Table of Contents
UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2019
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 001-32319
Sunstone Hotel Investors, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Maryland
20-1296886
(State or Other Jurisdiction ofIncorporation or Organization)
(I.R.S. EmployerIdentification Number)
200 Spectrum Center Drive, 21st FloorIrvine, California
92618
(Address of Principal Executive Offices)
(Zip Code)
Registrant’s telephone number, including area code: (949) 330-4000
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
Trading Symbol(s)
Name of Each Exchange on Which Registered
Common Stock, $0.01 par value
SHO
New York Stock Exchange
Series E Cumulative Redeemable Preferred Stock, $0.01 par value
SHO.PRE
Series F Cumulative Redeemable Preferred Stock, $0.01 par value
SHO.PRF
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 ⌧ No ◻
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ⌧ No ◻
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☒
Accelerated filer ☐
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ◻ No ☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
224,861,978 shares of Common Stock, $0.01 par value, as of August 2, 2019
SUNSTONE HOTEL INVESTORS, INC.
QUARTERLY REPORT ON
For the Quarterly Period Ended June 30, 2019
TABLE OF CONTENTS
Page
PART I—FINANCIAL INFORMATION
Item 1.
Financial Statements
2
Consolidated Balance Sheets as of June 30, 2019 (unaudited) and December 31, 2018
Unaudited Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2019 and 2018
3
Unaudited Consolidated Statements of Equity for the Three and Six Months Ended June 30, 2019 and 2018
4
Unaudited Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2019 and 2018
6
Notes to Unaudited Consolidated Financial Statements
8
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
25
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
44
Item 4.
Controls and Procedures
PART II—OTHER INFORMATION
Legal Proceedings
46
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
47
SIGNATURES
48
i
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
June 30,
December 31,
2019
2018
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents
$
741,503
809,316
Restricted cash
46,199
53,053
Accounts receivable, net
48,240
33,844
Prepaid expenses and other current assets
8,720
12,261
Total current assets
844,662
908,474
Investment in hotel properties, net
2,936,678
3,030,998
Finance lease right-of-use assets, net
54,991
—
Operating lease right-of-use assets, net
62,380
Deferred financing costs, net
3,131
3,544
Other assets, net
23,898
29,817
Total assets
3,925,740
3,972,833
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable and accrued expenses
32,092
30,425
Accrued payroll and employee benefits
20,407
25,039
Dividends and distributions payable
14,618
126,461
Other current liabilities
47,907
44,962
Current portion of notes payable, net
6,167
5,838
Total current liabilities
121,191
232,725
Notes payable, less current portion, net
968,090
971,225
Finance lease obligations, less current portion
27,120
27,009
Operating lease obligations, less current portion
52,097
Other liabilities
19,176
30,703
Total liabilities
1,187,674
1,261,662
Commitments and contingencies (Note 11)
Equity:
Stockholders’ equity:
Preferred stock, $0.01 par value, 100,000,000 shares authorized:
6.95% Series E Cumulative Redeemable Preferred Stock, 4,600,000 shares issued and outstanding at June 30, 2019 and December 31, 2018, stated at liquidation preference of $25.00 per share
115,000
6.45% Series F Cumulative Redeemable Preferred Stock, 3,000,000 shares issued and outstanding at June 30, 2019 and December 31, 2018, stated at liquidation preference of $25.00 per share
75,000
Common stock, $0.01 par value, 500,000,000 shares authorized, 228,206,823 shares issued and outstanding at June 30, 2019 and 228,246,247 shares issued and outstanding at December 31, 2018
2,282
Additional paid in capital
2,723,737
2,728,684
Retained earnings
1,243,002
1,182,722
Cumulative dividends and distributions
(1,469,456)
(1,440,202)
Total stockholders’ equity
2,689,565
2,663,486
Noncontrolling interest in consolidated joint venture
48,501
47,685
Total equity
2,738,066
2,711,171
Total liabilities and equity
See accompanying notes to consolidated financial statements.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
Three Months Ended June 30,
Six Months Ended June 30,
REVENUES
Room
208,735
220,304
380,593
400,580
Food and beverage
75,704
79,292
144,817
153,558
Other operating
18,457
17,851
35,166
34,755
Total revenues
302,896
317,447
560,576
588,893
OPERATING EXPENSES
51,846
54,900
100,092
105,995
48,399
50,885
95,221
101,039
4,367
4,357
8,332
8,298
Advertising and promotion
14,149
14,316
27,713
28,222
Repairs and maintenance
10,193
10,851
20,475
21,954
Utilities
6,533
6,974
13,198
14,449
Franchise costs
8,579
9,961
15,418
17,814
Property tax, ground lease and insurance
20,614
21,508
40,962
43,289
Other property-level expenses
34,015
35,518
66,855
69,425
Corporate overhead
8,078
7,594
15,594
14,696
Depreciation and amortization
36,524
37,334
72,911
74,022
Impairment loss
1,394
Total operating expenses
243,297
255,592
476,771
500,597
Interest and other income
4,811
2,966
9,735
4,457
Interest expense
(15,816)
(11,184)
(30,142)
(20,060)
Gain on sale of assets
15,659
Income before income taxes
48,594
53,637
63,398
88,352
Income tax (provision) benefit, net
(2,676)
(2,375)
436
1,365
NET INCOME
45,918
51,262
63,834
89,717
Income from consolidated joint venture attributable to noncontrolling interest
(1,955)
(2,374)
(3,554)
(4,813)
Preferred stock dividends
(3,207)
(6,414)
INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS
40,756
45,681
53,866
78,490
Basic and diluted per share amounts:
Basic and diluted income attributable to common stockholders per common share
0.18
0.20
0.24
0.35
Basic and diluted weighted average common shares outstanding
227,389
225,232
227,305
224,760
UNAUDITED CONSOLIDATED STATEMENTS OF EQUITY
(In thousands, except share and per share data)
Preferred Stock
Noncontrolling
Series E
Series F
Common Stock
Cumulative
Interest in
Number of
Additional
Retained
Dividends and
Consolidated
Shares
Amount
Paid in Capital
Earnings
Distributions
Joint Venture
Total Equity
Balance at December 31, 2018 (audited)
4,600,000
3,000,000
228,246,247
Amortization of deferred stock compensation
2,221
Issuance of restricted common stock, net
345,132
(4,439)
(4,435)
Forfeiture of restricted common stock
(3,932)
Common stock distributions and distributions payable at $0.05 per share
(11,429)
Series E preferred stock dividends and dividends payable at $0.434375 per share
(1,998)
Series F preferred stock dividends and dividends payable at $0.403125 per share
(1,209)
Distributions to noncontrolling interest
(1,950)
Net income
16,317
1,599
17,916
Balance at March 31, 2019
228,587,447
2,286
2,726,466
1,199,039
(1,454,838)
47,334
2,710,287
3,002
Issuance of restricted common stock
51,840
Repurchase of outstanding common stock
(432,464)
(4)
(5,731)
(5,735)
(11,411)
(788)
43,963
1,955
Balance at June 30, 2019
228,206,823
Balance at December 31, 2017 (audited)
225,321,660
2,253
2,679,221
932,277
(1,270,013)
48,440
2,582,178
2,113
297,013
(4,235)
(4,232)
(3,961)
(11,281)
(1,169)
36,016
2,439
38,455
Balance at March 31, 2018
225,614,712
2,256
2,677,099
968,293
(1,284,501)
49,710
2,602,857
49,513
1
(1)
(824)
(11,413)
(1,475)
Net proceeds from sale of common stock
2,590,854
26
44,315
44,341
48,888
2,374
Balance at June 30, 2018
228,254,255
2,283
2,724,379
1,017,181
(1,299,121)
50,609
2,685,331
5
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operating activities:
Bad debt expense
275
489
(15,663)
Noncash interest on derivatives and finance lease obligations, net
5,753
(4,177)
Depreciation
72,854
72,690
Amortization of franchise fees and other intangibles
57
1,463
Amortization of right-of-use assets
(270)
Amortization of deferred financing costs
1,396
1,492
5,022
4,865
Gain on hurricane-related damage
(1,100)
Deferred income taxes, net
(636)
(1,819)
Changes in operating assets and liabilities:
Accounts receivable
(14,671)
(12,286)
Prepaid expenses and other assets
4,578
(303)
Accounts payable and other liabilities
2,493
12,246
(4,632)
(5,755)
Net cash provided by operating activities
136,053
143,253
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of assets
137,036
Proceeds from property insurance
1,100
Acquisition deposit
(500)
Acquisition of hotel property and other assets
(193)
Acquisitions of intangible assets
(18,484)
Renovations and additions to hotel properties and other assets
(52,733)
(87,141)
Net cash (used in) provided by investing activities
(52,926)
32,011
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from common stock offerings
45,125
Payment of common stock offering costs
(784)
Repurchase of common stock for employee withholding obligations
Payments on notes payable
(3,789)
(3,764)
Payments of deferred financing costs
(5)
Dividends and distributions paid
(141,097)
(148,382)
(2,738)
(2,644)
Net cash used in financing activities
(157,794)
(114,686)
Net (decrease) increase in cash and cash equivalents and restricted cash
(74,667)
60,578
Cash and cash equivalents and restricted cash, beginning of period
862,369
559,311
Cash and cash equivalents and restricted cash, end of period
787,702
619,889
Supplemental Disclosure of Cash Flow Information
The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the consolidated balance sheets to the amount shown in the consolidated statements of cash flows:
544,900
74,989
Total cash and cash equivalents and restricted cash shown on the consolidated statements of cash flows
The Company paid the following amounts for interest and income taxes, during the six months ended June 30, 2019 and 2018:
Cash paid for interest
22,893
22,144
Cash paid for income taxes, net
272
242
Supplemental Disclosure of Noncash Investing and Financing Activities
The Company’s noncash investing and financing activities during the six months ended June 30, 2019 and 2018 consisted of the following:
Accrued renovations and additions to hotel properties and other assets
8,977
13,202
Amortization of deferred stock compensation — construction activities
201
214
14,620
7
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of Business
Sunstone Hotel Investors, Inc. (the “Company”) was incorporated in Maryland on June 28, 2004 in anticipation of an initial public offering of common stock, which was consummated on October 26, 2004. The Company elected to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes, commencing with its taxable year ended on December 31, 2004. The Company, through its 100% 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 acquiring, owning, asset managing and renovating or repositioning hotel properties, and may also selectively sell hotels that no longer fit its stated strategy.
As a REIT, certain tax laws limit the amount of “non-qualifying” income the Company can earn, including income derived directly from the operation of hotels. The Company leases all of its hotels to its TRS Lessee, which in turn enters into long-term management agreements with third parties to manage the operations of the Company’s hotels, in transactions that are intended to generate qualifying income. uAs of June 30, 2019, the Company had interests in 21 hotels (the “21 Hotels”), currently held for investment. The Company’s third-party managers included the following:
Number of Hotels
Subsidiaries of Marriott International, Inc. or Marriott Hotel Services, Inc. (collectively, “Marriott”)
Interstate Hotels & Resorts, Inc.
