UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED JUNE 30, 2004
Commission File Number 1-9240
TRANSCONTINENTAL REALTY INVESTORS, INC.
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
(469) 522-4200
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ¨. No x.
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x. No ¨.
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The accompanying Consolidated Financial Statements have not been audited by independent certified public accountants, but in the opinion of the management of Transcontinental Realty Investors, Inc. (“TCI”), all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of TCI’s consolidated balance sheets, consolidated results of operations and consolidated cash flows at the dates and for the periods indicated, have been included.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share)
June 30,
2004
December 31,
2003
Real estate held for investment
Less—accumulated depreciation
Real estate held for sale
Notes and interest receivable:
Performing (including $20,925 in 2004 and $18,793 in 2003 from affiliates and related parties)
Nonperforming, nonaccruing
Less—allowance for estimated losses
Investment in real estate entities
Marketable equity securities, at market value
Cash and cash equivalents
Other assets (including $1,770 in 2004 and $4,819 in 2003 from affiliates and related parties)
The accompanying notes are an integral part of these Consolidated Financial Statements.
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CONSOLIDATED BALANCE SHEETS—Continued
Liabilities:
Notes and interest payable
Liabilities related to assets held for sale
Other liabilities (including $4,999 in 2004 and $607 in 2003 to related parties)
Commitments and contingencies
Minority interest
Stockholders’ equity:
Preferred Stock Series C; $.01 par value; authorized, issued and outstanding 30,000 shares (liquidation preference $3,000)
Common stock, $.01 par value; authorized, 10,000,000 shares; issued and outstanding 8,113,669 shares in 2004 and 8,072,594 in 2003
Paid-in capital
Accumulated deficit
Accumulated other comprehensive loss
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CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three Months
Ended June 30,
For the Six Months
Property revenue:
Rents
Property expense:
Property operations (including $2,288 for six months of 2004 and $2,171 for six months of 2003 to affiliates and related parties)
Operating income
Land Operations:
Sales
Cost of Sales
Deferred Gain on Sale
Gain on Sales
Other income (loss):
Interest (including $310 for six months of 2004 and $506 for six months of 2003 from affiliates and related parties)
Gain on foreign currency transaction
Equity in loss of equity investees
Other expense:
Interest
Depreciation
Advisory fee to affiliates
Net income fee to affiliate
General and administrative (including $1,269 for six months of 2004 and $851 for six months of 2003 to affiliates and related parties)
Discount on sale of note receivable
Net loss from continuing operations
Discontinued operations:
Income (loss) from operations
Gain on sale of operations
Equity in investees gain on sale of real estate
Net income (loss)
Preferred dividend requirement
Net income (loss) applicable to common shares
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Basic earnings per share:
Net loss from continuing operations (before prior period adjustment)
Correction of accounting error in prior period (See Note 10.)
Discontinued operations
Diluted earnings per share:
Weighted average common shares used in computing earnings per share:
Basic
Diluted
Convertible Series C Preferred stock (246,914 shares) and options to purchase 30,000 shares of TCI’s common stock were excluded from the computation of diluted earnings per share for the six months ended June 30, 2004, because the effect of their inclusion would be antidilutive.
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CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Dollars in thousands)
Accumulated
Other
Comprehensive
Income/(Loss)
Stockholders’
Equity
Balance at December 31, 2003 as previously reported
Adjusted balance at January 1, 2004
Comprehensive income:
Unrealized loss on foreign currency translation
Unrealized gain on marketable securities
Net loss
Series C Preferred Stock cash dividend ($7.00 per share)
Balance, June 30, 2004
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities:
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities
Depreciation and amortization
Amortization of deferred borrowing costs
Gain on sale of real estate
Loss allocated to minority interest
Increase in interest receivable
Decrease in other assets
(Decrease) increase in interest payable
(Decrease) increase in other liabilities
Net cash provided by (used in) operating activities
Cash Flows from Investing Activities:
Collections on notes receivable
Funding of notes receivable
Acquisition of real estate (including $498 in 2004 from affiliates and related parties)
Real estate improvements
Payments made under interest rate swap agreement
Real estate construction
Proceeds from sale of real estate
Distributions from equity investees, net
Payments from (to) advisor
Deposits on pending purchases and financings
Purchase of marketable equity securities
Net cash used in investing activities
Cash Flows from Financing Activities:
Payments on notes payable
Proceeds from notes payable
Dividends paid to preferred shareholders
Deferred financing costs
Net cash provided by financing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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CONSOLIDATED STATEMENT OF CASH FLOWS—Continued
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest
Schedule of noncash investing and financing activities:
Notes payable assumed on purchase of real estate
Notes payable assumed by buyer on sale of real estate
Funds collected by affiliate on sale of note receivable
Notes receivable provided on sale of real estate
Note payable proceeds used by affiliate for purchase of real estate
Note payable proceeds used by affiliate for payment of debt
Real estate received from related party as payment of debt
Real estate purchased from affiliate increasing affiliate payable
Real estate received as paydown of note receivable
Note payable paid by affiliate
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NOTE 1. BASIS OF PRESENTATION
Transcontinental Realty Investors, Inc. (“TCI”) is a Nevada corporation and successor to a California business trust which was organized on September 6, 1983. TCI invests in real estate through direct ownership, leases and partnerships. TCI also invests in mortgage loans on real estate.
