XFRA:RX1 Strategic Hotels & Resorts, Inc. Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________________________
FORM 10-Q 
______________________________________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012
or
o
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: 001-32223
STRATEGIC HOTELS & RESORTS, INC.
(Exact name of registrant as specified in its charter)
______________________________________________
Maryland
 
33-1082757
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
200 West Madison Street, Suite 1700, Chicago, Illinois
 
60606-3415
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code: (312) 658-5000 
______________________________________________
Former name, former address and former fiscal year, if changed since last report:
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  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer
 
x
  
Accelerated filer
 
o
Non-accelerated filer
 
o  (Do not check if a smaller reporting company)
  
Smaller reporting company
 
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  o    No  x
The number of shares of common stock (par value $0.01 per share) of the registrant outstanding as of August 6, 2012 was 204,308,710.




STRATEGIC HOTELS & RESORTS, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2012
INDEX
 
WHERE TO FIND MORE INFORMATION:
We maintain a website at www.strategichotels.com. Through our website, we make available, free of charge, our annual proxy statement, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (SEC). The SEC maintains a website that contains these reports at www.sec.gov.
This report (and Exhibit 99.1 hereto) contains registered trademarks that are the exclusive property of their respective owners, which are companies other than us, including Fairmont®, Four Seasons®, Hilton®, Hyatt®, InterContinental®, Loews®, Marriott®, Michael Jordan’s Steak House®, Renaissance®, Ritz-Carlton® and Westin®. None of the owners of these trademarks, their affiliates or any of their respective officers, directors, agents or employees has or will have any liability or responsibility for any financial statements, projections or other financial information or other information contained in this report.



PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES (SHR)
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share Data)
 
 
 
June 30,
2012
 
December 31,
2011
Assets
 
 
 
 
Investment in hotel properties, net
 
$
1,661,252

 
$
1,692,431

Goodwill
 
40,359

 
40,359

Intangible assets, net of accumulated amortization of $9,754 and $8,915
 
30,147

 
30,635

Investment in unconsolidated affiliates
 
119,354

 
126,034

Cash and cash equivalents
 
76,180

 
72,013

Restricted cash and cash equivalents
 
46,243

 
39,498

Accounts receivable, net of allowance for doubtful accounts of $1,547 and $1,698
 
54,135

 
43,597

Deferred financing costs, net of accumulated amortization of $5,309 and $3,488
 
9,044

 
10,845

Deferred tax assets
 
1,964

 
2,230

Prepaid expenses and other assets
 
40,864

 
29,047

Total assets
 
$
2,079,542

 
$
2,086,689

Liabilities, Noncontrolling Interests and Equity
 
 
 
 
Liabilities:
 
 
 
 
Mortgages and other debt payable
 
$
995,817

 
$
1,000,385

Bank credit facility
 
50,000

 
50,000

Accounts payable and accrued expenses
 
228,936

 
249,179

Distributions payable
 

 
72,499

Deferred tax liabilities
 
47,509

 
47,623

Total liabilities
 
1,322,262

 
1,419,686

Noncontrolling interests in SHR’s operating partnership
 
5,513

 
4,583

Equity:
 
 
 
 
SHR’s shareholders’ equity:
 
 
 
 
8.50% Series A Cumulative Redeemable Preferred Stock ($0.01 par value per share; 4,148,141 shares issued and outstanding; liquidation preference $25.00 per share plus accrued distributions and $103,704 and $130,148 in the aggregate)
 
99,995

 
99,995

8.25% Series B Cumulative Redeemable Preferred Stock ($0.01 par value per share; 3,615,375 shares issued and outstanding; liquidation preference $25.00 per share plus accrued distributions and $90,384 and $112,755 in the aggregate)
 
87,064

 
87,064

8.25% Series C Cumulative Redeemable Preferred Stock ($0.01 par value per share; 3,827,727 shares issued and outstanding; liquidation preference $25.00 per share plus accrued distributions and $95,693 and $119,377 in the aggregate)
 
92,489

 
92,489

Common shares ($0.01 par value per share; 350,000,000 and 250,000,000 common shares authorized; 204,308,710 and 185,627,199 common shares issued and outstanding)
 
2,043

 
1,856

Additional paid-in capital
 
1,738,416

 
1,634,067

Accumulated deficit
 
(1,213,052
)
 
(1,190,621
)
Accumulated other comprehensive loss
 
(62,853
)
 
(70,652
)
Total SHR’s shareholders’ equity
 
744,102

 
654,198

Noncontrolling interests in consolidated affiliates
 
7,665

 
8,222

Total equity
 
751,767

 
662,420

Total liabilities, noncontrolling interests and equity
 
$
2,079,542

 
$
2,086,689

See accompanying notes to unaudited condensed consolidated financial statements.

3


STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES (SHR)
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In Thousands, Except Per Share Data)
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
 
Rooms
 
$
110,132

 
$
108,812

 
$
204,642

 
$
200,282

Food and beverage
 
71,931

 
74,441

 
134,410

 
137,323

Other hotel operating revenue
 
18,173

 
19,948

 
38,298

 
39,921

Lease revenue
 
1,165

 
1,277

 
2,330

 
2,492

Total revenues
 
201,401

 
204,478

 
379,680

 
380,018

Operating Costs and Expenses:
 
 
 
 
 
 
 
 
Rooms
 
29,983

 
29,818

 
58,559

 
56,445

Food and beverage
 
48,317

 
50,658

 
95,710

 
96,665

Other departmental expenses
 
51,084

 
53,825

 
100,649

 
104,498

Management fees
 
6,214

 
6,550

 
11,830

 
12,324

Other hotel expenses
 
12,763

 
13,467

 
26,372

 
26,825

Lease expense
 
1,143

 
1,257

 
2,311

 
2,453

Depreciation and amortization
 
25,277

 
30,091

 
50,767

 
60,696

Corporate expenses
 
2,866

 
11,957

 
16,676

 
26,434

Total operating costs and expenses
 
177,647

 
197,623

 
362,874

 
386,340

Operating income (loss)
 
23,754

 
6,855

 
16,806

 
(6,322
)
Interest expense
 
(19,080
)
 
(25,762
)
 
(38,685
)
 
(45,310
)
Interest income
 
50

 
51

 
80

 
83

Loss on early extinguishment of debt
 

 
(838
)
 

 
(838
)
Loss on early termination of derivative financial instruments
 

 
(29,242
)
 

 
(29,242
)
Equity in (losses) earnings of unconsolidated affiliates
 
(717
)
 
(2,799
)
 
203

 
(4,399
)
Foreign currency exchange (loss) gain
 
(168
)
 
147

 
(173
)
 
286

Other income, net
 
477

 
436

 
929

 
4,361

Income (loss) before income taxes and discontinued operations
 
4,316

 
(51,152
)
 
(20,840
)
 
(81,381
)
Income tax (expense) benefit
 
(350
)
 
(1,060
)
 
(815
)
 
588

Income (loss) from continuing operations
 
3,966

 
(52,212
)
 
(21,655
)
 
(80,793
)
(Loss) income from discontinued operations, net of tax
 
(535
)
 
101,034

 
(535
)
 
101,196

Net Income (Loss)
 
3,431

 
48,822

 
(22,190
)
 
20,403

Net (income) loss attributable to the noncontrolling interests in SHR’s operating partnership
 
(8
)
 
(224
)
 
109

 
(86
)
Net income attributable to the noncontrolling interests in consolidated affiliates
 
(379
)
 
(1,338
)
 
(350
)
 
(743
)
Net Income (Loss) Attributable to SHR
 
3,044

 
47,260

 
(22,431
)
 
19,574

Preferred shareholder dividends
 
(6,042
)
 
(7,722
)
 
(12,083
)
 
(15,443
)
Net (Loss) Income Attributable to SHR Common Shareholders
 
$
(2,998
)
 
$
39,538

 
$
(34,514
)
 
$
4,131

Amounts Attributable to SHR:
 
 
 
 
 
 
 
 
Income (loss) from continuing operations
 
$
3,579

 
$
(53,309
)
 
$
(21,896
)
 
$
(81,156
)
(Loss) income from discontinued operations
 
(535
)
 
100,569

 
(535
)
 
100,730

Net income (loss)
 
$
3,044

 
$
47,260

 
$
(22,431
)
 
$
19,574

Basic and Diluted (Loss) Income Per Share:
 
 
 
 
 
 
 
 
Loss from continuing operations attributable to SHR common shareholders
 
$
(0.01
)
 
$
(0.35
)
 
$
(0.18
)
 
$
(0.58
)
(Loss) income from discontinued operations attributable to SHR common shareholders
 

 
0.57

 

 
0.60

Net (loss) income attributable to SHR common shareholders
 
$
(0.01
)
 
$
0.22

 
$
(0.18
)
 
$
0.02

Weighted average common shares outstanding
 
202,021

 
176,141

 
194,979

 
166,820

See accompanying notes to unaudited condensed consolidated financial statements.

4


STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES (SHR)
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)
(In Thousands)
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2012
 
2011
 
2012
 
2011
Net Income (Loss)
 
$
3,431

 
$
48,822

 
$
(22,190
)
 
$
20,403

Other comprehensive income:
 
 
 
 
 
 
 
 
Gain (loss) on currency translation adjustments
 
283

 
(5,264
)
 
293

 
(7,907
)
Gain on derivatives and other activity
 
2,349

 
27,848

 
7,506

 
37,223

Other comprehensive income
 
2,632

 
22,584

 
7,799

 
29,316

Comprehensive Income (Loss)
 
6,063

 
71,406

 
(14,391
)
 
49,719

Comprehensive (income) loss attributable to the noncontrolling interests in SHR’s operating partnership
 
(19
)
 
(328
)
 
74

 
(222
)
Comprehensive income attributable to the noncontrolling interests in consolidated affiliates
 
(379
)
 
(1,338
)
 
(350
)
 
(743
)
Comprehensive Income (Loss) Attributable to SHR
 
$
5,665

 
$
69,740

 
$
(14,667
)
 
$
48,754

See accompanying notes to unaudited condensed consolidated financial statements.

