PEOPLE, PROPERTIES & BRANDS Legacy Hotels Real Estate Investment Trust 2006 Annual ReportFinancial Highlights 1 Letter to Unit Holders 3 Hotel Brand Overview 10 Management’s Discussion and Analysis 12 Consolidated Financial Statements 32 Notes to Consolidated Financial Statements 37 Supplemental Information 54 Hotel Portfolio 55 Corporate and Investor Information 56 CONTENTSFINANCIAL HIGHLIGHTS For the years ended December 31 2006 2005 2004 Comparable Operating Statistics1 Revenue per available room (“RevPAR”) $ 123.86 $ 117.99 $ 114.97 Average daily rate (“ADR”) 177.89 172.54 171.17 Occupancy 69.6% 68.4% 67.2% Operating Results (in millions of dollars, except per unit amounts) Revenues $ 816.7 $ 772.5 $ 754.0 Hotel EBITDA1 180.2 151.6 151.5 Diluted distributable income (loss)1 per unit 0.42 0.26 0.28 Diluted funds from operations1 per unit 0.76 0.52 0.50 Distributions declared per unit 0.32 0.32 0.24 1 See Non-GAAP Financial Measures on page 28. Financial Highlights 1 Willow Stream Spa, The Fairmont Empress, Victoria Our business has been built on the quality of our world-class properties, the exceptional level of service offered to our guests, and the value of the brands we partner with. We bolster these qualities with a focus on aggressive asset management, disciplined capital allocation and sound financial management. Together, our people, our properties and our brands, provide guests with unparalleled experiences, and offer our investors a superior long-term investment.LETTER TO UNIT HOLDERSLegacy is often recognized for owning unique hotel real estate in the most desirable locations — highly coveted traits for any type of real estate owner. In an environment where quality assets are scarce and an abundance of global capital looking for investments in the real estate space exists, we continue to believe in the solid underlying value of our portfolio. Combined with our ability to drive incremental value throughout the portfolio, we believe Legacy offers an exceptional investment opportunity. WHERE WE ARE Our operating results in 2006 improved significantly. The 5.0% increase in revenue per available room, or RevPAR, helped drive significant increases in operating margins and cash flow. Hotel EBITDA per room of $16,600 was the highest earned by the Trust in the past five years. This reflects diligent asset management, employees and brands’ efforts to drive earnings, as well as the contribution from high quality acquisitions made in recent years. As we’ve noted through the years, incremental revenue drives substantial improvements in margins and profits due to the industry’s high operating leverage, particularly in the luxury and first-class segments in which we operate. This year’s 6% revenue growth led to an 18% increase in hotel EBITDA and contributed to a 65% improvement in distributable income per unit. This improved operating performance, combined with a conservative payout ratio, has considerably improved the Trust’s financial position. Over the past few years, we have strengthened our balance sheet and liquidity with over $600 million in debt refinancings, including our $115 million refinancing of Fairmont The Queen Elizabeth in Montreal in February 2007. During the year we also secured an increased bank credit facility, thereby improving our liquidity and financial flexibility. As a result, our balance sheet is the strongest its been in years. Letter to Unit Holders 3 Fairmont The Queen Elizabeth, Montreal We had an outstanding 2006, delivering significant increases in operating results and earnings. Importantly, for the second year in a row, unit holders have enjoyed large increases in total returns. In 2006, your investment in Legacy generated total returns of over 20%. This followed returns of over 15% in 2005.A strong balance sheet enables us to take advantage of market opportunities, such as our acquisition of the 398-room Delta Bow Valley in September 2006. This $53.5 million acquisition represents our fourth asset in Calgary, one of the fastest growing markets in Canada. In March 2007, we acquired the fee interest in the Delta Beausejour in Moncton for $21.2 million. We have owned the leasehold interest in this property since Legacy’s inception in 1997. Both of these acquisitions are anticipated to be immediately accretive to our portfolio. Combined with strong market dynamics in Calgary and Moncton, our commitment to investing capital in these assets will provide further opportunities for improved performance at the hotels. WHERE WE ARE GOING We remain focused on maximizing unit holder value through our three strategic pillars; aggressive asset management, disciplined capital allocation and sound financial management. Looking forward to 2007 and beyond, our key management priorities include the following: • Continue to work with our brands and managers to identify revenue opportunities and operating efficiencies through improved productivity; • Invest capital in our existing portfolio to maintain our assets, and pursue repositioning opportunities to enhance their competitive position. These investments provide some of the highest yields and ensure that our hotels are competitively positioned within their markets; • Explore opportunities to maximize the value of existing assets. These could include developing excess land adjoining our properties, and the redevelopment of existing hotels spaces to alternative uses; Letter to Unit Holders 5 The Fairmont Winnipeg• Seek opportunities to complement our existing portfolio with the addition of luxury and first-class hotels in primary urban and resort locations in Canada and the U.S.; and • Reduce our cost of capital and maintain our financial flexibility through prudent cash flow management, and appropriate levels of leverage. The lodging industry continues to show signs of ongoing growth in demand and profitability. Overall supply projections remain low, although luxury supply is anticipated in a few of our markets over the next four years, namely Toronto, Vancouver and Seattle. This competitive supply reflects the fundamental value and growth outlook in these respective markets. Overall, positive economic indicators, growing corporate profits, and shifting demographics are all encouraging indicators for ongoing revenue and distributable income growth for our unit holders. We continue to believe that the luxury and first-class hotels will provide superior long-term returns to our unit holders through appreciation in net asset value and growth in profitability and distributable income. Letter to Unit Holders 7 The Fairmont Olympic Hotel, SeattleAs Legacy continues to evolve, so too does the corporate environment under which we are governed. In late 2006, the Canadian Ministry of Finance announced proposed changes to the current income trust legislation. It appears as though certain real estate investment trusts will be excluded from the impact of this proposed legislation. We will continue to evaluate the extent to which this legislation may affect Legacy. Irrespective of the outcome, these potential changes do not impact the underlying asset value and cash flow potential of our portfolio. Based on our belief that continued growth and value enhancing opportunities exist within Legacy, our Board of Trustees has undertaken a strategic planning review to determine the best avenue for us to realize this value. We look forward to the outcome of this strategic review and the Board’s guidance in helping us maximize the Trust’s potential. This has been a rewarding year for Legacy. Our performance in 2006 reflects the service excellence and commitment of each of our employees. Our properties and our brands provide the setting for a unique lodging experience, but it is our people who truly execute on this promise. I thank each of them for their contributions. I would like to sincerely thank you, our unit holders, for your ongoing support. Sincerely, Neil J. Labatte President and Chief Executive Officer March 13, 2007 Letter to Unit Holders 9 Fairmont Château Laurier, OttawaCalgary 1,422 rooms (4) Washington D.C. 415 rooms (1) Toronto 2,033 rooms (3) Saskatoon 225 rooms (1) Winnipeg 733 rooms (2) Seattle 450 rooms (1) Quebec City 618 rooms (1) Montreal 1,750 rooms (2) Vancouver 1,045 rooms (2) Victoria 477 rooms (1) Charlottetown 211 rooms (1) Halifax 496 rooms (2) Moncton 310 rooms (1) Edmonton 199 rooms (1) Ottawa 758 rooms (2) HOTEL BRAND OVERVIEW FAIRMONT HOTEL BY ROOM TOTAL (13 hotels) DELTA HOTEL BY ROOM TOTAL (12 hotels)FAIRMONT HOTELS & RESORTS In 1999, Canadian Pacific Hotels & Resorts acquired Fairmont Hotels, bringing together two companies, each with a century of rich history and exemplary hospitality. Fairmont Hotels & Resorts is now the largest luxury hotel management company in North America, offering guests luxurious accommodation in the most sought-after destinations. Over 50 distinctive hotels — including The Fairmont San Francisco, The Fairmont Banff Springs and London’s Savoy — promise travelers rich experiences and lasting memories in unparalleled settings. DELTA HOTELS Since it began in 1962, Delta Hotels has grown into Canada’s largest first-class hotel management company, with a diversified portfolio of 40 city-centre, airport and resort properties. It is a leading brand of choice for discerning owners and guests, an exemplary employer to 7,500 people and an active corporate citizen. SHERATON HOTELS & RESORTS Founded in 1937, Sheraton Hotels & Resorts operates a leading chain of upscale hotels with about 400 locations in 70 countries. Its properties target both business and leisure travelers with fullserrvic accommodations, fine dining, and other amenities. Hotel Brand Overview 11 Our portfolio of full-service city-centre properties are associated with the high-performing and well-known brands; Fairmont, Delta and Sheraton. Their expertise complements our portfolio and helps us maximize the performance of our assets.CAUTIONARY STATEMENTS FORWARD-LOOKING STATEMENTS In the interest of providing Legacy Hotels Real Estate Investment Trust (“Legacy” or the “Trust”) unit holders and potential investors with information regarding the Trust, certain statements contained in this Annual Report constitute forward-looking statements relating, but not limited to, Legacy’s operations, anticipated financial performance, business prospects and strategies. Forward-looking information typically contains statements with words such as “anticipate,” “believe,” “expect,” “plan,” “intend,” “forecast,” “project” or similar words suggesting future outcomes. Readers are cautioned not to place undue reliance on forward-looking statements, as there can be no assurance that the plans, intentions or expectations upon which they are based will occur. By its nature, Legacy’s forwardloookin information involves numerous assumptions, inherent risks and uncertainties, which may cause the Trust’s actual performance and financial results in future periods to differ materially from any estimates or projections of future performance or results expressed or implied by such forward-looking statements. These risks and uncertainties include, but are not limited to, the following factors: changes in business strategies; general global economic and business conditions; the effects of competition and pricing pressures; industry overcapacity; shifts in market demands; changes in laws and regulations, including environmental and regulatory laws; potential increases in maintenance and operating costs; uncertainties of litigation; labour disputes; timing of completion of capital or maintenance projects; currency and interest rate fluctuations; various events which could disrupt operations; and technological changes. Although Legacy believes that the expectations represented by such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to be correct. Furthermore, the forward-looking statements contained in this Annual Report are made as of the date of this Annual Report, and Legacy does not undertake any obligation to update publicly or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise. The forward-looking statements contained in this Annual Report are expressly qualified by this cautionary statement. NON-GAAP FINANCIAL MEASURES Certain measures in this Annual Report do not have any standardized meaning as prescribed by Canadian generally accepted accounting principles (“GAAP”) such as hotel earnings before interest, taxes, amortization, advisory fees and other income and expenses (“hotel EBITDA”), distributable income, funds from operations (“FFO”), and comparable hotel operating statistics, and therefore are considered non-GAAP measures. Legacy uses non-GAAP financial measures to assess its operating performance. Securities regulators require that entities caution readers that earnings and other measures adjusted to a basis other than GAAP do not have standardized meanings and are unlikely to be comparable to similar measures used by other companies. Please see Non-GAAP Financial Measures for a discussion of non-GAAP financial measures used by the Trust, including a reconciliation to GAAP financial measures. 