<PAGE> 1
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
-------------------
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarter ended
JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission file number 0-26304
SUNSTONE HOTEL INVESTORS, INC.
(Exact name of registrant as specified in its charter)
--------------------
Maryland 52-1891908
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
115 Calle de Industrias, Suite 201, San Clemente, CA 92672
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (714) 361-3900
- --------------------------------------------------------------------------------
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
As of August 13, 1998, there were 37,548,778 shares of Common Stock
outstanding.
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<PAGE> 2
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON FORM 10-Q
JUNE 30, 1998
TABLE OF CONTENTS
PART I -- FINANCIAL INFORMATION
<TABLE>
<CAPTION>
Page
----
<S> <C>
ITEM 1. FINANCIAL STATEMENTS
Sunstone Hotel Investors, Inc.
Consolidated Balance Sheets as of June 30, 1998 and December 31, 1997.............. 3
Consolidated Statements of Income for the Three and Six Months
Ended June 30, 1998 and 1997................................................... 4
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1998 and 1997................................................... 5
Notes to Consolidated Financial Statements......................................... 6
Sunstone Hotel Properties, Inc. ("Lessee")
Consolidated Balance Sheets as of June 30, 1998 and
December 31, 1997.............................................................. 10
Consolidated Statements of Operations for the Three and Six Months
Ended June 30, 1998 and 1997................................................... 11
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1998 and 1997................................................... 12
Notes to Consolidated Financial Statements......................................... 13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS....................................... 15
PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION........................................................ 25
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K......................................... 33
SIGNATURES ........................................................................... 34
</TABLE>
2
<PAGE> 3
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
------------- -------------
(Unaudited)
<S> <C> <C>
ASSETS:
Investments in hotel properties, net $ 839,314,000 $ 704,323,000
Notes receivable 6,062,000 6,085,000
Cash and cash equivalents 192,000 3,584,000
Restricted cash 2,605,000 2,421,000
Rent receivable - Lessee 12,452,000 7,641,000
Other assets, net 17,799,000 15,523,000
------------- -------------
$ 878,424,000 $ 739,577,000
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Revolving line of credit $ 263,800,000 $ 179,800,000
Notes payable 106,152,000 116,671,000
Accounts payable and other accrued expenses 12,563,000 10,937,000
Dividends payable to preferred shareholders 492,000 422,000
------------- -------------
383,007,000 307,830,000
------------- -------------
Commitments and contingencies
Minority interest 26,677,000 33,860,000
Stockholders' equity:
7.9% Class A Cumulative Convertible Preferred Stock,
$.01 par value, 10,000,000 authorized; 250,000
issued and outstanding as of June 30, 1998 and
December 31, 1997 (liquidation preference $100 per
share aggregating $25,000,000) 3,000 3,000
Common stock, $.01 par value, 150,000,000 authorized;
37,534,319 and 32,284,103 issued and outstanding
as of June 30, 1998 and December 31, 1997,
respectively 376,000 323,000
Additional paid-in capital 479,402,000 401,098,000
Distributions in excess of earnings (11,041,000) (3,537,000)
------------- -------------
468,740,000 397,887,000
------------- -------------
$ 878,424,000 $ 739,577,000
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE> 4
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- -------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
REVENUES:
Lease revenue - Lessee $ 24,775,000 $ 7,775,000 $ 48,462,000 $ 15,347,000
Interest income 83,000 124,000 140,000 321,000
------------ ------------ ------------ ------------
24,858,000 7,899,000 48,602,000 15,668,000
------------ ------------ ------------ ------------
EXPENSES:
Real estate related depreciation and
amortization 8,993,000 2,531,000 16,912,000 4,487,000
Interest expense and amortization of
financing costs 5,513,000 717,000 10,108,000 1,557,000
Real estate and personal property taxes
and insurance 2,883,000 684,000 5,662,000 1,360,000
General and administrative 871,000 269,000 2,374,000 801,000
------------ ------------ ------------ ------------
Total expenses 18,260,000 4,201,000 35,056,000 8,205,000
------------ ------------ ------------ ------------
Income before minority interest 6,598,000 3,698,000 13,546,000 7,463,000
Minority interest (324,000) (403,000) (675,000) (892,000)
------------ ------------ ------------ ------------
NET INCOME 6,274,000 3,295,000 12,871,000 6,571,000
Dividends on preferred shares (492,000) -- (979,000) --
------------ ------------ ------------ ------------
INCOME AVAILABLE TO COMMON SHAREHOLDERS $ 5,782,000 $ 3,295,000 $ 11,892,000 $ 6,571,000
============ ============ ============ ============
EARNINGS PER SHARE
Basic $ 0.15 $ 0.18 $ 0.33 $ 0.39
============ ============ ============ ============
Diluted $ 0.15 $ 0.17 $ 0.32 $ 0.39
============ ============ ============ ============
DIVIDENDS DECLARED PER SHARE $ 0.275 $ 0.25 $ 0.275 $ 0.25
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE> 5
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
---------------------------------
1998 1997
------------- -------------
(Restated)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 12,871,000 $ 6,571,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Minority interest 675,000 892,000
Depreciation and amortization 17,016,000 4,487,000
Amortization of financing costs 1,079,000 173,000
Changes in assets and liabilities:
Rent receivable - Lessee (4,611,000) (1,544,000)
Other assets, net (494,000) (359,000)
Accounts payable and other accrued expenses 1,627,000 (1,014,000)
Dividends payable to preferred shareholders 70,000 --
------------- -------------
Net cash provided by operating activities 28,233,000 9,206,000
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, improvements and additions
to hotel properties (145,626,000) (86,805,000)
Increase in restricted cash (184,000) --
Payments received on notes receivable 23,000 --
------------- -------------
Net cash used in investing activities (145,787,000) (86,805,000)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 69,713,000 118,282,000
Payment of deferred financing costs (1,283,000) (748,000)
Borrowings on revolving line of credit 137,000,000 24,900,000
Principal payments on revolving line of credit (53,000,000) (46,500,000)
Principal payments on notes payable (16,698,000) (8,119,000)
Distributions to common shareholders (19,396,000) (7,975,000)
Distributions to partners (1,195,000) (1,194,000)
Distributions to preferred shareholders (979,000) --
------------- -------------
Net cash provided by financing activities 114,162,000 78,646,000
------------- -------------
Net change in cash and cash equivalents (3,392,000) 1,047,000
Cash and cash equivalents, beginning of period 3,584,000 142,000
------------- -------------
Cash and cash equivalents, end of period $ 192,000 $ 1,189,000
============= =============
Cash paid for interest, net of amounts capitalized $ 8,785,000 $ 1,271,000
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE> 6
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF PRESENTATION
Sunstone Hotel Investors, Inc., a Maryland corporation (the "Company"),
was formed in 1995 as a real estate investment trust ("REIT"). At June 30, 1998,
the Company had a 94.6% interest in Sunstone Hotel Investors, L.P. (the
"Operating Partnership") which began operations as of August 16, 1995, upon
receipt of the proceeds from the Company's initial public offering (the
"Offering") and consummation of certain formation transactions. The Company
conducts all of its business through and is the sole general partner of the
Operating Partnership.