Highgate Hotels L.P. and an affiliate
Crestline Hotels & Resorts
Hilton Worldwide
Davidson Hotels & Resorts
Hyatt Corporation
Singh Hospitality, LLC
Total hotels owned as of June 30, 2019
21
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements as of June 30, 2019 and December 31, 2018, and for the three and six months ended June 30, 2019 and 2018, include the accounts of the Company, the Operating Partnership, the TRS Lessee and their controlled subsidiaries. All significant intercompany balances and transactions have been eliminated. If the Company determines that it has an interest in a variable interest entity, the Company will consolidate the entity when it is determined to be the primary beneficiary of the entity.
The accompanying interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and in conformity with the rules and regulations of the Securities and Exchange Commission. In the Company’s 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 the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the Securities and Exchange Commission on February 14, 2019. Operating results for the three and six months ended June 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.
The Company does not have any comprehensive income other than what is included in net income. If the Company has any comprehensive income in the future such that a statement of comprehensive income would be necessary, the Company will include such statement in one continuous consolidated statement of operations.
Certain prior year amounts in these financial statements have been reclassified to conform to the presentation for the three and six months ended June 30, 2019.
The Company has evaluated subsequent events through the date of issuance of these financial statements.
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP 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 differ materially from those estimates.
Earnings Per Share
The Company applies the two-class method when computing its earnings per share. Net income per share for each class of stock is calculated assuming all of the Company’s net income is distributed as dividends to each class of stock based on their contractual rights.
Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are considered participating securities and are included in the computation of earnings per share.
Basic earnings (loss) attributable to common stockholders per common share is computed based on the weighted average number of shares of common stock outstanding during each period. Diluted earnings (loss) attributable to common stockholders per common share is computed based on the weighted average number of shares of common stock outstanding during each period, plus potential common shares considered outstanding during the period, as long as the inclusion of such awards is not anti-dilutive. Potential common shares consist of unvested restricted stock awards and the incremental common shares issuable upon the exercise of stock options (before their expiration in April 2018), using the more dilutive of either the two-class method or the treasury stock method.
The following table sets forth the computation of basic and diluted earnings per common share (unaudited and in thousands, except per share data):
Numerator:
Distributions paid on unvested restricted stock compensation
(61)
(59)
(122)
(118)
Undistributed income allocated to unvested restricted stock compensation
(156)
(179)
(167)
(298)
Numerator for basic and diluted income attributable to common stockholders
40,539
45,443
53,577
78,074
Denominator:
Weighted average basic and diluted common shares outstanding
The Company’s unvested restricted shares associated with its long-term incentive plan and shares associated with common stock options, as applicable, have been excluded from the above calculation of earnings per share for the three and six months ended June 30, 2019 and 2018, as their inclusion would have been anti-dilutive.
Noncontrolling Interest
The Company’s consolidated financial statements include an entity in which the Company has a controlling financial interest. Noncontrolling interest is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. Such noncontrolling interest is reported on the consolidated balance sheets within equity, separately from the Company’s equity. On the consolidated statements of operations, revenues, expenses and net income or loss from the less-than-wholly owned subsidiary are
9
reported at their consolidated amounts, including both the amounts attributable to the Company and the noncontrolling interest. Income or loss is allocated to the noncontrolling interest based on its weighted average ownership percentage for the applicable period. The consolidated statements of equity include beginning balances, activity for the period and ending balances for each component of stockholders’ equity, noncontrolling interest and total equity.
At both June 30, 2019 and December 31, 2018, the noncontrolling interest reported in the Company’s consolidated financial statements consisted of a third-party’s 25.0% ownership interest in the Hilton San Diego Bayfront.
Investment in Hotel Properties
Investments in hotel properties, including land, buildings, furniture, fixtures and equipment (“FF&E”) and identifiable intangible assets are recorded at fair value upon acquisition. Property and equipment purchased after the hotel acquisition date is recorded at cost. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation is removed from the Company’s accounts and any resulting gain or loss is included in the statements of operations.
Depreciation expense is based on the estimated life of the Company’s assets. The life is based on a number of assumptions, including the cost and timing of capital expenditures to maintain and refurbish the Company’s hotels, as well as specific market and economic conditions. Hotel properties are depreciated using the straight-line method over estimated useful lives primarily ranging from five to 40 years for buildings and improvements and three to 12 years for FF&E. Intangible assets are amortized using the straight-line method over their estimated useful life or over the length of the related agreement, whichever is shorter.
The Company’s investment in hotel properties, net also includes initial franchise fees which are recorded at cost and amortized using the straight-line method over the terms of the franchise agreements ranging from 14 to 27 years. All other franchise fees that are based on the Company’s results of operations are expensed as incurred.
While the Company believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income or the gain or loss on the sale of any of the Company’s hotels. The Company has not changed the useful lives of any of its assets during the periods discussed.
Impairment losses are recorded on long-lived assets to be held and used by the Company when indicators of impairment are present and the future undiscounted net cash flows expected to be generated by those assets, based on the Company’s anticipated investment horizon, are less than the assets’ carrying amount. If such assets are considered to be impaired, the related assets are adjusted to their estimated fair value and an impairment loss is recognized. The impairment loss recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. The Company performs a fair value assessment using a discounted cash flow analysis to estimate the fair value of its hotel properties, taking into account each property’s expected cash flow from operations, the Company’s estimate of how long it will continue to own each property and estimated proceeds from the disposition of the property. The factors addressed in determining estimated proceeds from disposition include anticipated operating cash flow in the year of disposition and terminal capitalization rate. The Company’s judgement is required in determining the discount rate applied to estimated cash flows, the estimated growth of revenues and expenses, net operating income and margins, the need for capital expenditures, as well as specific market and economic conditions.
Fair value represents the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than a forced or liquidation sale. The estimation process involved in determining if assets have been impaired and in the determination of fair value is inherently uncertain because it requires estimates of current market yields as well as future events and conditions. Such future events and conditions include economic and market conditions, as well as the availability of suitable financing. The realization of the Company’s investment in hotel properties is dependent upon future uncertain events and conditions and, accordingly, the actual timing and amounts realized by the Company may be materially different from their estimated fair values.
Restricted Cash
Restricted cash is comprised of reserve accounts for debt service, interest reserves, seasonality reserves, capital replacements, ground leases, property taxes and any excess hotel-generated cash that is held in an account for the benefit of a lender. These restricted funds are subject to supervision and disbursement approval by certain of the Company’s lenders and/or hotel managers.
10
Revenue Recognition
Revenues are recognized when control of the promised goods or services is transferred to hotel guests, which is generally defined as the date upon which a guest occupies a room and/or utilizes the hotel’s services. Room revenue is recognized over a guest’s stay at a previously agreed upon daily rate. Additionally, some of the Company’s hotel rooms are booked through independent internet travel intermediaries. If the guest pays the independent internet travel intermediary directly, revenue for the room is recognized by the Company at the price the Company sold the room to the independent internet travel intermediary, less any discount or commission paid. If the guest pays the Company directly, revenue for the room is recognized by the Company on a gross basis, with the related discount or commission recognized in room expense. A majority of the Company’s hotels participate in frequent guest programs sponsored by the hotel brand owners whereby the hotel allows guests to earn loyalty points during their hotel stay. The Company expenses charges associated with these programs as incurred, and recognizes revenue at the amount it will receive from the brand when a guest redeems their loyalty points by staying at one of the Company’s hotels. In addition, some contracts for rooms or food and beverage services require an advance deposit, which the Company records as deferred revenue (or a contract liability) and recognizes once the performance obligations are satisfied.
Food and beverage revenue and other ancillary services revenue are generated when a customer chooses to purchase goods or services separately from a hotel room. These revenue streams are recognized during the time the goods or services are provided to the customer at the amount the Company expects to be entitled to in exchange for those goods or services. For those ancillary services provided by third parties, the Company assesses whether it is the principal or the agent. If the Company is the principal, revenue is recognized based upon the gross sales price. If the Company is the agent, revenue is recognized based upon the commission earned from the third party.
Additionally, the Company collects sales, use, occupancy and other similar taxes at its hotels. These taxes are collected from customers at the time of purchase, but are not included in revenue. The Company records a liability upon collection of such taxes from the customer, and relieves the liability when payments are remitted to the applicable governmental agency.
Trade receivables and contract liabilities consisted of the following (in thousands):
Trade receivables, net (1)
25,250
18,982
Contract liabilities (2)
17,052
16,711
Segment Reporting
The Company considers each of its hotels to be an operating segment, and allocates resources and assesses the operating performance for each hotel. Because all of the Company’s hotels have similar economic characteristics, facilities and services, the hotels have been aggregated into a single reportable segment, hotel ownership.
New Accounting Standards and Accounting Changes
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2016-02, “Leases (Topic 842)” (“ASU No. 2016-02”), which requires companies to record a right-of-use asset and a lease liability on the balance sheet for all leases with a term greater than 12 months regardless of their classification. All entities will classify leases as either operating or finance to determine how to recognize lease-related revenue and expense. Classification will continue to affect amounts that lessees and lessors record on the balance sheet. The new standard requires the following:
11
Subsequent to the issuance of ASU No. 2016-02, the FASB issued several clarifications and updates, including Accounting Standards Update No. 2018-01, “Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842” (“ASU No. 2018-01”) in January 2018, Accounting Standards Update No. 2018-10, “Codification Improvements to Topic 842, Leases” (“ASU No. 2018-10”) and Accounting Standards Update No. 2018-11, “Leases (Topic 842): Targeted Improvements” (“ASU No. 2018-11”) in July 2018, Accounting Standards Update No. 2018-20, “Leases (Topic 842): Narrow-Scope Improvements for Lessors” (“ASU No. 2018-20”) in December 2018 and Accounting Standards Update No. 2019-01, “Leases (Topic 842): Codification Improvements” (“ASU No. 2019-01”) in March 2019.
