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Sunstone Hotel Investors, Inc. (NYSE:SHO)

Q3 2009 Earnings Call

November 4, 2009 5:00 pm ET

Executives

Bryan Giglia – Vice President of Corporate Finance

Arthur L. Buser – President, Chief Executive Officer & Director

Kenneth E. Cruse – Chief Financial Officer & Senior Vice President

Mark Hoffman – Senior Vice President & Head of Asset Management

Analysts

David Loeb – Robert W. Baird & Co., Inc.

[Josh Addy] – Citigroup

Chris Woronka – Deutsche Bank Securities

Ryan Meliker – Morgan Stanley

Smedes Rose – Keefe, Bruyette & Woods

Mike Salinsky – RBC Capital Markets

Joseph Greff – JP Morgan

William Crow – Raymond James

Bryan Mahr – Collins Stewart

David Katz – Oppenheimer & Co.

Operator

Welcome to the Sunstone Hotel Investors third quarter earnings call. At this time all participants are in listen only mode. Following today’s prepared remarks instructions will be given for the question and answer session. (Operator Instructions) As a reminder, this conference is being recorded today, Wednesday November 4th. I would now like to turn the conference over to Mr. Bryan Giglia, Vice President of Corporate Finance of Sunstone Hotel Investors.

Bryan Giglia

By now you should have all received a copy of our earnings release which was released this afternoon. If you do not yet have a copy you can access it on the investor relations section of 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, 10Qs, 10Ks 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 EBITDA 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. Mark Hoffman, Senior Vice President & Head of Asset Management will also be available to answer questions during the Q&A portion of this call. To begin our discussion today I’d like to turn the call over to Art.

Arthur L. Buser

It’s only been a few weeks since our last call but at Sunstone it seems like we have news to report every couple of weeks, good news that is. During today’s call I’m going to address three topics: first, our third quarter results; then, and update on demand trends including prelim October RevPAR; and then finally and update on our acquisitions program. Ken is going to update you on our recent equity offering and our secured finance initiative and then finally I’m going to wrap up with some observations on the emerging cyclical opportunities.

Starting off with our current operations update, consistent with our preannouncement for the third quarter, our total portfolio RevPAR was down 20.2% to prior year, occupancy was down 4.9 points and rate made up the majority of the variance down 14.9%. We realized a 570 basis point margin decline in Q3 which translates in to a 48% save through meaning we met every dollar of revenue decline with $0.48 of expense savings during the quarter.

As we discussed on our prior business updates, with RevPAR declines being driven predominately by rate we expected our margins to be pressured during the quarter. That our Q3 margin decline was better than anticipated and better than our Q2 margin decline is a credit to the efforts of our asset management team and our operators so Mark thanks again to you and your team for that.

Adjusted EBITDA was $40.1 million and adjusted FFO per share was $0.14, both of which are generally in line with the Street consensus. In terms of regional performance, for the third quarter our California properties were down 20.9% in RevPAR. LA Orange County hotels were down 22.5% while our San Diego hotels were down 18.4% and that’s a huge improvement from down 30% earlier this year.

Our Southern region experienced a 19.8% RevPAR decline which is a reflection of continued softness in both Orlando and Atlanta. RevPAR in our other west region was down 22.5%. Our Midwest region was down just 16.9% to last year driven in large part by the continued strength of our Rochester portfolio which was down just 7.5%. The Rochester market continues to outperform primarily due to our strong relation with the Mayo Clinic.

Finally, our middle Atlantic region was down 20.2% for the third quarter. We continue to see relatively strong demand in Washington DC where RevPAR was down just 7.6%. Baltimore was down about 19.1% which is a slight improvement to the prior quarter. Our Boston properties were down just 16%. On the other end of the spectrum, New York City continued to show a high beta where RevPAR was down 30.1%.

On our previous update call we pointed out an increase in sell out nights in New York City and Boston. For example, we had 15 days at the Hilton Times Square in October where occupancy was between 98% and 100% and that’s compared to nine days in 2008. Rate was still lower for the same time period but we did have one day at a higher rate in 2008 and three days with higher RevPAR. Portfolio wide Q3 marked the first time this year where nine of our hotels had increases in occupancy over the prior year.

We continue to see an increase in positive data points in to the fourth quarter. Through October 19 of our hotels had increases in occupancy from 2008. Although we continue to see deterioration in rate, positive occupancy growth is a critical step towards restoring pricing power. Total portfolio RevPAR for October was down approximately 15% of which approximately 13% was driven by rate.

