<PAGE> 1
Information contained herein is subject to completion or amendment. A
registration statement relating to these securities has been filed with the
Securities and Exchange Commission. This prospectus supplement shall not
constitute an offer to sell or the solicitation of an offer to buy nor shall
there be any sale of these securities in any State in which such offer,
solicitation or sale would be unlawful prior to registration or qualification
under the securities laws of any such State.
This filing is made pursuant
to Rule 424(a) under
the Securities Act of
1933 in connection with
Registration No. 333-34377
PROSPECTUS SUPPLEMENT SUBJECT TO COMPLETION DATED JULY 29, 1998
- --------------------------------------------------------------------------------
(TO PROSPECTUS DATED JULY 29, 1998)
LOGO
2,000,000 SHARES OF ENHANCED PERPETUAL INCOME PREFERRED SECURITIES(SM)
The Enhanced Perpetual Income Preferred Securities(SM) offered hereby (the
"EPIPS"(SM)) are shares of a new series of preferred stock of Sunstone Hotel
Investors, Inc. ("Sunstone" or the "Company"). The Company is a leading
self-administered real estate investment trust ("REIT") whose portfolio consists
of 56 luxury, upscale and mid-price hotels located primarily in the Pacific and
Mountain regions of the United States with a total of 10,051 rooms. The hotels
operate under nationally recognized franchises, including brands affiliated with
Hilton Hotels Corporation(R), Holiday Hospitality Corporation(R), Marriott
International, Inc.(R) and Promus Hotel Corporation(R).
The EPIPS shares carry a liquidation preference of $25 per share (the
"Liquidation Preference"), plus accrued and unpaid dividends. Dividends on the
EPIPS shares will be cumulative from the date of original issuance and will be
payable quarterly in arrears on or about the fifteenth day of February, May,
August and November of each year, commencing on November 15, 1998 (the "Initial
Distribution Date"). Dividends will be payable in an amount per EPIPS share
equal to the greater of (i) $ per quarter (or $ per annum, equal to a rate
of % of the Liquidation Preference per annum) or (ii) the cash dividend
(exclusive of non-regular dividends) paid or payable on the number of Common
Shares (as defined below) into which an EPIPS share is then convertible
(determined on each of the quarterly dividend payment dates referred to above).
The initial dividend for the period in which the EPIPS shares are originally
issued will be prorated based on the number of days between the original
issuance thereof and the Initial Distribution Date.
The EPIPS shares are convertible, in whole or in part, at the option of the
holder, into shares of the Company's only class of common stock, par value $0.01
per share (the "Common Shares"), at a conversion price of $ per Common Share
(equivalent to a conversion rate of Common Shares for each EPIPS share),
subject to adjustment in certain events (the "Conversion Price"), at any time
following the initial issuance thereof, unless previously redeemed. It is
expected that the Conversion Price of the EPIPS shares will represent a 25%
premium to the most recent closing price of the Company's Common Shares on the
New York Stock Exchange (the "NYSE") at the time the EPIPS shares are priced.
The EPIPS shares are not redeemable prior to August , 2003, except in
certain limited circumstances relating to preserving the Company's status as a
REIT for federal income tax purposes. On and after August , 2003, the EPIPS
shares may be redeemed at the option of the Company in whole or in part (i) for
a number of Common Shares per EPIPS share equal to the Liquidation Preference
divided by the Conversion Price (i.e., the number of Common Shares into which
one EPIPS share would then be convertible at the holder's option) plus a cash
payment equal to all accrued and unpaid dividends through the date fixed for
redemption; provided that for 20 trading days within any period of 30
consecutive trading days, including the trading day immediately preceding the
announcement of such redemption, the closing price of the Common Shares on the
NYSE equals or exceeds the Conversion Price then in effect or (ii) for cash at a
redemption price of $25 per EPIPS share, plus accrued and unpaid dividends, if
any, thereon through the date of redemption. The EPIPS shares have no stated
maturity and will not be subject to any sinking fund or mandatory redemption
provisions.
On July 28, 1998, the last reported sale price of the Common Shares on the
NYSE was $12.3125 per share. The most recent quarterly dividend declared on the
Common Shares was $0.275 per share (equivalent to an annual dividend of $1.10
per share). The Company's Common Shares are listed on the NYSE under the symbol
"SSI." Application will be made to list the EPIPS shares on the NYSE. Trading of
the EPIPS shares on the NYSE is expected to commence within 30 days after the
initial issuance of the EPIPS shares under the symbol "SSI Pr." See
"Underwriting."
In order to maintain its qualification as a REIT for federal income tax
purposes, the Company's Amended Articles of Incorporation, as amended (the
"Charter") impose limitations on the number of shares of capital stock,
including EPIPS shares, that may be owned by any single person or affiliated
group. See "Certain Provisions of Maryland Law and of the Company's Articles of
Incorporation and Bylaws" in the accompanying Prospectus.
------------------------------
SEE "RISK FACTORS" BEGINNING ON PAGE S-12 OF THIS PROSPECTUS SUPPLEMENT AND
PAGE 5 OF THE ACCOMPANYING PROSPECTUS FOR A DISCUSSION OF CERTAIN FACTORS THAT
SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE EPIPS SHARES OFFERED
HEREBY.
------------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
<TABLE>
<S> <C> <C> <C>
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
PRICE TO PUBLIC UNDERWRITING DISCOUNTS(1) PROCEEDS TO COMPANY(2)
- ---------------------------------------------------------------------------------------------------------------------------------
Per Share $ $ $
- ---------------------------------------------------------------------------------------------------------------------------------
Total(3) $ $ $
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) The Company has agreed to indemnify the several Underwriters against certain
liabilities, including certain liabilities under the Securities Act of 1933,
as amended. See "Underwriting."
(2) Before deducting expenses payable by the Company estimated at $ .
(3) The Company has granted the Underwriters an option to purchase up to 300,000
additional EPIPS shares to cover over-allotments, if any. See
"Underwriting." If such option is exercised in full, the total Price to
Public, Underwriting Discounts and Proceeds to Company will be $ ,
$ and $ , respectively.
------------------------
The EPIPS shares offered hereby are offered by the Underwriters subject to
prior sale, when, as and if delivered to and accepted by them and subject to
approval of certain legal matters by counsel for the Underwriters. The
Underwriters reserve the right to withdraw, cancel or modify such offer and to
reject orders in whole or in part. It is expected that delivery of the EPIPS
shares will be made in New York, New York on or about August , 1998.
Joint Book-Running Managers
EVEREN SECURITIES, INC. BEAR, STEARNS & CO. INC.
------------------------
A.G. EDWARDS & SONS, INC.
RAYMOND JAMES & ASSOCIATES, INC.
SUTRO & CO.
INCORPORATED
The date of this Prospectus Supplement is August , 1998.
<PAGE> 2
AVAILABLE INFORMATION
The Company is subject to the information requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance
therewith files reports, proxy statements and other information with the
Securities and Exchange Commission (the "Commission"). Such reports, proxy
statements and other information filed by the Company can be inspected and
copied at the public reference facilities maintained by the Commission at Room
1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, and at
regional offices of the Commission located at 7 World Trade Center, 13th Floor,
New York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite
1400, Chicago, Illinois 60661-2511. Copies of such material can be obtained by
mail from the Public Reference Section of the Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549 at prescribed rates. The Commission also maintains
a web site that contains reports, proxy and information statements and other
information regarding registrants that file electronically with the Commission,
such as the Company, and the address is http://www.sec.gov. The Company's Common
Stock is listed on the NYSE, and reports, proxy statements and other information
concerning the Company can be inspected at the offices of the New York Stock
Exchange, Inc., 20 Broad Street, New York, New York 10005.
The Company has filed with the Commission a Registration Statement on Form
S-3 under the Securities Act of 1933, as amended (the "Securities Act"), and the
rules and regulations promulgated thereunder, with respect to the EPIPS shares
being sold in this Offering. This Prospectus Supplement, which is part of the
Registration Statement, does not contain all of the information set forth in the
Registration Statement and the exhibits. For further information concerning the
Company and the EPIPS shares offered hereby, reference is made to the
Registration Statement and the exhibits and schedules filed therewith, which may
be obtained as described above.
Certain information in this Prospectus Supplement has been obtained from
data published by Smith Travel Research, an industry research organization.
Smith Travel Research has not provided any form of consultation, advice or
counsel regarding this Offering and is not associated with the Company. As used
herein, the terms "luxury," "upscale" and "mid-price," respectively, mean the
segments of the lodging industry classified as such by Smith Travel Research in
its industry reports that consist of hotels with average daily room ("ADR")
rates (total revenues divided by the total number of rooms occupied) between the
85th and 100th percentile, 70th and 85th percentile and the 40th and 70th
percentile, respectively, of the average daily room rates of all hotels in the
markets in which the Company's hotels operate.
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE EPIPS SHARES AND
THE COMMON SHARES. SUCH TRANSACTIONS MAY INCLUDE THE PURCHASE OF EPIPS SHARES OR
COMMON SHARES FOR THE PURPOSE OF MAINTAINING OR STABILIZING THE PRICE OF THE
EPIPS SHARES, THE PURCHASE OF PREFERRED STOCK TO COVER SYNDICATE SHORT POSITIONS
AND THE IMPOSITION OF PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE
"UNDERWRITING."
S-1
<PAGE> 3
PROSPECTUS SUPPLEMENT SUMMARY
The following summary is qualified in its entirety by the more detailed
information and financial statements and the notes thereto appearing elsewhere
herein or incorporated by reference in the accompanying Prospectus to which this
Prospectus Supplement relates. Unless the context otherwise indicates, all
references herein to the "Company" include Sunstone and Sunstone Hotel
Investors, L.P. (the "Partnership" or "Sunstone LP") and their respective
subsidiaries. Except as otherwise noted, all of the information in this
Prospectus Supplement assumes no exercise of the Underwriters' over-allotment
option. Unless otherwise indicated, information presented is as of June 30, 1998
and hotel, room and operating data assumes that (i) the pending acquisition of a
mid-price hotel in California (the "Pending Acquisition") has been completed and
(ii) the disposition of six hotels consisting of five mid-price hotels located
in Idaho, Montana and Texas and one upscale hotel located in West Virginia
(collectively, the "Disposition Hotels") have been completed. This Prospectus
Supplement may contain forward-looking statements within the meaning of Section
27A of the Securities Act and Section 21E of the Exchange Act. The Company's
actual results could differ materially from those set forth in any such
forward-looking statements. Certain factors that might cause such a difference
are discussed in the section entitled "Risk Factors" commencing on page S-12 of
this Prospectus Supplement and page 5 of the accompanying Prospectus. The
Company cautions the reader, however, that the factors discussed in those
sections may not be exhaustive.
THE COMPANY
The Company is a leading self-administered equity REIT that owns a 94.6%
partnership interest in Sunstone LP, whose portfolio consists of eight luxury,
21 upscale and 27 mid-price hotels located primarily in the Pacific and Mountain
regions of the western United States. The Company's hotels operate primarily
under national franchises that are widely recognized in the lodging industry,
including brands affiliated with Hilton Hotels Corporation, Holiday Hospitality
Corporation, Marriott International, Inc. and Promus Hotel Corporation. The
Company's portfolio consists of 56 hotels, 55 of which were acquired and one of
which was developed, located in California (25 hotels), Utah (8), Colorado (6),
Arizona (5), Washington (5), Minnesota (4), Oregon (2) and New Mexico (1), with
a total of 10,051 rooms. For the year ended December 31, 1997, on a pro forma
basis after giving effect to the actual and pending acquisition or disposition
of hotels acquired or disposed of subsequent to January 1, 1997 as if such
acquisitions and dispositions had occurred on January 1, 1997, the Company's
revenue and EBITDA (as defined herein) would have been $94.4 million and $81.4
million, respectively.
The Company has historically focused, and plans to continue to focus its
acquisition strategy primarily in the western United States, where approximately
86.8% of the rooms in the Company's hotel portfolio are located. The Company
believes that favorable supply and demand fundamentals in the western United
States will continue to result in increased revenue per available room
("REVPAR"), specifically in the Pacific region of the United States, where
approximately 50.3% of the rooms in the Company's hotel portfolio are located.
In the Pacific region, the increase in lodging demand exceeded the increase in
supply by 0.6%, and REVPAR increased 8.2%, as compared to 5.3% for the industry
as a whole during 1997.
To enable Sunstone to satisfy certain federal income tax requirements for
qualification as a REIT, neither Sunstone nor Sunstone LP can operate the hotels
in which they invest. Accordingly, Sunstone LP leases the hotels to Sunstone
Hotel Properties, Inc. (the "Lessee") pursuant to the Percentage Leases (as
defined herein).
COMPANY STRENGTHS
Strong Acquisition History. Since December 31, 1995, the Company has
completed 24 acquisitions comprising a total of 44 hotels with 8,470 rooms, or
approximately 84.3% of its total room portfolio, for total consideration of
$662.8 million (including the acquisition of nine hotels for approximately
$121.9 million since January 1, 1998). The Company believes that it is
well-positioned to acquire hotel properties due to its ability to quickly
identify attractive acquisition opportunities, a successful history of
completing acquisitions, and its strong financial position.
S-2
<PAGE> 4
Diversified Hotel Portfolio. The Company's hotel portfolio has broad
geographic, brand and market segment diversification. The Company's 56 hotels
are located in eight states principally throughout the Pacific and Mountain
regions of the western United States. In addition, the Company's hotels are
affiliated with 10 different franchisors and serve three different price
segments, including luxury (25% of total rooms), upscale (39%) and mid-price
(36%) properties. The Company believes that its diversified hotel portfolio
allows it to access a wide distribution of lodging demand and enables it to
benefit from a continuous stream of hotel investment opportunities, a trend
toward industry consolidation and strong regional economic conditions.
Demonstrated History of Renovating and Repositioning Hotels. The Company
has demonstrated an ability to improve the cash flows of underperforming hotels
by renovating and repositioning hotels to improve both occupancy and room rates
by upgrading the quality of rooms and hotel facilities, and when appropriate,
rebranding hotels under national franchises. Since January 1996, the Company has
invested $74.2 million to renovate, redevelop and reposition 29 hotels. All of
the Company's luxury and upscale hotels and 23 of the Company's 27 mid-price
hotels were renovated within the last three years or are currently being
renovated.
Strong Financial Position. The Company has a strong financial position,
including for the year ended December 31, 1997 a pro forma Funds From Operations
("FFO") to preferred dividends coverage ratio of 9.2x and a pro forma EBITDA to
interest expense and preferred dividends coverage ratio of 3.5x.
Solid Relationships with Premier Brands. The Company's hotels are
franchised under some of the leading brand names in the lodging industry,
including Marriott, Hilton, Holiday Inn and Sheraton. Additionally, Marriott
International, Inc., approved the Company in 1997 as a qualified full-service
franchisee and entered into a preferred business relationship with the Company.
Upon completion of the conversion of three of its currently unbranded hotels and
one announced acquisition, approximately 30.4% of the Company's hotel portfolio,
or 17 hotels, will operate under a Marriott franchise agreement.
Experienced Management Team. The Company's senior management team has
extensive experience in the hospitality industry. Robert A. Alter, a co-founder
of the Company, is President, Chief Executive Officer and Chairman of the Board,
and has been actively involved in the Company since its inception and has been
active in hotel ownership and management since 1976. Charles L. Biederman, a
co-founder of the Company, has been engaged in the real estate development
business since 1962 and is Executive Vice President of the Company. Randy Hulce,
President and Chief Executive Officer of the Lessee since 1997, has been active
in sales, operations and asset management within the hotel industry for over 15
years.
BUSINESS STRATEGY
The Company seeks to grow revenues and maximize operating profits by
pursuing the following strategic initiatives, either directly or through the
Lessee:
Acquire Underperforming Properties. The Company intends to continue to
acquire underperforming luxury, upscale and mid-price hotels located principally
in the western United States that are, or can be, renovated or redeveloped and
repositioned by branding or rebranding the hotels with nationally recognized
franchises, with an increasing emphasis on multiple-property acquisitions. The
Company may make other selective acquisitions in markets outside of the western
United States from time to time should the appropriate opportunities arise. The
Lessee's experience in successfully operating hotels has given it significant
knowledge of a variety of markets and the ability to quickly identify strategic
acquisition opportunities. The Company believes that its increasing profile in
the hotel industry and its successful record of completing acquisitions will
enable it to continue to attract sellers of hotel portfolios.
Renovate, Redevelop or Rebrand Acquired Hotels. The Company's principal
internal growth strategy is to redevelop or extensively renovate its acquired
hotels and brand them with a national franchise that the Company believes will
generate higher REVPAR than that currently being generated. In addition to this
redevelopment strategy, the Company periodically renovates its hotels, not only
to satisfy requirements of its franchisors, but also in an effort to maintain or
increase its market share.
S-3
<PAGE> 5
Selectively Develop Additional Hotels. The Company may also selectively
develop new luxury, upscale and mid-price hotels which will operate under
national franchises in markets where room demand and other competitive factors
justify new construction. The Company is in the planning or construction phases
of developing five hotels, two of which are expected to open in 1998.
Implement Comprehensive Marketing and Management Strategies. The Lessee
implements a full complement of management and marketing programs at each
acquired hotel designed to maximize sales and operational efficiency. Each
hotel's sales personnel maintains active communications with its local and
regional demand generators and proactively plays a positive role in its
community to stimulate and sustain a local source of stable lodging demand. By
creating a highly visible and attractive property exterior and participating in
frequent user programs, promotional activities and reservation systems, the
Lessee is able to attract additional guests. The Company believes that the
implementation of focused sales and marketing programs alone -- before any
improvements to the physical condition of the hotel are made by the
Company -- have increased same-unit REVPAR growth.
Capitalize on Economies of Scale. As its operations have grown over the
past two years, the Lessee has enjoyed increasing economies of scale through the
implementation of standardized operations, yield management, purchasing,
training and property improvement programs. The Lessee's implementation of these
practices ensures consistency across its hotel portfolio and, on the whole, has
resulted in operational savings, increased efficiencies and improved
profitability within its hotel portfolio. The Company believes that additional
economies of scale will result as it continues to acquire additional properties
and portfolios of hotels.
Maintain Conservative Capital Structure. The Company intends to maintain a
conservative capital structure to enhance its access to the capital markets on
favorable terms that promote earnings growth. The Company's Charter limits the
Company's indebtedness to not more than 50% of the Company's investment in hotel
properties, at cost, after giving effect to the Company's use of proceeds from
any indebtedness. Additionally, the Company intends to finance the acquisition
of additional hotels, hotel renovations and non-recurring capital improvement
projects through (i) its $350 million revolving line of credit (the "Credit
Facility") and (ii) when market conditions warrant, the issuance of additional
debt and equity securities. While continuing to exceed dividend payment levels
required to maintain its REIT status, the Company intends to reduce over time
its payout ratio (i.e. the percentage of FFO it pays out in dividends to common
shareholders), enabling the Company to retain a larger portion of its earnings
for reinvestment purposes.
Dispose of Non-core Assets. The Company intends to dispose of hotels from
time to time to redeploy its capital to acquire hotels that fit more
strategically with its growth strategy. In particular, the Company currently
intends to sell certain of its non-core assets, primarily limited-service hotels
where competitive factors warrant, and to redeploy the proceeds therefrom to
acquire hotels which provide a fuller range of services and which service
markets with greater barriers to entry. Consistent with this strategy, the
Company has entered into agreements to sell the Disposition Hotels.
S-4
<PAGE> 6
HOTEL PORTFOLIO
THE HOTELS
The Company was organized as a REIT in August 1995 and, at such time,
acquired ten hotels. Subsequent to its formation, the Company completed the
acquisition of interests in 45 hotels and the development of one additional
hotel. The following tables provide certain information regarding these hotels:
<TABLE>
<CAPTION>
NUMBER OF AGGREGATE
NUMBER OF SUITES/ ACQUISITION
ACQUISITIONS(1) HOTELS ROOMS PRICE
--------------- --------- ---------- --------------
(IN MILLIONS)
<S> <C> <C> <C>
August 16, 1995 through December 31, 1995................ 12 1,581 $ 65.0
Year Ended December 31, 1996............................. 12 1,872 82.5
Year Ended December 31, 1997(2).......................... 23 5,279 458.4
Period Ended January 1, 1998 through July 31, 1998....... 9 1,319 121.9
-- ------ ------
Totals......................................... 56 10,051 $727.8
== ====== ======
</TABLE>
- ---------------
(1) Excludes the Disposition Hotels and includes the Pending Acquisition, and
includes two hotels on which the Company holds a participating mortgage
structured similar to the Percentage Leases. Upon sale of the Disposition
Hotels, the Company expects to acquire fee title to the hotels subject to
such participating mortgages.
(2) Includes 39 rooms constructed by the Company at its hotels for $2.2 million.
The Company's hotels represent the following franchise affiliations:
<TABLE>
<CAPTION>
NUMBER OF
NUMBER OF SUITES/ PERCENTAGE OF
FRANCHISE AFFILIATION (1) HOTELS ROOMS ROOMS
------------------------- --------- ---------- --------------
<S> <C> <C> <C>
Marriott(2).............................................. 17 2,975 29.6%
Holiday Inn(3)........................................... 16 2,534 25.2
Hampton Inn.............................................. 9 1,193 11.9
Independent(4)........................................... 3 1,133 11.3
Hilton................................................... 3 732 7.3
Hawthorn Suites.......................................... 3 583 5.8
Sheraton................................................. 1 295 2.9
Doubletree Hotels........................................ 1 213 2.1
Comfort Suites........................................... 1 166 1.7
Ramada................................................... 1 124 1.2
Best Western............................................. 1 103 1.0
-- ------ ------
Total.......................................... 56 10,051 100.0%
== ====== ======
</TABLE>
- ---------------
(1) Certain of the Company's planned changes in franchise affiliations are
included in this table, based on certain criteria, including approved
applications and executed license agreements pending project improvement
plans. There can be no assurance that the Company will receive final
approval from the applicable franchisor.
(2) Includes two acquired hotels which the Company anticipates converting to
Marriott franchises. The Company has obtained approval of these new
franchise licenses, subject to completion of renovations or improvements.
(3) Includes one acquired hotel which the Company anticipates converting to a
Holiday Inn franchise. The Company has an approved application, subject to
completion of renovations or improvements.
(4) Includes two hotels in Rochester, Minnesota acquired as part of a portfolio
of hotels in October 1997.
S-5
<PAGE> 7
The Company's hotels are located in the following markets as of June 30,
1998:
<TABLE>
<CAPTION>
NUMBER OF NUMBER OF PERCENTAGE OF
REGION HOTELS SUITES/ROOMS ROOMS
------ --------- ------------ -------------
<S> <C> <C> <C>
Pacific(1)............................................. 32 5,054 50.3
Mountain(2)............................................ 20 3,668 36.5
Minnesota.............................................. 4 1,329 13.2
-- ------ -----
Total........................................ 56 10,051 100.0%
== ====== =====
</TABLE>
- ---------------
(1) Includes California, Oregon and Washington.
(2) Includes Arizona, Colorado, New Mexico and Utah.
RECENT DEVELOPMENTS
RESULTS FOR THE THREE- AND SIX-MONTH PERIODS ENDED JUNE 30, 1998
The Company reported total revenues for the three months ended June 30,
1998 of $24.9 million, an increase of 215.2% from $7.9 million for the three
months ended June 30, 1997. Revenues for the six months ended June 30, 1998
increased 209.6% to $48.6 million from $15.7 million for the six months ended
June 30, 1997. Revenues increased primarily due to the completion of $527.2
million of hotel acquisitions and investments during the twelve months ended
June 30, 1998. For the three months and six months ended June 30, 1998, on a
same-unit basis, REVPAR for non-renovation hotels increased 4.3% and 6.8%,
respectively, over the corresponding period in the prior year. EBITDA increased
205.8% to $21.1 million for the three months ended June 30, 1998 from $6.9
million for the three months ended June 30, 1997 and increased 200.7% to $40.6
million for the six months ended June 30, 1998 from $13.5 million for the six
months ended June 30, 1997. For the three months and six months ended June 30,
1998, FFO per share increased 31.0% and 21.0%, respectively, over the
corresponding period in the prior year.
On April 28, 1998, the Company branded the previously independent 333-room
Provo Park hotel located in Provo, Utah as a full-service Marriott after
completing approximately $4.6 million in renovations. The extensive renovation
upgraded substantially all hotel areas including the lobby, guestrooms and
baths, restaurant, meeting rooms and the hotel's exterior.
On May 15, 1998, the Company also branded the previously independent
University Park hotel located in Salt Lake City, Utah as a full-service Marriott
hotel. The hotel recently underwent a $4.1 million renovation including lobby
and restaurant renovation as well as guest room, soft goods, furniture and guest
bath upgrades. For the month of June 1998, REVPAR increased 22.6%, from $60.70
to $74.43, driven by a 34.0% increase in ADR, from $81.26 to $108.89, while
occupancy declined 8.6%, from 74.7% to 68.3%. The renamed Salt Lake City
Marriott University Park is the third of six hotels from the acquisition of a
portfolio of hotels in October 1997 (the "Kahler Portfolio") to be branded as
full-service Marriotts.
On July 15, 1998, Sunstone rebranded the former Best Western in Ogden, Utah
as a full-service Marriott after completing $5.8 million in renovations. The
Company expects two additional hotels from the Kahler Portfolio to be branded as
Marriotts. The Sheraton San Marcos in Chandler, Arizona and the Olympia Park
hotel in Park City, Utah are under development and will be completed and carry
the Marriott flag by the end of 1998.
In the prior quarter, the Company branded the previously independent
194-room Kahler Plaza Hotel located in Rochester, Minnesota as a full-service
Marriott after completing $1.7 million in renovations. REVPAR for the month of
June 1998 increased 46.8%, from $94.07 to $138.05, driven by a 44.2% increase in
ADR, from $118.96 to $171.49, and an increase in occupancy from 79.1% to 80.5%.
DIVIDEND DECLARATION
On July 15, 1998, Sunstone declared a quarterly dividend of $0.275 per
share payable on August 14, 1998 to shareholders of record on July 31, 1998.
S-6
<PAGE> 8
INCREASE IN CREDIT FACILITY
On July 23, 1998, the Company amended its Credit Facility to (i) increase
total available borrowings from $300.0 million to $350.0 million, (ii) increase
the total amount available under the Credit Facility from 45% to 50% of the
aggregate value of the Company's eligible hotels and (iii) extend the term from
June 30, 1999 to June 30, 2000. The Company believes the new terms of its Credit
Facility improve the Company's financial flexibility to pursue favorable
acquisition opportunities while maintaining its cost of borrowing and improving
its access to funds. Borrowings under the Credit Facility accrue interest at a
rate as low as LIBOR plus 1.40% per annum, and as high as LIBOR plus 2.00% per
annum, based upon the leverage of the Company. At June 30, 1998, the Company's
actual borrowing rate was LIBOR plus 1.625%.
ACQUISITION ACTIVITY
The Company is in various stages of identifying, evaluating and negotiating
potential hotel portfolio and individual hotel acquisitions. The Company
believes that a number of attractive acquisition opportunities that satisfy its
acquisition criteria continue to exist in the western United States. In
addition, the Company is evaluating potential individual hotel and hotel
portfolio acquisitions which may provide strategic expansion opportunities into
new geographic regions. There can be no assurance, however, that any pending or
contemplated acquisitions will be consummated or that such acquisitions will be
beneficial to the Company. The following table sets forth the Company's
acquisition activity since March 31, 1998.
<TABLE>
<CAPTION>
NAME LOCATION ACQUISITION DATE NUMBER OF SUITES/ROOMS COST
---- -------- ---------------- ---------------------- -------------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Hilton................. Oxnard, CA April 10, 1998 160 $ 9.3
Santa Clarita,
Hampton Inn............ CA April 29, 1998 130 8.3
Marriott............... Napa, CA May 5, 1998 192 21.4
Days Inn............... Santa Clara, CA May 14, 1998 168 20.0
Pending Acquisition
(Independent)........ Santa Monica, CA August 31, 1998(1) 168 22.0
----- ------
Total.............................................. 818 $ 81.0
===== ======
</TABLE>
- ---------------
(1) Estimated closing date.
DISPOSITION ACTIVITY
The Company selectively sells or exchanges hotel properties which are
inconsistent with the Company's strategy to renovate and rebrand luxury, upscale
and mid-price hotels in the western United States. Accordingly, the Company
recently announced that it has entered into contracts to sell or exchange, in a
tax-deferred manner, six hotels comprising 1,112 rooms in Idaho, Montana, Texas
and West Virginia to various parties. The sales of the Disposition Hotels
described below are expected to close during the third quarter of 1998.
<TABLE>
<CAPTION>
ESTIMATED GROSS
NAME LOCATION DISPOSITION DATE NUMBER OF SUITES/ROOMS SALES PRICE
---- -------- ---------------- ---------------------- -------------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Green Oaks............. Fort Worth, TX August 1998 284 $ 6.0
Lakeview Resort........ Morgantown, WV August 1998 187 11.0
Various(1)............. ID and MT August 1998 651 30.5
----- ------
Total.............................................. 1,122 $ 47.5
===== ======
</TABLE>
- ---------------
(1) Represents the pending sales of the Quality Inn Pocatello Park, ID, the Best
Western Colonial Park, Helena, MT, the Best Western Canyon Springs, Twin
Falls, ID and the Boise Park Suites Radisson, Boise, ID to a single
purchaser.
S-7
<PAGE> 9
CONCURRENT SENIOR NOTES OFFERING
Concurrent with this Offering, the Partnership is separately offering $150
million aggregate principal amount of its senior notes (the "Senior Notes") to
institutional investors in a private placement pursuant to Rule 144A as to
non-U.S. persons pursuant to Regulation S under the Securities Act (the "Senior
Notes Offering"). The Senior Notes will be issued for a term of ten years, and
will be general unsecured obligations of the Company, ranking pari passu with
all senior debt of the Company, including indebtedness under the Credit
Facility. The Senior Notes are not redeemable until 2003, are redeemable
thereafter until 2006 at a premium and thereafter until maturity in 2008 at par.
There is no sinking fund established with respect to the Senior Notes. The
Senior Notes will be unconditionally guaranteed by the Company and certain of
its subsidiaries. This Offering and the proposed Senior Notes Offering are not
conditioned upon one another and, therefore, one offering may be consummated
without the other offering being consummated. The actual terms and size of the
Senior Notes Offering may differ from those above. See "Risk
Factors -- Concurrent Offerings."
This document does not constitute an offer to sell, or a solicitation of an
offer to buy, the Senior Notes. The Senior Notes will not be registered under
the Securities Act and may not be offered or sold in the United States absent
registration under the Securities Act or an applicable exemption from such
registration requirements.
POSSIBLE LESSEE RESTRUCTURING
Recently, the Board of Directors (the "Board") of the Company considered a
possible restructuring of its relationship with the Lessee, with a view towards
creating the optimal structure to fund the Company's growth. As part of such a
restructuring, the common shareholders of the Company may ultimately acquire an
interest in the capital stock and/or assets of the Lessee and/or the related
hotel management company, Sunstone Hotel Management, Inc. (the "Management
Company"), by way of merger, distribution of assets or a stock dividend to the
shareholders of the Company and to the third-party limited partners in Sunstone
LP. Similar to the Lessee, the Management Company is owned and controlled by Mr.
Alter. The Board of Directors of the Company has not determined the ultimate
structure, financial terms or proposed timing of any such transaction. The
Company anticipates that any such transaction would require the affirmative vote
of a majority of the Company's independent directors and a fairness opinion from
an investment bank concluding that such transaction is fair to the Company from
a financial point of view. In the event of such a transaction, holders of the
EPIPS shares would receive an adjustment in their Conversion Price. See
"Description of Capital Stock -- EPIPS -- Conversion Price Adjustments." There
can be no assurance that any such transaction between the Company and the Lessee
and/or the Management Company will occur.
S-8
<PAGE> 10
THE OFFERING
Securities Offered............ 2,000,000 shares of % Enhanced Perpetual
Income Preferred Securities ("EPIPS") of the
Company.