In connection with the Offering, the Company acquired seven hotels (the
"Sunstone Hotels") from seven entities controlled by officers and a director of
the Company and acquired three additional hotels (the "Acquisition Hotels" and
together, the "Initial Hotels") from unrelated third parties in exchange for (i)
units in the Operating Partnership ("Units"), (ii) the payment of mortgage
indebtedness for the Sunstone Hotels, and (iii) payment of cash to purchase the
Acquisition Hotels.
At June 30, 1998, the Company's portfolio included 61 hotel properties,
primarily located in the western United States, all of which are leased to
Sunstone Hotel Properties, Inc. (the "Lessee") under operating leases (the
"Percentage Leases") that provide for the payment of base and percentage rent.
The Lessee is owned by Robert A. Alter, Chairman and President of the Company
(80%), and Charles L. Biederman, Vice Chairman of the Company (20%). The Lessee
has entered into a management agreement pursuant to which all of the hotels are
managed by Sunstone Hotel Management, Inc. (the "Management Company"), of which
Mr. Alter is the sole shareholder.
Basis of Presentation:
The consolidated financial statements include the accounts of the
Company and its subsidiaries, including the Operating Partnership. All
significant intercompany transactions and balances have been eliminated.
The interim consolidated financial statements of the Company have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Company believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the audited consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997 and
Quarterly Reports on Form 10-Q for prior quarters of 1998. The financial
information presented herein reflects all adjustments, consisting only of normal
recurring accruals, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods presented. The results
for the three and six months ended June 30, 1998 are not necessarily indicative
of the results to be expected for the year ended December 31, 1998.
Restatement:
The interim financial statements as of and for the three and six months
ended June 30, 1997 have been restated to reflect the allocation of a fourth
quarter 1997 depreciation expense adjustment to the first three quarters of
1997.
6
<PAGE> 7
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION, continued
Reclassifications:
Certain prior period balances have been reclassified to conform with the
current period presentation.
New Accounting Standard:
In May 1998, the Emerging Issues Task Force of the Financial Accounting
Standards Board reached a consensus on Issue No. 98-9 ("EITF 98-9"),
Accounting for Contingent Rent in Interim Financial Periods. EITF 98-9 requires
lessors to defer recognition of contingent rental income until specified
thresholds that trigger the contingent rent are met. During the second quarter
of 1998, the Company amended the Percentage Leases with the Lessee for all its
hotels. The amendment provides for quarterly room revenue thresholds used in
calculating percentage rent due. As a result of such amendment, EITF 98-9 will
have no material impact on the Company's interim and annual financial
statements.
2. INVESTMENTS IN HOTEL PROPERTIES
During the second quarter of 1998, the Company acquired four hotel
properties with 650 rooms for aggregate consideration of $59.0 million,
including transaction costs, comprised of $50.9 million in cash, $6.2 million in
an assumed note payable and the issuance of 118,409 Units valued at $1.9
million, which are exchangeable for a like number of common stock of the
Company. Additionally, the Company completed, or was in the process of
completing, substantial renovations at seven of the hotel properties, and in
connection with such renovation, incurred costs of approximately $15.7 million.
3. REVOLVING LINE OF CREDIT
On July 23, 1998, the Company amended its revolving line of credit (the
"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, as defined, (iii) increase amount available for working capital purposes
from $15.0 million to $30.0 million, and (iv) extend the term from June 30, 1999
to June 30, 2000. 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%.
7
<PAGE> 8
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share. The 1997 amounts have been restated to comply with the
Financial Accounting Standards Board Statement No. 128, Earnings per Share.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------------------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Numerator:
Net income $ 6,274,000 $ 3,295,000 $ 12,871,000 $ 6,571,000
Dividends on preferred shares (492,000) -- (979,000) --
------------ ------------ ------------ ------------
Numerator for basic and diluted earnings
per share:
Income available to common shareholders
after effect of dilutive securities $ 5,782,000 $ 3,295,000 $ 11,892,000 $ 6,571,000
------------ ------------ ------------ ------------
Denominator:
Denominator for basic earnings per
share - weighted average shares
outstanding 37,530,453 18,792,843 36,491,409 16,813,760
Effect of dilutive securities:
Stock options 137,545 158,140 153,956 158,140
------------ ------------ ------------ ------------
Denominator for diluted earnings per
share - adjusted weighted average
shares and assumed conversion 37,667,998 18,950,983 36,645,365 16,971,900
============ ============ ============ ============
Basic earnings per share $ 0.15 $ 0.18 $ 0.33 $ 0.39
============ ============ ============ ============
Diluted earnings per share $ 0.15 $ 0.17 $ 0.32 $ 0.39
============ ============ ============ ============
</TABLE>
5. SUBSEQUENT EVENTS
On July 31, 1998, the Company sold five non-core hotel assets. Four of
the hotels with an aggregate of 651 rooms were sold to Cavanaughs Hospitality
Corporation for $30.3 million in cash, an amount that approximates the book
values of the respective hotels at the time of sale plus selling costs. The
following hotels were sold in conjunction with this transaction: the Boise Park
Suite hotel in Boise Idaho; the Pocatello Park Quality Inn in Pocatello, Idaho;
the Best Western Canyon Springs Park Hotel in Twin Falls, Idaho; and the Best
Western Colonial Inn in Helena, Montana.
Additionally, on July 31, 1998, the Company sold the 187-room Lakeview
Resort in Morgantown, West Virginia to GF Management for $11.0 million in cash,
an amount that approximates the book value of the hotel at the time of sale plus
selling costs.