Now looking ahead, while group pace for the remainder of 2009 remains down roughly 20% consisting of approximately at 15% decline in occupancy and 5% in rate, we’re continuing to see quality booking trends at our properties. 2010 pace is down approximately 24% consisting of approximately a 21% decline in occupancy and 3% in rate. While we believe that the booking quality is superior to the bookings made last year at this time, we are still down a sizeable percentage and expect rate to become a large contributor to the decline as we book additional groups.

Last call we commented on the Streets estimate and in our opinion they were overly optimistic. The current estimates reflect a fourth quarter RevPAR decline between 9% and 16% averaging about 11% to 12% decline. Now, our portfolio was down 15% in October which would require a meaningful RevPAR improvement in November/December to hit the midpoint of the Street’s estimates. We believe now, more than ever that the continuation of increasingly positive signs in terms of improving business and consumer sentiment point to an impending economic recovery setting the stage for a prolonged period of positive fundamentals in the lodging industry.

Let me finish up by talking about the acquisitions environment. We continue to see a meaningful increase in both marketed deals as well as off market conversations we’re having with a variety of parties. In the last two weeks we’ve delivered four expressions of interest for hotel acquisitions. As we evaluate and negotiate potential deals we continue to be methodical and disciplined in our underwriting and return criteria and we are unwilling to compromise either for the mere sake of deploying cash on our balance sheet.

We’re actively analyzing a variety of deals focused on the following criteria: valuation; value add synergies; outperforming markets; and potential pipelines and let me explain that a little bit. In terms of valuations, we’re looking at acquisitions that are going to trade at a discount relative to the company’s enterprise value per key or EBITDA multiple. In terms of value add acquisitions, as the cost of construction, renovations, labor and materials have decline from the peak, some say as much as 35% acquisitions where selective renovations and repositioning work really add value.

The synergies we look for are such as economies of scale, ownership efficiencies, improved pricing power, staff sharing, it might be realized by owning multiple hotels in the same market. In terms of outperforming markets, acquisitions in strong markets within MSAs that are expected to outperform the US average in most cases or even those that are going to outperform the top 20 markets. Finally, pipeline we’re looking for relationships with current owners of hotel real estate who may look to divest such real estate in the future in a larger scale.

In summary, we’re looking at acquisitions that are additive, simple where one plus one is more than two. We’re assuming that the market will not experience immediate and significant increases in RevPAR but that our strategy for and asset management of the property will create value. I’m spending about a third of my time now on acquisitions. We’ve built a track record executing on our cycle of appropriate strategy and creating shareholder value and intend to build upon that as we enter in to an acquisition environment.

With that, let me turn the call over to Ken to discuss our recent financing initiatives.

Kenneth E. Cruse

Over the past year we’ve capitalized on market conditions and executed on a well timed finance plan designed to improve our credit profile, enhance our corporate liquidity and increase our financial flexibility. Consistent with this plan, following our last business update call a few weeks ago, we raised additional capital through an overnight common equity offering. The offering was very well subscribed both by existing stockholders and by new investors. This positive response enabled us to increase the size of the offering from an initially planned $100 million up to a full $158.6 million.

This offering represents and important milestone for the company marking a shift in our business strategy from defense to cautious offense. We now have the offensive capacity to take advantage of market opportunities to selectively acquire hotels properties at discount valuations. We’re also focused on mitigating risk. To this end, another facet of our finance plan entails the selective restructuring of certain of our non-recourse mortgage loans where we believe the intricate value of the collateral no longer exceeds the principal amount of the associated mortgage and where hotel cash flows no longer support debt services under the existing debt terms.

As we’ve said before, these conditions have not been met nor do we expect they will be met for the majority of our portfolio. To date, five of our loans have met the criteria for renegotiation. In these cases where the lender is unwilling to amend the loan terms a deed back of the collateral and satisfaction of the debt may be warranted.

Let me run down the five loans in our restructuring programs. First, as previously discussed, the lenders’ representative for the W San Diego was unwilling to amend the loan and consequently we agreed to transfer the asset to a receiver which led to our deconsolidation of the hotel from our financials in the third quarter. Second, with respect to the Marriot Ontario the lenders’ representative has been similarly unwilling to amend the loan and we expect to complete the appointment of a receiver at some point in the fourth quarter at which time we will treat Ontario similarly to the W San Diego for accounting purposes.

Third, we’re finishing up an amendment of the $105 million mortgage on our Baltimore Renaissance. The mortgage is being converted to an interest only loan for a period of up to 30 months which will eliminate cash outflows associated with the loan of approximately $6 million over the 2.5 year amendment period. Fourth, we’re working on the renegotiation of the $29 million loan secured by our Westchester Renaissance. We’re still in the early phases of this negotiation and we’ll keep you appraised of our progress.

