avatar Sunstone Hotel Investors, Inc. Finance, Insurance, And Real Estate
  • Location: California 
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    A New Experience Annual Report 2007


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    You’ll find a new experience upon entering any one of Sunstone’s recently renovated hotels, as we’ve invested more than $275 million in capital improvements over the past two years. You’ll find a new experience upon meeting Sunstone’s new management team, as we’ve added talented professionals with diverse backgrounds and a wealth of industry knowledge. You’ll find a new experience when you explore our portfolio, as we’ve acquired nearly $2 billion in high-quality hotels in key markets since 2004. You’ll find a new experience in our affiliations with the best brands in the industry, as we’ve continued to grow our pool of Marriott, Hilton, Hyatt and Starwood flagged hotels. Experience Sunstone for Yourself.


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    Financial Highlights for 2007 (1) . Total Revenue increased by 23.6% to $1.057 billion . Income available to common stockholders per diluted share increased 196.6% to $1.75 . Adjusted EBITDA increased 23.0% to $310.1 million . Adjusted FFO available to common stockholders increased 21.1% to $180.6 million . Adjusted FFO available to common stockholders per diluted share increased 18.7% to $2.86 . Total capital expenditures were $135.2 million ( 1) Refer to reconciliation of non-GAAP financial measures on pages 62-63 of this Annual Report 6.0% 347 5.8% 322 5.5% 289 Weighted Average Average Rooms Interest Rate per Hotel $123 $1057 $112 $103 $855 $542 Total Revenue ( in millions) RevPAR 2005 2006 2007


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    Experience Orlando— —at the Renaissance Orlando Resort at SeaWorld ® An impressive $27 million—that’s what we’ve invested in this complete hotel renovation. Sunstone H otel Investors , Inc. A R07 It’s an experience that begins inside one of the world’s largest atriums where almost everything has been re-imagined—from the lounges, restaurants and retail shops to every one of the hotel’s 778 newly appointed guest rooms. The Renaissance Orlando Resort— just steps from SeaWorld® Orlando, Discovery Cove® and Aquatica®—is now a whole new world and resort experience all its own. 02 Bursts of color and natural light vibrantly bring to life the newly renovated Renaissance Orlando.


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    Sunstone H otel Investors , Inc. A R07 T he new Mist Sushi & Spirits Lounge offers a fun and inviting experience at the Renaissance Orlando Resort. 05


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    Experience Del Mar — —at the Marriott Del Mar-San Diego Although the Pacific Ocean is just minutes away, we’ve created a new retreat right here Sunstone H otel Investors , Inc. A R07 at the Marriott Del Mar-San Diego, investing nearly $2.6 million in renovations to the hotel’s main entry, outdoor lounge and pool areas. Designed as an extension to the locally acclaimed Arterra® Restaurant and Bar, the all-new poolside lounge—replete with new soft seating, fire pits and private cabanas—is a natural complement to the hotel’s idyllic San Diego setting. 07 Contemporary lines and warm earth tones have been combined in this renovation of the Marriott Del Mar’s outdoor lounge and pool areas.


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    Sunstone H otel Investors , Inc. A R07 Warm fire pits and comfortable seating invite a relaxing experience at the Marriott Del Mar’s new poolside lounge. 08


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    Experience Baltimore— —at the Renaissance Harborplace Hotel Along Baltimore’s Inner Harbor where the great Clipper ships were once launched, we Sunstone H otel Investors , Inc. A R07 celebrated a launch of our own with the completion of this $12.8 million renovation at our Renaissance Harborplace Hotel. At the center of this makeover—exuding the culture and sophistication of the region—is Watertable, the hotel’s new restaurant and lounge. Major renovations to the hotel’s lobby and meeting space also set the table for an upscale lodging experience. 10 Deep reds, dark woods and a classic east coast style create a sophisticated setting at the newly renovated Renaissance Harborplace Hotel.


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    Sunstone H otel Investors , Inc. A R07 A renovated room at the Renaissance Harborplace Hotel— exuding the culture and sophistication of Charm City. 13


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    Experience Washington D.C.— —at the Renaissance Washington D.C. In the revitalized heart of America’s Capital City, we’ve made significant capital Sunstone H otel Investors , Inc. A R07 improvements to our Renaissance Washington D .C., investing $9.8 million to renovate the hotel’s restaurant and more than 60,000 square feet of public space. Ideally located between the White House and Capitol Hill, the Renaissance Washington D .C. continues Sunstone’s mission of enhancing the quality of our hotels and, in turn, value for our stockholders. 15 T he renovated Renaissance Washington D.C.— in the heart of the American experience.


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    Experience Los Angeles— —at the Renaissance LAX We’ve taken off in Los Angeles with our recent acquisition of this luxurious hotel in Sunstone H otel Investors , Inc. A R07 the Los Angeles airport market. It’s the Renaissance LAX and virtually every facet of this property has been transformed—from the ultra contemporary architecture and design of its public areas and meeting space to the modern amenities in every one of its upscale guestrooms and suites. 16 Attention to detail makes the experience at the Renaissance LAX


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    Renaissance Westchester Renaissance Atlanta Concourse


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    Experience Sunstone— —in key markets Our experience is working. We continue to make impressive gains, maximizing stockholder Sunstone H otel Investors , Inc. A R07 value through our comprehensive approach to portfolio management. Today, Sunstone Hotel Investors has interests in 46 hotels with an aggregate of 16,085 rooms in some of the most desirable lodging markets across the country. In addition to the markets featured in these pages, you can also experience Sunstone in Atlanta, Boston, Chicago, Philadelphia and New York. We’ve completed major makeovers to many of our hotels, added solid properties in key gateway markets, enhanced our senior management team and deepened our brand relationships. Together, our properties, our team and our brand affiliations define a new experience at Sunstone. 19 Marriott Boston Quincy


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    To our stockholders: 2007 was a year of growth for Sunstone. We delivered outstanding financial results. In 2007, our revenues increased by 23.6% to $1.057 billion, our total RevPAR increased by 10.0% to $122.76, our Adjusted EBITDA increased by 23.0% to $310.1 million, and our Adjusted FFO Available to Common Stockholders per Diluted Share increased by 18.7%. Since 2004, our Adjusted FFO Available to Common Stockholders per Diluted Share has increased at a compounded annual growth rate of 13.6%. We effectively recycled capital. During the year, we meaningfully increased the overall quality of our portfolio by strategically investing capital into our core hotels and by harvesting gains in our non-core hotels. We tax- efficiently divested of seven non-core hotels, comprised of a total of 1,519 rooms with an average 2007 RevPAR of just $78. We redeployed our asset sale proceeds into the acquisition of three high-growth hotels with an average 2007 RevPAR of $136 (the 499-room Renaissance LAX, the 402-room Marriott Boston Long Wharf and the 464-room Marriott Boston Quincy). We invested wisely in our core portfolio. We invested over $275 million in our portfolio during the past two years, including major repositioning projects at the Hyatt Regency Century Plaza, Fairmont Newport Beach, Hilton Times Square, Renaissance Orlando and Renaissance Baltimore. We built a strong and flexible balance sheet. During the year, we restructured our corporate credit facility, replaced expensive mortgage debt with lower-cost exchangeable senior notes, and pre-paid certain mortgage debt with the proceeds from asset dispositions. Also, in 2007 we returned over $180 million to our stockholders through stock buybacks and dividends.


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    We cultivated an exceptional team. We completed a successful transition of our senior management team during the year. New leaders took key posts as Chief Financial Officer, General Counsel and Senior Vice President of Development. As a result, our team is now clearly defined and focused on executing on our strategy. 2008 will be a year of opportunity for Sunstone. We will stay the course. By remaining true to our basic strategy of disciplined capital allocation, conservative Sunstone H otel Investors , Inc. A R07 financial management and proactive asset management, we believe we have positioned Sunstone for strong performance under a wide range of economic scenarios in 2008 and beyond. Going forward, we will continue Sunstone’s transformation by seeking opportunities to enhance our portfolio through the sale of non-core hotels and the acquisition of hotels that meet our strategic objectives. We are positioned to perform. We believe the lodging sector is fundamentally sound, even in a slowing economy. We own a geographically diverse portfolio of principally institutional quality upper-upscale hotels. We have implemented new levels of discipline and accountability throughout the company, and we share a cohesive vision for creating long-term value. We will continue to focus on our core competencies as we drive internal growth, 21 while evaluating acquisition opportunities that will enhance our earnings, thereby allowing us to build long-term stockholder value. We truly appreciate your continued support of Sunstone. We are very proud of our accomplishments in 2007, and we look forward to continuing to develop your loyalty and trust in 2008 and beyond. Thank you. Robert A. Alter Kenneth E. Cruse Executive Chairman Chief Financial Officer


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    Table of Contents 23 Selected Financial Data 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations 38 Report of Independent Registered Public Accounting Firm 39 Consolidated Balance Sheets 40 Consolidated Income Statements 41 Consolidated Statements of Stockholders’ Equity 42 Consolidated Statements of Cash Flows 43 Notes to Consolidated Financial Statements 60 Report of Independent Registered Public Accounting Firm 61 Non-GAAP Financial Measures 62 Reconciliation of Non-GAAP Financial Measures 64 Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities 65 Corporate Information