Dividends..................... Dividends on the EPIPS shares will be
cumulative from the date of original issuance
and will be payable quarterly in arrears on or
about the fifteenth day of February, May,
August and November of each year, commencing on
November 15, 1998. Such February, May, August
and November dividends will be payable in an
amount per EPIPS share equal to the greater of
(i) $ per quarter (or $ per
annum)(equal to a rate of % of the
Liquidation Preference per annum) or (ii) the
cash dividend (exclusive of non-regular
dividends) paid or payable on the number of
Common Shares into which an EPIPS share is then
convertible (determined on each of the
quarterly dividend payment dates referred to
above). The initial dividend for the period in
which the EPIPS shares are originally issued
will be prorated based on the number of days
between the original issuance thereof and the
Initial Distribution Date, computed on the
basis of a 360-day year of twelve 30-day
months. See "Description of Capital
Stock -- EPIPS -- Dividends."
Conversion Rights............. The EPIPS shares shall be convertible, in whole
or in part, at the option of the holder at any
time, unless previously redeemed, into Common
Shares at a conversion price of $ per
Common Share (equivalent to a conversion rate
of Common Shares for each EPIPS
share), subject to adjustment in certain
circumstances. It is expected that the
conversion price of the EPIPS shares will
represent a 25% premium to the most recent NYSE
closing price of the Company's Common Shares at
the time the EPIPS shares are priced. See
"Description of Capital Stock --
EPIPS -- Conversion Rights."
Liquidation Preference........ The EPIPS shares carry a Liquidation Preference
of $25 per share plus accrued and unpaid
dividends, whether or not declared. See
"Description of Capital
Stock -- EPIPS -- Liquidation Preference."
Redemption at the Option of
the Company................... The EPIPS shares are not redeemable prior to
August , 2003, except in certain limited
circumstances relating to the ownership
limitation necessary to preserve the Company's
status as a REIT for federal income tax
purposes. On and after August , 2003, the
EPIPS shares may be redeemed at the option of
the Company in whole or in part for either (i)
a number of Common Shares per EPIPS share equal
to the Liquidation Preference divided by the
Conversion Price (i.e., the number of Common
Shares into which one EPIPS share would then be
convertible at the holder's option) plus a cash
payment equal to all accrued and unpaid
dividends through the date fixed for
redemption; provided that for 20 trading days
within any period of 30 consecutive trading
days, including the trading day immediately
preceding the announcement of such redemption,
the closing price of the Common Shares on the
NYSE equals or exceeds the Conversion Price
then in effect; and
S-9
<PAGE> 11
provided, further, that in order to exercise
this redemption option, the Company must issue
a press release announcing the redemption prior
to the opening of business on the second
trading day after the conditions in the
preceding proviso have been met or (ii) cash at
a redemption price of $25 per EPIPS share, plus
accrued and unpaid dividends, if any, thereon
through the date of redemption. See
"Description of Capital
Stock -- EPIPS -- Redemption."
Ranking....................... With respect to the payment of dividends and
amounts upon liquidation, the EPIPS shares will
rank senior to the Common Shares and pari passu
with the Company's 250,000 currently
outstanding Class A Shares of preferred stock
(as defined herein). The Company has no other
shares of capital stock outstanding. The
Company may issue additional shares of capital
stock that rank pari passu to the EPIPS shares
as to the payment of dividends or amounts upon
liquidation, dissolution and winding up
("Parity Stock") and, with approval from the
holders of two-thirds of the EPIPS shares, may
issue shares of beneficial interest that rank
senior to the EPIPS shares as to the payment of
dividends or amounts upon liquidation,
dissolution and winding up. The Company will
contribute the net proceeds from this Offering
to the Partnership in exchange for 2,000,000
units of % Enhanced Perpetual Income
Preferred Units of limited partnership interest
in the Partnership ("EPIP Units") equal in
number, and with terms identical to, the EPIPS
shares. A distribution on the EPIPS shares will
be preceded immediately by an identical
distribution on the EPIP Units. The EPIP Units
will rank pari passu with the 250,000 currently
outstanding preferred units of limited
partnership interest in the Partnership
(together with the EPIP Units, the "Preferred
Units"). See "Description of Capital
Stock -- EPIPS -- Ranking," "-- Dividends" and
"-- Liquidation Preference."
Maturity...................... The EPIPS shares have no stated maturity and
will not be entitled to the benefits of any
sinking fund or subject to any obligation on
the part of the Company to redeem or retire the
EPIPS shares. See "Description of Capital
Stock -- EPIPS."
Trading....................... Application will be made to list the EPIPS
shares on the NYSE. Trading of the EPIPS shares
on the NYSE is expected to commence within
30-days after the initial delivery of the EPIPS
shares under the symbol "SSI Pr." See
"Underwriting." The Company's class of Common
Shares, into which the EPIPS shares are
convertible, is listed on the NYSE under the
symbol "SSI."
Voting Rights................. Holders of EPIPS shares generally will have no
voting rights. However, in the event that
dividends on the EPIPS shares are in arrears
for six or more quarterly periods (whether
consecutive or not), the holders of EPIPS
shares (voting together, as a single class,
with the holders of all other shares of Parity
Stock upon which like voting rights have been
conferred and are exercisable) will be entitled
to vote for the election of two additional
directors to the Company's Board of Directors
until all dividends accumulated on such EPIPS
shares have been fully paid or declared and a
sum sufficient for the payment thereof set
aside for payment. Certain changes to the terms
of the EPIPS shares that would be materially
S-10
<PAGE> 12
adverse to the rights of holders of the EPIPS
shares cannot be made without the affirmative
vote of holders of at least two-thirds of the
outstanding EPIPS shares. In particular, the
approval of holders of two-thirds of the EPIPS
shares is required for the Company to issue
shares of capital stock that rank senior to the
EPIPS shares. See "Description of Capital
Stock -- EPIPS -- Voting Rights."
Transfer and Ownership
Limitations................... Subject to certain exceptions, no person,
directly or indirectly, may own more than 9.8%
of (i) the number of outstanding Common Shares
or (ii) the number of outstanding shares of
Preferred Stock (as defined herein), including
the EPIPS shares. See "Description of Capital
Stock -- EPIPS -- Restrictions on Ownership."
Use of Proceeds............... To repay outstanding indebtedness under the
Credit Facility. See "Use of Proceeds."
Risk Factors.................. See "Risk Factors" beginning on page S-12 of
this Prospectus Supplement and page 5 of the
accompanying Prospectus for a discussion of
factors to be considered before purchasing any
EPIPS shares offered hereby.
S-11
<PAGE> 13
RISK FACTORS
In evaluating the Company's business, prospective investors should
carefully consider the factors set forth below and in the accompanying
Prospectus before making an investment decision with respect to the EPIPS shares
being sold in this Offering. This Prospectus Supplement may contain
forward-looking statements which involve risks and uncertainties, and actual
results could differ materially from those discussed in any such forward-looking
statements. Certain of the factors that could cause actual results to differ
materially are discussed in this Prospectus Supplement and in the accompanying
Prospectus under the captions "Risk Factors."
CONCURRENT OFFERINGS
Concurrently with this Offering, the Partnership is separately offering
$150 million aggregate principal amount of its Senior Notes, which will be
unconditionally guaranteed by the Company and certain of its subsidiaries. The
Senior Notes Offering is expected to close a few days after this Offering,
however, there can be no assurances as to the timing, terms, size or probability
of the Senior Notes Offering. Consummation of the Senior Notes Offering will
require the consent of the lenders under the Credit Facility, which consent may
be withheld by such lenders. The consummation of this Offering is not
conditioned upon the consummation of the proposed Senior Notes Offering and,
therefore, one offering may be consummated without the other offering being
consummated. The Senior Notes are being offered and sold in a private placement
transaction exempt from registration under the Securities Act. Accordingly,
there is very little information publicly available to the investors of this
Offering describing the terms and conditions of the Senior Notes Offering. There
can be no assurance that the proposed Senior Notes Offering will be consummated
and, if so, on what terms. In addition, the Indenture governing the Senior Notes
may contain covenants which impact or restrict the Company's ability to pay
dividends on the EPIPS shares. See "Prospectus Supplement Summary -- Concurrent
Senior Notes Offering."
RISK OF LEVERAGE; RESTRICTIVE COVENANTS
The Company maintains a significant amount of indebtedness. As of June 30,
1998 after giving effect to this Offering and the proposed Senior Notes
Offering, and the application of the net proceeds herefrom and therefrom, the
aggregate outstanding principal amount of the Company's indebtedness would have
been $301.3 million, versus actual indebtedness at June 30, 1998 of $370.0
million. Since the Company intends to continue to acquire additional hotels and
the Company must distribute annually at least 95% of its taxable net income to
maintain its REIT status, the Company may need to borrow additional funds to
make investments or distributions. However, the Company's Charter limits
consolidated indebtedness to not more than 50% of the Company's investment in
hotel properties, at cost, on a consolidated basis, after giving effect to the
Company's use of proceeds from any indebtedness and is also subject to certain
restrictive financial covenants contained in the Credit Facility which may have
the effect of prohibiting the Company from obtaining additional capital. The
Company obtained the Credit Facility to provide, as necessary, funds for
investments in additional hotel properties, working capital and cash to make
distributions.
Upon consummation of this Offering and the proposed Senior Notes Offering,
the Company will have undrawn under the Credit Facility $304.9 million and
approximately $299.2 million in borrowing capacity under the debt limitation of
the Company's Charter. The Company's future acquisition, renovation,
redevelopment and rebranding activities will likely be financed with
indebtedness obtained under the Company's existing Credit Facility or under
credit facilities to be obtained by the Company in the future. Such credit
facilities may be collateralized by the Company's assets and contain restrictive
covenants.
The Senior Notes will impose, through various covenants, a number of
operational limitations on the Company, the Partnership and certain of their
subsidiaries, including restrictions on the incurrence of indebtedness, both
unsecured and secured, equal to a specified percentage of the assets of the
Company, the Operating Partnership and certain of their subsidiaries, sales of
assets, and distributions to shareholders.
The Company expects that up to 35% of the Senior Notes will be subject to
optional redemption by the Company, at a premium, in connection with an equity
offering by the Company. In the event of a "change of
S-12
<PAGE> 14
control" of the Company, the Partnership will be required to offer to repurchase
the outstanding Senior Notes at a 1% premium. In the event the Company grants
liens to secure the Credit Facility following the failure to meet certain
financial covenants, which the Company is obligated to do under the terms of the
Credit Facility, the terms of the Senior Notes require that the holders of the
Senior Notes be granted a security interest in the assets of the Partnership
equal and ratable to the security interest proposed to be granted to the lenders
under the Credit Facility.
The Credit Facility does contain, and the Indenture relating to the Senior
Notes will contain, restrictive covenants, including covenants limiting capital
expenditures, payment of dividends, incurrence of debt and sales of assets and
requiring the Company to achieve certain financial ratios, some of which could
become more restrictive over time. Among other consequences, the leverage of the
Company and such restrictive covenants and other terms of the Company's debt
instruments could impair the Company's ability to obtain additional financing in
the future, to make acquisitions and to take advantage of significant business
opportunities that may arise. In addition, the Company's leverage may increase
its vulnerability to adverse general economic and hotel industry conditions and
to increased competitive pressures.
The restrictive covenants and the level of the Company's indebtedness could
have important consequences to holders of the EPIPS shares, including, but not
limited to (i) a substantial portion of the Company's cash flow from operations
must be dedicated to the payment of principal and interest on the Senior Notes
and other indebtedness, which may severely limit or eliminate the Company's
ability to pay dividends on the EPIPS shares or the Common Shares, (ii) the
Company's ability to obtain additional debt financing in the future for working
capital, capital expenditures or acquisitions may be limited, (iii) the
Company's level of indebtedness could limit its flexibility in reacting to
changes in the industry and economic conditions generally, (iv) certain of the
Company's borrowings are at variable rates of interest, and a substantial
increase in interest rates could adversely affect the Company's ability to meet
debt service obligations, and (v) increased interest expense will reduce
earnings, if any. In addition, the Indenture and the existing Credit Facility
contain and future credit facilities could contain, financial and other
restrictive covenants that will limit the ability of the Company to, among other
things, borrow additional funds. Failure by the Company to comply with such
covenants could result in an event of default which, if not cured or waived,
could have a material adverse effect on the Company's results of operations,
liquidity and financial position.
There can be no assurance that the Company will be able to meet its present
or future debt service obligations and, to the extent that it cannot, it risks
the loss of certain of its assets to foreclosure. In addition, adverse economic
conditions could cause the terms on which borrowings become available to be
unfavorable. In such circumstances, if the Company is in need of capital to
repay indebtedness in accordance with its terms or otherwise, it could be
required to liquidate one or more investments in hotel properties at times which
may not permit realization of the maximum return on such investments.
Finally, creditors' claims against the Company, including the claims of
holders of the Senior Notes if the proposed Senior Notes Offering is
consummated, must be paid in full before the claims of shareholders in the event
of a liquidation, bankruptcy or winding up of the Company. See "Prospectus
Supplement Summary -- Concurrent Senior Notes Offering."
FINANCING AND ABILITY TO FUND FUTURE ACQUISITIONS
The Company historically has financed hotel acquisitions through advances
on the Credit Facility and issuances of equity securities. The Company intends
to finance future acquisitions of hotel properties, hotel renovations and
non-recurring capital improvements principally through the Credit Facility and,
when market conditions warrant, by issuing additional equity or debt securities.
There can be no assurance that the Company will have access to capital on
favorable terms. If the Company's access to capital is restricted, its ability
to acquire additional hotel properties may be adversely affected. A decline in
the Company's acquisition pace relative to historical periods may result in a
decline in earnings growth.
S-13
<PAGE> 15
USE OF PROCEEDS
The net proceeds to the Company from this Offering, after deducting the
underwriting discount and estimated offering expenses, are estimated to be
approximately $47.8 million (approximately $55.0 million if the Underwriters'
over-allotment option is fully exercised). The net proceeds from this Offering
will be used to repay outstanding indebtedness under the Credit Facility.
PRICE RANGE OF COMMON STOCK AND DIVIDEND PAYMENTS
The Company's Common Stock commenced trading on the Nasdaq National Market
on August 16, 1995 and since July 23, 1996, has been listed on the NYSE under
the symbol "SSI." The following table sets forth, for the periods indicated, the
high and low sales price information for the Company's Common Stock on the
Nasdaq National Market or NYSE, as applicable, and the dividends paid or
declared, as applicable.
<TABLE>
<CAPTION>
PER SHARE
DISTRIBUTION
HIGH LOW AMOUNT
-------- -------- ------------
<S> <C> <C> <C>
1995
Third Quarter (from August 16, 1995)...................... $ 9.625 $ 8.875 $0.115(1)
Fourth Quarter............................................ 10.500 7.875 0.230
1996
First Quarter............................................. $ 11.500 $ 9.750 $0.230
Second Quarter............................................ 11.625 9.875 0.230
Third Quarter............................................. 10.875 9.500 0.250
Fourth Quarter............................................ 13.625 10.000 0.250
1997
First Quarter............................................. $ 14.125 $ 12.000 $0.250
Second Quarter............................................ 14.750 12.625 0.250
Third Quarter............................................. 17.688 13.625 0.275
Fourth Quarter............................................ 18.188 15.063 0.275
1998
First Quarter............................................. $ 17.375 $ 14.875 $0.275
Second Quarter............................................ 16.500 12.500 0.275(2)
Third Quarter (through July 28, 1998)..................... 13.750 11.813
</TABLE>
- ---------------
(1) Represents the pro rata portion (for the period from August 16, 1995 to
September 30, 1995) of a quarterly distribution of $0.230 per share.
(2) Per share dividend to be paid August 14, 1998 to shareholders of record on
July 31, 1998.
As of June 30, 1998, there were approximately 715 record holders of the
Company's Common Stock. On July 28, 1998, the last reported sale price of the
Common Stock on the NYSE was $12.3125 per share. In addition, the Partnership
Units (which are exchangeable for Common Stock) were held by 48 entities and/or
individuals as of June 30, 1998. In order to comply with certain requirements
related to qualification of the Company as a REIT, the Company's Articles of
Incorporation limits the number of shares of Common Stock that may be
beneficially owned by any single person to 9.8% of the Company's outstanding
Common Stock.
Although the declaration of dividends is within the discretion of the Board
and depends on the Company's results of operations, Cash Available for
Distribution, the financial condition of the Company, tax considerations
(including those related to REITs) and other factors considered important by the
Board, the Company's policy is to make regular quarterly distributions to its
shareholders. The Company's ability to make distributions will depend on its
receipt of distributions from the Partnership. The Partnership's primary source
of revenue is, and will continue to be, rent payments under percentage leases
(the "Percentage Leases") for the hotels. The Company must rely on the operation
of its hotels to generate sufficient cash flow to permit the Lessee to meet its
rent obligations under the Percentage Leases. The Lessee had a net operating
loss of $2.0 million for the three months ended March 31, 1998 and an
accumulated deficit of $8.0 million as of
S-14
<PAGE> 16
March 31, 1998. The Lessee's obligations under the Percentage Leases are secured
by a blanket lien on substantially all of its assets and a pledge of 481,955
Partnership Units by Mr. Alter and Mr. Biederman pursuant to the Amended and
Restated Third Party Pledge Agreement. In 1997, the Partnership and the Lessee
amended the Percentage Leases for hotels then currently under renovation and any
future hotels to allow for the abatement of base rent related to rooms taken out
of service during major renovations.
Under the federal income tax provisions affecting REITs, the Company must
distribute at least 95% of its taxable income in order to avoid taxation as a
regular corporation. Moreover, the Company must distribute at least 85% of its
ordinary income and 95% of its capital gain net income to avoid certain excise
taxes applicable to REITs. Under certain circumstances, the Company may be
required to make distributions in excess of Cash Available for Distribution in
order to meet such distribution requirements. In such event, the Company would
seek to borrow the amount of the deficiency or sell assets to obtain the cash
necessary to make distributions to retain its qualification as a REIT for
federal income tax purposes. See "United States Federal Income Tax
Considerations -- Taxation of the Company" in the accompanying Prospectus.
\
S-15
<PAGE> 17
CAPITALIZATION
The following table sets forth the unaudited capitalization of the Company
(i) as of June 30, 1998 and (ii) as adjusted to give effect on such date to the
Pending Acquisition, the planned dispositions of the Disposition Hotels, this
Offering, the proposed concurrent Senior Notes Offering and the application of
the estimated net proceeds herefrom and therefrom as described under "Use of
Proceeds." The information set forth in the following table should be read in
connection with the financial statements and notes thereto incorporated by
reference in the accompanying Prospectus to which this Prospectus Supplement
relates and the pro forma financial information and notes thereto included
elsewhere herein.
<TABLE>
<CAPTION>
JUNE 30, 1998
-----------------------
ACTUAL AS ADJUSTED
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Long-term debt:
Revolving line of credit.................................. $263,800 $ 45,108
Senior Notes.............................................. -- 150,000
Notes payable............................................. 106,152 106,152
-------- --------
Total long-term debt.............................. 369,952 301,260
Minority Interest........................................... 26,677 30,910
Shareholders' equity:
Preferred Stock, $.01 par value, 10,000,000 shares
authorized:
7.9% Class A Cumulative Convertible Preferred Stock,
250,000 shares issued and outstanding, actual and as
adjusted (liquidation preference $100 per share
aggregating $25,000,000)(1)........................... 3 3
Enhanced Perpetual Income Preferred Securities, no
shares issued and outstanding, 2,000,000 shares issued
and outstanding as adjusted (liquidation preference
$25 per share aggregating $50,000,000)................ -- 20
Common Stock, $.01 par value, 150,000,000 shares
authorized; 37,534,319 shares issued and outstanding,
actual and as adjusted(2).............................. 376 376
Additional paid-in capital................................ 479,402 522,974
Distributions in excess of earnings....................... (11,041) (11,041)
-------- --------
Total shareholders' equity........................ 468,740 512,332
-------- --------
Total capitalization.............................. $865,369 $844,502
======== ========
</TABLE>
- ---------------
(1) The Class A Shares are initially convertible into 1,699,605 shares of Common
Stock and may be redeemed by the Company beginning five years after the
issuance date.
(2) Excludes 2,136,175 shares issuable upon redemption of Partnership Units
outstanding prior to this Offering and also excludes shares of Common Stock
issuable upon exercise of options granted under the Company's equity
incentive plans and upon exercise of outstanding warrants.
S-16
<PAGE> 18
SELECTED HISTORICAL AND PRO FORMA FINANCIAL INFORMATION
(IN THOUSANDS EXCEPT SHARE, PER SHARE AND RATIO DATA)
The following tables set forth selected historical and pro forma financial
information for the Company and the Lessee and should be read in conjunction
with the unaudited pro forma combined financial statements, the consolidated
financial statements, related notes, and other financial information included
elsewhere herein or incorporated by reference.
With respect to the Company and the Lessee, the following tables set forth
(i) selected historical operating and other financial information for the years
ended December 31, 1996 and 1997 and the three months ended March 31, 1997 and
1998, (ii) selected historical balance sheet data as of December 31, 1996 and
1997, and March 31, 1998, (iii) selected pro forma operating and other financial
information for the year ended December 31, 1997 and the three months ended
March 31, 1998 and (iv) selected pro forma balance sheet data as of March 31,
1998.
The selected historical financial information for the Company and the
Lessee as of and for the year ended December 31, 1997 has been derived from the
historical financial statements of the Company or the Lessee, audited by Ernst &
Young LLP, independent accountants, whose reports with respect thereto are
incorporated by reference in the accompanying Prospectus to which this
Prospectus Supplement relates. The selected historical financial information for
the Company and the Lessee as of December 31, 1996 and for the year then ended
have been derived from the historical financial statements of the Company and
the Lessee audited by Coopers & Lybrand L.L.P. (PricewaterhouseCoopers LLP after
June 30, 1998), independent accountants, whose reports with respect thereto are
incorporated by reference in the accompanying Prospectus to which this
Prospectus Supplement relates. The selected historical financial information for
the Company as of March 31, 1998 and for the Company and the Lessee for the
three months ended March 31, 1998 and 1997 have been derived from unaudited
historical financial statements of the Company and the Lessee.
Unaudited pro forma operating and other information for the three months
ended March 31, 1998 and for the year ended December 31, 1997 are presented as
if the acquisitions, pending acquisition and pending dispositions of the hotels
acquired or expected to be acquired or disposed of following January 1, 1997 and
the related financings and equity offerings in 1997 and 1998 through July 29,
1998, the Offering and the concurrent Senior Notes Offering all occurred on
January 1, 1997 and, therefore, incorporates certain assumptions that are
described in the notes to the Unaudited Pro Forma Combined Statements of
Operations included elsewhere herein. The unaudited pro forma balance sheet data
is presented as if the aforementioned transactions had occurred by March 31,
1998. The pro forma information does not purport to represent what the Company's
or the Lessee's financial position or results of operations would actually have
been if these transactions had, in fact, occurred on such date or at the
beginning of the period indicated, or to project the Company's or the Lessee's
financial position or results of operations at any future date or for any future
period.
S-17
<PAGE> 19
<TABLE>
<CAPTION>
SUNSTONE HOTEL INVESTORS, INC.
--------------------------------------------------------------------------------
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31,
--------------------------------------- --------------------------------------
PRO FORMA HISTORICAL PRO FORMA HISTORICAL
----------- ------------------------- ----------- ------------------------
1998 1998 1997(10) 1997 1997 1996
----------- ----------- ----------- ----------- ----------- ----------
<S> <C> <C> <C> <C> <C> <C>
OPERATING DATA:
Revenue
Lease revenue -- Lessee(1)... $ 24,512 $ 23,687 $ 7,572 $ 93,917 $ 44,680 $ 14,848
Interest income.............. 57 57 197 471 471 236
----------- ----------- ----------- ----------- ----------- ----------
Total revenue......... 24,569 23,744 7,769 94,388 45,151 15,084
----------- ----------- ----------- ----------- ----------- ----------
Expenses
Real estate related
depreciation and
amortization............... 8,239 7,919 1,956 31,398 14,749 4,514
Interest expense and
amortization of financing
costs...................... 4,455 4,595 840 19,058 6,365 1,558
Real estate and personal
property taxes and
insurance.................. 2,862 2,779 676 10,860 4,670 1,273
General and
administrative(2).......... 1,503 1,503 532 2,140 1,890 1,015
----------- ----------- ----------- ----------- ----------- ----------
Total expenses................. 17,059 16,796 4,004 63,456 27,674 8,360
----------- ----------- ----------- ----------- ----------- ----------
Income before minority
interest and extraordinary
item....................... 7,510 6,948 3,765 30,932 17,477 6,724
Minority interest in
Sunstone LP(3)........... (317) (351) (489) (1,767) (1,886) (1,090)
----------- ----------- ----------- ----------- ----------- ----------
Net income................... 7,193 6,597 3,276 29,165 15,591 5,634
Preferred dividends(4)....... (1,690) (487) -- (6,788) (422) --
----------- ----------- ----------- ----------- ----------- ----------
Net income available to
common shareholders........ $ 5,503 $ 6,110 $ 3,276 $ 22,377 $ 15,169 $ 5,634
=========== =========== =========== =========== =========== ==========
Earnings per common share(5)
Basic...................... 0.15 0.17 0.22 0.61 0.72 0.70
=========== =========== =========== =========== =========== ==========
Diluted.................... 0.15 0.17 0.22 0.61 0.71 0.69
=========== =========== =========== =========== =========== ==========
Weighted average number of
common shares outstanding
Basic...................... 37,502,364 35,452,364 14,834,676 36,595,952 21,089,971 8,041,805
Diluted.................... 37,672,732 35,622,732 14,959,722 36,754,112 21,248,131 8,123,938
OTHER DATA:
Lessee room revenue.......... $ 49,140 $ 47,910 $ 16,566 $ 190,977 $ 95,106 $ 34,085
Funds from operations(6)..... 15,749 14,867 5,721 62,330 32,226 11,238
Ratio of funds from
operations to preferred
dividends.................. 9.3x 30.5x -- 9.2x 76.4x --
EBITDA(7).................... 20,204 19,462 6,561 81,388 38,591 12,796
Ratio of EBITDA to interest
expense and preferred
dividends.................. 3.7x 4.2x 9.0x 3.5x 6.3x 9.6x
Ratio of earnings to combined
fixed charges and preferred
dividends(8)............... 1.6x 1.8x 4.1x 1.8x 2.6x 3.1x
Cash provided from operating
activities................. 10,061 2,172 24,316 11,669
Cash used in investing
activities................. (67,067) (47,999) (392,546) (82,757)
Cash provided by financing
activities................. 55,445 46,088 371,672 66,008
Cash available for
distribution(9)............ 13,402 12,585 5,031 52,552 26,314 9,108
</TABLE>
S-18
<PAGE> 20
<TABLE>
<CAPTION>
SUNSTONE HOTEL INVESTORS, INC.
-----------------------------------------------------
MARCH 31, DECEMBER 31,
------------------------- ----------------------
PRO FORMA HISTORICAL HISTORICAL
--------- ---------- ----------------------
1998 1998 1997 1996
--------- ---------- -------- --------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents........................ $ 2,023 $ 2,023 $ 3,584 $ 142
Investment in hotel properties, net.............. 796,978 763,138 704,323 152,937
Total assets..................................... 842,720 804,567 739,577 160,079
Debt:
Revolving line of credit....................... 25,063 192,800 179,800 40,400
Senior Notes................................... 150,000 - - -
Notes Payable.................................. 106,474 100,288 116,671 19,651
Total debt....................................... 281,537 293,088 296,471 60,051
Minority interest in Sunstone LP................. 31,399 25,605 33,860 15,978
Shareholders' equity............................. 516,577 472,667 397,887 80,801
</TABLE>
- ---------------
(1) With respect to the pro forma information, lease revenues from the Lessee
to the Company are calculated on a pro forma basis by applying the
contractual or anticipated rent provisions of the Percentage Leases to the
historical room, food and beverage and other revenues of the hotels
acquired or expected to be acquired following January 1, 1997, as if
January 1, 1997 was the beginning of the lease term and assumes the Company
owned and leased such hotels, excluding those where disposition is pending.
(2) Pro forma general and administrative expenses represent executive and other
compensation, legal, audit, and other expenses. These amounts are based on
historical general and administrative expenses as well as estimated 1998
expenses.
(3) Calculated as 5.44% and 7.32% of income before minority interest less
preferred dividends on a pro forma basis for the three months ended March
31, 1998 and the year ended December 31, 1997, respectively.
(4) Represents annual dividends on the Class A Preferred Stock (computed based
on 7.9% of the $25 million preferred stockholders' contribution) plus the
annual dividends on the EPIPS shares.
(5) Earnings per common share is computed by dividing net income applicable to
common shareholders by the weighted average number of common shares
outstanding. Diluted earnings per share amounts do not include the impact
of the conversion of preferred shares into common shares because the effect
is antidilutive.
(6) Management and industry analysts generally consider FFO to be one measure
of the financial performance of an equity REIT that provides a relevant
basis for comparison among REITs and it is presented to assist investors in
analyzing the performance of the Company. FFO under the National
Association of Real Estate Investment Trusts ("NAREIT") definition consists
of income before minority interest (computed in accordance with generally
accepted accounting principles), excluding gains or losses from debt
restructurings and sales of property, plus depreciation and amortization of
real property (including furniture and equipment but excluding amortization
of financing costs). FFO does not represent cash generated from operating,
investing or financing activities in accordance with generally accepted
accounting principles and is not necessarily indicative of cash available
to fund cash needs (such as for capital expenditures or payment of debt).
FFO should not be considered an alternative to net income as an indication
of the Company's financial performance or as an alternative to cash flows
from operating, investing or financing activities as a measure of
liquidity.
(7) EBITDA is computed by adding income before minority interest, interest
expense, depreciation and amortization expense and extraordinary expenses.
EBITDA is presented not as an alternative measure of operating results or
cash flow from operations (as determined in accordance with generally
accepted accounting principles), but because it is a widely accepted
financial indicator of a company's ability to incur and service debt.
(8) For purpose of computing the ratio of earnings to combined fixed charges
and preferred dividends, earnings consist of income before extraordinary
items and minority interest in the income of Sunstone LP, plus fixed
charges, excluding capitalized interest. Fixed charges consist of interest,
whether expensed or capitalized and amortization of financing costs.
(9) Cash Available for Distribution is computed by subtracting from FFO the sum
of (i) 4% of room revenues, which the Company is obligated by the
Percentage Leases to make available to the Lessee for the periodic
refurbishment and replacement of furniture, fixture and equipment at the
Hotels and (ii) amounts required to repay principal amortization on
long-term debt.
(10) The quarterly financial data for the three months ended March 31, 1997 has
been restated to reflect the allocation of a fourth quarter depreciation
expense adjustment to the first three quarters.
S-19
<PAGE> 21
DESCRIPTION OF CAPITAL STOCK
EPIPS
This description of the particular terms of the EPIPS shares offered hereby
supplements, and to the extent inconsistent therewith replaces, the description
of the general terms and provisions of the Preferred Stock set forth in the
accompanying Prospectus, to which description reference is hereby made.
General
The EPIPS shares will be shares of a new class of preferred stock of the
Company. The Company is authorized to issue up to 10,000,000 shares of preferred
stock, $.01 par value per share ("Preferred Stock"), in one or more series, with
such preferences, conversion or other rights, voting powers, restrictions,
limitations as to dividends, qualifications, or terms or conditions of
redemption in each case, if any, as the Board of Directors of the Company may
determine by adoption of applicable articles supplementary to the Company's
Charter, without any further vote or action by the shareholders. In connection
with the acquisition of a portfolio of hotels, on October 15, 1997, the Company
issued 250,000 shares of its newly designated 7.9% Class A Cumulative
Convertible Preferred Stock, (the "Class A Shares") all of which shares are
still outstanding and are held by a single voting "group" (as such term is used
in Section 13(d) of the Exchange Act). Consummation of the EPIPS offering is
subject to the consent of the holders of the Class A Shares. The Class A Shares
are described in the accompanying Prospectus on page 15. The Company has issued
no other shares of Preferred Stock.
Prior to the issuance of the EPIPS shares, the Board of Directors will
adopt articles supplementary (the "Articles Supplementary") designating the
terms of the EPIPS shares. The following summary of the terms and provisions of
the Articles Supplementary does not purport to be complete and is qualified in
its entirety by reference to the pertinent sections of the Charter and the
Articles Supplementary, each of which is available from the Company upon
request.