12 Legacy Hotels REIT 2006 Annual ReportMANAGEMENT’S DISCUSSION AND ANALYSIS The following management’s discussion and analysis (“MD&A”) is intended to assist readers in understanding Legacy, its history, business environment, strategies, performance and risk factors from the viewpoint of management of the Trust. The MD&A should be read in conjunction with the Consolidated Financial Statements and accompanying notes. The Consolidated Financial Statements of Legacy are prepared in accordance with Canadian GAAP. The Consolidated Financial Statements and MD&A are presented in millions of Canadian dollars unless otherwise stated. This MD&A is dated February 22, 2007. Additional information relating to Legacy, including its Annual Information Form, can be accessed on the Canadian Securities Administrators’ System for Electronic Document Analysis and Retrieval (“SEDAR”) located at www.sedar.com and on the Trust’s website at www.legacyhotels.ca. LEGACY’S BUSINESS Legacy is the largest Canadian lodging real estate investment trust (“REIT”), focused on the ownership of luxury and first-class hotels. The Trust believes the upper end of the lodging industry offers attractive investment opportunities in the long-term given the historically lower supply growth and the appeal of this segment with customers. Legacy was created in 1997 with the purchase of 11 Canadian city centre hotels. Since its inception, the portfolio has more than doubled to include 25 luxury and first-class hotels and resorts with over 11,000 guestrooms. With a presence across Canada and in two top U.S. markets, Legacy’s portfolio provides geographic diversification across major urban centres including landmark properties such as Fairmont Le Château Frontenac, The Fairmont Royal York, The Fairmont Empress and The Fairmont Olympic Hotel, Seattle. The size, location and recognition of many of the Trust’s hotels enables them to attract a diverse mix of guests. Legacy’s hotels are operated by hotel management companies under long-term agreements under which they earn base and incentive management fees related to the revenues and profitability of each hotel. Legacy provides operating funds, which the managers use to operate the property including purchasing inventory and paying wages, utilities, property taxes and other expenses. Legacy also provides capital funds, as appropriate, which the managers use to implement capital investments. Approximately 60% of Legacy’s revenues are generated from room nights and 35% from food and beverage services. Other revenue streams such as parking, retail operations, laundry and spa facilities contribute the remainder of the revenues earned by the properties. The primary operating expenses include labour, food and beverage costs, property operating costs, sales and marketing, utilities, and management fees. Other property level expenses include property taxes, ground rent for leasehold interests and property insurance. Many of these property level expenses are relatively fixed and do not necessarily change in accordance with revenue levels. Management’s Discussion and Analysis 13TRENDS IN THE LODGING INDUSTRY The balance between supply and demand drives growth in the lodging industry, each influenced by a number of factors, often beyond the industry’s control. The Canadian lodging industry has benefited from improving revenue per available room (“RevPAR”) trends over the past three years, growing approximately 6% each year. Looking ahead, industry forecasters expect continued positive trends, with demand growth anticipated to exceed supply growth which should lead to increased occupancy levels and average daily rates (“ADR”). DEMAND GROWTH ANTICIPATED TO EXCEED SUPPLY GROWTH Source: PKF Consulting DEMAND TRENDS Demand within the lodging industry historically has a high correlation with economic growth. A strong economy leads to increasing corporate profits and wages, and encourages increased spending on business and leisure travel. Demographic changes are also expected to play a major role in stimulating lodging demand with the aging baby boomers representing the strongest potential for the travel industry. The lodging industry also depends, to a varying degree, on air travellers as part of their customer base. Air lift capacity and affordability can influence lodging demand in any specific market. While the decision to travel may have been made, the final destination choice can be influenced by other factors. Over 85% of the Trust’s revenues are derived from its Canadian assets. Canada’s attractiveness as a travel destination, for both domestic and international guests, can have a significant impact on Legacy’s performance. Competition beyond the traditional lodging industry is intensifying with travel alternatives vying for a share of this growing market. The hotel industry has been responding to this evolution with many brands expanding into vacation ownership and the residential market. Considering its ownership position in world-renowned assets in desirable city-centre and resort locations, Legacy continues to evaluate opportunities to participate in this evolving competitive landscape including the development of excess land adjoining properties, and the redevelopment of existing hotel spaces to alternate use. Average Canadian dollar exchange rates relative to the U.S. dollar appreciated approximately 7% over 2006 and almost 40% since early 2003. Like many other Canadian businesses, the rising Canadian dollar presents a potential challenge to the Trust’s performance for two reasons. First, the rising relative cost can impact inbound U.S. travel demand to Canada and conversely, the cheaper relative cost of U.S. lodging may increase outbound Canadian travel. According to Statistics Canada, travel from the U.S. to Canada has shown an annual decline since 2005 and is not expected to increase until 2009. Despite the exchange rate’s increase, Canadian lodging remains relatively less expensive compared to alternative destinations, most notably the U.S. and Europe. Second, operating results generated by the two U.S. properties will be converted at a lower exchange rate thereby reducing their reported contribution. Both U.S. properties have U.S. denominated mortgages, which mitigates the currency movement’s operating cash flow impact. 14 Legacy Hotels REIT 2006 Annual ReportIn January 2007, the U.S. Department of Homeland Security implemented the first phase of its Western Hemisphere Travel Initiative, requiring all travellers entering the U.S. by air to show a valid passport or other approved identification card. This requirement will be extended to all other forms of travel, including by land and sea, in June 2009. This new travel requirement could impact inbound and outbound travel between Canada and the U.S. given the added travel inconvenience and expense. Given the world-renowned nature of many of its hotels, Legacy’s portfolio attracts a higher component of U.S. guests as compared to its Canadian lodging peers. As a result, Legacy’s portfolio could be disproportionately impacted by the potential impact on U.S. travel trends. SUPPLY TRENDS New supply is one of the more significant risks for the lodging industry given its immediate and direct impact on occupancies within a market. One of the main drivers of hotel supply is rising demand and, more importantly, rising ADR. Increasing ADR signals higher profits thereby stimulating potential new construction. Mitigating this trend, supply growth in the luxury and first-class segments is also affected by higher development and material costs, the lengthy time frame for construction and the availability of suitable development locations. Overall supply growth is projected to remain low in the next few years. In Canada, the level of hotel construction has grown at a compound annual rate of approximately 2% over the past five years. According to industry forecasters, Canadian lodging supply is expected to grow approximately 1% in 2007, below the estimated growth in demand of over 3%. There has been new luxury supply announced in certain of Legacy’s markets, notably Seattle, Vancouver, and Toronto. This supply will typically take two to four years to come in the market. Some of this planned supply may not ultimately come to market. Given the high cost of construction, new entrants into the luxury supply sector is an indication of the perceived strength of the lodging industry over the next several years. All of this announced new luxury supply includes a residential condominium component as part of the hotel project. The anticipated net increase in travel demand, as compared to supply, should translate into higher occupancy levels leading to growth in revenues and profitability. OUTLOOK Legacy’s portfolio of assets realized a 5% RevPAR increase in 2006 as compared to 2005. This growth was driven by a combination of ADR and occupancy improvement. A growing economy in Canada, improved corporate profits, and an active convention market in several of the Trust’s key markets each contributed to this growth. The Canadian and U.S. lodging industries are expected to show continued RevPAR growth with higher demand anticipated to outpace new supply. For 2007, industry experts in Canada and the U.S. forecast RevPAR growth within the higher segments at approximately 3% and 8%, respectively. Incremental revenue drives substantial improvements in margins and profitability due to the industry’s high fixed cost and related operating leverage, particularly in the luxury and first-class segments. The inherent leverage in Legacy’s operations should enable the Trust to deliver distributable income growth for unit holders. LEGACY’S STRATEGY Legacy’s focus continues to be on the ownership of luxury and first-class lodging real estate, which it expects will outperform other lodging segments over the long-term. The Trust is committed to its established objectives of providing competitive overall total returns to its unit holders through stable and growing distributions as well as capital appreciation. The Trust’s goal to maximize unit holder value is driven through aggressive asset management, disciplined capital allocation and sound financial management. Astute financial management will ensure appropriate balance sheet liquidity and risk. Tactically, the Trust will implement its strategies by focusing on four inter-related strategic initiatives as described below. Legacy’s strategy is focused on the optimum use of its real estate assets and identifying value enhancing opportunities within its portfolio as well as alternative capital redeployment opportunities, including further growth. Management’s Discussion and Analysis 15STRATEGIC INITIATIVES TO MAXIMIZE UNIT HOLDER VALUE FINANCIAL PERFORMANCE KEY PERFORMANCE INDICATORS The Trust has a number of key performance indicators that are used to evaluate the performance of the hotels. RevPAR measures room revenues for comparable properties and is a commonly used measure within the hotel industry to evaluate hotel operations. RevPAR is defined as the product of the ADR charged and the average daily occupancy achieved. Legacy calculates RevPAR by dividing room revenues for comparable properties by room nights available to guests for the period. See Non-GAAP Financial Measures for a discussion of what Legacy considers to be its comparable hotels. RevPAR does not include revenues from food and beverage or other services provided by the hotels. Representing approximately 60% of total revenues, RevPAR is generally considered to be the leading indicator of operating performance for Legacy’s portfolio. RevPAR changes driven by occupancy have different implications on overall revenues and operating income than do changes driven by ADR. Occupancy increases will generate additional incremental revenues such as food and beverage and will also result in higher room-related costs. ADR increases would not generate incremental revenue for ancillary services such as food and beverage, however, they also would not result in additional costs and therefore tends to have a greater impact on profitability. Profitability is also evaluated by measuring changes in the gross operating margin, which is defined as gross operating profit as a percentage of total revenues. Hotel EBITDA is another key performance indicator used to give management a more complete understanding of the ongoing hotel operating profitability including the Trust’s ability to service debt, fund capital expenditures and pay cash distributions. Distributable income and funds from operations (“FFO”) are also considered to be key performance indicators of Legacy’s profitability after all internal funding requirements including capital expenditures and debt service. See Non-GAAP Financial Measures for a further discussion of these financial measures. Each of these non-GAAP financial measures should be considered by investors as supplemental measures to GAAP performance measures such as total revenues, gross operating profit and earnings per unit. 16 Legacy Hotels REIT 2006 Annual Report I Asset Management & Capital Allocation Maximizing revenues, identifying operating efficiencies, maintaining and improving the hotels’ competitive positioning, and improving guest satisfaction. Investing in the assets to drive higher returns and enhance the value of the assets. IV Growth Reinvesting capital to acquire assets with significant long-term operating growth and capital appreciation potential. II Real Estate Utilization Optimizing real estate value through highest and best use utilization. These initiatives may include the development of excess land adjoining properties, the improvement of leasehold investments, and the redevelopment of existing hotel spaces to alternate use. III Leverage the Platform Evaluating current real estate holdings to optimize diversification and capitalize on embedded value.CORPORATE DEVELOPMENTS In 2006, Legacy issued 5.9 million units following the conversion of $51.3 principal amount of the Trust’s convertible debentures. The securities were convertible at the option of the holder into units of Legacy at a conversion price of $8.75. Following the end of the year, an additional $12.9 of principal amount was converted into 1.4 million Legacy units. As at February 21, 2007, $85.7 convertible debentures remained outstanding and are convertible into 9.8 million units of Legacy. Debenture holders have until March 15, 2007 to elect to convert their debentures prior to the maturity date of April 1, 2007. On February 12, 2007, Legacy reached an agreement to acquire the remaining interest in the 310-room Delta Beausejour hotel in Moncton for approximately $21.2 plus closing costs. Legacy currently owns the leasehold interest in the property, which expires in 2015. The acquisition is expected to be entirely financed by mortgage financing on the property approximating $25.0. Incremental mortgage proceeds will be used to partially fund a $6.0 capital investment program at the hotel. Closing is anticipated in March 2007. Legacy anticipates that this transaction will be beneficial to its cash flow and earnings. On February 9, 2007, Legacy completed a $115.0 floating rate mortgage refinancing for Fairmont The Queen Elizabeth in Montreal. The financing has a three and a half year term and a current rate at closing approximating 5.5%. Proceeds are being used to satisfy the existing $91.0 mortgage maturity, and for general corporate purposes. Notwithstanding the incremental mortgage proceeds, this refinancing represents annual interest savings of almost $0.5 given a 200 basis point interest rate reduction on the refinancing. Effective September 1, 2006, Legacy acquired the 398-room Delta Bow Valley hotel in Calgary, Alberta for $54.2, including closing costs. The acquisition was financed through the assumption of mortgage financing and vendor financing totalling $40.7, and Legacy’s available cash on hand. This acquisition represents Legacy’s fourth property in Calgary, one of the fastest growing markets in Canada. Legacy expects to invest approximately $4.0 in the property to renovate guestrooms over the next few years. New income trust legislation was proposed by the Finance Minister on October 31, 2006. See Critical Accounting Policies and Estimates — Income Taxes for a discussion of the potential implications for the Trust. RESULTS OF OPERATIONS (In millions, except per unit amounts) 2006 2005 2004 Revenues $ 816.7 $ 772.5 $ 754.0 Gross operating profit 265.8 237.2 236.7 GOP margin 32.5% 30.7% 31.4% Hotel EBITDA 180.2 151.6 151.5 Hotel EBITDA margin 22.1% 19.6% 20.1% Net income (loss) 6.4 (15.1) (12.9) Distributable income 44.5 26.6 29.6 FFO 80.0 54.5 52.5 Diluted net income (loss) per unit 0.05 (0.18) (0.15) Diluted distributable income per unit 0.42 0.26 0.28 FFO per unit 0.76 0.52 0.50 Distributions per unit 0.32 0.32 0.24 Total assets 1,883.5 1,870.5 1,937.2 Total long-term debt 894.1 870.9 890.3 Management’s Discussion and Analysis 172006 COMPARED TO 2005 REVENUES For 2006, revenues increased by $44.2, or 5.7%, to $816.7 (2005 – $772.5). The growth in revenues primarily reflects the increase in RevPAR of 5% driven by increases in occupancy of 1.2 points as well as ADR of 3.1%. The Delta Bow Valley hotel, acquired in September of 2006, contributed $7.0 in revenues for the year. Food and beverage revenues benefited from the overall increase in occupancy, as well as higher per customer sales. Performance through the first half of the year was particularly strong driven by an active business group environment in several key markets. Revenue by customer type Customers are classified along two broad categories: business and leisure, and further subdivided based on whether guests are travelling individually (transient) or as part of a group. A balanced customer mix helps minimize risk by limiting the Trust’s reliance on any individual customer group. PORTFOLIO ATTRACTS A DIVERSE MIX OF GUESTS ADR growth was achieved across each customer category in 2006. The business group customer showed the greatest year-over-year revenue improvement, benefiting from a robust corporate meeting and convention environment in several of Legacy’s key markets, notably Toronto, Vancouver and Seattle. Limited weekday room availability during certain high occupancy periods impacted the business transient customer demand but was offset by ADR growth achieved. Domestic leisure demand showed improvement through the year. Consistent with general industry trends, this was somewhat offset by softer U.S. leisure travel trends to Canada, and Legacy’s portfolio specifically. Legacy’s two primary summer leisure markets, Victoria and Quebec City, were particularly impacted given their greater reliance on the U.S. traveller during the peak leisure months. 