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SAN CLEMENTE, CA-The decision by Sunstone Hotel Investors not to make the June 1 payment on the $65 million mortgage on its W Hotel in San Diego reflects a “significant and continuing deterioration in demand for luxury lodging,” the REIT says in choosing what it terms an ” elective default” on the mortgage. Sunstone, which discussed the elective default both in a written statement and in a conference call, says that the performance of the 258-room W Hotel also suffered from the introduction of numerous new competitive hotels in the San Diego market, including a number of luxury boutique hotels, two additional Starwood-branded hotels and a 1,190-room convention hotel.

Sunstone president and CEO Art Buser said that the San Clemente-based REIT has attempted to work with the special servicer for the hotel’s $65 million CMBS mortgage over the past several months, but the special servicer declined the REIT’s proposed modifications of the loan. “At this point, the company does not expect further negotiation with the special servicer, and the company is prepared to convey the hotel to the lender in lieu of repayment,” Sunstone’s statement said. The mortgage bears an interest rate of 6.14% and is non-recourse to the REIT, with scheduled 2009 debt payments totaling approximately $4 million.

Sunstone cited “a number of unique, market and hotel-specific factors” that drove its decision to choose the elective default, adding that it might pursue similar options with certain of its other mortgaged hotels but that it believes such cases will be limited in number. According to Ken Cruse, Sunstone’s CFO, the company believes that the value of the W San Diego is now “meaningfully below” the $65 million it owes on the property.

News of the elective default prompted analysts at Milwaukee-based Robert W. Baird & Co. to issue a report that maintains Baird’s neutral rating on Sunstone’s stock and says that although the move involves risk, “We view it positively for shareholders as it is accretive to both net asset value and funds from operations.” The Baird analysts add that more instances of elective defaults or similar moves will occur in the hotel industry as hotel cash flows remain under pressure, both at Sunstone and in the REIT sector.

The W San Diego is managed by Starwood Hotels & Resorts under a franchise and management contract, which the special servicer might be able to terminate, depending on the specific terms of the contract. How the W Hotel situation plays out, “will likely be a case study for many more distressed hotels over the next several years,” the Baird analysts say.

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