Expert Efficiency - Investment Outlook - June 2006

Sunstone Hotel Investors has grown from its roots in sunny southern California to the heart of Times Square thanks to a steely discipline and a knack for capital allocation analysts rate as second to none.

By Staff -- HOTELS Magazine, 6/1/2006

The Sunstone executive team includes (l. to r.) Gary Stougaard, executive vice president and CIO; Jon Kline, executive vice president and CFO; and Robert Alter, president and CEO.

There is an efficiency about everything Robert Alter does. As CEO of Sunstone Hotel Investors, a San Clemente, California-based hotel real estate investment trust (REIT), Alter is not a man to waste anything-time, words, motion or money. His cut-to-the-chase style informs everything-from the way he looks at individual hotel assets to the way he reads the market. From where he stands, the prime targets could not be clearer: Upperupscale hotels with higher room counts in markets with high barriers to entry-such as the 444-room Hilton Times Square in New York City, which Sunstone purchased in March for US$242.5 million. "We will not see much new construction. Barriers to entry in urban markets are not going away and construction/ replacement costs are not going down. That means substantial opportunity to move rate," says Alter.

It also means now is the time to buy if the right deal comes along. A keen observer of macro and micro trends, Alter parts company with prospective buyers bemoaning a lackluster asset pool and overheated pricing.

"Hotels are still under-priced," he says. "In major European gateways, guests are paying upwards of US$350 per night (for a luxury or deluxe room). There are still plenty of U.S. markets where you can get the same category of room for US$170. By next year, that US$170 could be more like US$250 in some cities. Smith Travel Research (STR) says we are in the early stages of recovery. I am pretty comfortable with that," says Alter.

WHERE THE UPSIDE IS

An investor who works "one deal at a time," Alter likes to drill down to into data and demographics. Sunstone focuses on the top 200 RevPAR leading markets (out of a universe of 600 destinations tracked by STR). "Geography is about submarkets," says Alter. "I would not spend one minute looking at suburban Chicago hotels, but we have bid on four in the city center. Our Embassy Suites is doing great in downtown Chicago. The suburbs are struggling." Absorption rates for Class A office space is a big indicator for Sunstone in assessing market potential. California and the eastern seaboard figure prominently in Sunstone's growth plans. "It is not location, location, location. It is market, market, market," says Alter. "I am more comfortable making market bets than overweighting diversification."

This kind of thinking gets Sunstone a hearing with analysts such as John Arabia, principal, Street Advisors, a New York City-based boutique investment research firm. "If a REIT were buying properties just for the sake of diversification, it would be a negative. REITs should be focusing on hotels for which they can create value. Capital allocation and asset management are two of Sunstone's key strengths," says Arabia.

Though deals such as the Hilton Times Square pushed Sunstone onto the front page, Arabia says that it is a history of quiet, bottom-line driven deal making that makes Sunstone a REIT to watch. "Bob Alter is a hotel guy who knows the assets. He is not enamored with owning the sexiest portfolio. He wants to have a portfolio that makes money," says Arabia.

Profit motive is the driver for a portfolio that ranges from the Los Angeles area's Hyatt Regency Century Plaza to LAX's Courtyard by Marriott and from the newly rebranded Fairmont in Newport Beach, California, to Residence Inns by Marriotts and a Crowne Plaza. Some of Sunstone's best deals never even made the back page. "The US$27 million acquisition of the Sheraton Cerritos at Towne Center in Cerritos, California, (in the Orange County-Los Angeles corridor) was a very small deal, but it shows how focused Sunstone is. It is not a sexy market, but it was a fantastic deal that produced an economic cap rate of 10.2% or 10.3% and a 12.3% EBITDA yield," Arabia points out.

New to the Sunstone portfolio is the Hyatt Regency Century Plaza.

Alter, Sunstone CFO Jon Kline and the 56 employees who make up Sunstone's lean organization are in the hunt for more deals that can deliver like the Sheraton Cerritos. Going forward, the portfolio will take on a different look as Sunstone continues to divest smaller, non-core assets in favor of bigger box projects. Prime targets look more like hotels with 520 rooms than 250. Alter likes playing in the upper upscale, a category that generates 75% of Sunstone's revenues. "Our strategy is to buy as few assets with as high an EBITDA as possible. We would prefer one Hilton Times Square to 10 small assets," says Alter.

That is testimony to Sunstone's maturity. Buying some smaller hotels in secondary markets may not be a decision Sunstone would make now; but the deals worked when the company was building its asset base. Nor is there any need to hurry divestiture. "Sunstone needs to work its portfolio. But it can wait for the right price. There is no need for a fire sale on any assets," says Arabia.

Sunstone has redesigned and brought in Fairmont to turn around this Newport Beach hotel.

MONEY TALKS

Unlike some of its balance-sheet challenged competitors, Sunstone has the financial wherewithal to make big deals happen. A former investment banker, Kline has kept a tight rein on leverage without constraining growth. Leverage has remained in or around 50% since Sunstone went public in 2004. "We are very disciplined about how we finance our deals," says Kline. "Every deal involves 50% equity. We are going to continue to do that to keep our leverage on track."

Sunstone's conservative financial management enabled it to keep paying a dividend when a good number of other hotel REITs were cutting theirs. It also kept Sunstone's balance sheet sound enough to increase fixed rate debt from 48.4% in 2004 to 100% in the second quarter of 2006. Fixed rate debt with an

average maturity of nine years at an average interest rate of 5.75% gives Sunstone an interesting competitive advantage in an environment where interest rates look likely to rise. The company has less than US$25 million of debt coming due over the next four years.

