UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2006
OR
For the transition period from to
Commission file number 001-32319
Sunstone Hotel Investors, Inc.
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification Number)
903 Calle Amanecer, Suite 100
San Clemente, California
Registrant’s telephone number, including area code: (949) 369-4000
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes x No ¨
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
57,932,915 shares, of Common Stock, $0.01 par value, as of May 1, 2006
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON
For the Quarterly Period Ended March 31, 2006
TABLE OF CONTENTS
Item 1
Financial Statements:
Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005
Unaudited Consolidated Income Statements for the Three Months Ended March 31, 2006 and 2005
Consolidated Statements of Stockholders’ Equity as of March 31, 2006 (unaudited) and December 31, 2005
Unaudited Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005
Notes to Unaudited Consolidated Financial Statements
Item 2
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3
Quantitative and Qualitative Disclosures about Market Risk
Item 4
Disclosure Controls and Procedures
Legal Proceedings
Item 1A
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5
Other Information
Item 6
Exhibits
SIGNATURES
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PART I—FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
March 31,
2006
December 31,
2005
ASSETS
Current assets:
Cash and cash equivalents
Restricted cash
Accounts receivable, net
Due from affiliates
Inventories
Prepaid expenses
Current assets of discontinued operations
Total current assets
Investment in hotel properties, net
Investment in hotel properties held for sale, net
Other real estate, net
Deferred financing costs, net
Goodwill
Other assets, net
Other assets of discontinued operations, net
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses
Accrued payroll and employee benefits
Due to Management Company
Dividends payable
Other current liabilities
Current portion of notes payable
Current liabilities of discontinued operations
Total current liabilities
Notes payable, less current portion
Other liabilities
Total liabilities
Commitments and contingencies (Note 12)
Preferred stock, Series C Cumulative Convertible Redeemable Preferred Stock, $0.01 par value 4,102,564 shares issued and outstanding at March 31, 2006 and December 31, 2005, liquidation preference of $24.375 per share
Stockholders’ equity:
Preferred stock, $0.01 par value, 100,000,000 shares authorized. 8.0% Series A Cumulative Redeemable Preferred Stock, 4,850,000 issued and outstanding at March 31, 2006 and December 31, 2005, stated at liquidation preference of $25.00 per share
Common stock, $0.01 par value, 500,000,000 shares authorized, 57,691,546 shares issued and outstanding at March 31, 2006 and 52,190,649 shares issued and outstanding at December 31, 2005
Additional paid in capital
Retained earnings
Cumulative dividends
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes to consolidated financial statements.
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UNAUDITED CONSOLIDATED INCOME STATEMENTS
Three Months EndedMarch 31,
REVENUES
Room
Food and beverage
Other operating
Total revenues
OPERATING EXPENSES
Advertising and promotion
Repairs and maintenance
Utilities
Franchise costs
Property tax, ground lease, and insurance
Property general and administrative
Corporate overhead
Depreciation and amortization
Total operating expenses
Operating income
Interest and other income
Interest expense
Income before minority interest and discontinued operations
Minority interest
Income from continuing operations
Income from discontinued operations
NET INCOME
Preferred stock dividends and accretion
INCOME AVAILABLE TO COMMON STOCKHOLDERS
Basic per share amounts:
Income (loss) from continuing operations available to common stockholders
Basic income available to common stockholders per common share
Diluted per share amounts:
Diluted income available to common stockholders per common share
Weighted average common shares outstanding:
Basic
Diluted
Dividends paid per common share
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share and per share data)
Additional
Paid in
Capital
Retained
Earnings
Cumulative
Dividends
Number of
Shares
Balance at December 31, 2005 (audited)
Net proceeds from sale of common stock
Vesting of restricted common stock
Common dividends declared and payable at $0.30 per share
Series A preferred dividends declared and payable at $0.50 per share
Series C preferred dividends declared and payable at $0.393 per share
Accretion of discount on Series C preferred stock
Net income
Balance at March 31, 2006 (unaudited)
3
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Three Months Ended
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Bad debt expense (recovery)
Gain on sale of hotel properties
Loss on early extinguishment of debt
Depreciation
Amortization of deferred franchise fees
Amortization of deferred financing costs
Amortization of loan premiums
Amortization of deferred stock compensation
Gain on interest rate cap agreements
Changes in operating assets and liabilities:
Accounts receivable
Prepaid expenses and other assets
Accounts payable and other liabilities
Discontinued operations
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of hotel properties
Acquisitions of hotel properties
Additions to hotel properties and other real estate
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from preferred securities offerings
Payment of preferred securities offering costs
Proceeds from common stock offerings
Payment of common stock offerings costs
Proceeds from notes payable
Payments on notes payable
Payments of deferred financing costs
Dividends and distributions paid
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest
NONCASH FINANCING ACTIVITY
Dividends and distributions payable
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of Business
Sunstone Hotel Investors, Inc. (the “Company”), through its 100.0% controlling interest in Sunstone Hotel Partnership, LLC (the “Operating Partnership”), of which the Company is the sole managing member, and the subsidiaries of the Operating Partnership, including Sunstone Hotel TRS Lessee, Inc. (the “TRS Lessee”) and its subsidiaries, is currently engaged in owning, acquiring, selling, and renovating hotel properties. The Company operates as a real estate investment trust (“REIT”) for federal income tax purposes.
The Company was formed to succeed the businesses of Sunstone Hotel Investors, L.L.C. (“SHI”), WB Hotel Investors, LLC (“WB”), and Sunstone/WB Hotel Investors IV, LLC (“WB IV”) (collectively, the “Sunstone Predecessor Companies” or the “Predecessor”), which were engaged in owning, acquiring, selling, managing, and renovating hotel properties in the United States. The Company was incorporated in Maryland on June 28, 2004, in anticipation of an initial public offering of common stock (the “IPO”), which was consummated on October 26, 2004 concurrently with the consummation of various formation transactions. These transactions were designed to (i) enable the Company to raise the necessary capital to acquire properties from the Predecessor and repay certain mortgage debt relating thereto, (ii) provide a vehicle for future acquisitions, (iii) enable the Company to comply with certain requirements under the federal income tax laws and regulations relating to real estate investment trusts, (iv) facilitate potential financings and (v) preserve certain tax advantages for the Predecessor. From June 28, 2004 through October 26, 2004, the Company did not have any operations.