The Company adopted ASU No. 2016-02 on January 1, 2019, along with its related clarifications and amendments, and made the following elections:
Lessee Perspective: Adoption of the new standard resulted in the Company recording net balance sheet adjustments for right-of-use (“ROU”) assets and related lease obligations totaling $45.7 million for its operating leases. The Company also reclassified an $18.4 million ground lease intangible asset, net of accumulated amortization, from investment in hotel properties, net to operating lease ROU assets, net, and reclassified its existing deferred rent liabilities related to its operating leases totaling $13.0 million from other liabilities to operating lease obligations. The adjustments related to operating leases affected the Company’s January 1, 2019 consolidated balance sheet as follows (in thousands):
Balance Pre-Adoption
Adjustments
Balance Post-Adoption
64,075
Investment in hotel properties, net (intangible assets)
50,889
(18,398)
32,491
Total asset adjustments
45,677
Operating lease obligations, current and noncurrent
58,663
Other liabilities (deferred rent)
12,986
(12,986)
Total liability adjustments
Upon adoption of the new standard, the Company reclassified amounts related to its finance leases as follows (in thousands):
55,727
Investment in hotel properties, net (land)
611,993
(6,605)
605,388
Investment in hotel properties, net (buildings and improvements, net of accumulated depreciation)
2,167,680
(49,122)
2,118,558
Finance lease obligations, current and noncurrent
27,010
Capital lease obligations, current and noncurrent
(27,010)
12
The Company determines if a contract is a lease at inception. Leases with an initial term of 12 months or less are not recorded on the balance sheet. Expense for these short-term leases is recognized on a straight-line basis over the lease term. For leases with an initial term greater than 12 months, the Company records a ROU asset and a corresponding lease obligation. ROU assets represent the Company’s right to use an underlying asset for the lease term, and lease obligations represent the Company’s obligation to make fixed lease payments as stipulated by the lease. Operating lease obligations are recognized at the lease commencement date based on the present value of lease payments over the lease term. As the Company’s leases do not provide an implicit rate, the Company uses its incremental borrowing rate (“IBR”) based on information available at the commencement date in determining the present value of lease payments over the lease term. The IBR is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. In order to estimate the Company’s IBR, the Company first looks to its own unsecured debt offerings, and adjusts the rate for both length of term and secured borrowing using available market data as well as consultations with leading national financial institutions that are active in the issuance of both secured and unsecured notes.
Operating lease ROU assets are recognized at the lease commencement date, and include the amount of the initial operating lease obligation, any lease payments made at or before the commencement date, excluding any lease incentives received, and any initial direct costs incurred. For leases that have extension options that the Company can exercise at its discretion, management uses judgement to determine if it is reasonably certain that the Company will in fact exercise such option. If the extension option is reasonably certain to occur, the Company includes the extended term’s lease payments in the calculation of the respective lease liability. None of the Company’s leases contain any material residual value guarantees or material restrictive covenants. The Company reviews its right-of-use assets for indicators of impairment. If such assets are considered to be impaired, the related assets are adjusted to their estimated fair value and an impairment loss is recognized. The impairment loss recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets.
Lessor Perspective: For lease agreements in which the Company is the lessor, the Company analyzed the impact of the standard and determined that there was no material impact to the recognition, measurement, or presentation of these revenues. Upon adoption, the Company analyzed the lease and nonlease components, including real estate taxes and common area maintenance expenses, of its lease agreements and determined that the timing and pattern of transfer for both components are the same. In addition, the Company determined that the predominate component was the lease component and, as such, the leases will continue to qualify as operating leases and the Company will account for and present the lease component and the nonlease component as a single component. The Company will continue to collect nonlease amounts directly from its tenants, including real estate taxes and other expenses, and remit these amounts directly to third-parties. None of the Company’s tenants pay third-parties directly. The Company believes that all of its tenant receivables are probable of collection as of June 30, 2019.
See Note 8 for additional lease disclosures.
In June 2016, the FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU No. 2016-13”), which will replace today’s “incurred loss” approach with an “expected loss” model for instruments measured at amortized cost. For trade and other receivables, held-to-maturity debt securities, loans and other instruments, entities will be required to use a new forward looking “expected loss” model that generally will result in the earlier recognition of allowances for losses. In addition, entities will have to disclose significantly more information, including information they use to track credit quality by year of origination for most financing receivables. In November 2018, the FASB issued Accounting Standards Update No. 2018-19, “Codification Improvements to Topic 326, Financial Instruments-Credit Losses” (“ASU No. 2018-19”), which clarifies that operating lease receivables accounted for under ASC 842 are not in the scope of ASU No. 2016-13. Both ASU No. 2016-13 and ASU No. 2018-19 are effective during the first quarter of 2020. Both standards will require a modified retrospective approach, with early adoption permitted during the first quarter of 2019. The Company is currently evaluating the impact that ASU No. 2016-13 and ASU No. 2018-19 will have on its consolidated financial statements.
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3. Investment in Hotel Properties
Investment in hotel properties, net consisted of the following (in thousands):
Land
605,581
Buildings and improvements
2,957,631
2,983,308
Furniture, fixtures and equipment
497,082
486,441
Intangible assets
33,083
56,021
Franchise fees
778
Construction in progress
68,264
60,744
Investment in hotel properties, gross
4,162,419
4,199,285
Accumulated depreciation and amortization
(1,225,741)
(1,168,287)
4. Fair Value Measurements and Interest Rate Derivatives
Fair Value Measurements
As of June 30, 2019 and December 31, 2018, the carrying amount of certain financial instruments, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued expenses were representative of their fair values due to the short-term maturity of these instruments.
A fair value measurement is based on the assumptions that market participants would use in pricing an asset or liability in an orderly transaction. The hierarchy for inputs used in measuring fair value is as follows:
Level 1
Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2
Inputs reflect quoted prices for identical assets or liabilities in markets that are not active; quoted prices for similar assets or liabilities in active markets; inputs other than quoted prices that are observable for the asset or the liability; or inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3
Unobservable inputs reflecting the Company’s own assumptions incorporated in valuation techniques used to determine fair value. These assumptions are required to be consistent with market participant assumptions that are reasonably available.
As of June 30, 2019 and December 31, 2018, the only financial instruments that the Company measures at fair value on recurring bases are its interest rate derivatives, along with a life insurance policy and a related retirement benefit agreement. The Company estimates the fair value of its interest rate derivatives using Level 2 measurements based on quotes obtained from the counterparties, which are based upon the consideration that would be required to terminate the agreements. Both the life insurance policy and the related retirement benefit agreement, which are for a former Company associate, are valued using Level 2 measurements.
14
The following table presents the Company’s assets measured at fair value on a recurring and nonrecurring basis at June 30, 2019 and December 31, 2018 (in thousands):
Fair Value Measurements at Reporting Date
Total
June 30, 2019 (unaudited):
Interest rate cap derivative
Interest rate swap derivative
32
Life insurance policy (1)
398
Total assets measured at fair value at June 30, 2019
430
December 31, 2018:
Interest rate cap derivatives
Interest rate swap derivatives
4,789
386
Total assets measured at fair value at December 31, 2018
5,175
The following table presents the Company’s liabilities measured at fair value on a recurring and nonrecurring basis at June 30, 2019 and December 31, 2018 (in thousands):
885
Retirement benefit agreement (1)
Total liabilities measured at fair value at June 30, 2019
1,283
Total liabilities measured at fair value at December 31, 2018
15
Interest Rate Derivatives
The Company’s interest rate derivatives, which are not designated as effective cash flow hedges, consisted of the following at June 30, 2019 (unaudited) and December 31, 2018 (in thousands):
Estimated Fair Value of Assets (Liabilities) (1)
Strike / Capped
Effective
Maturity
Notional
Hedged Debt
Type
Rate
Index
Date
Hilton San Diego Bayfront
Cap
4.250
%
1-Month LIBOR
May 1, 2017
May 1, 2019
N/A
6.000
November 10, 2017
December 9, 2020
220,000
$85.0 million term loan
Swap
1.591
October 29, 2015
September 2, 2022
85,000
2,521
$100.0 million term loan
1.853
January 29, 2016
January 31, 2023
100,000
(885)
2,268
(853)
Noncash changes in the fair values of the Company’s interest rate derivatives resulted in increases (decreases) to interest expense for the three and six months ended June 30, 2019 and 2018 as follows (unaudited and in thousands):
Noncash interest on derivatives
3,578
(1,090)
5,642
(4,277)
Fair Value of Debt
As of June 30, 2019 and December 31, 2018, 77.5% and 77.6%, respectively, of the Company’s outstanding debt had fixed interest rates, including the effects of interest rate swap agreements. The Company uses Level 3 measurements to estimate the fair value of its debt by discounting the future cash flows of each instrument at estimated market rates.
The Company’s principal balances and fair market values of its consolidated debt as of June 30, 2019 (unaudited) and December 31, 2018 were as follows (in thousands):
June 30, 2019
December 31, 2018
Carrying Amount (1)
Fair Value
Debt
979,040
975,285
982,828
971,082
5. Other Assets
Other assets, net consisted of the following (in thousands):
Property and equipment, net
7,967
8,426
Goodwill
990
Deferred rent on straight-lined third-party tenant leases
3,190
3,177
Deferred income tax asset, net
8,739
8,407
Interest rate derivatives
Other receivables
2,170
3,209
Other
810
819
Total other assets, net
16
6. Notes Payable
Notes payable consisted of the following (in thousands):
Notes payable requiring payments of interest and principal, with fixed rates ranging from 4.12% to 5.95%; maturing at dates ranging from November 2020 through January 2025. The notes are collateralized by first deeds of trust on four hotel properties at both June 30, 2019 and December 31, 2018.
334,040
337,828
Note payable requiring payments of interest only, bearing a blended rate of one-month LIBOR plus 105 basis points; initial maturity in December 2020 with three one-year extensions. The note is collateralized by a first deed of trust on one hotel property.
Unsecured term loan requiring payments of interest only, with a blended interest rate based on a pricing grid with a range of 135 to 220 basis points over one-month LIBOR, depending on the Company's leverage ratios. LIBOR has been swapped to a fixed rate of 1.591%, resulting in an effective interest rate of 2.941%. Matures in September 2022.
Unsecured term loan requiring payments of interest only, with a blended interest rate based on a pricing grid with a range of 135 to 220 basis points over one-month LIBOR, depending on the Company's leverage ratios. LIBOR has been swapped to a fixed rate of 1.853%, resulting in an effective interest rate of 3.203%. Matures in January 2023.
Unsecured Senior Notes requiring semi-annual payments of interest only, bearing interest at 4.69%; maturing in January 2026.
120,000
Unsecured Senior Notes requiring semi-annual payments of interest only, bearing interest at 4.79%; maturing in January 2028.
Total notes payable
Current portion of notes payable
8,133
7,804
Less: current portion of deferred financing costs
(1,966)
Carrying value of current portion of notes payable
Notes payable, less current portion
970,907
975,024
Less: long-term portion of deferred financing costs
(2,817)
(3,799)
Carrying value of notes payable, less current portion
As of June 30, 2019, the Company had no outstanding amounts due under its credit facility.
