Form 10-Q

Sale of 4,102,564 shares of series C stock at a sales price of $24.13125 per share

Costs of offering

Net proceeds

10-Q 1 d10q.htm FORM 10-Q Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

¨	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 333-117141

Sunstone Hotel Investors, Inc.

(Exact Name of Registrant as Specified in Its Charter)


Maryland		20-1296886
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)

903 Calle Amanecer, Suite 100 San Clemente, California		92673
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (949) 369-4000

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of July 31, 2005, 41,877,321 shares, $0.01 par value per share, of the registrant’s common stock were outstanding.

SUNSTONE HOTEL INVESTORS, INC.

QUARTERLY REPORT ON

FORM 10-Q

For the Quarterly Period Ended June 30, 2005

TABLE OF CONTENTS


		Page
	PART I—FINANCIAL INFORMATION

Item 1	Financial Statements:

	Sunstone Hotel Investors, Inc. and the Sunstone Predecessor Companies:

	Consolidated Balance Sheets as of June 30, 2005 (unaudited) and December 31, 2004	1

	Unaudited Consolidated and Combined Statements of Operations for the Three and Six Months Ended June 30, 2005 and 2004	2

	Consolidated Statements of Stockholders’ Equity as of June 30, 2005 (unaudited) and December 31, 2004	3

	Unaudited Consolidated and Combined Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004	4

	Notes to Unaudited Consolidated and Combined Financial Statements	5

Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14

Item 3	Quantitative and Qualitative Disclosures about Market Risk	41

Item 4	Disclosure Controls and Procedures	41

	PART II—OTHER INFORMATION

Item 1	Legal Proceedings	42

Item 2	Changes in Securities and Use of Proceeds	42

Item 3	Defaults Upon Senior Securities	42

Item 4	Submission of Matters to a Vote of Security Holders	42

Item 5	Other Information	42

Item 6	Exhibits and Reports on Form 8-K	43

SIGNATURES		44

PART I—FINANCIAL INFORMATION

Item 1.

Financial Statements

SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)


	June 30, 2005			December 31, 2004
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	61,753		$	5,966
Restricted cash		34,581			28,910
Accounts receivable, net		34,751			28,273
Due from affiliates		213			147
Inventories		2,342			2,522
Prepaid expenses		2,760			2,297

Total current assets		136,400			68,115
Investment in hotel properties, net		1,537,826			1,127,272
Other real estate, net		7,283			7,519
Investment in unconsolidated joint venture		20,018			—
Deferred financing costs, net		7,476			7,638
Goodwill		27,299			28,493
Other assets, net		33,843			14,708

Total assets	$	1,770,145		$	1,253,745

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	21,745		$	25,021
Accrued payroll and employee benefits		4,421			5,814
Due to Management Company		17,214			15,401
Dividends payable		14,874			9,962
Distributions payable		1,054			1,054
Other current liabilities		20,527			18,902
Current portion of notes payable		2,716			45,009

Total current liabilities		82,551			121,163
Notes payable, less current portion		964,480			667,452
Other liabilities		2,539			2,968

Total liabilities		1,049,570			791,583
Commitments and contingencies (Note 12)
Minority interest		48,635			44,830
Stockholders’ equity:
Preferred stock, $0.01 par value, 50,000,000 shares authorized; Series A 4,850,000 shares issued and outstanding at June 30, 2005 and none at December 31, 2004, stated at liquidation preference of $25.00 per share		121,250			—
Common stock, $0.01 par value, 100,000,000 shares authorized, 41,877,321 shares issued and outstanding		419			345
Additional paid in capital		599,813			452,124
Deferred stock compensation		(7,169	)		(7,278	)
Accumulated deficit		(7,568	)		(17,897	)
Cumulative dividends		(34,805	)		(9,962	)

Total stockholders’ equity		671,940			417,332

Total liabilities and stockholders’ equity	$	1,770,145		$	1,253,745

See accompanying notes to consolidated and combined financial statements.

SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES AND

SUNSTONE PREDECESSOR COMPANIES

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share data)


	The Company			The Predecessor			The Company			The Predecessor
	Three Months Ended June 30, 2005			Three Months Ended June 30, 2004			Six Months Ended June 30, 2005			Six Months Ended June 30, 2004
REVENUES
Room	$	92,593		$	85,319		$	172,217		$	161,301
Food and beverage		28,986			27,863			54,761			53,401
Other operating		10,615			10,256			21,773			21,330
Management and other fees from affiliates		—			145			—			522

Total revenues		132,194			123,583			248,751			236,554

OPERATING EXPENSES
Room		19,449			18,563			37,233			35,943
Food and beverage		19,579			19,191			37,870			36,860
Other operating		7,063			7,102			14,242			14,123
Advertising and promotion		7,789			7,332			15,377			14,260
Repairs and maintenance		5,388			5,213			10,590			10,266
Utilities		4,696			4,763			9,734			9,752
Franchise costs		6,921			6,435			13,003			12,215
Property tax, ground lease, and insurance		5,640			6,639			12,032			13,261
Property general and administrative		16,549			10,794			29,001			20,714
Corporate general and administrative		2,763			6,811			5,751			11,433
Depreciation and amortization		14,942			13,893			29,005			27,732
Amortization of deferred stock compensation		483			—			1,014			—
Impairment loss		—			—			—			7,439

Total operating expenses		111,262			106,736			214,852			213,998

Operating income		20,932			16,847			33,899			22,556
Interest and other income		1,398			114			1,704			216
Interest expense		(15,247	)		(12,762	)		(27,415	)		(26,104	)

Income (loss) before minority interest, income taxes and discontinued operations		7,083			4,199			8,188			(3,332	)
Minority interest		(643	)		158			(794	)		166
Income tax benefit		—			1,502			—			199

Income (loss) from continuing operations before discontinued operations		6,440			5,859			7,394			(2,967	)
Income (loss) from discontinued operations		2,092			(2,004	)		2,935			(18,523	)

NET INCOME (LOSS)		8,532		$	3,855			10,329		$	(21,490	)

Preferred stock dividends		(2,414	)					(2,802	)

INCOME AVAILABLE TO COMMON STOCKHOLDERS	$	6,118					$	7,527

Basic and diluted per share amounts:
Income from continuing operations available to common stockholders	$	0.11					$	0.13
Income from discontinued operations		0.06						0.08

Income available to common stockholders per common share	$	0.17					$	0.21

Weighted average common shares outstanding:
Basic		35,591						35,061

Diluted		35,903						35,360

Dividends paid per common share	$	0.285					$	0.570

See accompanying notes to consolidated and combined financial statements.

SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands, except per share data)


	Preferred Stock			Common Stock			Additional Paid in Capital			Unearned and Accrued Stock Compensation
	Number of Shares	Amount		Number of Shares	Amount		Additional Paid in Capital			Unearned and Accrued Stock Compensation			Accumulated Deficit			Cumulative Dividends			Total
Balance at December 31, 2004 (audited)				34,518,616	$	345	$	452,124		$	(7,278	)	$	(17,897	)	$	(9,962	)	$	417,332
Net proceeds from sale of preferred stock	4,850,000	$	121,250					(3,799	)											117,451
Net proceeds from sale of common stock				7,344,000		74		155,703												155,777
Issuance of unvested restricted common stock				14,705				930			(930	)								—
Vesting of restricted common stock								(25	)		1,039									1,014
Common dividends declared and payable at $0.570 per share																	(22,041	)		(22,041	)
Preferred dividends declared and payable at $0.578 per share																	(2,802	)		(2,802	)
Reallocation of minority interest								(5,120	)											(5,120	)
Net income														10,329						10,329

Balance at June 30, 2005 (unaudited)	4,850,000	$	121,250	41,877,321	$	419	$	599,813		$	(7,169	)	$	(7,568	)	$	(34,805	)	$	671,940

See accompanying notes to consolidated and combined financial statements.

SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES AND

SUNSTONE PREDECESSOR COMPANIES

CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)


	The Company			The Predecessor
	Six Months Ended June 30, 2005			Six Months Ended June 30, 2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	10,329		$	(21,490	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Bad debt (recovery) expense		(724	)		136
Minority interest		794			(166	)
(Gain) loss on sale of hotel properties		(2,384	)		381
Depreciation		29,214			29,645
Amortization of deferred franchise fees		82			144
Amortization of deferred financing costs		2,444			2,510
Amortization of deferred stock compensation		1,014			—
Impairment loss—investment in hotel properties and discontinued operations		—			24,393
Loss on interest rate cap agreements		3			459
Deferred income taxes		—			(1,944	)
Changes in operating assets and liabilities:
Cash from discontinued operations		—			(207	)
Restricted cash		(5,671	)		2,431
Accounts receivable		(5,754	)		(4,618	)
Due from affiliates		(66	)		15
Inventories		180			(71	)
Prepaid expenses and other assets		(20,149	)		15
Accounts payable and other liabilities		(2,080	)		(2,498	)
Accrued payroll and employee benefits		(1,393	)		(516	)
Accrued pension liability		—			(96	)
Due to Management Company		1,813			—

Net cash provided by operating activities		7,652			28,523

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of hotel properties		27,165			29,370
Acquisition of unconsolidated joint venture		(20,018	)		—
Acquisitions of hotel properties		(439,135	)		(38,820	)
Additions to hotel properties and other real estate		(23,515	)		(33,065	)

Net cash used in investing activities		(455,503	)		(42,515	)

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from preferred securities offering		121,250			—
Payment of preferred securities offering costs		(3,799	)		—
Proceeds from common stock offerings		160,801			—
Payment of common stock offerings costs		(5,024	)		—
Proceeds from notes payable		535,380			28,663
Payments on notes payable		(280,645	)		(33,342	)
(Payments) refunds of deferred financing costs		(2,285	)		67
Acquisition of interest rate cap agreements		—			(8	)
Dividends and distributions paid		(22,040	)		—
Contributions from members		—			25,322
Distributions to members		—			(3,446	)
Contributions from minority interest holders		—			105
Distributions to minority interest holders		—			(15	)

Net cash provided by financing activities		503,638			17,346

Net increase in cash and cash equivalents		55,787			3,354
Cash and cash equivalents, beginning of period		5,966			20,229

Cash and cash equivalents, end of period	$	61,753		$	23,583

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest	$	24,829		$	24,550

Income taxes paid	$	343		$	1,013

NONCASH FINANCING ACTIVITY
Dividends and distributions payable	$	15,928		$	—

See accompanying notes to consolidated and combined financial statements.

SUNSTONE HOTEL INVESTORS, INC. AND SUBSIDIARIES AND

SUNSTONE PREDECESSOR COMPANIES

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS

1. Organization and Description of Business

Sunstone Hotel Investors, Inc. (the “Company”), through its 91.9% controlling interest in Sunstone Hotel Partnership, LLC (the “Operating Partnership”), of which the Company is the sole managing member, and the subsidiaries of the Operating Partnership, including Sunstone Hotel TRS Lessee, Inc. (the “TRS Lessee”) and its subsidiaries, is currently engaged in owning, acquiring, selling, and renovating hotel properties in the United States. The Company operates as a real estate investment trust (“REIT”) for federal income tax purposes.

The Company was formed to succeed the businesses of Sunstone Hotel Investors, L.L.C. (“SHI”), WB Hotel Investors, LLC (“WB”), and Sunstone/WB Hotel Investors IV, LLC (“WB IV”) (collectively, the “Sunstone Predecessor Companies” or the “Predecessor”), which were engaged in owning, acquiring, selling, managing, and renovating hotel properties in the United States. The Company was incorporated in Maryland on June 28, 2004, in anticipation of an initial public offering of common stock (the “IPO”), which was consummated on October 26, 2004, concurrently with the consummation of various formation transactions. These transactions were designed to (i) enable the Company to raise the necessary capital to acquire properties from the Predecessor and repay certain mortgage debt relating thereto, (ii) provide a vehicle for future acquisitions, (iii) enable the Company to comply with certain requirements under the federal income tax laws and regulations relating to real estate investment trusts, (iv) facilitate potential financings and (v) preserve certain tax advantages for the Predecessor. From June 28, 2004 through October 26, 2004, the Company did not have any operations.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements as of June 30, 2005 and December 31, 2004, and for the three and six months ended June 30, 2005 include the accounts of the Company, the Operating Partnership and the TRS Lessee and their subsidiaries. Property interests contributed to the Operating Partnership by the Predecessor have been accounted for as a reorganization of entities under common control in a manner similar to a pooling-of-interests. Accordingly, the contributed assets and assumed liabilities were recorded at the Predecessors’ historical cost basis. All significant intercompany balances and transactions have been eliminated.

The accompanying combined financial statements for the three and six months ended June 30, 2004 include the accounts of SHI, WB, and WB IV. Significant intercompany accounts and transactions have been eliminated for all periods presented.

The accompanying interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States and in conformity with the rules and regulations of the Securities and Exchange Commission. In our opinion, the interim financial statements presented herein reflect all adjustments, consisting solely of normal and recurring adjustments, which are necessary to fairly present the interim financial statements. These financial statements should be read in conjunction with the financial statements included in our Form 10-K, filed with the Securities and Exchange Commission on February 22, 2005.

