1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A ------------------- (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended DECEMBER 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.) 903 Calle Amanecer, San Clemente, CA 92673 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (949) 369-4000 - -------------------------------------------------------------------------------- Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $.01 (Title of Class) 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 [ ] Indicated by a check mark if disclosure of delinquent fliers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information -- statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Based on the closing sale price on New York Stock Exchange on March 5, 1999, the aggregate market value of the voting stock held by non-affiliates of the registrant was $289,345,000. As of March 5, 1999, there were 37,638,427 shares of Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part III of this Report incorporates information by reference from the definitive Proxy Statement for the Annual Meeting of Stockholders, to be held May 24, 1999. ================================================================================ 2 The Company hereby amends its Annual Report for the year ended December 31, 1998 on Form 10-K, dated March 5, 1999. The principal changes from the Form 10-K dated March 5, 1999, are as follows: (1) Page 29, Selected Financial Data - added "CASH FLOW FROM INVESTING ACTIVITIES" and "CASH FLOW USED IN FINANCING ACTIVITIES" data to the table. (2) Page 36, second paragraph, Funds from Operations ("FFO") - the FFO discussion was revised to include statements that FFO may not be comparable to FFO reported by other REITs that do not compute FFO in the same manner as the Company; that FFO should be considered in conjunction with cash flows from operating, investing and financing activities as presented in the Company's consolidated financial statements and notes thereto; and that FFO should not be considered as an alternative to cash flow from investing or financing activities determined in accordance with GAAP. ITEM 6. SELECTED FINANCIAL DATA The following tables set forth (i) selected historical financial information for the Company as of and for the years ended December 31, 1998, 1997 and 1996 and as of December 31, 1995 and for the period August 16, 1995 (inception) through December 31, 1995, (ii) historical information for the Lessee for the years ended December 31, 1998, 1997 and 1996 and the period August 16, 1995 (inception) to December 31, 1995, and (iii) historical information for the predecessor of the Company ("Sunstone Hotels") for the period January 1, 1995 through August 15, 1995 and for the year ended December 31, 1994. The following selected historical financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and notes thereto included in this Annual Report on Form 10-K. -2- 3 SUNSTONE HOTEL INVESTORS, INC. (THE COMPANY) Inception August 16, For the Years Ended December 31, 1995 to ----------------------------------------------- December 31, 1998 1997 1996 1995 ------------- ------------- ------------- ------------- REVENUES: Lease revenue - Lessee $ 98,682,000 $ 44,680,000 $ 14,848,000 $ 3,013,000 Interest and other income 473,000 471,000 236,000 47,000 ------------- ------------- ------------- ------------- 99,155,000 45,151,000 15,084,000 3,060,000 ------------- ------------- ------------- ------------- EXPENSES: Real estate related depreciation and amortization 35,835,000 14,749,000 4,514,000 968,000 Interest expense and amortization of financing costs 23,734,000 6,365,000 1,558,000 47,000 Real estate and personal property taxes and insurance 11,409,000 4,670,000 1,273,000 312,000 General and administrative 5,344,000 1,890,000 1,015,000 109,000 Cost of withdrawn offerings 1,450,000 -- -- -- ------------- ------------- ------------- ------------- Total expenses 77,772,000 27,674,000 8,360,000 1,436,000 ------------- ------------- ------------- ------------- Income before losses on dispositions of hotel properties, minority interest and extraordinary item 21,383,000 17,477,000 6,724,000 1,624,000 Losses on dispositions of hotel properties (3,574,000) -- -- -- Minority interest (851,000) (1,886,000) (1,090,000) (284,000) ------------- ------------- ------------- ------------- Income before extraordinary item 16,958,000 15,591,000 5,634,000 1,340,000 Extraordinary charge for early extinguishment of debt (net of $34,000 of minority interest) -- -- -- (159,000) ------------- ------------- ------------- ------------- NET