Interest Expense
Total interest incurred and expensed on the notes payable was as follows (unaudited and in thousands):
Interest expense on debt and finance lease obligations
11,484
11,479
22,993
22,745
3,634
(1,040)
698
745
Total interest expense
15,816
11,184
30,142
20,060
17
7. Other Current Liabilities and Other Liabilities
Other Current Liabilities
Other current liabilities consisted of the following (in thousands):
Property, sales and use taxes payable
19,203
15,684
Income tax payable
29
125
Accrued interest
7,091
7,306
Advance deposits
16,472
Management fees payable
1,248
1,142
3,864
3,994
Total other current liabilities
Other Liabilities
Other liabilities consisted of the following (in thousands):
Deferred revenue
5,255
5,017
Deferred rent
Deferred property taxes payable (1)
9,801
9,284
Interest rate derivative
Deferred income tax liability
304
3,235
3,112
Total other liabilities
18
8. Leases
Lessee Accounting
The Company has both operating and finance leases for ground, building, office and air leases, maturing in dates ranging from 2028 through 2097, including expected renewal options. Including all renewal options available to the Company, the lease maturity date extends to 2147. Leases were included on the Company’s consolidated balance sheet as follows (in thousands):
Finance Leases:
Right-of-use assets, net (land)
6,605
Right-of-use assets, net (buildings and improvements)
58,799
Accumulated depreciation
(10,413)
Right-of-use assets, net
Lease obligations, less current portion
Total lease obligations
27,121
Operating Leases:
4,599
56,696
Weighted Average Remaining Lease Term:
Finance leases
52.9 years
Operating leases
24.6 years
Weighted Average Discount Rate:
9.5
5.3
The components of lease expense were as follows (in thousands):
Three Months Ended
Six Months Ended
Finance lease cost:
368
736
Interest on lease obligations
645
1,289
Total finance lease cost
1,013
2,025
Operating lease cost (1)
3,229
6,378
19
Supplemental cash flow information related to leases was as follows (in thousands):
Cash paid for amounts included in the measurement of lease obligations:
Operating cash flows from operating leases
3,499
Right-of-use assets obtained in exchange for lease obligations:
Future maturities of the Company’s operating and finance lease obligations at June 30, 2019 were as follows (in thousands):
Operating Leases
Finance Leases
Year 1
7,494
2,357
Year 2
7,545
Year 3
7,595
2,437
Year 4
7,649
2,453
Year 5
7,704
Thereafter
77,854
134,994
Total lease payments
115,841
147,051
Less: interest (1)
(59,145)
(119,930)
Present value of lease obligations
Lessor Accounting
During the three and six months ended June 30, 2019, the Company recognized $2.8 million and $5.5 million, respectively, in lease-related revenue, which is included in other operating revenue on the Company’s unaudited consolidated statement of operations.
9. Stockholders’ Equity
Series E Cumulative Redeemable Preferred Stock
In March 2016, the Company issued 4,600,000 shares of its 6.95% Series E Cumulative Redeemable Preferred Stock (“Series E preferred stock”) with a liquidation preference of $25.00 per share for gross proceeds of $115.0 million. In conjunction with the offering, the Company incurred $4.0 million in preferred offering costs. On or after March 11, 2021, the Series E 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, but not including, the redemption date. Upon the occurrence of a change of control, as defined by the Articles Supplementary for Series E preferred stock, holders of the Series E preferred stock may, under certain circumstances, convert their preferred shares into shares of the Company’s common stock.
Series F Cumulative Redeemable Preferred Stock
In May 2016, the Company issued 3,000,000 shares of its 6.45% Series F Cumulative Redeemable Preferred Stock (“Series F preferred stock”) with a liquidation preference of $25.00 per share for gross proceeds of $75.0 million. In conjunction with the offering, the Company incurred $2.6 million in preferred offering costs. On or after May 17, 2021, the Series F 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, but not including, the redemption date. Upon the occurrence of a change of control, as defined by the Articles Supplementary for Series F preferred stock, holders of the Series F preferred stock may, under certain circumstances, convert their preferred shares into shares of the Company’s common stock.
In February 2017, the Company entered into separate “At the Market” Agreements (the “ATM Agreements”) with each of Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities LLC and Wells Fargo Securities, LLC. In accordance with the terms of the ATM Agreements, the Company may from time to time offer and sell shares of its common stock having an
20
aggregate offering price of up to $300.0 million. The Company did not issue any shares of its common stock in connection with the ATM agreements during the three and six months ended June 30, 2019. During 2017 and 2018, the Company issued a total of 7,467,709 shares of its common stock in connection with the ATM Agreements for gross proceeds of $124.5 million, leaving $175.5 million available for sale under the ATM Agreements. The Company paid a total of $2.3 million in costs during 2017 and 2018 in connection with common stock issued under the ATM Agreements.
In February 2017, the Company’s board of directors authorized a stock repurchase program to acquire up to an aggregate of $300.0 million of the Company’s common and preferred stock. During the second quarter of 2019, the Company repurchased 432,464 shares of its common stock for $5.7 million, leaving $294.3 million of remaining authorized capacity under the program (see Note 12). As of June 30, 2019, no shares of the Company’s preferred stock have been repurchased. Future repurchases will depend on various factors, including the Company’s capital needs, as well as the Company’s common and preferred stock price.
10. Long-Term Incentive Plan
Stock Grants
Restricted shares granted pursuant to the Company’s Long-Term Incentive Plan (“LTIP”) generally vest over a period of three years from the date of grant. Should a stock grant be forfeited prior to its vesting, the shares covered by the stock grant are added back to the LTIP and remain available for future issuance. Shares of common stock tendered or withheld to satisfy the grant or exercise price or tax withholding obligations upon the vesting of a stock grant are not added back to the LTIP.
Compensation expense related to awards of restricted shares are measured at fair value on the date of grant and amortized over the relevant requisite service period or derived service period.
The Company has elected to account for forfeitures as they occur. The Company’s amortization expense and forfeitures related to restricted shares for the three and six months ended June 30, 2019 and 2018 were as follows (unaudited and in thousands):
Amortization expense, including forfeitures
2,900
2,865
In addition, the Company capitalizes compensation costs related to restricted shares granted to certain employees whose work is directly related to the Company’s capital investment in its hotels. These capitalized costs totaled $0.1 million during both the three months ended June 30, 2019 and 2018, and $0.2 million during both the six months ended June 30, 2019 and 2018.
11. Commitments and Contingencies
Management Agreements
Management agreements with the Company’s third-party hotel managers require the Company to pay between 1.75% and 3.0% of total revenue of the managed hotels to the third-party managers each month as a basic management fee. In addition to basic management fees, provided that certain operating thresholds are met, the Company may also be required to pay incentive management fees to certain of its third-party managers. Total basic and incentive management fees incurred by the Company during the three and six months ended June 30, 2019 and 2018 were included in other property-level expenses on the Company’s consolidated statements of operations as follows (unaudited and in thousands):
Basic management fees
8,486
8,812
15,637
16,346
Incentive management fees
2,378
2,128
5,530
4,848
Total basic and incentive management fees
10,864
10,940
21,167
21,194
License and Franchise Agreements
The Company has entered into license and franchise agreements related to certain of its hotel properties. The license and franchise agreements require the Company to, among other things, pay monthly fees that are calculated based on specified percentages of certain revenues.
Total license and franchise fees incurred by the Company during the three and six months ended June 30, 2019 and 2018 were included in franchise costs on the Company’s consolidated statements of operations as follows (unaudited and in thousands):
Franchise assessments (1)
6,319
7,224
11,614
13,132
Franchise royalties
2,260
2,737
3,804
4,682
Total franchise costs
Renovation and Construction Commitments
At June 30, 2019, the Company had various contracts outstanding with third parties in connection with the ongoing renovations of certain of its hotel properties. The remaining commitments under these contracts at June 30, 2019 totaled $42.8 million.
Concentration of Risk
The concentration of the Company’s hotels in California, Florida, the greater Washington DC area, Hawaii, Illinois and Massachusetts exposes the Company’s business to economic and severe weather conditions, competition and real and personal property tax rates unique to these locales. As of June 30, 2019, 16 of the 21 Hotels were geographically concentrated as follows (unaudited):
Trailing 12-Month
Percentage of
Total Rooms
Consolidated Revenue
California
34
Florida
Greater Washington DC area
Hawaii
Illinois
Massachusetts
22
The Company has provided customary unsecured indemnities to certain lenders, including in particular, environmental indemnities. 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 indemnified parties for damages related to certain 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 or a claim against its environmental insurance policies.
At June 30, 2019, the Company had $0.4 million of outstanding irrevocable letters of credit to guarantee the Company’s financial obligations related to workers’ compensation insurance programs from prior policy years. The beneficiaries of these letters of credit may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation. No draws have been made through June 30, 2019.
The Company is subject to various claims, lawsuits and legal proceedings, including routine litigation arising in the ordinary course of business, regarding the operation of its hotels, its managers and other Company matters. While it is not possible to ascertain the ultimate outcome of such matters, the Company believes that the aggregate identifiable amount of such liabilities, if any, in excess of amounts covered by insurance will not have a material adverse impact on its financial condition or results of operations. The outcome of claims, lawsuits and legal proceedings brought against the Company, however, is subject to significant uncertainties.
12. Subsequent Event
From July 1, 2019 to August 2, 2019, the Company repurchased 3,344,845 shares of its common stock for $44.2 million, leaving $250.1 million of remaining authorized capacity under its $300.0 million stock repurchase program.
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Cautionary Statement
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. The Company intends such forward-looking statements to be covered by the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and includes this statement for purposes of complying with these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe the Company’s future plans, strategies, opinions and expectations, are generally identifiable by use of the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “project,” or similar expressions. You should not rely on forward-looking statements because they involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond the Company’s control, and which could materially affect actual results, performances or achievements. Accordingly, there is no assurance that the Company’s expectations will be realized. 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 14, 2019, 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. Except as otherwise required by federal securities laws, the Company disclaims any obligations or undertaking to publicly release any updates or revisions to any forward-looking statement contained herein (or elsewhere) to reflect any change in the Company’s expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Sunstone Hotel Investors, Inc. (the “Company,” “we,” “our” or “us”) is a Maryland corporation. We operate as a self-managed and self-administered real estate investment trust (“REIT”). A REIT is a corporation that directly or indirectly owns real estate assets and has elected to be taxable as a real estate investment trust. To qualify for taxation as a REIT, the REIT must meet certain requirements, including regarding the composition of its assets and the sources of its income. REITs generally are not subject to federal income taxes at the corporate level as long as they pay stockholder dividends equivalent to 100% of their taxable income. REITs are required to distribute to stockholders at least 90% of their REIT taxable income. We own, directly or indirectly, 100% of the interests of Sunstone Hotel Partnership, LLC (the “Operating Partnership”), which is the entity that directly or indirectly owns our hotel properties. We also own 100% of the interests of our taxable REIT subsidiary, Sunstone Hotel TRS Lessee, Inc., which, directly or indirectly, leases all of our hotels from the Operating Partnership, and engages independent third-parties to manage our hotels.
Our business is to acquire, own, asset manage and renovate or reposition hotels that we consider to be Long-Term Relevant Real Estate® (or LTRR®) in the United States, specifically hotels in urban and resort locations that benefit from significant barriers to entry by competitors and diverse economic drivers. As part of our ongoing portfolio management strategy, on an opportunistic basis, we may also selectively sell hotel properties that we believe do not meet our criteria of LTRR®. As of June 30, 2019, we had interests in 21 hotels currently held for investment (the “21 Hotels”), which average 513 rooms in size. Of the 21 Hotels, we classify 18 as upper upscale, two as upscale and one as luxury as defined by STR, Inc. All but two (the Boston Park Plaza and the Oceans Edge Resort & Marina) of the 21 Hotels are operated under nationally recognized brands such as Marriott, Hilton and Hyatt, which are among the most respected and widely recognized brands in the lodging industry. Our two unbranded hotels are located in top urban and resort markets that have enabled them to establish awareness with both group and transient customers.