The Company intends to contribute or otherwise transfer the net proceeds of
the sale of the EPIPS shares to the Partnership in exchange for EPIP Units of
partnership interest in the Partnership, the economic terms of which will be
substantially identical to the EPIPS shares. The Partnership will be required to
make all required distributions on the EPIP Units (which will mirror the
payments of dividends, including accrued and unpaid dividends upon redemption,
and of the liquidation preference amount of the EPIPS shares) prior to any
distribution of cash or assets to the holders of the Common Units or to the
holders of any other interests in the Partnership, except for any other series
of preferred units ranking pari passu with the EPIP Units as to distributions
and/or liquidation rights and except for distributions required to enable the
Company to maintain its qualification as a REIT.
Ranking
The EPIPS shares rank pari passu with the Company's outstanding Class A
Shares and senior to the Common Shares with respect to the payment of dividends
and amounts upon liquidation, dissolution or winding up of the Company.
While any EPIPS shares are outstanding, the Company may not authorize,
create or increase the authorized amount of any class or series of stock that
ranks senior to the EPIPS shares with respect to the payment of dividends or
amounts upon liquidation, dissolution or winding up without the consent of the
holders of two-thirds of the outstanding EPIPS shares. However, the Company may
create additional classes of stock, increase the authorized number of shares of
Preferred Stock or issue series of Preferred Stock ranking junior to or pari
passu with the EPIPS shares with respect, in each case, to the payment of
dividends and amounts upon liquidation, dissolution and winding up without the
consent of any holder of EPIPS shares. See "-- Voting Rights" below.
S-20
<PAGE> 22
Dividends
Holders of EPIPS shares are entitled to receive, when, as and if declared
by the Board of Directors of the Company, out of funds legally available for
payment, cumulative cash distributions.
Dividends on the EPIPS shares are payable quarterly in arrears on the
fifteenth calendar day of February, May, August and November of each year (each
a "Regular Distribution Date"), commencing November 15, 1998, and, in the case
of any accrued but unpaid dividends, at such additional times and for such
interim periods, if any, as determined by the Board of Directors. Each such
dividend is payable to holders of record as they appear on the stock records of
the Company at the close of business on such record dates, not exceeding 60 days
preceding the payment dates thereof, as shall be fixed by the Board of
Directors. Dividends will be payable in an amount per EPIPS share equal to the
greater of (i) $ per quarter (or $ per annum)(equal to a rate of %
of the Liquidation Preference per annum) or (ii) the cash dividend (exclusive of
non-regular dividends) paid or payable on the number of Common Shares into which
an EPIPS share is convertible on the applicable Regular Distribution Date. The
amount referred to in clause (ii) above shall be determined by multiplying the
number of Common Shares (or portions thereof) into which one EPIPS share is
convertible at the opening of business on the applicable Regular Distribution
Date multiplied by the aggregate cash distributions (exclusive of non-regular
distributions such as a special capital gain distribution) payable or paid on
one Common Share since the immediately preceding Regular Distribution Date).
Dividends will accrue from the date of the original issuance of the EPIPS shares
(i.e., the initial closing of this Offering), resulting in a partial dividend
for the period in which they are issued. The initial dividend accruing for the
period in which the EPIPS shares are originally issued will be prorated based on
the number of calendar days from, and including, the original issuance thereof
through, and including, the Initial Distribution Date. Such initial dividend and
any other dividends payable on the EPIPS shares for any period greater or less
than a full quarterly dividend period will be computed on the basis of a 360-day
year of twelve 30-day months. Dividends will be cumulative, whether or not in
any dividend period or periods there shall be funds of the Company legally
available for the payment of such dividends and whether or not such dividends
are authorized. Accumulations of dividends on the EPIPS shares will not bear
interest.
Except as provided in the next sentence, no dividend will be declared or
paid on any Parity Stock unless full cumulative dividends have been or
contemporaneously are declared and paid, or declared and a sum sufficient for
the payment thereof is set apart for such payment, on the EPIPS shares for all
prior dividend periods and the then current dividend period. If accrued
dividends on the EPIPS shares and any Parity Stock for all prior dividend
periods have not been paid in full, then any dividend declared on the EPIPS
shares and any Parity Stock for any dividend period will be declared ratably in
proportion to accrued and unpaid dividends on the EPIPS shares and such Parity
Stock.
Unless all dividends then required to be paid on the EPIPS shares and any
Parity Stock have been or contemporaneously are declared and paid, or declared
and a sum sufficient for the payment thereof is set apart for payment, the
Company will not (i) declare, pay or set apart funds for the payment of any
dividend or other distribution with respect to any Junior Stock (as herein
defined) or (ii) except as set forth in the following sentence, redeem, purchase
or otherwise acquire for consideration any Junior Stock (subject to certain
exceptions), through a sinking fund or otherwise. Notwithstanding the foregoing
limitations, the Company may, at any time, acquire shares of its capital stock,
without regard to rank, for the purpose of preserving its status as a REIT or
for purposes of an employee benefit plan of the Company.
As used herein, (i) the term "dividend" does not include dividends payable
solely in shares of Junior Stock on Junior Stock, or in options, warrants or
rights to holders of Junior Stock to subscribe for or purchase any Junior Stock
and (ii) the term "Junior Stock" means the Common Shares, and any other class of
capital stock of the Company now or hereafter issued and outstanding that ranks
junior to the EPIPS shares as to the payment of dividends or amounts upon
liquidation, dissolution or winding up of the Company and (iii) the term "Parity
Stock" means any other class or series of capital stock of the Company now or
hereafter issued and outstanding (including the Class A Shares) that ranks
equally with the EPIPS shares as to the payment of dividends and amounts upon
liquidation, dissolution or winding up of the Company.
S-21
<PAGE> 23
The Partnership will be required to make all required distributions to the
Company on the EPIP Units that will mirror the Company's payment of dividends on
the EPIPS shares (including accrued and unpaid dividends upon redemption, and of
the liquidation preference amount of the EPIPS shares) prior to any distribution
of cash or assets to the holders of the Common Units or to the holders of any
other interests in the Partnership, except for distributions required in
connection with any other shares of the Company ranking senior to or on a parity
with the EPIPS shares as to dividends and/or liquidation rights and except for
distributions required to enable the Company to maintain its qualification as a
REIT.
The Company's Credit Facility and the Indenture under which the Company's
Senior Notes will be issued include covenants that restrict the ability of the
Company to declare and pay dividends. In general, these agreements contain
exceptions to the limitations to allow the Partnership to make distributions
necessary to allow the Company to maintain its status as a REIT. The Company
does not believe that these covenants will adversely affect the ability of the
Partnership to make distributions in an amount sufficient to permit the Company
to pay dividends with respect to the EPIPS shares. See "Recent
Developments -- Concurrent Senior Notes Offering" and "Risk Factors -- Credit
Facility Limitations."
Redemption
The EPIPS shares are not redeemable by the Company prior to August ,
2003. On and after August , 2003, the Company at its option upon not less than
30 nor more than 60 days' written notice, may redeem the EPIPS shares, in whole
or in part, at any time or from time to time, but only to the extent it has or
will have funds legally available therefor, for either of the types of
consideration described below, as selected by the Company (the "Redemption
Consideration"): (i) for a number of authorized but previously unissued Common
Shares per EPIPS share equal to the Liquidation Preference divided by the
Conversion Price (i.e., the number of Common Shares into which one EPIPS share
would then be convertible at the holder's option, see "-- Conversion Rights"
below) plus a cash payment of accrued but unpaid dividends through the date
fixed for redemption (the "Redemption Date")(except as provided below), without
interest; provided that for 20 trading days within any period of 30 consecutive
trading days, including the trading day immediately preceding the announcement
of such redemption, the closing price of the Common Shares on the NYSE equals or
exceeds the Conversion Price then in effect; and provided, further, that in
order to exercise this redemption option, the Company must issue a press release
announcing the redemption (the "Press Release") prior to the opening of business
on the second trading day after the conditions in the preceding proviso have
been met; or (ii) for cash at a redemption price of $25.00 per EPIPS share, plus
all accrued and unpaid distributions thereon through the Redemption Date (except
as provided below), without interest.
The Redemption Date shall be selected by the Company, shall be specified in
the notice of redemption and shall not be less than 30 days nor more than 60
days after (i) the date on which the Company issued the Press Release, if such
redemption is pursuant to paragraph (i) above and (ii) the date notice of
redemption is sent by the Company, if such redemption is pursuant to paragraph
(ii) above. Holders of EPIPS shares to be redeemed shall surrender such EPIPS
shares at the place (or in the manner) designated in such notice and shall be
entitled to the consideration described above commencing on the Redemption Date.
If fewer than all of the outstanding EPIPS shares are to be redeemed, the
EPIPS shares to be redeemed shall be selected pro rata in proportion to the
number of EPIPS shares held by such holder (as nearly as may be practicable
without creating fractional EPIPS shares) or by any other equitable method
determined by the Company that will not result in a violation of the Ownership
Limitation provisions of the Company's Charter.
Notice of redemption will be given by mail or by publication (with
subsequent prompt notice by mail) in The Wall Street Journal or The New York
Times or, if neither is then being published, in any other daily newspaper of
national circulation, not less than 30 days nor more than 60 days prior to the
Redemption Date, and if such redemption is pursuant to paragraph (i) above, such
notice shall be given not more than ten (10) business days after the date on
which the Company issues the Press Release. No failure to give such notice or
any defect thereto or in the mailing thereof shall affect the validity of the
proceedings for the redemption of any EPIPS shares except as to the holder to
whom notice was defective or not given. Any notice which was mailed in the
manner herein provided shall be conclusively presumed to have been duly given on
S-22
<PAGE> 24
the date mailed whether or not the holder receives the notice. Each notice shall
state: (i) the Redemption Date; (ii) the type and amount of Redemption
Consideration; (iii) the number of EPIPS shares to be redeemed; (iv) the place
or places where certificates representing the EPIPS shares are to be surrendered
(and in the case of uncertificated EPIPS shares, if any, the manner in which
such EPIPS shares are to be surrendered) for the Redemption Consideration; (v)
that distributions on the EPIPS shares to be redeemed will cease to accrue on
such Redemption Date; (vi) the then-current Conversion Price; and (vii) that the
holder's conversion rights as to such EPIPS shares shall terminate on the
Redemption Date (see "-- Conversion Rights" below). If fewer than all the EPIPS
shares held by any holder are to be redeemed, the notice mailed to such holder
shall also specify the number of EPIPS shares to be redeemed from such holder.
From and after the Redemption Date, provided that notice has been published
or mailed as described above and that the Company has issued and made available
the number of Common Shares and/or amount of cash necessary to effect such
redemption (i) except as otherwise provided herein, dividends on the EPIPS
shares so called for redemption shall cease to accumulate or accrue (except
that, in the case of a Redemption Date after a dividend record date and prior to
the related dividend payment date, holders of EPIPS shares on the dividend
record date will be entitled on such dividend payment date to receive the
dividend payable on such EPIPS shares), (ii) said EPIPS shares shall no longer
be deemed to be outstanding and (iii) all rights of the holders thereof as
holders of EPIPS shares of the Company shall cease (except the rights to receive
the Redemption Consideration payable upon such redemption, without interest
thereon, upon surrender and endorsement of their certificates if so required and
to receive any dividends payable thereon). The Company's obligation to provide
Common Shares and/or cash in connection with any redemption of EPIPS shares
shall be deemed fulfilled if, on or before the Redemption Date, the Company
shall deposit with a bank or trust company that has a capital and surplus of at
least $50.0 million such number of Common Shares and such amount of cash as is
necessary for such redemption, in trust, with irrevocable instructions that such
Common Shares and/or cash be applied to the redemption of EPIPS shares so called
for redemption. In the case of any redemption pursuant to paragraph (i) above,
at the close of business on the Redemption Date, each holder of EPIPS shares to
be redeemed (unless the Company defaults in the delivery of the Common Shares or
cash payable on such Redemption Date) shall be deemed to be the record holder of
the number of Common Shares into which such EPIPS shares are to be converted at
a redemption, regardless of whether such holder has surrendered the certificates
representing the EPIPS shares to be so redeemed. No interest shall accrue for
the benefit of the holders of shares of EPIPS shares to be redeemed on any cash
so set aside by the Company. Subject to applicable escheat laws, any such cash
unclaimed at the end of two years from the Redemption Date shall revert to the
general funds of the Company, after which reversion the holders of EPIPS shares
so called for redemption shall look only to the general funds of the Company for
the payment of such cash. Except as provided above, the Company will make no
payment or allowance for unpaid dividends, whether or not in arrears, on EPIPS
shares to be redeemed.
As promptly as practicable after the surrender in accordance with said
notice of the certificates for any EPIPS shares so redeemed (properly endorsed
or assigned for transfer, if the Company shall so require and if the notice
shall so state), such certificates shall be exchanged for certificates
representing Common Shares and/or any cash (without interest thereon) for which
such EPIPS shares have been redeemed in accordance with such notice. If fewer
than all the EPIPS shares represented by any certificate are redeemed, then a
new certificate representing the unredeemed EPIPS shares shall be issued without
cost to the holders thereof.
No fractional Common Shares or scrip representing fractions of Common
Shares shall be issued upon redemption of the EPIPS shares. Instead of any
fractional interest in a Common Share that would otherwise be deliverable upon
redemption of EPIPS shares, the Company shall pay to the holder of such EPIPS
shares an amount in cash (rounded to the nearest cent) based on the current
market price of the Common Shares on the trading day immediately preceding the
notice of redemption date. If more than one EPIPS share shall be surrendered for
redemption at one time by the same holder, the number of full Common Shares
issuable upon redemption thereof shall be computed on the basis of the aggregate
number of EPIPS shares so surrendered.
Any Common Shares issued upon redemption of EPIPS shares shall be validly
issued, fully paid and non-assessable. The Company shall list on the NYSE,
subject to official notice of issuance, the Common Shares required to be
delivered upon any such redemption of EPIPS shares.
S-23
<PAGE> 25
The Company shall take any action necessary to ensure that any Common
Shares issued upon the redemption of EPIPS shares are freely transferable and
not subject to any resale restrictions under the Securities Act, or any
applicable state securities or blue sky laws (other than any Common Shares
issued upon redemption of any EPIPS shares which are held by an "affiliate" (as
defined in Rule 144 under the Securities Act) of the Company).
The Company will pay any and all documentary stamp or similar issue or
transfer taxes payable in respect of the issue or delivery of Common Shares or
other securities or property upon redemption of EPIPS shares; provided, however,
that the Company shall not be required to pay any tax that may be payable in
respect of any transfer involved in the issue or delivery of Common Shares or
other securities or property in a name other than that of the holder of the
EPIPS shares to be redeemed, and no such issue or delivery shall be made unless
and until the person requesting such issue or delivery has paid to the Company
the amount of any such tax or established, to the reasonable satisfaction of the
Company, that such tax has been paid.
The EPIPS shares have no stated maturity and will not be subject to any
sinking fund or mandatory redemption provisions (except as provided under
"Description of Common Stock and Preferred Stock -- Restrictions on Ownership of
Common Stock or Preferred Stock" in the accompanying Prospectus).
Unless all dividends then required to be paid on the EPIPS shares and any
Parity Stock have been or contemporaneously are declared and paid, or declared
and a sum sufficient for the payment thereof set apart for payment, (i) no EPIPS
shares and no other shares of Parity Stock may be redeemed unless all
outstanding shares of Parity Stock, including all outstanding EPIPS shares, are
simultaneously redeemed and (ii) the Company may not, except as set forth in the
following sentence, redeem, purchase or otherwise acquire for consideration any
EPIPS shares or any Parity Stock, otherwise than pursuant to a purchase or
exchange offer made on the same terms to all holders of EPIPS shares and any
Parity Stock. Notwithstanding the foregoing limitations, the Company may, at any
time, acquire shares of its capital stock, without regard to rank, for the
purpose of preserving its status as a REIT or for purposes of an employee
benefit plan of the Company.
Liquidation Preference
The holders of EPIPS shares are entitled to receive in the event of any
liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, $25.00 per EPIPS share plus an amount per EPIPS share equal to all
dividends (whether or not earned or declared) accrued and unpaid thereon to the
date of final distribution to such holders, and no more.
Until the holders of the EPIPS shares and holders of any Parity Stock have
been paid their respective liquidation preferences, plus such accrued and unpaid
dividends in full, no payment will be made to any holder of Junior Stock upon
the liquidation, dissolution or winding up of the Company. If, upon any
liquidation, dissolution or winding up of the Company, the assets of the
Company, or proceeds thereof, distributable among the holders of the EPIPS
shares and the shares of any Parity Stock are insufficient to pay in full the
Liquidation Preference plus such accrued and unpaid dividends and the
liquidation preference applicable with respect to any such Parity Stock, then
such assets, or the proceeds thereof, will be distributed among the holders of
the EPIPS shares and the shares of any such Parity Stock, ratably, in accordance
with the respective amounts which would be payable on such EPIPS shares and
shares of any such Parity Stock if all amounts payable thereon were to be paid
in full. Neither a consolidation or merger of the Company with another
corporation, a statutory share exchange by the Company, nor a sale, lease or
transfer of all or substantially all of the Company's assets will be considered
a liquidation, dissolution or winding up, voluntary or involuntary, of the
Company.
Voting Rights
Except as provided below, the holders of EPIPS shares will have no voting
rights.
If six quarterly dividends (whether or not consecutive) payable on the
EPIPS shares are in arrears, whether or not earned or declared, the number of
directors then constituting the Board of Directors of the Company will be
increased by two and the holders of the EPIPS shares voting together, as a
single class, with
S-24
<PAGE> 26
the holders of all other shares of Parity Stock upon which like voting rights
have been conferred and are exercisable (collectively, together with the EPIPS
shares, "Voting Preferred Shares"), will have the right to elect two additional
directors to serve on the Board of Directors at an annual meeting of
shareholders or a properly called special meeting of the holders of the Voting
Preferred Shares and at each subsequent annual meeting of shareholders until all
such dividends, together with the dividends for the then current quarterly
period, on the Voting Preferred Shares have been paid or declared and set aside
for payment.
The approval of two-thirds of the outstanding EPIPS shares, is required in
order to (i) amend the Charter to affect materially and adversely the rights,
preferences or voting power of the holders of the EPIPS shares, (ii) enter into
a share exchange that affects the EPIPS shares, consolidate with or merge into
another entity, or permit another entity to consolidate with or merge into the
Company, unless in each such case, each EPIPS share remains outstanding without
a material and adverse change to its terms and rights or is converted into or
exchanged for a share of preferred stock of the surviving entity having
preferences, rights, voting powers, restrictions, limitations as to
distributions, qualifications and terms and conditions of redemption identical
to those of an EPIPS share (except for changes that do not materially and
adversely affect the holders of the EPIPS shares) or (iii) amend the Charter to
authorize, reclassify, create or increase the authorized amount of any class of
stock having rights senior to the EPIPS shares with respect to the payment of
dividends or amounts upon the liquidation, dissolution or winding up of the
Company. However, the Company may increase the authorized number of shares of
Preferred Stock and may create additional classes of Parity Stock and Junior
Stock, increase the authorized number of shares of Parity Stock and Junior Stock
and issue additional series of Parity Stock and Junior Stock, all without the
consent of any holder of EPIPS shares.
Conversion Rights
The EPIPS shares will be convertible, in whole or in part, at any time, at
the option of the holders thereof, into authorized but previously unissued
Common Shares at a conversion price of $ per Common Share (equivalent to a
conversion rate of Common Shares for each EPIPS share), subject to
adjustment as described below ("Conversion Price"). The right to convert EPIPS
shares called for redemption will terminate at the close of business on the
Redemption Date. For information as to notices of redemption, see
"-- Redemption" above. For a description of the Company's Common Shares, see
"-- Underlying Common Shares" below.
Conversion of EPIPS shares, or a specified portion thereof, may be effected
by delivering certificates evidencing such EPIPS shares, together with written
notice of conversion and a proper assignment of such certificates to the Company
or in blank, to the office or agency to be maintained by the Company for that
purpose. Currently, such office is the principal corporate trust office of the
Transfer Agent described below.
Each conversion will be deemed to have been effected immediately prior to
the close of business on the date on which the certificates for EPIPS shares
shall have been surrendered and notice shall have been received by the Company
as aforesaid (and if applicable, payment of any amount equal to the dividend
payable on such shares shall have been received by the Company as described
below) and the conversion shall be at the Conversion Price in effect at such
time and on such date.
Holders of EPIPS shares at the close of business on a dividend record date
will be entitled to receive the dividend payable on such shares on the
corresponding dividend payment date notwithstanding the conversion of such
shares following such dividend record date and prior to such dividend payment
date. However, EPIPS shares surrendered for conversion during the period between
the close of business on any dividend record date and ending with the opening of
business on the corresponding dividend payment date (except EPIPS shares
converted after the issuance of a notice of redemption with respect to a
Redemption Date during such period or coinciding with such dividend payment
date, which will be entitled to such dividend) must be accompanied by payment of
an amount equal to the dividend payable on such EPIPS shares on such dividend
payment date. A holder of EPIPS shares on a dividend record date who (or whose
transferee) tenders any such EPIPS shares for conversion into Common Shares on
such dividend payment date will receive the dividend payable by the Company on
such EPIPS shares on such date, and the converting holder need not include
payment of
S-25
<PAGE> 27
the amount of such dividend upon surrender of EPIPS shares for conversion.
Except as provided above, the Company will make no payment or allowance for
unpaid dividends, whether or not in arrears, on converted EPIPS shares or for
dividends on the Common Shares issued upon such conversion.
Fractional Common Shares will not be issued upon conversion but, in lieu
thereof, the Company will pay a cash adjustment (rounded up to the nearest cent)
based on the current market price of the Common Shares on the trading day
immediately preceding the conversion date.
The Company shall at all times reserve and keep available, free from
preemptive rights, out of the aggregate of its authorized but unissued Common
Stock solely for the purpose of effecting conversion of the EPIPS shares, the
full number of Common Shares deliverable upon the conversion of all outstanding
EPIPS shares. For purposes of this provision, the number of Common Shares that
shall be deliverable upon the conversion of all outstanding EPIPS shares shall
be computed as if at the time of computation all such outstanding shares were
held by a single holder (and without regard to the ownership Limit set forth in
the Company's Charter).
The Company covenants that any Common Shares issued upon conversion of the
EPIPS shares shall be validly issued, fully paid and nonassessable.
The Company shall take any action necessary to ensure that any Common
Shares issued upon conversion of EPIPS shares are freely transferable and not
subject to any resale restrictions under the Act, or any applicable state
securities or blue sky laws (other than any Common Shares which are held by an
"affiliate" (as defined in Rule 144 under the Act)).
The Company will pay any and all documentary stamp or similar issue or
transfer taxes payable in respect of the issue or delivery of Common Shares or
other securities or property upon conversion of EPIPS shares; provided, however,
that the Company shall not be required to pay any tax that may be payable in
respect of any transfer involved in the issue or delivery of Common Shares or
other securities or property in a name other than that of the holder of the
EPIPS shares to be converted, and no such issue or delivery shall be made unless
and until the person requesting such issue or delivery has paid to the Company
the amount of any such tax or established, to the reasonable satisfaction of the
Company, that such tax has been paid.
Conversion Price Adjustments
The Conversion Price is subject to adjustment upon certain events,
including (i) the payment of dividends (and other distributions) payable in
Common Shares on any class of capital stock of the Company, (ii) the issuance to
all holders of Common Shares of certain rights or warrants entitling them to
subscribe for or purchase Common Shares at a price per share less than the fair
market value (as defined in the Articles Supplementary) per Common Share, (iii)
subdivisions, combinations and reclassifications of Common Shares and (iv)
distributions to all holders of Common Shares of evidences of indebtedness of
the Company or assets (including securities, but excluding those dividends,
rights, warrants and distributions referred to in clause (i), (ii) or (iii)
above and dividends and distributions paid in cash). In addition to the
foregoing adjustments, the Company will be permitted to make such reductions in
the Conversion Price as it considers to be advisable in order that any event
treated for Federal income tax purposes as a dividend of shares or share rights
will not be taxable to the holders of the Common Shares or, if that is not
possible, to diminish any income taxes that are otherwise payable because of
such event.
In case the Company shall be a party to any transaction (including, without
limitation, a merger, consolidation, statutory share exchange, tender offer for
all or substantially all of the Common Shares or sale of all or substantially
all of the Company's assets), in each case as a result of which Common Shares
will be converted into the right to receive stock, securities or other property
(including cash or any combination thereof), each EPIPS share will thereafter be
convertible into the kind and amount of shares of capital stock, securities and
other property receivable (including cash or any combination thereof) upon the
consummation of such transaction by a holder of that number of Common Shares or
fraction thereof into which one EPIPS share was convertible immediately prior to
such transaction (assuming such holder of Common Shares failed to exercise any
rights of election and received per Common Share the kind and amount of shares
of beneficial
S-26
<PAGE> 28
interest, securities or other property received per Common Share by a plurality
of non-electing Common Shares). The Company may not become a party to any such
transaction unless the terms thereof are consistent with the foregoing.
There shall be no other adjustment of the Conversion Price in case of the
issuance of any capital stock of the Company in a reorganization, acquisition or
other similar transaction.
If the Company shall take any action affecting the Common Shares, other
than action described in this provision, that in the opinion of the Board of
Directors would materially adversely affect the conversion rights of the holders
of EPIPS shares, the Conversion Price for the EPIPS shares may be adjusted, to
the extent permitted by law, in such manner, if any, and at such time as the
Board of Directors, in its sole discretion, may determine to be equitable under
the circumstances.
No adjustment of the Conversion Price is required to be made in any case
until cumulative adjustments amount to 1% or more of the Conversion Price. Any
adjustments not so required to be made will be carried forward and taken into
account in subsequent adjustments.
Restrictions on Ownership
For the Company to qualify as a REIT under the Code, not more than 50% in
value of its outstanding shares of capital stock may be owned, directly or
indirectly, by five or fewer individuals (as defined in the Code to include
certain entities) during the last half of a taxable year and the shares of
capital stock must be beneficially owned by 100 or more persons during at least
335 days of a taxable year of 12 months (or during a proportionate part of a
shorter taxable year). The Company's Charter contains provisions that restrict
the ownership and transfer of shares of capital stock. With certain exceptions,
the Charter provides that no person may own, or be deemed to own by virtue of
the attribution provisions of the Code, more than 9.8% of the total number (or
of the value of the total number, if less) of outstanding Common Shares or 9.8%
of the number (or the value of the total number, if less) of outstanding shares
of Preferred Stock of all series of the Company, including the EPIPS shares.
EPIPS shares or other shares owned in excess of such limits shall be deemed
"Shares-in-Trust" pursuant to the Company's Charter, in which case the holder
will lose certain ownership rights with respect to such EPIPS shares or other
shares and the Company will have the right to purchase such excess shares from
the holder. Due to the attribution rules that exist with respect to these
ownership restrictions, persons holding (or treated as holding under the
relevant attribution rules) EPIPS shares will be treated, for purposes of the
ownership restrictions, as owning the Common Shares into which their EPIPS
shares can be converted even prior to such conversion if such ownership would
cause ownership of Common Shares in excess of the applicable ownership limit.
Accordingly, potential purchasers of EPIPS shares should take their direct and
constructive ownership of Common Shares into account in determining whether they
can hold EPIPS shares without violating the ownership limit with respect to
Common Shares. The Company's Charter authorizes the Board of Directors, under
certain conditions, to grant exemptions from such Charter limits, provided that
such exemption would not cause the Company to fail to qualify as a REIT.
Exchange Listing
The Company intends to make application to list the EPIPS shares on the
NYSE, subject to official notice of issuance. If so approved, trading of the
EPIPS shares on the NYSE is expected to commence within a 30-day period after
the date of initial delivery of the EPIPS shares. See "Underwriting."
Transfer Agent, Registrar, Dividend Disbursing Agent, Conversion Agent and
Redemption Agent
The transfer agent, registrar, dividend disbursing agent, conversion agent
and redemption agent for the EPIPS shares, and the transfer agent, registrar and
dividend disbursing agent for the Common Shares, is ChaseMellon Shareholder
Services, 400 South Hope Street, 4th Floor, Los Angeles, California 90071, (213)
553-9718.
S-27
<PAGE> 29
UNDERLYING COMMON SHARES
The Common Shares of the Company issuable upon conversion or redemption of
the EPIPS shares are described in the accompanying Prospectus beginning on page
14.
UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS
The Company believes it has operated, and the Company intends to continue
to operate, in such a manner as to qualify as a REIT under the Internal Revenue
Code of 1986, as amended (the "Code"), but no assurance can be given that it
will at all times so qualify. See "Risk Factors -- Failure to Maintain REIT
Status" and "United States Federal Income Tax Considerations" in the
accompanying Prospectus.
In connection with this Offering, Brobeck, Phleger & Harrison LLP, counsel
to the Company, will render a legal opinion that the Company has qualified as a
REIT under the Code, commencing with the Company's taxable year ended December
31, 1995. Such legal opinion will be filed as an exhibit to the Registration
Statement of which the accompanying Prospectus is a part. Such legal opinion and
any opinions contained in this Prospectus Supplement or the accompanying
Prospectus as to the Company's qualification as a REIT under the Code will be
qualified in their entirety by the assumptions and qualifications contained in
such legal opinion and described in the Prospectus and this Prospectus
Supplement. For a more specific discussion of the federal income tax treatment
of the Company and its shareholders, the various requirements for qualification
as a REIT and the risks of disqualification as a REIT, reference is made to the
section of the accompanying Prospectus entitled "United States Federal Income
Tax Considerations."
The provisions of the Code pertaining to REITs are highly technical and
complex, and neither the Company nor Brobeck, Phleger & Harrison LLP can assure
that the Internal Revenue Service (the "IRS") will not successfully contest the
Company's qualification as a REIT. Upon audit, Brobeck, Phleger & Harrison LLP's
opinion is not binding on the IRS or the courts. Investors are urged to consult
their own tax advisors with respect to the appropriateness of an investment in
the EPIPS shares offered hereby and with respect to the tax consequences arising
under federal law and the laws of any state, municipality or other taxing
jurisdiction, including tax consequences resulting from such investor's own tax
characteristics. In particular, investors are urged to consult their own tax
advisors with respect to the new rules contained in the Taxpayer Relief Act of
1997, and foreign investors should consult their own tax advisors concerning the
tax consequences of an investment in the Company, including the possibility of
United States income tax withholding on Company distributions. See "United
States Federal Income Tax Considerations" in the accompanying Prospectus.
S-28
<PAGE> 30
UNDERWRITING
Subject to the terms and conditions contained in the underwriting agreement
(the "Underwriting Agreement"), the Company has agreed to sell to each of the
Underwriters named below (the "Underwriters"), and each of the Underwriters, for
whom EVEREN Securities, Inc., Bear, Stearns & Co. Inc., A.G. Edwards & Sons,
Inc., Raymond James & Associates, Inc., and Sutro & Co. Incorporated are acting
as representatives (the "Representatives"), have severally agreed to purchase
from the Company, the respective number of EPIPS shares set forth opposite their
names below.
<TABLE>
<CAPTION>
UNDERWRITER NUMBER OF EPIPS SHARES
----------- ----------------------
<S> <C>
EVEREN Securities, Inc..................................
Bear, Stearns & Co. Inc.................................
A.G. Edwards & Sons, Inc................................
Raymond James & Associates, Inc.........................
Sutro & Co. Incorporated................................
---------
Total......................................... 2,000,000
=========
</TABLE>
The Underwriting Agreement provides that the obligation of the Underwriters
to pay for and accept delivery of the EPIPS shares is subject to approval of
certain legal matters by counsel and to certain other conditions. The
Underwriters are obligated to take and pay for all EPIPS shares offered hereby
(other than those covered by the over-allotment option described below) if any
such shares are taken.
The Representatives have advised the Company that the Underwriters propose
to offer the EPIPS shares directly to the public at the public offering price
set forth on the cover page of this Prospectus Supplement and to certain dealers
at such price less a concession not in excess of $ per share. The
Underwriters may allow, and such dealers may reallow, a concession not in excess
of $ per share to certain other dealers.
The Company has granted to the Underwriters an option, exercisable for 30
days after the date of this Prospectus Supplement, to purchase up to 300,000
additional EPIPS shares to cover over-allotments, if any, at the public offering
price less the underwriting discount set forth on the cover page of this
Prospectus Supplement. If the Underwriters exercise this option, each
Underwriter will have a firm commitment, subject to certain conditions, to
purchase approximately the same percentage thereof which the number of EPIPS
shares to be purchased by it shown in the foregoing table bears to the total
number of EPIPS shares initially offered hereby.
