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Sunstone Hotel Investors, Inc. (NYSE:SHO)

Q2 2009 Earnings Call

August 05, 2009 5:00 pm ET

Executives

Bryan Giglia - VP of Corporate Finance

Art Buser - President and CEO

Ken Cruse - Chief Financial Officer

Analysts

David Loeb - Robert W. Baird

David Katz - Oppenheimer

Michael Salinsky - RBC Capital Markets

Joe Greff - JPMorgan

Ryan Meliker - Morgan Stanley

Dennis Forst - KeyBanc

Jeff Donnelly - Wells Fargo Securities

Chris Woronka - Deutsche Bank

Operator

Good afternoon, ladies and gentlemen. Welcome to the Sunstone Hotel Investors' second quarter 2009 earnings conference call. (Operator Instructions). Now, I would like to turn the conference over to Mr. Bryan Giglia, Vice President of Corporate Finance of Sunstone Hotel Investors. Please go ahead, sir.

Thank you. Good afternoon, everyone and thank you for joining us today. By now, you should have all received a copy of our earnings release and 10-Q which was released this afternoon. If you do not yet have a copy, you can access it on the Investor Relations tab on our website at www.sunstonehotels.com.

Before we begin this conference, I'd like to remind everyone that this call contains forward-looking statements that are subject to risks and uncertainties, including those described in our prospectuses, 10-Qs, 10-Ks and other filings with the SEC which could cause actual results to differ materially from those projected.

We caution you to consider those factors in evaluating our forward-looking statements. We also note that this call may contain non-GAAP financial information, including EBITDA, adjusted EBITDA, FFO, adjusted FFO, and hotel operating margins. We are providing that information as a supplement to information prepared in accordance with Generally Accepted Accounting Principles.

With us today are Art Buser, President and Chief Executive Officer, and Ken Cruse, Chief Financial Officer. To begin our discussion, I'd like to turn the call over to Art. Please go ahead.

Art Buser

Good afternoon, everybody, and thanks for joining us today. During today's call, we're going to cover six topics. First, are going to review recent hotel disposition. Second, I'll review RevPAR and demand trends. Finally, I'll discuss efficiency measures. Ken is then going to review our recently completed finance transactions, provide an update on our secure debt negotiations, and finally, we'll review our liquidity and credit statistics. At the end of the call as always we'll be available to address any unanswered questions.

We have had a very, very productive, albeit somewhat complicated second quarter. During the quarter, we completed more than $370 million of transactions, which helped to meaningfully transform the company, including a senior notes tender and consent, an equity offering, several asset sales, corporate reorganization, credit facility restructuring, and we initiated a secured debt restructuring program.

At the same time, we kept our eye on the ball as our operating statistics in terms of RevPAR and margins were largely in line with our peers. We also incurred $133.8 million of one-time and other charges, some of which did affect our EBITDA and FFO, which came in below market consensus.

The aforementioned transactions were aimed at increasing our liquidity and long-term stability, albeit at a cost of our short-terms earnings. For example, we incurred nearly $1 million in expenses related to corporate and property level reorganization, which will result in the long term in a much more efficient operations going forward.

Although we meaningfully increased our cash position as a result of our non-core asset sales, we also gave up the EBITDA associated with those properties. In addition, how this also was impacted was with some negative trends at some of our larger markets, including New York and San Francisco where RevPAR was down 31% and 34% respectively, with $100 reduction in ADR for New York City.

Before digging into the quarter, I'd like to provide a few high level observations on our business. As the lodging industry continues to face one of the most challenging downturns in recent history, our ongoing focus is on maximizing the profitability of our portfolio, and enhancing our corporate liquidity and financial flexibility. Although it appears that year-over-year RevPAR declines may have stabilized, lodging demand remains weak.

While we believe our industry will ultimately get back to and even exceed its previous peak operating levels, the road from here will be a long one, and with that in mind, we've positioned our balance sheet well to withstand the rigors of the current environment, and we continue to execute on liquidity improving initiatives.

So, with that as an overview, let me give you some details on the quarter. First of all, let me talk about our recent asset dispositions. Today, we announced the sale of the 202 room Hyatt Suites Atlanta for $8.5 million. We expect the hotel to generate approximately $300,000 to $400,000 of EBITDA in 2009, which means the sale was done at about an EBITDA multiple of 20 times.

At 202 rooms, this asset was considerably smaller than our typical hotel, and our typical hotel is about 347 rooms. Moreover, this hotel was one of our lowest EBITDA producers. In addition to the Hyatt Atlanta, subsequent to our first quarter call, we sold two other hotels, the Marriott Napa for $36 million, and the Marriott Riverside for $19.3 million. Taken collectively, the 2009 forecasted EBITDA for these three hotels was expected to be approximately $6 million. We realized a gain of $2.9 million on the Marriott Riverside sale and losses of $13.8 million on Marriott Napa, and $4.9 million on Hyatt Atlanta.

These dispositions generated more than $60 million in net additional liquidity for the company. These dispositions will most likely conclude our non-core asset divestitures for this year. In terms of RevPAR performance and demand, RevPAR for our portfolio of 39 wholly owned hotels, and these stats going to be excluding the W San Diego.