2006 REGIONAL REVPAR FOR COMPARABLE PORTFOLIO Variance British Columbia 6.4% Alberta, Saskatchewan and Manitoba 12.6% Ontario and Quebec 2.5% Atlantic Canada 2.8% United States (Cdn $) 3.3% Total 5.0% 18 Legacy Hotels REIT 2006 Annual ReportRevenue by geographic region Overall, RevPAR growth was achieved throughout the portfolio with disparities in those markets with a higher reliance on the U.S. summer leisure customer, namely Quebec City and Victoria. This softness somewhat offset strength from other markets within these regions. Western Canada, particularly Alberta, led growth across the portfolio driven by the region’s healthy economic environment. Improvement from the U.S. region was partially offset by the Canadian dollar’s appreciation in 2006. U.S. dollar RevPAR increased over 10% this year, driven by strength in Seattle. The U.S. dollar RevPAR growth is primarily driven by ADR increases. 2006 BRAND REVPAR FOR COMPARABLE PORTFOLIO Variance 5.1% 4.5% Revenue by brand Legacy owns 13 Fairmont managed assets representing approximately two-thirds of its room inventory and contributing about 75% of revenues for the Trust. Legacy also owns 12 Delta managed assets representing one-third of its room inventory and contributing about 25% of Legacy’s annual revenues. The Fairmont managed assets generally consist of larger assets in larger city centre locations. The Delta managed assets primarily consist of smaller assets in smaller city centre markets. RevPAR growth was relatively consistent across Legacy’s Fairmont and Delta portfolios of managed assets. Legacy’s Fairmont portfolio of managed assets benefited from a comparatively higher asset concentration in Western Canada, as compared to the Delta portfolio of assets. OPERATING EXPENSES Operating expenses increased 2.9% to $550.9 (2005 – $535.3) reflecting the partial year inclusion of the Delta Bow Valley hotel. Same store operating expenses excluding this asset showed an increase of about 2% reflecting additional costs incurred as a result of the 1.2 point occupancy improvement. Gross operating profit improved 12.1% to $265.8 (2005 – $237.2). Strong annual revenue growth and cost control efforts contributed to a 180 basis point gross operating margin improvement to 32.5% (2005 – 30.7%). Operating expenses also include base and incentive management fees, which are incurred based on the operating performance of the hotels. Total management fees in 2006 include a $1.9 management fee recovery owing from Fairmont. Excluding this amount, hotel management fees as a percentage of total revenues were higher at 3.3% (2005 – 3.1%). The increase is a direct result of the growth in incentive fees, given the improved profitability of most properties. In 2006, incentive management fees were incurred on approximately 60% of Legacy’s hotels compared to about half the portfolio in 2005. Overall, property taxes, rent and insurance expense were modestly lower for the year reflecting the successful settlement of a prior period property tax appeal of $1.1 in the third quarter. This recovery was somewhat offset by the partial year inclusion of the Delta Bow Valley hotel. Costs through the balance of the portfolio were relatively unchanged. Management’s Discussion and Analysis 19HOTEL EBITDA The higher gross operating profit contributed to an 18.9% improvement in operating income from hotel operations, or hotel EBITDA, to $180.2 (2005 – $151.6). This growth was primarily realized in the first half of the year based on stronger year-over-year group pattern demand over the period. Annual hotel EBITDA margin increased 250 basis points to 22.1% (2005 –19.6%). Margin improvements in 2006 reflect cost initiatives implemented in the fourth quarter of 2005, yet margins remain below peak historical levels. As RevPAR continues to increase, particularly as it relates to ADR, management expects to see further improvement in operating margins. OTHER ITEMS Amortization Amortization expense increased modestly to $77.0 due to the Delta Bow Valley hotel acquisition as well as regular maintenance capital and modest profit-improving capital investment activity in the portfolio over the prior periods. Trust Expenses Trust expenses primarily consist of the advisory fees paid to Fairmont for operational and administrative services provided [See Relationship with Fairmont Hotels & Resorts Inc.] as well as employee salary and other expenses, corporate insurance, regulatory compliance costs, and professional fees. Trust expenses are up $2.9 primarily reflecting a fourth quarter $1.2 foreign exchange loss relating to the repatriation of cash from the U.S as well as the second quarter inclusion of $1.1 in non-recurring costs associated with certain strategic initiatives. Interest Expense, Net Net interest expense is relatively unchanged. Additional interest incurred relating to the debt financing for the acquisition of the Delta Bow Valley hotel was offset by reduced interest charges associated with the fourth quarter conversion of $51.3 of Legacy’s convertible debentures. Under the terms of the Trust Indenture, holders of debentures who elect to convert their debentures are not entitled to accrued and unpaid interest. Interest accrued since the last interest payment on October 1, 2006 may be reversed in the first quarter of 2007 to the extent that additional debenture holders elect to convert their securities on or prior to March 15, 2007, the last day on which a debenture holder can elect to convert their debentures prior to the maturity date of April 1, 2007. At December 31, 2006, Legacy’s average interest rate was 7.4% (December 31, 2005 – 7.3%). Interest expense also includes amortization of convertible debenture issuance costs and debt issuance costs of $6.5 (2005 – $6.3). Income Tax Expense (Recovery) The future tax recovery of $2.5 (2005 – $3.2) reflects improved performance from the U.S. subsidiary corporations that accumulate tax losses during the initial periods after acquisition. These losses will be applied against the subsidiaries’ taxable income through 2026. Non-Controlling Interest Non-controlling interest consists of the exchangeable shares’ allocation of the income or loss of Legacy. Fairmont Hotels & Resorts Inc. (“FHR”) owns all of the outstanding exchangeable shares. On June 30, 2006, the holder of the exchangeable shares issued by a subsidiary of Legacy exercised its retraction right to convert two-thirds, or 9.8 million, of its exchangeable shares into units of Legacy. This noncaas transaction effectively reduced the non-controlling interest in Legacy from 14.7 million units, or 14.1% of outstanding units at June 30, 2006, to 4.9 million, or 4.4% of outstanding units at December 31, 2006. This change reduced the non-controlling interest allocation to earnings beginning in the third quarter of 2006. Net Income Higher hotel EBITDA contributed to a $21.5 improvement in the Trust’s net income. Diluted net income improved to $0.05 per unit (2005 – diluted loss per unit of $0.18). 20 Legacy Hotels REIT 2006 Annual ReportQUARTERLY RESULTS AND REVIEW OF FOURTH QUARTER PERFORMANCE Seasonality Due to the seasonal nature of operations, financial results are not evenly incurred throughout the year. Revenues are typically higher in the second and third quarters versus the first and fourth quarters in contrast to fixed costs such as amortization and interest, which are not significantly impacted by seasonal or short-term variations. In 2005, the portfolio’s seasonality was also affected by a group demand pattern which was weighted to the second half of the year. As a result, financial results for the first half of 2006 showed significant year-over-year strength as compared to more modest growth through the second half of the year. (unaudited) 2006 (in millions, except per unit amounts and operating statistics) Q1 Q2 Q3 Q4 Total RevPAR $ 95.69 $ 141.73 $ 147.16 $ 110.44 $ 123.86 ADR 157.08 185.96 194.28 168.55 177.89 Occupancy 60.9% 76.2% 75.8% 65.5% 69.6% Total revenues $ 158.8 $ 226.0 $ 223.0 $ 208.9 $ 816.7 Hotel EBITDA 13.1 61.2 65.0 40.9 180.2 Net income (loss) (24.1) 13.3 19.8 (2.6) 6.4 Distributable income (loss) (17.6) 25.7 30.7 5.7 44.5 FFO (10.7) 35.6 40.3 14.8 80.0 Diluted net income (loss) per unit $ (0.27) $ 0.15 $ 0.20 $ (0.03) $ 0.05 Diluted distributable income (loss) per unit (0.17) 0.24 0.28 0.05 0.42 Diluted FFO per unit (0.10) 0.32 0.36 0.14 0.76 Distributions per unit 0.08 0.08 0.08 0.08 0.32 (unaudited) 2005 (in millions, except per unit amounts and operating statistics) Q1 Q2 Q3 Q4 Total RevPAR $ 85.86 $ 129.66 $ 146.23 $ 109.64 $ 117.99 ADR 152.55 178.09 188.43 164.56 172.54 Occupancy 56.3% 72.8% 77.6% 66.6% 68.4% Total revenues $ 144.0 $ 208.0 $ 221.6 $ 198.9 $ 772.5 Hotel EBITDA 3.9 48.5 62.2 37.0 151.6 Net income (loss) (31.4) 4.6 17.2 (5.5) (15.1) Distributable income (loss) (24.4) 16.4 29.7 4.9 26.6 FFO (19.8) 23.7 37.9 12.7 54.5 Diluted net income (loss) per unit $ (0.35) $ 0.05 $ 0.19 $ (0.06) $ (0.18) Diluted distributable income (loss) per unit (0.23) 0.16 0.27 0.05 0.26 Diluted FFO per unit (0.19) 0.22 0.34 0.12 0.52 Distributions per unit 0.08 0.08 0.08 0.08 0.32 FOURTH QUARTER HIGHLIGHTS • Fourth quarter revenues increased by $10.0 or 5% as compared to 2005. Approximately half of this growth resulted from the inclusion of the Delta Bow Valley hotel following its acquisition in September. In addition, revenues benefited from a 6.4% improvement in food and beverage combined with a 0.7% RevPAR increase. • Hotel EBITDA increased 10.5% to $40.9 in the quarter driven by a100 basis point margin improvement. The prior year’s quarter included a $1.8 charge relating to operations restructuring initiatives. Excluding this one-time charge, margins were relatively unchanged. • Diluted distributable income was in line with the prior year at $0.05 per unit. • Diluted FFO improved 16.7% to $0.14 per unit (2005 – $0.12 per unit). Management’s Discussion and Analysis 21DISTRIBUTIONS TO UNIT HOLDERS The Trust has paid quarterly distributions of $0.08 per unit to unit holders since reinstating distributions in the second quarter of 2004. For 2006, Legacy earned $44.5 ($0.42 per unit) of reported distributable income, paid distributions to unit holders, including dividends on exchangeable shares, of $33.1 ($0.32 per unit) and retained a reserve of $11.4 ($0.10 per unit) for general Trust purposes. See Non-GAAP Financial Measures for a further discussion. In 2005, Legacy earned $0.26 per unit of reported distributable income and paid distributions of $0.32 per unit. Distributions paid in excess of distributable income in 2005 were temporarily financed through cash on hand. Management’s intention is to pay stable distributions yet establish distributions at a level below the reported distributable income achieved by the Trust. Short-term shortfalls in distributable income can be financed by the Trust, although over the long-term, management’s intention is to maintain a prudent payout ratio, which considers operating requirements of the business, while not retaining excess cash in the Trust. LIQUIDITY AND CAPITAL RESOURCES Legacy utilizes cash flow from operations and credit facilities to support operating requirements, to fund capital expenditures, to make acquisitions and to pay distributions to unit holders. At December 31, 2006, total liquidity, including undrawn credit facilities, approximated $144.6, compared to $113.0 at December 31, 2005. This increase primarily reflects the $30.0 increase in the credit facility in 2006. Legacy’s Declaration of Trust provides that consolidated indebtedness, which includes outstanding convertible debentures, may not exceed 60% of the Trust’s adjusted book value as defined in the Declaration of Trust. As at December 31, 2006, Legacy’s consolidated indebtedness was 43.2% of adjusted book value. Excluding convertible debentures, Legacy’s consolidated indebtedness approximated 38.9%. As at December 31, 2006, Legacy has $98.6 in outstanding convertible debentures, which mature on April 1, 2007. As at February 21, 2007, $85.7 remained outstanding. At December 31, 2006, Legacy’s primary contractual obligations consisted of long-term mortgage obligations. On February 9, 2007 Legacy announced the refinancing of the Farimont the Queen Elizabeth mortgage for $115.0, which was partially used to satisfy the $91.0 maturity. Legacy has no mortgage maturities until 2008. Mortgages are expected to be refinanced as they mature. Operating leases consist primarily of rental commitments with respect to leasehold interests in the Delta Calgary Airport, the Delta Halifax, the Delta Barrington, the Delta Beauséjour, the Delta Ottawa Hotel and Suites and The Fairmont Olympic Hotel, Seattle. Other obligations consist of contractual commitments in respect of certain capital projects. PAYMENTS DUE BY PERIOD After Contractual Obligations Total < 1 Year 1–3 Years 4–5 Years 5 Years Long-term debt $ 894.1 $ 109.4 $ 264.4 $ 393.6 $ 126.7 Operating leases 26.5 9.7 9.2 1.5 6.1 Other obligations 11.1 11.1 – – – Total $ 931.7 $ 130.2 $ 273.6 $ 395.1 $ 132.8 Legacy has several sources of funding available as outlined below: Cash from Operations Operations generate cash flow which is used primarily to fund distributions to unit holders, capital expenditures and debt service requirements. 