Upon sale of a hotel, the respective Percentage Lease terminates. As
provided for in the Percentage Leases and as compensation for the early
termination, the Company is required to (i) pay the Lessee a termination fee of
8
<PAGE> 9
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. SUBSEQUENT EVENTS, continued
an amount equal to the net profit earned by the Lessee with respect to the
hotels sold for the 12-month period preceding the sale or, (ii) offer to lease
the Lessee one or more substitute hotel facilities pursuant to a similar lease.
On July 30, 1998 the Operating Partnership commenced an offering of
approximately $150 million of Senior Notes due in 2008 in a private placement
pursuant to Rule 144A and to non-U.S. persons to Regulation S. The Senior Notes
will be unconditionally guaranteed by the Company.
On August 13, 1998, the Company completed the acquisition and
development of the newly built Pueblo Marriott in Pueblo, Colorado, for
approximately $12.0 million in cash. The 164-room full-service hotel is located
in historic downtown Pueblo and is connected to the 27,500 square foot Pueblo
Convention Center owned and built by the City of Pueblo. The seven-story hotel
includes a concierge level, two additional meeting rooms, a JW's Steakhouse and
lobby lounge and an indoor pool.
9
<PAGE> 10
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
------------ ------------
(Unaudited)
<S> <C> <C>
ASSETS:
Current assets
Cash and cash equivalents $ 9,440,000 $ 4,352,000
Receivables, net of allowance for doubtful accounts
of $209,000 and $267,000, respectively 11,222,000 10,037,000
Due from affiliates 845,000 321,000
Inventories 1,856,000 1,798,000
Prepaid expenses 575,000 306,000
------------ ------------
23,938,000 16,814,000
Management agreements, net 554,000 723,000
Property and equipment, net 906,000 3,116,000
Other assets 191,000 --
------------ ------------
$ 25,589,000 $ 20,653,000
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
Rent payable - Sunstone Hotel Investors, Inc. $ 12,452,000 $ 7,641,000
Accounts payable 9,488,000 8,836,000
Customer deposits 531,000 550,000
Sales taxes payable 2,536,000 1,640,000
Accrued payroll 2,316,000 3,093,000
Accrued vacation 2,232,000 1,795,000
Accrued bonuses 1,693,000 573,000
Capital lease obligation - current portion 58,000 55,000
Other accrued expenses 782,000 1,007,000
------------ ------------
32,088,000 25,190,000
Long-term liabilities
Capital lease obligation 336,000 366,000
Accrued pension liability 1,030,000 1,017,000
------------ ------------
33,454,000 26,573,000
Minority interest 96,000 119,000
Commitments
Stockholders' deficit:
Common stock, no par value, 1,000 shares authorized;
100 shares issued and outstanding -- --
Deficit (7,961,000) (6,039,000)
------------ ------------
$ 25,589,000 $ 20,653,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial Statements.
10
<PAGE> 11
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ -------------------------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
REVENUES:
Room $ 51,840,000 $ 17,935,000 $ 99,750,000 $ 34,501,000
Food and beverage 11,239,000 1,469,000 21,232,000 2,744,000
Other 8,166,000 999,000 15,358,000 2,002,000
------------- ------------- ------------- -------------
Total revenues 71,245,000 20,403,000 136,340,000 39,247,000
------------- ------------- ------------- -------------
EXPENSES:
Room 12,994,000 4,077,000 24,372,000 7,735,000
Food and beverage 9,386,000 1,262,000 17,926,000 2,296,000
Other 4,496,000 494,000 8,890,000 988,000
Franchise costs 1,839,000 722,000 3,257,000 1,390,000
Advertising and promotion 5,160,000 1,828,000 9,898,000 3,467,000
Utilities 2,785,000 901,000 5,214,000 1,792,000
Repairs and maintenance 3,006,000 719,000 5,581,000 1,374,000
Management fees - Sunstone Hotel
Management, Inc. -- 402,000 937,000 759,000
Rent expense - Sunstone Hotel
Investors, Inc. 24,775,000 7,775,000 48,462,000 15,347,000
General and administrative 6,734,000 1,903,000 13,725,000 3,734,000
------------- ------------- ------------- -------------
Total expenses 71,175,000 20,083,000 138,262,000 38,882,000
------------- ------------- ------------- -------------
NET (LOSS) INCOME $ 70,000 $ 320,000 $ (1,922,000) $ 365,000
============= ============= ============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
11
<PAGE> 12
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
---------------------------
1998 1997
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $(1,922,000) $ 365,000
Adjustments to reconcile net (loss) income to net
cash provided by (used in) operating activities:
Bad debt 86,000 --
Depreciation 94,000 --
Amortization 169,000 --
Changes in assets and liabilities:
Receivables, net (847,000) (1,137,000)
Due from affiliates 557,000 (143,000)
Inventories (32,000) (301,000)
Prepaid expenses and other assets (431,000) (179,000)
Rent payable - Sunstone Hotel Investors, Inc. 4,811,000 1,544,000
Accounts payable 652,000 (601,000)
Customer deposits (71,000) (124,000)
Sales taxes payable 896,000 533,000
Accrued payroll (777,000) (479,000)
Accrued vacation 437,000 110,000
Accrued bonuses 1,120,000 233,000
Accrued pension liability 13,000 --
Other accrued expenses (265,000) (24,000)
----------- -----------
Net cash provided by (used in) operating activities 4,490,000 (203,000)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (83,000) (71,000)
Proceeds from lessor upon execution of certain leases 708,000 --
----------- -----------
Net cash provided by (used in) investing activities 625,000 (71,000)
----------- -----------
CASH FLOWS USED IN FINANCING ACTIVITIES:
Payments on capital lease obligation (27,000) --
----------- -----------
Net cash used in financing activities (27,000) --
----------- -----------
Net change in cash and cash equivalents $ 5,088,000 $ (274,000)
Cash and cash equivalents, beginning of period 4,352,000 1,165,000
----------- -----------
Cash and cash equivalents, end of period $ 9,440,000 $ 891,000
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
12
<PAGE> 13
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO FINANCIAL STATEMENTS
(UNAUDITED)
---------------
1. ORGANIZATION AND BASIS OF PRESENTATION
Sunstone Hotel Properties, Inc. (the "Lessee") was incorporated in
Colorado in October 1994 and commenced operations effective with the completion
of an initial public stock offering (the "Offering") by Sunstone Hotel
Investors, Inc. (the "Lessor") on August 16, 1995. The Lessee leases hotel
properties which are primarily located in the western United States from the
Lessor pursuant to long-term leases (the "Percentage Leases"). The Lessee is
owned by Robert A. Alter, Chairman and President of the Lessor (80%), and
Charles L. Biederman, Director and Executive Vice President of the Lessor (20%).