Again for 39 wholly owned hotels, RevPAR was down 23.6% for the second quarter, made up of a 14% decline in ADR, and an 8.8% decline in occupancy. Year-to-date, RevPAR for the 39 hotel portfolio was down 19.7%, which was comprised of a 13% decline in ADR, and a 7.5% decline in occupancy.

Drilling down on specific regions, RevPAR at California hotels was down 27% during the second quarter, LA, Orange County hotels were down 23.6%, while San Diego hotels, again, excluding the W were down 32.7%. Our W hotel was down 37% in RevPAR for the quarter.

In the Midwest region, our Rochester hotels down 6.7% while the region as a whole was down 19.7% resulting from weakness in Chicago, Minneapolis and the Detroit regions. Turning to the Mid-Atlantic region RevPAR was down 22.3% for the quarter, and on a relative basis, D. C. and Boston continued to outperform the rest of the region. Specifically year-to-date, D. C. is flat while Boston is down approximately 14%. New York City and Baltimore continued to underperform, down 31% and 29% respectively for the quarter.

Southern region RevPAR declined 21.9% as a result of continued weakness in Orlando and Atlanta. The 26.4% decline in the Other West region reflects weakness in Portland due to new supply, and in Houston, due to a significant reduction in government business, which we believe is likely to lead to weaker results in that market going forward.

Our group booking pace for the remainder of 2009 is down 20% in terms of total revenue versus the same time last year, which reflects a 17% decline in occupancy, and a 4% decline in rate. Looking at our segmentation for the quarter, business transient revenue was down 32% to last year. Leisure revenue was off 4% as a result of increased demand, which was offset by lower rate due to discounting.

Contract business, which is made up of predominantly airline crews was down 5%, government business was up 9%, group demand down 16%. We've seen RevPAR slightly improve from May's bottom. In select markets, we have asked our operators to continue to hold rate even if it means giving up occupancy. This tactic works in some places, not in others. While RevPAR index is an important metric, you put NOI in the bank, and thus some hotels need to be more focused on that, and less on the behavior of their competitors. For the month of July, our 39 hotel portfolio RevPAR was down 18.8%, which represents a slight improvement to our Q2 performance.

So, now let me speak about efficiency measures. We continue to focus on controlling our expenses both at the corporate and property level, and I'm pleased with our ability to cut costs and deliver better than previously expected performance in the context of declining revenues.

Our property level cost cutting initiatives resulted in a solid 46% adjusted hotel EBITDA save through for the quarter. This means for every dollar of revenue decline, our operators were able to cut $0.46 in costs. This is a remarkable feet considering that the majority of the quarter's RevPAR decline came from rate. As you recall, our save through in Q1 was 58%, while we remained diligently focused on controlling costs as recent declines in reason RevPAR have been driven more by reductions in rate than by reductions in occupancy, margins have been very difficult to preserve.

That said, our asset management team continues to work with our operators to find new, more efficient ways to run our hotels. The team continues to evaluate additional energy, food and beverage, housekeeping and staffing initiatives. I really believe it's up to owners to drive innovation and in reinventing how hotels can be operated.

We've been asked on these calls; will cost cuts be lasting. A great result of a 'yes' answer can be found in the results of the D.C. Renaissance. This hotel has a year-over-year increase in revenue, and a year-over-year decrease in expenses. Moreover, the hotel has been able to achieve this in the context of increasing occupancy.

Year-to-date, the hotel's revenues are up $1.3 million, while its departmental profits are up $2.6 million. Costs per occupied room are down 7%. Support costs are down 3%. This is a great example of the new, more efficient operating models we're looking to implement throughout our portfolio.

To this end, we've asked our operators at each of our hotels to develop 'zero-based' staffing models similar to the one developed at D. C. renaissance. Over the past year and a half our asset management team has worked tirelessly with managers to streamline our operations resulting in a reduction of approximately 20% of management headcount in our brand managed hotels, and significant line level staffing reductions as well. Our properties are now working towards one final rightsizing exercise which I believe will result in the elimination of additional positions.

The quest for efficiencies does not end at the property level. During the second quarter, we closely evaluated our corporate staffing, reviewing each discipline to ensure proper staffing levels, and through this process, we eliminated 17 positions or approximately 40% of our corporate workforce, representing an annualized cash overhead savings of $2 to $3 million.

So, with that, I'd like to turn the call over to Ken to provide an update on our finance initiatives. Ken?

Ken Cruse

Great. Thanks a lot, Art. Good afternoon, everyone and thank you for joining us today. Today, I'll cover three topics. First, I'll provide a comprehensive review of our recent finance transactions and secured debt initiatives. Next, I'll review the one-time or unique items that affected our financial statements this quarter. Finally, I'll review our liquidity and credit statistics.

As Art mentioned, this was a very productive quarter for us with $370 million of transactions, which we believe will be very good for the company in the long run, but which also created a lot of noise during the quarter, and contributed to the $133.8 million of one-time and other expenses we booked during the quarter.

