-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HiWrehXbWXIAQK+lBXmUXDLaxxYdqEehO1XvCR8Zlwy1t/sTntzqp0a5jm444jOp 7eiOM/6RQ437BkoxXlUK0w== 0001017062-99-000532.txt : 19990331 0001017062-99-000532.hdr.sgml : 19990331 ACCESSION NUMBER: 0001017062-99-000532 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SUNSTONE HOTEL INVESTORS INC CENTRAL INDEX KEY: 0000930600 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 521891908 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-14375 FILM NUMBER: 99577275 BUSINESS ADDRESS: STREET 1: 903 CALLE AMANECER CITY: SAN CLEMENTE STATE: CA ZIP: 92673 BUSINESS PHONE: 949-369-4000 MAIL ADDRESS: STREET 1: 115 CALLE DE INDUSTRIAS STREET 2: SUITE 201 CITY: SAN CLEMENTE STATE: CA ZIP: 92672 10-K 1 FORM 10-K - SUNSTONE HOTEL INVESTORS, INC. ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ___________________ (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ______________ Commission file number 0-26304 SUNSTONE HOTEL INVESTORS, INC. (Exact name of registrant as specified in its charter) ____________________ Maryland 52-1891908 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification No.) 903 Calle Amanecer, San Clemente, CA 92673 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (949) 369-4000 - -------------------------------------------------------------------------------- Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $.01 (Title of Class) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicated by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] Based on the closing sale price on New York Stock Exchange on March 5, 1999, the aggregate market value of the voting stock held by non-affiliates of the registrant was $289,345,000. As of March 5, 1999, there were 37,638,427 shares of Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part III of this Report incorporates information by reference from the definitive Proxy Statement for the Annual Meeting of Stockholders, to be held May 24, 1999. ================================================================================ SUNSTONE HOTEL INVESTORS, INC. ANNUAL REPORT ON FORM 10-K DECEMBER 31, 1998 TABLE OF CONTENTS PART I Page ---- ITEMS 1. & 2. BUSINESS AND PROPERTIES............................... 1 ITEM 3. LEGAL PROCEEDINGS..................................... 26 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS... 26 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS................................... 27 ITEM 6. SELECTED FINANCIAL DATA............................... 28 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................... 30 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........................................... 39 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........... 39 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE................... 39 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.... 40 ITEM 11. EXECUTIVE COMPENSATION................................ 40 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............................................ 40 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........ 40 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K............................................ 41 -i- PART I Forward-Looking Statements When used throughout this Annual Report, the words "believes", "anticipates" and "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to the many risks and uncertainties which affect the Company's business, and actual results could differ materially from those projected and forecasted. These uncertainties, which include competition within the lodging industry, the balance between supply and demand for hotel rooms, the Company's continued ability to execute acquisitions and renovations, the effect of economic conditions, the availability of capital to finance planned growth, the Year 2000 Issue, and the liquidity of the Lessee, are described but are not limited to those disclosed in this Annual Report. These and other factors which could cause actual results to differ materially from those in the forward-looking statements are discussed under the heading "Risk Factors". Given these uncertainties, readers are cautioned not to place undue reliance on such statements. The Company also undertakes no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances. ITEMS 1. AND 2. BUSINESS AND PROPERTIES GENERAL Sunstone Hotel Investors, Inc. (the "Company") is a self-administered, equity real estate investment trust ("REIT") that through its 94.7% ownership interest in Sunstone Hotel Investors, LP (the "Operating Partnership") owns and leases luxury, upscale and mid-price hotels located primarily in the Pacific and Mountain regions of the western United States. The hotels operate primarily under national franchises that are among the most respected and widely recognized in the lodging industry, including brands affiliated with Marriott International, Inc., Bass Hotels and Resorts, Hilton Hotels Corporation and Promus Hotel Corporation. As of March 5, 1999, the Company's portfolio consisted of 56 hotels with a total of 10,086 rooms. The majority of the Company's hotel portfolio consists of luxury, upscale and mid-price full-service hotels and upscale extended-stay properties (approximately 84.5%) with the remainder of the Company's portfolio consisting of mid-price limited service properties. The Company's growth strategy is to maximize shareholder value by (i) acquiring underperforming and undercapitalized hotels that are in strong market locations with significant barriers to entry and (ii) improving such hotels' financial performance by renovating, redeveloping, rebranding and repositioning the hotels and through the implementation of focused sales and marketing programs. The Company's business strategy is to seek to increase market share at its hotels through an expansion of a strong base of direct sales and marketing with an emphasis on repeat customers. The Company's goal is to increase each hotel's customer base by providing a high level of guest satisfaction, high-quality hotels and quality food and beverage services. The Company's business strategy is to increase revenue per available room ("REVPAR") by increasing average daily rate ("ADR") and occupancy. This strategy is typically implemented by replacing certain discontinued group business with higher-rate group and transient business and by selectively increasing room rates. The Company's success with this strategy has been achieved primarily because of (i) the relatively high occupancy rates at certain of its hotels, (ii) the success of a superior marketing strategy implemented at each acquired hotel, and (iii) the effects of repositioning recently acquired hotels as high-quality properties with strong national franchises through the Company's redevelopment and rebranding program. The Company invests in one business segment, that of owning, developing and leasing hotel properties primarily in the western United States. See the consolidated financial statements and notes thereto included in Item 8 of this Annual Report on Form 10-K for financial information about the industry segment. -1- GROWTH STRATEGY The Company's principal growth strategy is to maximize shareholder value by increasing cash available for distribution on its Common Stock ("Cash Available for Distribution") per share by: . enhancing the operating performance of hotels owned by the Company through renovation, redevelopment, rebranding and repositioning, and through the implementation of focused management and marketing programs; . selectively developing new luxury, upscale and mid-price hotels in markets where room demand and other competitive factors justify new construction; and . when market conditions are appropriate, acquiring or investing in underperforming and undercapitalized luxury, upscale and mid-price hotels located principally in the western United States that are, or can be renovated, redeveloped and repositioned by branding or rebranding with nationally recognized franchises. The Company believes that its recently completed and planned future renovation, redevelopment, rebranding and repositioning activities, as well as improvements in management and marketing, will continue to fuel REVPAR growth at its hotels, thereby increasing percentage lease revenue to the Company. In addition, the Company believes that there will continue to be substantial acquisition, renovation, redevelopment, rebranding and repositioning opportunities in the luxury, upscale and mid-price hotel markets in the western United States. The Company believes these opportunities will result from the aging of a significant portion of the nation's hotel supply and the imposition of capital improvement requirements by certain national hotel franchisors on the owners of franchised hotels, many of which are small independent hotel companies or private hotel owners that may be unwilling or unable to satisfy such requirements. External Growth Strategy The Company's external growth strategy is to (i) acquire underperforming luxury, upscale and mid-price hotels located principally in the western United States that are, or can be renovated or redeveloped and repositioned by branding or rebranding the hotels with nationally recognized franchises, with an increasing emphasis on multiple-property acquisitions; (ii) selectively develop new luxury, upscale and mid-price hotels in markets where room demand and other competitive factors justify new construction; and (iii) dispose of non-core hotel assets that are inconsistent with the Company's external growth strategy. Acquisitions. When market conditions are appropriate, the Company intends to acquire hotels located principally in the western United States which meet one or more of the following criteria: (i) underperforming hotels which have the potential for improved performance through the implementation of quality management and marketing programs, and/or association with a national franchisor; (ii) hotels in a deteriorated physical condition that would benefit significantly from renovation or redevelopment; (iii) hotels in attractive locations that would benefit significantly by changing franchises to nationally recognized franchise brands that have a greater potential to produce significant REVPAR growth such as Marriott, Courtyard by Marriott, Residence Inn by Marriott, Holiday Inn Select, Holiday Inn Hotel & Suites and Hilton; (iv) hotels owned by franchisees who are unable or unwilling to meet capital improvement requirements of the franchisor; (v) hotels in markets with favorable room supply and demand fundamentals; and (vi) hotels in markets where there are significant barriers to entry, such as limited opportunities to change existing franchises at competitive hotels, scarcity of suitable hotel sites or zoning restrictions. Multiple Property Acquisitions. The Company's ability to close multiple- property acquisitions is dependent upon access to public equity, increased availability under the Company's unsecured revolving line of credit facility (the "Credit Facility") and other sources of equity and debt. In the past, the Company has successfully accessed the public equity markets on six different occasions and raised over $407.9 million. Additionally, the Company has increased the commitment under the Credit Facility from $30.0 million at the time of the Company's initial public offering ("IPO") on August 15, 1995, to $350.0 million. Furthermore, rather than paying cash, the Company also has the flexibility of issuing its common stock, preferred stock or units in the Operating Partnership ("Units") to -2- acquire hotels, which under certain circumstances allows the sellers to defer tax liability which would otherwise arise upon a sale for cash. There can be no assurances that the Company will continue to have access to sources of equity and debt. The Company has significant knowledge of a variety of markets and the ability to quickly identify strategic acquisition opportunities. Integration of Kahler. On October 15, 1997, the Company completed the acquisition of all the outstanding capital stock of Kahler Realty Corporation ("Kahler") from Westbrook Real Estate Fund I, L.P. and Westbrook Real Estate Co- Investment Partnership I, L.P. (collectively, "Westbrook"). Concurrently, the Company acquired the third-party ownership interests in three hotels that were previously partially owned by Kahler: the 220-room University Park Hotel in Salt Lake City, Utah (76% third-party ownership interest), and the 114-room Residence Inn and 333-room Provo Park Hotel in Provo, Utah (each a 50% third- party ownership interest). The aggregate purchase price of these acquisitions (the "Kahler Acquisition") was $372.3 million and was funded with the net proceeds from the Company's public offering in October 1997, the assumption of Kahler debt, the issuance of common and preferred stock to Westbrook and with borrowings from its then $200.0 million unsecured revolving line of credit. The Kahler portfolio purchased by the Company consisted of 17 hotels with 4,255 rooms (the "Kahler Hotels"), principally in two markets, the Mountain region states of Utah, Idaho, Montana and Arizona (11 hotels) and Rochester, Minnesota (four hotels). The largest number of rooms owned by Kahler were concentrated in Rochester, Minnesota, with four hotels and 1,329 rooms, three of which are connected by an underground walkway to the internationally renowned Mayo Clinic, and in the Salt Lake City area of Utah, with six hotels and 1,509 rooms. Originally, nine of the hotels were operated independently, with the balance operated under Sheraton, Hilton, Holiday Inn, Residence Inn and other national franchises. From the date of the Kahler Acquisition through 1998, the Company executed an extensive renovation program that included branding four of the previously independently operated hotels as full-service Marriott hotels and significant improvements to the two hotels operated under the Hilton and Sheraton franchises. The Company anticipates completing the renovation program for the Kahler Hotels during 1999 with one additional hotel branded as a full-service Marriott hotel and significant improvements made to two of the hotels connected to the Mayo Clinic which will continue to operate under the Kahler name. During 1998, the Company sold six of the Kahler Hotels because the location and size of these hotels were inconsistent with the Company's strategy of renovating and rebranding luxury, upscale and mid-price hotels in large metropolitan areas, as well as downtown and airport hotel markets. The six hotels sold with a total of 1,122 rooms, included the Boise Park Suite Hotel in Boise, Idaho; the Pocatello Park Quality Inn in Pocatello, Idaho; the Best Western Canyon Springs Park Hotel in Twin Falls, Idaho; the Best Western Colonial Inn in Helena, Montana; the Lakeview Resort and Conference Center in Morgantown, West Virginia and the Green Oaks Park Hotel in Fort Worth, Texas. The Kahler Acquisition was consistent with the Company's growth strategy of acquiring hotels with upside potential within the Pacific and Mountain regions of the western United States. The Company believes that the Kahler acquisition was attractive because the Kahler Hotel portfolio (i) contained primarily underperforming full service hotels with significant opportunities for renovation, redevelopment, rebranding and repositioning, (ii) included the largest number of rooms under common management in Rochester, Minnesota, and a significant concentration of hotel rooms in the Salt Lake City area of Utah, which the Company believes will enable it to be a leader in pricing and to achieve economies of scale in its operations, and (iii) included the Rochester, Minnesota hotels that service the Mayo Clinic. -3- Acquisitions and Investments. The following table sets forth certain information related to the Company's hotel acquisition and investment activity since January 1, 1997:
Acquisition Acquisition Number of Cost Date Brand Location Rooms (in Millions) - ------------- ---------------------------- -------------------------- --------- ------------- 1997 January Holiday Inn San Diego, California 218 $ 9.0 January Courtyard by Marriott Cypress, California 180 12.0 March Hawthorn Suites Kent, Washington 152 13.6 March Holiday Inn Select La Mirada, California 289 18.0 May Hawthorn Suites Sacramento, California 301 16.8 June Holiday Inn Hotel & Suites San Diego, California 151 11.8 July Best Western Lynnwood, Washington 103 7.4 August Holiday Inn Mission Valley San Diego, California 174 9.1 August Hawthorn Suites Anaheim, California 130 8.7 August Courtyard by Marriott Los Angeles, California 178 12.6 October Kahler Hotels (1)(2)(3) Midwest and Mountain Regions of the United States 3,133 322.2 December Residence Inn Sacramento, California 126 13.0 December Residence Inn San Diego, California 144 17.5 ---------- ------------- 5,279 471.7 ---------- ------------- 1998 January Ramada San Diego, California 124 $ 11.5 January Residence Inn Santa Clarita, California 90 11.3 January Fairfield Inn Santa Clarita, California 66 5.2 February Hilton Hotel Carson, California 221 12.5 April Radisson (1) Oxnard, California 160 9.3 April Hampton Inn Santa Clarita, California 130 8.7 May Marriott Napa, California 192 21.4 May Holiday Inn (1) Santa Clara, California 168 20.3 August Marriott Pueblo, Colorado 164 12.0 September Marriott (1) Santa Monica, California 168 22.0 ---------- ------------- 1,483 134.2 ---------- ------------- Total 6,762 $605.9 ========== =============
- ----------- (1) In cases where the Company has obtained approval of a new franchise license, subject to completion of certain renovations or improvements, the franchise brand indicated represents the approved new franchise brand. (2) Of the eleven Kahler Hotels currently owned by the Company, six are subject to Marriott franchise licenses, one is subject to a Hilton franchise license, one is subject to a Holiday Inn franchise license, one is subject to a Sheraton franchise license with the two remaining operated independently. (3) Excludes the six Kahler Hotels, with a total of 1,122 rooms and an aggregate acquisition cost of $50.1 million, which were sold during 1998. Selective Development of Additional Hotels The Company may also selectively develop new luxury, upscale and mid-price hotels which will operate under national franchises in markets where the Company believes room demand and other competitive factors justify new construction. The Company may develop hotels itself or may contract with unaffiliated developers who will build hotels and then sell them to the Company upon completion on pre-agreed terms. Such arrangements with developers will enable the Company to minimize risks associated with development. -4- The following table shows the Company's completed and in process developments:
Completed/ Expected Number of Completion Hotel Location Rooms Date - ------------------------------- ---------------------- ----------- -------------- Residence Inn by Marriott Highlands Ranch, CO 78 1996 Residence Inn (Room Addition) Highlands Ranch, CO 39 1997 Marriott Pueblo, CO 164 1998 Residence Inn by Marriott San Diego, CA 120 1999 Courtyard by Marriott Lynnwood, WA 141 1999 Hilton Garden Inn Sacramento, CA 153 1999
Disposition of Non-Core Hotel Assets The Company intends to dispose of hotels from time to time to redeploy its capital to acquire hotels that fit more strategically with its growth strategy. During 1998, the Company sold six hotels that were included in the October 1997 17-hotel Kahler Acquisition. The size and locations of these hotels were inconsistent with the Company's external growth strategy. Additionally, on February 2, 1999, the Company sold the 129-room limited service Hampton Inn located in Arcadia, California for $8.5 million. The Company continues to consider certain non-core hotel assets for disposition. Internal Growth Strategy The Company's internal growth strategy is to enhance the operating performance of hotels owned and acquired by the Company by (i) selectively renovating and redeveloping the hotels, and when advantageous rebranding them under national franchises, (ii) improving the marketing and management of the hotels, (iii) the Lessee subleasing restaurants in the hotels to national or regional restaurant companies, and (iv) selectively expanding the number of rooms at certain hotels where market conditions justify such expansion. Redevelopment and Renovation In conjunction with the Company's strategy of acquiring hotels that can benefit from extensive improvements, branding and repositioning, the Company's principal internal growth strategy is to redevelop or extensively renovate such hotels and brand them with a national franchise that the Company believes will generate higher REVPAR than that currently being generated. In addition to the redevelopment strategy, the Company periodically renovates its hotels, not only to satisfy requirements of the franchise agreements, but also to maintain or increase its market share. The Company has and intends, to the extent practicable, to continue to keep hotels operational while conducting renovation and redevelopment work. During 1998, the Company expended $68.2 million redeveloping and renovating 20 hotels. During 1997, the Company expended $48.8 million redeveloping and renovating 19 hotels. During 1999, the Company estimates it will expend approximately $34.0 million redeveloping and renovating seven of its recently acquired hotels, as well as, completing the renovation and redevelopment of certain hotels which were under renovation during the fourth quarter of 1998. The actual cost of redevelopment and renovation may exceed budgeted amounts for the reasons described under "Risk Factors - Risks Related To Development And Renovation Of Hotels." Scope of Renovation and Redevelopment. For those hotels whose franchise affiliation will not be changed, the Company typically makes renovations after acquisition not only to satisfy the existing franchisor's capital improvement plan, but more importantly to ensure a high level of guest satisfaction and consequently, increase market share and revenue. The Company also performs periodic routine maintenance to all of its hotels in order to keep them competitive. -5- Renovations typically consist of many of the following activities:
Guest Rooms Public Areas Exterior - -------------------------------------------- -------------------------------------- ------------------------------ . selectively replacing bedspreads, . replacing drapes and valances . repainting linens, drapes and valances . refinishing and selectively . seal coating parking lot . refinishing and selectively replacing replacing furniture . adding light furniture and televisions, and adding . replacing wallpaper and vinyl telephones with data ports and wallcovering voicemail, clock radios, coffeemakers, . repainting irons and ironing boards . recarpeting . replacing wallpaper and vinyl wallcovering . repainting . recarpeting
Redevelopments are expanded in scope and typically include many of the following activities:
Guest Rooms Public Areas Exterior - -------------------------------------------- ---------------------------------- ------------------------------ . replacing all bedspreads, linens, . replacing drapes and valances . repainting drapes and valances . replacing wallpaper and vinyl . installing new window . replacing all furniture wallcovering treatments and grill work . replacing televisions, adding . repainting . modifying the facade telephones with data ports and . recarpeting . constructing voicemail, clock radios, coffeemakers, . redecorating port-cochere irons and ironing boards . replacing furniture . repaving or seal . replacing wallpaper and vinyl . rebuilding reception area coating parking lot wallcovering . redesigning lobby for improved . adding lighting . repainting traffic flow . re-roofing . recarpeting . remodeling restaurant to . remodeling guestrooms, including standards of regional or national changing room layout and modifying restaurant operator closets . installing fire safety . remodeling guest bathrooms with new equipment, including sprinklers countertops, tile floors, plumbing and smoke detectors fixtures, lights and valances . installing fire safety equipment, including sprinklers and smoke detectors
-6- The following table sets forth certain information with respect to the Company's completed, pending and planned renovation and redevelopment activities and completed and pending changes in franchise affiliations. The table includes renovation and redevelopment work on certain hotels completed by affiliates of the Company prior to the transfer of the initial hotels to the Company in connection with the Initial Public Offering. The table does not include work completed by any other prior owners of the hotels. Completed, Pending and Planned Renovation and Redevelopment
Public Areas Guest Rooms ------------------------ --------------------- Add/ Expected Replace/ Upgrade Prior to be Refurbish Meeting Soft Guest Franchise Completed Completed Exterior Restaurant Lobby Space Goods Furniture Bath Affiliation --------- --------- --------- ---------- ----- ------- ----- --------- ----- ----------- Marriott Ogden, Utah.................. July 1998 x x x x x Best Western Park City, Utah.............. June 1999 x x x x x x Independent Provo, Utah.................. April 1998 x x x x x Independent Pueblo, Colorado............. August NEWLY CONSTRUCTED 1998 Rochester, Minnesota......... March 1998 x x x x x Kahler Salt Lake City, Utah ` May 1998 x x x Independent Santa Monica, California (1). April 2000 x x x x x x x Independent Courtyard by Marriott: Cypress, California.......... June 1997 x x x x x x x Ramada Hotel Fresno, California........... February x x x x x x x Hampton Inn 1994 Los Angeles, California...... June 1998 x x x x x x Riverside, California........ April 1999 x x x x x x x Days Inn Santa Fe, New Mexico (1)..... March 1999 x x x x x x x Doubletree Hotel Residence Inn by Marriott: Highlands Ranch, Colorado.... September NEWLY CONSTRUCTED 1996 Oxnard, California........... May 1997 x x x x x x x Radisson Suites Sacramento, California....... December x x x x x x 1998 San Diego, California........ March 1999 x x x x x x Hilton Carson, California........... March 1999 x x x x x x x Salt Lake City, Utah......... August x x x x x x x 1998 Sheraton Chandler, Arizona............ December x x x 1998 Holiday Inn Select: La Mirada, California........ August x x x x x x x Holiday Inn 1998 Renton (Seattle), Washington. July 1997 x x x x x x x Holiday Inn Holiday Inn Hotel & Suites: Craig, Colorado.............. March 1999 x x x x Kent (Seattle), Washington... October x x x x x x Cypress Inn 1996 Mesa, Arizona................ November x x x x x x x Holiday Inn 1997 Price, Utah.................. June 1997 x x x x x x x Days Inn San Diego (Old Town), January x x x x x x Ramada Hotel California.................. 1998 Holiday Inn: Flagstaff, Arizona........... July 1997 x x x x Provo, Utah.................. June x x x x x x 1994/ June 1997 x Rochester, Minnesota......... March 1999 x x x x x San Diego (Harbor), July 1997 x x x x x California.................. San Diego (Mission Valley), February x x x x x x x California.................. 1998 Santa Clara, California (1).. May 1999 x x x x x x Days Inn Steamboat Springs, Colorado.. June 1996 x x x x x Best Western Holiday Inn Express: Portland, Oregon............. October x x x x x x Cypress Inn 1996 Poulsbo, Washington.......... September x x x x x Cypress Inn 1996
-7- Completed, Pending and Planned Renovation and Redevelopment, continued
Public Areas Guest Rooms ------------------------ --------------------- Add/ Expected Replace/ Upgrade Prior to be Refurbish Meeting Soft Guest Franchise Completed Completed Exterior Restaurant Lobby Space Goods Furniture Bath Affiliation --------- --------- --------- ---------- ----- ------- ----- --------- ----- ----------- Hampton Inn: Clackamas (Portland), Oregon. October x x x x x x Cypress Inn 1996 Denver, Colorado............. June 1996 x x x Mesa, Arizona................ October x x x 1997 Oakland, California.......... July 1996 x x x x x Pueblo, Colorado............. February x x x x x x 1997 Santa Clarita, California.... February x x x x x x 1999 Silverthorne, Colorado....... June 1996/ x x x x June 1997 Tucson, Arizona.............. October x x x x x 1997 Hawthorn Suites: Anaheim, California.......... March 1999 x x Independent Kent, Washington............. September x x Independent 1998 Sacramento, California....... November x x x x x x x Independent 1998 Radisson: Oxnard, California (1)....... April 1999 x x x x x x x Hilton Best Western: Lynnwood, Washington......... September x x x x x x x 1998 Comfort Suites: South San Francisco, June 1997 x x x x x California.................. Ramada Limited: San Diego, California........ February x x x x x Independent 1999 Independent Kahler Inn & Suites - Rochester, Minnesota........ May 1999 x x x x x x x The Kahler Hotel - Rochester, Minnesota........ March 1999 x x x x x x x
__________ (1) In cases where the Company has obtained approval of a new franchise license, subject to completion of certain renovations or improvements, the franchise brand indicated represents the approved new franchise brand. -8- Franchise Rebranding. The Company believes that franchise affiliations can provide substantial advantages to certain hotels. Such advantages include brand recognition, access to national reservation systems, national direct sales efforts and national volume purchasing agreements, frequent stayer programs and technical and business assistance. The use of multiple franchise systems provides the Company with further diversification, less dependence on one brand and less vulnerability to new requirements of any individual franchise affiliation. The Company expects to focus its franchise affiliations on nationally recognized luxury and upscale hotel chains. During 1998, the Company rebranded and upgraded nine hotels with new and existing franchises. Franchise Awards. During 1998, the Company branded four Kahler Hotels as full-service Marriotts. In recognition of such achievements, the Company was named Developer of the Year by Marriott Hotels, Resorts and Suites at Marriott's 1998 National Franchise Conference. During 1999, the Company anticipates adding a Residence Inn, a Courtyard by Marriott and two additional full-service Marriott hotels to its portfolio. The two full-service Marriotts will be located in Santa Monica, California and Park City, Utah. In September 1998, at the annual Bass Hotels Worldwide Conference the Company demonstrated its leadership in quality and service excellence in the Holiday Inn brand segment by winning seven awards for hotels acquired and renovated in 1997. The hotels and their respective awards are as follows:
Hotel Location Award - ----------------------- --------------------- ------------------------ Holiday Inn Express Poulsbo, Washington Quality Excellence Award Holiday Inn Select Renton, Washington Modernization Award Holiday Inn Harbor View San Diego, California Modernization Award Holiday Inn & Suites Mesa, Arizona Modernization Award Holiday Inn & Suites San Diego, California Newcomer of the Year Holiday Inn & Suites Price, Utah Newcomer of the Year Holiday Inn Provo, Utah Torchbearer Award
The following table summarizes certain information with respect to the franchise affiliations of the hotels. Franchise Affiliations
Number Percentage Franchise Affiliations of Hotels Rooms of Rooms ---------------------- --------- ----- ---------- Marriott............................................................ 20 3,520 34.9% Holiday Inn......................................................... 16 2,534 25.1 Hampton Inn......................................................... 8 1,064 10.6 Kahler.............................................................. 2 965 9.6 Hawthorn Suites..................................................... 3 583 5.8 Hilton.............................................................. 2 572 5.7 Sheraton............................................................ 1 295 2.9 Comfort Suites...................................................... 1 166 1.6 Radisson (1)........................................................ 1 160 1.6 Ramada.............................................................. 1 124 1.2 Best Western........................................................ 1 103 1.0 -- ------ ----- Total............................................................. 56 10,086 100.0% == ====== =====
___________ (1) Includes Oxnard, California hotel which will be rebranded as a Radisson upon completion of renovation and improvements which are expected to be completed in the second quarter of 1999. -9- The typical term of a franchise agreement is 20 years for newly developed and constructed hotels and ten years for conversions of existing hotels. The Company believes that the loss of any one of its franchise agreements would not have a material adverse effect on the Company. Repositioning - Combining Renovations, Redevelopments and Rebranding with Comprehensive Marketing and Management Strategies The hotels acquired by the Company often lack adequate management and marketing programs. The operator of the hotels, Sunstone Hotel Properties, Inc., (the "Lessee") implements a full complement of management and marketing programs at each acquired hotel designed to maximize sales and operational efficiency. The Company believes that these management and marketing activities contribute to the growth in REVPAR for the Company's acquired hotels. The Lessee also has developed a sales program to direct and manage the sales activities of personnel located at each hotel and a program to ensure that sales staff are properly trained and that staffing levels are adequate. As part of the required reporting process, the sales staff at each hotel must contact every business within a five-mile radius to evaluate possible hotel demand and revenue potential. The Lessee is also obligated to have a sales manager at each hotel, as reasonably required by the Company, to coordinate, direct and manage the sales activities of personnel located at that hotel in order to maximize revenue. The combined efforts to reposition each of the Company's hotels have resulted in same-unit-sales, year-over-year revenue increases. The following table summarizes average occupancy, ADR and REVPAR on a same-unit-sales basis for the hotels during periods of stabilized operations (pre- and post- renovation) during the years ended December 31, 1998, 1997 and 1996:
For the Years Ended For the Years Ended For the Years Ended December 31, December 31, December 31, ------------------------------ -------------------------------- -------------------------------- 1998 1997 (1) 1997 1996 (1) 1996 1995 (1) ----------- -------------- ------------- -------------- ------------- -------------- Number of hotels 57 57 53 53 24 24 Number of rooms 10,215 10,215 9,854 9,854 3,389 3,389 Occupancy rate 70.1% 70.9% 67.9% 63.9% 66.7% 66.2% ADR $ 82.96 $ 76.06 $71.46 $ 64.35 $62.01 $ 57.51 REVPAR $ 58.16 $ 53.92 $48.51 $ 41.10 $41.38 $ 38.08 REVPAR % change 7.9% 18.0% 8.7%
________________ (1) The Company did not own certain hotels for the entire period presented. Expansions In certain cases, the Company may expand the number of rooms at a hotel where it believes it can achieve a favorable return on the cost of such expansion, and where occupancy, ADR and other market conditions are otherwise believed to justify such expansion, and where building permits can be obtained. During 1997, the Company completed the 39-room expansion of the Residence Inn Highlands Ranch (Denver), Colorado. During 1999, the Company anticipates completing a 24-room expansion of the Holiday Inn and Suites located in San Diego (Old Town), California. In order for the Company to qualify as a REIT under Federal income tax law, neither the Company nor the Operating Partnership can operate hotels. Therefore, the Company leases its hotels to the Lessee pursuant to percentage leases (the "Percentage Leases") with initial terms of ten years, which provide for rent payments based principally on a percentage of room revenues of the hotels. The Lessee is a Colorado corporation owned by Robert A. Alter, Chairman and President of the Company, and Charles L. Biederman, Vice Chairman and Executive Vice President of the Company. Certain management functions for the hotels including all finance and accounting responsibilities are provided by Sunstone Hotel Management, Inc., a Colorado corporation (the "Management Company"), pursuant to a management agreement between the Lessee and the Management Company -10- for a fee equal to 1% to 2% of gross revenues of the hotels plus reimbursement of accounting costs. The Management Company is wholly-owned by Mr. Alter. Hotel Properties Geographically, 48.8% and 38.0% of the Company's portfolio is located in the Pacific and Mountain regions, respectively, which collectively comprise the western United States. The western United States has experienced some of the fastest growth in population in the 1990's and, according to the Bureau of Census, is expected to continue to grow at a faster rate than the national average well into the next century. In addition, between 2000 and 2005 the population in the western United States is projected to grow 7.9% while the population growth in the northeast, Midwest and south is projected to grow 1.1%, 2.1% and 5.3%, respectively. While the Company's hotel portfolio is located primarily in the western United States, it is nevertheless diverse. The geographic distribution of the hotels, which are located in eight states, reflects the Company's belief that a certain amount of geographic distribution helps to insulate the Company's hotel portfolio from local market fluctuations that are typical for the hotel industry. The Company also has sought to increase its geographic distribution by focusing on major metropolitan areas. The following table summarizes the Company's presence in each of these eight markets: Location by Region
Number of Percentage Region Hotels Rooms of Rooms - ------------------------ --------- ----- ---------- Pacific (1)............. 31 4,925 48.8% Mountain (2)............ 21 3,832 38.0 Minnesota............... 4 1,329 13.2 -- ------ ------ Total................... 56 10,086 100.0% == ====== ======
- ---------- (1) Includes California, Oregon and Washington. (2) Includes Arizona, Colorado, New Mexico and Utah. The hotels consist of the following price segments: Price Segment
Number of Number of Percentage Segment Hotels Suites/Rooms of Rooms - ------------------------------- --------- ------------ ---------- Luxury......................... 9 2,751 27.3% Upscale........................ 28 4,762 47.2 Mid-Price...................... 19 2,573 25.5 -- ------ ----- Total.......................... 56 10,086 100.0% == ====== =====
-11- The hotels consist of the following service categories: Service Category
Number of Number of Percentage Category Hotels Suites/Rooms of Rooms - ---------------------------------------------------------- --------- ------------ ---------- Full-Service.............................................. 34 7,094 70.3% Extended-Stay............................................. 9 1,425 14.1 Limited Service........................................... 13 1,567 15.6 -- ------ ------ Total................................................ 56 10,086 100.0% == ====== =====
The following table sets forth additional information with respect to the Company's hotel portfolio as of March, 5, 1999:
Last Type of Service/ No. of Date Year Opened/ Renovated Hotel Segment (1) Product Rooms Acquired Redeveloped In ----- ------------ ---------------- ------ -------- ------------ --------- Marriott Hotel: Ogden, Utah Luxury Full 288 10/15/97 1982 1998 Park City, Utah (2) Luxury Full 203 10/15/97 1985 1999 * Provo, Utah Luxury Full 333 10/15/97 1982 1998 Rochester, Minnesota Luxury Full 194 10/15/97 1991 1998 Salt Lake City, Utah Luxury Full 220 10/15/97 1987 1998 Santa Monica, California (2) Luxury Full 168 9/3/98 1967 2000 * Hilton: Salt Lake City, Utah Luxury Full 351 10/15/97 1975 1998 Sheraton: Chandler, Arizona Luxury Full 295 10/15/97 1987 1999 * The Kahler Hotel: Rochester, Minnesota Luxury Full 699 10/15/97 Various 1999 * Marriott Hotel: Napa, California Upscale Full 192 5/5/98 1979 1997 Pueblo, Colorado Upscale Full 164 8/11/98 1998 N/A Courtyard by Marriott: Cypress, California Upscale Full 180 1/17/97 1990 1997 Fresno, California Upscale Full 116 8/16/95 1989 1994 Los Angeles, California Upscale Full 178 8/28/97 1996 1998 Riverside, California Upscale Full 163 4/1/96 1988 1994 Santa Fe, New Mexico (2) Upscale Full 213 8/16/95 1985 1999 * Hilton: Carson, California Upscale Full 221 2/19/98 1989 1998 Holiday Inn: Craig, Colorado Upscale Full 152 8/16/95 1981 1997 Flagstaff, Arizona Upscale Full 157 10/29/96 1987 1997 La Mirada, California Upscale Full 289 3/31/97 1984 1998 Mesa, Arizona Upscale Full 246 10/29/96 1985 1997 Price, Utah Upscale Full 151 8/12/96 1984 1997 Provo, Utah Upscale Full 78 8/16/95 1968 1994 Steamboat Springs, Colorado Upscale Full 82 8/16/95 1971 1996 Renton (Seattle), Washington Upscale Full 226 6/28/96 1968 1997 San Diego, California Upscale Full 218 1/17/97 1968 1997 San Diego, California (Old Town) Upscale Full 151 6/11/97 1986 1998
-12-
Last Type of Service/ No. of Date Year Opened/ Renovated Hotel Segment (1) Product Rooms Acquired Redeveloped In - ---------------------------------- ------------ ---------------- ------ -------- ------------ --------- Radisson: Oxnard, California (2) Upscale Full 160 4/9/98 1987 1996 Hawthorn Suites: Anaheim, California Upscale Extended-Stay 130 8/7/97 1992 1997 Kent, Washington Upscale Extended-Stay 152 3/11/97 1990 1997 Sacramento, California Upscale Extended-Stay 301 5/17/97 1988 1998 Residence Inn: Highlands Ranch (Denver), Colorado Upscale Extended-Stay 117 12/22/95 1996 N/A Oxnard, California Upscale Extended-Stay 251 12/19/96 1987 1997 Provo, Utah Upscale Extended-Stay 114 10/15/97 1996 N/A Sacramento, California Upscale Extended-Stay 126 12/30/97 1992 1998 San Diego, California Upscale Extended-Stay 144 12/30/97 1989 1998 Santa Clarita, California Upscale Extended-Stay 90 1/27/98 1997 N/A Holiday Inn: Kent (Seattle), Washington Mid-Price Full 125 2/2/96 1986 1996 Rochester, Minnesota Mid-Price Full 170 10/15/97 1969 1998 San Diego, California (Stadium) Mid-Price Full 174 8/7/97 1991 1998 Santa Clara, California (2) Mid-Price Full 168 5/13/98 1985 1988 Kahler Hotel: Rochester, Minnesota Mid-Price Full 266 10/15/97 Various 1999 * Best Western: Lynnwood, Washington Mid-Price Full 103 7/17/97 1978 1999 * Comfort Suites: San Francisco, California Mid-Price Limited 166 8/13/96 1985 1997 Fairfield Inn: Santa Clarita, California Mid-Price Limited 66 1/27/98 1997 N/A Hampton Inn: Clackamas, Oregon Mid-Price Limited 114 2/2/96 1986 1996 Denver, Colorado Mid-Price Limited 152 8/16/95 1986 1996 Mesa, Arizona Mid-Price Limited 118 8/16/95 1987 1997 Oakland, California Mid-Price Limited 152 12/18/95 1986 1996 Pueblo, Colorado Mid-Price Limited 112 8/16/95 1986 1997 Santa Clarita, California Mid-Price Limited 130 4/30/98 Silverthorne, Colorado Mid-Price Limited 160 8/16/95 1976 1997 Tucson, Arizona Mid-Price Limited 126 10/29/96 1986 1997 Holiday Inn: Portland, Oregon Mid-Price Limited 84 2/2/96 1986 1996 Poulsbo, Washington Mid-Price Limited 63 2/2/96 1986 1996 Ramada: San Diego, California Mid-Price Limited 124 1/23/98 1987 1998
- ------------ * Expected year of completion (1) Per F.W. Dodge segmentation criteria. (2) In cases when the Company has obtained approval of a new franchise license, subject to completion of certain renovations or improvements, the franchise brand indicated represents the approved new franchise brand. -13- The Percentage Leases In order for the Company to qualify as a REIT, neither the Company nor the Operating Partnership can operate any hotels. The Company, therefore, leases hotels to the Lessee typically for a term of ten years pursuant to Percentage Leases which provide for rent equal to base rent and percentage rent. Each Percentage Lease contains the provisions generally described below, and the Company intends that future Percentage Leases with respect to additional hotels it may acquire will contain substantially similar provisions, although the Independent Directors may, in their discretion, alter any of these provisions with respect to any proposed Percentage Lease, depending on the purchase price paid, economic conditions and other factors deemed relevant at the time. The Lessee will not lease or operate any hotel other than those owned by the Company without consent. Percentage Lease Terms. The Percentage Leases typically have a noncancelable term of ten years, subject to earlier termination upon the occurrence of defaults thereunder and certain other events (including provisions for damage to the hotels, condemnation of the hotels and termination of Percentage Leases on disposition of the hotels). Amounts Payable Under the Percentage Leases. During the term of each Percentage Lease, the Lessee is obligated to pay to the Company (i) base rent, (ii) percentage rent (which includes a specified percentage of room revenues, 5% of the Lessee's food and beverage revenues, 100% of any sublease and concession rentals and other net revenues described in the Percentage Leases), and (iii) certain other amounts, including interest accrued on any late payments or charges. Base rent accrues and is required to be paid monthly in arrears. Both the base rent and the threshold room revenue amount in each percentage rent formula is adjusted annually for inflation. The adjustment will be calculated at the beginning of each calendar year based upon the change in the CPI during the prior calendar year. Percentage rent, if any, is due monthly within 45 days after the end of each calendar month and is reconciled on a quarterly basis. In 1997, the Company and the Lessee amended the Percentage Leases for hotels then currently under renovation and for any future hotels to allow for the abatement of base rent related to rooms taken out of service during periods of major renovations. The following table sets forth the annual base rent and percentage rent formulas under the Percentage Leases for the hotels:
Annual 1998 Percentage Lease Annual --------------------------------- Room Base First Second Revenue Rent (1)(2) Tier Tier Threshold (1) -------------- ----------- ---------- ------------- Hotels: Marriott: Napa, California $ 1,455,000 34.0% 60.0% $ 4,275,000 Ogden, Utah 1,035,000 25.0% 62.0% 4,136,000 Park City, Utah 931,000 24.4% 62.0% 3,812,000 Provo, Utah 2,050,000 37.2% 62.0% 5,518,000 Pueblo, Colorado 756,000 26.0% 62.0% 2,910,000 Rochester, Minnesota 2,914,000 42.3% 62.0% 6,896,000 Salt Lake City, Utah 2,112,000 46.0% 62.0% 4,589,000 Santa Monica, California (3) 1,452,000 47.8% 62.0% 3,038,000 Courtyard by Marriott: Cypress, California 1,030,000 37.3% 62.0% 2,760,000 Fresno, California 433,000 30.0% 63.0% 1,444,000 Los Angeles, California (LAX) 972,000 46.8% 60.0% 2,075,000 Riverside, California 447,000 30.0% 60.0% 1,489,000 Santa Fe, New Mexico (3) 706,000 30.0% 63.0% 2,353,000
-14-
Annual 1998 Percentage Lease Annual --------------------------------- Room Base First Second Revenue Rent (1)(2) Tier Tier Threshold (1) -------------- ----------- ---------- ------------- Residence Inn by Marriott: Highlands Ranch (Denver), Colorado 537,000 39.0% 63.0% 1,376,000 Oxnard, California 1,118,000 32.0% 61.0% 3,492,000 Provo, Utah 673,000 34.6% 62.0% 1,946,000 Sacramento, California 983,000 43.2% 60.0% 2,276,000 San Diego, California 1,393,000 45.8% 60.0% 3,043,000 Santa Clarita, California 775,000 40.6% 60.0% 1,911,000 Fairfield Inn: Santa Clarita, California 370,000 36.5% 60.0% 1,015,000 Hilton: Salt Lake City, Utah 3,862,000 50.2% 62.0% 7,698,000 Carson, California 932,000 37.1% 60.0% 2,509,000 Holiday Inn Select: La Mirada, California 1,533,000 39.3% 60.0% 3,905,000 Renton (Seattle), Washington 843,000 30.0% 62.0% 2,810,000 Holiday Inn Hotel & Suites: Craig, Colorado 456,000 30.0% 60.0% 1,519,000 Kent (Seattle), Washington 598,000 36.0% 63.0% 1,660,000 Mesa, Arizona 830,000 31.0% 60.5% 2,677,000 Price, Utah 280,000 24.6% 60.0% 1,140,000 San Diego (Old Town), California 1,176,000 45.7% 60.0% 2,575,000 Holiday Inn: Flagstaff, Arizona 311,000 30.0% 61.5% 1,035,000 Provo, Utah 171,000 20.0% 65.0% 856,000 Rochester, Minnesota 246,000 9.2% 62.0% 2,668,000 San Diego, California 887,000 25.9% 62.0% 3,424,000 San Diego (Stadium), California 737,000 36.8% 60.0% 2,001,000 Santa Clara, California (3) 1,574,000 47.0% 60.0% 3,124,000 Steamboat Springs, Colorado 401,000 30.0% 60.0% 1,337,000 Holiday Inn Express: Portland, Oregon 383,000 32.3% 63.0% 1,186,000 Poulsbo, Washington 341,000 35.0% 63.0% 975,000 Hampton Inn: Clackamas (Portland), Oregon 461,000 38.0% 63.0% 1,212,000 Denver, Colorado 606,000 37.5% 63.0% 1,615,000 Mesa, Arizona 509,000 34.0% 63.0% 1,497,000 Oakland, California 442,000 22.0% 63.0% 2,010,000 Pueblo, Colorado 481,000 36.0% 63.0% 1,337,000 Santa Clarita, California 634,000 33.8% 60.0% 1,877,000 Silverthorne, Colorado 517,000 30.0% 63.0% 1,722,000 Tucson, Arizona 355,000 30.0% 62.0% 1,184,000
-15-
Annual 1998 Percentage Lease Annual --------------------------------- Room Base First Second Revenue Rent (1)(2) Tier Tier Threshold (1) -------------- ----------- ---------- ------------- Hawthorn Suites: Anaheim, California 833,000 39.4% 60.0% 2,115,000 Kent, Washington 1,124,000 40.2% 68.0% 2,796,000 Sacramento, California 1,610,000 35.5% 60.0% 4,530,000 Sheraton: Chandler, Arizona 2,904,000 34.7% 62.0% 8,358,000 Best Western: Lynnwood, Washington 580,000 45.5% 60.0% 1,274,000 Comfort Suites: South San Francisco, California 746,000 30.0% 60.0% 2,488,000 Ramada: San Diego, California 891,000 43.6% 60.0% 2,043,000 Radisson: Oxnard, California (3) 617,000 24.0% 62.0% 2,576,000 Kahler: Kahler Inn & Suites Rochester, Minnesota 1,730,000 47.4% 62.0% 3,653,000 The Kahler Hotel Rochester, Minnesota 4,147,000 35.2% 62.0% 11,779,000 ----------- $56,890,000 ===========
__________ (1) Effective January 1, 1996, 1997 and 1998, base rent payable and the room revenue thresholds under the Percentage Leases were adjusted based upon the change in the CPI for those hotels acquired in 1995, 1996 and 1997. The lease terms for Hampton Inn located in Arcadia, California which was sold subsequent to December 31, 1998 have been excluded. (2) Annual base rent amounts presented have not been prorated for those hotels acquired during 1998 and do not reflect 1998 rent abatement of $668,000. (3) In cases where the Company has obtained approval of a new franchise license, subject to completion of renovations or improvements, the franchise brand indicated represents the approved new franchise brand. Other than real estate and personal property taxes, ground lease rent, where applicable, the cost of certain furniture, fixtures and equipment, capital expenditures and insurance (other than workers' compensation insurance), which are obligations of the Company, the Percentage Leases require the Lessee to pay base rent, percentage rent, other additional charges and the operating expenses of the hotel (including workers' compensation insurance, utility, repairs and maintenance costs and other charges incurred in the operation of the hotel) during the terms of the Percentage Leases. The Percentage Leases also provide for rent reductions and abatements in the event of damage or destruction or during major renovation. Maintenance and Modifications. Under the Percentage Leases, the Company is required to pay for capital improvements at each hotel. In addition, the Percentage Leases obligate the Company to make available to the Lessee for the repair, replacement and refurbishment of furniture, fixtures and equipment in the hotel, when and as deemed necessary by the Lessee, an amount equal to 4.0% of room revenue per quarter on a cumulative basis, provided that such amount may be used for capital expenditures made by the Company with respect to the hotels. The annual amount is -16- carried forward to the extent that the Lessee or the Company has not expended such amount, and any unexpended amounts will remain with the Company upon termination of the Percentage Leases. Otherwise, the Lessee will be required, at its expense, to maintain the hotel in good order and to repair and to pay for all operating expenses of the hotel. The Company owns substantially all personal property including that portion affixed to, or deemed a part of, the real estate or improvements. Property Taxes and Insurance. The Company is responsible for paying real estate and personal property taxes on the hotels (except for taxes on personal property owned by the Lessee) and for paying all premiums for property, casualty, comprehensive general public liability (naming the Lessee as an additional named insured) and other insurance appropriate and customary for properties similar to the hotel, as determined by the Company. The Lessee is required to pay for workers' compensation insurance. The Company believes that the coverages specified in the Percentage Leases are of the type and amount customarily obtained by owners of hotels similar to the Company's hotels. Tax Status The Company has elected to be taxed as a REIT under Section 856 of the Code, commencing with its taxable year ending December 31, 1995. If the Company qualifies for taxation as a REIT, then under current federal income tax laws the Company generally will not be taxed at the corporate level to the extent it currently distributes at least 95% of its net taxable income to its stockholders. Even if the Company qualifies for taxation as a REIT, the Company may be subject to certain federal, state and local taxes on its income and property and to federal income and excise tax on its undistributed income. Competition Intense competition exists for investment opportunities in luxury, upscale and mid-priced hotels from entities organized for purposes substantially similar to the Company's objectives as well as from other purchasers of hotels. The Company competes for such hotel investment opportunities with entities which have substantially greater financial resources than the Company or better relationships with franchisors, sellers or lenders. These entities may also generally be able to accept more risk than the Company can prudently manage. Competition may generally reduce the number of suitable hotel investment opportunities offered to the Company and increase the bargaining power of property owners seeking to sell. The Company believes that the inclusion of not only underperforming, but also undercapitalized properties as well as secondary markets in its strategy lessens competition for the types of properties targeted by the Company. There are a number of companies which develop, construct and renovate hotels. Some of these companies perform these services only for their own portfolios, while others actively pursue contracts for these services with third party owners. There is a significant operational competition in the hotel industry. There are numerous hotel chains that operate on a national or regional basis, as well as other hotels, motor inns and other independent lodging establishments throughout the western United States. Competition is primarily in the areas of price, location, quality and services. Many of the Company's competitors have recognized trade names, greater resources and longer operating histories than the Company. However, the Company brands its hotels with strong national franchises and believes that its management and that of the Lessee is sufficiently experienced to efficiently manage its hotels, enabling the Company and Lessee to compete successfully. There can be no assurances, however, that competitors will not develop or renovate hotels in the markets in which the Company has historically operated. Increased competition may have a negative impact on the Company's operating results and consequently cash available for distribution. Seasonality The hotel industry is seasonal in nature and this seasonality is typically geographically and market specific. The effects of seasonality may be expected to cause significant quarterly fluctuations in the Company's Percentage -17- Lease revenues. Effects of this seasonality on the Company's operating results may change depending upon the locations and markets of additional hotels the Company acquires or develops. Environmental Matters Under various federal, state and local laws and regulations, an owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on such property. Such laws often impose such liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances on the property. The costs of removal or remediation of such substances may be substantial, and the presence of such substances, or the failure to promptly remediate such substances, may adversely affect the owner's ability to fully utilize such property without restriction, to sell such property or to borrow using such property as collateral. In connection with the ownership and operation of the hotels, the Company, and the Lessee, as the case may be, may be potentially liable for any such costs. The Company believes that its hotels are in compliance, in all material respects, with all federal, state and local ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which could have a material adverse effect on the Company, or the Lessee. The Company has not been notified by any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of its present or former properties. Employees Messrs. Alter and Biederman have each entered into employment agreements with the Company for one-year terms which renew automatically until terminated. While Mr. Alter is required to devote substantially all of his time to the business of the Company; Mr. Biederman is not. The Company has 28 other employees. The Lessee employed 4,948 people as of December 31, 1998 to operate the hotels leased from the Company. The Lessee has advised the Company that its relationship with its employees is good. The Lessee is subject to collective bargaining agreements at certain hotels it operates. At December 31, 1998, the percentage of employees covered by such collective bargaining agreements represent 11% of the total number of employees of the Lessee. None of the employees of the Company is a party to any collective bargaining agreement or other similar agreement. Minimizing the Risks of Potential Conflicts of Interest In order to minimize conflicts of interest inherent in the legal structure required to maintain the Company's status as a REIT, Messrs. Alter and Biederman each have entered into several agreements. Their respective employment agreements restrict competitive activities. Additionally, third party pledge agreements require each of Messrs. Alter and Biederman to pledge Units to the Company to secure obligations of the Lessee under the Percentage Leases limited to the total number of Units that Mr. Alter or Mr. Biederman must pledge to the current number owned of 481,955 shares representing a market value of $3.7 million at March 5, 1999. The Third Party Pledge Agreement subordinates the Company's lien on these Units to the lien in favor of an institutional lender providing a working capital line to the primary stockholder of the Lessee, Mr. Alter. The working capital line is to be used exclusively for the Lessee's general short-term working capital needs and is secured by a pledge of Mr. Alter's Units. In addition, Messrs. Alter and Biederman entered into a unit purchase agreement (the "Unit Purchase Agreement") with the Company and the Lessee requiring that the Lessee's income (net of shareholder tax liability) be used to either accumulate reserves to pay rent under the Percentage Leases or to purchase Units from the Operating Partnership at the then current price of the Company's common stock. The Percentage Leases also contain cross-default provisions permitting the Company to terminate the Percentage Leases, subject to certain conditions, upon a default by Messrs. Alter or Biederman under the Unit Purchase Agreement or any other agreement with the Company. Further, the Management Company has agreed not to collect any payments from the Lessee after receiving notice of an event of default under a Percentage Lease. Mr. Alter has personally guaranteed the Lessee's obligation to return any amounts received by the Management Company in violation of this agreement. -18- RISK FACTORS Distribution Of Substantially All Cash Available For Distribution Our hotels generate cash flow in the form of rent we receive from the Lessee, the entity that leases and operates our hotels. The Lessee's rent is tied to hotel operating performance and consists of base rent and rent that is a percentage of certain hotel revenues. In addition, we also have cash available from a bank line of credit with a maximum commitment of $350.0 million with the actual availability based on our assets and financial performance. We also have been able to raise cash by issuing equity securities in the public markets. We use these three sources of cash, from hotel operations, from borrowings and from sales of stock to fund our acquisition of hotels, renovation of hotels, recurring capital expenditures, operating expenses and the payment of dividends to our shareholders. Because of the recent conditions in the capital markets, it is currently difficult for many companies, especially REITs, to raise capital by issuing debt or equity securities. Therefore, we are more dependent on our cash flows from hotel operations and from our line of credit to fund our obligations. During 1998, we paid out approximately $44.7 million in distributions to our stockholders and minority interests which was approximately 78% of our $57.2 million of Funds From Operations. If our operating cash flows decreased or our availability under the line of credit were reduced, it will be necessary for us to reduce future acquisitions, defer or reduce the scope of renovations or capital expenditures, sell assets (including hotels) or to reduce our dividends paid to shareholders. Total Dependence On The Lessee And Payments Under The Percentage Leases Because of our status as a REIT, we are prohibited from operating hotels and must lease them to the Lessee or other third parties. Our ability to pay dividends to our shareholders depends on our Lessee's ability to generate sufficient revenue to pay percentage rent required under the Percentage Leases. We chose the Lessee because Messrs. Alter and Biederman, who own the Lessee, were involved in the management of certain hotels contributed as part of our initial public offering ("IPO") in 1995, and are motivated to maximize percentage rent paid under the Percentage Leases through their financial and ownership interests in us. The Lessee has incurred significant losses since its inception in 1995. At December 31, 1998, the Lessee's stockholders' deficit amounted to $10.5 million. At December 31, 1998, the Lessee's rent payable to the Company amounted to $7.5 million. Also at December 31, 1998, the Lessee's current liabilities exceeded its current assets by $9.8 million. The ability of the Lessee to fund its daily operations and continue to remain current on its substantial rent obligation to the Company is a result of the original terms under the Percentage Leases, for the payment of rent to the Company, which allow monthly base rent to be paid in arrears and monthly percentage rent to be paid within 45 days after the respective month-end. According to the Lessee, the losses are due to several factors, including: . the substantial number of renovations we undertook adversely affected occupancy rates and revenues at the hotels; . renovations caused greater revenue losses than expected; and . poorer performance at certain hotels than expected. There can be no assurance that the Lessee will generate adequate operating cash flows to meet its obligations. Other than its cash flow generated by operating the hotels, the Lessee has no financial resources or other assets to pay its operating obligations or its rent under the Percentage Leases. Messrs. Alter and Biederman have pledged 481,955 Units to secure the Lessee's obligations under the Percentage Leases. However, if the Lessee defaults under the Percentage Leases, the value of these Units and other assets of the Lessee will be insufficient to satisfy our claims against the Lessee. -19- Risks Related To Development And Renovation Of Hotels Subject to obtaining adequate capital resources, we intend to continue our growth strategy of acquiring hotels needing substantial renovation or redevelopment. This strategy creates significant risks including the following: . We may continue to incur significant renovation and construction cost overruns and time delays due to: - labor shortages; - changes in the scope of a project; - requirements imposed by local building inspectors; - discovery of defects in the building once renovation has begun; and - compliance with the Americans with Disabilities Act of 1990, which may require expensive modifications to existing hotels to bring them into compliance. . We may purchase a hotel or contract to acquire a hotel (after a third party completes construction) when market conditions are favorable but then face deteriorated local demand for hotel rooms when the hotel is available for occupancy resulting in revenues that are less than projected; . We may complete our renovation after significant delays reducing the amount of revenues expected to be received during the delay period; and . We may spend more than budgeted for a renovation project reducing our anticipated return on the investment. Conflicts Of Interest Between The Company and Certain Officers And Directors The relationship among Mr. Alter and Mr. Biederman, the Lessee, the Management Company and us creates several inherent conflicts of interest that may result in decisions being made by our management that are not in the best interests of our stockholders. The most significant conflicts of interest include the following: . As the owners of the Lessee, Mr. Alter and Mr. Biederman will benefit from any profits the Lessee may generate from the operation of the hotels and retain for itself, even though under the Unit Purchase Agreement, Messrs. Alter and Biederman have agreed to reinvest the Lessee's profits (net of tax liabilities) in additional units or retain the profits as security for future rent payments. . As the owner of the Management Company, Mr. Alter is entitled to the profits of the Management Company, which receives from the Lessee management fees (1% to 2% of gross revenues of the hotels) and reimbursements for certain accounting expenses. Because of the Lessee's current financial condition, the Management Company has agreed to abate payment of management fees and reimbursements, up to a maximum of $3.5 million during 1998. Through December 31, 1998, management fees amounting to $3.3 million have been abated. No such agreement is in effect for 1999 . . The Percentage Leases generally require us to pay a termination fee to the Lessee if we elect to sell a hotel and not replace it with a Percentage Lease for another hotel. As a result, our decisions about which hotels to sell may be influenced by the conflict of interest of Messrs. Alter and Biederman who, as owners of the Lessee, would benefit from the termination fee. . In connection with our IPO, Messrs. Alter and Biederman contributed tax free certain hotels that had a tax basis less than their fair market value. Significant taxable gains that would arise if we were to sell these hotels would be specifically allocated to Messrs. Alter and Biederman. Further, in order to prevent -20- adverse tax consequences to Messrs. Alter and Biederman, we must maintain mortgage debt at certain minimum levels. Because of these conflicts, our decisions concerning whether to sell certain hotels or to incur or repay debt will be influenced by the tax consequences for Messrs. Alter and Biederman. . We did not negotiate the Percentage Leases on an arm's length basis with the Lessee. The base rent, percentage rent and the economic terms of each Percentage Lease are determined by us and approved by the Lessee based on historical financial data and projected operating and financial data for each hotel. See "Total Dependence on the Lessee and Payments under the Percentage Leases." Reliance On Mr. Alter And Other Key Personnel Our success depends in large part upon our ability to attract and retain highly qualified personnel. Further, because our sole source of operating revenue is base and percentage rent paid by the Lessee, our success is also dependent on the Lessee's management's ability to effectively operate the hotels. Competition for qualified employees for us and the Lessee is extremely intense and there is no assurance that we or the Lessee can attract and retain qualified employees. In particular, we substantially rely on the hotel and real estate knowledge and experience and continuing services of Mr. Robert Alter, our Chairman, Chief Executive Officer and President. Our inability (or the Lessee's) to attract and retain qualified employees could negatively affect our ability to generate revenues and pay distributions to our shareholders. Investment Concentration In Single Industry Our investment strategy is to focus exclusively on acquiring and owning hotels. This strategy concentrates all our investment in a single industry and therefore does not diversify our sources of revenues. As a result, a downturn in the hotel industry will have a greater impact on our revenues and funds from operations than if we had a diversified portfolio of properties. In addition, because we have focused on the western United States and in the luxury, upscale and mid-price segments of the hotel industry, economic or other conditions that affect this geographic region or these segments may disproportionately impact us. Failure To Realize Benefits Of Recent Acquisitions We have grown rapidly since our IPO. This growth has required us, and, to a greater extent, the Lessee to develop scaleable operating systems, develop construction management procedures and systems and other procedures and systems to operate our multi-state hotel portfolio. If we, or the Lessee, fail to effectively integrate the acquired hotels into our operating systems, then we will not achieve the expected benefits of the acquisition. The revenues generated by the hotels we acquire are used to pay the debt service on the funds we borrow to fund these acquisitions. If the acquired hotels do not generate sufficient cash flow to fund debt service on the money borrowed to purchase those hotels, we will be required to service the debt with cash flows from other hotels which might adversely affect our cash available for other purposes, including distributions to our shareholders. Failure To Maintain REIT Status We intend to operate so as to be taxed as a REIT under the Internal Revenue Code of 1986, as amended. As long as we qualify for taxation as a REIT, with certain exceptions, we will not be taxed at the corporate level on our taxable income that is distributed to our shareholders. A REIT is subject to a number of organizational and operational requirements, including requirements as to the nature of its income and assets, distribution requirements, diversity of stock ownership requirements and record-keeping requirements. We intend to satisfy all of these requirements for treatment as a REIT. It is possible that we may fail to satisfy one or more of these requirements. Failure to qualify as a REIT would render us subject to tax on our income at regular corporate rates and we could not deduct distributions to our shareholders. Unless entitled to relief under certain Internal Revenue Code provisions, we also would be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property. -21- In order for us to be taxed as a REIT, the Partnership must be classified as a partnership for federal income tax purposes. If the Partnership were to be taxable as a corporation, because our ownership interest in the Partnership constitutes more than 10% of the Partnership's voting securities and exceeds 5% of the value of our assets, we would cease to qualify as a REIT. The imposition of corporate income tax on us and the Partnership would substantially reduce the amount of cash available for distribution to our shareholders. Ownership Limitation In order for us to maintain our qualification as a REIT, not more than 50% in value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals (which includes certain entities). Furthermore, if any shareholder or group of shareholders of the Lessee owns, actually or constructively, 10% or more of our stock we would likely lose our REIT status. To protect our REIT qualification, our Articles of Incorporation prohibit direct or indirect ownership of more than 9.8% of the outstanding shares of our stock by any person or group. Generally, the capital stock owned by affiliated owners will be aggregated for purposes of this ownership limitation. Subject to certain exceptions, any stock subject to a purported transfer that would prevent us from continuing to qualify as a REIT will be designated as "Shares-in-Trust" and transferred automatically to a trust effective on the day before the purported transfer of such stock. The record holder of the common or preferred stock that are designated as Shares-in-Trust will be required to submit such number of shares of stock to the trust and the beneficiary of the trust will be one or more charitable organizations that are named by us. Inability To Retain Earnings In order to qualify as a REIT, we generally are required each year to distribute to our shareholders at least 95% of our net taxable income (excluding any net capital gain). In addition, we are subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions paid by us with respect to any calendar year are less than the sum of (i) 85% of our ordinary income, (ii) 95% of our capital gain net income for that year, and (iii) any undistributed taxable income from prior periods. We intend to continue to make distributions to our shareholders to comply with the 95% distribution requirement and to avoid the nondeductible excise tax. Differences in timing between taxable income and cash available for distribution to our shareholders due to the seasonality of the hospitality industry could require us to borrow funds on a short-term basis to meet the 95% distribution requirement and to avoid the nondeductible excise tax. The Company May Not Be Able To Continue Its External Growth Rate Our growth strategy has been to acquire underperforming and undercapitalized hotels located in strong markets where we believe significant barriers to entry exist. We then seek to improve the hotels' financial performance by renovating, redeveloping, and repositioning the hotels and requiring the Lessee to implement a focused sales and marketing program. The current conditions in the equity and debt capital markets limit our ability to access new capital on favorable terms. Without additional capital to fund acquisitions we will not be able to continue to acquire additional hotels. We anticipate that our acquisition activity will diminish significantly for the remainder of 1999. Accordingly, we cannot assure you that our external growth rate will equal or exceed our recent historical external growth rate. Environmental Risks Various federal, state and local laws subject property owners or operators to liability for the costs of removal or remediation of certain hazardous substances released on property. These laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of the hazardous substances. The presence of or the failure to properly remediate hazardous substances may adversely affect occupancy of a contaminated hotel property, the ability to operate hotels, and our ability to sell or borrow against contaminated properties. In addition to the costs associated with investigation and remediation actions brought by governmental agencies, the presence of hazardous waste on a property could result in personal injury or similar claims or lawsuits. -22- Various laws also impose, on persons who arrange for the disposal or treatment of hazardous or toxic substances, liability for the cost of removal or remediation of hazardous or toxic substances at the disposal or treatment facility. These laws often impose liability whether or not the person arranging for the disposal ever owned or operated the disposal facility. The obligation to pay for these costs or our inability to pay for such costs, could adversely affect our operating costs and the value of our properties. Phase I environmental site assessments have been obtained on all of our owned properties. The purpose of Phase I environmental site assessments is to identify potential sources of contamination for which an owner may be responsible and to assess the status of environmental regulatory compliance. None of the environmental site assessments revealed any environmental condition, liability or compliance concern that we believe would have a material adverse affect on our business, assets or results of operations. Nor are we aware of any such condition, liability or concern by any other means. However, it is possible that the environmental site assessments relating to any one of the properties did not reveal all environmental conditions, liabilities or compliance concerns that arose at a property before or after the related review was completed. Real Estate Investment Risks In General Each of our hotels are subject to a variety of risks associated with real estate ownership. Some of these risks include: . Changes in national and local economic conditions; . Changes in interest rates; . Changes in costs of, or terms of, loans from lenders; . Changes in environmental laws; . The ongoing requirement to make capital improvements, repairs or maintenance; . Changes in the tax rates or laws; . The continuing requirement to pay operating expenses; . Changes in governmental requirements or zoning laws; . Occurrences beyond the control of an owner, such as natural disasters like earthquakes and weather, civil unrest or so-called "acts of God;" . The possibility of unexpected, uninsured or under-insured losses; and . Condemnation by a government agency seeking to use a property for a public purpose. Risks such as those listed above, and other risks which may occur from time to time, may adversely affect our profit from the property because they cause increased costs, expenses, liabilities, restrictions and operational delays. Such risks may also affect the price we may obtain on a sale of a property or whether the property can be sold at all. Uninsured And Under-Insured Losses We carry comprehensive policies of insurance for our hotels which include liability for personal injury, property damage, fire and extended coverage. We believe the coverage we carry is typical and customary for owners of hotels such as ours. Even though we carry the insurance referenced above, certain losses may be uninsurable by virtue of the type or amount of loss. Losses which result from catastrophes, such as hurricanes, tornadoes, earthquakes, floods or so- called "acts of God," may fall within that category. More than half of our hotels are located in California -23- and the Pacific northwest, an area which is subject to a high degree of seismic activity and risk. Although we carry earthquake insurance for our hotels, there is no assurance that such insurance will be available in the future under terms and amounts which are sufficient to provide adequate protection. It also could be possible that the current insurance coverage we carry would not be sufficient to pay the full market value or replacement cost of an affected hotel with a resulting loss of our entire investment. Therefore, a possibility does exist for substantial uninsured or under-insured losses as a result of an earthquake. Other factors also affect whether a loss is uninsured or under-insured and may include inflation, changes in law or environmental contamination. Such factors may affect whether insurance proceeds received by us are adequate to restore our entire investment in the property. Factors such as these may also make it impractical to use insurance proceeds to replace or repair our property