Fifth and finally, we continue to work with Mass Mutual, the administrative agent for the $246 million mortgage loan which matures in 2011 and which is secured by 11 hotels. We’re working to restructure this loan in a way that would either reduce the principal balance or eliminate the amortization and extend out the maturity. At this point Mass Mutual is analyzing the collateral portfolio and we expect them to come back to us with a response to our proposals in the upcoming weeks.

Since Mass Mutual not responded to our proposals in advance of our November 1st debt service payment date, we elected not to subsidize this payment which we expect will result in a default under the loan while negotiations are pending. Moreover, if we are unsuccessful in negotiating an acceptable restructuring terms, we may elect to deed back the 11 hotels securing this loan in satisfaction of the debt.

We’ve included certain operating statistics for this portfolio in today’s release to assist you in modeling the effect of a potential deed back. Some of the key points you should note, a deed back of this portfolio would eliminate a significant 2011 debt maturity in which we have approximately $100 million of cash we’ve earmarked to prefund the expected refinancing shortfall on this loan.

Second, as a result of the transformation of the company’s core portfolio over the last several years, most of the assets comprising the Mass Mutual portfolio lack strategic fit with the balance of the company’s assets. Specifically, six of the collateral hotels are limited service and quality. The average collateral hotel is approximately 30% smaller than the average hotel comprising the balance of the company’s portfolio. The average RevPAR of the Mass Mutual pool is approximately 15% below that of the balance of the company’s portfolio.

The collateral pool generally consist of older assets located in some of the more challenged markets in the US both in terms of new supply and declining demand including San Diego, Atlanta and Long Island. Given the average age of the collateral and the introduction of new market supply we project this portfolio will need meaningful capital investments over the next five years to remain competitive.

Finally, the current debt per key associated with this portfolio is just under $100,000 which we believe represents an attractive valuation for this portfolio in today’s market considering the items I just mentioned. As a final point on our secured debt restructuring program I’d like to reiterate that our non-recourse secured debt provides a contractual back stop to corporate risk. Where value and cash flow deficits exist, restructuring the debt is not an option it’s an obligation. Importantly, we don’t see our secured debt restructuring program as having a negative impact on our business plan going forward.

The commercial mortgage market is undergoing sweeping and fundamental changes. These changes will impact underwriting and lending standards for all commercial mortgage borrowers going forward and consequently we expect the commercial mortgage markets will generally be unattractive as a source of capital for the next several years. As capital markets are efficient, when one form of capital becomes unattractive it typically is replaced by another form of capital. Today, the high yield and convertible debt markets both represent very attractive alternatives to the property level mortgage market. To the extent that we would look to source new debt capital in the future, we would like to return to these markets first.

To finish up my comments, we’re focused on continuing to strengthen our balance sheet, improve our liquidity and deliver superior returns to our stockholders. Over the past year we’ve executed on a well conceived and well timed plan and we look forward to continuing to build on this track record going forward. As the [inaudible] improves, so will demand for lodging and we believe we have positioned Sunstone well to capitalize on the positive trends and market opportunities ahead.

I’ll now turn the call back over to Art to wrap up.

Arthur L. Buser

We are looking forward to the next phase of the cycle and as I mentioned, we’re now seeing early signs of firming demand even as private asset values remain low primarily the consequence of the ongoing defunction of property level mortgage markets Ken alluded to. As a result, we believe we’re moving in to a phase of the cycle where well capitalized proactive public companies may have opportunities to create significant value through acquisitions.

We believe the backgrounds and skill sets of the Sunstone team make us well qualified to capitalize on these emerging opportunities. Let me reiterate that we continue to run our business with a single focus, we exist to outperform. It’s been our strategy to create long term value by capitalizing on cyclical appropriate and market inefficiencies. As a result, we’ve made decisions which may have at the time appeared contrarian but which have proven to be correct.

Before we turn the call over to Q&A I’d like to share with you a general comment from our 60 plus investor meetings we’ve had over the last few months. What I am about to say is exactly what I said on the last call but it is really worth restating. The investment community in increasing numbers tell us that while they appreciate our tactics and strategy they wonder if others, particularly those newer returning to the space might not fully understand them.

With that comment taken to heart and seeing the number of new investors dialed in again today I believe it’s important to restate today and again in the future how we would like you to think about our company. Number one, we are leveraged to outperform, outperform in the pending recovery. Now, debt’s been a four letter word and it’s fixed cost has rightly been viewed as a negative for the majority of this year. As we experienced bottoming in the cycle and look towards recovery, our 5.6% weighted average debt with an average term of over six years and no one is going to get those terms any time soon.