Use of Estimates

The preparation of consolidated and combined financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

Accounts Receivable

Accounts receivable primarily represents receivables from hotel guests who occupy hotel rooms and utilize hotel services. Accounts receivable also includes receivables from customers who utilize the Company’s laundry facilities in Salt Lake City, Utah, and Rochester, Minnesota. The Company maintains an allowance for doubtful accounts sufficient to cover

potential credit losses. The Company’s accounts receivable at June 30, 2005 and December 31, 2004 includes an allowance for doubtful accounts of $846,000 and $2.2 million, respectively.

At June 30, 2005 and December 31, 2004, the Company had approximately $7.9 million and $12.3 million in accounts receivable, respectively, with one customer who is operating under a contract with the United States government. The Company has specifically reserved a portion of this particular receivable in the amount of $100,000 and $1.3 million at June 30, 2005 and December 31, 2004, respectively. Additionally, the Company has taken a $2.1 million reserve due to a contract interpretation issue with a customer relating to applicable contract rates during the period from early 2003 through May 2005.

Deferred Financing Costs

Interest expense related to the amortization of deferred financing costs was $1.3 million and $1.4 million for the three months ended June 30, 2005 and 2004, respectively, and $2.4 million and $2.5 million for the six months ended June 30, 2005 and 2004, respectively.

Minority Interest

Minority interest represents the limited membership interests in the Operating Partnership. The carrying value of the minority interest has been increased by the minority interests’ share of earnings and reduced by cash distributions and the purchase of limited partnership interests. The weighted average number of limited partnership units for the six months ended June 30, 2005, was 3,699,572. When the Company raises additional equity, it contributes the proceeds to the Operating Partnership for an equivalent number of partnership units. In the event of other changes in common equity, an adjustment to minority interest in the Operating Partnership and stockholders’ equity is recorded to reflect the Company’s increased or decreased ownership in the Operating Partnership. The reconciliation of minority interests for the six months ended June 30, 2005, is as follows (in thousands, except unit data):


	Minority Interests			Units
Balance at December 31, 2004 (audited)	$	44,830		3,699,572
Distributions payable		(2,109	)
Reallocation of minority interest		5,120
Net income		794

Balance at June 30, 2005 (unaudited)	$	48,635		3,699,572

Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per common share (in thousands, except per share data):


	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Numerator:
Net income	$	8,532		$	10,329
Less preferred dividends		(2,414	)		(2,802	)

Numerator for basic and diluted earnings available to common stockholders	$	6,118		$	7,527

Denominator:
Weighted average basic common shares outstanding		35,591			35,061
Unvested restricted stock awards		312			299

Weighted average diluted common shares outstanding		35,903			35,360

Basic and diluted earnings available to common stockholders per common share	$	0.17		$	0.21

Reclassifications

Certain amounts included in the combined financial statements for prior periods have been reclassified to conform with the most recent financial statement presentation.

3. Investment in Hotel Properties

Investment in hotel properties consisted of the following (in thousands):


	June 30, 2005			December 31, 2004
	(Unaudited)
Land	$	177,899		$	131,974
Buildings and improvements		1,374,099			1,025,136
Fixtures, furniture and equipment		191,203			154,293
Franchise fees		1,419			1,393
Construction in process		5,356			3,833

		1,749,976			1,316,629
Accumulated depreciation and amortization		(212,150	)		(189,357	)

	$	1,537,826		$	1,127,272

On June 23, 2005, the Company purchased interests in six Renaissance hotels for approximately $433.7 million. These Renaissance hotels are managed by Marriott International, Inc. (“Marriott”). Marriott’s reporting periods include 12 weeks each for the first, second and third quarters of the year and 16 weeks for the fourth quarter. Marriott’s second quarter ended on June 17, 2005, and, as such, the Company has not included any of the six hotels’ results of operations for the quarterly period ended June 30, 2005. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on the preliminary allocated purchase price for the eight days it owned the properties in the quarter.


Hotel	Location	Number of Rooms
Renaissance Long Beach Hotel	Long Beach, California	373
Renaissance Westchester Hotel	White Plains, New York	357
Renaissance Orlando Resort at SeaWorld Hotel	Orlando, Florida	780
Renaissance Harborplace Hotel	Baltimore, Maryland	622
Renaissance Washington, D.C. Hotel	Washington, D.C.	807
Renaissance Atlanta Concourse Hotel	Atlanta, Georgia	387

The acquisition of the Renaissance Orlando Resort at SeaWorld Hotel represents an 85% interest in that property and is being consolidated on the balance sheet. The acquisition of the Renaissance Washington, D.C. Hotel represents a 25% interest in that property and is recorded as an investment in unconsolidated joint venture on the balance sheet. In July 2005, the Company acquired the remaining 75% interest in the Renaissance Washington, D.C. Hotel.

On June 27, 2005, the Company purchased the 203-room Sheraton located in Cerritos, California for approximately $25.4 million. The results of operations for the four days the Company owned the hotel in June 2005 have been included in the statement of operations. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on the preliminary allocated purchase price for the four days it owned the properties in the quarter.

4. Discontinued Operations

As part of a strategic plan to dispose of non-core hotel assets, the Company and its Predecessor sold seven hotel properties during 2004 and two hotel properties during the six months ended June 30, 2005. These nine hotel properties met the “held for sale” and “discontinued operations” criteria in accordance with SFAS 144.

The following sets forth the discontinued operations for the three and six months ended June 30, 2005 and 2004, related to hotel properties held for sale (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Operating revenues	$	489		$	9,222		$	4,366		$	21,555
Operating expenses		(650	)		(8,810	)		(3,176	)		(18,866	)
Interest expense		(131	)		(925	)		(348	)		(1,760	)
Depreciation and amortization		—			(831	)		(291	)		(2,057	)
Impairment loss		—			—			—			(16,954	)
Gain (loss) on sale of hotels		2,384			(280	)		2,384			(381	)
Provision for income taxes		—			(380	)		—			(60	)

Income (loss) from discontinued operations	$	2,092		$	(2,004	)	$	2,935		$	(18,523	)

5. Other Real Estate

Other real estate consists of the following (in thousands):


	June 30, 2005			December 31, 2004
	(Unaudited)
Laundry facilities:
Land	$	1,600		$	1,600
Buildings and improvements		4,443			4,436
Fixtures, furniture and equipment		3,665			3,602

		9,708			9,638
Accumulated depreciation		(2,675	)		(2,369	)

		7,033			7,269
Land held for future development or sale		250			250

	$	7,283		$	7,519

6. Other Assets

Other assets at June 30, 2005, include $19.0 million held in escrow for the acquisition of the Sutton Place Hotel in Newport Beach, California, $3.5 million for the acquisition of the remaining 75% interest in the Renaissance Washington, D.C. Hotel, $2.0 million in capital expenditures for the Sutton Place Hotel and $9.3 million of other assets.

7. Derivative Financial Instruments

At June 30, 2005 and December 31, 2004, the Company held interest rate cap agreements to manage its exposure to interest rate risks related to its floating rate debt. The fair values of the interest rate cap agreements are included in deferred financing costs, net on the consolidated balance sheets as of June 30, 2005 and December 31, 2004. None of the Company’s interest rate cap agreements held as of June 30, 2005 and December 31, 2004 qualify for effective hedge accounting treatment under SFAS No. 133. Accordingly, changes in the fair value of the Company’s and the Predecessors’ interest rate cap agreements for the three months ended June 30, 2005 and 2004 resulted in a net loss of $4,000 and $23,000, respectively, and for the six months ended June 30, 2005 and 2004 resulted in a net loss of $3,000 and $459,000, respectively. The changes in fair value have been reflected as an increase in interest expense for the three and six months ended June 30, 2005 and 2004.

The following table summarizes the interest rate cap agreements (dollars in thousands):


	June 30, 2005		December 31, 2004
	(Unaudited)
Notional amount of variable rate debt	$	761,037	$	775,500
Fair value of interest rate caps	$	1	$	4
Interest rate cap rates		4.50% -7.19 %		2.65% -7.19 %
Maturity dates		September 2005 – May 2006		January 2005 – May 2006

8. Notes Payable

Notes payable consist of the following (in thousands):


	June 30, 2005			December 31, 2004
	(Unaudited)
Notes payable requiring payments of interest and principal, with interest at rates ranging from variable of one-month LIBOR plus 2.35% to fixed rates ranging from 4.98% to 9.88%; maturing at dates ranging from September 2007 through August 2024. The notes are collateralized by first deeds of trust on 44 hotel properties and one laundry facility.	$	892,196		$	626,029

Unsecured term loan facility in the amount of $75.0 million requiring monthly payments of interest only subject to an interest rate equal to either, at the Company’s option, a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, or six-month LIBOR, plus, in each case, a margin of 1.25% for base rate loans and 2.25% for LIBOR loans. The term loan facility matures in October 2008.		75,000			75,000

Secured revolving credit facility in the amount of $150.0 million requiring monthly payments of interest only on the principal amount drawn subject to an interest rate equal to either, at the Company’s option, a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, three- or six-month LIBOR, plus, in each case, an applicable margin based on the Company’s leverage. The applicable margin is a percentage rate per annum that ranges from 0.5% to 1.0% for base rate loans and 1.5% to 2.0% for LIBOR loans. The revolving credit facility also requires a quarterly fee of 0.5% on the average unused commitment on the facility and a 0.125% fee upon the issuance of each letter of credit. The revolving credit facility is secured by first deeds of trust on eight hotel properties. Total available under the revolving credit facility was $121.3 million at June 30, 2005. The revolving credit facility matures in October 2007 and has a one year extension.		—			5,500

Construction loan requiring monthly payments of interest only at one-month LIBOR plus 3.25% and is collateralized by one hotel. The loan was paid off in March 2005.		—			5,932

		967,196			712,461
Less: current portion		(2,716	)		(45,009	)

	$	964,480		$	667,452

In April 2005, the Company closed ten individual non cross-collateralized mortgage loans totaling $276.0 million. The loans are each for a term of ten years and have a fixed rate of 5.34%. The proceeds of these loans were used to repay $244.3 million of existing mortgage loans.

In June 2005, the Company closed $250.0 million in mortgage loans with terms ranging between seven and eleven years and a weighted average fixed interest rate of 5.14%. The proceeds of these loans were used to fund the acquisition of interests in six Renaissance hotels.

In June 2005, the Company assumed a $9.2 million fixed rate mortgage loan with a maturity date of August 2024 and a fixed interest rate of 8.78% in connection with the acquisition of the Sheraton Cerritos, Cerritos, California.

Total interest incurred and expensed on the notes payable is as follows (in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2004		2005		2004
Interest expense—continuing operations	$	11,151	$	11,717	$	22,201	$	23,624
Interest expense—discontinued operations		67		557		281		1,272
Prepayment penalty paid—continuing operations		2,834		—		2,834		—

	$	14,052	$	12,274	$	25,316	$	24,896

9. Income Taxes

The income tax benefit (provision) included in the consolidated and combined statements of operations is as follows (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Current:
Federal	$	—		$	(469	)	$	—		$	(1,456	)
State		—			99			—			(349	)

		—			(370	)		—			(1,805	)

Deferred:
Federal		609			1,850			2,057			1,910
State		156			563			526			831

		765			2,413			2,583			2,741
Valuation allowance		(765	)		(921	)		(2,583	)		(797	)

Income tax benefit	$	—		$	1,122		$	—		$	139

Benefit from (provision for) income taxes applicable to continuing operations and discontinued operations is as follows (in thousands):


	Three Months Ended June 30,					Six Months Ended June 30,
	2005		2004			2005		2004
Benefit from (provision for) continuing operations:
Current	$	—	$	(370	)	$	—	$	(1,805	)
Deferred		—		1,872			—		2,004

Benefit from continuing operations		—		1,502			—		199

Benefit from (provision for) discontinued operations:
Current		—		—			—		—
Deferred		—		(380	)		—		(60	)

Provision for discontinued operations		—		(380	)		—		(60	)

Benefit from income taxes	$	—	$	1,122		$	—	$	139

The provision for income taxes differs from the federal statutory rate due to various expenses that are not deductible for tax purposes.

The tax effects of temporary differences giving rise to the deferred tax assets (liabilities) are as follows (in thousands):


	June 30, 2005			December 31, 2004
Deferred tax assets:
NOL carryover	$	3,771		$	1,603
State taxes and other		7			16
Other reserves		4,677			4,258

Current deferred tax asset before valuation allowance		8,455			5,877

Deferred tax liabilities:
Depreciation		(58	)		(74	)
Other		(33	)		(22	)

		(91	)		(96	)

Net deferred tax assets		8,364			5,781
Valuation allowance		(8,364	)		(5,781	)

	$	—		$	—

The deferred tax assets at June 30, 2005 were primarily due to net operating loss carryforwards and timing differences in the deductibility of various reserves for tax purposes as compared to book purposes. A valuation allowance is maintained to offset its deferred tax assets due to uncertainties surrounding their realization.

At June 30, 2005 and December 31, 2004, the Company had federal net operating loss carryforwards of $9.6 million and $4.1 million, respectively, which begin to expire in 2024.

At June 30, 2005 and December 31, 2004, the Company had state net operating loss carryforwards of $9.6 million and $4.1 million, respectively, which begin to expire in 2011.