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements as of March 31, 2006 and December 31, 2005, and for the three months ended March 31, 2006 and March 31, 2005, include the accounts of the Company, the Operating Partnership and the TRS Lessee and their subsidiaries. All significant intercompany balances and transactions have been eliminated.
The accompanying interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States and in conformity with the rules and regulations of the Securities and Exchange Commission. In our opinion, the interim financial statements presented herein reflect all adjustments, consisting solely of normal and recurring adjustments, which are necessary to fairly present the interim financial statements. These financial statements should be read in conjunction with the financial statements included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on February 15, 2006.
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.
Reporting Periods
The results the Company reports in its consolidated statements of operations are based on results reported to the Company by its hotel managers. These hotel managers use different reporting periods. Sunstone Hotel Properties, Inc., a division of Interstate Hotels & Resorts, Inc. (the “Management Company”), the manager of 47 of the Company’s properties as of March 31, 2006, as well as two of the Company’s other managers, Hyatt Corporation and Fairmont Hotels & Resorts, which manage a combined total of four of the Company’s properties as of March 31, 2006, report results on a monthly basis. In contrast, Marriott International, Inc. (“Marriott”), the manager of ten of the Company’s properties as of March 31, 2006, uses a fiscal year ending on the Friday closest to December 31, and reports twelve weeks of operations for each of the first three quarters of the year and sixteen or seventeen weeks of operations for the fourth quarter of the year. The Company has elected to adopt quarterly close periods of March 31, June 30 and September 30, and an annual year end of December 31. As a result, the Company’s results of operations for the Marriott managed hotels include results from January 1 through March 24 for the first quarter, March 25 through June 16 for the second quarter, June 17 through September 8 for the third quarter, and September 9 through December 31 for the fourth quarter.
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Accounts Receivable
Accounts receivable primarily represents receivables from hotel guests who occupy hotel rooms and utilize hotel services. Accounts receivable also includes receivables from customers who utilize the Company’s laundry facilities in Salt Lake City, Utah, and Rochester, Minnesota. The Company maintains an allowance for doubtful accounts sufficient to cover potential credit losses. The Company’s accounts receivable at March 31, 2006 and December 31, 2005 includes an allowance for doubtful accounts of $0.7 million and $0.8 million, respectively.
At both March 31, 2006 and December 31, 2005, the Company had approximately $4.6 million in accounts receivable with one customer who is operating under a contract with the United States government. The Company has specifically reserved a portion of this particular receivable in the amount of $0.1 million at both March 31, 2006 and December 31, 2005.
Deferred Financing Costs
Interest expense related to the amortization of deferred financing costs was $0.9 million and $1.1 million for the three months ended March 31, 2006 and 2005.
Minority Interest
Prior to November 2005, minority interests of the Company represented the limited partnership interests in the Operating Partnership. The carrying value of the minority interest increased by the minority interests’ share of earnings and decreased by cash distributions and the purchase of limited partnership interests. In November 2005, the membership units held by the minority interest owners were converted to shares of common stock, and were subsequently sold in a public offering eliminating the minority interests of the Company. As such, the Company beneficially owns all of the membership interests in the Operating Partnership.
Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per common share (in thousands, except per share data):
Numerator:
Less preferred dividends and accretion
Numerator for basic and diluted earnings available to common stockholders
Denominator:
Weighted average basic common shares outstanding
Unvested restricted stock awards
Weighted average diluted common shares outstanding
Basic earnings available to common stockholders per common share
Diluted earnings available to common stockholders per common share
Shares of the Company’s Series C preferred stock have not been included in the above calculation of earnings per share for the three months ended March 31, 2006 as their effect would have been anti-dilutive. Unvested restricted stock has not been included in the above calculation for the three months ended March 31, 2006 as its effect would have been anti-dilutive to net loss from continuing operations available to common stockholders.
Reclassifications
Certain amounts included in the financial statements for prior periods have been reclassified to conform with the most recent financial statement presentation.
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3. Investment in Hotel Properties
Investment in hotel properties consisted of the following (in thousands):
Land
Buildings and improvements
Fixtures, furniture and equipment
Franchise fees
Construction in process
Accumulated depreciation and amortization
On January 10, 2006, the Company purchased the 284-room Marriott Del Mar located in San Diego, California for $69.1 million and named Marriott as manager. This hotel’s results of operations from the acquisition date of January 10, 2006 through Marriott’s first quarter ended March 24, 2006, have been included in the Company’s statement of operations. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
On March 17, 2006, the Company purchased the 444-room Hilton Times Square located in New York City for $241.3 million and named Sunstone Hotel Properties, Inc., a division of Interstate Hotels & Resorts, Inc., as manager. In addition, concurrently with the acquisition, the Company exercised its option and made an additional $15.0 million payment to convert the property to a franchise. This hotel’s results of operations from the acquisition date of March 17, 2006 through the first quarter ended March 31, 2006 have been included in the Company’s statement of operations. The allocation of the purchase price is preliminary as the Company is in the process of obtaining a purchase price allocation from an independent third party. The Company has included depreciation expense based on this preliminary allocated purchase price.
4. Discontinued Operations
As part of a strategic plan to dispose of non-core hotel assets, the Company sold one hotel during the three months ended March 31, 2006, for net proceeds of $25.5 million and a net gain on sale of $16.4 million, another hotel during the fourth quarter of 2005, and an additional two hotels during the second quarter of 2005. These four hotel properties met the “held for sale” and “discontinued operations” criteria in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.”