Our structure should provide outsized performance in the recovery even if we do not grow our portfolio. We are comfortable with our current level of debt and expect to see the company naturally deleverage through acquisitions, secured debt negotiations, the future refinancing of existing debt at lower LTVs. Number two, our track record has really been exemplary. Our tactics have been well timed and nimble and while at times controversial, have been consistently aimed at creating shareholder value.

Whether it was reducing our corporate staff from 40%, instituting significant property level efficiencies, deeding back hotels, buying back our convertible bonds this year for under $0.47 on the dollar, we are adding value. That said, going forward we intend to do just as we have done rather than making promises we intend to demonstrate through results our company is worthy of your interest. With that, I’d like to open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Loeb – Robert W. Baird & Co., Inc.

David Loeb – Robert W. Baird & Co., Inc.

I have some interest in a couple of things if you don’t mind going a little bit deeper. The Mass Mutual portfolio, you said in the press release that the present value of the hotels securing loans is currently less than the outstanding principle amount. I wonder if you could just expand a little on that, how important is the cap ex requirement relative to the value because looking at the numbers it looks like on NOI it’s providing about an 8.4% yield which does not look terrible in this environment.

Arthur L. Buser

That’s right and it’s good that you pick up on it. There are really two points there, one you have a cap ex for those hotels could be $60,000 to $70,000 a key over the next five years so that number is significant. Secondly, the trailing number EBITDA and the forward-looking number are probably fairly different as well because you’re right on a trailing basis it is a decent yield.

David Loeb – Robert W. Baird & Co., Inc.

Going back to the acquisition opportunities, how would you gage the probability of closing one or more acquisitions in the next two quarters, four quarters? And, do you plan on any external financing on those or will those likely be all cash?

Arthur L. Buser

Likely to be all cash. As I said, we’re comfortable with our amount of debt but we expect really to naturally delever over time. Can I go back to your first question because I think I told you cap ex of $60,000 to $70,000 a key and I think that number is more like $25,000 a key. Sorry about that.

David Loeb – Robert W. Baird & Co., Inc.

So probability of closings in the next two quarters or four quarters?

Arthur L. Buser

You know, acquisitions always involve the other party being as engaged and focused as you are. It is interesting to observe that when you advertise $400 million in the bank that prices go up. So, it’s difficult to say. As we noted, we’re continuing to send out letters of intent or verbal expressions and so it could be soon or it may not be at all again depending on what the other party does as we negotiate with them.

David Loeb – Robert W. Baird & Co., Inc.

I guess where I’m going with this is your comfortable with your leverage, you raised a big slug of equity, how comfortable are you that you’ll be able to invest that equity?

Arthur L. Buser

Fairly comfortable and that’s the reason that we went forward with it. The reason for the equity raise was we were seeing an increasing number of deals we thought would be additive. The one thing we knew for sure is he who shows up with cash has a higher probability of getting that deal than not and particularly on the off market deals where we approach somebody and attempt to induce them to sell. If that inducement includes a wait till I go to the market and get money and I’ll be back or here’s the cash and you get the deal done, the latter is much more persuasive.

David Loeb – Robert W. Baird & Co., Inc.

Can you give us a little color on the kinds of sellers? Are these distressed sellers, are these brand companies with assets that want to lighten up on, what’s the mix of who you’re talking to?

Arthur L. Buser

Just about everybody. On shore, off shore and it’s really less distressed. We don’t believe people waiting around with catcher’s mitts may get all the deals they think. Maybe that happens next year and if it does it’s a great thing for the market but as opposed to focusing on distressed sellers who like us are looking to kind of a trough and pending recovery and are really not focused on selling at a discount we’re selecting assets we think we can create value add that the current owner cannot. It’s more us outreaching to hotels we think we can create value than those that are distressed.

David Loeb – Robert W. Baird & Co., Inc.

One final topic, your chairman has been a bit of a seller of your shares, can you comment about that and about where you see his head relative to your board?

Arthur L. Buser

Meaning that the last part of the question where his head is relative to the board?

David Loeb – Robert W. Baird & Co., Inc.

Yes, in other words does Bob have a long term commitment to Sunstone or should we read his share sale as his moving away from active involvement?

Arthur L. Buser

His share sale is fairly consistent with what he did when Steve had the job prior to me when he was a seller of shares. So, I would say it’s the exact same thing that was contemplated at that time.

David Loeb – Robert W. Baird & Co., Inc.

Do you want to expand on that a little bit?

Arthur L. Buser

I don’t want to speak for Bob because I’m not Bob, when he hired Steve and hired me the idea was that Bob was going to be a net seller of shares as he was no longer the CEO and moved on to the board. As to what his future plans are I can’t speak to.