5


STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES (SHR)
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
 
 
Six Months Ended June 30,
 
 
2012
 
2011
Operating Activities:
 
 
 
 
Net (loss) income
 
$
(22,190
)
 
$
20,403

Adjustments to reconcile net (loss) income to net cash provided by operating activities (including discontinued operations):
 
 
 
 
Deferred income tax expense (benefit)
 
152

 
(2,288
)
Depreciation and amortization
 
50,767

 
60,696

Amortization of deferred financing and interest rate swap costs
 
6,445

 
12,361

Loss on early extinguishment of debt
 

 
838

Loss on early termination of derivative financial instruments
 

 
29,242

Equity in (earnings) losses of unconsolidated affiliates
 
(203
)
 
4,399

Share-based compensation
 
7,501

 
17,973

Gain on sale of assets
 

 
(103,605
)
Foreign currency exchange loss (gain)
 
708

 
(337
)
Recognition of deferred gains
 
(101
)
 
(1,323
)
Mark to market of derivative financial instruments
 
(2,717
)
 
(1,633
)
Increase in accounts receivable
 
(12,074
)
 
(10,646
)
Increase in other assets
 
(2,214
)
 
(2,689
)
Decrease in accounts payable and accrued expenses
 
(17,602
)
 
(8,187
)
Net cash provided by operating activities
 
8,472

 
15,204

Investing Activities:
 
 
 
 
Proceeds from sale of investments
 

 
9,000

Proceeds from sale of assets
 
1,991

 
55,280

Cash received from unconsolidated affiliates
 
6,883

 
780

Unconsolidated affiliates recapitalization
 

 
(92,703
)
Unrestricted cash acquired through acquisition and recapitalization
 

 
30,600

Unrestricted cash sold or contributed
 

 
(6,935
)
Increase in security deposits related to sale-leasebacks
 

 
(1,270
)
Acquisition of note receivable
 
(9,457
)
 

Capital expenditures
 
(18,111
)
 
(24,546
)
Increase in restricted cash and cash equivalents
 
(7,200
)
 
(6,377
)
Net cash used in investing activities
 
(25,894
)
 
(36,171
)
Financing Activities:
 
 
 
 
Proceeds from issuance of common stock
 
119,600

 
50,000

Equity issuance costs
 
(5,501
)
 
(531
)
Preferred stock tender costs
 
(54
)
 

Borrowings under bank credit facility
 
79,000

 
317,500

Payments on bank credit facility
 
(79,000
)
 
(218,000
)
Payments on mortgages and other debt
 
(5,758
)
 
(78,135
)
Acquisition of noncontrolling interest in consolidated affiliates
 

 
(19,402
)
Debt financing costs
 

 
(5,132
)
Distributions to preferred shareholders
 
(84,582
)
 

Distributions to holders of noncontrolling interests in consolidated affiliates
 
(841
)
 
(16
)
Interest rate swap costs
 

 
(33,340
)
Other financing activities
 
(782
)
 
(559
)
Net cash provided by financing activities
 
22,082

 
12,385

Effect of exchange rate changes on cash
 
(493
)
 
3,367

Net change in cash and cash equivalents
 
4,167

 
(5,215
)
Change in cash of assets held for sale
 

 
2,999

Cash and cash equivalents, beginning of period
 
72,013

 
78,842

Cash and cash equivalents, end of period
 
$
76,180

 
$
76,626

See accompanying notes to unaudited condensed consolidated financial statements.

6


STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES (SHR)
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS – Continued
(In Thousands)

 
 
Six Months Ended June 30,
 
 
2012
 
2011
Supplemental Schedule of Non-Cash Investing and Financing Activities:
 
 
 
 
Acquisition of hotel properties
 
$

 
$
89,273

Acquisition of noncontrolling interest
 
$

 
$
70,300

Gain on mark to market of derivative instruments (see notes 2 and 9)
 
$
(2,868
)
 
$
(9,783
)
(Decrease) increase in capital expenditures recorded as liabilities
 
$
(43
)
 
$
1,799

Cash Paid For (Receipts Of):
 
 
 
 
Interest, net of interest capitalized
 
$
34,277

 
$
35,280

Income taxes, net of refunds
 
$
(419
)
 
$
2,163

See accompanying notes to unaudited condensed consolidated financial statements.


7


STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. GENERAL
Strategic Hotels & Resorts, Inc. (SHR and, together with its subsidiaries, the Company) was incorporated in January 2004 to acquire and asset-manage upper upscale and luxury hotels that are subject to long-term management contracts. As of June 30, 2012, the Company’s portfolio included 17 full-service hotel interests located in urban and resort markets in: the United States; Punta Mita, Nayarit, Mexico; Hamburg, Germany; and London, England. The Company operates in one reportable business segment, hotel ownership.
SHR operates as a self-administered and self-managed real estate investment trust (REIT), which means that it is managed by its board of directors and executive officers. A REIT is a legal entity that holds real estate interests and, through payments of dividends to stockholders, is permitted to reduce or avoid federal income taxes at the corporate level. For SHR to continue to qualify as a REIT, it cannot operate hotels; instead it employs internationally known hotel management companies to operate its hotels under management contracts. SHR conducts its operations through its direct and indirect subsidiaries, including its operating partnership, Strategic Hotel Funding, L.L.C. (SH Funding), which currently holds substantially all of the Company’s assets. SHR is the sole managing member of SH Funding and holds approximately 99% of its membership units as of June 30, 2012. SHR manages all business aspects of SH Funding, including the sale and purchase of hotels, the investment in these hotels and the financing of SH Funding and its assets.
As of June 30, 2012, SH Funding owned interests in or leased the following 17 hotels:
1. Fairmont Chicago
  
10. InterContinental Miami
2. Fairmont Scottsdale Princess (1)
  
11. Loews Santa Monica Beach Hotel
3. Four Seasons Jackson Hole
  
12. Marriott Hamburg (4)
4. Four Seasons Punta Mita Resort
  
13. Marriott Lincolnshire Resort (5)
5. Four Seasons Silicon Valley
  
14. Marriott London Grosvenor Square (5)
6. Four Seasons Washington, D.C.
  
15. Ritz-Carlton Half Moon Bay
7. Hotel del Coronado (2)
  
16. Ritz-Carlton Laguna Niguel
8. Hyatt Regency La Jolla (3)
  
17. Westin St. Francis
9. InterContinental Chicago
  
 
(1)
This property is owned by an unconsolidated affiliate in which the Company indirectly holds an interest (see note 5). One land parcel at this property is subject to a ground lease arrangement.
(2)
This property is owned by an unconsolidated affiliate in which the Company indirectly holds an interest (see note 5).
(3)
This property is owned by a consolidated affiliate in which the Company indirectly holds a 53.5% interest.
(4)
The Company has a leasehold interest in this property.
(5)
These properties are subject to ground lease arrangements.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation:
The accompanying unaudited condensed consolidated financial statements and related notes have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and in conformity with the rules and regulations of the SEC applicable to interim financial information. As such, certain information and footnote disclosures normally included in complete annual financial statements prepared in accordance with GAAP have been omitted in accordance with the rules and regulations of the SEC. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, necessary to present fairly the financial position of the Company and its results of operations and cash flows for the interim periods presented. The Company believes the disclosures made are adequate to prevent the information presented from being misleading. However, the unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in SHR’s Annual Report on Form 10-K for the year ended December 31, 2011. The accompanying unaudited condensed consolidated financial statements include the accounts of SHR, its subsidiaries and other entities in which the Company has a controlling interest.

8

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

If the Company determines that it is the holder of a variable interest in a variable interest entity (VIE), and it is the primary beneficiary, then the Company will consolidate the entity. For entities that are not considered VIEs, the Company consolidates those entities it controls. It accounts for those entities over which it has a significant influence but does not control using the equity method of accounting. At June 30, 2012, SH Funding owned the following interests in unconsolidated affiliates, which are accounted for using the equity method of accounting: an interest in the unconsolidated affiliate that owns the Fairmont Scottsdale Princess (Fairmont Scottsdale Princess Venture), an interest in the unconsolidated affiliate that owns the Hotel del Coronado (Hotel del Coronado Venture), and an interest in the unconsolidated affiliate that owns the Four Seasons Residence Club Punta Mita (RCPM) (see note 5). At June 30, 2012, SH Funding also owned an 85.8% controlling interest in SHC KSL Partners, LP, that owns both a condominium-hotel development adjacent to the Hotel del Coronado (North Beach Venture) and a 40.0% interest in the Hotel del Coronado Venture (see note 5), and a controlling interest in the entity that owns the Hyatt Regency La Jolla hotel, which are consolidated in the accompanying financial statements.
All significant intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates:
The preparation of consolidated financial statements in conformity with GAAP 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 periods. Actual results could differ from those estimates.
Restricted Cash and Cash Equivalents:
At June 30, 2012 and December 31, 2011, restricted cash and cash equivalents included $21,499,000 and $19,135,000 respectively, that will be used for property and equipment replacement in accordance with hotel management or lease agreements. At June 30, 2012 and December 31, 2011, restricted cash and cash equivalents also included reserves of $24,744,000 and $20,363,000, respectively, required by loan and other agreements.
Income Taxes:
SHR has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the Tax Code). As a REIT, SHR generally will not be subject to U.S. federal income tax if it distributes 100% of its annual taxable income to its shareholders and complies with certain other requirements. As a REIT, SHR is subject to a number of organizational and operational requirements. If it fails to qualify as a REIT in any taxable year, SHR will be subject to U.S. federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates. Even if it qualifies for taxation as a REIT, it may be subject to foreign, state and local income taxes and to U.S. federal income tax and excise tax on its undistributed income. In addition, taxable income from SHR’s taxable REIT subsidiaries is subject to federal, foreign, state and local income taxes. Also, the foreign countries where the Company has operations do not recognize REITs under their respective tax laws. Accordingly, the Company is subject to tax in those jurisdictions.
Deferred tax assets and liabilities are established for net operating loss carryforwards and temporary differences between the financial reporting basis and the tax basis of assets and liabilities at the enacted tax rates expected to be in effect when the net operating loss carryforwards are utilized and when the temporary differences reverse. The Company evaluates uncertain tax positions in accordance with applicable accounting guidance. A valuation allowance for deferred tax assets is provided if the Company believes all or some portion of the deferred tax asset may not be realized. Any increase or decrease in the valuation allowance that results from a change in circumstances that causes a change in the estimated realizability of the related deferred tax asset is included in earnings.

