<PAGE> 1
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 MARCH 31, 1999
-----------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission file number 0-26304
SUNSTONE HOTEL INVESTORS, INC.
- -------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
--------------------
Maryland 52-1891908
- --------------------------------- -------------------
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
903 Calle Amanecer, San Clemente, CA 92673
- ---------------------------------------- ------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (949) 369-4000
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 May 11, 1999, there were 37,641,085 shares of Common Stock outstanding.
<PAGE> 2
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON FORM 10-Q
MARCH 31, 1999
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 March 31, 1999 and
December 31, 1998............................................. 3
Consolidated Statements of Operations for the Three Months
Ended March 31, 1999 and 1998................................. 4
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 1999 and 1998................................. 5
Notes to Consolidated Financial Statements........................ 6
SUNSTONE HOTEL PROPERTIES, INC. ("LESSEE")
Consolidated Balance Sheets as of March 31, 1999 and
December 31, 1998............................................. 10
Consolidated Statements of Operations for the Three Months
Ended March 31, 1999 and 1998................................. 11
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 1999 and 1998................................. 12
Notes to Consolidated Financial Statements........................ 13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS....................... 16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK............................................... 23
PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION......................................... 24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.......................... 31
SIGNATURES........................................................... 32
</TABLE>
2
<PAGE> 3
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
------------ -------------
(Unaudited)
<S> <C> <C>
ASSETS:
Investments in hotel properties, net $842,323,000 $840,974,000
Other real estate investment properties, net 19,410,000 17,027,000
Cash and cash equivalents 663,000 859,000
Restricted cash 3,173,000 2,853,000
Rent receivable - Lessee 12,347,000 7,498,000
Other assets, net 11,136,000 6,425,000
------------ ------------
$889,052,000 $875,636,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Revolving line of credit $287,500,000 $274,500,000
Notes payable 109,747,000 104,969,000
Accounts payable and other accrued expenses 21,761,000 18,921,000
Dividends payable to preferred stockholders 492,000 503,000
------------ ------------
419,500,000 398,893,000
------------ ------------
Commitments and contingencies (Note 6)
Minority interest 25,069,000 25,493,000
Stockholders' equity:
7.9% Class A Cumulative Convertible Preferred Stock,
$.01 par value, 10,000,000 authorized; 250,000 issued
and outstanding as of March 31, 1999 and December
31, 1998 (liquidation preference $100 per share
aggregating $25,000,000) 3,000 3,000
Common stock, $.01 par value, 150,000,000 authorized;
37,638,607 and 37,572,263 issued and outstanding
as of March 31, 1999 and December 31, 1998, respectively 377,000 376,000
Additional paid-in capital 480,004,000 479,848,000
Distributions in excess of earnings (35,901,000) (28,977,000)
------------ ------------
444,483,000 451,250,000
------------ ------------
$889,052,000 $875,636,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE> 4
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended
March 31,
----------------------------
1999 1998
------------ ------------
<S> <C> <C>
REVENUES:
Lease revenue - Lessee $ 24,762,000 $ 23,687,000
Interest and other income 130,000 57,000
------------ ------------
24,892,000 23,744,000
------------ ------------
EXPENSES:
Real estate related depreciation and amortization 9,989,000 7,919,000
Interest expense and amortization of financing costs 6,469,000 4,595,000
Real estate and personal property taxes and insurance 3,092,000 2,779,000
General and administrative 1,348,000 1,503,000
------------ ------------
Total expenses 20,898,000 16,796,000
------------ ------------
Income before gain on disposition of hotel property
and minority interest 3,994,000 6,948,000
Gain on disposition of hotel property 490,000 --
Minority interest (212,000) (351,000)
------------ ------------
NET INCOME 4,272,000 6,597,000
Distributions on preferred shares (487,000) (487,000)
------------ ------------
INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 3,785,000 $ 6,110,000
============ ============
EARNINGS PER SHARE
Basic $ 0.10 $ 0.17
============ ============
Diluted $ 0.10 $ 0.17
============ ============
DIVIDENDS DECLARED PER SHARE $ 0.285 $ 0.275
============ ============
</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>
Three Months Ended
March 31,
------------------------------
1999 1998
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 4,272,000 $ 6,597,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Minority interest 212,000 351,000
Depreciation and amortization 9,989,000 8,024,000
Amortization of financing costs 563,000 493,000
Gain on disposition of hotel property (490,000) --
Changes in operating assets and liabilities:
Rent receivable - Lessee (4,849,000) (4,533,000)
Other assets, net (1,037,000) (2,232,000)
Accounts payable and other accrued expenses 2,840,000 1,848,000
------------ ------------
Net cash provided by operating activities 11,500,000 10,548,000
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, improvements and additions to hotel properties (18,964,000) (66,734,000)
Acquisitions, improvements and additions to other real
estate investments (2,525,000) --
Proceeds from sale of hotel property 4,000,000 --
Restricted cash (320,000) (345,000)
Payments received on notes receivable 50,000 12,000
------------ ------------
Net cash used in investing activities (17,759,000) (67,067,000)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 97,000 69,618,000
Payment of deferred financing costs -- (1,155,000)
Borrowings on revolving line of credit 17,000,000 66,000,000
Principal payments on revolving line of credit (4,000,000) (53,000,000)
Borrowings on notes payable 5,475,000 --
Principal payments on notes payable (697,000) (16,383,000)
Distributions to common stockholders (10,709,000) (9,075,000)
Distributions to minority interests (605,000) (560,000)
Distributions to preferred stockholders (498,000) (487,000)
------------ ------------
Net cash provided by financing activities 6,063,000 54,958,000
------------ ------------
Net change in cash and cash equivalents (196,000) (1,561,000)
Cash and cash equivalents, beginning of period 859,000 3,584,000
------------ ------------
Cash and cash equivalents, end of period $ 663,000 $ 2,203,000
============ ============
</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, RELATIONSHIP WITH LESSEE AND BASIS OF PRESENTATION
Organization:
Sunstone Hotel Investors, Inc., a Maryland corporation (the "Company"),
was formed in September 1994 and commenced operations as a real estate
investment trust ("REIT") on August 15, 1995. At March 31, 1999, the Company had
a 94.8% interest in Sunstone Hotel Investors, L.P. (the "Operating Partnership")
which also commenced operations in August 1995. The Company conducts all of its
business through and is the sole general partner of the Operating Partnership.
At March 31, 1999, the Company's portfolio included 56 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, Chief Executive Officer
and President of the Company (80%), and Charles L. Biederman, Vice Chairman and
Executive Vice President 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.