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. Dollar amounts in tables are in thousands, except per share amounts. Certain balances for 2003 have been reclassified to conform to the 2004 presentation.
Operating results for the six month period ended June 30, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the Consolidated Financial Statements and notes included in TCI’s Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Form 10-K”).
Effective March 31, 2003, TCI financial results have been consolidated in the American Realty Investors, Inc. (“ARI”) Form 10-Q and related consolidated financial statements. As of June 30, 2004, ARI owned 80.0% of the outstanding TCI common shares.
TCI provides stock options to certain directors. TCI accounts for these stock options using the intrinsic method pursuant to the Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations. In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”), which amended SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The new standard provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, the statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in the annual and interim financial statements for fiscal years ending after December 15, 2002. In compliance with SFAS No. 148, TCI has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangement as defined by APB 25. If TCI had elected to recognize compensation cost for the issuance of options to directors of TCI based on the fair value at the grant dates for awards consistent with the fair value method prescribed by SFAS No. 123, net income (loss) and income (loss) per share would have been impacted as follows:
Net income (loss):
As reported
Proforma compensation expense, net of tax
Proforma
Basic earnings (loss) per share:
Diluted earnings (loss) per share:
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NOTE 2. REAL ESTATE
In 2004, TCI purchased the following property:
Property
Purchase
Price
Rate
Maturity
Date
First Quarter
Apartments
288 City Park(1)
Blue Lake Villas II(1)
Bridges on Kinsey(1)
Dakota Arms(1)
Lake Forest(1)
Vistas of Vance Jackson(1)
Land
Lubbock land
Railroad land
Vista Ridge land(2)
Second Quarter
Wildflower Villas(1)
Treehouse(3)
Rogers land
Cooks Lane land
Lacy Longhorn land(4)
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In 2003, TCI purchased the following property:
Heather Creek(1)
Capitol Hill(1)
Kingsland Ranch(1)
Shopping Centers
Bridgeview Plaza(2)
Cullman(2) (5)
Maumelle
Breakwater Bay(1)
Pulaski
In 2004, TCI sold the following property:
Net Cash
Received
Debt
Extinguished
Gain/(Loss)
on Sale
Office Buildings
Countryside Harmon
Countryside Retail
Brandeis(11)
Industrial Warehouses
Kelly (Pinewood)
Ogden Industrial
Texstar Warehouse(2)
K-Mart(2)
Allen
Red Cross
Sandstone
Waters Edge IV(7)
Cliffs of El Dorado(9)
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In 2004, TCI sold the following property (continued):
Atrium
4135 Beltline
Third Quarter
Kelly (Cash Road)
Rasor
In 2003, TCI sold the following property:
Gain
Willow Wick
McLeod
Tricon
Solco-Valley Ranch
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At June 30, 2004, TCI had the following properties under construction:
Amount
Expended
AdditionalAmount
to Expend
ConstructionLoan
Funding
288 City Park
Blue Lake Villas II
Bluffs at Vista Ridge
Bridges on Kinsey
Capitol Hill
Dakota Arms
Kingsland Ranch
Lake Forest
Vistas at Pinnacle Park
Vistas of Vance Jackson
Wildflower Villas
For the six months ended June 30, 2004, TCI completed the 248 unit DeSoto Ranch Apartments in DeSoto, Texas, the 314 unit Verandas at Cityview Apartments in Fort Worth, Texas, the 216 unit Mariposa Villas (Echo Valley) in Dallas, Texas and the 176 unit Breakwater Bay Apartments in Beaumont, Texas.