At June 30, 1998, 61 hotel properties were leased from the Lessor.
Basis of Presentation:
The consolidated financial statements include the accounts of the Lessee
and its subsidiaries. All significant intercompany transactions and balances
have been eliminated.
The interim consolidated financial statements of the Lessee have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Lessee believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the Lessee's audited consolidated financial statements included
in the Lessor's Annual Report on Form 10-K for the year ended December 31, 1997
and Quarterly Reports on Form 10-Q for prior quarters of 1998. The financial
information presented herein reflects all adjustments, consisting only of normal
recurring accruals, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods presented. The results
for the three and six months ended June 30, 1998 are not necessarily indicative
of the results to be expected for the year ended December 31, 1998.
Reclassifications:
Certain prior period balances have been reclassified to conform with the
current period presentation.
2. ACCUMULATED DEFICIT
From inception, the Lessee has incurred cumulative losses of $8.0
million. Net income of $70,000 for the three months ended June 30, 1998 and a
net loss of $2.0 million for the three months ended March 31, 1998 is
substantially due to the combined effects on the Lessee of (i) the effect of
renovating 13 of the Lessor's hotels, (ii) the transition to new management at
recently acquired hotels, and (iii) the operating leverage of certain Percentage
Leases.
The Lessee has remained current in its payments to the Lessor under the
terms of the Percentage Leases. During 1998, management of the Lessee
anticipates generating positive operating cash flow; however, there can be no
assurance that operating expectations will be met.
3. PERCENTAGE LEASE AGREEMENTS
During the quarter ended June 30, 1998, the Lessee executed four
additional Percentage Leases with the Lessor with terms similar to the existing
Percentage Leases. The aggregate future minimum rentals (base rents) payable
under these leases, exclusive of any base rent to be abated during periods of
major renovations is $4.0 million per year.
13
<PAGE> 14
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO FINANCIAL STATEMENTS
4. RELATED PARTY TRANSACTION
Sunstone Hotel Management, Inc. (the "Management Company"), a company
wholly owned by Robert A. Alter, Chairman of the Lessee, provides management
services to the Lessee pursuant to the terms of a management agreement. The
agreement has a one year term and is automatically renewed. Management fees are
computed on an individual hotel basis and range from 1% and 2% of gross
revenues. The cost of these services is classified as management fees in the
statements of operations. During the quarter ended June 30, 1998, $1,084,000 in
management fees were abated by the Management Company. Such abated fees will not
have to be paid by the Lessee in the future.
During the quarter ended June 30, 1998, the Lessee reconveyed to the
Lessor approximately $2,200,000 in china, glass, silver and linen that was
previously assigned to the Lessee by the Lessor and originally recorded by the
Lessee at the Lessor's cost. The transaction was recorded by the Lessee as a
reduction of the applicable asset accounts and a reduction of the amount due to
the Lessor, with no gain or loss being recognized.
5. SUBSEQUENT EVENTS
On July 31, 1998, the Lessor sold five non-core hotel assets which were
leased to the Lessee. Four of the hotels with an aggregate of 651 rooms were
sold to Cavanaughs Hospitality Corporation. The following hotels were sold in
conjunction with this transaction: the Boise Park Suite hotel in Boise Idaho;
the Pocatello Park Quality Inn in Pocatello, Idaho; the Best Western Canyon
Springs Park Hotel in Twin Falls, Idaho; and the Best Western Colonial Inn in
Helena, Montana. Additionally, on July 31, 1998, the Lessor sold the 187-room
Lakeview Resort in Morgantown, West Virginia to GF Management.
Upon sale of a hotel, the respective Percentage Lease terminates. As
provided for in the Percentage Lease and as compensation for the early
termination, the Lessor is required to (i) pay the Lessee a termination fee of
an amount equal to the net profit earned by the Lessee with respect to the
hotels sold for the 12-month period preceding the sale or, (ii) offer to lease
the Lessee one or more substitute hotel facilities pursuant to a similar lease.
14
<PAGE> 15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
When used throughout this report, the words "believes", "anticipates"
and "expects" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to the many risks and uncertainties
which affect the Company's business and actual results could differ materially
from those projected and forecasted. These risks and uncertainties, which
include competition within the lodging industry, the balance between supply and
demand for the hotel rooms, the Company's continued ability to execute
acquisitions and renovations, the effect of economic conditions, and the
availability of capital to finance planned growth, are described but are not
limited to those disclosed in this report. These and other factors which could
cause actual results to differ materially from those in the forward-looking
statements are discussed under the heading "Risk Factors". Given these risks and
uncertainties, readers are cautioned not to place undue reliance on such
statements. The Company also undertakes no obligation to publicly release the
result of any revisions to these forward-looking statements that may be made to
reflect any future events or circumstances.
GENERAL
The Company is a self-administered equity REIT that owns and leases
luxury, upscale and mid-price hotels located primarily in the Pacific and
Mountain regions of the western United States. The hotels operate primarily
under national franchises that are among the most respected and widely
recognized in the lodging industry, including brands affiliated with Hilton
Hotels Corporation, Holiday Hospitality Corporation, Marriott International,
Inc. and Promus Hotel Corporation. As of August 13, 1998, the Company's
portfolio consisted of 57 hotels with a total of 10,331 rooms, 45 of which were
acquired and two which were developed subsequent to the Company's IPO in August
1995. The majority of the Company's hotel portfolio consists of luxury, upscale
and mid-price full-service hotels and upscale extended-stay properties
(approximately 75%) with the remainder of the Company's portfolio consisting of
mid-price, limited service properties primarily located in markets where
significant barriers exist for new competitive supply.
The Company's growth strategy is to maximize shareholder value by (i)
acquiring underperforming and undercapitalized hotels that are in strong market
locations with significant barriers to entry, and (ii) improving such hotels'
financial performance by renovating, redeveloping, rebranding and repositioning
the hotels and through the implementation of focused sales and marketing
programs.