Operator

Your next question comes from [Josh Addy] – Citigroup.

[Josh Addy] – Citigroup

I just wanted to clarify something on your acquisition criteria, you want to buy things that are at a discount to your trading multiple but you also want to buy things that have renovation opportunities which suggest that the properties may be underperforming and need capital to be turned around. So, when you say that you want to buy things on a valuation discount do you mean on current earnings with immediate accretion or after a period of renovation and disruption or are they really two separate opportunities? Is there a bucket of things you would buy that is upfront accretion and then another bucket that maybe is dilutive immediately if it needs a period of renovation in front of it?

Arthur L. Buser

The latter. Clearly, to get something that was accretive on a multiple basis in a deep turn is probably unlikely so those different criteria are probably mutually exclusive.

[Josh Addy] – Citigroup

Of what you’re looking at today, do more of the properties fall in one of those baskets or the other? Or, do one of those types of acquisitions appeal to you more than the other based on what you’re seeing today in the market?

Arthur L. Buser

No, there’s not one that appeals more than the other. In the end I think the most important one is if it’s in our wheelhouse, if it’s something that Sunstone has done well or can do well and can we create value that is really probably one of the more important ones. But, if that occurred in Iowa City, probably less likely that we would buy it. So there again, the market is certainly important as well.

Operator

Your next question comes from Chris Woronka – Deutsche Bank Securities.

Chris Woronka – Deutsche Bank Securities

Just to kind of continue that last conversation from a different point, if hypothetically maybe something happens with the Mass Mutual portfolio, you’re all of a sudden 27 hotels, maybe you buy a few or more than a few, at what point do you then delever again? I’m just trying to figure out what your longer term targets are going to be on leverage and how you’re going to maybe tie those to the next cycle relative to how this panned out?

Arthur L. Buser

I can’t say that we have a specific target in deleveraging. I can say we’re heading towards being less leveraged than we are now and by the potential give back of Mass Mutual, that’s one step doing all equity acquisitions is another step and I think it will have a lot to do with pricing and availability of capital. You don’t want to say debt is always priced and again I think we’re seeing secured debt around 9%. We really loath to get a lot of that debt but if you see where corporate bonds come in or even where preferreds trade, you look at that as a different instrument. So, it’s difficult to say what the ideal capital structure is forever but those two transactions, again the potential of what happens with Mass Mutual and acquisitions will delever us.

Chris Woronka – Deutsche Bank Securities

Then I’ll just ask my standard inflation question, what are you guys thinking next year at the property level in terms of maybe you can break it down in to two buckets, things you think you can control and things you might not be able to control and how you see that maybe shaking out on a percentage basis as we look at I guess your adjusted base of 2008 costs?

Mark Hoffman

I think we’re just in the middle now of talking to the brands about the budget and so I would tell you that we are hoping to keep things to a very minimal but really not at a point now where we can look at that yet and give you really any thoughts about it at this point but we certainly hope to keep it down to a very small number.

Operator

Your next question comes from Ryan Meliker – Morgan Stanley.

Ryan Meliker – Morgan Stanley

Just a couple of quick questions here, first of all when we talk about the Mass Mutual portfolio I recall I think conversations I’ve had with you guys offline and the conversations online you guys had mentioned one of the main criteria in your willingness to hand back properties, specifically talking about the W in San Diego was the idea of not impacting your relationship with your relationship lender. Well, here we are looking at Mass Mutual which I believe is one of your relationship lenders, I’m wondering how all this is going forward and obviously you’re talking about all equity deals in the near term but have you had conversations with either Mass Mutual on your relationship with them or even other relationship lenders going forward you might be able to get debt through other means?

The second question I had was really just about the acquisitions, what types of properties you guys are looking at? Are they the typical full service properties in the primary markets or are you looking at things maybe in secondary and tertiary markets? It sounds like you’re shying away from limited service from what you indicated about the portfolio that you’re looking at potentially handing back. Any color you would have on that would be great also.

Kenneth E. Cruse

I’ll take the lending relationships question, a good question and that absolutely is a focus as we go to these renegotiations conducting an above board, fair, equitable, amicable practice wherever possible. The good news here is our lenders are very sophisticated third parties. When we entered in to these loan agreements they knew exactly what we were entering in to. These are non-recourse mortgages, the benefit of the bargain is if things go south in an unanticipated way, which is exactly what we are seeing today one of the points of the deal is there is a potential of deed back of the assets in satisfaction of the debt.

