11, 2006, a cash dividend of $0.18 per share will be paid to stockholders of record as of March 24, 2006. Capital Expenditures The management agreements for each of our hotels provide for the establishment of separate property improvement funds to cover, among other things, the cost of replacing and repairing furniture and fixtures at the hotel. Contributions to the property improvement fund are calculated as a percentage of hotel sales. In addition, we may be required to pay for the cost of certain additional improvements that are not permitted to be funded from the property improvement fund under the applicable management 61 agreement. As of December 31, 2005, we had set aside $23.1 million for capital projects in property improvement funds ($20.7 million) and lender held restricted cash ($2.4 million). Funds held in property improvement funds for one hotel are not permitted to be applied to any other property. We have a number of significant capital projects currently planned or underway and we expect to spend approximately $84 million on such projects in 2006. For a breakdown of the cost of such projects, please see “Our Properties.” A description of the significant 2005 actual and 2006 budgeted capital projects is as follows: • We substantially completed the renovation of the Courtyard Manhattan/Fifth Avenue during the year ended December 31, 2005. The project consisted of the renovation of the hotel guestrooms and public space. • We substantially completed the renovation of the Marriott Griffin Gate Resort during the year ended December 31, 2005. The project consisted of the renovation of the hotel ballroom, corridors and public space. • We completed a renovation of the Frenchman’s Reef & Morning Star Marriott Beach Resort during 2005. The project consisted of the replacement of case goods in a portion of the guestrooms. The renovation was funded from existing cash in the hotel’s property improvement fund. • We completed the renovation of the Los Angeles Airport Marriott in early 2006. The project consisted of the renovation of the hotel ballroom, conversion of a food outlet to a junior ballroom and renovation of the hotel bar. The renovation was funded from existing cash in the hotel’s property improvement fund. • We will accelerate the timing of a major room renovation at the Los Angeles Airport Marriott from 2007 to 2006. The project will consist of the renovation of the hotel guestrooms and bathrooms. Marriott International has agreed to fund $1.5 million of the cost of this renovation. • We are currently completing the major renovation and repositioning of the Torrance Marriott. The renovation is currently scheduled to be completed during the first half of 2006. The project consists of the renovation of the hotel guestroom soft goods and bathrooms, renovation of the hotel’s main ballroom and meeting rooms, renovation of the hotel lobby and conversion of a food and beverage outlet to meeting space. In early 2006 we completed the renovation of the hotel guestroom soft goods and bathrooms and renovation of the hotel’s main ballroom and meeting rooms. The renovation of the hotel lobby and conversion of a food and beverage outlet to meeting space will take place during the second quarter of 2006. • We are currently completing the renovation of the Bethesda Marriott Suites. The project consists of the renovation of the hotel guest suites. • We are currently completing the renovation of the Courtyard Manhattan/Midtown East which is expected to be completed by the end of the first quarter of 2006. The project consists of the renovation of the hotel guestrooms, renovation of the hotel lobby, renovation of the hotel restaurant and meeting space. • We have committed to significantly renovate the Oak Brook Hills Marriott Resort during 2006. We have accelerated the timing of a major portion of the room renovation from 2007 to 2006. The renovation will include the hotel guestrooms and bathrooms, the hotel main ballroom and meeting rooms and the hotel lobby. • We are doing a major renovation of the Orlando Airport Marriott during 2006, including a renovation of the rooms, bathrooms and public spaces. In addition, we are currently evaluating significant renovation projects at the Frenchman’s Reef & Morning Star Marriott Beach Resort and the Vail Marriott Mountain Resort & Spa. In particular, at the 62 Vail Marriott Mountain Resort & Spa, we are evaluating a major renovation of the ballrooms and at Frenchman’s Reef & Morning Star Marriott Beach Resort we are evaluating a renovation of certain guestrooms and balconies. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Non-GAAP Financial Measures We use the following two non-GAAP financial measures that we believe are useful to investors as key measures of our operating performance: (1) EBITDA and (2) FFO. These measures should not be considered in isolation or as a substitute for measures of performance in accordance with GAAP. EBITDA represents net income (loss) excluding: (1) interest expense; (2) provision for income taxes, including income taxes applicable to sale of assets; and (3) depreciation and amortization. We believe EBITDA is useful to an investor in evaluating our operating performance because it helps investors evaluate and compare the results of our operations from period to period by removing the impact of our capital structure (primarily interest expense) and our asset base (primarily depreciation and amortization) from our operating results. In addition, covenants included in our indebtedness use EBITDA as a measure of financial compliance. We also use EBITDA as one measure in determining the value of hotel acquisitions and dispositions. Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EBITDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2005 $ (7,335,940) 17,367,079 (1,353,261) 27,590,234 $ 36,268,112 Period from May 6, 2004 to December 31, 2004 $(2,117,625) 773,101 (1,582,113) 1,053,283 $ (1,873,354) We compute FFO in accordance with standards established by NAREIT, which defines FFO as net income (loss) (determined in accordance with GAAP), excluding gains (losses) from sales of property, plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures (which are calculated to reflect FFO on the same basis). We believe that the presentation of FFO provides useful information to investors regarding our operating performance because it is a measure of our operations without regard to specified non-cash items, such as real estate depreciation and amortization and gain or loss on sale of assets. We also use FFO as one measure in determining our results after taking into account the impact of our capital structure. Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate related depreciation and amortization . . . . . . . . . . . . . . . . . . . . . FFO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2005 $ (7,335,940) 27,590,234 $20,254,294 Period from May 6, 2004 to December 31, 2004 $ (2,117,625) 1,053,283 $ (1,064,342) 63 Critical Accounting Policies Our consolidated financial statements include the accounts of DiamondRock Hospitality Company and all consolidated subsidiaries. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. While we do not believe the reported amounts would be materially different, application of these policies involves the exercise of judgment and the use of assumptions as to future uncertainties and, as a result, actual results could differ materially from these estimates. We evaluate our estimates and judgments, including those related to the impairment of long- lived assets, on an ongoing basis. We base our estimates on experience and on various other assumptions that are believed to be reasonable under the circumstances. All of our significant accounting policies are disclosed in the notes to our consolidated financial statements. The following represent certain critical accounting policies that require us to exercise our business judgment or make significant estimates: Investment in Hotels. Investments in hotels, land improvements, building and furniture, fixtures and equipment and identifiable intangible assets are recorded at fair value in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Property and equipment are recorded at fair value based on analyses, including current replacement cost for similar capacity and allocated to buildings, improvements, furniture, fixtures and equipment based on analysis performed by management and appraisals received from independent third parties. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15 to 40 years for buildings and land improvements and one to ten years for furniture and equipment. Identifiable intangible assets are typically related to contracts, including ground lease agreements and hotel management agreements, which are recorded at fair value. Above-market and below-market contract values are based on the present value of the difference between contractual amounts to be paid pursuant to the contracts acquired and our estimate of the fair market contract rates for corresponding contracts. Contracts acquired that are at market do not have significant value. We typically enter into a new hotel management agreement based on market terms at the time of acquisition. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired. We review our investments in hotels for impairment whenever events or changes in circumstances indicate that the carrying value of the investments in hotels may not be recoverable. Events or circumstances that may cause us to perform a review include, but are not limited to, adverse changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of an investment in a hotel exceed the hotel’s carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying value to the estimated fair market value is recorded and an impairment loss recognized. Revenue Recognition. Hotel revenues, including room, golf, food and beverage, and other hotel revenues, are recognized as the related services are provided. Stock-based Compensation. We account for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. For share grants, total compensation expense is based on the 64 price of our common stock at the grant date. Compensation expense is recorded ratable over the vesting period, if any. Accounting for Key Money. Marriott has contributed to us certain amounts, which we refer to as Key Money, in exchange for the right to manage certain of our hotels. We defer Key Money received from a hotel manager in conjunction with entering into a long-term hotel management agreement and amortize the amount received against management fees over the term of the management agreement. Accounting for Yield Support. Marriott has provided us with operating cash flow guarantees for certain hotels will fund shortfalls of actual hotel operating income, which is net of management fees, compared to a negotiated target net operating income. We refer to these guarantees as “Yield Support”, or an adjustment to the base management fee otherwise payable. Yield Support received is recognized over the period earned if the Yield Support is not refundable and there is reasonable uncertainty of receipt at inception of the management agreement. Yield Support is recorded as an offset to base management fees. Inflation Operators of hotels, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates. Seasonality The operations of hotels historically have been seasonal depending on location, and accordingly, we expect some seasonality in our business. Historically, we have experienced approximately two-thirds of our annual income in the second and fourth quarters. New Accounting Pronouncements Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R”), Share-Based Payment, requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. We plan on adopting SFAS 123R on January 1, 2006 and the adoption of SFAS 123R is not expected to have a material impact on our results of operations, financial position or cash flows. FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143 (“FIN 47”), clarifies that the term “conditional asset retirement obligation” as used in Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (“SFAS 143”), refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and and/or method of settlement. Uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. We adopted the provisions of FIN 47 as of December 31, 2005. FIN 47 did not have a material impact on our results of operations, financial position, or cash flows. Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (“SFAS 154”), which supersedes APB Opinion No. 20, Accounting Changes (“APB 20”), and Statement of 65 Financial Accounting Standards No. 3, Reporting Accounting Changes in Interim Financial Statements, changes the requirements for the accounting for and reporting of a voluntary change in accounting principle. SFAS 154 also carries forward without change the guidance contained in APB 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. APB 20 previously required that most voluntary changes in accounting principle be recognized with a cumulative effect adjustment in net income of the period of the change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Contractual Obligations The following table outlines the timing of payment requirements related to the consolidated mortgage debt and other commitments of our operating partnership as of December 31, 2005. Long-Term Debt Obligations . . . . . . . . . . . . . . Operating Lease Obligations—Ground Leasesand Office Space . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total $ 428,395 Less than 1 year Payments due by period 1 to 3 years (in thousands) $42,060 $3,244 4 to 5 years $ 76,023 After 5 years $ 307,068 608,971 $1,037,366 1,648 $4,892 3,529 $ 45,589 3,646 $ 79,669 600,148 $ 907,216 Item 7a. Quantitative and Qualitative Disclosures About Market Risk and Risk Factors Quantitative and Qualitative Disclosures about Market Risk Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. In pursuing our business strategies, the primary market risk to which we are currently exposed, and which we expect to be exposed to in the future, is interest rate risk. Some of our outstanding debt has a variable interest rate. We use interest rate caps to manage our interest rate risks relating to our variable rate mortgage debt. Our total outstanding debt at December 31, 2005 was approximately $428.4 million, of which approximately $35 million, or 8.2%, was variable rate debt. If market rates of interest on our variable rate debt were to increase by 1.0%, or approximately 100 basis points, the increase in interest expense on our variable rate debt would decrease future earnings and cash flows by approximately $350,000 annually. On the other hand, if market rates of interest on our variable rate debt were to decrease by one percentage point, or approximately 100 basis points, the decrease in interest expense on our variable rate debt would increase future earnings and cash flow by approximately $350,000. If market rates of interest were to increase by 1.0%, or approximately 100 basis points, the decrease in the fair value of our fixed-rate debt would be $24.2 million. On the other hand, if market rates of interest were to decrease by one percentage point, or approximately 100 basis points, the increase in the fair value of our fixed-rate debt would be $24.2 million. As of December 31, 2005, the fair value of the $393.4 million of fixed-rate debt was approximately $388.7 million. Item 8. Financial Statements and Supplementary Data See Index to the Financial Statements on page F-1. 66 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures The Company’s management has evaluated, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act, and have concluded that as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to give reasonable assurances that information we disclose in reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms. There was no change in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act during the Company’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information None. PART III The information required by Items 10-14 is incorporated by reference to our proxy statement for the 2006 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report). Item 10. Directors and Executive Officers of the Registrant Information on our directors and executive officers is incorporated by reference to our 2006 proxy statement. Item 11. Executive Compensation The information required by this item is incorporated by reference to our 2006 proxy statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this item is incorporated by reference to our 2006 proxy statement. Item 13. Certain Relationships and Related Transactions The information required by this item is incorporated by reference to our 2006 proxy statement. Item 14. Principal Accounting Fees and Services The information required by this item is incorporated by reference to our 2006 proxy statement. 67 PART IV Item 15. Exhibits and Financial Statement Schedules 1. Financial Statements Included herein at pages F-1 through F-27. 2. Financial Statement Schedules The following financial statement schedule is included herein at pages F-28 through F-29: Schedule III—Real Estate and Accumulated Depreciation All other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted. 3. Exhibits The following exhibits are filed as part of this Form 10-K: Exhibit Number Description of Exhibit 3.1 Articles of Amendment and Restatement of DiamondRock Hospitality Company (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 3.2 Second Amended and Restated Bylaws of DiamondRock Hospitality Company (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 3.3 Amendment No. 1 to Second Amended and Restated Bylaws of DiamondRock Hospitality Company (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on March [ ], 2006) 4.1 Form of Certificate for Common Stock for DiamondRock Hospitality Company (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.1 Agreement of Limited Partnership of DiamondRock Hospitality Limited Partnership, dated as of June 4, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.2 Registration Rights Agreement among DiamondRock Hospitality Company, DiamondRock Hospitality Limited Partnership, Friedman, Billings, Ramsey & Co., Inc. and certain holders of the common stock of DiamondRock Hospitality Company, dated as of July 7, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.3 Form of Hotel Management Agreement (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.4 Form of TRS Lease (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.5 2004 Stock Option and Incentive Plan (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 68 Exhibit Number Description of Exhibit 10.6 Form of Restricted Stock Award Agreement (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no 333-123065)) 10.7 Form of Incentive Stock Option Agreement (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.8 Form of Non-Qualified Stock Option Agreement (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.9 Form of Deferred Stock Award Agreement (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123809) 10.10 Form of Indemnification Agreement between DiamondRock Hospitality Company and its directors and officers (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.11 Employment Agreement between DiamondRock Hospitality Company and William W. McCarten, dated as of June 4, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no 333-123065)) 10.12 Employment Agreement between DiamondRock Hospitality Company and John L. Williams, dated as of June 4, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.13 Employment Agreement between DiamondRock Hospitality Company and Mark W. Brugger, dated as of June 4, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.14 Employment Agreement between DiamondRock Hospitality Company and Michael D. Schecter, dated as of June 4, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.15 Employment Agreement between DiamondRock Hospitality Company and Sean M. Mahoney, dated as of June 30, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.16 Amended and Restated Restricted Stock Award Agreement between DiamondRock Hospitality Company and William W. McCarten, dated as of March 18, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.17 Amended and Restated Restricted Stock Award Agreement between DiamondRock Hospitality Company and John L. Williams, dated as of March 18, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.18 Amended and Restated Restricted Stock Award Agreement between DiamondRock Hospitality Company and Mark W. Brugger, dated as of March 18, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 69 Exhibit Number Description of Exhibit 10.19 Amended and Restated Restricted Stock Award Agreement between DiamondRock Hospitality Company and Michael D. Schecter, dated as of March 18, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.20 Amended and Restated Restricted Stock Award Agreement between DiamondRock Hospitality Company and Sean M. Mahoney, dated as of March 18, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.21 Information Acquisition Agreement between DiamondRock Hospitality Company and Marriott International, Inc., dated as of July 6, 2004 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.22 Amended and Restated Purchase Agreement by and among DiamondRock Frenchman’s Holdings, LLC, Capital Hotel Investments Financing I, LLC, BCM/CHI Cayman Islands, Inc. and BCM/CHI Frenchman’s Reef, Inc., dated June 23, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on June 29, 2005) 10.23 Purchase and Sale Agreement, by and among BCM/CHI Lax Owner, LLC and BCM/CHI LAX Tenant, Inc., and DiamondRock Hospitality Company dated May 3, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.24 Purchase and Sale Agreement, by and among BCM/CHI Alpharetta Owner, LLC and BCM/CHI Alpharetta Tenant, Inc., and DiamondRock Hospitality Company dated May 3, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.25 Purchase and Sale Agreement, by and among BCM/CHI Worthington Owner, L.P. and BCM/CHI Worthington Tenant, Inc., and DiamondRock Hospitality Company dated May 3, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.26 Purchase and Sale Agreement, by and between VAMHC, Inc. and DiamondRock Hospitality Limited Partnership dated May 3, 2005 (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 10.27 Amendment to Purchase and Sales Agreements, dated May 6, 2005, by and among DiamondRock Hospitality Company and BCM/CHI Cayman Islands, Inc., BCM/CHI Frenchman’s Reef, Inc., BCM/CHI Lax Owner, LLC and BCM/CHI LAX Tenant, Inc., BCM/CHI Alpharetta Owner, LLC and BCM/CHI Alpharetta Tenant, Inc., BCM/CHI Worthington Owner, L.P. and BCM/CHI Worthington Tenant, Inc. (incorporated by reference to the Registrant’s Registration Statement on Form S-11 filed with the Securities and Exchange Commission (File no. 333-123065)) 70 Exhibit Number Description of Exhibit 10.28 Credit Agreement dated as of July 8, 2005 by and among DiamondRock Hospitality Limited Partnership, a limited partnership formed under the laws of the State of Delaware, as Borrower, DiamondRock Hospitality Company, a corporation formed under the laws of the State of Maryland , each of the financial institutions initially a signatory hereto together with their assignees pursuant to Section 13.5.(d), Wachovia Bank, National Association, as Agent, Wachovia Capital Markets, LLC, Citigroup Global Markets Inc. and Banc of America Securities LLC, as Tri-Lead Arrangers and as Tri-Bookrunners, and each of Citicorp North America, Inc. and Bank of America, N.A., as Syndication Agents and as Documentation Agents (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 14, 2005) 10.29 Deferred Stock Award Agreement by and between DiamondRock Hospitality Company and William W. McCarten, dated June 1, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 28, 2005) 10.30 Deferred Stock Award Agreement by and between DiamondRock Hospitality Company and John L. Williams, dated June 1, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 28, 2005) 10.31 Deferred Stock Award Agreement by and between DiamondRock Hospitality Company and Mark W. Brugger, dated June 1, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 28, 2005) 10.32 Deferred Stock Award Agreement by and between DiamondRock Hospitality Company and Michael D. Schecter, dated June 1, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 28, 2005) 10.33 Deferred Stock Award Agreement by and between DiamondRock Hospitality Company and Sean M. Mahoney, dated June 1, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 28, 2005) 10.34 Hotel Purchase and Sale Agreement, by and between DiamondRock Orlando Airport, LLC and Teacher’s Retirement System of the State of Illinois, dated October 11, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on November 29, 2005) 10.35 First Amendment to Hotel Purchase and Sale Agreement, by and between DiamondRock Orlando Airport, LLC and Teacher’s Retirement System of the State of Illinois, dated November 23, 2005 (incorporated by reference to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on November 29, 2005) 31.1 Certification of Chief Executive Officer Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. 31.2 Certification of Chief Financial Officer Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. 32 Certification of Chief Executive Officer and Chief Financial Officer Required by Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended. 71 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES March 6, 2006 DIAMONDROCK HOSPITALITY COMPANY /s/ MICHAEL D. SCHECTER By: Name: Michael D. Schecter Title: General Counsel and Corporate Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: Name: Title: Chairman of the Board and Chief Executive /s/ WILLIAM W. MCCARTEN William W. McCarten Officer By: Name: John L. Williams Title: President and Chief Operating Officer and /s/ JOHN L. WILLIAMS Director By: Name: Title: /s/ MARK W. BRUGGER Mark W. Brugger Executive Vice President, Chief Financial Officer and Treasurer By: Name: Michael D. Schecter Title: General Counsel and Corporate Secretary /s/ MICHAEL D. SCHECTER By: Name: Sean M. Mahoney Title: Chief Accounting Officer and Corporate /s/ SEAN M. MAHONEY Controller By: Name: Daniel J. Altobello Title: Director /s/ DANIEL J. ALTOBELLO By: Name: W. Robert Grafton Title: Lead Director /s/ W. ROBERT GRAFTON By: Name: Maureen L. McAvey Title: Director /s/ MAUREEN L. MCAVEY By: Name: Gilbert T. Ray Title: Director /s/ GILBERT T. RAY 72 DIAMONDROCK HOSPITALITY COMPANY INDEX TO FINANCIAL STATEMENTS Reports of Independent Registered Public Accounting Firm. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page F-2 Consolidated Balance Sheets for DiamondRock Hospitality Company as of December 31, 2005 and 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-3 Consolidated Statements of Operations for DiamondRock Hospitality Company for the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004. . . . . . . . . F-4 Consolidated Statement of Shareholders’ Equity for DiamondRock Hospitality Company for the year ended December 31, 2005 and period from May 6, 2004 (Inception) to December 31, 2004 . . F-5 Consolidated Statements of Cash Flows for DiamondRock Hospitality Company for the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004. . . . . . . . . Notes to Financial Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-6 F-7 Schedule III—Real Estate and Accumulated Depreciation as of December 31, 2005 . . . . . . . . . . . . . . F-28 F-1 Report of Independent Registered Public Accounting Firm The Board of Directors DiamondRock Hospitality Company: We have audited the accompanying consolidated financial statements of DiamondRock Hospitality Company and subsidiaries (the “Company”) as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of DiamondRock Hospitality Company and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for the year ended December 31, 2005 and the period from May 6, 2004 (inception) to December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP McLean, Virginia March 8, 2006 F-2 DIAMONDROCK HOSPITALITY COMPANY CONSOLIDATED BALANCE SHEETS Property and equipment, at cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ASSETS Restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due from hotel managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Favorable lease asset, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase deposits and pre-acquisition costs. . . . . . . . . . . . . . . . . . . . . . Prepaid and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred financing costs, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets December 31, 2005 December 31, 2004 $899,309,856 (28,747,457) 870,562,399 $286,727,306 (1,084,867) 285,642,439 23,109,153 38,964,986 10,601,577 — 10,495,765 9,431,741 2,846,661 $ 966,012,282 17,482,515 2,626,262 — 3,272,219 4,340,259 76,983,107 1,344,378 $ 391,691,179 Liabilities: LIABILITIES AND SHAREHOLDERS’ EQUITY Debt, at face amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debt premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $428,394,735 2,782,322 $177,827,573 2,944,237 Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431,177,057 180,771,810 Deferred income related to Key Money, net . . . . . . . . . . . . . . . . . . . . . Unfavorable lease liability, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due to hotel managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends declared and unpaid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . Total other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,311,322 5,384,431 22,790,896 8,896,101 24,064,047 71,446,797 2,490,385 5,776,946 3,985,795 — 3,078,825 15,331,951 Shareholders’ Equity: Preferred stock, $.01 par value; 10,000,000 shares authorized; no shares issued and outstanding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — Common stock, $.01 par value; 100,000,000 shares authorized; 50,819,864 and 21,020,100 shares issued and outstanding at December 31, 2005 and 2004, respectively . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508,199 491,951,223 (29,070,994) 210,201 197,494,842 (2,117,625) Total shareholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463,388,428 195,587,418 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . $ 966,012,282 $ 391,691,179 The accompanying notes are an integral part of these consolidated financial statements. F-3 DIAMONDROCK HOSPITALITY COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended December 31, 2005 Period from May 6, 2004 (Inception) to December 31, 2004 Revenues: Rooms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $151,755,924 63,261,282 14,433,057 229,450,263 $ 5,137,370 1,507,960 428,534 7,073,864 Operating Expenses: Rooms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food and beverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other hotel expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,432,635 47,281,237 8,107,902 88,447,484 27,590,234 13,461,528 222,321,020 7,129,243 Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other expenses (income) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,548,635) 17,367,079 15,818,444 (8,689,201) 1,455,380 1,266,827 260,724 3,183,959 1,053,283 4,114,165 11,334,338 (4,260,474) (1,333,837) 773,101 (560,736) (3,699,738) Income tax benefit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,353,261 1,582,113 Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (7,335,940) $ (2,117,625) Loss per share: Basic and diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.19) $ (0.12) Weighted-average number of common shares outstanding: Basic and diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,145,789 18,162,916 The accompanying notes are an integral part of these consolidated financial statements. F-4 DIAMONDROCK HOSPITALITY COMPANY CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY Year Ended December 31, 2005 and Period from May 6, 2004 (Inception) to December 31, 2004 Formation transactions on May 6, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 $ 1 $ 999 $ — $ 1,000 Common Stock Shares Par Value Additional Paid-In Capital Accumulated Deficit Total Sale of common shares in private placement offering, less placement fees and expenses of $12,624,452 . . Issuance costs incurred related to 21,000,000 210,000 197,165,548 — 197,375,548 private placement . . . . . . . . . . . . . . . — — (1,028,588) — (1,028,588) Issuance and amortization of stock 20,000 — 21,020,100 200 — 210,201 1,356,883 — — (2,117,625) 1,357,083 (2,117,625) (2,117,625) 195,587,418 197,494,842 grants. . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2004 . . . . . . Sale of common shares in initial public offering, less placement fees and expenses of $3,353,504 . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . Issuance and amortization of stock 29,785,764 297,858 288,148,423 — — — 288,446,281 — (19,617,429) (19,617,429) grants. . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2005 . . . . . . 14,000 — 6,308,098 (7,335,940) 50,819,864 $508,199 $491,951,223 $(29,070,994) $ 463,388,428 — — (7,335,940) 6,307,958 140 — The accompanying notes are an integral part of these consolidated financial statements. F-5 DIAMONDROCK HOSPITALITY COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 2005 Period from May 6, 2004 (Inception) to December 31, 2004 $ (7,335,940) $ (2,117,625) 27,590,234 1,343,899 7,120,368 (7,837) (302,179) (115,118) 6,308,098 (2,104,371) 1,053,283 28,615 — 25,655 (10,814) 21,969 1,357,083 (1,521,213) (581,477) (2,626,262) 3,545,232 (825,554) Cash flows from operating activities: Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of deferred financing costs as interest . . . . . . . . . . . . . Non-cash straight-line ground rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market value adjustment to interest rate caps. . . . . . . . . . . . . . . . . . . Amortization of debt premium and unfavorable lease liability. . . . . Amortization of deferred income and corporate depreciation . . . . . Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in assets and liabilities: Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due to/from hotel managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) operating activities . . . . . . . . . . . . . . . . (832,736) (15,915,027) 4,076,637 19,826,028 Cash flows from investing activities: Hotel acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Receipt of deferred Key Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hotel capital expenditures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in restricted cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase deposits and pre-acquisition costs. . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (611,604,489) 8,008,750 (18,007,635) 1,726,776 — (619,876,598) (273,827,972) 2,500,000 — (480,515) (3,272,219) (275,080,706) Cash flows from financing activities: Proceeds from debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayments of mortgage debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Scheduled mortgage debt principal payments . . . . . . . . . . . . . . . . . . . . . Payment of financing costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for interest rate caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payment of costs related to sale of common stock . . . . . . . . . . . . . . . . . Payment of dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . Net (decrease) increase in cash and cash equivalents. . . . . . . . . . . . . . . . . Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents, end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental Disclosure of Cash Flow Information: Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-cash Investing and Financing Activities: Repayment of mortgage debt with restricted cash held in escrow . . . . . . 317,500,000 (56,948,685) (2,932,838) (2,846,182) — 291,799,785 (3,353,504) (10,719,372) 532,499,204 (67,551,366) 76,983,107 9,431,741 158,000,000 — — (1,372,993) (85,600) 197,376,548 (1,028,588) — 352,889,367 76,983,107 — $ 76,983,107 $ $ 15,601,243 1,005,629 $ $ $ 350,979 — $ 7,051,315 $ — The accompanying notes are an integral part of these consolidated financial statements. F-6 DIAMONDROCK HOSPITALITY COMPANY NOTES TO FINANCIAL STATEMENTS December 31, 2005 and 2004 1. Organization DiamondRock Hospitality Company (the “Company”) is a self-advised real estate investment company. The Company is committed to maximizing shareholder value through investing in premium full service hotels and, to a lesser extent, premium urban limited service hotels located throughout the United States. The Company differentiates ourselves because: • We are a disciplined acquirer of hotels. • We create value through aggressive asset management. • We are committed to a conservative capital structure. • We have an experienced management team. As of December 31, 2005, we owned fifteen hotels, comprising 6,119 rooms, located in the following markets: Atlanta, Georgia (2), Fort Worth, Texas, Lexington, Kentucky, Los Angeles (2 hotels), New York City (2 hotels), Northern California, Oak Brook, Illinois, Orlando, Florida, Salt Lake City, Washington D.C., St. Thomas, U.S. Virgin Islands and Vail, Colorado. The Company completed its initial public offering on June 1, 2005, issuing 29,785,764 shares of common stock (including the underwriters’ purchase of the over-allotment option for 3,698,764 shares) at a price of $10.50 per share, resulting in net proceeds, before deducting offering expenses, of approximately $291.8 million. We conduct our business through a traditional umbrella partnership REIT, or UPREIT, in which our hotel properties are owned by our operating partnership, DiamondRock Hospitality Limited Partnership, or subsidiaries of our operating partnership. We are the sole general partner of our operating partnership and currently own, either directly or indirectly, all of the limited partnership units of our operating partnership. 2. Summary of Significant Accounting Policies Basis of Presentation The Company’s financial statements include all of the accounts of the Company and its subsidiaries in accordance with United States generally accepted accounting principles. All intercompany accounts and transactions have been eliminated in consolidation. Cash and Cash Equivalents The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Fair Value of Financial Instruments The Company’s financial instruments include cash and cash equivalents and accounts payable and accrued expenses. Due to their short maturities, the carrying amounts of cash and cash equivalents and accounts payable and accrued expenses reasonably approximate fair value. See Note 13 for disclosures on fair values of debt and interest rate caps. F-7 Property and Equipment Investments in hotel properties, land, land improvements, building and furniture, fixtures and equipment and identifiable intangible assets are recorded at fair value in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations. Property and equipment purchased after the hotel acquisition date is recorded at cost. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation will be removed from the Company’s accounts and any resulting gain or loss will be included in the statements of operations. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 15 to 40 years for buildings, land improvements, and building improvements and one to ten years for furniture, fixtures and equipment. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the related assets. The Company reviews its investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause a review include, but are not limited to, adverse changes in the demand for lodging at the properties due to declining national or local economic conditions and/or new hotel construction in markets where the hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of a hotel exceed its carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying amount to the related hotel’s estimated fair market value is recorded and an impairment loss recognized. The Company will classify a hotel as held for sale in the period that the Company has made the decision to dispose of the hotel, a binding agreement to purchase the property has been signed under which the buyer has committed a significant amount of nonrefundable cash and no significant financing contingencies exist which could cause the transaction to not be completed in a timely manner. If these criteria are met, the Company will record an impairment loss if the fair value less costs to sell is lower than the carrying amount of the hotel and will cease recording depreciation expense. The Company will classify the loss, together with the related operating results, as discontinued operations on the statements of operations and classify the assets and related liabilities as held for sale on the balance sheets. Goodwill Goodwill represents the excess of the Company’s cost to acquire a business over the net amounts assigned to assets acquired and liabilities assumed. Goodwill is not amortized, but is evaluated for impairment annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company’s goodwill is classified within other assets in the accompanying consolidated balance sheets. Revenue Recognition Revenues from operations of the hotels are recognized when the services are provided. Revenues consist of room sales, golf sales, food and beverage sales, and other hotel department revenues, such as telephone and gift shop sales. Income Taxes The Company accounts for income taxes using the asset and liability method prescribed in SFAS 109, Accounting for Income Taxes. The deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between the financial statement carrying amounts of F-8 existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in earnings in the period when the new rate is enacted. The Company has elected, effective January 1, 2005, to be treated as a REIT under the provisions of the Internal Revenue Code and, as such, expects not to be subject to federal income tax after December 31, 2004, provided that the Company distributes all taxable income annually to the Company’s shareholders and complies with certain other requirements. In addition to paying federal and state taxes on any retained income, the Company may be subject to taxes on “built in gains” on sales of certain assets. The Company’s taxable REIT subsidiaries will generally be subject to federal