Relationship with Lessee:
The Company must rely solely on the Lessee to generate sufficient cash
flow from the operation of the hotels to enable the Lessee to meet its
substantial rent obligation to the Company under the Percentage Leases. The
Lessee has incurred significant losses from its inception in 1995. At March 31,
1999, the Lessee's stockholder's deficit amounted to $9.7 million. At March 31,
1999, the Lessee's rent payable to the Company amounted to $12.3 million. Also
at March 31, 1999, the Lessee's current liabilities exceeded its current assets
by $9.1 million. The ability of the Lessee to fund its daily operations and
continue to remain current on its substantial rent obligation to the Company is
a result of the original terms under the Percentage Leases, for the payment of
rent to the Company, which allow monthly base rent to be paid in arrears and
monthly percentage rent to be paid within 45 days after the respective month
end. The Company's management will continue to evaluate the financial condition
of the Lessee and continue to evaluate other factors regarding the relationship
between the Company and the Lessee.
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, 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 period presented. The
results for the three months ended March 31, 1999 are not necessarily indicative
of the results to be expected for the year ended December 31, 1999.
6
<PAGE> 7
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION, RELATIONSHIP WITH LESSEE AND BASIS OF PRESENTATION (continued)
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Significant estimates made in preparing
the consolidated financial statements include recoverability of long-lived
assets and the outcome of claims, litigation and other contingencies (See Note
6), actual results could differ materially from those estimates in the near
term.
Seasonality:
The hotel industry is seasonal in nature. Seasonal variations in
occupancy at the Company's hotels may cause quarterly fluctuations in the
Company's lease revenues.
Reclassifications:
Certain prior period balances have been reclassified to conform with
the current period presentation.
2. INVESTMENTS IN HOTEL PROPERTIES
Investments:
During the three months ended March 31, 1999, the Company completed, or
was in the process of completing, substantial renovations at eight of the hotel
properties, and in connection with such renovations, the Company incurred costs
of approximately $16.2 million.
Disposition of Non-Core Assets:
On February 2, 1999, the Company sold the 129-room limited service
Hampton Inn located in Arcadia, California for $8.5 million and recognized a
$490,000 gain. Included in other assets at March 31, 1999 is $4.3 million in
proceeds receivable related to this sale.
3. REVOLVING LINE OF CREDIT
Borrowings under the Credit Facility accrue interest at LIBOR plus
1.40% per annum, to LIBOR plus 2.00% per annum, based upon the leverage of the
Company. At March 31, 1999, the Company's actual borrowing rate was LIBOR plus
1.75%. 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. Under the terms
of the Credit Facility, the Company has an option to request a one year
extension of the term to June 30, 2001. The Company exercised its option,
effective March 31, 1999, and requested such an extension. The Credit Facility
lenders have 45 days to respond to the Company's request.
The Credit Facility contains financial covenants that require the
Company to maintain certain specified financial ratios. Under the most
restrictive of these provisions, the maximum additional indebtedness that could
be drawn by the Company under the Credit Facility for the acquisition and
renovation of the hotel properties would have been between $17.5 million and
$35.0 million at March 31, 1999, depending upon the use of the funds.
7
<PAGE> 8
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. NOTES PAYABLE
In February 1999, the Company completed the development of an office
building located in San Clemente, California. A portion of the building is used
by the Company as its corporate facility and a portion is leased to the Lessee
as its corporate facility. The remaining space will be leased to third parties.
The office building was financed with a $5.5 million promissory note dated
February 5, 1999 secured by a first deed of trust that requires monthly interest
only payments at LIBOR plus 2.25% and matures August 5, 2000. The Company has
the option to extend the maturity date for up to three years.
5. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share.
<TABLE>
<CAPTION>
Three Months Ended
March 31,
------------------------------
1999 1998
----------- ------------
<S> <C> <C>
Numerator:
Net income $ 4,272,000 $6,597,000
Distributions on preferred shares (487,000) (487,000)
----------- ----------
Numerator for basic and diluted earnings per share:
Income available to common stockholders after
effect of dilutive securities $ 3,785,000 $6,110,000
=========== ==========
Denominator:
Denominator for basic earnings per share - weighted
average shares outstanding 37,597,252 35,452,364
Effect of dilutive securities:
Stock options -- 170,368
----------- ----------
Denominator for diluted earnings per share - adjusted
weighted average shares and assumed conversions 37,597,252 35,622,732
=========== ==========
Basic and diluted earnings per share $0.10 $0.17
=========== ==========
</TABLE>
The computation of diluted earnings per share does not assume the
conversion of the 7.9% Class A Convertible Preferred Stock because their
inclusion would have been anti-dilutive. Additionally, the computation of
diluted earnings per share does not assume the conversion of the Operating
Partnership units because such conversion would not have any impact on diluted
earnings per share.
6. COMMITMENTS AND CONTINGENCIES
On April 5, 1999, the Company received an offer by SHP Acquisition, LLC
("SHP Acquisition"), formed by Robert A. Alter, certain management personnel of
the Lessee and Westbrook Funds III. The Lessee leases and operates each of the
Company's 56 hotels and is owned by Robert A. Alter, Chairman, President and
Chief Executive Officer of
8
<PAGE> 9
SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
6. COMMITMENTS AND CONTINGENCIES (continued)
the Company and Charles L. Biederman, Vice Chairman and Executive Vice President
of the Company. Westbrook Partners LLC is a New York based real estate
opportunity fund, an affiliate of which is a 9.6% stockholder in the Company,
whose managing principal, Paul Kazilionis, is a director of the Company. The
acquisition proposal is for all of the common stock of the Company at $9.50 to
$10.00 in cash per share. Under this proposal, the holders of outstanding
Operating Partnership units in the Operating Partnership (other than the
Company) would receive, at their option, either cash in an amount per Operating
Partnership unit equal to the cash price per common share or redeemable
perpetual preferred units in the Operating Partnership having a face value equal
to the cash price. The Company's 7.9% Class A Preferred Stock would be redeemed
in accordance with its term of a cash amount equal to its liquidation preference
plus accrued and unpaid dividends. The acquisition proposal is subject to
certain conditions, including due diligence review of the Company and obtaining
the necessary financing.