The Company has agreed to indemnify the Underwriters against certain
liabilities, including liabilities under the Securities Act, or to contribute to
payments the Underwriters may be required to make in respect thereof.
The Company has agreed that it will not, with certain exceptions, offer,
sell or otherwise dispose any EPIPS shares or Common Shares for a period of 90
days from the date of this Prospectus Supplement without the prior written
consent of EVEREN Securities, Inc. This prohibition will not affect Common
Shares issued by the Company in connection with acquisitions, or issued or
granted by the Company pursuant to any incentive plan, any dividend reinvestment
plan or the conversion or exercise of securities convertible or exercisable for
Common Shares. Certain of the Company's directors and executive officers have
agreed that, for a period of 90 days from the date of this Prospectus
Supplement, they will not, without the prior written consent of EVEREN
Securities, Inc. offer, sell or otherwise voluntarily dispose of any Common
Shares or any securities convertible into or exercisable for Common Shares.
Application will be made to list the EPIPS shares on the NYSE. Trading of
the EPIPS shares on the NYSE is expected to commence within the 30-day period
after the initial delivery of the EPIPS shares. The Representatives have advised
the Company that they intend to make a market in the EPIPS shares prior to the
commencement of trading on the NYSE. The Representatives will have no obligation
to make a market in the EPIPS shares, however, and may cease market marking
activities, if commenced, at any time.
S-29
<PAGE> 31
Until the distribution of the EPIPS shares is completed, rules of the
Commission may limit the ability of the Underwriters and certain selling group
members to bid for and purchase the EPIPS shares and the Common Shares. As an
exception to these rules, the Underwriters are permitted to engage in certain
transactions that stabilize the price of the EPIPS shares and the Common Shares.
Such transactions consist of bids or purchases for the purpose of pegging,
fixing or maintaining the price of the EPIPS shares and the Common Shares.
If the Underwriters create a short position in the EPIPS shares in
connection with this Offering, i.e., if they sell more EPIPS shares than are set
forth on the cover page of this Prospectus Supplement, the Representatives may
reduce that short position by purchasing EPIPS shares in the open market. The
Representatives may also elect to reduce any short position by exercising all or
part of the over-allotment option described above.
The Representatives also may impose a penalty bid on certain selling group
members. This means that if the Underwriters purchase EPIPS shares in the open
market to reduce any short position or to stabilize the price of the EPIPS
shares, they may reclaim the amount of the selling concession from the selling
group members who sold those shares as part of this Offering.
In general, purchases of a security for the purpose of stabilization or to
reduce a syndicate short position could cause the price of the security to be
higher than it might be in the absence of such purchases. The imposition of a
penalty bid might also have an effect on the price of a security to the extent
that it were to discourage resales of the security by purchasers in this
Offering.
Neither the Company nor any of the Underwriters makes any representation or
prediction as to the direction or magnitude of any effect that the transactions
described above may have on the price of the EPIPS shares or the Common Shares.
In addition, neither the Company nor any of the Underwriters makes any
representation that the Underwriters will engage in such transactions or that
such transactions, once commenced, will not be discontinued without notice.
Certain of the Underwriters or their respective affiliates have provided,
and may in the future provide, investment banking, financial advisory or
commercial banking services for the Company, for which they have received and
may receive customary compensation. EVEREN Securities, Inc., Bear, Stearns & Co.
Inc., A.G. Edwards & Sons, Inc. and Raymond James & Associates, Inc. have
co-managed one or more public equity offerings of the Company's Common Stock in
the last year for which they received customary compensation. Certain of the
Representatives intend to act as Initial Purchasers in connection with the
proposed Senior Notes Offering, for which they will receive customary
compensation.
Bear, Stearns & Co. Inc., one of the Representatives, is affiliated with
the NYSE specialist for the Company's Common Stock. Bear, Stearns & Co. Inc. has
in the past performed, and may continue to perform, investment banking and
financial advisory services for the Company and has received customary
compensation therefor. Bear, Stearns & Co. Inc. was the exclusive financial
advisor to the Company in connection with the acquisition of a portfolio of
hotels in October 1997 and, in addition, rendered a fairness opinion in
connection therewith, for which it received customary compensation.
LEGAL MATTERS
The validity of the EPIPS shares offered hereby and certain federal income
tax matters pertaining to the Company's status as a REIT will be passed upon for
the Company by Brobeck, Phleger & Harrison LLP. In addition, the description of
federal income tax consequences contained in the section of the Prospectus
Supplement and the accompanying Prospectus entitled "United States Federal
Income Tax Considerations" is based on the opinion of Brobeck, Phleger &
Harrison LLP. Roger Cohen, a partner at Brobeck, Phleger & Harrison LLP, is
Assistant Secretary of the Company and owns 3,560 shares of Common Stock and has
been granted options to purchase 4,500 shares of Common Stock. Certain legal
matters related to the Offering will be passed upon for the Underwriters by
O'Melveny & Myers LLP, San Francisco, California. In rendering their opinions,
Brobeck, Phleger & Harrison LLP and O'Melveny & Myers LLP will rely upon the
opinion of Ballard Spahr Andrews & Ingersoll as to certain matters of Maryland
law.
S-30
<PAGE> 32
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Introduction to Unaudited Pro Forma Combined Financial
Information............................................... F-2
SUNSTONE HOTEL INVESTORS, INC. ("SUNSTONE") -- Pro Forma
Combined Financial Information
Unaudited Pro Forma Combined Balance Sheet as of March 31,
1998................................................... F-3
Notes to Unaudited Pro Forma Combined Balance Sheet....... F-4
Unaudited Pro Forma Combined Statement of Income for the
Three Months Ended March 31, 1998...................... F-5
Unaudited Pro Forma Combined Statement of Income for the
Year Ended December 31, 1997........................... F-6
Notes to Unaudited Pro Forma Combined Statements of
Income................................................. F-7
SUNSTONE HOTEL PROPERTIES, INC. (THE "LESSEE") -- Pro Forma
Combined Statement of Operations
Unaudited Pro Forma Combined Statement of Operations for
the Three Months Ended March 31, 1998.................. F-10
Unaudited Pro Forma Combined Statement of Operations for
the Year Ended December 31, 1997....................... F-11
Notes to Unaudited Pro Forma Combined Statements of
Operations............................................. F-12
</TABLE>
All other schedules for which provision is made in the applicable accounting
regulations of the Securities and Exchange Commission are not required under the
related instructions or are inapplicable and therefore have been omitted.
F-1
<PAGE> 33
SUNSTONE HOTEL INVESTORS, INC. ("SUNSTONE")
SUNSTONE HOTEL PROPERTIES, INC. ("LESSEE")
INTRODUCTION TO UNAUDITED PRO FORMA COMBINED FINANCIAL INFORMATION
The unaudited pro forma combined balance sheet of Sunstone as of March 31,
1998 is presented as if the hotel and laundry facility acquisitions (through
July 29, 1998) and the pending acquisition of one hotel and pending dispositions
of six hotels (collectively the "Current Hotels") and related financings and
equity offerings and the Offering and the concurrent Senior Notes Offering all
had occurred by March 31, 1998.
Sunstone's and the Lessee's unaudited pro forma combined statements of
income and operations for the three months ended March 31, 1998 and for the year
ended December 31, 1997 are presented as if the completed and pending
acquisitions and dispositions of the Current Hotels and related financings and
equity offerings and the Offering and the concurrent Senior Notes Offering had
all occurred as of January 1, 1997. In management's opinion, all adjustments
necessary to reflect the effects of these transactions have been made.
The unaudited pro forma combined financial information is not necessarily
indicative of what Sunstone's or the Lessee's financial position or results of
operations would have been assuming consummation of the acquisitions and
dispositions of the Current Hotels and related financings, equity offerings and
the Offering and the concurrent Senior Notes Offering by March 31, 1998 or on
January 1, 1997, nor do they purport to project Sunstone's or the Lessee's
financial position or results of operations at any future date or for any future
period.
F-2
<PAGE> 34
SUNSTONE HOTEL INVESTORS, INC.
UNAUDITED PRO FORMA COMBINED BALANCE SHEET
AS OF MARCH 31, 1998
ASSETS
<TABLE>
<CAPTION>
OFFERING AND
SENIOR NOTES
OFFERING PRO FORMA
SUNSTONE HOTEL PRO FORMA CURRENT PRO FORMA SUNSTONE HOTEL
INVESTORS, INC. ADJUSTMENTS HOTELS ADJUSTMENTS INVESTORS, INC.
--------------- ----------- ------------ ------------- ---------------
(HISTORICAL) (PRO FORMA)
(A) (B)
<S> <C> <C> <C> <C> <C>
Investment in hotel
properties, net.......... $763,138,000 $33,840,000 $796,978,000 $ -- $796,978,000
Notes receivable........... 6,073,000 -- 6,073,000 -- 6,073,000
Cash and cash
equivalents.............. 2,023,000 -- 2,023,000 -- 2,023,000
Restricted cash............ 2,766,000 -- 2,766,000 -- 2,766,000
Rent
receivable -- Lessee..... 12,174,000 -- 12,174,000 -- 12,174,000
Other assets, net.......... 18,393,000 -- 18,393,000 4,313,000(C) 22,706,000
------------ ----------- ------------ ------------- ------------
$804,567,000 $33,840,000 $838,407,000 $ 4,313,000 $842,720,000
============ =========== ============ ============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Revolving line of credit... $192,800,000 $25,775,000 $218,575,000 $(193,512,000)(C) $ 25,063,000
Senior notes............... -- -- -- 150,000,000(C) 150,000,000
Notes payable.............. 100,288,000 6,186,000 106,474,000 -- 106,474,000
Accounts payable and other
accrued expenses......... 12,720,000 -- 12,720,000 -- 12,720,000
Dividends payable to
preferred shareholders... 487,000 -- 487,000 -- 487,000
------------ ----------- ------------ ------------- ------------
306,295,000 31,961,000 338,256,000 (43,512,000) 294,744,000
Minority interest.......... 25,605,000 3,054,000 28,659,000 2,740,000(D) 31,399,000
Stockholders' equity:
Preferred stock............ 3,000 -- 3,000 20,000(E) 23,000
Common stock............... 375,000 -- 375,000 -- 375,000
Additional paid-in
capital.................. 478,791,000 (1,175,000) 477,616,000 45,065,000(E) 522,681,000
Distributions in excess of
earnings................. (6,502,000) -- (6,502,000) -- (6,502,000)
------------ ----------- ------------ ------------- ------------
472,667,000 (1,175,000) 471,492,000 45,085,000 516,577,000
------------ ----------- ------------ ------------- ------------
$804,567,000 $33,840,000 $838,407,000 $ 4,313,000 $842,720,000
============ =========== ============ ============= ============
</TABLE>
The accompanying notes are an integral part of the pro forma combined statement
of operations.
F-3
<PAGE> 35
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED BALANCE SHEET
AS OF MARCH 31, 1998
(A) Reflects Sunstone's historical consolidated balance sheet as of March 31,
1998.
(B) Represents pro forma adjustments to reflect the assets, liabilities and
equity related to the Current Hotels acquired or expected to be acquired or
disposed of subsequent to March 31, 1998.
<TABLE>
<CAPTION>
TOTAL
FINANCED WITH ACQUISITION ADDITIONAL
ASSUMED (REPAYMENT OF) MINORITY (DISPOSITION) PAID IN
HOTEL DEBT LINE OF CREDIT INTEREST COST CAPITAL
----- ---------- -------------- ---------- ------------- -----------
<S> <C> <C> <C> <C> <C>
Acquisitions:
Hilton Inn, Oxnard,
CA................... $ -- $ 9,311,000 $ -- $ 9,311,000 $ --
Hampton Inn, Santa
Clarita, CA.......... 6,186,000 226,000 1,879,000(4) 8,291,000 --
Marriott, Napa, CA...... -- 21,406,000 -- 21,406,000 --
Days Inn, Santa Clara,
CA................... -- 20,012,000 -- 20,012,000 --
Independent, Santa
Monica, CA(1)........ -- 22,000,000 -- 22,000,000 --
Pending Dispositions(2)... -- (47,180,000) -- (47,180,000) --
Reallocation of minority
interest(3)............. -- -- 1,175,000 -- (1,175,000)
---------- ------------ ---------- ------------ -----------
$6,186,000 $ 25,775,000 $3,054,000 $ 33,840,000 $(1,175,000)
========== ============ ========== ============ ===========
</TABLE>
- ---------------
(1) Pending acquisition.
(2) Represents the pending sales of the Quality Inn Pocatello Park, ID, the
Best Western Colonial Park, Helena, MT, the Best Western Canyon
Springs, Twin Falls, ID, the Boise Park Suites, Boise, ID, the Green
Oaks Park Hotel, Fort Worth, TX, and the Lakeview Resort and Conference
Center, Morgantown, WV, and the application of the estimated net
proceeds of $47,180,000 to repayment of the revolving line of credit.
(3) Represents the reallocation of minority interest in order to reflect
the pro forma minority percentage as of March 31, 1998 (5.73%) prior to
the effect of the Offering and concurrent Senior Notes Offering.
(4) Represents 118,409 units in Sunstone LP at $15.87 per unit.
(C) Reflects application of (i) the gross proceeds from the Offering to payment
of offering costs and repayment of the revolving line of credit and (ii) the
gross proceeds from the concurrent Senior Notes Offering to payment of debt
issuance costs and repayment of the revolving line of credit.
(D) Represents the reallocation of minority interest in order to reflect the pro
forma minority percentage as of March 31, 1998 (5.73%).
(E) Represents the proceeds from the Offering net of offering costs and the
reallocation of minority interest in order to reflect the pro forma minority
percentage as of March 31, 1998 (5.73%).
F-4
<PAGE> 36
SUNSTONE HOTEL INVESTORS, INC.
UNAUDITED PRO FORMA COMBINED STATEMENT OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 1998
<TABLE>
<CAPTION>
OFFERING AND
SENIOR
NOTES
OFFERING PRO FORMA
SUNSTONE HOTEL PRO FORMA CURRENT PRO FORMA SUNSTONE HOTEL
INVESTORS, INC. ADJUSTMENTS HOTELS ADJUSTMENTS INVESTORS, INC.
--------------- ----------- ----------- ------------ ---------------
(HISTORICAL) (PRO FORMA)
(A) (B) (I)
<S> <C> <C> <C> <C> <C>
REVENUES
Lease revenue -- Lessee.......... $23,687,000 $825,000(C) $24,512,000 $ -- $ 24,512,000
Interest income.................. 57,000 -- 57,000 -- 57,000
----------- -------- ----------- ----------- --------------
23,744,000 825,000 24,569,000 -- 24,569,000
----------- -------- ----------- ----------- --------------
EXPENSES
Real estate related depreciation
and amortization............... 7,919,000 320,000(D) 8,239,000 -- 8,239,000
Interest expense and amortization
of financing costs............. 4,595,000 355,000(E) 4,950,000 (495,000)(J) 4,455,000
Real estate and personal property
taxes, ground rent and
insurance...................... 2,779,000 83,000(F) 2,862,000 -- 2,862,000
General and administrative....... 1,503,000 --(G) 1,503,000 -- 1,503,000
----------- -------- ----------- ----------- --------------
Total expenses......... 16,796,000 758,000 17,554,000 (495,000) 17,059,000
----------- -------- ----------- ----------- --------------
Income before minority
interest....................... 6,948,000 67,000 7,015,000 495,000 7,510,000
Minority interest................ (351,000) (4,000)(H) (355,000) 38,000(H) (317,000)
----------- -------- ----------- ----------- --------------
Net income....................... 6,597,000 63,000 6,660,000 533,000 7,193,000
Preferred dividends.............. (487,000) -- (487,000) (1,203,000)(K) (1,690,000)
----------- -------- ----------- ----------- --------------
Income (loss) available to common
shareholders................... $ 6,110,000 $ 63,000 $ 6,173,000 $ (670,000) $ 5,503,000
=========== ======== =========== =========== ==============
Earnings per Common Share
Outstanding
Basic.......................... $ 0.15
==============
Diluted........................ $ 0.15
==============
Weighted average number of common
shares outstanding(L)
Basic.......................... 37,502,364
==============
Diluted........................ 37,672,732
==============
</TABLE>
The accompanying notes are an integral part of the pro forma combined statement
of operations
F-5
<PAGE> 37
SUNSTONE HOTEL INVESTORS, INC.
UNAUDITED PRO FORMA COMBINED STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 1997
<TABLE>
<CAPTION>
OFFERING AND
SENIOR NOTES
OFFERING PRO FORMA
SUNSTONE HOTEL PRO FORMA CURRENT PRO FORMA SUNSTONE HOTEL
INVESTORS, INC. ADJUSTMENTS HOTELS ADJUSTMENTS INVESTORS, INC.
--------------- ----------- ----------- ------------ ---------------
(HISTORICAL)
(A) (B) (PRO FORMA) (I)
<S> <C> <C> <C> <C> <C>
REVENUES
Lease revenue -- Lessee......... $44,680,000 $49,237,000(C) $93,917,000 $ -- $93,917,000
Interest income................. 471,000 -- 471,000 -- 471,000
----------- ----------- ----------- ----------- -----------
45,151,000 49,237,000 94,388,000 -- 94,388,000
----------- ----------- ----------- ----------- -----------
EXPENSES
Real estate related depreciation
and amortization.............. 14,749,000 16,649,000(D) 31,398,000 -- 31,398,000
Interest expense and
amortization of financing
costs......................... 6,365,000 14,890,000(E) 21,255,000 (2,197,000)(J) 19,058,000
Real estate and personal
property taxes, ground rent
and insurance................. 4,670,000 6,190,000(F) 10,860,000 -- 10,860,000
General and administrative...... 1,890,000 250,000(G) 2,140,000 -- 2,140,000
----------- ----------- ----------- ----------- -----------
Total expenses........ 27,674,000 37,979,000 65,653,000 (2,197,000) 63,456,000
----------- ----------- ----------- ----------- -----------
Income before minority
interest...................... 17,477,000 11,258,000 28,735,000 2,197,000 30,932,000
Minority interest............... (1,886,000) (73,000)(H) (1,959,000) 192,000(H) (1,767,000)
----------- ----------- ----------- ----------- -----------
Net income...................... 15,591,000 11,185,000 26,776,000 2,389,000 29,165,000
Preferred dividends............. (422,000) (1,553,000)(M) (1,975,000) (4,813,000)(K) (6,788,000)
----------- ----------- ----------- ----------- -----------
Income (loss) available to
common shareholders........... $15,169,000 $ 9,632,000 $24,801,000 $(2,424,000) $22,377,000
=========== =========== =========== =========== ===========
Earnings per Common Share
Outstanding
Basic......................... $ 0.61
===========
Diluted....................... $ 0.61
===========
Weighted average number of common
shares outstanding(L)
Basic......................... 36,595,952
===========
Diluted....................... 36,754,112
===========
</TABLE>
The accompanying notes are an integral part of the pro forma combined statement
of operations.
F-6
<PAGE> 38
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND FOR THE YEAR ENDED DECEMBER 31,
1997
(A) Represents Sunstone's historical results of operations for the three months
ended March 31, 1998 and the year ended December 31, 1997, as applicable.
(B) Represents historical results of operations and pro forma adjustments to
Sunstone's historical results of operations assuming the acquisitions,
pending acquisition and pending dispositions of the Current Hotels listed
below and the related financings and equity offerings had occurred on
January 1, 1997.
<TABLE>
<CAPTION>
DATE ACQUIRED OR
ASSET OF INVESTMENT
----- ----------------
<S> <C>
Holiday Inn Harbor View, San Diego, CA...................... January 17, 1997
Courtyard Marriott, Cypress, CA............................. January 17, 1997
Hawthorn Suites, Kent WA.................................... March 11, 1997
Holiday Inn, La Mirada, CA.................................. March 31, 1997
Fountain Suites, Sacramento, CA............................. May 17, 1997
Holiday Inn & Suites, San Diego, CA......................... June 11, 1997
Best Western Landmark Inn, Lynnwood, WA..................... July 17, 1997
Holiday Inn Mission Valley Stadium, San Diego, CA........... August 7, 1997
Hawthorne Suites Ltd., Anaheim, CA.......................... August 7, 1997
Regency Plaza Hotel, Los Angeles, CA........................ August 28, 1997
Olympia Park, Park City, UT................................. October 15, 1997
Rochester Marriott, Rochester, MN........................... October 15, 1997
Marriott Ogden Park, Ogden, UT.............................. October 15, 1997
Provo Marriott, Provo, UT................................... October 15, 1997
Residence Inn by Marriott, Provo, UT........................ October 15, 1997
Holiday Inn, Rochester, MN.................................. October 15, 1997
Hilton, Salt Lake City, UT.................................. October 15, 1997
The Kahler Hotel, Rochester, MN............................. October 15, 1997
Sheraton, Chandler, AZ...................................... October 15, 1997
Economy Inn & Executive Suites, Rochester, MN............... October 15, 1997
Salt Lake Marriott, Salt Lake City, UT...................... October 15, 1997
Textile Care Services, Rochester, MN........................ October 15, 1997
Textile Care Services, Salt Lake City, UT................... October 15, 1997
Residence Inn by Marriott, Sacramento, CA................... December 30, 1997
Residence Inn by Marriott, San Diego, CA.................... December 30, 1997
Ramada Ltd., San Diego, CA.................................. January 26, 1998
Residence Inn, Santa Clarita, CA............................ January 27, 1998
Fairfield Inn, Santa Clarita, CA............................ January 27, 1998
Carson Hilton, Carson, CA................................... February 19, 1998
Hilton Inn, Oxnard, CA...................................... April 9, 1998
Hampton Inn, Santa Clarita, CA.............................. April 30, 1998
Marriott, Napa, CA.......................................... May 5, 1998
Days Inn, Santa Clara, CA................................... May 13, 1998
Independent, Santa Monica, CA............................... Pending Acquisition
Quality Inn Pocatello Park, Pocatello, ID (acquired October
15, 1997)................................................. Pending Disposition
Best Western Colonial Park, Helena, MT (acquired October 15,
1997)..................................................... Pending Disposition
Boise Park Suites, Boise, ID (acquired October 15, 1997).... Pending Disposition
Best Western Canyon Springs, Twin Falls, ID (acquired
October 15, 1997)......................................... Pending Disposition
Green Oaks Park Hotel, Fort Worth, TX (acquired October 15,
1997)..................................................... Pending Disposition
Lakeview Resort & Conference Center, Morgantown, WV
(acquired October 15, 1997)............................... Pending Disposition
</TABLE>
F-7
<PAGE> 39
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED STATEMENTS OF INCOME (CONTINUED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND FOR THE YEAR ENDED DECEMBER 31,
1997
(C) Represents lease payments from the Lessee to Sunstone calculated on a pro
forma basis by applying the contractual or anticipated provisions of the
Percentage Leases to the historical revenue of the Current Hotels acquired
during 1997 and 1998, plus the pending acquisition, assuming January 1,
1997 was the start of the lease term, less, for pending dispositions, the
actual lease payments from the Lessee to Sunstone recorded during the
period. The Percentage Leases provide for the payment of base rent plus
additional rent. The base rent is computed based upon 9.2% to 50.2% of a
specified room revenue breakpoint which ranges from $1,015,000 to
$11,720,000. Additional rent is computed based upon 60% to 68% of the
Lessee's room revenues in excess of the specified room revenue breakpoint,
plus 5% of the Lessee's food and beverage revenues and 100% of any sublease
and concession rentals and other net revenues.
(D) Represents depreciation and amortization on the hotels and other assets
acquired calculated on a pro forma basis less historical depreciation and
amortization on the pending dispositions, assuming the acquisitions,
pending acquisition and pending dispositions of the Current Hotels occurred
on January 1, 1997. Depreciation is computed using the straight-line method
and is based upon the estimated useful lives of three to 40 years for
buildings and improvements and two to ten years for furniture and
equipment. Franchise fees are amortized over estimated useful lives of ten
to 20 years.
(E) Represents pro forma interest expense and amortization of financing costs
which would have been incurred on the net borrowings under the line of
credit and assumed debt related to the purchase and pending purchase of
hotel properties and other assets, net of equity offering proceeds, between
the beginning of the period and the acquisition or offering dates, less
historical interest expense under the line of credit recorded during the
period related to the pending dispositions. The pro forma interest rates
used are based upon the applicable fixed or variable interest rates stated
in the applicable debt agreements. The variable interest rate used in each
period was the historical weighted average interest rate on the line of
credit for such periods.
(F) Represents real estate and personal property taxes, ground leases and
insurance expense that would have been incurred by Sunstone assuming the
Current Hotels acquired in 1997 and 1998 plus the pending acquisition were
acquired on January 1, 1997, based on historical amounts of property taxes
and ground lease expense and historical or estimated insurance premiums
based upon Sunstone's existing insurance policies, less the actual
historical amounts recorded during the period for the pending dispositions.
(G) Represents the estimated incremental corporate expenses that would have
been incurred assuming the Current Hotels were acquired on January 1, 1997.
(H) Calculated as a percentage of income before minority interest less
preferred dividends. The pro forma adjustment is required to reflect the
average percentage of Sunstone LP owned by parties other than Sunstone
during the three months ended March 31, 1998 (5.44%) and during 1997
(7.32%).
(I) Represents adjustments to Sunstone's results of operations assuming the
Offering and concurrent Senior Notes Offering had occurred on January 1,
1997.
(J) Reflects (a) the elimination of historical and pro forma interest expense
related to the line of credit that would have been retired with proceeds of
the Offering and concurrent Senior Notes Offering, (b) interest related to
the Senior Notes and (c) amortization of debt issuance costs related to the
Senior Notes Offering.
(K) Reflects the pro forma dividends on the Offering assuming the Offering had
occurred on January 1, 1997.
F-8
<PAGE> 40
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED STATEMENTS OF INCOME (CONTINUED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND FOR THE YEAR ENDED DECEMBER 31,
1997
(L) The weighted average number of common shares outstanding does not assume
the conversion of Sunstone LP units into common shares.
(M) Reflects the pro forma dividends on the 7.9% Class A Cumulative Convertible
Preferred Stock assuming such stock was issued on January 1, 1997.
F-9
<PAGE> 41
SUNSTONE HOTEL PROPERTIES, INC.
UNAUDITED PRO FORMA COMBINED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 1998
<TABLE>
<CAPTION>
SUNSTONE HOTEL PRO FORMA SUNSTONE HOTEL
PROPERTIES, INC. ADJUSTMENTS PROPERTIES, INC.
---------------- ----------- ----------------
(HISTORICAL) (PRO FORMA)
(A) (B)
<S> <C> <C> <C>
REVENUES
Room.............................................. $47,910,000 $ 1,230,000 $49,140,000
Food and beverage................................. 9,993,000 (1,068,000) 8,925,000
Other............................................. 7,192,000 (72,000) 7,120,000
----------- ----------- -----------
65,095,000 90,000 65,185,000
----------- ----------- -----------
EXPENSES
Room.............................................. 11,378,000 293,000 11,671,000
Food and beverage................................. 8,540,000 (797,000) 7,743,000
Other............................................. 4,394,000 (194,000) 4,200,000
Franchise costs................................... 1,418,000 107,000 1,525,000
Advertising and promotion......................... 4,738,000 (124,000) 4,614,000
Utilities......................................... 2,429,000 (114,000) 2,315,000
Repairs and maintenance........................... 2,575,000 (31,000) 2,544,000
Management fees to Sunstone Hotel Management,
Inc............................................. 937,000 120,000(C) 1,057,000
Rent expense to Sunstone.......................... 23,687,000 825,000(D) 24,512,000
General and administrative........................ 6,991,000 42,000 7,033,000
----------- ----------- -----------
67,087,000 127,000 67,214,000
----------- ----------- -----------
NET LOSS.......................................... $(1,992,000) $ (37,000) $(2,029,000)
=========== =========== ===========
</TABLE>
F-10
<PAGE> 42
SUNSTONE HOTEL PROPERTIES, INC.
UNAUDITED PRO FORMA COMBINED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1997
<TABLE>
<CAPTION>
SUNSTONE HOTEL PRO FORMA SUNSTONE HOTEL
PROPERTIES, INC. ADJUSTMENTS PROPERTIES, INC.
----------------- ------------ ----------------
(HISTORICAL) (PRO FORMA)
(A) (B)
<S> <C> <C> <C>
REVENUES
Room............................................. $ 95,106,000 $ 95,871,000 $190,977,000
Food and beverage................................ 14,159,000 26,602,000 40,761,000
Other............................................ 8,888,000 16,957,000 25,845,000
------------ ------------ ------------
118,153,000 139,430,000 257,583,000
------------ ------------ ------------
EXPENSES
Room............................................. 22,073,000 23,349,000 45,422,000
Food and beverage................................ 11,978,000 21,591,000 33,569,000
Other............................................ 5,154,000 10,168,000 15,322,000
Franchise costs.................................. 3,428,000 939,000 4,367,000
Advertising and promotion........................ 9,574,000 8,846,000 18,420,000
Utilities........................................ 5,013,000 5,850,000 10,863,000
Repairs and maintenance.......................... 4,719,000 5,822,000 10,541,000
Management fees to Sunstone Hotel Management,
Inc............................................ 1,776,000 2,239,000(C) 4,015,000
Rent expense to Sunstone......................... 44,680,000 49,237,000(D) 93,917,000
General and administrative....................... 11,889,000 12,214,000 24,103,000
------------ ------------ ------------
120,284,000 140,255,000 260,539,000
------------ ------------ ------------
NET LOSS......................................... $ (2,131,000) $ (825,000) $ (2,956,000)
============ ============ ============
</TABLE>
F-11
<PAGE> 43
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND FOR THE YEAR ENDED DECEMBER 31,
1997
(A) Represents the historical results of operations of the Lessee for the three
months ended March 31, 1998 and for the year ended December 31, 1997, as
applicable.
(B) Represents historical results of operations and pro forma adjustments to
Lessee's historical results of operations assuming the acquisitions,
pending acquisition and pending dispositions of the Current Hotels listed
below had occurred on January 1, 1997.
<TABLE>
<CAPTION>
DATE ACQUIRED OR
ASSET OF INVESTMENT
----- ----------------
<S> <C>
Holiday Inn
Harbor View,
San Diego,
CA.......... January 17, 1997
Courtyard
Marriott,
Cypress,
CA.......... January 17, 1997
Hawthorn
Suites, Kent
WA.......... March 11, 1997
Holiday Inn,
La Mirada,
CA.......... March 31, 1997
Fountain
Suites,
Sacramento,
CA.......... May 17, 1997
Holiday Inn &
Suites, San
Diego, CA... June 11, 1997
Best Western
Landmark
Inn,
Lynnwood,
WA.......... July 17, 1997
Holiday Inn
Mission
Valley
Stadium, San
Diego, CA... August 7, 1997
Hawthorne
Suites Ltd.,
Anaheim,
CA.......... August 7, 1997
Regency Plaza
Hotel, Los
Angeles,
CA.......... August 28, 1997
Olympia Park,
Park City,
UT.......... October 15, 1997
Rochester
Marriott,
Rochester,
MN.......... October 15, 1997
Marriott Ogden
Park, Ogden,
UT.......... October 15, 1997
Provo
Marriott,
Provo, UT... October 15, 1997
Residence Inn
by Marriott,
Provo, UT... October 15, 1997
Holiday Inn,
Rochester,
MN.......... October 15, 1997
Hilton, Salt
Lake City,
UT.......... October 15, 1997
The Kahler
Hotel,
Rochester,
MN.......... October 15, 1997
Sheraton,
Chandler,
AZ.......... October 15, 1997
Economy Inn &
Executive
Suites,
Rochester,
MN.......... October 15, 1997
Salt Lake
Marriott,
Salt Lake
City, UT.... October 15, 1997
Textile Care
Services,
Rochester,
MN.......... October 15, 1997
Textile Care
Services,
Salt Lake
City, UT.... October 15, 1997
Residence Inn
by Marriott,
Sacramento,
CA.......... December 30, 1997
Residence Inn
by Marriott,
San Diego,
CA.......... December 30, 1997
Ramada Ltd.,
San Diego,
CA.......... January 26, 1998
Residence Inn,
Santa
Clarita,
CA.......... January 27, 1998
Fairfield Inn,
Santa
Clarita,
CA.......... January 27, 1998
Carson Hilton,
Carson,
CA.......... February 19, 1998
Hilton Inn,
Oxnard,
CA.......... April 9, 1998
Hampton Inn,
Santa
Clarita,
CA.......... April 30, 1998
Marriott,
Napa, CA.... May 5, 1998
Days Inn,
Santa Clara,
CA.......... May 13, 1998
Independent,
Santa
Monica,
CA.......... Pending Acquisition
Quality Inn
Pocatello
Park,
Pocatello,
ID (acquired
October 15,
1997)....... Pending Disposition
Best Western
Colonial
Park,
Helena, MT
(acquired
October 15,
1997)....... Pending Disposition
Boise Park
Suites,
Boise, ID
(acquired
October 15,
1997)....... Pending Disposition
Best Western
Canyon
Springs,
Twin Falls,
ID (acquired
October 15,
1997)....... Pending Disposition
Green Oaks
Park Hotel,
Fort Worth,
TX (acquired
October 15,
1997)....... Pending Disposition
Lakeview
Resort &
Conference
Center,
Morgantown,
WV
(acquired
October 15,
1997)....... Pending Disposition
</TABLE>
(C) Represents the elimination of historical management fees, and the addition
of management fees to be incurred under the new management agreements for
the Current Hotels. The management fees were calculated based on the
contractual or expected terms of the management agreements.