10. Stockholders’ Equity

Series A Cumulative Redeemable Preferred Stock

In March 2005, the Company sold 4,850,000 shares of 8.0% Series A and B Cumulative Redeemable Preferred Stock with a liquidation preference of $25.00 per share for gross proceeds of $121.3 million. Underwriting and other costs of the offering totaled $3.8 million. Net proceeds of $117.5 million were contributed to the Operating Partnership in exchange for preferred units with economic terms substantially identical to the Series A and B preferred stock. Subsequent to this offering, the Series B were exchanged for an equivalent number of shares of Series A preferred stock. The net proceeds were used to reduce borrowings under our credit facility and for acquisitions. On or after March 17, 2010, the Series A preferred stock will be redeemable at our option, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus accrued and unpaid dividends up to and including the redemption date. Holders of Series A preferred stock will generally have no voting rights. However, if the Company is in arrears on dividends on the Series A preferred stock for six or more quarterly periods, whether or not consecutive, holders of the Series A preferred stock will be entitled to vote at our next annual meeting and each subsequent annual meeting of stockholders for the election of two additional directors to serve on our board of directors until all unpaid dividends and the dividend for the then-current period with respect to the Series A preferred stock have been paid or declared and a sum sufficient for the payment thereof set aside for payment. The Series A preferred stock has no maturity date and the Company is not required to redeem the Series A preferred stock at any time.

Common Stock

On October 26, 2004, the Company commenced operations after completing the IPO, which consisted of the sale of 21,294,737 shares of common stock at a price per share of $17.00, generating gross proceeds of $362.0 million. The proceeds to the Company, net of underwriters’ discount and offering costs, were $333.5 million. The proceeds from the IPO were used to acquire limited partnership interests in the Operating Partnership held by the Predecessors’ members as a result of the IPO for $195.9 million, repay secured notes payable of $210.1 million, and purchase a ground lessor’s interest in a ground lease under one of the properties that was purchased for $6.3 million. On November 23, 2004, as a result of the exercise of the underwriters’ over-allotment option, the Company sold an additional 3,165,000 shares of common stock resulting in gross proceeds of $53.8 million which it used to purchase an additional 3,165,000 limited partnership interests in the Operating Partnership from the Predecessor.

On June 10, 2005, the Company and selling stockholders completed a follow-on offering of 12,180,800 shares of common stock at a price per share of $23.40 (before underwriting discounts and offering costs). The public offering consisted of 3,000,000 primary shares, generating gross proceeds of $70.2 million and 9,180,800 secondary shares sold by affiliates of Westbrook Partners, LLC. The proceeds to the Company, net of underwriters’ discount and offering costs, were $65.3 million and were used for acquisitions.

On June 23, 2005, the Company completed a private offering to GIC Real Estate, an investment arm of the Government of Singapore, of 3,750,000 and 294,000 shares of common stock at a price per share of $20.65 and $21.97, respectively, generating gross proceeds of $83.9 million. The proceeds to the Company, net of offering costs, were $83.8 million and were used for acquisitions.

On June 28, 2005, the Company completed a private offering to Security Capital Preferred Growth Incorporated, an investment vehicle advised by Security Capital Research & Management Incorporated, of 300,000 shares of common stock at a price per share of $22.347, generating net proceeds of $6.7 million which were used for acquisitions.

11. Long-Term Incentive Plan

Restricted shares granted pursuant to the Company’s Long-Term Incentive Plan vest over periods from three to five years from the date of grant. The value of shares granted has been calculated based on the share price on the date of grant and

is being amortized as compensation expense over the vesting periods. For the three and six months ended June 30, 2005, the Company’s expense related to these restricted shares was $483,000 and $1.0 million, respectively. At June 30, 2005 and December 31, 2004, the unearned compensation related to restricted share grants was $7.2 million and $7.3 million, respectively, and has been classified as a component of stockholders’ equity in the accompanying balance sheet.

12. Commitments and Contingencies

Franchise Agreements

Total franchise costs incurred by the Company and Predecessor during the three and six months ended June 30, 2005 and 2004, were both $7.0 million and $13.4 million, respectively. Of the total franchise costs, franchise royalties were both $3.8 million for the three months ended June 30, 2005 and 2004, and $7.3 million and $7.4 million, respectively, for the six months ended June 30, 2005 and 2004. The remaining franchise costs include advertising, reservation and priority club assessments.

Renovation and Construction Commitments

At June 30, 2005 and December 31, 2004, the Company had various contracts outstanding with third parties in connection with the renovation of certain of the hotel properties. The remaining commitments under these contracts at June 30, 2005 and December 31, 2004 totaled $11.3 million and $7.8 million, respectively.

Operating Leases

Rent expense incurred pursuant to ground lease agreements for the three months ended June 30, 2005 and 2004 totaled $875,000 and $969,000, respectively, and for the six months ended June 30, 2005 and 2004 totaled $1.6 million and $1.9 million, respectively, and was included in property tax, ground lease and insurance in the accompanying statements of operations.

Rent expense incurred pursuant to the lease on the corporate facility for the three months ended June 30, 2005 and 2004 totaled $96,000 and $189,000, respectively, and for the six months ended June 30, 2005 and 2004 totaled $192,000 and $378,000, respectively, and was included in general and administrative expenses in the accompanying statements of operations.

Contract Interpretation Issue

The Company has a contract interpretation issue with a customer who is operating under a contract with the United States government. The ultimate resolution of this issue could result in the Company reimbursing this customer for certain amounts. The Company has reserved $2.1 million at June 30, 2005 related to this matter. However, the ultimate resolution of this matter could result in a reimbursement to the customer in an amount in excess of $2.1 million.

Other

At June 30, 2005 and December 31, 2004, the Company had $28.7 million and $34.8 million, respectively, of outstanding irrevocable letters of credit to guarantee the Company’s financial obligations related to the Management Company, workers’ compensation insurance programs and certain notes payable. The beneficiary may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation.

13. Transactions With Affiliates

Management Fees

On March 30, 2004, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel located in Nashville, Tennessee owned by an affiliate. The agreement expires March 30, 2009 and includes successive one-year renewal options. Pursuant to the agreement, the Company was to receive from the affiliate a base management fee of 2.5% of gross operating revenues, as defined. In connection with the IPO, this agreement was cancelled and a new agreement was entered into with Interstate Hotels & Resorts, Inc., or the Management Company.

On January 30, 2004, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel located in Beverly Hills, California owned by the affiliate. The agreement expires January 30, 2009 and includes successive one-year renewal options. Pursuant to the agreement, the Company was to receive from the affiliate a

base management fee of 2.5% of gross operating revenues, as defined. In connection with the IPO, this agreement was cancelled and a new agreement was entered into with the Management Company.

On May 22, 2002, the Predecessor entered into a management agreement with an affiliate to provide management services for the hotel property located in Nashville, Tennessee owned by the Westbrook related party. The agreement expires on May 22, 2007 and includes successive one-year renewal options. Pursuant to the agreement, the Predecessor is to receive from the Westbrook related party a base management fee of 4.0% of gross operating revenues, as defined. This agreement was terminated in February 2004 following the sale of the hotel.

On May 29, 2002, the Company entered into eight asset management agreements with an affiliate to provide asset management services for the hotel properties owned by the Westbrook related party. The agreements expire on May 29, 2007 and include successive one-year renewal options. Pursuant to the agreements, the Company is to receive an asset management fee of 1.0% of gross operating revenues, as defined. At December 31, 2004, none of the agreements were in effect due to the sale of all eight properties to an unaffiliated third party.

For the three and six months ended June 30, 2004, aggregate management fees and asset management fees earned from affiliates totaled $129,000 and $184,000, respectively. The Company did not earn any management fees for the three and six months ended June 30, 2005.

Asset Management Fees

Following the Company’s IPO, the Company entered into asset management agreements to supervise outstanding capital expenditure projects for four hotel properties owned by affiliates.

Accounting Fee

Prior to the Company’s IPO, the Company received an accounting fee from certain affiliates equal to $10 per available room per month. Aggregate accounting fees earned from affiliates totaled $16,000 and $20,000 for the three and six months ended June 30, 2004, respectively.

Acquisition Fees

During the three and six months ended June 30, 2004, in connection with successful acquisitions of hotel properties by certain affiliated companies, the Predecessor received aggregate acquisition fees in the amount of $0 and $318,000, respectively, in exchange for rendering services in connection with such acquisitions. Such acquisition fees were recognized as revenue and were included in management and other fees from affiliates. The Company did not earn any acquisition fees for the three and six months ended June 30, 2005.

Other Reimbursements

From time to time, the Company pays for certain expenses such as payroll, insurance and other costs on behalf of certain affiliates. The affiliates generally reimburse such amounts on a monthly basis. At June 30, 2005 and December 31, 2004, amounts owed to the Company by its affiliates amounted to $213,000 and $147,000 and are included in due from affiliates.

14. Subsequent Events

In July 2005, the Company acquired the 444-room Sutton Place Hotel in Newport Beach, California for $72.3 million and has named Fairmont Hotels & Resorts as manager. The Company has commenced a major renovation of the hotel’s guestrooms and public areas, anticipated to cost approximately $22.0 million. Following the acquisition, the hotel was re-named the Fairmont Newport Beach.

In July 2005, the Company completed its acquisition of the remaining 75% interest in the Renaissance Washington, D.C. Hotel. The Company had previously acquired 25% of the hotel as part of the six hotel Renaissance acquisition that closed on June 23, 2005. The hotel will continue to be operated by Marriott under the Renaissance Hotels & Resorts brand name.

In July 2005, the Company closed on the sale of 4,102,564 shares of Series C Convertible Redeemable Preferred Stock to Security Capital Preferred Growth Incorporated for gross proceeds of approximately $100.0 million. The convertible preferred stock was sold at a purchase price of $24.375, will pay a base dividend of 6.45%, will be convertible on a one for one basis into common stock and will be callable at par after five years. In certain circumstances, the holders of the series C preferred stock have the right to require the Company to redeem any or all of the series C preferred stock.

Cautionary Statement

This report contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “forecasts,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those expressed or implied by these forward-looking statements. In evaluating these statements, you should specifically consider the risks outlined in detail in our Form S-11, filed with the Securities and Exchange Commission on June 3, 2005, under the caption “Risk Factors” and elsewhere in this Form 10-Q, including but not limited to the following factors:

•

our level of outstanding debt, including secured and variable rate debt;

•

financial and other covenants in our debt;

•

conflicts of interests with our directors and Westbrook Real Estate Partners, LLC;

•

competition for the acquisition of hotels and in the operation of our hotels;

•

rising operating expenses;

•

relationships with and requirements of franchisors;

•

the need for renovations and other capital expenditures for our hotels;

•

the performance of Interstate Hotels & Resorts, Inc., the management company for a majority of our hotels;

•

the ground leases for ten of our hotels;

•

our need to operate as a REIT and comply with other applicable laws and regulations;

•

changes in business strategy or acquisition or disposition plans;

•

general economic and business conditions affecting the hotel and travel industry, both nationally and locally;

•

our ability to complete acquisitions;

•

the performance of acquired properties after they are acquired;

•

necessary capital expenditures on acquired properties; and

•

other events beyond our control.

These factors may cause our actual events to differ materially from the expectations expressed or implied by any forward-looking statement. We do not undertake to update any forward-looking statement.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We own primarily upper upscale and upscale hotels in the United States operated under leading brand names franchised or licensed from others, such as Marriott, Hilton, InterContinental, Hyatt, Starwood, Carlson and Wyndham.

Operations

Our financial data prior to October 26, 2004 is for our predecessor companies, who owned and operated the hotels during the periods presented. In conjunction with our initial public offering, we made substantial changes to our operations to effect the formation and structuring transactions as further discussed in our Form 10-K and to qualify and elect to be treated as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Code. As a result, our historical results of operations prior to October 26, 2004 are not indicative of our current results of operations.

Formation and structuring transactions and our initial public offering. The following items occurred and affect our future results of operations as a result of our initial public offering:

•

the payment of management fees to Interstate Hotels and Resorts, the Management Company, which has assumed responsibility for our hotel operations pursuant to the management agreements with us;

•

the reduction of corporate general and administrative costs as a result of the employee transfers to the Management Company;

•

the reflection of a minority interest to give effect to the interests in Sunstone Hotel Partnership owned by the predecessor companies;

•

the exclusion of two hotels that were not contributed to us;

•

the reduction in interest expense as a result of the repayment of some of our notes payable;

•

the reduction in ground lease expense reflecting the acquisition of the ground lessor’s interest in the land under the Embassy Suites Hotel, Chicago, Illinois; and

•

the incremental costs associated with operating as a public company.

The effects of these matters are described under “Unaudited Pro Forma Financial Data.”

REIT structure. For us to qualify as a REIT, our income cannot be derived from our operation of hotels. Therefore, consistent with the provisions of the Code, Sunstone Hotel Partnership and its subsidiaries have leased our hotel properties to our taxable REIT subsidiary lessee, Sunstone Hotel TRS Lessee, Inc., or the TRS Lessee, who has in turn contracted with “eligible independent contractors” to manage our hotels. Under the Code, an “eligible independent contractor” is an independent contractor who is actively engaged in the trade or business of operating “qualified lodging facilities” for any person unrelated to us and the TRS Lessee. Sunstone Hotel Partnership and the TRS Lessee will be consolidated into our financial statements for accounting purposes. Since we control both Sunstone Hotel Partnership and our TRS Lessee, our principal source of funds on a consolidated basis will be from the performance of our hotels. The earnings of the TRS Lessee will be subject to taxation like other C corporations, which will reduce our operating results, funds from operations and the cash otherwise available for distribution to our stockholders.