after it has been damaged or destroyed. Because Real Estate Investments Are Illiquid, We May Not Be Able To Sell Properties When Appropriate Real estate investments generally cannot be sold quickly. We may not be able to vary our portfolio promptly in response to economic or other conditions. This inability to respond promptly to changes in the performance of our investments could adversely affect our financial condition and ability to service debt and make distributions to our shareholders. Our Earnings And Cash Distributions Will Affect The Market Price Of Our Publicly Traded Securities We believe that the market value of a REIT's equity securities is based primarily upon the market's perception of the REIT's growth potential and its current and potential future cash distributions, and is secondarily based upon the real estate market value of the underlying assets. For that reason, REIT shares may trade at prices that are higher or lower than the net asset value per share. To the extent we retain operating cash flow for investment purposes, working capital reserves or other purposes, these retained funds, while increasing the value of our underlying assets, may not correspondingly increase the market price of our shares. Our failure to meet the market's expectations with regard to future earnings and cash distributions would likely adversely affect the market price of our publicly traded securities. Year 2000 Issue The term "Year 2000 issue" is a general term used to describe the complications that may be caused by existing computer hardware and software that were designed by the respective manufacturers without consideration of the upcoming change in the century. Many computer systems recognize calendar years by the last two digits in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish twenty-first century dates from twentieth century dates. If not corrected, computer systems may fail or create erroneous results which could have significant negative operational and financial consequences. We have adopted a Year 2000 Compliance Program (the "Compliance Program") to minimize disruptions to our business which could be caused by computer system error or failure. These computerized systems include information and non-information technology systems and applications, as well as, financial and operational reporting systems. For discussion of the Company's efforts to address the Year 2000 issue and the related Compliance Program see "Management's Discussion and Analysis of Financial Condition and Results of Operations, Year 2000 Issue." There can be no assurances that our Compliance Program will be properly and timely completed, and failure to do so could have a material adverse effect our business operations and financial condition. We cannot predict the actual effects of the Year 2000 issue on our business operations and financial condition. The actual effects may be impacted by: (i) whether significant third parties properly and timely address the Year 2000 issue; and (ii) whether broad-based or systemic economic failures may occur. We are also unable to predict the severity and duration of any such failures, which could include disruptions in passenger transportation or transportation systems generally, loss of utility and telecommunications services, the loss or disruption of hotel reservations made on centralized reservation systems and errors or failures in financial transactions or payment processing systems such as credit cards. Due to the general uncertainty inherent in the Year 2000 issue and our dependence on third parties, we are unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on us. Our Compliance Program -24- is expected to significantly reduce the level of uncertainty about the Year 2000 issue and we believe that the possibility of significant interruptions of normal operations should be reduced. Market Interest Rates May Have An Effect On The Value Of Our Publicly Traded Securities One of the factors that investors consider important in deciding whether to buy or sell shares of a REIT is the distribution rate on such shares (as a percentage of the price of such shares) relative to market interest rates. If market interest rates go up, prospective purchasers of REIT shares may expect a higher distribution rate. Higher interest rates would not, however, result in more funds for us to distribute and, in fact, would likely increase our borrowing costs and potentially decrease funds available for distribution. Thus, the higher market interest rates could cause the market price of our publicly traded securities to go down. Hotel Industry Risks Operating Risks. In addition to the investment risks associated with investing all of our resources in the hotel industry, we face operating risks associated with hotels. These risks include, among others, the following: . Competition for customers at our hotels from other hotels, many of which are owned by competitors who have significantly greater financial resources and marketing power and therefore compete with our hotels; . The risk of loss of market share in areas in which overbuilding occurs and adversely affects occupancy, ADR and REVPAR; . Erosion of operating margins arising from an increase in operating costs due to inflation or other factors that may exceed increases in REVPAR; . Dependence on demand for our accommodations from both business travelers, commercial travelers and tourism, each of which may be affected in different markets by different economic factors; . Strikes and other labor disturbances by the Lessee's employees which would seriously disrupt the Lessee's ability to provide services to hotel guests; . The deterioration of economic conditions either generally or in particular markets in which our hotels are located causing a reduction in demand for our accommodations. The Lessee's operating results at our hotels are directly affected by the factors described above and a significant decrease in operating revenues by the Lessee will adversely affect the Lessee's ability to make payments of rent under the percentage leases. Any reduction in such rent will reduce our cash and could adversely affect our ability to make distributions to our stockholders. Seasonality of Hotel Business and Our Hotels. The hotel industry in general is seasonal with certain periods generating greater revenues than others. In particular, our revenues are greater in the second and the third quarters than in the first and the fourth quarters. In addition, winter weather in the markets in which our hotels operate can severely impact the operating results of particular hotels, such as occurred in 1998 in Arizona due to the effects of El Nino. The Lessee's revenues can vary significantly from quarter to quarter. It is possible that the significant fluctuation of revenues in a particular quarter due to weather or other factors could cause us to earn less percentage rent than we had originally anticipated which could have an adverse effect on our ability to make distributions to our shareholders. Increased Competition from Overbuilding. The hotel industry has historically experienced cycles of overbuilding in certain geographic markets and product segments. This overbuilding increases competition for hotel guests, resulting in lower occupancies and lower ADRs thereby reducing revenues of the hotels effected by the increased competition. While our investment strategy is to acquire underperforming hotels in markets where we believe there are significant barriers to entry, we can give no assurance that the current hotel development activities, particularly in the limited service segment, will not create additional significant competition for our hotels. This -25- increased competition would reduce the revenues generated by the Lessee at the effected hotel, thus reducing percentage rent we receive and therefore potentially adversely effecting our distributions to our shareholders. Impact of Increased Operating Costs and Capital Expenditures. Our hotels need to be periodically renovated and furniture, fixtures and equipment replaced in order to remain competitive in their markets and to comply with the terms of franchise agreements under which our hotels are operated. Under our Percentage Leases, we are obligated to make available to the Lessee for periodic refurbishment of furniture, fixtures and equipment an amount equal to four percent (4%) of the room revenues of each hotel. Our ability to fund these and other capital expenditures including periodic replacement of furniture, fixtures and equipment will depend in part on the financial performance of the Lessee and our hotels. If these expenditures exceed our estimates, then the increased costs would adversely effect the cash available for other purposes such as making distributions to our stockholders. Alternatively, if we fail to make these expenditures, we may adversely effect the competitive position of the hotels and have an adverse effect on occupancy rates, ADRs and REVPAR. In certain instances, our failure to make certain capital expenditures may constitute a default under the applicable franchise agreement. Risks Of Operating Under Franchise Agreements. Of our 56 hotels, 54 are operated under franchise agreements with national franchisors. The Lessee is the franchisee and is responsible for complying with the franchise agreements. Under these arrangements, a franchisor provides marketing service and room reservations and certain other operating assistance, but requires the Lessee to pay significant fees as well as maintain the hotel in a certain required condition. If the Lessee fails to maintain these required standards or we fail to make required capital expenditures (or to fund the Lessee's expenditures) then there may be a termination of the franchise agreement and possible liability for damages. If the Lessee were to lose a franchise on a particular hotel, it could have a material adverse effect upon the operation, financing or value of that hotel due to the loss of the franchise name, marketing support and centralized reservation system. In addition, adverse publicity affecting a franchisor could reduce the revenues we receive from the hotels subject to such franchise. Any loss of revenues by the Lessee at a hotel because of loss of the franchise agreement would adversely effect the Lessee's ability to pay rent and could effect our ability to make distributions to our stockholders. Our Degree Of Leverage Could Limit Our Ability to Obtain Additional Financing Our Articles of Incorporation limits consolidated indebtedness to 50% of our investment in hotel properties, at cost on a consolidated basis, after giving effect to our use of proceeds from the indebtedness. As of December 31, 1998, our ratio of debt to total investment in hotel properties and other real estate investments was approximately 41%. The degree of leverage could have important consequences to our stockholders, including, effecting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, development or other general corporate purposes including the payment of distributions and could make us more vulnerable to a downturn in business or the economy. ITEM 3. LEGAL PROCEEDINGS Neither the Company nor the Operating Partnership is currently involved in any material litigation, nor, to the Company's knowledge, is any material litigation currently threatened against the Company or the Operating Partnership or any of the hotels. The Lessee and the Management Company have each advised the Company that it is currently is not involved in any material litigation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1998. -26- PART II ------- ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Price Range of Common Stock The Company's Common Stock is traded on the New York Stock Exchange under the ticker symbol "SSI". The following table sets forth the high and low stock prices for the last two fiscal years:
High Low ------- ------- 1997 Quarter Ended March 31....................... $14.000 $12.250 June 30........................ 14.500 12.625 September 30................... 18.125 13.750 December 31.................... 18.125 15.500 1998 Quarter Ended March 31....................... $17.375 $14.875 June 30........................ 16.500 12.500 September 30................... 13.750 8.313 December 31.................... 11.000 6.500
Stockholder Information As of March 5, 1999, there were approximately 868 record holders of the Company's Common Stock. On March 5, 1999, the last reported sale price of the Common Stock on the NYSE was $7.6875 per share. In addition, the Units (which are exchangeable for Common Stock) were held by 48 entities and/or individuals as of March 5, 1999. In order to comply with certain requirements related to qualification of the Company as a REIT, the Company's Articles of Incorporation limits the number of shares of Common Stock that may be beneficially owned by any single person to 9.8% of the Company's outstanding Common Stock. -27- Dividends The Company has adopted a policy of paying regular quarterly dividends on its common stock, and cash distributions have been paid on the Company's common stock with respect to each quarter since the Company's inception in 1995. The following table sets forth information regarding the declaration and payment of distributions by the Company for 1997 and 1998:
Per Share Quarter to Which Distribution Distribution Distribution Distribution Relates Record Date Payment Date Amount - ------------------------ ------------ ------------ ------------ 1997 Quarter Ended March 31 4/29/97 5/15/97 $ 0.25 June 30 7/31/97 8/15/97 $ 0.25 September 30 9/30/97 11/14/97 $0.275 December 31 1/31/98 2/15/98 $0.275 1998 Quarter Ended March 31 5/1/98 5/13/98 $0.275 June 30 7/31/98 8/12/98 $0.275 September 30 10/30/98 11/10/98 $0.285 December 31 2/1/99 2/15/99 $0.285
ITEM 6. SELECTED FINANCIAL DATA The following tables set forth (i) selected historical financial information for the Company as of and for the years ended December 31, 1998, 1997 and 1996 and as of December 31, 1995 and for the period August 16, 1995 (inception) through December 31, 1995, (ii) historical information for the Lessee for the years ended December 31, 1998, 1997 and 1996 and the period August 16, 1995 (inception) to December 31, 1995, and (iii) historical information for the predecessor of the Company ("Sunstone Hotels") for the period January 1, 1995 through August 15, 1995 and for the year ended December 31, 1994. The following selected historical financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and notes thereto included in this Annual Report on Form 10-K. -28- SUNSTONE HOTEL INVESTORS, INC. (The Company)
Inception August 16, 1995 to For the Years Ended December 31, December 31, -------------------------------------------- --------------- 1998 1997 1996 1995 ------------ ------------ ------------ --------------- REVENUES: Lease revenue - Lessee $ 98,682,000 $ 44,680,000 $ 14,848,000 $ 3,013,000 Interest and other income 473,000 471,000 236,000 47,000 ------------ ------------ ------------ ------------- 99,155,000 45,151,000 15,084,000 3,060,000 ------------ ------------ ------------ ------------- EXPENSES: Real estate related depreciation and amortization 35,835,000 14,749,000 4,514,000 968,000 Interest expense and amortization of financing costs 23,734,000 6,365,000 1,558,000 47,000 Real estate and personal property taxes and insurance 11,409,000 4,670,000 1,273,000 312,000 General and administrative 5,344,000 1,890,000 1,015,000 109,000 Cost of withdrawn offerings 1,450,000 -- -- -- ------------ ------------ ------------ ------------- Total expenses 77,772,000 27,674,000 8,360,000 1,436,000 ------------ ------------ ------------ ------------- Income before losses on dispositions of hotel properties, minority interest and extraordinary item 21,383,000 17,477,000 6,724,000 1,624,000 Losses on dispositions of hotel properties (3,574,000) -- -- -- Minority interest (851,000) (1,886,000) (1,090,000) (284,000) ------------ ------------ ------------ ------------- Income before extraordinary item 16,958,000 15,591,000 5,634,000 1,340,000 Extraordinary charge for early extinguishment of debt (net of $34,000 of minority interest) -- -- -- (159,000) ------------ ------------ ------------ ------------- NET INCOME 16,958,000 15,591,000 5,634,000 1,181,000 Distributions on preferred shares (1,975,000) (422,000) -- -- ------------ ------------ ------------ ------------- INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 14,983,000 $ 15,169,000 $ 5,634,000 $ 1,181,000 ============ ============ ============ ============= EARNINGS PER SHARE - DILUTED $0.40 $0.71 $0.69 $0.19 DIVIDENDS DECLARED PER COMMON SHARE $1.12 $1.05 $0.96 $0.35 FUNDS FROM OPERATIONS ("FFO") (1) $ 57,218,000 $ 32,226,000 $ 11,238,000 $ 2,592,000 CASH FLOW FROM OPERATING ACTIVITIES $ 63,911,000 $ 24,316,000 $ 11,669,000 $ 2,291,000 Balance Sheet and Other Data: Investments in hotel properties, net $840,974,000 $704,817,000 $152,937,000 $50,063,000 Total assets 875,636,000 739,577,000 160,079,000 57,226,000 Total debt 398,893,000 307,830,000 63,300,000 11,510,000 Number of properties owned at end of period 57 53 24 11 Number of rooms at end of period 10,215 9,854 3,389 1,477
________________ (1) See discussion of Funds From Operations in the "Liquidity and Capital Resources" section of Management's Discussion and Analysis of Financial Condition and Results of Operations. -29- SELECTED FINANCIAL INFORMATION (The Lessee and the Predecessor)
Sunstone Hotel Properties Inc. Sunstone Hotels (Predecessor) ------------------------------------------------------------------ ---------------------------------- From For the Period For the Year For the Years Ended December 31, August 16, January 1, Ended ------------------------------------------ 1995 (Inception) to 1995 to August 15, December 31, 1998 1997 1996 December 31, 1995 1995 1994 ------------------------------------------------------------------ ----------------- ------------ Hotel operating revenue $273,596,000 $118,153,000 $38,593,000 $7,925,000 $9,675,000 $13,863,000 Hotel operating expense 179,297,000 75,604,000 26,907,000 5,658,000 5,679,000 9,168,000 Operating Profit 94,299,000 42,549,000 11,686,000 2,267,000 3,996,000 4,695,000 Lease rent expense 98,682,000 44,680,000 14,848,000 3,013,000 -- -- Net income (loss) (4,383,000) (2,131,000) (3,162,000) (746,000) 1,674,000 398,000
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Comparison of the Years Ended December 31, 1998 and 1997 During 1998, the Company: . acquired 10 hotels for an aggregate purchase price of $134.2 million; . sold six non-core hotel properties located in tertiary markets for an aggregate sales price of $47.2 million; . invested $68.2 million in renovation and redevelopment to 20 hotels; . raised approximately $69.4 million of equity capital through the sale of common stock in a shelf offering; and . increased the commitment under Company's unsecured line of credit facility from $200.0 million at December 31, 1997 to $350.0 million by December 31, 1998. For the year ended December 31, 1998, lease revenue increased $54.0 million, to $98.7 million from $44.7 million for the corresponding period of 1997. The 120.8% increase is attributable to the net increase in hotels owned during 1998, ten hotels acquired and six hotels sold, the full year effect of hotels acquired during 1997 and net REVPAR increases for continuously owned hotels. The Company experienced strong revenue growth of its hotels during 1998. Total room revenue generated by the Company's hotels increased 115.0% to $204.5 million for 1998 from $95.1 million for 1997, primarily due to the increase in hotels owned during 1998 and 1997. On a same-unit-sales basis for the entire portfolio, the Company achieved a 5.0% increase in REVPAR for the year ended December 31, 1998 as compared to 1997. The 5.0% REVPAR growth for the year ended December 31, 1998 over 1997 was a result of both the performance of the recently repositioned hotels and the internal revenue growth from continuously owned and operated hotels. For comparative purposes, for the year ended December 31, 1998, the nationwide lodging industry REVPAR growth for the luxury, upscale and mid-price hotel segments, the segments most representative of the Company's hotels, were 3.2%, 2.9% and 3.5%, respectively. The 5.0% increase was driven by a 10.0% increase in ADR, from $75.02 in 1997 to $82.50 in 1998, while occupancy decreased three percentage points. -30- REVPAR for 1998 for the non-renovation hotels increased by 7.9% over 1997, from $53.92 to $58.16. Non-renovation hotels represent the Company's portfolio of hotels during periods of stabilized operations (pre- and post-renovation) in both 1998 and 1997. The 7.9% increase in REVPAR for non-renovation hotels was driven by a 9.1% increase in ADR, from $76.06 to $82.96, while occupancy decreased less than one percentage point. REVPAR for 1998 for the hotels that were undergoing renovation during certain months of 1998 or 1997, decreased 1.1% over the corresponding periods of 1997. During 1998, the Company invested $68.2 million redeveloping and renovating 20 hotels as compared to $48.8 million invested redeveloping and renovating 19 hotels during 1997. In conjunction with the current year redevelopment and renovation activities, the Company rebranded and upgraded nine hotels with new and existing franchises including four full-service Marriotts. The following table summarizes average occupancy, ADR and REVPAR on a same- unit-sales basis for the hotels for the years ended December 31, 1998, 1997 and 1996:
For the Years Ended For the Years Ended December 31 December 31 ----------------------------- --------------------------- 1998 1997 (1) 1997 1996 (1) ---------- ------------- ------------- ------------ Same-Unit Sales Analysis Number of Hotels 57 57 53 53 Number of Rooms 10,215 10,215 9,854 9,854 All Hotels: Occupancy 65.9% 69.0% 65.4% 65.9% ADR $ 82.50 $ 75.02 $70.75 $ 64.65 REVPAR $ 54.38 $ 51.79 $46.24 $ 42.57 REVPAR growth 5.0% 8.6% Non-renovation Hotels: Occupancy 70.1% 70.9% 67.9% 63.9% ADR $ 82.96 $ 76.06 $71.46 $ 64.35 REVPAR $ 58.16 $ 53.92 $48.51 $ 41.10 REVPAR growth 7.9% 18.0% Renovation Hotels: Occupancy 58.1% 65.6% 61.1% 68.4% ADR $ 81.46 $ 72.94 $67.90 $ 63.11 REVPAR $ 47.36 $ 47.87 $41.50 $ 43.19 REVPAR growth (1.1%) (3.9)%
- ------------------- (1) The Company did not own certain hotels for the entire period presented. The Company invested $217.8 million in the acquisition, renovation and development of hotel properties and other real estate assets during 1998. As a result of such investments, interest expense and amortization of financing costs increased to $23.7 million from $6.4 million, and real estate and personal property taxes and insurance increased to $11.4 million from $4.7 million, for the year ended December 31, 1998 in comparison to the prior year. Additionally, real estate related depreciation and amortization increased $21.1 million in 1998 over 1997. For the year ended December 31, 1998, general and administrative expenses increased $3.4 million, to $5.3 million from $1.9 million for the prior year. The increase in general and administrative expenses was primarily due to the acquisition of Kahler in October 1997, significant growth in the Company's hotel portfolio and additional personnel added to the staff of the Company. Additionally, the Company incurred increased recurring expenses for legal, accounting and tax services during 1998 due to the significant acquisition and hotel portfolio growth. Also, the -31- Company incurred $553,000 of costs related to the termination of a significant hotel portfolio acquisition that was under consideration. Increases in other general and administrative expenses were also incurred commensurate with the growth of the Company's hotel portfolio during 1998 and 1997. During 1998, the Company disposed of six non-core hotels, that were included in the acquisition of Kahler, for $47.2 million and recognized losses of $3.6 million. Additionally, the Company incurred $1.5 million in costs related to debt and equity offerings that were withdrawn due to market conditions. Accordingly, these costs were expensed in 1998. As a result of the above factors, net income available to common stockholders decreased $200,000 to $15.0 million in 1998 from $15.2 million. Earnings per share for 1998 were impacted by the 5.3 million and 21.3 million common shares that were issued during 1998 and 1997, respectively, and on a diluted basis was $0.40 per share as compared to $0.71 per share for 1997. (See discussion of Funds From Operations in "Liquidity and Capital Resources.") Comparison of the Years Ended December 31, 1997 and 1996 For the year ended December 31, 1997, lease revenues increased $29.9 million, to $44.7 million from $14.8 million for the corresponding period of 1996. The 202.0% increase is primarily due to the 27 hotels acquired during 1997, the full year effect of hotels acquired during 1996 and net REVPAR increases for continuously owned hotels. The Company experienced strong revenue growth of its hotels during 1997. Total room revenue from the Company's hotels increased 178.9% from $34.1 million to $95.1 million over 1996, primarily due to the completion of $521.8 million of hotel acquisitions during the preceding twelve months. On a same unit-sales basis for the entire portfolio, the Company achieved an 8.6% increase in REVPAR during 1997 compared to 1996. The 8.6% REVPAR growth for the year ended December 31, 1997 over 1996 was a result of both the performance of the recently repositioned hotels and the internal revenue growth from continuously owned and operated hotels. For comparative purposes, for the year ended December 31, 1997, the nationwide lodging industry, REVPAR growth for the luxury, upscale and mid-price hotel segments, the segments most representative of the Company's hotels, were 5.9%, 4.8% and 4.6%, respectively. The 8.6% increase was driven by a 9.4% increase in ADR from $64.65 in 1996 to $70.75 in 1997. REVPAR for 1997 for the non-renovation hotels increased by 18.0% over 1996, from $41.10 to $48.51. Non-renovation hotels represent the Company's portfolio of hotels during periods of stabilized operations (pre- and post-renovation) in both 1997 and 1996. The 18.0% increase in REVPAR for non-renovation hotels was driven by a 11.0% increase in average daily rate from $64.35 to $71.46, while occupancy increase four percentage points. REVPAR for 1997, for the hotels which were undergoing renovation during certain months of 1996 or 1997, decreased 3.9% over the corresponding periods of 1996. Interest expense and amortization of financing costs increased to $6.4 million from $1.6 million, and real estate and personal property taxes and insurance increased to $4.7 million from $1.3 million for the year ended December 31, 1997 in comparison to the prior year. Additionally, real estate related depreciation and amortization increased $10.2 million in 1997. These increases are attributable to the growth of the Company's hotel portfolio to 53 hotels during 1997 compared to 24 hotels owned during 1996. Acquisitions are typically initially financed with debt contributing to the increase in interest expense and amortization of financing costs. During 1997, the Company recorded increased general and administrative expenses relating to due diligence for hotels not acquired and other general and administrative costs incurred due to the growth of the Company's hotel portfolio. Additionally, effective January 1, 1997, the Company increased the compensation of the President and added a chief financial officer, corporate controller, cash manager and other administrative staff necessitated by the Company's growth. As a result, general and administrative expenses increased to $1.9 million from $1.0 million for the year ended December 31, 1997 in comparison to the prior year. -32- As a result of the above factors, net income available to common stockholders increased $9.6 million, to $15.2 million in 1997 from $5.6 million in 1996. Earnings per share on a diluted basis for 1997 was $0.71 per share as compared to $0.69 per share for 1996. (See discussion of Funds from Operations in "Liquidity and Capital Resources.") National Franchise Affiliations The Company generally believes that franchise affiliations provide advantages to its hotels. Such advantages include brand recognition, access to national reservation systems, national direct sales efforts and national volume purchasing agreements, and technical and business assistance. The use of multiple franchise systems provides the Company with further diversification, less dependence on the continued popularity of one brand and less vulnerability to new requirements of any individual franchise affiliation. The Company expects to focus its franchise affiliations on nationally recognized luxury upscale hotel chains. The following table summarizes certain information with respect to the current or anticipated franchise affiliations of the hotels. FRANCHISE AFFILIATIONS (As of and for the Year Ended December 31, 1998)
Percentage of Number of Percentage of Lease Lease Franchise Affiliation Hotels Rooms Rooms Revenues Revenues ---------------------------- ------------ ---------- ------------- ------------ -------------- Marriott - Full-Service, Courtyard and Residence Inn (1) 20 3,520 34.5% $34,555,000 35.0% Holiday Inns (1) 16 2,534 24.8 19,949,000 20.2 Kahler 2 965 9.4 11,198,000 11.3 Hampton Inns 9 1,193 11.7 9,797,000 9.9 Hilton 2 572 5.6 6,008,000 6.1 Hawthorn Suites 3 583 5.7 5,025,000 5.1 Sheraton 1 295 2.9 2,969,000 3.0 Comfort Suites 1 166 1.6 2,144,000 2.2 Ramada 1 124 1.2 1,340,000 1.4 Best Western 1 103 1.0 649,000 0.7 Radisson (1) 1 160 1.6 740,000 0.7 Other (2) -- -- -- 4,308,000 4.4 ---- ------ ----- ----------- ----- 57 10,215 100.0% $98,682,000 100.0% ==== ====== ===== =========== =====
__________ (1) In cases where the Company has obtained approval of a new franchise license, subject to completion of renovations or improvements, the franchise brand indicated represents the approved new franchise brand. (2) Represents six non-core hotel properties sold during the third quarter of 1998. -33- Seasonality and Regional Focus The Company focuses its current acquisition efforts principally on the Pacific region where supply and demand demographic trends are more favorable. The geographic distribution of the hotels, which are located in eight states, reflects the Company's belief that a certain amount of geographic distribution helps to insulate the Company's hotel portfolio from local market fluctuations that are typical for the hotel industry. The Company also has sought to increase its geographic distributions by focusing on major metropolitan areas. The following table summarizes the Company's presence in each of these eight markets: GEOGRAPHIC DIVERSIFICATION (As of and for the Year Ended December 31, 1998)
Percentage Number of Percentage of Lease of Lease Region Hotels Rooms Rooms Revenues Revenues - ------------------------------ ------------ ------------- ---------------- -------------- ----------- Pacific (1)................. 32 5,054 49.5% $46,423,000 47.0% Mountain (2)................ 21 3,832 37.5 30,854,000 31.3 Minnesota................... 4 1,329 13.0 17,097,000 17.3 Other (3)................... -- -- -- 4,308,000 4.4 -- ------- ---- ----------- ---- Total..................... 57 10,215 100% $98,682,000 100% == ====== ==== =========== ====
- --------------- (1) Includes California, Oregon and Washington (2) Includes Arizona, Colorado, New Mexico and Utah. (3) Includes the six non-core hotel properties sold during the third quarter of 1998. Such hotels are located in Idaho, Montana, Texas and West Virginia. Liquidity and Capital Resources Cash Flow Provided by Operating Activities. The Company's operating activities provide the principal source of cash to fund the Company's operating expenses, interest expense, recurring capital expenditures and distribution payments. The Company anticipates that its cash flow provided by leasing the hotels to the Lessee will provide the necessary funds on a short- and long-term basis to meet its operating cash requirements. (See discussion of the Lessee's stockholders' deficit in the following section, "The Lessee.") In 1998, the Company paid distributions totaling $44.7 million. Beginning with the third quarter of 1998, the Company increased its regular quarterly dividend 3.64% to $0.285 per share. The Company believes a regular program of capital improvements, including replacement and refurbishment of furniture, fixtures and equipment at its hotels, as well as the periodic renovation and redevelopment of certain of its hotels, is essential to maintaining the competitiveness of the hotels and maximizing revenue growth. The Company is required under the Percentage Leases to make available to the Lessee for the repair, replacement and refurbishment of furniture, fixtures and equipment an amount equal to 4% of the room revenue per quarter on a cumulative basis, provided that such amount may be used for capital expenditures made by the Company with respect to the hotels. The Company expects that this amount will be adequate to fund the required repairs, replacements and refurbishments and to maintain its hotels in a competitive condition. Cash Flows from Investing and Financing Activities. The Company intends to finance the acquisition of additional hotel properties, hotel renovations and non-recurring capital improvements principally through its $350 million unsecured revolving line of credit facility (the "Credit Facility") from its lenders (led by Bank One of Arizona, N.A., as the agent bank), proceeds from the disposition of certain non-core hotel assets and, when market conditions warrant, proceeds from the issuance of additional equity or debt securities. During 1998, the Company borrowed $182.2 million on the Credit Facility, raised $47.2 million through the disposition of non-core hotel assets and $69.9 million through issuance of common stock. As of December 31, 1998, approximately $163.2 million was available -34- under the Company's shelf registration statement and the Company had $75.5 million of unused commitment on the Credit Facility. The Credit Facility contains financial covenants that require the Company to maintain certain specified financial ratios. Under the most restrictive of these provisions, the Company's maximum additional indebtedness that could be incurred for the acquisition and renovation of hotel properties would have been between $23.7 million and $47.4 million at December 31, 1998, depending upon the use of the funds. On July 23, 1998, the Company amended the Credit Facility to (i) increase total commitment to $350.0 million, (ii) increase the total amount available under the Credit Facility from 45% to 50% of the aggregate value of the Company's eligible hotels, as defined, (iii) increase amount available for working capital purposes from $15.0 million to $30.0 million, and (iv) extend the term from June 30, 1999 to June 30, 2000. Borrowings under the Credit Facility accrue interest at LIBOR plus 1.40% per annum, to LIBOR plus 2.00% per annum, based upon the leverage of the Company. At December 31, 1998, the Company's actual borrowing rate was LIBOR plus 1.75%. The Credit Facility may be retired in whole or in part from the proceeds of public or private issuances of equity or debt securities by the Company and may be refinanced in whole or in part with fixed-rate financing. The Company may seek to obtain such financing if market conditions are appropriate in management's view. During 1998, the Company disposed of six non-core hotel assets that were included in the $372 million acquisition of Kahler Realty Corporation for $47.2 million in cash. These dispositions were structured as non-taxable exchange transactions. Additionally, on February 2, 1999, the Company sold the 129-room limited service Hampton Inn located in Arcadia, California for $8.5 million in cash. The Company continues to consider certain non-core hotel assets for disposition and has identified five additional hotels for disposition, primarily limited service hotels. As part of its investment strategy, the Company plans to acquire additional hotels. Future acquisitions are expected to be funded through the use of the Credit Facility or other borrowings, proceeds from the disposition of non-core hotel assets and the issuance of additional equity or debt securities. The Company's Articles of Incorporation limits consolidated indebtedness to 50% of the Company's investment in hotel properties, at cost on a consolidated basis, after giving effect to the Company's use of proceeds from any indebtedness. Management believes that it will have access to capital resources sufficient to satisfy the Company's cash requirements and to expand and develop its business in accordance with its current strategy for growth. During 1998, the Company used cash in the amount of $217.8 million as well as debt and the issuance of Units to acquire hotel properties and other real estate investments, including redevelopment and recurring capital expenditures. During 1998, the Company invested approximately $68.2 million in major renovations and conversions of 20 of its hotels. During the quarters ended March 31, 1998, June 30, 1998, September 30, 1998 and December 31, 1998, there were twelve, eleven, four and nine hotels under renovation, respectively. Certain of these hotels were under renovation for more than one quarter. The Company estimates it will invest an additional $34.0 million to complete the renovation of those hotels currently under renovation and certain other recently acquired hotels. Management believes the renovations should result in incremental increases in REVPAR after a ramp-up period at these renovation hotels and increased lease revenue for the Company. The Company selectively develops luxury and upscale hotels in markets where management believes room demand and other competitive factors justify new construction. On August 12, 1998, the Company completed its acquisition and development of the newly-built Pueblo Marriott in Pueblo, Colorado, for a cost of approximately $12.0 million that was funded with the Credit Facility. Additionally, the Company is in the construction phases of developing three additional hotels, which are expected to open in 1999. The Company estimates it will invest approximately $35.3 million to complete the development of these hotels. This development will be funded by approximately $21.0 million in loan proceeds from the existing construction lender for two of the hotels which are being built by third parties, proceeds from the February 1999 sale of the Hampton Inn located in Arcadia, California and the Credit facility. In conjunction with the on-going development activity, the Company has various contracts and commitments outstanding with third parties. The Company plans to fund remaining commitments under these agreements through the use of the Credit Facility, and proceeds from the disposition of certain non-core hotel assets. In addition, the Company may acquire additional hotels and invest additional cash for renovations during 1999. -35- The Company historically has financed hotel acquisitions through advances on the Credit Facility and the issuance of equity securities. The Company intends to finance future acquisitions of hotel properties, hotel renovations and non-recurring capital improvements principally through the Credit Facility, proceeds from the disposition of non-core hotel assets and, when market conditions warrant, by issuing additional equity or debt securities. There can be no assurance that the Company will have access to capital on favorable terms. If the Company's access to capital is restricted, its ability to acquire additional hotel properties or to complete development projects or major renovation projects may be adversely affected. A decline in the Company's acquisition pace relative to historical periods may result in a decline in earnings growth. Funds From Operations ("FFO"). Management believes that FFO is one measure of financial performance of an equity REIT, such as the Company. FFO (as defined at footnote below) grew by 78% to $57.2 in 1998 from $32.2 million in 1997.