INCOME 16,958,000 15,591,000 5,634,000 1,181,000 Distributions on preferred shares (1,975,000) (422,000) -- -- ------------- ------------- ------------- ------------- INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 14,983,000 $ 15,169,000 $ 5,634,000 $ 1,181,000 ============= ============= ============= ============= EARNINGS PER SHARE - DILUTED $ 0.40 $ 0.71 $ 0.69 $ 0.19 DIVIDENDS DECLARED PER COMMON SHARE $ 1.12 $ 1.05 $ 0.96 $ 0.35 CASH FLOW FROM OPERATING ACTIVITIES $ 63,911,000 $ 24,316,000 $ 11,669,000 $ 2,291,000 CASH FLOW USED IN INVESTING ACTIVITIES $(165,441,000) $(392,546,000) $ (82,757,000) $ (32,899,000) CASH FLOW FROM FINANCING ACTIVITIES $ 98,805,000 $ 371,672,000 $ 66,008,000 $ 35,824,000 FUNDS FROM OPERATIONS ("FFO") (1) $ 57,218,000 $ 32,226,000 $ 11,238,000 $ 2,592,000 Balance Sheet and Other Data: Investments in hotel properties, net $ 840,974,000 $ 704,817,000 $ 152,937,000 $ 50,063,000 Total assets 875,636,000 739,577,000 160,079,000 57,226,000 Total debt 398,893,000 307,830,000 63,300,000 11,510,000 Number of properties owned at end of period 57 53 24 11 Number of rooms at end of period 10,215 9,854 3,389 1,477 - --------------- (1) See discussion of Funds From Operations in the "Liquidity and Capital Resources" section of Management's Discussion and Analysis of Financial Condition and Results of Operations. -3- 4 SELECTED FINANCIAL INFORMATION (THE LESSEE AND THE PREDECESSOR) Sunstone Hotel Properties Inc. Sunstone Hotels (Predecessor) ------------------------------------------------ --------------------------------------------------- From For the Period For the Year For the Years Ended December 31, August 16, January 1, 1995 Ended ------------------------------------------------ 1995 (Inception) to to August 15, December 31, 1998 1997 1996 December 31, 1995 1995 1994 ------------ ------------ ----------- ----------------- ---------------- ----------- Hotel operating revenue $273,596,000 $118,153,000 $38,593,000 $7,925,000 $9,675,000 $13,863,000 Hotel operating expense 179,297,000 75,604,000 26,907,000 5,658,000 5,679,000 9,168,000 Operating Profit 94,299,000 42,549,000 11,686,000 2,267,000 3,996,000 4,695,000 Lease rent expense 98,682,000 44,680,000 14,848,000 3,013,000 -- -- Net income (loss) (4,383,000) (2,131,000) (3,162,000) (746,000) 1,674,000 398,000 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS COMPARISON OF THE YEARS ENDED DECEMBER 31, 1998 AND 1997 During 1998, the Company: o acquired 10 hotels for an aggregate purchase price of $134.2 million; o sold six non-core hotel properties located in tertiary markets for an aggregate sales price of $47.2 million; o invested $68.2 million in renovation and redevelopment to 20 hotels; o raised approximately $69.4 million of equity capital through the sale of common stock in a shelf offering; and o increased the commitment under Company's unsecured line of credit facility from $200.0 million at December 31, 1997 to $350.0 million by December 31, 1998. For the year ended December 31, 1998, lease revenue increased $54.0 million, to $98.7 million from $44.7 million for the corresponding period of 1997. The 120.8% increase is attributable to the net increase in hotels owned during 1998, ten hotels acquired and six hotels sold, the full year effect of hotels acquired during 1997 and net REVPAR increases for continuously owned hotels. The Company experienced strong revenue growth of its hotels during 1998. Total room revenue generated by the Company's hotels increased 115.0% to $204.5 million for 1998 from $95.1 million for 1997, primarily due to the increase in hotels owned during 1998 and 1997. On a same-unit-sales basis for the entire portfolio, the Company achieved a 5.0% increase in REVPAR for the year ended December 31, 1998 as compared to 1997. The 5.0% REVPAR growth for the year ended December 31, 1998 over 1997 was a result of both the performance of the recently repositioned hotels and the internal revenue growth from continuously owned and operated hotels. For comparative purposes, for the year ended December 31, 1998, the nationwide lodging industry REVPAR growth for the luxury, upscale and mid-price hotel segments, the segments most representative of the Company's hotels, were 3.2%, 2.9% and 3.5%, respectively. The 5.0% increase was driven by a 10.0% increase in ADR, from $75.02 in 1997 to $82.50 in 1998, while occupancy decreased three percentage points. -4- 5 REVPAR for 1998 for the non-renovation hotels increased by 7.9% over 1997, from $53.92 to $58.16. Non-renovation