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, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission file number 0-26304
SUNSTONE HOTEL INVESTORS, INC.
(Exact name of registrant as specified in its charter)
--------------------
Maryland 52-1891908
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
115 Calle de Industrias, Suite 201, San Clemente, CA 92672
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (714) 361-3900
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
As of May 14, 1998, there were 37,528,618 shares of Common Stock
outstanding.
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SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON FORM 10-Q
MARCH 31, 1998
TABLE OF CONTENTS
PART I -- FINANCIAL INFORMATION
Page
----
ITEM 1. FINANCIAL STATEMENTS
Sunstone Hotel Investors, Inc.
Consolidated Balance Sheets as of March 31, 1998 and
December 31, 1997.............................................................. 3
Consolidated Statements of Income for the Three Months
Ended March 31, 1998 and 1997.................................................. 4
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 1998 and 1997................................................. 5
Notes to Consolidated Financial Statements......................................... 6
Sunstone Hotel Properties, Inc. (the "Lessee")
Consolidated Balance Sheets as of March 31, 1998 and
December 31, 1997.............................................................. 10
Consolidated Statements of Operations for the Three Months
Ended March 31, 1998 and 1997.................................................. 11
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 1998 and 1997.................................................. 12
Notes to Consolidated Financial Statements......................................... 13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS....................................... 15
PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION -- RISK FACTORS........................................ 24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K......................................... 31
SIGNATURES ........................................................................... 32
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PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
1998 1997
------------- -------------
(Unaudited)
ASSETS:
Investments in hotel properties, net $ 763,138,000 $ 704,323,000
Notes receivable 6,073,000 6,085,000
Cash and cash equivalents 2,023,000 3,584,000
Restricted cash 2,766,000 2,421,000
Rent receivable - Lessee 12,174,000 7,641,000
Other assets, net 18,393,000 15,523,000
------------- -------------
$ 804,567,000 $ 739,577,000
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Revolving line of credit $ 192,800,000 $ 179,800,000
Notes payable 100,288,000 116,671,000
Accounts payable and other accrued expenses 12,720,000 10,937,000
Dividends payable to preferred shareholders 487,000 422,000
------------- -------------
$ 306,295,000 307,830,000
------------- -------------
Commitments and contingencies
Minority interest 25,605,000 33,860,000
Stockholders' equity:
7.9% Class A Cumulative Convertible Preferred Stock,
$.01 par value, 10,000,000 authorized; 250,000
issued and outstanding as of March 31, 1998
and December 31, 1997 (liquidation preference
$100 per share aggregating $25,000,000) 3,000 3,000
Common stock, $.01 par value, 50,000,000 authorized;
37,517,172 and 32,284,103 issued and outstanding
as of March 31, 1998 and December 31, 1997,
respectively 375,000 323,000
Additional paid-in capital 478,791,000 401,098,000
Distributions in excess of earnings (6,502,000) (3,537,000)
------------- -------------
472,667,000 397,887,000
------------- -------------
$ 804,567,000 $ 739,577,000
============= =============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three Months Ended
March 31,
-----------------------------------
1998 1997
------------ ------------
(Restated)
REVENUES:
Lease revenue - Lessee $ 23,687,000 $ 7,572,000
Interest income 57,000 197,000
------------ ------------
23,744,000 7,769,000
------------ ------------
EXPENSES:
Real estate related depreciation and
amortization 7,919,000 1,956,000
Interest expense and amortization of
financing costs 4,595,000 840,000
Real estate and personal property taxes and
insurance 2,779,000 676,000
General and administrative 1,503,000 532,000
------------ ------------
Total expenses 16,796,000 4,004,000
------------ ------------
Income before minority interest 6,948,000 3,765,000
Minority interest (351,000) (489,000)
------------ ------------
NET INCOME 6,597,000 3,276,000
Dividends on preferred shares (487,000) --
------------ ------------
INCOME AVAILABLE TO COMMON SHAREHOLDERS $ 6,110,000 $ 3,276,000
============ ============
EARNINGS PER SHARE
Basic $ 0.17 $ 0.22
============ ============
Diluted $ 0.17 $ 0.22
============ ============
DIVIDENDS DECLARED PER SHARE $ 0.275 $ 0.250
============ ============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
-----------------------------------
1998 1997
------------ ------------
(Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 6,110,000 $ 3,276,000
Adjustments to reconcile net income
to net cash provided by operating activities:
Minority interest 351,000 489,000
Depreciation and amortization 8,024,000 1,956,000
Amortization of financing costs 493,000 50,000
Changes in assets and liabilities:
Rent receivable -- Lessee (4,533,000) (1,962,000)
Other assets, net (2,232,000) (599,000)
Accounts payable and other accrued expenses 1,783,000 (1,038,000)
Dividends payable to preferred shareholders 65,000 --
------------ ------------
Net cash provided by operating activities 10,061,000 2,172,000
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, improvements and additions
to hotel properties (66,734,000) (47,999,000)
Increase in restricted cash (345,000) --
Payments received on notes receivable 12,000 --
------------ ------------
Net cash used in investing activities (67,067,000) (47,999,000)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 69,618,000 65,640,000
Payment of deferred financing costs (1,155,000) --
Borrowings on revolving line of credit 66,000,000 20,375,000
Principal payments on revolving line of credit (53,000,000) (27,500,000)
Principal payments on notes payable (16,383,000) (7,913,000)
Distributions to shareholders (9,075,000) (3,885,000)
Distributions to partners (560,000) (629,000)
------------ ------------
Net cash provided by financing activities 55,445,000 46,088,000
------------ ------------
Net change in cash and cash equivalents (1,561,000) 261,000
Cash and cash equivalents, beginning of period 3,584,000 142,000
------------ ------------
Cash and cash equivalents, end of period $ 2,023,000 $ 403,000
============ ============
Cash paid for interest $ 4,859,000 $ 863,000
============ ============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF PRESENTATION
Sunstone Hotel Investors, Inc., a Maryland corporation (the "Company"),
was formed in 1995 as a real estate investment trust ("REIT"). At March 31,
1998, the Company had a 94.9% interest in Sunstone Hotel Investors, L.P. (the
"Operating Partnership") which began operations as of August 16, 1995, upon
receipt of the proceeds from the Company's initial public offering (the
"Offering") and consummation of certain formation transactions. The Company
conducts all of its business through and is the sole general partner of the
Operating Partnership.
In connection with the Offering, the Company acquired seven hotels (the
"Sunstone Hotels") from seven entities controlled by officers and a director of
the Company and acquired three additional hotels (the "Acquisition Hotels" and
together, the "Initial Hotels") from unrelated third parties in exchange for (i)
units in the Operating Partnership ("Units"), (ii) the payment of mortgage
indebtedness for the Sunstone Hotels, and (iii) payment of cash to purchase the
Acquisition Hotels.
At March 31, 1998, the Company's portfolio included 57 hotel properties,
primarily located in the western United States, all of which are leased to
Sunstone Hotel Properties, Inc. (the "Lessee") under operating leases (the
"Percentage Leases") that provide for the payment of base and percentage rent.
The Lessee is owned by Robert A. Alter, Chairman and President of the Company
(80%), and Charles L. Biederman, Vice Chairman of the Company (20%). The Lessee
has entered into a management agreement pursuant to which all of the hotels are
managed by Sunstone Hotel Management, Inc. (the "Management Company"), of which
Mr. Alter is the sole shareholder.
Basis of Presentation:
The consolidated financial statements include the accounts of the
Company and its subsidiaries, including the Operating Partnership. All
significant intercompany transactions and balances have been eliminated.
The interim consolidated financial statements of the Company have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Company believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the audited consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997. 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, 1998 are not necessarily indicative
of the results to be expected for the year ended December 31, 1998.
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION, continued
Restatement:
The interim financial statements as of and for the three months ended
March 31, 1997 have been restated to reflect the allocation of a fourth quarter
1997 depreciation expense adjustment to the first three quarters of 1997.
Reclassifications:
Certain prior period balances have been reclassified to conform with the
current period presentation.
New Accounting Standards:
In March 1998, the Financial Accounting Standards Board Emerging Issues
Task Force ("EITF") reached a consensus on Issue 97-11 that internal
preacquisition costs related to the purchase of an operating property should be
expensed as incurred. The Company expects that the adoption of the consensus on
Issue 97-11 will result in increased general and administrative expenses in
future periods.