1998 1997 1996 Actual Actual Actual ------------------ ------------------ ------------------ Net Income $16,958,000 $15,591,000 $ 5,634,000 Add back: Real estate related depreciation and amortization 35,835,000 14,749,000 4,514,000 Losses on dispositions of hotel properties 3,574,000 -- -- Minority interest 851,000 1,886,000 1,090,000 ------------------ ------------------ ------------------ FFO assuming conversion of preferred shares $57,218,000 $32,226,000 $11,238,000 ================== ================== ==================
___________________ Management and industry analysts generally consider Funds From Operations to be one measure of the financial performance of an equity REIT that provides a relevant basis for comparison among REITs and it is presented to assist investors in analyzing the performance of the Company. Funds From Operations is defined as net income (computed in accordance with generally accepted accounting principles), excluding gains (losses) from debt restructuring and sales of property plus real estate related depreciation and amortization (excluding amortization of financing costs). FFO should be considered in conjunction with net income as presented in the Company's consolidated financial statements and Notes thereto. Funds From Operations does not represent cash generated from operating activities in accordance with generally accepted accounting principles and is not necessarily indicative of cash available to fund cash needs. Funds From Operations should not be considered an alternative to net income as an indication of the Company's financial performance or as an alternative to cash flows from operating activities as a measure of liquidity. Year 2000 Issue The term "Year 2000 issue" is a general term used to describe the complications that may be caused by existing computer hardware and software that were designed by the respective manufacturers without consideration of the upcoming change in the century. Many computer systems recognize calendar years by the last two digits in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish twenty-first century dates from twentieth century dates. If not corrected, computer systems may fail or create erroneous results causing disruptions of operations. The Company's in-house computer systems environment is limited to software and hardware developed by third parties. All of the Company's computer systems, consisting of financial reporting and accounting systems only, were installed in the last two years and management believes such systems are Year 2000 compliant. However, the Company's business is heavily dependent upon the efforts of the Lessee and third parties with whom the Lessee conducts significant business. -36- The Lessee relies on information technology ("IT") systems and other systems and facilities such as PBX switches, elevators, heating, ventilation and air conditioning, security, fire and life safety and other environmental systems ("embedded systems") to conduct its business. Both the IT and the embedded systems are subject to the Year 2000 Issue which, if not remedied in time, could have an impact on the operations of the Lessee. The Lessee may also be exposed to risk from third parties with whom the Lessee interacts who fail to adequately address their own Year 2000 issues. Such third parties include franchisors, vendors, suppliers and significant customers. To mitigate and minimize the number and seriousness of any disruptions caused by the Year 2000 Issue, the Company and the Lessee have developed and adopted a Year 2000 Compliance Program (the "Compliance Program") which involves the following four phases: assessment, which includes development of an action plan and inventorying of hotel systems, remediation, testing and implementation. With the assistance of outside consultants, site surveys are being performed and all hotel systems will be identified and inventoried and will include information such as the manufacturer or vendor who performed the installation, currently services or maintains each system. The Lessee has begun contacting these vendors to obtain certification relating to their Year 2000 compliance testing. In addition, all parties for building systems that service leased premises, or a facility within leased premises are located and are operated and controlled by or interact with a software program will be identified and contacted. It should be noted that due to the complexity of some of the systems, in many cases, the only way to determine the potential impact of the systems would be to verify the Year 2000 effect with the particular vendor. The assessment phase was completed in February 1999. Status of Progress in Becoming Year 2000 Compliant, Including Timetable for Completion of Each Remaining Phase - Hotel and Lessee Systems: Based on the results of the site assessments, the identified IT and embedded systems will be replaced or upgraded. The system upgrades will be prioritized according to their critical importance. Life safety systems and emergency services will take priority in accordance with the steps laid out in the Compliance Program. The various vendors associated with any system replacements or upgrades will be contacted to determine their readiness to deal with these system enhancements. Performance of certain testing by the vendors may be required in several cases to ensure Year 2000 compliance. All vendors, manufacturers, service personnel, consultants, contractors, lessees and lessors will be requested to prepare a letter certifying and warranting that all systems, utilities and services containing time and date-related coding and internal programs, shall continue without interruption beyond December 31, 1999. The implementation will be monitored and managed on a real-time basis to ensure a smooth upgrade of the systems. Completion of the implementation and testing phases for all significant systems is expected by June 30, 1999, with all remediated systems fully tested and implemented by September 30, 1999, with 100% completion targeted for October 31, 1999. Nature and Level of Importance of Third Party Systems and Their Exposure to the Year 2000: The Lessee is in the process of surveying its vendors and service providers that are critical to the Lessee's business to determine whether they are Year 2000 compliant. The Lessee expects that these surveys will be completed by the end of the second quarter of 1999, but cannot guarantee that all vendors or service providers will respond to the survey, and therefore the Lessee may not be able to determine Year 2000 compliance of those vendors or service providers. By the end of the second quarter of 1999, the Lessee will determine the extent to which the Lessee will be able to replace those vendors not in compliance. There may be instances in which the Lessee will have no alternative but to remain with non-compliant vendors or service providers. The inability of vendors to complete their Year 2000 resolution process in a timely fashion could materially impact the Company and the Lessee. The effect of compliance by vendors is not determinable. Cost of Addressing Year 2000 Issues: The Company estimates that total cost for the Year 2000 compliance review, evaluation, assessment and remediation efforts should not exceed $1.0 million and will be funded by the Company through its operating cash flows. To date, the costs incurred to address the Year 2000 issue consist primarily of services provided by outside -37- consultants for onsite system surveys and total $163,000 which was expensed by the Company in 1999. The remaining balance is also anticipated to be expended in 1999. Risks Presented by Year 2000 Issues: Management of the Company and the Lessee believe they have an effective plan in place to resolve the Year 2000 Issue in a timely manner. As noted above, the Lessee has not yet completed all necessary phases of the Year 2000 program. In the event that the Lessee does not complete any additional phases, the Lessee may encounter system failures associated with third-party vendors such as disruptions in passenger transportation or transportation systems generally, loss of utility and telecommunications services, the loss or disruption of hotel reservations made on centralized reservation systems and errors or failures in financial transactions or payment processing systems such as credit cards. These disruptions could adversely affect the Company and the Lessee, their businesses and their financial conditions. The Company and the Lessee cannot predict the actual effects of the Year 2000 Issue on their businesses, such effects depend on numerous uncertainties such as whether significant third parties have properly and timely addressed the Year 2000 Issue, and whether broad-based or systemic economic failures may occur. Due to the general uncertainty inherent in the Year 2000 Issue and the Company's and Lessee's dependence on third parties, Management is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact. Contingency Plan: The Lessee is in the process of developing its contingency plan for the systems operated an maintained by the Lessee and the hotels. This is necessary in order to provide for the most likely worst case scenarios regarding Year 2000 compliance. The contingency plan is expected to be completed in 1999. Impact of Inflation The Company's business is affected by general economic conditions, including the impact of inflation and interest rates. Substantially all of the Company's Percentage Leases allow, on an annual basis, for adjustments in the rent payable thereunder, and thus may enable the Company to seek increases in base rents, which generally serves to minimize the risk to the Company of the adverse effects of inflation. For construction, the Company has entered into various contracts for the developmental and construction of new hotel properties. These are fixed-fee contracts and thus partially insulate the Company from inflationary risk. The Lessee For a discussion of the Lessee's revenue operations and a comparison of the year ended December 31, 1998 to 1997, see "Results of Operations" of the Company. Additionally, the Lessee has incurred significant losses from its inception in 1995. At December 31, 1998, the Lessee's stockholders' deficit amounted to $10.5 million. At December 31, 1998, the Lessee's rent payable to the Company amounted to $7.5 million. Also at December 31, 1998, the Lessee's current liabilities exceeded its current assets by $9.8 million. The ability of the Lessee to fund its daily operations and continue to remain current on its substantial rent obligation to the Company is a result of the original terms under the Percentage Leases, for the payment of rent to the Company, which allow monthly base rent to be paid in arrears and monthly percentage rent to be paid within 45 days after the respective month-end. The Lessee's losses from inception are primarily attributable to the substantial renovations to the Company's hotels which the Lessee operates and the original terms of the Percentage Leases. During 1998, 1997 and 1996, a significant portion of the Company's hotel portfolio underwent renovation and redevelopment, 20, 19 and 8 hotels, respectively. -38- Such renovations were made in conjunction with the Company's strategy of acquiring hotels that can benefit from extensive improvements, reflagging and repositioning, resulting in higher potential revenue. There can be no assurance, however, that the Lessee's operating results will improve because of various factors described under "Risk Factors." During periods of significant renovation, the hotels generally do not generate sufficient revenue to meet operating expenses, including lease payments. During 1998, the Lessee entered into a $1.5 million line of credit that expires on December 29, 1999 with its primary stockholder, Mr. Alter. The line of credit is to be used exclusively for general short-term working capital needs. As of December 31, 1998, $650,000 was outstanding on the line of credit. Through March 5, 1999, an additional $800,000 was drawn on the line of credit and $644,000 was repaid. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's exposure to market risk for changes in interest rates relates primarily to the Company's current and future debt obligations. The Company is vulnerable, however, to significant fluctuations of interest rates on its floating rate debt, repricing on its fixed rate debt at various points in the future and future debt. The following table provides information about the Company's financial instruments that are sensitive to changes in interest rates. For debt obligations, the table presents principal cash flows and related weighted- average interest rates by expected maturity dates.
Fair Value 1999 2000 2001 2002 2003 Thereafter Total 12/31/98 ----------------------------------------------------------------------------------------- (dollars in thousands) Liabilities Tax-exempt mortgage bond financings... $ 740 $ 792 $ 857 $ 926 $ 1,009 $ 24,366 $28,690 $28,690 Average interest rate (1)........... Unsecured line of credit.............. 274,500 274,500 274,500 Average interest rate............... LIBOR + 1.75% Fixed mortgage notes payable.......... 7,661 1,196 1,272 30,596 598 12,356 53,679 55,457 Average interest rate............... 9.57% 8.70% 8.57% 7.99% 9.53% 9.42% Variable mortgage notes payable....... 22,600 22,600 22,600 Average interest rate............... LIBOR + 2.25%
__________ (1) The average interest rates are variable tax-exempt rates and are adjusted on a weekly or monthly basis. The weighted average interest rate as of December 31, 1998 was 3.75%. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by Regulation S-X are included in this Annual Report on Form 10-K commencing on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Information with respect to changes in accountants has been previously filed on Current Report on Form 8-K dated July 7, 1997 with disclosure under Item 4 regarding a change in the Company's certifying accountants and is incorporated herein by reference. There were no disagreements with accountants on accounting and financial disclosure. -39- PART III -------- Certain information required by Part III is omitted from this Report in that the Company has filed a definitive proxy statement pursuant to Regulation 14A (the "Proxy Statement") for its Annual Meeting of Stockholders to be held May 24, 1999 and the information included therein is incorporated herein by reference. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to directors of the Company is incorporated by reference from the information under the caption "Election of Director-Nominees" in the Company's Proxy Statement. Information with respect to executive officers of the Company is incorporated by reference from the information under the caption "Executive Officers" in the Company's Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information under the caption "Executive Compensation and Other Information" in the Company's Proxy Statement is Incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the caption "Stock Ownership of Management and Principal Stockholders" in the Company's Proxy Statement is Incorporated by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Certain Transactions" in the Company's Proxy Statement is Incorporated by reference. -40- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this report: 1. Financial Statements See Index to Financial Statements on page F-1. 2. Financial Statement Schedule See Index to Financial Statements on page F-1. 3. Exhibits:
EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 3.1 Amended Articles of Incorporation of the Company, as further amended by the Articles of Amendment of the Company, as filed with the State Department of Assessments and Taxation of Maryland on November 9, 1994, filed as Exhibit 3.1 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 3.2 Amended and Restated Bylaws of the Company, as currently in effect filed as Exhibit 3.2 to the Company's Registration Statement No. 333-65037 and incorporated herein by this reference. 3.3 Articles of Amendment of the Company, as filed with the State Department of Assessments and Taxation of Maryland on June 19, 1995, filed as Exhibit 3.3 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 3.4 Articles of Amendment of the Company, as filed with the State Department of Assessments and Taxation of Maryland on August 14, 1995, filed as Exhibit 3.4 to the Company's Current Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by this reference 3.5 Articles of Amendment of the Company, as filed with the State Department of Assessments and Taxation of Maryland on May 2, 1997, filed as Exhibit 3.5 to the Company's Current Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 3.5.1 Articles of Amendment of the Company, as filed with the State Department of Assessments and Taxation of Maryland on April 21, 1998, filed as Exhibit 3.5 to the Company's Registration Statement No. 333-65037 and incorporated herein by this reference. 3.6 Articles Supplementary Classifying Shares of 7.9% Class A Cumulative Convertible Preferred Stock, as filed with the State Department of Assessments and Taxation of Maryland on October 14, 1997, filed as Exhibit 3.6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 and incorporated herein by this reference. 10.1 thru Omitted 10.1.14 10.1.15 Second Amended and Restated Agreement of Limited Partnership dated as of October 4, 1997, filed as Exhibit 10.1.15 to the Company's 1997 Annual Report on Form 10-K and incorporated herein by this reference. 10.1.16* Counterpart Second Amended and Restated Agreement of Limited Partnership for Admission of Additional Limited Partner to Sunstone Hotel Investors, dated April 30, 1998. 10.2 Form of Percentage Lease, filed as Exhibit 10.2 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 10.2.1 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn Hotel located in Denver S.E., Colorado, filed as Exhibit 10.2.1 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.2 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn Hotel located in Pueblo, Colorado, filed as Exhibit 10.2.2 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.3 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Courtyard By Marriott Hotel located in Fresno, California, filed as Exhibit 10.2.3 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.4 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Courtyard By Marriott Hotel located in Fresno, California, filed As Exhibit 10.2.4 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.5 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn Hotel located in Steamboat Springs, Colorado, filed as Exhibit 10.2.5 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.6 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn Hotel located in Craig, Colorado, filed as Exhibit 10.2.6 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.7 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn Hotel located in Provo, Utah, filed as Exhibit 10.2.7 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.8 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P. as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn Hotel located in Silverthorne, Colorado, filed as Exhibit 10.2.7 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.9 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Doubletree Hotel located in Santa Fe, New Mexico, filed as Exhibit 10.2.9 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.10 Lease Agreement dated as of August 16, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn Hotel located in Arcadia, California, filed as Exhibit 10.2.10 to the Company's 1995 10-K and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 10.2.11 Lease Agreement dated as of December 13, 1995 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn Hotel located in Oakland, California, filed as Exhibit 10.2.11 to the Company's 1995 10-K and incorporated herein by this reference. 10.2.12 Lease Agreement dated February 2, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Cypress Inn Hotel located in Clackamas, Oregon, filed as Exhibit 10.2.12 to the Company's Quarterly Quarter 1996 10-Q for the quarter ended March 31, 1996 and incorporated herein by this reference. 10.2.13 Lease Agreement dated February 2, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Cypress Inn Hotel located in Kent, Washington, filed as Exhibit 10.2.13 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996 and incorporated herein by this reference. 10.2.14 Lease Agreement dated February 2, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Cypress Inn Hotel located in Poulsbo, Washington, filed as Exhibit 10.2.14 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996 and incorporated herein by this reference. 10.2.15 Lease Agreement dated February 2, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Cypress Inn Hotel located in Portland, Oregon, filed as Exhibit 10.2.15 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996 and incorporated herein by this reference. 10.2.16 Lease Agreement dated March 28, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Courtyard by Marriott Hotel located in Riverside, California, filed as Exhibit 10.2.16 to the Company's Registration Statement No. 333-07685 and incorporated herein by this reference. 10.2.17 Lease Agreement dated June 28, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn Hotel located in Renton, Washington, filed as Exhibit 10.2.17 to the Company's Registration Statement No. 333-07685 and incorporated herein by this reference. 10.2.18 Lease Agreement dated August 13, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Days Inn Hotel located in Price, Utah, filed as Exhibit 10.2.18 to the Company's Registration Statement No. 333-07685 and incorporated herein by this reference. 10.2.19 Lease Agreement dated September 20, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Residence Inn Hotel located in Highlands Ranch, Colorado, filed as Exhibit 10.2.18 to the Company's Registration Statement No. 333-07685 and incorporated herein by this reference. 10.2.20 Lease Agreement dated August 13, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Comfort Suites Hotel located in South San Francisco, California, filed as Exhibit 10.2.20 to the Company's Registration Statement No. 333-07685 and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 10.2.21 Lease Agreement dated October 29, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hampton Inn located in Tucson, Arizona. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.21 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.22 Lease Agreement dated October 29, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn located in Mesa, Arizona. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.22 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.23 Lease Agreement dated October 29, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn located in Flagstaff, Arizona. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.23 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.24 Lease Agreement dated December 19, 1996 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Radisson Suites located in Oxnard, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.24 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.25 Lease Agreement dated January 17, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn located in San Diego, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.25 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by this reference. 10.2.26 Lease Agreement dated January 17, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Ramada Hotel located in Cypress, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.26 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by this reference. 10.2.27 Lease Agreement dated March 10, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Hawthorne Suites Hotel located in Kent, Washington. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.27 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 10.2.28 Lease Agreement dated March 31, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn located in La Mirada, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.28 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by this reference. 10.2.29 Lease Agreement dated May 6, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Fountain Suites located in Sacramento, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.29 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.30 Lease Agreement dated June 11, 1997 by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Ramada Plaza Hotel located in Old Town, San Diego, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.30 to the Company's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 1997 and incorporated herein by this reference. 10.2.31 Lease Agreement dated July 17, 1997, by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Best Western located in Lynnwood, Washington. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.31 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997 and incorporated herein by this reference. 10.2.32 Lease Agreement dated August 7, 1997, by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Holiday Inn located in San Diego, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.32 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997 and incorporated herein by this reference. 10.2.33 Lease Agreement dated August 7, 1997, by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Crystal Suites located in Anaheim, California. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.33 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997 and incorporated herein by this reference. 10.2.34 Lease Agreement dated August 28, 1997, by and between Sunstone Hotel Investors, L.P., as lessor, and Sunstone Hotel Properties, Inc., as lessee, for the Regency Plaza located in Los Angeles. Substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The material differences between this Exhibit and Exhibit 10.2 are set forth in the schedule filed as Exhibit 10.2.34 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997 and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- Lease Agreement by and between Sunstone Hotel Investors, L.P. or its subsidiaries as lessor, and Sunstone Hotel Properties, Inc., as lessee, substantially identical to Exhibit 10.2; full text omitted pursuant to Instruction 2 to Item 601 of Regulation S-K and incorporated herein by this reference. 10.2.36* Lease Agreements entered into in 1998 by and between Sunstone Hotel Investors, L.P. or its subsidiaries as lessor, and Sunstone Hotel Properties, Inc., as lessee for various hotel properties. Full text of leases omitted pursuant to Instruction 2 to Item 601 of Regulation S-K. The hotel properties subject to the leases, the dates of the leases and the material differences between the leases and the lease filed as Exhibit 10.2 are set forth in the Schedule of Material Differences Among Percentage Leases for 1998. 10.3 Form of Right of First Refusal and Option to Purchase, filed as Exhibit 10.3 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.4 Form of Alter Employment Agreement, filed as Exhibit 10.4 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.5 Form of Biederman Employment Agreement, filed as Exhibit 10.5 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.6 Form of Indemnification Agreement to be entered into with officers and directors of the Company, filed as Exhibit 10.6 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.7 1994 Stock Incentive Plan, filed as Exhibit 10.7 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.7.1 Amendment to the 1994 Stock Incentive Plan filed on March 17, 1997 as Appendix A to the Company's 1997 Proxy Statement and incorporated herein by this reference. 10.7.2 Amendment to the 1994 Stock Incentive Plan filed on February 27, 1999 as Appendix A to the Company's 1998 Preliminary Proxy Statement and incorporated herein by this reference. 10.8 Form of Notice of Grant of Stock Option and Form of Stock Option Agreement (and Addendum thereto) to be generally used in connection with the Discretionary Option Grant Program of the 1994 Stock Incentive Plan, filed as Exhibit 10.8 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.9 Form of Stock Purchase Agreement to be generally used in connection with the Discretionary Option Grant Program of the 1994 Stock Incentive Plan, filed as Exhibit 10.9 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.10 1994 Directors Plan, filed as Exhibit 10.10 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.10.1 Amendment to the 1994 Directors Plan filed on March 17, 1997 as Appendix B with the Company's 1997 Proxy Statement and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - ----------------------------------------------------------------------------------------------------------------- 10.11 Form of Notice of Grant of Automatic Stock Option, Automatic Stock Option Agreement, Stock Purchase Agreement and Automatic Direct Stock Issuance Agreement to be generally used in connection with the 1994 Directors Plan, filed as Exhibit 10.11 to the Company's Registration Statement No. 33-84346 and incorporated herein by this reference. 10.12 thru Omitted 10.20 10-22 thru Omitted 10.30.17 10.30.18 Amended and Restated Third Party Pledge Agreement among the Partnership, Robert A. Alter and Charles Biederman, effective August 28, 1997 filed as Exhibit 10.30.18 to the Company's 1997 Annual Report on Form 10-K and incorporated herein by this reference. 10.31 Omitted 10.31.1 Amended and Restated Revolving Credit Agreement dated as of October 10, 1997, among Sunstone Hotel Investors, L.P., Bank One Arizona, NA, Credit Lyonnais New York Branch, Wells Fargo Bank, National Association, filed as Exhibit 10.31.1 to the Company's 1997 Annual Report on Form 10-K/A filed on October 16, 1998 and incorporated herein by this reference. 10.31.2 First Amendment to Amended and Restated Revolving Credit Agreement, dated January 26, 1998, among Sunstone Hotel Investors, L.P., Bank One Arizona, NA, Credit Lyonnais New York Branch, Wells Fargo Bank, National Association, filed as Exhibit 10.31.1 to the Company's 1998 Annual Report on Form 10-K and incorporated herein by this reference. 10.31.3* Second Amendment to Amended and Restated Revolving Credit Agreement, dated July 22, 1998, among Sunstone Hotel Investors, L.P., Bank One Arizona, NA, Credit Lyonnais New York Branch, Wells Fargo Bank, National Association. 10.31.4* Third Amendment to Amended and Restated Revolving Credit Agreement, dated August 28, 1998, among Sunstone Hotel Investors, L.P., Bank One Arizona, NA, Credit Lyonnais New York Branch, Wells Fargo Bank, National Association. 10.32 Stock Purchase Agreement among the Company, Westbrook Real Estate Fund I, L.P., Westbrook Real Estate Co-Investment Partnership I, L.P. and Kahler Realty Corporation dated as of August 5, 1997, filed on August 14, 1997 as Exhibit 10.1 to the Company's Current Report on Form 8-K and incorporated herein by this reference. 10.33 Registration Rights Agreement among the Company, Westbrook Real Estate Fund I, L.P., Westbrook Real Estate Co-Investment Partnership I, L.P. dated as of October 15, 1997 and filed as Exhibit 10.33 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.34 Asset Purchase Agreement by and between Sunstone Hotels, LLC and Sunstone Hotel Properties, Inc., dated October 14, 1997 and filed as Exhibit 10.34 to the Company's Annual Report on Form 10-K/A on March 30, 1998 and incorporated herein by this reference. 10.35 First Amendment to Asset Purchase Agreement dated December 19, 1997 and filed as Exhibit 10.24.1 to the Company's Annual Report on Form 10-K/A on March 30, 1998 and incorporated herein by this reference.
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EXHIBIT NO. DESCRIPTION - -------------------------------------------------------------------------------- 21 List of Subsidiaries of the Registrant. 23.1* Consent of Ernst & Young LLP 23.2* Consent of PricewaterhouseCoopers LLP 27* Financial Data Schedule
_______________________ * Filed herewith. (b) Reports on Form 8-K; all other exhibits previously filed. No reports on Form 8-K were filed during the fourth quarter of 1998. -48- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Clemente, State of California, on March 5, 1999. SUNSTONE HOTEL INVESTORS, INC. By: /s/ ROBERT A. ALTER --------------------------------------- Robert A. Alter President, Secretary and Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10K has been signed below by the following persons in the capacities and on the dates indicated: Signature Title Date - ------------------------- ---------------------------------- ------------- /s/ ROBERT A. ALTER President, Secretary and Chairman March 5, 1999 - ------------------------- of the Board of Directors Robert A. Alter (Principal Executive Officer) /s/ CHARLES L. BIEDERMAN Vice Chairman of the Board of March 5, 1999 - ------------------------- Directors Charles L. Biederman /s/ R. TERRENCE CROWLEY Chief Operating Officer (Principal March 5, 1999 - ------------------------- Financial and Accounting Officer) R. Terrence Crowley Director - ------------------------- C. Robert Enever /s/ LAURENCE GELLER Director March 5, 1999 - ------------------------- Laurence Geller /s/ DAVID E. LAMBERT Director March 5, 1999 - ------------------------- David E. Lambert /s/ H. RAYMOND BINGHAM Director March 5, 1999 - ------------------------- H. Raymond Bingham /s/ FREDRIC H. GOULD Director March 5, 1999 - ------------------------- Fredric H. Gould Director - ------------------------- Paul D. Kazilionis /s/ EDWARD H. SONDKER Director March 5, 1999 - ------------------------- Edward H. Sondker -49- INDEX TO FINANCIAL STATEMENTS
Page ---- SUNSTONE HOTEL INVESTORS, INC. Report of Independent Auditors.......................................... F-2 Consolidated Balance Sheets as of December 31, 1998 and 1997............ F-3 Consolidated Statements of Operations for the Years Ended December 31, 1998, 1997 and 1996.................................................... F-4 Consolidated Statements of Equity for the Years Ended December 31, 1998, 1997 and 1996.......................................................... F-5 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996.................................................... F-6 Notes to Consolidated Financial Statements.............................. F-7 Schedule III--Real Estate and Accumulated Depreciation as of December 31, 1998............................................................... F-27 Report of Predecessor Accountants....................................... F-29 SUNSTONE HOTEL PROPERTIES, INC. (THE "LESSEE") Report of Independent Auditors.......................................... F-30 Consolidated Balance Sheets as of December 31, 1998 and 1997............ F-31 Consolidated Statements of Operations for the Years Ended December 31, 1998, 1997 and 1996.................................................... F-32 Consolidated Statements of Changes in Stockholders' Deficit for the Years Ended December 31, 1998, 1997 and 1996........................... F-33 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996.................................................... F-34 Notes to Consolidated Financial Statements.............................. F-35 Report of Predecessor Accountants....................................... F-46
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. F-1 REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Stockholders Sunstone Hotel Investors, Inc. We have audited the accompanying consolidated balance sheets of Sunstone Hotel Investors, Inc. (the "Company") as of December 31, 1998 and 1997 and the related consolidated statements of operations, equity and cash flows for the years then ended. Our audits also included the financial statement schedule listed in the Index to Financial Statements. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sunstone Hotel Investors, Inc. as of December 31, 1998 and 1997 and the consolidated results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ ERNST & YOUNG LLP Newport Beach, California February 19, 1999 F-2 SUNSTONE HOTEL INVESTORS, INC. CONSOLIDATED BALANCE SHEETS
December 31, -------------------------- 1998 1997 ------------ ------------ ASSETS: Investments in hotel properties, net $840,974,000 $704,817,000 Other real estate investment properties, net 17,027,000 11,459,000 Cash and cash equivalents 859,000 3,584,000 Restricted cash 2,853,000 2,421,000 Rent receivable--Lessee 7,498,000 7,641,000 Other assets, net 6,425,000 9,655,000 ------------ ------------ $875,636,000 $739,577,000 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY: Revolving line of credit $274,500,000 $179,800,000 Notes payable 104,969,000 116,671,000 Accounts payable and other accrued expenses 18,921,000 10,937,000 Dividends payable to preferred shareholders 503,000 422,000 ------------ ------------ 398,893,000 307,830,000 ------------ ------------ Commitments and contingencies (Note 10) Minority interest 25,493,000 33,860,000 Stockholders' equity: 7.9% Class A Cumulative Convertible Preferred Stock, $.01 par value, 10,000,000 authorized; 250,000 issued and outstanding as of December 31, 1998 and 1997 (liquidation preference $100 per share aggregating $25,000,000) 3,000 3,000 Common stock, $.01 par value, 150,000,000 authorized; 37,572,263 and 32,284,103 issued and outstanding as of December 31, 1998 and 1997, respectively 376,000 323,000 Additional paid-in capital 479,848,000 401,098,000 Distributions in excess of earnings (28,977,000) (3,537,000) ------------ ------------ 451,250,000 397,887,000 ------------ ------------ $875,636,000 $739,577,000 ============ ============