Our mission is to create meaningful value for our stockholders by producing superior long-term returns through the ownership of LTRR® in the hospitality sector. Our values include transparency, trust, ethical conduct, honest communication and discipline. As demand for lodging generally fluctuates with the overall economy, we seek to own a portfolio of hotels that will maintain a high appeal with travelers over long periods of time and will generate economic earnings materially in excess of recurring capital requirements. Our strategy is to maximize stockholder value through focused asset management and disciplined capital recycling, which is likely to include selective acquisitions and dispositions, while maintaining balance sheet flexibility and strength. Our goal is to maintain appropriate leverage and financial flexibility to position the Company to create value throughout all phases of the operating and financial cycles.
Operating Activities
Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following:
Expenses. Our expenses consist of the following:
Other Revenue and Expense. Other revenue and expense consists of the following:
Operating Performance Indicators. The following performance indicators are commonly used in the hotel industry:
Factors Affecting Our Operating Results. The primary factors affecting our operating results include overall demand for hotel rooms, the pace of new hotel development, or supply, and the relative performance of our operators in increasing revenue and controlling hotel operating expenses.
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With respect to improving RevPAR index, we continually work with our hotel operators to optimize revenue management initiatives while taking into consideration market demand trends and the pricing strategies of competitor hotels in our markets. We also develop capital investment programs designed to ensure each of our hotels is well renovated and positioned to appeal to groups and individual travelers fitting target guest profiles. Increased capital investment in our properties may lead to short-term revenue disruption and negatively impact RevPAR index. Our revenue management initiatives are generally oriented towards maximizing ADR even if the result may be lower occupancy than may be achieved through lower ADR. Increases in RevPAR attributable to increases in ADR may be accompanied by minimal additional expenses, while increases in RevPAR attributable to higher occupancy may result in higher variable expenses such as housekeeping, guest supplies, labor and utilities expense. Our Comparable Portfolio RevPAR index increased 340 basis points during the first six months of 2019 as compared to the same period in 2018. The increase in our Comparable Portfolio RevPAR index was primarily due to increases in the RevPAR index at the Wailea Beach Resort post-repositioning, the Hilton Times Square, which benefited from the temporary closure of a nearby Hilton hotel, and at the Four 2018 Renovation Hotels. These increases were partially offset by decreases in the RevPAR index at two of the Four 2019 Renovation Hotels.
We continue to work with our operators to identify operational efficiencies designed to reduce expenses while minimally affecting guest experience and hotel employee satisfaction. Key asset management initiatives include working with our operators to optimize hotel staffing levels (albeit ultimate staffing levels are determined by our operators), increasing the efficiency of the hotels, such as installing energy efficient management and inventory control systems, and selectively combining certain food and beverage outlets. Our operators may have difficulty implementing certain operational efficiency initiatives and success levels may vary, as most categories of variable operating expenses, such as utilities and housekeeping labor costs, fluctuate with changes in occupancy. Furthermore, our hotels operate with significant fixed costs, such as general and administrative expense, insurance, property taxes, and other expenses associated with owning hotels, over which our operators have little control. Our operators have experienced, either currently or in the past, increases in hourly wages, employee benefits, utility costs and property insurance, which have negatively affected our operating margins. Moreover, our operators are limited in their ability to reduce expenses without affecting brand standards or the competitiveness of our hotels.
Operating Results. The following table presents our unaudited operating results for our total portfolio for the three months ended June 30, 2019 and 2018, including the amount and percentage change in the results between the two periods.
Change $
Change %
(in thousands, except statistical data)
(11,569)
(5.3)
(3,588)
(4.5)
606
3.4
(14,551)
(4.6)
Hotel operating
164,680
173,752
(9,072)
(5.2)
(1,503)
(4.2)
484
6.4
(810)
(2.2)
(1,394)
(100.0)
(12,295)
(4.8)
1,845
62.2
(41.4)
(5,043)
(9.4)
Income tax provision, net
(301)
(12.7)
(5,344)
(10.4)
419
17.6
(4,925)
(10.8)
28
The following table presents our unaudited operating results for our total portfolio for the six months ended June 30, 2019 and 2018, including the amount and percentage change in the results between the two periods.
(19,987)
(5.0)
(8,741)
(5.7)
411
1.2
(28,317)
321,411
341,060
(19,649)
(5.8)
(2,570)
(3.7)
898
6.1
(1,111)
(1.5)
(23,826)
5,278
118.4
(10,082)
(50.3)
(15,659)
(24,954)
(28.2)
Income tax benefit, net
(929)
(68.1)
(25,883)
(28.8)
1,259
26.2
(24,624)
(31.4)
Operating Statistics. The following table includes comparisons of the key operating metrics for our Comparable Portfolio.
Change
Occ%
ADR
RevPAR
Comparable Portfolio
87.4
243.43
212.76
87.1
239.25
208.39
30
bps
1.7
2.1
83.3
234.15
195.05
83.1
227.59
189.13
2.9
3.1
Summary of Operating Results. The year-over-year comparability of our operations is affected by changes in our portfolio resulting from hotel acquisitions, dispositions or renovations. We sold six hotels in 2018 (the “Six Sold Hotels”): two hotels in the first quarter of 2018; one hotel in the third quarter of 2018; and three hotels in the fourth quarter of 2018. In addition, renovations at the Four 2019 Renovation Hotels negatively impacted our operating results during both the three and six months ended June 30, 2019, and the Four 2018 Renovation Hotels negatively impacted our operating results during the same periods in 2018.
Room revenue. Room revenue decreased $11.6 million, or 5.3%, for the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
The sale of four hotels during the third and fourth quarters of 2018 (the “Four Sold Hotels”) caused room revenue to decrease by $16.0 million in the second quarter of 2019 as compared to the same period in 2018.
Room revenue generated by the 21 Hotels increased $4.4 million during the second quarter of 2019 as compared to the same period in 2018, due to a $3.6 million increase in ADR combined with a $0.8 million increase due to occupancy. The overall increase in ADR was primarily driven by changes in the average daily rate at the following hotels:
Increases
Decreases
Boston hotels
Chicago hotels
Hyatt Regency San Francisco
Renaissance Washington DC
Renaissance Long Beach
Wailea Beach Resort
The increase in the 21 Hotels’ occupancy during the second quarter of 2019 as compared to the same period in 2018 was caused by 13,046 additional transient room nights, partially offset by 9,494 fewer group room nights. The overall changes in room nights occurred primarily at the following hotels:
Group Room Nights
JW Marriott New Orleans
Marriott Boston Long Wharf
Renaissance Harborplace
Transient Room Nights
Renaissance Los Angeles Airport
Renaissance Orlando at SeaWorld®
Room revenue generated by the 21 Hotels was negatively impacted during the second quarter of 2019 as compared to the same period in 2018 by the Four 2019 Renovation Hotels, where a combined total of 10,278 room nights were out of service, displacing approximately $2.6 million in room revenue based on the hotels achieving a combined potential 85.0% occupancy rate and RevPAR of $216.25 without the renovations.
For the six months ended June 30, 2019, room revenue decreased $20.0 million, or 5.0%, as compared to the six months ended June 30, 2018.
The Six Sold Hotels caused room revenue to decrease by $31.5 million in the first six months of 2019 as compared to the same period in 2018.
Room revenue generated by the 21 Hotels increased $11.5 million during the first six months of 2019 as compared to the same period in 2018, due to a $10.6 million increase in ADR combined with a $0.9 million increase due to occupancy. The overall increase in ADR was primarily driven by changes in the average daily rate at the following hotels:
Oceans Edge Resort & Marina
The increase in the 21 Hotels’ occupancy during the first six months of 2019 as compared to the same period in 2018 was caused by 5,416 additional transient room nights, partially offset by 1,803 fewer group room nights. The overall changes in room nights occurred primarily at the following hotels:
Boston Park Plaza
Hilton Garden Inn Chicago Downtown/Magnificent Mile
Room revenue generated by the 21 Hotels was negatively impacted during the first six months of 2019 as compared to the same period in 2018 by the Four 2019 Renovation Hotels, where a combined total of 19,678 room nights were out of service, displacing approximately $4.7 million in room revenue based on the hotels achieving a combined potential 79.1% occupancy rate and RevPAR of $195.63 without the renovations.
Food and beverage revenue. Food and beverage revenue decreased $3.6 million, or 4.5%, for the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
The Four Sold Hotels caused food and beverage revenue to decrease by $7.2 million in the second quarter of 2019 as compared to the same period in 2018.
Food and beverage revenue generated by the 21 Hotels increased $3.6 million during the second quarter of 2019 as compared to the same period in 2018 primarily due to changes in both banquet and event technology revenue and outlet revenue at the following hotels:
Banquet and Event Technology Revenue
Embassy Suites Chicago
Hyatt Centric Chicago Magnificent Mile
Outlet Revenue
For the six months ended June 30, 2019, food and beverage revenue decreased $8.7 million, or 5.7%, as compared to the six months ended June 30, 2018.
The Six Sold Hotels caused food and beverage revenue to decrease by $14.1 million in the first six months of 2019 as compared to the same period in 2018.
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Food and beverage revenue generated by the 21 Hotels increased $5.4 million during the first six months of 2019 as compared to the same period in 2018 primarily due to changes in both banquet and event technology revenue and outlet revenue at the following hotels:
Renaissance Westchester
Other operating revenue. Other operating revenue increased $0.6 million, or 3.4%, for the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
Other operating revenue generated by the 21 Hotels increased $1.9 million during the three months ended June 30, 2019 as compared to the same period in 2018, primarily due to increased facility fees, marina and watersports revenue, commission revenue, tenant lease revenue and parking revenue, partially offset by decreases in cancellation and attrition revenue and other miscellaneous revenues.
The Four Sold Hotels caused other operating revenue to decrease by $1.3 million in the second quarter of 2019 as compared to the same period in 2018.
For the six months ended June 30, 2019, other operating revenue increased $0.4 million, or 1.2%, as compared to the six months ended June 30, 2018.
Other operating revenue generated by the 21 Hotels increased $2.9 million during the six months ended June 30, 2019 as compared to the same period in 2018, primarily due to increased facility fees, marina and watersports revenue, commission revenue, tenant lease revenue and parking revenue. These increases were partially offset as we recognized $0.8 million in business interruption proceeds related to Hurricane Irma at the Oceans Edge Resort & Marina during the first quarter of 2018, with no corresponding revenue recognized during the first six months of 2019. In addition, cancellation and attrition revenue decreased during the first six months of 2019 as compared to the same period in 2018.
The Six Sold Hotels caused other operating revenue to decrease by $2.5 million in the first six months of 2019 as compared to the same period in 2018.