2. INVESTMENTS IN HOTEL PROPERTIES
During the first quarter of 1998, the Company acquired four hotel
properties with 501 rooms for an aggregate of $40.5 million in cash.
Additionally, the Company completed, or was in the process of completing,
substantial renovations at 12 of the hotel properties, and in connection with
such renovation, incurred costs of approximately $25.4 million.
3. REVOLVING LINE OF CREDIT
On January 26, 1998, the Company increased its unsecured revolving line
of credit facility (the "Credit Facility") from $200.0 million to $300.0 million
and reduced its borrowing rate. The Credit Facility accrues interest at a rate
as low as LIBOR plus 1.40% per annum based upon the leverage of the Company,
with provisions for reduced rates upon receipt by the Company of an investment
grade rating.
4. EQUITY
On February 11, 1998, the Company completed a shelf offering for
4,500,000 shares of its common stock. The offering price of the shares sold was
$16.375 per share, resulting in gross proceeds of approximately $73.7 million
and net proceeds (less underwriters' discount and offering costs) of
approximately $69.8 million. The Company used the net proceeds of the offering
to finance the acquisition of additional hotels and to repay outstanding
indebtedness under the Credit Facility.
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share. The 1997 amounts have been restated to comply with the
Financial Accounting Standards Board Statement No. 128, Earnings per Share.
Three Months Ended
March 31,
-----------------------------------
1998 1997
------------ ------------
Numerator:
Net income $ 6,597,000 $ 3,276,000
Dividends on preferred shares (487,000) --
------------ ------------
Numerator for basic and diluted earnings per share
Income available to common shareholders after effect of
dilutive securities $ 6,110,000 $ 3,276,000
------------ ------------
Denominator:
Denominator for basic earnings per share - weighted
average shares outstanding 35,452,364 14,834,676
Effect of dilutive securities:
Stock options 170,368 125,046
------------ ------------
Denominator for diluted earnings per share - adjusted
weighted average shares and assumed conversion 35,622,732 14,959,722
============ ============
Basic earnings per share $ 0.17 $ 0.22
============ ============
Diluted earnings per share $ 0.17 $ 0.22
============ ============
6. SUBSEQUENT EVENTS
On April 9, 1998, the Company acquired the 160-room Hilton Inn in
Oxnard, California from Westbrook Partners for $9.3 million in cash. The hotel
consists of one six-story building and two 2-story buildings which include
meeting rooms, a restaurant and lounge, a beauty salon and barber shop, a gift
shop, a tennis court and fitness track and a swimming pool and spa.
On April 30, 1998, the Company acquired the 130-room Hampton Inn in
Santa Clarita, California from Valencia Hotel Limited Partnership for
approximately $8.3 million. The purchase price was funded with the assumption of
$6.2 million of existing indebtedness, the issuance of 118,409 Units valued at
$1.9 million with the balance of the purchase price funded with cash. The hotel
consists of a single four-story building with meeting rooms, a small business
center, swimming pool and spa.
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SUNSTONE HOTEL INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. SUBSEQUENT EVENTS, continued
On May 5, 1998, the Company acquired the 192-room Marriott Hotel in Napa
Valley, California from Host Marriott for approximately $21.0 million in cash.
The Napa Valley Marriott Hotel is located at the gateway to California's
renowned wine country. The hotel has approximately 10,000 square feet of meeting
space, an executive conference center, restaurant and bar and grill, swimming
pool and spa and tennis courts.
On May 13, 1998, the Company acquired the 168-room Days Inn Hotel in
Santa Clara, California from MOA-CS Corporation for approximately $20.0 million
in cash. The hotel consists of three four-story buildings with meeting rooms,
two restaurants, a fitness center, swimming pool and spa.
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SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
1998 1997
------------ ------------
(Unaudited)
ASSETS:
Current assets
Cash and cash equivalents $ 8,721,000 $ 4,352,000
Receivables, net of allowance for doubtful accounts of
$192,000 and $267,000, respectively 10,432,000 10,037,000
Due from affiliates -- 330,000
Inventories 1,916,000 1,798,000
Prepaid expenses 368,000 306,000
------------ ------------
21,437,000 16,823,000
Management agreements, net 654,000 723,000
Property and equipment, net 3,264,000 3,116,000
Other assets 115,000 --
------------ ------------
$ 25,470,000 $ 20,662,000
============ ============
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
Rent payable - Sunstone Hotel Investors, Inc. $ 12,174,000 $ 7,641,000
Due to affiliates 1,454,000 9,000
Accounts payable 8,740,000 8,836,000
Customer deposits 896,000 550,000
Sales taxes payable 2,398,000 1,640,000
Accrued payroll 2,357,000 3,093,000
Accrued vacation 1,811,000 1,795,000
Accrued bonuses 1,067,000 573,000
Capital lease obligation - current portion 56,000 55,000
Other accrued expenses 1,031,000 1,007,000
------------ ------------
31,984,000 25,199,000
Long-term liabilities
Capital lease obligation 352,000 366,000
Accrued pension liability 1,069,000 1,017,000
------------ ------------
33,405,000 26,582,000
------------ ------------
Minority interest 96,000 119,000
Commitments
Stockholders' deficit:
Common stock, no par value, 1,000 shares authorized; 100 shares
issued and outstanding -- --
Deficit (8,031,000) (6,039,000)
------------ ------------
$ 25,470,000 $ 20,662,000
============ ============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31,
-----------------------------------
1998 1997
------------ ------------
REVENUES:
Room $ 47,910,000 $ 16,566,000
Food and beverage 9,993,000 1,275,000
Other 7,192,000 1,003,000
------------ ------------
Total revenues 65,095,000 18,844,000
------------ ------------
EXPENSES:
Room 11,378,000 3,632,000
Food and beverage 8,540,000 1,034,000
Other 4,394,000 521,000
Franchise costs 1,418,000 668,000
Advertising and promotion 4,738,000 1,639,000
Utilities 2,429,000 891,000
Repairs and maintenance 2,575,000 655,000
Management fees - Sunstone Hotel Management, Inc. 937,000 356,000
Rent expense - Sunstone Hotel Investors, Inc. 23,687,000 7,572,000
General and administrative 6,991,000 1,831,000
------------ ------------
Total expenses 67,087,000 18,799,000
------------ ------------
NET (LOSS) INCOME $ (1,992,000) $ 45,000
============ ============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31,
----------------------------------
1998 1997
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $ (1,992,000) $ 45,000
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Bad debt 16,000 --
Depreciation 256,000 --
Amortization 99,000 --
Changes in assets and liabilities:
Receivables, net 13,000 (912,000)
Due from affiliates 2,456,000 --
Inventories (92,000) 21,000
Prepaid expenses and other assets (178,000) (72,000)
Rent payable - Sunstone Hotel Investors, Inc. 4,533,000 1,962,000
Accounts payable (96,000) (1,482,000)
Customer deposits 294,000 (98,000)
Sales taxes payable 758,000 361,000
Accrued payroll (736,000) (286,000)
Accrued vacation 16,000 83,000
Accrued bonuses 494,000 51,000
Due to affiliates (1,475,000) 251,000
Accrued pension liability 52,000 --
Other accrued expenses (16,000) (93,000)
------------ ------------
Net cash provided by (used in) operating activities 4,402,000 (169,000)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (33,000) (5,000)
Proceeds from lessor upon execution of certain leases 13,000 --
------------ ------------
Net cash used in investing activities (20,000) (5,000)
------------ ------------
CASH FLOWS USED IN FINANCING ACTIVITIES:
Payments on capital lease obligation (13,000) --
------------ ------------
Net cash used in financing activities (13,000) --
------------ ------------
Net change in cash and cash equivalents 4,369,000 (174,000)
Cash and cash equivalents, beginning of period 4,352,000 1,165,000
------------ ------------
Cash and cash equivalents, end of period $ 8,721,000 $ 991,000
============ ============
The accompanying notes are an integral part of these financial statements.