22 Legacy Hotels REIT 2006 Annual ReportLines of Credit Legacy has a line of credit with major banking institutions to finance temporary shortfalls in cash resulting from business seasonality and capital expenditures. The credit facility may also be used to provide short-term financing in the event of an acquisition of a new hotel. In 2006, Legacy increased its $110.0 credit facility by an additional $30.0 to $140.0 as two assets were added to the security pool. As at December 31, 2006, the credit facility was secured by nine properties. Legacy’s ability to utilize the full amount may be impacted based on the cash flows generated by the secured properties. At December 31, 2006, the full $140.0 was available for use by Legacy against which, letters of credit outstanding amounted to $8.1. The credit facility matures in December 2007 and is expected to be renewed under similar or more favourable terms. Issuing Additional Debt Legacy also has the ability to raise funds by mortgaging its properties or by issuing either debt or convertible debt securities. The Trust typically uses long-term debt financing to refinance existing debt or to finance an acquisition. The choice of debt instrument used is dependent on then-current market conditions. The ability to secure debt financing on reasonable terms is ultimately dependent on market conditions and the lender’s determination of Legacy’s creditworthiness. Issuing Additional Equity Securities Legacy’s listing on The Toronto Stock Exchange gives it the ability to access, subject to market conditions, additional equity through the issuance of additional units or other equity instruments. When issued, additional equity is most often used to finance an acquisition or repay debt. Management believes that the Trust’s credit facilities, cash on hand and expected cash flow from operations, when combined with the potential to access debt and equity markets, will allow Legacy to meet all of its financial commitments. SOURCES AND USES OF CASH Operating Activities Cash flow generated from operations improved $23.3 to $91.8 (2005 – $68.5) reflecting improved hotel operating performance. In 2007, cash generated from operations is expected to improve as the portfolio benefits from continued growth in occupancy levels and ADR, as well as the full year contribution from its 2006 hotel acquisition. Investing Activities Legacy invests capital in its portfolio to maintain its assets, and pursue repositioning opportunities to enhance their competitive position. These investments provide some of the highest yields and ensure that the Trust’s hotels are competitively positioned within their markets. Capital expenditures in 2006 totalled $34.0 (2005 – $30.2) reflecting regular maintenance capital as well as modest profit-improving capital investment activity in the portfolio. Typically, a portion of capital planned for one year is carried into the following year based on occupancies and the desire not to displace business. Approximately $30.0 in capital projects previously scheduled to be spent in 2006 will be completed in 2007. As the lodging industry’s performance continues to accelerate, Legacy will consider profit-improving investments in its portfolio over the next several years to take advantage of market strengths and opportunities, as well as to better position its hotels against new supply and renovated competitive product. Investing activities include the funding of capital expenditure reserves pursuant to certain mortgage agreements. This restricted cash will be used to fund capital expenditures in future periods. Investing activities in 2006 also reflect the $12.3 cash portion of the acquisition of the Delta Bow Valley hotel. Financing Activities Financing activities reflect 2006 distributions of $0.32 per unit (2005 – $0.32 per unit) to unit holders and exchangeable share holders as well as regular principal mortgage repayments. A total of 6.1 million units were issued in 2006 (2005 – nil) representing the modest exercise of options as well as the non-cash impact of convertible debentures conversion. Management’s Discussion and Analysis 23UNIT INFORMATION Units Outstanding at December 31 (in millions) 2006 2005 Units outstanding 105.3 89.4 Exchangeable shares 4.9 14.7 110.2 104.1 Potential issuance of units: Conversion of convertible debentures (conversion price $8.75) 11.2 17.1 Options outstanding (weighted average strike price $9.45 (2005 – $9.31) 4.3 4.6 RELATIONSHIP WITH FAIRMONT HOTELS & RESORTS INC. Legacy has entered into several agreements with FHR through its subsidiaries Fairmont Hotels Inc. (“Fairmont”) and Delta Hotels Limited (“Delta”) to manage its hotels and to provide the Trust with strategic advice and day-todda administrative services. A summary of related party agreements and transactions with FHR is found in notes 16 and 17 of the Consolidated Financial Statements. ADVISORY AGREEMENT Fairmont provides operational and administrative services to Legacy and advises its Trustees regarding major decisions. In return for these services, Legacy pays an advisory fee equal to 0.4% of a defined asset base, an acquisition fee of 0.65% of the total acquisition price of any properties that the Trust acquires and a disposition fee of 0.25% of the aggregate sale price of any properties sold. The Trust does not pay any fees on acquisitions or dispositions between FHR and Legacy. Over the past several years, Legacy’s management team has been strengthened by internalizing the key positions of the Chief Executive Officer and the Chief Financial Officer. Added resources should enable the Trust to maximize the substantial growth opportunities that exist within its assets. In 2006, Fairmont agreed to offset $1.9 (2005 – $1.5) of costs paid directly by the Trust against the fees Legacy pays pursuant to the Advisory Agreement. Legacy may terminate the Advisory Agreement upon the approval of two-thirds of the votes cast by the Independent Trustees and the approval of two-thirds of the votes cast by the unit holders, and upon twelvemonnth notice. Fairmont may terminate the agreement upon not less than 120 days notice. The Advisory Agreement expires in February 2009. The agreement will be automatically renewed for additional terms of five years each, subject to the consent of FHR and a majority vote of the Independent Trustees. MANAGEMENT AGREEMENTS Legacy has entered into various long-term management contracts with subsidiaries of FHR to manage all of its hotels. Pursuant to these management agreements, the Trust pays base and incentive management fees. Base fees range from 2% to 3% of total hotel revenues and incentive fees are calculated based on net operating income from hotel operations plus amortization, less capital replacement reserve, in excess of certain specified threshold amounts. The terms of these management agreements are generally consistent with those negotiated by FHR with its other third party owners. The incentive fees for the 11 hotels initially acquired by Legacy (“Initial Portfolio”) are calculated based on both the profitability of each of the hotels as well as the overall profitability of the Initial Portfolio. Fairmont and Delta also provide central reservations, sales and marketing, central procurement, accounting, management information, employee training and other services for which they are reimbursed on a cost recovery basis in accordance with the management agreements. This is consistent with hotel industry practice. 24 Legacy Hotels REIT 2006 Annual ReportSTRATEGIC ALLIANCE AGREEMENT Legacy has entered into a Strategic Alliance Agreement with FHR to co-operate in certain areas related to the purchase and sale of hotels, the development of new hotels that may be considered for investment by the Trust and other areas related to the ownership and management of hotels. This agreement gives Legacy the first opportunity to acquire any hotel or resort property that FHR owns or has the opportunity to acquire. Most of the provisions of the Strategic Alliance Agreement will terminate upon the termination of the Advisory Agreement. OWNERSHIP Legacy is the largest owner of Fairmont and Delta properties. As at December 31, 2006 Legacy owned 13 of 51 Fairmont managed properties and 12 of 40 Delta managed properties. In turn, FHR is Legacy’s largest unit holder with an approximate 22.4% (2005 – 23.7%) interest in the Trust. BOARD REPRESENTATION Based on its hotel management contracts and ownership position in Legacy, as at December 31, 2006, FHR has the ability to appoint three Trustees to Legacy’s Board. This representation, as outlined in the Declaration of Trust, is based on the following criteria: • One appointee so long as FHR manages at least 2,800 rooms on behalf of Legacy, • One additional appointee based on an ownership level in Legacy of 10% or more, and, • One additional appointee based on an ownership level in Legacy of 20% or more. RISK MANAGEMENT Legacy is subject to the normal operating risks consistent with hotel ownership. The following is a discussion of key risks and uncertainties facing the Trust on a day-to-day basis, and the strategies adopted to mitigate these risks. However, it should not be assumed that this discussion is exhaustive or that the strategies adopted to mitigate these risks will be effective. MARKET FLUCTUATIONS The Trust’s properties are subject to the normal operating risks common to the hotel industry, including cyclicality. Mitigating this risk, Legacy has a collection of centrally located, unique hotels, managed by recognized hotel brands. These attributes attract customers and help ensure long-term demand for the Trust’s hotels. Legacy further mitigates risks by having a geographically diversified portfolio of assets, thereby limiting the Trust’s reliance on any specific market. In addition, the portfolio benefits from a diverse customer mix, which limits its reliance on any one individual travel segment. In addition, the Trust has a line of credit to ensure that the fluctuations in cash flow will not affect its ability to operate in the normal course of business. NEW SUPPLY An increase in competitive hotel supply that outpaces the growth in demand could impact occupancies in any specific market, and at Legacy’s assets specifically. This risk is partially mitigated by having a geographically diversified portfolio of assets, many of which are in markets with significant barriers to entry given limited development opportunities. The Trust maintains an active capital investment program in order to maintain, and enhance, its assets’ competitive position against new supply and competitive upgrades. INTEREST RATES Approximately 85% of Legacy’s debt has a fixed interest rate. Legacy’s Declaration of Trust limits its exposure to floating rate debt to no more than 25% of its gross asset value. A 100 basis point change in interest rates would result in an increase or decrease in annual interest expense and cash flow of approximately $1.0. Management’s Discussion and Analysis 25FOREIGN EXCHANGE Currency risk arises as a normal part of business given the Trust’s ownership of assets in the U.S. In 2006, the U.S. assets contributed approximately 12% of Legacy’s revenues. All operating costs at these hotels are denominated in U.S. dollars. In addition, the mortgages on each of these assets are denominated in U.S. dollars thereby mitigating some of the impact of foreign exchange movements on net cash flow. A 1% change in the Canadian foreign exchange rate would result in an increase or decrease in annual net cash flow of approximately $0.2. LABOUR Legacy’s hotels rely heavily on employees and their ability to provide high-quality personal service to guests. The Trust is party to a number of collective agreements, representing 15 of its 25 hotels. Union and collective agreement relationships are a key priority for Legacy. In 2006, the Trust successfully settled four labour contracts and is currently in negotiations with three hotels. In addition, primary labour contracts in Winnipeg, Victoria and Ottawa expire in 2007. The potential financial impact of a labour disruption is dependent on a number of factors including the asset involved, the duration of the labour disruption and its timing. Although it is not possible to predict the outcome of negotiations, management is optimistic that satisfactory settlements with its unions can be reached. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Legacy’s significant accounting policies are found in note 2 of the Consolidated Financial Statements. The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and contingencies. Management bases its estimates on historical experience and on other assumptions that are believed to be reasonable under the circumstances. Under different assumptions or conditions, the actual results may differ, potentially materially, from those previously estimated. Many of the conditions impacting these assumptions and estimates are outside of Legacy’s control. These estimates and assumptions are evaluated on a periodic basis. Management believes the following critical accounting policies involve the more significant judgments and estimates used in the preparation of Legacy’s Consolidated Financial Statements. PROPERTY AND EQUIPMENT Due to the relatively large proportion of property and equipment relative to total assets, the selection of the amortization method and length of the amortization period, could have a material impact on Legacy’s net income. Property and equipment is amortized on a straight-line basis over its estimated economic life, except for buildings on leased land, which are amortized over the lesser of the term of the lease, including renewal options and the economic life of the building. If the estimated economic lives of all property and equipment were to be decreased by one year, amortization expense recorded in 2006 would have increased by $3.9. Such a change in estimate would have very little impact on Legacy’s financial condition since key financial stakeholders such as lenders do not typically rely on the historical cost of property and equipment. VALUATION OF LONG-LIVED ASSETS The carrying value of each long-lived asset is evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Long-lived assets are reviewed at the individual hotel level, the lowest level for which identifiable cash flows are largely independent, when testing for and measuring impairment. Impairment losses are recognized when the carrying amount of long-lived assets exceeds the sum of the undiscounted cash flows expected to result from their use and eventual disposition and are measured as the amount by which the long-lived asset’s carrying amount exceeds its fair value. Management believes that asset impairment would be highly unlikely due to the expected performance of the properties. 