<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
SEPTEMBER 30, 1998
OR
[x] 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: (949) 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 November 13, 1998, there were 37,556,484 shares
of Common Stock outstanding.
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<PAGE> 2
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON FORM 10-Q
SEPTEMBER 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 September 30, 1998 and
December 31, 1997.............................................................. 3
Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 1998 and 1997.............................................. 4
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1998 and 1997.............................................. 5
Notes to Consolidated Financial Statements......................................... 6
Sunstone Hotel Properties, Inc. ("Lessee")
Consolidated Balance Sheets as of September 30, 1998 and
December 31, 1997.............................................................. 9
Consolidated Statements of Operations for the Three and Nine Months
Ended September 30, 1998 and 1997.............................................. 10
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1998 and 1997.............................................. 11
Notes to Consolidated Financial Statements......................................... 12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL 14
CONDITION AND RESULTS OF OPERATIONS.......................................
PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION........................................................ 24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K......................................... 32
SIGNATURES ........................................................................... 33
</TABLE>
2
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PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- -------------
(Unaudited)
<S> <C> <C>
ASSETS:
Investments in hotel properties, net $ 833,380,000 $ 704,323,000
Notes receivable 1,748,000 6,085,000
Cash and cash equivalents 3,255,000 3,584,000
Restricted cash 2,936,000 2,421,000
Rent receivable - Lessee 14,499,000 7,641,000
Other assets, net 18,764,000 15,523,000
------------- -------------
$ 874,582,000 $ 739,577,000
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Revolving line of credit $ 263,900,000 $ 179,800,000
Notes payable 105,717,000 116,671,000
Accounts payable and other accrued expenses 15,377,000 10,937,000
Dividends payable to preferred shareholders 498,000 422,000
------------- -------------
385,492,000 307,830,000
------------- -------------
Commitments and contingencies
Minority interest 26,324,000 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 September 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;
37,556,664 and 32,284,103 issued and outstanding as of
September 30, 1998 and December 31, 1997, respectively 376,000 323,000
Additional paid-in capital 479,664,000 401,098,000
Distributions in excess of earnings (17,277,000) (3,537,000)
------------- -------------
462,766,000 397,887,000
------------- -------------
$ 874,582,000 $ 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 Nine Months Ended
September 30, September 30,
------------------------------- -------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
(Restated) (Restated)
<S> <C> <C> <C> <C>
REVENUES:
Lease revenue - Lessee $ 28,907,000 $ 12,129,000 $ 77,369,000 $ 27,476,000
Interest income 135,000 42,000 275,000 363,000
------------ ------------ ------------ ------------
29,042,000 12,171,000 77,644,000 27,839,000
------------ ------------ ------------ ------------
EXPENSES:
Real estate related depreciation and
amortization 9,326,000 3,043,000 26,238,000 7,530,000
Interest expense and amortization of
financing costs 6,948,000 1,218,000 17,056,000 2,775,000
Real estate and personal property taxes and
insurance 2,773,000 1,071,000 8,435,000 2,431,000
General and administrative 1,604,000 550,000 3,978,000 1,351,000
Losses on dispositions of hotel
properties 3,574,000 -- 3,574,000 --
------------ ------------ ------------ ------------
Total expenses 24,225,000 5,882,000 59,281,000 14,087,000
------------ ------------ ------------ ------------
Income before minority interest 4,817,000 6,289,000 18,363,000 13,752,000
Minority interest (232,000) (720,000) (907,000) (1,612,000)
------------ ------------ ------------ ------------
NET INCOME 4,585,000 5,569,000 17,456,000 12,140,000
Dividends on preferred shares (498,000) -- (1,477,000) --
------------ ------------ ------------ ------------
INCOME AVAILABLE TO COMMON SHAREHOLDERS $ 4,087,000 $ 5,569,000 $ 15,979,000 $ 12,140,000
============ ============ ============ ============
EARNINGS PER SHARE
Basic $ 0.11 $ 0.27 $ 0.43 $ 0.67
============ ============ ============ ============
Diluted $ 0.11 $ 0.27 $ 0.43 $ 0.67
============ ============ ============ ============
DIVIDENDS DECLARED PER SHARE $ 0.285 $ 0.275 $ 0.835 $ 0.775
============ ============ ============ ============
</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>
Nine Months Ended
September 30,
---------------------------------
1998 1997
------------- -------------
(Restated)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 17,456,000 $ 12,140,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Minority interest 907,000 1,612,000
Depreciation and amortization 26,238,000 7,530,000
Amortization of financing costs 1,648,000 331,000
Losses on dispositions of hotel properties 3,574,000 --
Changes in assets and liabilities:
Rent receivable?Lessee (6,858,000) (4,531,000)
Other assets, net (82,000) (1,481,000)
Accounts payable and other accrued expenses 4,441,000 (986,000)
------------- -------------
Net cash provided by operating activities 47,324,000 14,615,000
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, improvements and additions
to hotel properties (201,004,000) (129,189,000)
Proceeds from sale of hotel properties 47,238,000 --
Increase in restricted cash (515,000) --
Payments received on notes receivable 5,510,000 2,452,000
------------- -------------
Net cash used in investing activities (148,771,000) (126,737,000)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 69,854,000 119,070,000
Payment of deferred financing costs (2,811,000) (1,020,000)
Net proceeds from issuance of partnership units -- 161,000
Borrowings on revolving line of credit 167,100,000 73,400,000
Principal payments on revolving line of credit (83,000,000) (46,500,000)
Principal payments on notes payable (17,133,000) (17,741,000)
Distributions to common shareholders (29,719,000) (13,072,000)
Distributions to partners (1,772,000) (1,997,000)
Distributions to preferred shareholders (1,401,000) --
------------- -------------
Net cash provided by financing activities 101,118,000 112,301,000
------------- -------------
Net change in cash and cash equivalents (329,000) 179,000
Cash and cash equivalents, beginning of period 3,584,000 142,000
------------- -------------
Cash and cash equivalents, end of period $ 3,255,000 $ 321,000
------------- -------------
Cash paid for interest $ 18,661,000 $ 3,041,000
============= =============
</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 September 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 September 30, 1998, the Company's portfolio includes 57 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 nine months ended September 30, 1998 are not necessarily
indicative of the results to be expected for the year ended December 31, 1998.
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, Accounting for Contingent
Rent in Interim Financial Periods, (`EITF 98-9"). EITF 98-9 requires lessors to
defer recognition of contingent rental income until specified thresholds that
trigger the contingent rent are met. The Company amended the Percentage Leases
with the Lessee to provide for quarterly room revenue thresholds used in
calculating percentage rent due. As a result of such amendment, EITF 98-9 has no
material impact on the Company's interim and annual financial statements.
6
<PAGE> 7
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Rent Receivable - Lessee:
At September 30, 1998, all rent payments due from the Lessee are
current. Under the terms of the Percentage Leases, base rent is due from the
Lessee in arrears and percentage rent is due 45 days after the end of each
respective month. As such and as of September 30, 1998, the $14.5 million due
from the Lessee consists of percentage rent for the months of August and
September 1998 and base rent for the month of September 1998.
Restatement:
The interim financial statements as of and for the three and nine months
ended September 30, 1997 have been restated to reflect the allocation of a
fourth quarter 1997 depreciation expense adjustment to the first three quarters
of 1997.
Reclassifications:
Certain prior period balances have been reclassified to conform with the
current period presentation.
2. HOTEL PROPERTIES
Investments:
On August 12, 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 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.
On September 3, 1998, The Company acquired the Pacific Shore Hotel in
Santa Monica, California, for approximately $22.0 million in cash. The property
is located on Ocean Avenue across from the Pacific Ocean, two blocks from the
Santa Monica Pier and the Santa Monica entertainment, shopping, restaurant and
theater district. The 168-room full-service hotel includes a restaurant and
lounge, pool and spa, fitness center, gift shop and meeting rooms.