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SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO FINANCIAL STATEMENTS
(UNAUDITED)
---------------
1. ORGANIZATION AND BASIS OF PRESENTATION:
Sunstone Hotel Properties, Inc. (the "Lessee") was incorporated in
Colorado in October 1994 and commenced operations effective with the completion
of an initial public stock offering (the "Offering") by Sunstone Hotel
Investors, Inc. (the "Lessor") on August 16, 1995. The Lessee leases hotel
properties which are primarily located in the western United States from the
Lessor pursuant to long-term leases (the "Percentage Leases"). The Lessee is
owned by Robert A. Alter, Chairman and President of the Lessor (80%), and
Charles L. Biederman, Director and Executive Vice President of the Lessor (20%).
At March 31, 1998, 57 hotel properties were leased from the Lessor.
Basis of Presentation:
The consolidated financial statements include the accounts of the Lessee
and its subsidiaries. All significant intercompany transactions and balances
have been eliminated.
The interim consolidated financial statements of the Lessee have been
prepared without audit in accordance with generally accepted accounting
principles for interim information and with the instructions for Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The Lessee believes that the disclosures are
adequate to make the information presented not misleading when read in
conjunction with the Lessee's audited consolidated financial statements included
in the Lessor's Annual Report on Form 10-K for the year ended December 31, 1997.
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, 1998 are not
necessarily indicative of the results to be expected for the year ended December
31, 1998.
Reclassifications:
Certain prior period balances have been reclassified to conform with the
current period presentation.
2. ACCUMULATED DEFICIT:
From inception, the Lessee has incurred cumulative losses of $8.0
million. The $2.0 million loss for the quarter ended March 31, 1998 is
substantially due to the combined effects on the Lessee of (i) off-peak seasonal
activity typically experienced during the first quarter at certain hotels,
representing a $1.4 million loss and (ii) the effect of renovating seven of the
Company's hotels, representing a $442,000 loss. Additional losses are primarily
attributable to the transition to new management at recently acquired hotels and
to the operating leverage of certain Percentage Leases.
The Lessee has remained current in its payments to the Company under the
terms of the Percentage Leases. During 1998, management of the Lessee
anticipates generating positive operating cash flow; however, there can be no
assurance that operating expectations will be met.
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SUNSTONE HOTEL PROPERTIES, INC.
NOTES TO FINANCIAL STATEMENTS
3. PERCENTAGE LEASE AGREEMENTS
During and subsequent to the quarter ended March 31, 1998, the Lessee
executed eight additional Percentage Leases with the Lessor with terms similar
to the existing Percentage Leases. The aggregate future minimum rentals (base
rents) payable under these leases, exclusive of any base rent to be abated
during periods of major renovations is $6.8 million per year.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-Looking Statements
When used throughout this report, the words "believes", "anticipates"
and "expects" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to the many risks and uncertainties
which affect the Company's business and actual results could differ materially
from those projected and forecasted. These risks and uncertainties, which
include competition within the lodging industry, the balance between supply and
demand for the hotel rooms, the Company's continued ability to execute
acquisitions and renovations, the effect of economic conditions, and the
availability of capital to finance planned growth, are described but are not
limited to those disclosed in this report. These and other factors which could
cause actual results to differ materially from those in the forward-looking
statements are discussed under the heading "Risk Factors". Given these risks and
uncertainties, readers are cautioned not to place undue reliance on such
statements. The Company also undertakes no obligation to publicly release the
result of any revisions to these forward-looking statements that may be made to
reflect any future events or circumstances.
GENERAL
The Company is a self-administered equity REIT that owns and leases
luxury, upscale and mid-price hotels located primarily in the Pacific and
Mountain regions of the western United States. The hotels operate primarily
under national franchises that are among the most respected and widely
recognized in the lodging industry, including brands affiliated with Hilton
Hotels Corporation, Holiday Hospitality Corporation, Marriott International,
Inc. and Promus Hotel Corporation. As of May 12, 1998, the Company's portfolio
consisted of 61 hotels with a total of 11,005 rooms, 48 of which were acquired
and one which was developed subsequent to the Company's IPO in August 1995. The
majority of the Company's hotel portfolio consists of luxury, upscale and
mid-price full-service hotels and upscale extended-stay properties
(approximately 82%) with the remainder of the Company's portfolio consisting of
mid-price, limited service properties primarily located in markets where
significant barriers exist for new competitive supply.
The Company's growth strategy is to maximize shareholder value by (i)
acquiring underperforming and undercapitalized hotels that are in strong market
locations with significant barriers to entry, and (ii) improving such hotels'
financial performance by renovating, redeveloping, rebranding and repositioning
the hotels and through the implementation of focused sales and marketing
programs.
The Company's business strategy encompasses increasing revenue per
available room ("REVPAR") by increasing average daily rate ("ADR") and
occupancy. This strategy is typically implemented by replacing certain
discontinued group business with higher-rate group and transient business and by
selectively increasing room rates. Success with this strategy has been achieved
because of (i) the relatively high occupancy rates at certain of its hotels,
(ii) the success of a superior marketing strategy implemented at each acquired
hotel, and (iii) the effects of repositioning recently acquired hotels as
high-quality properties with strong national franchisers through the Company's
redevelopment and rebranding program.
RESULTS OF OPERATIONS OF THE COMPANY
Comparison of the Quarter Ended March 31, 1998 and 1997
During the first quarter of 1998, the Company:
- Acquired 4 hotels for aggregate purchase prices of $40.5
million;
- Invested $25.4 million in renovation and redevelopment to
recently acquired hotels;
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- Raised approximately $73.7 million of equity capital through the
sale of common stock in a follow-on offering; and
- Increased availability under the Company's unsecured bank credit
facility from $200.0 million to $300.0 million.
For the quarter ended March 31, 1998, income available to common
shareholders increased 84.9% to $6.1 million from $3.3 million for the
corresponding quarter of 1997, while diluted earnings per share decreased to
$.17 per share from $.22 per share, a 22.7% decrease. The decrease in diluted
earnings per share was primarily due to the effects of recognizing straight-line
depreciation expense for 12 hotels which were undergoing significant renovation
during the first quarter of 1998, as compared to eight hotels undergoing
significant renovation during the first quarter of 1997. Revenues increased
$15.9 million, or 203.9%, to $23.7 million from $7.8 million for the first
quarter of 1997. The increase in revenues is substantially attributable to the
execution of the Company's external growth strategy, as well as increases in
REVPAR of both continuously owned and recently acquired hotels. For a discussion
of Funds from Operations, see "Liquidity and Capital Resources."
External Growth. During the quarter ended March 31, 1998, the Company
acquired four hotels comprising 501 rooms for aggregate purchase prices of
approximately $40.5 million. For the last twelve months ended March 31, 1998,
the Company acquired 29 hotels with 6,063 rooms for aggregate purchase prices of
approximately $509.7 million, which contributed $14.5 million of the $15.9
million increase in revenues.
Internal Growth. On a same-unit-sales basis, the Company achieved a 9.8%
and a 2.2% increase in REVPAR for non-renovation hotels and for all hotels,
respectively, for the first quarter of 1998 over the corresponding quarter of
1997.
REVPAR for the non-renovation hotels increased significantly by 9.8%,
from $46.51 to $51.08, over the first quarter of 1997. Non-renovation hotels
consist of 37 of the Company's 57 hotels that were not undergoing significant
renovation either in the first quarter of 1997 or 1998. The 9.8% increase in
REVPAR was driven by a 11.1% increase in ADR, from $69.99 to $77.74, and offset
by an approximately one percentage point decrease in occupancy, to 65.7%.
The strong revenue performance of the Company's hotel portfolio in the
first quarter of 1998 was not only due to the results from the Company's
recently redeveloped hotels, but also due to the internal growth of continuously
owned and recently acquired hotels and hotel investments as indicated in the
following table:
SELECTED REVPAR PERFORMERS FOR FIRST QUARTER OF 1998
REVPAR
-------------------------------------------
Rooms 1997(1) 1998 % Change
---------- ---------- ---------- ----------
Holiday Inn Express - Poulsbo, Washington 63 $ 29.89 $ 40.17 34.4%
Holiday Inn - San Diego (Stadium), California 174 45.40 60.34 32.9
Kahler Inn & Suites - Rochester, Minnesota 266 41.06 50.75 23.6
Holiday Inn Hotel & Suites - Kent, Washington 125 42.87 52.00 21.3
Residence Inn - San Diego, California 144 83.15 101.02 21.5
(1) The Company did not own certain of these hotels for the entire period
presented.
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REVPAR for the first quarter of 1998 for the 1997-renovation hotels
(eight hotels), which were undergoing renovation during the first quarter of
1997, increased 4.4% over the corresponding quarter of 1997.