As Art mentioned, our transactions this quarter included the repurchase of $123.5 million of our exchangeable notes, $100 million equity offering, and $85 million credit facility amendment, and $64 million of asset sales. Through these transactions, we increased our total cash position by more than $66 million to $240 million from $174 million last quarter. We also decreased our indebtedness by 8% or $127 million from $1.645 billion to $1.518 billion, with an additional $94 million of secured debt related to the W San Diego and Westchester Renaissance, currently subject to selected default pending either deed back or significant terms modification.

We also increased our financial flexibility by significantly reducing the covenants contained in our credit facility and our exchangeable notes and venture. Let me walk you through the specifics of each of these of these transactions. First of all, the exchangeable notes repurchases.

In May, we successfully completed the tender offer for $123.5 million face value of our exchangeable notes for just $86.5 million in cash or at 30% discount to par. During the first quarter, we repurchased $64 million of the notes in a series of open market repurchases for $30.4 million or a 52% discount to face. So year-to-date, we have repurchased $187.5 million face value of our notes for $116.9 million, which equates to a 38% discount to par on average.

Our gross gain on the notes repurchases was approximately $71 million, and for accounting purposes, after adjusting for the effect of the accounting rule APB 14-1, we booked a net $26.6 million gain on the extinguishment of debt during the second quarter, in addition to a $28 million gain during the first quarter, resulting in a $54.6 million GAAP gain comprehensively.

We now have $62.5 million of the notes remaining, which bear an interest rate of 4.6%, run rate annual cash interest expense will be approximately $2.9 million on the remaining notes. Actual 2009 cash interest will be approximately $5.6 million, reflecting the effect of the intra-year repurchase. Also pursuant to APB 14-1, we'll continue to recognize the non-cash interest expense charge of approximately $200,000 per quarter.

Next was the equity offering. In May, we issued a total of 20.7 million shares of common equity at $5 per share for net proceeds of just under $100 million. We used the cash from this offering to replenish cash used for the senior notes for purchase, and to bolster our liquidity.

As a result of the offering, we now expect to finish the year with approximately 75.2 million of common shares outstanding. We also amended our credit facility. In June, we closed on the amendment which reduced our facility's minimum fixed charge coverage covenant from 1.5 to 1 to 1.0 to 1 with added flexibility to drop to 0.9 to 1 for a period of up to four quarters, and we eliminated the facility's 65% maximum total leverage covenant replacing it with a 9.5 to 1 maximum net debt to EBITDA covenant, which may be increased to 10.5 to 1 for a period of up to four quarters.

We also reduced the collateral pool supporting the credit facility from 10 hotels to five, and the interest rate on the facility is based on grid pricing ranging from 375 to 525 basis points over LIBOR. The facility matures in 2012 assuming we exercise a one year extension option. The amended facility has a LIBOR floor of 150 basis points. Pursuant to the amendment we've0 reduced the facility size from $200 million to $85 million and we have no amounts outstanding on the facility at this time.

Finally, our secured debt negotiations. During the quarter we announced that we elected to cease the subsidization of debt service on the $65 million mortgage encumbering our W Hotel in San Diego. During the quarter we wrote the hotel down to a value of $29.3 million resulting in a $60 million impairment charge. We continue to work with the servicer toward affecting a transfer of this asset, and while we cannot give specifics on timing, we hope to complete the deed back of this hotel by the end of the year.

In addition to the W Hotel, San Diego, we have also elected to cease subsidization of debt service on the $29.5 million mortgage loan encumbering our Renaissance Westchester. Further reconciliation provided in our earnings release, we expect the hotel to generate approximately 1.5 million of EBITDA in 2009.

We're currently in discussions with lender's representatives on several of our mortgage loans, including the Westchester loan which meet two criteria, first debt services coverages now or is expected to be below one times and remain below one times for a prolonged period of time; and two, our internal evaluation for the collateral asset is less than the value of the debt.

At the end of the second quarter, three of our hotels securing non-recourse mortgages were not covering debt service on a trailing 12-month basis. In other words, they met that first criteria. The primary goal of our secured debt program is to achieve loan amendments, which will benefit Sunstone through partial or full principal reductions. Our proposals are also aimed at providing a better outcome for our lenders than just straight deed backs of the assets.

Other than noting the status of the W, San Diego and Renaissance Westchester deals, we would prefer not to provide additional details in terms of the specific mortgages or the terms of our proposals at this time, as such information maybe counterproductive to our negotiations and could be potentially damaging to the operations of the subject hotels.

In addition, most of our debt contains certain confidentiality provisions. I would like to make it clear that we recognize that our continued ability to access the credit and equity markets as we demonstrated last quarter speaks to the strength of our lender and investor relationships. It's with that in mind that we're conducting our ongoing secured debt negotiations in a way that's aimed at strengthening, rather than undermining our lender relationships.

Let me shift over to income statement items. You saw a number of impairment losses or charges taken this quarter. We performed a detail inter-quarter impairment analysis, as of June 30, which resulted in a total of 131.9 million of goodwill, impairment, and other losses during the quarter and these were really related to four items.