Disposition of Non-Core Assets:
During the third quarter of 1998, the Company disposed of six non-core
hotel assets that were included in the $372 million acquisition of Kahler Realty
Corporation on October 15, 1997. These dispositions were structured as
non-taxable exchange transactions; however, for financial reporting purposes,
approximately $3.6 million in losses were recognized for the three and nine
months ended September 30, 1998. The disposition transactions are as follows:
On July 31, 1998, 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, aggregating 651 rooms, were acquired by Cavanaughs Hospitality
Corporation for $30.3 million in cash.
On July 31, 1998, the 187-room Lakeview Resort in Morgantown, West
Virginia, was acquired by GF Management for $11.1 million in cash.
On September 3, 1998, the leasehold interest in the 284-room Green Oaks
Hotel in Fort Worth, Texas, was acquired by Calstar, LLC ("Calstar") for $5.8
million in cash.
7
<PAGE> 8
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 the 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 September 30, 1998, the
Company's actual borrowing rate was LIBOR plus 2.0%.
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 Nine Months Ended
September 30, September 30,
--------------------------------------------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Numerator:
Net income $ 4,585,000 $ 5,569,000 $ 17,456,000 $ 12,140,000
Dividends on preferred shares (498,000) -- (1,477,000) --
------------ ------------ ------------ ------------
Numerator for basic and diluted
earnings per share:
Income available to common
shareholders after effect of
dilutive securities $ 4,087,000 $ 5,569,000 $ 15,979,000 $ 12,140,000
------------ ------------ ------------ ------------
Denominator:
Denominator for basic earnings per share -
weighted average shares 37,547,460 20,397,961 36,843,426 18,008,493
Effect of dilutive securities:
Stock options -- 158,140 102,637 158,140
------------ ------------ ------------ ------------
Denominator for diluted earnings per share
- adjusted weighted average shares and
assumed conversions 37,547,460 20,556,101 36,946,063 18,166,633
============ ============ ============ ============
Basic and diluted earnings per share $ 0.11 $ 0.27 $ 0.43 $ 0.67
============ ============ ============ ============
</TABLE>
8
<PAGE> 9
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Unaudited)
<S> <C> <C>
ASSETS:
Current assets
Cash and cash equivalents $ 5,104,000 $ 4,352,000
Receivables, net of allowance for doubtful accounts of
$377,000 and $267,000, respectively 14,203,000 10,037,000
Due from affiliates 1,360,000 321,000
Inventories 1,634,000 1,798,000
Prepaid expenses 523,000 306,000
------------ ------------
22,824,000 16,814,000
Management agreements, net 456,000 723,000
Property and equipment, net 136,000 3,116,000
Other assets 303,000 --
------------ ------------
$ 23,719,000 $ 20,653,000
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
Rent payable - Sunstone Hotel Investors, Inc. $ 14,499,000 $ 7,641,000
Accounts payable 7,272,000 8,836,000
Customer deposits 420,000 550,000
Sales taxes payable 2,443,000 1,640,000
Accrued payroll 2,362,000 3,093,000
Accrued vacation 1,804,000 1,795,000
Accrued bonuses 1,009,000 573,000
Capital lease obligation - current portion -- 55,000
Other accrued expenses 623,000 1,007,000
------------ ------------
30,432,000 25,190,000
Long-term liabilities
Capital lease obligation -- 366,000
Accrued pension liability 997,000 1,017,000
------------ ------------
31,429,000 26,573,000
------------ ------------
Minority interest -- 119,000
Commitments
Stockholders' deficit:
Common stock, no par value, 1,000 shares authorized;
100 shares issued and outstanding -- --
Deficit (7,710,000) (6,039,000)
------------ ------------
$ 23,719,000 $ 20,653,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
9
<PAGE> 10
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------- ---------------------------------
1998 1997 1998 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
REVENUES:
Room $ 58,535,000 $ 24,622,000 $ 158,285,000 $ 59,123,000
Food and beverage 10,267,000 1,471,000 31,499,000 4,215,000
Other 7,911,000 1,926,000 23,269,000 3,928,000
------------- ------------- ------------- -------------
Total revenues 76,713,000 28,019,000 213,053,000 67,266,000
------------- ------------- ------------- -------------
EXPENSES:
Room 13,127,000 5,159,000 37,499,000 12,894,000
Food and beverage 8,516,000 1,377,000 26,442,000 3,673,000
Other 4,884,000 705,000 13,774,000 1,693,000
Franchise costs 2,136,000 1,709,000 5,393,000 4,266,000
Advertising and promotion 5,606,000 1,495,000 15,504,000 3,795,000
Utilities 3,236,000 1,261,000 8,450,000 3,053,000
Repairs and maintenance 3,008,000 940,000 8,589,000 2,314,000
Management fees - Sunstone Hotel
Management, Inc. -- 548,000 937,000 1,307,000
Rent expense - Sunstone Hotel
Investors, Inc. 28,907,000 12,129,000 77,369,000 27,476,000
General and administrative 7,042,000 2,364,000 20,767,000 6,097,000
------------- ------------- ------------- -------------
Total expenses 76,462,000 27,687,000 214,724,000 66,568,000
------------- ------------- ------------- -------------
NET INCOME (LOSS) $ 251,000 $ 332,000 $ (1,671,000) $ 698,000
============= ============= ============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
10
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SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
-----------------------------
1998 1997
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(1,671,000) $ 698,000
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Gain on sale of sewage treatment plant (141,000) --
Bad debt 310,000 --
Depreciation 11,000 --
Amortization 267,000 --
Changes in assets and liabilities:
Receivables, net (4,051,000) (3,367,000)
Due from affiliates (42,000) (1,347,000)
Inventories 190,000 1,000
Prepaid expenses and other assets (492,000) (221,000)
Rent payable - Sunstone Hotel Investors, Inc. 6,858,000 4,531,000
Accounts payable (1,564,000) (557,000)
Customer deposits (182,000) --
Sales taxes payable 803,000 853,000
Accrued payroll (731,000) (75,000)
Accrued vacation 9,000 198,000
Accrued bonuses 436,000 235,000
Due to affiliates -- 79,000
Accrued pension liability (20,000) --
Other accrued expenses (520,000) 411,000
----------- -----------
Net cash provided by (used in) operating activities (530,000) 1,439,000
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (59,000) (105,000)
Net proceeds from sale of sewage treatment plant 525,000 --
Proceeds from lessor upon execution of certain leases 816,000 --
----------- -----------
Net cash provided by (used in) investing activities 1,282,000 (105,000)
----------- -----------
Net change in cash and cash equivalents $ 752,000 $ 1,334,000
Cash and cash equivalents, beginning of period 4,352,000 1,165,000
----------- -----------
Cash and cash equivalents, end of period $ 5,104,000 $ 2,499,000
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
11
<PAGE> 12
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED 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 September 30, 1998, 57 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 nine months ended September 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 $7.7
million. The net loss of $1.7 million for the nine months ended September 30,
1998 was substantially due to the combined effects on the Lessee of (i) the
effect of renovating the Lessor's hotels, and (ii) the transition to new
management at recently acquired hotels.
3. PERCENTAGE LEASE AGREEMENTS
At September 30, 1998, all rent payments due the Lessor are current.
Under the terms of the Percentage Leases, base rent is payable to the Lessor in
arrears and percentage rent is payable 45 days after the end of each respective
month. As such and as of September 30, 1998, the $14.5 million due the Lessor
consists of percentage rent for the months of August and September 1998 and base
rent for the month of September 1998.
During the quarter ended September 30, 1998, the Lessor disposed of six
hotel properties and the related Percentage Leases were terminated. The Lessee
also executed two additional Percentage Leases with the Lessor with terms
similar to the existing Percentage Leases.
12
<PAGE> 13
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. RELATED PARTY TRANSACTIONS
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% to 2% of gross revenues.