The accompanying notes are an integral part of these financial statements. F-3 SUNSTONE HOTEL INVESTORS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, ------------------------------------- 1998 1997 1996 ----------- ----------- ----------- REVENUES: Lease revenue--Lessee $98,682,000 $44,680,000 $14,848,000 Interest and other income 473,000 471,000 236,000 ----------- ----------- ----------- 99,155,000 45,151,000 15,084,000 ----------- ----------- ----------- EXPENSES: Real estate related depreciation and amortization 35,835,000 14,749,000 4,514,000 Interest expense and amortization of financing costs 23,734,000 6,365,000 1,558,000 Real estate and personal property taxes and insurance 11,409,000 4,670,000 1,273,000 General and administrative 5,344,000 1,890,000 1,015,000 Cost of withdrawn offerings 1,450,000 -- -- ----------- ----------- ----------- Total expenses 77,772,000 27,674,000 8,360,000 ----------- ----------- ----------- Income before losses on dispositions of hotel properties and minority interest 21,383,000 17,477,000 6,724,000 Losses on dispositions of hotel properties (3,574,000) -- -- Minority interest (851,000) (1,886,000) (1,090,000) ----------- ----------- ----------- NET INCOME 16,958,000 15,591,000 5,634,000 Distributions on preferred shares (1,975,000) (422,000) -- ----------- ----------- ----------- INCOME AVAILABLE TO COMMON STOCKHOLDERS $14,983,000 $15,169,000 $ 5,634,000 =========== =========== =========== EARNINGS PER SHARE (Note 9) Basic $ 0.40 $ 0.72 $ 0.70 =========== =========== =========== Diluted $ 0.40 $ 0.71 $ 0.69 =========== =========== ===========
The accompanying notes are an integral part of these financial statements. F-4 SUNSTONE HOTEL INVESTORS, INC. CONSOLIDATED STATEMENTS OF EQUITY
Preferred Common Stock Stock Additional Distributions -------------------- --------------- Paid-In in Excess of Total Shares $ Shares $ Capital Earnings ------------ ---------- -------- ------- ------ ------------ ------------- Balance at December 31, 1995 $ 37,495,000 6,322,000 $ 63,000 -- $ -- $ 37,432,000 $ -- Issuance of common stock, net 43,151,000 4,614,457 46,000 -- -- 43,105,000 -- Distributions declared (5,642,000) -- -- -- -- -- (5,642,000) Net income 5,634,000 -- -- -- -- -- 5,634,000 Redeemed Operating Partnership Units in excess of book value (7,000) -- -- -- -- (7,000) -- Reallocation of minority interest 170,000 -- -- -- -- 170,000 -- ------------ ---------- -------- ------- ------ ------------ ------------ Balance at December 31, 1996 80,801,000 10,936,457 109,000 -- -- 80,700,000 (8,000) Issuance of common stock, net 306,067,000 21,347,646 214,000 -- -- 305,853,000 -- Issuance of preferred stock 25,000,000 -- -- 250,000 3,000 24,997,000 -- Distributions declared (18,698,000) -- -- -- -- -- (18,698,000) Income available to common stockholders 15,169,000 -- -- -- -- -- 15,169,000 Redeemed Operating Partnership Units in excess of book value (184,000) -- -- -- -- (184,000) -- Reallocation of minority interest (10,268,000) -- -- -- -- (10,268,000) -- ------------ ---------- -------- ------- ------ ------------ ------------ Balance at December 31, 1997 397,887,000 32,284,103 323,000 250,000 3,000 401,098,000 (3,537,000) Issuance of common stock, net 77,857,000 5,288,160 53,000 -- -- 77,804,000 -- Distributions declared (40,423,000) -- -- -- -- -- (40,423,000) Income available to common stockholders 14,983,000 -- -- -- -- -- 14,983,000 Redeemed Operating Partnership Units in excess of book value (32,000) -- -- -- -- (32,000) -- Reallocation of minority interest 978,000 -- -- -- -- 978,000 -- ------------ ---------- -------- ------- ------ ------------ ------------ Balance at December 31, 1998 $451,250,000 37,572,263 $376,000 250,000 $3,000 $479,848,000 $(28,977,000) ============ ========== ======== ======= ====== ============ ============
The accompanying notes are an integral part of these financial statements. F-5 SUNSTONE HOTEL INVESTORS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, ------------------------------------------ 1998 1997 1996 ------------- ------------- ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 16,958,000 $ 15,591,000 $ 5,634,000 Adjustments to reconcile net income to net cash provided by operating activities: Minority interest 851,000 1,886,000 1,090,000 Depreciation and amortization 35,835,000 14,849,000 4,514,000 Amortization of financing costs 2,222,000 637,000 221,000 Losses on dispositions of hotel properties 3,574,000 -- -- Changes in operating assets and liabilities: Rent receivable--Lessee 143,000 (5,281,000) (1,714,000) Other assets, net 50,000 (996,000) 21,000 Accounts payable and other accrued expenses 4,278,000 (2,370,000) 1,903,000 ------------- ------------- ------------ Net cash provided by operating activities 63,911,000 24,316,000 11,669,000 ------------- ------------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition, improvements and additions to hotel properties (212,689,000) (378,019,000) (83,857,000) Acquisition, improvements and additions to other real estate investments (5,092,000) (11,558,000) -- Proceeds from sale of hotel properties 47,238,000 -- 1,100,000 Restricted cash (432,000) 44,000 -- Issuance of notes receivable -- (5,474,000) -- Payments received on notes receivable 5,534,000 2,461,000 -- ------------- ------------- ------------ Net cash used in investing activities (165,441,000) (392,546,000) (82,757,000) ------------- ------------- ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from issuance of common stock 69,854,000 273,317,000 43,151,000 Contributions from minority interests -- 483,000 -- Payment of deferred financing costs (3,144,000) (1,720,000) (308,000) Borrowings on revolving line of credit 182,200,000 185,900,000 53,200,000 Principal payments on revolving line of credit (87,500,000) (46,500,000) (21,200,000) Principal payments on notes payable (17,881,000) (18,233,000) (411,000) Distributions to common stockholders (40,423,000) (18,698,000) (7,096,000) Distributions to minority interests (2,407,000) (2,877,000) (1,328,000) Distributions to preferred stockholders (1,894,000) -- -- ------------- ------------- ------------ Net cash provided by financing activities 98,805,000 371,672,000 66,008,000 ------------- ------------- ------------ Net change in cash and cash equivalents (2,725,000) 3,442,000 (5,080,000) Cash and cash equivalents, beginning of year 3,584,000 142,000 5,222,000 ------------- ------------- ------------ Cash and cash equivalents, end of year $ 859,000 $ 3,584,000 $ 142,000 ============= ============= ============ SUPPLEMENTAL DISCLOSURE: Cash paid for interest, net of amounts capitalized $ 22,238,000 $ 4,942,000 $ 1,337,000 ============= ============= ============
The accompanying notes are an integral part of these financial statements. F-6 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1998 1. Organization, Relationship with Lessee and Basis of Presentation Organization: Sunstone Hotel Investors, Inc., a Maryland corporation (the "Company"), was formed in September 1994 and commenced operations as a real estate investment trust ("REIT") on August 15, 1995. At December 31, 1998, the Company had a 94.7% interest in Sunstone Hotel Investors, L.P. (the "Operating Partnership") which also commenced operations in August 1995. The Company conducts all of its business through and is the sole general partner of the Operating Partnership. At December 31, 1998, the Company's portfolio included 57 hotel properties, primarily located in the western United States, all of which are leased to Sunstone Hotel Properties, Inc. (the "Lessee") under operating leases (the "Percentage Leases") that provide for the payment of base and percentage rent. The Lessee is owned by Robert A. Alter, Chairman and President of the Company (80%), and Charles L. Biederman, Vice Chairman of the Company (20%). The Lessee has entered into a management agreement pursuant to which all of the hotels are managed by Sunstone Hotel Management, Inc. (the "Management Company"), of which Mr. Alter is the sole shareholder. Relationship with Lessee: The Company must rely solely on the Lessee to generate sufficient cash flow from the operation of the hotels to enable the Lessee to meet its substantial rent obligation to the Company under the Percentage Leases. The Lessee has incurred significant losses from its inception in 1995. At December 31, 1998, the Lessee's stockholder's deficit amounted to $10.5 million. At December 31, 1998, the Lessee's rent payable to the Company amounted to $7.5 million. Also at December 31, 1998, the Lessee's current liabilities exceeded its current assets by $9.8 million. The ability of the Lessee to fund its daily operations and continue to remain current on its substantial rent obligation to the Company is a result of the original terms under the Percentage Leases, for the payment of rent to the Company, which allow monthly base rent to be paid in arrears and monthly percentage rent to be paid within 45 days after the respective month-end. The Company's management will continue to evaluate the financial condition of the Lessee and continue to evaluate other factors regarding the relationship between the Company and the Lessee. Basis Of Presentation: The consolidated financial statements include the accounts of the Company and its subsidiaries, including the Operating Partnership. All significant intercompany transactions and balances have been eliminated. 2. Summary of Significant Accounting Policies Investments In Hotel Properties and Other Real Estate: Hotel properties and other real estate assets are recorded at cost, less accumulated depreciation. During periods of construction or major renovation, interest attributable to hotel rooms under construction or major renovation and not in service is capitalized until such rooms are available for their intended use under a specific identification method. Interest related to other real estate is capitalized to the real estate project while under development until the project is ready for its intended use. Hotel properties and other completed real estate investments are depreciated using the straight-line method over estimated useful lives ranging from five to F-7 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, (continued) Investments In Hotel Properties and Other Real Estate, continued: thirty-five years for buildings and improvements and three to ten years for furniture, fixtures and equipment. A gain or loss is recorded to the extent the amounts ultimately received upon disposition differ from the book values of the hotel assets. Franchise fees are recorded at cost and amortized using the straight-line method over the lives of the franchise agreements ranging from 10 to 20 years. The Company recognizes impairment losses on long-lived assets when indicators of impairment are present and the estimated undiscounted cash flows to be generated by those assets are less than the carrying amount of the assets. Long-lived assets held for sale are reported at the lower of their carrying amount or fair value less selling costs. At December 31, 1998, management believes that the sum of the expected future undiscounted cash flows excluding interest charges, for each hotel property and other real estate assets is greater than assets' respective carrying amount. Accordingly, no such impairment losses have been recognized by the Company on its hotel properties and other real estate assets. Cash And Cash Equivalents: Cash and cash equivalents are defined as cash on hand and in banks plus all short-term investments with an original maturity of three months or less. Restricted Cash: Restricted cash is comprised of reserve accounts for capital replacements, property taxes and debt service. These restricted funds are subject to supervision and approval by the respective lenders. Rent Receivable Lessee: At December 31, 1998, all rent payments due from the Lessee are current. Under the terms of the Percentage Leases, monthly base rent is due from the Lessee in arrears and percentage rent is due 45 days after the end of each respective month. As of December 31, 1998, the $7.5 million due from the Lessee consists of percentage rent for the months of November and December 1998 and base rent for the month of December 1998. Other Assets: Other assets consist primarily of notes receivable, deferred financing costs, liquor license costs and prepaid expenses. Amortization of deferred financing costs is computed using the straight-line method over the life of the related loan based upon the terms of the loan agreements. Offering Costs: Specific incremental costs incurred in connection with securities offerings are deferred and charged against the gross proceeds of the related offerings. Deferred costs related to aborted offerings are expensed in the period the offering is aborted. F-8 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued Minority Interest: Minority interest carried on the balance sheet is adjusted periodically upon issuance of either common stock of the Company or Operating Partnership units. Minority interest is based on the number of Operating Partnership units outstanding held by affiliates and unrelated parties divided by the sum of total Operating Partnership units outstanding at the measurement date (Note 8). Minority interest adjustments are recorded as adjustments to additional paid-in capital. Concentrations: The Company must rely solely on the Lessee to generate sufficient cash flow from the operation of the hotels to enable the Lessee to meet rent obligations under the Percentage Leases. In 1998, 1997 and 1996, the Company earned rents of $98.7 million, $44.7 million and $14.8 million, respectively, representing 99.5%, 99.0% and 98.4%, respectively, of the Company's total revenue, all of which was earned from the Percentage Leases with the Lessee (Note 11). See the Lessee's consolidated financial statements included elsewhere herein. The Company currently invests primarily in hotel properties. The hotel industry is highly competitive and the Company's hotel investments are subject to competition from other hotels for guests. Each of the Company's hotels competes for guests primarily with other similar hotels in its immediate vicinity and other similar hotels in its geographic market. The Company believes that brand recognition, location, the quality of the hotel and services provided, and price are the principal competitive factors affecting its hotel investments. At December 31, 1998 and 1997, the Company had cash amounts in banks that were in excess of federally insured amounts. Lease Revenue Recognition: All of the Company's operating hotel properties are leased to the Lessee under Percentage Leases (Note 11). The Company recognizes lease revenue when earned over the terms of the respective Percentage Leases. Start-Up Costs and Advertising Expense: Start-up costs and advertising and promotion costs are expensed when incurred. Income Taxes: The Company expects to qualify as a REIT under the Internal Revenue Code of 1986, as amended. A REIT will generally not be subject to federal income taxation to the extent that it distributes at least 95% of its taxable income to its stockholders and complies with other requirements. The Company is subject to state income and franchise taxes in certain states in which it operates. Stock-Based Compensation: The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for its Stock Incentive Plans and its Directors Plan. F-9 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued Earnings Per Share: Basic and diluted earnings per share is calculated in accordance with FASB Statement No. 128, Earnings per Share ("Statement No. 128"). All earnings per share amounts for all periods have been presented and where appropriate, restated to conform to the requirements of Statement No. 128 (Note 9). Fair Value Of Financial Instruments: Management has estimated the fair value of its financial instruments. Considerable judgment is required in interpreting market data in order to develop estimates of the fair value of the Company's financial instruments. Accordingly, the estimated values are not necessarily indicative of the amounts that could be realized in current market exchanges. For those financial instruments for which it is practical to estimate fair value, management believes that the carrying amounts of the Company's financial instruments reasonably approximate their fair value at December 31, 1998 and 1997. Use Of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates in the near term. Significant estimates made in preparing the consolidated financial statements include recoverability of long-lived assets and the outcome of any claims and litigation that may arise in the ordinary course of business. Seasonality: The hotel industry is seasonal in nature. Seasonal variations in revenues at the Company's hotels may cause quarterly fluctuations in the Company's lease revenues. Reclassifications: Certain prior year balances have been reclassified to conform to the current year presentation. New Accounting Standards: During 1998, the Company adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information ("Statement No. 131"). Statement No. 131 superseded FASB Statement No. 14, Financial Reporting for Segments of A Business Enterprise. Statement No. 131 establishes standards for the way that public business enterprises report information regarding reportable operating segments. The adoption of Statement No. 131 did not affect the results of operations or financial position of the Company. The Company's hotel properties generated lease revenues from a single lessee though its Percentage Leases. The Company separately evaluates the performance of each of its hotels. However, because each of the hotels have similar economic characteristics, facilities and services, the hotel properties have been aggregated into a single dominant segment. The Company evaluates performance and allocates resources primarily based on revenue per available room, average daily rate and the occupancy rates of individual hotels. F-10 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued New Accounting Standard, continued: In 1998, the Company adopted the Emerging Issues Task Force of the Financial Accounting Standards Board's consensus on Issue No. 97-11 ("EITF 97-11"), Accounting for Internal Costs Relating to Real Estate Property Acquisitions. EITF 97-11 requires internal preacquisition costs related to the purchase of an operating property be expensed as incurred. As a result of the adoption of EITF 97-11 for the year ended December 31, 1998, the Company expensed $252,000 in internal acquisition costs. 3. Investments In Hotel Properties Investments in hotel properties consists of the following at December 31:
1998 1997 ------------ ------------ Land $116,531,000 $ 93,456,000 Buildings and improvements 657,066,000 549,770,000 Fixtures, furniture and equipment 113,121,000 77,247,000 Construction in process 19,710,000 15,991,000 ------------ ------------ 906,428,000 736,464,000 Accumulated depreciation and amortization (65,454,000) (31,647,000) ------------ ------------ Investments in hotel properties, net $840,974,000 $704,817,000 ============ ============
1998 Investments: During 1998, the Company acquired ten hotel properties for aggregate consideration of $134.2 million, including transaction costs, comprised of $126.1 million in cash, $6.2 million in an assumed note payable and the issuance of 118,409 units valued at $1.9 million which are exchangeable for a like number of shares of common stock of the Company. Also during 1998, the Company completed, or was in the process of completing, substantial renovations at 20 of the hotel properties, and in connection with such renovation, the Company incurred costs of approximately $68.2 million. 1998 Disposition of Non-Core Assets: During 1998, the Company disposed of six non-core hotel assets, that were included in the acquisition of Kahler Realty Corporation, for $47.2 million and recognized losses of $3.6 million. 1997 Kahler Acquisition: On October 15, 1997, the Company completed the acquisition of all the outstanding capital stock of Kahler Realty Corporation ("Kahler") from Westbrook Real Estate Fund I, L.P. and Westbrook Real EstateCo-Investment Partnership I, L.P. (collectively, "Westbrook") for aggregate consideration of $372.3 million (the "Kahler Acquisition"), including the concurrent buyout of minority interests in certain hotels that were partially owned by Kahler. In addition, the Company may be required to pay up to $16.0 million in additional consideration, based upon specified future operating results of the acquired hotels. Any unpaid adjustment to the purchase price will be treated as additional consideration and capitalized to the hotel properties. The Kahler Acquisition was funded with the net proceeds from the Company's public offering in October 1997, the assumption of Kahler debt, the issuance of common and preferred stock to Westbrook and with borrowings from the Company's unsecured revolving line of credit. The Kahler portfolio purchased by the Company consisted of 17 hotels with 4,255 rooms (the "Kahler Hotels"), principally in two markets, the Mountain region states of Utah, Idaho, Montana and Arizona (11 hotels) and Rochester, Minnesota (four hotels). F-11 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investments In Hotel Properties, continued Other 1997 Investments: During 1997, the Company acquired or invested in 12 hotel properties, excluding the Kahler Acquisition, for aggregate consideration of $150.4 million, including transaction costs, comprised of $121.4 million in cash, $20.5 million in assumed notes payable and the issuance of 624,740 Units valued at $8.5 million, which are exchangeable for a like number of shares of common stock of the Company. During 1997, the Company completed, or was in the process of completing, substantial renovations at 19 of the hotel properties, and in connection with such renovations, incurred costs of approximately $48.8 million. The Kahler Acquisition and all of the other hotels properties acquired in 1998 and 1997 have been accounted for as purchase transactions and, accordingly, the results of operations of the acquisitions have been included in the Company's consolidated results of operations from the respective dates of acquisition. 4. Other Real Estate Investments Other real estate investments consists of the following at December 31:
1998 1997 ----------- ----------- Laundry facilities Land $ 2,867,000 $ 2,867,000 Buildings and improvements 6,857,000 6,857,000 Fixtures, furniture and equipment 1,911,000 1,834,000 ----------- ----------- 11,635,000 11,558,000 Accumulated depreciation (502,000) (99,000) ----------- ----------- 11,133,000 11,459,000 Land held for future development or sale 1,497,000 -- Office building under development Land 650,000 -- Construction in progress 3,747,000 -- ----------- ----------- 4,397,000 -- ----------- ----------- $17,027,000 $11,459,000 =========== ===========
Upon completion, a portion of the office building will be used by the Company as its corporate facility, a portion will be leased to the Lessee as its corporate facility and the remaining space will be leased to third parties. 5. Other Assets Other assets consists of the following at December 31:
1998 1997 ---------- ---------- Notes receivable $1,724,000 $6,085,000 Deferred financing costs, net of accumulated amortization of $3,061,000 in 1998 and $839,000 in 1997 2,661,000 1,739,000 Prepaid expenses and other 2,040,000 1,831,000 ---------- ---------- $6,425,000 $9,655,000 ========== ==========
F-12 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Revolving Line Of Credit On July 23, 1998, the Company amended its revolving line of credit (the "Credit Facility") to (i) increase the total commitment to $350.0 million; (ii) increase total borrowings under the Credit Facility from 45% to 50% of the aggregate value of the Company's eligible hotels, as defined; (iii) increase the amount available for working capital purposes to $30.0 million; and (iv) extend the term to June 30, 2000. Borrowings under the Credit Facility accrue interest at LIBOR plus 1.40% per annum, to LIBOR plus 2.00% per annum, based upon the leverage of the Company. The Credit Facility may be used for acquisition, capital improvements, working capital and general corporate purposes and requires the Company to pay an annual fee of 0.25% on the unused portion. As of December 31, 1998 and 1997, the undrawn commitment under the Credit Facility was $66.1 million and $11.1 million (net of $9.4 million and $10.1 million reserved as collateral for other indebtedness and development of a hotel), respectively. The Credit Facility contains financial covenants that require the Company to maintain certain specified financial ratios. Under the most restrictive of these provisions, the Company's maximum additional indebtedness that could be incurred for the acquisition and renovation of hotel properties would have been between $23.7 million and $47.4 million at December 31, 1998, depending upon the use of the funds. At December 31, 1998, the Company was in compliance with all Credit Facility financial covenants. The weighted average interest rates on outstanding borrowings at December 31, 1998 and 1997 were 7.52% and 7.73%, respectively. Interest incurred under the Company's revolving line of credit, during 1998, 1997 and 1996, totaled $18.2 million, $4.4 million and $2.0 million, respectively, of which $4.3 million, $2.3 million and $1.1 million was capitalized for the years ended December 31, 1998, 1997 and 1996, respectively. 7. Notes Payable Notes payable consist of the following at December 31:
1998 1997 ------------ ------------ $2,100,000 note payable dated June 9, 1994; monthly payments of principal and interest at 9.76%, maturing in 2004; collateralized by a first deed of trust, assignment of rents and fixtures $ 1,930,000 $ 1,978,000 $1,000,000 note payable dated October 12, 1994; monthly payments of principal and interest at 8.73%; maturing in 2014; collateralized by a second deed of trust, assignment of rents and fixtures 905,000 930,000 $9,000,000 note payable dated September 26, 1995; monthly payments of principal and interest at 9.95%; maturing in 1999; collateralized by a first deed of trust, assignment of rents and fixtures (repaid in January 1998) -- 7,622,000 $9,500,000 note payable dated December 28, 1993; monthly payments of principal and interest at 9.67%; maturing in 1999; collateralized by a first deed of trust, assignment of rents and fixtures (repaid in January 1998) -- 8,343,000 $3,420,000 note payable dated May 27, 1994; monthly payments of principal and interest at 8.25%; maturing in 2004; collateralized by a first deed of trust, assignment of rents and fixtures 3,301,000 3,350,000
F-13 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Notes Payable, continued
1998 1997 ------------ ------------ $10,000,000 note payable dated September 1, 1992; monthly payments of principal and interest at 9.88%; maturing in 2013; collateralized by a first deed of trust, assignment of rents and fixtures 8,793,000 9,059,000 $33,000,000 note payable dated October 10, 1997; monthly payments of principal and interest at 7.96%; maturing in 2002; collateralized by a first deed of trust, assignment of rents and fixtures 32,221,000 32,944,000 $22,600,000 note payable dated October 14, 1997; monthly payments of interest only at LIBOR plus 2.25%; maturing in 2000; collateralized by a first deed of trust, assignment of rents and fixtures 22,600,000 22,600,000 $13,120,000 industrial development bonds dated July 9, 1997; monthly payments of principal and interest at a variable rate ranging from 2.8% to 4.4% during 1998 with principal amounts deposited into a restricted cash account; maturing in 2015; collateralized by a first deed of trust, assignment of rents and fixtures 12,870,000 13,060,000 $6,400,000 note payable dated February 27, 1989; monthly payments of principal and interest at 10.375%; maturing in 1999; collateralized by a first deed of trust, assignment of rents and fixtures 6,139,000 -- $9,500,000 industrial development bonds dated December 1, 1985; monthly payments of principal and interest at a variable rate ranging from 3.5% to 4.0% during 1998 with principal amounts deposited into a restricted cash account; maturing in 2015; collateralized by a first deed of trust, assignment of rents and fixtures and irrevocable letter of credit for $8,935,000 and expires on July 25, 2000 8,320,000 8,495,000 $9,700,000 industrial development bonds dated October 10, 1986; monthly payments of principal and interest at a variable rate of 4.4% during 1998 with principal amounts deposited into a restricted cash account; maturing in 2013; collateralized by a first deed of trust, assignment of rents and fixtures and irrevocable letter of credit for $7,600,000 and expires on September 15, 1999 7,500,000 7,900,000 $390,000 note payable dated December 19, 1997; with no interest if paid in full on the maturity date of January 5, 1999; collateralized by a first deed of trust, assignment of rents and fixtures (repaid in January 1999) 390,000 390,000 ------------ ------------ $104,969,000 $116,671,000 ============ ============
Notes payable are secured by hotel properties carried at $256.3 million at December 31, 1998. Interest incurred on mortgage notes payable was $7.6 million, $3.6 million and $506,000 for the years ended December 31, 1998, 1997 and 1996, respectively. F-14 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Notes Payable, continued Future principal maturities of notes payable at December 31, 1998, are as follows: 1999 $ 8,401,000 2000 24,588,000 2001 2,129,000 2002 31,522,000 2003 1,607,000 Thereafter 36,722,000 ------------ $104,969,000 ============
8. Equity 1996 Stock Offerings: On August 7, 1996, the Company completed an offering for 4,000,000 shares of its common stock. On September 10, 1996, 600,000 shares of common stock were issued by the Company upon the full exercise of the underwriters' over- allotment option. The offering price of the shares sold was $10.00 per share, resulting in gross proceeds of approximately $46.0 million and net proceeds (after deducting the underwriters' discount and offering costs) of approximately $43.1 million. 1997 Stock Offerings: On January 6, 1997, the Company completed an offering for 4,000,000 shares of its common stock. Concurrently, 600,000 shares of common stock were issued by the Company upon the full exercise of the underwriters' over-allotment option. The offering price of the shares sold in the offering was $13.00 per share, resulting in gross proceeds of approximately $59.8 million and net proceeds (after deducting the underwriters' discount and offering costs) of approximately $56.8 million. On March 31, 1997, the Company completed an offering for 700,000 shares of its common stock. On April 28, 1997, 105,000 shares of common stock were issued by the Company upon the full exercise of the underwriter's over- allotment option. The offering price of the shares sold was $13.75 per share, resulting in gross proceeds of approximately $11.1 million and net proceeds (after deducting the underwriter's discount and offering costs) of approximately $10.6 million. On May 6, 1997, the Company completed an offering for 4,000,000 shares of common stock. The offering price of the shares sold was $13.375 per share, resulting in gross proceeds of approximately $53.5 million and net proceeds (after deducting the underwriters' discount and offering costs) of approximately $51.4 million. On October 15, 1997, in connection with the closing of the Kahler Acquisition, the Company completed an offering for 9,000,000 shares of common stock. The offering price of the shares sold was $17.25 per share, resulting in gross proceeds of approximately $155.3 million and net proceeds (after deducting the underwriters' discount and offering costs) of approximately $147.1 million. On November 7, 1997, 490,000 shares of common stock were issued by the Company upon the partial exercise of the underwriter's over- allotment option. The offering price of the shares sold was $17.25 per share, resulting in gross proceeds of approximately $8.5 million and net proceeds (after deducting the underwriter's discount and offering costs) of approximately $8.0 million. Additionally, the Company issued 2,284,262 shares of common stock at a price of $14.01 per share, for a total of $32,000,000 and 250,000 shares of 7.9% Class A Cumulative Convertible Preferred Stock at $100 per share for a total of $25,000,000, to Westbrook. F-15 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Equity, continued 1997 Stock Offerings, continued: In October 1997, the Company filed a shelf registration statement with the Securities and Exchange Commission providing for the issuance of up to $325 million of common stock, preferred stock and warrants to purchase common stock and preferred stock. This registration statement was in addition to the registration statement providing for the issuance of up to $200 million in securities, which was filed in 1996. The Company intends to use the proceeds raised from any securities issued under its shelf registration statement for general corporate purposes, including the acquisition and development of additional hotels, the renovation of currently owned hotels, and the repayment of debt. 1998 Stock Offerings: On February 11, 1998, the Company completed a shelf offering for 4,500,000 shares of its common stock. The offering price of the shares sold was $16.375 per share, resulting in gross proceeds of approximately $73.7 million and net proceeds (after deducting the underwriters' discount and offering costs) of approximately $69.4 million. The Company used the net proceeds of the offering to finance the acquisition of additional hotels and to repay outstanding indebtedness under the Credit Facility. Availability under the Company's shelf registration statement was $163.2 million at December 31, 1998. Subject to certain limitations, the Board of Directors is authorized to issue, from the 10,000,000 authorized but unissued shares of capital stock of the Company, Preferred Stock in such classes or series as the Board of Directors may determine. In connection with the Kahler Acquisition on October 15, 1997, the Company issued 250,000 shares of its newly designated 7.9% Class A Cumulative Convertible Preferred Stock (the "Class A Shares"). The holders of the Class A Shares are entitled to one vote for each share of Common Stock into which such holder's Class A Shares could then be converted, and with respect to such vote, such holder shall have full voting rights and powers equal to the voting rights and powers of the holders of Common Stock. The holders of Class A Shares shall be entitled to vote, together with holders of Common Stock as a single class. Subject to preferences that may be applicable to any future class of Preferred Stock, the holders of Class A Shares are entitled to receive, ratably, a dividend equal to the greater of (i) 7.9% per share per annum or (ii) the percentage dividend that would be paid on the Common Stock into which the Preferred Stock is convertible. Each Class A Share is convertible at the option of the holder at any time into a number of shares of Common Stock that is equal to the quotient obtained by dividing $100 by $14.7093, subject to adjustment for stock splits, stock dividends, recapitalizations and the like. On or at any time after the fifth anniversary of issuance of the Class A Shares, the Company may, at its option, redeem the Class A Shares in whole or in part by paying an amount equal to the redemption percentage of $100.00 per share then in effect (as adjusted for any stock dividends, combinations or splits), plus all accrued but unpaid dividends on such shares. The redemption percentage declines one percent per year, from 105% to par commencing in 2002. F-16 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Equity, continued Distributions: The Company has adopted a policy of paying regular quarterly distributions on its common stock. Cash distributions have been paid on the Company's common stock with respect to each quarter since its inception. The following table sets forth information regarding the Company's distributions for 1997 and 1998:
Per Share Quarter to Which Distribution Distribution Distribution Distribution Relates Record Date Payment Date Amount -------------------- ------------ ------------ ------------ 1997 1st Quarter 4/29/97 5/15/97 $0.25 2nd Quarter 7/31/97 8/15/97 $0.25 3rd Quarter 9/30/97 11/14/97 $0.275 4th Quarter 1/31/98 2/16/98 $0.275 1998 1st Quarter 5/1/98 5/13/98 $0.275 2nd Quarter 7/31/98 8/12/98 $0.275 3rd Quarter 10/30/98 11/10/98 $0.285 4th Quarter 2/1/99 2/15/99 $0.285
Reconciliation of Operating Partnership Units Outstanding:
Year Ended December 31, 1998 Year Ended December 31, 1997 --------------------------------------------- --------------------------------------------- Company Affiliates Other Total Company Affiliates Other Total ---------- ---------- --------- ---------- ---------- ---------- --------- ---------- Balance at beginning of year 32,284,103 1,416,240 1,331,087 35,031,430 10,936,457 1,455,799 706,347 13,098,603 Stock options exercised 3,000 3,000 41,860 41,860 Stock awards issued 20,984 20,984 13,766 13,766 Warrants exercised 50,850 50,850 Operating Partnership units redeemed/exchanged 735,911 (16,355) (727,256) (7,700) 58,446 (90,409) (31,963) Dividend reinvestment plan and additional cash investment plan 28,265 28,265 54,312 54,312 Common stock offerings 4,500,000 4,500,000 21,179,262 21,179,262 Contributions of hotel properties 118,892 118,892 624,740 624,740 ---------- --------- --------- ---------- ---------- --------- --------- ---------- Balance at end of year 37,572,263 1,399,885 722,723 39,694,871 32,284,103 1,416,240 1,331,087 35,031,430 ---------- --------- --------- ---------- ---------- --------- --------- ---------- Ownership interest at end of year 94.7% 3.5% 1.8% 100.0% 92.2% 4.0% 3.8% 100.0% ========== ========= ========= ========== ========== ========= ========= ==========
At December 31, 1998, the Company has reserved 7.5 million shares of common stock for its various stock plans, for redemptions and conversions of Operating Partnership units and for public offerings. F-17 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share:
For the Year Ended December 31, ------------------------------------ 1998 1997 1996 ----------- ----------- ---------- Numerator: Net income $16,958,000 $15,591,000 $5,634,000 Distributions on preferred shares (1,975,000) (422,000) -- ----------- ----------- ---------- Numerator for basic and diluted earnings per share Income available to common shareholders after effect of dilutive securities $14,983,000 $15,169,000 $5,634,000 =========== =========== ========== Denominator: Denominator for basic earnings per share-- weighted average shares outstanding 37,023,109 21,089,971 8,041,805 Effect of dilutive securities: Stock options 83,889 158,160 82,133 ----------- ----------- ---------- Denominator for diluted earnings per share-- adjusted weighted average shares and assumed conversions 37,106,998 21,248,131 8,123,938 =========== =========== ========== Basic earnings per share $ 0.40 $ 0.72 $ 0.70 =========== =========== ========== Diluted earnings per share $ 0.40 $ 0.71 $ 0.69 =========== =========== ==========
The computation of diluted earnings per share did not assume the conversion of the 7.9% Class A Preferred Shares because their inclusion would have been anti-dilutive. 10. Commitments and Contingencies Development Agreements: In July 1997, the Company entered into a purchase agreement to acquire a to be developed hotel property located in Denver, Colorado. The guaranteed maximum purchase price to the Company was $7.6 million. In order to secure its obligation to perform under the purchase agreement, the Company was required to provide a limited repayment guarantee of the construction loan. Such repayment guarantee was not to exceed 25% of the revised project cost budget. At December 31, 1998, the Company was negotiating a settlement agreement with the seller whereby it will be released from its obligation to acquire the hotel. The tentative terms of the settlement agreement include, among other things (i) a release of the Company from its partial guarantee of the seller's construction loan; (ii) a requirement for the Company to provide a $500,000 letter of credit as security on the seller's construction loan; and (iii) the Company's option (but not obligation) to take over the lender's position if the seller is in default of its debt to the lender and the Company pays off the unpaid principal and interest due the lender. Additionally, the Company will sell approximately $1.3 million in furniture fixtures and equipment it purchased for the hotel to the seller for an amount which approximates the Company's cost. F-18 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commitments and Contingencies, continued Development Agreements, continued: In November 1997, the Company entered into a purchase agreement to acquire a to be developed hotel property located in Sacramento, California. The guaranteed maximum purchase price to the Company is $13.3 million. The seller is required to pay for all project costs and is at risk for any project cost overruns. Construction of the hotel is to be satisfactory to the Company and completed within a specified period after commencement of construction, subject to certain extensions. During 1997 and 1998, the Company advanced the seller approximately $3.3 million of project financing. Such amounts were secured by a deed of trust and included in notes receivable. In July 1998 all amounts secured by the deed of trust and accrued interest owed, totaling approximately $3.5 million, were repaid. The Company has not recognized interest income on the amounts advanced to the seller. In December 1997, the Company entered into a purchase agreement to acquire a to be developed hotel property located in San Diego, California. The guaranteed maximum purchase price to the Company is $14.5 million. The seller is required to pay for all project costs and is at risk for any project cost overruns. Construction of the hotel is to be satisfactory to the Company and completed within a specified period after commencement of construction, subject to certain extensions. During 1997 and 1998, the Company advanced the seller approximately $3.0 million of project financing. Such amounts were secured by a deed of trust and included in notes receivable. In September 1998, all amounts secured by the deed of trust and accrued interest owed, totaling approximately $3.2 million, were repaid. The Company has not recognized interest income on the amounts advanced to the seller. At December 31, 1998, the Company has various contracts outstanding with third parties in connection with the renovation of the Company's hotel properties. The Company's remaining commitments under these contracts at December 31, 1998 and 1997 totaled approximately $37.5 million and $25.4 million, respectively. Litigation: The Company is involved from time to time in various claims and legal actions in the ordinary course of business. Management does not believe that the impact of such matters will have a material adverse effect on the Company's financial position or results of operations when resolved. Ground Leases: Through December 31, 1998, the Company was obligated under the terms of seven ground leases. Future minimum payments due under the terms of the ground leases in effect at December 31, 1998 are as follows: 1999 $ 1,619,000 2000 1,619,000 2001 1,619,000 2002 1,158,000 2003 419,000 Thereafter 16,330,000 ----------- $22,764,000 -----------
Rent expense incurred pursuant to these ground lease agreements totaled $1,635,000, $633,000 and $90,000 in 1998, 1997 and 1996, respectively. F-19 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commitments and Contingencies, continued Capital Leases: Furniture, fixtures and equipment includes $285,000 for telephone equipment that is being leased and has been capitalized at December 31, 1998. Future minimum payments under the capital lease at December 31, 1998 are as follows: 1999 $ 92,000 2000 209,000 2001 123,000 -------- 424,000 Amounts representing interest (58,000) -------- $366,000 ========
Franchise Agreements: The Company has guaranteed the Lessee's obligations under the terms of certain franchise agreements. These agreements require the Lessee to, among other things, pay monthly fees that are calculated based on specified hotel revenues. Additionally, these franchise agreements generally contain specific standards for, and restrictions and limitations on, the operation and maintenance of the hotels which are established by the franchisors to maintain uniformity in the system created by each such franchisor. Such standards generally regulate the appearance of the hotel, quality and type of goods and services offered, signage, and protection of marks. Compliance with such standards may from time to time require significant expenditures for capital improvements which are borne by the Company. 11. Percentage Lease Agreements As of December 31, 1998, the Company had 57 Percentage Leases with the Lessee. Future minimum rentals (base rents) to be received by the Company from the Lessee under the Percentage Leases in effect at December 31, 1998 are as follows: 1999 $ 57,524,000 2000 57,524,000 2001 57,524,000 2002 57,524,000 2003 57,524,000 Thereafter 198,908,000 ------------ $486,528,000 ============
The term of each lease is ten years. The Percentage Leases contain various covenants and are cross-defaulted. The minimum rent due under each lease is the greater of base rent (subject to annual adjustments based on increases in the United States Consumer Price Index) or percentage rent. Percentage rent is calculated as 9% to 50% of room revenues, up to a certain baseline revenue (the base rent component) then 60% to 68% of room revenues in excess of the baseline revenues. Generally, percentage rent includes 5% of food and beverage revenue and 100% of net other revenues. Rental income pursuant to the Percentage Leases in 1998, 1997 and 1996 was F-20 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Percentage Lease Agreements, continued $98.7 million, $44.7 million and $14.8 million, respectively, of which $40.2 million, $19.8 million and $6.8 million, respectively, was in excess of base rents. The stockholders of the Lessee have pledged a subordinated interest in 481,955 Operating Partnership Units as collateral for the lease payments. In 1997, the Lessor and Lessee amended the Percentage Leases for hotels then currently under renovation and for any future hotels to allow for the abatement of base rent related to rooms taken out of service during major renovations. For the year ended December 31, 1998, rent abatement related to major renovations totaled $668,000. No rent was abated in prior years. Upon the sale of a hotel, the respective Percentage Lease terminates. As provided for in the Percentage Leases and as compensation for the early termination, the Company is required to (i) pay the Lessee a termination fee of an amount equal to the net profit earned by the Lessee with respect to the hotel sold for the 12-month period preceding the sale or, (ii) offer to lease the Lessee one or more substitute hotel facilities pursuant to a similar lease. During 1998, the Company sold six hotels and terminated the related Percentage Leases. Such terminated leases were replaced with new leases in 1998 and no termination fee was due the Lessee. During February 1999, the Company sold one hotel and terminated the related Percentage Lease. The Company anticipates offering the Lessee a substitute hotel facility within the 180 days allowed under the Percentage Lease. Pursuant to the Percentage Leases, the Company is required to make available to the Lessee for the repair, replacement and refurbishment of furniture, fixtures and equipment in the hotels, when and as deemed necessary by the Lessee, an amount equal to 4% of room revenue per quarter on a cumulative basis. To the extent the amount is not fully utilized by the Lessee in any year, the Company may use the amount to fund certain capital expenditures. The Company is responsible for payment of (i) real estate and personal property taxes on its hotel properties (except to the extent that personal property associated with the hotels is owned by the Lessee), (ii) casualty insurance on the hotels, (iii) business interruption insurance on the hotels, and (iv) general liability insurance. The Lessee is required to pay for workers' compensation and other insurance appropriate and customary for properties similar to the Company's hotels with the Company as an additional named insured. 12. Stock Plans The Company accounts for stock option and warrant grants to employees in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), and related Interpretations in accounting for its employee stock options because the Company believes the alternative fair value accounting provided for under Statements of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation ("Statement No. 123"), requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, if the stock options are granted at the market price of the underlying stock on the date of grant, no compensation expense is recognized. Pro forma information regarding net income and earnings per share is required by Statement No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. These pro forma effects are not likely to be representative of the effects on reported pro forma net income for future years because options vest over several years and additional awards are generally made each year. The fair value for these options was estimated at the date of grant using a Black- Scholes option pricing model with the following weighted average assumptions for 1998, 1997 and 1996, respectively: risk-free interest rates from 5.88% to 7.88%, from 5.89% to 6.75% and from 6.48% to 6.85%; dividend yields from 6.47% to 13.41%, from 6.38% to 8.54% and 7.10%; volatility factors of the expected market price of the Company's common stock of 0.332, 0.330 and 0.279; and a weighted average expected life of the option of seven and ten years. F-21 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Stock Plans, continued The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows:
For the Years Ended December 31, ---------------------------------- 1998 1997 1996 ----------- ----------- ---------- Pro forma net income available to common stockholders $14,434,000 $15,006,000 $5,559,000 Pro forma net income available to common stockholders per share: Basic $ 0.39 $ 0.71 $ 0.69 Diluted 0.39 0.71 0.68
The weighted average remaining contracted life of all employee stock options outstanding at December 31, 1998 is eight years. The weighted average grant date fair value of stock options with stock prices equal to their exercise prices issued during 1998, 1997 and 1996 is $3.40, $3.29 and $0.96, respectively. The weighted average grant date fair value of stock options with stock prices in excess of their exercise prices issued during 1997 is $4.21. 1994 Stock Incentive Plan: Under the 1994 Stock Incentive Plan, as amended, officers, nonemployee members of the Board of Directors and key employees and consultants of the Company are eligible to be granted options and warrants to purchase common stock of the Company. Through December 31, 1998, the Company's Board of Directors have set aside 2,400,000 shares of common stock to be issued pursuant to the 1994 Stock Incentive Plan. The 1994 Stock Incentive Plan is being administered by a committee established by the Company's Board of Directors. All options granted have exercise prices equal to their quoted market prices on the dates granted, have ten year terms and vest and become fully exercisable over five years. Effective September 25, 1998, the Company agreed to issue two of its officers an aggregate of 454,500 transferable warrants to purchase 454,500 shares of the Company's common stock in exchange for the officers surrendering to the Company for cancellation 454,500 options previously issued to them under the 1994 Stock Incentive Plan. The warrants have exercise prices ranging from $9.50 to $16.63. The exercise price of each warrant issued is identical to each stock option being surrendered. The warrant exercise prices were equal to or in excess of the quoted market price of the Company's common stock on September 25, 1998. The warrants will become exercisable 13 months after September 25, 1998 and can be exercised anytime prior to September 24, 2003. A summary of the Company's 1994 Stock Incentive Plan activity and related information, excluding the issuance of 454,500 warrants and cancellation of 454,500 options effective September 25, 1998, as previously discussed, for the years ended December 31, 1998, 1997 and 1996 follows: F-22 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Stock Plans, continued
Number of Weighted Available for Options and Exercise Price Average Future Grant Warrants Per Share Exercise Price ------------- ----------- --------------- -------------- Outstanding at December 31, 1995 260,000 240,000 $ 9.50 $ 9.50 Granted (247,900) 247,900 9.88 to 10.50 10.42 --------- --------- Outstanding at December 31, 1996 12,100 487,900 9.50 to 10.50 9.97 Additional options and warrants authorized 700,000 -- -- -- Granted (355,000) 355,000 12.88 to 17.25 16.95 Exercised -- (38,680) 9.50 to 10.50 9.83 --------- --------- Outstanding at December 31, 1997 357,100 804,220 9.50 to 17.25 13.06 Additional options and warrants authorized 1,200,000 -- -- -- Granted (244,100) 244,100 10.50 to 17.25 16.48 Forfeited 35,000 (35,000) 12.88 to 17.00 16.41 --------- --------- Outstanding at December 31, 1998 1,348,000 1,013,320 9.50 to 17.25 13.75 ========= =========
Options exercisable and their weighted average exercise prices at December 31: 1996 48,000 $ 9.50 1997 106,900 9.81 1998 274,720 11.70
1994 Directors Plan: In September 1994, the Company adopted the 1994 Directors Plan (the "Directors Plan"), as amended, under which nonemployee members of the Board of Directors of the Company are eligible to be granted options to purchase common stock of the Company. Through December 31, 1998, the Company's Board of Directors have set aside 150,000 shares of common stock to be issued pursuant to the Directors Plan. All options granted through December 31, 1998 had exercise prices equal to their quoted market prices on the dates granted, have ten year terms and vest immediately. A summary of the Company's Directors Plan, activity and related information for the years ended December 31, 1998, 1997 and 1996 follows:
Weighted Available for Number of Exercise Price Average Future Grant Options Per Share Exercise Price ------------- --------- --------------- -------------- Outstanding at December 31, 1995 150,000 -- $ -- $ -- Granted (15,000) 15,000 9.75 to 10.13 9.94 Exercised -- (1,500) 9.75 9.75 ------- ------ Outstanding at December 31, 1996 135,000 13,500 9.75 to 10.13 9.96 Granted (9,000) 9,000 12.88 to 14.50 14.23 Exercised -- (3,000) 9.75 to 10.13 9.94 ------- ------ Outstanding at December 31, 1997 126,000 19,500 9.75 to 14.50 11.93 Granted (18,000) 18,000 8.50 to 17.00 11.73 Exercised -- (3,000) 10.13 to 14.50 12.31 ------- ------ Outstanding at December 31, 1998 108,000 34,500 8.50 to 17.00 11.79 ======= ======
F-23 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Stock Plans, continued 1997 Supplemental Stock Option Plan: In October 1997, the Company adopted the 1997 Supplemental Stock Option Plan (the "Supplemental Plan"), as amended under which employees, who are neither officers nor members of the Board of Directors of the Company are eligible to be granted options to purchase common stock of the Company. Through December 31, 1998, the Company's Board of Directors have set aside 20,000 shares of common stock to be issued pursuant to the Supplemental Plan. All options granted through December 31, 1998 had exercise prices less than their quoted market prices on the dates granted, have ten-year terms and vest over five years. A summary of the Company's Supplemental Plan activity and related information for the years ended December 31, 1998 and 1997 follows:
Weighted Available for Number of Exercise Price Average Future Grant Options Per Share Exercise Price ------------- --------- -------------- -------------- Outstanding at December 31, 1996 -- -- $ -- $ -- Authorized, October 10, 1997 20,000 -- -- -- Granted (15,300) 15,300 14.01 14.01 Forfeited 3,000 (3,000) 14.01 14.01 ------- ------ Outstanding at December 31, 1997 7,700 12,300 14.01 14.01 Forfeited 3,000 (3,000) 14.01 14.01 ------- ------ Outstanding at December 31, 1998 10,700 9,300 14.01 14.01 ======= ======
At December 31, 1998, options exercisable and their weighted average exercise price were 1,860 and $14.01, respectively. No options were exercisable at December 31, 1997 and 1996. 13. Quarterly Financial Information (Unaudited) Summarized quarterly financial data for the year ended December 31, 1998 and for the year ended December 31, 1997, which have been restated to comply with Statement No. 128 and to reflect the allocation of a fourth quarter depreciation expense adjustment to the first three quarters, is as follows:
For the Quarter Ended ----------------------------------------------- March 31, June 30, September December 1998 1998 30, 1998 31, 1998 ----------- ----------- ----------- ----------- Lease revenues $23,687,000 $24,775,000 $28,907,000 $21,313,000 Net income (loss) 6,597,000 6,274,000 4,585,000 (498,000) Basic earnings (loss) per share 0.17 0.15 0.11 (0.03) Diluted earnings (loss) per share 0.17 0.15 0.11 (0.03) For the Quarter Ended ----------------------------------------------- March 31, June 30, September December 1997 1997 30, 1997 31, 1997 ----------- ----------- ----------- ----------- Lease revenues $ 7,572,000 $ 7,775,000 $12,129,000 $17,204,000 Net income 3,276,000 3,295,000 5,569,000 3,029,000 Basic earnings per share 0.22 0.18 0.27 0.10 Diluted earnings per share 0.22 0.17 0.27 0.10
F-24 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. Related Party Transactions The Management Company provides certain accounting and management services for the Company. The Company expensed $171,000, $142,000 and $60,000 for these services for the years ended December 31, 1998, 1997 and 1996, respectively, and such costs are included in general and administrative expenses in the statements of and operations. Additionally, certain Management Company employee salaries, identifiable employee expenses and other costs incurred in connection with acquisition and construction and renovation services are reimbursed by the Company. During the years ended December 31, 1998 and 1997, $18,000 and $341,000, respectively, was incurred for such costs. No reimbursements were made to the Management Company in 1996. Certain Lessee employee salaries and identifiable employee expenses incurred in connection with acquisition and construction services are reimbursed by the Company. During the years ended December 31, 1998, 1997 and 1996, $962,000, $634,000 and $200,000 was paid to the Lessee for such services, respectively. The Company reimburses the Lessee for capitalizable costs that the Lessee incurs on behalf of the Company during periods of major renovation of the hotel properties and capitalizes such costs to the related hotel properties. The total costs reimbursable to the Lessee during 1998 and 1997 totaled $1.6 million and $1.8 million, respectively. No reimbursements were made to the Lessee in 1996. In addition, the Company reimburses the Lessee for general and administrative expenses incurred by the Lessee on behalf of the Company. The total costs reimbursable to the Lessee during 1998 and 1997 totaled $167,000 and $80,000, respectively. During 1998, the Lessee reconveyed to the Company certain hotel telephone equipment that was being leased pursuant to a capital lease agreement. The equipment carried at $404,000 and related capital lease obligation of $421,000 were previously assigned to the Lessee by the Company and originally recorded at the Company's costs. The Company agreed to assume the capital lease obligation and to reimburse the Lessee for all lease payments made by the Lessee since the equipment was assigned to the Lessee in October 1997. During 1998, the Lessee reconveyed to the Company approximately $2.2 million in china, glass, silver and linen that was previously assigned to the Lessee by the Company and originally recorded by the Lessee at the Company's cost. 15. Pro Forma Financial Information (Unaudited) The unaudited pro forma financial information set forth below is presented as if: (i) the acquisition, development and disposition of hotel properties, and (ii) the equity offerings completed in 1998 and 1997, had occurred on January 1, 1997. The pro forma financial information is not necessarily indicative of what actual results of operations of the Company would have been assuming the acquisition, development and disposition of the hotel properties, and the equity offerings completed in 1998 and 1997 had occurred on January 1, 1997, nor does it purport to represent the results of operations for future periods. F-25 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. Pro Forma Financial Information (Unaudited), continued
For the Year Ended December 31, ------------------------------- 1998 1997 --------------- --------------- (Unaudited) Lease revenues $97,561,000 $92,710,000 Net income 16,332,000 26,749,000 Basic earnings per share 0.38 0.66 Diluted earnings per share 0.38 0.66
16. Subsequent Events Subsequent to December 31, 1998, the Company declared a dividend of $0.285 per common share which was paid February 15, 1999. On February 2, 1999, the Company sold the 129-room Hampton Inn located in Arcadia, California for $8.5 million. In February 1999, the Company completed the development of an office building located in San Clemente, California. A portion of the building is used by the Company as its corporate facility and a portion is leased to the Lessee as its corporate facility. The remaining space will be leased to third parties. The office building was financed with a $5.5 million note payable dated February 5, 1999 collateralized by a first deed of trust with monthly interest payments at LIBOR plus 2.25% and maturing August 5, 2000. The Company has the option to extend the maturity date for up to three years. F-26 SUNSTONE HOTEL INVESTORS, INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION as of December 31, 1998
Cost Capitalized Initial Subsequent to Gross Amount at Cost to Company Acquisition Close of Period ---------------------- --------------------- ---------------------- Buildings Buildings Buildings and and and Description Encumbrances Land Improvements Land Improvements Land Improvements Totals(a) - ----------- ------------ --------- ------------ -------- ------------ --------- ------------ --------- Courtyard by Marriott - Fresno $ $ 800,000 $2,936,460 $150,000 $ 805,585 $ 950,000 $3,742,045 $4,692,045 Doubletree - Santa Fe 2,296,000 8,610,000 -- 1,925,778 2,296,000 10,535,778 12,831,778 Hampton Inn - Arcadia 1,660,500 6,226,875 -- 229,979 1,660,500 6,456,854 8,117,354 Hampton Inn - Denver 1,250,462 2,597,505 -- 1,128,775 1,250,462 3,726,280 4,976,742 Hampton Inn - Mesa 900,000 2,117,321 -- 830,611 900,000 2,947,932 3,847,932 Hampton Inn - Oakland 1,223,045 3,109,435 542 505,554 1,223,587 3,614,989 4,838,576 Hampton Inn - Pueblo 607,183 1,745,054 335,438 562,288 942,621 2,307,342 3,249,963 Hampton Inn - Silverthorne 1,337,625 5,016,094 1,925 1,317,849 1,339,550 6,333,943 7,673,493 Holiday Inn - Steamboat Springs 400,000 2,959,000 56,157 2,431,108 456,157 5,390,108 5,846,265 Holiday Inn Hotel & Suites - Craig 70,000 915,024 207,098 1,608,186 277,098 2,523,210 2,800,308 Holiday Inn Select - Renton 2,119,815 5,622,685 71 6,590,826 2,119,886 12,213,511 14,333,397 Residence Inn - Highlands Ranch 809,159 4,151,567 155,226 3,142,845 964,385 7,294,412 8,258,797 Comfort Suites - S. San Francisco 1,731,368 8,935,209 -- 1,670,516 1,731,368 10,605,725 12,337,093 Courtyard by Marriott - Riverside 2,835,218 395,323 3,098,797 -- 92,242 395,323 3,191,039 3,586,362 Holiday Inn - Price 240,167 4,034,833 235,459 3,238,786 475,626 7,273,619 7,749,245 Hampton Inn - Clackamas -- 2,261,998 3,322 2,388,215 3,322 4,650,213 4,653,535 Hampton Inn - Tucson 500,000 5,817,500 -- 753,399 500,000 6,570,899 7,070,899 Holiday Inn - Flagstaff 1,148,000 6,072,000 -- 1,466,892 1,148,000 7,538,892 8,686,892 Holiday Inn - Provo 850,000 1,116,708 5,266 1,273,985 855,266 2,390,693 3,245,959 Holiday Inn Express - Portland (Stark) 376,254 1,643,824 27,211 1,845,029 403,465 3,488,853 3,892,318 Holiday Inn Express - Poulsbo 613,485 1,558,033 21,996 1,088,776 635,481 2,646,809 3,282,290 Holiday Inn Hotel & Suites - Kent 1,166,955 2,963,452 21,996 1,966,519 1,188,951 4,929,971 6,118,922 Holiday Inn Hotel & Suites - Mesa CC 1,800,000 11,025,000 -- 4,714,690 1,800,000 15,739,690 17,539,690 Residence Inn - Oxnard 2,894,000 11,996,825 -- 1,715,799 2,894,000 13,712,624 16,606,624 Best Western - Lynnwood 2,952,000 4,090,985 -- 887,744 2,952,000 4,978,729 7,930,729 Best Western - Ogden 7,500,000 1,481,911 11,460,688 -- 4,242,386 1,481,911 15,703,074 17,184,985 Clinic View Inn & Suites - Rochester 1,666,170 16,703,101 -- 63,314 1,666,170 16,766,415 18,432,585 Courtyard by Marriott - Cypress 1,216,537 10,340,564 -- 1,255,013 1,216,537 11,595,577 12,812,114 Crystal Suites - Anaheim -- 6,167,984 -- 1,021,243 -- 7,189,227 7,189,227 Hawthorn Suites - Kent 3,301,165 1,744,000 11,607,036 -- 1,075,544 1,744,000 12,682,580 14,426,580 Hawthorn Suites - Sacramento 3,517,000 11,619,998 -- 4,504,695 3,517,000 16,124,693 19,641,693 Hilton - Salt Lake City 22,600,000 8,926,272 33,785,121 -- 9,869,417 8,926,272 43,654,538 52,580,810 Holiday Inn - La Mirada 3,001,000 13,541,158 -- 4,129,065 3,001,000 17,670,223 20,671,223 Holiday Inn - Rochester 1,099,890 6,691,023 -- 164,616 1,099,890 6,855,639 7,955,529 Holiday Inn - San Diego 875,062 7,438,037 -- 4,812,050 875,062 12,250,087 13,125,149 Holiday Inn - San Diego (Stadium) -- 9,943,238 -- 304,701 -- 10,247,939 10,247,939 Marriott - Rochester 1,851,300 36,162,150 -- 2,218,810 1,851,300 38,380,960 40,232,260 Marriott - Park City (c) 2,259,675 15,909,442 -- 340,485 2,259,675 16,249,927 18,509,602 Marriott - Provo 1,117,314 22,120,724 -- 3,620,537 1,117,314 25,741,261 26,858,575 Ramada Plaza - San Diego (Old Town) 1,188,000 10,258,897 380,814 3,428,080 1,568,814 13,686,977 15,255,791 Regency Plaza - LAX -- 11,120,680 -- 812,639 -- 11,933,319 11,933,319 Residence Inn - Provo 893,851 5,603,726 -- 44,213 893,851 5,647,939 6,541,790 Residence Inn - Sacramento 2,020,000 9,590,182 -- 704,154 2,020,000 10,294,336 12,314,336 Life on Which Depreciation In Latest Statement of Financial Accumulated Date of Date Position is Description Depreciation(b) Construction Acquired Conducted - ----------- -------------- ------------ -------- ------------- Courtyard by Marriott - Fresno $1,040,447 1989 1995 5-35 Doubletree - Santa Fe 2,026,753 1985 1995 5-35 Hampton Inn - Arcadia 1,018,761 1989 1995 5-35 Hampton Inn - Denver 1,988,610 1986 1995 5-35 Hampton Inn - Mesa 846,575 1987 1995 5-35 Hampton Inn - Oakland 337,544 1986 1995 5-35 Hampton Inn - Pueblo 1,232,418 1986 1995 5-35 Hampton Inn - Silverthorne 769,525 1976 1995 5-35 Holiday Inn - Steamboat Springs 2,764,140 1971 1995 5-35 Holiday Inn Hotel & Suites - Craig 560,040 1981 1995 5-35 Holiday Inn Select - Renton 884,726 1968 1995 5-35 Residence Inn - Highlands Ranch 496,556 1996 1995 5-35 Comfort Suites - S. San Francisco 885,253 1985 1996 5-35 Courtyard by Marriott - Riverside 365,216 1988 1996 5-35 Holiday Inn - Price 512,761 1984 1996 5-35 Hampton Inn - Clackamas 422,944 1986 1996 5-35 Hampton Inn - Tucson 496,762 1986 1996 5-35 Holiday Inn - Flagstaff 561,671 1987 1996 5-35 Holiday Inn - Provo 231,224 1968 1996 5-35 Holiday Inn Express - Portland (Stark) 311,010 1986 1996 5-35 Holiday Inn Express - Poulsbo 260,356 1986 1996 5-35 Holiday Inn Hotel & Suites - Kent 478,439 1986 1996 5-35 Holiday Inn Hotel & Suites - Mesa CC 1,051,861 1985 1996 5-35 Residence Inn - Oxnard 990,158 1987 1996 5-35 Best Western - Lynnwood 209,752 1978 1997 5-35 Best Western - Ogden 587,755 1982 1997 5-35 Clinic View Inn & Suites - Rochester 762,423 Various 1997 5-35 Courtyard by Marriott - Cypress 721,262 1990 1997 5-35 Crystal Suites - Anaheim 305,760 1992 1997 5-35 Hawthorn Suites - Kent 774,378 1990 1997 5-35 Hawthorn Suites - Sacramento 724,543 1988 1997 5-35 Hilton - Salt Lake City 1,786,645 1975 1997 5-35 Holiday Inn - La Mirada 964,833 1984 1997 5-35 Holiday Inn - Rochester 315,248 1969 1997 5-35 Holiday Inn - San Diego 594,714 1968 1997 5-35 Holiday Inn - San Diego (Stadium) 468,546 1991 1997 5-35 Marriott - Rochester 1,694,705 1991 1997 5-35 Marriott - Park City 729,906 1985 1997 5-35 Marriott - Provo 1,082,601 1982 1997 5-35 Ramada Plaza - San Diego (Old Town) 657,817 1986 1997 5-35 Regency Plaza - LAX 520,786 1996 1997 5-35 Residence Inn - Provo 258,919 1996 1997 5-35 Residence Inn - Sacramento 361,523 1992 1997 5-35
F-27 SUNSTONE HOTEL INVESTORS, INC. SCHEDULE III--REAL ESTATE AND ACCUMULATED DEPRECIATION (continued) as of December 31, 1998
Cost Capitalized Initial Subsequent to Cost to Company Acquisition ------------------------- ----------------------- Buildings Buildings and and Description Encumbrances Land Improvements Land Improvements - ----------- ------------ ------------ ------------ ---------- ------------ Residence Inn - San Diego 3,130,000 12,798,740 -- 852,005 Sheraton - Chandler 13,260,000 18,752,580 23,712,592 1,241,439 2,395,024 The Kahler Hotel - Rochester 32,221,493(c) 3,410,748 43,097,136 -- 1,121,988 Marriott (University) - Salt Lake City 8,320,000 -- 25,238,738 -- 2,650,919 Days Inn - Santa Clara 7,291,944 11,880,357 -- 128,469 Fairfield Inn - Santa Clarita 1,606,752 3,229,381 -- 127,340 Hampton Inn - Santa Clarita 6,138,659 2,142,565 5,406,343 -- 261,890 Hilton - Carson 1,830,000 9,403,847 -- 1,084,313 Marriott - Napa 8,624,880 11,265,026 -- 17,426 Marriott - Pueblo -- 9,430,049 -- 261,781 Pacific Shores - Santa Monica -- 21,006,510 -- 91,947 Radisson - Oxnard 1,637,220 6,793,478 -- 202,573 Residence Inn - Santa Clarita 2,191,026 8,198,217 -- 109,063 Vacation Inn - San Diego 2,070,000 8,521,100 -- 300,624 ----------- ------------ ------------ ---------- ----------- $96,176,535 $113,687,038 $560,667,447 $2,843,960 $96,398,300 =========== ============ ============ ========== =========== Investments in Other Real Estate Properties - ------------------------------------------- TCS - Rochester $ 8,792,939 $ 2,867,301 $ 5,256,717 $ -- $ -- TCS - Salt Lake City -- -- 1,600,686 -- -- Land held for future development or sale -- 1,496,556 -- -- -- Land under development -- 649,819 -- -- -- ----------- ------------ ------------ ---------- ----------- $ 8,792,939 $ 5,013,676 $ 6,857,403 $ -- $ -- =========== ============ ============ ========== =========== Life on Which Gross Amount at Depreciation Close of Period In Latest ------------------------- Statement of Buildings Financial and Accumulated Date of Date Position is Description Land Improvements Totals(a) Depreciation(b) Construction Acquired Conducted - ----------- ------------ ------------ ------------ --------------- ------------ -------- ------------- Residence Inn - San Diego 3,130,000 13,650,745 16,780,745 482,815 1989 1997 5-35 Sheraton - Chandler 19,994,019 26,107,616 46,101,635 1,115,579 1987 1997 5-35 The Kahler Hotel - Rochester 3,410,748 44,219,124 47,629,872 1,983,715 Various 1997 5-35 Marriott (University) - Salt Lake City -- 27,889,657 27,889,657 1,204,137 1987 1997 5-35 Days Inn - Santa Clara 7,291,944 12,008,826 19,300,770 291,614 1985 1998 5-35 Fairfield Inn - Santa Clarita 1,606,752 3,356,721 4,963,473 109,520 1997 1998 5-35 Hampton Inn - Santa Clarita 2,142,565 5,668,233 7,810,798 134,855 1988 1998 5-35 Hilton - Carson 1,830,000 10,488,160 12,318,160 327,440 1990 1998 5-35 Marriott - Napa 8,624,880 11,282,452 19,907,332 274,219 1979 1998 5-35 Marriott - Pueblo -- 9,691,830 9,691,830 146,077 1998 1998 5-35 Pacific Shores - Santa Monica -- 21,098,457 21,098,457 256,562 1967 1998 5-35 Radisson - Oxnard 1,637,220 6,996,051 8,633,271 189,776 1987 1998 5-35 Residence Inn - Santa Clarita 2,191,026 8,307,280 10,498,306 275,589 1997 1998 5-35 Vacation Inn - San Diego 2,070,000 8,821,724 10,891,724 291,081 1988 1998 5-35 ------------ ------------ ------------ ------------ $116,530,998 $657,065,747 $773,596,745 $41,138,845 ============ ============ ============ ============ Investments in Other Real Estate Properties - ------------------------------------------- TCS - Rochester $ 2,867,301 $ 5,256,717 $ 8,124,018 $ 113,346 1993 1997 5-35 TCS - Salt Lake City -- 1,600,686 1,600,686 389,058 1980 1997 5-35 Land held for future development or sale 1,496,556 -- 1,496,556 -- Land under development 649,819 -- 649,819 -- ------------ ------------ ------------ ------------ $ 5,013,676 $ 6,857,403 $ 11,871,079 $ 502,404 ============ ============ ============ ============
Hotel Properties Other Real Estate Investments ---------------------------------------- ----------------------------------- 1996 1997 1998 1996 1997 1998 ------------ ------------ ------------ ----------- ----------- ----------- (a) Reconciliation of Land and Buildings and Improvements: Balance at the beginning of the year $ 52,012,431 $147,323,633 $643,225,814 -- -- $ 9,724,705 Additions during year: Acquisitions 88,198,970 467,135,296 122,528,695 -- 9,724,705 -- Improvements 11,062,230 28,766,885 54,903,283 -- -- 2,146,374 Disposals during the year (3,949,998) -- (47,061,047) -- -- -- ------------ ------------ ------------ ----------- ----------- ----------- Balance at end of year $147,323,633 $643,225,814 $773,596,745 $ -- $ 9,724,705 $11,871,079 ============ ============ ============ =========== =========== =========== (b) Reconciliation of Accumulated Depreciation: Balance at beginning of year $ 6,735,996 $ 9,558,217 $ 19,223,317 $ -- $ -- $ 99,000 Depreciation for the year 2,861,351 9,665,100 23,216,159 -- 99,000 403,404 Retirement (39,130) -- (1,300,631) -- -- -- ------------ ------------ ------------ ----------- ----------- ----------- Balance at end of year $ 9,558,217 $ 19,223,317 $ 41,138,845 $ -- $ 99,000 $ 502,404 ============ ============ ============ =========== =========== =========== (c) The $32,221,493 encumbrance is cross-collateralized by Park City Marriott and the Kahler Hotel.