and state income taxes. In order for the income from our hotel property investments to constitute “rents from real properties” for purposes of the gross income test required for REIT qualification, the income we earn cannot be derived from the operation of any of our hotels. Therefore, we lease each of our hotel properties to a wholly-owned subsidiary of Bloodstone TRS, Inc., our existing taxable REIT subsidiary, or TRS, except for the Frenchman’s Reef & Morning Star Marriott Beach Resort, which is owned by a Virgin Islands corporation, which we have elected to be treated as a TRS. Earnings (Loss) Per Share Basic earnings (loss) per share is calculated by dividing net loss by the weighted-average common shares outstanding during the period. Diluted earnings per share is calculated by dividing net loss by the weighted-average common shares outstanding during the period plus other potentially dilutive securities such as restricted stock awards or shares issuable in the event of conversion of operating partnership units. No adjustment is shown for the potentially dilutive effect of 747,000 shares of restricted stock, as the impact is anti-dilutive during periods when the Company incurs a net loss and, accordingly, diluted loss per share is equal to basic loss per share. Stock-based Compensation The Company accounts for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. For restricted stock awards, the total compensation expense is equal to the fair value of the award. The compensation expense is recorded over the period in which the restrictions lapse (i.e., vesting period). Comprehensive Income (Loss) Comprehensive income includes net income (loss) as currently reported by the Company on the consolidated statement of operations adjusted for other comprehensive income items. The Company does not have any items of comprehensive income (loss) other than the net loss. Segment Information SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”), requires public entities to report certain information about operating segments. See Note 14. Restricted Cash Restricted cash primarily consists of reserves for replacement of furniture and fixtures held by our hotel managers and cash held in escrow pursuant to lender requirements. F-9 Deferred Financing Costs Financing costs are recorded at cost and consist of loan fees and other costs incurred in connection with the issuance of debt. Amortization of deferred financing costs is computed using a method, which approximates the effective interest method over the remaining life of the debt and is included in interest expense in the accompanying statements of operations. Hotel Working Capital The due from hotel managers consists of hotel level accounts receivable, periodic hotel operating distributions due to owner and prepaid and other assets held by the hotel managers on the Company’s behalf. The liabilities incurred by the hotel managers are comprised of liabilities incurred on behalf of the Company in conjunction with the operation of the hotels which are legal obligations of the Company. Key Money Key Money received in conjunction with entering into hotel management agreements is deferred and amortized over the term of the hotel management agreement. Deferred Key Money is classified as deferred income in the accompanying consolidated balance sheet and amortized against management fees on the accompanying consolidated statements of operations. Debt Premiums Debt premiums are recorded to adjust the stated value of assumed debt to fair value at the acquisition date of a hotel. Debt premiums are amortized over the remaining life of the debt to interest expense on the accompanying consolidated statements of operations. Derivative Instruments The Company may be party to interest rate swaps in the future and is currently party to interest rate caps, which are considered derivative instruments. The fair value of the interest rate swaps and interest rate caps are recorded on the Company’s balance sheet and gains or losses from the changes in the market value of the contracts are recorded in other income or expense. See Note 13 for disclosures on fair values of the interest rate caps. Straight-Line Rent The Company records rent expense on leases that provide for minimum rental payments that increase in pre-established amounts over the remaining term of the lease on a straight-line basis. Use of Estimates The preparation of the financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Concentration of Credit Risk Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and cash equivalents. We maintain cash and cash equivalents with various high credit-quality financial institutions. We perform periodic evaluations of the relative credit standing of these financial institutions and limit the amount of credit exposure with any one institution. F-10 Yield Support Marriott has provided the Company with operating cash flow guarantees for certain hotels and will reimburse an amount of the management fee if actual hotel operating income is less than a negotiated target net operating income. We refer to these guarantees as “Yield Support”, or reimbursement of management fees otherwise payable. Yield Support is recognized over the period earned if the Yield Support is not refundable and there is reasonable uncertainty of receipt at inception of the management agreement. Yield Support is recorded as an offset to base management fees on the accompanying consolidated statement of operations. There was no Yield Support earned during the year ended December 31, 2005 or the period from May 6, 2004 (Inception) to December 31, 2004. Recent Accounting Pronouncements FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143 (“FIN 47”), clarifies that the term “conditional asset retirement obligation” as used in Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (“SFAS 143”), refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and and/or method of settlement. Uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. The Company adopted the provisions of FIN 47 as of December 31, 2005. FIN 47 did not have a material impact on the Company’s results of operations, financial position, or cash flows. 3. Property and Equipment Property and equipment as of December 31, 2005 and 2004 consists of the following: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Land improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture, fixtures and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate office equipment and construction in progress. . . . . . . . . . . . . . Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2005 $125,466,000 5,593,922 689,789,027 73,864,151 4,596,756 899,309,856 (28,747,457) $ 870,562,399 December 31, 2004 $ 28,320,000 5,593,922 231,300,990 21,287,175 225,219 286,727,306 (1,084,867) $ 285,642,439 4. Capital Stock Common Shares The Company is authorized to issue up to 100,000,000 shares of common stock, $.01 par value per share. Each outstanding share of common stock entitles the holder to one vote on all matters submitted to a vote of stockholders. Holders of the Company’s common stock are entitled to receive dividends when authorized by the Company’s board of directors out of assets legally available for the payment of dividends. On July 7, 2004, the Company closed on the sale of 21,000,000 shares of common stock, including 150,000 shares acquired by certain senior executives of the Company, at a price of $10 per share, in a private placement (the “Offering”). The Offering resulted in gross proceeds of $210 million and net F-11 proceeds (after deducting placement fees and offering expenses) of approximately $196.3 million. As of December 31, 2004, the Company had 21,020,100 shares of common stock outstanding. On June 1, 2005, the Company consummated its initial public offering of common stock, selling 29,785,764 shares (including the underwriters’ subsequent purchase of the over-allotment option of 3,698,764 shares) at a price of $10.50 per share. We received net proceeds (after deducting offering expenses) of approximately $288.4 million. Preferred Shares The Company is authorized to issue up to 10,000,000 shares of preferred stock, $.01 par value per share. The Company’s board of directors is required to set for each class or series of preferred stock the terms, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications, and terms or conditions of redemption. As of December 31, 2005 and 2004, respectively, there were no shares of preferred stock outstanding. Operating Partnership Units Holders of Operating Partnership units have certain redemption rights, which enable them to cause the Operating Partnership to redeem their units in exchange for cash per unit equal to the market price of the Company’s common stock, at the time of redemption, or, at the option of the Company for shares of the Company’s common stock on a one-for-one basis. The number of shares issuable upon exercise of the redemption rights will be adjusted upon the occurrence of stock splits, mergers, consolidations or similar pro-rata share transactions, which otherwise would have the effect of diluting the ownership interests of the limited partners or the stockholders of the Company. As of December 31, 2005 and 2004, respectively, there were no Operating Partnership units held by unaffiliated third parties. 5. Stock Incentive Plan As of December 31, 2005, the Company has issued or committed to issue 1,170,333 shares of our common stock under our 2004 Stock Option and Incentive Plan, including 747,000 shares of restricted common stock to the Company’s officers and employees, 34,000 shares of common stock issued to the Company’s Directors and a commitment to issue 389,333 shares of deferred common stock. The commitment represents the promise of the Company to issue a number of shares of the Company’s common stock upon the earlier of (i) a sale event or (ii) five years after the date of grant. As of December 31, 2005, the Company’s officers and employees have been awarded 747,000 shares of restricted common stock. None of the recipients were required to pay for such shares of common stock. Shares issued to our officers’ and employees vest over a three-year period from the date of the grant. The Company recorded compensation expense related to the restricted common stock of officers and employees of $2,420,048 and $1,157,083 during the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004, respectively. As of December 31, 2005, the Company’s Directors have been awarded 34,000 shares of common stock. Shares issued to our Directors were fully vested upon issuance. The Company recorded compensation expense related to the common stock of Directors of $151,800 and $200,000 during the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004, respectively. At the time of the initial public offering, the Company committed to issue 382,500 shares of deferred common stock to the Company’s senior executive officers. These deferred stock awards are fully vested and represent the promise of the Company to issue a number of shares of the Company’s common stock to each senior executive officer upon the earlier of (i) a sale event or (ii) five years after the date of grant, F-12 which was the initial public offering completion date (the “Deferral Period”). However, if an executive’s service with the Company is terminated for “cause” prior to the expiration of the Deferral Period, all deferred stock unit awards will be forfeited. The executive officers are restricted from transferring the shares until the fifth anniversary of the initial public offering completion date. During 2005, the Company recorded $3,736,250 of stock-based compensation expense related to this deferred common stock award, which is included in corporate expenses in the accompanying statements of operations. As of December 31, 2005, the Company has a commitment to issue 389,333 shares under this plan. The share commitment increased from 382,500 to 389,333 during the year as a result of all dividends being reinvested into our common stock at the dividend payment dates closing price of our common stock. In total, for the year ended December 31, 2005, and the period from May 6, 2004 (Inception) to December 31, 2004, the Company recorded $6,308,098 and $1,357,083, respectively, of stock-based compensation expense related to these awards which is included in corporate expenses in the accompanying statements of operations. 6. Earnings Per Share Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted-average number of common shares outstanding. Diluted earnings per share is calculated by dividing net income available to common shareholders, that has been adjusted for dilutive securities, by the weighted-average number of common shares outstanding including dilutive securities. No effect is shown for securities that are anti-dilutive. The following is a reconciliation of the calculation of basic and diluted earnings per share: Period from May 6, 2004 (Inception) to December 31, 2004 Year Ended December 31, 2005 Basic Earnings per Share Calculation: Numerator: Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends on unvested restricted common stock . . . Net loss after dividends on unvested restricted $ (7,335,940) $ (2,117,625) — (280,222) common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (7,616,162) $ (2,117,625) Weighted-average number of common shares outstanding—basic. . . . . . . . . . . . . . . . . . . . . . . . . . . 39,145,789 18,162,916 Basic loss per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.19) $ (0.12) Diluted Earnings per Share Calculation: Numerator: Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends on unvested restricted common stock . . . Net loss after dividends on unvested restricted $ (7,335,940) $ (2,117,625) — (280,222) common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (7,616,162) $ (2,117,625) Weighted-average number of common shares outstanding—basic. . . . . . . . . . . . . . . . . . . . . . . . . . . Unvested restricted common stock . . . . . . . . . . . . . . . Weighted-average number of common shares 39,145,789 — 18,162,916 — outstanding—diluted . . . . . . . . . . . . . . . . . . . . . . . . . 39,145,789 18,162,916 Diluted loss per share . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.19) $ (0.12) F-13 7. Debt The Company has incurred property specific mortgage debt in conjunction with the acquisition of certain of the Company’s hotels. The mortgage debt is recourse solely to specific assets, except for fraud, misapplication of funds and other customary recourse provisions. As of December 31, 2005, nine of our fifteen hotel properties were secured by mortgage debt. The Company’s mortgage debt contains certain property specific covenants and restrictions, including minimum debt service coverage ratios as well as restrictions to incur additional debt without lender consent. The following table sets forth information regarding the Company’s debt as of December 31, 2005: Principal Balance Prepayment Penalties $19,305,400 Yes(1) Interest Rate 7.69% Maturity Date Amortization Provisions 2/23 25 years Property Bethesda Marriott Suites . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . . . Griffin Gate Marriott Resort . . . . . . . . . Los Angeles Airport Marriott . . . . . . . . . Courtyard Manhattan/Fifth Avenue. . . . 62,500,000 No(2) 30,442,250 Yes(4) No(2) 82,600,000 No(5) 23,000,000 Courtyard Manhattan/Midtown East . . . Orlando Airport Marriott . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . Renaissance Worthington . . . . . . . . . . . . Senior Secured Credit Facility. . . . . . . . . No(8) 44,130,896 59,000,000 No(2) 38,016,189 Yes(8) No(2) 57,400,000 No 12,000,000 Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $428,394,735 8/15 1/10 7/15 1/07(7) 30 years(3) 25 years Interest Only Interest Only 12/09 12/15 12/14 7/15 7/08 25 years 30 years (9) 20 years(10) 30 years(11) Interest Only 5.44% 5.11% 5.30% LIBOR + 2.70% (7.075% as of December 31, 2005)(6) 5.195% 5.68% 5.50% 5.40% LIBOR + 1.45 (5.7575% as of December 31, 2005) (1) The debt may be prepaid. If it is prepaid prior to August 2012, it is subject to a prepayment fee equal to the greater of i) one percent of the outstanding principal amount or ii) a yield maintenance premium determined as set forth in the Deed of Trust. (2) Prepayment of the debt on the Los Angeles Airport Marriott, Renaissance Worthington and Orlando Airport Marriott is not permitted until the earlier of (i) two years after securitization (the lender intends to sell all or a portion of the debt through one or more public offerings) or (ii) four years from the closing date. Thereafter, we may pay a defeasance deposit in lieu of a prepayment of the debt. Prepayment in full will be permitted at par on the last three payment dates before the maturity date. For the loan secured by the mortgage on Frenchman’s Reef & Morning Star Marriott Beach Resort, we may release the lien of mortgage through a defeasance deposit at any time after the earlier of (i) two years after securitization or (ii) thirty months after the closing date of the loan. (3) The debt has a three-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. (4) We may not prepay the loan without the express written consent of the lender, and we have no right to prepay the debt until October 2009. Notwithstanding the foregoing, if the lender accepts prepayment of the debt prior to October 2009, we must pay a penalty equal to the greater of (i) 1% of the outstanding principal and (ii) the present value, as of the prepayment calculation date, of a series of monthly payments over the remaining term of the loan, each equal to the amount of interest that would be due on the portion of the loan being prepaid, assuming an annual interest rate of 5.11% over the discounted reinvestment yield, as such term is defined in the agreement. (5) The debt may be prepaid at par. (6) We have entered into an interest rate cap agreement on this debt. Breakage fees may be payable if the debt is repaid. (7) The debt allows for three one-year extensions provided that certain conditions are met. F-14 (8) The debt may not be prepaid until three months prior to the maturity date of the mortgage loan (the “Prepayment Release Date”). For Salt Lake City Marriott Downtown, we may prepay the loan on or after the Prepayment Release Date without payment of fees. However, we must pay to the lender, simultaneously with such prepayment, the interest that would have accrued on the outstanding principal balance of the loan at the regular interest rate through the end of the interest period in which such prepayment occurs. (9) The debt has a five-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. (10) There is an accelerated amortization provision based on a predetermined formula of available cash flow. (11) The debt has a four-year interest only period. After the expiration of that period, the debt will amortize based on a thirty-year schedule. On July 8, 2005, the Company entered into a three-year, $75.0 million senior secured revolving credit facility from Wachovia Bank, National Association, as administrative agent under the credit facility, and Citicorp North America, Inc. and Bank of America, N.A., as co-syndication agents under the credit facility. The senior secured credit facility is guaranteed by substantially all of our material subsidiaries and is secured by first mortgages on certain of our qualifying properties, which make up the “borrowing base.” The Torrance Marriott and the Vail Marriott Mountain Resort & Spa are the two hotel properties currently comprising the borrowing base. We may add hotels to the borrowing base if certain conditions in the credit facility are met. Interest is paid on the periodic advances under the credit facility at varying rates, based upon either LIBOR or the applicable prime rate, plus an agreed upon additional margin amount. The interest rate depends upon our level of outstanding indebtedness in relation to the value of our assets from time to time, as follows: Prime rate margin. . . . . . . . . . . . . . . . . . . . . . . LIBOR margin . . . . . . . . . . . . . . . . . . . . . . . . . 70% or greater 1.25% 2.00% Leverage Ratio 65% to 70% 1.00% 1.75% less than 65% 0.75% 1.45% In addition to the interest payable on amounts outstanding under the credit facility, we are required to pay an annual amount equal to 0.35% of the unused portion of the credit facility. The Company incurred interest and unused credit facility fees of $254,237 during the year ended December 31, 2005. The Company has $12 million drawn on the senior secured credit facility as of December 31, 2005. In addition , the Company provided the Orlando Airport Marriott mortgage lender with an $11.4 million letter of credit secured by the Company’s senior secured credit facility as security for certain capital improvements of the Orlando Airport Marriott required under the mortgage debt. During January and February 2006, the Company drew an additional $16 million under the senior secured credit facility. In connection with our acquisition of the Los Angeles Airport Marriott and the Renaissance Worthington, we incurred debt secured by property specific mortgages that aggregate $140.0 million. These borrowings consist of an $82.6 million mortgage on the Los Angeles Airport Marriott and a $57.4 million mortgage on the Renaissance Worthington. Each loan is secured by a first mortgage lien on the applicable hotel. Interest on each of the mortgages is fixed at a rate equal to 5.30%, in the case of the Los Angeles Airport Marriott mortgage debt, and at 5.40%, in the case of the Renaissance Worthington mortgage debt. Until August 11, 2009, with respect to the Renaissance Worthington loan, we will pay only interest. From and after August 11, 2009, with respect to the Renaissance Worthington loan, we will pay interest and principal, with the amount of principal being determined based upon a 30-year amortization schedule. The Los Angeles Airport Marriott loan is interest only for the full term. For each loan, we will be obligated to repay all unpaid principal on July 11, 2015. On July 29, 2005, the Company entered into debt secured by a mortgage on the Frenchman’s Reef & Morning Star Marriott Resort. The debt has a principal balance of $62.5 million, a term of 10 years, bears F-15 interest at 5.44%, and is interest only for the first three years and then amortizes on a 30-year schedule. In conjunction with the closing of the debt, the lender required $2.9 million of the loan proceeds to be set aside into a lender held escrow account to pre-fund certain capital improvements of the Frenchman’s Reef & Morning Star Marriott Resort required under the mortgage debt. During the fourth quarter of 2005 the lender reduced the escrow requirement to $1.2 million. On December 15, 2005, the Company entered into mortgage debt in connection with the acquisition of the Orlando Airport Marriott. The mortgage debt has a principal balance of $59 million, a term of 10 years, bears interest at 5.68 percent, and is interest only for the first five years and then amortizes on a 30-year schedule. In conjunction with the closing of the mortgage debt, the Company provided the lender with an $11.4 million letter of credit secured by the Company’s senior secured credit facility as security for certain capital improvements of the Orlando Airport Marriott required under the mortgage debt. The Company repaid the $20 million mortgage debt on The Lodge at Sonoma, a Renaissance Resort and Spa on June 16, 2005. The Company recorded a loss of approximately $179,000 related to the repayment. The loss consisted of the write-off of the unamortized deferred financing costs and the early termination penalty and is classified within interest expense on the accompanying statements of operations. The Company repaid the $44 million mortgage debt on the Torrance Marriott on June 2, 2005 with approximately $37 million of cash and the application of $7 million restricted cash held in escrow. The Company recorded a loss of approximately $526,000 related to the repayment which consisted of the write- off of the unamortized deferred financing costs. The loss is classified within interest expense on the accompanying statements of operations. The aggregate debt maturities as of December 31, 2005 are as follows: 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,243,603 26,436,201 15,624,265 44,579,048 31,443,682 307,067,936 $428,394,735 8. Acquisitions 2004 Acquisitions On October 27, 2004 the Company acquired The Lodge at Sonoma, a Renaissance Resort & Spa, a 182-room hotel located in Sonoma, California from Marriott for approximately $32.3 million, (including working capital). The acquisition’s effective date was September 11, 2004. Hotel earnings for the period from September 11, 2004 to October 26, 2004 were accounted for as a reduction of the purchase price for accounting purposes. The hotel is currently managed by a subsidiary of Marriott under a new management agreement. On November 19, 2004, the Company acquired the Courtyard by Marriott Midtown East, a 307-room hotel located in Midtown Manhattan, New York for approximately $78.9 million (including working capital). Marriott entered into an Assignment and Assumption of Purchase and Sale Agreement with the Company whereby the Company assumed Marriott’s rights, title and interest in Marriott’s Purchase and Sale Agreement with a third party for the acquisition of the hotel. The hotel is currently managed by a subsidiary of Marriott under a new management agreement. Marriott provided the Company with $2.5 million (“Key Money”) to enter into the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. F-16 On December 15, 2004, the Company acquired the Salt Lake City Marriott Downtown, a 510-room hotel located in Salt Lake City, Utah for total consideration of approximately $53.3 million (including working capital). The Company leases the land underlying the Salt Lake City Marriott Downtown pursuant to a ground lease that provides for ground lease payments that are calculated based on a percentage of gross revenues. The Company reviewed the terms of the ground lease and the terms of the hotel management agreement in conjunction with the hotel purchase accounting and concluded that the ground lease and management agreement terms were consistent with current market terms. The hotel is currently managed by a subsidiary of Marriott. On December 15, 2004, the Company acquired the Bethesda Marriott Suites, a 274-suite hotel located in Bethesda, Maryland for total consideration of approximately $41.9 million (including working capital). The Company leases the land underlying the Bethesda Marriott Suites pursuant to a ground lease that provides for ground lease rental payments that are stipulated in the ground lease and increase 5.5 percent per annum over the remaining eighty-three year term of the lease. The Company concluded that the ground lease terms are above current market and recorded a $5.8 million unfavorable lease provision at the acquisition date. The hotel is currently managed by a subsidiary of Marriott under a new management agreement. The Company reviewed the terms of the hotel’s mortgage debt in conjunction with the purchase accounting. The Company concluded that the current mortgage terms were above current market and, accordingly, the Company recorded a $3.0 million debt premium to record the debt at fair value as of the acquisition date. On December 20, 2004, the Company acquired the Hotel 5A, formerly the Clarion Fifth Avenue, a 189-room hotel located in Midtown Manhattan, New York for total consideration of approximately $39.7 million (including working capital). The hotel was converted to a Courtyard by Marriott in early 2005 and is currently operated by a subsidiary of Marriott and is currently known as the Courtyard Manhattan / Fifth Avenue. The Company leases the land underlying the Courtyard Manhattan / Fifth Avenue pursuant to a ground lease that provides for ground lease rental payments that are stipulated in the ground lease and increase in pre-established amounts over the remaining eighty year term of the lease. The Company reviewed the terms of the ground lease in conjunction with the hotel purchase accounting and concluded that the ground lease terms were consistent with current market terms. In the first quarter of 2005, Marriott paid the TRS of the Company $1.0 million, which was an incentive to enter into the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. On December 22, 2004, the Company acquired the Marriott Griffin Gate Resort, a 408-room hotel located in Lexington, Kentucky for total consideration of approximately $49.8 million (including working capital). The acquisition’s effective date was September 11, 2004. Hotel earnings for the period from September 11, 2004 to December 22, 2004 were accounted for as a reduction of the purchase price for accounting purposes. The hotel is managed by a subsidiary of Marriott under a new management agreement. 