The cost of these services is classified as management fees in the statements of
operations. During the three and nine months ended September 30, 1998, $1.2
million and $2.3 million, respectively, 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 September 30, 1998, the Lessee reconveyed to
the Lessor certain hotel telephone equipment that was being leased pursuant to a
capital lease agreement. The equipment and related capital lease were previously
assigned to the Lessee by the Lessor and originally recorded at the Lessor's
costs. The Lessor agreed to assume the capital lease obligation and to reimburse
the Lessee for all lease payments made by the Lessee since the equipment was
assigned on October 15, 1997.
13
<PAGE> 14
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, Bass Hotels & Resorts, Marriott International, Inc. and
Promus Hotel Corporation. As of November 13, 1998, the Company's portfolio
consisted of 57 hotels with a total of 10,215 rooms, 45 of which were acquired
and two of 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 83%) 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 new competition, 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 September 30, 1998 to 1997 and the Nine
Months Ended September 30, 1998 to 1997
Revenues increased $16.8 million, or 138%, to $29.0 million for the
three months ended September 30, 1998 from $12.2 million for the corresponding
quarter of 1997. For the nine months ended September 30, 1998, revenues
increased $49.8 million, or 179%, to $77.6 million from $27.8 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."
14
<PAGE> 15
Income available to common shareholders decreased 26.7% to $4.1 million
for the three months ended September 30, 1998 from $5.6 million for the
corresponding quarter of 1997, while diluted earnings per share decreased to
$0.11 from $0.27 per share, a 59.3% decrease. For the nine months ended
September 30, 1998, income available to common shareholders increased 32.2% to
$16.0 million from $12.1 million for the corresponding period of 1997, while
diluted earnings per share decreased to $0.43 from $0.67 per share, an 35.8%
decrease. The decreases in diluted earnings per share for the three and nine
months ended September 30, 1998, are attributable to losses on dispositions of
non-core hotel assets recognized for financial reporting purposes totaling $3.6
million, and the renovation of a significant number of hotels that were acquired
in conjunction with the acquisition of Kahler Realty Corporation on October 15,
1997.
External Growth. During the quarter ended September 30, 1998, the
Company acquired two hotels, one of which was newly-built, with a total of 332
rooms for approximately $34.0 million in cash. For the twelve months ended
September 30, 1998, the Company acquired, net of dispositions, 26 hotels with
5,368 rooms for aggregate purchase prices of approximately $504.0 million, which
contributed $15.9 million and $39.8 million of the net increase in revenues for
the three and nine month periods ended September 30, 1998, respectively.
Internal Growth. On a same-unit-sales basis, the Company achieved an
8.6% increase and 7.5% increase in REVPAR for non-renovation hotels and for all
hotels, respectively, for the third quarter of 1998 over the corresponding
quarter of 1997.
REVPAR for the non-renovation hotels increased by 8.6%, from $60.73 to
$65.94, over the third quarter of 1997. Non-renovation hotels consist of 48 of
the Company's 57 hotels that were not undergoing significant renovation either
in the third quarter of 1997 or 1998. The 8.6% increase in REVPAR was driven by
a 9.9% increase in the average daily rate, from $78.21 to $85.97, offset by a
decrease in occupancy, from 77.7% to 76.7%.
The strong revenue performance of the Company's hotel portfolio in the
third 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 hotels as indicated in the following table:
SELECTED REVPAR PERFORMERS FOR THIRD QUARTER OF 1998
<TABLE>
<CAPTION>
REVPAR
----------------------------------------
Rooms 1997(1) 1998 % Change
----- ------- ---- --------
<S> <C> <C> <C> <C>
Marriott - Rochester, Minnesota 180 $105.76 $149.61 41.5%
The Kahler Hotel - Rochester, Minnesota 699 50.82 64.85 27.6
Residence Inn by Marriott - Provo, Utah 114 49.56 60.67 22.4
Courtyard by Marriott - Cypress, California 180 56.31 68.70 22.0
Holiday Inn & Suites - Price, Utah 151 38.20 45.53 19.2
</TABLE>
- ----------------
(1) The Company did not own certain of these hotels for the entire period
presented.
REVPAR for the third quarter of 1998 for the five hotels, which were
undergoing renovation during the third quarter of 1997, increased 25.7% over the
corresponding quarter of 1997.
REVPAR for the third quarter of 1998 for the four hotels, which were
undergoing renovation during the third quarter of 1998, decreased 15.2% over the
corresponding quarter in 1997, a period during which these hotels were not
undergoing renovation. In the aggregate, REVPAR for the third quarter of 1998
for the 1997- and 1998-renovation hotels (nine hotels) decreased 0.2% over the
corresponding quarter of 1997.
15
<PAGE> 16
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
nine months ended September 30, 1998.
SUMMARY OPERATING DATA
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
----------------- --------------------
1998 1997 1998 1997
------ ------ ------ ------
<S> <C> <C> <C> <C>
SAME-UNIT-SALES ANALYSIS
ALL HOTELS(1):
Occupancy 72.8% 75.1% 67.9% 72.0%
ADR $83.64 $75.49 $83.07 $74.58
REVPAR $60.91 $56.67 $56.37 $53.68
REVPAR growth 7.5% 5.0%
NON-RENOVATION HOTELS(1):
Occupancy 76.7% 77.7% 72.5% 73.9%
ADR $85.97 $78.21 $84.02 $76.05
REVPAR $65.94 $60.73 $60.91 $56.23
REVPAR growth 8.6% 8.3%
RENOVATION HOTELS(2):
Occupancy 56.8% 64.5% 59.1% 68.3%
ADR $70.58 $62.21 $80.89 $71.60
REVPAR $40.09 $40.15 $47.84 $48.88
REVPAR growth (0.2)% (2.1)%
</TABLE>
- ----------
(1) Excludes the six hotels which were sold during the third quarter of
1998.
(2) Includes the four hotels undergoing renovation in the third quarter of
1998 and five hotels undergoing renovation in the third quarter of 1997.
Interest expense and amortization of financing costs increased $5.7
million to $6.9 million for the three months ended September 30, 1998 from $1.2
million for the corresponding quarter of 1997. For the nine months ended
September 30, 1998, interest expense and amortization of financing costs
increased $14.3 million, to $17.1 million from $2.8 million for the
corresponding period of 1997. Additionally, real estate and personal property
taxes and insurance increased 155% to $2.8 million for the three months ended
September 30, 1998 from $1.1 million for the corresponding quarter of 1997. For
the nine months ended September 30, 1998, real estate and personal property
taxes and insurance increased $6.0 million, or 250%, to $8.4 million from $2.4
million for the corresponding period of 1997. These increases are attributable
to the growth of the Company's hotel portfolio to 57 hotels as of September 30,
1998 compared to 34 hotels owned as of September 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 nine month periods ended September 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
September 30, 1998, general and administrative expenses increased $1.1 million,
to $1.6 million from $550,000 for the corresponding quarter of 1997. For the
nine months ended September 30, 1998, general and administrative expenses
increased $2.6 million, to $4.0 million from $1.4 million for the corresponding
period of 1997. Necessitated by the Company's growth, additional personnel,
including the Company's Chief Operating Officer and General Counsel and Director
of Finance, were added to the staff of the Company subsequent to the third
quarter of 1997. Increases in other general and administrative expenses were
also incurred commensurate with the growth of the Company's hotel portfolio to
57 from 34 hotels as of September 30,1998 and 1997, respectively.
16
<PAGE> 17
Renovations, Rebranding and Upgrades
The Company continued to implement its strategy of renovating,
rebranding and repositioning its recently acquired hotels and, during the third
quarter of 1998, invested $18.1 million in renovations to certain of these
hotels.
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 renovation and will be completed and carry the Marriott
flag during the fourth quarter of 1998.