9

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the three and six months ended June 30, 2012 and 2011, income tax (expense) benefit related to continuing operations is summarized as follows (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Current tax (expense):
 
 
 
 
 
 
 
Europe
$
(189
)
 
$
(42
)
 
$
(230
)
 
$
(48
)
Mexico

 
(405
)
 

 
(629
)
United States
(123
)
 

 
(433
)
 
(1,402
)
 
(312
)
 
(447
)
 
(663
)
 
(2,079
)
Deferred tax (expense) benefit:
 
 
 
 
 
 
 
Mexico
(156
)
 
366

 
(580
)
 
227

United States
118

 
(979
)
 
428

 
2,440

 
(38
)
 
(613
)
 
(152
)
 
2,667

Total income tax (expense) benefit
$
(350
)
 
$
(1,060
)
 
$
(815
)
 
$
588

Per Share Data:
Basic (loss) income per share is computed by dividing the net (loss) income attributable to SHR common shareholders by the weighted average common shares outstanding during each period. Diluted (loss) income per share is computed by dividing the net (loss) income attributable to SHR common shareholders as adjusted for the impact of dilutive securities, if any, by the weighted average common shares outstanding plus potentially dilutive securities. Dilutive securities may include restricted stock units (RSUs), options to purchase shares of SHR common stock (Options), stock units payable in SHR’s common stock under the Company’s Deferral Program (as defined in note 10) (Deferral Program Stock Units) and noncontrolling interests that have an option to exchange their interests to shares of SHR common stock. No effect is shown for securities that are anti-dilutive. The following table sets forth the components of the calculation of loss from continuing operations attributable to SHR common shareholders for the three and six months ended June 30, 2012 and 2011 (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Numerator:
 
 
 
 
 
 
 
Income (loss) from continuing operations attributable to SHR
$
3,579

 
$
(53,309
)
 
$
(21,896
)
 
$
(81,156
)
Preferred shareholder dividends
(6,042
)
 
(7,722
)
 
(12,083
)
 
(15,443
)
Loss from continuing operations attributable to SHR common shareholders
$
(2,463
)
 
$
(61,031
)
 
$
(33,979
)
 
$
(96,599
)
Denominator:
 
 
 
 
 
 
 
Weighted average common shares – basic and diluted
202,021

 
176,141

 
194,979

 
166,820

Securities that could potentially dilute basic (loss) income per share in the future that are not included in the computation of diluted (loss) income per share because they are anti-dilutive as of June 30, 2012 and 2011 are as follows (in thousands):
 
Computation For Three Months Ended June 30,
 
Computation For
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Noncontrolling interests
853

 
853

 
853

 
853

Options, RSUs and Deferral Program Stock Units
2,609

 
3,186

 
2,609

 
3,186


10

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Accumulated Other Comprehensive Loss:
The Company’s accumulated other comprehensive loss (OCL) results from mark to market of certain derivative financial instruments and unrealized gains or losses on foreign currency translation adjustments (CTA). The following tables provide the components of accumulated OCL as of June 30, 2012 and 2011 (in thousands):
 
Derivative  and
Other
Activity
 
CTA
 
Accumulated OCL
Balance at January 1, 2012
$
(49,510
)
 
$
(21,142
)
 
$
(70,652
)
Other comprehensive income
7,543

 
256

 
7,799

Balance at June 30, 2012
$
(41,967
)
 
$
(20,886
)
 
$
(62,853
)
 
Derivative  and
Other
Activity
 
CTA
 
Accumulated OCL
Balance at January 1, 2011
$
(94,933
)
 
$
(12,231
)
 
$
(107,164
)
Other comprehensive income (loss)
37,223

 
(7,907
)
 
29,316

Balance at June 30, 2011
$
(57,710
)
 
$
(20,138
)
 
$
(77,848
)
New Accounting Guidance:
In December 2011, the Financial Accounting Standards Board (FASB) clarified that when a parent (reporting entity) ceases to have a controlling financial interest in a subsidiary that is in substance real estate as a result of a default on the subsidiary's nonrecourse debt, the reporting entity should apply the guidance on sales of real estate. The provisions are effective for public companies for fiscal years and interim periods within those years, beginning on or after June 15, 2012. When adopted, the new guidance is not expected to materially impact the Company's financial statements.
In September 2011, the FASB amended its guidance on the testing of goodwill impairment to allow an entity the option to first assess qualitative factors to determine whether the current two-step process is necessary. Under the amended guidance, the calculation of the reporting unit’s fair value (step one of the goodwill impairment test) is not required unless, as a result of the qualitative assessment, it is more likely than not that the fair value of the reporting unit is less than the unit’s carrying amount. If it is not more likely than not that the fair value of the reporting unit is less than the carrying amount, further testing of goodwill for impairment would not be performed. The Company adopted the new guidance on January 1, 2012 and the guidance did not have a material impact on the Company’s financial statements.
In June 2011, the FASB issued new guidance that amends current comprehensive income guidance. The new guidance eliminates the option to present the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, the Company must report comprehensive income in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. Additionally, the guidance requires an entity to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The Company adopted the new guidance on January 1, 2012, except for the presentation requirements for reclassification adjustments, which has been deferred indefinitely. The adoption of the new guidance did not have a material impact on the Company’s financial statements.



11

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. INVESTMENT IN HOTEL PROPERTIES, NET
The following summarizes the Company’s investment in hotel properties as of June 30, 2012 and December 31, 2011, excluding the leasehold interest in the Marriott Hamburg and unconsolidated affiliates (in thousands):
 
 
June 30,
2012
 
December 31,
2011
Land
 
$
334,048

 
$
334,048

Land held for development
 
103,089

 
103,089

Leasehold interest
 
11,633

 
11,633

Buildings
 
1,316,756

 
1,316,029

Building and leasehold improvements
 
80,134

 
80,134

Site improvements
 
29,206

 
29,205

Furniture, fixtures and equipment
 
443,062

 
431,502

Improvements in progress
 
21,545

 
14,726

Total investment in hotel properties
 
2,339,473

 
2,320,366

Less accumulated depreciation
 
(678,221
)
 
(627,935
)
Total investment in hotel properties, net
 
$
1,661,252

 
$
1,692,431

Consolidated hotel properties
 
14

 
14

Consolidated hotel rooms
 
6,078

 
6,078

Note Receivable
In January 2012, the Company acquired, at a discount to par value, a note receivable that is secured by a property adjacent to the Fairmont Chicago hotel for $10,507,000, of which $1,050,000 was paid as an escrow deposit during the year ended December 31, 2011.
 
4. DISCONTINUED OPERATIONS
The results of operations of hotels sold or assets held for sale are classified as discontinued operations and segregated in the consolidated statements of operations for all periods presented. The following is a summary of (loss) income from discontinued operations for the three and six months ended June 30, 2012 and 2011 (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Hotel operating revenues
$

 
$
938

 
$

 
$
9,743

Operating costs and expenses

 
828

 

 
9,510

Operating income

 
110

 

 
233

Foreign currency exchange (loss) gain
(535
)
 
(7
)
 
(535
)
 
51

Other income, net

 

 

 
326

Income tax expense

 
(20
)
 

 
(379
)
Gain on sale

 
100,951

 

 
100,965

(Loss) income from discontinued operations
$
(535
)
 
$
101,034

 
$
(535
)
 
$
101,196

Assets Sold:
Paris Marriott Champs Elysees (Paris Marriott)
On April 6, 2011, the Company sold its leasehold interest in the Paris Marriott hotel for consideration of €29,200,000 ($41,567,000). As part of the transaction, the Company received an additional €13,500,000 ($18,901,000) related to the release of the security deposit and other closing adjustments, of which €1,600,000 ($1,991,000) was received in the second quarter of 2012.