Factors Affecting Our Results of Operations

Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following:

•

Room revenue, which is primarily driven by occupancy and average daily rate;

•

Food and beverage revenue, which is primarily driven by occupancy and banquet/catering bookings;

•

Other operating revenue, which consists of ancillary hotel revenue such as telephone, transportation, parking, spa, entertainment and other guest services and is primarily driven by occupancy. Additionally, this category includes operating revenue from our two commercial laundry facilities located in Rochester, Minnesota and Salt Lake City, Utah and our electronic purchasing platform, Buy Efficient, L.L.C.; and

•

Management and other fees from affiliates, which consists of other non-operating income and management and other fees from our affiliates prior to our initial public offering.

The following performance indicators are commonly used in the hotel industry:

•

occupancy;

•

average daily rate, or ADR; and

•

revenue per available room, or RevPAR, which is the product of occupancy and ADR, but does not include food and beverage revenue, other operating revenue or management and other fees from affiliates.

Operating costs and expenses. Our operating costs and expenses consist of the following:

•

Room expense, which like room revenue, is primarily driven by occupancy and, therefore, has a significant correlation with room revenue;

•

Food and beverage expense, which like food and beverage revenue, is primarily driven by occupancy and banquet and catering bookings and, therefore, has a significant correlation with food and beverage revenue;

•

Other operating expense, which consists of the corresponding expense of other operating revenue, advertising and promotion, repairs and maintenance, utilities, and franchise fees and assessments categories;

•

Property tax, ground lease and insurance expense, which consists of the expenses associated with property tax, ground lease and insurance payments, each of which are primarily fixed expenses;

•

Property general and administrative expense, which consists of our property-level general and administrative expenses, such as payroll and related costs, professional fees, and travel expenses, as well as management fees with respect to our hotels;

•

Corporate general and administrative expense, which consists of our corporate-level expenses such as payroll and related costs, professional fees, travel expenses and office rent; and

•

Depreciation and amortization expense, which consists of depreciation on our hotel buildings, improvements, furniture, fixtures and equipment (since January 1, 2002, we have not amortized our goodwill).

Most categories of variable operating expenses, such as utilities and certain labor costs, such as housekeeping, fluctuate with changes in occupancy. Increases in RevPAR attributable to improvements in occupancy are accompanied by increases in most categories of variable operating costs and expenses. Increases in RevPAR attributable to improvements in ADR typically only result in increases in limited categories of operating costs and expenses, primarily credit card commissions, franchise fees and franchise assessments. Thus, improvements in ADR have a more significant impact on improving our operating margins than occupancy.

We continually seek to improve our operating leverage, which generally refers to the ability to generate incremental profit based on limited variable costs. Notwithstanding our efforts to reduce variable costs, there are limits to how much we or the Management Company and our other operators can accomplish in that regard without affecting the competitiveness of our hotels and our guests’ experiences at our hotels. Furthermore, we have significant fixed costs, such as depreciation and amortization, insurance and other expenses associated with owning hotels that do not necessarily decrease when circumstances such as market factors cause a reduction in our hotel revenue. For example, we have experienced increases in wages, employee benefits (especially workers’ compensation in our California hotels and health insurance) and utility costs, which negatively affected our operating margin. Our historical performance may not be indicative of future results, and our future results may be worse than our historical performance.

Acquisition, Sale and Major Redevelopment Activity

Our results during the periods discussed have been, and our future results will be, affected by our acquisition, sale and redevelopment activity during the applicable period.

Acquisition of hotels. The following table sets forth the hotels that we have acquired or developed since the beginning of 2004 and indicates their room count and acquisition date:


Hotel	Rooms	Acquisition Date
Sutton Place Hotel, Newport Beach, California	444	July 11, 2005
Sheraton Hotel, Cerritos, California	203	June 27, 2005
Renaissance Orlando Resort at Sea World, Orlando, Florida⁽¹⁾	780	June 23, 2005
Renaissance Harborplace, Baltimore, Maryland	622	June 23, 2005
Renaissance Concourse, Atlanta, Georgia	387	June 23, 2005
Renaissance Long Beach, Long Beach, California	373	June 23, 2005
Renaissance Westchester, White Plains, New York	357	June 23, 2005
Renaissance Washington, D.C., Washington, D.C.	807	June 23, 2005	⁽²⁾
Residence Inn by Marriott, Rochester, Minnesota	80	June 18, 2004	⁽³⁾
JW Marriott, Cherry Creek, Colorado⁽⁴⁾	196	April 28, 2004

⁽¹⁾	Acquired 85% ownership interest.

⁽²⁾	Acquired 25% ownership interest on June 23, 2005. The remaining 75% interest was acquired subsequent to the end of the second quarter of 2005 on July 13, 2005.

⁽³⁾	Opening date of developed hotel.

⁽⁴⁾	Following our initial public offering, this hotel is not a part of our hotel portfolio.

The aggregate cost for these nine hotel acquisitions, excluding the 25% ownership interest in the Washington D.C. hotel, through June 30, 2005 was approximately $439.1 million, or $161,000 per room.

Sale of hotels. The following table sets forth the hotels that have been sold since the beginning of 2004 and indicates their room count and sale date:


Hotel	Rooms	Sale Date
Doubletree, Carson, California	224	April 14, 2005
Holiday Inn, Mesa, Arizona	246	April 14, 2005
San Marcos Resort, Chandler, Arizona	295	November 18, 2004


Hotel	Rooms	Sale Date
Holiday Inn, Flagstaff, Arizona	156	November 10, 2004
Concord Hotel and Conference Center, Concord, California	324	September 30, 2004
Four Points Sheraton, Silverthorne, Colorado	160	August 27, 2004
Holiday Inn, Anchorage, Alaska	247	May 27, 2004
Holiday Inn, La Mirada, California	292	May 18, 2004
Hawthorn Suites, Anaheim, California	129	April 15, 2004

The aggregate net sale proceeds for the nine closed hotel dispositions through June 30, 2005 were $85.5 million, or $41,000 per room. The results of operations of all of the hotels identified above and the gains or losses on dispositions through June 30, 2005 are included in discontinued operations for all periods presented through the time of sale. The proceeds from the sales are included in our cash flows from investing activities for the respective periods.

The following table summarizes our portfolio and room data since the beginning of 2004 through June 30, 2005 adjusted for the hotels acquired and sold during the respective periods.


	January 1, 2004 through December 31, 2004		January 1, 2005 through June 30, 2005
Portfolio Data—Hotels
Number of hotels—beginning of period	61		54
Add: Acquisitions	—		7	⁽¹⁾
Add: Developments	2	⁽²⁾	—
Less: Sales	7		2
Less: Assets not included	2	⁽³⁾	—

Number of hotels—end of period	54		59
Portfolio Data—Rooms
Number of rooms—beginning of period	14,901		13,183
Add: Acquisitions	—		3,529	⁽⁴⁾
Add: Developments	276		—
Add: Room expansions	20		—
Less: Sales	1,603		470
Less: Assets not included	411	⁽³⁾	—

Number of rooms—end of period	13,183		16,242
Average rooms per hotel—end of period	244		275

⁽¹⁾	Includes 25% ownership interest in Renaissance Washington, D.C. The remaining 75% ownership interest was acquired subsequent to the end of the second quarter of 2005 on July 13, 2005.

⁽²⁾	Reflects the opening of the Residence Inn by Marriott, Rochester, Minnesota and the acquisition of the JW Marriott, Cherry Creek, Colorado.

⁽³⁾	Reflects the exclusion of the JW Marriott, Cherry Creek, Colorado (196 rooms) and the Embassy Suites Hotel, Los Angeles, California (215 rooms) as a result of our initial public offering.

⁽⁴⁾	Reflects all 807 rooms of the Renaissance Washington D.C. Hotel of which we owned a 25% interest as of June 30, 2005. We acquired the remaining 75% in July 2005.

Operating Results

Comparison of Three Months Ended June 30, 2005 to Three Months Ended June 30, 2004

The following table presents our unaudited operating results for the three months ended June 30, 2005 and 2004, including the amount and percentage change in the results between the two periods. The operating results for 2004 have been derived by combining the predecessor companies’ results for the period of April 1, 2004 through June 30, 2004.


	Three Months Ended June 30, 2005			Three Months Ended June 30, 2004			$ Change			% Change
	(dollars in thousands, except statistical data)
REVENUES
Room	$	92,593		$	85,319		$	7,274		8.5	%
Food and beverage		28,986			27,863			1,123		4.0	%
Other operating		10,615			10,256			359		3.5	%
Management and other fees from affiliates		—			145			(145	)	(100.0	)%

Total revenues		132,194			123,583			8,611		7.0	%

OPERATING EXPENSES
Room		19,449			18,563			886		4.8	%
Food and beverage		19,579			19,191			388		2.0	%
Other hotel		37,497			37,484			13		0.0	%
Property general and administrative		16,549			10,794			5,755		53.3	%
Corporate general and administrative		2,763			6,811			(4,048	)	(59.4	)%
Depreciation and amortization		14,942			13,893			1,049		7.6	%
Deferred stock compensation		483			—			483		0.0	%

Total operating expenses		111,262			106,736			4,526		4.2	%

Operating income		20,932			16,847			4,085		24.2	%
Interest and other income		1,398			114			1,284		1126.3	%
Interest expense		(15,247	)		(12,762	)		(2,485	)	(19.5	)%

Income before minority interest, income taxes and discontinued operations		7,083			4,199			2,884		NA
Minority interest		(643	)		158			(801	)	NA
Income tax benefit		—			1,502			(1,502	)	(100.0	)%

Income from continuing operations before discontinued operations		6,440			5,859			581		NA
Income (loss) from discontinued operations		2,092			(2,004	)		4,096		NA

NET INCOME		8,532		$	3,855		$	4,677		NA

Preferred stock dividends		(2,414	)

INCOME AVAILABLE TO COMMON STOCKHOLDERS	$	6,118


Operating Statistics
Occupancy⁽¹⁾		74.8	%		73.5	%		1.3	%	1.8	%
Average daily rate⁽¹⁾	$	107.08		$	98.36		$	8.72		8.9	%
RevPAR⁽¹⁾	$	80.10		$	72.29		$	7.81		10.8	%

⁽¹⁾	Excludes hotels held in discontinued operations, which are described under “—Income (loss) from discontinued operations.”

Room revenue. Room revenue increased $7.3 million, primarily attributable to organic growth in our existing portfolio base of $9.4 million due to increases in ADR and occupancy, partially offset by $2.1 million related to properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies.

Food and beverage revenue. The food and beverage revenue increase was primarily driven by higher occupancy during 2005, partially offset by properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies.

Other operating revenue. Other revenue increased due to growth in our electronic purchasing platform, Buy Efficient, L.L.C. and the Rochester, Minnesota laundry facility, partially offset by properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies and the continuing trend of declining telephone revenue.

Management and other fees from affiliates. Management and other fees from affiliates in 2004 relate to the Doubletree, Nashville, Tennessee and Residence Inn by Marriott, Beverly Hills, California, which are properties owned by affiliates. As a result of our initial public offering, we no longer receive any management or other fees from these hotels.

Other hotel expenses. Increase in other hotel expenses was primarily driven by higher occupancy and a mid-year 2004 acquisition, partially offset by properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies and ground lease expense incurred in 2004 but which ground lease was purchased as a part of our formation and structuring transactions.

Property general and administrative expense. Property general and administrative expense increased $5.8 million as a result of the $2.1 million reserve for the contract interpretation issue with a customer, $2.2 million in management and accounting fees payable to the Management Company that were not payable in 2004 prior to our initial public offering, other hotel specific expenses, such as increased credit card commissions and franchise fees associated with the overall increase in revenue, and a mid-year 2004 acquisition, partially offset by properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies. The $2.1 million reserve relates to a contract interpretation issue with a customer regarding applicable contract rates during the period from early 2003 through May 2005.

Corporate general and administrative expense. Corporate general and administrative expense decreased as a result of the expected decrease in salaries and wages attributable to the transfer of certain employees to the management company, partially offset by the increased costs of being a public company.

Depreciation and amortization expense. Depreciation and amortization increased as a result of the increase in our depreciable asset base and a mid year 2004 acquisition, partially offset by properties that were included in our second quarter 2004 results of operations but were not contributed to us by the predecessor companies.

Interest expense. Interest expense increased $2.5 million primarily as a result of a loan prepayment penalty of $2.8 million and a write-off of deferred financing fees of $0.7 million which were partially offset by higher interest expense of $0.6 million in 2004 due to greater average outstanding loan balances and higher amortization of deferred financing fees of $0.5 million in 2004.

Our total notes payable, including the current portion, was $967.2 million at June 30, 2005 and $712.5 million at December 31, 2004, with a weighted average interest rate per annum of approximately 5.3% at June 30, 2005 and 6.1% at December 31, 2004. At June 30, 2005, 90.9% of the amount outstanding under our notes payable was fixed and 9.1% of the amount outstanding under our notes payable was floating.