26 Legacy Hotels REIT 2006 Annual ReportGOODWILL A goodwill impairment test is performed on an annual basis, and in certain circumstances, between annual tests. These tests are based on a fair market value analysis of the reporting unit, which uses such methods as discounted cash flow projections and peer comparisons of earnings multipliers. Based on Legacy’s current operations and goodwill levels, management believes that it is highly unlikely that any goodwill impairment charge will be required. Unanticipated changes in industry and market conditions, however, may require Legacy to consider restructuring, disposing or otherwise exiting certain operations, which could result in an impairment of goodwill. INCOME TAXES Pursuant to its Declaration of Trust, all of the taxable income earned directly by Legacy in the year is distributable to unit holders and such distributions are deducted for income tax purposes. Legacy’s corporate subsidiaries use the liability method when accounting for income taxes. Under this method, future tax assets and liabilities are recognized based on differences between the bases of assets and liabilities used for financial statement and income tax purposes, using substantively enacted tax rates. Legacy’s subsidiaries have $53.4 of non-capital tax loss carry forwards. Management has assumed that the subsidiaries will be able to use virtually all of their non-capital loss carry forwards prior to their expiration and has therefore recorded a future tax asset for most loss carry forward balances. In the event that future earnings do not meet management’s projections, it may be necessary to write down the amount of benefits recorded. New income trust legislation was proposed by the Canadian Finance Minister on October 31, 2006. Indications are that certain real estate investment trusts will be excluded from this proposed legislation. It is prudent to assume that Legacy’s taxable status would change if the proposed tax changes are enacted and are applicable to Legacy. If applicable to Legacy, once the tax rules are substantively enacted, this would result in Legacy recording future income tax liabilities in respect of temporary differences that are expected to reverse after 2010. CHANGES IN ACCOUNTING POLICIES Legacy adopted several new standards issued by the Canadian Institute of Chartered Accountants (“CICA”) which impacted 2006 financial results. These changes to the accounting policies are found in note 2 of the audited financial statements. NON-MONETARY TRANSACTIONS In June 2005, the CICA issued Section 3831, “Non-Monetary Transactions,” which introduces new requirements for non-monetary transactions initiated on or after January 1, 2006. The amended requirements will result in nonmoneetar transactions being measured at fair values unless certain criteria are met, in which case, the transaction is measured at carrying value. Adoption of the new standard did not have an impact on Legacy’s financial position, results of operations or cash flow. DILUTED EARNINGS PER UNIT In September 2005, the CICA issued Emerging Issues Committee Abstract 155 (“EIC-155”), “The Effect of Contingently Convertible Instruments on the Computation of Diluted Earnings per Share,” which requires the application of the “if-converted method” to account for the potential dilution relating to the conversion of contingently convertible instruments, such as Legacy’s convertible debentures. In the fourth quarter of 2005, EIC-155 was applied retroactively, with restatement of prior periods diluted earnings per unit. Adoption of this standard did not have an impact on Legacy’s financial position, results of operations or cash flow because the effect was anti-dilutive. Management’s Discussion and Analysis 27PENDING ACCOUNTING CHANGES The following are upcoming accounting changes to Canadian GAAP that will have an impact on Legacy’s financial statement presentation. Details on these and any other recent accounting changes can be found on the web site of the Accounting Standards Board of Canada at www.acsbcanada.org. FINANCIAL INSTRUMENTS In January 2005, the CICA issued Section 3855 “Financial Instruments — Recognition and Measurement”, Section 3865 “Hedges”, and Section 1530 “Comprehensive Income”. Legacy is required to apply these new standards for its fiscal year ending December 31, 2007. Section 3855 prescribes when a financial asset, financial liability or non-financial derivative is to be recognized on the balance sheet and the measurement of such amount. It also specifies how financial instrument gains and losses are to be presented. Section 3865 is applicable for designated hedging relationships and builds on existing Canadian standards by specifying how hedge accounting is applied and what disclosures are necessary when it is applied. Section 1530 introduces new standards for the presentation and disclosure of components of comprehensive income. Comprehensive income is defined as the change in net assets of an enterprise during a reporting period from transactions and other events and circumstances from non-owner sources. It includes all changes in net assets during a period except those resulting from investments by owners and distributions to owners. When Legacy adopts the new requirements on January 1, 2007, a new section of unit holders’ equity called Accumulated Other Comprehensive Income will be presented. Adoption of these standards as at January 1, 2007 will result in the reclassification of $46.6 from the Cumulative Foreign Currency Translation Adjustments to a reduction of Accumulated Other Comprehensive Income on the Consolidated Statements of Unit holders’ Equity. In addition, deferred financing costs currently shown as Other assets on the Consolidated Balance Sheets will be netted against Long-term debt. These presentation changes will have no impact on Legacy’s cash flow, distributable income or net income per unit. NON-GAAP FINANCIAL MEASURES Included in this MD&A are certain non-GAAP financial measures, which are measures of Legacy’s historical or future financial performance that are not calculated and presented in accordance with GAAP. These non-GAAP financial measures are unlikely to be comparable to similar measures presented by other entities. They are as follows: (i) comparable hotel statistics, (ii) hotel EBITDA, (iii) distributable income, and (iv) FFO. The following discussion defines these terms and presents why management believes they are useful supplemental measures of Legacy’s performance. COMPARABLE HOTEL OPERATING STATISTICS Comparable hotels are considered to be properties owned by Legacy for at least the entire current and prior periods. Management considers RevPAR, ADR and Occupancy to be meaningful indicators of hotel performance. RevPAR measures room revenues for comparable properties and is a commonly used measure within the hotel industry to evaluate hotel performance. RevPAR is defined as the product of the ADR charged and the average daily occupancy achieved. For the periods presented, comparable hotel operating statistics exclude results from the Delta Bow Valley hotel since it was not part of the portfolio for the entire current and prior periods. 28 Legacy Hotels REIT 2006 Annual ReportHOTEL EBITDA Hotel EBITDA is defined as income before interest, taxes, amortization, trust expenses and non-controlling interest. Hotel EBITDA is a commonly used measure of performance by lodging real estate owners, which, when considered with GAAP measures, gives management a more complete understanding of the Trust’s ability to service debt, fund capital expenditures and pay cash distributions. It also facilitates comparisons between Legacy and its competitors. Management believes that hotel EBITDA is one of Legacy’s key performance indicators since it helps management, lenders and investors evaluate the ongoing hotel profitability. Management considers hotel EBITDA to be a meaningful indicator of hotel performance. The following reconciles hotel EBITDA to net income (loss): 2006 2005 Hotel EBITDA $ 180.2 $ 151.6 Deduct (add): Amortization of property and equipment 77.0 75.3 Trust expenses 17.4 14.5 Interest expense, net 82.8 82.6 Income tax recovery, net (2.5) (3.2) Net income (loss) before non-controlling interest $ 5.5 $ (17.6) Non-controlling interest (0.9) (2.5) Net income (loss) $ 6.4 $ (15.1) DISTRIBUTABLE INCOME Reported distributable income is calculated as net income (loss) before amortization, income taxes and special charges less the capital replacement reserve. Amortization of property and equipment is replaced with the capital replacement reserve, which is established by the Trust. The prior period cash receipt from FHR relating to management contracts for the two U.S. hotels is taxable and is therefore included in the calculation of distributable income. For accounting purposes, this amount is deferred and amortized as a reduction in hotel management fee expense over the life of the respective management contracts, which are estimated at 50 years. Distributable income under the Declaration of Trust, as distinct from reported distributable income, may reflect additional provisions, reserves and adjustments determined by the Trustees in their discretion. For 2006, Legacy earned $44.5 ($0.42 per unit) of reported distributable income, paid distributions to unit holders, including dividends on exchangeable shares, of $33.1 ($0.32 per unit) and retained a reserve of $11.4 ($0.10 per unit) for general Trust purposes. In 2005, Legacy earned $26.6 ($0.26 per unit) of reported distributable income and paid distributions of $32.0 ($0.32 per unit). Distributions paid in excess of distributable income in 2005 were financed through cash on hand. Distributable income per unit is based on the average number of units and exchangeable shares outstanding on each distribution record date during the period. This provides a better reflection of the income distributable to unit holders at each distribution date than the weighted-average method. Management’s Discussion and Analysis 29Distributable income and distributable income per unit have been calculated as follows: (in millions, except per unit amounts) 2006 2005 Net income (loss) $ 6.4 $ (15.1) Add (deduct): Non-controlling interest (0.9) (2.5) Amortization of property and equipment 77.0 75.3 Income tax expense (recovery), net (2.5) (3.2) Cash receipt on management contract, net (0.4) 3.8 Accretion of convertible debenture issuance cost 1.3 1.4 Capital replacement reserve (36.4) (33.1) Distributable income $ 44.5 $ 26.6 Average units outstanding on distribution record dates (millions) 98.2 89.4 Average exchangeable shares outstanding on distribution record dates (millions) 7.4 14.7 Basic and diluted units outstanding 105.6 104.1 Diluted distributable income per unit $ 0.42 $ 0.26 Distributions declared per unit $ 0.32 $ 0.32 For the years ended December 31, 2006 and 2005, debentures convertible into 11.2 million (2005 –17.1 million) units and the associated distributable income impact were excluded from the computation of diluted distributable income per unit because their effect was anti-dilutive. During 2006, $51.3 principal amount of convertible debentures were converted to 5.9 million units of the Trust. Following the end of the year, an additional $12.9 principal amount were converted to 1.4 million units of the Trust. The impact of these additional conversions will be included in the calculation of distributable income per unit in future periods. The following table reconciles cash flows from operating activities to distributable income in accordance with Canadian Securities Administrators Staff Notice 52-306 (Revised) Non-GAAP Financial Measures. Management considers distributable cash to be equivalent to distributable income. The reconciliation consists primarily of the capital replacement reserve and items which do not involve cash flow. Distributable income in excess of distributions paid in 2006 was reserved by the Board of Trustees for general Trust purposes. Distributions paid in excess of distributable income in 2005 were financed through cash on hand. 2006 2005 Cash flow from operations $ 91.8 $ 68.5 Add (deduct): Changes in non-cash working capital (2.8) (7.7) Amortization of deferred financing costs (5.2) (4.9) Cash receipt on management contract, net (0.4) 3.8 Other (2.5) – Capital replacement reserve (36.4) (33.1) Distributable income $ 44.5 $ 26.6 Distributions declared $ 33.1 $ 32.0 30 Legacy Hotels REIT 2006 Annual ReportFUNDS FROM OPERATIONS The Real Property Association of Canada (“REALpac”), defines FFO as net income, excluding gains (or losses) from sales of depreciable real estate and extraordinary items, plus depreciation and amortization, future income taxes and after adjustments for equity accounted for entities and non-controlling interests. Legacy presents FFO per unit calculated as FFO divided by the weighted-average number of fully diluted units and exchangeable shares outstanding during the period. Legacy believes that FFO per diluted unit is a useful supplemental measure of the Trust’s operating performance and that the presentation of FFO per diluted unit, when combined with the primary GAAP presentation of net income per unit, provides beneficial information to investors. By excluding the effect of real estate amortization and gains and losses from sales of real estate, all of which are based on historical cost accounting and which may be of limited significance in evaluating current performance, management believes that such a measure can facilitate comparisons of operating performance between periods and with other REITs. Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. As noted by REALpac in its November 2004 “White Paper on Funds From Operations”, since real estate values have historically risen or fallen with market conditions, many industry investors have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. For these reasons, REALpac adopted the definition of FFO in order to promote an industry-wide measure of REIT operating performance. FFO is not intended to be used as a measure of the cash generated by Legacy, nor its distribution paying capacity. FFO and FFO per unit have been calculated as follows: (in millions, except per unit amounts) 2006 2005 Net income (loss) $ 6.4 $ (15.1) Add (deduct): Non-controlling interest (0.9) (2.5) Amortization of property and equipment 77.0 75.3 Future income tax recovery (2.5) (3.2) FFO $ 80.0 $ 54.5 Diluted units outstanding (millions) 105.0 104.1 Diluted FFO per unit $ 0.76 $ 0.52 DISCLOSURE CONTROLS AND PROCEDURES The Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the Trust’s disclosure controls and procedures as at the financial year ended December 31, 2006. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective as at December 31, 2006 to provide reasonable assurance that material information relating to the Trust, including its consolidated subsidiaries, would be made known to them by others within those entities. INTERNAL CONTROL OVER FINANCIAL REPORTING There have been no changes in the Trust’s internal control over financial reporting that occurred during the most recent interim period ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, the Trust’s internal control over financial reporting. Management’s Discussion and Analysis 31MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING The information in this Annual Report is the responsibility of management. The Consolidated Financial Statements have been prepared by management in accordance with Canadian generally accepted accounting principles and include certain amounts based on management’s best estimates and careful judgement. Management maintains a system of internal controls to provide reasonable assurance that relevant and reliable financial information is produced, and that assets are safeguarded and transactions are authorized, recorded and reported properly. To augment the internal control system, Legacy maintains a program of internal audits covering significant aspects of the operations and the internal audit department reports its findings and recommendations to management and the Audit Committee of the Board of Trustees. The Board of Trustees carries out its responsibility for the Consolidated Financial Statements and the Annual Report principally through its Audit Committee, consisting of three members, all of whom are Independent Trustees. The Committee reviews the Consolidated Financial Statements and the Annual Report with management and the independent auditors prior to submission to the Board for approval. It also reviews the recommendations of both the independent and internal audits for improvements to internal controls as well as the actions of management to implement such recommendations. Neil J. Labatte Robert M. Putman President and Chief Executive Officer Vice President and Chief Financial Officer Toronto, Ontario February 22, 2007 AUDITORS’ REPORT We have audited the consolidated balance sheets of Legacy Hotels Real Estate Investment Trust as at December 31, 2006 and 2005 and the consolidated statements of operations, unit holders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Trust’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of Legacy Hotels Real Estate Investment Trust as at December 31, 2006 and 2005 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. PricewaterhouseCoopers LLP Chartered Accountants Toronto, Ontario February 22, 2007 32 Legacy Hotels REIT 2006 Annual ReportCONSOLIDATED BALANCE SHEETS As at December 31, 2006 and 2005 (in millions of Canadian dollars) 2006 2005 ASSETS Current assets Cash and cash equivalents $ 12.3 $ 18.6 Restricted cash (note 4) 7.5 5.2 Accounts receivable (note 17) 55.6 43.9 Inventory 5.7 5.5 Prepaid expenses 4.9 4.5 86.0 77.7 Property and equipment (note 5) 1,734.9 1,726.0 Other assets (notes 6 and 18) 13.3 18.2 Future income taxes (note 9) 13.6 13.2 Goodwill 35.4 35.4 $ 1,883.2 $ 1,870.5 LIABILITIES Current liabilities Accounts payable and accrued liabilities (note 17) $ 94.7 $ 78.2 Current portion of long-term debt (note 7) 109.4 16.3 Convertible debentures (note 8) 98.6 – 302.7 94.5 Long-term debt (note 7) 784.7 854.6 Convertible debentures (note 8) – 149.7 Other liabilities (notes 17 and 18) 30.8 29.4 Future income taxes (note 9) 31.4 33.3 1,149.6 1,161.5 Non-controlling interest (note 10) 33.2 103.5 Unit holders’ equity (note 11) 700.4 605.5 $ 1,883.2 $ 1,870.5 Commitments and contingencies (note 20) Approved by the Board of Trustees Neil J. Labatte Richard M. Kelleher Trustee Trustee The accompanying notes are an integral part of these consolidated financial statements. Consolidated Financial Statements 33CONSOLIDATED STATEMENTS OF OPERATIONS For the years ended December 31, 2006 and 2005 (in millions of Canadian dollars, except per unit amounts) 2006 2005 Revenues Room $ 490.0 $ 462.4 Food and beverage 280.8 266.4 Other 45.9 43.7 816.7 772.5 Operating expenses 550.9 535.3 Gross operating profit 265.8 237.2 Hotel management fees (notes 16 and 17) 25.2 24.1 Property taxes, rent and insurance 60.4 61.5 Operating income from hotel operations before undernoted items 180.2 151.6 Other expenses Amortization of property and equipment 77.0 75.3 Trust expenses (note 17) 17.4 14.5 94.4 89.8 Income before interest expense and income tax recovery and non-controlling interest 85.8 61.8 Interest expense, net (note 13) 82.8 82.6 Income (loss) before income tax recovery and non-controlling interest 3.0 (20.8) Income tax recovery (note 9) Current – – Future (2.5) (3.2) (2.5) (3.2) Income (loss) before non-controlling interest 5.5 (17.6) Non-controlling interest (0.9) (2.5) Net income (loss) for the year $ 6.4 $ (15.1) Basic net income (loss) per unit (note 14) $ 0.07 $ (0.17) Diluted net income (loss) per unit (note 14) $ 0.05 $ (0.18) The accompanying notes are an integral part of these consolidated financial statements. 34 Legacy Hotels REIT 2006 Annual ReportCONSOLIDATED STATEMENTS OF UNIT HOLDERS’ EQUITY For the years ended December 31, 2006 and 2005 (in millions of Canadian dollars, except otherwise noted) Unit holder Cumulative Conversion Foreign Number of Cumulative Rights on Currency Units Cumulative Net Income Cumulative Contributed Convertible Translation (millions) Capital (Loss) Distributions Surplus Debentures Adjustments Total Unit holders’ equity December 31, 2004 89.4 $ 795.7 $ 213.0 $ (314.9) $ 0.3 $ 1.5 $ (40.9) $ 654.7 Net loss for the year (15.1) (15.1) Distributions paid (28.6) (28.6) Change in accounting policy for unit-based compensation 0.1 0.1 Change in foreign currency translation adjustments (5.6) (5.6) Unit holders’ equity December 31, 2005 89.4 $ 795.8 $ 197.9 $ (343.5) $ 0.3 $ 1.5 $ (46.5) $ 605.5 Net income for the year 6.4 6.4 Distributions paid (31.4) (31.4) Unit options exercised (note 12) 0.2 1.7 1.7 Conversion of convertible debentures (note 8) 5.9 51.8 (0.5) 51.3 Conversion of exchangeable shares (note 10) 9.8 67.0 67.0 Change in foreign currency translation adjustments (0.1) (0.1) Unit holders’ equity December 31, 2006 105.3 $ 916.3 $ 204.3 $ (374.9) $ 0.3 $ 1.0 $ (46.6) $ 700.4 The accompanying notes are an integral part of these consolidated financial statements. Consolidated Financial Statements 35CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2006 and 2005 (in millions of Canadian dollars) 2006 2005 CASH PROVIDED BY (USED IN) Operating activities Net income (loss) for the year $ 6.4 $ (15.1) Items not affecting cash Amortization of property and equipment 77.0 75.3 Amortization of convertible debenture issuance costs and accretion to the face amount of the principal 1.3 1.4 Non-controlling interest (0.9) (2.5) Future income taxes (2.5) (3.2) Other 7.7 4.9 Changes in non-cash working capital (note 15) 2.8 7.7 91.8 68.5 Investing activities Acquisition (note 3) (12.3) – Additions to property and equipment (34.0) (30.2) Proceeds from sale of property and equipment 0.1 – Increase in restricted cash (2.3) (3.0) Increase in other assets (1.8) (4.6) (50.3) (37.8) Financing activities Distributions paid (31.4) (28.6) Dividends on exchangeable shares (1.7) (3.4) Net proceeds from equity units 1.7 0.1 Mortgage principal payments (16.4) (15.0) Other (0.1) (0.1) (47.9) (47.0) Translation adjustments affecting cash and cash equivalents 0.1 (0.3) Decrease in cash and cash equivalents during the year (6.3) (16.6) Cash and cash equivalents — beginning of year 18.6 35.2 Cash and cash equivalents — end of year $ 12.3 $ 18.6 Supplemental disclosure Income taxes paid $ 0.8 $ 1.6 Interest paid $ 76.5 $ 75.7 The accompanying notes are an integral part of these consolidated financial statements. 36 Legacy Hotels REIT 2006 Annual ReportNOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 (in millions of Canadian dollars, except per unit amounts) 1. BASIS OF PRESENTATION Legacy Hotels Real Estate Investment Trust (“Legacy” or the “Trust”) is an unincorporated closed-end real estate investment trust created by a declaration of trust dated as of September 11, 1997, as amended on June 20, 2005 (the “Declaration of Trust”). Legacy commenced its operations on November 10, 1997 upon the completion of its initial public offering and a simultaneous issuance of debt. Upon the completion of these offerings, Legacy acquired interests in 11 first-class and luxury full-service business hotels (the “Initial Hotel Portfolio”) from a subsidiary of Fairmont Hotels & Resorts Inc. (“FHR”). Legacy has since acquired interests in 14 additional hotel properties. The hotel portfolio as at December 31, 2006 consists of 25 hotels, of which 23 are located in 13 Canadian cities throughout nine provinces. The remaining two hotels are located in Washington, D.C. and Seattle, Washington. The properties are owned by Legacy except for Delta Calgary Airport, Delta Halifax, Delta Barrington, Delta Beauséjour, Delta Ottawa Hotel and Suites and The Fairmont Olympic Hotel, Seattle, in which Legacy holds longteer leasehold interests. The operations of Legacy, including its strategy, investments and management, are subject to the general direction and control of its trustees (the “Trustees”). In accordance with the Declaration of Trust, and subject to certain exceptions, a majority of the Trustees must be independent of Legacy and FHR or any of their affiliates. All of Legacy’s properties are managed by subsidiaries of FHR under management agreements. In addition, FHR provides operational and administrative services to Legacy under an advisory agreement. All transactions under such agreements between Legacy and FHR are described in note 16. As at December 31, 2006, FHR owns an approximate 22.4 % (2005 – 23.7%) interest in Legacy. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) and reflect the following policies: PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the results of operations of Legacy and its subsidiaries, all of which are wholly-owned. FOREIGN CURRENCY TRANSLATION Foreign currency assets and liabilities of Legacy’s operations are translated at the rate of exchange in effect at the balance sheet dates for monetary items and at the historical exchange rates for non-monetary items. Foreign currency revenues and expenses are translated at the exchange rate in effect on the dates of the related transactions. Gains and losses resulting from the translation of assets and liabilities denominated in foreign currencies are included in income. The accounts of self-sustaining subsidiaries, where the functional currency is other than the Canadian dollar, are translated using the year-end exchange rate for assets and liabilities and the average exchange rates in effect for the year for revenues and expenses. Exchange gains or losses arising from translation of such accounts are deferred and included under unit holders’ equity as foreign currency translation adjustments. FINANCIAL INSTRUMENTS Legacy may use derivative products from time to time to hedge its exposure to interest rate movements on underlying debt. Legacy designates its interest rate instruments as hedges of the interest expense on the underlying debt. Interest expense on the underlying debt is adjusted to include the payments made or received under the interest rate instruments. Notes to Consolidated Financial Statements 37USE OF ESTIMATES The preparation of consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and revenues and expenses for the reporting period. Estimates are based on historical experience and on other assumptions that are believed at the time to be reasonable under the circumstances. The actual results may differ from those previously estimated. Estimates are used when accounting for items and matters such as amortization, goodwill and long-lived asset impairment assessment, future income taxes, employee future benefits and contingencies. CASH AND CASH EQUIVALENTS Cash equivalents consist of short-term investments that are highly liquid and have initial terms to maturity of three months or less. INVENTORY Inventory, comprised of operating supplies including food and beverage, is valued at the lower of cost, determined on a first-in, first-out basis, and replacement cost. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Legacy’s policy is to capitalize major renewals and replacements and interest incurred during the renovation period of major renovations to existing facilities. Interest is capitalized based on the borrowing rate of debt for the project or if no specific financing is obtained, Legacy’s average cost of borrowing. Maintenance, repairs and minor renewals and replacements are charged against income when incurred. Amortization is provided on a straight-line basis at rates designed to write off the assets over their estimated economic lives, except for buildings on leased land, which are amortized over the lesser of the term of the lease, including reasonably assured renewal options, and the economic life of the building. The annual rates of amortization are as follows: Buildings 40 years Furniture, fixtures and equipment 5 –17 years Leasehold interests over the term of the leases (including reasonably assured renewal options) Legacy’s long-lived assets, consisting of property and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. Long-lived assets are reviewed at the individual hotel level, the lowest level for which identifiable cash flows are largely independent, when testing for and measuring impairment. A two-step process is used to assess the impairment of long-lived assets held for use, with the first step determining when impairment is recognized and the second step measuring the amount of the impairment. Impairment losses are recognized when the carrying amount of long-lived assets exceeds the sum of the undiscounted cash flows expected to result from their use and eventual disposition and are measured as the amount by which the long-lived asset’s carrying amount exceeds its fair value. DEBT DISCOUNT AND OTHER ISSUANCE EXPENSES Debt discount and other issuance expenses are capitalized. These are included in other assets and amortized to interest expense over the terms of the related debt. GOODWILL Goodwill represents the excess of purchase price over the fair value of net identifiable assets acquired in a business combination accounted for under the purchase method. 