REVPAR for the first quarter of 1998 for the 1998-renovation hotels
(12 hotels), which were undergoing renovation during the first quarter of 1998,
decreased 10.6% over the corresponding quarter in 1997, a period during which
these hotels were not undergoing renovation. In the aggregate, REVPAR for the
first quarter of 1998 for the 1997- and 1998-renovation hotels (20 hotels)
decreased 6.5% over the corresponding quarter of 1997.
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, 1998.
SELECTED FINANCIAL INFORMATION
Three Months Ended
March 31,
------------------------------
1998 1997
------------ ------------
SAME-UNIT-SALES ANALYSIS
ALL HOTELS:
Occupancy 63.5% 68.4%
ADR $ 81.86 $ 74.30
REVPAR $ 51.98 $ 50.84
REVPAR growth 2.2%
NON-RENOVATION HOTELS:
Occupancy 65.7% 66.5%
ADR $ 77.74 $ 69.99
REVPAR $ 51.08 $ 46.51
REVPAR growth 9.8%
RENOVATION HOTELS(1):
Occupancy 60.3% 71.2%
ADR $ 88.23 $ 79.99
REVPAR $ 53.24 $ 56.97
REVPAR growth (6.5)%
- ----------------
(1) Includes the twelve hotels undergoing renovation in the first quarter
of 1998 and the eight hotels undergoing renovation in the first quarter
of 1997.
During the first quarter of 1998, interest expense and amortization of
financing costs increased to $4.6 million from $840,000 for the corresponding
quarter of 1997. Additionally, real estate and personal property taxes and
insurance increased $2.1 in the first quarter of 1998. These increases are
attributable to the growth of the Company's hotel portfolio to 57 hotels during
the first quarter of 1998 compared to 28 hotels owned during the corresponding
quarter of 1997. Acquisitions are typically initially financed with debt
contributing to the increase in interest expense and amortization of financing
costs.
During the first quarter of 1998, the Company recorded increased general
and administrative expenses attributable to the growth of the Company's hotel
portfolio and depreciation of non-real estate assets. Necessitated by the
Company's growth, additional personnel, including the Company's General Counsel
and Director of Finance, were added to the staff of the Company subsequent to
the first quarter of 1997. Additionally, in conjunction with the acquisition of
a hotel company during the fourth quarter of 1997, certain non-real estate
assets were acquired. Depreciation of these assets are included in general and
administrative expenses. Increases in other general and
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administrative expenses were also incurred commensurate with the growth of the
Company from 28 hotels at the end of the first quarter of 1997 to 57 hotels at
the end of the first quarter of 1998. As a result of the preceding, general and
administrative expenses increased to $1.5 million from $532,000 for the first
quarter of 1998 in comparison to the corresponding quarter of 1997.
In March 1998, the Financial Accounting Standards Board Emerging Issues
Task Force ("EITF") reached a consensus on Issue 97-11 that internal
preacquisition costs related to the purchase of an operating property should be
expensed as incurred. The Company expects that the adoption of the consensus on
Issue 97-11 will result in increased general and administrative expenses in
future periods.
Renovations, Rebranding and Upgrades
Sunstone continued to implement its strategy of renovating, rebranding
and repositioning its recently acquired hotels and, during the first quarter of
1998, invested $25.4 million in renovations to certain of these hotels during
the first quarter of 1998.
In conjunction with such renovation activity, the Company branded the
previously independent 194-room Kahler Plaza Hotel as the full-service Marriott
Rochester. The hotel recently underwent a $1.7 million renovation, which
included upgraded guestroom soft goods, furniture and guest baths, and extensive
renovation of the lobby and restaurant. In the first month as a full-service
Marriott, April 1998, ADR increased 24.9%, to $153.51 from $122.90 for the
corresponding month of the prior year. The significant ADR increase translated
into a corresponding 18.2% increase in REVPAR. The Marriott Rochester is the
first of five hotels from the Kahler portfolio of 17 hotels acquired during the
fourth quarter of 1997, to be branded as a full-service Marriott. Subsequent to
the first quarter of 1998, the 333-room Provo Park Hotel in Utah was flagged as
a luxury, full-service Marriott and the 220-room University Park Hotel in Utah
was branded as the Marriott University Park. Both these hotels underwent major
renovations, totaling approximately $5.8 million, during the fourth quarter of
1997 and the first quarter of 1998. Sunstone expects one additional hotel to be
branded by the end of the second quarter of 1998 and the remaining hotel to
carry the Marriott flag by the end of 1998.
During the second quarter of 1998, the Company also rebranded the former
Ramada Hotel - San Diego (Old Town), California to a Holiday Inn and Suites and
branded the previously independent Vacation Inn - San Diego (Old Town),
California as a Ramada Hotel. Additionally, the Company anticipates rebranding
the independent Fountain Suites - Sacramento, California to a Hawthorn Suites
and upgrading the Holiday Inn - La Mirada, California to a Holiday Inn Select
during the second quarter of 1998.
Management believes that its internal growth strategy of improving each
hotel's revenue performance by renovating, rebranding, and repositioning the
asset not only has an immediate impact on financial performance, but also will
create long term value and growth.
National Franchise Affiliations. The Company generally believes that
franchise affiliations provide advantages to certain hotels. Such advantages
include brand recognition, access to national reservation systems, national
direct sales efforts and national volume purchasing agreements, and technical
and business assistance. The use of multiple franchise systems provides the
Company with further diversification, less dependence on the continued
popularity of one brand and less vulnerability to new requirements of any
individual franchise affiliation. The Company expects to focus its franchise
affiliations on nationally recognized upscale hotel chains.
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The following table summarizes certain information with respect to the
current or anticipated franchise affiliations of the hotels:
FRANCHISE AFFILIATIONS
(As of and for the Three Months Ended March 31, 1998)
Percentage
Number of Percentage of Lease of Lease
Franchise Affiliation (1) Hotels Rooms Rooms Revenues Revenues
----------- ----------- ----------- ----------- -----------
Marriott - (2) (3) 15 2,605 25.2% $ 7,066,000 29.8%
Holiday Inns 15 2,366 22.8 4,370,000 18.5
Hampton Inns 8 1,063 10.3 2,733,000 11.5
Kahler 2 965 9.3 2,464,000 10.4
Independent 4 887 8.6 1,211,000 5.1
Hawthorn Suites (4) 3 583 5.6 1,257,000 5.3
Hilton 2 572 5.5 1,492,000 6.3
Best Western 3 364 3.5 598,000 2.5
Sheraton 1 295 2.8 1,433,000 6.0
Doubletree Hotels 1 213 2.1 191,000 0.8
Comfort Suites 1 166 1.6 469,000 2.0
Quality Inn 1 152 1.5 132,000 0.6
Ramada 1 124 1.2 271,000 1.2
----------- ----------- ----------- ----------- -----------
57 10,355 100.0% $23,687,000 100.0%
=========== =========== =========== =========== ===========
- ---------------
(1) Certain of the Company's planned changes in franchise affiliations are
included in this table. There can be no assurance that the Company will
receive final approval from the applicable franchisor.
(2) Includes full-service Marriott hotels, Residence Inn, Fairfield Inn and
Courtyard by Marriott.
(3) Includes two hotels from the Kahler portfolio with 491 rooms which the
Company anticipates converting to full-service Marriott franchises. The
Company has obtained approval of these new franchise licenses, subject
to completion of renovations or improvements.
(4) Includes the Anaheim and Sacramento, California hotels which will be
rebranded as Hawthorn Suites hotels upon completion of renovation and
improvements which are expected to be completed in the second quarter of
1998.
Seasonality and Regional Focus
The Company currently focuses its acquisition efforts principally on the
Pacific and Mountain regions which collectively comprise the western United
States where favorable demand demographic trends currently exist. The geographic
distribution of the hotels, which are located in 12 states, reflects the
Company's belief that a certain amount of geographic distribution helps to
insulate the Company's hotel portfolio from local market fluctuations and
off-peak seasonal operations that are typical for the hotel industry. The
Company has also sought to increase its geographic distributions by focusing on
major metropolitan areas.