hotels represent the Company's portfolio of hotels during periods of stabilized operations (pre- and post-renovation) in both 1998 and 1997. The 7.9% increase in REVPAR for non-renovation hotels was driven by a 9.1% increase in ADR, from $76.06 to $82.96, while occupancy decreased less than one percentage point. REVPAR for 1998 for the hotels that were undergoing renovation during certain months of 1998 or 1997, decreased 1.1% over the corresponding periods of 1997. During 1998, the Company invested $68.2 million redeveloping and renovating 20 hotels as compared to $48.8 million invested redeveloping and renovating 19 hotels during 1997. In conjunction with the current year redevelopment and renovation activities, the Company rebranded and upgraded nine hotels with new and existing franchises including four full-service Marriotts. The following table summarizes average occupancy, ADR and REVPAR on a same-unit-sales basis for the hotels for the years ended December 31, 1998, 1997 and 1996: For the Years Ended For the Years Ended December 31 December 31 ------------------------- ----------------------- 1998 1997(1) 1997 1996(1) ------- ------- ------- ------- SAME-UNIT SALES ANALYSIS Number of Hotels 57 57 53 53 Number of Rooms 10,215 10,215 9,854 9,854 ALL HOTELS: Occupancy 65.9% 69.0% 65.4% 65.9% ADR $ 82.50 $ 75.02 $ 70.75 $ 64.65 REVPAR $ 54.38 $ 51.79 $ 46.24 $ 42.57 REVPAR growth 5.0% 8.6% NON-RENOVATION HOTELS: Occupancy 70.1% 70.9% 67.9% 63.9% ADR $ 82.96 $ 76.06 $ 71.46 $ 64.35 REVPAR $ 58.16 $ 53.92 $ 48.51 $ 41.10 REVPAR growth 7.9% 18.0% RENOVATION HOTELS: Occupancy 58.1% 65.6% 61.1% 68.4% ADR $ 81.46 $ 72.94 $ 67.90 $ 63.11 REVPAR $ 47.36 $ 47.87 $ 41.50 $ 43.19 REVPAR growth (1.1%) (3.9)% - --------- (1) The Company did not own certain hotels for the entire period presented. The Company invested $217.8 million in the acquisition, renovation and development of hotel properties and other real estate assets during 1998. As a result of such investments, interest expense and amortization of financing costs increased to $23.7 million from $6.4 million, and real estate and personal property taxes and insurance increased to $11.4 million from $4.7 million, for the year ended December 31, 1998 in comparison to the prior year. Additionally, real estate related depreciation and amortization increased $21.1 million in 1998 over 1997. For the year ended December 31, 1998, general and administrative expenses increased $3.4 million, to $5.3 million from $1.9 million for the prior year. The increase in general and administrative expenses was primarily due to the acquisition of Kahler in October 1997, significant growth in the Company's hotel portfolio and additional personnel added to the staff of the Company. Additionally, the Company incurred increased recurring expenses for legal, accounting and tax services during 1998 due to the significant acquisition and hotel portfolio growth. Also, the -5- 6 Company incurred $553,000 of costs related to the termination of a significant hotel portfolio acquisition that was under consideration. Increases in other general and administrative expenses were also incurred commensurate with the growth of the Company's hotel portfolio during 1998 and 1997. During 1998, the Company disposed of six non-core hotels, that were included in the acquisition of Kahler, for $47.2 million and recognized losses of $3.6 million. Additionally, the Company incurred $1.5 million in costs related to debt and equity offerings that were withdrawn due to market conditions. Accordingly, these costs were expensed in 1998. As a result of the above factors, net income available to common stockholders decreased $200,000 to $15.0 million in 1998 from $15.2 million. Earnings per share for 1998 were impacted by the 5.3 million and 21.3 million common shares that were issued during 1998 and 1997, respectively, and on a diluted basis was $0.40 per share as compared to $0.71 per share for 1997. (See discussion of Funds From Operations in "Liquidity and Capital Resources.") COMPARISON OF THE YEARS ENDED DECEMBER 31, 1997 AND 1996 For the year ended December 31, 1997, lease revenues increased $29.9 million, to $44.7 million from $14.8 million for the corresponding period of 1996. The 202.0% increase is primarily due to the 27 hotels acquired during 1997, the full year effect of hotels acquired during 1996 and net REVPAR increases for continuously owned hotels. The Company experienced strong revenue growth of its hotels during 1997. Total room revenue from the Company's hotels increased 178.9% from $34.1 million