Provision for income taxes. As limited liability companies, the predecessor companies were pass-through entities and not liable for Federal and certain state income taxes, which were the responsibility of their respective members. However, some of our predecessor companies were corporations that were liable for taxes on their earnings. We maintain a taxable REIT subsidiary which is liable for taxes on its earnings. The change in the tax provision is attributable to the historical tax benefit for our predecessor companies being eliminated.

Income (loss) from discontinued operations. As described under “—Acquisition, Sale and Major Redevelopment Activity—Sale of Hotels,” we sold seven hotels in 2004 and two hotels during the second quarter of 2005. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these hotels as discontinued operations. The improvement of $4.1 million in discontinued operations was due to a $1.7 million improvement in income from discontinued operations in 2005 compared to 2004 and a $2.4 million gain on sale in 2005.

Comparison of Six Months Ended June 30, 2005 to Six Months Ended June 30, 2004

The following table presents our unaudited operating results for the six months ended June 30, 2005 and 2004, including the amount and percentage change in the results between the two periods. The operating results for 2004 have been derived by combining the predecessor companies’ results for the period of January 1, 2004 through June 30, 2004.


	Six Months Ended June 30, 2005			Six Months Ended June 30, 2004			$ Change			% Change
	(dollars in thousands, except statistical data)
REVENUES
Room	$	172,217		$	161,301		$	10,916		6.8	%
Food and beverage		54,761			53,401			1,360		2.5	%
Other operating		21,773			21,330			443		2.1	%
Management and other fees from affiliates		—			522			(522	)	(100.0	)%

Total revenues		248,751			236,554			12,197		5.2	%

OPERATING EXPENSES
Room		37,233			35,943			1,290		3.6	%
Food and beverage		37,870			36,860			1,010		2.7	%
Other hotel		74,978			73,877			1,101		1.5	%
Property general and administrative		29,001			20,714			8,287		40.0	%
Corporate general and administrative		5,751			11,433			(5,682	)	(49.7	)%
Depreciation and amortization		29,005			27,732			1,273		4.6	%
Deferred stock compensation		1,014			—			1,014		0.0	%
Impairment loss		—			7,439			(7,439	)	(100.0	)%

Total operating expenses		214,852			213,998			854		.4	%

Operating income		33,899			22,556			11,343		50.3	%
Interest and other income		1,704			216			1,488		688.9	%
Interest expense		(27,415	)		(26,104	)		(1,311	)	(5.0	)%

Income (loss) before minority interest, income taxes and discontinued operations		8,188			(3,332	)		11,520		NA
Minority interest		(794	)		166			(960	)	NA
Income tax benefit		—			199			(199	)	(100.0	)%

Income (loss) from continuing operations before discontinued operations		7,394			(2,967	)		10,361		NA
Income (loss) from discontinued operations		2,935			(18,523	)		21,458		NA

NET INCOME (LOSS)		10,329		$	(21,490	)	$	31,819		NA

Preferred stock dividends		(2,802	)

INCOME AVAILABLE TO COMMON STOCKHOLDERS	$	7,527

Operating Statistics
Occupancy⁽¹⁾		72.0	%		70.3	%		1.7	%	2.4	%
Average daily rate⁽¹⁾	$	104.55		$	97.68		$	6.87		7.0	%
RevPAR⁽¹⁾	$	75.28		$	68.67		$	6.61		9.63	%

⁽¹⁾	Excludes hotels held in discontinued operations, which are described under “—Income (loss) from discontinued operations.”

Room revenue. Room revenue increased $10.9 million, primarily attributable to organic growth in our existing portfolio base of $14.8 million due to increases in ADR and occupancy, partially offset by $3.9 million related to properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies.

Food and beverage revenue. The food and beverage revenue increase was primarily driven by higher occupancy during 2005 and a mid year 2004 acquisition partially offset by properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies.

Other operating revenue. Our increased occupancy led to increases in other operating revenue, such as parking, entertainment and guest services, and operating revenue also increased due to a mid-year 2004 acquisition, partially offset by

properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies and the continuing trend of declining telephone revenue.

Other hotel expenses. Increase in other hotel expenses was primarily driven by higher occupancy and a mid-year 2004 acquisition, partially offset by properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies and ground lease expense incurred in 2004 but which ground lease was purchased as a part of our formation and structuring transactions.

Property general and administrative expense. Property general and administrative expense increased $8.3 million as a result of the $2.1 million reserve for the contract interpretation issue with a customer, $4.2 million in management and accounting fees payable to the Management Company that were not payable in 2004 prior to our initial public offering, other hotel specific expenses, such as increased credit card commissions and franchise fees associated with the overall increase in revenue, and a mid-year 2004 acquisition, partially offset by properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies.

Depreciation and amortization expense. Depreciation and amortization increased as a result of the increase in our depreciable asset base and a mid year 2004 acquisition, partially offset by properties that were included in our first half 2004 results of operations but were not contributed to us by the predecessor companies.

Interest expense. Interest expense increased $1.3 million primarily as a result of a loan prepayment penalty of $2.8 million and a write-off of deferred financing fees of $0.7 million which were partially offset by higher interest expense of $1.5 million in 2004 due to greater average outstanding loan balances and higher amortization of deferred financing fees and loss on interest rate caps of $0.7 million in 2004.

Impairment loss. Impairment loss in 2004 consists of hotel impairment losses of $7.4 million at six hotels and does not include any goodwill impairment loss. The hotel impairment loss in 2004 related to our determination that the current carrying values of the hotels were no longer recoverable based on estimated future cash flows to be generated by the hotels. This determination resulted from certain depressed hotel markets. The fair values of the hotels were determined using factors such as net operating cash flows, terminal capitalization rates and replacement costs as described under “—Critical Accounting Policies—Impairment of long-lived assets.”

Income (loss) from discontinued operations. As described under “—Acquisition, Sale and Major Redevelopment Activity—Sale of Hotels,” we sold seven hotels in 2004 and have two hotels held for sale at June 30, 2005 (which were subsequently sold). Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these hotels as discontinued operations. The improvement of $21.4 million in discontinued operations was due to impairment losses on disposals of $17.0 million taken in 2004, a $2.0 million improvement in income from discontinued operations in 2005 compared to 2004 and a $2.4 million gain on sale in 2005.

UNAUDITED PRO FORMA FINANCIAL DATA

For the Three and Six Months Ended June 30, 2004

The following unaudited pro forma financial data for the three and six months ended June 30, 2004, gives effect to (1) hotels not contributed to us by the predecessor companies, (2) our formation and structuring transactions, (3) our initial public offering, including the sale of shares to Robert A. Alter, and the application of the net proceeds and (4) the incurrence of debt under our new term loan facility and the application of the net proceeds.

The historical financial information for the three and six months ended June 30, 2004 has been derived from the unaudited combined financial statements of the Sunstone Predecessor Companies, which are included elsewhere in this Form 10-Q. The unaudited pro forma combined statement of operations data for the three and six months ended June 30, 2004 is presented as if the transactions had occurred as of the beginning of the periods indicated.

The contribution or sale to us of hotels and interests in entities by the Sunstone Predecessor Companies in the formation and structuring transactions were accounted for at the historical cost of such assets similar to a pooling of interests as the Sunstone Predecessor Companies are all under common control.

As of June 30, 2005 and For the Three and Six Months Ended June 30, 2005

The following unaudited pro forma financial data as of June 30, 2005 and for the three and six months ended June 30, 2005, gives effect to (1) the acquisition of the remaining 75% interest in the Renaissance Hotel, Washington D.C., (2) the acquisition of Sheraton, Cerritos, California, (3) the sale by us of 4,102,564 shares of series C convertible redeemable preferred stock, (4) the acquisition of five Renaissance Hotels and a 25% interest in one Renaissance Hotel (the “CTF Acquired Properties”), (5) the acquisition of the Sutton Place Hotel, (6) the sale of 3,750,000 shares of common stock at $20.65 per share and the sale of 294,000 shares of common stock at $21.97 per share to GIC Real Estate, (7) the sale of 300,000 shares of common stock at $22.347 per share to Security Capital Preferred Growth Incorporated and the sale of 3,000,000 shares of common stock at $23.40 (before underwriters’ discount and offering costs) per share to the public, (8) the placement of $250.0 million of fixed rate debt, (9) the replacement of existing debt with $276.0 million in fixed rate debt and (10) the sale by us of 4,850,000 shares of 8.0% series A cumulative redeemable preferred stock.

The following unaudited pro forma financial statements as of June 30, 2005 and for the three and six months ended June 30, 2005 give effect to the above transactions if they had not already occurred as if they had occurred on June 30, 2005 for purposes of the unaudited pro forma balance sheet as of June 30, 2005, and on January 1, 2005 for purposes of the unaudited pro forma statement of operations for the three and six months ended June 30, 2005.

The unaudited pro forma financial data and related notes are presented for informational purposes only and do not purport to represent what our results of operations would actually have been if the transactions had in fact occurred on the dates discussed above. They also do not project or forecast our results of operations for any future date or period.

We believe that the pro forma information is useful to better understand the ongoing operations and financial performance during the periods presented.

The unaudited pro forma financial data should be read together with our historical consolidated and combined financial statements and related notes included elsewhere in this Form 10-Q and with the information set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The pro forma adjustments are based on available information and upon assumptions that we believe are reasonable; however, we cannot assure you that actual results will not differ from the pro forma information and perhaps in material and adverse ways.

SUMMARY UNAUDITED PRO FORMA FINANCIAL AND OPERATING DATA

Three Months Ended June 30, 2005 Compared to the Pro Forma Three Months Ended June 30, 2004

The following table presents our unaudited operating results and statistics for the three months ended June 30, 2005 and pro forma three months ended June 30, 2004, including the amount and percentage change in the results between the two periods.


	Three Months Ended June 30, 2005			Pro Forma Three Months Ended June 30, 2004			$ Change			% Change
	(dollars in thousands, except statistical data)
Operating Results
Revenues	$	132,194		$	120,667		$	11,527		9.6	%
Operating income	$	20,932		$	17,516		$	3,416		19.5	%
Income (loss) from continuing operations before minority interest, income taxes and discontinued operations	$	7,083		$	(6,367	)	$	13,450		NA
Operating Statistics
Occupancy		74.8	%		73.6	%		1.2	%	1.6	%
Average daily rate	$	107.08		$	97.95		$	9.13		9.3	%
RevPAR	$	80.10		$	72.09		$	8.01		11.1	%

Six Months Ended June 30, 2005 Compared to the Pro Forma Six Months Ended June 30, 2004

The following table presents our unaudited operating results and statistics for the six months ended June 30, 2005 and pro forma six months ended June 30, 2004, including the amount and percentage change in the results between the two periods.


	Six Months Ended June 30, 2005			Pro Forma Six Months Ended June 30, 2004			$ Change			% Change
	(dollars in thousands, except statistical data)
Operating Results
Revenues	$	248,751		$	230,982		$	17,769		7.7	%
Operating income	$	33,899		$	20,528		$	13,371		65.1	%
Income (loss) from continuing operations before minority interest, income taxes and discontinued operations	$	8,188		$	(1,782	)	$	9,970		NA
Operating Statistics
Occupancy		72.0	%		70.2	%		1.8	%	2.6	%
Average daily rate	$	104.55		$	97.31		$	7.24		7.4	%
RevPAR	$	75.28		$	68.31		$	6.97		10.2	%

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA INCOME STATEMENT

For the Three Months Ended June 30, 2004

(Unaudited)

(In thousands, except per share data)


	Historical			Hotel Eliminations ⁽¹⁾			Management Company ⁽²⁾			Other Adjustments ⁽³⁾			Offering ⁽⁴⁾			Pro Forma
REVENUES
Room	$	85,319		$	(2,120	)										$	83,199
Food and beverage		27,863			(475	)											27,388
Other operating		10,256			(176	)											10,080
Management and other fees from affiliates		145								$	(145	)					—

Total revenues		123,583			(2,771	)		—			(145	)		—			120,667

OPERATING EXPENSES
Room		18,563			(516	)											18,047
Food and beverage		19,191			(420	)											18,771
Other hotel		37,484			(1,097	)											36,387
General and administrative		17,605			(723	)	$	(15,390	)		(1,492	)					—
General and administrative—corporate		—									2,763						2,763
General and administrative—property operations		—						10,971									10,971
Management fee expense		—						2,409									2,409
Amortization of deferred stock compensation		—									483						483
Depreciation and amortization		13,893			(573	)											13,320

Total operating expenses		106,736			(3,329	)		(2,010	)		1,754						103,151

Operating income (loss)		16,847			558			2,010			(1,899	)					17,516
Interest and other income		114															114
Interest expense		(12,762	)		446									1,053			(11,263	)

Income (loss) from continuing operations before minority interest and income taxes		4,199			1,004			2,010			(1,899	)		1,053			6,367
Minority interest		158												(674	)		(516	)
Provision for income taxes		1,502									(1,502	)					—

Income (loss) from continuing operations	$	5,859		$	1,004		$	2,010		$	(3,401	)	$	379		$	5,851

Income per share from continuing operations:
Basic																$	0.14

Diluted																$	0.14

Common shares outstanding:
Basic																	41,877

Diluted																	42,197

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA CONDENSED INCOME STATEMENT

For the Three Months Ended June 30, 2004

(Unaudited)

(In thousands, except per share data)

Notes to Unaudited Pro Forma Income Statement for the Three Months Ended June 30, 2004

(1)

Represents the elimination of the JW Marriott, Cherry Creek, Colorado and the Embassy Suites Hotel, Los Angeles, California, which were not contributed to us by the Sunstone Predecessor Companies. The other hotels sold in 2004 are included in discontinued operations and, therefore, are not included in this column.