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The following table summarizes the Company's presence in each of these
12 markets:
GEOGRAPHIC DIVERSIFICATION
(As of and for the Three Months Ended March 31, 1998)
PERCENTAGE PERCENTAGE
NUMBER OF OF LEASE OF LEASE
REGION HOTELS ROOMS ROOMS REVENUES REVENUES
----------- ----------- ----------- ----------- -----------
Mountain (1)...... 24 4,319 41.7% $10,356,000 43.7%
Pacific (2)....... 27 4,236 40.9 9,158,000 38.7
Minnesota......... 4 1,329 12.8 3,543,000 14.9
Other (3)......... 2 471 4.6 630,000 2.7
----------- ----------- ----------- ----------- -----------
Total......... 57 10,355 100.0% $23,687,000 100.0%
=========== =========== =========== =========== ===========
GEOGRAPHIC DIVERSIFICATION
(As of May 14, 1998)
PERCENTAGE
NUMBER OF OF
REGION HOTELS ROOMS ROOMS
------------ ------------ ------------
Pacific (2)......... 31 4,886 44.4%
Mountain (1)........ 24 4,319 39.3
Minnesota........... 4 1,329 12.1
Other (3)........... 2 471 4.2
------------ ------------ ------------
Total.......... 61 11,005 100.0%
============ ============ ============
- ------------
(1) Includes Arizona, Colorado, Idaho, Montana, New Mexico and Utah.
(2) Includes California, Oregon and Washington
(3) The Company is considering the sale or exchange of the two Kahler Hotels
located in Texas and West Virginia.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Provided by Operating Activities. The Company's operating
activities provide the principal source of cash to fund the Company's operating
expenses, interest expense, recurring capital expenditures and dividend
payments. The Company anticipates that its cash flow provided by leasing the
hotels to the Lessee will provide the necessary funds on a short- and long-term
basis to meet its operating cash requirements. In the first quarter of 1998, the
Company paid dividends and distributions totaling $9.6 million representing
$0.275 per share or Unit on a quarterly basis.
Cash Flows from Investing and Financing Activities. 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 also 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
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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.
Additionally, the Company intends to finance the acquisition of
additional hotel properties, hotel renovations and non-recurring capital
improvements principally through its $300 million unsecured revolving line of
credit facility (the "Credit Facility") from its lenders (led by Bank One of
Arizona, N.A., as the agent bank) and, when market conditions warrant, to issue
additional equity or debt securities. On January 26, 1998, the Company increased
the Credit Facility from $200.0 million to $300.0 million and reduced its
borrowing rate. The Credit Facility accrues interest at a rate as low as LIBOR
plus 1.40% per annum based upon the leverage of the Company, with provisions for
reduced rates upon receipt by the Company of an investment grade rating. During
the first quarter of 1998, the Company raised $66.0 million through issuance of
debt and $69.6 million through issuance of common stock. As of March 31, 1998,
the Company had $107.2 million of unused credit on the Credit Facility and had
$97.1 million available under the Credit Facility (net of $10.1 million reserved
availability for the development of hotels) and approximately $106.2 million
available under the Company's shelf registration statement.
Up to $15.0 million of the Credit Facility may be used for working
capital purposes. The Credit Facility has a two year term, maturing July 1,
1999, with a one-year extension option in favor of the Company. The Credit
Facility may be retired in whole or in part from the proceeds of public or
private issuances of equity or debt securities by the Company and may be
refinanced in whole or in part with fixed-rate financing. The Company may seek
to obtain such a stand-alone debt facility if market conditions are appropriate
in management's view.
As part of its investment strategy, the Company plans to acquire
additional hotels. Future acquisitions are expected to be funded through the use
of the Credit Facility or other borrowings and the issuance of additional equity
or debt securities. The Company's Articles of Incorporation limits consolidated
indebtedness to 50% of the Company's investment in hotel properties, at cost on
a consolidated basis, after giving effect to the Company's use of proceeds from
any indebtedness. Management believes that it will have access to capital
resources sufficient to satisfy the Company's cash requirements and to expand
and develop its business in accordance with its strategy for future growth.
During the first quarter of 1998, the Company used cash in the amount of $66.7
million to acquire hotel assets, including redevelopment and recurring capital
expenditures.
During the first quarter of 1998, the Company invested approximately
$25.4 million in major renovations of 12 of its hotels. The Company is currently
completing the renovation of those hotels started during the first quarter of
1998 and anticipates renovating additional recently acquired hotels for
approximately $40.8 million. In conjunction with the on-going renovation
activity, the Company has various contracts and commitments outstanding with
third parties. The Company plans to fund remaining commitments under these
agreements through the use of the Credit Facility and the issuance of additional
equity and debt securities. Management believes the renovation should result in
incremental increases in REVPAR at these renovation hotels and increased lease
revenue for the Company. In addition, the Company may acquire additional hotels
and invest additional cash for renovations during 1998.
Year 2000
Management has examined the Year 2000 issue and believes that it will
not have a material effect on the business, results of operations or financial
condition of the Company.
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Funds from Operations ("FFO")
Management believes that FFO is a useful measure of financial
performance of an equity REIT, such as the Company. FFO (as defined) (1) grew by
161.4% to $14.9 from $5.7 million.
Three Months Ended
March 31,
-----------------------------------
1998 1997(2)
------------ ------------
Net Income $ 6,597,000 $ 3,276,000
Less dividends on preferred shares (487,000) --
------------ ------------
Net income available to common shareholders 6,110,000 3,276,000
Add back:
Depreciation 7,919,000 1,956,000
Minority interest 351,000 489,000
Dividends on preferred shares 487,000 --
------------ ------------
FFO diluted for conversion of preferred shares $ 14,867,000 $ 5,721,000
============ ============
- -------------
(1) Management and industry analysts generally consider funds from
operations to be a useful measure of the financial performance of an
equity REIT that provides a relevant basis for comparison among REITs
and it is presented to assist investors in analyzing the performance of
the Company. Funds From Operations is defined as income before minority
interest (computed in accordance with generally accepted accounting
principles), excluding gains (losses) from debt restructuring and sales
of property plus real estate related depreciation and amortization
(excluding amortization of financing costs). Funds From Operations does
not represent cash generated from operating activities in accordance
with generally accepted accounting principles and is not necessarily
indicative of cash available to fund cash needs. Funds From Operations
should not be considered an alternative to net income as an indication
of the Company's financial performance or as an alternative to cash
flows from operating activities as a measure of liquidity.
(2) Certain amounts have been restated to reflect the allocation of a fourth
quarter depreciation expense adjustment to the first three quarters of
1997.
The Lessee
For a discussion of the Lessee's revenue operations and a comparison of
the quarter ended March 31, 1998 to 1997, see "Results of Operations" of the
Company. Additionally, for the first quarter of 1998, the Lessee reported a net
loss of $2.0 million. Notwithstanding the net loss, cash flows were provided by
operating activities during the first quarter of 1998 in the amount of $4.4
million.
From inception, the Lessee has incurred cumulative losses of $8.0
million. The $2.0 million loss for the quarter ended March 31, 1998 is
substantially due to the combined effects on the Lessee of (i) off-peak seasonal
activity typically experienced during the first quarter at certain hotels,
representing a $1.4 million loss and (ii) the effect of renovating several of
the Company's hotels, representing a $442,000 loss. Additional losses are
primarily attributable to the transition to new management at recently acquired
hotels and to the operating leverage of certain Percentage Leases.
Typically, the Company's renovations and redevelopments of acquired
hotels are extensive, involving refurbishing exteriors, renovations to
restaurants and lobbies and extensive renovations to guest rooms, including
guest bath, furniture and soft goods. The Company typically expends 10% to 30%
of the purchase price on renovations which typically last approximately three to
six months. During the renovations, the Lessee's revenues are significantly
reduced. In addition, there is typically a brief ramp up period of approximately
one to three months before the renovated hotels produce positive cash flow for
the Lessee. Management of the Company and the Lessee believe that the renovation
related losses represent costs that have a reasonable assurance of future
economic benefit that will be derived from significantly improved operating
performance of the renovated and redeveloped hotels.
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The Lessee has access to a $1.5 million working capital line of credit.
Executives of the Lessee have pledged $7.6 million of units to secure
obligations of the Lessee to the Company under the Percentage Leases. The Lessee
anticipates that cash provided by operations will be an adequate source of
liquidity for the foreseeable future.