Item number one was the write-off of 1.1 million of goodwill, associated with three hotels, which included 500,000 for the Marriott Salt Lake City; 400,000 for the Marriott Rochester; and 200,000 on Holiday Inn Express, San Diego. Number two was 64.5 million of impairment losses on three hotels, which included a 30.2 million write-down for the Renaissance Westchester; [25.4 million] for the Marriott Del Mar; and 8.9 million on the Marriott Ontario.

Item number three was 64.9 million of impairment losses associated with either discontinued operations or operations held for non-sale disposition, which was just the W Hotel in San Diego, as I mentioned that was 60 million. On the discontinued operations we wrote down 4.9 million related to the Hyatt, Atlanta.

The final component of the 139 -- 131.9 million of goodwill and impairment losses during the quarter was a 1.4 million impairment write-down related to the costs associated with the potential time share development in Newport Beach, California. At this time we've decided not to proceed with that project.

Additional moving parts. During the second quarter, we booked several one time items that impact our properties income statements. During the quarter, we booked $1.5 million property tax assessments for tax years related to 2004 through 2008. These reflect one-time charges associated with the State of California treating our 2004 IPO as a change in control of those hotels. Therefore requiring Prop. 13 reassessments, as of the end of 2004.

These one-time costs were partially offset by approximately 600,000 of credits associated with a Prop. A, tax repeal dating back to 2002. We excluded the net effect of these items in the hotel operating schedule we provided in the earnings release. The majority of the property tax assessments booked during the quarter are currently under appeal, which based on past results could result in credits, but may take some time to resolve.

During the second quarter, we also realized $230,000 of the hotel level expense related to one-time severance payments associated with restructurings and reorganizations. We also incurred approximately $800,000 net servants expense associated with our corporate work force reorganization.

Adjusting for the severance charge, Q2 cash overhead expense was approximately 2.9 million. Full year cash overhead excluding stock amortization and one-year charges is now expected to be approximately $15 to $15.5 million for our company. Shifting over to credit statistics, as of the end of the quarter, our corporate net debt-to-EBITDA was 6.14 times and our fixed charge coverage ratio was 1.46 times.

Our total cash position increased by, as I mentioned, 66 million and our total indebtedness stands at 1.5 billion. 100% of our debt is fixed, at an average rate of just 5.64%. Our average maturity is 6.6 years out with our first maturity not incurring until December of 2010.

To wrap it up, this was a productive and somewhat complicated quarter, but as Art mentioned the transactions, which contributed to the noise this quarter were also aimed at improving our stability and profitability going forward. We thank you all very much for your time today and we appreciate your continued interest in Sunstone. I'll now turn this call back over to Art to wrap this up. Thanks.

Art Buser

Thanks, Ken. It's easy in this current environment to throw your hands up in the air and can see to the overpowering economic headwinds and sit and wait for the economy to improve. Clearly, that's not how we run our business. We exist to outperform. Over the last quarter, we have improved our balance sheet to allow our company to emerge from this phase of the cycle in a position of strength.

While we generally performed in line with our peers this quarter, that's not good enough for us. We made decisions over the long run that will position us to outperform. We carefully examined every aspect of our operation and made difficult, but appropriate adjustments at both the property and corporate levels. We rebalanced our capital structure buying back debt at a significant discount, issuing equity, amending our credit facility, divesting of non-core assets, reducing our overall liquidity.

Last, we're actively addressing our secured debt portfolio with a realistic valuation and a willingness to walk away from assets if we're unable to restructure its debt. This is not a process we take lightly, but we truly believe that the difficult decisions we make now will position Sunstone to be truly best in class.

In closing, I want you to know I take comfort in -- and I'm optimistic about three things. First, the economic cycle will improve and the hotel industry is highly linked to its recovery. Two, the hotel industry is positioned for an accelerated recovery with muted supply and outsized profit growth as evidenced by our D. C. Renaissance. Savvy owners can achieve increased revenue and decrease the expenses. Three, I'm optimistic about our company. We are leveraged for the recovery. 5.6% long-term debt is like California coast, they're just not making any of that anymore, and I'm mostly confident in this company because of the people in it. People make the difference in the hotel business, and in the business of hotels.

I've said from the first call I was on a year ago, Sunstone has a Super Bowl quality team. A year ago there were 47 people here, now there's 27, and yet I'd say, we're accomplishing more now. That speaks volumes to the strength of character, the true excellence in execution I see at our office. I see that same level of excellence at our hotels that are making equally hard choices, staying open to new ideas, success today requires adaptability and non-defensive outlook. We are fortunate to have such people.

With that, I'd like to open the call to questions. So operator, please go ahead.

Question-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, we'll now begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of David Loeb with Robert W. Baird. Please go ahead.

David Loeb - Robert W. Baird

Hi, Ken. On the first topic, you mentioned three hotels that were not covering their debt service. Is that excluding the W or including the W?

Ken Cruse

That's inclusive of the W.

David Loeb - Robert W. Baird

Inclusive of the W?

Ken Cruse

Correct.