F-28 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors Sunstone Hotel Investors, Inc. We have audited the accompanying consolidated statements of operations, equity and cash flows of Sunstone Hotel Investors, Inc. and its subsidiaries (the "Company") for the year ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Sunstone Hotel Investors, Inc. and its subsidiaries for the year ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND LLP San Francisco, California February 28, 1997 F-29 REPORT OF INDEPENDENT AUDITORS To the Board of Directors Sunstone Hotel Properties, Inc. We have audited the accompanying consolidated balance sheets of Sunstone Hotel Properties, Inc. (the "Lessee") as of December 31, 1998 and 1997, and the related consolidated statements of operations, changes in stockholders' deficit and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Lessee's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sunstone Hotel Properties, Inc. at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles. /S/ ERNST & YOUNG LLP Newport Beach, California February 19, 1999 F-30 SUNSTONE HOTEL PROPERTIES, INC. CONSOLIDATED BALANCE SHEETS
December 31, ------------------------- 1998 1997 ------------ ----------- ASSETS Current assets: Cash and cash equivalents $ 3,639,000 $ 4,352,000 Receivables, net of allowance for doubtful accounts of $388,000 in 1998 and $267,000 in 1997 10,771,000 10,037,000 Due from affiliates, net 164,000 321,000 Inventories 1,824,000 1,798,000 Prepaid expenses and other current assets 640,000 306,000 ------------ ----------- 17,038,000 16,814,000 Management agreements, net 366,000 752,000 Property and equipment, net 154,000 3,116,000 Other assets 420,000 204,000 ------------ ----------- $ 17,978,000 $20,886,000 ============ =========== LIABILITIES AND STOCKHOLDERS' DEFICIT Current liabilities Rent payable--Sunstone Hotel Investors, Inc. $ 7,498,000 $ 7,641,000 Accounts payable 8,811,000 8,836,000 Accrued payroll and employee benefits 6,697,000 5,461,000 Sales taxes payable 1,915,000 1,640,000 Stockholder line of credit 650,000 -- Other liabilities 1,295,000 1,845,000 ------------ ----------- 26,866,000 25,423,000 Long-term liabilities Capital lease obligation -- 366,000 Accrued pension liability 1,603,000 1,017,000 ------------ ----------- 28,469,000 26,806,000 ------------ ----------- Commitments and contingencies (Notes 5 and 6) Minority interest -- 119,000 Stockholders' deficit Common stock, no par value, 100,000 shares authorized; 125 shares issued and outstanding 498,000 -- Accumulated deficit (Note 3) (10,422,000) (6,039,000) Accumulated other comprehensive loss (567,000) -- ------------ ----------- (10,491,000) (6,039,000) ------------ ----------- $ 17,978,000 $20,886,000 ============ ===========
The accompanying notes are an integral part of these financial statements. F-31 SUNSTONE HOTEL PROPERTIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, -------------------------------------- 1998 1997 1996 ------------ ----------- ----------- REVENUES: Room $204,492,000 $95,106,000 $34,085,000 Food and beverage 41,857,000 14,159,000 2,576,000 Other 27,247,000 8,888,000 1,932,000 ------------ ----------- ----------- Total revenues 273,596,000 118,153,000 38,593,000 ------------ ----------- ----------- EXPENSES: Room 47,585,000 22,073,000 9,041,000 Food and beverage 34,474,000 11,978,000 2,436,000 Other 17,382,000 5,154,000 1,265,000 Advertising and promotion 20,719,000 9,574,000 3,895,000 Repairs and maintenance 11,314,000 4,719,000 1,829,000 Utilities 10,960,000 5,013,000 2,034,000 Franchise costs 7,229,000 3,428,000 1,326,000 Management fees to related party 937,000 1,776,000 983,000 Rent expense--Sunstone Hotel Investors, Inc. 98,682,000 44,680,000 14,848,000 General and administrative 28,697,000 11,889,000 4,098,000 ------------ ----------- ----------- Total expenses 277,979,000 120,284,000 41,755,000 ------------ ----------- ----------- NET LOSS $ (4,383,000) $(2,131,000) $(3,162,000) ============ =========== ===========
The accompanying notes are an integral part of these financial statements. F-32 SUNSTONE HOTEL PROPERTIES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' DEFICIT
Common Stock, no par Other Total -------------------- Accumulated Comprehensive Stockholders' Shares Amount Deficit Loss Deficit ---------------------- ------------ ------------- ------------- Balance at December 31, 1995 125 $ -- $ (746,000) $ -- $ (746,000) Net loss -- -- (3,162,000) -- (3,162,000) ------- ------------ ------------ --------- ------------ Balance at December 31, 1996 125 -- (3,908,000) -- (3,908,000) Net loss -- -- (2,131,000) -- (2,131,000) ------- ------------ ------------ --------- ------------ Balance at December 31, 1997 125 -- (6,039,000) -- (6,039,000) Contributions -- 498,000 -- -- 498,000 Net loss -- -- (4,383,000) -- (4,383,000) Minimum pension liability adjustment -- -- -- (567,000) (567,000) ------- ------------ ------------ --------- ------------ Balance at December 31, 1998 125 $ 498,000 $(10,422,000) $(567,000) $(10,491,000) ======= ============ ============ ========= ============
The accompanying notes are an integral part of these financial statements. F-33 SUNSTONE HOTEL PROPERTIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, ------------------------------------- 1998 1997 1996 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(4,383,000) $(2,131,000) $(3,162,000) Adjustments to reconcile net loss to net cash (used in) provided by operating activities: Gain on sale of assets (266,000) -- -- Bad debt expense 382,000 267,000 -- Depreciation 67,000 53,000 -- Amortization 386,000 94,000 -- Deferred compensation expense 309,000 -- -- Changes in operating assets and liabilities: Receivables (692,000) (2,011,000) (751,000) Inventories -- (140,000) (389,000) Prepaid expenses and other current assets (116,000) 91,000 (45,000) Other assets (222,000) -- -- Rent payable--Sunstone Hotel Investors, Inc. (143,000) 5,281,000 1,715,000 Accounts payable (25,000) (1,060,000) 2,034,000 Accrued payroll and employee benefits 1,236,000 3,250,000 618,000 Sales taxes payable 275,000 1,416,000 (1,000) Due from affiliates, net 2,050,000 (1,852,000) (170,000) Accrued pension liability 19,000 (180,000) -- Other liabilities (683,000) (976,000) 535,000 ----------- ----------- ----------- Net cash (used in) provided by operating activities (1,806,000) 2,102,000 384,000 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (95,000) (174,000) (19,000) Net proceeds from sale of assets 525,000 -- -- Proceeds from Lessor upon execution of certain leases 13,000 1,269,000 -- ----------- ----------- ----------- Net cash provided by (used in) investing activities 443,000 1,095,000 (19,000) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from stockholder line of credit 650,000 -- -- Payments on capital lease obligation -- (10,000) -- ----------- ----------- ----------- Net cash provided by (used in) financing activities 650,000 (10,000) -- ----------- ----------- ----------- Net (decrease) increase in cash and cash equivalents (713,000) 3,187,000 365,000 Cash and cash equivalents, beginning of year 4,352,000 1,165,000 800,000 ----------- ----------- ----------- Cash and cash equivalents, end of year $ 3,639,000 $ 4,352,000 $ 1,165,000 =========== =========== ===========
The accompanying notes are an integral part of these financial statements. F-34 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization Sunstone Hotel Properties, Inc. (the "Lessee") was incorporated in Colorado in August 1995 and commenced operations effective with the completion of an initial public stock offering by Sunstone Hotel Investors, Inc. (the "Lessor") on August 16, 1995. The Lessee leases hotel properties, which are primarily located in the western United States, from the Lessor pursuant to long-term leases (the "Percentage Leases"). The Lessee operates 100% of the hotel properties owned by the Lessor. The Lessee is owned by Robert A. Alter, Chairman and President of the Lessor (80%), and Charles L. Biederman, Director and Executive Vice President of the Lessor (20%). At December 31, 1998, 57 hotel properties were leased from the Lessor. 2. Summary of Significant Accounting Policies Consolidation: The accompanying financial statements include the accounts of the Lessee and its subsidiaries in which it has controlling interests. All significant intercompany transactions have been eliminated in consolidation. Cash And Cash Equivalents: Cash and cash equivalents are defined as cash on hand and in banks plus all short-term investments with an original maturity of three months or less. Receivables: Accounts receivable primarily represents receivables from hotel guests who occupy hotel rooms and utilize the hotel services. Accounts receivable also includes receivables from customers who utilize the Lessee's laundry facilities in Salt Lake City, Utah, and Rochester, Minnesota. The Lessee maintains an allowance for doubtful accounts at a level which the Lessee's management believes is sufficient to cover potential credit losses. Inventories: Inventories, consisting primarily of food and beverages are stated at the lower of cost or market, with cost determined on a method that approximates first-in, first-out basis. Management Agreements: Management agreements are carried at the Lessor's allocated cost of such agreements prior to the agreements being assigned to the Lessee. The allocated costs were based upon the estimated fair value of the management agreements in connection with the Lessor's acquisition of the stock of Kahler Realty Corporation in October 1997. The management agreements are amortized over the estimated term of the related agreements ranging from one to ten years. Accumulated amortization totaled $480,000 and $94,000 at December 31, 1998 and 1997, respectively. Property and Equipment: Property and equipment is stated on the basis of cost and includes computer equipment and other hotel equipment. Property and equipment is depreciated on a straight-line basis over the estimated useful lives ranging from 3 to 25 years. F-35 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued During 1998, the Lessee reconveyed to the Lessor certain hotel telephone equipment that was being leased pursuant to a capital lease agreement. The equipment carried at $404,000 and related capital lease obligation of $421,000 were previously assigned to the Lessee by the Lessor and originally recorded by the Lessee at the Lessor's costs. The Lessor agreed to assume the capital lease obligation and to reimburse the Lessee for all lease payments made by the Lessee since the equipment was assigned to the Lessee in October 1997. The transaction was recorded by the Lessee as a reduction of the applicable asset, the related accumulated depreciation and a reduction of the capital lease obligation. During 1998, the Lessee reconveyed to the Lessor approximately $2.2 million in china, glass, silver and linen that was previously assigned to the Lessee by the Lessor and originally recorded by the Lessee at the Lessor's cost. The transaction was recorded by the Lessee as a reduction of the applicable asset accounts and a reduction of the amount due to the Lessor, with no gain or loss being recognized. During 1998, the sewage treatment plant and related assets were sold to a third party for net proceeds of $650,000, of which $125,000 of the proceeds were received by the Lessor and recorded by the Lessee as a receivable from the Lessor. A gain of $266,000 was recognized in connection with the sale of these assets. Property and equipment consists of the following at December 31:
1998 1997 -------- ---------- Land $ -- $ 26,000 Sewage treatment plant and equipment -- 521,000 -------- ---------- -- 547,000 Hotel and computer equipment 233,000 2,622,000 -------- ---------- 233,000 3,169,000 Accumulated depreciation (79,000) (53,000) -------- ---------- $154,000 $3,116,000 ======== ==========
Depreciation expense for 1998, 1997 and 1996 totaled $67,000, $53,000 and $0, respectively. Revenue Recognition: Revenue is recognized as earned, which is generally defined as the date upon which a guest occupies a room or utilizes the hotel's services. Other Revenues: Other revenues consist of revenues derived from incidental hotel services such as concession, movie, golf, retail, fitness services and sublease revenues relating to the restaurants and retail shops. Revenues from incidental hotel services are recognized in the period the related services are provided. Sublease revenues for 1998 and 1997 totaled $2.5 million and $344,000, respectively. In 1998, other revenues also include the $266,000 gain on the sale of the sewage treatment plant and related assets. F-36 SUNSTONE HOTEL INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued Advertising and Promotion Costs: Advertising and promotion costs are expensed when incurred. Advertising and promotion costs represent the expense for franchise advertising and reservation systems under the terms of the hotel franchise agreements and general and administrative expenses that are directly attributable to advertising and promotions. Franchise Costs: Franchise costs represent the expense for franchise royalties under the terms of hotel franchise agreements, generally ranging from 10 to 20 years. Rent Expense: Rent expense is recognized as incurred to the Lessor under the Percentage Leases commencing on the date the lease is executed. Percentage rent is accrued prior to the Lessee achieving the baseline revenue that triggers the percentage rental expense when achievement of the baseline revenue is considered probable. Income Taxes: The Lessee has elected to be treated as an S Corporation under Subchapter S of the Internal Revenue Code. As a Subchapter S Corporation, the tax attributes of the Lessee will pass through to its stockholders, who will then owe any income related taxes. Accordingly, the accompanying statements of operations and stockholders' deficit do not include income tax expense. Fair Value of Financial Instruments: Management has estimated the fair value of its financial instruments. Considerable judgment is required in interpreting market data in order to develop estimates of the fair value of the Lessee's financial instruments. Accordingly, the estimated values are not necessarily indicative of the amounts that could be realized in current market exchanges. For those financial instruments for which it is practical to estimate fair value, management believes that the carrying amounts of the Lessee's financial instruments reasonably approximate their fair value at December 31, 1998 and 1997. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates in the near term. Reclassifications: Certain prior year balances have been reclassified to conform with the current year presentation. F-37 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies, continued Seasonality: The hotel industry is seasonal in nature. Seasonal variations in revenues may cause quarterly fluctuations in the Lessee's revenues. Comprehensive Income (Loss): In 1998, the Lessee adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS No. 130"), which establishes new standards for reporting and displaying of comprehensive income and its components; however, the adoption of SFAS No. 130 had no impact on the Lessee's net loss. SFAS 130 requires that the minimum pension liability adjustment be included in other comprehensive income (loss) which is reflected on the consolidated statements of changes in stockholders' deficit. There were no items of other comprehensive income in 1997 or 1996. Reportable Segments: During 1998, the Company adopted Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information ("Statement No. 131"). Statement No. 131 superseded Statement No. 14, Financial Reporting for Segments of a Business Enterprise. Statement No. 131 establishes standards for the way that public business enterprises report information regarding reportable operating segments. The adoption of Statement No. 131 did not affect the results of operations or financial position of the Lessee. The Lessee operates the Lessor's hotel properties which generated room, food and beverage and other revenues through the renting of hotel rooms and the operations of the food and beverage outlets to a diverse base of customers. The Lessee separately evaluates the performance of each of its hotels. However, because each of the hotels have similar economic characteristics, facilities and services, the hotel properties have been aggregated into a single dominant segment. The Lessee evaluates performance and allocates resources primarily based on revenue per available room, average daily rate and the occupancy rate of individual hotels. 3. Stockholders' Deficit The Lessee has incurred significant losses from its inception in 1995. At December 31, 1998, the Lessee's stockholders' deficit amounted to $10.5 million. At December 31, 1998, the Lessee's rent payable to the Lessor amounted to $7.5 million. Also at December 31, 1998, the Lessee's current liabilities exceeded its current assets by $9.8 million. The ability of the Lessee to fund its daily operations and continue to remain current on its substantial rent obligation to the Lessor is a result of the original terms under the Percentage Leases, for the payment of rent to the Lessor, which allow monthly base rent to be paid in arrears and monthly percentage rent to be paid within 45 days after the respective month end. The Lessee's $4.4 million net loss in 1998 as well as the $2.1 million and $3.2 million net losses in 1997 and 1996, respectively, were primarily due to the substantial renovations at the hotels the Lessee operates, resulting in a substantial number of rooms taken out of service which adversely impacted the hotels' operations and profitability. In 1998, 1997 and 1996, 20, 19 and 8 hotels, respectively, were subject to substantial renovations. Such renovations were made in conjunction with the Lessor's strategy of acquiring hotels that can benefit from extensive improvements, reflagging and repositioning, resulting in higher potential revenue. During periods of renovation, the hotels generally do not generate sufficient revenue to meet operating expenses, including lease payments. Accordingly, the Lessee incurred substantial operating losses primarily due to the terms of the Percentage Leases. F-38 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Stockholder Line of Credit On December 30, 1998, the Lessee entered into a $1.5 million line of credit with its primary stockholder. The line of credit bears interest at the prime rate plus 0.25%, is unsecured and has a maturity date of December 29, 1999. The line of credit is to be used exclusively for general short-term working capital needs. As of December 31, 1998, the unpaid balance on the line of credit was $650,000. 5. Other Commitments and Contingencies Ten of the Lessee's hotels have telephone service agreements with a telecommunications company which call for contingent payments based upon telephone usage. These agreements expire in June 2000. Expenses incurred pursuant to these service agreements totaled $2.9 million, $533,000 and $0 in 1998, 1997 and 1996, respectively. The Lessee has entered into various license and franchise agreements related to certain hotel properties. The agreements have terms ranging between 4 and 28 years and expire between 2001 and 2026. The agreements require the Lessee to, among other things, pay various monthly fees that are calculated based on specified percentages of certain specified revenues. The Lessee's obligations under certain of the agreements are guaranteed by either its shareholders or the Lessor. The Franchise Agreements generally contain specific standards for, and restrictions and limitations on, the operation and maintenance of the hotels which are established by the franchisors to maintain uniformity in the system created by each such franchisor. Such standards generally regulate the appearance of the hotel, quality and type of goods and services offered, signage, and protection of marks. Compliance with such standards may from time to time require significant expenditures for capital improvements which will be borne by the Lessor. The Lessee is involved from time to time in various claims and legal actions in the ordinary course of business. Management does not believe that the resolution of such matters will have a material adverse effect on the Lessee's financial position or results of operations when resolved. 6. Percentage Lease Agreements The Lessee has future commitments to the Lessor under the Percentage Leases through 2008. At December 31, 1998, future minimum rentals (base rents) payable under the Percentage Leases, exclusive of any base rent which may be abated during periods of major renovation, with the Lessor are as follows: 1999 $ 57,524,000 2000 57,524,000 2001 57,524,000 2002 57,524,000 2003 57,524,000 Thereafter 198,908,000 ------------ $486,528,000 ============
F-39 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Percentage Lease Agreements, (continued) The term of each lease is ten years. The Percentage Leases contain various covenants and are cross-defaulted. The rent payable under each lease is the greater of base rent (subject to annual adjustments based on increases in the United States Consumer Price Index) or percentage rent. Percentage rent is calculated as 9% to 50% of room revenues, up to a certain baseline revenue (the base rent component), then 60% to 68% of room revenues in excess of the baseline revenues. Generally, percentage rent also includes 5% of food and beverage revenue and 100% of net other revenues. Rent expense pursuant to the Percentage Leases for the year ended December 31, 1998, 1997 and 1996 was $98.7 million, $44.7 million and $14.8 million, respectively, of which $40.2 million, $19.8 million and $6.8 million, respectively, was in excess of base rents. The stockholders of the Lessee have collateralized the lease payments by pledging 481,955 of their Operating Partnership units of Sunstone Hotel Investors, L.P., a majority-owned partnership of the Lessor. At December 31, 1998, 317,645 of the Operating Partnership units pledged by the primary stockholder are also pledged to a senior lender to secure the credit facility issued to the primary stockholder. This credit facility will be used by the primary stockholder to fund the short-term working capital needs of the Lessee (see Note 4). The Lessor has subordinated its right under the collateral to the senior lender. In 1997, the Lessor and Lessee amended the Percentage Leases for hotels then currently under renovation and for any future hotels to allow for the abatement of base rent related to rooms taken out of service during major renovations. The Lessor abated $668,000 and $0 of base rent during 1998 and 1997, respectively. Upon the sale of a hotel by the Lessor, the respective Percentage Lease terminates. As provided for in the Percentage Leases and as compensation for the early termination, the Lessor is required to (i) pay the Lessee a termination fee of an amount equal to the net profit earned by the Lessee with respect to the hotels sold for the 12-month period preceding the sale or, (ii) offer to lease the Lessee one or more substitute hotel facilities pursuant to a similar lease. During 1998, the Lessor sold six hotels and terminated the related Percentage Leases. Such terminated leases were replaced with new leases in 1998 and no termination fee was due from the Lessor. Pursuant to the Percentage Leases, the Lessor is required to make available to the Lessee for the repair, replacement and refurbishment of furniture, fixtures and equipment in the hotels, when and as deemed necessary by the Lessee, an amount equal to 4% of room revenue per quarter on a cumulative basis. To the extent the amount is not fully utilized by the Lessee in any year, the Lessor may use the amount to fund certain capital expenditures. The Lessor is responsible for payment of (i) real estate and personal property taxes on its hotel properties (except to the extent that personal property associated with the hotels is owned by the Lessee), (ii) casualty insurance on the hotels, (iii) business interruption insurance on the hotels, and (iv) general liability insurance. The Lessee is required to pay for workers' compensation and other insurance appropriate and customary for properties similar to the Lessor's hotels with the Lessor as an additional named insured. 7. Retirement Plans The Lessee has a defined benefit plan covering union employees at certain properties located in Rochester, Minnesota. This was previously a plan of Kahler Realty Corporation ("Kahler"), which was assumed by the Lessor in connection with its acquisition of Kahler on October 15, 1997. The plan was assigned to the Lessee upon execution of the Percentage Leases of the related Kahler Hotels. Pension contributions and expenses for this plan are determined based on the actuarial cost of current service. During 1998, the Lessee adopted the requirements of SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits ("SFAS No. 132"), which requires the Lessee to revise the disclosures about pension and other postretirement benefit plans. SFAS No. 132 only revises the disclosure and does not change the measurement or recognition of those plans. Accordingly, the adoption of SFAS No. 132 did not have any impact on the financial position, operations or cash flows of the Lessee. F-40 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Retirement Plans, continued Net periodic pension cost for the defined benefit plan includes the following components for the year ended December 31, 1998 and for the period October 15, 1997 to December 31, 1997:
October 15, For the 1997 Year Ended through December December 31, 1998 31, 1997 ----------- ----------- Change in the Projected Benefit Obligation ("PBO") PBO at beginning of year $ 3,509,000 $ 3,467,000 Service cost 147,000 30,000 Interest cost 269,000 51,000 Benefits paid (185,000) (29,000) Actuarial loss (gain) 569,000 (10,000) ----------- ----------- PBO at end of year $ 4,309,000 $ 3,509,000 =========== =========== Change in the fair value of plan assets Fair value of assets at beginning of year $ 2,492,000 $ 2,597,000 Employer contributions 198,000 -- Benefits paid (185,000) (29,000) Actual return on assets 201,000 (76,000) ----------- ----------- Fair value of assets at end of year(1) $ 2,706,000 $ 2,492,000 =========== =========== Components of accrued pension cost Funded status $(1,603,000) $(1,017,000) Unrecognized net actuarial loss 567,000 -- ----------- ----------- Accrued pension cost $(1,036,000) $(1,017,000) =========== =========== Amounts recognized in the consolidated balance sheets Accrued pension liability $(1,603,000) $(1,017,000) Accumulated other comprehensive loss 567,000 -- ----------- ----------- Accrued pension cost recognized $(1,036,000) $(1,017,000) =========== =========== Change in the additional minimum pension liability recognized Change in accrued pension cost $ 567,000 $ -- ----------- ----------- Change in other comprehensive loss $ 567,000 $ -- =========== =========== Components of the net periodic pension cost recognized as expense Service cost $ 147,000 $ 30,000 Interest cost 269,000 51,000 Expected return on plan assets (200,000) (43,000) Amortization of unrecognized net actuarial loss 1,000 -- ----------- ----------- Net periodic pension cost recognized as expense $ 217,000 $ 38,000 =========== =========== Key economic assumptions Weighted-average discount rate 6.50% 7.00% Weighted-average expected long-term return on plan assets 8.00% 8.00%
The accumulated projected benefit obligation for the plan was $4.3 million and $3.5 million on December 31, 1998 and 1997, respectively. - -------- (1) Plan assets consist primarily of equity and fixed income securities. F-41 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Retirement Plans, continued The benefit formula is based upon a monthly benefit level of $14 times the years of benefit service. The Lessee's funding policy is to contribute amounts to the plan sufficient to meet minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such additional amount as the Lessee may determine appropriate from time to time. The Lessee also provides post-retirement benefits to a fixed number of retired employees of acquired hotels relating to service provided prior to 1992. At December 31, 1998 and 1997, the estimated liability was $137,000 and $179,000, respectively, and is included in other accrued expenses. The Lessee's employees may participate, subject to eligibility, in Sunstone Hotel Properties, Inc.'s Retirement and Savings Plan (the "401(k) Plan"). Employees are eligible to participate in the 401(k) Plan after attaining 21 years of age and performing one year of service and working at least 1,000 hours. Up to 6% of employee contributions are matched by the Lessee at 25%. Matching contributions made by the Lessee totaled $358,000, $69,000 and $11,000 for the years ended December 31, 1998, 1997 and 1996, respectively. 8. Stock Appreciation Rights Plan In July 1996, the Lessee adopted the 1996 Stock Appreciation Rights Plan (the "SAR Plan"), as amended, under which employees, consultants and nonemployee members of the Board of Directors of the Lessee are eligible to receive stock appreciation rights that are based upon the quoted market prices of the Lessor's common stock. All rights were issued at prices equal to the quoted market prices of the Lessor's common stock on the dates granted, had ten-year terms and vested over five years. Effective September 25, 1998, the SAR Plan was terminated and all unexercised stock appreciation rights issued under the SAR Plan are being canceled. The Lessee's stockholders have agreed to settle the Lessee's liability under the SAR Plan by assigning their personal warrants to acquire the Lessor's common stock to the holders of the stock appreciation rights being canceled. The fair value of the warrants being assigned effective September 25, 1998 was computed to be $498,000 based on the Black Scholes option pricing model. The $498,000 fair value was recorded as an equity contribution from the Lessee's stockholders. Deferred compensation expense of $498,000 was recorded on the balance sheet effective September 25, 1998, and will be amortized over the future vesting period of the assigned warrants. At December 31, 1998, the remaining unamortized deferred compensation expense totaled $189,000. The warrants being assigned will vest in accordance with the original vesting schedule of the stock appreciation rights being canceled. The stock warrants will be exercisable beginning October 25, 1999 and will expire September 25, 2003. 9. Other Related Party Transactions Sunstone Hotel Management, Inc. (the "Management Company"), a company wholly owned by the Lessee's primary stockholder, provides management services to the Lessee pursuant to the terms of a management agreement. The agreement has a one year term and is automatically renewed. Management fees are computed based on 1% to 2% of gross revenues. The cost of these services is classified as management fees in the statements of operations. In 1998, management fees totaling $3.3 million were permanently abated by the Management Company. Certain Lessee employees' salaries and identifiable employee expenses incurred in connection with acquisition and construction services are reimbursed by the Lessor. The reimbursements are recorded as a reduction of the related expenses. During the years ended December 31, 1998, 1997 and 1996, $962,000, $634,000 and $200,000 was reimbursed to the Lessee for such services, respectively. F-42 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Other Related Party Transactions, continued Upon the execution of each Percentage Lease, the Lessor assigns all hotel operating assets and liabilities to the Lessee at the Lessor's cost. The Lessee records all such hotel operating assets and liabilities at the Lessor's cost with a corresponding net amount payable to or receivable from the Lessor, depending on whether net assets or liabilities were assigned. During 1998, 1997 and 1996, the net assets assigned in this manner totaled $218,000, $1.9 million and $147,000, respectively. In connection with the Lessor's acquisition of Kahler Realty Corporation in October 1997, the Lessor assigned net liabilities to the Lessee and paid the Lessee $1.1 million, plus an additional $200,000 of assigned cash. The Lessee is reimbursed by the Lessor for certain costs it incurs related to the Lessor's renovation of the hotels. The total costs incurred and reimbursable by the Lessor totaled $1.6 million and $1.8 million in 1998 and 1997, respectively. No reimbursements were made to the Lessee in 1996. In addition, the Lessor reimburses the Lessee for general and administrative expenses incurred by the Lessee on behalf of the Lessor. The total costs reimbursable to the Lessee during 1998 and 1997 totaled $167,000 and $80,000, respectively. Amounts due from affiliates primarily represents reimbursements due from the Lessor netted with the amounts due to the Lessor for net hotel operating assets assigned by the Lessor to the Lessee upon the execution of each Percentage Lease. 10. Credit Risk and Collective Bargaining Agreements Financial instruments that potentially subject the Lessee to significant concentrations of credit risk consist principally of cash investments and trade accounts receivable. The Lessee maintains cash and cash equivalents and certain other financial instruments with various financial institutions. These financial institutions are located throughout the country and the Lessee's policy is designed to limit exposure to any one institution. The Lessee performs periodic evaluations of the relative credit standing of those financial institutions that are considered in the Lessee's investment strategy. At December 31, 1998 and 1997, the Lessee had amounts in banks that were in excess of federally- insured amounts. Concentrations of credit risk with respect to trade accounts receivable include accounts receivable from hotel guests from Middle Eastern countries totaling $1.7 million which represents 15% of total accounts receivable at December 31, 1998. Credit is extended based on an evaluation of the guests' financial condition, and collateral is generally not required. The Lessee provides for potential credit losses relating to the accounts receivable from these guests based on the Lessee's historical experience. Historically, credit losses associated with these accounts receivable have not been material to the hotels' results of operations. The Lessee is subject to collective bargaining agreements at certain hotels it operates. At December 31, 1998, the percentage of employees covered by such collective bargaining agreements represent approximately 11% of the total number of employees. 11. Year 2000 Issues (Unaudited) The term "Year 2000 Issue" is a general term used to describe the complications that may be caused by existing computer hardware and software that were designed by the respective manufacturers without consideration of the upcoming change in the century. Many computer systems recognize calendar years by the last two digits in the date code field. Beginning in the year 2000, these date code fields will need to accept four digit entries to distinguish twenty-first century dates from twentieth century dates. If not corrected, computer systems may fail or create erroneous results causing disruptions of operations. F-43 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Year 2000 Issues (Unaudited), continued The Lessee relies on information technology ("IT") systems and other systems and facilities such as PBX switches, elevators, heating, ventilation and air conditioning, security, fire and life safety and other environmental systems ("embedded systems") to conduct its business. Both the IT and the embedded systems are subject to the Year 2000 Issue which, if not remedied in time, could have an impact on the operations of the Lessee. The Lessee also may be exposed to risks from third parties with whom the Lessee interacts who fail to adequately address their own Year 2000 issues. Such third parties include franchisers, vendors, suppliers and significant customers. To mitigate and minimize the number and seriousness of any disruptions caused by the Year 2000 Issue, the Lessee has developed and adopted a Year 2000 Compliance Program (the "Compliance Program") which involves the following four phases: assessment, which includes development of an action plan and inventorying of the hotels' systems, remediation, testing, and implementation. With the assistance of outside consultants, site surveys are being performed and all hotels' systems will be identified and inventoried and will include information such as the manufacturer or vendor who performed the installation, currently services or maintains each system. The Lessee has begun contacting these vendors to obtain certification relating to their Year 2000 compliance testing. In addition, all parties for building systems that service leased premises, or a facility within which leased premises are located and are operated and controlled by or interact with a software program will be identified and contacted. It should be noted that due to the complexity of some of the systems, in many cases, the only way to determine the potential impact of the systems would be to verify the Year 2000 effect with the particular vendor. The assessment phase will be completed by the end of the first quarter 1999. Status of Progress in Becoming Year 2000 Compliant, Including Timetable for Completion of Each Remaining Phase--Hotel and Lessee Systems Based on the results of the site assessments, the identified IT and embedded systems will be replaced or upgraded. The system upgrades will be prioritized according to their critical importance. Life safety systems and emergency services will take priority in accordance with the steps laid out in the action plan. The various vendors associated with any system replacements or upgrades will be contacted to determine their readiness to deal with these system enhancements. Performance of certain testing by the vendors may be required in several cases to ensure Year 2000 compliance. All vendors, manufacturers, service personnel, consultants, contractors, lessees and lessors will be requested to prepare a letter certifying and warranting that all systems, utilities and services containing time and date-related coding and internal programs, shall continue without interruption beyond December 31, 1999. The implementation will be monitored and managed on a real-time basis to ensure a smooth upgrade of the systems. Completion of the implementation and testing phases for all significant systems is expected by June 30, 1999, with all remediated systems fully tested and implemented by September 30, 1999, with 100% completion targeted for October 31, 1999. Nature and Level of Importance of Third Party Systems and their exposure to the Year 2000. The Lessee is in the process of surveying its vendors and service providers that are critical to the Lessee's business to determine whether they are Year 2000 compliant. The Lessee expects that these surveys will be completed by the end of the second quarter of 1999, but cannot guarantee that all vendors or service providers will respond to the survey, and therefore the Lessee may not be able to determine Year 2000 compliance of those vendors or service providers. By the end of the second quarter of 1999, the Lessee will determine the extent to which the Lessee will be able to replace those vendors not in compliance. There may be instances in which the Lessee will have no alternative but to remain with non-compliant vendors or service providers. The inability of vendors to complete their Year 2000 resolution process in a timely fashion could materially impact the Lessee. The effect of compliance by vendors is not determinable. F-44 SUNSTONE HOTEL PROPERTIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Year 2000 Issues (Unaudited), continued Cost of Addressing Year 2000 Issues: The Lessee estimates that total costs for the Year 2000 compliance review, evaluation, assessment and remediation efforts should not exceed $1.0 million and will be funded by the Lessor through its operating cash flows. To date, the costs incurred to address the Year 2000 issue consist primarily of services provided by outside consultants for on-site system surveys at a total cost of $163,000 which was expensed by the Lessor in the first quarter of 1999. The remaining balance is anticipated to be expended in 1999. Risks Presented by Year 2000 Issues: Management of the Lessee believes it has an effective plan in place to resolve the Year 2000 Issue in a timely manner. As noted above, the Lessee has not yet completed all necessary phases of the Year 2000 program. In the event that the Lessee does not complete any additional phases, the Lessee may encounter system failures associated with third-party vendors such as disruptions in passenger transportation or transportation systems generally, loss of utility and telecommunications services, the loss or disruption of hotel reservations made on centralized reservation systems and errors or failures in financial transactions or payment processing systems such as credit cards. These disruptions could adversely affect the Lessee, its business and its financial condition. The Lessee cannot predict the actual effects of the Year 2000 Issue on its business; such effects depend on numerous uncertainties such as whether significant third parties have properly and timely address the Year 2000 Issue and whether broad-based or systemic economic failures may occur. Due to the general uncertainty inherent in the Year 2000 Issue and the Lessee's dependence on third parties, the Lessee is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Lessee. Contingency Plan: The Lessee is in the process of developing its contingency plan for the systems operated and maintained by the Lessee and the hotels. This is necessary in order to provide for the most likely worst case scenarios regarding Year 2000 compliance. The contingency plan is expected to be completed in 1999. 12. Subsequent Events In January 1999, an additional $800,000 was drawn on the stockholder line of credit by the Lessee for working capital needs. In February 1999, the Lessee paid down $644,000, plus related unpaid accrued interest, on the stockholder line of credit. In February 1999, the Lessor sold a hotel property located in Arcadia, California and the related Percentage Lease was terminated. No termination fee is due from the Lessor in connection with the lease termination as the Lessor anticipates offering the Lessee a substitute hotel facility within the 180 days allowed under the Percentage Lease agreement. On February 15, 1999, the Lessee began leasing office space from the Lessor when it moved its corporate facilities into a building owned by the Lessor. F-45 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors Sunstone Hotel Properties, Inc. We have audited the accompanying consolidated statement of operations, stockholders' deficit, and cash flows of Sunstone Hotel Properties, Inc. and its subsidiaries (the "Lessee") for the year ended December 31, 1996. These financial statements are the responsibility of the Lessee's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Sunstone Hotel Properties, Inc. and its subsidiaries for the year ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND LLP San Francisco, California February 28, 1997 F-46 EX-10.1(16) 2 COUNTERPART SECOND AMENDED AND RESTATED AGREEMENT EXHIBIT 10.1.16 COUNTERPART SECOND AMENDED AND RESTATED AGREEMENT OF LIMITED PARTNERSHIP FOR ADMISSION OF ADDITIONAL LIMITED PARTNER TO SUNSTONE HOTEL INVESTORS, L.P. This Counterpart Second Amended and Restated Agreement of Limited Partnership for Admission of Additional Limited Partner to Sunstone Hotel Investors, L.P. (this "Counterpart Partnership Agreement") is executed as of the --------------------------------- date set forth on the signature page by Sunstone Hotel Investors, Inc., a Maryland corporation, in its individual capacity (the "Company") and in its ------- capacity as the General Partner (the "General Partner") of Sunstone Hotel --------------- Investors, L.P. (the "Partnership") and the individual listed on the signature ----------- page, as the newly admitted limited partner of the Partnership (the "Additional ---------- Limited Partner"). All defined terms not otherwise defined herein shall have - --------------- the meaning set forth in the Agreement (as defined below). RECITALS A. WHEREAS, the General Partner and certain Limited Partners executed that certain Second Amended and Restated Agreement of Limited Partnership dated as of October 14, 1997 (the "Agreement"), amending and restating that certain First --------- Amended and Restated Limited Partnership Agreement dated as of August 16, 1995, governing, among other things, the rights and obligations of the constituent partners of the Partnership. B. WHEREAS, the Additional Limited Partner has entered into a Capital Contribution Agreement (the "Contribution Agreement") with the Partnership pursuant to which the hotel owned by the Additional Limited Partner will be contributed to the Partnership. C. WHEREAS, pursuant to Section 2.3(a) of the Capital Contribution Agreement between Additional Limited Partner and the Partnership, the Partnership shall, upon Closing (as defined in the Contribution Agreement), admit Additional Limited Partner as a limited partner of the Partnership, and shall issue to Additional Limited Partner the number of Partnership Units equal to the Acquisition Value (as defined in the Contribution Agreement) divided by the Unit Closing Value (as defined in the Contribution Agreement). D. WHEREAS, the General Partner consents, as evidenced by its signature, to the said issuance of Partnership Units and to the admission of the Additional Limited Partner as a Limited Partner as of effective date of issuance listed on Schedule A attached hereto (the "Effective Date"). E. WHEREAS, in order to evidence the issuance of the Partnership Units and the admission of the Additional Limited Partner into the Partnership, and the agreement of the Additional Limited Partner to be bound by the terms of the Agreement, the parties hereto are executing this Counterpart Partnership Agreement. NOW, THEREFORE, the parties hereto agree as follows: 1. Admission of Additional Limited Partner. The Additional Limited Partner --------------------------------------- is hereby admitted as a Additional Limited Partner effective as of Effective Date and the General Partner acknowledges and confirms that upon delivery of the executed copy of this Counterpart Partnership Agreement, the Additional Limited Partner will have complied with all requirements for admission as a Limited Partner of the Partnership and as such shall have all rights of a Limited Partner including without limitation Redemption Rights and Registration Rights. The General Partner shall, if it has not already done so, instruct the Transfer Agent to issue the number of Partnership Units listed on Schedule A and to reflect such issuance on the Partnership Unitholder Ledger. The Additional Limited Partner has listed its address for notices on Schedule A. 2. Agreement to be Bound. The Additional Limited Partner acknowledges it --------------------- has read and understands the Agreement and hereby agrees to be bound by each of the terms and conditions of the Agreement, which are hereby incorporated by reference in full as if set forth herein. 3. Power of Attorney. The Additional Limited Partner hereby irrevocably ----------------- constitutes and appoints the General Partner, any Liquidator, and authorized officers and attorneys-in-fact of each, and each of those acting singly, in each case with full power of substitution, as its true and lawful agent and attorney- in-fact, with full power and authority in its name and place instead to perform any of the acts set forth in Section 8.2 of the Agreement. ----------- 4. Representation of Additional Limited Partner. Without limiting any -------------------------------------------- representations and warranties set forth in the Contribution Agreement, the Additional Limited Partner hereby represents and warrants to the General Partner and to the Partnership that its acquisition of its Partnership Interest is made for its own account for investment purposes only and not with a view to the resale or distribution of such Partnership Interest. The Additional Limited Partner hereby agrees that its will not sell, assign or otherwise transfer its Partnership Interest or any fraction thereof, whether voluntarily or by operation of law or judicial sale or otherwise, to any Person who does not make the representations and warranties to the General Partners set forth in Section 9.1(a) and similarly agrees not to sell, assign or transfer such Partnership Interest or fraction thereof to any Person who does not similarly represent, warrant and agree. 5. Authority of Authorized Representative. Listed on Schedule A is the -------------------------------------- person who is the authorized representative of the Additional Limited Partner. The General Partner and the Partnership are permitted to rely on the authority of such authorized representative to bind the Additional Limited Partner for all purposes including, without limitation, for the payment of dividends, for the giving of notices, for the vote or approval of any issues for which the consents or the approval of the Limited Partners is required under the Agreement. The Additional Limited Partner may authorize a new authorized representative by providing written notice to the General Partner at its executive office, together with evidence in a form satisfactory to the General Partner including, if requested, an opinion of counsel, confirming that the new authorized representative has the authority to bind the Additional Limited Partner. The Additional Limited Partner hereby represents and warrants that all consents, approvals or other actions that were necessary in order to authorize the Contribution Agreement and the decisions to be made by the Additional Limited Partner under the Partnership Agreement have been properly authorized and approved in accordance with the terms of the partnership agreement or other charter document of the Additional Limited Partner. IN WITNESS WHEREOF, the parties hereto have executed this Counterpart Partnership Agreement as of the date first written above. GENERAL PARTNER ADDITIONAL LIMITED PARTNER SUNSTONE HOTEL INVESTORS, INC., a Maryland corporation and the sole General Partner --------------------------- Name of Entity --------------------------- By: Authorized Signature ------------------------- Robert A. Alter Its: President --------------------------- Printed Name --------------------------- Title SCHEDULE A ---------- Information Regarding Admission of Additional Limited Partner Name of Additional Limited Partner: ------------------------- Nature of Entity (e.g., Partnership, L.L.C., etc.): ------------------------- Effective Date: ------------------------- Address: ------------------------- Authorized Representative: ------------------------- No. of Units: ------------------------- EX-10.2(36) 3 SCHEDULE OF MATERIAL DIFFERENCES EXHIBIT 10.2.36 SCHEDULE OF MATERIAL DIFFERENCES AMONG PERCENTAGE LEASES FOR 1998 The following lists of material differences between the Percentage Lease filed as Exhibit 10.2 and the Percentage Lease identified by Exhibit 10.2.36 and is being filed pursuant to Instruction 2 to Item 601 of Regulation S-K.