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    Selected Financial Data The Company was formed to succeed to the businesses of Sunstone Hotel Investors, L.L.C. (“SHI”), WB Hotel Investors, LLC (“WB”), and Sunstone/WB Hotel Investors IV, LLC (“WB IV”) (collectively, the “Sunstone Predecessor Companies” or the “Predecessor”), which were engaged in owning, acquiring, selling, managing, and renovating hotel properties in the United States. The following table sets forth selected financial information for the Company and the Predecessor, that has been derived from the consolidated and combined financial statements and notes. This information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated and combined financial statements and related notes included elsewhere in this Annual Report. The Company The Predecessor (1) Period Period Year Ended Year Ended Year Ended October 26 to January 1 to Year Ended December 31, December 31, December 31, December 31, October 25, December 31, 2007 2006 2005 2004 2004 2003 (Dollars in thousands) Operating Data: Revenues: Sunstone H otel Investors , Inc. A R07 Room $ 688,921 $ 549,834 $ 343,701 $ 39,380 $ 206,586 $ 218,448 Food and beverage 289,655 228,315 147,679 18,995 76,740 88,596 Other operating 78,163 77,106 50,367 6,844 32,036 31,591 Management and other fees from affiliates — — — 4 688 705 Total revenues 1,056,739 855,255 541,747 65,223 316,050 339,340 Operating Expenses: Room 152,808 123,004 76,766 9,325 44,380 51,075 Food and beverage 209,971 163,423 103,704 12,850 52,634 62,084 Other operating 41,816 38,095 28,831 4,542 21,444 21,968 Advertising and promotion 55,340 47,312 34,010 4,020 18,100 20,511 Repairs and maintenance 40,449 34,607 22,482 2,989 12,808 15,109 Utilities 37,429 32,863 22,022 2,840 12,557 13,787 23 Franchise costs 37,493 30,673 18,651 2,655 14,532 15,018 Property tax, ground lease and insurance 58,706 53,464 29,580 3,734 17,188 22,301 Property general and administrative 119,210 98,057 61,401 8,198 25,769 26,231 Corporate overhead 28,270 19,037 14,483 7,175 23,214 25,187 Depreciation and amortization 119,855 90,392 58,490 8,157 36,188 38,964 Impairment loss — — — — 1,245 5,139 Total operating expenses 901,347 730,927 470,420 66,485 280,059 317,374 Operating income (loss) 155,392 124,328 71,327 (1,262) 35,991 21,966 Equity in earnings (losses) of unconsolidated joint ventures ( 3,588) 140 — — — — Interest and other income 9,261 4,208 3,079 154 560 773 Interest expense ( 98,907) (91,052) (51,547) (13,239) (34,940) (41,831) Income (loss) before minority interest, income taxes, and discontinued operations 62,158 37,624 22,859 (14,347) 1,611 (19,092) Minority interest — — (1,761) 2,706 125 (17) Income tax benefit — — — — 54 2,913 Income (loss) from continuing operations 62,158 37,624 21,098 (11,641) 1,790 (16,196) Income (loss) from discontinued operations 63,505 15,613 9,107 (6,256) (19,993) (6,070) Net income (loss) 125,663 53,237 30,205 $ (17,897) $ (18,203) $ (22,266) Preferred stock dividends and accretion ( 20,795) (19,616) (10,973) Undistributed income allocated to Series C preferred stock ( 1,583) — — Income available to common stockholders $ 103,285 $ 33,621 $ 19,232 Income (loss) from continuing operations available to common stockholders per common share $ 0.70 $ 0.31 $ 0.25 $ (0.42) Net income (loss) available to common stockholders per common share $ 1.75 $ 0.59 $ 0.47 $ (0.54) Cash dividends declared per common share $ 1.31 $ 1.22 $ 1.155 $ 0.285 Cash flows provided by (used in) operating activities $ 213,979 $ 163,076 $ 113,403 $ (236) $ 33,064 $ 60,034 Balance Sheet Data: Investment in hotel properties, net $ 2,786,821 $ 2,477,514 $ 2,054,001 $ 1,127,272 $ 1,227,537 Total assets 3,049,152 2,760,373 2,249,189 1,253,745 1,364,942 Total debt 1,722,151 1,499,828 1,181,178 712,461 917,652 Total liabilities 1,855,721 1,623,294 1,290,164 791,583 1,033,993 Equity 1,093,935 1,037,783 859,929 417,332 330,345 (1) In connection with our public offering in 2004, we undertook certain formation and structuring transactions with respect to our operating and capital structure to prepare for operation as a public company. These transactions affect the comparability of our results from and after October 26, 2004 and our results prior to that date.


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    Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 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, as amended (the “Code”), Sunstone Hotel Partnership, LLC (the “Operating Partnership”) and its subsidiaries have leased our hotel properties to Sunstone Hotel TRS Lessee (the “TRS Lessee”), which has in turn contracted with “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 Sunstone H otel Investors , Inc. A R07 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. 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. 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%. 24 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 following table sets forth the hotels we have acquired since January 1, 2005: Hotels Rooms Acquisition Date 2007: Marriott Boston Quincy, Quincy, Massachusetts 464 May 1, 2007 Marriott Long Wharf, Boston, Massachusetts 402 March 23, 2007 LAX Renaissance, Los Angeles, California 499 January 4, 2007 2006: W Hotel, San Diego, California 258 June 26, 2006 Embassy Suites, La Jolla, California 340 May 17, 2006 Hilton Times Square, New York City, New York 460 March 17, 2006 Del Mar Marriott, San Diego, California 284 January 10, 2006 2005: Hyatt Regency Century Plaza, Los Angeles, California 726 October 5, 2005 Fairmont Hotel, Newport Beach, California 444 July 11, 2005 Sheraton Hotel, Cerritos, California 203 June 27, 2005 Renaissance Orlando Resort at Sea World, Orlando, Florida(1) 778 June 23, 2005 Renaissance Harborplace, Baltimore, Maryland 622 June 23, 2005 Renaissance Concourse, Atlanta, Georgia 387 June 23, 2005 Renaissance Long Beach, Long Beach, California 374 June 23, 2005 Renaissance Westchester, White Plains, New York 347 June 23, 2005 Renaissance Washington, D.C., Washington D.C. 807 June 23, 2005(2) Total January 1, 2005 to December 31, 2007 7,395 (1) Acquired 85% ownership interest. (2) Acquired 25% ownership interest on June 23, 2005, and the remaining 75% interest July 13, 2005. The aggregate cost for these 16 hotel acquisitions was approximately $1.9 billion, or $257,000 per room.


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    Investment 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 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., or Strategic, to own and operate BuyEfficient, LLC, an electronic purchasing platform that allows members to procure food, operating supplies, furniture, fixtures and Sunstone H otel Investors , Inc. A R07 equipment. Under the terms of the agreement, Strategic acquired a 50% interest in BuyEfficient, LLC 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 to operate BuyEfficient, LLC. Prior to this sale, all of BuyEfficient, LLC’s revenue and expenses were reflected on the appropriate line of our income statements. After this sale, our 50% interest in BuyEfficient, LLC is reflected on our balance sheet as investment in unconsolidated joint ventures, and on our income statements as equity in earnings (losses) of unconsolidated joint ventures. Dispositions. The following table sets forth the hotels we have sold since January 1, 2005: Hotels Rooms Disposition Date 2007: Sheraton, Salt Lake City, Utah 362 December 20, 2007 Courtyard by Marriott, Oxnard, California 166 June 29, 2007 25 Courtyard by Marriott, Riverside, California 163 June 29, 2007 Hawthorn Suites, Sacramento, California 272 June 29, 2007 Hilton Garden Inn, Lake Oswego, Oregon 179 June 29, 2007 Residence Inn by Marriott, Oxnard, California 251 June 29, 2007 Residence Inn by Marriott, Sacramento, California 126 June 29, 2007 2006: Holiday Inn, Rochester, Minnesota 170 December 21, 2006 Courtyard by Marriott, Fresno, California 116 September 13, 2006 Courtyard by Marriott, Lynnwood, Washington 164 September 13, 2006 Courtyard by Marriott, Santa Fe, New Mexico 213 September 13, 2006 Crowne Plaza, Englewood, New Jersey 194 September 13, 2006 Crowne Plaza, Williamsburg, Virginia 303 September 13, 2006 Hawthorn Suites, Kent, Washington 152 September 13, 2006 Holiday Inn, Boise, Idaho 265 September 13, 2006 Holiday Inn, Craig, Colorado 152 September 13, 2006 Holiday Inn, Price, Utah 151 September 13, 2006 Holiday Inn, Renton, Washington 226 September 13, 2006 Holiday Inn, San Diego (Stadium), California 175 September 13, 2006 Marriott, Ogden, Utah 292 September 13, 2006 Marriott, Pueblo, Colorado 164 September 13, 2006 Holiday Inn, Hollywood, California 160 March 15, 2006 2005: Holiday Inn, Provo, Utah 78 December 22, 2005 Doubletree, Carson, California 224 April 14, 2005 Holiday Inn, Mesa, Arizona 246 April 14, 2005 Total January 1, 2005 to December 31, 2007 4,964 The aggregate net sale proceeds for the 25 hotel dispositions through December 31, 2007 was $373.4 million, or $75,000 per room. The results of operations of all of the hotels identified above and the gains or losses on dispositions through December 31, 2007 are included in discontinued operations for all periods presented through the time of sale. The proceeds from the sales are included in our cash flows from investing activities for the respective periods.


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    The following table summarizes our portfolio and room data from the beginning of 2005 through December 31, 2007, adjusted for the hotels acquired and sold during the respective periods. 2007 2006 2005 Portfolio Data—Hotels Number of hotels—beginning of period 49 60 54 Add: Acquisitions 3 4 9 Less: Sales ( 7) (15) (3) Number of hotels—end of period 45 49 60 Sunstone H otel Investors , Inc. A R07 Portfolio Data—Rooms Number of rooms—beginning of period 15,758 17,333 13,183 Add: Acquisitions 1,365 1,322 4,701 Add: Room expansions 21 — — Less: Sales ( 1,519) (2,897) (548) Less: Rooms converted to other usage — — (3) Number of rooms—end of period 15,625 15,758 17,333 Average rooms per hotel—end of period 347 322 289 Renovations. During 2007, we spent $135.2 million on capital investments. This included repositioning projects completed during the year at the Renaissance Orlando, Renaissance Baltimore, Renaissance Long Beach, Hyatt Regency Century Plaza, Hilton Times Square and Embassy Suites La Jolla hotels. 26 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. During the second quarter of 2007, we drew down an additional $27.0 million of the credit facility to fund our purchase of the Marriott Boston Quincy, and to fund other working capital requirements. During the fourth quarter, we drew down an additional $10.0 million of the credit facility to fund working capital requirements. We repaid $24.0 million of the credit facility in April 2007, and $141.0 million in June 2007, using proceeds we received from the sale of six hotel properties, and repaid the remaining $10.0 million balance in November 2007. As of December 31, 2007, 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, provided we continue to meet certain loan covenants, from May 2007 until the maturity date of 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.