to $95.1 million over 1996, primarily due to the completion of $521.8 million of hotel acquisitions during the preceding twelve months. On a same unit-sales basis for the entire portfolio, the Company achieved an 8.6% increase in REVPAR during 1997 compared to 1996. The 8.6% REVPAR growth for the year ended December 31, 1997 over 1996 was a result of both the performance of the recently repositioned hotels and the internal revenue growth from continuously owned and operated hotels. For comparative purposes, for the year ended December 31, 1997, the nationwide lodging industry, REVPAR growth for the luxury, upscale and mid-price hotel segments, the segments most representative of the Company's hotels, were 5.9%, 4.8% and 4.6%, respectively. The 8.6% increase was driven by a 9.4% increase in ADR from $64.65 in 1996 to $70.75 in 1997. REVPAR for 1997 for the non-renovation hotels increased by 18.0% over 1996, from $41.10 to $48.51. Non-renovation hotels represent the Company's portfolio of hotels during periods of stabilized operations (pre- and post-renovation) in both 1997 and 1996. The 18.0% increase in REVPAR for non-renovation hotels was driven by a 11.0% increase in average daily rate from $64.35 to $71.46, while occupancy increase four percentage points. REVPAR for 1997, for the hotels which were undergoing renovation during certain months of 1996 or 1997, decreased 3.9% over the corresponding periods of 1996. Interest expense and amortization of financing costs increased to $6.4 million from $1.6 million, and real estate and personal property taxes and insurance increased to $4.7 million from $1.3 million for the year ended December 31, 1997 in comparison to the prior year. Additionally, real estate related depreciation and amortization increased $10.2 million in 1997. These increases are attributable to the growth of the Company's hotel portfolio to 53 hotels during 1997 compared to 24 hotels owned during 1996. Acquisitions are typically initially financed with debt contributing to the increase in interest expense and amortization of financing costs. During 1997, the Company recorded increased general and administrative expenses relating to due diligence for hotels not acquired and other general and administrative costs incurred due to the growth of the Company's hotel portfolio. Additionally, effective January 1, 1997, the Company increased the compensation of the President and added a chief financial officer, corporate controller, cash manager and other administrative staff necessitated by the Company's growth. As a result, general and administrative expenses increased to $1.9 million from $1.0 million for the year ended December 31, 1997 in comparison to the prior year. -6- 7 As a result of the above factors, net income available to common stockholders increased $9.6 million, to $15.2 million in 1997 from $5.6 million in 1996. Earnings per share on a diluted basis for 1997 was $0.71 per share as compared to $0.69 per share for 1996. (See discussion of Funds from Operations in "Liquidity and Capital Resources.") NATIONAL FRANCHISE AFFILIATIONS The Company generally believes that franchise affiliations provide advantages to its 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 luxury upscale hotel chains. 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 Year Ended December 31, 1998) Percentage of Number of Percentage of Lease Lease Franchise Affiliation Hotels Rooms Rooms Revenues Revenues - ------------------------------- --------------- ------------------ ------------------ ------------------ --------------- Marriott - Full-Service, Courtyard and Residence Inn(1) 20 3,520 34.5% $34,555,000 35.0% Holiday Inns (1) 16 2,534 24.8 19,949,000 20.2 Kahler 2 965 9.4 11,198,000 11.3 Hampton Inns 9 1,193 11.7 9,797,000 9.9 Hilton 2 572 5.6 6,008,000 6.1 Hawthorn Suites 3 583 5.7 5,025,000 5.1 Sheraton 1 295 2.9 2,969,000 3.0 Comfort Suites 1 166 1.6 2,144,000 2.2 Ramada 1 124 1.2 1,340,000 1.4 Best Western 1 103 1.0 649,000 0.7 Radisson (1) 1 160 1.6 740,000 0.7 Other (2) - - - 4,308,000 4.4 --------------- ------------------ ------------------ ------------------ --------------- 57 10,215 100.0% $98,682,000 100.0% =============== ================== ================== ================== =============== (1) In cases where the Company has obtained approval of a new franchise license, subject to completion of renovations or improvements, the franchise brand indicated represents the approved new franchise brand. (2) Represents six non-core hotel properties sold during the third quarter of 1998. -7- 8 