The Company's business strategy encompasses increasing revenue per
available room ("REVPAR") by increasing average daily rate ("ADR") and
occupancy. This strategy is typically implemented by replacing certain
discontinued group business with higher-rate group and transient business and by
selectively increasing room rates. Success with this strategy has been achieved
because of (i) the relatively high occupancy rates at certain of its hotels,
(ii) the success of a superior marketing strategy implemented at each acquired
hotel, and (iii) the effects of repositioning recently acquired hotels as
high-quality properties with strong national franchises through the Company's
redevelopment and rebranding program.
RESULTS OF OPERATIONS
Comparison of the Three Months Ended June 30, 1998 to 1997 and the Six Months
Ended June 30, 1998 to 1997
Revenues increased $17.0 million, or 215%, to $24.9 million for the
three months ended June 30, 1998 from $7.9 million for the corresponding quarter
of 1997. For the six months ended June 30, 1998, revenues increased $32.9
million, or 210%, to $48.6 million from $15.7 million for the corresponding
period of 1997. The increase in revenues is substantially attributable to the
execution of the Company's external growth strategy, as well as increases in
REVPAR of both continuously owned and recently acquired hotels. For a related
discussion of Funds From Operations, see "Liquidity and Capital Resources."
15
<PAGE> 16
Income available to common shareholders increased 75.8% to $5.8 million
for the three months ended June 30, 1998 from $3.3 million for the corresponding
quarter of 1997, while diluted earnings per share decreased to $0.15 from $0.17
per share, an 11.8% decrease. For the six months ended June 30, 1998, income
available to common shareholders increased 80.3% to $11.9 million from $6.6
million for the corresponding period of 1997, while diluted earnings per share
decreased to $0.32 from $0.39 per share, an 18.0% decrease. The decrease in
diluted earnings per share was primarily due to distributions to preferred
shareholders accrued in the three and six month periods ended June 30, 1998. The
related preferred stock was issued during the third quarter of 1997.
Additionally, the effect of recognizing straight-line depreciation for 13 hotels
undergoing significant renovation during the three and six month periods ended
June 30, 1998 also contributed to the decline in diluted earnings per share. The
depreciable cost basis of these 13 luxury and upscale hotels exceeds the
depreciable cost basis of the eleven upscale and mid-price hotels that were
undergoing significant renovation during the corresponding periods of 1997.
External Growth. During the quarter ended June 30, 1998, the Company
acquired four hotels with a total of 650 rooms for aggregate purchase prices of
approximately $59.0 million. For the last twelve months ended June 30, 1998, the
Company acquired 31 hotels with 6,261 rooms for aggregate purchase prices of
approximately $527.5 million, which contributed $13.6 million and $28.2 million
of the increase in revenues for the three and six month periods ended June 30,
1998, respectively.
Internal Growth. On a same-unit-sales basis, the Company achieved a 4.3%
increase in REVPAR for both non-renovation hotels and the entire hotel portfolio
for the second quarter of 1998 over the corresponding quarter of 1997.
REVPAR for all non-renovation hotels increased by 4.3%, from $54.21 to
$56.56, over the second quarter of 1997. Non-renovation hotels consist of 43 of
the Company's 61 hotels that were not undergoing significant renovation either
in the second quarter of 1997 or 1998.
The operating performance of the Company's non-renovation hotel
portfolio was negatively impacted by certain non-core hotel assets previously
identified for sale and non-recurring market factors which affected three
non-renovation hotels. The non-recurring market factors include (i) adjacent
public construction activity, and (ii) severe weather conditions in certain
markets.
Sale of Non-Core Hotel Assets. On July 31, 1998, the Company sold five
hotels with a total of 838 rooms for an aggregate sales price of $41.3 million
in cash. The hotels sold are the following: the Boise Park Suite Hotel in Boise,
Idaho; the Pocatello Park Quality Inn in Pocatello, Idaho; the Best Western
Canyon Springs Park Hotel in Twin Falls, Idaho; the Best Western Colonial Inn in
Helena, Montana and the Lakeview Resort in Morgantown, West Virginia.
Additionally, the 284-room Green Oaks Park hotel in Fort Worth, Texas has also
been identified for sale. The sale of these limited service hotels located in
tertiary markets are consistent with the Company's strategy to focus on the
acquisition, renovation, rebranding and repositioning of luxury and upscale
hotels in large urban and airport markets in the western United States.
Excluding the six sale hotels discussed above, REVPAR for non-renovation
hotels increased 6.3% for the second quarter of 1998 over the corresponding
quarter of 1997.
Non-Recurring Factors. Overall gains in REVPAR growth were not only
moderated by management's re-evaluation of its asset repositioning strategy for
the previously acquired Kahler hotels, which were subsequently sold, but also by
the disruption of business caused by construction activity in the City of
Anaheim, California as well as at Disneyland affecting the performance of the
Hawthorn Suites in Anaheim. Additionally, unfavorable weather conditions
affected tourism demand throughout Arizona and directly impacted the Sheraton
San Marcos hotel in Chandler and the Hampton Inn in Phoenix.
Excluding the six sale hotels and those hotels impacted by the
non-recurring factors discussed above, REVPAR for non-renovation hotels
increased 9.5% for the second quarter of 1998 over the corresponding quarter of
1998. The 9.5% increase was driven by a 10.9% increase in the ADR, from $75.24
to $83.44, and a decrease in occupancy, from 72.4% to 71.4%.
16
<PAGE> 17
The strong revenue performance of the Company's hotel portfolio in the
second quarter of 1998 was not only due to the results from the Company's
recently redeveloped hotels, but also due to the internal growth of continuously
owned and recently acquired hotels as indicated in the following table:
SELECTED REVPAR PERFORMERS FOR SECOND QUARTER OF 1998
<TABLE>
<CAPTION>
REVPAR
--------------------------
Rooms 1997(1) 1998 % Change
----- ------- ---- --------
<S> <C> <C> <C> <C>
Economy Inn & Executive Suites by Kahler -
Rochester, Minnesota 266 $45.42 $ 57.92 27.5%
Marriott - Rochester, Minnesota 194 97.02 124.55 28.4
Hampton Inn - Oakland, California 152 48.61 61.35 26.2
Residence Inn - Provo, Utah 114 43.55 50.54 16.1
Hampton Inn - Portland, Oregon 114 34.57 44.74 29.4
</TABLE>
- ------------
(1) The Company did not own certain of these hotels for the entire period
presented.
REVPAR for the second quarter of 1998 for the 1997-renovation hotels
(eleven hotels), which were undergoing renovation during the second quarter of
1997, increased 35.1% over the corresponding quarter of 1997.
