Sunstone Hotel Investors, Inc. - Quarter Report: 2008 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2008

OR

For the transition period from                      to                     

Commission file number 001-32319

Sunstone Hotel Investors, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code: (949) 369-4000

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

58,729,452 shares of Common Stock, $0.01 par value, as of May 5, 2008

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SUNSTONE HOTEL INVESTORS, INC.

QUARTERLY REPORT ON

FORM 10-Q

For the Quarterly Period Ended March 31, 2008

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PART I—FINANCIAL INFORMATION

SUNSTONE HOTEL INVESTORS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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SUNSTONE HOTEL INVESTORS, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

See accompanying notes to consolidated financial statements.

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SUNSTONE HOTEL INVESTORS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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SUNSTONE HOTEL INVESTORS, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to consolidated financial statements.

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SUNSTONE HOTEL INVESTORS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Description of Business

Sunstone Hotel Investors, Inc. (the “Company”) was incorporated in Maryland on June 28, 2004 in anticipation of an initial public offering of common stock, which was consummated on October 26, 2004. The Company, through its 100% controlling interest in Sunstone Hotel Partnership, LLC (the “Operating Partnership”), of which the Company is the sole managing member, and the subsidiaries of the Operating Partnership, including Sunstone Hotel TRS Lessee, Inc. (the “TRS Lessee”) and its subsidiaries, is currently engaged in acquiring, owning, asset managing, renovating and, on a strategic basis, selling hotel properties. The Company operates as a real estate investment trust (“REIT”) for federal income tax purposes.

As a REIT, certain tax laws limit the amount of “non-qualifying” income the Company can earn, including income derived directly from the operation of hotels. As a result, the Company leases all of its hotels to its TRS Lessee, which in turn enters into long-term management agreements with third parties to manage the operations of the Company’s hotels. As of March 31, 2008, the Company owned 45 hotels, and its third-party managers included Sunstone Hotel Properties, Inc., a division of Interstate Hotels & Resorts, Inc. (“Interstate SHP”), manager of 26 of the Company’s hotels; subsidiaries of Marriott International, Inc. or Marriott Hotel Services, Inc. (collectively, “Marriott”), managers of 13 of the Company’s hotels; and Hyatt Corporation (“Hyatt”), Fairmont Hotels & Resorts (U.S.) (“Fairmont”), Hilton Hotels Corporation (“Hilton”) and Starwood Hotels & Resorts Worldwide, Inc. (“Starwood”), collectively manager of six of the Company’s hotels. In addition to its owned hotels, the Company has a 38% equity interest in a joint venture that owns the Doubletree Guest Suites Hotel Times Square, located in New York City, New York.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements as of March 31, 2008 and December 31, 2007, and for the three months ended March 31, 2008 and March 31, 2007, include the accounts of the Company, the Operating Partnership, the TRS Lessee and their subsidiaries. All significant intercompany balances and transactions have been eliminated.

The accompanying interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and in conformity with the rules and regulations of the Securities and Exchange Commission. In the Company’s opinion, the interim financial statements presented herein reflect all adjustments, consisting solely of normal and recurring adjustments, which are necessary to fairly present the interim financial statements. These financial statements should be read in conjunction with the financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007, filed with the Securities and Exchange Commission on February 21, 2008, as amended by the Company’s Form 10-K/A filed with the Securities and Exchange Commission on February 25, 2008.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Reporting Periods

The results the Company reports in its consolidated statements of operations are based on results reported to the Company by its hotel managers. These hotel managers use different reporting periods. Marriott uses a fiscal year ending on the Friday closest to December 31 and reports twelve weeks of operations for each of the first three quarters of the year and sixteen or seventeen weeks of operations for the fourth quarter of the year. The Company’s other hotel managers report operations on a standard monthly calendar. The Company has elected to adopt quarterly close periods of March 31, June 30 and September 30, and an annual year end of December 31. As a result, the Company’s 2008 results of operations for the Marriott managed hotels include results from December 29 through March 21 for the first quarter, March 22 through June 13 for the second quarter, June 14 through September 5 for the third quarter, and September 6 through January 2 for the fourth quarter. The Company’s 2007 results of operations for the Marriott managed hotels include results from December 30 through March 23 for the first quarter, March 24 through June 15 for the second quarter, June 16 through September 7 for the third quarter, and September 8 through December 28 for the fourth quarter.

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Accounts Receivable

Accounts receivable primarily represents receivables from hotel guests who occupy hotel rooms and utilize hotel services. Accounts receivable also includes receivables from customers who utilize the Company’s laundry facilities in Salt Lake City, Utah, and Rochester, Minnesota. The Company maintains an allowance for doubtful accounts sufficient to cover potential credit losses. The Company’s accounts receivable at March 31, 2008 and December 31, 2007 each include an allowance for doubtful accounts of $0.4 million. At March 31, 2008 and December 31, 2007, the Company had approximately $3.6 million and $5.0 million, respectively, in accounts receivable with one customer who is operating under a contract with the United States government. No amounts have been reserved for this receivable as of either March 31, 2008 or December 31, 2007 as all amounts have been deemed to be collectible.