Now, all that said it would be naïve for us to assume that our counter parties would not have some sort of an emotional reaction to these renegotiations. To their credit, I think those emotional reactions have been kept to a minimum throughout this process and more importantly, as I said in my prepared comments, one way or the other we don’t see the commercial mortgage market as being an attractive vehicle for sourcing debt for the next several years. We do see, as Art mentioned, some other avenues for sourcing debt to the extent that we’re looking to bring on debt capital because the markets are efficient. We don’t see the mortgage markets as being a direct source of debt capital for us.

Arthur L. Buser

In terms of markets, never say never. The one thing I’ve observed in the business of transactions is when you make the box too small sometimes you miss the opportunity to make money and in the end the real goal is to make a spread above what your cost of capital is. So if there were limited service assets that were urban, you know New York, Boston, you could convert something to a Garden Inn or a Residence Inn that’s something we would certainly look at or even an Embassy Suites.

What we like about those sort of brands are if you believe we’re in a choppier slow recovery and we are stuck in a place where frugality wins out, those kind of brands people don’t shy away from and have great flow through and provide a great edge in a choppy market and can also get great upside in urban locations.

Operator

Your next question comes from Smedes Rose – Keefe, Bruyette & Woods.

Smedes Rose – Keefe, Bruyette & Woods

Art, I just wanted to go back to your opening remarks for a second because you talked about it sounded like you were sort of optimistic on the occupancy side but then you mentioned that rates continue to deteriorate. So, is it fair to say that occupancy is firming but is still lower portfolio wide year-over-year and rates are still declining year-over-year? And on that, is the pace of decline accelerating or is it just that they’re down year-over-year but the pace is slowing?

Arthur L. Buser

The first part of your statement spot on, you’re correct. The second derivative of change is obviously slowing. We hit the bottom -24 RevPAR kind of April/May now being in the mid teens clearly that’s backed off.

Smedes Rose – Keefe, Bruyette & Woods

Margin going in to 2010 just has to really start to come under a lot of pressure right because if it’s going to be rate driven going forward and you start to anniversary your cost cutting initiatives and it sounds like even though everyone wants to keep their costs low there’s got to be pressure from a labor perspective after two years of basically no increases? Is that just a fair thing that we should be thinking about? I mean, it sounded like you were kind of saying fourth quarter estimates are too high, can you talk about maybe the 2010 consensus outlook?

Arthur L. Buser

In terms of 2010 the reason we haven’t given guidance is for instance we had our monthly meeting and of the 19 hotels that had higher occupancy thank last year only one or two of them budgeted 30 days out that that might happen. So, given that even the people on the ground can’t call the numbers a month out, and what I would add anecdotally to that is a year ago we sat in budget meetings and our roll up was 2009 down 6.7%, that was only 1,000 basis points off. So I don’t think there’s anything I can give you for 2010.

Smedes Rose – Keefe, Bruyette & Woods

Then my last question just in your markets can you talk a little bit about supply? I mean obviously we see what it is on a nationwide basis but relative to say to the kind of 2% growth that I think people are looking for next year?

Arthur L. Buser

Let me go back, I didn’t answer the first part of your previous question. You were absolutely thinking about margins correct, if next year occupancy is flat or up and you have the same guests or more guests at a lower rate that becomes very difficult to control expenses and so I think we’ve always talked about what I’ll call a RevPAR deflection of 1%, EBITDA down 2% to 3%, that’s at the worse end of that range or even beyond that. So yes, you absolutely should think about the pressure on margins and since Mark and team have been cutting out costs for 16 months, practically two years at some point there’s less things to cut.

Smedes Rose – Keefe, Bruyette & Woods

On the supply side?

Arthur L. Buser

On the supply side kind of city by city, New York has been advertised as being 14% but that’s metro wide and there’s a bit of [inaudible] Times Square, it’s kind of almost a different market segment because it’s lower priced so it will be interesting to see how that impacts New York, or Orlando has had a 6% increase, the new Waldorf and the Hilton as well, we had three hotels opening up there so Orlando has been particularly hard hit.

Houston has a lot of announced projects, we don’t know how much of that is in ground. I think Intercon had announced they had 20 new projects being proposed there so Houston has a possibility of getting a fair bit of supply. Miami is digesting its supply but doesn’t seem to have a lot more. Southern California has gotten it’s share but there’s probably not much coming after that. Boston, none. In Chicago except for the shrink wrap Shangri-La and some other hotels, not much coming there either.

Operator

Your next question comes from Mike Salinsky – RBC Capital Markets.

Mike Salinsky – RBC Capital Markets

Art in your comments you mentioned a 15% decline in October, can you just give us the details as to what the breakout is occupancy versus rate on that?

Arthur L. Buser

Almost 14% of the 15% was rate and only a point was occ so it was really just about – sorry I’m getting corrected 13%.