SEASONALITY AND REGIONAL FOCUS The Company focuses its current acquisition efforts principally on the Pacific region where supply and demand demographic trends are more favorable. The geographic distribution of the hotels, which are located in eight 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 that are typical for the hotel industry. The Company also has sought to increase its geographic distributions by focusing on major metropolitan areas. The following table summarizes the Company's presence in each of these eight markets: GEOGRAPHIC DIVERSIFICATION (As of and for the Year Ended December 31, 1998) Percentage Number of Percentage of Lease of Lease Region Hotels Rooms Rooms Revenues Revenues - ---------------------------------------- --------------------------------------------------------------------------- Pacific (1)......................... 32 5,054 49.5% $46,423,000 47.0% Mountain (2)........................ 21 3,832 37.5 30,854,000 31.3 Minnesota........................... 4 1,329 13.0 17,097,000 17.3 Other (3)........................... - - - 4,308,000 4.4 --------------------------------------------------------------------------- Total.......................... 57 10,215 100% $98,682,000 100% =========================================================================== (1) Includes California, Oregon and Washington (2) Includes Arizona, Colorado, New Mexico and Utah. (3) Includes the six non-core hotel properties sold during the third quarter of 1998. Such hotels are located in Idaho, Montana, 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 distribution 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. (See discussion of the Lessee's stockholders' deficit in the following section, "The Lessee.") In 1998, the Company paid distributions totaling $44.7 million. Beginning with the third quarter of 1998, the Company increased its regular quarterly dividend 3.64% to $0.285 per share. The Company believes a regular program of capital improvements, including replacement and refurbishment of furniture, fixtures and equipment at its hotels, as well as the periodic renovation and redevelopment of certain of its hotels, is essential to maintaining the competitiveness of the hotels and maximizing revenue growth. The Company is required under the Percentage Leases to make available to the Lessee for the repair, replacement and refurbishment of furniture, fixtures and equipment an amount equal to 4% of the room revenue per quarter on a cumulative basis, provided that such amount may be used for capital expenditures made by the Company with respect to the hotels. The Company expects that this amount will be adequate to fund the required repairs, replacements and refurbishments and to maintain its hotels in a competitive condition. Cash Flows from Investing and Financing Activities. The Company intends to finance the acquisition of additional hotel properties, hotel renovations and non-recurring capital improvements principally through its $350 million unsecured revolving line of credit facility (the "Credit Facility") from its lenders (led by Bank One of Arizona, N.A., as the agent bank), proceeds from the disposition of certain non-core hotel assets and, when market conditions warrant, proceeds from the issuance of additional equity or debt securities. During 1998, the Company borrowed $182.2 million on the Credit Facility, raised $47.2 million through the disposition of non-core hotel assets and $69.9 million through issuance of common stock. As of December 31, 1998, approximately $163.2 million was available -8- 9 under the Company's shelf registration statement and the Company had $75.5 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 Company's maximum additional indebtedness that could be incurred for the acquisition and renovation of hotel properties would have been between $23.7 million and $47.4 million at December 31, 1998, depending upon the use of the funds. On July 23, 1998, the Company amended the Credit Facility to (i) increase total commitment to $350.0 million, (ii) increase the total amount available under the Credit Facility from 45% to 50% of the aggregate value of the Company's eligible hotels, as defined, (iii) increase amount available for working capital purposes from $15.0 million to $30.0 million, and (iv) extend the term from June 30, 1999 to June 30, 2000. Borrowings under the Credit Facility accrue interest at LIBOR plus 1.40% per annum, to LIBOR plus 2.00% per annum, based upon the leverage of the Company. At December 31, 1998, 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. During 