Deferred Financing Costs

Interest expense related to the amortization of deferred financing costs was $0.4 million and $0.3 million for the three months ended March 31, 2008 and 2007, respectively.

Earnings Per Share

The Company applies the two-class method as required by the Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share” (“EITF No. 03-6”). EITF No. 03-6 requires the net income per share for each class of stock (common stock and convertible preferred stock) to be calculated assuming 100% of the Company’s net income is distributed as dividends to each class of stock based on their contractual rights. To the extent the Company has undistributed earnings in any calendar quarter, the Company will follow the two-class method of computing earnings per share.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share,” basic loss attributable to common stockholders per common share is computed based on the weighted average number of shares of common stock outstanding during each period. Diluted loss attributable to common stockholders per common share is computed based on the weighted average number of shares of common stock outstanding during each period, plus unvested restricted stock awards considered outstanding during the period, as long as the inclusion of such awards is not anti-dilutive.

The following table sets forth the computation of basic and diluted loss per common share (in thousands, except per share data):

Shares of the Company’s Series C preferred stock have not been included in the above calculation of loss per share for the three months ended March 31, 2008 and 2007 as their effect would have been anti-dilutive. Unvested restricted stock units and shares associated with our long-term incentive plan and the accounting effects of the Forward Sale Agreement have not been included in the above calculation for either the three months ended March 31, 2008 or 2007 as their effect would have been anti-dilutive.

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3. Investment in Hotel Properties

Investment in hotel properties consisted of the following (in thousands):

Acquired properties are included in the Company’s results of operations from the date of acquisition. The following unaudited pro forma results of operations reflect the Company’s results as if the acquisitions which occurred during the first and second quarters in 2007 had occurred on January 1, 2007. In the Company’s opinion, all significant adjustments necessary to reflect the effects of the acquisitions have been made (in thousands, except per share data):

4. Discontinued Operations

As part of a strategic plan to dispose of non-core hotel assets, the Company sold seven hotel properties in the second and fourth quarters of 2007 for net proceeds of $179.3 million and a net gain of $59.9 million. These seven hotel properties met the “held for sale” and “discontinued operations” criteria in accordance with SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.”

The following sets forth the discontinued operations for the three months ended March 31, 2007, related to hotel properties that have been sold (in thousands):

5. Other Real Estate

Other real estate consists of the following (in thousands):

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6. Investments in Unconsolidated Joint Ventures

In December 2006, the Company entered into a joint venture agreement with Whitehall Street Global Real Estate Limited Partnership 2005 and Highgate Holdings to acquire the 460-room Doubletree Guest Suites Hotel Times Square in New York City, New York. The $68.5 million initial investment was funded entirely from cash on hand and was comprised of two parts: (i) a $28.5 million mezzanine loan, which bore an interest rate of 8.5% on a face value of $30.0 million and (ii) a $40.0 million equity investment representing a 38% ownership interest in the joint venture. In April 2007, the Company sold the $28.5 million mezzanine loan for net proceeds of $29.0 million. Annual dividends on the Company’s equity investment are senior to the returns on equity to both Whitehall and Highgate and begin at 8.0% and grow to 9.25% over a nine-year period. In addition, the Company’s equity investment is entitled to receive a pro-rata share of any excess equity distributions made by the joint venture.

In December 2007, the Company entered into a joint venture agreement with Strategic Hotels & Resorts, Inc. (“Strategic”) to own and operate BuyEfficient, LLC, an electronic purchasing platform that allows members to procure food, operating supplies, furniture, fixtures and equipment. Under the terms of the agreement, Strategic acquired a 50% interest in BuyEfficient, LLC from the Company for a gross sales price of $6.3 million. As part of this transaction, the Company reclassified its remaining 50% share in BuyEfficient, LLC to investments in unconsolidated joint ventures and recognized a gain on sale of $6.1 million.

7. Goodwill

The Company follows the requirements of SFAS No. 142, “Goodwill and Other Intangible Assets” (“FAS No. 142”). Under FAS No. 142, goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. As a result, the carrying value of goodwill allocated to the hotel properties and other real estate is reviewed at least annually and when facts and circumstances suggest that it may be impaired. Such review entails comparing the carrying value of the individual hotel property (the reporting unit) including the allocated goodwill to the fair value determined for that hotel property. If the aggregate carrying value of the hotel property exceeds the fair value, the goodwill of the hotel property is impaired to the extent of the difference between the fair value and the aggregate carrying value, not to exceed the carrying amount of the allocated goodwill.

8. Other Assets

Other assets consist of the following (in thousands):

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9. Notes Payable

Notes payable consist of the following (in thousands):

The Company was not in default on any of its loan covenants at either March 31, 2008 or December 31, 2007.

During the first quarter of 2008, the Company drew down $12.0 million of its $200.0 million credit facility (the “credit facility”) to fund general working capital requirements. The Company repaid the entire $12.0 million balance in March 2008. As of March 31, 2008, the Company had no outstanding indebtedness under its credit facility, and had $10.8 million in outstanding irrevocable letters of credit backed by the credit facility, leaving, as of that date, $189.2 million available under the credit facility.