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    Operating Performance Indicators. The following performance indicators are commonly used in the hotel industry: . occupancy; . average daily rate, or ADR; . revenue per available room, or RevPAR, which is the product of occupancy and ADR, but does not include food and beverage revenue, or other operating revenue; . comparable RevPAR growth, which we define as the change in RevPAR generated by hotels we owned as of the end of the reporting period, but excluding those hotels that experienced material and prolonged business interruption due to renovations, re-branding or property damage during either the current or preceding calendar year. For hotels that were not owned for the entirety of the comparison periods, comparable RevPAR is calculated using RevPAR generated during periods of prior ownership. We refer to this subset of our hotels used to calculate comparable RevPAR growth as our “Comparable Portfolio”; Sunstone H otel Investors , Inc. A R07 . hotel operating margin, which is the product of total operating income divided by total revenues; . comparable hotel operating margin, which is the operating margin of our Comparable Portfolio; and . operating leverage, which is the product of incremental operating income divided by incremental revenues. Revenues. Substantially all of our revenues are derived from the operation of our hotels. Specifically, our revenues consist of the following: . Room revenues, which is the product of the number of rooms sold and the ADR; . Food and beverage revenues, which is comprised of revenues realized in the hotel food and beverage outlets as well as banquet and catering events; and . Other operating revenues, which include ancillary hotel revenue such as performance guaranties and other items primarily driven by occupancy such as telephone, transportation, parking, spa, entertainment and other guest services. Additionally, this category includes operating revenue from our two commercial laundry facilities located in Rochester, Minnesota and Salt Lake City, Utah. Prior to December 2007, this category also included operating revenue from BuyEfficient, LLC. As described above, in December 2007 we entered into a joint venture agreement with Strategic and sold a 50% interest in BuyEfficient, LLC to Strategic. Going forward, in 27 accordance with the equity method of accounting, our 50% share of BuyEfficient, LLC’s earnings will now be shown on the line item equity in earnings (losses) of unconsolidated joint ventures. Due to our continued investment in BuyEfficient, LLC, no amounts have been reclassified to discontinued operations. Expenses. Our expenses consist of the following: . Room expense, which is primarily driven by occupancy and, therefore, has a significant correlation with room revenue; . Food and beverage expense, which is primarily driven by food and beverage sales and banquet and catering bookings and, therefore, has a significant correlation with food and beverage revenue; . Other operating expense, which includes the corresponding expense of other operating revenue, advertising and promotion, repairs and maintenance, utilities, and franchise fees; . Property general and administrative expense, which includes our property-level general and administrative expenses, such as payroll and related costs, professional fees, travel expenses, and management fees; . Property tax, ground lease and insurance expense, which includes the expenses associated with property tax, ground lease and insurance payments, each of which is primarily a fixed expense; . Corporate overhead expense, which includes our corporate-level expenses such as payroll and related costs, amortization of deferred stock compensation, professional fees, travel expenses and office rent; and . Depreciation and amortization expense, which includes depreciation on our hotel buildings, improvements, furniture, fixtures and equipment. Other Revenue and Expense. Other revenue and expense consists of the following: . Equity in earnings (losses) of unconsolidated joint ventures, which includes our portion of earnings or losses from our joint ventures; . Interest and other income, which includes interest we have earned on our restricted and unrestricted cash accounts as well as any gains or losses we have recognized on sales of assets other than hotels; . Interest expense, which includes interest expense incurred on our outstanding debt, amortization of deferred financing fees, prepayment penalties and costs associated with early extinguishment of debt; and . Preferred stock dividends and accretion, which includes dividends earned on our Series A and Series C preferred stock and redemption value accretion on our Series C preferred stock 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.


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    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. Operating Results The following table presents our operating results for 2007 and 2006, including the amount and percentage change in the results between Sunstone H otel Investors , Inc. A R07 the two periods. These period amounts can be found in our consolidated financial statements and related notes included elsewhere in this Annual Report. 2007 2006 Change $ Change % (Dollars in thousands, except statistical data) Revenues Room $ 688,921 $ 549,834 $ 139,087 25.3% Food and beverage 289,655 228,315 61,340 26.9 Other operating 78,163 77,106 1,057 1.4 Total revenues 1,056,739 855,255 201,484 23.6 Operating expenses 28 Hotel operating 634,012 523,441 110,571 21.1 Property general and administrative 119,210 98,057 21,153 21.6 Corporate overhead 28,270 19,037 9,233 48.5 Depreciation and amortization 119,855 90,392 29,463 32.6 Total operating expenses 901,347 730,927 170,420 23.3 Operating income 155,392 124,328 31,064 25.0 Equity in earnings (losses) of unconsolidated joint ventures ( 3,588) 140 (3,728) N/A Interest and other income 9,261 4,208 5,053 120.1 Interest expense ( 98,907) (91,052) (7,855) 8.6 Income from continuing operations 62,158 37,624 24,534 65.2 Income from discontinued operations 63,505 15,613 47,892 306.7 N et income 125,663 53,237 72,426 136.0 Preferred stock dividends and accretion ( 20,795) (19,616) (1,179) 6.0 Undistributed income allocated to Series C preferred stock ( 1,583) — (1,583) N/A Income available to common stockholders $ 103,285 $ 33,621 $ 69,664 207.2


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    The following table presents our operating results for 2006 and 2005, including the amount and percentage change in the results between the two periods. These period amounts can be found in our consolidated financial statements and related notes included elsewhere in this Annual Report. 2006 2005 Change $ Change % (Dollars in thousands, except statistical data) Revenues Room $ 549,834 $ 343,701 $ 206,133 60.0% Food and beverage 228,315 147,679 80,636 54.6 Other operating 77,106 50,367 26,739 53.1 Sunstone H otel Investors , Inc. A R07 Total revenues 855,255 541,747 313,508 57.9 Operating expenses Hotel operating 523,441 336,046 187,395 55.8 Property general and administrative 98,057 61,401 36,656 59.7 Corporate overhead 19,037 14,483 4,554 31.4 Depreciation and amortization 90,392 58,490 31,902 54.5 Total operating expenses 730,927 470,420 260,507 55.4 Operating income 124,328 71,327 53,001 74.3 Equity in earnings of unconsolidated joint venture 140 — 140 N/A Interest and other income 4,208 3,079 1,129 36.7 Interest expense (91,052) (51,547) (39,505) 76.6 29 Income before minority interest and discontinued operations 37,624 22,859 14,765 64.6 Minority interest — (1,761) 1,761 N/A Income from continuing operations 37,624 21,098 16,526 78.3 Income from discontinued operations 15,613 9,107 6,506 72.4 N et income 53,237 30,205 23,032 76.3 Preferred stock dividends and accretion (19,616) (10,973) (8,643) 78.8 Income available to common stockholders $ 33,621 $ 19,232 $ 14,389 74.8 Revenues. Total revenue for the year ended December 31, 2007 was $1.1 billion as compared to $855.3 million for the year ended December 31, 2006 and $541.7 million for the year ended December 31, 2005. Total revenue for 2007 included room revenue of $688.9 million, food and beverage revenue of $289.7 million, and other revenue of $78.2 million. Total revenue for 2006 included room revenue of $549.8 million, food and beverage revenue of $228.3 million, and other revenue of $77.1 million. Total revenue for 2005 included room revenue of $343.7 million, food and beverage revenue of $147.7 million, and other revenue of $50.4 million. Included in the following tables are comparisons of the key operating metrics for our hotel portfolio for the years ended December 31, 2007, 2006 and 2005. The comparisons do not include the results of operations for the seven hotels sold in 2007, the 15 hotels sold during 2006, and the three hotels sold during 2005. Because 16 of our hotels owned as of December 31, 2007 were acquired during 2005, 2006 and 2007, the key operating metrics for the total hotel portfolio and the comparable hotel portfolio reflect the results of operations of those seven hotels under previous ownership for either a portion of or the years ended December 31, 2007, 2006 and 2005. 2007 2006 Change Occ% ADR RevPAR Occ% ADR RevPAR Occ% ADR RevPAR Total Hotel Portfolio (45 hotels) 76.3% $160.89 $ 122.76 73.0% $ 152.82 $ 111.56 3.3% 5.3% 10.0% Comparable Hotel Portfolio (41 hotels)(1) 76.8% $156.45 $ 120.15 74.8% $ 149.02 $ 111.47 2.0% 5.0% 7.8% 2006 2005 Change Occ% ADR RevPAR Occ% ADR RevPAR Occ% ADR RevPAR Total Hotel Portfolio (45 hotels) 73.0% $ 152.82 $ 111.56 72.6% $ 142.40 $ 103.38 0.4% 7.3% 7.9% Comparable Hotel Portfolio (42 hotels)(2) 74.4% $ 150.25 $ 111.79 73.4% $ 140.45 $ 103.09 1.0% 7.0% 8.4%


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    Hotel Operating Margins 2007 2006 Change Total Hotel Portfolio (45 hotels) 28.8% 26.2% 2.6% Comparable Hotel Portfolio (41 hotels)(1) 30.1% 28.9% 1.2% Hotel Operating Margins 2006 2005 Change Total Hotel Portfolio (45 hotels) 26.2% 25.2% 1.0% Sunstone H otel Investors , Inc. A R07 Comparable Hotel Portfolio (42 hotels)(2) 28.2% 26.7% 1.5% (1) Includes hotel properties owned on December 31, 2007, excluding hotels that experienced material disruption during the reporting periods (Fairmont Newport Beach, Hyatt Regency Century Plaza, Renaissance Baltimore and Renaissance Orlando). (2) Includes hotel properties owned on December 31, 2007, excluding hotels that experienced material disruption during the reporting periods (Fairmont Newport Beach, Hyatt Regency Century Plaza, and Marriott Tyson’s Corner). For the year ended December 31, 2007, RevPAR for our pro forma total portfolio increased 10.0% to $122.76 from the same period in 2006. Occupancy increased 3.3 percentage points to 76.3%, while ADR increased 5.3% to $160.89. For our pro forma comparable hotel portfolio, RevPAR increased 7.8% to $120.15 from the same period in 2006. Occupancy increased 2.0 percentage points to 76.8%, while ADR increased 5.0% to $156.45. For the year ended December 31, 2006, RevPAR for our pro forma total portfolio increased 7.9% to $111.56 from the same period in 2005. Occupancy increased 0.4 percentage points to 73.0%, while ADR increased 7.3% to $152.82. For our pro forma comparable hotel 30 portfolio, RevPAR increased 8.4% to $111.79 from the same period in 2005. Occupancy increased 1.0 percentage points to 74.4%, while ADR increased 7.0% to $150.25. The increases in our RevPAR for the years ended December 31, 2007 and 2006 were significantly affected by increases in RevPAR at several of our recently renovated hotels. Room revenue. Room revenue increased $139.1 million, or 25.3%, for the year ended December 31, 2007 as compared to the year ended December 31, 2006. We acquired seven hotels during the period from January 1, 2006 to December 31, 2007: Del Mar Marriott, Hilton Times Square, Embassy Suites La Jolla, W Hotel San Diego, LAX Renaissance, Marriott Long Wharf, and Marriott Boston Quincy (which we refer to as the “seven hotels”). The seven hotels contributed $85.5 million to room revenue during 2007. In addition, growth in the hotels we acquired prior to December 31, 2005 (which we refer to as our “existing portfolio”) contributed $53.6 million to room revenue during 2007 due to increases in both occupancy ($21.4 million) and ADR ($32.2 million). Room revenue increased $206.1 million, or 60.0% for the year ended December 31, 2006 as compared to the year ended December 31, 2005. We acquired 13 hotels during the period from January 1, 2005 to December 31, 2006: Renaissance Concourse, Renaissance Harborplace, Renaissance Long Beach, Renaissance Orlando, Renaissance Westchester, Renaissance Washington D.C., Sheraton Hotel Cerritos, Fairmont Newport Beach, Hyatt Regency Century Plaza, Marriott Del Mar, Hilton Times Square, Embassy Suites La Jolla, and the W Hotel San Diego (which we refer to as the “13 hotels”). The 13 hotels contributed $184.4 million to room revenue during 2006. In addition, growth in the hotels we acquired prior to December 31, 2004 (which we refer to as our “2006 existing portfolio”) contributed $21.7 million to room revenue during 2006 due to increases in both occupancy ($2.3 million) and ADR ($19.4 million). Food and beverage revenue. Food and beverage revenue increased $61.3 million, or 26.9%, for the year ended December 31, 2007 as compared to the year ended December 31, 2006. The seven hotels contributed $26.7 million to food and beverage revenue during 2007. Food and beverage revenue generated from our existing portfolio increased $34.6 million during 2007 as compared to 2006, due primarily to higher occupancy levels at the hotels. Food and beverage revenue increased $80.6 million, or 54.6%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. The 13 hotels contributed $77.9 million to food and beverage revenue during 2006. Food and beverage revenue generated from our 2006 existing portfolio increased $2.7 million during 2006 as compared to 2005. Other operating revenue. Other operating revenue increased $1.1 million, or 1.4%, for the year ended December 31, 2007 as compared to the year ended December 31, 2006. The seven hotels contributed $6.3 million to other operating revenue during 2007. Other operating revenue generated from our existing portfolio decreased $5.2 million during 2007 as compared to 2006 primarily due to decreased revenue recognized from a performance guaranty provided by the manager of the Hyatt Regency Century Plaza. We recognized $2.8 million in other operating revenue from this performance guaranty during 2007 as compared to $17.4 million recognized during 2006. As of the end of our third quarter 2007, we have fully utilized the entire $27.0 million performance guaranty. Partially offsetting this