1998, the Company disposed of six non-core hotel assets that were included in the $372 million acquisition of Kahler Realty Corporation for $47.2 million in cash. These dispositions were structured as non-taxable exchange transactions. Additionally, on February 2, 1999, the Company sold the 129-room limited service Hampton Inn located in Arcadia, California for $8.5 million in cash. The Company continues to consider certain non-core hotel assets for disposition and has identified five additional hotels for disposition, primarily limited service hotels. As part of its investment strategy, the Company plans to acquire additional hotels. Future acquisitions are expected to be funded through the use of the Credit Facility or other borrowings, proceeds from the 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 cash requirements and to expand and develop its business in accordance with its current strategy for growth. During 1998, the Company used cash in the amount of $217.8 million as well as debt and the issuance of Units to acquire hotel properties and other real estate investments, including redevelopment and recurring capital expenditures. During 1998, the Company invested approximately $68.2 million in major renovations and conversions of 20 of its hotels. During the quarters ended March 31, 1998, June 30, 1998, September 30, 1998 and December 31, 1998, there were twelve, eleven, four and nine hotels under renovation, respectively. Certain of these hotels were under renovation for more than one quarter. The Company estimates it will invest an additional $34.0 million 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. On August 12, 1998, the Company completed its acquisition and development of the newly-built Pueblo Marriott in Pueblo, Colorado, for a cost of approximately $12.0 million that was funded with the Credit Facility. Additionally, the Company is in the construction phases of developing three additional hotels, which are expected to open in 1999. The Company estimates it will invest approximately $35.3 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, proceeds from the February 1999 sale of the Hampton Inn located in Arcadia, California and the Credit facility. In conjunction with the on-going development activity, the Company has various contracts and commitments outstanding with third parties. The Company plans to fund remaining commitments under these agreements through the use of the Credit Facility, and proceeds from the disposition of certain non-core hotel assets. In addition, the Company may acquire additional hotels and invest additional cash for renovations during 1999. -9- 10 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 or to complete development projects or major renovation projects may be adversely affected. A decline in the Company's acquisition pace relative to historical periods may result in a decline in earnings growth. Funds From Operations ("FFO"). Management believes that FFO is one measure of financial performance of an equity REIT, such as the Company. FFO (as defined at footnote below) grew by 78% to $57.2 in 1998 from $32.2 million in 1997. 1998 1997 1996 Actual Actual Actual ----------- ----------- ----------- Net Income $16,958,000 $15,591,000 $ 5,634,000 Add back: Real estate related depreciation and amortization 35,835,000 14,749,000 4,514,000 Losses on dispositions of hotel properties 3,574,000 -- -- Minority interest 851,000 1,886,000 1,090,000 ----------- ----------- ----------- FFO assuming conversion of preferred shares $57,218,000 $32,226,000 $11,238,000 =========== =========== =========== - ------------------- Management and industry analysts generally consider Funds From Operations to be an appropriate measure of the performance of an equity REIT. The White Paper on Funds From Operations approved by the Board of Governors of the National Association of Real Estate Investment Trusts ("NAREIT") defines Funds From Operations as net income or loss (computed in accordance with GAAP), excluding gains or losses from debt restructuring and sales of property, plus real estate related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. The Company computes Funds From Operations in accordance with standards established by NAREIT, adjusted for minority interest, which may not be comparable to Funds From Operations reported by other REITs that do not define the term in accordance with the current NAREIT definition or that interpret the current NAREIT definition differently than the Company. Funds From Operations should be considered