12

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. INVESTMENT IN UNCONSOLIDATED AFFILIATES
Investment in unconsolidated affiliates as of June 30, 2012 and December 31, 2011 includes the following (in thousands): 
 
June 30, 2012
 
December 31, 2011
Fairmont Scottsdale Princess Venture (a)
$
28,534

 
$
27,367

Hotel del Coronado Venture (b)
86,829

 
94,876

RCPM (c)
3,991

 
3,791

Total investment in unconsolidated affiliates
$
119,354

 
$
126,034

(a)
The Company has 50% ownership interests in the entities that own the Fairmont Scottsdale Princess hotel, FMT Scottsdale Holdings, L.L.C. and Walton/SHR FPH Holdings, L.L.C. (together, the Fairmont Scottsdale Princess Venture). The Company jointly controls the venture with an unaffiliated third party, an affiliate of Walton Street Capital, L.L.C. (Walton Street) and serves as the managing member. The Company also serves as the hotel’s asset manager and is entitled to earn a quarterly base management fee equal to 1.0% of total revenues during years one and two following the formation of the Fairmont Scottsdale Princess Venture, 1.25% during years three and four, and 1.5% thereafter, as well as certain project management fees. The Company recognized fees of $183,000 and $11,000 for the three months ended June 30, 2012 and 2011, respectively, and $386,000 and $11,000 for the six months ended June 30, 2012 and 2011, respectively, which are included in other income, net on the consolidated statements of operations. In connection with the Fairmont Scottsdale Princess Venture, the Company is entitled to certain promote payments after Walton Street achieves a specified return.
The Fairmont Scottsdale Princess Venture has a $133,000,000 mortgage that matures December 2013 with an option for an extension through April 9, 2015, subject to certain conditions. Interest is payable monthly at the London Interbank Offered Rate (LIBOR) plus 0.36%.
(b)
SHC KSL Partners, LP, a consolidated affiliate of the Company, has an ownership interest in BSK Del Partners, L.P. (Hotel del Coronado Venture) that owns the Hotel del Cornado. An unaffiliated third party, an affiliate of Blackstone Real Estate Advisors VI L.P. (Blackstone) is the general partner of the Hotel del Coronado Venture with a 60.0% ownership interest, and the Company, through its ownership interest in SHC KSL Partners, LP, is a limited partner with an indirect 34.3% ownership interest. The Company acts as asset manager and is entitled to earn a quarterly asset management fee equal to 1.0% of gross revenue, certain development fees, and when applicable, an incentive fee equal to one-third of the incentive fee paid to the hotel operator under the hotel management agreement. As part of the Hotel del Coronado Venture with Blackstone, SHC KSL Partners, LP earn a profit-based incentive fee of 20.0% of all distributions of the Hotel del Coronado Venture that exceed both a 20.0% internal rate of return and two times return on invested equity. The Company recognized fees of $218,000 and $221,000 for the three months ended June 30, 2012 and 2011, respectively, and $414,000 and $1,514,000 for the six months ended June 30, 2012 and 2011, respectively, which are included in other income, net on the consolidated statements of operations.
The Hotel del Coronado Venture has $425,000,000 of mortgage and mezzanine loans that mature March 2013 with three, one-year extension options, subject to certain conditions. After the third year of the loans, the final two one-year extensions require payment to the lender of a 25 basis point extension fee. Interest is payable at a weighted average rate of LIBOR plus 4.80%, subject to a 1.0% LIBOR floor. Additionally, the Hotel del Coronado Venture purchased a two-year, 2.0% LIBOR cap, which was required by the loans.
(c)
The Company owns a 31% interest in, and acts as asset manager for, an unconsolidated affiliate, formed with two unaffiliated parties, that is developing the RCPM, a luxury vacation home product that is being sold in fractional and whole ownership interests on the property adjacent to the Company’s Four Seasons Punta Mita Resort in Mexico. The Company earns asset management fees and recognizes income, on the percentage not owned by the Company. These fees amounted to $58,000 and $13,000 for the three months ended June 30, 2012 and 2011, respectively, and $71,000 and $33,000 for the six months ended June 30, 2012 and 2011, respectively, and are included in other income, net in the consolidated statements of operations.

13

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Condensed Combined Financial Information of Investment in Unconsolidated Affiliates
The following is summarized financial information for the Company’s unconsolidated affiliates as of June 30, 2012 and December 31, 2011 and for the three and six months ended June 30, 2012 and 2011 (in thousands): 
 
June 30, 2012
 
December 31, 2011
Assets
 
 
 
Investment in hotel properties, net
$
711,150

 
$
719,231

Intangible assets, net
43,002

 
43,616

Cash and cash equivalents
22,147

 
35,251

Restricted cash and cash equivalents
30,077

 
31,844

Prepaid expenses and other assets
35,992

 
31,297

Total assets
$
842,368

 
$
861,239

Liabilities and Partners’ Equity
 
 
 
Mortgage and other debt payable
$
558,000

 
$
558,000

Other liabilities
50,458

 
52,274

Partners’ equity
233,910

 
250,965

Total liabilities and partners’ equity
$
842,368

 
$
861,239

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Revenues
 
 
 
 
 
 
 
Hotel operating revenue
$
53,657

 
$
34,338

 
$
111,483

 
$
62,600

Residential sales
6,441

 
905

 
7,630

 
2,543

Total revenues
60,098

 
35,243

 
119,113

 
65,143

Expenses
 
 
 
 
 
 
 
Hotel operating expenses
39,664

 
24,630

 
80,615

 
45,591

Residential costs of sales
4,457

 
298

 
4,873

 
839

Depreciation and amortization
8,574

 
5,826

 
17,116

 
10,289

Other operating expenses
1,781

 
2,193

 
2,936

 
4,071

Total operating expenses
54,476

 
32,947

 
105,540

 
60,790

Operating income
5,622

 
2,296

 
13,573

 
4,353

Interest expense, net
(7,967
)
 
(7,702
)
 
(15,988
)
 
(14,256
)
Other (expenses) income, net
(56
)
 
(1,039
)
 
62

 
(1,557
)
Net loss
$
(2,401
)
 
$
(6,445
)
 
$
(2,353
)
 
$
(11,460
)
Equity in (losses) earnings in unconsolidated affiliates
 
 
 
 
 
 
 
Net loss
$
(2,401
)
 
$
(6,445
)
 
$
(2,353
)
 
$
(11,460
)
Partners’ share of loss of unconsolidated affiliates
1,316

 
3,585

 
1,711

 
6,474

Adjustments for basis differences, taxes and intercompany eliminations
368

 
61

 
845

 
587

Total equity in (losses) earnings of unconsolidated affiliates
$
(717
)
 
$
(2,799
)
 
$
203

 
$
(4,399
)
To the extent that the Company’s cost basis is different than the basis reflected at the unconsolidated affiliate level, the basis difference, excluding amounts attributable to land and goodwill, is amortized over the life of the related asset and included in the Company’s share of equity in (losses) earnings of the unconsolidated affiliates.
 


14

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. OPERATING LEASE AGREEMENTS
In June 2004, the Company recorded a sale of the Marriott Hamburg, and the Company’s leaseback of the hotel was reflected as an operating lease. A deferred gain was recorded in conjunction with the sale and is being recognized as a reduction of lease expense over the life of the lease. The Company recognized $50,000 and $56,000 of the deferred gain for the three months ended June 30, 2012 and 2011, respectively, and for the six months ended June 30, 2012 and 2011, recognized $101,000 and $109,000, respectively. As of June 30, 2012 and December 31, 2011, the deferred gain on the sale of the Marriott Hamburg recorded in accounts payable and accrued expenses on the accompanying consolidated balance sheets amounted to $3,504,000 and $3,655,000, respectively. On a monthly basis, the Company makes minimum rent payments aggregating to an annual total of €3,719,000 (adjusting by an index formula) ($4,709,000 based on the foreign exchange rate as of June 30, 2012) and pays additional rent based upon the performance of the hotel, which are recorded as lease expense in the Company’s consolidated statements of operations. A euro-denominated security deposit at June 30, 2012 and December 31, 2011 was $2,406,000 and $2,462,000, respectively, and is included in other assets on the Company’s consolidated balance sheets. The Company subleases its interest in the Marriott Hamburg to a third party. The Company has reflected the sublease arrangement as an operating lease and records lease revenue.
In June 2004, the Company recorded a sale of the Paris Marriott, and the Company’s leaseback of the hotel was reflected as an operating lease. A deferred gain was recorded in conjunction with the sale and was being recognized as a reduction of lease expense over the life of the lease. On April 6, 2011, the Company sold its leasehold interest in the Paris Marriott (see note 4). The results of operations have been classified as discontinued operations in the consolidated statements of operations for all periods presented. Prior to the sale of the leasehold interest, the Company recognized $62,000 as amortization of the deferred gain in (loss) income from discontinued operations as a reduction to lease expense for the three months ended June 30, 2011, and $1,214,000 for the six months ended June 30, 2011. When the sale of the leasehold interest closed, the remaining unamortized deferred gain was recognized as a gain on sale of the Paris Marriott in (loss) income from discontinued operations. On a monthly basis, the Company made minimum rent payments and paid additional rent based upon the performance of the hotel, which were included in (loss) income from discontinued operations, in the Company’s consolidated statements of operations.
Lease payments related to office space are included in corporate expenses on the consolidated statements of operations and lease payments related to hotel ground leases are included in other hotel expenses on the consolidated statements of operations.
 