The following sets forth the discontinued operations for the three months ended March 31, 2006 and 2005, related to hotel properties held for sale (in thousands):
Operating revenues
Operating expenses
Depreciation and amortization expense
Gain on sale of hotels
The following sets forth the assets and liabilities related to the discontinued operations at March 31, 2006 and December 31, 2005 (in thousands):
Hotel properties held for sale, net
Total assets of discontinued operations
LIABILITIES
Total liabilities of discontinued operations
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5. Other Real Estate
Other real estate consists of the following (in thousands):
Office building and laundry facilities:
Accumulated depreciation
Land held for future development or sale
During the first quarter of 2006, the Company purchased land and an office building adjacent to one of its hotels in Troy, Michigan for $4.4 million.
6. Other Assets
Other assets consist of the following (in thousands):
Corporate property and equipment, net
Pre-acquisition costs
Other receivables
Other
During the first quarter of 2006, the Company received payment in full for its $4.7 million note receivable generated from its 2004 sale of the San Marcos Resort & Conference Center in Chandler, Arizona. This note was previously written down to market value, resulting in a loss of $350,000 recognized during the fourth quarter of 2004. Upon full payment of this note in the first quarter of 2006, this loss was reversed, and a $92,000 payment was made by the Company for the termination of the management agreement at the hotel, resulting in additional net proceeds and gain of $258,000 recognized on the sale by the Company.
7. Derivative Financial Instruments
At March 31, 2006 and December 31, 2005, the Company held interest rate cap agreements to manage its exposure to interest rate risks related to its floating rate debt. The fair values of the derivatives are recorded as interest rate cap agreement assets, and are included in deferred financing costs, net on the consolidated balance sheets as of March 31, 2006 and December 31, 2005. None of the Company’s derivatives held as of March 31, 2006 and December 31, 2005 qualify for effective hedge accounting treatment under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Accordingly, changes in the fair value of the Company’s derivatives for the three months ended March 31, 2006 and March 31, 2005 resulted in a net gain of $1,000 during both periods. The changes in fair value have been reflected as a decrease in interest expense for the three months ended March 31, 2006 and 2005.
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The following table summarizes the interest rate cap agreements (dollars in thousands):
Notional amount of variable rate debt
Fair value of interest rate caps
LIBOR rate at which expense is capped
Maturity dates
8. Notes Payable
Notes payable consist of the following (in thousands):
Notes payable requiring payments of interest and principal, with fixed rates ranging from 4.98% to 9.88%; maturing at dates ranging from September 2007 through August 2024. The notes are collateralized by first deeds of trust on 39 hotel properties and one laundry facility.
Unsecured term loan facility in the amount of $75.0 million requiring monthly payments of interest only subject to an interest rate at the Company’s option, equal to either a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, or six-month LIBOR, plus, in each case, a margin of 1.25% for base rate loans and 2.25% for LIBOR loans. The term loan facility matures in October 2008, but was repaid in full in April 2006.
Secured revolving credit facility in the amount of $150.0 million requiring monthly payments of interest only on the principal amount drawn subject to an interest rate at the Company’s option, equal to either a fluctuating rate equal to Citibank, N.A.’s base rate or a periodic fixed rate equal to one-, two-, three- or six-month LIBOR, plus, in each case, an applicable margin based on the Company’s leverage. The applicable margin is a percentage rate per annum that ranges from 0.5% to 1.0% for base rate loans and 1.5% to 2.0% for LIBOR loans. The revolving credit facility also requires a quarterly fee of 0.5% on the average unused commitment on the facility and a 0.125% fee upon the issuance of each letter of credit. The revolving credit facility is secured by first deeds of trust on seven hotel properties. Total available under the revolving credit facility was $112.7 million at March 31, 2006. The revolving credit facility matures in October 2007 and has a one year extension.
Less: current portion
In January 2006, the Company obtained a $48.0 million fixed rate mortgage loan with a maturity date of January 2016 and a fixed interest rate of 5.69% in connection with the acquisition of the Marriott Del Mar, San Diego, California.
In February 2006, the Company refinanced two of its hotel properties. As such, the Company replaced a $36.9 million mortgage at a fixed interest rate of 8.25% scheduled to mature in 2008, with an eleven-year $75.0 million mortgage at a fixed interest rate of 5.58%. Additionally, the Company replaced a $35.8 million mortgage at a fixed rate of 8.25% scheduled to mature in 2008, with a ten-year $34.0 million mortgage at a fixed rate of 5.66%. In connection with these transactions, the Company recorded a one-time charge of $7.4 million for loss on early extinguishment of debt related to the cost associated with the defeasance of the previous debt.
In March 2006, the Company assumed an $81.0 million fixed rate mortgage loan with a maturity date of December 2010 and an interest rate of 5.92% in connection with the acquisition of the Hilton Times Square.
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Total interest incurred and expensed on the notes payable is as follows (in thousands):
Continuing operations:
Deferred financing fees
Gain on interest rate cap
Discontinued operations:
9. Series C Cumulative Convertible Redeemable Preferred Stock
In July 2005, the Company sold 4,102,564 shares of Series C Cumulative Convertible Redeemable Preferred Stock (“Series C preferred stock”) with a liquidation preference of $24.375 per share, convertible on a one-for-one basis, to Security Capital Preferred Growth, Incorporated, an investment vehicle advised by Security Capital Research & Management Incorporated, for gross proceeds of $99.0 million, or $24.13 per share, which included a 1% discount to the conversion price/liquidation preference. Other costs of the offering totaled $130,000. Net proceeds of $99.0 million were contributed to the Operating Partnership in exchange for preferred units with economic terms substantially identical to the Series C preferred stock. The net proceeds were used to partially finance the Company’s acquisition of six Renaissance hotels. On or after July 8, 2010, the Series C preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $24.375 per share, plus accrued and unpaid dividends up to and including the redemption date. The holders have the right to require the Company to redeem the Series C preferred stock in the event of any of the following: (1) a change in control of the Company, if certain conditions are not met; (2) a REIT termination event; or (3) a termination of the Company’s listing on either the New York Stock Exchange or NASDAQ. In general, holders of Series C preferred stock vote on an as-converted basis as a single class with holders of the Company’s common tock. If the Company is in violation of certain financial ratios for four consecutive quarters, the holders have the right to elect one director to serve on the Company’s board of directors. In addition, if the Company is in arrears on dividends on the Series C preferred stock for four or more quarters, the holders have the right to elect additional directors to serve on the Company’s board of directors. Subject to a limited exception, holders of Series C preferred stock cannot elect more than an aggregate of two directors. The holders are eligible to receive a participating dividend should the Company’s common dividend increase beyond $1.34 per share per annum. The Series C preferred stock has no maturity date and, except as set forth above, the Company is not required to redeem the Series C preferred stock at any time.