David Loeb - Robert W. Baird

For you guys to actually do a mid-year impairment, my understanding of the accounting is that, it takes a lot to get you to do that. I certainly understand the sensitivity of not talking about which assets you're not covering debt service or not talking about which assets may go back to lenders that you're referring to, but just trying to read the tea leaves here, you took impairments on three assets, one of which you decided to stop subsidizing interest. Can you talk a little bit more about the circumstances surrounding Marriott Del Mar, Marriott Ontario and why you chose to take those impairments? Did you eliminate all of the equity investment in those assets?

Ken Cruse

Sure. Good question. First of all, our impairment analysis is done in accordance with FAS 144. You're absolutely right, it's required to be done once per year, but if conditions or circumstances warrant, companies are advised to run that more frequently than just once per year. So, we've been running it every quarter. We have a very standardized approach for our 144 analysis. We treat every asset essentially equally. We try not to cherry-pick or isolate specific assets, and develop a specific set of assumptions associated with those assets. I think you can draw some conclusions in terms of how those operations are performing since they did fall off the analysis, but I will tell you, we did not specifically identify or isolate those assets when we ran the analysis.

David Loeb - Robert W. Baird

So is there any equity left above Ontario, for example, above the $25.7 million mortgage or Del Mar above the $48 million mortgage?

Ken Cruse

I mentioned in my comments, we don't want to talk specifically about transactions other than what I said in the prepared remarks. There are a couple of reasons. It could impair our ability to negotiate new deal terms on the debt.

David Loeb - Robert W. Baird

I understand that. I was really trying to approach it from the other side, which is impairment, and if you can't talk to that either, I understand that.

Ken Cruse

Yes. We don't want to give any additional specifics there.

David Loeb - Robert W. Baird

One more if I may. On the Series C preferred stock, and the risk of the financial ratio violation. I gather you don't expect to have a lot of taxable income anyway, but this could clearly limit your ability to pay common stock dividends. Might it under some circumstances impair your REIT status? Might it call into question your ability to pay required distributions?

Ken Cruse

We're still able to make distributions required to meet our REIT status or to maintain our REIT status.

David Loeb - Robert W. Baird

So the restriction is, you can't pay anything more than REIT status?

Ken Cruse

Correct.

David Loeb - Robert W. Baird

You said in here that you may incur a 50 basis point per quarter dividend increase.

Ken Cruse

Under the terms of the agreement we would.

David Loeb - Robert W. Baird

So if you violate in the second half, you will be paying 50 basis points more per quarter?

Ken Cruse

Correct.

David Loeb - Robert W. Baird

That's all I have for right now. Thanks.

Operator

Our next question comes from the line of David Katz with Oppenheimer. Please go ahead.

David Katz - Oppenheimer

Hi. Can we split the business a little bit between leisure versus group versus transient, and just spend a moment talking about what you're seeing in those different business lines? How that has evolved and sequentially, I guess, is probably the best way to look at it?

Ken Cruse

Sure. David, do you want me to talk about year-to-date or just for the quarter?

David Katz - Oppenheimer

Both.

Art Buser

What we're generally seeing is, at business traveler, there's both a reduction in occupied room, clearly a reduction in rate. In leisure, there has been a pickup in the second quarter in terms of the number of guests. In fact, occupied rooms are up year-over-year, but that's been done at a discount. So, when our leisure revenue is off, it's really lower ADR, higher number of occupied rooms.

In terms of group business, group demand is down 16, and kind of looking forward, our pace is also down 20%. The other smaller piece of our business, government demand is up 9%, and that is really a function of, again, lower rate, but much higher occupied rooms because, again, there's certainly been increased demand nationwide for government business.

David Katz - Oppenheimer

Can we go back to the group piece for one second? You know, we've heard from quite a few companies this week already talking about some improvement in some of the metrics they track on group, and some of that may also be just their expectation that attrition rates may ease next year and some of the traffic patterns may improve. Do you have a view about that?

Art Buser

Attrition rate and booking window, people have talked about a lot, and candidly, the booking window has been decreasing since 2001 or 2002, and we've looked at our booking window for our assets. Candidly, it's all over the math. There are some where the booking window is decreased 8%, there's some that there's 30%. The big houses still book business three years out. The smaller hotels that have more of the corporate business traveler are booked closer in and probably have a higher degree of variability.

In terms of attrition or people talk about wash. At the peak of the market wash was 10%. A lot of hotels now are looking at attrition that they're experiencing at 20%. Overall, when I take a look at the wash factor, and the booking window, is that a couple hundred basis points in terms of impact on what your pace is? Maybe it is. I don't look at it as saying, well, but for those things the pace would be a lot better.

David Katz - Oppenheimer

One more. I just want to clarify on the analysis or highlighting the list of hotels that you would characterize as not cash flowing, and I assume, if I heard correctly you're comparing EBITDA with the debt service, right? Are taxes included, excluded, are we looking really at cash versus cash?

Ken Cruse

We're looking at cash versus cash on that analysis and just to be clear, that's a trailing 12 month analysis.

David Katz - Oppenheimer

That's trailing 12 months, so you're not taking any forward-looking view on it at all, which presumably might, I guess in aggregate that cash flow might be going down in the next four quarters, but there could be circumstances where it might be going back up?

Ken Cruse

Right.

David Katz - Oppenheimer

For another.