2005 Acquisitions On January 5, 2005, the Company acquired the Torrance Marriott, a 487-room hotel located in Torrance, California, for total consideration of approximately $72 million (including working capital and $10 million pre-funded for future capital expenditures). The hotel is currently managed by a subsidiary of Marriott. In early 2005, Marriott paid the Company’s taxable REIT subsidiary $3.0 million of Key Money in exchange for the right to manage the hotel pursuant to the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. The Company entered into $44 million of mortgage debt on the Torrance Marriott which was repaid on June 2, 2005. F-17 On June 23, 2005, the Company acquired a portfolio of four hotels (Renaissance Worthington, Marriott Atlanta Alpharetta, Frenchman’s Reef & Morning Star Marriott Beach Resort and Los Angeles Airport Marriott) from affiliates of Capital Hotel Investments, LLC (“CHI”) for approximately $314.9 million (including working capital). In connection with the purchase, the Company assumed the existing Marriott management agreements, which all expire in 2031 and provide for two 10-year extensions at Marriott’s option. These agreements provide for a base management fee of 3% of the applicable hotel’s gross revenues, and an incentive management fee of 25% of available cash flow (after payment of a 10.75% priority return on the prior owner’s investment), which is not subordinated to debt service. The terms of the assumed management contract were consistent with current market terms. In conjunction with this acquisition, the Company entered into an $82.6 million mortgage loan on the Los Angeles Airport Marriott and a $57.4 million mortgage loan on the Renaissance Worthington. On June 24, 2005, the Company acquired the Vail Marriott Mountain Resort & Spa from Vail Resorts, Inc. for approximately $64.9 million (including working capital). A subsidiary of Vail Resorts, Inc. currently manages the hotel under a management agreement that commenced on the date of acquisition. The management agreement expires in 2020. The agreement provides for a base management fee of 3% of the hotel’s gross revenues, and an incentive management fee of (i) 20%, if the hotel achieves operating profits above an 11% return on our invested capital or (ii) 25%, if the hotel achieves operating profits above a 15% return of invested capital, as defined. On July 22, 2005, the Company acquired the SpringHill Suites Atlanta Buckhead for approximately $34.1 million (including working capital). A subsidiary of Marriott International, Inc. manages the hotel under a management agreement that commenced on the date of acquisition. Marriott paid the Company’s taxable REIT subsidiary $0.5 million of Key Money as an incentive to enter into the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. The management agreement expires in 2035 and has two 10 year renewal options. The agreement provides for a base management fee that will range between 5% - 6.5% of the hotel’s gross revenues, and an incentive management fee of 25% of hotel operating profits above a 12% return on our invested capital. In addition, Marriott provided the Company with a cash flow guaranty for each of fiscal years 2006 and 2007 operating cash flow. The guarantee provides that Marriott will reduce its base management fee should the actual hotel operating income be less than a prescribed amount during fiscal years 2006 and 2007. The annual guarantee obligation of Marriott is capped at $0.1 million for each of 2006 and 2007, respectively. On July 29, 2005, the Company acquired the Oak Brook Hills Resort & Conference Center for approximately $65.7 million (including working capital). The hotel was converted to the Oak Brook Hills Marriott Resort on July 29, 2005 and is managed by a subsidiary of Marriott International, Inc. under a management agreement that commenced on the date of acquisition. The Company leases the land underlying the golf course adjacent to the Oak Brook Hills Marriott Resort pursuant to a ground lease that provides for ground lease payments of $1 per year through the date of the first extension option in 2025, at which time, if extended, the lease payments will be adjusted to market. The Company reviewed the terms of the ground lease in conjunction with the hotel purchase accounting and concluded that the terms of the ground lease were below current market and recorded a $10.8 million favorable lease asset at the acquisition date. Marriott paid the Company’s taxable REIT subsidiary $2.5 million of Key Money in exchange for the right to manage the hotel pursuant to the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. The management agreement expires in 2035. The agreement provides for a base management fee of 3% of the hotel’s gross revenues, and an incentive management fee of 20% of hotel operating profits above a 10.75% return on our invested capital. In addition, Marriott provided the Company with a cash flow guarantee for the fiscal years 2006 and 2007 operating cash flow. The guarantee provides that Marriott will fund the deficit of actual hotel F-18 operating income from a prescribed amount during each of fiscal years 2006 and 2007. The total guarantee obligation of Marriott is capped at $2.5 million. On December 16, 2005 the Company acquired the Orlando Airport Marriott for approximately $71.6 million (including working capital). A subsidiary of Marriott currently manages the hotel under a management agreement that commenced on the date of acquisition. Marriott paid the Company’s taxable REIT subsidiary $1.0 million of Key Money as an incentive to enter into the management agreement. The Key Money was deferred and will be recognized over the term of the management agreement. The management agreement expires in 2035. The agreement provides for a base management fee of 3% of the hotel’s gross revenues, and an incentive management fee of 20% - 25% of hotel operating profits above a 10.75% return on our invested capital. In addition, Marriott provided the Company with a cash flow guaranty for the fiscal year 2006 operating cash flow. The guarantee provides that Marriott will reduce its base management fee should the actual hotel operating income be less than a prescribed amount during fiscal year 2006. The 2006 guarantee obligation of Marriott is capped at $1.0 million. The acquisitions allocations, which may be adjusted if any of the assumptions underlying the purchase accounting change, of the purchase prices of the hotels to the acquired assets and liabilities are as follows (in thousands): Land . . . . . . . . . . . . . . . . . . . . . . . . Building. . . . . . . . . . . . . . . . . . . . . . Furniture, fixtures and equipment . . . . . . . . . . . . . . . . . Total fixed assets . . . . . . . . . . . . . . Favorable lease asset . . . . . . . . . . FF&E escrow and restricted cash . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax liability . . . . . . . Hotel working capital accrued liabilities and other assets, net . . . . . . . . . . . . . . . . . . . . . . . . Purchase price . . . . . . . . . . . . . . . . CHI Portfolio $60,936 231,056 Vail $5,800 53,037 Torrance $7,241 51,517 Buckhead $3,900 28,182 Oak Brook $9,500 39,128 Orlando $9,769 57,803 11,113 303,105 — 5,000 63,837 — 3,409 62,167 — 2,310 34,392 — 4,800 53,428 10,830 2,916 70,488 — 11,456 (3,896) — 10,000 — — — 4,201 $314,866 1,093 $64,930 (152) $72,015 (306) $34,086 1,489 $65,747 1,116 $71,604 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Land improvements . . . . . . . . . . . . . . . . . . . Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture, fixtures and equipment . . . . . . . Total fixed assets. . . . . . . . . . . . . . . . . . . . . . Unfavorable lease liability . . . . . . . . . . . . . . Debt premium. . . . . . . . . . . . . . . . . . . . . . . . FF&E escrow and restricted cash . . . . . . . . Hotel working capital and other Sonoma $ 3,951 5,594 17,865 4,846 32,256 — — 800 Courtyard Midtown East $ 16,500 — 54,664 1,500 72,664 — — 4,539 Courtyard Salt Lake $ — $ — — 33,779 1,000 34,779 — — 4,331 Fifth Avenue Griffin Gate Bethesda $ — — 46,271 3,425 49,696 (5,780) (2,952) 830 $ 7,869 — 33,428 6,650 47,947 — — 2,955 — 45,292 3,825 49,117 — — 3,761 assets, net . . . . . . . . . . . . . . . . . . . . . . . . . Purchase price. . . . . . . . . . . . . . . . . . . . . . . . (711) $ 32,345 1,654 $ 78,857 467 $ 53,345 630 $ 39,740 (1,060 ) $ 49,842 98 $ 41,892 The acquired properties are included in our results of operations from the respective dates of acquisition. The following unaudited pro forma results of operations reflect these transactions as if each had occurred on the first day of the fiscal year presented. In our opinion, all significant adjustments necessary to reflect the effects of the acquisitions have been made; however, a preliminary allocation of the F-19 purchase price to land and buildings was made, and we will finalize the allocation after all information is obtained. Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share—basic and diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2005 $352,181,275 8,122,355 0.16 $ Year Ended December 31, 2004 $ 325,939,880 5,571,637 0.11 $ On March 1, 2006, the Company signed a purchase agreement to acquire the 1,192 room Chicago Marriott Downtown Magnificent Mile for a purchase price of $295 million plus approximately $11 million of net consideration in the form of an assumed property tax liability and other adjustments. The acquisition will include the assumption of $220 million of floating-rate debt, which the Company intends to refinance with fixed-rate debt shortly after closing the acquisition. The Company made a $5 million non-refundable deposit upon entering into the purchase agreement. The Company intends to raise equity capital to assist in funding the acquisition, and filed a Form S-11 with the SEC dated March 8, 2006. 9. Dividends During the second fiscal quarter the Company’s Board of Directors declared a cash dividend of $0.0326 per share of our common stock. The dividend was paid on June 28, 2005 to stockholders of record as of June 17, 2005. During the third fiscal quarter the Company’s Board of Directors declared a cash dividend of $0.1725 per share of our common stock. The dividend was paid on September 27, 2005 to stockholders of record as of September 9, 2005. During the fourth fiscal quarter the Company’s Board of Directors declared a cash dividend of $0.1725 per share of our common stock. The dividend was paid on January 17, 2006 to stockholders of record as of December 30, 2005. 10. Income Taxes The Company elected for REIT status effective January 1, 2005. As a REIT, the Company generally will not be subject to federal income tax on that portion of its ordinary income or net capital gain that it currently distributes to its stockholders. Bloodstone TRS, Inc., the Company’s taxable REIT subsidiary, will continue to be subject to federal and state income taxes. The Company recorded a charge of $1.4 million to reverse the deferred tax assets that are not realizable by the Company in the first quarter of 2005 as a result of its REIT election. The deferred tax assets related to Bloodstone TRS, Inc. were not reversed. In addition, the Company distributed $2.3 million during 2005 to eliminate 2004 non-REIT earnings and profits, regardless of the Company’s 2005 REIT taxable income. The Company’s (provision) benefit for income taxes consists of the following: Year Ended December 31, 2005 $(354,534) (134,356) (488,890) 1,346,775 447,919 47,457 1,842,151 $1,353,261 Period from May 6, 2004 (Inception) to December 31, 2004 $(616,942) (262,775) (879,717) 1,728,840 732,990 — 2,461,830 $1,582,113 Current—Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred—Federal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . F-20 A reconciliation of the statutory Federal tax benefit to our income tax benefit is as follows: Year Ended December 31, 2005 Period from May 6, 2004 (Inception) to December 31, 2004 Statutory Federal tax benefit (@35%) . . . . . . . . . . . . . . . . . State income tax benefit, net of Federal tax benefit . . . . . . REIT election deferred tax asset write off . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(2,435,065) $(1,294,908) (306,215) — 19,010 $(1,353,261) $(1,582,113) (378,479) 1,404,085 56,198 The Company is required to pay franchise taxes in certain jurisdictions. The Company accrued approximately $130,000 of franchise taxes during the year ended December 31, 2005, which are classified as corporate expenses in the accompanying consolidated statements of operations. In addition, the Company is subject to state income taxes which are calculated as if the subsidiary owning the Griffin Gate Marriott was a stand-alone corporation. The Company accrued approximately $138,000 of state income taxes during the year ended December 31, 2005. Deferred income taxes are recognized for temporary differences between the financial reporting bases of assets and liabilities and their respective tax bases and for operating loss and tax credit carryforwards based on enacted tax rates expected to be in effect when such amounts are paid. However, deferred tax assets are recognized only to the extent that it is more likely than not that they will be realizable based on consideration of available evidence, including future reversals of existing taxable temporary differences, projected future taxable income and tax planning strategies. The total deferred tax assets and liabilities are as follows: Deferred income related to Key Money. . . . . . . . . . . . . . Net operating loss carryforwards . . . . . . . . . . . . . . . . . . . . Building and FF&E basis difference recorded in purchase accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative minimum tax credit carryforwards . . . . . . . . Ground leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pre-opening costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Valuation allowance. . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Land basis difference recorded in purchase accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset, net. . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2005 $4,170,397 1,059,827 December 31, 2004 $1,080,827 — 364,519 354,534 — — — 5,949,277 — 5,949,277 — — 128,205 179,795 1,118,529 2,507,356 — 2,507,356 (4,259,962) (1,331,856) — (5,591,818) $357,459 — (40,831) (4,695) (45,526) $2,461,830 The Company believes that it will have sufficient future taxable income, including future reversals of existing taxable temporary differences, projected future taxable income and tax planning strategies to realize existing deferred tax assets. F-21 The Frenchman’s Reef & Morning Star Marriott Beach Resort is owned by a subsidiary that has elected to be treated as a taxable REIT subsidiary, and is subject to USVI income taxes. The Company is party to a tax agreement with the USVI that reduces the income tax rate to approximately 4%. This arrangement expires on December 31, 2009. If the arrangement is not extended the Company will be subject to an income tax rate of 37.4%. The Company believes that this agreement will be extended. 11. Related Party Transactions Marriott Investment Sourcing Relationship As of December 31, 2005, Marriott International Inc. (“Marriott”) owns approximately 8.6% of our common stock. While there is no contractual relationship binding upon the Company and Marriott, the Company considers Marriott to be the Company’s preferred hotel management company. Management Agreements The Company is party to hotel management agreements with Marriott for fourteen of the fifteen properties owned as of December 31, 2005. The fifteenth hotel, the Vail Marriott Mountain Resort & Spa, is managed by a subsidiary of Vail Resorts, Inc. The Company acquired the Vail Marriott Mountain Resort & Spa from Vail Resorts, Inc. The managers are responsible for hiring, with the Company retaining veto rights on certain executive level employees, training and supervising the managers and employees required to operate the properties and for purchasing supplies, for which they generally will be reimbursed by the Company. Marriott (through the Vail Marriott Mountain Resort and Spa franchise agreement) will provide centralized reservation systems, national advertising, marketing and promotional services, as well as various accounting and data processing services. The managers will also prepare and implement annual operations budgets that will be subject to certain limited review and approval rights by the Company. The following table sets forth the effective date, initial term and the number of renewal terms at the option of the manager under the respective management agreements for each of the Company’s acquired hotel properties: The Lodge at Sonoma, a Renaissance Resort and Spa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan / Midtown East. . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . Courtyard Manhattan / Fifth Avenue . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . Date of Agreement Initial Term Number of Renewal Terms 10/2004 11/2004 12/2001 01/2005 12/2004 12/2004 1/2005 9/2000 9/2000 9/2000 9/2000 6/2005 7/2005 7/2005 11/2005 20 years 30 years 30 years 30 years 20 years 21 years 40 years 30 years 30 years 30 years 30 years 15 ½ years 30 years 30 years 30 years One ten year period Two ten year periods Three fifteen year periods None One ten year period Two ten year periods None Two ten year periods Two ten year periods Two ten year periods Two ten year periods None Two ten year periods None None F-22 The following table sets forth the base management fee and incentive management fee, generally due and payable each fiscal year, for each of our seven properties. Courtyard Manhattan/Midtown East. . . . . . . . . . . . . . . . . . . . . . . . . . Torrance Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salt Lake City Marriott Downtown . . . . . . . . . . . . . . . . . . . . . . . . . . . Marriott Griffin Gate Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bethesda Marriott Suites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Courtyard Manhattan/Fifth Avenue . . . . . . . . . . . . . . . . . . . . . . . . . . The Lodge at Sonoma, a Renaissance Resort & Spa . . . . . . . . . . . . Marriott Atlanta Alpharetta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Frenchman’s Reef & Morning Star Marriott Beach Resort . . . . . . Los Angeles Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Renaissance Worthington . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vail Marriott Mountain Resort & Spa . . . . . . . . . . . . . . . . . . . . . . . . SpringHill Suites Atlanta Buckhead . . . . . . . . . . . . . . . . . . . . . . . . . . Oak Brook Hills Marriott Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orlando Airport Marriott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Base Management Fee(1) 5% 3% 3% 3% 3% 5% (8) 3% 3% 3% 3% 3% 3% 5% (11) 3% 3% Incentive Management Fee(2) 25%(3) 20%(4) Not more than 20%(5) 20%(6) 50%(7) 25%(9) 20%(10) 25%(12) 25%(13) 25%(14) 25%(15) 20%(16) 25%(17) 20% or 30%(18) 20% or 25%(19) (1) As a percentage of gross revenues. (2) Based on a percentage of hotel operating profits above a negotiated return on our investment capital as more fully described in the following footnotes. (3) Calculated as a percentage of operating profits in excess of 10.75% of the sum of (i) $73.7 million and (ii) the amount of certain capital expenditures. (4) Calculated as a percentage of operating profits in excess of the sum of (i) $7.5 million and (ii) 10.75% of certain capital expenditures. (5) The incentive management fee is equal to the available cash flow for each fiscal year, subject to a cap of 20% of operating profit for such fiscal year. Commencing with the fiscal year 2002, the operating profit with respect to each fiscal year is reduced by an amount equal to 10.75% of all material capital expenditures funded by the TRS lessee; provided that the material capital expenditures are included in the calculation of the incentive management fee with respect to the fiscal year or fiscal years during which such expenditures occurred (on a pro rata basis). (6) Calculated as a percentage of operating profits in excess of the sum of (i) $5.5 million and (ii) 10.75% of certain capital expenditures. (7) Calculated as a percentage of operating profits in excess of the sum of (i) the payment of certain loan procurement costs, (ii) 10.75% of certain capital expenditures, (iii) an agreed-upon return on certain expenditures and (iv) the value of certain amounts paid into a reserve account established for the replacement, renewal and addition of certain hotel goods. (8) The base management fee will be equal to 5.5% of gross revenues for fiscal years 2010 through 2014 and 6% for fiscal year 2015 and thereafter until the expiration of the agreement. Also, beginning in 2007, the base management fee may increase to 5.5% at the beginning of the next fiscal year if operating profits equal or exceed $4.7 million, and beginning in 2011, the base management fee may increase to 6.0% at the beginning of the next fiscal year if operating profits equal or exceed $5.0 million. (9) Calculated as a percentage of operating profits in excess of 12% of the sum of (i) $38.8 million and (ii) the amount of certain capital expenditures, less 5% of the total real estate tax bill (for as long as the hotel is leased to a party other than the manager). (10) Calculated as a percentage of operating profits in excess of the sum of (i) $3.6 million and (ii) 10.75% of capital expenditures. (11) The base management fee will be equal to 6% of gross revenues for fiscal years 2008 through 2016 and 6.5% of gross revenues thereafter. In the event that the property’s operating profit is below certain thresholds in 2007 and 2008, the base management fee may be reduced by up to $100,000 per year. In addition, in the event that the hotel’s operating profit is above certain F-23 thresholds starting in 2008, the base management fee will be increased to 6.5% and if the hotel’s operating profit is above an additional threshold starting in 2012, the base management fee will be increased to 7.0% (12) Calculated as a percentage of operating profits in excess of the sum of (i) $4,085,000 and (ii) 10.75% of certain capital expenditures. (13) Calculated as a percentage of operating profits in excess of the sum of (i) $8,403,813 and (ii) 10.75% of certain capital expenditures. (14) Calculated as a percentage of operating profits in excess of the sum of (i) $9,417,000 and (ii) 10.75% of certain capital expenditures. (15) Calculated as a percentage of operating profits in excess of the sum of (i) $7,616,698 and (ii) 10.75% of certain capital expenditures. (16) Calculated as a percentage of operating profits in excess of 11% of our invested capital. The incentive management fee rises to 25% if the hotel achieves operating profits in excess of 15% of our invested capital. (17) Calculated as a percentage of operating profits in excess of the sum of (i) $4,085,928 and (ii) 12% of certain capital expenditures and pre-conversion expenses. (18) Calculated as a percentage of operating profits in excess of the sum of (i) $8,094,750 and (ii) 10.75% of certain capital expenditures. The percentage of operating profits is 20% except from 2011 through 2025 when it is 30%. (19) Calculated as a percentage of operating profits in excess of 10.75% of our acquisition costs plus certain capital expenditures. We estimate that the threshold will be approximately $9 million. The percentage of operating profits is 20% except from 2011 through 2025 when it is 25%. The Company paid $8,107,902 and $260,724 of management fees during the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004. The management fees for the year ended December 31, 2005 consisted of $634,000 of incentive management fees and $7,473,902 of base management fees. All management fees earned during the period from May 6, 2004 (Inception) to December 31, 2004 related to base management fees. Other Business Relationships with Marriott The Company is party to the following arrangements with Marriott: • The Company was party to a one-year lease agreement that terminated on August 31, 2005 for approximately 4,000 square feet of office space at Marriott’s headquarters for the Company’s corporate offices for approximately $190,000 per year. In addition, the Company reimbursed Marriott for approximately $45,000 of leasehold improvement costs for the leased space. The Company moved from Marriott’s headquarters in September 2005. • The Company was party to a shared services agreement with Marriott that terminated on August 31, 2005. The shared services agreement provided the Company with access to certain information technology and telephone and Internet systems as long as the Company continues to lease its corporate offices from Marriott. The Company moved from Marriott’s headquarters in September 2005. The cost of these services was approximately $73,000 and $249,000 for the period from May 6, 2004 to December 31, 2004 and the year ended December 31, 2005, respectively. As of December 31, 2005, the liabilities incurred by the hotel managers are comprised of liabilities incurred by the Company’s hotel managers in conjunction with the operation of the hotels which are legal obligations of the Company. As of December 31, 2005, the due from managers is primarily comprised of hotel level accounts receivable, periodic hotel operating distributions due to owner and prepaid and other assets held by the hotel managers on the Company’s behalf. Franchise Agreement With respect to the Vail Marriott Mountain Resort & Spa, the Company’s taxable REIT subsidiary lessee entered into a franchise agreement with Marriott International, Inc. which expires on December 17, F-24 2021. The franchise agreement is generally non-terminable by us or by Marriott except upon an event of default or in the case of certain events of casualty or condemnation. In connection with the franchise agreement, the Company’s taxable REIT subsidiary lessee pays Marriott a franchise fee equal to 6% of gross room sales and 3% of gross food and beverage sales. In addition, our TRS lessee pays Marriott an amount equal to 1% of gross room and 1% of gross room sales for use in chain-wide advertising, promotions and sales. 