In September 1998, at the annual Bass Hotels & Resorts Worldwide
Conference in New Orleans, Louisiana, the Company and the Lessee demonstrated
their leadership in quality and service excellence in the Holiday Inn brand
segment by winning seven awards for hotels acquired and renovated in 1997. The
hotels and their respective awards are as follows:
<TABLE>
<CAPTION>
Awards
------------------------
<S> <C>
Holiday Inn Express - Poulsbo, Washington Quality Excellence Award
Holiday Inn Select - Renton, Washington Modernization Award
Holiday Inn Harbor View - San Diego, California Modernization Award
Holiday Inn & Suites - Mesa, Arizona Modernization Award
Holiday Inn & Suites - San Diego, California Newcomer of the Year
Holiday Inn & Suites - Price, Utah Newcomer of the Year
Holiday Inn - Provo, Utah Torchbearer Award
</TABLE>
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.
17
<PAGE> 18
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 September 30, 1998)
<TABLE>
<CAPTION>
Percentage
Number of Percentage of Lease of Lease
Franchise Affiliation Hotels Rooms Rooms Revenues Revenues
- --------------------- ------ ----- ----- -------- --------
<S> <C> <C> <C> <C> <C>
Marriott - (1) (2) 18 3,139 30.7% $ 9,946,000 34.4%
Holiday Inns 16 2,534 24.8 6,198,000 21.5
Hampton Inns 9 1,193 11.7 2,633,000 9.1
Kahler 2 965 9.5 3,331,000 11.5
Hawthorn Suites 3 583 5.7 1,376,000 4.8
Hilton 3 732 7.2 1,895,000 6.6
Doubletree Hotels 1 213 2.1 665,000 2.3
Comfort Suites 1 166 1.6 647,000 2.2
Ramada 1 124 1.2 408,000 1.4
Sheraton 1 295 2.9 349,000 1.2
Best Western 1 103 1.0 266,000 0.9
Independent 1 168 1.6 272,000 0.9
Sold non-core hotels - - - 921,000 3.2
-- ------ ----- ------------ -----
57 10,215 100.0% $ 28,907,000 100.0%
== ====== ===== ============ =====
</TABLE>
- ----------
(1) Includes full-service Marriott hotels, Residence Inn, Fairfield Inn and
Courtyard by Marriott.
(2) 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.
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 nine
states as of November 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 distribution by focusing on major metropolitan areas.
18
<PAGE> 19
The following table summarizes the Company's presence in each of these
markets:
GEOGRAPHIC DIVERSIFICATION
(As of and for the Three Months Ended September 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).................. 32 5,054 49.5% $ 14,679,000 50.8%
Mountain (2)................. 21 3,832 37.5 8,017,000 27.7
Minnesota.................... 4 1,329 13.0 5,290,000 18.3
Sold non-core assets......... - - - 921,000 3.2
-- ------ ----- ------------ -----
Total.................... 57 10,215 100.0% $ 28,907,000 100.0%
== ====== ===== ============ =====
</TABLE>
- ----------
(1) Includes California, Oregon and Washington.
(2) Includes Arizona, Colorado, New Mexico and Utah.
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 nine months ended
September 30, 1998, the Company paid dividends and distributions totaling $33.0
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.
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), proceeds from the
disposition of certain non-core hotel assets and, when market conditions
warrant, to issue additional equity or debt securities. During the nine months
ended September 30, 1998, the Company borrowed $167.1 million on the Credit
Facility, raised $47.2 million through the disposition of non-core hotel assets
and $69.9 million through issuance of common stock. As of September 30, 1998,
the Company had $86.1 million of unused credit on the Credit Facility and
approximately $163.2 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.
19
<PAGE> 20
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 September 30, 1998, the Company's actual
borrowing rate was LIBOR plus 2.00%. 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 financing if market
conditions are appropriate in management's view.
During the third quarter of 1998, the Company disposed of six non-core
hotel assets that were included in the $372 million acquisition of Kahler Realty
Corporation on October 15, 1997. These dispositions were structured as
non-taxable exchange transactions and are as follows:
On July 31, 1998, 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, aggregating 651 rooms, were acquired by Cavanaughs Hospitality
Corporation for $30.3 million in cash.
On July 31, 1998, the 187-room Lakeview Resort in Morgantown, West
Virginia, was acquired by GF Management for $11.1 million in cash.
On September 3, 1998, the leasehold interest in the 284-room Green Oaks
Hotel in Fort Worth, Texas, was acquired by Calstar, LLC ("Calstar") for $5.8
million in cash.
The Company continues to consider certain non-core hotel assets for
disposition and has identified an additional six hotels, primarily limited
service.
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, proceeds from the dispositon of
non-core hotel assets 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 current strategy for future growth. During
the nine months ended September 30, 1998, the Company used cash in the amount of
$199.5 million as well as debt and the issuance of Units to acquire hotel
assets, including redevelopment and recurring capital expenditures.
During the nine months ended September 30, 1998, the Company invested
approximately $59.2 million in major renovations and conversions of 13 of its
hotels. During the quarters ended March 31, 1998, June 30, 1998, and September
30, 1998, there were twelve, eleven and four hotels under renovation,
respectively. Certain of these hotels were under renovation more than one
period. The Company estimates it will invest an additional $52.9 million to
complete the renovation of those hotels currently under renovation and
additional recently acquired hotels. Management believes the renovations should
result in incremental increases in REVPAR at these renovation hotels and
increased lease revenue for the Company. The Company selectively develops luxury
and upscale hotels in markets where management believes 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, which are expected to
open 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 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 proceeds from the disposition of certain non-core hotel. In
addition, the Company may acquire additional hotels and invest additional cash
for renovations during the fourth quarter of 1998.
The Company historically has financed hotel acquisitions through
advances on the Credit Facility and issuances of equity securities. The Company
intends to finance future acquisitions of hotel properties, hotel renovations
and non-
20
<PAGE> 21
recurring capital improvements principally through the Credit Facility, proceeds
from the disposition of non-core hotel assets and, when market conditions
warrant, by issuing additional equity or debt securities. There can be no
assurance that the Company will have access to capital on favorable terms. If
the Company's access to capital is restricted, its ability to acquire additional
hotel properties may be adversely affected. A decline in the Company's
acquisition pace relative to historical periods may result in a decline in
earnings growth.
YEAR 2000 ISSUE
The term "Year 2000 issue" is a general term used to describe the
complications that may be caused by existing computer hardware and software that
were designed by the respective manufacturers without consideration of the
upcoming change in the century. Many computer systems recognize calendar years
by the last two digits in the date code field. Beginning in the year 2000, these
date code fields will need to accept four digit entries to distinguish
twenty-first century dates from twentieth century dates. If not corrected,
computer systems may fail or create erroneous results causing disruptions of
operations.
The Company's in-house computer systems environment is limited to
software and hardware developed by third parties. All of the Company's computer
systems, consisting of financial reporting and accounting systems only, were
installed in the last two years and management believes such systems are Year
2000 compliant. However, the Company's business is heavily dependent upon the
efforts of the Lessee and third parties with whom the Lessee conducts
significant business. As such, the Company, in concert with the Lessee, has
developed and adopted a Year 2000 Compliance Program (the "Compliance Program")
to mitigate and minimize the number and seriousness of any disruptions that may
occur with respect to the Year 2000 compliance of computerized systems utilized
and relied upon by the Company and the Lessee. These computerized systems
include information and non-information technology systems and applications, as
well as, financial and operational reporting systems.
State of Year 2000 Readiness:
The Compliance Program consists of four phases:
o Development of an action plan;
o Inventorying of property systems;
o Collation and evaluation of property inventories; and
o Implementation and testing of upgrade solutions.
To date, the Company has developed an action plan. This plan calls for,
among other things, a dedicated team to be assembled to address the Year 2000
issue, establishing the scope of the inventorying of hotel systems,
identification of potential business risks and exposure associated with third
parties, primarily vendors and service providers, and prioritizing system
remediation and upgrades. Execution of the action plan has been segregated into
two separate phases: hotel and Lessee systems and third-party systems.