F-12
<PAGE> 44
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO UNAUDITED PRO FORMA COMBINED STATEMENTS OF OPERATIONS (CONTINUED)
(D) Represents rent expense calculated on a pro forma basis by applying the
contractual or expected rent provisions of the Percentage Leases to the
historical revenues of the Current Hotels acquired during 1997 and 1998,
plus hotels expected to be acquired assuming January 1, 1997 was the start
of the lease term, less, for pending dispositions, the actual rent expense
recorded during the period.
F-13
<PAGE> 45
PROSPECTUS
$325,000,000
LOGO
COMMON STOCK
PREFERRED STOCK
WARRANTS
Sunstone Hotel Investors, Inc. ("Sunstone" or the "Company") may from time
to time offer in one or more series or classes (i) shares of its common stock,
par value $0.01 per share (the "Common Stock"), (ii) shares of its preferred
stock, par value $0.01 per share (the "Preferred Stock"), and/or (iii) warrants
to purchase Preferred Stock or Common Stock (the "Warrants") in amounts, at
prices and on terms to be determined at the time of offering, with an aggregate
public offering price of up to $325,000,000. The Common Stock, Preferred Stock,
and Warrants (collectively, the "Offered Securities") may be offered, separately
or together, in separate series or classes, in amounts, at prices and on terms
to be set forth in one or more supplements to the Prospectus (each a "Prospectus
Supplement").
The specific terms of the Offered Securities in respect to which this
Prospectus is being delivered will be set forth in a future Prospectus
Supplement and will include (i) in the case of Common Stock, the specific title
and stated value, any voting, dividend and other rights, and public offering
price, (ii) in the case of Preferred Stock, the specific title and stated value,
any dividend, liquidation, redemption, conversion, voting and other rights,
share and price adjustment mechanisms, and public offering price and (iii) in
the case of Warrants, the term, exercise price, share and price adjustment
mechanisms, voting and other rights, detachability, and public offering price.
In addition, such specific terms may include limitations on direct or beneficial
ownership and restrictions on transfer of the Offered Securities, in each case
as may be appropriate to preserve the status of the Company as a real estate
investment trust ("REIT") for United States federal income tax purposes.
Each Prospectus Supplement will also contain information, where applicable,
about United States federal income tax considerations relating specifically to,
and any listing on a securities exchange of, the Offered Securities covered by
such Prospectus Supplement.
The Offered Securities may be offered directly, through agents designated
from time to time by the Company, or to or through underwriters or dealers. If
any agents or underwriters are involved in the sale of any of the Offered
Securities, their names, and any applicable purchase price, fee, commission or
discount arrangement between or among them, will be set forth, or will be
calculable from the information set forth, in the applicable Prospectus
Supplement. See "Plan of Distribution." No Offered Securities may be sold
without delivery of the applicable Prospectus Supplement describing the method
and terms of the offering of such series or class of Offered Securities.
SEE "RISK FACTORS" BEGINNING ON PAGE 5 FOR A DISCUSSION OF CERTAIN FACTORS
THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE OFFERED SECURITIES
OFFERED HEREBY.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
THIS PROSPECTUS MAY NOT BE USED TO CONSUMMATE SALES OF OFFERED SECURITIES UNLESS
ACCOMPANIED BY A PROSPECTUS SUPPLEMENT. THE DELIVERY IN ANY JURISDICTION OF THIS
PROSPECTUS, TOGETHER WITH A PROSPECTUS SUPPLEMENT RELATING TO SPECIFIC OFFERED
SECURITIES, SHALL NOT CONSTITUTE AN OFFER IN SUCH JURISDICTION OF ANY OTHER
OFFERED SECURITIES COVERED BY THIS PROSPECTUS BUT NOT DESCRIBED IN SUCH
PROSPECTUS SUPPLEMENT.
The date of this Prospectus is July 29, 1998.
<PAGE> 46
AVAILABLE INFORMATION
The Company is subject to the information requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance
therewith files reports, proxy statements and other information with the
Securities and Exchange Commission (the "Commission"). Such reports, proxy
statements and other information filed by the Company can be inspected and
copied at the public reference facilities maintained by the Commission at Room
1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, and at
regional offices of the Commission located at 7 World Trade Center, 13th Floor,
New York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite
1400, Chicago, Illinois 60661-2511. Copies of such material can be obtained by
mail from the Public Reference Section of the Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549 at prescribed rates.
The Company files information electronically with the Commission, and the
Commission maintains a Web Site that contains reports, proxy and information
statements and other information regarding registrants that file electronically
with the Commission, such as the Company, and the address is http://www.sec.gov.
The Company's Common Stock is listed on the New York Stock Exchange (the
"NYSE"), and reports, proxy statements and other information concerning the
Company can be inspected at the offices of the New York Stock Exchange, Inc., 20
Broad Street, New York, New York 10005.
The Company has filed with the Commission a Registration Statement on Form
S-3 under the Securities Act of 1933, as amended (the "Securities Act"), and the
rules and regulations promulgated thereunder, with respect to the Offered
Securities. This Prospectus, which is part of the Registration Statement, does
not contain all of the information set forth in the Registration Statement and
the exhibits. For further information concerning the Company and the Offered
Securities, reference is made to the Registration Statement and the exhibits and
schedules filed therewith, which may be obtained as described above.
INCORPORATION OF CERTAIN INFORMATION BY REFERENCE
The following documents, which have been filed with the Commission, are
hereby incorporated by reference:
1. Annual Report on Form 10-K of the Company for the fiscal year ended
December 31, 1997;
2. Quarterly Report on Form 10-Q for the quarter ended March 31, 1998;
3. Current Reports on Form 8-K filed with the Commission on January 29,
1998, February 9, 1998 and July 29, 1998; and
4. The description of the Common Stock of the Company included in the
Company's Registration Statement on Form 8-A, filed with the Commission
on June 26, 1995; and on Form 8-A/A, filed with the Commission on July
19, 1996.
In addition, all reports and other documents subsequently filed by the
Company with the Commission pursuant to Section 13, 14 or 15(d) of the Exchange
Act after the date of this Prospectus and prior to the termination of the
offering shall be deemed to be incorporated by reference in this Prospectus and
to be a part hereof from the date of the filing of such documents (such
documents, and the documents enumerated above, being herein referred to as
"Incorporated Documents;" provided however, that the documents enumerated above
or subsequently filed by the Company pursuant to Section 13, 14 or 15(d) of the
Exchange Act prior to the filing of the Company's next Annual Report on Form
10-K with the Commission shall not be Incorporated Documents or be incorporated
by reference in this Prospectus or be a part hereof from and after any such
filing of an Annual Report on Form 10-K). Any statement contained in a document
incorporated or deemed to be incorporated by reference herein shall be deemed to
be modified or superseded for purposes of this Prospectus to the extent that a
statement contained herein (or in any other subsequently filed document which
also is or is deemed to be incorporated by reference herein) modifies or
supersedes such statement. Any statements so modified or superseded shall not be
deemed to constitute a part of this Prospectus, except as so modified or
superseded.
2
<PAGE> 47
The Company will provide without charge to each person to whom this
Prospectus is delivered, upon written or oral request of such person, a copy of
any or all of the documents referred to above which have been or may be
incorporated by reference in this Prospectus (other than certain exhibits to
such documents). Requests for such documents should be directed to Sunstone
Hotel Investors, Inc., 115 Calle de Industrias, Suite 201, San Clemente,
California 92672, Attention: Secretary (telephone: (949) 361-3900).
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THE COMPANY
The Company is a leading self-administered equity real estate investment
trust ("REIT") that owns a 94.6% partnership interest in Sunstone LP, whose
portfolio consists of eight luxury, 21 upscale and 27 mid-price hotels located
primarily in the Pacific and Mountain regions of the western United States. The
Company's hotels operate primarily under national franchises that are widely
recognized in the lodging industry, including brands affiliated with Hilton
Hotels Corporation(R), Holiday Hospitality Corporation(R), Marriott
International, Inc.(R) and Promus Hotel Corporation(R). The Company's portfolio
consists of 56 hotels, 55 of which were acquired and one of which was developed,
located in California (25 hotels), Utah (8), Colorado (6), Arizona (5),
Washington (5), Minnesota (4), Oregon (2) and New Mexico (1), with a total of
10,051 rooms.
In order for the Company to qualify as a REIT for United States federal
income tax purposes, neither the Company nor the Partnership can operate hotels.
Therefore, the Partnership leases the hotels to Sunstone Hotel Properties, Inc.,
a Colorado corporation (the "Lessee") pursuant to percentage leases with an
initial term of ten years (the "Percentage Leases"), which provide for rent
payments based principally on a percentage of room revenues at the hotels. The
Lessee pays the franchise fees, management fees and certain other operating
expenses of the hotels. The Lessee is owned by Robert A. Alter, Chairman and
President of the Company, and Charles L. Biederman, director and Executive Vice
President of the Company. The hotels are managed by Sunstone Hotel Management,
Inc., a Colorado corporation (the "Management Company") pursuant to a management
agreement between the Lessee and the Management Company for a fee equal to 1% to
2% of gross revenues of the hotels (plus reimbursement of accounting costs). The
Management Company is wholly-owned by Mr. Alter.
On October 15, 1997, the Company acquired all of the outstanding capital
stock of Kahler Realty Corporation, a Minnesota corporation ("Kahler") from
Westbrook Real Estate Fund I, L.P. and Westbrook Real Estate Co-Investment
Partnership I, L.P. (collectively, the "Westbrook Funds") for an aggregate
purchase price of approximately $372.3 million (the "Kahler Acquisition"). The
purchase price may be increased by as much as $16.5 million pursuant to a
formula based on the 1999 earnings of the Kahler assets. Any additional purchase
price may be paid at the Company's option in cash or shares of Common Stock.
Kahler owned and operated 17 hotels (the "Kahler Hotels") with 4,255 rooms,
principally in two markets, the intermountain region of Utah, Idaho, Montana and
Arizona (11 hotels) and Rochester, Minnesota (four hotels). The largest number
of rooms are concentrated in Rochester, Minnesota with four hotels and 1,329
rooms and in the Salt Lake City area of Utah, with six hotels and 1,509 rooms.
Nine of the hotels are operated independently, while the balance is operated
under Sheraton, Hilton, Holiday Inn, Best Western and Quality Inn franchises.
The acquisition of Kahler almost doubled the number of hotel rooms owned or
operated by the Company.
The Company's principal executive office is located at 115 Calle de
Industrias, Suite 201, San Clemente, California 92672; telephone number (949)
361-3900. The Company's website is located at http://www.sunstonehotels.com.
The Company's Common Stock is listed on the NYSE under the symbol "SSI."
USE OF PROCEEDS
The Company intends to invest the net proceeds from any sale of the Offered
Securities in the Partnership in exchange for an additional ownership interest
in the Partnership. Unless otherwise indicated in a future Prospectus
Supplement, the Partnership intends to use the net proceeds from any sale of
Offered Securities for general corporate purposes, including, without
limitation, the acquisition and development of additional hotels, the
maintenance and renovation of currently owned hotels, and the repayment of debt.
Pending application of the net proceeds, such net proceeds may either be used to
temporarily repay outstanding indebtedness or may be invested in
interest-bearing accounts and short-term, interest-bearing securities, in a
manner consistent with the Company's ability to qualify for taxation as a REIT.
Such investments may include, for example, government and government agency
securities, certificates of deposit, interest-bearing bank deposits and mortgage
loan participations.
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RISK FACTORS
In evaluating the Company's business, prospective investors should
carefully consider the factors set forth in this section in addition to other
information set forth in the accompanying Prospectus Supplement before making an
investment decision with respect to the Offered Securities. This Prospectus may
contain forward-looking statements which involve risks and uncertainties, and
actual results could differ materially from those discussed in any such
forward-looking statements. Certain of the factors that could cause actual
results to differ materially are discussed below.
IMPEDIMENTS TO GROWTH AND INCREASING CASH AVAILABLE FOR DISTRIBUTION
The Company's ability to increase cash available for distribution on its
Common Stock ("Cash Available for Distribution") will depend significantly on
the Company's ability to acquire or develop additional hotels at attractive
prices. Risks associated with this growth strategy include:
Competition For Future Acquisitions. There is competition for investment
opportunities in luxury, upscale and mid-price hotels from entities organized
for purposes substantially similar to the Company's objectives as well as from
other purchasers of hotels. The Company is competing for such hotel investment
opportunities with entities which have substantially greater financial resources
than the Company or better relationships with franchisors, sellers or lenders.
These entities may also generally be able to accept more risk than the Company
prudently can manage. There can be no assurance that competition will not
generally reduce the number of suitable hotel investment opportunities offered
to the Company and increase the bargaining power of property owners seeking to
sell.
Renovation and Redevelopment Risks. The Company faces risks arising from
its strategy of acquiring hotels in need of substantial renovation or
redevelopment, particularly the risk that the cost or time to complete the
renovation or redevelopment will exceed the budgeted amount. Such delays or cost
overruns may arise from shortages of materials or skilled labor, a change in the
scope of the original project, the need to comply with building code or other
legal requirements, the discovery of structural or other latent defects with a
hotel once construction has commenced and other risks inherent in the
construction process. These risks are increased by the significant number of
renovations the Company is currently undertaking as a result of the significant
number of hotels recently acquired by the Company. In particular, renovation and
redevelopment must comply with the Americans with Disabilities Act of 1990 (the
"ADA"), which provides that all public accommodations meet certain federal
requirements related to access and use by disabled persons. The Company may be
required to make substantial modifications at the hotels to comply with the ADA.
Cost overruns incurred during renovation and redevelopment projects increase the
Company's total investment in a hotel and may reduce the Company's anticipated
return on such investment. Delays in completing such renovation and
redevelopment projects decrease the Lessee's operations at the hotel, resulting
in lower revenues which either increases the Lessee's operating losses or, if a
rental abatement is provided, reduces rent received by the Company. Delays or
cost overruns in connection with renovations or redevelopments, and any related
rental abatements could have a material adverse effect on Cash Available for
Distribution.
Development Risks. A component of the Company's growth strategy is to
develop new hotels in markets where room supply and other competitive factors
justify new construction or to purchase such hotels from unaffiliated developers
after they have been completed. New project development will increase the
Company's indebtedness and is subject to a number of other risks, including
risks of construction delays or cost overruns, the risk that required zoning,
occupancy and other government permits might not be obtained, and the risk that
projects might not be completed. Additional risks of development projects
include the risks associated with effectively marketing a hotel in order to
ramp-up occupancy at projected room rates after the hotel has been opened. Any
failure to complete a development project in a timely manner and within budget
or to ramp-up occupancy after completion of the project could have a material
adverse effect on the Company's results of operations and Cash Available for
Distribution.
TOTAL DEPENDENCE ON THE LESSEE AND PAYMENTS UNDER THE PERCENTAGE LEASES
Certain tax rules relating to the qualification of a REIT prohibit the
Company and the Partnership from operating hotels. Therefore, the Partnership
enters into Percentage Leases with the Lessee, and the Lessee
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operates the hotels and pays rent to the Partnership based, in large part, on
the revenues from the hotels. Consequently, the Company relies entirely on the
Lessee to effectively operate the Company's hotels in a manner which generates
sufficient cash flow to enable the Lessee to timely make the rent payments under
the applicable Percentage Leases. Ineffective operation of the hotels may result
in the Lessee's being unable to pay rent at the higher tier level necessary for
the Company to fund distributions to shareholders because payment of base rent
alone is insufficient for such purposes. In the event that all or a portion of
such higher tier rent is not received by the Partnership, the Company may not be
able to make such distributions to its shareholders. There can be no assurance
that the Company will receive such higher tier rent from the Lessee or that the
Lessee will even be able to pay base rent in light of its historical performance
of incurring operating losses since its inception. The Lessee controls the daily
operations of the hotels under the Percentage Leases, which have non-cancelable
initial terms of ten years. The Company selected the Lessee without
consideration of other lessees because Mr. Alter and Mr. Biederman, who own the
Lessee, owned and were involved in the management of a number of the hotels
contributed to the Company in connection with its IPO in 1995 (the "IPO").
Except as set forth in the Percentage Leases, neither the Company nor the
Partnership has the authority to require the Lessee to operate the hotels in a
manner that results in a maximization of rent to the Company. Other than working
capital to operate the hotels, the Lessee only has nominal assets, which will
likely be insufficient to satisfy any claims the Company may have if the Lessee
defaults under the Percentage Leases. Mr. Alter and Mr. Biederman have entered
into an agreement (the "Third Party Pledge Agreement"), whereby the obligations
of the Lessee under the Percentage Leases are secured with a pledge of Mr.
Alter's and Mr. Biederman's Units, up to 481,955 Units. This may limit the
Company's ability to recover in full for any claims it may have against the
Lessee for defaults under the Percentage Leases. The amendment to the Third
Party Pledge Agreement also subordinated the Company's lien on the majority of
Mr. Alter's Units to the lien in favor of an institutional lender providing a
working capital line to the Lessee guaranteed by Mr. Alter and secured by a
pledge of a significant portion of Mr. Alter's Units. The obligations of the
Lessee under the Percentage Leases are not secured by any additional security
deposits or guarantees by third parties. The Lessee had a net operating loss of
$2.0 million for the three months ended March 31, 1998 and an accumulated
deficit of $8.0 million as of March 31, 1998. Consequently, both the Company and
the Lessee are substantially dependent upon the operations of its hotels. In
1997, the Company and the Lessee amended the Percentage Leases for hotels then
currently under renovation and any future hotels to allow for the abatement of
base rent related to rooms taken out of service during major renovations.
Consequently, both the Company and the Lessee are substantially dependent upon
the operations of the hotels. See "-- Hotel Industry Risks."
MULTIPLE-HOTEL ACQUISITION RISKS
The Company has increasingly emphasized, and intends to continue to
emphasize, acquisitions of multiple hotels in a single transaction in order to
reduce acquisition expenses per hotel and enable the Company to more rapidly
expand its hotel portfolio. Consistent with this emphasis, in October 1997, the
Company completed the acquisition of a portfolio of 17 hotels, which almost
doubled the Company's room total. Multiple-hotel acquisitions, such as portfolio
acquisitions are, however, more complex than single-hotel acquisitions and the
risk that a multiple-hotel acquisition will not close may be greater than in a
single-hotel acquisition.
Such portfolio acquisitions, whether by stock or asset purchase, may also
result in the Company owning hotels in geographically dispersed markets. For
instance, several of the Company's hotels are located in areas geographically
removed from most of the Company's hotel portfolio. This geographic diversity
will place significant additional demands on the Company's ability to manage
such operations. In addition, the Company's costs for a hotel portfolio
acquisition that does not close are generally greater than for an individual
hotel acquisition which does not close. If the Company fails to close
multiple-hotel acquisitions, its ability to increase Cash Available for
Distribution will be limited. See "-- Dependence on Acquisitions to Increase
Cash Available for Distribution." Another risk associated with multiple-hotel
acquisitions is that a seller may require that a group of hotels be purchased as
a package, even though one or more of the hotels in the package does not meet
the Company's investment criteria. In such cases, the Company may purchase the
group of
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hotels with the intent to re-sell those which do not meet its geographic or
operating parameters. There can be no assurance, however, as to how quickly the
Company could sell or exchange such hotels or the terms on which they could be
sold or exchanged. Such hotels might reduce Cash Available for Distribution if
they operate at a loss during the time the Company owns them, or if the Company
sells them at a loss. In addition, any gains on the sale of such hotels within
four years of the date of acquisition could be subject to a 100% tax. See
"United States Federal Income Tax Considerations."
The Company may finance multiple-hotel acquisitions by issuing shares of
Common Stock or Partnership Units which are convertible into Common Stock. Such
issuances may have an adverse effect on the market price of the Common Stock.
See "-- Adverse Effect of Shares Available for Future Issuance and Sale on
Market Price of Common Stock."
FAILURE TO MANAGE RAPID GROWTH
To successfully implement its acquisition strategy, the Company must
integrate the hotels it acquires into its existing operations. Since the closing
of the IPO, the Company's portfolio of hotel properties has increased
dramatically and the Company also entered into geographic markets where it
previously did not have any properties. As a result, the consolidation of
functions and integration of departments, systems and procedures of acquired
properties with the Company's existing operations presents a significant
management challenge, and the failure to integrate such properties into the
Company's management and operating structures could have a material adverse
effect on the results of operations and financial condition of the Company.
The Company continues to accelerate its acquisition activity. As a result,
the Company's recent acquisitions will place significant demands on the
Company's management and other resources. There can be no assurances that these
hotels and other business operations can be integrated successfully, that there
will be any operating efficiencies between these hotels or that the combined
businesses can be operated profitably. The failure to integrate and operate
these hotels successfully could have a material adverse effect on the Company's
business and future prospects. Also, certain of the Company's hotels are in the
same geographic regions and may, therefore, compete with one another. There can
be no assurance that any acquisition, and in particular any subsequent
multiple-hotel portfolio acquisition, will not adversely affect the operations,
revenues or prospects of the Company's hotels located in such geographic areas.
CONFLICTS OF INTEREST BETWEEN THE COMPANY AND CERTAIN OFFICERS AND DIRECTORS
Because of Mr. Alter's and Mr. Biederman's ownership in and positions with
the Company and the Lessee and Mr. Alter's ownership of the Management Company,
there are inherent conflicts of interest between the Lessee, the Management
Company and the Company in the leasing, acquisition, disposition, operation and
management of the Company's hotels. Accordingly, the interests of shareholders
may not have been, and in the future may not be, reflected fully in all
decisions made or actions taken by the officers and directors of the Company. In
the event revenues from the Company's hotels increase significantly over prior
periods and operating expenses with respect thereto are less than historical or
projected operating expenses, the Lessee could disproportionately benefit. In
addition, the Lessee pays a management fee of between 1% and 2% of gross
revenues from the Company's hotels and reimburses certain accounting expenses to
the Management Company, which is wholly owned by Mr. Alter. As a result, there
may be conflicts of interest in connection with the sale of certain hotels.
Unrealized gain from the sale to the Company of certain hotels contributed to
the Company in connection with its IPO is specially allocated to Mr. Alter and
Mr. Biederman and any sale of such hotels by the Partnership may cause adverse
tax consequences to them. In addition, the reduction of mortgage indebtedness by
the Partnership at any time below certain levels would create adverse tax
consequences to Mr. Alter and Mr. Biederman. These conflicts may result in
decisions relating to the sale of certain hotels and/or the incurrence or
repayment of indebtedness which do not reflect solely the interests of the
Company and the shareholders. In addition, the Company will generally be
required under the Percentage Leases to pay a lease termination fee to the
Lessee if the Company elects to sell a hotel and not replace it with another
hotel. The payment of a termination fee to the Lessee, which is owned by Mr.
Alter and Mr. Biederman, may also result in decisions regarding the sale of a
hotel which do not reflect solely the interests of the Company and its
shareholders.
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INVESTMENT CONCENTRATION IN SINGLE INDUSTRY
The Company's current strategy is to acquire interests exclusively in hotel
properties. The Company will not seek to invest in assets selected to reduce the
risks associated with investments in the hotel industry, and will be subject to
risks inherent in concentrating investments in a single industry. Therefore, the
adverse effect on the Company's lease revenue and Cash Available For
Distribution resulting from a downturn in the hotel industry will be more
pronounced than if the Company had diversified its investments outside of the
hotel industry. In addition, the Company's hotels are concentrated in the
luxury, upscale and mid-price segments of the hotel industry and therefore, any
adverse changes in these segments of the hotel industry may disproportionately
impact the Company, due to the Company's concentration in those segments.
EMPHASIS ON MARRIOTT
Fourteen of the Company's 56 hotels are operated under, and three are in
the process of being converted to, the Marriott brand. Accordingly, the Company
is subject to risks inherent in concentrating the Company's investments in the
Marriott brand, such as a reduction in business following adverse publicity
related to the brand, which could have an adverse effect on the Company's lease
revenues and its ability to satisfy its debt service requirements.
RELIANCE ON MR. ALTER AND OTHER KEY PERSONNEL
The Company's future success and its ability to manage future growth
depends in large part upon the efforts of its senior management and its ability
to attract and retain key executive officers and other highly qualified
personnel. In particular, the Company places substantial reliance on the hotel
industry knowledge and experience and the continued services of Robert A. Alter,
the Company's Chairman, Chief Executive Officer and President. Competition for
such personnel is intense and there can be no assurance that the Company will be
successful in attracting and retaining such personnel. Accordingly, there can be
no assurance that the Company's senior management will be able to successfully
execute or implement the Company's growth and operating strategies. In addition,
the loss of Mr. Alter's services or the Company's inability to attract and
retain highly qualified personnel may adversely affect the operations of the
Company and Cash Available for Distribution.
HOTEL INDUSTRY RISKS
Operating Risks and Competition. Many of the Company's competitors have
substantially greater marketing and financial resources than the Company and the
Lessee. In addition, the Company's hotels are subject to all operating risks
common to the hotel industry. The hotel industry has experienced volatility in
the past, as have the Company's hotels. Hotel industry risks include, among
other things, competition from other hotels; over-building in the hotel industry
which has adversely affected occupancy, average daily rate ("ADR") and revenue
per available room ("REVPAR") increases in operating costs due to inflation and
other factors, which may not necessarily be offset by increased room rates;
dependence on business and commercial travelers and tourism; strikes and other
labor disturbances of hotel employees for hotels owned by the Company; increases
in energy costs and other expenses of travel; and adverse effects of general and
local economic conditions. These factors could decrease room revenues of the
hotels and adversely affect the Lessee's ability to make payments of rent under
the Percentage Leases to the Company, and therefore reduce Cash Available for
Distribution.
Seasonality of Hotel Business and the Company's Hotels. The hotel industry
is seasonal in nature. Generally, revenues for the Company's hotels are greater
in the first and third quarters than in the second and fourth quarters. In
addition, weather conditions in the midwest and eastern parts of the United
States can cause fluctuations in revenues, particularly in the winter months.
This seasonality can be expected to cause quarterly fluctuations in the
Company's Percentage Lease revenues which may be insufficient to provide all of
the Cash Available for Distribution necessary to pay dividends in a given
quarter.
Increased Competition Resulting From Overbuilding. The hotel industry has
historically experienced cycles of overbuilding in certain geographic markets
and product segments. Such overbuilding increases
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competition for hotel guests, resulting in lower occupancies and lower ADRs,
thereby reducing the profitability of the hotels affected by the increased
competition. While the Company's investment strategy is to acquire
underperforming hotels or hotels where there are significant barriers to entry,
there can be no assurance that the current hotel development activities,
particularly in the Company's limited service segment, will not create
additional significant competition for the Company's hotels. Such increased
competition would reduce the revenue generated by the Lessee, thus reducing
percentage rent paid to the Company and Cash Available for Distribution.
IMPACT OF INCREASED OPERATING COSTS AND CAPITAL EXPENDITURES
Hotels in general, including the Company's hotels, have an ongoing need for
renovations and other capital improvements, including periodic replacement of
furniture, fixtures and equipment. In this regard, the Company may spend
significant dollars renovating, rebranding or repositioning a number of its
hotels to maximize financial performance; however, the Company is unable to
estimate the amounts to be expended at this time. In addition, the franchise
agreements under which the Company's hotels are operated impose specified
operating standards and may permit the franchisor to condition the continuation
of a franchise agreement on the completion of capital improvements. Under the
terms of the Percentage Leases, the Company is also obligated to pay the cost of
certain capital expenditures at its hotels and to pay for furniture, fixtures
and equipment. The ability of the Company to fund these and other capital
expenditures and periodic replacement of furniture, fixtures and equipment will
depend in part on the financial performance of the Lessee and the hotels. If
these expenses exceed the Company's estimate, the additional expenses could have
a material adverse effect on Cash Available for Distribution. Furthermore, any
inability or failure to fund these expenditures could have a material adverse
effect on occupancy rates, ADRs and REVPAR and may constitute a breach under the
franchise agreements.
NO ARMS-LENGTH BARGAINING ON PERCENTAGE LEASES
The terms of the Percentage Leases were not negotiated on an arm's-length
basis and, accordingly, may not reflect fair market values or terms. The lease
payments under the Percentage Leases have been, and will be, calculated with
reference to historical financial data and the projected operating and financial
performance of the hotels. The Company does not own any interest in the Lessee.
All of the capital stock in the Lessee is owned by Messrs. Alter and Biederman.
As a result, such persons may have a conflict of interest with the Company in
the performance of their management services to the Company in connection with
the Percentage Leases.
FRANCHISE RISKS
Fifty-three of the Company's hotels are operated pursuant to franchise or
license agreements and additional hotels may be or will become subject to
franchise arrangements. The Lessee will hold the franchise or license agreements
for the hotels and will be responsible for complying with the terms of these
agreements. Such franchise or license arrangements are often helpful in
providing marketing services and room reservations to hotels, but these
arrangements also impose financial obligations on hotels generally related to
maintaining the condition of hotels and the payment of franchise fees.
Continuation of such franchises is subject to specified operating standards and
other terms and conditions. Franchisors periodically inspect franchised hotels
to confirm compliance. In addition, franchisors may require the Company to fund
significant capital improvements to the hotels in the future to maintain such
franchises. The failure of the Lessee to maintain required standards or adhere
to terms and conditions imposed by the franchisor may result in the loss of a
license or termination of the franchise or damages as a result of the breach. It
is possible that a franchisor could condition the continuation of a franchise on
the completion of capital improvements or replacements of furniture, fixtures
and equipment which the Company's Board of Directors determines are too
expensive or otherwise unwarranted in light of general economic conditions or
operating results or prospects of the affected hotel. The loss of a franchise
could have a material adverse effect upon the operation, financing or value of
the hotel subject to the franchise because of the loss of associated name
recognition, marketing support and centralized reservation systems. There can be
no assurance that an alternative franchise arrangement can be
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obtained or that significant expenditures might not be imposed as a condition to
obtaining a new franchise. The loss of a franchise for one or more of the hotels
could have a material adverse effect on the Company's revenues under the
Percentage Leases and Cash Available for Distribution to its shareholders.
DEPENDENCE ON ACQUISITIONS TO INCREASE CASH AVAILABLE FOR DISTRIBUTION
The Company's success in implementing its growth plan will depend
significantly on the Company's ability to acquire additional hotels at
attractive prices. After the ramp-up of certain of the hotels which were
recently redeveloped or renovated and repositioned or which are expected to be
redeveloped or renovated and repositioned in the near future, internal growth in
ADR and occupancy for the hotels is not expected to provide as much growth in
Cash Available for Distribution as will acquisition of additional hotels.
However, since the Company intends to borrow funds to purchase, redevelop or
renovate and reposition hotels, the Company will be subject to the risks
associated with increased indebtedness, such as paying debt service even if cash
flow from such additional hotels is not sufficient to cover such costs.
FAILURE TO MAINTAIN REIT STATUS
The Company intends to operate so as to be taxed as a REIT under Sections
856-860 of the Internal Revenue Code of 1986, as amended (the "Code"). As long
as the Company qualifies for taxation as a REIT, with certain exceptions, the
Company will not be taxed at the corporate level on its taxable income that is
distributed to its shareholders. A REIT is subject to a number of organizational
and operational requirements, including requirements as to the nature of its
income and assets, distribution requirements, diversity of stock ownership
requirements and record-keeping requirements. While the Company intends to
satisfy all of these requirements for treatment as a REIT, it is possible that
the Company may in the future fail to satisfy one or more of these requirements.