7. INDEBTEDNESS
Mortgages and Other Debt Payable:
Certain subsidiaries of SHR are the borrowers under various financing arrangements. These subsidiaries are separate legal entities and their respective assets and credit are not available to satisfy the debt of SHR or any of its other subsidiaries.
Mortgages and other debt payable at June 30, 2012 and December 31, 2011 consisted of the following (in thousands):
 
 
 
 
 
 
Balance Outstanding at
Debt
 
Spread (a)
(basis  points)
 
Current Maturity
 
June 30, 2012
 
December 31, 2011
Hyatt Regency La Jolla
 
1.00
%
 
September 2012
 
$
97,500

 
$
97,500

Marriott London Grosvenor Square
 
1.10
%
 
October 2013
 
113,226

 
113,659

Four Seasons Washington, D.C. (b)
 
3.15
%
 
July 2014
 
130,000

 
130,000

Loews Santa Monica Beach Hotel (b)
 
3.85
%
 
July 2015
 
110,000

 
110,000

InterContinental Miami (b)
 
3.50
%
 
July 2016
 
85,000

 
85,000

Fairmont Chicago
 
Fixed

 
June 2017
 
96,478

 
97,750

Westin St. Francis
 
Fixed

 
June 2017
 
217,137

 
220,000

InterContinental Chicago
 
Fixed

 
August 2021
 
145,000

 
145,000

Total mortgages payable (c)
 
 
 
 
 
994,341

 
998,909

Other debt (d)
 
Fixed

 
January 2013
 
1,476

 
1,476

Total mortgages and other debt payable
 
 
 
 
 
$
995,817

 
$
1,000,385

(a)
Interest on mortgage loans is paid monthly at the applicable spread over LIBOR (0.25% at June 30, 2012) for all

15

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

mortgage loans except for those secured by the Marriott London Grosvenor Square (£72,100,000 and £73,130,000 at June 30, 2012 and December 31, 2011, respectively), the Fairmont Chicago, the Westin St. Francis and the InterContinental Chicago hotels. Interest on the Marriott London Grosvenor Square loan is paid quarterly at the applicable spread over three-month GBP LIBOR (0.90% at June 30, 2012). Interest on the Fairmont Chicago and Westin St. Francis loans is paid monthly at an annual fixed rate of 6.09%, and interest on the InterContinental Chicago loan is paid monthly at an annual fixed rate of 5.61%.
(b)
The mortgage loan secured by the Four Seasons Washington, D.C. hotel has two, one-year extension options, the mortgage loan secured by the InterContinental Miami hotel has two, one-year extension options, and the mortgage loan secured by the Loews Santa Monica Beach Hotel has three, one-year extension options. All of the extension options are subject to certain conditions. The maturity dates in the table exclude extension options.
(c)
All of these loan agreements require maintenance of financial covenants, all of which the Company was in compliance with at June 30, 2012.
(d)
The North Beach Venture assumed the mortgage loan on a hotel-condominium unit, which accrues interest at an annual fixed rate of 5.0% and is secured by the hotel-condominium unit. The hotel-condominium unit, with a carrying value of $1,594,000, is included in other assets on the consolidated balance sheets as of June 30, 2012 and December 31, 2011.
Other Debt:
In connection with the acquisition of a 60-acre oceanfront land parcel in Punta Mita, Nayarit, Mexico, in October 2007, the Company executed two $17,500,000 non-interest bearing promissory notes. On September 30, 2008, the Company paid the first of the $17,500,000 non-interest bearing promissory notes. In August 2009, the Company entered into an agreement with the holder of the promissory note whereby the holder released the Company from its final installment payment of $17,500,000 that was due in August 2009 in exchange for the Company agreeing to provide the note holder with the right to an interest in the property. The Company will receive a preferred position which will entitle it to receive the first $12,000,000 of distributions generated from the property with any excess distributions split equally among the partners. The Company’s obligations under this agreement, recorded as other liabilities in accounts payable and accrued expenses on the Company’s consolidated balance sheets, are subject to the note holder being able to obtain certain permits and licenses to develop the land and the execution of an amended partnership agreement.
Bank Credit Facility:
On June 30, 2011, SH Funding entered into a $300,000,000 secured bank credit facility agreement. The agreement contains an accordion feature allowing for additional borrowing capacity up to $400,000,000, subject to the satisfaction of customary conditions set forth in the agreement. The agreement has a maturity date of June 30, 2014, with the right to extend the maturity date for an additional one-year period with an extension fee, subject to certain conditions. Under the agreement, SH Funding has a letter of credit sub-facility of $75,000,000, which is secured by the bank credit facility. Letters of credit reduce the borrowing capacity under the bank credit facility.
The interest rate at June 30, 2012 was 3.25% and the weighted average interest rate for the three and six months ended June 30, 2012 was 3.26% and 3.27%, respectively. At June 30, 2012, maximum availability under the bank credit facility was $300,000,000 and there was $50,000,000 of borrowings outstanding under the bank credit facility and outstanding letters of credit of $1,850,000 (see note 12). The agreement also requires maintenance of financial covenants, all of which SH Funding and SHR were in compliance with at June 30, 2012.

16

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Debt Maturity:
The following table summarizes the aggregate maturities (assuming all extension options exercised) as of June 30, 2012 for all mortgages and other debt payable and the Company’s bank credit facility (in thousands):
Years ending
December 31,
Amounts
2012 (remainder)
$
103,380

2013
123,950

2014
13,872

2015
65,046

2016
145,861

Thereafter
593,708

Total
$
1,045,817

Interest Expense:
Total interest expense in continuing and discontinued operations includes a reduction related to capitalized interest of $369,000 and $314,000 for the three months ended June 30, 2012 and 2011, respectively, and $679,000 and $546,000 for the six months ended June 30, 2012, and 2011, respectively. Total interest expense in continuing and discontinued operations includes amortization of deferred financing costs of $904,000 and $642,000 for the three months ended June 30, 2012 and 2011, respectively, and $1,807,000 and $1,922,000 for the six months ended June 30, 2012 and 2011, respectively.

8. EQUITY AND DISTRIBUTION ACTIVITY
Common Shares:
The following table presents the changes in the issued and outstanding shares of SHR common stock since December 31, 2011 (excluding 853,461 units of SH Funding (OP Units) outstanding at June 30, 2012 and December 31, 2011, which are redeemable for shares of SHR common stock on a one-for-one basis, or the cash equivalent thereof, subject to certain restrictions and at the option of SHR) (in thousands):
Outstanding at December 31, 2011
185,627

RSUs redeemed for shares of SHR common stock
282

Common stock issued
18,400

Outstanding at June 30, 2012
204,309

Common Stock
In April 2012, SHR completed a public offering of common stock by issuing 18,400,000 shares at a public offering price of $6.50 per share. After underwriting discounts and commissions and transaction expenses, SHR raised net proceeds of approximately $114,099,000. These proceeds were used for general corporate purposes, including, without limitation, reducing the Company’s borrowings under its secured bank credit facility, funding the payment of accrued and unpaid preferred dividends, repaying other debt and funding capital expenditures and working capital. In connection with this offering, SHR’s board of directors approved an increase in the number of shares of common stock that SHR is authorized to issue from 250,000,000 to 350,000,000, and SHR’s charter was amended accordingly.
As of June 30, 2012, no shares of SHR common stock have been repurchased under the $50,000,000 share repurchase program.
Stockholder Rights Plan
In November 2008, SHR’s board of directors adopted a stockholder rights plan. Under the plan, SHR declared a dividend of one preferred share purchase right (Right) for each outstanding share of SHR common stock. The dividend was payable on November 28, 2008 to the stockholders of record as of the close of business on November 28, 2008. Each Right will allow its holder to purchase from SHR one thousandth of a share of a new series of SHR participating preferred stock for $20.00, once the Rights become exercisable. The Rights will become exercisable and will separate from SHR’s common stock only upon the occurrence of certain events. On November 24, 2009, SHR entered into an amendment to extend the stockholder rights plan

17

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

through November 30, 2012, unless the rights are earlier redeemed or amended by SHR’s board of directors.
Distributions to Shareholders and Unitholders
On November 4, 2008, SHR’s board of directors elected to suspend the quarterly dividend to holders of shares of SHR common stock.
Preferred Stock:
SHR’s charter provides that it may issue up to 150,000,000 shares of preferred stock, $0.01 par value per share. SHR’s 8.50% Series A Cumulative Redeemable Preferred Stock, 8.25% Series B Cumulative Redeemable Preferred Stock, and 8.25% Series C Cumulative Redeemable Preferred Stock have perpetual lives and SHR may redeem them at $25.00 per share plus accrued distributions.
Distributions
Distributions are declared quarterly to holders of shares of SHR preferred stock. In February 2009, SHR’s board of directors elected to suspend the quarterly dividend beginning with the first quarter of 2009 to holders of shares of SHR’s Series A Cumulative Redeemable Preferred Stock, Series B Cumulative Redeemable Preferred Stock and Series C Cumulative Redeemable Preferred Stock. Dividends on the preferred stock are cumulative.
In connection with the preferred stock tender offers in the fourth quarter of 2011, SHR’s board of directors authorized, and SHR declared, the payment of accrued and unpaid dividends on its preferred stock through September 30, 2011, and dividends for the quarter ended December 31, 2011 (collectively, the Unpaid Dividends). The Unpaid Dividends were paid on June 29, 2012 to holders of record as of June 15, 2012. In February 2012 and May 2012, SHR’s board of directors authorized, and SHR declared, the payment of preferred dividends for the quarter ended March 31, 2012 and the quarter ended June 30, 2012, respectively. These dividends were also paid on June 29, 2012 to holders of record as of June 15, 2012.
On June 29, 2012, SHR paid dividends on its preferred stock as follows:
 
Distribution
(in thousands)
 
Per Share
8.50% Series A Cumulative Redeemable Preferred Stock
$
30,852

 
$
7.44

8.25% Series B Cumulative Redeemable Preferred Stock
$
26,099

 
$
7.22

8.25% Series C Cumulative Redeemable Preferred Stock
$
27,631

 
$
7.22

Noncontrolling Interests:
The following tables reflect the reconciliation of the beginning and ending balances of the equity attributable to SHR and the noncontrolling owners (in thousands):
 
 
SHR
Shareholders’
Equity
 
Nonredeemable
Noncontrolling
Interests
 
Total
Permanent
Shareholders’
Equity
 
Total
Redeemable
Noncontrolling
Interests
(Temporary
Equity) (a)
Balance at December 31, 2011
 
$
654,198

 
$
8,222

 
$
662,420

 
$
4,583

Common shares issued
 
113,574

 