The initial carrying value of the Series C preferred stock was recorded at its sales price less costs to issue on the date of issuance. This carrying value is periodically adjusted so that the carrying value will equal the redemption value on the redemption date, which is the earliest date available for the Company to redeem the Series C preferred stock. The carrying value will also be periodically adjusted for any accrued and unpaid dividends, if any. At March 31, 2006 and December 31, 2005, the Series C preferred stock carrying value consisted of the following (in thousands):
Initial fair value, sales price of $99.0 million
Redemption value accretion
10. Stockholders’ Equity
Series A Cumulative Redeemable Preferred Stock
In March 2005, the Company sold 4,850,000 shares of 8.0% Series A and B Cumulative Redeemable Preferred Stock with a liquidation preference of $25.00 per share for gross proceeds of $121.3 million. Underwriting and other costs of the offering totaled $3.8 million. Net proceeds of $117.5 million were contributed to the Operating Partnership in exchange for preferred units with economic terms substantially identical to the Series A and B preferred stock. Subsequent to this offering, the Series B shares were exchanged for an equivalent number of shares of Series A preferred stock. The net proceeds were
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used to reduce borrowings under the Company’s credit facility and for acquisitions. On or after March 17, 2010, the Series A preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus accrued and unpaid dividends up to and including the redemption date. Holders of Series A preferred stock will generally have no voting rights. However, if the Company is in arrears on dividends on the Series A preferred stock for six or more quarterly periods, whether or not consecutive, holders of the Series A preferred stock will be entitled to vote at its next annual meeting and each subsequent annual meeting of stockholders for the election of two additional directors to serve on the Company’s board of directors until all unpaid dividends and the dividend for the then-current period with respect to the Series A preferred stock have been paid or declared and a sum sufficient for the payment thereof set aside for payment. The Series A preferred stock has no maturity date and the Company is not required to redeem the Series A preferred stock at any time.
Common Stock
On February 2, 2006, the Company completed a follow-on offering of 5,500,000 shares of common stock at a price per share of $28.80 (before underwriting discounts and offering costs), generating gross proceeds of $158.4 million. The proceeds to the Company, net of offering costs, were $158.1 million and were used for acquisitions.
11. Long-Term Incentive Plan
Restricted shares and restricted share units granted pursuant to the Company’s Long-Term Incentive Plan generally vest over periods from three to five years from the date of grant. The value of shares granted has been calculated based on the share price on the date of grant and is being amortized as compensation expense over the vesting periods. For the three months ended March 31, 2006 and 2005, the Company’s expense related to these restricted shares and restricted share units was $807,000 and $531,000, respectively.
12. Commitments and Contingencies
Franchise Agreements
Total franchise costs incurred by the Company during the three months ended March 31, 2006 and 2005 totaled $7.4 million and $6.4 million, respectively. Of the total franchise costs, franchise royalties totaled $3.8 million and $3.4 million, respectively, for the three months ended March 31, 2006 and 2005. The remaining franchise costs include advertising, reservation and priority club assessments. Franchise costs included in discontinued operations totaled $0.1 million and $0.4 million, respectively, for the three months ended March 31, 2006 and 2005.
Renovation and Construction Commitments
At March 31, 2006 and December 31, 2005, the Company had various contracts outstanding with third parties in connection with the renovation of certain of the hotel properties. The remaining commitments under these contracts at March 31, 2006 and December 31, 2005 totaled $33.9 million and $28.2 million, respectively.
Operating Leases
Rent expense incurred pursuant to ground lease agreements for the three months ended March 31, 2006 and 2005 totaled $1.9 million and $0.7 million, respectively and was included in property tax, ground lease and insurance in the accompanying statements of operations.
Rent expense incurred pursuant to the lease on the corporate facility for the three months ended March 31, 2006 and 2005 totaled $116,000 and $96,000 and was included in general and administrative expenses in the accompanying statements of operations.
The Company has provided unsecured environmental indemnities to certain lenders. The Company has performed due diligence on the potential environmental risks including obtaining an independent environmental review from outside environmental consultants. These indemnities obligate the Company to reimburse the guaranteed parties for damages related to environmental matters. There is no term or damage limitation on these indemnities; however, if an environmental matter arises, the Company could have recourse against other previous owners.
At March 31, 2006 and December 31, 2005, the Company had $27.3 million and $27.4 million, respectively, of outstanding irrevocable letters of credit to guarantee the Company’s financial obligations related to the Management Company, workers’ compensation insurance programs and certain notes payable. The beneficiary may draw upon these
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letters of credit in the event of a contractual default by the Company relating to each respective obligation. No draws have been made through March 31, 2006.
13. Transactions With Affiliates
Other Reimbursements
From time to time, the Company pays for certain expenses such as payroll, insurance and other costs on behalf of certain affiliates. The affiliates generally reimburse such amounts on a monthly basis. At both March 31, 2006 and December 31, 2005, amounts owed to the Company by its affiliates amounted to $2.0 million and are included in due from affiliates.