Mike Salinsky – RBC Capital Markets

Second, a bookkeeping question here, the W San Diego even though that’s been handed to the receiver is that going to continue to run through discontinued ops then until the title is officially transferred?

Kenneth E. Cruse

Good question. That will run through disco ops until the title is transferred at which point the entire thing on the balance sheet will hit discontinued ops as well as it’s currently on discontinued ops for the income statement. If you look at the balance sheet you’ll see it as current liabilities of discontinued operations.

Mike Salinsky – RBC Capital Markets

Any guesstimate as to what timing on that is going to be?

Kenneth E. Cruse

It’s largely out of our control. We’re certainly working with the special server and the receiver to effect the final deed back on the title but it could be several months or longer.

Mike Salinsky – RBC Capital Markets

Then just another bookkeeping question here, with the Mass Mutual life insurance loan there, you mentioned that the value of the portfolio is less than the debt in place but yet you’re still showing a book value north of that. Why wasn’t there an impairment on that at that point?

Kenneth E. Cruse

A good question. The impairment analysis is based on the recoverability so the recoverability test looks at undiscounted cash flows over an expected hold period and so when we look at that portfolio we used a certain waiting that would anticipate the portfolio going back on the revisionary cash flow on a give back of the cash flow of the allocated loan amounts and then there’s also certain probability weighting that we would continue to hold the assets and then monetize those assets at some point in the future. When you run that sort of a recoverability test there’s no impairment. But, you’re exactly right that the book value is approximately $14 million above the debt value.

Mike Salinsky – RBC Capital Markets

Then finally, I think you mentioned a couple of times that you’re in discussions right now looking out to 2010. Now, I’m not looking for guidance ranges or anything like that but just kind of what are the major topics right now that you are discussing with your operators and kind of what are the areas of focus they’re kind of pushing back on for 2010?

Arthur L. Buser

The number one issue is wages. Wages are 40% to 45% of revenues. That’s the one thing clearly that we control. Smedes had asked the question and I don’t think I fully answered it, boy if people don’t get raises after two years what about that because that’s a consideration but if next year’s negative RevPAR and therefore EBITDA is down a multiple of that can you really increase people’s wages in that environment.

I think as owners we at Sunstone and Mark and team especially are going to be getting together and sit down with operators and say, “Listen, it’s a very difficult thing to do in this environment.” So, that is the number one issue that will be front and center in the next 30 days. I think that’s probably the biggest thing. Everyone wants to increase rates and trying to get people to do that at the appropriate time is a challenge but it’s really wages is the most important.

Mike Salinsky – RBC Capital Markets

What percentage do you guys have of union exposure?

Arthur L. Buser

Union exposure we just have two hotels.

Kenneth E. Cruse

We don’t really have any union exposure per say, it’s just a couple of hotels. The brands are asking currently for in the range of a couple of percent for wage increases 2% to 2.5% and that’s what we’re trying to discuss.

Operator

Your next question comes from Joseph Greff – JP Morgan.

Joseph Greff – JP Morgan

Art, you mentioned earlier about sellout rates in New York and I believe Boston in October, is there any trend there? Is it largely weekend or midweek, is it leisure, is it business mix, is there a trend there that you’ve noticed?

Arthur L. Buser

It’s all been midweek particularly in New York. The last weekend but that kind of fell in to November was the marathon as well as the World Series but otherwise it’s kind of a Tuesday, Wednesday, Thursday pattern so the good news is it really is the business travelers came back. Mark, in Boston is it the same thing?

Mark Hoffman

Boston has been a little bit of both, both midweek and [fall] which is traditionally usually a strong period in Boston so both midweek and weekend in Boston as well.

Joseph Greff – JP Morgan

Then when you think about 2010, what type of occupancy increases would you need to see where you would start adding to headcount at the property level across your portfolio?

Arthur L. Buser

It’s difficult to say. It varies a lot, if a hotel is running 65 and going to 67 is different than if it’s at 72 going to 75. Mark, you were a GM for a lot of years, is it 300 basis points, is it 500 basis points?

Mark Hoffman

I can’t imagine that even if occupancy went up 300 to 500 basis points that we’d be adding much if any labor at the hotels right now. It’s really variable and I think again we’ve worked hard to create a new business model at most of our hotels that we expect that will continue past this current cycle.

Operator

Your next question comes from William Crow – Raymond James.

William Crow – Raymond James

Art, now that you’ve got the capital and you’re out there beating the bushes for acquisitions, can you describe the landscape of competition that you’re finding?