12. Commitments and Contingencies Litigation The Company is not involved in any material litigation nor, to its knowledge, is any material litigation threatened against the Company. Ground Leases Three of our hotels are subject to ground lease agreements that cover all of the land underlying the respective hotel: • The Bethesda Marriott Suites is subject to a ground lease that runs until 2087. There are no renewal options. • The Courtyard Manhattan/Fifth Avenue is subject to a ground lease that runs until 2085, inclusive of one 49-year renewal option. • The Salt Lake City Marriott Downtown is subject to two ground leases: one ground lease covers the land under the hotel and the other ground lease covers the portion of the hotel that extends into the Crossroads Plaza Mall. The term of the ground lease covering the land under the hotel runs through 2056, inclusive of our renewal options, and the term of the ground lease covering the extension runs through 2017, inclusive of the remaining ten-year renewal option. In addition, part of one of the parking garages adjacent to one of our hotels is subject to a ground lease agreement: • A portion of the parking garage relating to the Renaissance Worthington is subject to three ground leases that cover, contiguously with each other, approximately one-fourth of the land on which the parking garage is constructed. Each of the ground leases has a term that runs through July 2067, inclusive of the three 15-year renewal options contained in each ground lease. Finally, two of the golf courses adjacent to two of our hotels are subject to a ground lease agreement: • The golf course which is part of the Marriott Griffin Gate Resort is subject to a ground lease covering approximately 54 acres. The ground lease runs through 2033, inclusive of our renewal options. We have the right, beginning in 2013 and upon the expiration of any 5-year renewal term, to purchase the property covered by such ground lease for an amount ranging from $27,500 to $37,500 per acre, depended on which renewal term has expired. The ground lease also grants us the right to purchase the leased property upon a third party offer to purchase such property on the same terms and conditions as the third party offer. We are also the sub-sublessee under another minor ground lease of land adjacent to the golf course, with a term expiring in 2020. • The golf course which is part of the Oak Brook Hills Marriott Resort is subject to a ground lease covering approximately 110 acres. The ground lease runs through 2045 including renewal options. F-25 These ground leases generally require us to make rental payments (including a percentage of gross receipts as percentage rent with respect to the Courtyard Manhattan/Fifth Avenue ground lease) and payments for all, or in the case of the ground leases covering the Salt Lake City Marriott Downtown extension and a portion of the Marriott Griffin Gate Resort golf course, our tenant’s share of, charges, costs, expenses, assessments and liabilities, including real property taxes and utilities. Furthermore, these ground leases generally require us to obtain and maintain insurance covering the subject property. We record ground rent payments on a straight-line basis as required by U.S. generally accepted accounting principles. Ground rent expense was $8,807,216 and $353,410 for the year ended December 31, 2005 and the period from May 6, 2004 to December 31, 2004, respectively. Cash paid for ground rent was $1,650,139 and $53,215 for the year ended December 31, 2005 the period from May 6, 2004 to December 31, 2004, respectively. Future minimum annual rental commitments under non-cancelable operating leases as of December 31, 2005 are as follows: 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2007. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,621,245 2,519,087 2,481,931 2,240,393 2,016,683 600,206,582 $612,085,921 13. Fair Value of Financial Instruments The fair value of certain financial assets and liabilities and other financial instruments as of December 31, 2005 and 2004 are as follows: Mortgage debt. . . . . . . Interest rate cap agreements . . . . . . . As of December 31, 2005 Fair Value $ 411,666,570 Carrying Amount $ 416,394,735 As of December 31, 2004 Fair Value $ 180,779,372 Carrying Amount $ 177,827,573 16,070 16,070 59,944 59,944 The fair value of all other financial assets and liabilities are equal to their carrying amount. 14. Segment Information The Company considers each of our hotels to be an operating segment. However, we aggregate these operating segments into one reportable segment using the criteria established by SFAS 131, including the similarities of our product offering, types of customers and method of providing service. F-26 The following table sets forth revenues and investment in hotel assets represented by the following geographical areas as of December 31, 2005 and 2004 and for the year ended December 31, 2005 and the period from May 6, 2004 (Inception) to December 31, 2004. Los Angeles . . . . . . . . . . . . . . . . . . . . . . . . . . . . New York . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US Virgin Islands . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15. Quarterly Operating Results (Unaudited) Total revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . Operating (loss) income. . . . . . . . . . . . . . . . . . Net (loss) income . . . . . . . . . . . . . . . . . . . . . . . Earnings (loss) per share: Revenues Investment 2005 $ 46,495,000 35,339,000 19,708,000 127,908,263 $ 229,450,263 2004 $ — 3,244,000 — 3,829,864 $ 7,073,864 2005 $174,736,000 111,496,000 72,711,000 511,619,399 $ 870,562,399 2004 $ — 107,025,000 — 178,617,439 $ 285,642,439 2005 Quarter Ended March 25 $26,348,781 28,952,944 September 9 June 17 $65,407,001 $33,515,716 61,392,831 35,514,860 $ (2,604,163) $ (1,999,144) $ 4,014,170 $ (5,261,511) $ (5,824,555) $ 2,196,468 December 31 $ 104,178,765 96,460,385 7,718,380 1,553,658 $ $ Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ (0.25) $ (0.25) $ (0.20) $ (0.20) $ 0.04 0.04 $ $ 0.03 0.03 Total revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss per share: 2004 Quarter Ended September 10 — $ 1,724,867 December 31 $ 7,073,864 9,609,471 $(1,724,867) $(2,535,607) $ (720,273) $(1,397,352) Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ (0.05) $ (0.05) $ (0.07) (0.07) F-27 n o i t a i c e r p e D r a e Y e f i L n o i t i s i u q c A f o t e N k o o B e u l a V d e t a l u m u c c A n o i t a i c e r p e D y n a p m o C y t i l a t i p s o H k c o R d n o m a i D n o i t a i c e r p e D d e t a l u m u c c A d n a e t a t s E l a e R — I I I e l u d e h c S 5 0 0 2 , 1 3 r e b m e c e D f o s A s s o r G t a s t n u o m A r a e Y f o d n E g n i d l i u B d n a s t s o C d e z i l a t i p a C o t t n e u q e s b u S g n i d l i u B d n a l a t o T s t n e m e v o r p m I d n a L n o i t i s i u q c A s t n e m e v o r p m I d n a L s e c n a r b m u c n E n o i t p i r c s e D s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 4 0 0 2 4 0 0 2 4 0 0 2 4 0 0 2 4 0 0 2 5 0 0 2 5 0 0 2 5 0 0 2 5 0 0 2 5 0 0 2 9 0 7 , 7 7 7 , 9 6 ) 8 2 3 , 4 3 5 , 1 ( 7 3 0 , 2 1 3 , 1 7 7 3 0 , 2 1 8 , 4 5 0 0 0 , 0 0 5 , 6 1 0 0 4 , 1 8 5 , 4 4 ) 7 7 1 , 4 3 2 , 1 ( 7 7 5 , 5 1 8 , 5 4 7 7 5 , 5 1 8 , 5 4 4 3 8 , 7 7 7 , 3 3 ) 0 8 0 , 7 0 9 ( 4 1 9 , 4 8 6 , 4 3 4 1 9 , 4 8 6 , 4 3 — — 6 8 1 , 3 5 4 , 4 4 ) 9 2 3 , 2 0 2 , 1 ( 5 1 5 , 5 5 6 , 5 4 5 1 5 , 5 5 6 , 5 4 — 4 3 3 , 9 5 3 , 0 4 ) 0 2 0 , 2 6 8 ( 4 5 3 , 1 2 2 , 1 4 4 5 3 , 2 5 3 , 3 3 0 0 0 , 9 6 8 , 7 7 5 1 , 6 7 6 , 6 5 ) 4 0 0 , 0 7 2 , 1 ( 1 6 1 , 6 4 9 , 7 5 1 6 1 , 5 0 7 , 0 5 0 0 0 , 1 4 2 , 7 7 2 1 , 7 8 6 , 6 3 ) 1 4 8 , 8 3 4 ( 8 6 9 , 5 2 1 , 7 3 8 6 9 , 2 0 5 , 3 3 0 0 0 , 3 2 6 , 3 1 6 7 , 4 7 6 , 7 6 ) 7 9 6 , 5 3 7 ( 8 5 4 , 0 1 4 , 8 6 8 5 4 , 7 9 6 , 0 5 0 0 0 , 3 1 7 , 7 1 8 2 8 , 9 9 3 , 6 0 1 ) 8 5 7 , 7 7 0 , 1 ( 6 8 5 , 7 7 4 , 7 0 1 6 8 5 , 7 7 3 , 3 8 0 0 0 , 0 0 1 , 4 2 4 7 0 , 5 2 1 , 8 7 ) 1 1 5 , 2 0 8 ( 5 8 5 , 7 2 9 , 8 7 5 8 5 , 7 2 4 , 3 6 0 0 0 , 0 0 5 , 5 1 s r a e Y 0 4 5 0 0 2 1 5 8 , 4 9 6 , 7 5 ) 4 0 9 , 2 8 6 ( 5 5 7 , 7 7 3 , 8 5 5 5 7 , 7 7 5 , 2 5 0 0 0 , 0 0 8 , 5 s r a e Y 0 4 s r a e Y 0 4 s r a e Y 0 4 5 0 0 2 5 0 0 2 5 0 0 2 9 5 0 , 5 6 6 , 1 3 ) 3 2 9 , 2 1 3 ( 2 8 9 , 7 7 9 , 1 3 2 8 9 , 7 7 0 , 8 2 0 0 0 , 0 0 9 , 3 9 5 5 , 3 1 2 , 7 4 ) 3 5 1 , 4 3 4 ( 2 1 7 , 7 4 6 , 7 4 2 1 7 , 7 4 1 , 8 3 0 0 0 , 0 0 5 , 9 0 3 3 , 3 3 5 , 7 6 ) 3 7 3 , 3 6 ( 3 0 7 , 6 9 5 , 7 6 3 0 7 , 7 2 8 , 7 5 0 0 0 , 9 6 7 , 9 s r a e Y 0 4 4 0 0 2 6 7 3 , 8 1 7 , 5 2 $ ) 6 6 2 , 3 5 9 ( $ 2 4 6 , 1 7 6 , 6 2 $ 2 4 6 , 0 2 7 , 2 2 $ 0 0 0 , 1 5 9 , 3 $ — — — 6 7 0 , 0 1 1 8 3 8 , 4 7 5 , 4 3 7 7 5 , 5 1 8 , 5 4 — — ) 9 8 1 , 6 1 0 , 8 3 ( ) 0 0 0 , 0 0 0 , 3 2 ( — — — — — — — — — — — 1 6 1 , 5 0 7 , 0 5 0 0 0 , 1 4 2 , 7 8 6 9 , 2 0 5 , 3 3 0 0 0 , 3 2 6 , 3 — — 4 5 3 , 2 5 3 , 3 3 0 0 0 , 9 6 8 , 7 ) 0 5 2 , 2 4 4 , 0 3 ( 5 1 5 , 5 5 6 , 5 4 — ) 0 0 4 , 5 0 3 , 9 1 ( 8 5 4 , 7 9 6 , 0 5 0 0 0 , 3 1 7 , 7 1 ) 0 0 0 , 0 0 5 , 2 6 ( 6 8 5 , 7 7 3 , 3 8 0 0 0 , 0 0 1 , 4 2 ) 0 0 0 , 0 0 6 , 2 8 ( 5 8 5 , 7 2 4 , 3 6 0 0 0 , 0 0 5 , 5 1 ) 0 0 0 , 0 0 4 , 7 5 ( 5 5 7 , 7 7 5 , 2 5 0 0 0 , 0 0 8 , 5 2 8 9 , 7 7 0 , 8 2 0 0 0 , 0 0 9 , 3 2 1 7 , 7 4 1 , 8 3 0 0 0 , 0 0 5 , 9 — — — 3 0 7 , 7 2 8 , 7 5 0 0 0 , 9 6 7 , 9 ) 0 0 0 , 0 0 0 , 9 5 ( 7 3 0 , 2 1 8 , 4 5 0 0 0 , 0 0 5 , 6 1 ) 6 9 8 , 0 3 1 , 4 4 ( 5 8 5 , 7 3 3 , 8 0 8 $ ) 4 6 3 , 1 1 5 , 2 1 ( $ 9 4 9 , 8 4 8 , 0 2 8 $ 9 4 9 , 2 8 3 , 5 9 6 $ 0 0 0 , 6 6 4 , 5 2 1 $ 6 7 0 , 0 1 1 $ 3 7 8 , 2 7 2 , 5 9 6 $ 0 0 0 , 6 6 4 , 5 2 1 $ ) 5 3 7 , 4 9 3 , 6 1 4 ( $ . . . . . . . . . . r a t S g n i n r o M & f e e R s ’ n a m h c n e r F . . . . . . . . . . . . . . . t r o s e R h c a e B t t o i r r a M t t o i r r a M t r o p r i A s e l e g n A s o L . . . n o t g n i h t r o W e c n a s s i a n e R . . . . . . . . . . . . . . . . . . . . . t s a E n w o t n w o D t t o i r r a M y t i C e k a L t l a S n w o t d i M / n a t t a h n a M d r a y t r u o C . . . . . . . . . . . . . . . . . . . . . a t t e r a h p A a t n a l t l A t t o i r r a M h t f i F / n a t t a h n a M d r a y t r u o C . . . . . . . . . . . . . . e u n e v A t r o s e R e t a G n i f f i r G t t o i r r a M . . . . . . s e t i u S a d s e h t e B t t o i r r a M . . . . . t t o i r r a M e c n a r r o T F-28 . . . . . . . . . . . . . . . . . . . . . . a p S & t r o s e R n i a t n u o M t t o i r r a M l i a V . . . . . . . . . . . . . . . . . . . . . . . . d a e h k c u B t r o s e R t t o i r r a M s l l i H k o o r B k a O a t n a l t A s e t i u S l l i H g n i r p S . . . . . . . . . . . t t o i r r a M t r o p r i A o d n a l r O . . . . . . . . . . . . . . . . l a t o T $ 2 4 6 , 0 2 7 , 2 2 $ 0 0 0 , 1 5 9 , 3 $ — $ . . . . a p S d n a t r o s e R e c n a s s i a n e R a , a m o n o S t a e g d o L e h T DiamondRock Hospitality Company Schedule III—Real Estate and Accumulated Depreciation As of December 31, 2005 Notes: A) The change in total cost of properties for the fiscal year ended December 31, 2005 is as follows: Balance at December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions: $265,214,912 Acquisitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to purchase accounting . . . . . . . . . . . . . . . . . . . . . . . . . 555,071,001 110,076 452,960 Deductions: Dispositions and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — $820,848,949 B) The change in accumulated depreciation of real estate assets for the fiscal year ended December 31, 2005 is as follows: Balance at December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dispositions and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 467,577 12,043,787 — $12,511,364 C) The aggregate cost of properties for Federal income tax purposes is approximately $811,472,507 as of December 31, 2005 F-29 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.1 I, William W. McCarten, certify that: 1. I have reviewed this Annual Report on Form 10-K of DiamondRock Hospitality Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 6, 2006 /s/ William W. McCarten William W. McCarten Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 I, Mark W. Brugger, certify that: 1. I have reviewed this Annual Report on Form 10-K of DiamondRock Hospitality Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: March 6, 2006 /s/ Mark W. Brugger Mark W. Brugger Executive Vice President and Chief Financial Officer (Principal Financial Officer) Exhibit 32 Certification Pursuant to Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350(a) and (b)) The undersigned officers, who are the Chief Executive Officer and Chief Financial Officer of DiamondRock Hospitality Company (the “Company”), each hereby certifies to the best of his knowledge, that the Company’s Annual Report on Form 10-K to which this certification is attached (the “Report”), as filed with the Securities and Exchange Commission on the date hereof, fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ William W. McCarten William W. McCarten Chairman of the Board and Chief Executive Officer March 6, 2006 /s/ Mark W. Brugger Mark W. Brugger Executive Vice President, Chief Financial Officer and Treasurer March 6, 2006 C O R P O R AT E I N F O R M AT I O N ........................... CORPORATE HEADQUARTERS DiamondRock Hospitality Company 6903 Rockledge Drive Suite 800 Bethesda, Maryland 20817 (240) 744-1150 FAX (240) 744-1199 ANNUAL MEETING DiamondRock Hospitality Company will hold its annual meeting of shareholders on April 27, 2006, at 11:00 am EST at the Bethesda Marriott Suites, 6711 Democracy Boulevard, Bethesda, Maryland 20817. A formal notice and proxy will be mailed before the meeting to shareholders entitled to vote. REGISTRAR AND STOCK TRANSFER AGENT American Stock Transfer & Trust Company 59 Maiden Lane New York, New York 10038 (212) 936-5100 www.amstock.com BOARD OF DIRECTORS William W. McCarten Chairman of the Board and Chief Executive Officer W. Robert Grafton Lead Independent Director Daniel J. Altobello Independent Director Maureen L. McAvey Independent Director and Senior Resident Fellow and ULI/Klingbeil Family Chair, Urban Development at the Urban Land Institute Gilbert T. Ray Independent Director John L. Williams Director and President and Chief Operating Officer EXECUTIVE OFFICERS William W. McCarten Chief Executive Officer John L. Williams President and Chief Operating Officer Mark W. Brugger Executive Vice President, Chief Financial Officer and Treasurer Michael D. Schecter General Counsel and Secretary Sean M. Mahoney Chief Accounting Officer and Corporate Controller INTERNET ACCESS A corporate profile, recent press releases, SEC filings, property locations and other information about DiamondRock Hospitality Company can be found on the World Wide Web at www.drhc.com. INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM KPMG LLP 1660 International Drive McLean,Virginia 22102 OTHER SHAREHOLDER INFORMATION For information about DiamondRock Hospitality Company and its subsidiaries, including copies of its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, you may call our corporate headquarters or submit a written request to Investor Relations. Our Chief Executive Officer and Chief Financial Officer have furnished the Sections 302 and 906 certifications required by the U.S. Securities and Exchange Commission in our Annual Report on Form 10-K. In addition, our Chief Executive Officer has certified to the NYSE that he is not aware of any violations by us of NYSE corporate governance standards. 6903 ROCKLEDGE DRIVE, SUITE 800 BETHESDA, MARYLAND 20817 (240) 744-1150 WWW.DRHC.COM 

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