Ken Cruse

There's also seasonality involved in there as well kind of quarter-to-quarter.

Operator

Our next question comes from the line of Michael Salinsky with RBC Capital Markets. Please go ahead.

Michael Salinsky - RBC Capital Markets

Most of my questions actually were answered, by two predecessors there, but just had one question relating to dispositions. I mean are there any markets if you were to fall below coverage on that where you would keep the asset just as more of a strategic decision or are all assets at this point under evaluation if they fall below coverage?

Art Buser

Yeah, again, Mike, I'd refer you to our previous calls. What we really look at is, it's less of a market issue and more of the three tests, as it cover the existing debt service and we feel it falls below, the value of the asset falls below that of the debt and so the market or the submarket certainly as evidenced by the W, where San Diego is down some, but the RevPAR index of that hotel is falling from 130 to 80. There's a case where, San Diego is a great long-term market, it's been hit by a lot of new supply, and it has good group demand, transient demand, and leisure demand. But that submarket within the San Diego market was even hit harder. It's less of a market issue and just more of kind of performance in the context of that debt.

Michael Salinsky - RBC Capital Markets

Just to be clear, are you guys still holding the W right now, that has not been taken back by the CMBS group?

Ken Cruse

That's right.

Operator

Thank you. Our next question is from the line of Joe Greff with JPMorgan. Please go ahead.

Joe Greff - JPMorgan

Most of my questions have been addressed. Just one final one, maybe kind of an odd one, hopefully you can answer it. If you look at your current 38 properties in your portfolio, what was the peak EBITDA on that in the aggregate?

Ken Cruse

You want to know the peak EBITDA for the 39 hotel portfolio?

Joe Greff - JPMorgan

Yes.

Ken Cruse

Hold on. Let us look into our little schedule here.

Art Buser

Do you have a second question while we're looking that up, Joe?

Joe Greff - JPMorgan

No. That was it, guys.

Ken Cruse

About 250. $250million.

Operator

Our next question is a follow-up from the line of David Loeb with Robert W. Baird. Please go ahead.

David Loeb - Robert W. Baird

Just had one, Art, you mentioned trying to balance rate and occupancy and working to maximize the cash flow. On Host's call this morning they talked about New York where occupancies remain very high, but whenever they try to cut rate, they just lose massive amounts of business and that trade-off doesn't really work. Can you give a little bit more color about your tests of that and which markets are more price sensitive and which were lesser, what some of the characteristics are that might lead you to be able to maximize profit and lose a little market share and where you might not be able to do that?

Art Buser

New York is one of those markets where rate shopping is done very competitively, and if you're too far out of the line, you could lose a lot of occupancy. We always say in Times Square, you're always going to fill, it's just a question at what rate. What we've asked our operators to do is, listen, we're not going to hold you to RevPAR index tests this quarter, that's one of our main dashboard items. Instead, maximize NOI, hold rate and let the occupancy fall-off and see if, in fact, you're in a better spot in terms of cash flow.

You really need to do that after over a 30, 60, 90-day period and you pretty quickly get a sense of kind of just watching I mean, it's a bit like the stock market. You're watching electronically and since about a third of our business comes over the Internet, you get a real quick sense of what prices are getting hit, what prices aren't and you can see kind of, which markets have a little bit of a gap where the customers going to actually pay more for something and which ones where if you stick $5 out, you're not going to get anything at all.

It has some to do with demand, being occupancy, but some of it has to do with kind of, is the product that much different than others in the Rochester market, for example, is a market where we see that there are customers willing to pay a certain price, who want a certain kind of product. As we mentioned, New York is a market where varies, there are times where you see that, but another times when that's clearly not -- clearly not the case.

David Loeb - Robert W. Baird

The bottom line in this experiment is you're moving down this road, but it's not like you think you can do a whole lot better than what you've done with previous positioning of these assets. Am I reading you right on that?

Art Buser

Across our portfolio, don't expect that half or even a quarter of our hotels are going to be able to do this. We just feel in a face of ever declining ADRs someone has to be the first to try to hold rate because in a constant face of rates going down, there has to be an effort to try to hold rates and we're trying to find which markets, is that really a sensible strategy and which ones are you going to get no business at all and it doesn't make sense. It's not going to be material to our business, but we're hoping to find a couple of markets where that holds and makes a difference in the performance for that hotel.

David Loeb - Robert W. Baird

That's very helpful. Thank you and clearly you're not afraid of being first.

Art Buser

Thanks, David.

Ken Cruse

Yeah, David, this is Ken. I wanted to follow-up on your earlier question. You asked the question about our impairment analysis and what that implied in terms of the book equity of those assets. You can actually get to those details on our filing, so let me walk you through the math a little bit, but what I would caution you and the listeners to remember, to bear into mind, we're very careful not to make long-term decisions based on short-term conditions, but based on our impairment analysis, we are required to mark those assets down to current fair market value, valuations. Once again, we don't necessarily believe that the current spot market is representative of the true future potential for the assets.

David Loeb - Robert W. Baird

Right. But to some degree, Ken, just to make sure I'm understanding that, your assessment of current fair market value and your need to do that test, it's a very long-term analysis, right? It's permanent impairment basically?