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    decrease, other operating revenue in our existing portfolio grew during 2007 due to increased internet usage, telephone, transportation and parking revenue caused by the increased occupancy, combined with attrition fees collected by our hotels, as well as increased revenue generated by our electronic purchasing platform, BuyEfficient, LLC and by one of our laundry facilities. In December 2007, we entered into a joint venture agreement with Strategic whereby Strategic purchased a 50% interest in BuyEfficient, LLC from us for a gross sales price of $6.3 million. Other operating revenue in future periods, therefore, will decrease as our 50% share of BuyEfficient, LLC will now be shown as part of equity in earnings (losses) of unconsolidated joint ventures. Other operating revenue increased $26.7 million, or 53.1%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. The 13 hotels contributed $25.2 million to other operating revenue during 2006. A substantial portion of our other operating revenue in 2006 resulted from a performance guaranty provided by the manager of the Hyatt Regency Century Plaza. We used Sunstone H otel Investors , Inc. A R07 a total of $17.4 million of the $27.0 million performance guaranty during 2006 and $6.8 million during 2005 for a total of $24.2 million cumulatively. Other operating revenue generated from our 2006 existing portfolio increased $1.5 million during 2006 as compared to 2005 primarily due to increased attrition and cancellation fees collected by our hotels, combined with increased revenue generated by our electronic purchasing platform, BuyEfficient, LLC and by one of our laundry facilities. 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 $110.6 million, or 21.1%, for the year ended December 31, 2007 as compared to the year ended December 31, 2006. The seven hotels contributed $66.1 million to hotel operating expenses during 2007. In addition, hotel operating expense in our existing portfolio increased $44.5 million during 2007 as compared to 2006. These higher costs in our existing portfolio during 2007 were driven by our increases in related revenues, the direct result of higher occupancy as well as an increase in advertising cost. Hotel operating expenses increased $187.4, or 55.8%, during the year ended December 31, 2006 as compared to the year ended December 31 31, 2005. The 13 hotels contributed $176.3 million in other operating expenses during 2006. In addition, hotel operating expenses in our 2006 existing portfolio increased $11.1 million during 2006 as compared to 2005. These higher costs in our 2006 existing portfolio during 2006 were driven by our increases in related revenues, the direct result of higher occupancy. Additionally, property and liability insurance premiums were higher as well as property taxes due to supplemental tax bills received on several of our hotels. Property general and administrative expense. Property general and administrative expense increased $21.2 million, or 21.6%, for the year ended December 31, 2007 as compared to the year ended December 31, 2006. The seven hotels contributed $13.7 million to property general and administrative expense. In addition, property general and administrative expense in our existing portfolio increased $7.5 million primarily due to wage increases and to other hotel specific expenses, such as increased credit card commissions, and management fees, associated with the overall increase in revenue. Property general and administrative expense increased $36.7 million, or 59.7%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. The 13 hotels contributed $31.9 million to property general and administrative expense during 2006. In addition, property general and administrative expense in our 2006 existing portfolio increased $4.8 million due to increases in management fees payable to our management companies, and other hotel specific expenses, such as increased credit card commissions, associated with the overall increase in revenue. Corporate overhead expense. Corporate overhead expense increased $9.2 million, or 48.5%, during the year ended December 31, 2007 as compared to the year ended December 31, 2006, primarily due to executive officer severance costs which totaled $3.5 million and costs related to the chief executive officer succession which totaled $1.5 million, as well as increases in compensation, including bonus accruals, deferred stock compensation and related payroll expenses, and increases in other corporate expenses. The costs associated with executive officer severance and the chief executive officer succession are one-time costs, accordingly, we do not expect to see these types of costs in 2008. Corporate overhead expense increased $4.6 million, or 31.4%, during the year ended December 31, 2006 as compared to the year ended December 31 2005, primarily as a result of increases in payroll and related expenses, including deferred stock compensation expense. Depreciation and amortization expense. Depreciation and amortization expense increased $29.5 million, or 32.6% during the year ended December 31, 2007 as compared to the year ended December 31, 2006. The seven hotels contributed $15.7 million in depreciation and amortization expense during 2007. Depreciation and amortization expense in our existing portfolio increased by $13.8 million. Depreciation and amortization expense increased $31.9 million, or 54.5%, during the year ended December 31, 2006 as compared to the year ended December 31, 2005. The 13 hotels contributed $30.9 million in depreciation and amortization expense during 2006. Depreciation and amortization expense in our 2006 existing portfolio increased by $1.0 million.


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    Equity in earnings (losses) of unconsolidated joint ventures. Equity in earnings (losses) of unconsolidated joint ventures totaled a loss of $3.6 million for the year ended December 31, 2007 as compared to income of $0.1 million for the year ended December 31, 2006, and zero for the year ended December 31, 2005. In 2007, we recognized a $3.6 million loss on our Doubletree Times Square joint venture, which we originally purchased in December 2006, and nominal income on our BuyEfficient, LLC 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, LLC to Strategic. In 2006, we recognized income of $0.1 million on our Doubletree Times Square joint venture. Interest expense. Interest expense is as follows (in thousands): Year Ended Year Ended Year Ended Sunstone H otel Investors , Inc. A R07 December 31, December 31, December 31, 2007 2006 2005 Interest expense $ 96,280 $ 78,681 $ 45,748 Deferred financing fees 1,859 4,298 3,134 Prepayment penalties 415 — 2,665 Write-off loan premium ( 465) (1,903) — Costs associated with early extinguishments of debt 818 9,976 — $ 98,907 $ 91,052 $ 51,547 Interest expense increased $7.9 million, or 8.6%, during the year ended December 31, 2007 as compared to the year ended December 31, 2006. As a result of new loans obtained to finance our acquisitions and the issuance by the Operating Partnership of exchangeable senior notes, interest expense includes an additional $17.7 million in interest incurred during the year ended December 31, 2007 compared to 32 the year ended December 31, 2006. In addition, interest expense in 2007 includes $0.8 million in loss on early extinguishment of debt, $0.4 million in prepayment penalties, and a credit of $0.5 million due to the write-off of a loan premium as a result of repayments of two mortgage loans before their maturity dates. Partially offsetting these increases, interest expense was reduced in 2007 as compared to 2006 due to a $10.0 million loss on early extinguishment of debt and a credit of $1.9 million incurred in 2006 associated with the defeasance of debt. In addition, amortization of deferred financing fees decreased $2.4 million during 2007 as compared to 2006. Interest expense increased $39.5 million, or 76.6% during the year ended December 31, 2006 as compared to the year ended December 31, 2005. We incurred an additional $33.0 million in interest expense during 2006 as compared to 2005 due to greater outstanding loan balances in 2006 as compared to 2005, because we obtained additional loans to finance our acquisitions. Additionally, we incurred an increase in deferred financing fees amortization of $1.2 million, and, in connection with our refinancing of three hotel properties during 2006, we incurred a loss on early extinguishment of debt of $10.0 million related to the cost associated with the defeasance of the debt being refinanced. These increases were partially offset by a $1.9 million credit due to the write-off of a loan premium as a result of the refinanced debt, and a decrease of $2.8 million in prepayment penalties during 2006 as compared to 2005. Our total notes payable, including the current portion, was $1,722.2 million at December 31, 2007 and $1,499.8 million at December 31, 2006, with a weighted average interest rate per annum of approximately 5.5% at December 31, 2007 and 5.8% at December 31, 2006. At December 31, 2007, the interest rates for all of our outstanding notes payable were fixed. Income from discontinued operations. Income from discontinued operations totaled $63.5 million for the year ended December 31, 2007, $15.6 million for the year ended December 31, 2006, and $9.1 million for the year ended December 31, 2005. As described under “Factors Affecting Our Results of Operations—Dispositions,” we sold seven hotels in 2007, 15 hotels in 2006, and three hotels in 2005. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we have reclassified the results of operations for these hotels as discontinued operations. Preferred stock dividends and accretion. Preferred stock dividends and accretion increased $1.2 million, or 6.0% during the year ended December 31, 2007 as compared to the year ended December 31, 2006, due to 2.2 million shares of Series A preferred stock that were issued in April 2006. Preferred stock dividends and accretion increased $8.6 million, or 78.8% during the year ended December 31, 2006 as compared to the year ended December 31, 2005, due to 2.2 million shares of Series A preferred stock that were issued in April 2006, 4.1 million shares of Series C that were issued in July 2005 and 4.9 million shares of Series A preferred stock that were issued in March 2005. Liquidity and Capital Resources Historical. During the periods presented, our sources of cash included our operating activities, working capital, proceeds from notes payable including our Operating Partnership’s debt securities and our credit facility, sales of hotel properties, other real estate, and a 50%