Hotel and Lessee Systems. The Lessee has completed a preliminary
assessment of computer systems operated and maintained by the Lessee and the
hotels. These systems include information technology and other computer systems
(such as automated time clocks, point-of-sale, non-information technology
systems, including embedded systems that operate security systems, phone
systems, energy management systems and other systems). Based on the results of
this preliminary assessment, the Lessee has prioritized the systems that may
require remediation or upgrades and has set the scope for inventorying hotel
systems. Additionally, the Lessee is currently evaluating proposals from
independent third parties to perform an inventory and assessment of all of its
computerized systems and applications. This inventory and assessment will
determine the resources needed, necessary remediation or upgrades, remediation
plan and the time frame to become Year 2000 compliant. The Lessee expects this
inventorying phase to be completed in the first quarter of 1999.
Additionally, the Lessee expects implementation and testing of system
remediation and upgrades to be completed during 1999.
21
<PAGE> 22
Third-Party Systems. The Lessee is also surveying its vendors and
service providers that are critical to the Lessee's business to determine
whether they are Year 2000 compliant. The Lessee expects that these surveys will
be completed in the first quarter of 1999, but cannot guarantee that all vendors
or service providers will comply with the survey, and therefore the Lessee may
not be able to determine Year 2000 compliance of those vendors or service
providers. By the end of the first quarter of 1999, the Lessee will determine
the extent to which the Lessee will be able to replace those vendors not in
compliance. There may be instances in which the Lessee will have no alternative
but to remain with non-compliant vendors or service providers. The costs of the
Compliance Program and the date on which the Lessee believes it will complete
the Year 2000 modifications are based on management's best estimates, which were
derived utilizing numerous assumptions of future events, including the continued
availability of certain resources, third party modification plans and other
factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to, the availability and cost of personnel trained in this area, the
ability to locate and correct all relevant computer codes, and similar
uncertainties.
Cost of Addressing Year 2000 Issues:
The Company estimates that total costs for the Year 2000 compliance
review, evaluation, assessment and remediation efforts should not exceed $1.0
million, although there can be no assurance that actual costs will not exceed
this amount. As of September 30, 1998, the cost to the Company for addressing
the Year 2000 issue consists primarily of services provided by existing Company
and Lessee personnel. The Company anticipates expending $250,000 during the
fourth quarter of 1998, with the balance of the $1.0 million expended in 1999.
Risks Presented by Year 2000 Issues:
There can be no assurances that the Company's Compliance Program or Year
2000 remediation by third parties will be properly and timely completed, and
failure to do so could have a material adverse effect on the Company, the
Lessee, its business and its financial condition. The Company cannot predict the
actual effects of the Year 2000 issue on its business, such effects depend on
numerous uncertainties such as: (i) whether significant third parties have
properly and timely address the Year 2000 issue; and (ii) whether broad-based or
systemic economic failures may occur. The Company is also unable to predict the
severity and duration of any such failures, which could include disruptions in
passenger transportation or transportation systems generally, loss of utility
and telecommunications services, the loss or disruption of hotel reservations
made on centralized reservation systems and errors or failures in financial
transactions or payment processing systems such as credit cards. Due to the
general uncertainty inherent in the Year 2000 issue and the Company's dependence
on third parties, the Company is unable to determine at this time whether the
consequences of Year 2000 failures will have a material impact on the Company.
The Compliance Program is expected to significantly reduce the level of
uncertainty about the Year 2000 issue and management believes that the
possibility of significant interruptions of normal operations should be reduced.
Contingency Plan:
The Company is in the process of developing its contingency plan for the
systems operated and maintained by the Lessee and the hotels to provide for the
most reasonably likely worst case scenarios regarding Year 2000 compliance. This
contingency plan is expected to be completed in 1999.
22
<PAGE> 23
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 nine months ended September 30, 1998 grew by 89.9% and 126.4%,
respectively, over the corresponding periods of 1997.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- -------------------------------
1998 1997(2) 1998 1997(2)
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net Income $ 4,585,000 $ 5,569,000 $ 17,456,000 $ 12,140,000
Less dividends on preferred shares (498,000) -- (1,477,000) --
------------ ------------ ------------ ------------
Income available to common
shareholders 4,087,000 5,569,000 15,979,000 12,140,000
Add back:
Real estate related depreciation
and amortization 9,326,000 3,043,000 26,238,000 7,530,000
Losses on dispositions of hotel
properties 3,574,000 -- 3,574,000 --
Minority interest 232,000 720,000 907,000 1,612,000
Dividends on preferred shares 498,000 -- 1,477,000 --
------------ ------------ ------------ ------------
FFO assuming conversion of preferred
shares $ 17,717,000 $ 9,332,000 $ 48,175,000 $ 21,282,000
============ ============ ============ ============
</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 nine months ended September 30, 1998 to 1997, see "Results of
Operations" of the Company. Additionally, for the three and nine months ended
September 30, 1998, the Lessee reported net income of $251,000 and a net loss of
$1.7 million, respectively
From inception, the Lessee has incurred cumulative losses of $7.7
million. Net loss of $1.7 million for the nine months ended September 30, 1998
was substantially due to the combined effects on the Lessee of (i) the effect of
renovating the Lessor's hotels, and (ii) the transition to new management at
recently acquired hotels.
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 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.
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PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION
RISK FACTORS
DISTRIBUTION OF SUBSTANTIALLY ALL CASH AVAILABLE FOR DISTRIBUTION
Our hotels generate cash flow in the form of rent we receive from
Sunstone Hotel Properties, Inc. (the "Lessee"), the entity that leases and
operates our hotels. The Lessee's rent is tied to hotel operating performance
and consists of base rent and rent that is a percentage of certain hotel
revenues. In addition, we also have cash available from a bank line of credit
with a maximum availability of $350 million with the actual availability based
on our assets and financial performance. We also have been able to raise cash by
issuing equity securities in the public markets. We use these three sources of
cash -- cash from hotel operations, from borrowings and from sales of stock
- -- to fund our acquisition of hotels, renovation of hotels, recurring
capital expenditures, operating expenses and the payment of dividends to our
shareholders. Because of the recent conditions in the capital markets, it is
currently difficult for many companies, especially Real Estate Investment Trusts
("REITS"), to raise capital by issuing debt or equity securities. Therefore, we
are more dependent on our cash flows from hotel operations and from our line of
credit to fund our obligations. If our operating cash flows decreased or our
availability under the line of credit were reduced, it may be necessary for us
to reduce future acquisitions, defer or reduce the scope of renovations or
capital expenditures, sell assets (including hotels) or to reduce our dividends
paid to shareholders.
TOTAL DEPENDENCE ON THE LESSEE AND PAYMENTS UNDER THE PERCENTAGE LEASES
Because of our status as a REIT, we are prohibited from operating hotels
and must lease them to the Lessee. Our ability to pay dividends to our
shareholders depends on our Lessee's ability to generate sufficient revenue to
pay percentage rent required under the leases. We chose the Lessee because
Messrs. Alter and Biederman, who own the Lessee, were involved in the management
of certain hotels contributed as part of our initial public offering ("IPO") in
1995, and are motivated to maximize percentage rent paid under the leases
through their financial and ownership interests in us.
The Lessee has incurred operating losses since its inception and has an
accumulated deficit of $7.7 million as of September 30, 1998. According to the
Lessee, the losses are due to several factors including:
o the substantial number of renovations we undertook adversely
affected occupancy rates and revenues at the hotels;
o renovations caused greater revenue losses than expected; and
o poorer performance at certain hotels than expected.
The Lessee has informed us that it expects to generate adequate cash
flow to meet its obligations under the leases and to operate the hotels during
1998 and thereafter. This is due in part to the fact that, since April 1, 1998,
the Management Company has abated management fees it collects from the Lessee,
and anticipates continuing to do so up to a maximum total of $3.5 million. There
can be no assurance, however, that the Lessee will generate adequate operating
cash flows to meet its obligations. Other than its cash flow generated by
operating the hotels, the Lessee has no financial resources or other assets to
pay its operating obligations or its rent under the percentage leases. Messrs.