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PART II -- OTHER INFORMATION
ITEM 5. OTHER INFORMATION
RISK FACTORS
IMPEDIMENTS TO GROWTH AND INCREASING CASH AVAILABLE FOR DISTRIBUTION
The Company's ability to increase cash available for distribution on its
Common Stock ("Cash Available for Distribution") will depend significantly on
the Company's ability to acquire or develop additional hotels at attractive
prices. Risks associated with this growth strategy include:
Competition For Future Acquisitions. There will be competition for
investment opportunities in mid-price and upscale hotels from entities organized
for purposes substantially similar to the Company's objectives as well as other
purchasers of hotels. The Company is competing for such hotel investment
opportunities with entities which have substantially greater financial resources
than the Company or better relationships with franchisors, sellers or lenders.
These entities may also generally be able to accept more risk than the Company
prudently can manage. Competition may generally reduce the number of suitable
hotel investment opportunities offered to the Company and increase the
bargaining power of property owners seeking to sell.
Renovation and Redevelopment Risks. The Company faces risks arising from
its strategy of acquiring hotels in need of substantial renovation or
redevelopment, particularly the risk that the cost or time to complete the
renovation or redevelopment will exceed the budgeted amount. Such delays or cost
overruns may arise from shortages of materials or skilled labor, a change in the
scope of the original project, the need to comply with building codes or other
legal requirements, the discovery of structural or other latent problems with a
hotel once construction has commenced and other risks inherent in the
construction process. These risks are increased by the significant number of
renovations the Company is currently undertaking as a result of the significant
number of hotels recently acquired by the Company. In addition, renovation and
redevelopment must comply with the Americans with Disabilities Act of 1990 (the
"ADA"), which provides that all public accommodations meet certain federal
requirements related to access and use by disabled persons. The Company may be
required to make substantial modifications at the hotels to comply with the ADA.
Cost overruns incurred during renovation and redevelopment projects increase the
Company's total investment in a hotel and may reduce the Company's anticipated
return on such investment. Delays in completing such renovation and
redevelopment projects decrease the Lessee's operations at the hotel resulting
in lower revenues which either increases the Lessee's operating losses or, if a
rental abatement is provided, reduces rent received by the Company. Delays or
cost overruns in connection with renovations or redevelopment, and any related
rental abatements, could have a material adverse effect on Cash Available for
Distribution.
Development Risks. A component of the Company's growth strategy is to
develop new hotels in markets where room supply and other competitive factors
justify new construction or to purchase such hotels from unaffiliated developers
after they have been completed. New project development will increase the
Company's indebtedness and is subject to a number of other risks, including
risks of construction delays or cost overruns, the risk that required zoning,
occupancy and other governmental permits might not be obtained, and the risk
that projects might not be completed. Additional risks of development projects
include the risks associated with effectively marketing a hotel in order to ramp
up occupancy at projected room rates after the hotel has been opened. Any
failure to complete a development project in a timely manner and within budget
or to ramp up occupancy after completion of the project could have a material
adverse effect on the Company's results of operations and Cash Available for
Distribution.
TOTAL DEPENDENCE ON THE LESSEE AND PAYMENTS UNDER THE PERCENTAGE LEASES
Certain tax rules relating to the qualification of a REIT prohibit the
Company and Sunstone Hotel Investors, L.P. (the "Partnership") from operating
hotels. Therefore, the Partnership enters into Percentage Leases with the
Lessee, and the Lessee operates the hotels and pays rent to the Partnership
based, in large part, on the revenues from the hotels. Consequently, the Company
relies entirely on the Lessee to effectively operate the Company's hotels in
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a manner which generates sufficient cash flow to enable the Lessee to timely
make the rent payments under the applicable Percentage Leases. Ineffective
operation of the hotels may result in the Lessee being unable to pay rent at the
higher tier level necessary for the Company to fund distributions to
shareholders because payment of base rent alone is insufficient for such
purposes. In the event that all or a portion of such higher tier rent is not
received by the Partnership, the Company may not be able to make such
distributions to its partners (thus jeopardizing the Company's ability to pay
dividends to its shareholders). There can be no assurance that the Company will
receive such higher tier rent from the Lessee or that the Lessee will even be
able to pay base rent in light of its historical performance of incurring
operating losses since its inception. The Lessee controls the daily operations
of the hotels under the Percentage Leases, which have non-cancelable initial
terms of ten years. The Company selected the Lessee without consideration of
other lessees because Mr. Alter and Mr. Biederman, who own the Lessee, owned and
were involved in the management of a number of the hotels contributed to the
Company in connection with its IPO in 1995 (the "IPO") and because Mr. Alter and
Mr. Biederman own significant Units in the Partnership and options to acquire
Common Stock of the Company, and therefore have an incentive to cause the Lessee
to maximize rents. Except as set forth in the Percentage Leases, neither the
Company nor the Partnership has the authority to require the Lessee to operate
the hotels in a manner that results in a maximization of rent to the Company.
Other than working capital to operate the hotels, the Lessee has only nominal
assets, which will likely be insufficient to satisfy any claims the Company may
have if the Lessee defaults under the Percentage Leases. Mr. Alter and Mr.
Biederman have entered into an agreement (the "Third Party Pledge Agreement")
whereby the obligations of the Lessee under the Percentage Leases are secured
with a pledge of Mr. Alter?s and Mr. Biederman?s Units (up to 481,955 Units) in
the Partnership. This may limit the Company's ability to recover in full for any
claims it may have against the Lessee for defaults under the Percentage Leases.
The amendment to the Third Party Pledge Agreement also subordinated the
Company's lien on the majority of Mr. Alter?s Units to the lien in favor of an
institutional lender providing a working capital line to the Lessee guaranteed
by Mr. Alter and secured by a pledge of a significant portion of Mr. Alter?s
Units. The obligations of the Lessee under the Percentage Leases are not secured
by any additional security deposits or guarantees by third parties. The Lessee
had a net operating loss of $2.0 million for the three months ended March 31,
1998, and a net working capital deficit of $8.0 million as of March 31, 1998.
Consequently, both the Company and the Lessee are substantially dependent upon
the operations of the hotels. See "Hotel Industry Risks."
MULTIPLE-HOTEL ACQUISITION RISKS
The Company has increasingly emphasized and intends to continue to
emphasize acquisitions of multiple hotels in a single transaction in order to
reduce acquisition expenses per hotel and enable the Company to more rapidly
expand its hotel portfolio. Consistent with this emphasis, on October 15, 1997,
the Company closed the Kahler Acquisition which almost doubled the Company's
room total. Multiple-hotel acquisitions, such as the Kahler Acquisition, are;
however, more complex than single-hotel acquisitions and the risk that a
multiple-hotel acquisition will not close may be greater than in a single-hotel
acquisition.
Such portfolio acquisitions, whether by stock or asset purchase, may
also result in the Company owning hotels in geographically dispersed markets.
For instance, several of the Kahler Hotels are located in areas geographically
removed from most of the Company's hotel portfolio. This geographic diversity
will place significant additional demands on the Company's ability to manage
such operations. In addition, the Company's costs for a hotel portfolio
acquisition that does not close are generally greater than for an individual
hotel acquisition, which does not close. If the Company fails to close
multiple-hotel acquisitions, its ability to increase Cash Available for
Distribution will be limited. See "Dependence on Acquisitions to Increase Cash
Available For Distribution." Another risk associated with multiple-hotel
acquisitions is that a seller may require that a group of hotels be purchased as
a package, even though one or more of the hotels in the package does not meet
the Company's investment criteria. In such cases, the Company may purchase the
group of hotels with the intent to re-sell those, which do not meet its
criteria. It is anticipated that any hotel acquired in the Kahler Acquisition
that does not fit geographic or operating parameters of the Company may be sold
or exchanged, including the Kahler Hotels located in Texas and West Virginia. In
such circumstances, however, there can be no assurance as to how quickly the
Company could sell or exchange such hotels or the terms on which they could be
sold or exchanged. Such hotels might reduce Cash Available for Distribution if
they operate at a loss during the time the Company owns them, or if the Company
sells them at a loss. In addition, any gains on the sale of such hotels within
four years of the date of acquisition may be subject to a 100% tax.
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The Company may finance multiple-hotel acquisitions by issuing shares of
Common Stock or Units in the Partnership which are convertible into Common
Stock. Such issuances may have an adverse effect on the market price of the
Common Stock.