Annual lst Tier Tier 2nd Tier Food/Beverage Name City State Inception Base Rent Amount Percent Percent Percent - -------------------- ------------- ----- --------- ------------ ---------- ------- -------- ------------- Ramada Old Town San Diego CA 1/23/98 $ 891,000 $2,043,000 43.6% 60% 5% Residence Inn Santa Clarita CA 1/27/98 $ 775,000 $1,911,000 40.6% 60% 5% Fairfield Inn Santa Clarita CA 1/27/98 $ 370,000 $1,015,000 36.5% 60% 5% Hilton Inn Carson CA 2/19/98 $ 932,000 $2,509,000 37.1% 60% 5% Radisson Oxnard CA 4/9/98 $ 617,000 $2,576,000 24.0% 62% 5% Hampton Inn Santa Clarita CA 4/30/98 $ 634,000 $1,877,000 33.8% 60% 5% Napa Valley Marriott Napa CA 5/5/98 $1,455,000 $4,275,000 34.0% 60% 5% Days Inn Santa Clara CA 5/13/98 $1,574,000 $3,124,000 47.0% 60% 5% Pueblo Marriott Pueblo CO 8/13/98 $ 756,000 $2,910,000 26.0% 62% 5% Pacific Shore Hotel Santa Monica CA 9/4/98 $1,452,000 $3,038,000 47.8% 62% 5%
EX-10.31(3) 4 2ND AMENDMENT TO REVOLVING CREDIT AGREEMENT EXHIBIT 10.31.3 SECOND AMENDMENT TO AMENDED AND RESTATED REVOLVING CREDIT AGREEMENT THIS SECOND AMENDMENT TO AMENDED AND RESTATED REVOLVING CREDIT AGREEMENT ("Amendment") is dated as of July 22, 1998, among SUNSTONE HOTEL INVESTORS, L.P., a Delaware limited partnership, as the Borrower, BANK ONE, ARIZONA, NA, as a Lender, as Issuing Bank, as Administrative Agent and as Co- Agent, CREDIT LYONNAIS NEW YORK BRANCH, as a Lender, as Documentation Agent and as Co-Agent, WELLS FARGO BANK, NATIONAL ASSOCIATION, as a Lender, as Syndication Agent and as Co-Agent, DRESDNER BANK AG, NEW YORK AND GRAND CAYMAN BRANCHES, as a Lender, and SOCIETE GENERALE, SOUTHWEST AGENCY, as a Lender (collectively, the "Original Bank Group"), NATIONSBANK, N.A. (successor to NATIONSBANK OF TEXAS, N.A.), as a Lender, COMMERZBANK AG, LOS ANGELES BRANCH, as a Lender, and THE LONG-TERM CREDIT BANK OF JAPAN, LTD., LOS ANGELES AGENCY, as a Lender (collectively, the "Syndication Banks") and AMSOUTH BANK, as a Lender ("AmSouth"). W I T N E S S E T H: WHEREAS, the Borrower and the Original Bank Group entered into that certain Amended and Restated Revolving Credit Agreement dated as of October 10, 1997, as amended by First Amendment to Amended and Restated Revolving Credit Agreement dated as of January 26, 1998 (the "Credit Agreement") providing for Loans to the Borrower not to exceed $300,000,000 at any time outstanding; and WHEREAS, by Assignment and Acceptance dated March 20, 1998, Bank One, Arizona, NA, Credit Lyonnais New York Branch and Wells Fargo Bank, National Association (collectively, the "Co-Agents") assigned to the Syndication Banks and First American Bank Texas, S.S.B. ("First American") interests in the Co- Agents' Commitments; and WHEREAS, on or before the date hereof, the interests of First American as a Lender under the Credit Agreement have been terminated and AmSouth Bank has become a Lender under the Credit Agreement with a Commitment in the amount of $25,000,000.00; and WHEREAS, the Borrower has requested the Lenders to increase the total Commitments to $350,000,000 and, pursuant to Section 2.17 of the Credit Agreement, the Borrower has requested the Lenders to extend the Final Maturity Date to July 1, 2000; and WHEREAS, the Lenders have agreed to increase the total Commitments and to extend the Final Maturity Date as requested by the Borrower, subject to the modification of 1 certain other provisions of the Credit Agreement, all on and subject to the terms and conditions hereinafter set forth. NOW, THEREFORE, in consideration of the covenants and agreements herein contained, the parties hereto amend the Credit Agreement, and covenant and agree, as follows: 1. Defined Terms. -------------- 1.1 Terms used herein and not defined herein shall have the meanings provided therefor in the Credit Agreement. 1.2 The definitions of the following terms in the Credit Agreement are hereby amended as follows: (a) The definition of the term "Applicable Margin" is hereby amended by adding, at the end of the table therein, the following status and amounts: Unused Base Rate Eurodollar Rate Commitment Loans Loans Fee --------- --------------- ---------- Level IX Status 0.375% 2.00% 0.30% (b) The definition of the term "Borrowing Base" is hereby amended by changing the reference "45%" to "50%." (c) The definition of the term "Contingent Obligation" is hereby amended by adding the following sentence immediately following the first sentence thereof: Notwithstanding the foregoing, the Contingent Obligations of the Borrower shall not include any guarantee of the obligations of the Manager or the Operating Lessee to pay fees under a License until such time as the licensor notifies the Borrower that such fees have not been paid when due or otherwise makes demand upon the Borrower for payment thereof. (d) The definition of the term "Status" is hereby amended by deleting from the definition of "Level VIII Status" therein the period at the end of the sentence and inserting in lieu thereof "; and" and by adding the following paragraph thereafter: "Level IX Status" exists at any date if, at such date, (i) --------------- neither Level IV Status nor any Status above Level IV Status exists and (ii) Sunstone has a Leverage Ratio of 45% or more. 2 1.3 The following definition is hereby added to the Credit Agreement: "Year 2000 Compliant" means, with respect to any Person or property, that all software, hardware, equipment, goods or systems utilized by or material to the physical operations, business operations or financial reporting of such Person or property will perform date-sensitive functions (including leap year calculations) as properly and efficiently after December 31, 1999 as performed prior to January 1, 2000. 2. Increase of Commitments. (a) The aggregate amount of the ----------------------- Commitments is hereby increased by $50,000,000 to $350,000,000, and from and after the Funding Date the Commitment of each Lender is as set forth in Schedule -------- II attached hereto and hereby incorporated herein, which replaces Schedule II to - -- ----------- the Credit Agreement. (b) On the date ("Funding Date") heretofore or hereafter designated by the Administrative Agent, AmSouth and each of the Co-Agents shall fund to the Administrative Agent such amounts as may be required to cause each of them to hold Loans in the proportion that its Commitment bears to all Commitments (as increased and adjusted as provided in paragraph 3), and the Administrative Agent shall distribute the funds so received to the other Lenders in such amounts as may be required to cause each of them to hold Loans in the proportion that its Commitment bears to all Commitments (as increased and adjusted as provided in paragraph 3). The first payment of interest received by the Administrative Agent after the Funding Date shall be paid to the Lenders in amounts adjusted to reflect the adjustments of their respective pro rata shares of the Loans as of the Funding Date. 3. Extension of Final Maturity Date. The Final Maturity Date is -------------------------------- hereby extended to July 1, 2000. Pursuant to the provisions of Section 2.17(b) of the Credit Agreement, an extension fee in the amount of 0.25% of the Commitments is due and payable by the Borrower on the date hereof, but no extension fee is payable with respect to the $50,000,000 increase in the Commitments provided for in Paragraph 2(a) above. 4. Modification of Section 2.17. Section 2.17 is hereby amended by ---------------------------- changing the reference "thirty (30) days" in each place in which it occurs to "forty-five (45) days". 5. Modification of Section 5.18. Section 5.18(c) is hereby amended ---------------------------- by changing the reference "$15,000,000" to "$30,000,000." 6. Modification of Section 6.4. Section 6.4 is hereby amended --------------------------- (a) by changing in subparagraph (i) thereof the phrase "multiplied by four and one-half (4-1/2)" to "multiplied by five (5)" and (b) by changing, in both subparagraph (i) and subparagraph (ii) thereof, the references "forty-five percent (45%)" to "fifty percent (50%)." 3 7. Acquisition of Newly-Constructed Hotels. The following --------------------------------------- provision is hereby added to the Credit Agreement: 6.8. Acquisition of Newly-Constructed Hotels. (a) Neither Sunstone nor --------------------------------------- the Borrower nor any of their respective Subsidiaries shall consummate (whether or not contractually obligated to do so) the acquisition of a newly-constructed Hotel unless (i) taking into account all Indebtedness of Sunstone as of the date of such acquisition (including without limitation any Indebtedness incurred, directly or indirectly, to finance such acquisition in whole or in part), Sunstone shall be in compliance with the provisions of Sections 6.4, 6.5 and 6.6 upon the consummation of such acquisition and (ii) the Borrower shall furnish to the Administrative Agent prior to such acquisition a certificate of the chief financial officer of Sunstone (together with such supporting documentation as the Administrative Agent shall require) with respect to such compliance, all in form and substance satisfactory to the Administrative Agent. For purposes of establishing such compliance with the provisions of Sections 6.4, 6.5 and 6.6 as of the date of acquisition of such Hotel, all determinations shall be made on the basis of the financial statements as at the end of the most recent Fiscal Quarter preceding the date of such acquisition, except that (A) Total Indebtedness (in the case of Section 6.4), Total Secured Recourse Indebtedness (in the case of Section 6.5) and Non-Recourse Indebtedness (in the case of Section 6.6) shall each be determined as of the date of acquisition of such Hotel and (B) all Hotels (but only those Hotels) owned by the Borrower and its Subsidiaries as of the date of acquisition of such Hotel (and including such Hotel) shall be included for purposes of determining such compliance. In the event that, as of the date of acquisition of such Hotel, the financial statements for the most recent Fiscal Quarter are not yet available, the certificate required to be delivered under clause (ii) above shall be prepared on the basis of reasonable estimates by the Borrower's management of the applicable financial information as at the end of such most recent Fiscal Quarter, and such certificate shall then be promptly updated when the financial statements for such Fiscal Quarter are available. (b) Not later than thirty (30) days after the date on which the Borrower, Sunstone or any of their respective Subsidiaries enter into a contract to acquire a Hotel to be constructed or under construction, the Borrower shall provide the Administrative Agent with a copy of such contract, along with a general description of such Hotel (including location and number of rooms). 8. Financial Statements. Section 7.11(g) is hereby modified by -------------------- changing the reference "one hundred (100) days" to "one hundred twenty (120) days." 9. Year 2000 Covenant. The following provision is hereby added to ------------------ the Credit Agreement: 4 7.25 Year 2000 Covenant. The Borrower shall ensure that Sunstone, ------------------ the Borrower and each of their Subsidiaries are Year 2000 Compliant in a timely manner, but in no event later than October 1, 1999. The Borrower shall use its best efforts to cause the Operating Lessee, the Manager and each of the Hotels owned by Sunstone, the Borrower or any of their Subsidiaries to be Year 2000 Compliant in a timely manner and shall cause each of the foregoing to be Year 2000 Compliant not later than December 31, 1999 if the failure to be Year 2000 Compliant could have a Material Adverse Effect. The Borrower shall, or shall cause the Operating Lessee or Manager to, make reasonable inquiries of all major contractors of the Borrower, Sunstone, their Subsidiaries, the Hotels, the Operating Lessee and the Manager to confirm that such major contractors are, or will be no later than December 31, 1999, Year 2000 Compliant and will request from such major contractors reasonable verification thereof. For purposes of this section, "major contractors" means those Persons who make payments, or furnish goods or services, to the Borrower, Sunstone, any of their Subsidiaries, any of the Hotels, the Operating Lessee or the Manager, the failure of which Persons to be Year 2000 Compliant could have a Material Adverse Effect. In furtherance of this covenant, the Borrower shall, in addition to any other necessary actions, perform or cause to be performed a comprehensive review and assessment of all software, hardware, equipment, goods and systems utilized or material to the physical operations, business operations or financing reporting of the Borrower, Sunstone, their Subsidiaries, the Hotels, the Operating Lessee and the Manager, and shall adopt or cause to be adopted a detailed plan for the testing, remediation and monitoring of such software, hardware, equipment, goods and systems to ensure compliance with the foregoing provisions. The Borrower shall, within thirty (30) days of the Administrative Agent's written request, provide to the Administrative Agent such certification or other evidence of the Borrower's compliance with the provisions of this section as the Administrative Agent may from time to time reasonably require. 10. Limitations on Development, Construction, Renovation and -------------------------------------------------------- Purchase of Hotels. Section 8.5 is hereby amended and restated in its entirety - ------------------ as follows: 8.5 Limitations on Development, Construction, Renovation and -------------------------------------------------------- Purchase of Hotels. Neither Sunstone nor the Borrower shall or shall ------------------ permit any of their respective Subsidiaries to (a) engage in the development or construction of any Hotels with respect to which the cost to complete the same shall be any time exceed, for all such development and construction in the aggregate, the lesser of (i) ten percent (10%) of Total Hotel Value and (ii) $50,000,000, (b) engage in the renovation of (including construction of additions to) any Hotels with respect to which the cost to complete the same shall at any time exceed in the aggregate the lesser of (i) fifteen percent (15%) of Total Hotel Value and (ii) $100,000,000, or (in the aggregate with costs described in clause (a)) the lesser of (A) twenty percent (20%) of Total Hotel Value and (B) $125,000,000, (c) contract to purchase or acquire any Hotels under construction or to 5 be constructed with respect to which the purchase price and other consideration payable therefor shall at any time exceed in the aggregate the lesser of (i) fifteen percent (15%) of Total Hotel Value and (ii) $120,000,000 (without regard to whether the payment thereof is a recourse obligation of Sunstone, the Borrower or any of their respective Subsidiaries), or (d) engage in the development or construction of Hotels (without regard to whether the same is permitted under clauses (a), (b) or (c) above) or enter into any agreements to purchase Hotels (whether under construction, to be constructed or otherwise) or other assets, unless Sunstone, the Borrower or such Subsidiary (as applicable) at all times has available sources of capital equal to the total cost to complete such development or construction and to pay in full the cost of the purchase of such Hotels or other assets (to the extent that the payment of such cost of purchase constitutes a recourse obligation of Sunstone, the Borrower or its Subsidiary), which available sources of capital may include the Available Credit to the extent that the Borrower may borrow the same for the purposes required. 11. Pricing. Notwithstanding anything to the contrary set forth in ------- the Credit Agreement, the Borrower shall deliver to the Administrative Agent, on or before the date hereof, the quarterly financial statements provided for in Section 7.11(a) for the Fiscal Quarter ending June 30, 1998, together with the Compliance Certificate provided for in Section 7.11(e) setting forth the Leverage Ratio as of the end of such Fiscal Quarter, provided, however, that, to -------- ------- the extent that all financial information necessary to deliver such financial statements and Compliance Certificate is not then available, Borrower may satisfy the requirements of this paragraph by delivering financial statements and information in sufficient detail to determine the Leverage Ratio at the end of such Fiscal Quarter. Notwithstanding anything to the contrary contained in the Credit Agreement, the Funding Date shall be the Pricing Date with respect to the determination of Status based on the Leverage Ratio for the Fiscal Quarter ending June 30, 1998, Status shall be determined on such date and such Status shall remain in effect until a change in Status thereafter occurs. The provisions of this paragraph shall not relieve the Borrower of any of its obligations under Section 7.11 of the Credit Agreement and shall not affect any Pricing Date or any determination of Status except as expressly set forth herein. 12. Closing Deliveries. Prior to or simultaneously with the ------------------ execution and delivery of this Amendment, and as a condition to this Amendment, the Borrower shall deliver to the Administrative Agent the following: (a) Payment of (i) the fees provided for in Paragraph 3 above, (ii) the fees provided for in the letter agreements dated May 20, 1998 and July 14, 1998 and (iii) all costs and expenses (including reasonable attorneys' fees and expenses) incurred in connection with this Amendment; (b) Notes payable to AmSouth and each of the Co-Agents, each such Note to be in the amount of such Lender's Commitment (as provided in Paragraph 2(a)); 6 (c) The Consent of Guarantors attached to this Amendment; (d) Certificates of good standing, certified corporate resolutions and incumbency certificates with respect to, and opinions of counsel for, the Borrower and Sunstone, all in form and substance satisfactory to the Administrative Agent; and (e) The financial statements and Compliance Certificate provided for in Paragraph 11 above. 13. Ratification. The Credit Agreement (as amended hereby) and the ------------ other Loan Documents are hereby ratified and remain in full force and effect. 14. Execution in Counterparts. This Amendment may be executed in ------------------------- any number of counterparts and by different parties hereto in separate counterparts, each of which 7 when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same agreement. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed by their respective officers, thereunto duly authorized, as of the date first above written. BORROWER: SUNSTONE HOTEL INVESTORS, L.P. By: Sunstone Hotel Investors, Inc. its general partner By: _____________________________ Name: Title: LENDERS: BANK ONE, ARIZONA, NA as Administrative Agent, Co-Agent, Issuing Bank and Lender By: _____________________________ Name: Title: CREDIT LYONNAIS NEW YORK BRANCH as Documentation Agent, Co-Agent and Lender By: _____________________________ Name: Title: WELLS FARGO BANK, NATIONAL ASSOCIATION as Syndication Agent, Co-Agent and Lender 8 By: _____________________________ Name: Title: 9 DRESDNER BANK AG, NEW YORK AND GRAND CAYMAN BRANCHES, as Lender By: _____________________________ Name: Title: By: _____________________________ Name: Title: SOCIETE GENERALE, SOUTHWEST AGENCY, as Lender By: _____________________________ Name: Title: NATIONSBANK OF TEXAS, N.A., as Lender By:_____________________________ Name: Title: COMMERZBANK AG, LOS ANGELES BRANCH, as Lender By:______________________________ Name: Title: By:_______________________________ Name: Title: THE LONG-TERM CREDIT BANK OF JAPAN, LTD., LOS ANGELES AGENCY, as Lender 10 By:________________________________ Name: Title: AMSOUTH BANK, as Lender By:_____________________________ Name: Title: 11 CONSENT OF GUARANTORS --------------------- Each of the undersigned, being a Guarantor (as defined in the Credit Agreement referred to in the foregoing Amendment) does hereby consent to the foregoing Amendment, and ratify and affirm that the Guaranty (as defined in the Credit Agreement) heretofore executed by the undersigned remains in full force and effect for the benefit of the Lenders under the Credit Agreement, as amended by the foregoing Amendment. This Consent of Guarantors may be executed in counterparts and by different parties hereto in separate counterparts, each of which when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same document. IN WITNESS WHEREOF, the undersigned have executed and delivered this Consent of Guarantors as of this ____ day of July, 1998. Sunstone Hotel Investors, Inc. By: _________________________ Its: ________________________ _____________________________ Robert A. Alter _____________________________ Charles Biederman _____________________________ Daniel E. Carsello _____________________________ Gerald N. Clark _____________________________ C. Robert Enever Peacock, LLC By: _________________________ Its: ________________________ Shivani, L.L.C. By: _________________________ 12 Its: ________________________ SCHEDULE II COMMITMENTS Lender Commitment ------ ---------- Bank One, Arizona, NA $ 66,000,000.00 Credit Lyonnais New York Branch $ 66,000,000.00 Wells Fargo Bank, National $ 66,000,000.00 Association Dresdner Bank AG, New York $ 35,000,000.00 and Grand Cayman Branches Societe Generale, Southwest $ 27,000,000.00 Agency NationsBank of Texas, NA $ 27,000,000.00 AmSouth Bank $ 25,000,000.00 Commerzbank AG, Los Angeles Branch $ 19,000,000.00 The Long-Term Credit Bank of Japan, Ltd., Los Angeles Agency $ 19,000,000.00 --------------- TOTAL: $350,000,000.00 =============== 13 EX-10.31(4) 5 3RD AMENDMENT TO REVOLVING CREDIT AGREEMENT EXHIBIT 10.31.4 THIRD AMENDMENT TO AMENDED AND RESTATED REVOLVING CREDIT AGREEMENT THIS THIRD AMENDMENT TO AMENDED AND RESTATED REVOLVING CREDIT AGREEMENT ("Amendment") is dated as of August 12, 1998, among SUNSTONE HOTEL INVESTORS, L.P., a Delaware limited partnership, as the Borrower, BANK ONE, ARIZONA, NA, as a Lender, as Issuing Bank, as Administrative Agent and as Co- Agent, CREDIT LYONNAIS NEW YORK BRANCH, as a Lender, as Documentation Agent and as Co-Agent, WELLS FARGO BANK, NATIONAL ASSOCIATION, as a Lender, as Syndication Agent and as Co-Agent, DRESDNER BANK AG, NEW YORK AND GRAND CAYMAN BRANCHES, as a Lender, and SOCIETE GENERALE, SOUTHWEST AGENCY, as a Lender, NATIONSBANK, N.A. (successor to NATIONSBANK OF TEXAS, N.A.), as a Lender, COMMERZBANK AG, LOS ANGELES BRANCH, as a Lender, THE LONG-TERM CREDIT BANK OF JAPAN, LTD., LOS ANGELES AGENCY, as a Lender and AMSOUTH BANK, as a Lender. W I T N E S S E T H: WHEREAS, the Borrower and the Lenders are party to that certain Amended and Restated Revolving Credit Agreement (as amended, supplemented or otherwise modified from time to time, the "Credit Agreement") dated as of October 10, 1997, and heretofore amended by First Amendment to Amended and Restated Revolving Credit Agreement dated as of January 26, 1998 and by Second Amendment to Amended and Restated Revolving Credit Agreement dated as of July 22, 1998; and WHEREAS, the Borrower has requested the Lenders to consent to the Senior Notes (as hereinafter defined) and the Lenders have agreed to consent thereto, all on and subject to the terms and conditions hereinafter set forth. NOW, THEREFORE, in consideration of the covenants and agreements herein contained, the parties hereto amend the Credit Agreement, and covenant and agree, as follows: 1. Defined Terms. ------------- 1.1 Terms used herein and not defined herein shall have the meanings provided therefor in the Credit Agreement. 1.2 The following definitions in the Credit Agreement are hereby amended: 1 (a) The definition of the term "Guaranty" is hereby amended and restated as follows: "Guaranty" means the Sunstone Guaranty, any Subsidiary Guaranty or any of the Limited Guaranties. (b) The definition of the term "Unencumbered" is hereby amended by inserting at the end of the second parenthetical phrase at the end of subparagraph (c) the following: but excluding the equal and ratable liens provided for in Section 3.4(d). 1.3 The following definitions are hereby added to the Credit Agreement: "Indenture" means the Indenture among Borrower, Sunstone and U.S. Trust Company, California, N.A., as trustee, under which the Senior Notes shall be issued. "Offering Memorandum" means that certain Private Placement Offering Memorandum dated as of July 29, 1998 providing for the issuance of the Senior Notes. "Senior Notes" means the notes to be issued by the Borrower in an aggregate principal amount not to exceed $150,000,000, pursuant to and in accordance with the Offering Memorandum. "Subsidiary Guaranty" means a guaranty executed by a Subsidiary of the Borrower or of Sunstone, in substantially the form of the Sunstone Guaranty (but modified as required by the Administrative Agent to reflect the execution thereof by such Subsidiary rather than by Sunstone), guarantying the principal of and interest on the Loan and all other Obligations, as such guaranty may be amended, supplemented or otherwise modified from time to time. 2. Consent to Senior Notes. The Lenders hereby consent to the sale ----------------------- and issuance of the Senior Notes by the Borrower and the execution and delivery by the Borrower and Sunstone of the Indenture at any time on or before August 31, 1998, provided that all of the terms and provisions (including without limitation the covenants of the Borrower and Sunstone) are the same as those set forth in the Offering Memorandum in all material respects. To the extent, if any, that the requirements of Section 7.24 of the Credit Agreement have not heretofore been satisfied with respect to the Borrower's request for the consent of the Lenders to the Senior Notes, such requirements are hereby waived. (b) The Borrower hereby agrees to furnish to the Administrative Agent, prior to the execution and delivery thereof by the Borrower and Sunstone, a true, correct and 2 complete copy of the Indenture, for approval by the Administrative Agent, provided, however, that, as long as the Indenture is in conformity with the terms and provisions set forth in the Offering Memorandum, the Administrative Agent shall not unreasonably withhold its approval thereof. 3. Amendment of Section 3.4. Section 3.4 is hereby amended by adding ------------------------ the following subparagraph (d) at the end thereof: (d) Notwithstanding the foregoing provisions of this Section 3.4, the Lenders hereby agree that any Lien granted to the Administrative Agent for the benefit of the Lenders under this Section 3.4 may, to the extent required under the Indenture, be granted, on an equal and ratable basis, to the then Trustee under the Indenture for the benefit of the holders of the Senior Notes, and that the grant of such Lien to the Administrative Agent and such Trustee on an equal and ratable basis shall satisfy the requirements of this Section 3.4. 4. Amendment to Section 8.2. Section 8.2 is hereby amended (a) by ------------------------ deleting the period at the end thereof and inserting in lieu thereof "; or" and (b) by adding the following subparagraph (viii) thereafter: (viii) the Senior Notes, provided that Borrower shall not cause or -------- permit any Subsidiary of the Borrower or Sunstone to execute and deliver a guaranty of the Senior Notes unless and until such Subsidiary shall execute and deliver to the Agent, for the benefit of the Lenders, a Subsidiary Guaranty. 5. Amendment of Section 8.7. The following sentence is hereby added ------------------------ at the end of Section 8.7: Neither the Borrower nor Sunstone shall modify or amend the Indenture or any of the Senior Notes in any material respect, without the prior written consent of the Required Lenders, which shall not be unreasonably withheld. 6. Amendment of Section 8.15. Section 8.15 of the Credit Agreement ------------------------- is hereby amended by adding, immediately prior to the period at the end of subparagraph (ii) thereof, the following: and provided further that no Lien may be granted to the Trustee under ---------------- the Indenture or otherwise for the benefit of the holders of the Senior Notes (except as provided in Section 3.4(d)). 3 7. Amendment of Section 9.1. Section 9.1 of the Credit Agreement is ------------------------ hereby amended (a) by deleting the period at the end thereof and inserting in lieu thereof "; or" and (b) by adding the following subparagraph (r): (r) The Borrower shall make or be required to make, either by reason of the "Asset Sales" covenant or "Change in Control" provisions in the Indenture, an "Offer to Purchase" (as that term is defined in the Indenture) offering to purchase any or all of the Senior Notes. 8. Consent of Guarantors. Prior to or simultaneously with the --------------------- execution and delivery of this Amendment, and as a condition to this Amendment, the Borrower shall deliver to the Administrative Agent the Consent of Guarantors attached to this Amendment. 9. Expenses. Borrower shall pay all costs and expenses of the -------- Administrative Agent (including reasonable attorneys' fees and expenses) incurred in connection with this Amendment. 10. Ratification. The Credit Agreement (as amended hereby) and the ------------ other Loan Documents are hereby ratified and remain in full force and effect. 11. Execution in Counterparts. This Amendment may be executed in any ------------------------- number of counterparts and by different parties hereto in separate counterparts, each of which 4 12. when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same agreement. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed by their respective officers, thereunto duly authorized, as of the date first above written. BORROWER: SUNSTONE HOTEL INVESTORS, L.P. By: Sunstone Hotel Investors, Inc. its general partner By: ____________________________ Name: Title: LENDERS: BANK ONE, ARIZONA, NA as Administrative Agent, Co-Agent, Issuing Bank and Lender By: ____________________________ Name: Title: CREDIT LYONNAIS NEW YORK BRANCH as Documentation Agent, Co-Agent and Lender By: ____________________________ Name: Title: WELLS FARGO BANK, NATIONAL ASSOCIATION as Syndication Agent, Co-Agent and Lender By: ____________________________ Name: Title: 5 DRESDNER BANK AG, NEW YORK AND GRAND CAYMAN BRANCHES, as Lender By: ____________________________ Name: Title: By: ____________________________ Name: Title: SOCIETE GENERALE, SOUTHWEST AGENCY, as Lender By: ____________________________ Name: Title: NATIONSBANK, N.A., as Lender By:_____________________________ Name: Title: COMMERZBANK AG, LOS ANGELES BRANCH, as Lender By:_____________________________ Name: Title: By:_____________________________ Name: Title: 6 THE LONG-TERM CREDIT BANK OF JAPAN, LTD., LOS ANGELES AGENCY, as Lender By:_____________________________ Name: Title: AMSOUTH BANK, as Lender By:_____________________________ Name: Title: CONSENT OF GUARANTORS --------------------- Each of the undersigned, being a Guarantor (as defined in the Credit Agreement referred to in the foregoing Amendment) does hereby consent to the foregoing Amendment, and ratify and affirm that the Guaranty (as defined in the Credit Agreement) heretofore executed by the undersigned remains in full force and effect for the benefit of the Lenders under the Credit Agreement, as amended by the foregoing Amendment. This Consent of Guarantors may be executed in counterparts and by different parties hereto in separate counterparts, each of which when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same document. IN WITNESS WHEREOF, the undersigned have executed and delivered this Consent of Guarantors as of this day of August, 1998. ---- Sunstone Hotel Investors, Inc. By: _________________________ Its: ________________________ _____________________________ Robert A. Alter _____________________________ Charles Biederman 7 _____________________________ Daniel E. Carsello _____________________________ Gerald N. Clark _____________________________ C. Robert Enever Peacock, LLC By: _________________________ Its: ________________________ Shivani, L.L.C. By: _________________________ Its: ________________________ 8 EX-23.1 6 CONSENT OF ERNST & YOUNG LLP EXHIBIT 23.1 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements (Form S-3 No.s 333-3477, 333-13911 and 333-41683 and Form S-8 No. 333-14179), as amended, of Sunstone Hotel Investors, Inc. of our report dated February 19, 1999, with respect to the consolidated financial statements and schedule of Sunstone Hotel Investors, Inc. and our report dated February 19, 1999 with respect to the consolidated financial statements of Sunstone Hotel Properties, Inc. included in this Annual Report (Form 10-K) for the year December 31, 1998. /s/ ERNST & YOUNG LLP Newport Beach, California March 25, 1999 EX-23.2 7 CONSENT OF PRICEWATERHOUSECOOPERS EXHIBIT 23.2 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Sunstone Hotel Investors, Inc. on Form S-3 (File No. 333-34377), Form S-3 (File No. 333-31683), Form S-3 (File No. 333-13911), and Form S-3 (File No. 333-14179) of our report dated February 28, 1997 on our audit of the consolidated financial statements of Sunstone Hotel Investors, Inc. for the year ended December 31, 1996 and of our report dated February 28, 1997 on our audit of the consolidated financial statements of Sunstone Hotel Properties, Inc. (the "Lessee") for the year ended December 31, 1996, which reports are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand LLP San Francisco, California March 29, 1999 EX-27 8 FINANCIAL DATA SCHEDULE
5 1 U.S. DOLLARS YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 1 3,712,000 0 9,222,000 0 0 0 923,957,000 (65,956,000) 875,636,000 0 379,469,000 0 3,000 376,000 450,871,000 875,636,000 0 99,155,000 0 53,439,000 1,450,000 0 23,734,000 14,983,000 14,983,000 14,983,000 0 0 0 14,983,000 0.40 0.40
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