In response to the acquisition proposal, the Company formed a Special
Committee of the Board of Directors, comprised of all the independent members of
the Board of Directors, to study the proposal and consider the Company's
alternatives. The Special Committee has appointed Goldman, Sachs & Co. to act as
its independent financial advisor to evaluate the proposal made by SHP
Acquisition and to review the Company's strategic alternatives. The Special
Committee also appointed the law firm of Altheimer & Gray to act as its
independent legal advisor. The Special Committee and its advisors are currently
in the process of considering the acquisition proposal and the Company's
alternatives.
In connection with the proposed acquisition, eight lawsuits have been
filed naming the Company, certain directors and officers of the Company and
other parties as defendants. The factual basis alleged to underlie all eight
lawsuits are essentially identical. Substantively, they assert that Robert A.
Alter, Charles L. Biederman and Paul Kazilionis, in conjunction with Westbrook
Partners LLC (and other purported Westbrook affiliated entities), SHP
Acquisition and the Lessee, have offered an unfair buyout price for the
outstanding shares of the Company. Plaintiffs in each of these lawsuits purport
to seek both injunctive relief and damages on behalf of the purported class
based upon these allegations. Management is unable to determine whether these
lawsuits will have a material adverse effect on the Company's financial position
or results of operations. The Company intends to defend the actions vigorously.
No amounts related to these lawsuits or the proposed acquisition have been
accrued in the accompanying financial statements.
7. OTHER SUBSEQUENT EVENTS
On May 11, 1999, the Company repaid a $6.1 million promissory note with
proceeds from a new $16.1 million promissory note that requires monthly interest
only payments at LIBOR plus 2.25%, matures October 30, 1999 and is secured by
hotel properties with a net book value of $24.6 million at March 31, 1999.
On April 28, 1999, the Company accepted two offers which have not
closed from third parties to purchase an aggregate $2.5 million in Common Stock
through the Company's Dividend Reinvestment and Stock Purchase Plan (the
"Plan"). The Plan provides for the issuance of Common Stock at a price based on
the twelve day trading period subsequent to acceptance and subject to certain
thresholds and discounts as set by the Company.
9
<PAGE> 10
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
------------ -------------
(Unaudited)
<S> <C> <C>
ASSETS:
Current assets
Cash and cash equivalents $ 6,764,000 $ 3,639,000
Receivables, net of allowance for doubtful
accounts of $234,000 and $388,000, respectively 10,963,000 10,771,000
Due from affiliates, net 230,000 164,000
Inventories 1,826,000 1,824,000
Prepaid expenses and other current assets 769,000 640,000
------------ ------------
20,552,000 17,038,000
Management agreements, net 333,000 366,000
Property and equipment, net 148,000 154,000
Other assets 465,000 420,000
------------ ------------
$ 21,498,000 $ 17,978,000
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT:
Current liabilities
Rent payable - Sunstone Hotel Investors, Inc. $ 12,347,000 $ 7,498,000
Accounts payable 6,621,000 8,811,000
Accrued payroll and employee benefits 5,613,000 6,697,000
Sales taxes payable 2,533,000 1,915,000
Due to affiliates, net 456,000 --
Stockholder line of credit 800,000 650,000
Other liabilities 1,245,000 1,295,000
------------ ------------
29,615,000 26,866,000
Long-term liability
Accrued pension liability 1,598,000 1,603,000
------------ ------------
31,213,000 28,469,000
------------ ------------
Commitments and contingencies (Note 5)
Stockholders' deficit
Common stock, no par value, 100,000 shares
authorized; 125 shares issued and
outstanding 498,000 498,000
Accumulated deficit (Note 2) (9,646,000) (10,422,000)
Accumulated other comprehensive loss (567,000) (567,000)
------------ ------------
(9,715,000) (10,491,000)
------------ ------------
$ 21,498,000 $ 17,978,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
10
<PAGE> 11
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended
March 31,
--------------------------
1999 1998
----------- ------------
<S> <C> <C>
REVENUES:
Room $52,651,000 $47,910,000
Food and beverage 8,972,000 9,993,000
Other 6,694,000 7,192,000
----------- ------------
Total revenues 68,317,000 65,095,000
----------- -----------
EXPENSES:
Room 11,742,000 11,378,000
Food and beverage 6,936,000 8,540,000
Other 3,858,000 4,394,000
Advertising and promotion 5,391,000 4,738,000
Repairs and maintenance 2,400,000 2,575,000
Utilities 2,590,000 2,429,000
Franchise costs 2,044,000 1,418,000
Management and accounting fees to related party 1,398,000 1,234,000
Rent expense - Sunstone Hotel Investors, Inc. 24,762,000 23,687,000
General and administrative 6,420,000 6,694,000
----------- -----------
Total expenses 67,541,000 67,087,000
----------- -----------
NET INCOME (LOSS) $ 776,000 $(1,992,000)
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
11
<PAGE> 12
SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended
March 31,
---------------------------
1999 1998
----------- ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 776,000 $(1,992,000)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Bad debt expense -- 16,000
Depreciation 20,000 256,000
Amortization 33,000 99,000
Changes in operating assets and liabilities:
Receivables, net (192,000) 13,000
Due from affiliates, net (66,000) 2,456,000
Inventories (2,000) (92,000)
Prepaid expenses and other current assets (129,000) (63,000)
Other assets (45,000) (115,000)
Rent payable - Sunstone Hotel Investors, Inc. 4,849,000 4,533,000
Accounts payable (2,190,000) (96,000)
Accrued payroll and employee benefits (1,084,000) (226,000)
Sales taxes payable 618,000 758,000
Due to affiliates, net 456,000 (1,475,000)
Accrued pension liability (5,000) 52,000
Other liabilities (50,000) 278,000
----------- -----------
Net cash provided by operating activities 2,989,000 4,402,000
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (14,000) (33,000)
Proceeds from Lessor upon execution of
certain leases -- 13,000
----------- -----------
Net cash used in investing activities (14,000) (20,000)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from stockholder line of credit 800,000 --
Payments on stockholder line of credit (650,000) --
Payments on capital lease obligation -- (13,000)
----------- -----------
Net cash provided by (used in) financing activities 150,000 (13,000)
----------- -----------
Net change in cash and cash equivalents 3,125,000 4,369,000
Cash and cash equivalents, beginning of period 3,639,000 4,352,000
----------- -----------
Cash and cash equivalents, end of period $ 6,764,000 $ 8,721,000
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
12
<PAGE> 13
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 by Sunstone Hotel Investors, Inc. (the
"Lessor") on August 15, 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 operates 100% of the
hotel properties owned by the Lessor. 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 March 31, 1999, the Lessee
leased 56 hotel properties 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, 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 months ended March 31, 1999 are not
necessarily indicative of the results to be expected for the year ended December
31, 1999.