Total interest incurred and expensed on the notes payable is as follows (in thousands):

10. Series C Cumulative Convertible Redeemable Preferred Stock

In July 2005, the Company sold 4,102,564 shares of Series C Cumulative Convertible Redeemable Preferred Stock (“Series C preferred stock”) with a liquidation preference of $24.375 per share to Security Capital Preferred Growth, Incorporated, an investment vehicle advised by Security Capital Research & Management Incorporated, for gross proceeds of $99.0 million, or $24.13 per share, which included a 1% discount to the conversion price/liquidation preference. Other costs of the offering totaled $130,000. Net proceeds of $99.0 million were contributed to the Operating Partnership in exchange for preferred membership units with economic terms substantially identical to the Series C preferred stock. The net proceeds were used to partially finance the Company’s acquisition of six Renaissance hotels. The Series C preferred stock is convertible into shares of the Company’s common stock at the option of the holder on a one-for-one basis, subject to customary antidilution provisions, including stock splits, stock dividends, non-cash distributions and above-market issuer self-tender or exchange offers. On or after July 8, 2010, the Series C preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $24.375 per share, plus accrued and unpaid dividends up to and including the redemption date. The holders of the Series C preferred stock have the right to require the Company to redeem the Series C preferred stock in the event of any of the following: (1) a change in control of the Company, if certain conditions are not met; (2) a REIT termination event; or (3) a termination of the Company’s listing on either the New York Stock Exchange or NASDAQ. In general, holders of Series C preferred stock vote on an as-converted basis as a single class with holders of the Company’s common stock. If the Company is in violation of certain financial ratios for four consecutive quarters, the holders have the right to elect one director to serve on the Company’s board of directors. In

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addition, if the Company is in arrears on dividends on the Series C preferred stock for four or more quarters, the holders have the right to elect additional directors to serve on the Company’s board of directors. Subject to a limited exception, holders of Series C preferred stock cannot elect more than an aggregate of two directors. The holders are eligible to receive a participating dividend should the Company’s dividend on its common stock increase beyond $0.339 per share per quarter. The current quarterly dividend on the Series C preferred stock is $0.404 per share. The Series C preferred stock has no maturity date and, except as set forth above, the Company is not required to redeem the Series C preferred stock at any time.

The initial carrying value of the Series C preferred stock was recorded at its sales price less costs to issue on the date of issuance. This carrying value is periodically adjusted so that the carrying value will equal the redemption value on the redemption date, which is the earliest date available for the Company to redeem the Series C preferred stock. The carrying value will also be periodically adjusted for any accrued and unpaid dividends, if any. At March 31, 2008 and December 31, 2007, the Series C preferred stock carrying value consisted of the following (in thousands):

11. Stockholders’ Equity

Series A Cumulative Redeemable Preferred Stock

In March 2005, the Company sold an aggregate of 4,850,000 shares of 8.0% Series A and B Cumulative Redeemable Preferred Stock (“Series A preferred stock” and “Series B preferred stock”, respectively) with a liquidation preference of $25.00 per share for gross proceeds of $121.3 million. Underwriting and other costs of the offering totaled $3.8 million. Net proceeds of $117.5 million were contributed to the Operating Partnership in exchange for preferred membership units with economic terms substantially identical to the Series A and B preferred stock. Subsequent to this offering, the shares of Series B preferred stock were exchanged for an equivalent number of shares of Series A preferred stock. The net proceeds were used to reduce borrowings under the Company’s credit facility and for acquisitions. On or after March 17, 2010, the Series A preferred stock will be redeemable at the Company’s option, in whole or in part, at any time or from time to time, for cash at a redemption price of $25.00 per share, plus accrued and unpaid dividends up to and including the redemption date. Holders of Series A preferred stock generally have no voting rights. However, if the Company is in arrears on dividends on the Series A preferred stock for six or more quarterly periods, whether or not consecutive, holders of the Series A preferred stock will be entitled to vote at its next annual meeting and each subsequent annual meeting of stockholders for the election of two additional directors to serve on the Company’s board of directors until all unpaid dividends and the dividend for the then-current period with respect to the Series A preferred stock have been paid or declared and a sum sufficient for the payment thereof set aside for payment. The Series A preferred stock has no maturity date and the Company is not required to redeem the Series A preferred stock at any time.

In April 2006, the Company sold an additional 2,200,000 shares of Series A preferred stock with a liquidation preference of $25.00 per share for gross proceeds of $55.0 million. The proceeds to the Company, net of offering costs, were $54.2 million, and were used together with proceeds of certain debt refinancings to repay the Company’s term loan facility.

Common Stock

In July 2006, the Company entered into a forward sale agreement (the “Forward Sale Agreement”) with an affiliate of Citigroup Global Markets Inc. as the forward counterparty, relating to 4,000,000 shares of the Company’s common stock. In connection with the execution of the Forward Sale Agreement and at the Company’s request, Citigroup Global Markets Inc., as agent for the forward counterparty, borrowed and sold in a public offering 4,000,000 shares of common stock. In April 2007, the Company settled the Forward Sale Agreement for net proceeds of $110.0 million, including $0.4 million in related expenses paid in 2006. The proceeds were used to fund a portion of the acquisition price of the Marriott Boston Quincy hotel. The Forward Sale Agreement was accounted for as an equity instrument and did not qualify as a derivative liability.