Failure to qualify as a REIT would render the Company subject to tax (including
any applicable minimum tax) on its taxable income at regular corporate rates and
distributions to the shareholders would not be deductible by the Company. Unless
entitled to relief under certain Code provisions, the Company also would be
disqualified from treatment as a REIT for the four taxable years following the
year during which qualification was lost. Even if the Company qualifies for
taxation as a REIT, the Company may be subject to certain state and local taxes
on its income and property.
In order for the Company to be taxed as a REIT, the Partnership must be
classified as a partnership for federal income tax purposes. If the Partnership
were to be taxable as a corporation, because the Company's ownership interest in
the Partnership constitutes more than 10% of the Partnership's voting securities
and exceeds 5% of the value of the Company's assets, the Company would cease to
qualify as a REIT. The imposition of corporate income tax on the Company and the
Partnership would substantially reduce the amount of Cash Available for
Distribution.
See "United States Federal Income Tax Considerations" for a discussion of
the material tax consequences and risks of an investment in the Company.
OWNERSHIP LIMITATION RESULTING IN LOSS OF REIT STATUS
In order for the Company to maintain its qualification as a REIT, not more
than 50% in value of its outstanding stock may be owned, directly or indirectly,
by five or fewer individuals (as defined in the Code to include certain
entities). Furthermore, if any shareholder or group of shareholders of the
Lessee owns, actually or constructively, 10% or more of the stock of the
Company, the Lessee could become a related party tenant of the Partnership,
which likely would result in loss of REIT status for the Company. For the
purpose of preserving the Company's REIT qualification, the Company's Articles
of Incorporation prohibit direct or indirect ownership of more than 9.8% of the
outstanding shares of any class of the Company's stock by any person or group
(the "Ownership Limitation"). Generally, the capital stock owned by affiliated
owners will be aggregated for purposes of the Ownership Limitation. Subject to
certain exceptions, any transfer of Common or Preferred Stock that would prevent
the Company from continuing to qualify as a REIT under the Code will be
designated as "Shares-in-Trust" and transferred automatically to a trust (the
"Share Trust") effective on the day before the purported transfer of such Common
or Preferred Stock. The record holder of the Common
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or Preferred Stock that are designated as Shares-in-Trust will be required to
submit such number of shares of Common or Preferred Stock to the Share Trust and
the beneficiary of the Share Trust will be one or more charitable organizations
that are named by the Company.
INABILITY TO RETAIN EARNINGS
In order to qualify as a REIT, Sunstone generally is required each year to
distribute to its shareholders at least 95% of its net taxable income (excluding
any net capital gain). In addition, Sunstone is subject to a 4% nondeductible
excise tax on the amount, if any, by which certain distributions paid by it with
respect to any calendar year are less than the sum of (i) 85% of its ordinary
income, (ii) 95% of its capital gain net income for that year, and (iii) any
undistributed taxable income from prior periods. Sunstone intends to continue to
make distributions to its shareholders to comply with the 95% distribution
requirement and to avoid the nondeductible excise tax. Sunstone's income
consists primarily of its share of the income of Sunstone LP, and Sunstone's
Cash Available For Distribution consists primarily of its share of cash
distributions from Sunstone LP. Differences in timing between taxable income and
Cash Available For Distribution due to the seasonality of the hospitality
industry could require Sunstone to borrow funds on a short-term basis to meet
the 95% distribution requirement and to avoid the nondeductible excise tax.
REAL ESTATE INVESTMENT RISKS IN GENERAL
The Company's hotels are and will be subject to varying degrees of risk
generally incident to the ownership of real property. Income from the hotels may
be adversely affected by changes in national and local economic conditions,
changes in interest rates and in the availability, cost and terms of mortgage
funds, the impact of present or future environmental legislation and compliance
with environmental laws, the ongoing need for capital improvements, changes in
real estate tax rates and other operating expenses, changes in governmental
rules (such as those requiring upgrades for disabled persons) and fiscal
policies, civil unrest, acts of God, including earthquakes, hurricanes and other
natural disasters (which may result in uninsured losses), acts of war, changes
in zoning laws, and other factors which are beyond the control of the Company.
In addition, real estate investments are relatively illiquid, and the ability of
the Company to vary its portfolio in response to changes in economic and other
conditions will be limited.
DISTRIBUTION OF SUBSTANTIALLY ALL OF CASH AVAILABLE FOR DISTRIBUTION;
DISTRIBUTIONS INCLUDE RETURN OF CAPITAL
Consistent with the Company's practice of acquiring properties in need of
renovation or redevelopment, the Company's annual distributions to shareholders
have constituted a high percentage of the Company's Cash Available for
Distribution. If this continues, the Company will retain little or no cash from
the rent payments under the Percentage Leases, and expenditures for additional
acquisitions or future capital improvements would have to be funded from
borrowings, or from proceeds from the sale of assets (including the hotels), or
debt or equity securities. In addition, a percentage of the estimated annual
distribution has constituted a return of capital rather than a distribution of
retained earnings. Consequently, there is a risk that the distribution rate has
been set too high and may not be sustainable.
UNINSURED AND UNDERINSURED LOSSES
Each of the Company's hotels is covered by comprehensive policies of
insurance, including liability, fire and extended coverage. The Company believes
such specified coverage is of the type and amount customarily obtained by owners
of real property assets, including hotels. However, there are certain types of
losses, generally of a catastrophic nature, such as earthquakes, hurricanes and
floods, that may be uninsurable or not economically insurable. Twenty-four of
the Company's hotels are located in California, which is subject to relatively
higher seismic risks. Although each of such hotels was constructed under the
more recent and stringent post-1984 building codes that were intended to reduce
the likelihood or extent of damage from seismic activity, no assurance can be
given that an earthquake would not cause substantial damage and losses. The
Company presently maintains and currently intends to continue to maintain
earthquake insurance on each of its hotels located in California. The Company's
Board of Directors may exercise discretion in determining
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amounts, coverage limits and the deductibility provisions of insurance, with a
view to maintaining appropriate insurance coverage on the Company's investments
at a reasonable cost and on suitable terms. This may result in insurance
coverage that, in the event of a substantial loss, would not be sufficient to
pay the full current market value or current replacement cost of the Company's
lost investment. Inflation, changes in building codes and ordinances,
environmental considerations, and other factors also might make it impractical
to use insurance proceeds to replace the property after such property has been
damaged or destroyed. Under such circumstances, the insurance proceeds received
by the Company might not be adequate to restore its economic position with
respect to such property.
ENVIRONMENTAL MATTERS
Under various federal, state, and local environmental laws, ordinances and
regulations, a current or previous owner or operator of real property may be
liable for the costs of removal or remediation of hazardous or toxic substances
on, under or in such property. Such laws often impose liability whether or not
the owner or operator knew of, or was responsible for, the presence of such
hazardous or toxic substances. Under certain limited circumstances, liability
may also extend to persons holding a security interest in the property. In
addition, the presence of hazardous or toxic substances, or the failure to
properly remediate contaminated property, may adversely affect the owner's
ability to dispose of such property, to fully utilize such property without
restriction or to borrow using such property as collateral. Persons who arrange
for the disposal or treatment of hazardous or toxic substances may also be
liable for the costs of removal or remediation of such substances at the
disposal or treatment facility, whether or not such facility is or ever was
owned or operated by such person. Certain environmental laws and common law
principles could be used to impose liability for release of hazardous or toxic
substances, including the release of asbestos-containing materials ("ACMs") into
the air, and third parties may seek recovery from owners or operators of real
properties for personal injury or property damage associated with such releases,
including exposure to released ACMs. Environmental laws may also impose
restrictions on the manner in which property may be used or businesses may be
operated, and these restrictions may require expenditures. Environmental laws
provide for sanctions in the event of noncompliance and may be enforced by
governmental agencies or, in certain circumstances, by private parties. In
connection with the ownership of its hotels and any subsequently acquired
hotels, the Company may be potentially liable for such costs. Other federal,
state and local laws, ordinances and regulations require abatement or removal of
certain asbestos containing materials in the event of demolition or certain
renovations or remodeling and govern emissions of and exposure to asbestos
fibers in the air. The operation and subsequent removal of certain underground
storage tanks also are regulated by federal and state laws. The cost of
defending against claims of liability, of compliance with environmental
regulatory requirements or of remediating a contaminated property could
materially adversely affect the business, assets or results of operations of the
Company and, consequently, the Company's ability to satisfy its debt service
requirements.
IMPACT OF THE YEAR 2000 ISSUE
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any computer program
that has date-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in similar normal business activities. The Company recently assessed its
internal computer systems and believes that the current systems used will
properly utilize dates beyond December 31, 1999. The Company has been informed
that the Lessee and the Management Company are in the process of studying the
Year 2000 issue, including inquiries of their vendors. Upon the completion of
the Lessee's and the Management Company's study, which is expected in late 1998,
the Company believes it will be able to determine the extent to which the
Company is vulnerable to a third parties' failure to remediate their own Year
2000 issues and the costs associated with resolving this issue. The Company does
not currently anticipate that the Year 2000 issue will have a material adverse
effect upon the Company's business results of operations or financial condition.
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ADVERSE EFFECT OF SHARES AVAILABLE FOR FUTURE ISSUANCE AND SALE ON MARKET PRICE
OF COMMON STOCK
The Company's Articles of Incorporation authorize the Board of Directors to
issue up to 160,000,000 shares of capital stock, consisting of 150,000,000
shares of Common Stock and 10,000,000 shares of Preferred Stock. As of June 30,
1998, the Board of Directors was able to reclassify and issue an aggregate of
approximately 112,000,000 unissued or unreserved shares of Common Stock and to
classify and issue 9,750,000 shares of Preferred Stock. The Company's
acquisition strategy depends in part on access to additional capital through
sales and issuances of equity securities. The market price of the Common Stock
may be adversely affected by the availability for future sale and issuance of
such unissued and unreserved shares of Common Stock and Preferred Stock and the
consequent dilutive effect of such issuances.
In addition, the market price of the Common Stock may also be adversely
affected by the availability for future sale and issuance of shares of Common
Stock that could be issued upon the redemption of Units of the Partnership. The
Company recently filed a registration statement and may at any time in the
future file additional registration statements to give the limited partners of
the Partnership the ability to sell shares of Common Stock issued upon
redemption of Units. In addition, the Westbrook Funds were granted certain
registration rights in connection with the shares issued to them in the Kahler
Acquisition.
RISK OF DILUTION
As hotel acquisition opportunities arise from time to time, the Company may
issue additional shares of Common Stock or Preferred Stock to raise the capital
necessary to finance the hotel acquisitions or may issue Common Stock or
Preferred Stock or Partnership Units which are redeemable on a one-to-one basis
for Common Stock to acquire hotels. Such issuances could result in dilution of
shareholders' equity.
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DESCRIPTION OF COMMON STOCK AND PREFERRED STOCK
The following summary description of Common Stock and Preferred Stock of
the Company is subject to and qualified in its entirety by reference to Maryland
law described herein, and to the Articles of Incorporation and Bylaws of the
Company (and any amendments or supplements thereto) which are filed as exhibits
to, or incorporated by reference in, the Registration Statement of which this
Prospectus is a part.
GENERAL
The Articles of Incorporation of the Company provide that the Company may
issue up to 160,000,000 shares of capital stock, consisting of 150,000,000
shares of Common Stock, $0.01 par value per share, and 10,000,000 shares of
Preferred Stock, $0.01 par value per share. As of June 30, 1998, (i) 37,534,319
shares of Common Stock were issued and outstanding, (ii) 1,000,000 shares of
Common Stock were reserved for issuance under the Company's Dividend
Reinvestment and Stock Purchase Plan, (iii) 2,400,000 shares of Common Stock
were reserved for issuance under the Company's 1994 Stock Incentive Plan, (iv)
150,000 shares of Common Stock were reserved for issuance under the 1994
Directors Plan, (v) 1,699,605 shares of Common Stock were reserved for issuance
upon conversion of Preferred Stock, (vi) 39,670,314 shares of Common Stock were
reserved for issuance upon the conversion of units of Partnership interest
("Units") into Common Stock (each Unit is convertible into one share of Common
Stock at the Unitholder's election), and (vii) 17,042 shares of Common Stock
were reserved for issuance upon the conversion of warrants or for other
purposes. As of June 30, 1998, 250,000 shares of Preferred Stock were issued and
outstanding.
The following description sets forth certain general terms and provisions
of the Common Stock to which any Prospectus Supplement may relate, including a
Prospectus Supplement providing that Common Stock will be issuable upon
conversion of Preferred Stock or upon the exercise of Warrants issued by the
Company. The Common Stock is listed on the NYSE under the symbol "SSI."
ChaseMellon Shareholder Services LLC is the Company's registrar and transfer
agent for the Common Stock and Partnership Units.
COMMON STOCK
All shares of Common Stock offered hereby will, when issued, be duly
authorized, fully paid and nonassessable. Subject to the preferential rights of
any other shares, series or class of shares of capital stock that may from time
to time come into existence, and to the provisions of the Company's Articles of
Incorporation regarding owning shares in excess of the Ownership Limitation,
holders of Common Stock will be entitled to receive dividends on such Common
Stock if, as and when authorized and declared by the Board of Directors of the
Company out of assets legally available therefor and to share ratably in the
assets of the Company legally available for distribution to its shareholders in
the event of its liquidation, dissolution or winding-up after payment of, or
adequate provision for, all known debts and liabilities of the Company. The
Company intends to continue its practice of paying regular quarterly dividends
to the holders of its Common Stock.
Holders of the Company's Common Stock can elect to participate in the
Company's Dividend Reinvestment and Stock Purchase Plan (the "Plan") and have
all or part of their dividends reinvested in additional shares of Common Stock.
Participants in the Plan can also purchase additional shares of Common Stock
with cash (subject to certain limitations). The terms of the Plan are described
in a separate prospectus which may be obtained by calling the Plan
administrator, Mellon Bank, N.A., at (888) 261-6776.
Subject to the provisions of the Articles of Incorporation regarding owning
shares in excess of the Ownership Limitation, each outstanding share of Common
Stock entitles the holder to one vote on all matters submitted to a vote of
shareholders, including the election of directors, and, except as otherwise
required by law or except as provided with respect to any other class or series
of shares of stock, the holders of such shares of Common Stock will possess the
exclusive voting power. There is no cumulative voting in the election of
directors, which means that the holders of a majority of the outstanding shares
of Common Stock can elect all of the directors then standing for election and
the holders of the remaining shares, if any, will not be able to elect any
directors.
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Holders of Common Stock have no conversion, sinking fund, redemption rights
or any preemptive rights to subscribe for any securities of the Company, nor do
they have any preference, appraisal or exchange rights.
PREFERRED STOCK
Subject to limitations prescribed by Maryland law and the Company's
Articles of Incorporation, the Board of Directors is authorized to issue, from
the 10,000,000 authorized but unissued shares of capital stock of the Company,
Preferred Stock in such classes or series as the Board of Directors may
determine and to establish from time to time the number of shares of Preferred
Stock to be included in any such class or series and to fix the designation and
any preferences, conversion and other rights, voting powers, restrictions,
limitations as to dividends, qualifications and terms and conditions of
redemption of the shares of any such class or series, and such other subjects or
matters as may be fixed by resolution of the Board of Directors. As of the date
of this Prospectus, 250,000 shares of Preferred Stock are outstanding. The
issuance of Preferred Stock may have the effect of delaying, deferring or
preventing a change in control of the Company or other transaction in which
holders of shares of Common Stock might receive a premium for such shares over
the market price.
7.9% Class A Cumulative Convertible Preferred Stock
In connection with a portfolio acquisition, the Company issued 250,000
shares of its newly designated 7.9% Class A Cumulative Convertible Preferred
Stock (the "Class A Shares"). The holders of the Class A Shares are entitled to
one vote for each share of Common Stock into which such holder's Class A Shares
could then be converted, and with respect to such vote, such holder has full
voting rights and powers equal to the voting rights and powers of the holders of
Common Stock. The holders of Class A Shares are entitled to vote, together with
holders of Common Stock as a single class. Subject to preferences that may be
applicable to any future class of Preferred Stock, the holders of Class A Shares
are entitled to receive, ratably, a dividend equal to the greater of (i) 7.9%
per share per annum or (ii) the percentage dividend that would be paid on the
Common Stock into which the Preferred Stock is convertible. In the event of a
liquidation, dissolution or winding up of the Company, subject to the rights of
future classes of Preferred Stock, the holders of Class A Shares are entitled to
receive, prior and in preference to the holders of Common Stock, an amount per
share equal to $100.00 for each outstanding Class A Share, plus accrued and
unpaid dividends. The Class A Shares have no preemptive rights.
Each Class A Share is convertible at the option of the holder at any time
into a number of shares of Common Stock that is equal to the quotient obtained
by dividing $100 by $14.7093, subject to adjustment for stock splits, stock
dividends, recapitalizations and the like. On or at any time after the fifth
anniversary of issuance of the Class A Shares, the Company may, at its option,
redeem the Class A Shares in whole or in part by paying an amount equal to the
redemption percentage of $100.00 per share then in effect (as adjusted for any
stock dividends, combinations or splits), plus all accrued but unpaid dividends
on such shares. The redemption percentage declines one percent per year, from
105% to par commencing in 2002. There are no sinking fund provisions applicable
to the Class A Shares. All outstanding Class A Shares will, upon issuance, be
fully paid and non-assessable.
Terms of Future Classes of Preferred Stock
Preferred Stock, upon issuance against full payment of the purchase price
therefor, will be fully paid and nonassessable. The specific terms of any future
class or series of Preferred Stock to be offered hereby will be described in the
Prospectus Supplement relating to that class or series, including a Prospectus
Supplement providing that Preferred Stock may be issuable upon the exercise of
Warrants issued by the Company. In addition, the terms of any class or series of
Preferred Stock which may be issued will be set forth in Articles Supplementary
to the Company's Articles of Incorporation which will be filed with the Maryland
Department of Assessments and Taxation and as an exhibit to (or incorporated by
reference in) the Registration Statement of which this Prospectus is a part. The
description of Preferred Stock set forth below and the description of the terms
of a particular class or series of Preferred Stock set forth in a Prospectus
Supplement
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do not purport to be complete and are qualified in their entirety by reference
to the articles supplementary relating to that class or series.
The preferences and other terms of the Preferred Stock of each class or
series will be fixed by the Articles Supplementary relating to such class or
series. A Prospectus Supplement, relating to each class or series, will specify
the terms of the Preferred Stock as follows:
(1) The title and stated value of such Preferred Stock;
(2) The number of shares of such Preferred Stock offered, the liquidation
preference per share and the offering price of such Preferred Stock;
(3) The dividend rate(s), period(s), and/or payment date(s) or method(s)
of calculation thereof applicable to such Preferred Stock;
(4) Whether dividends payable on such Preferred Stock is cumulative or not
and, if cumulative, the date from which dividends on such Preferred
Stock shall accumulate;
(5) The provision for a sinking fund, if any, for such Preferred Stock;
(6) The provision for redemption, if applicable, of such Preferred Stock;
(7) Any listing of such Preferred Stock on any securities exchange;
(8) The terms and conditions, if applicable, upon which such Preferred
Stock will be converted into Common Stock of the Company, including
the conversion price (or manner of calculation thereof);
(9) A discussion of any material United States federal income tax
considerations applicable to such Preferred Stock (in addition to
those discussed herein);
(10) Any limitations on direct or beneficial ownership and restrictions on
transfer, in each case as may be appropriate to preserve the status of
the Company as a REIT;
(11) The relative ranking and preferences of such Preferred Stock as to
dividend rights and rights upon liquidation, dissolution or winding up
of the affairs of the Company;
(12) Any limitations on issuance of any class or series of preferred stock
ranking senior to or on parity with such class or series of Preferred
Stock as to dividend rights and rights upon liquidation, dissolution
or winding up of the affairs of the Company;
(13) Any voting rights of such Preferred Stock; and
(14) Any other specific terms, preferences, rights, limitations or
restrictions of such Preferred Stock.
Registrar and Transfer Agent
The registrar and transfer agent for any class or series of the Preferred
Stock offered hereby will be set forth in the applicable Prospectus Supplement.
CLASSIFICATION OR RECLASSIFICATION OF COMMON STOCK OR PREFERRED STOCK
Subject to limitations prescribed by Maryland law and the Company's
Articles of Incorporation, the Board of Directors is authorized to classify and
reclassify any unissued portion of the authorized shares of capital stock to
provide for the issuance of shares in other classes or series, including other
classes or series of Common Stock or Preferred Stock, to establish the number of
shares in each class or series and to fix the designation and any preferences,
conversion and other rights, voting powers, restrictions, limitations as to
dividends, qualifications and terms and conditions of redemption of such class
or series. The rights, preferences, privileges and restrictions of such class or
series will be fixed by Articles Supplementary to the Company's Articles of
Incorporation relating to such class or series. A Prospectus Supplement will
specify the terms of any such class or series offered hereby.
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RESTRICTIONS ON OWNERSHIP OF COMMON STOCK OR PREFERRED STOCK
The following is a description of the restrictions on ownership of the
Common Stock and Preferred Stock. There may be additional provisions that
further restrict ownership and transfer, which will be described in any
applicable Prospectus Supplement. Such description is, and will be, qualified in
its entirety by any supplements to the Articles of Incorporation or Bylaws filed
as exhibits to, or incorporated by reference in, the Registration Statement of
which this Prospectus is a part.
For the Company to qualify as a REIT under the Code, it must meet certain
requirements concerning the ownership of its outstanding shares of capital
stock. Specifically, not more than 50% in value of the Company's outstanding
shares may be owned, directly or indirectly, by five or fewer individuals (as
defined in the Code to include certain entities) during the last half of a
taxable year, and the Company must be beneficially owned by 100 or more persons
during at least 335 days of a taxable year of 12 months or during a
proportionate part of a shorter taxable year. See "United States Federal Income
Tax Considerations -- Requirements for Qualification." In addition, the Company
must meet certain requirements regarding the nature of its gross income in order
to qualify as a REIT. One such requirement is that at least 75% of the Company's
gross income for each year must consist of rents from real property and income
from certain other real property investments. The rents received by the
Partnership from the Lessee would not qualify as rents from real property, which
would result in loss of REIT status for the Company, if the Company were at any
time to own, directly or constructively, 10% or more of the ownership interests
in the Lessee within the meaning of Section 856(d)(2)(B) of the Code. See
"United States Federal Income Tax Considerations -- Requirements for
Qualification -- Income Tests."
Because the Board of Directors believes it is essential for the Company to
qualify as a REIT, the Articles of Incorporation, subject to certain exceptions
described below, provides that no person may own, or be deemed to own by virtue
of the constructive ownership provisions of the Code, more than 9.8% of the
lesser in value of the total number or value of the outstanding shares of Common
Stock or the outstanding shares of Preferred Stock (the "Ownership Limitation").
The constructive ownership rules of the Code are complex and may cause shares
owned actually or constructively by two or more related individuals and/or
entities to be constructively owned by one individual or entity. As a result,
the acquisition of less than 9.8% of the outstanding shares of Common Stock or
9.8% of the shares of Preferred Stock (or the acquisition of an interest in an
entity which owns the shares) by an individual or entity could cause that
individual or entity (or another individual or entity) to own constructively in
excess of 9.8% of the outstanding shares of Common Stock or 9.8% of the
outstanding shares of Preferred Stock, and thus subject such shares to the
Ownership Limitation provisions of the Articles of Incorporation. The Ownership
Limitation also prohibits any transfer of Common Stock or Preferred Stock that
would (i) result in the Common Stock and Preferred Stock being owned by fewer
than 100 persons (determined without reference to any rules of attribution),
(ii) result in the Company being "closely held" within the meaning of Section
856(h) of the Code, or (iii) cause the Company to own, directly or
constructively, 10% or more of the ownership interests in a tenant of the
Company's real property, within the meaning of Section 856(d)(2)(B) of the Code.
Except as otherwise provided below, any such acquisition or transfer of the
Company's capital stock (including any constructive acquisition or transfer of
ownership) shall be null and void, and the intended transferee or owner will
acquire no rights to, or economic interests in, the shares.
Subject to certain exceptions described below, any purported transfer of
Common Stock or Preferred Stock that would (i) result in any person owning,
directly or indirectly, Common Stock or Preferred Stock in excess of the
Ownership Limitation, (ii) result in the Common Stock and Preferred Stock being
owned by fewer than 100 persons (determined without reference to any rules of
attribution), (iii) result in the Company being "closely held" within the
meaning of Section 856(h) the Code, or (iv) cause the Company to own, directly
or constructively, 10.0% or more of the ownership interests in a tenant of the
Company's or the Partnership's real property, within the meaning of Section
856(d)(2)(B) of the Code, will be designated as "Shares-in-Trust" and
transferred automatically to a trust (the "Share Trust") effective on the day
before the purported transfer of such Common Stock or Preferred Stock. The
record holder of the Common Stock or Preferred Stock that are designated as
Shares-in-Trust (the "Prohibited Owner") will be required to submit such number
of shares of Common Stock or Preferred Stock to the Share Trust for designation
in the name of
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a trustee to be designated by the Company (the "Share Trustee"). The beneficiary
of the Share Trust (the "Beneficiary") will be one or more charitable
organizations that are named by the Company.
Shares-in-Trust will remain issued and outstanding Common Stock or
Preferred Stock and will be entitled to the same rights and privileges as all
other shares of the same class or series. The Share Trust will receive all
dividends and distributions on the Shares-in-Trust and will hold such dividends
or distributions in trust for the benefit of the Beneficiary. The Share Trustee
will vote all Shares-in-Trust. The Share Trustee will designate a permitted
transferee of the Shares-in-Trust, provided that the permitted transferee (i)
purchases such Shares-in-Trust for valuable consideration and (ii) acquires such
Shares-in-Trust without such acquisition resulting in a transfer to another
Share Trust.
The Prohibited Owner with respect to Shares-in-Trust will be required to
repay to the Share Trust the amount of any dividends or distributions received
by the Prohibited Owner (i) that are attributable to any Shares-in-Trust and
(ii) for which the record date was on or after the date that such shares became
Shares-in-Trust. The Prohibited Owner generally will receive from the Share
Trustee the lesser of (i) the price per share such Prohibited Owner paid for the
Common Stock or Preferred Stock that were designated as Shares-in-Trust (or, in
the case of a gift or devise, the market price (based on a five day trading
average) per share on the date of such transfer) and (ii) the price per share
received by the Share Trustee from the sale or other disposition of such
Shares-in-Trust. Any amounts received by the Share Trustee in excess of the
amounts to be paid to the Prohibited Owner will be distributed to the
Beneficiary.
The Shares-in-Trust will be deemed to have been offered for sale to the
Company, or its designee, at a price per share equal to the lesser of (i) the
price per share in the transaction that created such Shares-in-Trust (or, in the
case of a gift or devise, the market price per share on the date of such
transfer) or (ii) the market price per share on the date that the Company, or
its designee, accepts such offer. The Company will have the right to accept such
offer for a period of ninety days after the later of (i) the date of the
purported transfer which resulted in such Shares-in-Trust and (ii) the date the
Company determines in good faith that a transfer resulting in such
Shares-in-Trust occurred.
Any person who acquires or attempts to acquire Common Stock or Preferred
Stock in violation of the foregoing restrictions, or any person who owned shares
of Common Stock or Preferred Stock that were transferred to a Share Trust, will
be required (i) to give immediately written notice to the Company of such event
and (ii) to provide to the Company such other information as the Company may
request in order to determine the effect, if any, of such transfer on the
Company's status as a REIT.
All persons who own, directly or indirectly, more than 5% (or such lower
percentages as required pursuant to regulations under the Code) of the
outstanding shares of Common Stock and Preferred Stock must within 30 days after
January 1 of each year, provide to the Company a written statement or affidavit
stating the name and address of such direct or indirect owner, the number of
shares of Common Stock and Preferred Stock owned directly or indirectly, and a
description of how such shares are held. In addition, each direct or indirect
shareholder shall provide to the Company such additional information as the
Company may request in order to determine the effect, if any, of such ownership
on the Company's status as a REIT and to ensure compliance with the Ownership
Limitation.
The Ownership Limitation generally will not apply to the acquisition of
shares of Common Stock or Preferred Stock by an underwriter that participates in
a public offering of such shares. In addition, the Board of Directors, upon
receipt of a ruling from the Internal Revenue Service or an opinion of counsel
and upon such other conditions as the Board of Directors may direct, may exempt
a person from the Ownership Limitation under certain circumstances. The
foregoing restrictions will continue to apply until the Board of Directors, with
the approval of the holders of at least two-thirds of the outstanding shares of
all votes entitled to vote on such matter at a regular or special meeting of the
shareholders of the Company, determines to terminate its status as a REIT.
The Ownership Limitation will not be automatically removed even if the REIT
provisions of the Code are changed so as to remove any ownership concentration
limitation. Any change of the Ownership Limitation would require an amendment to
the Articles of Incorporation. Such amendment requires the affirmative vote
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of holders holding at least two-thirds of the outstanding shares entitled to
vote on the matter. In addition to preserving the Company's status as a REIT,
the Ownership Limitation may have the effect of delaying, deferring,
discouraging or preventing a transaction or a change in control of the Company
without the approval of the Board of Directors.
Any certificates representing shares of Common Stock or Preferred Stock
will bear a legend referring to the restrictions described above.
DESCRIPTION OF WARRANTS
The Company currently has warrants outstanding to purchase Partnership
Units. The Company may issue Warrants for the purchase of its Preferred Stock or
Common Stock. Warrants may be issued independently or together with any other
Offered Securities offered by any Prospectus Supplement and may be attached to
or separate from such Offered Securities. Each series of Warrants will be issued
under a separate warrant agreement (each, a "Warrant Agreement") to be entered
into between the Company and a warrant agent specified in the applicable
Prospectus Supplement (the "Warrant Agent"). The Warrant Agent will act solely
as an agent of the Company in connection with the Warrants of such series and
will not assume any obligation or relationship of agency or trust for or with
any provisions of the Warrants offered hereby. Further terms of the Warrants and
the applicable Warrant Agreements will be set forth in the applicable Prospectus
Supplement.
The applicable Prospectus Supplement will describe the terms of the
Warrants in respect of which this Prospectus is being delivered, including,
where applicable, the following:
(1) The title of such Warrants;
(2) The aggregate number of such Warrants;
(3) The price or prices at which such Warrants will be issued;
(4) The designation, terms and number of shares of Preferred Stock or
Common Stock purchasable upon exercise of such Warrants;
(5) The designation and terms of the Common Stock or Preferred Stock, if
any, with which such Warrants are issued and the number of such
Warrants issued with the Common Stock or Preferred Stock;
(6) The date, if any, on and after which such Warrants and the related
Preferred Stock or Common Stock will be separately transferable;
(7) The price at which each share of Preferred Stock or Common Stock
issuable upon exercise of such Warrants may be purchased;
(8) The date on which the right to exercise such Warrants shall commence
and the date on which such right shall expire;
(9) The minimum or maximum amount of such Warrants which may be exercised
at any one time;
(10) Information with respect to book-entry procedures, if any;
(11) A discussion of certain Federal income tax considerations specifically
related to such Warrants; and
(12) Any other terms of such Warrants, including terms, procedures and
limitations relating to the exchange and exercise of such Warrants.
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CERTAIN PROVISIONS OF MARYLAND LAW AND
OF THE COMPANY'S ARTICLES OF INCORPORATION AND BYLAWS
The following summary of certain provisions of Maryland law and of the
Articles of Incorporation and Bylaws of the Company does not purport to be
complete and is qualified in its entirety by reference to Maryland law and the
Articles of Incorporation and Bylaws of the Company (and any amendments and
supplements thereto) which are filed as exhibits to, or incorporated by
reference in, the Registration Statement of which this Prospectus is a part.
ANTI-TAKEOVER EFFECT OF CERTAIN PROVISIONS OF MARYLAND LAW AND OF THE COMPANY'S
ARTICLES OF INCORPORATION AND BYLAWS
The provisions in the Articles of Incorporation regarding the Ownership
Limitation and the classification of the Board of Directors, the business
combination provisions of the Maryland General Corporation Law ("MGCL"), the
control shares acquisition provisions of the MGCL, and the advance notice
provisions of the Bylaws could have the effect of delaying, deferring,
discouraging or preventing a transaction or a change in control of the Company
in which holders of some, or a majority, of the capital stock of the Company
might receive a premium for their shares over the then prevailing market price
or which such holders might believe to be otherwise in their best interest.