Ken Cruse

The test has a couple of different screens. The first level is the recoverability test. It is what you've got on the books for the asset recoverable and we look at that based on an undiscounted stream of cash flows for the asset. As I mentioned in my earlier comments, we're very conservative and very consistent in how we apply that first test. So, we have a very low growth rate, very low flow through rates for each of the assets, and we try not to be specific in terms of setting up different assumptions for different assets.

So the result is, in a trough situation, you do have assets that run up against that test, and as we mentioned, we had three assets this quarter in our ongoing portfolio that failed the test. If you fail that [CLIF] test or the recoverability test, then you mark it to fair value. The fair value analysis, again, is based on current market conditions. So, if you look at the numbers that we gave you today on the Del Mar Marriott , for example, we marked that down by $25.4 million.

The debt on that asset is $48.5 million. So, our current book value of the asset is about 38, 38.8 is what we've got it on the books for. Ontario Marriott, we took a $9 million impairment charge on. The debt on that asset is $26.5 million. We've got it now as a book value of $16.5 million. Then finally on the Westchester Renaissance. Debt on the asset as I mentioned on the call was $29.5 million, and we took an impairment of $30 million. Our current book value is $24.4 million.

David Loeb - Robert W. Baird

So in Westchester, for example, assuming you eventually dispose of that, you'd actually have a $5.1 million gain?

Ken Cruse

Yeah. At this point, we'd book a gain.

David Loeb - Robert W. Baird

That actually helps a lot. Thank you very much for coming back to that.

Operator

Our next question comes from the line of Ryan Meliker with Morgan Stanley. Please go ahead.

Ryan Meliker - Morgan Stanley

Just a quick question for you regarding how are you guys are calculating your long-term value of hotels that you might be potentially returning to lenders. I'm sure you can't provide a lot of detail, but if you can give some methodology, that would be helpful.

I was also curious on what your thoughts are if a property may not be generating negative debt service coverage, but is immaterial overall, but your long-term value of the asset is below the loan value, would you consider giving those back as well? Thanks.

Art Buser

We can't say we've come across an asset yet, never say never where it's not meeting debt service but it's value is below the long-term value of the loan. Again, the screens we're using are that it must meet both. To your first question, yes, it really varies greatly market by market. Again, the W is the best known one, and there is a market where we have belief in long-term, you just add the number of rooms that are there and kind of look at how long will it take for those rooms to be absorbed.

I am giving you more methodology than numbers, but kind of looking at how many years is it going to take for market occupancy to get to a point where there's going to be rate pressure where you're going to start to see that come up, and then rate come with, and you get back to what were peak numbers kind of for San Diego more late '06, early '07. For that market, again, it's much more of a supply issue than it is a economic engine issue. While we look at the overall macro numbers, it is really much more market driven based on the supply and the economic engine.

Ryan Meliker - Morgan Stanley

So it sounds like you're doing something more along the lines of a DCF than a rooms revenue multiplier or anything like that?

Art Buser

Yes. We look at all those metrics, but at the end, we look at it mostly in a DCF.

Operator

Thank you. Our next question comes from the line of Dennis Forst with KeyBanc. Please go ahead.

Dennis Forst - KeyBanc

Just one quick point of clarification, please. The Westchester property, that's part of the 39 ongoing properties?

Art Buser

Yes.

Dennis Forst - KeyBanc

Is it not in the same category as the W which is not part of the 39?

Ken Cruse

The W because, we defaulted and as we noted in our comments, we have concluded that we are no longer going to negotiate with the special servicer, and we are working with them to accommodate a deed back. The W fell into a category of assets held for non-sale. Westchester is not currently in that category. We're hopeful that we're going to work through an amicable resolution on that deal rather than do a deed back.

Dennis Forst - KeyBanc

You'll continue to operate it. Did their numbers in the second quarter and the third quarter flow through the normal part of the income statement?

Ken Cruse

Yes. Correct.

Operator

Thank you. Our next question comes from the line of Jeff Donnelly with Wells Fargo. Please go ahead.

Jeff Donnelly - Wells Fargo Securities

Good afternoon, guys. Ken, I guess considering that mark-to-market test you were just describing, I think it was David. In determining that fair market value, can you just talk about maybe some of the approaches, you put more or less emphasis on whether it's DCF or EBITDA?

Ken Cruse

As Art said on the last question, it's done asset by asset. We do a full model of the operations of each hotel, so we model out all the departments of each hotel in fact when we do these models. Then we do a 10 year model, and it's a DCF based calculation. We also factor into that model though any future CapEx needs for the asset, and present value of add back as well. Our cap rate is based on our expected cost to capital plus a hurdle rate minus the growth rate in the year of aversion. So, we have a fairly standardized approach in terms of coming up with the valuation, but the assumptions for each asset are very different depending on market conditions.

Jeff Donnelly - Wells Fargo

That's helpful. I just wanted to be clear. Can you share with us maybe what the range of discount rates that you typically use in that DCF over that time horizon? Just to be clear, is that an unleveraged or leveraged analysis?

Ken Cruse

It's an unleveraged analysis, and we tend to use a mid-teens to upper teens discount rate.