Transactions With Others
The Company purchases telecommunications equipment from Gemini Telemanagement Systems, or GTS, a telecommunications equipment provider based in Redwood City, California. The Company’s Chief Executive Officer and President, Robert A. Alter, is a 5.2% stockholder in GTS, and his brother, Richard Alter, is the majority stockholder in GTS. The Company paid GTS $42,000 and $218,000, respectively for the three months ended March 31, 2006 and 2005.
14. Subsequent Events
In April 2006, the Company sold 2.2 million shares of 8.0% Series A Cumulative Redeemable Preferred Stock with a liquidation value of $25.00 per share for gross proceeds of approximately $54.5 million.
In April 2006, the Company repaid in full the $75.0 million unsecured subordinated term loan with the proceeds from the Series A Cumulative Redeemable Preferred Stock offering and cash on hand from the refinancing discussed below.
In April 2006, the Company refinanced one existing mortgage loan that would have matured in 2008. The Company incurred a prepayment penalty of approximately $3.0 million to defease the prior mortgage. The old loan had a principal balance of $52.9 million, a fixed interest rate of 7.5% and a maturity date of 2008. The new loan is for $135.0 million, has a fixed interest rate of 5.95% and matures in 2021.
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Cautionary Statement
This report contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “forecasts,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those expressed or implied by these forward-looking statements. In evaluating these statements, you should specifically consider the risks outlined in detail in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on February 15, 2006, under the caption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, including but not limited to the following factors:
These factors may cause our actual events to differ materially from the expectations expressed or implied by any forward-looking statement. We do not undertake to update any forward-looking statement.
Overview
We own primarily luxury, upper upscale and upscale hotels in the United States operated under leading brand names franchised or licensed from others, such as Marriott, Hilton, Hyatt, Fairmont, Starwood, and Wyndham.
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Operations
REIT structure. For us to qualify as a REIT, our income cannot be derived from our operation of hotels. Therefore, consistent with the provisions of the Internal Revenue Code of 1986, as amended, and the rules and regulations thereunder (the “Code”), Sunstone Hotel Partnership and its subsidiaries have leased our hotel properties to our taxable REIT subsidiary lessee, Sunstone Hotel TRS Lessee, Inc., or the TRS Lessee, which has in turn contracted with “eligible independent contractors” to manage our hotels. Under the Code, an “eligible independent contractor” is an independent contractor who is actively engaged in the trade or business of operating “qualified lodging facilities” for any person unrelated to us and the TRS Lessee. Sunstone Hotel Partnership and the TRS Lessee are consolidated into our financial statements for accounting purposes. Since we control both Sunstone Hotel Partnership and our TRS Lessee, our principal source of funds on a consolidated basis are from the performance of our hotels. The earnings of the TRS Lessee are subject to taxation like other C corporations, which reduce our operating results, funds from operations and the cash otherwise available for distribution to our stockholders.
Factors Affecting Our Results of Operations
Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following:
The following performance indicators are commonly used in the hotel industry:
Operating costs and expenses. Our operating costs and expenses consist of the following:
Most categories of variable operating expenses, such as utilities and certain labor costs, such as housekeeping, fluctuate with changes in occupancy. Increases in RevPAR attributable to improvements in occupancy are accompanied by increases in most categories of variable operating costs and expenses. Increases in RevPAR attributable to improvements in ADR typically only result in increases in limited categories of operating costs and expenses, primarily credit card commissions,
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franchise fees and franchise assessments. Thus, improvements in ADR have a more significant impact on improving our operating margins than occupancy.
We continually seek to improve our operating leverage, which generally refers to the ability to generate incremental profit based on limited variable costs. Notwithstanding our efforts to reduce variable costs, there are limits to how much we or the Management Company and our other operators can accomplish in that regard without affecting the competitiveness of our hotels and our guests’ experiences at our hotels. Furthermore, we have significant fixed costs, such as depreciation and amortization, insurance, principal and interest payments on our debt, and other expenses associated with owning hotels that do not necessarily decrease when circumstances such as market factors cause a reduction in our hotel revenue. For example, we have experienced increases in wages, employee benefits (especially health insurance), and utility costs, which negatively affected our operating margin. Our historical performance may not be indicative of future results, and our future results may be worse than our historical performance.
Acquisition, Sale and Major Redevelopment Activity
Our results during the periods discussed have been, and our future results will be, affected by our acquisition, sale and redevelopment activity during the applicable period.
Acquisition of hotels. The following table sets forth the hotels that we have acquired or developed since the beginning of 2005 and indicates their room count and acquisition date:
Hotel
Hilton Times Square, New York City, New York
Del Mar Marriott, San Diego, California
Hyatt Century Plaza, Los Angeles, California
Fairmont Hotel, Newport Beach, California
Sheraton Hotel, Cerritos, California
Renaissance Orlando Resort at Sea World, Orlando, Florida(1)
Renaissance Harborplace, Baltimore, Maryland
Renaissance Concourse, Atlanta, Georgia
Renaissance Long Beach, Long Beach, California
Renaissance Westchester, White Plains, New York
Renaissance Washington, D.C., Washington, D.C.
The aggregate cost for the two hotels acquired during our first quarter of 2006 totaled approximately $325.4 million, or $447,000 per room.
Sale of hotels. The following table sets forth the hotels that we have sold since the beginning of 2005 and indicates their room count and sale date:
Holiday Inn, Hollywood, California
Holiday Inn, Provo, Utah
Doubletree, Carson, California
Holiday Inn, Mesa, Arizona
The aggregate net sale proceeds for the one hotel disposed of during our first quarter of 2006 were $25.5 million, or $160,000 per room. The results of operations of all of the hotels identified above and the gains or losses on dispositions through March 31, 2006 are included in discontinued operations for all periods presented through the time of sale. The proceeds from the sales are included in our cash flows from investing activities for the respective periods.