In June 2007, the Company’s board of directors authorized the Company to repurchase up to $100.0 million of the Company’s common stock on or prior to December 31, 2007. Through the expiration of this authorization on December 31, 2007, the Company repurchased 3,129,810 shares of its common stock at a cost of $86.4 million. In February 2008, the Company’s board of directors authorized the Company to repurchase up to $150.0 million of the Company’s common stock on or prior to December 31, 2008. During the first quarter of 2008, the Company repurchased 734,307 shares of its common stock at a cost of $11.8 million under the current stock repurchase authorization. As of March 31, 2008, the Company had remaining authorization to repurchase up to $138.2 million of its common stock.

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12. Long-Term Incentive Plan

Restricted shares and restricted share units granted pursuant to the Company’s Long-Term Incentive Plan generally vest over periods from three to five years from the date of grant. The value of shares granted has been calculated based on the share price on the date of grant and is being amortized as compensation expense in accordance with the Company’s policy on a straight-line basis over the vesting periods for the entire award. For the three months ended March 31, 2008 and 2007, the Company’s expense related to these restricted shares and restricted share units was $1.6 million and $1.8 million, respectively.

13. Commitments and Contingencies

Management Agreements

Management agreements with the Company’s third-party hotel managers require the Company to pay between 1% and 3.5% of total revenue of the managed hotels to the third-party managers each month as a basic management fee. Total basic management fees incurred by the Company during the three months ended March 31, 2008 and 2007 were $6.4 million and $6.0 million, respectively. Basic management fees included in property general and administrative expense were $6.4 million and $5.8 million, respectively, for the three months ended March 31, 2008 and 2007. Discontinued operations included zero and $0.2 million, respectively, of basic management fees for the three months ended March 31, 2008 and 2007.

In addition to basic management fees, provided that certain operating thresholds are met, the Company may also be required to pay certain of its third-party managers an incentive management fee. Total incentive management fees incurred by the Company were $1.0 million and $0.9 million for the three months ended March 31, 2008 and 2007, respectively, all of which were included in property general and administrative expense.

License and Franchise Agreements

The Company has entered into license and franchise agreements related to certain of its hotel properties. The license and franchise agreements require the Company to, among other things, pay monthly fees that are calculated based on specified percentages of certain revenues. The license and franchise agreements generally contain specific standards for, and restrictions and limitations on, the operation and maintenance of the hotels which are established by the franchisors to maintain uniformity in the system created by each such franchisor. Such standards generally regulate the appearance of the hotel, quality and type of goods and services offered, signage and protection of trademarks. Compliance with such standards may from time to time require significant expenditures for capital improvements which will be borne by the Company.

Total franchise costs incurred by the Company during the three months ended March 31, 2008 and 2007 totaled $8.3 million and $8.4 million, respectively. Of the total franchise costs, franchise royalties totaled $3.4 million and $3.7 million, for the three months ended March 31, 2008 and 2007, respectively. The remaining franchise costs included advertising, reservation and priority club assessments. Franchise costs included in discontinued operations totaled zero and $0.8 million for the three months ended March 31, 2008 and 2007, respectively.

Renovation and Construction Commitments

At March 31, 2008, the Company had various contracts outstanding with third parties in connection with the renovation of certain of its hotel properties. The remaining commitments under these contracts at March 31, 2008 totaled $25.7 million.

Operating Leases

Total rent expense incurred pursuant to ground lease agreements for the three months ended March 31, 2008 and 2007 totaled $2.1 million and $1.8 million, respectively, all of which was included in property tax, ground lease and insurance.

Rent expense incurred pursuant to the lease on the corporate facility totaled $102,000 and $116,000 for the three months ended March 31, 2008 and 2007, respectively, and is included in corporate overhead in the accompanying statements of operations.

Other

The Company has provided unsecured environmental indemnities to certain lenders. The Company has performed due diligence on the potential environmental risks, including obtaining an independent environmental review from outside environmental consultants. These indemnities obligate the Company to reimburse the indemnified parties for damages related to certain environmental matters. There is no term or damage limitation on these indemnities; however, if an environmental matter arises, the Company could have recourse against other previous owners.

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At March 31, 2008, the Company had $10.8 million of outstanding irrevocable letters of credit to guaranty the Company’s financial obligations related to workers’ compensation insurance programs and certain notes payable. The beneficiary may draw upon these letters of credit in the event of a contractual default by the Company relating to each respective obligation. No draws have been made through March 31, 2008.

14. Transactions With Affiliates

Other Reimbursements

From time to time, the Company pays for certain expenses such as payroll, insurance and other costs on behalf of certain affiliates. The affiliates generally reimburse such amounts on a monthly basis. At March 31, 2008 and December 31, 2007, amounts owed to the Company by its affiliates amounted to $0.1 million and $0.9 million, respectively, and are included in due from affiliates.