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    interest in BuyEfficient, LLC, and proceeds from our public and private offerings of common and preferred stock. Our primary uses for cash were for 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 $214.0 million for 2007 compared to $163.1 million for 2006, and $113.4 million in 2005. The increase in 2007 as compared to 2006 was primarily due to decreases in our restricted cash accounts because we had received previously restricted cash held by lenders in conjunction with our early pay-off of two mortgage loans, combined with increased earnings of our hotels during 2007. The increase in 2006 as compared to 2005 was primarily due to additional cash generated from our acquired properties and increased cash flow generated by our 2006 existing portfolio. Sunstone H otel Investors , Inc. A R07 Investing activities. Net cash used in investing activities in 2007, 2006 and 2005 was as follows (in thousands): Year Ended Year Ended Year Ended December 31, December 31, December 31, 2007 2006 2005 Proceeds from sale of hotel properties, other real estate and 50% interest in subsidiary $ 185,728 $ 157,718 $ 31,412 Restricted cash – replacement reserve 5,993 (2,074) (26,793) Proceeds received from sale of note receivable 29,047 — — Cash received from (contributed to) unconsolidated joint ventures 426 (68,574) — Acquisitions of hotel properties ( 403,249) (448,373) (907,342) Additions to hotel properties and other real estate ( 135,231) (139,364) (71,555) Net cash used in investing activities $ ( 317,286) $ (500,667) $ (974,278) 33 Our cash used in investing activities fluctuates primarily based on acquisitions, dispositions and renovation of hotels. Net cash used in investing activities was $317.3 million during 2007 compared to $500.7 million for 2006, and $974.3 million for 2005. During 2007, we acquired three hotels for $410.7 million, including an $8.4 million deposit paid at the end of 2006, and paid an additional $0.9 million for a hotel acquired in 2006, for a total cash outlay of $403.2 million. In addition, we received net proceeds of $179.3 million from the sale of seven hotels, $6.3 million from the sale of a 50% interest in our subsidiary BuyEfficient , LLC, of which $0.3 million was contributed to the new joint venture with Strategic to operate BuyEfficient, LLC, and $0.4 million from the sale of a vacant land parcel for a total of $185.7 in net proceeds received. During 2007, we also paid cash of $135.2 million for renovations to our hotels, received $29.0 million from the sale of a note receivable, decreased the balance in our restricted cash replacement reserve accounts by $6.0 million, and received $0.4 million from our unconsolidated joint ventures. During 2006, we acquired four hotels for $522.2 million, including the assumption of $81.0 million in debt and a $6.5 million deposit paid at the end of 2005, acquired an office building and land adjacent to one of our hotels for $4.4 million, incurred additional costs of $0.8 million related to our 2005 acquisitions, and paid an $8.5 million deposit for a hotel purchased in January 2007, for a total cash outlay of $448.4 million. In addition, in 2006, we paid cash of $68.6 million to acquire a 38% ownership interest in a joint venture to acquire an additional hotel, $139.4 million for renovations to our hotels, increased the balance in our restricted cash replacement reserve accounts by $2.1 million, and received net proceeds of $157.7 million from the sale of 15 hotels combined with the collection of additional proceeds from a hotel we sold in 2004. During 2005, we acquired nine hotels for $963.9 million, including the assumption of $63.1 million in debt and paid $6.5 million in other deposits to be applied to 2006 acquisitions, for a total of $907.3 million. In addition, we paid cash of $71.6 million for renovations to our hotels, increased the balance in our restricted cash replacement reserve accounts by $26.8 million, and we received net proceeds of $31.4 million from the sale of three hotels and a vacant land parcel. Financing activities. Net cash provided by financing activities was $141.7 million for the year ended December 31, 2007 compared to $349.1 million for the year ended December 31, 2006, and $872.4 million for the year ended December 31, 2005. Net cash provided by financing activities for 2007 consisted primarily of proceeds from the issuance of notes payable of $426.0 million, including our Operating Partnership’s debt securities, and net proceeds from the settlement of a forward sale agreement (with an affiliate of Citigroup Global Markets Inc. as the forward counterparty, relating to 4,000,000 shares of our common stock) of $110.4 million, partially offset by $204.5 million of principal payments on notes payable, $86.4 million used to repurchase shares of our common stock, $96.3 million of dividends paid to our stockholders, and $7.5 million in deferred financing costs. Net cash provided by financing activities in 2006 consisted primarily of proceeds from notes payable of $440.5 million, and net proceeds from our preferred and common stock offerings of $54.1 million and $157.7 million, respectively, partially offset by $202.9 million of principal payments on notes payable and $10.0 million related to the cost associated with the defeasance of debt we refinanced, $86.7 million of dividends, and $3.7 million in deferred financing costs.


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    Net cash provided by financing activities in 2005 consisted primarily of net proceeds from our preferred securities and primary common stock offerings of $216.3 million and $312.2 million, respectively, and proceeds from notes payable of $701.2 million, partially offset by $56.8 million of dividends and distributions to our stockholders and holders of membership units in the Operating Partnership (all of which were converted to common stock in the fourth quarter of 2005), $295.6 million of principal payments on notes payable and $4.8 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, sale 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 Sunstone H otel Investors , Inc. A R07 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 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 December 31, 2007, 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. 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 34 Marriott Long Wharf. In April 2007, we amended one of our mortgage loans to provide for partial collateral releases and to eliminate amortization from May 2007 until the maturity date of May 2011, at which time the outstanding loan balance of $248.2 million will be due and payable. In May 2007, we amended the credit facility. The interest rate on the amended credit facility continues to be based on grid pricing, with the interest rate spread to LIBOR changing based on our overall leverage ratio. The pricing grid sets forth in four tiers the applicable interest rate spread at leverage ratios for us as follows: tier 1 up to and including 50%, tier 2 greater than 50% and less than or equal to 55%, tier 3 greater than 55% and less than or equal to 60%, and tier 4 greater than 60%. The interest rate spreads for each of the various tiers contained in the amended credit facility are 90 basis points, 105 basis points, 125 basis points and 150 basis points for tiers 1 to 4, respectively, which are 25 to 35 basis points lower than the applicable spreads contained in credit facility prior to its amendment. In addition, we extended the initial maturity date on the credit facility from 2010 to 2011. In June 2007, we repaid a $175.0 million mortgage loan with a maturity date of December 2014, incurring $0.4 million in prepayment penalties. Also 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, shares of our common stock, or a combination of cash and shares of 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 on 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 addition, in August 2007, we repaid a $13.1 million mortgage loan with a maturity date of September 2007, and 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. As of December 31, 2007, all of our outstanding debt has 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.


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    Contractual Obligations The following table summarizes our payment obligations and commitments as of December 31, 2007 (in thousands): Payment due by period Less than 1 to 3 3 to 5 More than Contractual obligations Total 1 year years years 5 years (In thousands) Notes payable $ 1,722,151 $ 9,815 $ 109,365 $ 342,778 $ 1,260,193 Interest obligations on notes payable 851,642 96,661 189,161 151,266 414,554 Operating lease obligations 314,683 4,905 9,564 8,519 291,695 Sunstone H otel Investors , Inc. A R07 Construction commitments 22,326 22,326 — — — Employment obligations 2,950 1,050 1,200 700 — Total $ 2,913,752 $ 134,757 $ 309,290 $ 503,263 $ 1,966,442 Capital Expenditures and Reserve Funds We believe we maintain each of our hotels in good repair and condition and in general conformity with applicable management agreements, ground and air leases, laws and regulations. Our capital expenditures primarily relate to the ongoing maintenance of our hotels and are budgeted in the reserve accounts described in the following paragraph. We also incur capital expenditures for renovation and development. We spent $135.2 million during 2007 on our hotels. For 2008, our renovation budget includes $22.3 million of contractual construction commitments. If we acquire, renovate or develop additional hotels in the future, our capital expenditures will increase. Our capital expenditures also fluctuate from year to year, because we are not required to spend the entire amount in the reserve accounts each year. With respect to our hotels that are operated under franchise agreements with major national hotel brands and for all of our hotels subject 35 to a first mortgage lien, we are obligated to maintain a furniture, fixture and equipment, or FF&E, reserve account for future planned and emergency-related capital expenditures at these hotels. The amount funded into each of these reserve accounts is determined pursuant to the management, franchise and loan agreements for each of the respective hotels, ranging between 1.0% and 5.0% of the respective hotel’s total annual revenue. As of December 31, 2007, $30.7 million was available in restricted cash reserves for future capital expenditures at our hotels. According to the respective loan agreements, the reserve funds are to be held by the respective lenders in a restricted cash account. Off-Balance Sheet Arrangements Our off-balance sheet arrangements consist of our ownership interest in two joint ventures. For further discussion of these joint ventures and their effect on our financial condition, results of operations and cash flows, see Note 6 to the Consolidated Financial Statements. Seasonality As is typical of the lodging industry, we experience some seasonality in our business as indicated in the table below. Revenue for certain of our hotels is generally affected by seasonal business patterns (e.g., the first quarter is strong in Orlando, the second quarter is strong for the Mid-Atlantic business hotels, and the fourth quarter is strong for New York City). Quarterly revenue also may be adversely affected by renovations, our managers’ ability to generate business and by events beyond our control, such as extreme weather conditions, terrorist attacks or alerts, public health concerns, airline strikes, economic factors and other considerations affecting travel. Revenues for our comparable hotel portfolio by quarter during 2006 and 2007 were as follows (dollars in thousands): First Second Third Fourth Quarter Quarter Quarter Quarter Total Revenues 2006 $ 172,574 $ 195,659 $ 188,208 $ 212,695 $ 769,136 2006 revenues as a percentage of total 22.4% 25.4% 24.5% 27.7% 2007 $ 184,689 $ 209,987 $ 206,730 $ 233,001 $ 834,407 2007 revenues as a percentage of total 22.1% 25.2% 24.8% 27.9% Inflation Inflation may affect our expenses, including, without limitation, by increasing such costs as labor, food, taxes, property and casualty insurance and utilities.


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    Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience, information that is currently available to us and on various other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our combined financial statements. Sunstone H otel Investors , Inc. A R07 . Impairment of long-lived assets. We periodically review each property for possible impairment. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. In this analysis of fair value, we use discounted cash flow analysis to estimate the fair value of our properties taking into account each property’s expected cash flow from operations, holding period and proceeds from the disposition of the property. The factors addressed in determining estimated proceeds from disposition include anticipated operating cash flow in the year of disposition, terminal capitalization rate and selling price per room. Our judgment is required in determining the discount rate applied to estimated cash flows, growth rate of the properties, the need for capital expenditures, as well as specific market and economic conditions. Additionally, the classification of these assets as held-for-sale (if applicable) requires the recording of these assets at their estimated fair value less estimated selling costs which can affect the amount of impairment recorded. 36 . Depreciation and amortization expense. Depreciation expense is based on the estimated useful life of our assets. The life of the assets is based on a number of assumptions, including the cost and timing of capital expenditures to maintain and refurbish our hotels, as well as specific market and economic conditions. Hotel properties and other completed real estate investments are depreciated using the straight-line method over estimated useful lives ranging from five to 35 years for buildings and improvements and three to 12 years for furniture, fixtures and equipment. While management believes its estimates are reasonable, a change in the estimated lives could affect depreciation expense and net income or the gain or loss on the sale of any of our hotels. We have not changed the estimated useful lives of any of our assets during the periods discussed. N ew Accounting Standards and Accounting Changes We have adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), as of January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes,” and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Based on our evaluation, we have concluded that there are no significant uncertain tax positions requiring recognition in our financial statements. Our evaluation was performed for the tax years ended December 31, 2004, 2005 and 2006. These are the tax years which remained subject to examination by major tax jurisdictions as of December 31, 2007. We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. In the event we receive an assessment for interest and/or penalties, it will be classified in the financial statements as tax expense. In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (the “FSP”). The FSP amends FAS 157 to delay the effective date of FAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (that is, at least annually). For items within its scope, the FSP defers the effective date of FAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. We do not believe adoption will have a material effect on our financial condition, results of operations and cash flow. In February 2007, the FASB issued Statement No. 159, “T he Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. FAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. We are currently evaluating the effect, if any, the adoption of FAS 159 will have on our financial condition, results of operations and cash flow.