Seasonality:
The hotel industry is seasonal in nature. Seasonal variations in hotel
occupancy may cause quarterly fluctuations in the Lessee's revenues.
Use of Estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Significant estimates include estimates
related to claims, legal actions and other similar contingencies (see Note 5)
and actual results could differ materially from those estimates in the near
term.
Reclassifications:
Certain prior period balances have been reclassified to conform with
the current period presentation.
13
<PAGE> 14
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. STOCKHOLDERS' DEFICIT
During the three months ended March 31, 1999, the Lessee had net income
of $776,000; however, the Lessee has incurred significant losses from its
inception in 1995. At March 31, 1999, the Lessee's stockholders' deficit
amounted to $9.7 million. At March 31, 1999, the Lessee's rent payable to the
Lessor amounted to $12.3 million. Also at March 31, 1999, the Lessee's current
liabilities exceeded its current assets by $9.1 million. The ability of the
Lessee to fund its daily operations and continue to remain current on its
substantial rent obligation to the Lessor is a result of the original terms
under the Percentage Leases, for the payment of rent to the Lessor, which allow
monthly base rent to be paid in arrears and monthly percentage rent to be paid
within 45 days after the respective month end.
3. PERCENTAGE LEASE AGREEMENTS
At March 31, 1999, 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 March 31, 1999, the $12.3 million due the Lessor
consists of percentage rent for the months of February and March 1999 and base
rent for the month of March 1999.
Certain Percentage Leases, as amended, allow for the abatement of base
rent related to rooms taken out of service during major renovations. The Lessor
abated $281,000 and $0 of base rent during the three months ended March 31, 1999
and 1998, respectively.
During the three months ended March 31, 1999, the Lessor disposed of
one hotel property and the related Percentage Lease was terminated. The Lessor
anticipates offering the Lessee a substitute hotel facility within the 180 days
allowed under the Percentage Lease and as such no termination fee was due from
the Lessor.
4. CERTAIN TRANSACTIONS WITH RELATED PARTIES
Sunstone Hotel Management, Inc. (the "Management Company"), a company
wholly owned by Robert A. Alter, Chairman of the Lessee, provides management and
accounting 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. Accounting fees are computed as a fixed amount per room on
an individual hotel basis and range from $8.50 to $11.50 per room per month.
During the three months ended March 31, 1999, $1.1 million and $315,000, in
management and accounting fees were incurred, respectively, and during the three
months ended March 31, 1998, $937,000 and $297,000 in management fees and
accountings fees were incurred, respectively. Amount due to affiliates
represents management and accounting fees payable to the Management Company
reduced by reimbursements due from the Management Company for certain expenses
paid by the Lessee on behalf of the Management Company.
Upon the execution of each Percentage Lease, the Lessor assigns certain
hotel operating assets and liabilities to the Lessee at the Lessor's net book
value. The Lessee records all such hotel operating assets and liabilities at the
Lessor's costs with a corresponding net amount payable to or receivable from the
Lessor, depending on whether net assets or liabilities were assigned. The Lessor
also reimburses the Lessee for costs it incurs related to the Lessor's
renovation of hotels and for certain general and administrative costs incurred
by the Lessee on behalf of the Lessor. Amounts due from affiliates primarily
includes reimbursements due from the Lessor reduced by the amount due to the
Lessor for net hotel operating assets assigned by the Lessor to the Lessee upon
the execution of each Percentage Lease.
The Lessee has a $1.5 million line of credit with its primary
stockholder. The line of credit bears interest at the prime rate plus 0.25%, is
unsecured and has a maturity date of December 29, 1999. The line is to be used
exclusively for general short-term working capital needs. In January 1999, an
additional $800,000 was drawn on the stockholder
14
<PAGE> 15
SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. CERTAIN TRANSACTIONS WITH RELATED PARTIES (continued)
line of credit by the Lessee for working capital needs. In February 1999, the
Lessee paid down the line of credit by $644,000, plus related unpaid accrued
interest. Interest incurred on the line of credit during the three months ended
March 31, 1999 totaled $14,000.
On February 15, 1999, the Lessee began leasing office space from the
Lessor when it moved its corporate facilities into a building owned by the
Lessor.
5. COMMITMENTS AND CONTINGENCIES
On April 5, 1999, the Lessor received an acquisition offer from SHP
Acquisition, LLC ("SHP Acquisition" ), formed by Robert A. Alter, certain
management personnel of the Lessee and Westbrook Funds III. Westbrook Partners
LLC is a New York based real estate opportunity fund, an affiliate of which is a
9.6% stockholder in the Lessor, whose managing principal, Paul Kazilionis, is a
director of the Lessor.
In connection with the proposed acquisition, eight lawsuits have been
filed naming the Lessor, certain directors and officers of the Lessor and other
parties including the Lessee and its shareholders as defendants. The factual
basis alleged to underlie all eight lawsuits are essentially identical.
Substantively, they assert that Robert A. Alter, Charles L. Biederman and Paul
Kazilionis, in conjunction with Westbrook Partners, LLC (and other purported
Westbrook affiliated entities), SHP Acquisition and the Lessee, have offered an
unfair buyout price for the outstanding shares of the Lessor. Plaintiffs in
each of these lawsuits purport to seek both injunctive relief and damages on
behalf of the purported class based upon these allegations. Management is unable
to determine whether these lawsuits will have a material adverse effect on the
Lessee's financial position or results of operations. The Lessee intends to
defend the actions vigorously. No amounts related to these lawsuits or the
proposed acquisition have been accrued in the accompanying financial statements.
The Lessee is involved from time to time in various claims and legal
actions in the ordinary course of business. Management does not believe that the
resolution of such matters will have a material adverse effect on the Lessee's
financial position or results of operations when resolved.
15
<PAGE> 16
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 uncertainties, which include
competition within the lodging industry, the balance between supply and demand
for hotel rooms, the Company's continued ability to execute acquisitions and
renovations, the effect of economic conditions, the availability of capital to
finance planned growth, the Year 2000 Issue, and the liquidity of the Lessee,
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 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. The following
discussion should be read in conjunction with the financial statements included
elsewhere in this report, as well as the information presented in the Company's
Annual Report on Form 10-K for the year ended December 31, 1998.