Alter and Biederman have pledged 481,955 Units to secure the Lessee's
obligations under the Percentage Leases. However, if the Lessee defaults under
the Percentage Leases, the value of these Units and other assets of the Lessee
will likely be insufficient to satisfy our claims against the Lessee.
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<PAGE> 25
RISKS RELATED TO DEVELOPMENT AND RENOVATION OF HOTELS
Subject to obtaining adequate capital resources, we intend to continue
our growth strategy of acquiring hotels needing substantial renovation or
redevelopment. This strategy creates significant risks including the following:
o We may incur significant cost renovation and construction
overruns and time delays due to:
-- labor shortages;
-- changes in the scope of a project;
-- requirements imposed by local building inspectors;
-- discovery of defects in the building once renovation has
begun; and
-- compliance with the Americans with Disabilities Act of 1990,
which may require expensive modifications to existing hotels
to bring them into compliance.
o We may purchase a hotel or contract to acquire a hotel (after a
third party completes construction) when market conditions are
favorable but then face deteriorated local demand for hotel
rooms when the hotel is available for occupancy resulting in
revenues that are less than projected;
o We may complete our renovation after significant delays reducing
the amount of revenues expected to be received during the delay
period; and
o We may spend more than budgeted for a renovation project
reducing our anticipated return on the investment.
CONFLICTS OF INTEREST BETWEEN THE COMPANY AND CERTAIN OFFICERS AND DIRECTORS
The relationship among Mr. Alter and Mr. Biederman, us, the Lessee and
the Management Company create several inherent conflicts of interest that may
result in decisions being made by our management that are not in the best
interests of our shareholders. The most significant conflicts of interest
include the following:
o As the owners of the Lessee, Mr. Alter and Mr. Biederman will
benefit from any profits the Lessee may generate from the
operation of the hotels and retain for itself, even though under
the Unit Purchase Agreement, Messrs. Alter and Biederman have
agreed to reinvest the Lessee's profits (net of tax liabilities)
in additional units or retain the profits as security for future
rent payments.
o As the owner of the Management Company, Mr. Alter is entitled to
the profits of the Management Company, which receives from the
Lessee management fees (1% to 2% of gross revenues of the
hotels) and reimbursements for certain accounting expenses.
Because of the Lessee's current financial condition, the
Management Company has agreed to abate payment of management
fees and reimbursements, up to a maximum of $3.5 million.
o The Percentage Leases generally require us to pay a termination
fee to the Lessee if we elect to sell a hotel and not replace it
with a lease for another hotel. As a result, our decisions about
which hotels to sell may be influenced by the conflict of
interest of Messrs. Alter and Biederman who, as owners of the
Lessee, would benefit from the termination fee.
o In connection with our IPO, Messrs. Alter and Biederman
contributed tax free certain hotels that had a tax basis less
than their fair market value. Significant taxable gains that
would arise if we were to sell these hotels would be
specifically allocated to Messrs. Alter and Biederman. Further,
in order to prevent adverse tax consequences to Messrs. Alter
and Biederman, we must maintain mortgage debt at certain minimum
levels. Because of these conflicts, our decisions concerning
whether to sell certain hotels or to incur or repay debt will be
influenced by the tax consequences for Messrs. Alter and
Biederman.
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<PAGE> 26
o We did not negotiate the percentage leases on an arm's length
basis with the Lessee. The base rent, percentage rent and the
economic terms of each percentage lease are determined by us and
approved by the Lessee based on historical financial data and
projected operating and financial data for the hotel. See "Total
Dependence on the Lessee and Payments under the Percentage
Leases."
RELIANCE ON MR. ALTER AND OTHER KEY PERSONNEL
Our success depends in large part upon our ability to attract and retain
highly qualified personnel. Further, because our sole source of operating
revenue is base and percentage rent paid by the Lessee, our success is also
dependent on the Lessee's management's ability to effectively operate the
hotels. Competition for qualified employees for us and the Lessee is extremely
intense and there is no assurance that we or the Lessee can attract and retain
qualified employees. In particular, we substantially rely on the hotel and real
estate knowledge and experience and continuing services of Mr. Robert Alter, our
Chairman, Chief Executive Officer and President. Our inability (or the Lessee's)
to attract and retain qualified employees could negatively affect our ability to
generate revenues and pay distributions to our shareholders.
INVESTMENT CONCENTRATION IN SINGLE INDUSTRY
Our investment strategy is to focus exclusively on acquiring and owning
hotels. This strategy concentrates all our investment in a single industry and
therefore does not diversify our sources of revenues. As a result, a downturn in
the hotel industry will have a greater impact on our revenues and funds from
operations than if we had a diversified portfolio of properties. In addition,
because we have focused on the western United States and in the luxury, upscale
and mid-price segments of the hotel industry, economic or other conditions that
affect this geographic region or these segments may disproportionately impact
us.
FAILURE TO REALIZE BENEFITS OF RECENT ACQUISITIONS
We have grown rapidly since our IPO. This growth has required us, and,
to a greater extent, the Lessee to develop scaleable operating systems, develop
construction management procedures and systems and other procedures and systems
to operate our multi-state hotel portfolio. If we, or the Lessee, fail to
effectively integrate the acquired and renovated hotels into our operating
systems, then we will not achieve the expected benefits of the acquisition. The
revenues generated by the hotels we acquire are used to pay the debt service on
the funds we borrow to fund these acquisitions. If the acquired hotels do not
generate sufficient cash flow to fund debt service on the money borrowed to
purchase those hotels, we will be required to service the debt with cash flows
from other hotels which might adversely affect our cash available for other
purposes, including distributions to our shareholders.
FAILURE TO MAINTAIN REIT STATUS
We intend to operate so as to be taxed as a REIT under the Internal
Revenue Code of 1986, as amended. As long as we qualify for taxation as a REIT,
with certain exceptions, we will not be taxed at the corporate level on its
taxable income that is distributed to our 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. We intend to
satisfy all of these requirements for treatment as a REIT. It is possible that
we may fail to satisfy one or more of these requirements. Failure to qualify as
a REIT would render us subject to tax on our income at regular corporate rates
and we could not deduct distributions to our shareholders. Unless entitled to
relief under certain Internal Revenue Code provisions, we also would be
disqualified from treatment as a REIT for the four taxable years following the
year during which qualification was lost. Even if we qualify for taxation as a
REIT, we may be subject to certain state and local taxes on our income and
property.
In order for us 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 our ownership interest in the
Partnership
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constitutes more than 10% of the Partnership's voting securities and exceeds 5%
of the value of our assets, we would cease to qualify as a REIT. The imposition
of corporate income tax on us and the Partnership would substantially reduce the
amount of cash available for distribution to our shareholders.
OWNERSHIP LIMITATION
In order for us to maintain our qualification as a REIT, not more than
50% in value of our outstanding stock may be owned, directly or indirectly, by
five or fewer individuals (which includes certain entities). Furthermore, if any
shareholder or group of shareholders of the Lessee owns, actually or
constructively, 10% or more of our stock we would likely lose our REIT status.
To protect our REIT qualification, our Articles of Incorporation prohibit direct
or indirect ownership of more than 9.8% of the outstanding shares of any class
of our stock by any person or group. Generally, the capital stock owned by
affiliated owners will be aggregated for purposes of this ownership limitation.
Subject to certain exceptions, any stock subject to a purported transfer that
would prevent us from continuing to qualify as a REIT will be designated as
"Shares-in-Trust" and transferred automatically to a trust effective on the day
before the purported transfer of such 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 stock to the trust and the beneficiary of the
trust will be one or more charitable organizations that are named by us.