Certain significant provisions which might have this effect are described below.
CLASSIFICATION OF THE BOARD OF DIRECTORS
The Bylaws provide that the number of directors of the Company may be
established by the Board of Directors but may not be fewer than three nor more
than nine. The directors may increase the number of directors by a vote of a
least 80% of the members of the Board of Directors, provided that the number of
directors shall never be less than the number required by Maryland law and that
the tenure of office of a director shall not be affected by any decrease in the
number of directors. Any vacancy will be filled, including a vacancy created by
an increase in the number of directors, at any regular meeting or at any special
meeting called for that purpose, by a majority of the remaining directors,
except that a vacancy resulting from an increase in the number of directors must
be filled by a majority of the entire Board of Directors.
Pursuant to the Articles of Incorporation the Board of Directors will be
divided into three classes of directors. As the term of each class expires,
directors in that class will be elected by the shareholders of the Company for a
term of three years and until their successors are duly elected and qualify.
Classification of the Board of Directors is intended to assure the continuity
and stability of the Company's business strategies and policies as determined by
the Board of Directors. Shareholders will have no right to cumulative voting in
the election of directors. Consequently, at each annual meeting of shareholders,
the holders of a majority of the shares of Common Stock present in person or by
proxy at such meeting will be able to elect all of the successors of the class
of directors whose terms expire at that meeting.
The classified board provision could have the effect of making the
replacement of incumbent directors more time consuming and difficult, which
could delay, defer, discourage or prevent an attempt by a third party to obtain
control of the Company or other transaction, even though such an attempt or
other transaction might be beneficial to the Company and its shareholders. At
least two annual meetings of shareholders, instead of one, will generally be
required to effect a change in a majority of the Board of Directors. Thus, the
classified board provision could increase the likelihood that incumbent
directors will retain their positions.
REMOVAL OF DIRECTORS
The Articles of Incorporation provide that a director may be removed with
or without cause by the affirmative vote of at least two-thirds of the votes
entitled to be cast in the election of directors. This provision when coupled
with the provision in the Bylaws authorizing the Board of Directors to fill
vacant directorships, could preclude shareholders from removing incumbent
directors except upon the existence of a substantial affirmative vote and by
filling the vacancies created by such removal with their own nominees upon the
affirmative vote of a majority of the votes entitled to be cast in the election
of directors.
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LIMITATION OF LIABILITY AND INDEMNIFICATION
The Articles of Incorporation and Bylaws limit the liability of the
Company's directors and officers for money damages to the Company and its
shareholders to the fullest extent permitted from time to time by Maryland law.
Maryland law presently permits the liability of directors and officers to a
corporation or its shareholders for monetary damages to be limited, except (i)
to the extent that it is proved that the director or officer actually received
an improper benefit or profit, or (ii) to the extent that a judgment or other
final adjudication is entered in a proceeding based on a finding that the
director's or officer's action, or failure to act, was the result of active and
deliberate dishonesty and was material to the cause of action, as adjudicated in
the proceeding. This provision does not limit the ability of the Company or its
shareholders to obtain other relief, such as an injunction or rescission.
The Articles of Incorporation and Bylaws require the Company to indemnify
its directors and officers to the fullest extent permitted from time to time by
Maryland law. The Company's Articles of Incorporation and Bylaws also permit the
Company to indemnify employees, agents and other persons acting on behalf of or
at the request of the Company. The MGCL generally permits a corporation to
indemnify its directors, officers and certain other parties against judgments,
penalties, fines, settlements and reasonable expenses actually incurred by them
in connection with any proceeding to which they may be made a party by reason of
their service to or at the request of the Company. Indemnification under the
provisions of the MGCL is not deemed exclusive to any other rights, by
indemnification or otherwise, to which an officer or director may be entitled
under the Articles of Incorporation or Bylaws, or under resolutions of
shareholders or directors, contract or otherwise. It is the position of the
Commission that indemnification of directors and officers for liabilities
arising under the Securities Act is against public policy and is unenforceable
pursuant to Section 14 of the Securities Act.
BUSINESS COMBINATIONS
Under the MGCL, certain "business combinations" (including a merger,
consolidation, share exchange or, in certain circumstances, an asset transfer or
issuance or reclassification of equity securities) between a Maryland
corporation and any person who beneficially owns ten percent or more of the
voting power of such corporation's shares or an affiliate of such corporation
who, at any time within the two-year period prior to the date in question, was
the beneficial owner of ten percent or more of the voting power of the
then-outstanding voting shares of such corporation (an "Interested Shareholder")
or an affiliate thereof are prohibited for five years after the most recent date
on which the Interested Shareholder became an Interested Shareholder.
Thereafter, any such business combination must be recommended by the board of
directors of such corporation and approved by the affirmative vote of at least
(a) 80% of the votes entitled to be cast by holders of outstanding voting shares
of such corporation and (b) two-thirds of the votes entitled to be cast by
holders of voting shares of such corporation other than shares held by the
Interested Shareholder with whom (or with whose affiliate) the business
combination is to be effected, unless, among other things, such corporation's
shareholders receive a minimum price (as defined in the MGCL) for their shares
and the consideration is received in cash or in the same form as previously paid
by the Interested Shareholder for its shares. These provisions of Maryland law
do not apply, however, to business combinations that are approved or exempted by
the board of directors of a corporation prior to the time that the Interested
Shareholder becomes an Interested Shareholder. The Board of Directors has
exempted from these provisions of the MGCL any business combination with certain
officers and directors of the Company, and all present or future affiliates or
associates of, or any other person acting in concert or as a group with, any of
the foregoing persons and any other business combination which may arise in
connection with the Company formation transactions generally.
CONTROL SHARE ACQUISITIONS
The MGCL provides that "control shares" of a Maryland corporation acquired
in a "control share acquisition" have no voting rights except to the extent
approved by a vote of two-thirds of the votes entitled to be cast on the matter,
excluding shares owned by the acquiror, by officers or by directors who are
employees of a corporation. "Control Shares" are voting shares which, if
aggregated with all other such shares previously acquired by the acquiror, or in
respect of which the acquiror is able to exercise or direct the exercise of
voting
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power (except solely by virtue of a revocable proxy), would entitle the acquiror
to exercise voting power in electing directors within one of the following
ranges of voting power: (i) one-fifth or more but less than one-third (ii)
one-third or more but less than a majority, or (iii) a majority or more of all
voting power. Control Shares do not include shares the acquiring person is then
entitled to vote as a result of having previously obtained shareholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
A person who has made or proposes to make a control share acquisition, upon
satisfaction of certain conditions (including an undertaking to pay expenses),
may compel the board of directors of a corporation to call a special meeting of
shareholders to be held within 50 days of demand to consider the voting rights
of the shares. If no request for a meeting is made, the corporation may itself
present the question at any shareholders meeting.
If voting rights are not approved at the meeting or if the acquiring person
does not deliver an acquiring person statement as required by the statute, then,
subject to certain conditions and limitations, a corporation may redeem any or
all of the control shares (except those for which voting rights have previously
been approved) for fair value determined, without regard to the absence of
voting rights for the control shares, as of the date of the last control share
acquisition by the acquiror or of any meeting of shareholders at which the
voting rights of such shares are considered and not approved. If voting rights
for control shares are approved at a shareholders meeting and the acquiror
becomes entitled to vote a majority of the shares entitled to vote, all other
shareholders may exercise appraisal rights. The fair value of the shares as
determined for purposes of such appraisal rights may not be less than the
highest price per share paid by the acquiror in the control share acquisition,
and certain limitations and restrictions otherwise applicable to the exercise of
dissenters' rights do not apply in the context of a control share acquisition.
The control share acquisition statute does not apply to shares acquired in
a merger, consolidation or share exchange, if the corporation is a party to the
transaction, or to acquisitions approved or exempted by the articles of
incorporation or bylaws of a corporation.
The Bylaws of the Company contain a provision exempting from the control
share acquisition statute any and all acquisitions by any person of the
Company's Common Stock or Preferred Stock. There can be no assurance that such
provision will not be amended or eliminated in the future.
AMENDMENTS TO THE COMPANY'S ARTICLES OF INCORPORATION AND BYLAWS
The Articles of Incorporation may only be amended by the affirmative vote
of the holders of not less than a majority of the votes entitled to be cast on
the matter, except that any proposal (i) to permit cumulative voting in the
election of directors, (ii) to alter provisions of the Articles of Incorporation
requiring a majority of the directors to be independent directors or provisions
of the Articles of Incorporation relative to the classification of the Company's
Board of Directors into three classes, removal of directors, preemptive rights,
indemnification of corporate agents and limitation of liability of officers and
directors, or (iii) that would terminate the Company's status as a REIT for tax
purposes, may not be amended, altered, changed or repealed without the
affirmative vote of at least two-thirds of all of the votes entitled to be cast
on the matter. Subject to the right of the Company's shareholders to adopt,
alter or repeal the Bylaws, the Bylaws may be amended by the Board of Directors,
except for provisions of the Bylaws relating to the sale of certain hotels and
transactions involving the Company in which an advisor, director or officer has
an interest, which may be altered or repealed only upon the vote of shareholders
holding at least two-thirds of the outstanding shares of stock entitled to vote
generally in the election of directors.
DISSOLUTION OF THE COMPANY
Pursuant to the Articles of Incorporation, the dissolution of the Company
must be approved and advised by the Board of Directors and approved by the
affirmative vote of the holders of a majority of all of the votes entitled to be
cast on the matter.
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OPERATIONS
The Company is generally prohibited from engaging in certain activities,
including incurring consolidated indebtedness, in the aggregate, in excess of
50% of the Company's investment in hotels at cost, and acquiring or holding
property or engaging in any activity that would cause the Company to fail to
qualify as a REIT.
UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS
The following is a summary of material federal income tax considerations
that may be relevant to a prospective holder of the Offered Securities. The
discussion contained herein does not address all aspects of taxation that may be
relevant to particular holders of the Offered Securities in light of their
personal investment or tax circumstances, or to certain types of holders
(including insurance companies, tax-exempt organizations, financial institutions
or broker-dealers, foreign corporations, and persons who are not citizens or
residents of the United States) subject to special treatment under the federal
income tax laws. In addition, this discussion does not address the specific tax
consequences of an investment in Warrants. Such tax consequences will be
summarized in the Prospectus Supplement relating to the offering of Warrants.
This discussion as to tax consequences is based on current provisions of
the Code, existing, temporary, and currently proposed Treasury Regulations
promulgated under the Code, the legislative history of the Code, existing
administrative rulings and practices of the Internal Revenue Service (the "IRS"
or the "Service"), and judicial decisions. No assurance can be given that future
legislative, judicial, or administrative actions or decisions, which may be
retroactive in effect, will not affect the accuracy of any statements in this
Prospectus with respect to the transactions entered into or contemplated prior
to the effective date of such changes.
EACH PROSPECTIVE PURCHASER IS ADVISED TO CONSULT HIS OWN TAX ADVISOR
REGARDING THE SPECIFIC TAX CONSEQUENCES TO HIM OF THE PURCHASE, OWNERSHIP, AND
SALE OF THE OFFERED SECURITIES AND OF THE COMPANY'S ELECTION TO BE TAXED AS A
REIT, INCLUDING THE FEDERAL, STATE, LOCAL, FOREIGN, AND OTHER TAX CONSEQUENCES
OF SUCH PURCHASE, OWNERSHIP, SALE, AND ELECTION, AND OF POTENTIAL CHANGES IN
APPLICABLE TAX LAWS.
TAXATION OF THE COMPANY
The Company has elected to be taxed as a REIT under Sections 856 through
860 of the Code, effective for its taxable year ended on December 31, 1995. In
connection with each offering made pursuant to this Prospectus, the Company will
receive an opinion of its counsel, Brobeck, Phleger & Harrison LLP, that,
commencing with the inception of the Company's taxable year ended December 31,
1995, the Company has been organized and operated in conformity with the
requirements for qualification as a REIT under the Code, and that its
organization and contemplated method of operation as of the date of such opinion
will enable it to continue to meet the requirements for qualification and
taxation as a REIT under the Code for 1998 and subsequent taxable years.
Investors should be aware, however, that Brobeck, Phleger & Harrison LLP's
opinion is not binding upon the Service or any court. It must be emphasized that
Brobeck, Phleger & Harrison LLP's opinion will be based and conditioned upon the
accuracy of various representations and assumptions as to factual matters,
including representations regarding the nature of the Company's properties and
income during 1995 and subsequently and the future conduct of its business.
Moreover, qualification and taxation as a REIT depends upon the Company's
ability to meet on a continuing basis, the various qualification tests imposed
under the Code discussed below. Counsel will not review the Company's compliance
with those tests on a continuing basis. Accordingly, no assurance can be given
that the actual results of the Company's operation will satisfy all of the
requirements for qualification as a REIT.
The sections of the Code relating to qualification and operation as a REIT
are highly technical and complex. The following discussion sets forth the
material aspects of the Code sections that govern the federal income tax
treatment of a REIT and its shareholders. The discussion is qualified in its
entirety by the applicable Code provisions, Treasury Regulations promulgated
thereunder, and administrative and judicial interpretations thereof, all of
which are subject to change prospectively or retrospectively.
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Assuming the Company qualifies for taxation as a REIT, it generally will
not be subject to federal corporate income tax on its net income that is
distributed currently to its shareholders. That treatment substantially
eliminates the "double taxation" (i.e., taxation at both the corporate and
shareholder levels) that generally results from investment in a corporation.
However, the Company will be subject to federal income tax in the following
circumstances. First, the Company will be taxed at regular corporate rates on
any undistributed REIT taxable income, including undistributed net capital
gains. Furthermore, under certain circumstances, the Company may be subject to
the "alternative minimum tax" on its items of tax preference.
Third, if the Company has (i) net income from the sale or other disposition of
"foreclosure property" that is held primarily for sale to customers in the
ordinary course of business or (ii) other nonqualifying income from foreclosure
property, it will be subject to tax at the highest corporate rate on such
income. Fourth, if the Company has net income from prohibited transactions
(which are, in general, certain sales or other dispositions of property (other
than foreclosure property) held primarily for sale to customers in the ordinary
course of business), such income will be subject to a 100% tax. Fifth, if the
Company should fail to satisfy the 75% gross income test or the 95% gross income
test (as discussed below), and has nonetheless maintained its qualification as a
REIT because certain other requirements have been met, it will be subject to a
100% tax on the net income attributable to the greater of the amount by which
the Company fails the 75% or 95% gross income test. Sixth, if the Company should
fail to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year, (ii) 95% of its REIT capital gain net income
for such year, and (iii) any undistributed taxable income from prior periods,
the Company would be subject to a 4% excise tax on the excess of such required
distribution over the amounts actually distributed. Seventh, if the Company
acquires any asset from a C corporation (i.e., a corporation generally subject
to full corporate-level tax) in a transaction in which the basis of the asset in
the Company's hands is determined by reference to the basis of the asset (or any
other asset) in the hands of the C corporation and the Company recognizes gain
on the disposition of such asset during the 10-year period beginning on the date
on which such asset was acquired by the Company, then the Company would be
taxable to the extent of such asset's "built-in-gain." Such taxation of the
Company on "built-in gains" will be applicable to gain on the disposition of
assets received by the Company upon the liquidation of Kahler and its
subsidiaries.
REQUIREMENTS FOR QUALIFICATION
Earnings and Profits
In order to maintain its REIT status, the Company was required to
distribute any earnings and profits that it acquired as a result of the Kahler
Acquisition on or before December 31, 1997. In connection with the Kahler
Acquisition, the Company has received a certification from the auditors for
Kahler that, subject to certain assumptions set forth therein, the
pre-acquisition earnings and profits of Kahler were $28.5 million (not
considering the cash distribution described immediately below), and the
Company's auditors have reviewed and approved this certification and the
workpapers of Kahler's auditors. In rendering any tax opinion in connection with
an offering under this Prospectus, Brobeck, Phleger & Harrison LLP will assume
that this certification is correct, a factual question upon which counsel has
expressed no opinion. However, the certification is not binding on the IRS, and
there can be no assurance that it will not be successfully challenged.
Immediately prior to the Kahler Acquisition, Kahler made a $28.75 million
distribution to its shareholders. The Company received a private letter ruling
from the IRS confirming that Kahler's pre-acquisition distribution will be
treated as a "dividend" for tax purposes, and thus reduced Kahler's
pre-acquisition earnings and profits by the amount of the distribution.
Based on the IRS's ruling and the certifications from Kahler's and the
Company's auditors, the Company anticipates that it had no non-REIT earnings and
profits as of the end of its 1997 taxable year. In the event, however, that the
Company had any such non-REIT earnings and profits, it would be disqualified as
a REIT in 1997 and thereafter.
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Other Requirements
The Code defines a REIT as a corporation, trust or association (i) that is
managed by one or more trustees or directors; (ii) the beneficial ownership of
which is evidenced by transferable shares, or by transferable certificates of
beneficial interest; (iii) that would be taxable as a domestic corporation but
for Sections 856 through 860 of the Code; (iv) that is neither a financial
institution nor an insurance company subject to certain provisions of the Code;
(v) the beneficial ownership of which is held by 100 or more persons; (vi) not
more than 50% in value of the outstanding shares of which is owned, directly or
indirectly, by five or fewer individuals (as defined in the Code to include
certain entities) during the last half of each taxable year (the "5/50 Rule");
(vii) that makes an election to be a REIT (or has made such election for a
previous taxable year) and satisfies all relevant filing and other
administrative requirements established by the Service that must be met in order
to elect and to maintain REIT status; (viii) that uses a calendar year for
federal income tax purposes and complies with the recordkeeping requirements of
the Code and Treasury Regulations promulgated thereunder; and (ix) that meets
certain other tests, described below, regarding the nature of its income and
assets. The Company's Articles of Incorporation provide for restrictions
regarding transfer of the Company's stock that are intended to assist the
Company in continuing to satisfy the share ownership requirements described in
(v) and (vi) above. See "Description of Common Stock and Preferred Stock --
Restrictions on Ownership of Common Stock or Preferred Stock."
In the case of a REIT that is a partner in a partnership, Treasury
Regulations provide that the REIT will be deemed to own its proportionate share
of the assets of the partnership and will be deemed to be entitled to the gross
income of the partnership attributable to such share. In addition, the assets
and gross income of the partnership will retain the same character in the hands
of the REIT as in the partnership for purposes of Section 856 of the Code,
including for purposes of the gross income and asset tests described below.
Thus, assuming the Partnership is classified as a partnership rather than as a
corporation for tax purposes, the Company's proportionate share of the assets,
liabilities and items of income of the Partnership will be treated as assets and
gross income of the Company for purposes of applying the requirements described
herein.
Income Tests
In order for the Company to maintain its qualification as a REIT, the
Company must annually satisfy certain requirements relating to the nature of its
gross income. First, at least 75% of the Company's gross income (excluding gross
income from prohibited transactions) for each taxable year must consist of
defined types of income derived directly or indirectly from investments relating
to real property or mortgages on real property (including "rents from real
property" and, in certain circumstances, interest) or temporary investment
income. Second, at least 95% of the Company's gross income (excluding gross
income from prohibited transactions) for each taxable year must be derived from
such real property or temporary investments, and from dividends, other types of
interest, and gain from the sale or disposition of stock or securities, or from
any combination of the foregoing. Third, in taxable years through 1997, not more
that 30% of the Company's gross income (including gross income from prohibited
transactions) for each taxable year could be gain from the sale or other
disposition of (i) stock or securities held for less than one year, (ii) dealer
property that was not foreclosure property, and (iii) certain real property held
for less than four years (apart from involuntary conversions and sales of
foreclosure property). The 30% test does not apply in taxable years after 1997.
The specific application of these tests to the Company is discussed below.
Rents received by the Company will qualify as "rents from real property" in
satisfying the gross income requirements for a REIT described above only if
several conditions are met. First, the amount of rent must not be based in whole
or in part on the income or profits of any person. However, an amount received
or accrued generally will not be excluded from the term "rents from real
property" solely by reason of being based on a fixed percentage or percentages
of receipts or sales. Second, rents received from a tenant will not qualify as
"rents from real property" in satisfying the gross income tests if the Company,
or an owner of 10% or more of the Company, directly or constructively owns 10%
or more of such tenant (a "Related Party Tenant"). Third, if rent attributable
to personal property leased in connection with a lease of real property is
greater than 15% of the total rent received under the lease, then the portion of
rent attributable to such personal property will not qualify as "rents from real
property." Finally, for rents received to qualify as "rents from real property,"
the
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Company generally must not operate or manage the property or furnish or render
services to the tenants of such property, other than through an "independent
contractor" who is adequately compensated and from whom the Company derives no
revenue. The "independent contractor" requirement, however, does not apply to
the extent the services provided by the Company are "usually or customarily
rendered" in connection with the rental of space for occupancy only and are not
otherwise considered "rendered to the occupant."
Pursuant to percentage leases (the "Percentage Leases"), Sunstone Hotel
Properties, Inc., a Colorado corporation (the "Lessee") has leased from the
Partnership the land, buildings, improvements, furnishings and equipment
comprising the hotels for a 10-year period. The Percentage Leases provide that
the Lessee is obligated to pay to the Partnership (i) the greater of base rent
("Base Rent") or percentage rent ("Percentage Rent," and with Base Rent,
collectively, the "Rents") and (ii) certain other additional charges (the
"Additional Charges"). The Percentage Rent is calculated by multiplying fixed
percentages by the room revenues for each of the hotels in excess of certain
levels. Both the Base Rent and the threshold room revenue amount in each
Percentage Rent formula will be adjusted for inflation. The adjustment will be
calculated at the beginning of each calendar year based on the change in the CPI
during the prior calendar year. The Base Rent accrues and is required to be paid
monthly and the Percentage Rent (if any) accrues and is required to be paid
quarterly. In order for the Base Rent, the Percentage Rent and the Additional
Charges to constitute "rents from real property," the Percentage Leases must be
respected as true leases for federal income tax purposes and not treated as
service contracts, joint ventures or some other type of arrangement.
Brobeck, Phleger & Harrison LLP is of the opinion that the Percentage
Leases will be treated as true leases for federal income tax purposes. Such
opinion is based, in part, on the following facts and representations of the
Company described below: (i) the Partnership and the Lessee intend for their
relationship to be that of a lessor and lessee and such relationship will be
documented by lease agreements, (ii) the Lessee will have the right to exclusive
possession and use and quiet enjoyment of the hotels during the term of the
Percentage Leases, (iii) the Lessee will bear the cost of, and be responsible
for, day-to-day maintenance and repair of the hotels, other than the cost of
certain capital expenditures, and will dictate how the hotels are operated and
maintained, (iv) the Lessee will bear all of the costs and expenses of operating
the hotels (including the cost of any inventory used in their operation) during
the term of the Percentage Leases (other than real and personal property taxes,
insurance (other than workers' compensation insurance) and the cost of
repairing, replacing or refurbishing furniture, fixtures and equipment, to the
extent such costs do not exceed the amounts to be made available to the Lessee
for such costs by the Partnership under each Percentage Lease), (v) the Lessee
will benefit from any savings in the costs of operating the hotels during the
term of the Percentage Leases, (vi) in the event of damage or destruction to a
hotel, the Lessee will be at economic risk because it will be obligated either
(A) to restore the property to its prior condition, in which event it will bear
all costs of such restoration in excess of any insurance proceeds or (B) to
purchase the hotel for an amount generally equal to the fair market value of the
Property, less any insurance proceeds, (vii) the Lessee will indemnify the
Partnership against all liabilities imposed on the Partnership during the term
of the Percentage Leases by reason of (A) injury to persons or damage to
property occurring at the hotels or (B) the Lessee's use, management,
maintenance or repair of the hotels, and (viii) the Lessee will be obligated to
pay substantial fixed rent for the period of use of the hotels and (ix) the
Lessee stands to incur substantial losses (or reap substantial gains) depending
on how successfully it operates the hotels.
Investors should be aware that there are no controlling Treasury
Regulations, published rulings, or judicial decisions involving leases with
terms substantially the same as the Percentage Leases that discuss whether such
leases constitute true leases for federal income tax purposes. Counsel's opinion
regarding the Percentage Leases is not binding on the Service or the courts.
Thus, counsel can provide no assurance that the Service will not assert
successfully a contrary position. If the Percentage Leases are recharacterized
as service contracts or partnership agreements, rather than true leases, part or
all of the payments that the Partnership receives from the Lessee would not be
considered rent or would not otherwise satisfy the various requirements for
qualification as "rents from real property." In that case, the Company would not
be able to satisfy either the 75% or 95% gross income tests and, as a result,
would lose its REIT status.
As stated above, in order for the Rents to constitute "rents from real
property," the Rents attributable to personal property leased in connection with
the lease of the real properties comprising a hotel must not be
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greater than 15% of the Rents received under the Percentage Lease. The portion
of the Rents attributable to the personal property in a hotel is the amount that
bears the same ratio to total Rent for the taxable year as the average of the
adjusted bases of the personal property in the hotel at the beginning and at the
end of the taxable year bears to the average of the aggregate adjusted bases of
both the real and personal property comprising the hotel at the beginning and at
the end of such taxable year (the "Adjusted Basis Ratio"). The Company has
determined and represented to counsel (and counsel's opinion assumes) that the
amount of any Rent attributable to personal property and not qualifying as
"rents from real property" has not and will not be of a significant magnitude
(together with other disqualified income) to cause the Company to fail the 95%
gross income test or 75% gross income test as described above. In addition,
Ernst & Young LLP has provided an analysis confirming this representation. There
can be no firm assurance, however, that the amount of the Company's gross income
not qualifying as "rents from real property" under the 15% adjusted basis ratio
test described above will not be of a sufficient magnitude to cause the Company
to fail to satisfy the 95% or 75% gross income test and thus lose its REIT
status.
Another requirement for qualification of the Rents as "rents from real
property" is that the Percentage Rent must not be based in whole or in part on
the income or profits of any person. The Percentage Rent, however, will qualify
as "rents from real property" if it is based on percentages of receipts or sales
and the percentages (i) are fixed at the time the Percentage Leases are entered
into, (ii) are not renegotiated during the term of the Percentage Leases in a
manner that has the effect of basing Percentage Rent on income or profits, and
(iii) conform with normal business practice. More generally, the Percentage Rent
will not qualify as "rents from real property" if, considering the Percentage
Leases and all the surrounding circumstances, the arrangement does not conform
with normal business practice, but is in reality used as a means of basing the
Percentage Rent on income or profits. Counsel's opinion assumes, based on
representations of the Company, that (i) the Percentage Rent will be based at
all times on revenues from the hotels that are established in the Percentage
Leases, (ii) the Percentage Rent has not and will not be renegotiated during the
terms of the Percentage Leases in a manner that has the effect of basing the
Percentage Rent on income or profits and (ii) the Percentage Leases and the
Percentage Rent conform with normal business practice. Furthermore, the Company
has represented that, with respect to other hotels that it acquires in the
future, it will not charge rent for any property that is based in whole or in
part on the income or profits of any person (except by reason of being based on
a fixed percentage of gross revenues, as described above). In the event that any
of the foregoing representations of the Company is or has been inaccurate, the
Company could fail or cease to qualify as a REIT.
A third requirement for qualification of the Rents as "rents from real
property" is that the Company must not own, directly or constructively, 10% or
more of the Lessee. The constructive ownership rules generally provide that, if
10% or more in value of the shares of the Company are owned, directly or
indirectly, by or for any person, the Company is considered as owning the shares
of the Lessee owned, directly or indirectly, by or for such person. The Company
has represented that it has not and will not at any time directly or indirectly
own any stock of the Lessee. However, because Mr. Alter and Mr. Biederman each
owns more than 10% of the stock of the Lessee, the Company would be deemed to
own more than 10% of the stock of the Lessee if either Mr. Alter or Mr.
Biederman at any time owns, directly, indirectly or constructively, 10% or more
in value of the shares of the Company's stock. Under the Company's Articles of
Incorporation, neither Mr. Alter nor Mr. Biederman is entitled to acquire a 10%
interest in the Company. In addition, the Partnership Agreement provides that a
redeeming partner (including Messrs. Alter and Biederman) will receive cash,
rather than shares of Common Stock, at the election of the Company or if the
acquisition of shares of Common Stock by such partner would result in such
partner or any other person owning, directly or constructively, more than 9.8%
of the Company for purposes of the related party tenant rule. Thus, the Company
should never own, directly or constructively, 10% of more of the Lessee.
Furthermore, the Company has represented that, with respect to other hotels that
it acquires in the future, it will not rent any property to a related party
tenant.
A fourth requirement for qualification of the Rents as "rents from real
property" is that the Company cannot furnish or render noncustomary services to
the Lessee (or tenants of the hotels), or manage or operate the hotels or any
leased properties, other than through an independent contractor who is
adequately
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compensated and from whom the Company itself does not derive or receive any
income. Provided that the Percentage Leases are respected as true leases, the
Company should satisfy that requirement because neither the Company nor the
Partnership will be performing any services other than customary ones for the
Lessee. The Company has also represented that, with respect to other hotels that
it acquires in the future, it will not perform noncustomary services with
respect to the tenant of the property and will not be managing or operating such
hotels. As described above, if the Percentage Leases are recharacterized as
service contracts or partnership agreements, the Rents likely would be
disqualified as "rents from real property" because the Company would be
considered to furnish or render nonqualifying services to the occupants of the
hotels and to manage or operate the hotels other than through an independent
contractor who is adequately compensated and from whom the Company derives or
receives no income.
If the Rents from a hotel do not qualify as "rents from real property"
because the rents attributable to personal property exceed 15% of the total
Rents for a taxable year, the portion of the Rents from that hotel that is
attributable to personal property will not be qualifying income for purposes of
either the 75% or 95% gross income tests. The Company would lose its REIT status
in this event only if the Rents attributable to personal property in all of its
hotels (plus any other nonqualifying income) during a taxable year exceed 5% of
the Company's gross income during the year. If, however, the Rents do not
qualify as "rents from real property" because either (i) the Percentage Rent is
considered based on income or profits of the Lessee, (ii) the Company owns,
directly or constructively, 10% or more of the Lessee, or (iii) the Company
furnishes noncustomary services to the Lessee or tenants of the hotels, or
manages or operates the hotels other than through a qualifying independent
contractor, none of the Rents would qualify as "rents from real property." In
that case, the Company would lose its REIT status because it would be unable to
satisfy either the 75% or 95% gross income tests.
In addition to the Rents, the Lessee is required to pay to the Partnership
the Additional Charges. To the extent that the Additional Charges represent
either (i) reimbursements of amounts paid by the Partnership to third parties
that the Lessee is obligated to bear or (ii) penalties for nonpayment or late
payment of such amounts, the Additional Charges should qualify as "rents from
real property." To the extent, however, that the Additional Charges represent
interest that is accrued on the late payment of the Rents or the Additional
Charges, the Additional Charges should not qualify as "rents from real
property," but instead should be treated as interest that qualifies for the 95%
gross income test.
Any gross income derived from a prohibited transaction is taken into
account in applying the 30% income test necessary to qualify as a REIT for
taxable years through 1997. In addition, the net income from that transaction is
subject to a 100% tax. The term "prohibited transaction" generally includes a
sale or other disposition of property (other than foreclosure property) that is
held primarily for sale to customers in the ordinary course of a trade or
business. The Company and the Partnership believe that no asset owned by the
Company or the Partnership has or will be held for sale to customers in the
ordinary course of business of the Company or the Partnership. Whether property
is held "primarily for sale to customers in the ordinary course of a trade or
business" will depend, however, on the facts and circumstances from time to
time. The Company and the Partnership will attempt to comply with the terms of
safe-harbor provisions in the Code prescribing when asset sales will not be
characterized as prohibited transactions. Complete assurance cannot be given,
however, that the Company or the Partnership can comply with the safe-harbor
provisions of the Code or avoid owning property that may be characterized as
property held "primarily for sale to customers in the ordinary course of a trade
or business."
If the Lessee defaults on its obligations under a Percentage Lease for a
hotel, the Company terminates the Lessee's leasehold interest, and the Company
is unable to find a qualifying replacement lessee for such hotel within 90 days
of such termination, gross income from hotel operations conducted by the Company
from such hotel would cease to qualify for the 75% and 95% gross income tests.
In such event, the Company likely would be unable to satisfy the 75% and 95%
gross income tests and, thus, would fail to qualify as a REIT.