GENERAL
Sunstone Hotel Investors, Inc. (the "Company") is a self-administered,
equity real estate investment trust ("REIT") that through its 94.8% ownership
interest in Sunstone Hotel Investors, LP (the "Operating Partnership"), 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 Marriott
International, Inc., Bass Hotels and Resorts, Hilton Hotels Corporation and
Promus Hotel Corporation. As of May 11, 1999, the Company's portfolio consisted
of 56 hotels with a total of 10,086 rooms. The majority of the Company's hotel
portfolio consists of luxury, upscale and mid-price full-service hotels and
upscale extended-stay properties (approximately 84.5%) with the remainder of the
Company's portfolio consisting of mid-price limited service properties.
The Company's growth strategy is to maximize shareholder value by (i)
acquiring underperforming and undercapitalized hotels that are in strong market
locations with significant barriers to entry and (ii) improving such hotels'
financial performance by renovating, redeveloping, rebranding and repositioning
the hotels and through the implementation of focused sales and marketing
programs.
The Company's business strategy is to seek to increase market share at
its hotels through an expansion of a strong base of direct sales and marketing
with an emphasis on repeat customers. The Company's goal is to increase each
hotel's customer base by providing a high level of guest satisfaction,
high-quality hotels and quality food and beverage services.
PROPOSED ACQUISITION
On April 5, 1999, the Company received an offer by SHP Acquisition, LLC
("SHP Acquisition"), formed by Robert A. Alter, certain management personnel of
the Lessee and Westbrook Funds III. The Lessee leases and operates each of the
Company's 56 hotels and is owned by Robert A. Alter, Chairman, President and
Chief Executive Officer of the Company and Charles L. Biederman, Vice Chairman
and Executive Vice President of the Company. Westbrook Partners LLC is a New
York based real estate opportunity fund, which is a 9.6% stockholder in the
Company, whose managing principal, Paul Kazilionis, is a director of the
Company. The acquisition proposal is for all of the common stock of the Company
at $9.50 to $10.00 in cash per share. Under this proposal, the holders of
outstanding Operating Partnership units in the Operating Partnership (other than
the Company) would receive, at their option, either cash in an amount per
Operating Partnership unit equal to the cash price per common share or
redeemable perpetual preferred units in the Operating Partnership having a face
value equal to the cash price. The Company's 7.9% Class A Preferred Stock would
be redeemed in accordance with its term of a cash amount equal to its
liquidation preference plus accrued and
16
<PAGE> 17
unpaid dividends. The acquisition proposal is subject to certain conditions,
including due diligence review of the Company and obtaining the necessary
financing.
In response to the acquisition proposal, the Company formed a Special
Committee of the Board of Directors, comprised of all the independent members of
the Board of Directors, to study the proposal and consider the Company's
alternatives. The Special Committee has appointed Goldman, Sachs & Co. to act as
its independent financial advisor to evaluate the proposal made by SHP
Acquisition and to review the Company's strategic alternatives. The Special
Committee also appointed the law firm of Altheimer & Gray to act as its
independent legal advisor. The Special Committee and its advisors are currently
in the process of considering the acquisition proposal and the Company's
alternatives.
RESULTS OF OPERATIONS
Comparison of the Three Months Ended March 31, 1999 to 1998
For the three months ended March 31, 1999, lease revenues increased
$1.1 million, to $24.8 million from $23.7 million for the corresponding quarter
of 1998. The 4.6% growth is attributable to the net increase in investment in
hotel properties during 1998 and the first quarter of 1999. During 1998, the
Company acquired ten hotels and disposed of six non-core hotels. Additionally,
one hotel was sold during the first quarter of 1999. Net REVPAR increases for
continuously owned hotels also contributed to the 4.6% growth in lease revenues.
Total room revenue generated by the Company's hotels increased 10.0% to
$52.7 million for the first quarter of 1999 from $47.9 million for the
corresponding quarter of 1998. On a same-unit-sales basis for the entire hotel
portfolio, REVPAR increased 5.9% to $56.98 for the first quarter of 1999 from
$53.82 for the first quarter of 1998. The 5.9% growth in REVPAR was driven by an
increase in the ADR, to $86.96 from $84.01, and an increase in occupancy, to
65.5% from 64.1%.
REVPAR for the non-renovation hotels increased by 6.3% to $54.30 for
the first quarter of 1999 from $51.07 for the first quarter of 1998.
Non-renovation hotels include 38 of the Company's 56 hotels which were not under
renovation in either the first quarter of 1999 or 1998. The 6.3% growth in
REVPAR was driven by an increase in the ADR, to $80.89 from $79.02, and an
increase in occupancy, to 67.1% from 64.6%.
Within the portfolio of non-renovation hotels, those hotels branded
with Marriott franchises achieved 14.9% REVPAR growth for the first quarter of
1999 over the corresponding quarter of 1998. These Marriott hotels represent
34.0% of non-renovation hotel rooms available and 36.8% of non-renovation hotels
(14 of 38 hotels). Additionally, the non-renovation hotels located in the
Pacific region achieved 8.9% REVPAR growth for the first quarter of 1999. The
Pacific region hotels represent 50.5% of non-renovation hotel rooms available
and 55.3% of total non-renovation hotels (21 of 38 hotels).
During the first quarter of 1999, the Company invested $16.2 million
redeveloping and renovating eight hotels as compared to $25.4 million invested
redeveloping and renovation twelve hotels during the first quarter of 1998.
17
<PAGE> 18
The following table summarizes average occupancy rate, ADR and REVPAR,
on a same-unit-sales basis, for the Company's hotels owned during the three
months ended March 31, 1999.
SUMMARY OPERATING DATA
<TABLE>
<CAPTION>
Three Months Ended
March 31,
--------------------
1999 1998
---- ----
<S> <C> <C>
SAME-UNIT-SALES ANALYSIS
ALL HOTELS(1):
Occupancy 65.5% 64.1%
ADR $86.96 $84.01
REVPAR $56.98 $53.82
REVPAR growth 5.9%
NON-RENOVATION HOTELS(1):
Occupancy 67.1% 64.6%
ADR $80.89 $79.02
REVPAR $54.30 $51.07
REVPAR growth 6.3%
RENOVATION HOTELS(2):
Occupancy 63.0% 62.2%
ADR $96.43 $89.66
REVPAR $60.78 $55.74
REVPAR growth 9.0%
</TABLE>
- ------------------
(1) Excludes the Hampton Inn located in Arcadia, California which was sold
during the first quarter of 1999.
(2) Includes six hotels undergoing renovation in the first quarter of 1999 and
ten hotels undergoing renovation in the first quarter of 1998. Two hotels
that were under renovation during the first quarter of both 1999 and 1998
have been excluded.