1a.	Represents the elimination of room revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	325
	Embassy Suites Hotel, Los Angeles, California		1,795

		$	2,120

1b.	Represents the elimination of food and beverage revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	184
	Embassy Suites Hotel, Los Angeles, California		291

		$	475

1c.	Represents the elimination of other operating revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	45
	Embassy Suites Hotel, Los Angeles, California		131

		$	176

1d.	Represents the elimination of room expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	169
	Embassy Suites Hotel, Los Angeles, California		347

		$	516

1e.	Represents the elimination of food and beverage expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	211
	Embassy Suites Hotel, Los Angeles, California		209

		$	420

1f.	Represents the elimination of other hotel expenses from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	316
	Embassy Suites Hotel, Los Angeles, California		781

		$	1,097

1g.	Represents the elimination of general and administrative expenses from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	518
	Embassy Suites Hotel, Los Angeles, California		205

		$	723

1h.	Represents the elimination of depreciation and amortization expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	281
	Embassy Suites Hotel, Los Angeles, California		292

		$	573

1i.	Represents the elimination of interest expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	230
	Embassy Suites Hotel, Los Angeles, California		216

		$	446

(2)	Represents the transfer to the Management Company of employee-related expenses from the corporation that managed 45 of our hotels and employed the employees for those hotels (as well as certain corporate personnel involved in hotel management) prior to our initial public offering in October 2004:


Transfer of employee-related expenses	$	10,971
Management fee expense		2,409

	$	13,380

(3)	Other adjustments represents:


3a.	Elimination of management and other fees from affiliates as a result of the formation and structuring transactions	$	145


3b.	Costs of being a public company based on 2005 actual results:
	Continuing costs	$	1,492
	Additional costs		1,271

		$	2,763

3c.	Reflects the grants of restricted stock unit awards	$	483


3d.	Elimination of provision for income taxes	$	1,502

(4)	The effect of the application of the net proceeds of our initial public offering, the concurrent sale of shares to Robert A. Alter and the incurrence of debt under our term loan facility and the application of the net proceeds Under our new term loan facility.


4a.	Reflects the reduction of ground lease expense as a result of the purchase of land under the Embassy Suites Hotel, Chicago, Illinois.	$	—


4b.	Reflects the change in interest expense for the following items:
	Decrease in interest expense for the repayment of debt with the net proceeds of our initial public offering	$	2,405
	Increase in interest expense for debt under the new term loan facility		(1,352	)

		$	1,053

	If market rates of interest on the term loan facility increase by approximately 1.00%, or 100 basis points, the interest expense would increase by approximately $188 for the full quarter.

4c.	Represents the membership units in Sunstone Hotel Partnership owned by the Sunstone Predecessor Companies following our initial public offering.	$	516
			158

		$	674

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA CONDENSED INCOME STATEMENT

For the Six Months Ended June 30, 2004

(Unaudited)

(In thousands, except per share data)


	Historical			Hotel Eliminations ⁽¹⁾			Management Company ⁽²⁾			Other Adjustments ⁽³⁾			Offering ⁽⁴⁾			Pro Forma
REVENUES
Room	$	161,301		$	(3,958	)										$	157,343
Food and beverage		53,401			(766	)											52,635
Other operating		21,330			(326	)											21,004
Management and other fees from affiliates		522								$	(522	)					—

Total revenues		236,554			(5,050	)		—			(522	)		—			230,982

OPERATING EXPENSES
Room		35,943			(837	)											35,106
Food and beverage		36,860			(618	)											36,242
Other hotel		73,877			(1,901	)								(286	)		71,690
General and administrative		32,147			(1,059	)	$	(28,103	)		(2,985	)					—
General and administrative—corporate		—									5,751						5,751
General and administrative—property operations		—						22,552									22,552
Management fee expense		—						3,822									3,822
Amortization of deferred stock compensation		—									1,014						1,014
Depreciation and amortization		27,732			(893	)											26,839
Impairment loss		7,439															7,439

Total operating expenses		213,998			(5,308	)		(1,729	)		3,780			(286	)		210,455

Operating income (loss)		22,556			258			1,729			(4,302	)		286			20,527
Interest and other income		216															216
Interest expense		(26,104	)		688									2,891			(22,525	)

Income (loss) from continuing operations before minority interest and income taxes		(3,332	)		946			1,729			(4,302	)		3,177			(1,782	)
Minority interest		166												(22	)		144
Provision for income taxes		199									(199	)					—

Income (loss) from continuing operations	$	(2,967	)	$	946		$	1,729		$	(4,501	)	$	3,155		$	(1,638	)

Loss per share from continuing operations:
Basic																$	(0.04	)

Diluted																$	(0.04	)

Common shares outstanding:
Basic																	41,877

Diluted																	41,877

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA INCOME STATEMENT

For the Six Months Ended June 30, 2004

(Unaudited)

(In thousands, except per share data)

Notes to Unaudited Pro Forma Income Statement for the Six Months Ended June 30, 2004

(1)


1a.	Represents the elimination of room revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	325
	Embassy Suites Hotel, Los Angeles, California		3,633

		$	3,958

1b.	Represents the elimination of food and beverage revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	184
	Embassy Suites Hotel, Los Angeles, California		582

		$	766

1c.	Represents the elimination of other operating revenue from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	45
	Embassy Suites Hotel, Los Angeles, California		281

		$	326

1d.	Represents the elimination of room expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	169
	Embassy Suites Hotel, Los Angeles, California		668

		$	837

1e.	Represents the elimination of food and beverage expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	211
	Embassy Suites Hotel, Los Angeles, California		407

		$	618

1f.	Represents the elimination of other hotel expenses from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	316
	Embassy Suites Hotel, Los Angeles, California		1,585

		$	1,901

1g.	Represents the elimination of general and administrative expenses from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	680
	Embassy Suites Hotel, Los Angeles, California		379

		$	1,059

1h.	Represents the elimination of depreciation and amortization expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	281
	Embassy Suites Hotel, Los Angeles, California		612

		$	893

1i.	Represents the elimination of interest expense from the following hotels:
	JW Marriott, Cherry Creek, Colorado	$	230
	Embassy Suites Hotel, Los Angeles, California		458

		$	688

(2)	Represents the transfer to the Management Company of employee-related expenses from the corporation that managed 45 of our hotels and employed the employees for those hotels (as well as certain corporate personnel involved in hotel management) prior to our initial public offering in October 2004:


Transfer of employee-related expenses	$	22,552
Management fee expense		3,822

	$	26,374

(3)	Other adjustments represents:


3a.	Elimination of management and other fees from affiliates as a result of the formation and structuring transactions	$	522


3b.	Costs of being a public company based on 2005 actual results:
	Continuing costs	$	2,985
	Additional costs		2,766

		$	5,751

3c.	Reflects the grants of restricted stock unit awards	$	1,014


3d.	Elimination of provision for income taxes	$	199

(4)	The effect of the application of the net proceeds of our initial public offering.


4a.	Reflects the reduction of ground lease expense as a result of the purchase of land under the Embassy Suites Hotel, Chicago, Illinois.	$	286


4b.	Reflects the change in interest expense for the following items:
	Decrease in interest expense for the repayment of debt with the net proceeds of this offering	$	5,291
	Increase in interest expense for debt under the new term loan facility		(2,400	)

		$	2,891

	If market rates of interest on the term loan facility increase by approximately 1.00%, or 100 basis points, the interest expense would increase by approximately $188 for the full quarter.

4c.	Represents the membership units in Sunstone Hotel Partnership owned by the Sunstone Predecessor Companies following our initial public offering.	$	(144	)
			166

		$	22

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA BALANCE SHEET

June 30, 2005

(Unaudited)

(In thousands)


	Historical			Renaissance Washington D.C. ⁽¹⁾			Sutton Place Hotel ⁽²⁾			Financing Transactions ⁽³⁾			Pro Forma
ASSETS
Current assets:
Cash and cash equivalents	$	61,753		$	(81,194	)	$	(72,250	)	$	98,500		$	6,809
Restricted cash		34,581												34,581
Accounts receivable, net		34,751												34,751
Due from affiliates		213												213
Inventories		2,342												2,342
Prepaid expenses and other current assets		2,760												2,760

Total current assets		136,400			(81,194	)		(72,250	)		98,500			81,456
Investment in hotel properties, net		1,537,826			121,671
					20,018
					13,493			72,250						1,765,258
Other real estate, net		7,283												7,283
Investment in unconsolidated joint venture		20,018			(20,018	)								—
Deferred financing costs, net		7,476												7,476
Goodwill		27,299												27,299
Other assets, net		33,843												33,843

Total assets	$	1,770,145		$	53,970		$	—		$	98,500		$	1,922,615

LIABILITIES AND MEMBERS’ EQUITY
Current liabilities:
Accounts payable and other accrued expenses	$	21,745											$	21,745
Accrued payroll and employee benefits		4,421												4,421
Due to Management Company		17,214												17,214
Dividends payable		14,874												14,874
Distributions payable		1,054												1,054
Other current liabilities		20,527												20,527
Current portion of secured notes payable		2,716												2,716

Total current liabilities		82,551												82,551
Notes payable, less current portion		964,480			40,477
					13,493									1,018,450
Other liabilities		2,539												2,539

Total liabilities		1,049,570			53,970									1,103,540
Minority interests		48,635												48,635
Series C convertible redeemable preferred stock											99,000			99,000
Stockholders’ equity
Preferred stock		121,250												121,250
Common stock		419												419
Additional paid in capital		599,813									(500	)		599,313
Unearned and accrued stock compensation		(7,169	)											(7,169	)
Accumulated deficit		(7,568	)											(7,568	)
Cumulative dividends		(34,805	)											(34,805	)

Total stockholders’ equity		671,940									(500	)		671,440

Total liabilities and equity	$	1,770,145		$	53,970		$	—		$	98,500		$	1,922,615

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA BALANCE SHEET

June 30, 2005

(Unaudited)

(In thousands)

Notes to Unaudited Pro Forma Balance Sheet as of June 30, 2005

(1)	Represents the acquisition of a 75% interest in Renaissance Washington, Washington D.C.:


Cash paid for the 75% interest in the Renaissance Washington, Washington D.C.	$	78,414
Debt assumed		40,477

Purchase price		118,891
Closing costs		2,780

Total costs	$	121,671

Reclassification of the investment in unconsolidated joint venture (due to our first having acquired only a 25% ownership interest in this hotel) to investment in hotel properties, net	$	20,018

Debt assumed in the acquisition of the 25% interest in Renaissance Washington, Washington D.C.	$	13,493

(2)	Represents the acquisition of the Sutton Place Hotel, Newport Beach, California:


Cash paid for the Sutton Place Hotel, Newport Beach, California	$	71,750
Closing costs		500

Total costs to acquire the Sutton Place Hotel, Newport Beach, California	$	72,250

(1)	Represents the sale of series C convertible redeemable preferred stock:

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA CONDENSED INCOME STATEMENT

For the Three Months Ended June 30, 2005

(Unaudited)

(In thousands, except per share data)


	Historical			CTF Acquired Properties ⁽¹⁾		Renaissance Westchester ⁽²⁾		Renaissance Washington D.C. ⁽³⁾		Sutton Place Hotel ⁽⁴⁾		Sheraton Cerritos ⁽⁵⁾		Financing Transactions ⁽⁶⁾			Pro Forma
REVENUES
Room	$	92,593		$	19,899	$	2,745	$	10,757	$	3,034	$	1,665				$	130,693
Food and beverage		28,986			10,761		1,927		4,111		1,945		1,236					48,966
Other operating		10,615			2,122		305		1,700		179		77					14,998
Management and other fees from related parties		—																—

Total revenues		132,194			32,782		4,977		16,568		5,158		2,978					194,657

OPERATING EXPENSES
Room		19,449			4,779		773		2,615		786		401					28,803
Food and beverage		19,579			8,507		1,511		3,309		1,508		719					35,133
Other hotel		37,497			6,441		1,174		3,163		722		369					49,366
General and administrative
General and administrative—corporate		2,763																2,763
General and administrative—property operations		16,549			6,073		1,166		2,388		716		538					27,430
Amortization of deferred stock compensation		483																483
Depreciation and amortization		14,942			2,346		331		890		452		160					19,121

Total operating expenses		111,262			28,146		4,955		12,365		4,184		2,187					163,099

Operating income (loss)		20,932			4,636		22		4,203		974		791					31,558
Interest and other income		1,398																1,398
Interest expense		(15,247	)												(615	)		(15,862	)

Income (loss) from continuing operations before minority interest and income taxes		7,083			4,636		22		4,203		974		791		(615	)		17,094
Minority interest		(643	)												(418	)		(1,061	)
Income tax benefit		—																—

Income (loss) from continuing operations		6,440			4,636		22		4,203		974		791		(1,033	)		16,033
Preferred stock dividends		(2,414	)												(1,612	)		(4,026	)

Income available to common stockholders	$	4,026		$	4,636	$	22	$	4,203	$	974	$	791	$	(2,645	)	$	12,007