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    In December 2007, the FASB issued revised Statement No. 141 “Business Combinations” (“FAS 141R”). FAS 141R will change the accounting for business combinations. Under FAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. FAS 141R will change the accounting treatment and disclosure for certain specific items in a business combination. FAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. FAS 141R will have an impact on accounting for business combinations once adopted but the effect is dependent upon acquisitions at that time. In December 2007, the FASB issued Statement No. 160 “N oncontrolling Interests in Consolidated Financial Statements— An Amendment of ARB No. 51” (“FAS 160”). FAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary Sunstone H otel Investors , Inc. A R07 and for the deconsolidation of a subsidiary. FAS 160 is effective for fiscal years beginning on or after December 15, 2008. We do not currently expect the adoption of FAS 160 to have a material impact on our consolidated financial position, results of operations and cash flows. Quantitative and Qualitative Disclosures About Market Risk To the extent that we incur debt with variable interest rates, our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. At December 31, 2007, none of our outstanding debt was subject to variable interest rates. Controls and Procedures ( a) Evaluation of Disclosure Controls and Procedures Based upon an evaluation of the effectiveness of disclosure controls and procedures, our Chief Executive Officer (CEO) and Chief 37 Financial Officer (CFO) have concluded that as of the end of the period covered by our Annual Report, our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the rules and forms of the SEC and is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. ( b) Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Due to its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on its evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2007. Ernst &Young LLP, an independent registered public accounting firm, has audited the Consolidated Financial Statements included in this Annual Report and, as part of its audit, has issued its reports, included herein on the effectiveness of our internal control over financial reporting. ( c) Changes in Internal Control over Financial Reporting There was no change in our internal control over financial reporting that occurred during the most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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    Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Sunstone Hotel Investors, Inc. We have audited Sunstone Hotel Investors, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Sunstone Hotel Investors, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. Sunstone H otel Investors , Inc. A R07 We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in 38 accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Sunstone Hotel Investors, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Sunstone Hotel Investors, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 of Sunstone Hotel Investors, Inc. and our report dated February 5, 2008 expressed an unqualified opinion thereon. Irvine, California February 5, 2008


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    Consolidated Balance Sheets December 31, December 31, 2007 2006 (In thousands, except per share data) ASSETS Current assets: Cash and cash equivalents $ 67,412 $ 29,029 Restricted cash 48,442 65,669 Accounts receivable, net 36,703 41,695 Due from affiliates 932 1,383 Inventories 3,190 3,089 Sunstone H otel Investors , Inc. A R07 Prepaid expenses 9,021 7,006 Total current assets 165,700 147,871 Investment in hotel properties, net 2,786,821 2,477,514 Other real estate, net 14,526 14,673 Investment in unconsolidated joint ventures 35,816 68,714 Deferred financing costs, net 12,964 7,381 Goodwill 16,251 22,249 Other assets, net 17,074 21,971 Total assets $ 3,049,152 $ 2,760,373 LIABILITIES AN D STOCKHOLDERS’ EQUITY 39 Current liabilities: Accounts payable and accrued expenses $ 28,540 $ 31,912 Accrued payroll and employee benefits 18,133 12,338 Due to Interstate SHP 15,051 16,607 Dividends payable 25,995 23,826 Other current liabilities 39,817 32,354 Current portion of notes payable 9,815 23,231 Total current liabilities 137,351 140,268 Notes payable, less current portion 1,712,336 1,476,597 Other liabilities 6,034 6,429 Total liabilities 1,855,721 1,623,294 Commitments and contingencies (Note 14) — — Preferred stock, Series C Cumulative Convertible Redeemable Preferred Stock, $0.01 par value, 4,102,564 shares authorized, issued and outstanding at December 31, 2007 and 2006, liquidation preference of $24.375 per share 99,496 99,296 Stockholders’ equity Preferred stock, $0.01 par value, 100,000,000 shares authorized. 8.0% Series A Cumulative Redeemable Preferred Stock, 7,050,000 shares issued and outstanding at December 31, 2007 and 2006, stated at liquidation preference of $25.00 per share 176,250 176,250 Common stock, $0.01 par value, 500,000,000 shares authorized, 58,815,271 shares issued and outstanding at December 31, 2007 and 57,775,089 shares issued and outstanding at December 31, 2006 588 578 Additional paid in capital 987,554 958,591 Retained earnings 191,208 65,545 Cumulative dividends ( 261,665) (163,181) Total stockholders’ equity 1,093,935 1,037,783 Total liabilities and stockholders’ equity $ 3,049,152 $ 2,760,373 See accompanying notes to consolidated financial statements.


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    Consolidated Income Statements Year Ended Year Ended Year Ended December 31, December 31, December 31, 2007 2006 2005 (In thousands, except per share data) REVEN UES Room $ 688,921 $ 549,834 $ 343,701 Food and beverage 289,655 228,315 147,679 Other operating 78,163 77,106 50,367 Total revenues 1,056,739 855,255 541,747 Sunstone H otel Investors , Inc. A R07 OPERATIN G EXPEN SES Room 152,808 123,004 76,766 Food and beverage 209,971 163,423 103,704 Other operating 41,816 38,095 28,831 Advertising and promotion 55,340 47,312 34,010 Repairs and maintenance 40,449 34,607 22,482 Utilities 37,429 32,863 22,022 Franchise costs 37,493 30,673 18,651 Property tax, ground lease, and insurance 58,706 53,464 29,580 Property general and administrative 119,210 98,057 61,401 Corporate overhead 28,270 19,037 14,483 Depreciation and amortization 119,855 90,392 58,490 Total operating expenses 901,347 730,927 470,420 40 Operating income 155,392 124,328 71,327 Equity in earnings (losses) of unconsolidated joint ventures ( 3,588) 140 — Interest and other income 9,261 4,208 3,079 Interest expense ( 98,907) (91,052) (51,547) Income before minority interest and discontinued operations 62,158 37,624 22,859 Minority interest — — (1,761) Income from continuing operations 62,158 37,624 21,098 Income from discontinued operations 63,505 15,613 9,107 N ET IN COME 125,663 53,237 30,205 Preferred stock dividends and accretion ( 20,795) (19,616) (10,973) Undistributed income allocated to Series C preferred stock ( 1,583) — — IN COME AVAILABLE TO COMMON STOCKHOLDERS $ 103,285 $ 33,621 $ 19,232 Basic per share amounts: Income from continuing operations available to common stockholders $ 0.70 $ 0.31 $ 0.25 Income from discontinued operations available to common stockholders 1.05 0.28 0.22 Net income available to common stockholders per common share $ 1.75 $ 0.59 $ 0.47 Diluted per share amounts: Income from continuing operations available to common stockholders $ 0.67 $ 0.31 $ 0.25 Income from discontinued operations available to common stockholders 1.08 0.28 0.22 Net income available to common stockholders per common share $ 1.75 $ 0.59 $ 0.47 Weighted average common shares outstanding: Basic 58,998 57,247 40,655 Diluted 59,139 57,409 40,761 Dividends paid per common share $ 1.31 $ 1.22 $ 1.155 See accompanying notes to consolidated financial statements.


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    Consolidated Statements of Stockholders’ Equity Preferred Stock Common Stock Additional Retained Number of Number of Paid in Earnings Cumulative Shares Amount Shares Amount Capital (Deficit) Dividends Total (In thousands, except per share data) Balance at December 31, 2004 34,518,616 $ 345 $ 444,846 $ (17,897) $ (9,962) $ 417,332 Net proceeds from sale of Series A preferred stock 4,850,000 $ 121,250 (3,799) 117,451 Offering costs from sale of Series C preferred stock (130) (130) Sunstone H otel Investors , Inc. A R07 Net proceeds from sale of common stock 13,936,909 140 312,100 312,240 Issuance of unvested restricted common stock 35,552 — Vesting of restricted common stock 1,992 1,992 Common dividends declared and payable at $1.155 per share (51,616) (51,616) Series A preferred dividends declared and payable at $1.578 per share (7,652) (7,652) Series C preferred dividends declared and payable at $0.786 per share (3,225) (3,225) Accretion of discount on Series C preferred stock (96) (96) Conversion of minority interest membership units in the Operating Partnership to common shares 3,699,572 37 43,391 43,428 41 Net income 30,205 30,205 Balance at December 31, 2005 4,850,000 121,250 52,190,649 522 798,304 12,308 (72,455) 859,929 Net proceeds from sale of Series A preferred stock 2,200,000 55,000 (842) 54,158 Net proceeds from sale of common stock 5,500,000 55 157,652 157,707 Vesting of restricted common stock 84,440 1 3,677 3,678 Common dividends declared and payable at $1.22 per share (71,277) (71,277) Series A preferred dividends declared and payable at $2.00 per share (13,000) (13,000) Series C preferred dividends declared and payable at $1.572 per share (6,449) (6,449) Accretion of discount on Series C preferred stock (200) (200) Net income 53,237 53,237 Balance at December 31, 2006 7,050,000 176,250 57,775,089 578 958,591 65,545 (163,181) 1,037,783 Net proceeds from sale of common stock 4,000,000 40 110,388 110,428 Vesting of restricted common stock 169,992 1 5,167 5,168 Repurchase of outstanding common stock (3,129,810) (31) (86,392) 834 (85,589) Common dividends declared and payable at $1.31 per share (78,723) (78,723) Series A preferred dividends declared and payable at $2.00 per share (14,100) (14,100) Series C preferred dividends declared and payable at $1.583 per share (6,495) (6,495) Accretion of discount on Series C preferred stock (200) (200) Net income 125,663 125,663 Balance at December 31, 2007 7,050,000 $ 176,250 58,815,271 $ 588 $ 987,554 $ 191,208 $ ( 261,665) $1,093,935 See accompanying notes to consolidated financial statements