Jeff Donnelly - Wells Fargo

Do you ever give any consideration to a leveraged analysis of these?

Ken Cruse

If you can tell me what that's going to cost, we'll start running leveraged analysis. We've always wanted to run these analyses based on the characteristics of the asset themselves. We do a real estate evaluation, and we look at that on an unleveraged basis. Then, once we're ready to close on a deal, we'll layer in the benefits of the leverage so to speak.

Jeff Donnelly - Wells Fargo

Just switching gears, I think earlier you were talking about how you were trying to test in certain markets about whether or not you had pricing power. I know every day is different effectively for every hotel and every market is different, but when you look on a very macro level, the top 25 hotel markets are going to see not only supply growth in '09, very likely going to see continued 3% plus supply growth in 2010. Do you really think we're at a point that you can really be pushing that sort of pricing power test considering the supply outlook, and also giving that we're running at occupancy levels that are frankly so much below where they've been historically? Is it too early to be trying that I guess?

Art Buser

Never too early to try. You're right, when you look at the US on a macro level, particularly with those drivers, the answer would be why you would try that. The reality is the average only tells you the average. There were some markets who had more demand in the month of June than they did the year before. So, it's really week-by-week, street corner by street corner, and that's why revenue managers, that job is so important, because you are watching the tape practically to kind of look at how things trade, and there are some markets where, okay, there's not price resistance, let's move up a little more and see what happens.

Listen I'm not talking about a sea change, but I am talking about there are submarkets within certain markets. We even see that within one market, in one submarket of a market, there's pricing power and in another place there's not that you really have to play it on an isolated basis. I'm not calling the end of rate decline for the US market yet.

Operator

Our next question comes from the line of Chris Woronka with Deutsche Bank. Please go ahead.

Chris Woronka - Deutsche Bank

I joined the call a little bit late. Sorry, if you've already addressed this. Can you maybe give us some general color on what, if anything, has changed in the last three months or so in terms of buyers? How their underwriting hotels, and what they're looking for in capital structure and maybe you could reference to one of the three I think you've sold to-date? Do they see something different for the asset or is it a financial transaction or what are they seeing, what are they trying to get out of it?

Art Buser

Chris, in all the cases totally different reasons, most cases either all cash or recourse debt. I would say in all cases what the three buyers had in common, they had a very specific idea, use, cost of capital vision that met with that hotel uniquely. It wasn't as if there was a broad pool of people that had kind of similar views. Buying universe is still very thin, underwriting techniques and values still come up with widely varied answers.

No one is counting on debt. We didn't in particular count on anybody who said they needed debt at closing unless there was recourse, we knew they weren't going to be there. I think the other thing in common is clear these were all smaller transactions, getting things done 30, 20 million and under is possible, but, everyone is loath to place large sums of money and it's funny, 2007 people would have said if it's not 250 million, don't call me because I only want to place money in large pools.

Now people want to be below 25 million because they want to make small metered debts. The other thing they all have in common is seven years, six years, five years from now, they believe their hotels are going to be worth a lot more money and in the interim they don't really have any pressure to show any kind of earnings growth and they're prepared for down drafts in earnings as evidenced by Atlanta where it's trading at a 20 multiple. Clearly, that was bought with a vision that they're going to greatly increase operations and profitability over the long run.

Chris Woronka - Deutsche Bank

Just a follow up on pricing. We all [tend to dismiss travel] conference in the last few days and, I think they kind of made the point that in a lot of markets it's one hotel or two hotels that kind of, we'll call them the weaker links that tend to lead the whole market down and cause the higher quality hotels to follow suite. Do you guys agree with that? I know it's going to be market-specific, but is that generally true? How do you think about that, if you do try to push on the way up, do they follow you or do they fight back with lower rates?

Art Buser

Generally speaking concepts five or six hotels, number five and number six are the ones where their only competitive advantage is price and they keep going south and, again, this is where you have to watch the tape. They keep going south until they start pulling away business from others. On the way up, I mean what we're very focused on is the higher you remain, the higher you're going to get on the next cycle. I think, Four Seasons proved that on one of the past cycles where particularly the New York Four Seasons where they kept rates and it got, made it a lot easier to get the $700 or $800 and somebody who cut their rate in half. We think about it the same way, but again, it all comes down to if that weaker competitor offers such a cheap deal that they basically suck all the business out and there's no extra demand, then you've got to make that profit decision if you're going to play in that game [it is a real through channels] or another way that you don't lose all or the majority of the business.

Operator

At this time there are no further questions. I'd like to turn it back to management for any closing remarks.

Art Buser

Okay. I appreciate everybody listening in today. This was a very complicated quarter. I appreciate all the questions and our opportunity to give clarification. I'm very proud of what this team has done and look forward to our next inter-quarter call in the next 60 days. Thank you very much.

Ken Cruse

Thank you.

Operator

Thank you, sir. Ladies and gentlemen, that does conclude our conference for today. Thank you very much for your participation and for using ACT conferencing. You may now disconnect.

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Source: Sunstone Hotel Investors, Inc. Q2 2009 Earnings Call Transcript
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