The revenue performance of the Company's hotel portfolio in the first
quarter of 1999 was due to the results from the Company's recently redeveloped
hotels and internal growth of continuously owned and recently acquired hotels as
indicated in the following table:
SELECTED REVPAR PERFORMERS FOR FIRST QUARTER OF 1999
<TABLE>
<CAPTION>
REVPAR
------------------------------------
Rooms 1998(1) 1999 % Change
----- ------- ---- --------
<S> <C> <C> <C> <C>
Courtyard by Marriott - Los Angeles, (LAX) California 178 $32.28 $72.26 123.9%
Holiday Inn Old Town - San Diego, California 151 50.92 73.62 44.6
Holiday Inn Select - La Mirada, California 289 33.34 47.32 41.9
Marriott - Ogden, Utah 288 33.41 47.07 40.9
Holiday Inn & Suites - Price, Utah 151 25.39 33.38 31.5
Marriott - Provo, Utah 333 34.44 44.95 30.5
Marriott - Napa, California 192 60.46 69.28 14.6
Marriott - Santa Monica, California (2) 168 75.72 83.34 10.1
</TABLE>
- -------------------
(1) The Company did not own certain hotels for the entire period presented.
(2) The Company has obtained approval for the indicated franchise license,
subject to completion of certain renovation or improvements.
18
<PAGE> 19
Interest expense and amortization of financing costs increased to $6.5
million for the quarter ended March 31, 1999 from $4.6 million for the
corresponding quarter of 1998. This increase is attributable to increased
borrowings outstanding on the Credit Facility and a reduction in the amount of
interest capitalized related to hotels undergoing major renovations. Real estate
and personal property taxes and insurance increased to $3.1 million for the
quarter ended March 31, 1999 from $2.8 million for the corresponding quarter of
1998. Additionally, real estate related depreciation and amortization increased
$2.1 million, to $10.0 million from $7.9 million. These increases are consistent
with the net increase in investment in hotel and other real estate properties.
During the three months ended March 31, 1999, the Company invested $17.5 million
(net of $4.0 million in proceeds from the sale of one hotel) in the renovation
and development of hotel and other real estate properties. Real estate
investments are typically initially financed with debt, contributing to the
increase in interest expense and amortization of financing costs.
During the first quarter of 1999, the Company disposed of the 129-room
Hampton Inn located in Arcadia, California, for $8.5 million and recognized a
$490,000 gain.
As a result of the above factors, net income available to common
stockholders decreased $2.3 million, to $3.8 million for the first quarter of
1999 from $6.1 million for the corresponding quarter of 1998. Earnings per share
for the first quarter of 1999 were impacted by the 5.3 million common shares
that were issued during 1998, and on a diluted basis was $0.10 per share as
compared to $0.17 per share for the corresponding quarter of 1998. (See
discussion of Funds From Operations in "Liquidity and Capital Resources").
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 eight
states as of May 11, 1999, 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.
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 distribution
payments. The Company anticipates that its annual cash flow provided by leasing
the hotels to the Lessee will provide the necessary funds to meet its annual
operating cash requirements. (See discussion of the Lessee's stockholders'
deficit in the following section, "The Lessee.") During the first quarter of
1999, the Company made distributions to stockholders and minority interest
holders totaling $11.8 million.
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 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, proceeds from
the issuance of additional equity or debt securities. During the three months
ended March 31, 1999, the Company borrowed $17.0 million on the Credit Facility
and $5.5 million under a promissory note secured by the Company's corporate
facility. Additionally, the Company received $4.0 million net proceeds from the
disposition of the 129-room
19
<PAGE> 20
limited service Hampton Inn located in Arcadia, California. As of March 31,
1999, approximately $163.2 million was available under the Company's shelf
registration statement and the Company had $62.5 million of unused commitment on
the Credit Facility. The Credit Facility contains financial covenants that
require the Company to maintain certain specified financial ratios. Under the
most restrictive of these provisions, the maximum additional indebtedness that
could be drawn by the Company under the Credit Facility for the acquisition and
renovation of hotel properties would have been between $17.5 million and $35.0
million at March 31, 1999, depending upon the use of the funds.
Borrowings under the Credit Facility accrue interest at LIBOR plus
1.40% per annum, to LIBOR plus 2.00% per annum, based upon the leverage of the
Company. At March 31, 1999, the Company's actual borrowing rate was LIBOR plus
1.75%. 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.
Under the terms of the Credit Facility, the Company has an option to
request a one year extension of the term to June 30, 2001. The Company exercised
its option, effective March 31, 1999, and requested such an extension. The
Credit Facility lenders have 45 days to respond the Company's request.
As part of its investment strategy, the Company may acquire additional
hotels. Future acquisitions are expected to be funded through the use of the
Credit Facility or other borrowings, proceeds from the disposition 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 existing commitments and develop its business in
accordance with its current strategy for limited growth.
During the three months ended March 31, 1999, the Company invested
approximately $16.2 million in major renovations of eight of its hotels. The
Company estimates it will invest an additional $25.8 million through the first
quarter of 2000 to complete the renovation of those hotels currently under
renovation and certain other recently acquired hotels. Management believes the
renovations should result in incremental increases in REVPAR after a ramp-up
period 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. The Company is in the construction phases of developing three
additional hotels, which are expected to open in 1999. The Company estimates it
will invest approximately $33.4 million to complete the development of these
hotels. This development will be funded by approximately $21.0 million in loan
proceeds from the existing construction lender for two of the hotels which are
being built by third parties, $7.5 million in loan proceeds from a third party
lender secured by the hotel being developed by the Company and the Credit
Facility.
In conjunction with the on-going renovation and development activity,
the Company has various contracts and commitments outstanding with third
parties. The Company plans to fund these remaining obligations through the use
of the Credit Facility and proceeds from the disposition of certain non-core
hotel assets. In addition, the Company may invest additional cash for
renovations during 1999.
On May 11, 1999, the Company repaid a $6.1 million promissory note with
proceeds from a new $16.1 million promissory note that requires monthly interest
only payments at LIBOR plus 2.25%, matures October 30, 1999 and is secured by
certain hotel properties. Additionally, on April 28, 1999, the Company accepted
two offers, which have not closed, from third parties to purchase an aggregate
$2.5 million in Common Stock through the Company's Dividend Reinvestment and
Stock Purchase Plan (the "Plan"). The Plan provides for the issuance of Common
Stock at a share price based on the twelve day trading period subsequent to
acceptance and subject to certain thresholds and discounts as set by the
Company. The Company anticipates using the proceeds from the preceding
transactions to repay an existing $3.1 million note payable and for general
working capital purposes.