Transactions With Others

The Company purchases telecommunications equipment from Gemini Telemanagement Systems (“GTS”), a telecommunications equipment provider based in Redwood City, California. The Company’s interim Chief Executive Officer and Executive Chairman of the Board of Directors, Robert A. Alter, is a 5.2% stockholder in GTS, and his brother, Richard Alter, is the majority stockholder in GTS. The Company paid GTS $306,000 and $114,000 for the three months ended March 31, 2008 and 2007, respectively.

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Cautionary Statement

This report contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “should,” “will” or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those expressed or implied by these forward-looking statements. In evaluating these statements, you should specifically consider the risks outlined in detail in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on February 21, 2008, under the caption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, including but not limited to the following factors:

These factors may cause our actual events to differ materially from the expectations expressed or implied by any forward-looking statement. We do not undertake to update any forward-looking statement.

Overview

We own primarily luxury, upper upscale and upscale hotels in the United States operated under leading brand names, such as Marriott, Hilton, Hyatt, Fairmont and Starwood. Our portfolio also includes midscale hotels.

Operations

REIT structure. To qualify as a REIT, we are precluded from directly operating and earning income from our hotels. Therefore, consistent with the provisions of the Internal Revenue Code of 1986, as amended, and the rules and regulations thereunder (the “Code”), the Operating Partnership and its subsidiaries have leased our hotel properties to the TRS Lessee, which in turn has contracted “eligible independent contractors” to manage our hotels. Under the Code, an “eligible independent contractor” is an independent contractor who is actively engaged in the trade or business of operating “qualified lodging facilities” for any person unrelated to us and the TRS Lessee. The Operating Partnership and the TRS Lessee are consolidated into our financial statements for accounting purposes. The income of the TRS Lessee is subject to taxation like other C corporations, which may reduce our operating results, funds from operations and the cash otherwise available for distribution to our stockholders.

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Factors Affecting Our Results of Operations

Acquisitions. In January 2007, we acquired the 499-room LAX Renaissance hotel located in Los Angeles, California for approximately $65.2 million and retained Marriott as manager. The acquisition was initially funded through a draw on our credit facility, which we ultimately repaid with a portion of the proceeds we received in June 2007 from the sale of six hotel properties.

In March 2007, we acquired the 402-room Marriott Long Wharf hotel located in Boston, Massachusetts for approximately $228.5 million and retained Marriott as manager. In connection with this acquisition we obtained a $176.0 million mortgage loan with a maturity date of April 2017 and a fixed interest rate of 5.58%. The balance of the purchase price was funded through a draw on our credit facility, which we ultimately repaid with a portion of the proceeds we received in June 2007 from the sale of six hotel properties. Subsequent to this acquisition, we added an additional 10 rooms at this hotel, increasing the room count to 412.

In May 2007, we acquired the 464-room Marriott Boston Quincy hotel located in Quincy, Massachusetts for approximately $117.0 million and retained Marriott as manager. The acquisition was funded primarily through the settlement of our Forward Sale Agreement, with the balance funded through a draw on our credit facility, which we ultimately repaid with a portion of the proceeds we received in June 2007 from the sale of six hotel properties.

The following table sets forth the hotels that we have acquired since January 1, 2007:

Investments in unconsolidated joint ventures. In December 2006, we entered into a joint venture agreement with Whitehall Street Global Real Estate Limited Partnership 2005 and Highgate Holdings to acquire the 460-room Doubletree Guest Suites Hotel Times Square located in New York City, New York. Our total initial investment in the joint venture was approximately $68.5 million. Our total initial investment was funded entirely from cash on hand and was comprised of two parts: (i) a $28.5 million mezzanine loan, which bore an interest rate of 8.5% on a face value of $30.0 million and (ii) a $40.0 million equity investment representing a 38% ownership interest in the joint venture. In April 2007, we sold the $28.5 million mezzanine loan for net proceeds of $29.0 million. The total debt of the joint venture is $300.0 million, including the $30.0 million mezzanine loan.

In December 2007, we entered into a joint venture agreement with Strategic Hotels & Resorts, Inc. (“Strategic”), to own and operate BuyEfficient, LLC (“BuyEfficient”), an electronic purchasing platform that allows members to procure food, operating supplies, furniture, fixtures and equipment. Under the terms of the agreement, Strategic acquired a 50% interest in BuyEfficient from us for $6.3 million. As part of this transaction, we recognized a gain on sale of $6.1 million, and contributed $0.3 million to the new joint venture with Strategic. Prior to this sale, all of BuyEfficient’s revenue and expenses were reflected on the appropriate line of our statements of operations. After this sale, our 50% interest in BuyEfficient is reflected on our balance sheet as investments in unconsolidated joint ventures, and on our statements of operations as equity in net losses of unconsolidated joint ventures.

Dispositions. The following table sets forth the hotels we have sold since January 1, 2007:

Renovations. During the first quarter of 2008, we invested $31.8 million in capital improvements.