Hotel operating expenses. Hotel operating expenses, which are comprised of room, food and beverage, advertising and promotion, repairs and maintenance, utilities, franchise costs, property tax, ground lease and insurance, and other hotel operating expenses decreased $9.1 million, or 5.2%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
The Four Sold Hotels caused hotel operating expenses to decrease by $14.8 million in the second quarter of 2019 as compared to the same period in 2018.
Hotel operating expenses generated by the 21 Hotels increased $5.7 million during the three months ended June 30, 2019 as compared to the same period in 2018. This increase is primarily related to the corresponding increases in room revenue, food and beverage revenue and other operating revenue. In addition, hotel operating expenses increased in the second quarter of 2019 as compared to the same period in 2018 due to the following increased expenses: advertising and promotion due to increased payroll and related expenses in this department; repairs and maintenance due to increased payroll and related expenses in this department, as well as increased building repairs; property and liability insurance due to increased rates; taxes at the Hyatt Regency San Francisco due to
new taxes imposed by the city; and Hawaii general excise tax due to higher revenue at the Wailea Beach Resort. Slightly offsetting these increases, the following expenses decreased: rent expense at the Renaissance Washington DC due to our May 2018 purchase of the exclusive perpetual rights to a small portion of the hotel’s meeting space, restaurant and fitness center that were previously leased; and ground lease expense at the Hilton San Diego Bayfront due to decreased percentage rent and at the JW Marriott New Orleans due to our purchase of the land underlying the hotel in July 2018.
For the six months ended June 30, 2019, hotel operating expenses decreased $19.6 million, or 5.8%, as compared to the six months ended June 30, 2018.
The Six Sold Hotels caused hotel operating expenses to decrease by $29.9 million in the first six months of 2019 as compared to the same period in 2018.
Hotel operating expenses generated by the 21 Hotels increased $10.3 million during the six months ended June 30, 2019 as compared to the same period in 2018, primarily due to the same reasons noted above in the discussion regarding the second quarter. In addition, property taxes increased in the first six months of 2019 as compared to the same period in 2018 due to increased rates and assessments received at several of our hotels.
Other property-level expenses. Other property-level expenses decreased $1.5 million, or 4.2%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
The Four Sold Hotels caused other property-level expenses to decrease by $3.4 million in the second quarter of 2019 as compared to the same period in 2018.
Other property-level expenses generated by the 21 Hotels increased $1.9 million in the second quarter of 2019 as compared to the same period in 2018, primarily due to increased payroll and related expenses, basic and incentive management fees, legal fees, and computer hardware and software expenses. These increases were partially offset by decreased credit and collection expenses.
For the six months ended June 30, 2019, other property-level expenses decreased $2.6 million, or 3.7%, as compared to the six months ended June 30, 2018.
The Six Sold Hotels caused other property-level expenses to decrease by $7.2 million in the first six months of 2019 as compared to the same period in 2018.
Other property-level expenses generated by the 21 Hotels increased $4.6 million in the first six months of 2019 as compared to the same period in 2018, primarily due to increased payroll and related expenses, basic and incentive management fees, legal fees, computer hardware and software expenses, and other expenses.
Corporate overhead expense. Corporate overhead expense increased $0.5 million, or 6.4%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018, primarily due to increased payroll and related expenses, deferred stock compensation, investor relations and legal fees.
Corporate overhead expense increased $0.9 million, or 6.1%, during the six months ended June 30, 2019 as compared to the six months ended June 30, 2018, primarily due to increased payroll and related expenses, deferred stock compensation, investor relations, legal fees and office rent.
Depreciation and amortization expense. Depreciation and amortization expense decreased $0.8 million, or 2.2%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018.
The Four Sold Hotels caused depreciation and amortization to decrease by $2.1 million in the second quarter of 2019 as compared to the same period in 2018.
Depreciation and amortization expense generated by the 21 Hotels increased $1.3 million in the second quarter of 2019 as compared to the same period in 2018, due to increased depreciation and amortization at our newly renovated hotels and corporate office space. These increases were partially offset by decreases in the amortization of intangible assets, consisting of advanced deposits related to our purchases of the Boston Park Plaza and the Wailea Beach Resort, which were fully amortized in June 2018 and July 2018, respectively, as well as by assets at our hotels being fully depreciated.
For the six months ended June 30, 2019, depreciation and amortization expense decreased $1.1 million, or 1.5%, as compared to the six months ended June 30, 2018.
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The Six Sold Hotels caused depreciation and amortization to decrease by $4.2 million in the first six months of 2019 as compared to the same period in 2018.
Depreciation and amortization expense generated by the 21 Hotels increased $3.1 million in the first six months of 2019 as compared to the same period in 2018, primarily due to the same reasons noted above in the discussion regarding the second quarter.
Impairment loss. Impairment loss was zero for both the three and six months ended June 30, 2019, and $1.4 million for both the three and six months ended June 30, 2018. During the second quarter of 2018, we recorded an impairment loss of $1.4 million on two hotels that we subsequently sold in October 2018.
Interest and other income. Interest and other income increased $1.8 million, or 62.2%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018. During the second quarter of 2019, we recognized $3.8 million in interest income, $0.9 million related to a contingency funding payment received from the prior owner of one of our hotels and $0.1 million in vendor rebates and other miscellaneous income. During the second quarter of 2018, we recognized $1.9 million in interest and miscellaneous income, along with $1.1 million in insurance proceeds for hurricane-related property damage at two hotels that we subsequently sold in October 2018.
For the six months ended June 30, 2019, interest and other income increased $5.3 million, or 118.4%, as compared to the six months ended June 30, 2018. During the first six months of 2019, we recognized $7.4 million in interest income, $1.0 million related to an area of protection agreement with Hyatt Corporation for the Hyatt Regency San Francisco, $0.9 million related to a contingency funding payment received from the prior owner of one of our hotels, $0.1 million in energy rebates due to energy efficient renovations at our hotels and $0.3 million in vendor rebates and other miscellaneous income. During the first six months of 2018, we recognized $3.3 million in interest and miscellaneous income, along with $1.1 million in insurance proceeds for hurricane-related property damage at two hotels that we subsequently sold in October 2018 and $0.1 million in energy rebates.
Interest expense. We incurred interest expense as follows (in thousands):
Interest expense increased $4.6 million, or 41.4%, during the three months ended June 30, 2019 as compared to the three months ended June 30, 2018, and increased $10.1 million, or 50.3%, during the six months ended June 30, 2019 as compared to the six months ended June 30, 2018.
The increase in interest expense for both the three and six months ended June 30, 2019 as compared to the same periods in 2018 is primarily due to the noncash changes in the fair market values of our derivatives, which caused interest expense to increase $4.7 million and $9.9 million, respectively. Excluding the noncash impact from changes in the fair market values of our derivatives, interest expense would have decreased a nominal amount and increased $0.2 million in the second quarter and first six months of 2019 as compared to the same periods in 2018, respectively. Higher interest on our variable rate debt caused interest expense to increase during both the second quarter and first six months of 2019 as compared to the same periods in 2018. These increases were partially offset by decreases in interest expense resulting from lower debt balances due to monthly amortization and lower interest expense on our term loans, which we amended and repriced in October 2018.
Our weighted average interest rate per annum, including our variable rate debt obligation, was approximately 4.2% at both June 30, 2019 and 2018. Approximately 77.5% and 77.7% of our outstanding notes payable had fixed interest rates at June 30, 2019 and 2018, respectively.
Gain on sale of assets. Gain on sale of assets totaled zero for both the three and six months ended June 30, 2019, and zero and $15.7 million for the three and six months ended June 30, 2018, respectively. During the first quarter of 2018, we recognized a $15.7 million gain on the sale of two hotels.
Income tax (provision) benefit, net. Income tax (provision) benefit, net totaled a net provision of $2.7 million and $2.4 million for the three months ended June 30, 2019 and 2018, respectively, and a net benefit of $0.4 million and $1.4 million for the six months
ended June 30, 2019 and 2018, respectively. We lease our hotels to the TRS Lessee and its subsidiaries, which are subject to federal and state income taxes. In addition, we and the Operating Partnership may also be subject to various state and local income taxes.
During the second quarter and first six months of 2019, we recognized a deferred income tax provision of $2.6 million and a deferred income tax benefit of $0.6 million, respectively, related to adjustments to our deferred tax assets, net. Our earnings are seasonal, resulting in quarterly fluctuations in our taxable income. We anticipate our deferred tax assets will continue to decrease during 2019 as our earnings increase based on the historical seasonal earnings pattern of our hotels. During the second quarter and first six months of 2019, we also recognized a nominal amount and $0.2 million, respectively, of combined current federal and state income tax expense based on 2019 projected taxable income net of operating loss carryforwards for our taxable entities.
During the three and six months ended June 30, 2018, we recognized a deferred income tax provision of $2.1 million and a deferred income tax benefit of $1.8 million, respectively, related to adjustments to our deferred tax assets, net. During the second quarter and first six months of 2018, we also recognized combined current federal and state income tax expense of $0.2 million and $0.5 million, respectively, based on 2018 projected taxable income net of operating loss carryforwards for our taxable entities.
Income from consolidated joint venture attributable to noncontrolling interest. Income from consolidated joint venture attributable to noncontrolling interest, which represents the outside 25.0% interest in the entity that owns the Hilton San Diego Bayfront, totaled $2.0 million and $2.4 million for the three months ended June 30, 2019 and 2018, respectively, and $3.6 million and $4.8 million for the six months ended June 30, 2019 and 2018, respectively.
Preferred stock dividends. Preferred stock dividends were as follows (in thousands):
Series E preferred stock
1,998
3,996
Series F preferred stock
1,209
2,418
Total preferred stock dividends
3,207
6,414
Non-GAAP Financial Measures. We use the following “non-GAAP financial measures” that we believe are useful to investors as key supplemental measures of our operating performance: EBITDAre; Adjusted EBITDAre, excluding noncontrolling interest; FFO attributable to common stockholders; Adjusted FFO attributable to common stockholders; and Comparable Portfolio revenues. These measures should not be considered in isolation or as a substitute for measures of performance in accordance with GAAP. In addition, our calculation of these measures may not be comparable to other companies that do not define such terms exactly the same as the Company. These non-GAAP measures are used in addition to and in conjunction with results presented in accordance with GAAP. They should not be considered as alternatives to net income, cash flow from operations, or any other operating performance measure prescribed by GAAP. These non-GAAP financial measures reflect additional ways of viewing our operations that we believe, when viewed with our GAAP results and the reconciliations to the corresponding GAAP financial measures, provide a more complete understanding of factors and trends affecting our business than could be obtained absent this disclosure. For example, we believe that Comparable Portfolio revenues are useful to both us and investors in evaluating our operating performance by removing the impact of non-hotel results such as the amortization of favorable and unfavorable tenant lease contracts. We also believe that our use of Comparable Portfolio revenues is useful to both us and our investors as it facilitates the comparison of our operating results from period to period by removing fluctuations caused by any acquisitions or dispositions, as well as by those hotels that we classify as held for sale, those hotels that are undergoing a material renovation or repositioning and those hotels whose room counts have materially changed during either the current or prior year. We strongly encourage investors to review our financial information in its entirety and not to rely on a single financial measure.