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The following table summarizes our portfolio and room data since the beginning of 2005 through March 31, 2006 adjusted for the hotels acquired and sold during the respective periods.
January 1,
through
Portfolio Data—Hotels
Number of hotels—beginning of period
Add: Acquisitions
Less: Sales
Number of hotels—end of period
Portfolio Data—Rooms
Number of rooms—beginning of period
Less: Rooms converted to other usage
Number of rooms—end of period
Average rooms per hotel—end of period
Operating Results
Comparison of Three Months Ended March 31, 2006 to Three Months Ended March 31, 2005
The following table presents our unaudited operating results for the three months ended March 31, 2006 and 2005, including the amount and percentage change in the results between the two periods.
Hotel operating
Preferred stock dividends
Operating Statistics
Occupancy(1)
Average daily rate(1)
RevPAR(1)
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Room revenue. Room revenue increased $58.3 million, or 74.5%, to $136.6 million for the three months ended March 31, 2006, from $78.3 million for the three months ended March 31, 2005. This increase was primarily due to $50.4 million generated from the eleven hotels we acquired subsequent to March 31, 2005. In addition, organic growth in our existing portfolio base contributed $7.9 million due to increases in both occupancy ($0.2 million) and ADR ($7.7 million).
Food and beverage revenue. Food and beverage revenue increased $32.5 million, or 127.0%, to $58.1 million for the three months ended March 31, 2006 from $25.6 million for the three months ended March 31, 2005. This increase was primarily driven by $30.7 million contributed by the eleven hotels we acquired subsequent to March 31, 2005, as well as $1.8 million generated from increased restaurant revenue at our existing locations during 2006 as compared with 2005.
Other operating revenue. Other operating revenue increased $6.5 million, or 59.2%, to $17.4 million for the three months ended March 31, 2006 from $11.0 million for the three months ended March 31, 2005. The eleven hotels we acquired subsequent to March 31, 2005 contributed $6.2 million to other operating revenue during the first quarter of 2006. In addition, organic growth contributed $0.3 million, primarily due to our electronic purchasing platform, Buy Efficient, L.L.C.
Hotel operating expenses. Hotel operating expenses, which are comprised of room, food and beverage, advertising and promotion, repairs and maintenance, utilities, and other hotel operating expenses, increased $58.6 million, or 80.8%, to $131.2 million for the three months ended March 31, 2006 from $72.6 million for the same time period in 2005. The eleven hotels we acquired subsequent to March 31, 2005 contributed $55.6 million in hotel operating expense during our first quarter of 2006. In addition, hotel operating expenses in our hotel portfolios as of March 31, 2005 increased $3.0 million during our first quarter of 2006 as compared with the same time period in 2005 primarily as a result of increases in room expense and franchise costs due to increases in occupancy and revenue, and as a result of increases in utility expense due to increases in energy costs.
Property general and administrative expense. Property general and administrative expense increased $13.1 million, or 106.6%, to $25.3 million for the three months ended March 31, 2006 from $12.3 million for the three months ended March 31, 2005. Of the increase, our newly acquired hotels contributed $11.0 million during the first quarter of 2006. The remaining increase was due to $2.1 million in management and accounting fees payable to the Management Company, and other hotel specific expenses, such as increased credit card commissions, associated with the overall increase in revenue.
Corporate overhead expense. Corporate overhead expense increased to $5.9 million during the first quarter of 2006 as compared with $3.5 million during the same time period in 2005, primarily as a result of increases in payroll and related expenses, including deferred stock compensation expense.
Depreciation and amortization expense. Depreciation and amortization increased $9.1 million to $23.0 million for the three months ended March 31, 2006 from $13.9 million for the three months ended March 31, 2005, primarily as a result of the eleven hotels acquired since the end of our first quarter of 2005, which contributed $8.7 million. Our hotels owned as of March 31, 2005 contributed an additional $0.4 million due to increased depreciation on capital expenditures related to renovation projects at several of these hotels.
Interest expense. Interest expense increased $14.7 million to $26.8 million for the three months ended March 31, 2006 from $12.1 million for the three months ended March 31, 2005. This increase was primarily due to greater outstanding loan balances in 2006 as compared with 2005, as we obtained additional loans to finance our acquisitions. As such, we incurred an additional $7.7 million in interest expense during the first quarter of 2006 as compared to the same time period in 2005. In addition, in connection with our refinancing of two hotel properties during the first quarter of 2006, we incurred a one-time charge of $7.4 million for loss on early extinguishment of debt related to the cost associated with the defeasance of the debt being refinanced. The higher interest was partially offset by a decrease in deferred financing fees amortization of $0.3 million in 2006 as compared to 2005.
Our total notes payable, including the current portion, was $1,356.1 million at March 31, 2006 and $667.7 million at March 31, 2005, with a weighted average interest rate per annum of approximately 5.9% at March 31, 2006 and 6.5% at March 31, 2005. At March 31, 2006, 93.7% of the amount outstanding under our notes payable was fixed and 6.3% of the amount outstanding under our notes payable was floating.
Income from discontinued operations. Income from discontinued operations was $16.8 million for the three months ended March 31, 2006, and $1.1 million for the three months ended March 31, 2005. As described under “—Acquisition, Sale and Major Redevelopment Activity—Sale of Hotels,” two hotels were sold during the second quarter of 2005, one was sold during the fourth quarter of 2005, and one hotel was sold during the first quarter of 2006. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these four hotels as discontinued operations.
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Liquidity and Capital Resources
Historical. During the periods presented, our historical sources of cash included our operating activities, working capital, long-term notes payable, bank credit facilities, sales of hotel properties, contributions by the Predecessor and proceeds of our public and private offerings of common and preferred stock. Our primary uses for cash were for acquisitions of hotels, capital expenditures for hotels, operating expenses, distributions to the Predecessor, repayment of notes payable and dividends.