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Indebtedness. During the first quarter of 2007, we drew down $138.0 million of our $200.0 million credit facility to fund our purchases of the Renaissance LAX and the Marriott Long Wharf, and to fund other working capital requirements. We repaid $24.0 million of the credit facility in April 2007, and repaid the remaining balance in June 2007, using proceeds we received from the sale of six hotel properties. During the first quarter of 2008, we drew down $12.0 million of the credit facility to fund our working capital requirements. We repaid the entire $12.0 million in March 2008. As of March 31, 2008, we had no outstanding indebtedness under our credit facility, and had $10.8 million outstanding irrevocable letters of credit backed by the credit facility, leaving, as of that date, $189.2 million available under the credit facility.

In March 2007, we obtained a $176.0 million mortgage loan with a maturity date of April 2017 and a fixed interest rate of 5.58% in connection with the acquisition of the Marriott Long Wharf. In addition, in April 2007, we amended one of our mortgage loans to eliminate amortization and to provide for partial collateral releases, so long as we continue to meet certain loan covenants until the maturity date in May 2011, at which time the outstanding loan balance of $248.2 million will be due and payable. We also repaid a $175.0 million mortgage loan in June 2007, which had a maturity date of December 2014. In connection with this repayment, we incurred prepayment penalties of $0.4 million.

In June 2007, the Operating Partnership issued an aggregate $250.0 million of exchangeable senior notes with a maturity date of July 2027 and an interest rate of 4.60%. Interest on the notes is payable semi-annually in arrears on January 15 and July 15 of each year, beginning January 15, 2008. The notes, subject to specified events and other conditions, are exchangeable into, at our option, cash, our common stock, or a combination of cash and our common stock. The initial exchange rate for each $1,000 principal amount of notes is 28.9855 shares of our common stock, representing an exchange price of approximately $34.50 per common share. The initial exchange rate is subject to adjustment under certain circumstances. The Operating Partnership does not have the right to redeem the notes, except to preserve our REIT status, before January 20, 2013, and may redeem the notes, in whole or in part, thereafter at a redemption price equal to 100% of the principal amount of the notes to be redeemed, plus any accrued and unpaid interest. Upon specified change in control events as well as specified dates, holders of the notes may require the Operating Partnership to repurchase their notes, in whole or in part, for cash equal to 100% of the principal amount of the notes to be repurchased, plus any accrued and unpaid interest. The notes are the senior unsecured obligations of the Operating Partnership. We and all of our subsidiaries that are guarantors under our credit facility have guaranteed the Operating Partnership’s obligations under the notes.

In August 2007, we repaid a $13.1 million mortgage loan with a maturity date of September 2007.

In December 2007, we repaid an $8.7 million mortgage loan with an effective maturity date of August 2009, incurring a loss on early extinguishment of debt of $0.8 million.

Operating Performance Indicators. The following performance indicators are commonly used in the hotel industry:

Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following:

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Expenses. Our expenses consist of the following:

Other Revenue and Expense. Other revenue and expense consists of the following:

Most categories of variable operating expenses, such as utilities and certain labor costs, such as housekeeping, fluctuate with changes in occupancy. Increases in RevPAR attributable to improvements in occupancy are accompanied by increases in corresponding categories of variable operating costs and expenses. Increases in RevPAR attributable to improvements in ADR typically result in more limited increases in operating costs and expenses, primarily credit card commissions and management and franchise fees. Thus, changes in ADR generally have a more significant effect on our operating margins than changes in occupancy.

We continually work with our operators to improve our operating leverage, which generally refers to our ability to retain incremental revenue as profit by minimizing incremental operating expenses. There are, however, limits to how much our operators can accomplish in this regard without affecting the competitiveness of our hotels and our guests’ experiences at our hotels. Furthermore, our hotels operate with significant fixed costs, such as general and administrative expense, insurance, property taxes, and other expenses associated with owning hotels that our operators cannot necessarily control. For example, we have experienced increases in hourly wages, employee benefits (especially health insurance), and utility costs, which negatively affected our operating margin. Our historical performance may not be indicative of future results, and our future results may be worse than our historical performance.

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Operating Results

The following table presents our unaudited operating results for our total portfolio for the three months ended March 31, 2008 and 2007, including the amount and percentage change in the results between the periods. Our total portfolio represents the results of operations included in the consolidated statements of operations, and includes 45 hotels (15,620 rooms) as of March 31, 2008 and 44 hotels (15,156 rooms) as of March 31, 2007. The results of operations for the seven hotels that were sold in 2007 are included in income from discontinued operations for the three months ended March 31, 2007.

2008 Compared to 2007

Revenues. Total revenue for the three months ended March 31, 2008 was $248.7 million as compared to $227.4 million for the same period in 2007. Total revenue for the three months ended March 31, 2008 included room revenue of $160.8 million, food and beverage revenue of $69.7 million, and other revenue of $18.2 million. Total revenue for the three months ended March 31, 2007 included room revenue of $146.4 million, food and beverage revenue of $64.1 million, and other revenue of $16.9 million.

Included in the following tables are comparisons of the key operating metrics for our hotel portfolio for the three months ended March 31, 2008 and 2007. The comparisons do not include the results of operations for the seven hotels sold in 2007. Because three of our hotels owned as of March 31, 2008 were acquired during 2007, the key operating metrics for the total hotel portfolio and the comparable hotel portfolio reflect the results of operations of those three hotels under previous ownership for either a portion of or the entire three months ended March 31, 2007.