FAILURE TO MANAGE RAPID GROWTH; FAILURE TO SUCCESSFULLY INTEGRATE KAHLER
To successfully implement its acquisition strategy, the Company must
integrate the hotels acquired since the IPO and any other subsequently acquired
hotels into its existing operations. Since the closing of the IPO, the Company's
portfolio of hotel properties has increased dramatically. During such period,
the Company also entered geographic markets where it previously did not have any
properties. As a result, the consolidation of functions and integration of
departments, systems and procedures of acquired properties with the Company's
existing operations presents a significant management challenge, and the failure
to integrate such properties into the Company's management and operating
structures could have a material adverse effect on the results of operations and
financial condition of the Company.
The Company continues to accelerate its acquisition activity. As a
result, the Company's recent acquisitions, including that of the Kahler Hotels,
will place significant demands on the Company's management and other resources.
There can be no assurances that these hotels and other business operations can
be integrated successfully, that there will be any operating efficiencies
between the hotels or that the combined businesses can be operated profitably.
The failure to integrate and operate these hotels successfully could have a
material adverse effect on the Company's business and future prospects. Also,
certain of these hotels are in the same geographic regions and may, therefore,
compete with one another. There can be no assurance that the Kahler Acquisition
or any other acquisition (in particular any subsequent multiple hotel portfolio
acquisition) will not adversely affect the operations, revenues or prospects of
the Company's other hotels located in such geographic areas.
GEOGRAPHIC CONCENTRATION OF KAHLER; NEW MARKETS
The concentration of four Kahler Hotels with 1,329 rooms in Rochester,
Minnesota and six Kahler Hotels with 1,509 rooms in and around the Salt Lake
City area of Utah, makes Kahler dependent on factors such as the local economy,
local competition, increases in local real and personal property tax rates and
local catastrophes. The results of operations of the Kahler Hotels in Rochester,
Minnesota, are also dependent on the level of demand generated by the Mayo
Clinic for hotel accommodations by patients and by medical conferences organized
by the Mayo Clinic, and may be negatively affected by weather conditions,
particularly in the winter months. Significant disruption in these local markets
that result in decreased operating performance of the Kahler Hotels will have a
material adverse effect on the Company's results of operations and Cash
Available for Distribution.
CONFLICTS OF INTEREST BETWEEN THE COMPANY AND CERTAIN OFFICERS AND DIRECTORS
Because of Mr. Alter's and Mr. Biederman's ownership in and positions
with the Company and the Lessee and Mr. Alter's ownership of the Management
Company, there are inherent conflicts of interest between the Lessee, the
Management Company and the Company in the leasing, acquisition, disposition,
operation and management of the Company's hotels. See "Total Dependence on the
Lessee and Payments Under the Percentage Leases." Accordingly, the interests of
shareholders may not have been, and in the future may not be, reflected fully in
all decisions made or actions taken by the officers and directors of the
Company. In the event revenues from the Company's hotels increase significantly
over prior periods and operating expenses with respect thereto are less than
historical or projected operating expenses, the Lessee could disproportionately
benefit. In addition, the Lessee pays a management fee of between 1% and 2% of
gross revenues from the Company's hotels and reimburses certain accounting
expenses to the Management Company, which is 100% owned by Mr. Alter. As a
result, there may be conflicts of interest in connection with the sale of
certain hotels. Unrealized gain from the sale to the Company of certain hotels
contributed to the Company in connection with its IPO is specially allocated to
Mr. Alter and Mr. Biederman and any sale of such hotels by the Partnership may
cause adverse tax consequences to them. In addition,
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the reduction of mortgage indebtedness by the Partnership at any time below
certain levels would create adverse tax consequences to Mr. Alter and Mr.
Biederman. These conflicts may result in decisions relating to the sale of
certain hotels and/or the incurrence or repayment of indebtedness which do not
reflect solely the interests of the Company and the shareholders. In addition,
the Company will generally be required under the Percentage Leases to pay a
lease termination fee to the Lessee if the Company elects to sell a hotel and
not replace it with another hotel. The payment of a termination fee to the
Lessee, which is owned by Mr. Alter and Mr. Biederman, may also result in
decisions regarding the sale of a hotel which do not reflect solely the
interests of the Company and its shareholders.
RELIANCE ON MR. ALTER AND OTHER KEY PERSONNEL
The Company's future success and its ability to manage future growth
depends in large part upon the efforts of its senior management and its ability
to attract and retain key executive officers and other highly qualified
personnel. In particular, the Company places substantial reliance on the hotel
industry knowledge and experience and the continued services of Robert A. Alter,
the Company's Chairman and President. Competition for such personnel is intense
and there can be no assurance that the Company will be successful in attracting
and retaining such personnel. Accordingly, there can be no assurance that the
Company's senior management will be able to successfully execute or implement
the Company's growth and operating strategies. In addition, the loss of Mr.
Alter?s services or the Company's inability to attract and retain highly
qualified personnel may adversely affect the operations of the Company and Cash
Available for Distribution.
HOTEL INDUSTRY RISKS
Operating Risks and Competition. Many of the Company's competitors have
substantially greater marketing and financial resources than the Company and the
Lessee. In addition, the Company's hotels are subject to all operating risks
common to the hotel industry. The hotel industry has experienced volatility in
the past, as have the Company's hotels. Hotel industry risks include, among
other things, competition from other hotels; over-building in the hotel
industry, which has adversely affected occupancy, average daily rate ("ADR") and
revenue per available room ("REVPAR") increases in operating costs due to
inflation and other factors, and may not necessarily be offset by increased room
rates; dependence on business and commercial travelers and tourism; strikes and
other labor disturbances of hotel employees for hotels owned by the Company;
increases in energy costs and other expenses of travel, and adverse effects of
general and local economic conditions. These factors could decrease room
revenues of the hotels and adversely affect the Lessee's ability to make
payments of rent under the Percentage Leases to the Company, and therefore
reduce Cash Available for Distribution.
Seasonality of Hotel Business and the Company's Hotels. The hotel
industry is seasonal in nature. Generally, revenues for the Company's hotels are
greater in the first and third quarters than in the second and fourth quarters.
In addition, weather conditions in the midwest and eastern parts of the United
States can cause fluctuations in revenues, particularly in the winter months.
This seasonality can be expected to cause quarterly fluctuations in the
Company's Percentage Lease revenues which may be insufficient to provide all of
the Cash Available for Distribution necessary to pay dividends in a given
quarter.
Increased Competition Resulting From Overbuilding. The hotel industry
has historically experienced cycles of overbuilding in certain geographic
markets and product segments. Such overbuilding increases competition for hotel
guests, resulting in lower occupancies and lower ADRs, thereby reducing the
profitability of the hotels affected by the increased competition. While the
Company's investment strategy is to acquire underperforming hotels or hotels
where there are significant barriers to entry, there can be no assurance that
the current hotel development activities, particularly in the Company's limited
service segment, will not create additional significant competition for the
Company's hotels. Such increased competition would reduce the revenue generated
by the Lessee, thus reducing percentage rent paid to the Company and Cash
Available for Distribution.
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IMPACT OF INCREASED OPERATING COSTS AND CAPITAL EXPENDITURES
Hotels in general, including the Company's hotels, have an ongoing need
for renovations and other capital improvements, including periodic replacement
of furniture, fixtures and equipment. In this regard, the Company may spend
significant dollars renovating, rebranding or repositioning a number of the
hotels to maximize financial performance; however, the Company is unable to
estimate the amounts to be expended at this time. In addition, the franchise
agreements under which the Company's hotels are operated impose specified
operating standards and may permit the franchisor to condition the continuation
of a franchise agreement on the completion of capital improvements. Under the
terms of the Percentage Leases, the Company is obligated to pay the cost of
certain capital expenditures at its hotels and to pay for furniture, fixtures
and equipment. The ability of the Company to fund these and other capital
expenditures and periodic replacement of furniture, fixtures and equipment will
depend in part on the financial performance of the Lessee and the hotels. If
these expenses exceed the Company's estimate, the additional expenses could have
an adverse effect on Cash Available for Distribution. Furthermore, any inability
or failure to fund these expenditures could have a material adverse effect on
occupancy rates, ADRs and REVPAR and may constitute a breach under the franchise
agreements.