Operating activities. Net cash provided by operating activities was $28.7 million for the three months ended March 31, 2006 compared to $16.2 million for the three months ended March 31, 2005. This increase was primarily due to additional cash generated from our newly acquired properties during the three months ended March 31, 2006, partially offset by an increase in restricted cash made in connection with acquisitions that closed in 2006.
Investing activities. Our cash used in investment activities fluctuates primarily based on acquisitions, sales and renovations of hotels. Net cash used in investing activities was $250.1 million in the three months ended March 31, 2006 compared to $13.7 million in the three months ended March 31, 2005. During the three months ended March 31, 2006, we acquired two hotels for $325.4 million, which includes the assumption of $81.0 million in debt and a $6.5 million deposit paid at the end of 2005, and acquired an office building and land adjacent to one of our hotels for $4.4 million, for a total of $242.3 million. In addition, we paid cash of $33.6 million for renovations to our hotels, and we have received net proceeds of $25.8 million from the sale of one hotel combined with the collection of additional proceeds from a hotel we sold in 2004. During the same time period in 2005, we invested $13.7 million of capital expenditures in our hotels.
Financing activities. Net cash provided by financing activities was $223.8 million for the three months ended March 31, 2006 compared to $61.4 million for the three months ended March 31, 2005. Net cash provided by financing activities for the three months ended March 31, 2006 consisted primarily of net proceeds from our common stock offerings of $158.1 million and proceeds from notes payable of $167.5 million, partially offset by $73.7 million of principal payments on notes payable and $7.4 million related to the cost associated with the defeasance of debt we refinanced, $19.8 million of dividends and distributions to our shareholders, and $0.9 million in deferred financing costs. Net cash provided by financing activities for the three months ended March 31, 2005 consisted primarily of net proceeds from our preferred securities offerings of $117.5 and proceeds from notes payable of $0.2 million, partially offset by $45.0 million of principal payments on notes payable, $11.0 million of dividends and distributions to our shareholders, and $0.3 million in deferred financing costs.
Future. We expect our primary uses for cash to be for acquisitions of hotels, capital expenditures for hotels, operating expenses, debt service and distributions to holders of our common and preferred stock. We also expect our primary sources of cash will continue to come from the operations of our hotels and our working capital. In addition, we have a $150.0 million secured revolving credit facility.
We believe that our capital structure, including our $150.0 million revolving credit facility and cash flow from operations, will provide us with sufficient liquidity to meet our current operating expenses and other expenses directly associated with our business and properties for the foreseeable future, and in any event for at least the next twelve months. Our $150.0 million revolving credit facility, of which we have drawn down $10.0 million and of which $27.3 million currently backs outstanding irrevocable letters of credit, leaving $112.7 million available at March 31, 2006, is subject to compliance with applicable loan ratios. We have interest rate protection agreements covering all of our variable rate debt, which accounted for 6.3% of our total outstanding indebtedness at March 31, 2006. In January 2006, we obtained a $48.0 million fixed rate mortgage loan with a maturity date of January 2016 and a fixed interest rate of 5.69%. In February 2006, we refinanced two of our hotel properties, replacing a $36.9 million mortgage at a fixed interest rate of 8.25% scheduled to mature in 2008, with an eleven-year $75.0 million mortgage at a fixed interest rate of 5.58%, and replacing a $35.8 million mortgage at a fixed rate of 8.25% scheduled to mature in 2008, with a ten-year $34.0 million mortgage at a fixed rate of 5.66%. In March 2006, we assumed an $81.0 million fixed rate mortgage loan with a maturity date of December 2010 and a fixed interest rate of 5.92%. As of March 31, 2006, 93.7% of our outstanding debt is fixed rate. The majority of our mortgage debt is secured by a single asset rather than a cross-collateralized multi-property pool. We believe this structure is appropriate for the operating characteristics of our business and provides flexibility for assets to be sold subject to the existing debt.
In the future, we may also explore other financing alternatives, including our sale of equity and debt securities. Our ability to incur additional debt depends on a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions imposed by existing lenders under our existing notes payable, including our revolving credit facility. Our ability to raise funds through the issuance of equity securities depends on, among other things, general market conditions for hotel companies and REITs and market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time. However, the capital markets may not be available to us when needed on favorable terms or at all.
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Contractual Obligations
The following table summarizes our payment obligations and commitments as of March 31, 2006 (in thousands):
Contractual obligations
Less than
1 year
1 to 3
years
3 to 5
More than
5 years
Notes payable
Interest obligations on notes payable(1)
Operating lease obligations
Construction commitments
Employment obligations
Total
Capital Expenditures and Reserve Funds
We believe we maintain each of our hotels in good repair and condition and in conformity with applicable franchise agreements, ground leases, laws and regulations. Our capital expenditures primarily relate to the ongoing maintenance of our hotels and are budgeted in the reserve accounts described in the following paragraph. We also incur capital expenditures following the acquisition of hotels for renovation and development. Our capital expenditures for 2006 are expected to be approximately $125.0 million to $140.0 million, of which we paid cash of $33.6 million in the first quarter of 2006. This renovation budget includes $33.9 million of contractual construction commitments and discretionary amounts in excess of our contractual requirements. All of these amounts are expected to be funded out of our cash and reserve accounts. If we acquire, renovate or develop additional hotels in the future, our capital expenditures will increase. Our capital expenditures also fluctuate from year to year, since we are not required to spend the entire amount in the reserve accounts each year.
With respect to our hotels that are operated under franchise agreements with major national hotel brands and for all of our hotels subject to a first mortgage lien, we are obligated to maintain a furniture, fixture and equipment, or FF&E, reserve account for future planned and emergency-related capital expenditures at these hotels. The amount funded into each of these reserve accounts is determined pursuant to the management, franchise and loan agreements for each of the respective hotels, ranging between 4.0% and 5.0% of the respective hotel’s total annual revenue. As of March 31, 2006, $36.2 million was available in restricted cash reserves for future capital expenditures at our hotels. According to the respective loan agreements, the reserve funds are to be held by the respective lenders in a restricted cash account.