38 Legacy Hotels REIT 2006 Annual ReportGoodwill is subject to impairment tests on at least an annual basis and, additionally, whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit. The fair value of the reporting unit is estimated using a combination of the income or discounted cash flows approach and the market approach, which utilizes comparable companies’ data. If the carrying amount of the reporting unit exceeds its fair value, then a second step is performed to measure the amount of impairment loss, if any. Any impairment loss, measured as the amount by which the carrying amount of the reporting unit’s goodwill exceeds its fair value, would be recognized as a charge for impairment in the consolidated statements of operations. REVENUE RECOGNITION Revenues are generated primarily from room occupancy and food and beverage services. Other revenues include revenues from parking facilities, laundry services and retail stores rental. Revenues are recognized when services are provided and ultimate collection is reasonably assured. UNIT-BASED COMPENSATION Legacy records compensation expense for all unit options granted to employees using the fair value method. Under this method, compensation expense for unit options is measured at fair value at the grant date using an option pricing method and is recognized over the vesting period. Any cash paid by the employees on the exercise of unit options is credited to unit holders’ equity. INCOME TAXES Legacy is taxed as a mutual fund trust for income tax purposes. Pursuant to the Declaration of Trust, all of the taxable income earned directly by Legacy in the year is distributable to unit holders and such distributions are deducted for income tax purposes. Consequently, no provision for income taxes under the liability method of accounting for income taxes is required for Legacy. Legacy’s subsidiaries are corporations subject to income taxes. These subsidiaries also use the liability method to account for income taxes, under which future income tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities, and are measured using the substantively enacted income tax rates and laws that are expected to be in effect in the years in which the future income tax assets or liabilities are expected to be settled or realized. The effect of changes in income tax rates on future income tax assets and liabilities is recognized in the period in which the change occurs. Valuation allowances are recorded unless it is more likely than not that a future income tax asset will be realized. New income trust legislation was proposed by the Canadian Finance Minister on October 31, 2006. Indications are that certain real estate investment trusts will be excluded from this proposed legislation. It is prudent to assume that Legacy’s taxable status would change if the proposed tax changes are enacted and are applicable to Legacy. If applicable to Legacy, once the tax rules are substantively enacted, this would result in Legacy recording future income tax liabilities in respect of temporary differences that are expected to reverse after 2010. NET INCOME OR LOSS PER UNIT Basic net income or loss per unit is calculated by dividing net income (loss) attributable to unit holders by the weighted average number of units outstanding during the year. The calculation of diluted earnings (loss) per unit includes the effect of Legacy’s exchangeable shares which are classified as non-controlling interest. The dilutive effect on net income (loss) per unit resulting from the options outstanding is calculated using the treasury stock method and the “if-converted” method is used to account for potential dilution related to Legacy’s exchangeable shares and the convertible debentures if applicable. COMPARATIVE FIGURES Certain of the prior year’s figures have been reclassified to conform with the presentation adopted in 2006. Notes to Consolidated Financial Statements 39CHANGES IN ACCOUNTING POLICIES Diluted Earnings Per Unit In September 2005, The Canadian Institute of Chartered Accounts (CICA) issued Emerging Issues Committee Abstract 155 (“EIC-155”), “The Effect of Contingently Convertible Instruments on the Computation of Diluted Earnings per Share”, which requires the application of the “if-converted” method to account for the potential dilution relating to the conversion of contingently convertible instruments, such as Legacy’s convertible debentures. In the fourth quarter of 2005, EIC-155 was applied retroactively, with restatement of prior period diluted earnings per unit. Although this standard requires potential conversion of the convertible debentures to be reflected in diluted earnings per unit, the effect was anti-dilutive in 2006 and 2005. Non-monetary Transactions In June 2005, the CICA issued Section 3831, “Non-Monetary Transactions”, which introduces new requirements for non-monetary transactions initiated on or after January 1, 2006. The amended requirements will result in nonmoneetar transactions being measured at fair values unless certain criteria are met, in which case, the transaction is measured at carrying value. Adoption of the new standard did not have an impact on Legacy’s financial position, results of operations or cash flow. Liabilities and Equity Effective January 1, 2005, Legacy adopted the CICA’s new accounting requirements on the classification of financial instruments as liabilities or equity. The CICA amended its disclosure requirements surrounding the presentation of financial instruments that may be settled in cash or by an issuer’s own equity instruments, at the issuer’s discretion, as liabilities. As a result of these new guidelines, convertible debentures presented as equity on Legacy’s consolidated balance sheets prior to 2005 were reclassified as debt. Correspondingly, interest paid on the convertible debentures and the amortization of convertible debenture issuance costs and accretion of unit holder conversion rights are presented as interest expense on Legacy’s consolidated statements of operations, as opposed to their previous presentation on the consolidated statements of deficit. Although the convertible debentures can no longer be classified as equity in their entirety, the principal amount has been allocated between debt and equity elements and classified separately in the consolidated balance sheets. The debt element was calculated at the time of issuance by discounting the stream of future payments at the prevailing market rate at the time for a similar liability that did not have an associated conversion feature. As disclosed in note 8, $148.5 was recorded as long-term debt with the balance of $1.5 recorded as unit holder conversion rights on convertible debentures within unit holders’ equity. The amount recorded as long-term debt is being accreted to the face value of the debt over the five-year term following the issuance. Variable Interest Entities Effective January 1, 2005, Legacy adopted CICA Accounting Guideline No. 15 (“AcG-15”), “Consolidation of Variable Interest Entities” (“VIEs”). AcG-15 provides criteria for the identification of VIEs and further criteria for determining what entity, if any, should consolidate them. AcG-15 defines a VIE as an entity that either does not have sufficient equity at risk to finance its activities without subordinated financial support or where the equity investors lack the characteristics of a controlling financial interest. VIEs are subject to consolidation by an entity if that entity is deemed the primary beneficiary of the VIE. The primary beneficiary is the party that is either exposed to a majority of the expected losses from the VIE’s activities or is entitled to receive a majority of the VIE’s residual returns or both. Adoption of the new standard did not have an impact on Legacy’s financial position, results of operations or cash flow. 40 Legacy Hotels REIT 2006 Annual Report3. ACQUISITION Legacy acquired the Delta Bow Valley hotel, effective September 1, 2006, for a purchase price of $54.2, including closing expenses and the assumption of $1.2 in working capital deficit. Closing costs included an acquisition fee payable of $0.3 to a wholly owned subsidiary of FHR. The purchase was partially satisfied by the assumption of an existing mortgage and a new financing totalling $40.7, with the balance settled in cash. The purchase price of this acquisition has been allocated to the identifiable assets acquired and liabilities assumed on the basis of their respective estimated fair value on the acquisition date as follows: Land $ 8.3 Building 43.4 Furniture, fixture and equipment 2.5 Inventory 0.1 Working capital deficit (1.2) Long-term debt (40.7) Other liabilities (0.1) Cash consideration $ 12.3 The purchase price was finalized in the fourth quarter of 2006. 4. RESTRICTED CASH 2006 2005 Cash balance $ 7.5 $ 5.2 Restricted cash represents capital expenditure reserves pursuant to certain mortgage agreements. 5. PROPERTY AND EQUIPMENT 2006 2005 Accumulated Accumulated Cost amortization Net Cost amortization Net Land $ 187.4 $ – $ 187.4 $ 179.4 $ – $ 179.4 Buildings 1,617.5 (194.5) 1,423.0 1,561.4 (151.1) 1,410.3 Furniture, fixtures and equipment 297.7 (188.0) 109.7 276.5 (156.2) 120.3 Leasehold interests 25.7 (10.9) 14.8 25.4 (9.4) 16.0 $ 2,128.3 $ (393.4) $ 1,734.9 $ 2,042.7 $ (316.7) $ 1,726.0 6. OTHER ASSETS 2006 2005 Deferred financing costs $ 10.1 $ 16.1 Other 3.2 2.1 $ 13.3 $ 18.2 Deferred financing costs consist primarily of debt issuance costs. Notes to Consolidated Financial Statements 417. LONG-TERM DEBT 2006 2005 Mortgages payable, secured by the assets of certain hotel properties, with a weighted average rate of 7.4% and 7.3% as at December 31, 2006 and 2005, respectively, maturing between February 2007 and April 2014. $ 883.7 $ 870.9 Unsecured loan at a rate of 5.5% maturing January 2011 10.4 – 894.1 870.9 Less: Current portion of long-term debt 109.4 16.3 $ 784.7 $ 854.6 Long-term debt is repayable over the next five years and thereafter as follows: 2007 $ 109.4 2008 86.0 2009 178.4 2010 64.0 2011 329.6 Thereafter 126.7 $ 894.1 Included in long-term debt as at December 31, 2006 is an amount of $123.2 (US$ 106.2) denominated in U.S. dollars (2005 – $127.1; US$ 108.7). Subsequent to December 31, 2006, Legacy completed the refinancing of $91.0 in long-term debt which matured on February 1, 2007. This debt was replaced with a new $115.0, floating rate mortgage maturing July, 2010. BANK LOANS Legacy has a secured, revolving credit facility totalling $140.0 (2005 – $110.0) designed to provide financing for operations, acquisitions and other capital investments. The credit facility, maturing December 2007, is secured by nine of Legacy’s properties. Legacy’s ability to utilize the full amount may be impacted by the cash flows generated by these secured properties. As at December 31, 2006 and 2005, no amount was drawn on this facility. Letters of credit amounting to $8.1 (2005 – $6.5) were outstanding as at December 31, 2006 against this facility. 8. CONVERTIBLE DEBENTURES In 2002, Legacy issued $150 in principal amount of 7.75%, unsecured, subordinated, convertible debentures maturing on April 1, 2007 (the “Convertible Debentures”). The Convertible Debentures may be converted into Legacy units at the option of the holder on or before March 15, 2007 at a conversion price of $8.75 per Legacy unit, subject to certain adjustments in accordance with the terms of the Trust Indenture governing the terms of the Convertible Debentures. The Convertible Debentures may be redeemed by Legacy after April 1, 2004, in whole at any time or in part from time to time, on at least 30 days’ notice at a redemption price equal to par plus accrued and unpaid interest, provided that the current market price is at least 115% of the then current conversion price. The term “current market price” is defined to mean the weighted-average trading price of Legacy units on the Toronto Stock Exchange for the 20 consecutive trading days ending five trading days preceding the date of the applicable event. Legacy may elect to pay interest and principal upon maturity or redemption by issuing units to a trustee in the case of interest payments and to the Convertible Debentures holders in the case of payment of principal. The number of units to be issued upon redemption will be determined by dividing the principal amount of the Convertible Debentures by 95% of the current market price of the units on the date fixed for redemption or the maturity date. As described in Note 2, $148.5 was recorded as long-term debt and $1.5 was recorded as unit holder conversion rights within unit holders’ equity as at the date of issuance. 42 Legacy Hotels REIT 2006 Annual ReportDuring the year ended December 31, 2006, $51.3 (2005 – $ nil) of the 7.75% convertible debentures were converted into 5.9 million (2005 – nil) Legacy units at the convertible debenture holders’ option. Following the end of the year, $12.9 principal amount of the convertible debentures was converted into 1.4 million Legacy units. 9. INCOME TAXES Pursuant to its Declaration of Trust, all of the taxable income earned directly by Legacy in the year is distributable to unit holders and such distributions are deducted for income tax purposes. Consequently, no provision for income taxes under the liability method of accounting for income taxes is required for Legacy. Legacy’s corporate subsidiaries were subject to tax on taxable income in 2006 at an average income tax rate of approximately 31% (2005 – 35%). To the extent that any Part VI.1 taxes are paid, a deduction in determining taxable income equal to three times of the Part VI.1 taxes is available. Legacy’s effective income tax expense (recovery) and the provision (recovery) reconciled to the Canadian statutory tax rate is as follows: 2006 2005 Provision (recovery) at Canadian statutory rate $ 1.0 $ (7.3) Foreign tax rate differentials 0.2 – Reduction in tax rates (1.0) – Part VI.1 tax credit (0.7) (1.4) Tax effect of income (loss) attributable to unit holders (2.3) 4.7 Other 0.3 0.8 Income tax recovery $ (2.5) $ (3.2) The future income tax assets and future income tax liabilities recognized on the consolidated balance sheets are comprised of the following: 2006 2005 Future income tax assets Non-capital loss carry-forwards of wholly-owned U.S. subsidiaries expiring up to 2026 $ 12.2 $ 11.1 Temporary differences on deferred revenues of wholly-owned U.S. subsidiaries 7.6 7.8 Temporary differences on property and equipment of wholly-owned U.S. subsidiaries (6.4) (6.4) Other 0.2 0.7 $ 13.6 $ 13.2 Future income tax liabilities1 Non-capital loss carry-forwards of wholly-owned Canadian subsidiaries expiring up to 2026 $ 5.0 $ 4.9 Temporary differences on property and equipment of wholly-owned Canadian subsidiaries (36.6) (37.6) Other 0.2 (0.6) $ (31.4) $ (33.3) 1 Under Canadian tax laws, Legacy is precluded from directly carrying on a hotel business. Hotel operations for the Trust’s directly held properties are therefore carried on by Canadian corporate subsidiaries. There are temporary differences consisting of the tax basis of depreciated assets in excess of accounting values. A related potential benefit of $21.7 (2005 – $18.9) has not been recognized. As at December 31, 2006, Legacy’s corporate subsidiaries had the following non-capital loss carry-forwards available to reduce future taxable income of the wholly-owned subsidiaries: Total Future income losses tax assets Non-capital losses Canada $ 16.3 $ 5.0 United States 37.1 12.2 $ 53.4 $ 17.2 Notes to Consolidated Financial Statements 43The subsidiaries have non-capital losses expiring in the following years: 2007 $ – 2008 5.6 2009 4.9 2010 0.1 2011 1.7 Thereafter 41.1 $ 53.4 10. NON-CONTROLLING INTEREST Exchangeable shares issued by a subsidiary are entitled to a per share dividend equal to Legacy’s ordinary unit distribution, less Part VI.1 taxes payable by the subsidiary as a result of paying these dividends. After a minimum holding period of five years, ended January 31, 2006, each exchangeable share is redeemable by the holder at the fair market value of a Legacy unit. The redemption shall be satisfied by the delivery of one unit for each share exchanged. The exchangeable shares are tied to voting certificates issued by Legacy that are entitled to one vote per voting certificate at meetings of unit holders. On June 30, 2006 the holder of the exchangeable shares exercised its right to convert 9.8 million of the 14.7 million exchangeable shares originally issued and took delivery of 9.8 million Legacy units pursuant to the terms of the agreement. This transaction resulted in an increase of cumulative capital and a reduction of noncontrrollin interest of $67.0. As at December 31, 2006, there were 4.9 million exchangeable shares outstanding (2005 –14.7 million). The holder has agreed not to exchange the remaining exchangeable shares unless the combined debt service coverage on certain of Legacy’s assets is greater than an agreed level which currently has not been met. 11. UNIT HOLDERS’ EQUITY Each unit represents a unit holder’s proportionate undivided beneficial interest in Legacy and confers the right to one vote at any meeting of unit holders and to participate pro rata in any distributions by Legacy and, in the event of termination of Legacy, in the net assets of Legacy remaining after satisfaction of all liabilities. As at December 31, 2006 there were 105.3 million units outstanding (2005 – 89.4 million). During 2006, 9.8 million units were issued pursuant to the conversion described in note 10 and 5.9 million units were issued pursuant to the conversion described in note 8. In addition, 0.2 million units (2005 – nil) were issued under the exercise of unit options for cash proceeds of $1.7 (2005 – nil). Legacy has a distribution reinvestment plan (“DRIP”), which permits participants to acquire additional units of Legacy by reinvesting cash distributions on units they hold. Legacy has the option of satisfying the DRIP by issuing units from treasury or buying such units in the market. For 2006 and 2005, Legacy elected to buy such units in the market. 