 
113,574

 
525

RSUs redeemed for common shares
 
2

 

 
2

 


Net (loss) income
 
(22,431
)
 
350

 
(22,081
)
 
(109
)
CTA
 
292

 

 
292

 
1

Derivatives and other activity
 
7,472

 

 
7,472

 
34

Share-based compensation
 
3,593

 

 
3,593

 
18

Distributions
 
(12,083
)
 
(841
)
 
(12,924
)
 

Preferred stock tender costs
 
(54
)
 

 
(54
)
 

Redemption value adjustment
 
(715
)
 

 
(715
)
 
715

Other
 
254

 
(66
)
 
188

 
(254
)
Balance at June 30, 2012
 
$
744,102

 
$
7,665

 
$
751,767

 
$
5,513


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STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

 
 
SHR
Shareholders’
Equity
 
Nonredeemable
Noncontrolling
Interests
 
Total
Permanent
Shareholders’
Equity
 
Total
Redeemable
Noncontrolling
Interests
(Temporary
Equity) (a)
Balance at December 31, 2010
 
$
620,262

 
$
25,082

 
$
645,344

 
$
5,050

Common shares issued
 
211,180

 

 
211,180

 
1,004

RSUs redeemed for common shares
 
2

 

 
2

 

Net income
 
19,574

 
743

 
20,317

 
86

CTA
 
(7,870
)
 

 
(7,870
)
 
(37
)
Derivatives and other activity
 
37,050

 

 
37,050

 
173

Share-based compensation
 
10,264

 

 
10,264

 
47

Distributions
 

 
(16
)
 
(16
)
 

Redemption value adjustment
 
(522
)
 

 
(522
)
 
522

Noncontrolling interests assumed
 

 
10,725

 
10,725

 

Acquisition of noncontrolling interest
 
(63,601
)
 
(26,581
)
 
(90,182
)
 

Other
 
802

 
225

 
1,027

 
(802
)
Balance at June 30, 2011
 
$
827,141

 
$
10,178

 
$
837,319

 
$
6,043

(a)
The historical cost of the redeemable noncontrolling interests is based on the proportional relationship between the carrying value of equity associated with SHR’s common shareholders relative to that of the unitholders of SH Funding, as SH Funding units may be exchanged into shares of SHR common stock on a one-for-one basis. The interests held by the noncontrolling partners are stated at the greater of carrying value or their redemption value.
As of June 30, 2012 and December 31, 2011, the redeemable noncontrolling interests had a redemption value of approximately $5,513,000 (based on the June 29, 2012 SHR common share closing price of $6.46) and $4,583,000 (based on the December 30, 2011 SHR common share closing price of $5.37), respectively. As of June 30, 2011 and December 31, 2010, the redeemable noncontrolling interests had a redemption value of approximately $6,043,000 (based on the June 30, 2011 SHR common share closing price of $7.08) and $5,050,000 (based on the December 31, 2010 SHR common share closing price of $5.29), respectively.
 
9. DERIVATIVES
The Company manages its interest rate risk by varying its exposure to fixed and variable rates while attempting to minimize its interest costs. The Company manages its fixed interest rate and variable interest rate risk through the use of interest rate caps and swaps. The Company enters into interest rate caps and swaps with high credit quality counterparties and diversifies its positions among such counterparties in order to reduce its exposure to credit losses. The caps limit the Company’s exposure on its variable-rate debt that would result from an increase in interest rates. The Company’s lenders, as stipulated in the respective loan agreements, generally require such caps. Upon extinguishment of debt, income effects of cash flow hedges are reclassified from accumulated OCL to interest expense, equity in earnings (losses) of unconsolidated affiliates, loss on early extinguishment of debt, or (loss) income from discontinued operations, as appropriate. The Company records all derivatives at fair value as either other assets or accounts payable and accrued expenses in the accompanying consolidated balance sheets.
The valuation of the interest rate swaps and caps is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The Company incorporates credit valuation adjustments (CVA) to appropriately reflect its own nonperformance risk and the respective counterparty’s nonperformance risk. When assessing nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.
Except for the CVA, all inputs used to measure fair value of the derivative financial instruments are Level 2 inputs. The Company has concluded that the inputs used to measure its CVA are Level 3 inputs. If the inputs used to measure fair value fall in different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety.
The Company reviews the fair value hierarchy classifications each reporting period. Changes in the observability of the

19

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

valuation attributes may result in a reclassification of certain financial assets or liabilities. Such reclassifications are reported as transfers into and out of Level 3, or between other levels, at the fair value at the beginning of the reporting period in which the changes occur. The Company assessed the impact of the CVA on the overall fair value of its derivative instruments and concluded that the CVA does not have a significant impact to the fair values as of June 30, 2012. The Company reclassified its derivative financial instruments from Level 3 to Level 2 as unobservable inputs to the valuation model became insignificant during the six months ended June 30, 2012. As of June 30, 2012, all derivative liabilities are categorized as Level 2.
Derivatives in Cash Flow Hedging Relationships:
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.
The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated OCL and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the six months ended June 30, 2012 and 2011, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.
Amounts reported in accumulated OCL related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. During the next twelve months, the Company estimates that an additional $20,760,000 will be reclassified as an increase to interest expense.
As of June 30, 2012, the Company had the following outstanding interest rate derivatives that were designated as cash flow hedges of interest rate risk:
Interest Rate Derivatives
Number of Instruments
 
Notional Amount
(in  thousands)
Interest rate swaps
2
 
$
200,000

Interest rate swap
1
 
£
72,100

At June 30, 2012 and December 31, 2011, the aggregate notional amount of the Company’s domestic interest rate swaps designated as cash flow hedges was $200,000,000. The Company’s current domestic swaps have fixed pay rates against LIBOR of 5.23% and 5.27% and maturity dates of December 2015 and February 2016, respectively.
In addition, at June 30, 2012 and December 31, 2011, the Company had a GBP LIBOR interest rate swap agreement with a notional amount of £72,100,000 and £73,130,000, respectively. The swap has a current fixed pay rate against GBP LIBOR of 5.72% and a maturity date of October 2013.
Termination and De-designation of Cash Flow Hedges
On June 20, 2011, the Company terminated five interest rates swaps and recorded a charge of $27,257,000 in loss on early termination of derivative financial instruments in the consolidated statements of operations for the three and six months ended June 30, 2011. In addition, the Company de-designated one interest rate swap as a cash flow hedge and recorded a charge of $1,985,000 in loss on early termination of derivative financial instruments in the consolidated statements of operations for the three and six months ended June 30, 2011. In February 2011, the Company terminated three interest rate swaps with no immediate charges to earnings.
Derivatives Not Designated as Hedging Instruments:
Derivatives not designated as hedges are not speculative and are used to manage the Company’s exposure to interest rate movements and other identified risks but do not meet hedge accounting requirements. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings. As of June 30, 2012, the Company had the following outstanding interest rate derivatives that were not designated as hedging instruments:
Interest Rate Derivatives
Number of Instruments
 
Notional Amount
(in thousands)
Interest rate swaps
2
 
$
200,000

Interest rate cap
1
 
$
130,000


20

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

At June 30, 2012 and December 31, 2011, the aggregate notional amount of the Company’s domestic interest rate swaps not designated as cash flow hedges was $200,000,000. The Company’s current domestic swaps have fixed pay rates against LIBOR of 4.90% and 4.96% and maturity dates of September 2014 and December 2014, respectively.
At June 30, 2012 and December 31, 2011, the aggregate notional amount of the Company’s interest rate cap agreements was $130,000,000 and $324,750,000, respectively. The Company’s current interest rate cap has a LIBOR strike rate of 4.00% and a maturity date of July 2013.
Fair Values of Derivative Instruments:
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as of June 30, 2012 and December 31, 2011 (in thousands):
 
 
 
Fair Value as of
 
Balance Sheet Location
 
June 30, 2012
 
December 31, 2011
Derivatives in cash flow hedging relationships:
 
 
 
 
 
Interest rate swaps
Accounts payable and
accrued expenses
 
$
(39,687
)
 
$
(42,527
)
Derivatives not designated as hedging instruments:
 
 
 
 
 
Interest rate swaps
Accounts payable and
accrued expenses
 
$
(21,151
)
 
$
(23,867
)
Interest rate cap
Accounts payable and
accrued expenses
 
$

 
$

The following table reflects transfers out of Level 3 for all derivative financial instruments categorized as Level 3 as of January 1, 2012 (in thousands):
 
Beginning Balance
 
Transfers Out of Level 3
 
Ending Balance
Interest rate swaps
(66,394
)
 
$
66,394

 
$

 
The Company does not have any fair value measurements using inputs based on quoted prices in active markets (Level 1) or significant unobservable inputs (Level 3) as of June 30, 2012. The following table reflects changes in interest rate swap liabilities categorized as Level 2 for the six months ended June 30, 2012 (in thousands):
Balance as of January 1, 2012
$
(66,394
)
Mark to market adjustments
5,556

Balance as of June 30, 2012
$
(60,838
)
The Company did not have any fair value measurements using inputs based on quoted prices in active markets (Level 1 or Level 2) as of June 30, 2011. The following table reflects changes in interest rate swap liabilities categorized as Level 3 for the six months ended June 30, 2011 (in thousands):
Balance as of January 1, 2011
$
(98,330
)
Interest rate swap terminations (b)
33,311

Mark to market adjustments
(876
)
Balance as of June 30, 2011
$
(65,895
)
(b)
In June 2011, the Company paid $29,672,000 which included accrued interest of $253,000 and termination fees of $29,000, to terminate five interest rate swaps. In February 2011, the Company paid termination fees of $4,201,000, which included accrued interest of $280,000, to terminate three interest rate swaps.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Effect of Derivative Instruments on the Statements of Operations:
The tables below present the effect of the Company’s derivative financial instruments on the statements of operations for the three and six months ended June 30, 2012 and 2011 (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Derivatives in Cash Flow Hedging Relationships
 