"We believe that Sunstone can purchase at least US$100 million in additional hotels in 2006 without any equity funding," says UBS's William Truelove, analyst, and Michelle Ko, associate analyst, New York City. "This keeps its 2006 estimated debt to EBITDA ratio at 4.5x. In our view, 5.0x or less is an appropriate target ratio." More acquisitions at the quality level of the Hilton Times Square, with its estimated 12.8x 2006 EBITDA, could justify a higher valuation multiple for Sunstone. The combination of Sunstone's deal strategy and financial solidity already moved USB's price target up US$3, to US$35 per share.

TURNAROUND SPECIALIST

It is not just what Sunstone buys that is earning "buy" recommendations from analysts; it is what Sunstone does with the assets after purchase. The Newport Beach property is a case in point. Industry watchers who toured the property just after its purchase saw some guestrooms that were acceptable, others that were "terrible;" a poorly laid out lobby and spaces that generally did not show well. Sunstone brought in the Fairmont flag and gave the new operator an elegant new design that suits the hotel's upmarket location: a "great" rooms package; a lobby redesigned to have a better look and flow; and more saleable spaces. "Sunstone knows how to spend the right amount of money to position the hotel in the market," says Arabia.

Renovating and repositioning hotels is a core part of Sunstone's business model. Buying hotels with substantive upside not only builds appreciation potential; it eases the pressure to grow for growth's sake. "If we have to stand pat, we can do that," says Alter, who has been an owner of hotels since 1976 and is a past president of the Holiday Inn Franchise Association and a member of the Marriott Franchise board. "We have a lot of possibilities to explore within the existing portfolio. Some of them are US$100 opportunities; some are US$100 million."

Rated as an expert asset manager, Sunstone is looking at inventive ways to raise the revenue bar-from parking charges to adding concession such as Starbucks. It is also looking past conventional wisdom about hotel profit models. "You will see our hotels begin to bring back some functions that were outsourced, and that includes food and beverage. Our operators can do it just as well. And, they can be more profitable," Alter says. He proved his point at Chicago's Embassy Suites. While popular locally based restaurant group Lettuce Entertain You continues to operate the hotel's restaurant, the hotel's management took back the catering function. Based on current bookings, Sunstone's US$750,000 investment in catering, which included construction of a second kitchen, should realize a payback in less than two years. Sunstone has a leg up on most REITs in terms of asset management skills. Forty-seven of its 62 hotels are managed by Sunstone Hotel properties, a separate entity sold to Interstate Hotels & Resorts, Arlington, Virginia, in 2004. "The role of the asset manager is to take the best practices of both sides and get the best return," says Alter. Kline acknowledges that executing that role is more complex than defining it. "There is some level of inherent conflict between an owner and operator. The operator is paid on the top line; the owner is focused on the bottom line," Kline says. "To make it work, we need to have general managers we respect and we need to give them solid support."

The tangible side of that support comes in the form of re-investment to keep properties at the head of the pack. Alter has no time for egodriven amenity creep. "Weak competitors add amenities to build market share. Yes, a hotel has to have certain amenities-even niceties-to stay number one, two or three in the market. But, you have to be careful. If you roll out a new bedding package, soon, every hotel will have a new bedding package. At the end of the day, you win with service," says Alter.

Sunstone bought the Hilton Times Square for US$242.5m.

Branding is another weapon in the battle for appreciation. Fifteen of Sunstone's hotels are brand managed; the rest operate under franchises. Alter admits to sharing the love-hate relationship most owners feel toward brands. But he does not under-estimate their business-building value. Proven brands are the logical choice for the size and category of assets in Sunstone's portfolio. Still, up and comers with a good story will find their place.

Marriott's Renaissance brand is gaining growing distribution with Sunstone. A few years ago, not many owners would have given it a second look. "Renaissance is the next big growth brand," predicts Alter. "Marriott is already in every one of those top 200 markets we track. Renaissance is not. Since buying Renaissance, Marriott has taken a cash-starved brand, culled the weak properties and retained the strong ones. The new builds look great. Marriott has refocused the brand around quality assets and significant hotels that should do well in their locations." Sunstone worked on the Renaissance purchase together with Marriott and Walton Street.

A LOOK AHEAD

Not surprisingly, Alter is optimistic about further opportunities in the hotel market. STR's prediction that the industry can sustain doubledigit rate increases "for the foreseeable future" should keep Sunstone on a growth track. It would take a major change in the financial climate to put the brakes on this current phase of acquisition. "We have raised equity a number of times to fund acquisitions, as have several other REITs. If the equity markets close down, it will cause a significant shift in the acquisition environment," says Alter.

Sunstone is a strong believer in the future of Marriott's Renaissance brand, including its property in Orlando.

Having reached a scale big enough to have secured its 2006 inclusion in the Standard & Poor's REIT Composite Index , Sunstone has the luxury of waiting for the deals that build EBITDA in the short term and drive down the cost of capital in the mid- to long term. "Sunstone does not have to buy lower quality assets for the sake of earnings accretion," says Arabia. "Its mission statement is not about growth for growth's sake. Each acquisition has to be shown to have profit potential. Too many REITs got into trouble by being over-extended. I would rather see a few good acquisitions than a lot of acquisitions."

The beauty of the tax-advantaged REIT structure is that it allows for good deal making at every point in the cycle. Alter terms it "a perpetual vehicle." At the same time Sunstone is buying, it is selling-in its case, assets "with smaller, limited features." Despite its public status and the pressures of quarterlies, Sunstone is a patient investor. "We have had hotel brokers call us and ask if we wanted to make US$50 million or US$100 million on a flip," says Kline. "It was tempting, but we said 'no.'We focus on the long term."