in conjunction with net income and cash flows from operating, investing and financing activities as presented in the Company's consolidated financial statements and notes thereto. Funds From Operations should not be considered as an alternative to net income (determined in accordance with GAAP) as an indication of the Company's financial performance or to cash flow from operating, investing or financing activities (determined in accordance with GAAP) as a measure of the Company's liquidity, nor is it indicative of funds available to fund the Company's cash needs, including its ability to make cash distributions. Funds From Operations may include funds that may not be available for management's discretionary use due to the requirements to conserve funds for capital expenditures and property acquisitions and other commitments. 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 -10- 11 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. All 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. 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 -11- 12 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 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. IMPACT OF INFLATION The Company's business is affected by general economic conditions, including the impact of inflation and interest rates. Substantially all of the Company's Percentage Leases allow, on an annual basis, for adjustments in the rent payable thereunder, and thus may enable the Company to seek increases in base rents, which generally serves to minimize the risk to the Company of the adverse effects of inflation. For construction, the Company has entered into various contracts for the developmental and construction of new hotel properties. These are fixed-fee contracts and thus partially insulate the Company from inflationary risk. THE LESSEE For a discussion of the Lessee's revenue operations and a comparison of the year ended December 31, 1998 to 1997, see "Results of Operations" of the Company. Additionally, the Lessee has incurred significant losses from its inception in 1995. At December 31, 1998, the Lessee's stockholders' deficit amounted to $10.5 million. At December 31, 1998, the Lessee's rent payable to the Company amounted to $7.5 million. Also at December 31, 1998, the Lessee's current liabilities exceeded its current assets by $9.8 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 -12- 13 significant portion of the Company's hotel portfolio underwent renovation and redevelopment, 20, 19 and 8 hotels, respectively. 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. During 1998, the Lessee entered into a $1.5 million line of credit that expires on December 29, 1999 with its primary stockholder, Mr. Alter. The line of credit is to be used exclusively for general short-term working capital needs. As of December 31, 1998, $650,000 was outstanding on the line of credit. Through March 5, 1999, an additional $800,000 was drawn on the line of credit and $644,000 was repaid. -13- 14 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Clemente, State of California, on July 6, 1999. SUNSTONE HOTEL INVESTORS, INC. By: /s/ ROBERT A. ALTER ------------------------------------ Robert A. Alter President, Secretary and Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K/A has been signed below by the following persons in the capacities and on the dates indicated: SIGNATURE TITLE DATE --------- ----- ---- /s/ ROBERT A. ALTER President, Secretary and Chairman July 6, 1999 - ---------------------------------- of the Board of Directors (Principal Executive Robert A. Alter Officer) /s/ CHARLES L. BIEDERMAN Vice Chairman of the Board of Directors July 6, 1999 - ---------------------------------- Charles L. Biederman /s/ R. TERRENCE CROWLEY Chief Operating Officer (Principal Financial July 6, 1999 - ---------------------------------- and Accounting Officer) R. Terrence Crowley /s/ C. ROBERT ENEVER Director July 6, 1999 - ---------------------------------- C. Robert Enever /s/ LAURENCE GELLER Director July 6, 1999 - ---------------------------------- Laurence Geller /s/ DAVID E. LAMBERT Director July 6, 1999 - ---------------------------------- David E. Lambert /s/ H. RAYMOND BINGHAM Director July 6, 1999 - ---------------------------------- H. Raymond Bingham /s/ FREDRIC H. GOULD Director July 6, 1999 - ---------------------------------- Fredric H. Gould - ---------------------------------- Director July 6, 1999 Paul D. Kazilionis /s/ EDWARD H. SONDKER Director July 6, 1999 - ---------------------------------- Edward H. Sondker -14-