We present EBITDAre in accordance with guidelines established by the National Association of Real Estate Investment Trusts (“NAREIT”), as defined in its September 2017 white paper “Earnings Before Interest, Taxes, Depreciation and Amortization for Real Estate.” We believe EBITDAre is a useful performance measure to help investors evaluate and compare the results of our operations from period to period in comparison to our peers. NAREIT defines EBITDAre as net income (calculated in accordance with GAAP) plus interest expense, income tax expense, depreciation and amortization, gains or losses on the disposition of depreciated property (including gains or losses on change in control), impairment write-downs of depreciated property and of investments in unconsolidated affiliates caused by a decrease in the value of depreciated property in the affiliate, and adjustments to reflect the entity’s share of EBITDAre of unconsolidated affiliates.
We make additional adjustments to EBITDAre when evaluating our performance because we believe that the exclusion of certain additional items described below provides useful information to investors regarding our operating performance, and that the presentation of Adjusted EBITDAre, excluding noncontrolling interest, when combined with the primary GAAP presentation of net income, is beneficial to an investor’s complete understanding of our operating performance. In addition, we use both EBITDAre and Adjusted EBITDAre, excluding noncontrolling interest as measures in determining the value of hotel acquisitions and dispositions.
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We adjust EBITDAre for the following items, which may occur in any period, and refer to this measure as Adjusted EBITDAre, excluding noncontrolling interest:
36
The following table reconciles our unaudited net income to EBITDAre and Adjusted EBITDAre, excluding noncontrolling interest for our total portfolio for the three and six months ended June 30, 2019 and 2018 (in thousands):
Operations held for investment:
Income tax provision (benefit), net
2,676
2,375
(436)
(1,365)
Loss (gain) on sale of assets
EBITDAre
100,934
103,555
166,451
168,165
Amortization of favorable and unfavorable contracts, net
Amortization of right-of-use assets (1)
(251)
(229)
(447)
Finance lease obligation interest — cash ground rent
(590)
(589)
(1,179)
(1,178)
Hurricane-related insurance proceeds net of uninsured losses
(1,084)
(1,015)
Prior year property tax adjustments, net
109
136
298
117
Prior owner contingency funding
(900)
Noncontrolling interest:
(640)
(1,279)
(1,278)
(558)
(489)
(1,118)
(924)
Amortization of right-of-use asset (1)
73
145
(1,812)
(2,329)
(2,835)
(4,523)
Adjusted EBITDAre, excluding noncontrolling interest
99,122
101,226
163,616
163,642
Adjusted EBITDAre, excluding noncontrolling interest was $99.1 million and $101.2 million for the three months ended June 30, 2019 and 2018, respectively, and $163.6 million for both the six months ended June 30, 2019 and 2018. Adjusted EBITDAre, excluding noncontrolling interest decreased during the second quarter and first six months of 2019 as compared to the same periods in 2018, primarily due to the sale of the Four Sold Hotels and the Six Sold Hotels, respectively. Excluding the impact of these hotel sales, Adjusted EBITDAre, excluding noncontrolling interest would have increased $4.2 million and $11.0 million for the second quarter and first six months of 2019 as compared to the same periods in 2018, respectively, primarily due to additional EBITDAre generated by the Four 2018 Renovation Hotels and by both the Boston Park Plaza and the Wailea Beach Resort, combined with an increase in interest and other income. These increases were partially offset by renovation-related disruption at the Four 2019 Renovation Hotels.
We believe that the presentation of FFO attributable to common stockholders provides useful information to investors regarding our operating performance because it is a measure of our operations without regard to specified noncash items such as real estate depreciation and amortization, any real estate impairment loss and any gain or loss on sale of real estate assets, all of which are based on historical cost accounting and may be of lesser significance in evaluating our current performance. Our presentation of FFO attributable to common stockholders conforms to the NAREIT definition of “FFO applicable to common shares.” Our presentation may not be comparable to FFO reported by other REITs that do not define the terms in accordance with the current NAREIT definition, or that interpret the current NAREIT definition differently than we do.
We also present Adjusted FFO attributable to common stockholders when evaluating our operating performance because we believe that the exclusion of certain additional items described below provides useful supplemental information to investors regarding our ongoing operating performance, and may facilitate comparisons of operating performance between periods and our peer companies. We adjust FFO attributable to common stockholders for the following items, which may occur in any period, and refer to this measure as Adjusted FFO attributable to common stockholders:
37
38
The following table reconciles our unaudited net income to FFO attributable to common stockholders and Adjusted FFO attributable to common stockholders for our total portfolio for the three and six months ended June 30, 2019 and 2018 (in thousands):
Real estate depreciation and amortization (1)
35,900
36,876
71,670
73,104
Real estate depreciation and amortization
FFO attributable to common stockholders
76,016
83,317
124,257
136,047
Real estate amortization of right-of-use assets (1)
146
138
297
286
Noncash income tax provision (benefit), net
2,648
2,147
Real estate amortization of right-of-use asset (1)
Noncash interest on derivative, net
5,710
4,957
(6,459)
Adjusted FFO attributable to common stockholders
81,726
83,685
129,214
129,588
Adjusted FFO attributable to common stockholders was $81.7 million and $83.7 million for the three months ended June 30, 2019 and 2018, respectively, and $129.2 million and $129.6 million for the six months ended June 30, 2019 and 2018, respectively. Adjusted FFO attributable to common stockholders decreased during the second quarter and first six months of 2019 as compared to the same periods in 2018, primarily due to the sale of the Four Sold Hotels and the Six Sold Hotels, respectively. Excluding the impact of these hotel sales, Adjusted FFO attributable to common stockholders would have increased $4.3 million and $9.2 million for the second quarter and first six months of 2019 as compared to the same periods in 2018, respectively, primarily due to the same reasons noted in the discussion above regarding Adjusted EBITDAre, excluding noncontrolling interest.
Liquidity and Capital Resources
During the periods presented, our sources of cash included our operating activities and working capital, as well as proceeds from sales of hotels and other assets, property insurance and our common stock issuances pursuant to separate “At the Market” Agreements (the “ATM Agreements”) with each of Merrill Lynch, Pierce, Fenner & Smith Incorporated, J.P. Morgan Securities LLC and Wells Fargo Securities, LLC. Our primary uses of cash were for capital expenditures for hotels and other assets, acquisitions of assets, operating expenses, repurchases of our common stock, repayment of notes payable, dividends and distributions on our common and preferred stock and distributions to our joint venture partner. We cannot be certain that traditional sources of funds will be available in the future.
Operating activities. Our net cash provided by or used in operating activities fluctuates primarily as a result of changes in hotel revenue and the operating cash flow of our hotels. Our net cash provided by or used in operating activities may also be affected by changes in our portfolio resulting from hotel acquisitions, dispositions or renovations. Net cash provided by operating activities was $136.1 million and $143.3 million for six months ended June 30, 2019 and 2018, respectively. The net decrease to cash provided by operating activities during the first six months of 2019 as compared to the same period in 2018 was primarily due to the sale of the Six Sold Hotels and renovation-related disruption at the Four 2019 Renovation Hotels, partially offset by increased operating cash generated by the 21 Hotels, including the Four 2018 Renovation Hotels, combined with increased interest and other income.
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Investing activities. Our net cash provided by or used in investing activities fluctuates primarily as a result of acquisitions, dispositions and renovations of hotels and other assets. Net cash used in or provided by investing activities during the first six months of 2019 as compared to the first six months of 2018 was as follows (in thousands):
During the first six months of 2019, we paid $0.2 million to purchase an additional wet boat slip at the Oceans Edge Resort & Marina and invested $52.7 million for renovations and additions to our portfolio and other assets.
During the first six months of 2018, we received proceeds of $137.0 million from our sales of the Marriott Philadelphia, the Marriott Quincy and surplus FF&E, along with $1.1 million in insurance proceeds for hurricane-related property damage at two hotels we subsequently sold in October 2018. These cash inflows were partially offset as we paid a deposit of $0.5 million towards our July 2018 purchase of land underlying the JW Marriott New Orleans, paid a total of $18.5 million for acquisitions of intangible assets, including $18.4 million to purchase the exclusive perpetual rights to a small portion of the Renaissance Washington DC’s meeting space, restaurant and fitness center that were previously leased and $0.1 million to purchase two additional dry boats slips at the Oceans Edge Resort & Marina, and invested $87.1 million for renovations and additions to our portfolio and other assets.
Financing activities. Our net cash provided by or used in financing activities fluctuates primarily as a result of our distributions paid, issuance and repurchase of common stock, issuance and repayment of notes payable, and our issuance and redemption of other forms of capital, including preferred equity. Net cash used in financing activities during the first six months of 2019 as compared to the first six months of 2018 was as follows (in thousands):
During the first six months of 2019, we paid the following: $5.7 million to repurchase 432,464 shares of our outstanding common stock; $4.4 million to repurchase common shares to satisfy the tax obligations in connection with the vesting of restricted common shares issued to employees; $3.8 million in principal payments on our notes payable; $141.1 million in dividends and distributions to our common and preferred stockholders; and $2.7 million in distributions to the noncontrolling interest in the Hilton San Diego Bayfront.
During the first six months of 2018, we received total net proceeds of $44.3 million from the issuance of our common stock. This cash inflow was offset as we paid the following: $4.2 million to repurchase common shares to satisfy the tax obligations in connection with the vesting of restricted common shares issued to employees; $3.8 million in principal payments on our notes payable; $5,000 in deferred financing costs related to refinancing the loan secured by the Hilton San Diego Bayfront; $148.4 million in dividends and distributions to our common and preferred stockholders; and $2.6 million in distributions to the noncontrolling interest in the Hilton San Diego Bayfront.
Future. We expect our primary uses of cash to be for operating expenses, capital investments in our hotels, repayment of principal on our notes payable and possibly our credit facility, interest expense, dividends and distributions on our common and preferred stock, potential purchases of debt or other securities in other hotels, and acquisitions of hotels or interests in hotels, including
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possibly hotel portfolios. We may also repurchase shares of our common and/or preferred stock pursuant to the February 2017 stock repurchase program authorized by our board of directors. Under the terms of the program, we are authorized to repurchase up to an aggregate of $300.0 million of our common and preferred stock. Through June 30, 2019, we have repurchased 432,464 shares of our common stock for a total purchase price of $5.7 million, leaving $294.3 million of remaining authorized capacity under the program. Future repurchases will depend on various factors, including our capital needs, as well as the price of our common and preferred stock.