 
 
 
 
 
 
Interest rate swaps:
 
 
 
 
 
 
 
Effective portion of loss recognized in accumulated OCL
$
(2,679
)
 
$
(8,077
)
 
$
(3,233
)
 
$
(8,789
)
Effective portion of loss reclassified into interest expense
$
(5,227
)
 
$
(8,485
)
 
$
(10,938
)
 
$
(18,518
)
Effective portion of loss reclassified into loss on early termination of derivative financial instruments
$

 
$
(27,440
)
 
$

 
$
(27,440
)
Ineffective portion of loss recognized in interest expense
$
(796
)
 
$
(4,236
)
 
$
(1,587
)
 
$
(4,562
)
Mark to market loss recognized in loss on early termination of derivative financial instruments
$

 
$
(1,802
)
 
$

 
$
(1,802
)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Derivatives Not Designated as Hedging Instruments
 
 
 
 
 
 
 
Interest rate swaps:
 
 
 
 
 
 
 
Ineffective losses recognized in interest expense
$
(1,184
)
 
$
(5,123
)
 
$
(2,012
)
 
$
(5,028
)
Interest rate cap:
 
 
 
 
 
 
 
Loss recognized in other income, net
$

 
$

 
$
(3
)
 
$
(23
)
Credit-risk-related Contingent Features:
The Company has agreements with each of its derivative counterparties that contain a provision where if the Company defaults and its indebtedness is accelerated or declared due or capable of being accelerated or declared due, then the Company could also be declared in default on its derivative obligations associated with the relevant indebtedness.
As of June 30, 2012, the termination value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $63,814,000. As of June 30, 2012, the Company has not posted any collateral related to these agreements. If the Company had breached any of these provisions at June 30, 2012, it would have been required to settle its obligations under the agreements at their termination value of $63,814,000. The Company has not breached any of the provisions as of June 30, 2012.
 
10. SHARE-BASED EMPLOYEE COMPENSATION PLANS
Second Amended and Restated 2004 Incentive Plan:
On June 21, 2004, SHR adopted the 2004 Incentive Plan (the Plan). The Plan provided for the grant of equity-based awards in the form of, among others, Options, RSUs, and stock appreciation rights (SARs), which are collectively referred to as the Awards. On May 22, 2008, SHR’s shareholders approved SHR’s Amended and Restated 2004 Incentive Plan (the Amended Plan). The Amended Plan: (a) added OP Units as an additional type of award; (b) adjusted the number of authorized shares from 3,000,000 shares of SHR common stock to 4,200,000 shares of SHR common stock or OP Units; (c) limited the maximum term of Options and SARs to no more than 10 years and prohibited the repricing of Options and SARs; and (d) established minimum vesting periods for certain awards. On May 19, 2011, SHR’s shareholders approved SHR’s Second Amended and Restated 2004 Incentive Plan (the Amended and Restated Plan) pursuant to which the number of securities authorized and reserved for issuance increased from 4,200,000 shares of SHR common stock or OP Units to 9,700,000 shares of SHR common stock or OP Units. The termination date of the Amended and Restated Plan was also extended from June 21, 2014 to December 31, 2016.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

RSUs:
In 2011, a portion of the cash bonuses earned by certain executives in 2010 was deferred, and the method of payment was modified to performance-based RSUs in lieu of cash. SHR granted 169,064 performance-based RSUs to these executives that will vest upon the later to occur of (i) the Company’s achievement of positive funds from operations for a fiscal year and (ii) SHR’s commencement of payment of the preferred stock dividend on a current basis. These performance-based RSUs vested with the payment of the preferred stock dividends on June 29, 2012. In February 2012, SHR granted certain employees a target grant of 569,427 performance shares under a performance share plan that provides the recipient the opportunity to earn between zero and 160.0% of the target (up to a maximum of 911,083 performance shares), based on the relative total shareholder return of the shares of SHR common stock, as defined in the agreement, over the period from January 2, 2012 through December 31, 2014.
The Company recorded compensation expense of $1,770,000 and $1,197,000 related to RSUs and performance share awards (net of estimated forfeitures) for the three months ended June 30, 2012 and 2011, respectively and $2,729,000 and $1,974,000 for the six months ended June 30, 2012 and 2011, respectively. The compensation expense is recorded in corporate expenses on the accompanying consolidated statements of operations. As of June 30, 2012, there was unrecognized compensation expense of $3,983,000 related to nonvested RSUs and $3,138,000 related to performance share awards granted under the Amended and Restated Plan. That cost is expected to be recognized over a weighted average period of 1.87 years for nonvested RSUs and 2.50 years for performance share awards.
Value Creation Plan:
On August 27, 2009, SHR adopted the Value Creation Plan to further align the interests and efforts of key employees to the interests of SHR’s stockholders in creating stockholder value and providing key employees an added incentive to work towards the Company’s growth and success. The Value Creation Plan provides for the payment of up to 2.5% of SHR’s market capitalization (limited to a maximum market capitalization based on a common stock price of $20.00 per share) to be provided to participants in the Value Creation Plan in 2012 if the highest average closing price of SHR’s common stock during certain consecutive twenty trading day periods in 2012 is at least $4.00 (Normal Distribution Amount). In addition, if a change of control occurs at any time prior to December 31, 2012, participants in the Value Creation Plan will generally not be entitled to the Normal Distribution Amount and will instead be entitled to receive 2.5% of SHR’s market capitalization based on the value of a share of SHR’s common stock upon the change of control (Change of Control Price), regardless of whether the Change of Control Price is less than $4.00 or greater than $20.00. A total of up to one million units issuable under SHR’s Value Creation Plan (VCP Units) (representing the opportunity to earn an amount equal to 2.5% of SHR’s market capitalization) can be allocated under the Value Creation Plan to key employees. Payments upon a unit of distribution may be made in cash, in shares of SHR’s common stock (subject to approval by SHR’s stockholders), in some combination thereof or in any other manner approved by the committee of the board administering the Value Creation Plan. On February 21, 2012, SHR adopted an amendment to the Value Creation Plan (the VCP Amendment). Pursuant to the terms of the VCP Amendment, no more than 174,828,353 shares of SHR’s common stock will be included in the calculation of SHR’s market capitalization as set forth in the Value Creation Plan. As of June 30, 2012, all one million VCP Units have been granted under the Value Creation Plan.
Deferral Program:
On June 29, 2011, SHR and its president and chief executive officer, Laurence S. Geller, entered into the Strategic Hotels & Resorts, Inc. Value Creation Plan Normal Unit Distributions Deferral Election and Deferral Program (Deferral Program). Pursuant to the Deferral Program, Mr. Geller elected to defer up to 50% of his share of the Normal Distribution Amount that may be paid pursuant to the Value Creation Plan currently contemplated to be paid in cash within 30 days after the end of each 2012 calendar quarter and to have such Normal Distribution Amount instead be converted into Deferral Program Stock Units on the basis of the fair market value of a share of SHR common stock at the time the Normal Distribution Amount would otherwise have been paid. Each Deferral Program Stock Unit will be converted on a one-for-one basis into a share of SHR common stock on January 2, 2014 or if earlier, upon a change of control of SHR or the first business day of the calendar month following six months after Mr. Geller’s termination of employment.
Prior to the Deferral Program, the Company accounted for the entire Value Creation Plan as a liability award because of its cash settlement feature and recorded the liability in accounts payable and accrued expenses. At the deferral election date, the Company bifurcated the Value Creation Plan and began accounting for the portion of the award payable in stock units as an equity award and continued accounting for the portion of the award payable in cash as a liability award. For the equity award, the Company established a fair value of $13,050,000 and reclassified $8,894,000 from accounts payable and accrued expenses to additional paid-in capital, which represented amounts previously recognized as compensation expense. The remaining balance will be recognized as compensation expense over the remaining derived service period. The fair value of the liability award is re-measured at the end of each reporting period, and the Company makes adjustments to the compensation expense

23

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

and liability to reflect the fair value.
The unrecognized compensation expense related to the equity component of the award at June 30, 2012 was $0. The fair value of the liability component of the award at June 30, 2012 was $4,314,000. Total compensation expense recognized in corporate expenses on the consolidated statements of operations under the Value Creation Plan for the three months ended June 30, 2012 and 2011 was $(3,167,000) and $6,818,000, respectively, and $4,772,000 and $15,999,000 for the six months ended June 30, 2012 and 2011, respectively. In April 2012, the Company paid $18,357,000 pursuant to the Value Creation Plan and in April 2012, Mr. Geller received 1,238,941 Deferral Program Stock Units in connection with the distribution of his share of the Normal Distribution Amount under the Value Creation Plan.
 
11. RELATED PARTY TRANSACTIONS
Cory Warning, the son-in-law of Laurence Geller, the Company’s president and chief executive officer, serves as Vice President, Investments for the Company. Mr. Warning’s base salary in 2012 and 2011 was $180,000 and $175,000, respectively. Mr. Warning received cash bonuses in 2012 and 2011 of $108,000 and $108,000, respectively. Mr. Warning received grants of RSUs of 4,698 and 13,809, in 2012 and 2011, respectively, and a grant of 9,538 performance share awards in 2012. In 2010, Mr. Warning received a grant of 5,000 units under the Company’s Value Creation Plan.
 