INABILITY TO RETAIN EARNINGS
In order to qualify as a REIT, we generally are required each year to
distribute to our shareholders at least 95% of our net taxable income (excluding
any net capital gain). In addition, we are subject to a 4% nondeductible excise
tax on the amount, if any, by which certain distributions paid by us with
respect to any calendar year are less than the sum of (i) 85% of our ordinary
income, (ii) 95% of our capital gain net income for that year, and (iii) any
undistributed taxable income from prior periods. We intend to continue to make
distributions to our shareholders to comply with the 95% distribution
requirement and to avoid the nondeductible excise tax. Differences in timing
between taxable income and cash available for distribution to our shareholders
due to the seasonality of the hospitality industry could require us to borrow
funds on a short-term basis to meet the 95% distribution requirement and to
avoid the nondeductible excise tax.
THE COMPANY MAY NOT BE ABLE TO CONTINUE ITS EXTERNAL GROWTH RATE
Our growth strategy has been to acquire underperforming and
undercapitalized hotels located in strong markets where we believe significant
barriers to entry exist. We then seek to improve the hotels' financial
performance by renovating, redeveloping, and repositioning the hotels and
requiring the Lessee to implement a focused sales and marketing program. The
current conditions in the equity and debt capital markets limit our ability to
access new capital on favorable terms. Without additional capital to fund
acquisitions we will not be able to continue to acquire additional hotels. We
anticipate that our acquisition activity will diminish significantly for the
remainder of 1998 and likely in 1999. Accordingly, we cannot assure you that our
external growth rate will equal or exceed our recent historical external growth
rate.
ENVIRONMENTAL RISKS
Various federal, state and local laws subject property owners or
operators to liability for the costs of removal or remediation of certain
hazardous substances released on property. These laws often impose liability
without regard to whether the owner or operator knew of, or was responsible for,
the release of the hazardous substances. The presence of or the failure to
properly remediate hazardous substances may adversely affect occupancy of a
contaminated hotel property, the ability to operate hotels, and our ability to
sell or borrow against contaminated properties. In addition to the costs
associated with investigation and remediation actions brought by governmental
agencies, the presence of hazardous waste on a property could result in personal
injury or similar claims or lawsuits.
Various laws also impose, on persons who arrange for the disposal or
treatment of hazardous or toxic substances, liability for the cost of removal or
remediation of hazardous or toxic substances at the disposal or
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treatment facility. These laws often impose liability whether or not the person
arranging for the disposal ever owned or operated the disposal facility. The
obligation to pay for these costs or our inability to pay for such costs, could
adversely affect our operating costs and the value of our properties.
Phase I environmental site assessments have been obtained on all of our
owned properties. The purpose of Phase I environmental site assessments is to
identify potential sources of contamination for which an owner may be
responsible and to assess the status of environmental regulatory compliance.
None of the environmental site assessments revealed any environmental condition,
liability or compliance concern that we believe would have a material adverse
affect on our business, assets or results of operations. Nor are we aware of any
such condition, liability or concern by any other means. However, it is possible
that the environmental site assessments relating to any one of the properties
did not reveal all environmental conditions, liabilities or compliance concerns
that arose at a property before or after the related review was completed.
REAL ESTATE INVESTMENT RISKS IN GENERAL
Each of our hotels are subject to a variety of risks associated with
real estate ownership. Some of these risks include:
o Changes in national and local economic conditions;
o Changes in interest rates;
o Changes in costs of, or terms of, loans from lenders;
o Changes in environmental laws;
o The ongoing requirement to make capital improvements, repairs or
maintenance;
o Changes in the tax rates or laws;
o The continuing requirement to pay operating expenses;
o Changes in governmental requirements or zoning laws;
o Occurrences beyond the control of an owner, such as natural
disasters like earthquakes and weather, civil unrest or
so-called "acts of God;"
o The possibility of unexpected, uninsured or under-insured
losses; and
o Condemnation by a government agency seeking to use a property
for a public purpose.
Risks such as those listed above, and other risks which may occur from
time to time, may adversely affect our profit from the property because they
cause increased costs, expenses, liabilities, restrictions and operational
delays. Such risks may also affect the price we may obtain on a sale of a
property or whether the property can be sold at all.
UNINSURED AND UNDER-INSURED LOSSES
We carry comprehensive policies of insurance for our hotels which
include liability for personal injury, property damage, fire and extended
coverage. We believe the coverage we carry is typical and customary for owners
of hotels such as ours. Even though we carry the insurance referenced above,
certain losses may be uninsurable by virtue of the type or amount of loss.
Losses which result from catastrophes, such as hurricanes, tornadoes,
earthquakes, floods or so-called "acts of God," may fall within that category.
More than half of our hotels are located in California and the pacific
northwest, an area which is subject to a high degree of seismic activity and
risk. Although we carry earthquake insurance for our hotels, there is no
assurance that such insurance will be available in the future under terms and
amounts which are sufficient to provide adequate protection. It also could be
possible that the current insurance coverage we carry would not be sufficient to
pay the full market value or replacement cost of an affected hotel with a
resulting loss of our entire investment. Therefore, a possibility does exist for
substantial uninsured or under-insured losses as a result of an earthquake.
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Other factors also affect whether a loss is uninsured or under-insured
and may include inflation, changes in law or environmental contamination. Such
factors may affect whether insurance proceeds received by us are adequate to
restore our entire investment in the property. Factors such as these may also
make it impractical to use insurance proceeds to replace or repair our property
after it has been damaged or destroyed.
BECAUSE REAL ESTATE INVESTMENTS ARE ILLIQUID, WE MAY NOT BE ABLE TO SELL
PROPERTIES WHEN APPROPRIATE
Real estate investments generally cannot be sold quickly. We may not be
able to vary our portfolio promptly in response to economic or other conditions.
This inability to respond promptly to changes in the performance of our
investments could adversely affect our financial condition and ability to
service debt and make distributions to our shareholders.
OUR EARNINGS AND CASH DISTRIBUTIONS WILL AFFECT THE MARKET PRICE OF OUR PUBLICLY
TRADED SECURITIES
We believe that the market value of a REIT's equity securities is based
primarily upon the market's perception of the REIT's growth potential and its
current and potential future cash distributions, and is secondarily based upon
the real estate market value of the underlying assets. For that reason, REIT
shares may trade at prices that are higher or lower than the net asset value per
share. To the extent we retain operating cash flow for investment purposes,
working capital reserves or other purposes, these retained funds, while
increasing the value of our underlying assets, may not correspondingly increase
the market price of our shares. Our failure to meet the market's expectations
with regard to future earnings and cash distributions would likely adversely
affect the market price of our publicly traded securities.
YEAR 2000 ISSUE
The term "Year 2000 issue" is a general term used to describe the
complications that may be caused by existing computer hardware and software that
were designed by the respective manufacturers without consideration of the
upcoming change in the century. Many computer systems recognize calendar years
by the last two digits in the date code field. Beginning in the year 2000, these
date code fields will need to accept four digit entries to distinguish
twenty-first century dates from twentieth century dates. If not corrected,
computer systems may fail or create erroneous results which could have
significant negative operational and financial consequences. We have adopted a
Year 2000 Compliance Program (the "Compliance Program") to minimize disruptions
to our business which could be caused by computer system error or failure. These
computerized systems include information and non-information technology systems
and applications, as well as, financial and operational reporting systems. For
discussion of the Company's efforts to address the Year 2000 issue and the
relate Compliance Program see "Management's Discussion and Analysis of Financial
Condition and Results of Operations, Year 2000 Issue."
There can be no assurances that our Compliance Program will be properly
and timely completed, and failure to do so could have a material adverse effect
our business operations and financial condition. We cannot predict the actual
effects of the Year 2000 issue on our business operations and financial
condition. The actual effects may be impacted by: (i) whether significant third
parties properly and timely address the Year 2000 issue; and (ii) whether
broad-based or systemic economic failures may occur. We are also unable to
predict the severity and duration of any such failures, which could include
disruptions in passenger transportation or transportation systems generally,
loss of utility and telecommunications services, the loss or disruption of hotel
reservations made on centralized reservation systems and errors or failures in
financial transactions or payment processing systems such as credit cards. Due
to the general uncertainty inherent in the Year 2000 issue and our dependence on
third parties, we are unable to determine at this time whether the consequences
of Year 2000 failures will have a material impact on us. Our Compliance Program
is expected to significantly reduce the level of uncertainty about the Year 2000
issue and we believe that the possibility of significant interruptions of normal
operations should be reduced.