Income per share to common stockholders:
Basic																	$	0.29

Diluted																	$	0.28

Common shares outstanding ⁽⁷⁾:
Basic																		41,877

Diluted																		42,197

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA CONDENSED INCOME STATEMENT

For the Three Months Ended June 30, 2005

(Unaudited)

(In thousands, except per share data)

Notes to Unaudited Pro Forma Income Statement for the Three Months Ended June 30, 2005


(1)	Represents the acquisition of the CTF Acquired Properties:
	Room revenue	$	19,899

	Food and beverage revenue	$	10,761

	Other operating revenue	$	2,122

	Room expense	$	4,779

	Food and beverage expense	$	8,507

	Other hotel expenses	$	6,441

	General and administrative	$	6,073

	Depreciation and amortization	$	2,346

(2)	Represents the acquisition of the Renaissance Westchester, White Plains, New York:
	Room revenue	$	2,745

	Food and beverage revenue	$	1,927

	Other operating revenue	$	305

	Room expense	$	773

	Food and beverage expense	$	1,511

	Other hotel expenses	$	1,174

	General and administrative	$	1,166

	Depreciation and amortization	$	331

(3)	Represents the acquisition of the remaining 75% interest in the Renaissance Washington, Washington, D.C.:
	Room revenue	$	10,757

	Food and beverage revenue	$	4,111

	Other operating revenue	$	1,700

	Room expense	$	2,615

	Food and beverage expense	$	3,309

	Other hotel expenses	$	3,163

	General and administrative	$	2,388

	Depreciation and amortization	$	890

(4)	Represents the acquisition of the Sutton Place Hotel, Newport Beach, California:
	Room revenue	$	3,034

	Food and beverage revenue	$	1,945

	Other operating revenue	$	179

	Room expense	$	786

	Food and beverage expense	$	1,508

	Other hotel expenses	$	722

	General and administrative	$	716

	Depreciation and amortization	$	452

(5)	Represents the acquisition of the Sheraton Cerritos, Cerritos, California:
	Room revenue	$	1,665

	Food and beverage revenue	$	1,236

	Other operating revenue	$	77

	Room expense	$	401

	Food and beverage expense	$	719

	Other hotel expenses	$	369


	General and administrative	$	538

	Depreciation and amortization	$	160

(6)	Represents the Financing Transactions:
	6a. Reflects the net change in interest resulting from the fixed rate mortgage loan refinance and the new debt incurred in connection with the purchase of the CTF Acquired Properties, the Renaissance Washington, Washington, D.C. and the Sheraton Cerritos
	Actual interest expense	$	15,247
	Net increase in interest expense		615

	Pro forma interest expense	$	15,862

	6b. Reflects a full period of preferred stock dividends on the 4,102,564 shares of series C convertible redeemable preferred stock	$	1,612

	6c. Record minority interest for the pro forma period:
	Pro forma income available to minority interest holders and common stockholders	$	13,068
	Minority ownership percentage		8.12	%

	Minority interest	$	1,061

(7)	The shares used in the basic and diluted income available to common stockholders is as follows:
	Basic shares outstanding as of June 30, 2005		41,877
	Unvested restricted stock grants made to employees		320

	Diluted shares outstanding		42,197

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA CONDENSED INCOME STATEMENT

For the Six Months Ended June 30, 2005

(Unaudited)

(In thousands, except per share data)


	Historical			CTF Acquired Properties ⁽¹⁾		Renaissance Westchester ⁽²⁾			Renaissance Washington D.C. ⁽³⁾		Sutton Place Hotel ⁽⁴⁾		Sheraton Cerritos ⁽⁵⁾		Financing Transactions ⁽⁶⁾			Pro Forma
REVENUES
Room	$	172,217		$	40,646	$	5,206		$	19,506	$	6,064	$	3,363				$	247,002
Food and beverage		54,761			22,741		3,273			8,071		3,787		2,312					94,945
Other operating		21,773			4,608		593			2,070		362		157					29,563
Management and other fees from related parties		—																	—

Total revenues		248,751			67,995		9,072			29,647		10,213		5,832					371,510

OPERATING EXPENSES
Room		37,233			9,669		1,444			4,909		1,613		837					55,705
Food and beverage		37,870			17,012		2,766			6,718		2,969		1,421					68,756
Other hotel		74,978			12,237		2,093			5,224		1,445		770					96,747
General and administrative
General and administrative—corporate		5,751																	5,751
General and administrative—property operations		29,001			12,908		2,207			5,155		1,416		1,084					51,771
Amortization of deferred stock compensation		1,014																	1,014
Depreciation and amortization		29,005			4,691		661			1,779		903		320					37,359

Total operating expenses		214,852			56,517		9,171			23,785		8,346		4,432					317,103

Operating income (loss)		33,899			11,478		(99	)		5,862		1,867		1,400					54,407
Interest and other income		1,704																	1,704
Interest expense		(27,415	)													(4,309	)		(31,724	)

Income (loss) from continuing operations before minority interest and income taxes		8,188			11,478		(99	)		5,862		1,867		1,400		(4,309	)		24,387
Minority interest		(794	)													(531	)		(1,325	)
Income tax benefit		—																	—

Income (loss) from continuing operations		7,394			11,478		(99	)		5,862		1,867		1,400		(4,840	)		23,062
Preferred stock dividends		(2,802	)													(2,037	)
																(3,224	)		(8,063	)

Income available to common stockholders	$	4,592		$	11,478	$	(99	)	$	5,862	$	1,867	$	1,400	$	(10,101	)	$	14,999

Income (loss) per share to common stockholders:
Basic																		$	0.36

Diluted																		$	0.36

Common shares outstanding ⁽⁷⁾:
Basic																			41,877

Diluted																			42,197

SUNSTONE HOTEL INVESTORS, INC.

PRO FORMA INCOME STATEMENT

For the Six Months Ended June 30, 2005

(Unaudited)

(In thousands, except per share data)

Notes to Unaudited Pro Forma Income Statement for the Six Months Ended June 30, 2005


(1)	Represents the acquisition of the CTF Acquired Properties:
	Room revenue	$	40,646

	Food and beverage revenue	$	22,741

	Other operating revenue	$	4,608

	Room expense	$	9,669

	Food and beverage expense	$	17,012

	Other hotel expenses	$	12,237

	General and administrative	$	12,908

	Depreciation and amortization	$	4,691

(2)	Represents the acquisition of the Renaissance Westchester, White Plains, New York:
	Room revenue	$	5,206

	Food and beverage revenue	$	3,273

	Other operating revenue	$	593

	Room expense	$	1,444

	Food and beverage expense	$	2,766

	Other hotel expenses	$	2,093

	General and administrative	$	2,207

	Depreciation and amortization	$	661

(3)	Represents the acquisition of the remaining 75% interest in the Renaissance Washington, Washington, D.C.:
	Room revenue	$	19,506

	Food and beverage revenue	$	8,071

	Other operating revenue	$	2,070

	Room expense	$	4,909

	Food and beverage expense	$	6,718

	Other hotel expenses	$	5,224

	General and administrative	$	5,155

	Depreciation and amortization	$	1,779

(4)	Represents the acquisition of the Sutton Place Hotel, Newport Beach, California:
	Room revenue	$	6,064

	Food and beverage revenue	$	3,787

	Other operating revenue	$	362

	Room expense	$	1,613

	Food and beverage expense	$	2,969

	Other hotel expenses	$	1,445

	General and administrative	$	1,416

	Depreciation and amortization	$	903

(5)	Represents the acquisition of the Sheraton Cerritos, Cerritos, California:
	Room revenue	$	3,363

	Food and beverage revenue	$	2,312

	Other operating revenue	$	157

	Room expense	$	837

	Food and beverage expense	$	1,421

	Other hotel expenses	$	770


	General and administrative	$	1,084

	Depreciation and amortization	$	320

(6)	Represents the Financing Transactions:
	6a. Reflects the net change in interest resulting from the fixed rate mortgage loan refinance and the new debt to be incurred in connection with the purchase of the CTF Acquired Properties, the Renaissance Washington, Washington, D.C. and the Sheraton Cerritos
	Actual interest expense	$	27,415
	Net increase in interest expense		4,309

	Pro forma interest expense	$	31,724

	6b. Reflects a full period of preferred stock dividends on the 4,850,000 shares of 8.0% series A preferred stock
	Actual preferred stock dividends	$	388
	Increase in preferred stock dividends for full period		2,037

	Pro forma preferred stock dividends	$	2,425

	6c. Reflects a full period of preferred stock dividends on the 4,102,564 shares of series C convertible redeemable preferred stock	$	3,224

	6d. Record minority interest for the pro forma period:
	Pro forma income available to minority interest holders and common stockholders	$	16,324
	Minority ownership percentage		8.12	%

	Minority interest	$	1,325

(7)	The shares used in the basic and diluted income available to common stockholders is as follows:
	Basic shares outstanding as of June 30, 2005		41,877
	Unvested restricted stock grants made to employees		320

	Diluted shares outstanding		42,197

Liquidity and Capital Resources

Historical. During the periods presented, our historical sources of cash included our operating activities, working capital, long-term notes payable, bank credit facilities, contributions by the Sunstone Predecessor Companies and proceeds of our public and private offerings of common and preferred stock. Our primary uses for cash were for acquisitions of hotels, capital expenditures for hotels, operating expenses, distributions to the Sunstone Predecessor Companies, repayment of notes payable and dividends.

Operating activities. Net cash provided by operating activities was $7.7 million for the six months ended June 30, 2005 compared to $28.7 million for the six months ended June 30, 2004. This decrease was primarily due to $24.6 million of deposits and expenditures made in connection with acquisitions that closed in July 2005, and an increase in restricted cash resulting from the purchase of interests in six Renaissance hotels partially offset by improved profitability during the six months ended June 30, 2005.

Investing activities. Our cash used in investment activities fluctuates primarily based on acquisitions, sales and renovations of hotels. Net cash used in investing activities was $455.5 million in the six months ended June 30, 2005 compared to $42.5 million in the six months ended June 30, 2004. In the first half of 2005, we acquired six hotels and a 25% interest in another hotel for $459.2 million and invested $23.5 million of capital expenditures in our hotels. Additionally, we received net proceeds of $27.2 million from the sale of two hotels. In the first half of 2004, we developed and acquired two hotels for $49.6 million and invested $22.3 million of capital expenditures in our hotels. Additionally, we received net proceeds of $29.4 million from the sale of three hotels.

Financing activities. Net cash provided by financing activities was $503.6 million for the six months ended June 30, 2005 compared to $17.3 million for the six months ended June 30, 2004. Net cash provided by financing activities for the six months ended June 30, 2005 consisted primarily of net proceeds from our preferred securities and common stock offerings of $117.5 million and $155.8 million, respectively, and proceeds from notes payable of $535.4 million; partially offset by $22.0 million of dividends and distributions to our shareholders and OP unit holders, $280.1 million of principal payments on notes payable and $2.3 million in deferred financing costs. Net cash provided by financing activities for the six months ended June 30, 2004 consisted primarily of proceeds from notes payable of $28.7 million and contributions from the Sunstone Predecessor Companies of $25.4 million partially offset by $3.5 million of distributions to the Sunstone Predecessor Companies and $33.3 million of principal payments on notes payable.

Future. We expect our primary uses for cash to be for acquisitions of hotels, capital expenditures for hotels, operating expenses, debt service and distributions to holders of our common and preferred stock and membership units in our Operating Partnership. We also expect our primary sources of cash will continue to come from the operations of our hotels and our working capital. In addition, we have a $150.0 million senior secured revolving credit facility.

We believe that our capital structure, including our $150.0 million revolving credit facility and cash flow from operations, will provide us with sufficient liquidity to meet our current operating expenses and other expenses directly associated with our business and properties. We have interest rate protection agreements covering all of our variable rate debt, which accounted for 9.1% of our total outstanding indebtedness at June 30, 2005. In April 2005, the Company closed ten individual non cross-collateralized fixed rate mortgage loans totaling $276.0 million. The loans are each for a term of ten years with a fixed rate of 5.34%. As of July 31, 2005, 91.4% of the Company’s outstanding debt is fixed rate. We believe this debt capital structure is appropriate for the operating characteristics of our business and provides for significant prepayment and refinancing flexibility.

In the future, we may also explore other financing alternatives, including our sale of equity and debt securities. Our ability to incur additional debt depends on a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by existing lenders under our existing notes payable, including our revolving credit facility. Our ability to raise funds through the issuance of equity securities depends on, among other things, general market conditions for hotel companies and REITs and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time. However, the capital markets may not be available to us when needed on favorable terms or at all.

Contractual Obligations

The following table summarizes our payment obligations and commitments as of June 30, 2005 (in thousands):


	Payment due by period
Contractual obligations	Total		Less than 1 year		1 to 3 years		3 to 5 years		More than 5 years
	(in thousands)
Notes payable	$	967,196	$	2,716	$	39,653	$	102,944	$	821,883
Operating lease obligations		195,595		3,466		7,056		7,167		177,906
Construction commitments		11,336		11,336		—		—		—
Employment obligations		4,425		1,275		2,183		967		—

Total	$	1,178,552	$	18,793	$	48,892	$	111,078	$	999,789

Capital Expenditures and Reserve Funds

We believe we maintain each of our hotels in good repair and condition and in conformity with applicable franchise agreements, ground leases, laws and regulations. Our capital expenditures primarily relate to the ongoing maintenance of our hotels and are budgeted in the reserve accounts described in the following paragraph. We also incur capital expenditures following the acquisition of hotels for renovation and development. Our capital expenditures for 2005 are expected to be approximately $65.0 million to $75.0 million. This renovation budget includes our $11.3 million of contractual construction commitments. All of these amounts are expected to be funded out of our cash and reserve accounts. Our capital expenditures could increase if we determine to acquire, renovate or develop additional hotels in the future. Our capital expenditures also fluctuate from year to year, since we are not required to spend the entire amount in the reserve accounts each year.