20
<PAGE> 21
The Company historically has financed hotel acquisitions through
advances on the Credit Facility and the issuance of equity securities. The
Company intends to finance future acquisitions of hotel properties, hotel
renovations and non-recurring capital improvements principally through the
Credit Facility, 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, to complete development or major
renovation projects or to pay distributions may be adversely affected. A decline
in the Company's acquisition pace relative to historical periods may result in a
decline in earnings.
Funds From Operations ("FFO")
Management believes that funds from operations ("FFO") is a useful
measure of financial performance of an equity REIT, such as the Company. FFO (as
defined in the footnote below) for the three months ended March 31, 1999
decreased by 5.9% over the corresponding period of 1998.
<TABLE>
<CAPTION>
Three Months Ended
March 31,
------------------------------
1999 1998
------------ ------------
<S> <C> <C>
Net Income $ 4,272,000 $ 6,597,000
Add (subtract):
Real estate related depreciation
and amortization 9,989,000 7,919,000
Gain on disposition of hotel property (490,000) --
Minority interest 212,000 351,000
------------ ------------
Funds from operations $ 13,983,000 $ 14,867,000
============ ============
</TABLE>
Management and industry analysts generally consider funds from operations to be
one measure of the financial performance of an equity REIT that provides a
relevant basis for comparison among REITs and it is presented to assist
investors in analyzing the performance of the Company. Funds from operations is
defined as net income (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 should be considered in
conjunction with net income as presented in the Company's consolidated financial
statements and Notes thereto. 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.
The Lessee
For a discussion of the Lessee's revenue operations and a comparison of
the three months ended March 31, 1999 to 1998, see "Results of Operations" of
the Company. Additionally, the Lessee has incurred significant losses from its
inception in 1995. At March 31, 1999, the Lessee's stockholders' deficit
amounted to $9.7 million. At March 31, 1999, the Lessee's rent payable to the
Company amounted to $12.3 million. Also at March 31, 1999, the Lessee's current
liabilities exceeded its current assets by $9.1 million. The ability of the
Lessee to fund its daily operations and continue to remain current on its
substantial rent obligation to the Company is a result of the original terms
under the Percentage Leases, for the payment of rent to the Company, which allow
monthly base rent to be paid in arrears and monthly percentage rent to be paid
within 45 days after the respective month end.
The Lessee's losses from inception are primarily attributable to the
substantial renovations to the Company's hotels which the Lessee operates and
the original terms of the Percentage Leases. During 1998, 1997 and 1996, a
significant portion of the Company's hotel portfolio underwent renovation and
redevelopment, representing 20, 19 and 8 hotels, respectively.
21
<PAGE> 22
Such renovations were made in conjunction with the Company's strategy
of acquiring hotels that can benefit from extensive improvements, reflagging and
repositioning, resulting in higher potential revenue. There can be no assurance,
however, that the Lessee's operating results will improve because of various
factors described under "Risk Factors." During periods of significant
renovation, the hotels generally do not generate sufficient revenue to meet
operating expenses, including lease payments.
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.
The Lessee relies on information technology ("IT") systems and other
systems and facilities such as PBX switches, elevators, heating, ventilation and
air conditioning, security, fire and life safety and other environmental systems
("embedded systems") to conduct its business. Both the IT and the embedded
systems are subject to the Year 2000 Issue which, if not remedied in time, could
have an impact on the operations of the Lessee. The Lessee may also be exposed
to risk from third parties with whom the Lessee interacts who fail to adequately
address their own Year 2000 issues. Such third parties include franchisors,
vendors, suppliers and significant customers.
To mitigate and minimize the number and seriousness of any disruptions
caused by the Year 2000 Issue, the Company and the Lessee have developed and
adopted a Year 2000 Compliance Program (the "Compliance Program") which involves
the following four phases: assessment, which includes development of an action
plan and inventorying of hotel systems, remediation, testing and implementation.
With the assistance of outside consultants, site surveys are being performed and
all hotel systems will be identified and inventoried and will include
information such as the manufacturer or vendor who performed the installation,
currently services or maintains each system. The Lessee has begun contacting
these vendors to obtain certification relating to their Year 2000 compliance
testing. In addition, all parties for building systems that service leased
premises, or a facility within leased premises are located and are operated and
controlled by or interact with a software program will be identified and
contacted. It should be noted that due to the complexity of some of the systems,
in many cases, the only way to determine the potential impact of the systems
would be to verify the Year 2000 effect with the particular vendor. The
assessment phase was completed in February 1999.
Status of Progress in Becoming Year 2000 Compliant, Including Timetable for
Completion of Each Remaining Phase - Hotel and Lessee Systems:
Based on the results of the site assessments, the identified IT and
embedded systems will be replaced or upgraded. The system upgrades will be
prioritized according to their critical importance. Life safety systems and
emergency services will take priority in accordance with the steps laid out in
the Compliance Program. The various vendors associated with any system
replacements or upgrades will be contacted to determine their readiness to deal
with these system enhancements. Performance of certain testing by the vendors
may be required in several cases to ensure Year 2000 compliance. Certain
vendors, manufacturers, service personnel, consultants, contractors, lessees and
lessors will be requested to prepare a letter certifying and warranting that all
systems, utilities and services containing time and date-related coding and
internal programs, shall continue without interruption beyond December 31, 1999.
The implementation will be monitored and managed on a real-time basis to ensure
a smooth upgrade of the systems. Completion of the implementation and testing
phases for all significant systems is expected by June 30, 1999, with all
remediated systems fully tested and implemented by September 30, 1999, with 100%
completion targeted for October 31, 1999.
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Nature and Level of Importance of Third Party Systems and Their Exposure to the
Year 2000:
The Lessee is in the process of 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
by the end of the second quarter of 1999, but cannot guarantee that all vendors
or service providers will respond to 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 second 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 inability of
vendors to complete their Year 2000 resolution process in a timely fashion could
materially impact the Company and the Lessee. The effect of compliance by
vendors is not determinable.
Cost of Addressing Year 2000 Issues:
The Company estimates that total cost for the Year 2000 compliance
review, evaluation, assessment and remediation efforts should not exceed $1.0
million and will be funded by the Company through its operating cash flows. To
date, the costs incurred to address the Year 2000 issue consist primarily of
services provided by outside consultants for onsite system surveys and total
$163,000 which was expensed by the Company in the first quarter of 1999. The
remaining balance is also anticipated to be expended in 1999.