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MARKET INTEREST RATES MAY HAVE AN EFFECT ON THE VALUE OF OUR PUBLICLY TRADED
SECURITIES
One of the factors that investors consider important in deciding whether
to buy or sell shares of a REIT is the distribution rate on such shares (as a
percentage of the price of such shares) relative to market interest rates. If
market interest rates go up, prospective purchasers of REIT shares may expect a
higher distribution rate. Higher interest rates would not, however, result in
more funds for us to distribute and, in fact, would likely increase our
borrowing costs and potentially decrease funds available for distribution. Thus,
the higher market interest rates could cause the market price of our publicly
traded securities to go down.
HOTEL INDUSTRY RISKS
Operating Risks. In addition to the investment risks associated with
investing all of our resources in the hotel industry, we face operating risks
associated with hotels. These risks include, among others, the following:
o Competition for customers at our hotels from other hotels, many
of which are owned by competitors who have significantly greater
financial resources and marketing power and therefore compete
with our hotels;
o The risk of loss of market share in areas in which overbuilding
occurs and adversely affects occupancy, average daily rate
("ADR") and revenue per available room ("REVPAR");
o Erosion of operating margins arising from an increase in
operating costs due to inflation or other factors that may exceed
increases in REVPAR;
o Dependence on demand for our accommodations from both business
travelers, commercial travelers and tourism, each of which may be
affected in different markets by different economic factors;
o Strikes and other labor disturbances by the Lessee's employees
which would seriously disrupt the Lessee's ability to provide
services to hotel guests;
o The deterioration of economic conditions either generally or in
particular markets in which our hotels are located causing a
reduction in demand for our accommodations.
The Lessee's operating results at our hotels are directly affected by
the factors described above and a significant decrease in operating revenues by
the Lessee will adversely affect the Lessee's ability to make payments of rent
under the percentage leases. Any reduction in such rent will reduce our cash and
could adversely affect our ability to make distributions to our shareholders.
Seasonality of Hotel Business and Our Hotels. The hotel industry in
general is seasonal with certain periods generating greater revenues than
others. In particular, our revenues are greater in the second and the third
quarters than in the first and the fourth quarters. In addition, winter weather
in the markets in which our hotels operate can severely impact the operating
results of particular hotels, such as occurred last year in Arizona due to the
effects of El Nino. The Lessee's revenues can vary significantly from quarter to
quarter. It is possible that the significant fluctuation of revenues in a
particular quarter due to weather or other factors could cause us to earn less
percentage rent than we had originally anticipated which could have an adverse
effect on our ability to make distributions to our shareholders.
Increased Competition from Overbuilding. The hotel industry has
historically experienced cycles of overbuilding in certain geographic markets
and product segments. This overbuilding increases competition for hotel guests
resulting in lower occupancies and lower ADRs thereby reducing revenues of the
hotels effected by the increased competition. While our investment strategy is
to acquire underperforming hotels in markets where we believe there are
significant barriers to entry, we can give no assurance that the current hotel
development activities, particularly in the limited service segment, will not
create additional significant competition for our hotels. This increased
competition would reduce the revenues generated by the Lessee at the effected
hotel, thus reducing percentage rent we receive and therefore potentially
adversely effecting our distributions to our shareholders.
Impact of Increased Operating Costs and Capital Expenditures. Our hotels
need to be periodically renovated and furniture, fixtures and equipment replaced
in order to remain competitive in their markets and to comply with the
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terms of franchise agreements under which our hotels are operated. Under our
percentage leases, we are obligated to make available to the Lessee for periodic
refurbishment of fixture, furniture and equipment an amount equal to four
percent (4%) of the room revenues of each hotel. Our ability to fund these and
other capital expenditures including periodic replacement of furniture, fixtures
and equipment will depend in part on the financial performance of the Lessee and
our hotels. If these expenditures exceed our estimates, then the increased costs
would adversely effect the cash available for other purposes such as making
distributions to our shareholders. Alternatively, if we fail to make these
expenditures, we may adversely effect the competitive position of the hotels and
have an adverse effect on occupancy rates, ADRs and REVPAR. In certain
instances, our failure to make certain capital expenditures may constitute a
default under the applicable franchise agreement.
RISKS OF OPERATING UNDER FRANCHISE AGREEMENTS.
Of our 57 hotels, 54 are or will be operated under franchise agreements
with national franchisors. The Lessee is the franchisee and is responsible for
complying with the franchise agreement. Under these arrangements, a franchisor
provides marketing service and room reservations and certain other operating
assistance, but requires the Lessee to pay significant fees as well as maintain
the hotel in certain required condition. If the Lessee fails to maintain these
required standards or we fail to make required capital expenditures (or to fund
the Lessee's expenditures) then there may be a termination of the franchise
agreement and possible liability for damages. If the Lessee were to lose a
franchise on a particular hotel, it could have a material adverse effect upon
the operation, financing or value of that hotel due to the loss of the franchise
name, marketing support and centralized reservation system. In addition, adverse
publicity affecting a franchisor could reduce the revenues we receive from the
hotels subject to such franchise. Any loss of revenues by the Lessee at a hotel
because of loss of the franchise agreement would adversely effect the Lessee's
ability to pay rent and could effect our ability to make distributions to our
shareholders.
OUR DEGREE OF LEVERAGE COULD LIMIT OUR ABILITY TO OBTAIN ADDITIONAL FINANCING
Our Articles of Incorporation limits consolidated indebtedness to 50% of
our investment in hotel properties, at cost on a consolidated basis, after
giving effect to our use of proceeds from the indebtedness. As of September 30,
1998 our ratio of debt to total investment in hotels was approximately 41%. The
degree of leverage could have important consequences to our shareholders,
including, effecting our ability to obtain additional financing in the future
for working capital, capital expenditures, acquisitions, development or other
general corporate purposes including the payment of distributions and could make
us more vulnerable to a downturn in business or the economy.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 - Financial Data Schedule
(b) Report on Form 8-K:
(1) Current Report on Form 8-K dated July 30, 1998 with disclosure
under Item 5 regarding announcement of the Company's proposed
private placement of $150 million Senior Notes Due 2008.
(2) Current Report on Form 8-K dated July 30, 1998 with disclosure
under Item 5 regarding announcement of the Company's proposed
public offering of $50 million enhanced Perpetual Income
Preferred Securities (SM).
(3) Current Report on Form 8-K dated July 30, 1998 with disclosure
under Item 5 regarding the Company's announcement of its
financial results for the quarter ended June 30, 1998.
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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 November 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
33
<PAGE> 34
EXHIBIT NUMBER
Exhibit Number Description
- -------------- -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JUL-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,191,000
<SECURITIES> 0
<RECEIVABLES> 16,247,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 889,640,000
<DEPRECIATION> (56,260,000)
<TOTAL-ASSETS> 874,582,000
<CURRENT-LIABILITIES> 0
<BONDS> 369,617,000
0
3,000
<COMMON> 376,000
<OTHER-SE> 462,387,000
<TOTAL-LIABILITY-AND-EQUITY> 874,582,000
<SALES> 0
<TOTAL-REVENUES> 29,042,000
<CGS> 0
<TOTAL-COSTS> 13,935,000
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 3,574,000
<INTEREST-EXPENSE> 6,948,000
<INCOME-PRETAX> 4,585,000
<INCOME-TAX> 4,585,000
<INCOME-CONTINUING> 4,585,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,585,000
<EPS-PRIMARY> 0.11
<EPS-DILUTED> 0.11
</TABLE>
