Audit Report on Sunstone Hotel Investors, Inc.’s Compliance with Its Lease Agreement to Operate the Hilton Times Square Hotel

EXECUTIVE SUMMARY

The New York City Economic Development Corporation (EDC) administers the lease (the Lease) for the Hilton Times Square Hotel (the Hilton), located at 234 West 42nd Street.  The Hilton was built by FC 42 Hotel, LLC, and sold to Sunstone Hotel Investors, Inc. (Sunstone), in March 2006. EDC is responsible for ensuring Sunstone complies with Lease terms, including the payment of all rents due the City.

In accordance with terms defined in the Lease, Sunstone must pay a “Base Rent” and an additional “Percentage Rent.”  For the period April 1, 2006, through April 30, 2020, the Percentage Rent is to be calculated by determining the greater of either the minimum amount specified in the Lease or, alternatively, a “Formula Percentage Rent” based on the “Adjusted Gross Revenues (AGR)” and the “Adjusted Total Hotel Project Cost (ATHPC).”    For the period May 1, 2020, through December 12, 2095, Percentage Rent will be based only on the above-described Formula Percentage Rent; the minimum amount specified in the Lease will no longer be applicable.  For Calendar Year 2012, Sunstone paid the City rent of $1,772,194, consisting of the Base Rent of $683,032 and the specified minimum Percentage Rent of $1,089,162.  (See Appendix I Sunstone Reported Occupancy, Revenues, and Expenses, and Rents Paid, Calendar Year 2008 through Calendar Year 2012.)

In addition to rent, Sunstone must also annually contribute the greater of  either 3 percent of “Gross Revenues”   for such Lease Year or the amount required by the Recognized Mortgagee then most senior in lien to be contributed to the FF&E Replacement Reserve for each such Lease Year to a segregated reserve account for the replacement or refurbishing of “Furniture, Fixtures, and Equipment (FF&E),” pay “Impositions” as defined in the lease, and maintain specified types and amounts of insurance coverage.  To ensure compliance with these and other lease provisions, the Lease requires Sunstone to submit to the City financial and operating reports and certified copies of insurance policies.

Audit Findings and Conclusions

The audit found that Sunstone generally maintained adequate controls over its revenue recording and reporting processes and paid the Base Rent due the City in a timely manner.

However, our review also found that Sunstone improperly calculated the Formula Percentage Rent in two ways.  First, Sunstone appears to have overstated ATHPC by as much as $19.8 million and second, it understated AGR by $1 million.  The result of these two errors has been an understatement of the Percentage Rent due the City which could result in future repeated underpayments to the City up through and including the Lease end date of December 12, 2095.  (See Appendix II Comparative 2011 ATHPC and Formula Percentage Rent Calculations.)  Because the minimum Percentage Rent specified in the Lease for the scope period has been greater than the alternative Formula Percentage Rent properly calculated, our adjustments did not result in additional Percentage Rents due the City.  However, by reporting the correct lower amount of ATHPC, the Formula Percentage Rent could become due sooner and in greater amounts, which would increase the total amount of money Sunstone would be obligated to pay to the City under the Lease.

The audit also found that Sunstone miscalculated the Percentage Rent based on a misinterpretation of the Formula Percentage Rent.  This miscalculation did not result in an understatement of Percentage Rent due the City.  Rather, the proper application of the Formula Percentage Rent may result in lower Percentage Rent payments being due. (See Appendix III Comparative 2011 Formula Percentage Rent Methodologies and Calculations.)

Additionally, the audit found that Sunstone did not make or maintain required FF&E reserve contributions totaling $3.1 million and improperly disbursed FF&E funds totaling $7.3 million.  Sunstone also did not submit to ESDC and EDC required financial and operating reports, rendering them unable to effectively assess, monitor, and hold Sunstone accountable for its performance.

Finally, in connection with our audit of Sunstone, we observed that EDC did not adequately monitor Sunstone to ensure its compliance with Lease terms.

Audit Recommendations

To address these issues, we make 14 recommendations—8 to Sunstone and 6 to EDC—including that Sunstone should:

• Properly calculate the Formula Percentage Rent.
• Replenish $4,424,615 to the FF&E reserve account ($3,093,862 for contributions that were not made or maintained, $908,721 for interest, and $422,032 for improper disbursements).
• Make and maintain FF&E contributions as required by the Lease.
• Use FF&E reserve account funds only for FF&E qualifying expenses as stipulated by the Lease.
• Maintain documentation evidencing how FF&E funds are used as required by the Lease.
• Submit to EDC, in the manner and time frames specified by the Lease, required financial and operating reports including but not limited to: annual audited property-level financial statements; monthly STR reports comparing Hilton’s performance to that of the Competitive Set regarding occupancy, average room rate, and other data; property inspection reports; and certified FF&E reserve account depository statements, and budgeted and actual utilization reports with explanations of variances.

With regard to Sunstone, EDC should:

• Ensure that Sunstone properly calculates the Formula Percentage Rent in accordance with the Lease.
• Routinely demand and review the monthly and annual reports submitted by Sunstone to ensure the accuracy of the calculation of the Formula Percentage Rent.
• Ensure that Sunstone replenishes $4,424,615 to the FF&E reserve account.
• Ensure that Sunstone submits to EDC, in the manner and time frames specified by the Lease, required financial and operating reports including but not limited to: annual audited property-level financial statements; monthly STR reports comparing Hilton’s performance to that of the Competitive Set regarding occupancy, average room rate, and other data; property inspection reports; and certified FF&E reserve account depository statements, and budgeted and actual utilizations reports with explanations of variances.

Sunstone and EDC Responses

In their responses, both Sunstone and EDC maintained that when calculating Percentage Rent, ATHPC was not overstated and asserted that the Initial Total Hotel Project Cost (ITHPC) should be $113.3 million based, in large part, on a sample development budget included in the Lease.

Sunstone also asserted that it does not owe any money to the FF&E reserve account and moreover, that Sunstone had overfunded this account.  EDC agreed “that maintaining a FF&E account is appropriate” and indicated that it will “ensure that the proper amount is funded and maintained in the future.”  However, EDC did not agree to ensure that Sunstone replenishes $4,424,615 to the FF&E reserve account.

With regard to the report’s remaining findings, both Sunstone and EDC indicated that they already did or will in the future implement the report’s recommendations.

As the Lease administrator, EDC has a responsibility to ensure that Sunstone fulfills its Obligations, properly calculates Percentage Rent, and makes all Lease-required payments.  Since Percentage Rents are based, in part, on ITHPC throughout the life of the 97-year Lease ending December 12, 2095, EDC should ensure Lease compliance by determining the proper value of ITHPC as expressly required by the Lease rather than rely on a sample budget.

Additionally, Sunstone does in fact owe $4,424,615 to the FF&E reserve account. Sunstone’s assertion that it overfunded the FF&E reserve account is based largely on a $3,450,000 contribution that Sunstone claimed that it made in 2010.  However, these funds were not deposited in and do not relate to Sunstone’s Lease-required FF&E Replacement Reserve account.  If Sunstone does not immediately replenish the FF&E reserve account, EDC should send Sunstone a written notice demanding that it replenish $4,424,615 to the FF&E reserve account within 30 days and pursue all remedies available to it under the Lease if Sunstone does not comply.

Sunstone’s and EDC’s responses and our rebuttals are discussed in greater detail in this report.