44 Legacy Hotels REIT 2006 Annual Report12. UNIT OPTION PLAN Under Legacy’s unit option plan, options may be granted to certain key employees, trustees and employees and directors of its affiliates to purchase units of Legacy at a price not less than the market value of the units at the grant date. As at December 31, 2006, pursuant to the plan, there were 4,282,224 (2005 – 4,612,224) options to acquire units outstanding. These options expire ten years after the grant date, from November 2007 to February 2014. Options vest at the rate of 50% after two years from the grant date and the balance one year thereafter. The maximum number of units reserved for issuance under the plan is 5,629,449. During 2006 and 2005, no options were granted. Unit-based compensation expense under Legacy’s unit option plan for these two years is nominal. 2006 2005 Weighted-Weighted-Number of units average Number of units average (thousands) exercise price (thousands) exercise price Outstanding — beginning of year 4,612 $ 9.31 4,687 $ 9.30 Granted – – – – Exercised (240) 7.01 (15) 6.75 Cancelled (90) 8.98 (60) 8.79 Outstanding — end of year 4,282 $ 9.45 4,612 $ 9.31 Exercisable — end of year 4,267 $ 9.46 4,588 $ 9.32 Information relating to unit options outstanding as at December 31, 2006 is as follows: Options outstanding Options exercisable Weighted Number of average Weighted Number of Weighted unit options remaining average unit options average Range of outstanding contractual exercise exercisable exercise exercise prices (thousands) life (years) price (thousands) price $5.65 – $6.75 155 1.6 $ 6.25 155 $ 6.25 $7.18 – $8.90 690 3.3 8.40 675 8.43 $9.80 – $9.95 3,437 0.8 9.80 3,437 9.80 4,282 1.3 $ 9.45 4,267 $ 9.46 13. INTEREST EXPENSE, NET 2006 2005 Mortgage interest $ 64.0 $ 63.4 Convertible debentures interest 10.6 11.6 Bank loans interest and other 1.5 1.8 Amortization of debt discount and issuance expenses 6.8 6.3 82.9 83.1 Less Interest capitalized – 0.1 Interest income 0.1 0.4 0.1 0.5 $ 82.8 $ 82.6 Notes to Consolidated Financial Statements 4514. NET INCOME (LOSS) PER UNIT Basic net income (loss) per unit is based on the net income (loss) attributable to unit holders divided by the weighted average number of units outstanding during the year. Diluted net income (loss) per unit is computed as follows: 2006 2005 Net income (loss) attributable to unit holders $ 6.4 $ (15.1) Non-controlling interests (0.9) (2.5) Part VI.1 deduction credit adjustment for non-controlling interest (0.7) (1.4) Diluted net income (loss) attributable to unit holders $ 4.8 $ (19.0) Weighted average number of units outstanding (in millions) 95.1 89.4 Weighted average number of exchangeable shares outstanding (in millions) 9.8 14.7 Dilutive effect of unit options (in millions) 0.1 – Diluted weighted average number of units (in millions) 105.0 104.1 Basic net income (loss) per unit $ 0.07 $ (0.17) Diluted net income (loss) per unit $ 0.05 $ (0.18) For the years ended December 31, 2006 and 2005, debentures convertible into 11.2 million and 17.1 million units respectively and the associated net income (loss) impact, were excluded from the computation of diluted net income (loss) per unit because their effect was anti-dilutive. 15. CHANGES IN NON-CASH WORKING CAPITAL 2006 2005 Decrease (increase) in accounts receivable $ (11.5) $ (3.7) Decrease (increase) in inventory (0.3) 1.2 Decrease (increase) in prepaid expenses (0.2) 1.1 Increase (decrease) in accounts payable and accrued liabilities 14.8 9.1 $ 2.8 $ 7.7 16. AGREEMENTS MANAGEMENT AGREEMENTS Legacy entered into long-term management agreements in November 1997 with Canadian Pacific Hotels Management Corporation (“CPHMC”), a subsidiary of FHR, to manage the Initial Hotel Portfolio, with an initial term of 50 years and renewal periods of 25 years, exercisable at the option of CPHMC. Delta Hotels Limited (“Delta”), a subsidiary of FHR, provides management services for four of the hotels in the Initial Hotel Portfolio and eight other Delta branded hotels under separate management agreements. Fairmont Hotels Inc. (“Fairmont”), a subsidiary of FHR, provides management services for the remaining seven hotels in the Initial Hotel Portfolio and five other Legacy properties under separate management agreements. In addition, Fairmont provides management services to CPHMC for the Sheraton Suites Calgary Eau Claire. Pursuant to these management agreements, CPHMC, Fairmont and Delta are entitled to a base management fee and an incentive management fee. The base management fee ranges from 2% to 3% of total hotel revenues. For the hotels included in the Initial Hotel Portfolio, the incentive fee is based on both the profitability of each of the hotels and the overall profitability of the Initial Hotel Portfolio. The incentive fee is calculated based on net operating income from hotel operations plus amortization less the capital replacement reserve, in excess of a threshold amount. In the event that the overall profitability of the Initial Hotel Portfolio does not exceed that target, the aggregate incentive fee determined on the profitability of each hotel that would otherwise be payable may be deferred. Such deferred incentive fee may become payable in a future year. For the 14 hotels not included in the Initial Hotel Portfolio, the incentive fee is based on the profitability of each hotel and is calculated on a basis similar to the incentive fee calculation for the Initial Hotel Portfolio. 46 Legacy Hotels REIT 2006 Annual ReportADVISORY AGREEMENT Legacy entered into an Advisory Agreement in November 1997, as amended in December 2000, with CPHMC to provide operational and administrative services to Legacy and to advise the Trustees regarding major decisions. The initial term was extended to February 2009 and will be automatically renewed for additional terms of five years each, subject to the consent of CPHMC and the majority of the independent trustees. This agreement was assigned by CPHMC to Fairmont in 1999. Legacy may terminate the Advisory Agreement for cause (events of default or material breach) at any time. Legacy may also terminate the Advisory Agreement other than for cause at any time upon the approval of twothiird of the votes cast by the independent trustees and the approval of two-thirds of the votes cast by the unit holders and upon 12 months’ notice. Fairmont may terminate the Advisory Agreement at any time upon not less than 120 days notice. Fairmont is entitled to the following fees under the Advisory Agreement: • an advisory fee equal to 0.40% of the asset base as defined; • an acquisition fee of 0.65% of the total acquisition price of any additional property acquired by Legacy other than purchased from a related party; and • a disposition fee of 0.25% of the aggregate sale price of any property sold by Legacy, other than to a related party. STRATEGIC ALLIANCE AGREEMENT Legacy and FHR entered into a Strategic Alliance Agreement in 1997, as amended in December 2000, to coopeerat in certain areas related to the purchase and sale of hotels, the development of new hotels that may be considered for investment by Legacy and other areas related to the ownership and management of hotels. Most of the provisions of the Strategic Alliance Agreement will terminate upon the termination of the Advisory Agreement. 17. RELATED PARTY TRANSACTIONS Fees charged to Legacy by CPHMC, Fairmont and Delta during the year were as follows: 2006 2005 Management fees $ 25.2 $ 24.1 Advisory fees, classified within trust expenses 7.0 7.3 Acquisition fee 0.3 – $ 32.5 $ 31.4 Included in accounts receivable as at December 31, 2006 was $1.9 (2005 – $ nil) owing by Fairmont, that was offset against management fees otherwise payable. Late in 2004, Legacy internalized certain management functions which were provided by Fairmont pursuant to the Advisory Agreement. In 2006, Fairmont agreed to offset $1.9 (2005– $1.5) of the management costs paid directly by Legacy against the advisory fees otherwise payable. In addition, CPHMC, Fairmont and Delta provide central reservations, sales and marketing, central purchasing, accounting, management information, employee training and other services for which they are reimbursed on a cost recovery basis in accordance with management agreements. In 2006, the total amount charged to Legacy by CPHMC, Fairmont and Delta was $29.4 (2005 – $28.0). Included in accounts payable and accrued liabilities as at December 31, 2006 is $7.1 (2005 – $4.0) owing to Fairmont and Delta. Included in other long-term liabilities as at December 31, 2006 is $3.0 (2005 – $2.8) owing to Fairmont and Delta for deferred incentive fees not yet due since certain targets as described in note 16 were not met. Notes to Consolidated Financial Statements 47In connection with the acquisition of The Fairmont Washington, D.C. and The Fairmont Olympic Hotel, Seattle, Washington, Legacy and FHR entered into reciprocal loan agreements in the aggregate amount of US$86.6. These loans mature in October 2008 and October 2013 and bear interest at normal commercial rates payable quarterly in arrears. In the event that either Legacy or FHR does not make its required interest or principal payments, the other party is not required to make its payment either. If such payment has already been made, it must be returned. These loans meet all the requirements for a right of setoff and, as such, are presented on a net basis in the financial statements. Prior to 2006, Legacy received payments from FHR totaling US$18.0 with respect to entering into long-term, incentive-based management agreements for its two U.S. hotels, The Fairmont Olympic Hotel and The Fairmont Washington, D.C. This amount was deferred and is being amortized into income as a reduction of management fees expense over the 50-year term of the agreements, which includes the renewal terms. As at December 31, 2006, the unamortized balance included in other liabilities is $19.3 (2005 – $19.9). All related party transactions were recorded at the exchange amount, which is the amount of consideration established and agreed to by the related parties. Related party transactions for employee future benefits are disclosed in note 18. 18. EMPLOYEE FUTURE BENEFITS On January 1, 2005, Legacy assumed sponsorship and administration of a defined benefit pension plan and a supplemental defined benefit pension plan from FHR. An actuarial valuation of the plans was prepared as at December 31, 2004 following which plan assets and obligations were transferred by FHR to the plans. The defined benefit pension plan is a funded plan whereas the supplemental pension plan is not funded. Legacy also provides other post-retirement benefits, primarily life insurance and health care coverage. Pension benefits are based principally on years of service and compensation rates near retirement. A portion of the benefits provided by the defined benefit pension plan is indexed at 50% of annual inflation after retirement. The costs of these defined benefit pension plans and other post-retirement benefits plans are actuarially determined using the projected benefit method pro-rated on service and management’s best estimate of expected plan investment performance, salary escalation, retirement ages of employees and expected health care costs. Market values are used for calculating the expected return on plan assets. The projected benefit obligation is discounted using a market interest rate at the end of the year on high-quality corporate debt instruments. For the defined benefit pension plan and the supplemental pension plan, transitional assets/obligations and past service costs due to changes in plan provisions are amortized on a straight-line basis over the expected average remaining service life of employees covered by the plan. The portion of net actuarial gains and losses in excess of 10% of the greater of the plan obligation and the fair value of the plan assets is amortized on a straight-line basis over the expected average remaining service life of the employees covered by the plan. Legacy uses a measurement date of December 31 for all its pension and other post-retirement benefits. The next required funding valuation of the defined benefit pension plan and the supplemental pension plan will be completed no later than December 31, 2007. 48 Legacy Hotels REIT 2006 Annual ReportBENEFIT OBLIGATIONS 2006 2005 Defined Supple-Other post-Defined Supple-Other post-Benefit mental retirement Benefit mental retirement Pension Pension benefits Pension Pension benefits Benefit obligation — beginning of year $ 2.6 $ 4.7 $ 6.1 $ – $ 3.1 $ 5.1 Transfer from FHR – – – 2.4 0.8 – Service cost 0.1 0.3 0.1 0.1 0.3 0.1 Interest cost 0.1 0.2 0.3 0.2 0.2 0.3 Plan participants’ contributions 0.1 – – – – – Actuarial loss (gain) – (0.2) (0.1) (0.1) 0.3 0.9 Benefits paid – – – – �