Derivative Financial Instruments
We use derivative financial instruments, in the form of interest rate caps, to manage our exposure to the interest rate risks related to the following variable rate debt. Following the repayment of some of our floating rate debt with the proceeds from our initial public offering and our subsequent transactions which eliminated substantially all of our floating rate debt, we own interest rate caps having aggregate notional amounts well in excess of our floating rate debt. The fair value of our interest rate caps at March 31, 2006 was approximately $4,000. As of March 31, 2006, our interest rate caps consisted of the following:
LIBOR Rate at
which Exposureis Capped
Interest RateCap
Maturity
The net settlements, if any, paid or received under these interest rate cap agreements are accrued consistent with the terms of the agreements and are recognized in interest expense over the term of the related debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. We generally use outside consultants to determine the fair values of our derivative instruments. Such methods generally incorporate market conventions and techniques such as discounted cash flow analysis and option pricing models to determine fair value. We believe these methods of estimating fair value result in general approximation of value, and such value may or may not actually be realized. For the three months ended March 31, 2006, our mark to market adjustments of these contracts resulted in a net gain of $1,000.
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Off-Balance Sheet Arrangements
At March 31, 2006, we did not have any off-balance sheet arrangements.
Seasonality
The lodging business is seasonal in nature, and we experience some seasonality in our business as indicated in the table below. Revenue for hotels in tourist areas generally is substantially greater during tourist season (i.e., second and third quarter) than other times of the year. Quarterly revenue also may be adversely affected by events beyond our control, such as extreme weather conditions, terrorist attacks or alerts, public health concerns (such as SARS and bird flu), airline strikes, economic factors and other considerations affecting travel. Our revenues by quarter during 2005 and 2006 were as follows (dollars in thousands):
First
Quarter
Second
Third
Fourth
Revenues
Inflation
Inflation may affect our expenses, including, without limitation, by increasing such costs as taxes, property and casualty insurance and utilities.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.
We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our combined financial statements.
Accrual of self-insured obligations. We are self-insured up to certain amounts with respect to employee medical, employee dental, general liability insurance, personal injury claims, workers’ compensation, automobile liability
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and other coverages. We establish reserves for our estimates of the loss that we will ultimately incur on reported claims as well as estimates for claims that have been incurred but not yet reported. Our reserves, which are reflected in “Due to Management Company” and other liabilities in our consolidated and combined balance sheets, are based on actuarial valuations and our history of claims. Our actuaries incorporate historical loss experience and judgments about the present and expected levels of costs per claim. Trends in actual experience are an important factor in the determination of these estimates. We believe that our estimated reserves for such claims are adequate, however, actual experience in claim frequency and amount could materially differ from our estimates and adversely affect our results of operations, cash flow, liquidity and financial condition.
New Accounting Standards and Accounting Changes
In December 2004, the FASB issued Statement No. 153 (“FAS 153”), “Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions” (“APB 29”). FAS 153 is based on the principle that nonmonetary asset exchanges should be recorded and measured at the fair value of the assets exchanged, with certain exceptions. This standard requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (i) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits or (ii) the transactions lack commercial substance (as defined). In addition, the FASB decided to retain the guidance in APB 29 for assessing whether the fair value of a nonmonetary asset is determinable within reasonable limits. The new standard is the result of the convergence project between the FASB and the International Accounting Standards Board (“IASB”). We adopted this standard for nonmonetary asset exchanges in 2006. The adoption of FAS 153 did not have an impact on our consolidated financial statements.
On June 1, 2005 the FASB issued SFAS 154, “Accounting Changes and Error Corrections,” which replaces APB 20, “Accounting Changes,” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes made in fiscal years beginning after June 1, 2005. We adopted this standard for accounting changes in interim financial statements in 2006. The adoption of FAS 154 did not have an impact on our financial position, results of operations or cash flows.
On February 16, 2006 the FASB issued SFAS 155, “Accounting for Certain Hybrid Instruments,” which amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140. This statement is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. We do not expect our adoption of this new standard to have a material impact on our financial position, results of operations or cash flows.
Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. Some of our outstanding debt has a variable interest rate. As described in “—Derivative Financial Instruments” above, we use some derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors. As of March 31, 2006, our total outstanding debt was approximately $1,356.1 million, of which approximately $85.0 million, or 6.3%, was variable rate debt. If market rates of interest on our variable rate debt decrease by 1.0% or 100 basis points, the decrease in interest expense on our variable rate debt would increase future earnings and cash flows by approximately $850,000 annually. On the other hand, if market rates of interest on our variable debt increase by 1.0% or 100 basis points, the increase in interest expense on our variable debt would decrease future earnings and cash flows by approximately $850,000 annually.
Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of a reduced level of overall economic activity. If overall economic activity is significantly reduced, we may take actions to further mitigate our exposure. However, because we cannot determine the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.
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Evaluation of Disclosure Controls and Procedures. Based upon an evaluation of the effectiveness of disclosure controls and procedures, Sunstone Hotels Investors, Inc.’s Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have concluded that as of the end of the period covered by this Quarterly Report on Form 10-Q our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the Securities and Exchange Commission and is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting. During our most recent fiscal quarter, there has not occurred any change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II—OTHER INFORMATION
There have been no material developments during the three months ended March 31, 2006 to the suit against our predecessor companies which was filed by a hotel guest who became ill and alleged the illness resulted from exposure to a Legionella bacteria during a stay at one of our formerly owned hotels as described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 under the heading “Legal Proceedings.”
There have been no material changes from risk factors as previously disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the period ended December 31, 2005, filed with the SEC on February 15, 2006.
None.
The following Exhibits are filed as a part of this report:
Description
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Jon D. Kline
(Principal Financial Officer and Duly Authorized Officer)
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