With respect to our hotels that are operated under franchise agreements with major national hotel brands and for all of our hotels subject to a first mortgage lien, we are obligated to maintain a furniture, fixture and equipment, or FF&E, reserve account for future planned and emergency-related capital expenditures at these hotels. The amount funded into each of these reserve accounts is determined pursuant to the management, franchise and loan agreements for each of the respective hotels, ranging between 4.0% and 5.0% of the respective hotel’s total annual revenue. As of June 30, 2005, $20.2 million was available in restricted cash reserves for future capital expenditures at our hotels. According to the respective loan agreements, the reserve funds are to be held by the respective lenders in a restricted cash account.

Derivative Financial Instruments

We use derivative financial instruments, primarily interest rate caps, to manage our exposure to the interest rate risks related to the following variable rate debt. Following the repayment of some of our floating rate debt with the proceeds from our initial public offering, we own interest rate caps having aggregate notional amounts well in excess of our floating rate debt. At June 30, 2005, our interest rate caps consisted of the following:


As of June 30, 2004 Notional Amount		LIBOR Rate at which Exposure is Capped		Interest Rate Cap Maturity
(in millions)
$	359.5	5.90		9/1/2005
	224.5	6.75	⁽¹⁾	1/3/2006
	54.5	6.50		1/3/2006
	60.0	4.50		10/11/2005
	18.2	4.50		10/11/2005
	38.0	6.30		11/11/2005
	6.3	4.50		5/22/2006

$	761.0

⁽¹⁾	Reflects the weighted average of the seven tranches of mortgages, each with specific notional amounts and LIBOR cap agreements.

The net settlements, if any, paid or received under these interest rate cap agreements are accrued consistent with the terms of the agreements and are recognized in interest expense over the term of the related debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. We generally use outside consultants to determine the fair values of our derivative instruments. Such methods generally incorporate market conventions and techniques such as discounted cash flow analysis and option pricing models to determine fair value. We believe these methods of estimating fair value result in general approximation of value, and such value may or may not actually be realized. For the six months ended June 30, 2005, our mark to market adjustments of these contracts resulted in a net loss of $3,000.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements during the periods presented and did not have any upon the completion of our offering.

Seasonality

The lodging business is seasonal in nature, and we experience some seasonality in our business as indicated in the table below. Revenue for hotels in tourist areas generally are substantially greater during tourist season than other times of the year. Quarterly revenue also may be adversely affected by events beyond our control, such as extreme weather conditions, terrorist attacks or alerts, SARS, airline strikes, economic factors and other considerations affecting travel.

Our revenues by quarter during 2004 and 2005 were as follows (dollars in thousands):


	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Revenues
2004	$	112,971	$	123,583	$	132,174	$	122,561
2005	$	116,557	$	132,194

Inflation

Inflation may affect our expenses, including, without limitation, by increasing such costs as taxes, property and casualty insurance and utilities.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated and combined financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.

We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our combined financial statements.

•

Impairment of long-lived assets. We periodically review each property for possible impairment. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. In this analysis of fair value, we use discounted cash flow analysis to estimate the fair value of our properties taking into account each property’s expected cash flow from operations, holding period and proceeds from the disposition of the property. The factors addressed in determining estimated proceeds from disposition include anticipated operating cash flow in the year of disposition, terminal capitalization rate and selling price per room. Our judgment is required in determining the discount rate applied to estimated cash flows, growth rate of the properties, the need for capital expenditures, as well as specific market and economic conditions. Additionally, the classification of these assets as held-for-sale requires the recording of these assets at their estimated fair value less estimated selling costs which can affect the amount of impairment recorded.

•

Depreciation and amortization expense. Depreciation expense is based on the estimated useful life of our assets. The life of the assets are based on a number of assumptions, including the cost and timing of capital expenditures to maintain and refurbish our hotels, as well as specific market and economic conditions. Hotel properties and other completed real estate investments are depreciated using the straight-line method over estimated useful lives ranging from five to 35 years for buildings and improvements and three to 12 years for furniture, fixtures and equipment. While management believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income or the gain or loss on the sale of any of our hotels. We have not changed the estimated useful lives of any of our assets during the periods discussed.

•

Derivative instruments and hedging activities. Derivative instruments and hedging activities require us to make judgments on the nature of our derivatives and their effectiveness as hedges. These judgments determine if the changes in fair value of the derivative instruments are reported as a component of interest expense in the consolidated and combined statements of operations or as a component of equity on the consolidated and combined balance sheets. While we believe our judgments are reasonable, a change in a derivative’s fair value or effectiveness as a hedge could affect expenses, net income and equity. None of our derivatives held during the periods presented qualified for effective hedge accounting treatment.

•

Accrual of self-insured obligations. We are self-insured up to certain amounts with respect to employee medical, employee dental, general liability insurance, personal injury claims, workers’ compensation, automobile liability and other coverages. We establish reserves for our estimates of the loss that we will ultimately incur on reported claims as well as estimates for claims that have been incurred but not yet reported. Our reserves, which are reflected in Due to Management Company, accrued payroll and employee benefits and other liabilities in our consolidated and combined balance sheets, are based on actuarial valuations and our history of claims. Our actuaries incorporate historical loss experience and judgments about the present and expected levels of costs per claim. Trends in actual experience are an important factor in the determination of these estimates. We believe that our estimated reserves for such claims are adequate, however, actual experience in claim frequency and amount could materially differ from our estimates and adversely affect our results of operations, cash flow, liquidity and financial condition.

New Accounting Standards and Accounting Changes

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment. SFAS 123(R) requires all share-based payments to employees, including grants of common stock, to be recognized in the financial statements based on their fair values. The adoption of the provisions of SFAS 123(R) had no material impact to us.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Some of our outstanding debt has a variable interest rate. As described in “—Derivative Financial Instruments” above, we use some derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of June 30, 2005, our total outstanding debt was approximately $967.2 million, of which approximately $88.1 million, or 9.1%, was variable rate debt. If market rates of interest on our variable rate debt decrease by 1.0% or approximately 100 basis points, the decrease in interest expense on our variable rate debt would increase future earnings and cash flows by approximately $881,000 annually. On the other hand, if market rates of interest on our variable debt increase by 1.0% or approximately 100 basis points, the increase in interest expense on our variable debt would decrease future earnings and cash flows by approximately $881,000 annually.

Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of a reduced level of overall economic activity. If overall economic activity is significantly reduced, we may take actions to further mitigate our exposure. However, because we cannot determine the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.

Item 4.

Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this quarterly report on Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of such date, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in applicable SEC’s rules and forms. No system of controls, no matter how well designed and operated, can provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

There have been no changes in our internal control over financial reporting that occurred during the three months ended June 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II—OTHER INFORMATION

Item 1.

Legal Proceedings

We are involved from time to time in various claims, disputes and other legal actions in the ordinary course of business. We do not believe that the resolution of such additional matters will have a material adverse effect on our financial position or results of operations when resolved.

Item 2.

Changes in Securities and Use of Proceeds

Not applicable.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At the Sunstone Hotel Investors, Inc., Annual Meeting of Stockholders on May 10, 2005, the following individuals were elected to the Board of Directors:


Director	Votes For	Votes Witheld
Robert A. Alter	15,850,994	6,385
Lewis N. Wolff	15,850,594	6,785
Z. Jamie Behar	15,850,284	7,095
Barbara S. Brown	15,850,834	6,545
Anthony W. Dona	15,850,534	6,845
Paul D. Kazilionis	15,817,020	40,359
Johnathan H. Paul	15,849,944	7,435
Keith P. Russell	15,850,584	6,795
David M. Siegel	15,851,084	6,295

There were no broker non-votes.

The following proposal was ratified at the Company’s Annual Meeting:


	Votes For	Votes Against	Abstain	Broker Non-Votes
Ratification of the Audit Committee’s appointment of Ernst & Young LLP to act as the independent registered public accounting firm for fiscal year ending December 31, 2005	15,769,451	86,593	1,335	0

Item 5.

Other Information

None.

Item 6.

Exhibits

The following Exhibits are filed as a part of this report:


Exhibit Number		Description

3.1		Articles of Amendment and Restatement of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 3.1 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

3.2		Bylaws of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 3.2 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

3.3		Form of Articles Supplementary for Series A Preferred Stock (incorporated by reference to Exhibit 3.3 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

3.4		Form of Articles Supplementary for Series B Preferred Stock (incorporated by reference to Exhibit 3.4 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

3.5		Form of Articles Supplementary for Series C Preferred Stock (incorporated by reference to Exhibit 3 to Form 8-K (File No. 001-32319) filed by the Company).

4.2		Letter furnished to Securities and Exchange Commission agreeing to furnish certain debt instruments (incorporated by reference to Exhibit 4.2 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

4.3		Form of Specimen Certificate of Series A Preferred Stock of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 4.1 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

4.4		Form of Specimen Certificate of Series B Preferred Stock of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 4.3 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

4.5		Form of Specimen Certificate of Series C Preferred Stock of Sunstone Hotel Investors, Inc.

10.1		Purchase and Sale Agreement between Marriott International, Inc. and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.1 to Form 8-K (File No. 001-32319) filed by the Company).

10.2		Stock Purchase Agreement between BIP REIT Private Limited and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.2 to Form 8-K (File No. 001-32319) filed by the Company).

10.3		Registration Rights Agreement between BIP REIT Private Limited and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.3 to Form 8-K (File No. 001-32319) filed by the Company).

10.4		Escrow Agreement among BIP REIT Private Limited, Sunstone Hotel Investors, Inc. and Citibank, N.A., dated April 27, 2005 (incorporated by reference to Exhibit 10.4 to Form 8-K (File No. 001-32319) filed by the Company).

10.5		Purchase Agreement among Security Capital Preferred Growth Incorporated, Sunstone Hotel Investors, Inc. and Sunstone Hotel Partnership, LLC, dated April 27, 2005 (incorporated by reference to Exhibit 10.5 to Form 8-K (File No. 001-32319) filed by the Company).

10.6		Amendment No. 1 to the Term Credit Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K (File No. 005-80106) filed by the Company).

31.1		Certification of CEO Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of CFO Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements 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.


	Sunstone Hotel Investors, Inc.

Date: August 8, 2005	By:	/s/ JON D. KLINE
		Jon D. Kline (Principal Financial Officer and Duly Authorized Officer)

EXHIBIT INDEX


Exhibit Number		Description

3.1		Articles of Amendment and Restatement of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 3.1 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

3.2		Bylaws of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 3.2 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

3.3		Form of Articles Supplementary for Series A Preferred Stock (incorporated by reference to Exhibit 3.3 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

3.4		Form of Articles Supplementary for Series B Preferred Stock (incorporated by reference to Exhibit 3.4 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

3.5		Form of Articles Supplementary for Series C Preferred Stock (incorporated by reference to Exhibit 3 to Form 8-K (File No. 001-32319) filed by the Company).

4.2		Letter furnished to Securities and Exchange Commission agreeing to furnish certain debt instruments (incorporated by reference to Exhibit 4.2 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).

4.3		Form of Specimen Certificate of Series A Preferred Stock of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 4.1 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

4.4		Form of Specimen Certificate of Series B Preferred Stock of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 4.3 to the registration statement on Form S-11 (File No. 333-123102) filed by the Company).

4.5		Form of Specimen Certificate of Series C Preferred Stock of Sunstone Hotel Investors, Inc.

10.1		Purchase and Sale Agreement between Marriott International, Inc. and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.1 to Form 8-K (File No. 001-32319) filed by the Company).

10.2		Stock Purchase Agreement between BIP REIT Private Limited and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.2 to Form 8-K (File No. 001-32319) filed by the Company).

10.3		Registration Rights Agreement between BIP REIT Private Limited and Sunstone Hotel Investors, Inc., dated April 27, 2005 (incorporated by reference to Exhibit 10.3 to Form 8-K (File No. 001-32319) filed by the Company).

10.4		Escrow Agreement among BIP REIT Private Limited, Sunstone Hotel Investors, Inc. and Citibank, N.A., dated April 27, 2005 (incorporated by reference to Exhibit 10.4 to Form 8-K (File No. 001-32319) filed by the Company).

10.5		Purchase Agreement among Security Capital Preferred Growth Incorporated, Sunstone Hotel Investors, Inc. and Sunstone Hotel Partnership, LLC, dated April 27, 2005 (incorporated by reference to Exhibit 10.5 to Form 8-K (File No. 001-32319) filed by the Company).

10.6		Amendment No. 1 to the Term Credit Agreement (incorporated by reference to Exhibit 10.1 to Form 8-K (File No. 005-80106) filed by the Company).

31.1		Certification of CEO Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of CFO Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002