FRANCHISE RISKS
Fifty-four of the Company's hotels are operated pursuant to franchise or
license agreements and additional hotels may be or will become subject to
franchise arrangements. The Lessee will hold the franchise or license agreements
for the hotels and will be responsible for complying with the terms of these
agreements. Such franchise or license arrangements are often helpful in
providing marketing services and room reservations to hotels, but these
arrangements also impose financial obligations on hotels generally related to
maintaining the condition of hotels and the payment of franchise fees.
Continuation of such franchises is subject to specified operating standards and
other terms and conditions. Franchisors periodically inspect franchised hotels
to confirm compliance. In addition, franchisors may require the Company to fund
significant capital improvements to the hotels in the future to maintain such
franchises. The failure of a franchisee to maintain standards or adhere to terms
and conditions imposed by the franchisor may result in the loss of a license or
termination of the franchise or damages as a result of the breach. It is
possible that a franchisor could condition the continuation of a franchise on
the completion of capital improvements or replacements of furniture, fixtures
and equipment which the Board of Directors determines are too expensive or
otherwise unwarranted in light of general economic conditions or operating
results or prospects of the affected hotel. The loss of a franchise could have a
material adverse effect upon the operation, financing or value of the hotel
subject to the franchise because of the loss of associated name recognition,
marketing support and centralized reservation systems. There can be no assurance
that an alternative franchise arrangement can be obtained or that significant
expenditures might not be imposed as a condition to obtaining a new franchise.
The loss of a franchise for one or more of the hotels could have a material
adverse effect on the Company's revenues under the Percentage Leases and Cash
Available for Distribution to its shareholders.
DEPENDENCE ON ACQUISITIONS TO INCREASE CASH AVAILABLE FOR DISTRIBUTION
The Company's success in implementing its growth plan will depend
significantly on the Company's ability to acquire additional hotels at
attractive prices. After the ramp-up of certain of the hotels which were
recently redeveloped or renovated and repositioned or which are expected to be
redeveloped or renovated and repositioned in the near future, internal growth in
ADR and occupancy for the hotels is not expected to provide as much growth in
Cash Available for Distribution as will acquisition of additional hotels.
However, since the Company intends to borrow funds to purchase, redevelop or
renovate and reposition hotels, the Company will be subject to the risks
associated with increased indebtedness, such as paying debt service even if cash
flow from such additional hotels is not sufficient to cover such costs.
FAILURE TO MAINTAIN REIT STATUS
The Company intends to operate so as to be taxed as a REIT under
Sections 856-860 of the Internal Revenue Code of 1986 as amended (the "Code").
As long as the Company qualifies for taxation as a REIT, with certain
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exceptions, the Company will not be taxed at the corporate level on its taxable
income that is distributed to its shareholders. A REIT is subject to a number of
organizational and operational requirements, including requirements as to the
nature of its income and assets, distribution requirements, diversity of stock
ownership requirements and record-keeping requirements. While the Company
intends to satisfy all of these requirements for treatment as a REIT, it is
possible that the Company may in the future fail to satisfy one or more of these
requirements. Failure to qualify as a REIT would render the Company subject to
tax (including any applicable minimum tax) on its taxable income at regular
corporate rates and distributions to the shareholders in any such year would not
be deductible by the Company. Unless entitled to relief under certain Code
provisions, the Company also would be disqualified from treatment as a REIT for
the four taxable years following the year during which qualification was lost.
Even if the Company qualifies for taxation as a REIT, the Company may be subject
to certain state and local taxes on its income and property.
In order for the Company to be taxed as a REIT, the Partnership must be
classified as a partnership for federal income tax purposes. If the Partnership
were to be taxable as a corporation, because the Company's ownership interest in
the Partnership constitutes more than 10% of the Partnership's voting securities
and exceeds 5% of the value of the Company's assets, the Company would cease to
qualify as a REIT. The imposition of corporate income tax on the Company and the
Partnership would substantially reduce the amount of Cash Available for
Distribution.
OWNERSHIP LIMITATION RESULTING IN LOSS OF REIT STATUS
In order for the Company to maintain its qualification as a REIT, not
more than 50% in value of its outstanding stock may be owned, directly or
indirectly, by five or fewer individuals (as defined in the Code to include
certain entities). Furthermore, if any shareholder or group of shareholders of
the Lessee owns, actually or constructively, 10% or more of the stock of the
Company, the Lessee could become a related party tenant of the Partnership,
which likely would result in loss of REIT status for the Company. For the
purpose of preserving the Company's REIT qualification, the Company's Articles
of Incorporation prohibit direct or indirect ownership of more than 9.8% of the
outstanding shares of any class of the Company's stock by any person or group
(the "Ownership Limitation"). Generally, the capital stock owned by affiliated
owners will be aggregated for purposes of the Ownership Limitation. Subject to
certain exceptions, any transfer of Common or Preferred Stock that would prevent
the Company from continuing to qualify as a REIT under the Code will be
designated as "Shares-in-Trust" and transferred automatically to a trust (the
"Share Trust") effective on the day before the purported transfer of such Common
or Preferred Stock. The record holder of the Common or Preferred Stock that are
designated as Shares-in-Trust will be required to submit such number of Common
or Preferred Stock to the Share Trust and the beneficiary of the Share Trust
will be one or more charitable organizations that are named by the Company.
REAL ESTATE INVESTMENT RISKS IN GENERAL
The Company's hotels will be subject to varying degrees of risk
generally incident to the ownership of real property. Income from the hotels may
be adversely affected by changes in national and local economic conditions,
changes in interest rates and in the availability, cost and terms of mortgage
funds, the impact of present or future environmental legislation and compliance
with environmental laws, the ongoing need for capital improvements, changes in
real estate tax rates and other operating expenses, changes in governmental
rules (such as those requiring upgrades for disabled persons) and fiscal
policies, civil unrest, acts of God, including earthquakes, hurricanes and other
natural disasters (which may result in uninsured losses), acts of war, changes
in zoning laws, and other factors which are beyond the control of the Company.
In addition, real estate investments are relatively illiquid, and the ability of
the Company to vary its portfolio in response to changes in economic and other
conditions will be limited.
POSSIBLE LIABILITY RELATING TO ENVIRONMENTAL MATTERS
Under various federal, state and local environmental laws, ordinances
and regulations, a current or previous owner or operator of real property may
become liable for the costs of removal or remediation of hazardous or toxic
substances on, under or in such property. Such laws often impose liability
without regard to whether the owner or operator knew of, or was responsible for,
the presence of
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such hazardous or toxic substances. The presence of hazardous or toxic
substances, or the failure to properly remediate such substances when present,
may adversely affect the owner's ability to sell or rent such real property or
to borrow using such real property as collateral. Persons who arrange for the
disposal or treatment of hazardous or toxic wastes may be liable for the costs
of removal or remediation of such wastes at the disposal or treatment facility,
regardless of whether such facility is owned or operated by such person. Other
federal, state and local laws, ordinances and regulations require abatement or
removal of certain asbestos containing materials in the event of demolition or
certain renovations or remodeling and govern emissions of and exposure to
asbestos fibers in the air. The operation and subsequent removal of certain
underground storage tanks also are regulated by federal and state laws.
DISTRIBUTION OF SUBSTANTIALLY ALL OF CASH AVAILABLE FOR DISTRIBUTION;
DISTRIBUTIONS INCLUDE RETURN OF CAPITAL
Consistent with the Company's practice of acquiring properties in need
of renovation or redevelopment, the Company's annual distributions to
shareholders have constituted a high percentage of the Company's Cash Available
for Distribution. If this continues, the Company will retain little or no cash
from the rent payments under the Percentage Leases, and expenditures for
additional acquisitions or future capital improvements would have to be funded
from borrowings, or from proceeds from the sale of assets (including the hotels)
or debt or equity securities. In addition, a percentage of the estimated annual
distribution has constituted a return of capital rather than a distribution of
retained earnings. Consequently, there is a risk that the distribution rate has
been set too high and may not be sustainable.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 - Financial Data Schedule
(b) Report on Form 8-K:
None
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of San
Clemente, State of California, on May 14, 1998.
SUNSTONE HOTEL INVESTORS, INC.
By: /s/Robert A. Alter
-------------------------------
Robert A. Alter
President, Secretary and
Chairman of the Board of Directors
By:/s/Kenneth J. Biehl
-------------------------------
Kenneth J. Biehl
Vice President and
Chief Financial Officer
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Exhibit Index
Exhibit
Number Description
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27 Financial Data Schedule