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    Consolidated Statements of Cash Flows Year Ended Year Ended Year Ended December 31, December 31, December 31, 2007 2006 2005 (In thousands) CASH FLOWS FROM OPERATIN G ACTIVITIES Net income $ 125,663 $ 53,237 $ 30,205 Adjustments to reconcile net income to net cash provided by operating activities: Bad debt expense (recovery) 538 796 (170) Minority interest — — 1,761 Gains on sale of hotel properties, other real estate and 50% interest in subsidiary ( 66,019) (9,048) (2,431) Loss on early extinguishment of debt 818 9,976 — Depreciation 117,544 101,486 73,029 Sunstone H otel Investors , Inc. A R07 Amortization of deferred franchise fees and other intangibles 5,701 351 129 Amortization of deferred financing costs 1,923 4,834 3,996 Amortization of loan premiums ( 709) (2,486) (609) Amortization of deferred stock compensation 5,168 3,677 1,992 Impairment loss – Goodwill and discontinued operations — 4,920 — Equity in (earnings) losses of unconsolidated joint ventures 3,588 (140) — Changes in operating assets and liabilities: Restricted cash 11,234 (9,290) 1,398 Accounts receivable 3,707 647 (14,695) Due from affiliates 451 611 (1,847) Inventories ( 104) (260) (307) Prepaid expenses and other assets ( 6,748) (32) (628) Accounts payable and other liabilities 6,643 3,244 14,412 42 Accrued payroll and employee benefits 6,137 3,378 3,146 Due to Interstate SHP ( 1,556) (2,902) 4,099 Discontinued operations — 77 (77) Net cash provided by operating activities 213,979 163,076 113,403 CASH FLOWS FROM IN VESTIN G ACTIVITIES Proceeds from sale of hotel properties, other real estate and 50% interest in subsidiary 185,728 157,718 31,412 Restricted cash – replacement reserve 5,993 (2,074) (26,793) Proceeds received from sale of note receivable 29,047 — — Cash received from (contributed to) unconsolidated joint ventures 426 (68,574) — Acquisitions of hotel properties ( 403,249) (448,373) (907,342) Additions to hotel properties and other real estate ( 135,231) (139,364) (71,555) Net cash used in investing activities ( 317,286) (500,667) (974,278) CASH FLOWS FROM FIN AN CIN G ACTIVITIES Proceeds from preferred stock offering — 55,000 220,250 Payment of preferred stock offering costs — (842) (3,929) Proceeds from common stock offering 110,895 158,400 320,979 Payment of common stock offering costs ( 467) (693) (8,739) Payment for repurchases of outstanding common stock ( 86,423) — — Proceeds from notes payable 426,000 440,542 701,207 Payments on notes payable ( 204,494) (212,868) (295,633) Payments of deferred financing costs ( 7,506) (3,726) (4,847) Dividends and distributions paid ( 96,315) (86,731) (56,841) Net cash provided by financing activities 141,690 349,082 872,447 Net increase in cash and cash equivalents 38,383 11,491 11,572 Cash and cash equivalents, beginning of year 29,029 17,538 5,966 Cash and cash equivalents, end of year $ 67,412 $ 29,029 $ 17,538 SUPPLEMEN TAL DISCLOSURES OF CASH FLOW IN FORMATION Cash paid for interest $ 94,648 $ 92,824 $ 56,265 N ON CASH IN VESTIN G ACTIVITY Sale of 50% interest in subsidiary Assets $ 1,235 $ — $ — Liabilities $ 908 $ — $ — N ON CASH FIN AN CIN G ACTIVITY Assumption of debt in connection with acquisitions of hotel properties $ — $ 81,000 $ 63,143 Receipt of note receivable $ — $ 5,600 $ — Dividends and distributions payable $ 25,995 $ 23,826 $ 19,831 See accompanying notes to consolidated financial statements.


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    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 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 Sunstone H otel Investors , Inc. A R07 from the operation of hotels. As a result, the Company leases all of its hotel properties to its TRS Lessee, which in turn has entered into long-term management agreements with third parties to manage the operations of the Company’s hotels. As of December 31, 2007, the Company owned 45 hotels, and its third-party managers included Sunstone Hotel Properties, Inc., a division of Interstate Hotels & Resorts, Inc. (“Interstate SHP”), the manager of 26 of the Company’s hotels; Marriott (as defined below), manager of 13 of the Company’s hotels; and Hyatt Corporation (“Hyatt”), Fairmont Hotels &Resorts (“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 leased hotels, the Company has a 38% equity interest in a joint venture that owns the Doubletree 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 December 31, 2007 and 2006, and for the years ended December 31, 2007, 2006 and 2005, include the accounts of the Company, the Operating Partnership, the TRS Lessee and their subsidiaries. All significant intercompany balances and transactions have been eliminated. 43 Minority interest for the year ended December 31, 2005 represents the allocation of earnings to outside equity interests of the Operating Partnership. Certain amounts included in the consolidated financial statements for prior years have been reclassified to conform to the most recent financial statement presentation. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“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 income statements are based on results reported to the Company by its hotel managers. These hotel managers use different reporting periods. Subsidiaries of Marriott International, Inc., or Marriott Hotel Services, Inc. (collectively, “Marriott”), use a fiscal year ending on the Friday closest to December 31, and report twelve weeks of operations each for 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 results of operations for the Marriott-managed hotels for the year ended December 31, 2007 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. The Company’s 2006 results of operations for the Marriott-managed hotels include results from December 31 through March 24 for the first quarter, March 25 through June 16 for the second quarter, June 17 through September 8 for the third quarter, and September 9 through December 29 for the fourth quarter. The Company’s 2005 results of operations for the Marriott-managed hotels include results from January 1 through March 25 for the first quarter, March 26 through June 17 for the second quarter, June 18 through September 9 for the third quarter, and September 10 through December 30 for the fourth quarter. Cash and Cash Equivalents Cash and cash equivalents are defined as cash on hand and in banks plus all short-term investments with an original maturity of three months or less. The Company maintains cash and cash equivalents and certain other financial instruments with various financial institutions. These financial institutions are located throughout the country and the Company’s policy is designed to limit exposure to any one institution. The Company performs periodic evaluations of the relative credit standing of those financial institutions that are considered in the


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    Company’s investment strategy. At December 31, 2007 and 2006, the Company had amounts in banks that were in excess of federally insured amounts. Restricted Cash Restricted cash is comprised of reserve accounts for debt service, interest reserves, capital replacements, ground leases, property taxes and insurance impounds. These restricted funds are subject to supervision and disbursement approval by certain of the Company’s lenders. 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, Sunstone H otel Investors , Inc. A R07 Minnesota. The Company maintains an allowance for doubtful accounts sufficient to cover potential credit losses. The Company’s accounts receivable at December 31, 2007 and 2006 includes an allowance for doubtful accounts of $0.4 million and $0.6 million, respectively. At December 31, 2007 and 2006, the Company had approximately $5.0 million and $4.0 million, respectively, in accounts receivable with one customer who is operating under a contract with the United States government. The Company has specifically reserved a portion of these particular receivables in the amount of $14,000 and $50,000, respectively. Inventories Inventories, consisting primarily of food and beverages, are stated at the lower of cost or market, with cost determined on a method that approximates first-in, first-out basis. Investments In Hotel Properties, Other Real Estate and Franchise Fees Hotel properties and other real estate assets are recorded at cost, less accumulated depreciation. Hotel properties and other completed 44 real estate investments are depreciated using the straight-line method over estimated useful lives ranging from five to 35 years for buildings and improvements and three to 12 years for furniture, fixtures and equipment. Intangible assets are amortized using the straight-line method over their estimated useful life or over the length of the related agreement, whichever is shorter. Initial franchise fees are recorded at cost and amortized using the straight-line method over the lives of the franchise agreements ranging from six to 20 years. All other franchise fees that are based on the Company’s results of operations are expensed as incurred. The Company follows the requirements of Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“FAS No. 144”). FAS No. 144 requires impairment losses to be recorded on long-lived assets to be held and used by the Company when indicators of impairment are present and the future undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amount. When an impairment loss is required for assets to be held and used by the Company, the related assets are adjusted to their estimated fair values. When an impairment loss is required for assets held for sale, the related assets are adjusted to their estimated fair values, less costs to sell. Operating results of any long-lived assets with their own identifiable cash flows that are disposed of or held for sale are removed from income from continuing operations and reported as discontinued operations. Depreciation ceases when a property is held for sale. The operating results for any such assets for any prior periods presented must also be reclassified as discontinued operations. Based on the Company’s review, management believes that there were no other impairments on its long-lived assets held for use and that the carrying values of its hotel properties and other real estate are recoverable at December 31, 2007. Fair value represents the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than a forced or liquidation sale. The estimation process involved in determining if assets have been impaired and in the determination of fair value is inherently uncertain because it requires estimates of current market yields as well as future events and conditions. Such future events and conditions include economic and market conditions, as well as the availability of suitable financing. The realization of the Company’s investment in hotel properties and other real estate is dependent upon future uncertain events and conditions and, accordingly, the actual timing and amounts realized by the Company may be materially different from their estimated fair values. Deferred Financing Costs Deferred financing costs consist of loan fees and other financing costs related to the Company’s outstanding indebtedness and are amortized to interest expense over the terms of the related debt. Upon repayment of the underlying debt, any related unamortized deferred financing cost is charged to interest expense. During 2007 and 2006, approximately $7.5 million and $3.7 million, respectively, were incurred and paid, related to new debt and debt refinancings. Such costs are being amortized over the related terms of the loans. Interest expense related to the amortization of deferred financing costs was $1.9 million, $4.8 million, and $4.0 million for the years ended December 31, 2007, 2006 and 2005, respectively.


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    Goodwill The Company follows the requirements of Statement 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. In conjunction with the sale of seven hotel properties during the second and fourth quarters of 2007 and 14 hotel properties during the third and fourth quarters of 2006, the Company wrote off the goodwill associated with these properties totaling $6.0 million against gain on sale of hotels in 2007 and $4.9 million to impairment loss in Sunstone H otel Investors , Inc. A R07 2006. The amounts are included in income/(loss) from discontinued operations. The fair values of the reporting units were determined using factors such as net operating cash flows, terminal capitalization rates and replacement costs. Based on the Company’s review at December 31, 2007 and December 31, 2006, management believes that there were no additional impairments on its goodwill. Property and Equipment Property and equipment is stated on the cost basis and includes computer equipment and other corporate office equipment and furniture. Property and equipment is depreciated on a straight-line basis over the estimated useful lives ranging from three to 12 years. The cost basis of property and equipment amounted to $7.1 million and $7.5 million at December 31, 2007 and 2006, respectively. Accumulated depreciation amounted to $5.7 million at both December 31, 2007 and 2006. Property and equipment net of related accumulated depreciation is included in other assets. Investment in Unconsolidated Joint Ventures In December 2007, the Company entered into a joint venture agreement with Strategic Hotels &Resorts, Inc. (“Strategic”) to own and 45 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. In December 2006 the Company entered into a joint venture agreement to obtain a 38% interest in the Doubletree Guest Suites Hotel in New York City, New York. The Company accounts for both of these ownership interests using the equity method. The Company’s accounting policies are consistent with those of the unconsolidated joint ventures Fair Value of Financial Instruments As of December 31, 2007 and 2006, the carrying amount of certain financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses were representative of their fair values due to the short-term maturity of these instruments. As of December 31, 2007, all of the Company’s outstanding debt has fixed interest rates. The Company’s fixed-rate mortgage debt is at commensurate terms with similar debt instruments based on risk, collateral, and other characteristics, except for two mortgage loans assumed in 2005, one of which was defeased in 2007 and the other of which was refinanced in 2006. During 2006, the Company adjusted the carrying value of the loan repaid in 2007 by $0.7 million. This adjustment is included in Other Liabilities. Management believes the carrying value of the mortgage and other debt is a reasonable estimation of its fair value as of December 31, 2007 and 2006. Revenue Recognition Room revenue and food and beverage revenue are recognized as earned, which is generally defined as the date upon which a guest occupies a room and/or utilizes the hotel’s services. Additionally, some of the Company’s hotel rooms are booked through independent Internet travel intermediaries. Revenue for these rooms is booked at the price the Company sold the room to the independent Internet travel intermediary less any discount or commission paid. Other operating revenues consist of revenues derived from incidental hotel services such as concessions, movie rentals, retail sales, fitness services, internet access, telephone, sublease revenues relating to the restaurants and retail shops. Additionally, as part of the Company’s purchase of the Hyatt Regency Century Plaza, the Company entered into a 30-year term agreement with Hyatt whereby Hyatt provided the Company with a limited performance guaranty that ensured, subject to certain limitations, a return on equity to the Company. Under the terms of this agreement, were net cash flow generated by the hotel to be insufficient to cover the Company’s debt service related to this hotel, plus a 10% return on the Company’s equity investment in the hotel, Hyatt was obligated to pay the Company the difference, up to $27.0 million over the term of the agreement. The Company recognized into revenue quarterly, the amount due from Hyatt under this agreement. The Company used a total of $2.8 million of the $27.0 million performance guaranty during 2007, $17.4 million during 2006, and $6.8 million during 2005 for a total of $27.0 million cumulatively. Also, as an adjunct to the Company’s hotels located in Rochester, Minnesota and Salt Lake City, Utah, the Company operates commercial laundries at those locations providing laundry services to the Company’s hotels and other third parties in the respective locations. Revenues from incidental hotel services, management agreements, and laundry services are recognized in the period the related services are provided or the revenue is earned. Prior to December 7, 2007, the Company wholly owned BuyEfficient, LLC, an online purchasing platform that offers volume discounts