REVPAR for the second quarter of 1998 for the 1998-renovation hotels
(seven hotels), which were undergoing renovation during the second quarter of
1998, decreased 17.2% over the corresponding quarter in 1997, a period during
which these hotels were not undergoing renovation. In the aggregate, REVPAR for
the second quarter of 1998 for the 1997- and 1998-renovation hotels (18 hotels)
increased 4.3% over the corresponding quarter of 1997.
17
<PAGE> 18
The following table summarizes average occupancy rate, ADR and REVPAR,
on a same-unit-sales basis, for the Company's hotels owned during the three and
six months ended June 30, 1998.
SUMMARY OPERATING DATA
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------- -----------------
1998 1997 1998 1997
------ ------ ------ ------
<S> <C> <C> <C> <C>
SAME-UNIT-SALES ANALYSIS
ALL HOTELS:
Occupancy 65.9% 70.6% 64.7% 69.6%
ADR $80.31 $71.87 $80.96 $72.90
REVPAR $52.90 $50.73 $52.35 $50.73
REVPAR growth 4.3% 3.2%
NON-RENOVATION HOTELS:
Occupancy 69.5% 73.2% 67.7% 69.8%
ADR $81.33 $74.11 $79.67 $72.36
REVPAR $56.56 $54.21 $53.97 $50.52
REVPAR growth 4.3% 6.8%
REVPAR growth(2) 6.3% n/m
RENOVATION HOTELS(1):
Occupancy 59.3% 65.9% 59.7% 69.2%
ADR $78.15 $67.41 $83.31 $73.80
REVPAR $46.35 $44.45 $49.75 $51.07
REVPAR growth 4.3% (2.6)%
</TABLE>
----------
(1) Includes the seven hotels undergoing renovation in the second
quarter of 1998 and the eleven hotels undergoing renovation in the
second quarter of 1997.
(2) Excludes five hotels sold subsequent to the second quarter of 1998
and one additional hotel identified for sale. For discussion, see
"Results of Operations - External Growth."
Interest expense and amortization of financing costs increased $4.8
million, to $5.5 million for the three months ended June 30, 1998 from $717,000
for the corresponding quarter of 1997. For the six months ended June 30, 1998,
interest expense and amortization of financing costs increased $8.5 million to
$10.1 million from $1.6 million for the corresponding period of 1997.
Additionally, real estate and personal property taxes and insurance increased
321%, to $2.9 million for the three months ended June 30, 1998 from $684,000 for
the corresponding quarter of 1997. For the six months ended June 30, 1998, real
estate and personal property taxes and insurance increased $4.3 million, or
316%, to $5.7 million from $1.4 million for the corresponding period of 1997.
These increases are attributable to the growth of the Company's hotel portfolio
to 61 hotels as of June 30, 1998 compared to 30 hotels owned as of June 30,
1997. Acquisitions are typically initially financed with debt contributing to
the increase in interest expense and amortization of financing costs.
During the three and six month periods ended June 30, 1998, the Company
recorded increased general and administrative expenses attributable to the
growth of the Company's hotel portfolio. For the three months ended June 30,
1998, general and administrative expenses increased $602,000, to $871,000 from
$269,000 for the corresponding quarter of 1997. For the six months ended June
30, 1998, general and administrative expenses increased $1.6 million, to $2.4
million from $801,000 for the corresponding period of 1997. Necessitated by the
Company's growth, additional personnel, including the Company's General Counsel
and Director of Finance, were added to the staff of the Company subsequent to
the second quarter of 1997. Increases in other general and administrative
expenses were also incurred commensurate with the growth of the Company's hotel
portfolio to 61 from 30 hotels as of June 30,1998 and 1997, respectively.
18
<PAGE> 19
Renovations, Rebranding and Upgrades
Sunstone continued to implement its strategy of renovating, rebranding
and repositioning its recently acquired hotels and, during the second quarter of
1998, invested $15.7 million in renovations to certain of these hotels during
the second quarter of 1998.
In conjunction with such renovation activity, the Company branded the
previously independent 333-rrom 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.
During the second quarter of 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 Kahler portfolio to be branded as full-service Marriotts.
On July 15, 1998, Sunstone rebranded the former Ogden Park hotel in
Ogden, Utah as a full-service Marriott after completing $5.8 million in
renovations. The Company expects one additional hotel from the Kahler portfolio,
the Olympia Park hotel in Park City, Utah, to be branded as a Marriott. This
hotel is currently 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%.
Management believes that its internal growth strategy of improving each
hotel's revenue performance by renovating, rebranding, and repositioning the
asset not only has an immediate impact on financial performance, but also will
create long term value and growth.
19
<PAGE> 20
The following table summarizes certain information with respect to the
current or anticipated franchise affiliations of the hotels:
FRANCHISE AFFILIATIONS
(As of and for the Three Months Ended June 30, 1998)
<TABLE>
<CAPTION>
Percentage
Number of Percentage of Lease of Lease
Franchise Affiliation (1) Hotels Rooms Rooms Revenues Revenues
- --------------------- --------- ----- ------------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Marriott - (2) (3) 17 2,975 27.1% $ 7,584,000 30.7%
Holiday Inns 16 2,534 23.0 5,110,000 20.6
Hampton Inns 9 1,193 10.8 2,434,000 9.8
Kahler 2 965 8.8 2,609,000 10.5
Independent 3 709 6.4 1,161,000 4.7
Hawthorn Suites (4) 3 583 5.3 1,342,000 5.4
Hilton 3 732 6.7 1,793,000 7.2
Best Western 3 364 3.3 666,000 2.7
Sheraton 1 295 2.7 679,000 2.8
Doubletree Hotels 1 213 1.9 279,000 1.1
Comfort Suites 1 166 1.5 577,000 2.3
Quality Inn 1 152 1.4 168,000 0.7
Ramada 1 124 1.1 373,000 1.5
----------- ----------- ----------- -------------- --------
61 11,005 100.0% $ 24,775,000 100.0%
=========== =========== =========== ============== ========
</TABLE>
- ----------
(1) Certain of the Company's planned changes in franchise affiliations are
included in this table. There can be no assurance that the Company will
receive final approval from the applicable franchisor.
(2) Includes full-service Marriott hotels, Residence Inn, Fairfield Inn and
Courtyard by Marriott.
(3) Includes one hotel from the Kahler portfolio with 203 rooms which the
Company anticipates converting to full-service Marriott franchise. The
Company has obtained approval of this new franchise license, subject to
completion of renovations or improvements.