Risks Presented by Year 2000 Issues:
Management of the Company and the Lessee believe they have an effective
plan in place to resolve the Year 2000 Issue in a timely manner. As noted above,
the Lessee has not yet completed all necessary phases of the Year 2000 program.
In the event that the Lessee does not complete any additional phases, the Lessee
may encounter system failures associated with third-party vendors such as
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. These
disruptions could adversely affect the Company and the Lessee, their businesses
and their financial conditions. The Company and the Lessee cannot predict the
actual effects of the Year 2000 Issue on their businesses, such effects depend
on numerous uncertainties such as whether significant third parties have
properly and timely addressed the Year 2000 Issue, and whether broad-based or
systemic economic failures may occur. Due to the general uncertainty inherent in
the Year 2000 Issue and the Company's and Lessee's dependence on third parties,
Management is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact.
Contingency Plan:
The Lessee is in the process of developing its contingency plan for the
systems operated an maintained by the Lessee and the hotels. This is necessary
in order to provide for the most likely worst case scenarios regarding Year 2000
compliance. The contingency plan is expected to be completed in 1999.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 1998 for detailed disclosure about quantitative and qualitative
disclosures about market risk which have not materially changed since December
31, 1998.
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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 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 the Credit Facility with a maximum commitment of $350.0 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 -- 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 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 Credit Facility to fund our
obligations. During the three months ended March 31, 1999, we paid out
approximately $11.8 million in distributions to our stockholders and minority
interests which was approximately 84% of our $14.0 million of funds from
operations. If our operating cash flows decreased or our availability under the
Credit Facility were reduced, it will 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 or other third parties. 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 Percentage 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 Percentage Leases through their financial and
ownership interests in us.
The Lessee has incurred significant losses since its inception in 1995.
At March 31, 1999, the Lessee's stockholders' deficit amounted to $9.7 million.
At March 31, 1999, the Lessee's rent payable to the Company amounted to $12.3
million. Also at March 31, 1999, the Lessee's current liabilities exceeded its
current assets by $9.1 million. The ability of the Lessee to fund its daily
operations and continue to remain current on its substantial rent obligation to
the Company is a result of the original terms under the Percentage Leases, for
the payment of rent to the Company, which allow monthly base rent to be paid in
arrears and monthly percentage rent to be paid within 45 days after the
respective month-end. There can be no assurances, however, that the Lessee will
continue to make its rent payments in a timely fashion.
According to the Lessee, the losses are due to several factors,
including:
- the substantial number of renovations we undertook adversely affected
occupancy rates and revenues at the hotels;
- renovations caused greater revenue losses than expected; and
- poorer performance at certain hotels than expected.
There can be no assurance 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 a subordinated interest in 481,955
Units to secure the Lessee's obligations under the Percentage Leases. However,
if the
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Lessee defaults under the Percentage Leases, the value of these Units and other
assets of the Lessee will be insufficient to satisfy our claims against the
Lessee.
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:
- We may continue to incur significant renovation and construction cost
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.
- 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;
- We may complete our renovation after significant delays reducing the
amount of revenues expected to be received during the delay period;
and
- 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, the Lessee, the
Management Company and us creates several inherent conflicts of interest that
may result in decisions being made by our management that are not in the best
interests of our stockholders. The most significant conflicts of interest
include the following:
- 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.
- 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.
- 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
Percentage 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.
- 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
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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.
- 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 each 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 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 our
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.
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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 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 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 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 treatment
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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:
- Changes in national and local economic conditions;
- Changes in interest rates;
- Changes in costs of, or terms of, loans from lenders;
- Changes in environmental laws;
- The ongoing requirement to make capital improvements, repairs or
maintenance;
- Changes in the tax rates or laws;
- The continuing requirement to pay operating expenses;
- Changes in governmental requirements or zoning laws;
- Occurrences beyond the control of an owner, such as natural disasters
like earthquakes and weather, civil unrest or so-called "acts of God;"
- The possibility of unexpected, uninsured or under-insured losses; and
- 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
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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.
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 and the Lessee's efforts to address the Year 2000
issue and the related 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:
- 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;
- The risk of loss of market share in areas in which overbuilding occurs
and adversely affects occupancy, ADR and REVPAR;
- Erosion of operating margins arising from an increase in operating
costs due to inflation or other factors that may exceed increases in
REVPAR;
- 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;
- Strikes and other labor disturbances by the Lessee's employees which
would seriously disrupt the Lessee's ability to provide services to
hotel guests;
- 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 stockholders.
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. 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.
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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
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 furniture, fixtures 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 stockholders. 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 56 hotels, 54 are operated under franchise agreements with
national franchisors. The Lessee is the franchisee and is responsible for
complying with the franchise agreements. 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 a certain 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
stockholders.
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 March 31,
1999, our ratio of debt to total investment in hotel properties and other real
estate investments was approximately 42%. Our Credit Facility has further
restrictions on the amount of Company indebtedness. The degree of leverage could
have important consequences to our stockholders, 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.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 - Financial Data Schedule
(b) Report on Form 8-K:
No reports on Form 8-K were filed during the first quarter of
1999.
31
<PAGE> 32
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 May 11, 1999.
SUNSTONE HOTEL INVESTORS, INC.
By: /s/ Robert A. Alter
----------------------------------
Robert A. Alter
President, Secretary and
Chairman of the Board of Directors
By: /s/ R. Terrence Crowley
----------------------------------
R. Terrence Crowley
Chief Operating Officer
(Principal Financial and
Accounting Officer)
32
<PAGE> 33
EXHIBIT INDEX
-------------
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 3,836,000
<SECURITIES> 0
<RECEIVABLES> 14,021,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 936,251,000
<DEPRECIATION> (74,518,00)
<TOTAL-ASSETS> 889,052,000
<CURRENT-LIABILITIES> 0
<BONDS> 397,247,000
0
3,000
<COMMON> 377,000
<OTHER-SE> 444,103,000
<TOTAL-LIABILITY-AND-EQUITY> 889,052,000
<SALES> 0
<TOTAL-REVENUES> 24,892,000
<CGS> 0
<TOTAL-COSTS> 14,641,000
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 6,469,000
<INCOME-PRETAX> 3,785,000
<INCOME-TAX> 3,785,000
<INCOME-CONTINUING> 3,785,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,785,000
<EPS-PRIMARY> 0.10
<EPS-DILUTED> 0.10
</TABLE>