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    to third parties. Revenues generated by BuyEfficient, LLC prior to December 7, 2007 were included in the Company’s other operating revenue, and consisted of transactions fees, development fees, and rebate sales as BuyEfficient, LLC charges the third party for the installation associated with configuring the third party’s information technology system with the purchasing platform and access rights to the purchasing platform. Fees for the installation are typically based on time and materials and are recognized as the services are performed. Fees associated with access rights are based on a percentage of the price of goods purchased by the third party from the vendor and are recognized when earned. On December 7, 2007 the Company entered into a joint venture agreement with Strategic whereby Strategic acquired a 50% interest in BuyEfficient, LLC from the Company. In accordance with the equity method of accounting, the Company’s share of BuyEfficient LLC’s earnings is now shown in equity in earnings (losses) of unconsolidated joint ventures. Sunstone H otel Investors , Inc. A R07 Advertising and Promotion Costs Advertising and promotion costs are expensed when incurred. Advertising and promotion costs represent the expense for advertising and reservation systems under the terms of the hotel franchise and brand management agreements and general and administrative expenses that are directly attributable to advertising and promotions. Income Taxes For the years ended December 31, 2007, 2006 and 2005, the Company elected to be treated as a REIT pursuant to the Code. Management believes that the Company has qualified and intends to continue to qualify as a REIT. Therefore, the Company is permitted to deduct distributions paid to our stockholders, eliminating the federal taxation of income represented by such distributions at the company level. REITs are subject to a number of organizational and operational requirements. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax (including any applicable alternative minimum tax) on taxable income at regular corporate tax rates. 46 With respect to taxable subsidiaries, the Company accounts for income taxes in accordance with Statement No. 109, Accounting for Income Taxes. Accordingly, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Minority Interest Prior to November 2005, minority interests of the Company represented the limited partnership interests in the Operating Partnership. The carrying value of the minority interest increased by the minority interests’ share of earnings and decreased by cash distributions and the purchase of limited partnership interests. During November 2005, the membership units held by the minority interest owners were converted to shares of common stock of the Company and were subsequently sold in a public offering eliminating the minority interests of the Company. As such, the Company beneficially owns all of the membership interests in the Operating Partnership. Dividends The Company pays quarterly dividends to its Series A Cumulative Redeemable and Series C Cumulative Convertible Redeemable preferred stockholders, as well as its common stockholders, as declared by the Board of Directors. The Company’s ability to pay dividends is dependent on the receipt of distributions from the Operating Partnership. 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. Basic income available to common stockholders per share is computed based on the weighted average number of shares of common stock outstanding during each period. Diluted income available to common stockholders per share of common stock is computed based on the weighted average number of shares of common stock outstanding during each period, plus convertible redeemable preferred stock and unvested restricted stock awards considered outstanding during the period, in accordance with Statement of Financial Accounting Standards No. 128, “Earnings per Share.”


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    The following table sets forth the computation of basic and diluted earnings per common share (in thousands, except per share data): Year Ended Year Ended Year Ended December 31, December 31, December 31, 2007 2006 2005 Numerator: Net income $ 125,663 $ 53,237 $ 30,205 Less preferred dividends and accretion ( 20,795) (19,616) (10,973) Less undistributed income allocated to Series C Preferred Stock ( 1,583) — — Numerator for basic and diluted earnings available to common stockholders $ 103,285 $ 33,621 $ 19,232 Sunstone H otel Investors , Inc. A R07 Denominator: Weighted average basic common shares outstanding 58,998 57,247 40,655 Unvested restricted stock awards 141 162 106 Weighted average diluted common shares outstanding 59,139 57,409 40,761 Basic earnings available to common stockholders per common share $ 1.75 $ 0.59 $ 0.47 Diluted earnings available to common stockholders per common share $ 1.75 $ 0.59 $ 0.47 Shares of the Company’s Series C preferred stock have not been included in the above calculation of earnings per share for the years ended December 31, 2007, 2006 and 2005 as their effect would have been anti-dilutive. During the third quarter of 2007, the Company revised its methodology for computation of diluted earnings per share by applying the treasury stock method to unvested restricted stock awards. In prior periods, the Company included the entire weighted average number 47 of unvested restricted stock awards in diluted shares outstanding. This revision had no effect on basic or diluted earnings per share as reported by the Company for the year ended December 31, 2005. For the year ended December 31, 2006, the change resulted in a $0.01 increase in diluted income available to common stockholders per common share. As a result of this revision, the unvested restricted stock awards for purposes of calculating diluted earnings per share have been decreased by 282,000 shares and 198,000 shares for the years ended December 31, 2006 and 2005, respectively. There was no change in the number of shares for purposes of basic earnings per share. Segment Reporting Under the provision of Statement No. 131, Disclosure about Segments of an Enterprise and Related Information (“FAS No. 131”), the Company’s operations are at this time conducted and aggregated under one segment, hotel operations. Recent Accounting Pronouncements In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement N o. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. The provisions of FIN 48 became effective for the Company’s fiscal year beginning January 1, 2007. Based on the Company’s evaluation, the Company has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2004, 2005 and 2006. These are the tax years which remained subject to examination by major tax jurisdictions as of December 31, 2007. The Company may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. In the event the Company receives an assessment for interest and/or penalties, it will be classified in the financial statements as tax expense. In September 2006, the FASB issued Statement No. 157 (“FAS 157”), “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (the “FSP”). The FSP amends FAS 157 to delay the effective date of FAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (that is, at least annually). For items within its scope, the FSP defers the effective date of FAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Company does not believe adoption will have a material effect on its financial condition, results of operations and cash flow. In February 2007, the FASB issued Statement No. 159, “T he Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. FAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November, 15, 2007. The Company is currently evaluating the effect, if any, the adoption of FAS 159 will have on its financial condition, results of operations and cash flow.


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    In December 2007, the FASB issued revised Statement No. 141 “Business Combinations” (“FAS 141R”). FAS 141R will change the accounting for business combinations. Under FAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. FAS 141R will change the accounting treatment and disclosure for certain specific items in a business combination. FAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. FAS 141R will have an impact on accounting for business combinations once adopted but the effect is dependent upon acquisitions at that time. In December 2007, the FASB issued Statement No. 160 “N oncontrolling Interests in Consolidated Financial Statements— An Amendment of ARB N o. 51” (“FAS 160”). FAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary Sunstone H otel Investors , Inc. A R07 and for the deconsolidation of a subsidiary. FAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not currently expect the adoption of FAS 160 to have a material impact on its consolidated financial position, results of operations and cash flows. 3. Investment in Hotel Properties Investment in hotel properties consisted of the following (in thousands): December 31, 2007 2006 Land $ 439,387 $ 384,242 Buildings and improvements 2,370,563 2,067,930 Fixtures, furniture and equipment 295,111 264,870 Intangibles 42,863 35,736 48 Franchise fees 1,396 1,382 Construction in process 24,426 30,808 3,173,746 2,784,968 Accumulated depreciation and amortization ( 386,925) (307,454) $ 2,786,821 $ 2,477,514 In January 2007, the Company purchased the 499-room LAX Renaissance located in Los Angeles, California for $65.2 million and retained Marriott as manager. This hotel’s results of operations from the acquisition date of January 4, 2007 through Marriott’s fourth quarter ended December 28, 2007, have been included in the Company’s income statements. In March 2007, the Company purchased the 402-room Marriott Long Wharf located in Boston, Massachusetts for $228.5 million and retained Marriott as manager. This hotel’s results of operations from the acquisition date of March 23, 2007 through Marriott’s fourth quarter ended December 28, 2007, have been included in the Company’s income statements. In April 2007, the Company paid an additional $0.8 million as part of a purchase price true-up for the Marriott Del Mar located in San Diego, California, originally purchased by the Company in January 2006. In December 2007, the Company accrued an additional $0.1 million to be paid in January 2008. In May 2007, the Company purchased the 464-room Marriott Boston Quincy Hotel located in Quincy, Massachusetts for a purchase price of $117.0 million and retained Marriott as manager. This hotel’s results of operations from the acquisition date of May 1, 2007 through Marriott’s fourth quarter ended December 28, 2007, have been included in the Company’s income statements. On January 10, 2006, the Company purchased the 284-room Marriott Del Mar located in San Diego, California for $69.1 million and named Marriott as manager. This hotel’s results of operations from the acquisition date of January 10, 2006 through Marriott’s fourth quarter ended December 29, 2006, have been included in the Company’s income statements. On March 17, 2006, the Company purchased the 444-room Hilton Times Square located in New York City for $241.5 million and named the Interstate SHP as manager. In addition, concurrently with the acquisition, the Company exercised an option and made an additional $15.0 million payment to convert the property to a franchise. This hotel’s results of operations from the acquisition date of March 17, 2006 through the fourth quarter ended December 31, 2007 have been included in the Company’s income statements. On May 17, 2006, the Company purchased the 335-room Embassy Suites La Jolla located in San Diego, California for $100.7 million and named Hilton Hotels Corporation as manager. This hotel’s results of operations from the acquisition date of May 17, 2006 through the fourth quarter ended December 31, 2007, have been included in the Company’s income statements.

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