We expect our primary sources of cash will continue to be our operating activities, working capital, notes payable and our credit facility, dispositions of hotel properties, and proceeds from public and private offerings of debt securities and common and preferred stock. Our financial objectives include the maintenance of our credit ratios, appropriate levels of liquidity and continued balance sheet strength. Consistent with maintaining our low leverage and balance sheet strength, in the near-term, we expect to fund future acquisitions, if any, largely through cash on hand, appropriate amounts of newly-issued debt, the issuance of common or preferred equity, provided that our stock price is at an attractive level, or by proceeds received from sales of existing assets in order to selectively grow the quality and scale of our portfolio. 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 alternate sources of capital in an effort to minimize our capital costs and maximize our financial flexibility, including under the ATM Agreements we entered into in February 2017. Under the terms of the ATM Agreements, we may issue and sell from time to time through or to the managers, as sales agents and/or principals, shares of our common stock having an aggregate offering amount of up to $300.0 million. Through June 30, 2019, we have received $122.3 million in net proceeds from the issuance of 7,467,709 shares of our common stock in connection with the ATM Agreements, leaving $175.5 million available for sale under the ATM Agreements. However, when needed, the capital markets may not be available to us on favorable terms or at all.
Cash Balance. As of June 30, 2019, our unrestricted cash balance was $741.5 million. By minimizing our need to access external capital by maintaining higher than typical cash balances, our financial security and flexibility are meaningfully enhanced because we are able to fund our business needs (including payment of cash distributions on our common stock, if declared) and near-term debt maturities with our cash on hand. Certain of our loan agreements contain cash trap provisions that may be triggered if the performance of the hotels securing the loans decline. During the second quarter of 2019, these provisions were triggered for the loan secured by the Hilton Times Square, and, beginning in July 2019, excess cash generated by the hotel will be deposited directly into a lockbox account for the benefit of the lender and included in restricted cash on our consolidated balance sheet.
Debt. As of June 30, 2019, we had $979.0 million of consolidated debt, $787.7 million of cash and cash equivalents, including restricted cash, and total assets of $3.9 billion. We believe that by controlling debt levels, staggering maturity dates and maintaining a highly flexible capital structure, we will have lower capital costs than more highly leveraged companies, or companies with limited flexibility due to restrictive corporate-level financial covenants.
As of June 30, 2019, all of our outstanding debt had fixed interest rates or had been swapped to fixed interest rates, except the $220.0 million non-recourse mortgage on the Hilton San Diego Bayfront, which is subject to an interest rate cap agreement that caps the interest rate at 6.0% until December 2020. Our remaining mortgage debt is in the form of single asset non-recourse loans rather than cross-collateralized multi-property pools. In addition to our mortgage debt, as of June 30, 2019, we have two unsecured corporate-level term loans as well as the Senior Notes. We currently believe this structure is appropriate for the operating characteristics of our business as it isolates risk and provides flexibility for various portfolio management initiatives, including the sale of individual hotels subject to existing debt.
As of June 30, 2019, we have no outstanding amounts due under our credit facility.
We may in the future seek to obtain mortgages on one or more of our 16 unencumbered hotels (subject to certain stipulations under our unsecured term loans and Senior Notes), 14 of which are currently held by subsidiaries whose interests are pledged to our credit facility. Our 16 unencumbered hotels include: Boston Park Plaza; Courtyard by Marriott Los Angeles; Embassy Suites Chicago; Hilton Garden Inn Chicago Downtown/Magnificent Mile; Hilton New Orleans St. Charles; Hyatt Centric Chicago Magnificent Mile; Hyatt Regency San Francisco; Marriott Boston Long Wharf; Marriott Portland; Oceans Edge Resort & Marina; Renaissance Harborplace; Renaissance Long Beach; Renaissance Los Angeles Airport; Renaissance Orlando at SeaWorld®; Renaissance Westchester; and Wailea Beach Resort. Should we obtain secured financing on any or all of our unencumbered hotels, the amount of capital available through our credit facility may be reduced.
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Contractual Obligations. The following table summarizes our payment obligations and commitments as of June 30, 2019 (in thousands):
Payment due by period
Less Than
1 to 3
3 to 5
More than
1 year
years
5 years
Notes payable
412,979
192,173
365,755
Interest obligations on notes payable (1)
176,397
42,184
59,693
37,459
37,061
Finance lease obligations, including imputed interest (2)
4,794
4,906
Operating lease obligations, including imputed interest (2) (3)
15,140
15,353
Payments-in-lieu of taxes obligation
64,076
894
1,789
59,604
Construction commitments
42,846
Employment obligations
1,988
1,527,239
105,896
494,395
251,680
675,268
Capital Expenditures and Reserve Funds
We believe we maintain each of our hotels in good repair and condition and in general conformity with applicable franchise and management agreements, ground, building and air 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 for cyclical renovations, hotel repositionings and development. We invested $52.7 million in our portfolio and other assets during the first six months of 2019. As of June 30, 2019, we have contractual construction commitments totaling $42.8 million for ongoing renovations. If we renovate or develop additional hotels or other assets in the future, our capital expenditures will likely increase.
With respect to our hotels that are operated under management or franchise agreements with major national hotel brands and for all of our hotels subject to first mortgage liens, we are obligated to maintain an 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 zero and 5.0% of the respective hotel’s applicable annual revenue. As of June 30, 2019, our balance sheet includes restricted cash of $42.2 million, which was held in FF&E reserve accounts for future capital expenditures at the majority of the 21 Hotels. According to certain loan agreements, reserve funds are to be held by the lenders or managers in restricted cash accounts, and we are not required to spend the entire amount in such reserve accounts each year.
Seasonality and Volatility
As is typical of the lodging industry, we experience some seasonality in our business as indicated in the table below. Revenue for certain of our hotels is generally affected by seasonal business patterns (e.g., the first quarter is strong in Hawaii, Key West and Orlando, the second quarter is strong for the Mid-Atlantic business hotels, and the fourth quarter is strong for Hawaii, Key West and New York City). Quarterly revenue also may be adversely affected by renovations and repositionings, our managers’ effectiveness in generating business and by events beyond our control, such as extreme weather conditions, natural disasters, terrorist attacks or alerts, civil unrest, public health concerns, government shutdowns, airline strikes or reduced airline capacity, economic factors and other
42
considerations affecting travel. Revenues for our Comparable Portfolio by quarter for 2018 and 2019 were as follows (dollars in thousands):
First
Second
Third
Fourth
Revenues
Quarter
2018:
271,446
289,308
280,852
1,159,053
Sold hotel revenues (1)
(23,610)
(24,514)
(12,440)
(6,501)
(67,065)
Non-hotel revenues (2)
(832)
(21)
(25)
(4,987)
(5,865)
Total Comparable Portfolio revenues (3)
247,004
292,912
276,843
269,364
1,086,123
Quarterly Comparable Portfolio revenues as a percentage of total annual revenues
22.7
27.0
25.5
24.8
100.0
2019:
257,680
(23)
257,657
302,871
Inflation
Inflation may affect our expenses, including, without limitation, by increasing such costs as labor, employee-related benefits, food, commodities, 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 accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.
We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.
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In addition, the acquisition of a hotel property or other entity requires an analysis to determine if it qualifies as the purchase of a business or an asset. If the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, then the transaction is an asset acquisition. Transaction costs associated with asset acquisitions are capitalized and subsequently depreciated over the life of the related asset, while the same costs associated with a business combination are expensed as incurred and included in corporate overhead on our consolidated statements of operations. Also, asset acquisitions are not subject to a measurement period, as are business combinations.
We review any uncertain tax positions and, if necessary, we will record the expected future tax consequences of uncertain tax positions in the consolidated financial statements. Tax positions not deemed to meet the “more-likely-than-not” threshold are recorded as a tax benefit or expense in the current year. We are required to analyze all open tax years, as defined by the statute of limitations, for all major jurisdictions, which includes federal and certain states.
Quantitative and Qualitative Disclosures About Market Risk
To the extent that we incur debt with variable interest rates, 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. We have no derivative financial instruments held for trading purposes. We use derivative financial instruments, which are intended to manage interest rate risks on our floating rate debt.
As of June 30, 2019, 77.5% of our debt obligations are fixed in nature, which largely mitigates the effect of changes in interest rates on our cash interest payments. If the market rate of interest on our variable-rate debt increases or decreases by 100 basis points, interest expense would increase or decrease, respectively, our future consolidated earnings and cash flows by approximately $2.2 million based on the variable rate at June 30, 2019. After adjusting for the noncontrolling interest in the Hilton San Diego Bayfront, this increase or decrease in interest expense would increase or decrease, respectively, our future consolidated earnings and cash flows by $1.7 million, based on the variable rate at June 30, 2019.
Attached as exhibits to this Form 10-Q are the certifications required by Rule 13a-14 of the Securities Exchange Act of 1934, as amended. This section includes information concerning the controls and control evaluations referred to in the certifications.
Evaluation of Disclosure Controls and Procedures. Based upon an evaluation of the effectiveness of disclosure controls and procedures, our 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 fiscal quarter to which this Quarterly Report on Form 10-Q relates, 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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None.
(c)Issuer Purchases of Equity Securities:
Period
Total Numberof SharesPurchased
Average PricePaid per Share
Total Number ofShares Purchasedas Part of PubliclyAnnounced Plansor Programs
Maximum Number(or AppropriateDollar Value) ofShares that May YetBe Purchased Underthe Plans or Programs
April 1, 2019 — April 30, 2019
May 1, 2019 — May 31, 2019
June 1, 2019 — June 30, 2019
432,464
$ 13.24
$ 294,273,139
The following Exhibits are filed as a part of this report:
ExhibitNumber
Description
Articles of Amendment and Restatement of Sunstone Hotel Investors, Inc. (incorporated by reference to Exhibit 3.1 to the registration statement on Form S-11 (File No. 333-117141) filed by the Company).
3.2
Second Amended and Restated Bylaws of Sunstone Hotel Investors, Inc. effective as of November 15, 2018 (incorporated by reference to Exhibit 3.1 to Form 8-K, filed by the Company on November 15, 2018).
3.3
Articles Supplementary Prohibiting the Company From Electing to be Subject to Section 3-803 of the Maryland General Corporation Law Absent Shareholder Approval (incorporated by reference to Exhibit 3.1 to Form 8-K, filed by the Company on April 29, 2013).
Articles Supplementary for Series E preferred stock (incorporated by reference to Exhibit 3.5 to the registration statement on Form 8-A, filed by the Company on March 10, 2016).
3.5
Articles Supplementary for Series F preferred stock (incorporated by reference to Exhibit 3.5 to the registration statement on Form 8-A, filed by the Company on May 16, 2016).
31.1
Certification of Principal Executive Officer Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Principal Financial Officer Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS
XBRL Instance Document - The instance document does not appear in the interactive data file because its XBRL tags are embedded within the Inline XBRL document.*
101.SCH
XBRL Taxonomy Extension Schema Document. *
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document. *
101.LAB
XBRL Taxonomy Extension Label Linkbase Document. *
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document. *
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document. *
104
Cover page from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2019 formatted in Inline XBRL (included in Exhibit 101).
*
Filed herewith.
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.
Date: August 5, 2019
By:
/s/ Bryan A. Giglia
Bryan A. Giglia(Chief Financial Officer and Duly Authorized Officer)