(4) Includes the Sacramento, California hotel which will be rebranded as a
Hawthorn Suites hotel upon completion of renovation and improvements which
are expected to be completed in the third quarter of 1998.
Seasonality and Regional Focus
The Company currently focuses its acquisition efforts principally on the
Pacific and Mountain regions which collectively comprise the western United
States. The geographic distribution of the hotels, which are located in 9 states
as of August 13, 1998, reflects the Company's belief that a certain amount of
geographic distribution helps to insulate the Company's hotel portfolio from
local market fluctuations and off-peak seasonal operations that are typical for
the hotel industry. The Company has also sought to increase its geographic
distributions by focusing on major metropolitan areas.
20
<PAGE> 21
The following table summarizes the Company's presence in each of these
markets:
GEOGRAPHIC DIVERSIFICATION
(As of and for the Three Months Ended June 30, 1998)
<TABLE>
<CAPTION>
PERCENTAGE PERCENTAGE
NUMBER OF OF LEASE OF LEASE
REGION HOTELS ROOMS ROOMS REVENUES REVENUES
- ------ --------- ----- ---------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Pacific (1).................. 31 4,886 44.4% $ 11,964,000 48.3%
Mountain (2)................. 24 4,319 39.2 8,092,000 32.7
Minnesota.................... 4 1,329 12.1 3,984,000 16.0
Other (3).................... 2 471 4.3 735,000 3.0
--------- ----- ---------- ------------ ----------
Total.................... 61 11,005 100.0% $ 24,775,000 100.0%
========= ====== ========== ============ ==========
</TABLE>
GEOGRAPHIC DIVERSIFICATION
(As of August 13, 1998)
<TABLE>
<CAPTION>
NUMBER OF PERCENTAGE
REGION HOTELS ROOMS OF ROOMS
- ------ ------ ----- --------
<S> <C> <C> <C>
Pacific (1).................. 31 4,886 47.3%
Mountain (2)................. 21 3,832 37.1
Minnesota.................... 4 1,329 12.9
Other (3).................... 1 284 2.7
------ ------ --------
Total................... 57 10,331 100.0%
====== ====== ========
</TABLE>
(1) Includes California, Oregon and Washington.
(2) Includes Arizona, Colorado, New Mexico and Utah.
(3) The Company is considering the sale or exchange of the one Kahler Hotel
located in Texas.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Provided by Operating Activities. The Company's operating
activities provide the principal source of cash to fund the Company's operating
expenses, interest expense, recurring capital expenditures and dividend
payments. The Company anticipates that its cash flow provided by leasing the
hotels to the Lessee will provide the necessary funds on a short- and long-term
basis to meet its operating cash requirements. During the six months ended June
30, 1998, the Company paid dividends and distributions totaling $20.6 million
representing $0.275 per share or Unit on a quarterly basis.
The Company believes a regular program of capital improvements,
including replacement and refurbishment of furniture, fixtures and equipment at
its hotels, as well as the periodic renovation and redevelopment of certain of
its hotels, is essential to maintaining the competitiveness of the hotels and
maximizing revenue growth. The Company is required under the Percentage Leases
to make available to the Lessee for the repair, replacement and refurbishment of
furniture, fixtures and equipment an amount equal to 4% of the room revenue per
quarter on a cumulative basis, provided that such amount may be used for capital
expenditures made by the Company with respect to the hotels. The Company expects
that this amount will be adequate to fund the required repairs, replacements and
refurbishments and to maintain its hotels in a competitive condition.
21
<PAGE> 22
Cash Flows from Investing and Financing Activities. The Company intends
to finance the acquisition of additional hotel properties, hotel renovations and
non-recurring capital improvements principally through its $350 million
unsecured revolving line of credit facility (the "Credit Facility") from its
lenders (led by Bank One of Arizona, N.A., as the agent bank) and, when market
conditions warrant, to issue additional equity or debt securities. During the
six months ended June 30, 1998, the Company raised $137.0 million through the
issuance of debt and $69.7 million through issuance of common stock. As of June
30, 1998, the Company had $36.2 million of unused credit on the Credit Facility
and had $26.1 million available under the Credit Facility (net of $10.1 million
reserved availability for the development of hotels) and approximately $106.2
million available under the Company's shelf registration statement.
On July 23, 1998, the Company amended the 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, as defined, (iii) increase
amount available for working capital purposes from $15.0 million to $30.0
million, and (iv) extend the term from June 30, 1999 to June 30, 2000.
On July 31, 1998, the Company sold five non-core hotel assets for
approximately $40.3 million in cash. The proceeds from the sales were used to
repay the Credit Facility.
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%. The Credit Facility may be retired in
whole or in part from the proceeds of public or private issuances of equity or
debt securities by the Company and may be refinanced in whole or in part with
fixed-rate financing. The Company may seek to obtain such a stand-alone debt
facility if market conditions are appropriate in management's view.
As part of its investment strategy, the Company plans to acquire
additional hotels. Future acquisitions are expected to be funded through the use
of the Credit Facility or other borrowings and the issuance of additional equity
or debt securities. The Company's Articles of Incorporation limits consolidated
indebtedness to 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. Management believes that it will have access to capital
resources sufficient to satisfy the Company's cash requirements and to expand
and develop its business in accordance with its strategy for future growth.
During the six months ended June 30, 1998, the Company used cash in the amount
of $145.6 million as well as debt and the issuance of Units to acquire hotel
assets, including redevelopment and recurring capital expenditures.
During the six months ended June 30, 1998, the Company invested
approximately $41.1 million in major renovations and conversions of 13 of its
hotels. During the quarters ended March 31, 1998 and June 30, 1998, there were
twelve and eleven hotels under renovation, respectively. Certain of these hotels
were under renovation during both periods. The Company estimates it will invest
an additional $67.1 million to complete the renovation of those hotels currently
under renovation and additional recently acquired hotels. Also, the Company
selectively develops luxury and upscale hotels in markets where room demand and
other competitive factors justify new construction. On August 12, 1998, the
Company completed its acquisition and development of the newly built Pueblo
Marriott in Pueblo, Colorado, for a cost of approximately $12.0 million that was
funded with the Credit Facility. Additionally, the Company is in the planning or
construction phases of developing four additional hotels, one of which is
expected to open in 1998 and the remainder in 1999. The Company estimates it
will invest approximately $45.2 million, funded by the Credit Facility, to
complete the development of these hotels. In conjunction with the on-going
renovation and development activity, the Company has various contracts and
commitments outstanding with third parties. The Company plans to fund remaining
commitments under these agreements through the use of the Credit Facility and
the issuance of additional equity and debt securities. Management believes the
renovations should result in incremental increases in REVPAR at these renovation
hotels and increased lease revenue for the Company. In addition, the Company may
acquire additional hotels and invest additional cash for renovations during
1998.
