Robert A. Alter VITAL STATISTICS:Sunstone Hotel Investors, Inc. HEADQUARTERS ADDRESS: 903 Calle Amanecer, Suite 100, San Clemente, CA 92673 TELEPHONE: 949-369-4000 WEB SITE: www.sunstonehotels.com TICKER: NYSE: SHO KEY EXECUTIVES: Robert A. Alter, president and CEO; Jon D. Kline, chief financial officer; Gary A. Stougaard, chief investment officer; William M. Wagner, chief accounting officer; Andrew W. Gross, senior vice president and general counsel 52-WEEK HIGH: $31.45 52-WEEK LOW: $21.53

By Phil Britt

By acquiring upscale properties in need of improvement and investing the capital to improve them to upper-upscale condition, Sunstone Hotel Investors, Inc. (NYSE: SHO) has grown quickly since its IPO two years ago and expects to build upon that growth in a lodging market that is still recovering from the downturn that occurred after Sept. 11, 2001.

Sunstone survived the downturn through aggressive cost cutting and careful balance sheet management. Now, while still keeping a close eye on its balance sheet, the hotel REIT is buying higher-end properties while disposing of those at the lower end.

Nearly three quarters of Sunstone's properties are in the top 15 largest metropolitan markets, with most properties in Washington, D.C/Baltimore (15.8 percent), Los Angeles (12.8 percent) and San Diego (11 percent), based on a percentage of the company's estimated 2006 EBITDA. The majority of the company's properties are located in downtown areas, where there is a higher barrier to entry than in suburban locations, says Robert A. Alter, Sunstone's president and CEO.

Since going public on Oct. 26, 2004 with $17 per share, the company's price had appreciated to just above $30 per share by mid-September 2006.

"Our growth is on track as far as getting analysts to understand our story," Alter says.

Sunstone Story

Sunstone has flip-flopped from public to private and back again, having formed in 1985 with its first IPO in 1995. Then in 1999, Sunstone was taken private in a successful management buy-out in partnership with private equity firm Westbrook Partners. The company went public again in October 2004.

The lobby of the Century City Hyatt in Los Angeles

According to Alter, the company's shares were under priced when Westbrook Partners took the company private in 1999. Then in order to monetize the investment, Sunstone went back public in 2004, when the market was more favorable.

Ever since the company's 2004 offering, Sunstone has consistently met or exceeded guidance for revenue per available room (RevPAR) growth, EBITDA and adjusted funds from operations (AFFO) per share.

Second quarter 2006 results included 10 percent RevPAR growth for hotels owned during the entire quarter, and 9.2 percent over the second quarter 2005. Adjusted EBITDA was $71.8 million, an 80.9 percent increase over the second quarter 2004.

In July 2006, Sunstone closed a four-year, $200 million unsecured revolving credit facility, replacing the previous $150 million secured revolving credit agreement. The interest rate for the $200 million agreement is based on grid pricing with spreads over LIBOR, and is 25 basis points lower than the $150 million facility.

Also in July 2006, the company agreed to sell 4 million shares of common stock in a forward sale agreement with a Citigroup Global Markets, Inc. affiliate. The agreement fixes the net proceeds at $27.75 per share, and gives the company the right to settle in multiple draws at any time within one year. The net proceeds, assuming physical settlement of the forward sale agreement, are expected to be approximately $110 million.

Sunstone's Strategy

According to John Arabia, principal with Green Street Advisors, "Sunstone has been successful since its 2004 IPO. They've had good material gains, and they have benefited from strong winds at their backs the current hotel recovery." It appears that their strategy is working and they understand the assets and their markets, he says.

The lounge at the Fairmont in Newport Beach

Sunstone finds properties that need a capital infusion to move from the lower tier to the upper-upscale market, enabling the property to command higher rates from guests and meetings.

"We get a 30 percent to 40 percent return on new renovations, and investors quickly see positive returns from such investments," Alter says.

Arabia also adds that the company distinguishes itself by superior asset management and by maximizing its return on assets.

Upscale Upgrades

Sunstone has used financial arrangements to raise money to upgrade and reposition its properties, which Alter says is the best way to maximize the returns for investors.

The lobby of the W Hotel in San Diego

As an example, he points to the late 2005 purchase and renovation of the 444-room Sutton Place in Newport Beach, Calif. According to Alter, the previous owners did not spend money on upgrades, so the hotel had fallen from an upper-upscale to a mid-range hotel. "They were losing their high-end customers by renting rooms cheaply on the Internet," Alter says. Sunstone purchased the property for approximately $72 million and immediately started a $30 million renovation of guest rooms and public areas.

Other projects include a new driveway and spa, which, at press time, was to be completed in the fall of 2006. The hotel was renamed Fairmont Newport Beach and reopened early 2006 under Fairmont Hotels and Resorts management.

Similarly, in 2005, Sunstone acquired Century Plaza in Los Angeles for $293 million, re-branded it as a Hyatt hotel and upgraded the lobby area while also cutting costs by changing the terms of some non-core services. Sunstone reduced expenses by $300,000 per year by eliminating capital improvement to the onsite laundry facility and outsourcing laundry services. Sunstone also renegotiated the parking agreement, which increased profit by approximately $200,000. Other additions to bring revenue include a coffee/retail outlet and hotel bar.

"We're repositioning it to make it the area's leading meetings hotel," Alter says.

Sunstone is also disposing of hotels that comprise of the lower end of its portfolio. In 2006, Sunstone sold two of its smallest properties, a 78-room Holiday Inn in Provo, Utah, and a 160-room Holiday Inn in Hollywood, Calif.

Sunstone completed $1 billion in 2005 acquisitions and continues to be aggressive in 2006. Its latest acquisition was the W Hotel in San Diego for $96 million completed in June 2006. The hotel features 240 guestrooms and 19 suites with proximity to popular local destinations. The W Hotel in San Diego marked the first acquisition of a hotel with that name, adding another popular, well-recognized brand to Sunstone's portfolio.

Based upon the hotel's 2006 forecast, the purchase price equates to approximately 12 times the 2006 EBITDA. Sunstone closed on a fixed-rate first mortgage loan totaling $65 million at a rate of 6.14 percent with the acquisition. The loan's principle will mature in 2018. The balance of the purchase price was funded through a draw on the company's revolving credit facility.

"The W Hotel in San Diego is a one-of-a-kind asset that leads the downtown market in RevPAR," Alter says. "We believe that San Diego will continue to be one of the top performing U.S. hotel markets, benefiting from a combination of strong business demand drivers, robust convention business and a healthy tourism industry."

Sunstone will continue to look for properties like the W that the company believes adds to the top end of its portfolio of upper-upscale hotels, while divesting hotels that are more in the mid-market range. Proceeds from divestitures will be reinvested in the more upscale properties.

Growth via acquisition and repositioning already owned properties should continue the strong returns for Sunstone shareholders, according to Alter.

"The last cycle was a 10-year one," he says, calling 2006 the third year of the current up trend. "I think we have some great growth ahead."

Arabia also expects the REIT to continue to benefit from the continued rebound in the upscale sector of the hotel market, which he says will out-perform the rest of the hotel sector, with RevPAR increases for 2006 and 2007 in the low double digits, around the range Sunstone reported for the second quarter.