12. COMMITMENTS AND CONTINGENCIES
Environmental Matters:
Generally, the properties acquired by the Company have been subjected to environmental site assessments. While some of these assessments have led to further investigation and sampling, none of the environmental assessments have revealed, nor is the Company aware of any environmental liability that it believes would have a material effect on its business or financial statements. 
Litigation:
The Company is party to various claims and routine litigation arising in the ordinary course of business. Based on discussions with legal counsel, the Company does not believe that the results of these claims and litigation, individually or in the aggregate, will have a material effect on its business or financial statements.
Letters of Credit:
As of June 30, 2012, the Company provided a $250,000 letter of credit related to its office space lease and a $1,600,000 letter of credit in connection with an obligation to complete certain repairs to the underground parking garage at the Four Seasons Washington, D.C. hotel.
Construction Contracts:
The Company has executed various contracts related to construction activities. As of June 30, 2012, the Company’s obligations under these contracts amounted to approximately $8,528,000. The construction activities are expected to be completed in 2012.
 
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
As of June 30, 2012 and December 31, 2011, the carrying amounts of certain financial instruments employed by the Company, including cash and cash equivalents, restricted cash and cash equivalents, accounts receivable, and accounts payable and accrued expenses were representative of their fair values because of the short-term maturity of these instruments.
At June 30, 2012 and December 31, 2011, the fair value of the fixed-rate mortgage and other debt approximated the carrying value of $460,091,000 and $464,226,000, respectively. In addition, the fair value of new or recently refinanced variable-rate debt, which included the Company’s bank credit facility and mortgage loans secured by the Four Seasons Washington, D.C. hotel, the Loews Santa Monica Beach Hotel, and the InterContinental Miami hotel approximated the carrying value of $375,000,000 at June 30, 2012 and December 31, 2011.
To calculate the estimated fair value of the remaining variable-rate mortgage debt as of June 30, 2012, the Company estimated that the current market spread over the applicable index (LIBOR or GBP LIBOR) would be in the range of 350 to 450 basis

24

STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

points as compared to the current contractual spread as disclosed (see note 7). Using these estimated market spreads, the Company estimated the fair value of the remaining variable-rate mortgage debt to be approximately $6,000,000 to $7,000,000 lower than the total carrying value of $210,726,000. For every 100 basis point change in the assumed market spread, the corresponding change in the fair value of the total variable-rate debt would be approximately $1,000,000.
To calculate the estimated fair value of the remaining variable-rate mortgage debt as of December 31, 2011, the Company estimated that the current market spread over the applicable index (LIBOR or GBP LIBOR) would be in the range of 350 to 450 basis points as compared to the current contractual spread as disclosed (see note 7). Using these estimated market spreads, the Company estimated the fair value of the remaining variable-rate mortgage debt to be approximately $6,000,000 to $9,000,000 lower than the total carrying value of $211,159,000. For every 100 basis point change in the assumed market spread, the corresponding change in the fair value of the total variable-rate debt would be approximately $3,000,000.
The Company estimated the fair value of the debt using a future discounted cash flow analysis based on the use and weighting of multiple market inputs being considered. Based on the frequency and availability of market data, all inputs used to measure the estimated fair value of the debt are Level 2 inputs. The primary sensitivity in these calculations is based on the selection of appropriate discount rates.
Interest rate swap and cap agreements have been recorded at their estimated fair values.
 
14. GEOGRAPHIC AND BUSINESS SEGMENT INFORMATION
The Company operates in one reportable business segment, hotel ownership. As of June 30, 2012, the Company’s foreign operations (excluding discontinued operations) and long-lived assets consisted of one Mexican hotel property, two Mexican development sites, a 31% interest in a Mexican unconsolidated affiliate, and two European properties, including a leasehold interest in a German hotel property.
The following tables present revenues (excluding unconsolidated affiliates and discontinued operations) and long-lived assets for the geographical areas in which the Company operates (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
United States
$
182,379

 
$
184,866

 
$
341,766

 
$
341,925

Mexico
8,153

 
8,594

 
18,083

 
19,155

Europe
10,869

 
11,018

 
19,831

 
18,938

Total
$
201,401

 
$
204,478

 
$
379,680

 
$
380,018

 
June 30, 2012
 
December 31, 2011
Long-lived Assets:
 
 
 
United States
$
1,469,200

 
$
1,496,513

Mexico
169,012

 
169,729

Europe
93,546

 
97,183

Total
$
1,731,758

 
$
1,763,425

 


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STRATEGIC HOTELS & RESORTS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. MANAGEMENT AGREEMENTS
The Company has amended terms of its management agreements with various hotel operators. Consideration resulting from these amendments are classified as deferred credits and will be recognized ratably in earnings (as an offset to management fee expense) over the expected remaining initial terms of the respective management agreements. At June 30, 2012 and December 31, 2011, deferred credits of $7,009,000 and $7,431,000, respectively, were included in accounts payable and accrued expenses on the consolidated balance sheets.
Asset Management Agreements
The Company has entered into asset management agreements with unaffiliated third parties to provide asset management services to four hotels not owned by the Company. On March 11, 2011, the Company purchased two of these hotels and terminated the respective asset management agreements. Under the remaining agreements, the Company earns base management fees and has the potential to earn additional incentive fees. The Company earned fees of $100,000 and $62,000 for the three months ended June 30, 2012 and 2011, respectively, and fees of $200,000 for the six months ended June 30, 2012 and 2011, under these agreements, which are included in other income, net in the consolidated statements of operations.
 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Note on Forward-Looking Statements
On one or more occasions, we may make statements regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events. All statements other than statements of historical facts included or incorporated by reference in this Form 10-Q are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act).
Words or phrases such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “targets,” “will,” “will continue,” “will likely result” or other comparable expressions or the negative of these words or phrases identify forward-looking statements. Forward-looking statements reflect our current views about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause actual results or outcomes to differ materially from those expressed in any forward-looking statement. We caution that while we make such statements in good faith and we believe such statements are based on reasonable assumptions, including without limitation, management’s examination of historical operating trends, data contained in records and other data available from third parties, we cannot assure you that our projections will be achieved.
Some important factors that could cause actual results or outcomes for us to differ materially from these forward-looking statements are discussed in the cautionary statements contained in Exhibit 99.1 to this Form 10-Q, which are incorporated herein by reference. In assessing forward-looking statements contained herein, readers are urged to read carefully all cautionary statements contained in this Form 10-Q.
Overview
We were incorporated in Maryland in January 2004 to acquire and asset-manage upper upscale and luxury hotels (as defined by Smith Travel Research). Our accounting predecessor, Strategic Hotel Capital, L.L.C. (SHC LLC) was founded in 1997 by Laurence Geller, our president and chief executive officer, Goldman, Sachs & Co.’s Whitehall Fund and others. We made an election to be taxed as a real estate investment trust (REIT) under the Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the Tax Code). On June 29, 2004, we completed our initial public offering (IPO) of our common stock. Prior to the IPO, 21 hotel interests were owned by SHC LLC. Concurrent with and as part of the transactions relating to the IPO, a reverse spin-off distribution to shareholders separated SHC LLC into two companies, a new, privately-held SHC LLC, with interests, at that time, in seven hotels and Strategic Hotels & Resorts, Inc. (SHR), a public entity with interests, at that time, in 14 hotels. See “Item 1. Financial Statements -1. General” for the hotel interests owned or leased by us as of June 30, 2012.
We operate as a self-administered and self-managed REIT, which means that we are managed by our board of directors and executive officers. A REIT is a legal entity that holds real estate interests and, through payments of dividends to stockholders, is permitted to reduce or avoid federal income taxes at the corporate level. To continue to qualify as a REIT, we cannot operate hotels; instead we employ internationally known hotel management companies to operate our hotels under management contracts. We conduct our operations through our direct and indirect subsidiaries including our operating partnership, Strategic Hotel Funding, L.L.C. (SH Funding), which currently holds substantially all of our assets. We are the managing member of SH Funding and hold approximately 99% of its membership units as of June 30, 2012. We manage all business aspects of SH Funding, including the sale and purchase of hotels, the investment in these hotels and the financing of SH Funding and its assets.
Throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section, references to “we”, “our”, “us”, and “the Company” are references to SHR together, except as the context otherwise requires, with its consolidated subsidiaries, including SH Funding.
When presenting the U.S. dollar equivalent amount for any amounts expressed in a foreign currency, the U.S. dollar equivalent amount has been computed based on the exchange rate on the date of the transaction or the exchange rate prevailing on June 30, 2012, as applicable, unless otherwise noted.
Key Indicators of Operating Performance
We evaluate the operating performance of our business using a variety of operating and other information that includes financial information prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) such as total revenues, operating income (loss), net income (loss), and earnings per share, as well as non-GAAP financial information. In addition, we use other information that may not be financial in nature, including statistical information

27


and comparative data. We use this information to measure the performance of individual hotels, groups of hotels, and/or our business as a whole. Key indicators that we evaluate include average daily occupancy, average daily rate (ADR), revenue per available room (RevPAR), and Total RevPAR, which are more fully discussed under “- Factors Affecting Our Results of Operations – Revenues.” We also evaluate Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), Comparable EBITDA, Funds from Operations (FFO), FFO-Fully Diluted, and Comparable FFO as supplemental non-GAAP measures to GAAP performance measures. We provide a more detailed discussion of the non-GAAP financial measures under “-Non-GAAP Financial Measures.”
Outlook
The lodging industry began its recovery near the end of the first quarter of 2010, after one of the worst downturns in its history. Luxury demand, in which our portfolio has the highest concentration of assets, has experienced positive RevPAR growth beginning with the week of February 20, 2010, following 96 consecutive weeks of negative RevPAR growth. RevPAR and occupancy gains continued in the second quarter of 2012, primarily driven by improved demand in transient business.
The second quarter of 2012 represented the tenth consecu