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For the three months ended March 31, 2008, RevPAR for our total portfolio increased 3.1% to $116.69 from the same period in 2007. Occupancy decreased 120 basis points to 72.0%, while ADR increased 4.8% to $162.07. For our Comparable Portfolio, RevPAR increased 1.6% to $115.36 from the same period in 2007. Occupancy decreased 200 basis points to 72.2%, while ADR increased 4.4% to $159.78.

Room revenue. Room revenue increased $14.4 million, or 9.9%, for the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. We acquired three hotels during 2007: Renaissance LAX, Marriott Long Wharf, and Marriott Boston Quincy (which we refer to as the “three hotels”). The three hotels contributed $8.3 million to room revenue during our first quarter 2008. In addition, growth in the hotels we acquired prior to January 1, 2007 (which we refer to as our “existing portfolio”) contributed $6.1 million to the increase in room revenue during our first quarter 2008, due to an increase in ADR ($8.1 million) partially offset by a decrease in occupancy ($2.0 million).

Food and beverage revenue. Food and beverage revenue increased $5.6 million, or 8.8%, for the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. The three hotels contributed $2.9 million of food and beverage revenue during our first quarter 2008. Food and beverage revenue generated from our existing portfolio increased $2.7 million during our first quarter 2008 as compared to the same period in 2007, due primarily to renovation disruption in 2007 at the Renaissance Long Beach and the Renaissance Orlando, combined with increased restaurant revenue generated by our other hotels.

Other operating revenue. Other operating revenue increased $1.2 million, or 7.3%, for the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. The three hotels contributed $1.0 million to other operating revenue during our first quarter 2008. Other operating revenue generated from our existing portfolio increased $0.2 million during our first quarter 2008 as compared to the same period in 2007, primarily due to an increase in transportation and parking revenue generated by several hotels as a result of increased occupancy, combined with an increase in revenue at one of our laundry facilities. These revenue increases were partially offset by decreased revenue recognized from a performance guaranty provided by the manager of the Hyatt Regency Century Plaza. We recognized $1.0 million in other revenue from this performance guaranty during the first quarter 2007. As of the end of our third quarter 2007, we had fully utilized the $27.0 million performance guaranty; therefore, no performance guaranty revenue was recognized in our first quarter 2008. In addition, other revenue decreased in 2008 as compared to 2007 because BuyEfficient’s operations are now included in equity in net losses of unconsolidated joint ventures.

Hotel operating expenses. Hotel operating expenses, which are comprised of room, food and beverage, advertising and promotion, repairs and maintenance, utilities, and other hotel operating expenses, increased $14.2 million, or 10.0%, during the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. The three hotels contributed $8.9 million to hotel operating expense during our first quarter 2008. In addition, hotel operating expenses in our existing portfolio increased $5.3 million during our first quarter 2008 as compared to the same period in 2007. These higher costs in our existing portfolio for the three months ended March 31, 2008 were primarily a result of increases in room expense and food and beverage expenses due to increases in related revenue, combined with increases in utility expenses as a result of higher energy costs.

Property general and administrative expense. Property general and administrative expense increased $2.6 million, or 10.0%, during the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. The three hotels contributed $1.7 million in property general and administrative expense during our first quarter 2008. Property general and administrative expenses in our existing portfolio increased $0.9 million during our first quarter 2008 as compared to the same period in 2007, primarily due to wage increases and to other hotel specific expenses, such as increased credit card commissions, bad debt expense and management fees associated with the overall increase in revenue.

Corporate overhead expense. Corporate overhead expense decreased $0.6 million, or 7.8%, during the three months ended March 31, 2008 as compared to the three months ended March 31, 2007, primarily as a result of decreased bonus expense during the first quarter of 2008, which was partially offset by increased minimum tax payments and sales tax expense.

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Depreciation and amortization expense. Depreciation and amortization expense increased $5.4 million, or 20.6%, during the three months ended March 31, 2008 as compared to the three months ended March 31, 2007. The three hotels contributed $2.5 million in depreciation and amortization expense during our first quarter 2008. Our existing portfolio contributed an additional $2.9 million in depreciation and amortization expense during the three months ended March 31, 2008 as compared to the same period in 2007.

Equity in net losses of unconsolidated joint ventures. Equity in net losses of unconsolidated joint ventures totaled $1.5 million for the three months ended March 31, 2008 as compared to $1.4 million for the three months ended March 31, 2007. In the first quarter of 2008, we recognized a $1.5 million loss on our interest in the Doubletree Guest Suites Hotel Times Square joint venture, which we originally purchased in December 2006, and nominal income on our BuyEfficient joint venture, which began to be accounted for as an unconsolidated joint venture in December 2007 following our sale of a 50% interest in BuyEfficient. In the first quarter of 2007, we recognized a $1.4 million loss on our interest in the Doubletree Guest Suites Hotel Times Square joint venture.