If the Company fails to satisfy one or both of the 75% or 95% gross income
tests for any taxable year, it may nevertheless qualify as a REIT for such year
if it is entitled to relief under certain provisions of the Code. Those relief
provisions will be generally available if the Company's failure to meet such
tests is due to
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reasonable cause and not due to willful neglect, the Company attaches a schedule
of the sources of its income to its return, and any incorrect information on the
schedule was not due to fraud with intent to evade tax. It is not possible,
however, to state whether in all circumstances the Company would be entitled to
the benefit of these relief provisions. As discussed above in "-- Taxation of
the Company," even if those relief provisions apply, a 100% tax would be imposed
with respect to the amount by which it fails the 75% or 95% gross income tests.
No such relief is available for violations of the 30% income test, which was
applicable for taxable years through 1997.
Asset Tests
The Company, at the close of each quarter of its taxable year, also must
satisfy two tests relating to the nature of its assets. First, at least 75% of
the value of the Company's total assets must be represented by cash or cash
items (including certain receivables), government securities, "real estate
assets," or, in cases where the Company raises new capital through share or
long-term (at least five-year) debt offerings, temporary investments in stock or
debt instruments during the one-year period following the Company's receipt of
such capital. The term "real estate assets" includes interests in real property,
interests in mortgages on real property to the extent the mortgage balance does
not exceed the value of the associated real property, and shares of other REITs.
For purposes of the 75% asset test, the term "interest in real property"
includes an interest in land and improvements thereon, such as buildings or
other inherently permanent structures (including items that are structural
components of such buildings or structures), a leasehold in real property, and
an option to acquire real property (or a leasehold in real property). Second, of
the investments not included in the 75% asset class, the value of any one
issuer's securities owned by the Company may not exceed 5% of the value of the
Company's total assets and the Company may not own more than 10% of any one
issuer's outstanding voting securities (except for its ownership interest in the
stock of a qualified REIT subsidiary).
For purposes of the asset requirements, the Company will be deemed to own
its proportionate share of the assets of the Partnership, rather than its
partnership interest in the Partnership, assuming that the Partnership is
treated as a partnership and not as a corporation for tax purposes. The Company
has represented that, as of the end of each quarter since the commencement of
its taxable year ended December 31, 1995, (i) at least 75% of the value of its
total assets were represented by assets qualifying under the 75% asset test, and
(ii) it has not owned any securities that do not satisfy the 75% asset test. The
Company has represented that it has not and will not acquire or dispose, or
cause the Partnership to acquire or dispose, of assets in a way that would cause
it to violate the asset tests for REIT status.
Distribution Requirements
The Company, in order to qualify as a REIT, is required to distribute
dividends (other than capital gain dividends) to its shareholders in an amount
at least equal to (i) the sum of (A) 95% of its "REIT taxable income" (computed
without regard to the dividends paid deduction and its net capital gain) and (B)
95% of the net income (after tax), if any, from foreclosure property, minus (ii)
the sum of certain items of noncash income. Such distributions must be paid in
the taxable year to which they relate, or in the following taxable year if
declared before the Company timely files its tax return for such year and if
paid on or before the first regular dividend payment after such declaration. To
the extent that the Company does not distribute all of its net capital gain or
distributes at least 95%, but less than 100%, of its "REIT taxable income," as
adjusted, it will be subject to tax thereon at regular ordinary and capital
gains corporate tax rates. Furthermore, if the Company should fail to distribute
during each calendar year at least the sum of (i) 85% of its REIT ordinary
income for such year, (ii) 95% of its REIT capital gain income for such year,
and (iii) any undistributed taxable income from prior periods, the Company would
be subject to a 4% nondeductible excise tax on the excess of such required
distribution over the amounts actually distributed. The Company has represented
that, for its taxable years through 1997, the Company made distributions
sufficient to satisfy the foregoing distribution requirements. The Company
intends in the future to make timely distributions sufficient to satisfy all
annual distribution requirements. However, there can be no assurance that the
Company will at all times have sufficient available cash to satisfy such
distribution requirements.
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Recordkeeping Requirement
Pursuant to applicable Treasury Regulations, in order to qualify as a REIT,
the Company must maintain certain records and request on an annual basis certain
information from its shareholders designed to disclose the actual ownership of
its outstanding shares. The Company has represented that it complied with these
requirements on a timely basis for its 1995 through 1997 taxable years and
intends to comply with such requirements for its 1998 taxable year and future
taxable years. Counsel has not and will not monitor such compliance by the
Company. For taxable years through 1997, the penalty for failure to obtain
information as to actual ownership was disqualification as a REIT. For 1998 and
thereafter, monetary penalties of up to $50,000 apply.
Anti-Abuse Regulations
The Treasury Regulations authorize the Service, in certain "abusive"
transactions involving partnerships, to disregard the form of the transaction
and recast it for federal tax purposes as the Service deems appropriate (the
"Anti-Abuse Regulations"). The Anti-Abuse Regulations would apply where a
partnership is formed or utilized in connection with a transaction (or series of
related transactions) with a principal purpose of substantially reducing the
present value of the partners' aggregate federal tax liability in a manner
inconsistent with the intent of the partnership provisions of the Code. Counsel
believes that the Anti-Abuse Regulations will not have any adverse impact on the
Company's ability to qualify as a REIT. However, because the Anti-Abuse
Regulations are extremely broad in scope and would be applied based on an
analysis of all of the facts and circumstances, counsel can give no assurance
that the Service will not successfully apply the Anti-Abuse Regulations to the
Company.
FAILURE TO QUALIFY
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company will be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to the shareholders in any year in which
the Company fails to qualify will not be deductible by the Company nor will they
be required to be made. In such event, to the extent of current and accumulated
earnings and profits, all distributions to shareholders will be taxable as
ordinary income and, subject to certain limitations of the Code, corporate
distributees may be eligible for the dividends received deduction. Unless
entitled to relief under specific statutory provisions, the Company also will be
disqualified from taxation as a REIT for the four taxable years following the
year during which the Company ceased to qualify as a REIT. It is not possible to
state whether in all circumstances the Company would be entitled to such
statutory relief.
TAXATION OF TAXABLE SHAREHOLDERS
As long as the Company qualifies as a REIT, distributions made to the
Company's taxable shareholders out of current or accumulated earnings and
profits (and not designated as capital gain dividends) will be taken into
account by such shareholders as ordinary income and will not be eligible for the
dividends received deduction generally available to corporations. Distributions
that are designated as capital gain dividends will be taxed as long-term capital
gains (to the extent they do not exceed the Company's actual net capital gain
for the taxable year) without regard to the period for which the shareholder has
held his shares of Common Stock or Preferred Stock. However, corporate
shareholders may be required to treat up to 20% of certain capital gain
dividends as ordinary income. Distributions in excess of current and accumulated
earnings and profits will not be taxable to a shareholder to the extent that
they do not exceed the adjusted basis of the shareholder's Common Stock or
Preferred Stock, but rather will reduce the adjusted basis of such shares. To
the extent that distributions in excess of current and accumulated earnings and
profits exceed the adjusted basis of a shareholder's Common Stock or Preferred
Stock, such distributions will be included in income as capital gain assuming
the shares of Common Stock or Preferred Stock are capital assets in the hands of
the shareholder. In addition, any distribution declared by the Company in
October, November, or December of any year and payable to a shareholder of
record on a specified date in any such month will be treated as both paid by the
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Company and received by the shareholder on December 31 of such year, provided
that the distribution is actually paid by the Company during January of the
following calendar year.
For a taxable year of the Company commencing in 1998 and thereafter, a
Company shareholder at the close of the taxable year must include, in computing
his or her long-term capital gains for his or her taxable year in which the last
day of the Company's taxable year falls, the amount (if any) of undistributed
net capital gains of the Company that the Company designates by written notice
to the shareholder ("Designated Retained Capital Gains"). The shareholder will
be deemed to have paid his or her share of the taxes paid by the Company on the
Designated Retained Capital Gains. The shareholder's basis in the Company's
shares will be increased by the amount of the Designated Retained Capital Gains
in excess of the taxes deemed paid by the shareholder.
Shareholders may not include in their individual income tax returns any net
operating losses or capital losses of the Company. Instead, such losses would be
carried over by the Company for potential offset against its future income
(subject to certain limitations). Taxable distributions from the Company and
gain from the disposition of the Common Stock or Preferred Stock will not be
treated as passive activity income and, therefore, shareholders generally will
not be able to apply any "passive activity losses" (such as losses from certain
types of limited partnerships in which the shareholder is a limited partner)
against such income. In addition, taxable distributions from the Company and
gain from the disposition of shares of Common Stock or Preferred Stock generally
will be treated as investment income for purposes of the investment interest
limitations. The Company will notify shareholders after the close of the
Company's taxable year as to the portions of the distributions attributable to
that year that constitute ordinary income, return of capital, and capital gain.
TAXATION OF SHAREHOLDERS ON THE DISPOSITION OF THE COMMON STOCK OR PREFERRED
STOCK
In general, any gain or loss realized upon a taxable disposition of the
Common Stock or Preferred Stock by a shareholder who is not a dealer in
securities will be treated as capital gain or loss. In the case of individuals,
the maximum rate of federal income tax applicable to capital gains is 20% in the
case of assets held for more than 12 months. No preferential rate of capital
gains tax applies in the case of corporations. Any loss upon a sale or exchange
of shares of Common Stock or Preferred Stock by a shareholder who has held such
shares for six months or less (after applying certain holding period rules),
will be treated as a long-term capital loss to the extent of distributions from
the Company and Designated Retained Capital Gains required to be treated by such
shareholder as long-term capital gain. All or a portion of any loss realized
upon a taxable disposition of the shares of Common Stock or Preferred Stock may
be disallowed if the shares of Common Stock or Preferred Stock are purchased
within 30 days before or after the disposition.
INFORMATION REPORTING REQUIREMENTS AND BACKUP WITHHOLDING
The Company will generally report to its shareholders and the Service the
amount of distributions paid during each calendar year, and the amount of tax
withheld, if any. Under the backup withholding rules, a shareholder may be
subject to backup withholding at the rate of 31% with respect to distributions
paid unless such holder (i) is a corporation or comes within certain other
exempt categories and, when required, demonstrates this fact or (ii) provides a
taxpayer identification number, certifies as to no loss of exemption from backup
withholding, and otherwise complies with the applicable requirements of the
backup withholding rules. A shareholder who does not provide the Company with
his correct taxpayer identification number also may be subject to penalties
imposed by the Service. Any amount paid as backup withholding will be creditable
against the shareholder's income tax liability. In addition, the Company may be
required to withhold a portion of capital gain distributions to any shareholders
who fail to certify their non-foreign status to the Company.
TAXATION OF TAX-EXEMPT SHAREHOLDERS
Tax-exempt entities, including qualified employee pension and profit
sharing trusts and individual retirement accounts ("Exempt Organizations"),
generally are exempt from federal income taxation. However, they are subject to
taxation on their unrelated business taxable income ("UBTI"). While many
investments in
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real estate generate UBTI, the Service has issued a published ruling that
dividend distributions by a REIT to an exempt employee pension trust do not
constitute UBTI, provided that the shares of the REIT are not otherwise used in
an unrelated trade or business of the exempt employee pension trust. Thus,
amounts distributed by the Company to Exempt Organizations generally should not
constitute UBTI. However, if an Exempt Organization finances its acquisition of
the Preferred Stock or Common Stock with debt, a portion of its income from the
Company will constitute UBTI pursuant to the "debt-financed property" rules.
Furthermore, social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans that are
exempt from taxation under paragraphs (7), (9), (17), and (20), respectively, of
Code Section 501(c) are subject to different UBTI rules, which generally will
require them to characterize distributions from the Company as UBTI. In
addition, in certain circumstances a pension trust that owns more than 10% of
the Company's shares is required to treat a percentage of the dividends from the
Company as UBTI (the "UBTI Percentage"). The UBTI Percentage is the gross income
derived from an unrelated trade or business (determined as if the Company were a
pension trust) divided by the gross income of the Company for the year in which
the dividends are paid. The UBTI rule applies only if (i) the UBTI Percentage is
at least 5%, (ii) the Company qualifies as a REIT by reason of the modification
of the 5/50 Rule that allows the beneficiaries of the pension trust to be
treated as holding shares of the Company in proportion to their actuarial
interests in the pension trust, and (iii) either (A) one pension trust owns more
than 25% of the value of the Company's shares or (B) a group of pension trusts
individually holding more than 10% of the value of the Company's shares
collectively own more than 50% of the value of the Company's shares.
While an investment in the Company by an Exempt Organization generally is
not expected to result in UBTI except in the circumstances described in the
preceding paragraph, any UBTI that does arise from such an investment will be
combined with all other UBTI of the Exempt Organization for a taxable year. Any
net UBTI will be subject to tax. If the gross income taken into account in
computing UBTI exceeds $1,000, the Exempt Organization is obligated to file a
tax return for such year on IRS Form 990-T. Neither the Company, the Board of
Directors, nor any of their Affiliates expects to undertake the preparation or
filing of IRS Form 990-T for any Exempt Organization in connection with an
investment by such Exempt Organization in the Company.
OTHER TAX CONSEQUENCES
State or Local Taxes
The Company, the Partnership, or the Company's shareholders may be subject
to state or local taxation in various state or local jurisdictions, including
those in which it or they own property, transact business, or reside. The state
and local tax treatment of the Company and its shareholders may not conform to
the federal income tax consequences discussed above. CONSEQUENTLY, PROSPECTIVE
SHAREHOLDERS SHOULD CONSULT THEIR OWN TAX ADVISORS REGARDING THE EFFECT OF STATE
AND LOCAL TAX LAWS ON AN INVESTMENT IN THE COMPANY.
Dividend Reinvestment Program
Under the Company's Dividend Reinvestment and Stock Purchase Plan,
shareholders participating in the program will be deemed to have received the
gross amount of any cash distributions which would have been paid by the Company
to such shareholders had they not elected to participate. These deemed
distributions will be treated as actual distributions from the Company to the
participating shareholders and will retain the character and tax effect
applicable to distributions from the Company generally. See "-- Taxation of
Shareholders." Shares of Common Stock received under the program will have a
holding period beginning with the day after purchase, and a tax basis equal to
the gross amount of the deemed distribution.
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TAX ASPECTS OF THE PARTNERSHIP
Classification as a Partnership
The Company will be entitled to include in its income its distributive
share of the Partnership's income and to deduct its distributive share of the
Partnership's losses only if the Partnership is classified for federal income
tax purposes as a partnership rather than as association taxable as a
corporation. Brobeck, Phleger & Harrison LLP is of the opinion that the
Partnership will be treated as a partnership for Federal income tax purposes.
This opinion is based on the provisions of the Partnership Agreement and certain
factual representations of the Company and the Partnership. No assurance can be
given that the Service will not challenge the status of the Partnership as a
partnership for federal income tax purposes. If such challenge were sustained by
a court, the Partnership would be treated as a corporation for federal income
tax purposes.
Under Section 7704 of the Code, a partnership is treated as a corporation
for federal income tax purposes if it is a "publicly traded partnership" (except
in situations in which 90% or more of the partnership's gross income is of a
specified type). A partnership is deemed to be publicly traded if its interests
are either (i) traded on an established securities market, or (ii) readily
tradable on a secondary market (or the substantial equivalent thereof). While
the Partnership Units will not be traded on an established securities market,
they could possibly be deemed to be traded on a secondary market or its
equivalent due to the redemption rights enabling the partners to dispose of
their Units.
The Treasury Department has issued regulations (the "PTP Regulations")
governing the classification of partnerships under Section 7704. These
regulations provide that the classification of partnerships is generally based
on a facts and circumstances analysis. However, the regulations also provide
limited "safe harbors" which preclude publicly traded partnership status.
Pursuant to one of those safe harbors, interests in a partnership will not be
treated as readily tradable on a secondary market or the substantial equivalent
thereof if (i) all interests in the partnership were issued in a transaction (or
transactions) that was not required to be registered under the Securities Act,
and (ii) the partnership does not have more than 100 partners at any time during
the partnership's taxable year. In determining the number of partners in a
partnership for this purpose, a person owning an interest in a flow-through
entity (i.e., a partnership, grantor trust, or S corporation) that owns an
interest in the partnership is treated as a partner in such partnership only if
(x) substantially all of the value of the person's interest in the flow-through
entity is attributable to the flow-through entity's interest (direct or
indirect) in the partnership and (y) a principal purpose of the use of the
tiered arrangement is to permit the partnership to satisfy the 100-partner
limitation. Furthermore, pursuant to Notice 88-75 issued by the Internal Revenue
Service, through the year 2005, an existing partnership may qualify for
non-publicly traded status if it has less than 500 partners (looking through to
the ultimate owners in the case of flow-through entities), does not issue any
Units registered under the Securities Act and does not enter into a substantial
new line of business.
The Partnership currently has less than 100 actual partners and less than
500 partners calculated on a "look-through" basis. The Partnership has not
issued any Units required to be registered under the Securities Act. Thus, the
Partnership presently qualifies for the safe harbors provided in Notice 88-75
and the PTP Regulations. However, there is no assurance that the Partnership
will at all times in the future be able to avoid treatment as a publicly traded
partnership.
Even if the Partnership were ever to be classified as a publicly traded
partnership, it would nevertheless be treated as a partnership for federal
income tax purposes (rather than an association taxable as a corporation) if at
least partnership) consists of "qualifying income" within the meaning of Section
7704(c)(2) of the Code (including interest, dividends, "real property rents" and
gains from the disposition of real property). The Partnership has represented
that, if in any taxable year the Partnership falls outside of an applicable safe
harbor from publicly traded partnership status, it will satisfy the gross income
test set forth in Section 7704(c)(2) of the Code in that taxable year and each
subsequent taxable year. Among other things, this will require that the
President of the Company, Mr. Robert A. Alter (or any other shareholder of the
Lessee who owns at least 10% of the stock of the Lessee) own less than a 5%
interest in the Partnership in the particular taxable year. Counsel's opinion as
to the classification of the Partnership is based on an assumption
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that the Partnership will either (i) continue to fall within a safe harbor from
publicly traded partnership status, or (ii) if the Partnership is ever treated
as a publicly traded partnership, it will satisfy the qualifying income test of
Section 7704(c)(2) of the Code in the taxable year in which such treatment
commences and all years thereafter.
If for any reason the Partnership were taxable as a corporation, rather
than as a partnership, for federal income tax purposes, the Company would not be
able to satisfy the income and asset requirements for REIT status. Thus the
Company would be subject to tax as a regular corporation and would not receive a
deduction for dividends paid to its shareholders. See "-- Requirements for
Qualification -- Income Tests" and "-- Requirements for Qualification -- Asset
Tests." In addition, any change in the Partnership's status for tax purposes
might be treated as a taxable event, in which case the Company might incur a tax
liability without any related cash distribution. Further, items of income and
deduction of the Partnership would not pass through to its partners, and its
partners would be treated as shareholders for tax purposes. Consequently, the
Partnership would be required to pay income tax at corporate tax rates on its
net income, and distributions to its partners would constitute dividends that
would not be deductible in computing the Partnership's taxable income.
The following discussion assumes that the Partnership will be treated as a
partnership for federal income tax purposes.
Income Taxation of the Partnership and Its Partners
Partners, Not the Partnership, Subject to Tax. A partnership is not a
taxable entity for federal income tax purposes. Rather, the Company will be
required to take into account its allocable share of the Partnership's income,
gains, losses, deductions, and credits for any taxable year of the Partnership
ending within or with the taxable year of the Company, without regard to whether
the Company has received or will receive any distribution from the Partnership.
Partnership Allocations. Although a partnership agreement generally will
determine the allocation of income and losses among partners, such allocations
will be disregarded for tax purposes under Section 704(b) of the Code if they do
not comply with the provisions of Section 704(b) of the Code and the Treasury
Regulations promulgated thereunder. If an allocation is not recognized for
federal income tax purposes, the item subject to the allocation will be
reallocated in accordance with the partners' interests in the partnership, which
will be determined by taking into account all of the facts and circumstances
relating to the economic arrangement of the partners with respect to such item.
Brobeck Phleger & Harrison LLP is of the opinion that the allocations of taxable
income and loss set forth in the Partnership Agreement comply with the
requirements of Section 704(b) of the Code and the Treasury Regulations
promulgated thereunder.
Tax Allocations With Respect to Contributed Properties. Pursuant to Section
704(c) of the Code, income, gain, loss, and deduction attributable to
appreciated or depreciated property that is contributed to a partnership in
exchange for an interest in the partnership must be allocated for federal income
tax purposes in a manner such that the contributor is charged with, or benefits
from, the unrealized gain or unrealized loss associated with the property at the
time of the contribution. The amount of such unrealized gain or unrealized loss
is generally equal to the difference between the fair market value of the
contributed property at the time of contribution and the adjusted tax basis of
such property at the time of contribution. The Treasury Department has issued
regulations requiring partnerships to use a "reasonable method" for allocating
items affected by Section 704(c) of the Code and outlining certain reasonable
allocation methods.
Under the Partnership Agreement, depreciation or amortization deductions of
the Partnership generally will be allocated among the partners in accordance
with their respective interests in the Partnership, except to the extent
required under Code Section 704(c). In addition, gain on sale of a hotel will be
specially allocated to the Partners who contributed the hotel to the Partnership
to the extent of any "built-in" gain with respect to such hotel for federal
income tax purposes.
Basis in Partnership Interest. The Company's adjusted tax basis in its
Partnership interest in the Partnership generally will be equal to (i) the
amount of cash and the basis of any other property contributed to
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the Partnership by the Company, (ii) increased by (A) its allocable share of the
Partnership's income and (B) its allocable share of indebtedness of the
Partnership, and (iii) reduced, but not below zero, by (A) the Company's
allocable share of the Partnership's loss and (B) the amount of cash distributed
to the Company (including deemed distributions as a result of reductions in the
Company's allocable share of indebtedness of the Partnership).
Treatment of Partnership Distributions. Partnership distributions to the
Company will not generally constitute taxable distributions. However, to the
extent that Partnership distributions, or any decrease in the Company's share of
the indebtedness of the Partnership (such decrease being considered a
constructive cash distribution to the partners), exceeds the Company's adjusted
tax basis in its Partnership interest, such distributions (including such
constructive distributions) would constitute taxable income to the Company. Such
distributions and constructive distributions normally would be characterized as
capital gain.
Sale of the Partnership's Property. Generally, any taxable gain realized by
the Partnership on the sale of property by the Partnership will be capital gain
or gain described in Section 1231 of the Code, except for any portion of such
gain that is treated as depreciation or cost recovery recapture or attributable
to inventory or property held for sale to customers in the ordinary course of
business. Any taxable gain recognized by the Partnership on the disposition of
any hotels originally contributed to the Partnership by the Partners will
generally be allocated first to the contributing Partners under Section 704(c)
of the Code to the extent of their "built-in gain" on those hotels for federal
income tax purposes. Any remaining taxable gain recognized by the Partnership on
the disposition of the hotels will generally be allocated among the partners in
accordance with their respective percentage interests in the Partnership.
The Company's share of any gain realized by the Partnership on the sale of
any property held by the Partnership as inventory or other property held
primarily for sale to customers in the ordinary course of the Partnership's
trade or business will be treated as income from a prohibited transaction that
is subject to a 100% penalty tax. Such prohibited transaction income also may
have an adverse effect upon the Company's ability to satisfy the income tests
for REIT status. The Company, however, does not presently intend to allow the
Partnership to acquire or hold any property that represents inventory or other
property held primarily for sale to customers in the ordinary course of the
Company's or the Partnership's trade or business. See "-- Requirements for
Qualification -- Income Tests."
PLAN OF DISTRIBUTION
The Company may sell the Offered Securities to one or more underwriters for
public offering and sale by them or may sell the Offered Securities to investors
directly or through agents, which agents may be affiliated with the Company.
Any such underwriter or agent involved in the offer and sale of the Offered
Securities will be named in any applicable Prospectus Supplement.
Sales of Offered Securities offered pursuant to any applicable Prospectus
Supplement may be effected from time to time in one or more transactions at a
fixed price or prices which may be changed, at prices related to the prevailing
market prices at the time of sale, or at negotiated prices. The Company also
may, from time to time, authorize underwriters acting as the Company's agents to
offer and sell the Offered Securities upon the terms and conditions set forth in
the applicable Prospectus Supplement. In connection with the sale of Offered
Securities, underwriters may be deemed to have received compensation from the
Company in the form of underwriting discounts or commissions and may also
receive commissions from purchasers of Offered Securities for whom they may act
as agent. Underwriters may sell Offered Securities to or through dealers, and
such dealers may receive compensation in the form of discounts, concessions or
commissions from the underwriters and/or commissions from the purchasers for
whom they may act as agent.
Any underwriting compensation paid by the Company to underwriters or agents
in connection with the offering of Offered Securities, and any discounts,
concessions or commissions allowed by underwriters to participating dealers,
will be set forth in any applicable Prospectus Supplement. Underwriters, dealers
and agents participating in the distribution of the Offered Securities may be
deemed to be underwriters, and any
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<PAGE> 80
discounts and commissions received by them and any profit realized by them on
resale of the Offered Securities may be deemed to be underwriting discounts and
commissions under the Securities Act. Underwriters, dealers and agents may be
entitled, under agreements entered into with the Company and the Partnership, to
indemnification against and contribution toward certain civil liabilities,
including liabilities under the Securities Act. Any such indemnification
agreements will be described in any applicable Prospectus Supplement.
Unless otherwise specified in any related Prospectus Supplement, each
series of Offered Securities will be a new issue with no established trading
market, other than the Common Stock which is listed on the NYSE. Any shares of
Common Stock sold pursuant to a Prospectus Supplement will be listed on such
exchange, subject to official notice of issuance. The Company may elect to list
any class or series of Preferred Stock and any series of Warrants on any
exchange, but neither is obligated to do so. It is possible that one or more
underwriters may make a market in a series of Offered Securities, but will not
be obligated to do so and may discontinue any market making at any time without
notice. Therefore, no assurance can be given as to the liquidity of the trading
market for the Offered Securities.
If so indicated in the applicable Prospectus Supplement, the Company may
authorize dealers acting as the Company's agents to solicit offers by certain
institutions to purchase Offered Securities from the Company at the public
offering price set forth in such Prospectus Supplement pursuant to Delayed
Delivery Contracts ("Contracts") providing for payment and delivery on the date
or dates stated in such Prospectus Supplement. Each Contract will be for an
amount not less than, and the aggregate principal amount of Offered Securities
sold pursuant to Contracts shall be not less nor more than, the respective
amounts stated in the applicable Prospectus Supplement. Institutions with whom
Contracts, when authorized, may be made include commercial and savings banks,
insurance companies, pension funds, investment companies, educational and
charitable institutions, and other institutions but will in all cases be subject
to the approval of the Company, as the case may be. Contracts will not be
subject to any conditions except (i) the purchase by an institution of the
Offered Securities covered by its Contracts shall not at the time of delivery be
prohibited under the laws of any jurisdiction in the United States to which such
institution is subject, and (ii) if the Offered Securities are being sold to
underwriters, the Company, as the case may be, shall have sold to such
underwriters the total principal amount of the Offered Securities less the
principal amount thereof covered by Contracts.
Certain of the underwriters and their affiliates may be customers of,
engage in transactions with and perform services for, the Company or the
Partnership in the ordinary course of business.
LEGAL MATTERS
The validity of the Offered Securities will be passed upon for the Company
by Brobeck, Phleger & Harrison LLP, Irvine, California. In rendering its
opinions, Brobeck, Phleger & Harrison LLP will rely on the opinion of Ballard
Spahr Andrews & Ingersoll, Baltimore, Maryland, as to certain matters of
Maryland law. Roger Cohen, a partner at Brobeck, Phleger & Harrison LLP, is
Assistant Secretary of the Company and owns 3,560 shares of Common Stock and has
been granted options to purchase 4,500 shares of Common Stock. In addition, the
description of federal income tax consequences contained in the section of this
Prospectus entitled "United States Federal Income Tax Considerations" and
certain federal income tax matters pertaining to the Company's status as a REIT
will be based on the opinion of Brobeck, Phleger & Harrison LLP.
EXPERTS
The consolidated financial statements of Sunstone Hotel Investors, Inc. at
December 31, 1997 and for the year then ended and the consolidated financial
statements of Sunstone Hotel Properties, Inc. at December 31, 1997 and for the
year then ended, all appearing in Sunstone Hotel Investors, Inc.'s Annual Report
on Form 10-K for the year ended December 31, 1997 have been audited by Ernst &
Young LLP, independent auditors, and the consolidated financial statements of
Sunstone Hotel Investors, Inc. as of December 31, 1996 and for the year ended
December 31, 1996, and the period August 16, 1995 to December 31, 1995, and the
combined
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<PAGE> 81
financial statements of Sunstone Hotels (Predecessor) for the period January 1,
1995 to August 15, 1995, and the consolidated financial statements of Sunstone
Hotel Properties, Inc. as of December 31, 1996 and for the year ended December
31, 1996 and for the period August 16, 1995 to December 31, 1995, all appearing
in the Company's Annual Report on Form 10-K for the year ended December 31, 1997
have been audited by Coopers & Lybrand L.L.P. (PricewaterhouseCoopers LLP after
June 30, 1998), independent auditors, as set forth in their reports thereon
included therein and incorporated herein by reference, in reliance upon such
reports given upon the authority of such firms as experts in accounting and
auditing.
The consolidated financial statements of Kahler Realty Corporation and
subsidiaries as of December 31, 1996, December 31, 1995, and January 1, 1995 and
for the years then ended appearing in the Company's Current Report on Form 8-K
dated as of August 22, 1997, have been audited by KPMG Peat Marwick LLP,
independent certified public accountants, as set forth in their reports thereon
included therein and incorporated herein by reference, in reliance upon such
reports given upon the authority of such firms as experts in accounting and
auditing.
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<PAGE> 82
- ------------------------------------------------------
NO PERSONS HAVE BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS OTHER THAN THOSE CONTAINED OR INCORPORATED BY REFERENCE IN THIS
PROSPECTUS SUPPLEMENT OR THE PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION
OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE
COMPANY OR THE UNDERWRITERS. THIS PROSPECTUS SUPPLEMENT AND THE PROSPECTUS DO
NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY ANY
SECURITIES OTHER THAN THOSE TO WHICH IT RELATES, OR AN OFFER OR SOLICITATION
WITH RESPECT TO THOSE SECURITIES TO WHICH IT RELATES TO ANY PERSONS IN ANY
JURISDICTION WHERE SUCH OFFER OR SOLICITATION WOULD BE UNLAWFUL. THE DELIVERY OF
THIS PROSPECTUS SUPPLEMENT AND THE PROSPECTUS AT ANY TIME DOES NOT IMPLY THAT
THE INFORMATION CONTAINED OR INCORPORATED BY REFERENCE HEREIN AT ITS DATE IS
CORRECT AS OF ANY TIME SUBSEQUENT TO ITS DATE.
------------------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
PROSPECTUS SUPPLEMENT
Available Information...................... S-1
Prospectus Supplement Summary.............. S-2
Risk Factors............................... S-12
Use of Proceeds............................ S-14
Price Range of Common Stock and Dividend
Payments................................. S-14
Capitalization............................. S-16
Selected Historical and Pro Forma Financial
Information.............................. S-17
Description of Capital Stock............... S-20
United States Federal Income Tax
Considerations........................... S-28
Underwriting............................... S-29
PROSPECTUS
Available Information...................... 2
Incorporation of Certain Information by
Reference................................ 2
The Company................................ 4
Use of Proceeds............................ 4
Risk Factors............................... 5
Description of Common Stock and Preferred
Stock.................................... 14
Description of Warrants.................... 19
Certain Provisions of Maryland Law and of
the Company's Articles of Incorporation
and Bylaws............................... 20
United States Federal Income Tax
Considerations........................... 23
Plan of Distribution....................... 35
Legal Matters.............................. 36
Experts.................................... 36
</TABLE>
------------------------------------------------------
PROSPECTUS SUPPLEMENT August , 1998
------------------------------------------------------
2,000,000 SHARES
SUNSTONE HOTEL INVESTORS, INC.
LOGO
ENHANCED PERPETUAL INCOME
PREFERRED SECURITIES(SM)
------------------------------------
EVEREN SECURITIES, INC.
BEAR, STEARNS & CO. INC.
A.G. EDWARDS & SONS, INC.
RAYMOND JAMES &
ASSOCIATES, INC.
SUTRO & CO. INCORPORATED
------------------------------------------------------