Arthur L. Buser

Bill, it’s widely varied. We bid on one deal broadly marketed, we were told there were over 20 bidders, we didn’t make the second round. Having been a broker I couldn’t tell if that was broker talk or not. The off marketed deals, clearly we’re the only one out there. I don’t know how many of our other REIT brethren are out there but the majority of it is private equity. The challenge for them is that they can’t get debt and if they do it’s pretty expensive so kind of deals that have a lower initial yield we probably are in a unique position to get something done that they can’t.

Everybody has money or is raising money. Everybody wants to buy deals. Many are kind of waiting for the generational opportunities. I think as you best claimed the best opportunity that never came but today there are a lot of people looking but not a lot of people acting.

Operator

Your next question comes from Bryan Mahr – Collins Stewart.

Bryan Mahr – Collins Stewart

Kind of a quick question, we’re seeing recently in a number of the top 25 markets fairly strong occupancy numbers and you can run down the usual suspects, New York, Boston, a couple of others and yet we’re still seeing rate down kind of mid to high teens. What can you guys do, if anything, to induce the operators to more closely match rate with the new found occupancy in those markets?

Arthur L. Buser

Bryan, it’s difficult particularly for brand managed hotels, we don’t run revenue management. But what we do, let’s say for example one of our hotels sold out is look for build up for that date and say, “Okay, you sold out on 15 days, let’s look at the build up and when the Yankees made the Word Series did you shut all your B buckets, C buckets and only sell A buckets?” When they present the facts and look at them it’s pretty clear what they should have been doing. So, it’s more on that basis than asking them to get aggressive. We and Mark working with the team has also asked them about experimenting. Let’s hold the rates let’s not be punitive to people for being experimental with the rates.

Again, it’s really street corner by street corner, it’s kind of middle of the week what do I do on a Tuesday and Wednesday, I might discount on the weekend. It’s really going back and proving to them what are the data points they should have focused on that should have allowed them to close off lower rated buckets because every hotel needs some base business. But, really getting them to see the mistakes of the past and apply them going forward. Since a lot of hotels instead of management fees they do have some incentive to try and make more money.

Operator

Your next question comes from David Katz – Oppenheimer & Co.

David Katz – Oppenheimer & Co.

The Mass Mutual portfolio, is that an all or nothing deal? I mean is it possible that some of those assets are conveyed while others stay with you? Then, I have just one other question about that?

Kenneth E. Cruse

Look, we as I said in my comments, are endeavoring to negotiate a restructuring of that loan and that restructuring could take any number of different forms. It certainly could entail the release of certain of the collateral assets, a partial pay down of the loan, an extension of the term, what have you. As we’ve said to Mass Mutual we’re open to discussion points here and we’re perfectly willing to work with them on solutions that would work for both sides. Stay tuned, we do expect to have some news on that one for you all in the next few weeks.

David Katz – Oppenheimer & Co.

If we look at some of the discussion of covenants in the release, it does make mention of I think a prior amendment that you had made where if you were to default on the indebtedness in excess of $300 million, and I realize this Mass Mutual portfolio is a little bit less than that, but if that were to be considered [inaudible] an acceleration then it would trigger some other senior events, right? Am I interpreting that correctly? I guess I just want to be clear on whether or not a default of that Mass Mutual portfolio mortgage would then be considered potentially a trigger of some of these others if it were in conjunction with something else that would exceed $300 million.

Kenneth E. Cruse

What you’re referring to is our exchangeable senior notes of which there is just $62.5 million remaining outstanding. Those notes contain a covenant, it’s a cross acceleration covenant so if in excess of $300 million of our indebtedness is not only in default but is also deemed due and payable in advance of its maturity date and that condition is not addressed within a 30 day period then the trustee has the right to put the notes back to us at par. As I mentioned there’s only $62.5 million of those notes left and in fact we have prefunded all of our expected obligations through 2014 so we’ve got cash in our balance sheet here that’s earmarked to prefund that maturity when it occurs so to us it’s almost a non-event, it’s almost a benefit to the company to have those notes accelerated today because we’ll eliminate the indebtedness and address it now and the fixed expense associated with it.

David Katz – Oppenheimer & Co.

So you’re not expecting it to occur but you’ve prepared for it in case it does?

Kenneth E. Cruse

Precisely.

Operator

Ladies and gentlemen that does conclude our question and answer session for today. I’d like to turn the call back to Mr. Buser for any closing comments.

Arthur L. Buser

We appreciate your time today as well as your continued interest in Sunstone and we look forward to speaking with you on our inter quarter update call or seeing you.

Operator

Ladies and gentlemen this concludes the Sunstone Hotel Investors third quarter earnings call. We thank you for your participation. You may now disconnect.

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Source: Sunstone Hotel Investors, Inc. Q3 2009 Earnings Call Transcript
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