Interest expense. Interest expense is as follows (in thousands):

Interest expense increased $2.0 million, or 8.7%, during the three months ended March 31, 2008 as compared to the same period during 2007. Interest expense includes an additional $1.8 million incurred during the three months ended March 31, 2008 as compared to the same period in 2007, as a result of a new loan obtained to finance our acquisition of the Marriott Long Wharf combined with the issuance by the Operating Partnership of exchangeable senior notes, which was partially offset by our repayment of three loans. In addition, interest expense increased in the first quarter of 2008 as compared to the first quarter of 2007 due to a $0.2 million increase in amortization of deferred financing fees.

Our total notes payable, including the current portion, was $1,720.1 million on March 31, 2008 and $1,811.9 million on March 31, 2007, with a weighted average interest rate per annum of approximately 5.5% on March 31, 2008 and 5.8% on March 31, 2007. On March 31, 2008, the interest rates for all of our outstanding notes payable were fixed.

Income from discontinued operations. Income from discontinued operations was zero during the three months ended March 31, 2008 as compared to income of $1.3 million for the three months ended March 31, 2007. As described under “—Factors Affecting Our Results of Operations—Dispositions,” seven hotels were sold during 2007. Consistent with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have classified the gains on sale as discontinued operations and reclassified the results of operations for these seven hotels as discontinued operations.

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Liquidity and Capital Resources

Historical. During the periods presented, our sources of cash included our operating activities, working capital, proceeds from notes payable, our credit facility, and distributions received from our unconsolidated joint ventures. Our primary uses of cash were hotel acquisitions, capital expenditures for hotels, operating expenses, repayment of notes payable, repurchases of our common stock, and dividends on our common and preferred stock.

Operating activities. Net cash provided by operating activities was $21.4 million for the three months ended March 31, 2008 compared to $22.3 million for the three months ended March 31, 2007. This decrease was primarily due to reductions in our liability balances combined with increases in our receivable balances due to the timing of payments.

Investing activities. Net cash used in investing activities during the first three months of 2008 compared to the first three months of 2007 was as follows (in thousands):

Our cash used in investing activities fluctuates primarily based on acquisitions, dispositions and renovations of hotels. Net cash used in investing activities was $26.6 million during the first three months of 2008 compared to $324.4 million for the three months ended March 31, 2007. During the three months ended March 31, 2008, we paid an additional $11,000 for two hotels acquired in 2007. In addition, we paid cash of $31.8 million for renovations to our hotels, received $4.0 million from one of our unconsolidated joint ventures and decreased the balance in our restricted cash replacement reserve accounts by $1.2 million. During the same period in 2007, we acquired two hotels for $293.7 million, including an $8.4 million deposit paid at the end of 2006, and paid a $2.0 million deposit on the Marriott Boston Quincy, for a total cash outlay of $287.3 million. In addition, during the first quarter of 2007, we paid cash of $37.0 million for renovations to our hotels, increased the balance in our restricted cash replacement reserve accounts by $0.5 million, and received $0.4 million from our unconsolidated joint venture.

Financing activities. Net cash used in financing activities was $39.9 million for the three months ended March 31, 2008 compared to net cash provided of $288.1 million for the three months ended March 31, 2007. Net cash used in financing activities for the three months ended March 31, 2008 consisted primarily of $2.0 million of principal payments on notes payable, $11.8 million used to repurchase shares of our common stock, and $26.0 million of dividends paid to our stockholders. Net cash provided by financing activities for the three months ended March 31, 2007 consisted primarily of proceeds from notes payable of $314.0 million, partially offset by $2.0 million of principal payments on notes payable, $23.8 million of dividends paid to our stockholders, and $0.1 million in deferred financing costs.

Future. We expect our primary uses of cash to be for acquisitions of hotels, capital expenditures for hotels, operating expenses, repayment of principal on our notes payable, interest expense and dividends. We expect our primary sources of cash will continue to be our operating activities, working capital, notes payable, our credit facility, sales of hotel properties, and proceeds from public and private offerings of debt securities and common and preferred stock. Our ability to incur additional debt depends on a number of financial factors, including our leverage, the value of our unencumbered assets and borrowing restrictions imposed by lenders under our existing notes payable and our credit facility. Our ability to raise funds through the issuance of equity securities depends on, among other things, general market conditions for hotel companies and REITs and specific market perceptions about us. We will continue to analyze which source of capital is most advantageous to us at any particular point in time. However, the capital markets may not be available to us when needed on favorable terms or at all.

We believe that our capital structure, including the available balance of our $200.0 million credit facility and cash flow from operations, will provide us with sufficient liquidity to meet our current operating expenses and other expenses directly associated with our business for the foreseeable future, and in any event for at least the next twelve months. As of March 31, 2008, our credit facility had no amount outstanding, and had $10.8 million backing outstanding irrevocable letters of credit, leaving $189.2 million available under the credit facility. We are subject to compliance with applicable credit ratios under the credit facility.

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As of March 31, 2008, all of our outstanding debt had fixed interest rates. The majority of our mortgage debt is in the form of single asset loans rather than cross-collateralized multi-property pools. We believe this structure is appropriate for the operating characteristics of our business and provides flexibility for assets to be sold subject to the existing debt.

Contractual Obligations

The following table summarizes our payment obligations and commitments as of March 31, 2008 (in thousands):