The Company historically has successfully 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
22
<PAGE> 23
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.
Year 2000
The Company has been informed that the Lessee is in the process of
studying the Year 2000 issue, including inquiries of their vendors. Upon the
completion of the Lessee'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.
Funds From Operations ("FFO")
Management believes that FFO is a useful measure of financial
performance of an equity REIT, such as the Company. FFO (as defined) (1) for the
three and six months ended June 30, 1998 grew by 150.3% and 154.9%,
respectively, over the corresponding periods of 1997.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- ---------------------------
1998 1997(2) 1998 1997(2)
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net Income $ 6,274,000 $3,295,000 $12,871,000 $ 6,571,000
Less dividends on preferred shares (492,000) - (979,000) -
----------- ---------- ----------- -----------
Net income available to common
shareholders 5,782,000 3,295,000 11,892,000 6,571,000
Add back:
Depreciation 8,993,000 2,531,000 16,912,000 4,487,000
Minority interest 324,000 403,000 675,000 892,000
Dividends on preferred shares 492,000 - 979,000 -
----------- ---------- ----------- -----------
FFO assuming conversion of preferred
shares $15,591,000 $6,229,000 $30,458,000 $11,950,000
=========== ========== =========== ===========
</TABLE>
- ----------
(1) Management and industry analysts generally consider funds from operations to
be a useful 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. Funds From
Operations is defined as income before minority interest (computed in
accordance with generally accepted accounting principles), excluding gains
(losses) from debt restructuring and sales of property plus real estate
related depreciation and amortization (excluding amortization of financing
costs). Funds From Operations does not represent cash generated from
operating activities in accordance with generally accepted accounting
principles and is not necessarily indicative of cash available to fund cash
needs. Funds From Operations 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 activities as a measure of
liquidity.
(2) Certain amounts have been restated to reflect the allocation of a fourth
quarter depreciation expense adjustment to the first three quarters of 1997.
The Lessee
For a discussion of the Lessee's revenue operations and a comparison of
the three and six months ended June 30, 1998 to 1997, see "Results of
Operations" of the Company. Additionally, for the three and six months ended
June 30, 1998, the Lessee reported net income of $70,000 and a net loss of $1.9
million, respectively. Notwithstanding the net loss, cash flows were provided by
operating activities during the six months ended June 30, 1998 in the amount of
$4.5 million.
From inception, the Lessee has incurred cumulative losses of $8.0
million. Net income of $70,000 for the three months ended June 30, 1998 and
a net loss of $2.0 million for the three months ended March 31, 1998
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are substantially due to the combined effects on the Lessee of (i) the effect of
renovating 13 of the Company's hotels, (ii) the transition to new management at
recently acquired hotels, and (iii) the operating leverage of certain Percentage
Leases.
Typically, the Company's renovations and redevelopments of acquired
hotels are extensive, involving refurbishing exteriors, renovations to
restaurants and lobbies and extensive renovations to guest rooms, including
guest bath, furniture and soft goods. The Company typically expends 10% to 30%
of the purchase price on renovations which typically take approximately three to
six months to complete. During the renovations, the Lessee's revenues are
significantly reduced. In addition, there is typically a brief ramp up period of
approximately one to three months before the renovated hotels produce positive
cash flow for the Lessee. Management of the Company and the Lessee believe that
the renovation related losses represent costs that have a reasonable assurance
of future economic benefit that will be derived from significantly improved
operating performance of the renovated and redeveloped hotels.
The Lessee has access to a $1.5 million working capital line of credit.
Executives of the Lessee have pledged Units, which, as of June 30, 1998, had a
value of approximately $6.4 million, to secure obligations of the Lessee to the
Company under the Percentage Leases. The Lessee anticipates that cash provided
by operations will be an adequate source of liquidity for the foreseeable
future.
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PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION
RISK FACTORS
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 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
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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 an accumulated deficit
of $8.0 million as of June 30, 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."
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 execute 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
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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.
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
Seventeen of the Company's 57 hotels are operated under, and one is 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
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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 mid-west 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 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
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
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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 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.
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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 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, the Company 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, the Company 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. The Company intends
to continue to make distributions to its shareholders to comply with the 95%
distribution requirement and to avoid the nondeductible excise tax. The
Company's income consists primarily of its share of the income of the Operating
Partnership, and the Company's Cash Available For Distribution consists
primarily of its share of cash distributions from the Operating Partnership.
Differences in timing between taxable income and Cash Available For Distribution
due to the seasonality of the hospitality industry could require the Company 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
maybe 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
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
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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 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.
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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
year1900 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
Year2000 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.
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.
32
<PAGE> 33
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 - Financial Data Schedule
(b) Report on Form 8-K:
None
33
<PAGE> 34
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of San
Clemente, State of California, on August 13, 1998.
SUNSTONE HOTEL INVESTORS, INC.
By: /s/ Robert A. Alter
----------------------------------
Robert A. Alter
President, Secretary and
Chairman of the Board of Directors
By: /s/ Kenneth J. Biehl
----------------------------------
Kenneth J. Biehl
Vice President and
Chief Financial Officer
34
<PAGE> 35
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------ -----------
<C> <S>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> APR-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 2,797,000
<SECURITIES> 0
<RECEIVABLES> 18,514,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 887,774,000
<DEPRECIATION> (48,460,000)
<TOTAL-ASSETS> 878,424,000
<CURRENT-LIABILITIES> 0
<BONDS> 369,952,000
0
3,000
<COMMON> 376,000
<OTHER-SE> 468,361,000
<TOTAL-LIABILITY-AND-EQUITY> 878,424,000
<SALES> 0
<TOTAL-REVENUES> 24,858,000
<CGS> 0
<TOTAL-COSTS> 13,071,000
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 5,513,000
<INCOME-PRETAX> 6,274,000
<INCOME-TAX> 6,274,000
<INCOME-CONTINUING> 6,274,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 6,274,000
<EPS-PRIMARY> 0.15
<EPS-DILUTED> 0.15
</TABLE>