NOTE 3. NOTES AND INTEREST RECEIVABLE
In March 2004, TCI sold 492.531 acres in Collin County, Texas to a third party for $20.0 million. TCI provided $7.2 million of the purchase price as seller financing for a portion of the land on a contingent basis. The note bears interest at 7% and matures in September 2004. The buyer has the option to convey the contingent land back to TCI for cancellation of the note. The purchaser also has the option to extend the note to December 2004 with a $1.1 million extension payment prior to the maturity date.
In June 2003, TCI sold the 104 unit Willow Wick Apartments in North Augusta, South Carolina, for $2.7 million and provided $42,000 of the purchaser’s closing costs as seller financing. The note bears interest at a fixed rate of 5% and requires all interest and principal payments be paid at maturity in December 2003. This loan was extended until February 2004 and $10,000 was received in March 2004. This note, including accrued but unpaid interest, was paid in June 2004. TCI agreed to discount the note $2,000 and recognized a loss of $2,000.
In July 2003, an unsecured loan of $22,000 was made to an individual. The note bears interest at a fixed rate of 12% and requires all interest and principal payments be paid at maturity in January 2004. This note, including accrued and unpaid interest, was paid in full in March 2004.
In August 2001, TCI agreed to fund up to $5.6 million secured by a second lien on an office building in Dallas, Texas. The note receivable bore interest at a variable rate, prime rate plus 3%, required monthly interest only payments and matured in January 2003. As of September 2003, TCI has funded a total of $4.3 million and the note is classified as nonperforming. The collateral used to secure TCI’s second lien was seized by the first lien holder. On March 11, 2004, TCI agreed to accept an assignment of claims in litigation as security for the note. TCI is also working on securing additional collateral for this note and restructuring the terms of the note but a new agreement has not been reached. The current agreement requires interest to accrue at the default rate of 18%.
In March 2002, TCI sold the 174,513 sq.ft. Hartford Office Building in Dallas, Texas, for $4.0 million and provided the $4.0 million purchase price as seller financing and an additional $1.4 million line of credit for leasehold improvements in the form of a first lien mortgage note. The note bears interest at a variable interest rate, currently 7.0% per annum, requires monthly interest only payments and matures in March 2007. As of June 2004, TCI funded $354,000 of the additional line of credit.
In July 2002, TCI entered into an agreement to fund up to $300,000 under a revolving line of credit secured by 100% interest in a partnership of the borrower. The line of credit bears interest at 12.0% per annum and requires monthly interest only payments, and matures in June 2005. As of June 2004, TCI has funded $300,000 of the line of credit.
In September 2002, TCI sold a 36 acre tract of the Palm Desert land parcel for $3.6 million and provided $2.7 million as seller financing in the form of a first lien mortgage note. The note bears interest at 8.0% per annum, requires quarterly interest only payments and matures in September 2004. In March 2003, the note was sold to a financial institution for $2.6 million.
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Related Party. In March 2004, TCI sold a K-Mart in Cary, North Carolina to BCM for $3.2 million, including the assumption of debt. TCI also provided $1.5 million of the purchase price as seller financing. The note bears interest at the prime rate plus 2%, which is currently 6.5%, and matures in April 2005.
In March 2004, TCI sold the Texstar Warehouse in Arlington, Texas to BCM for $2.4 million, including the assumption of debt. TCI also provided $1.3 million of the purchase price as seller financing. The note bears interest at the prime rate plus 2%, which is currently 6.5%, and matures in April 2005.
NOTE 4. INVESTMENT IN REAL ESTATE ENTITIES
Real estate entities. TCI’s investment in real estate entities at June 30, 2004 included equity securities of two publicly traded real estate entities, Income Opportunity Realty Investors, Inc. (“IORI”) and ARI, related parties, and interests in real estate joint venture partnerships. Basic Capital Management, Inc. (“BCM”), TCI’s advisor until July 1, 2003, also served as advisor to IORI and ARI until July 1, 2003. Effective July 1, 2003, BCM was replaced as contractual advisor to TCI by Prime Asset Management, Inc., (“PAMI”). Effective August 18, 2003, PAMI changed its name to Prime Income Asset Management, Inc., (“PIAMI”). On October 1, 2003, Prime Income Asset Management, LLC, (“Prime”) replaced PIAMI as the advisor to TCI. ARI is a related party that owns 80% of TCI’s common stock and consolidates TCI’s financial accounts and operations.
TCI accounts for its investment in IORI and ARI and the joint venture partnerships using the equity method.
TCI’s investment in real estate entities, accounted for using the equity method, at June 30, 2004, was as follows:
Investee
Percentage
of TCI’sOwnership atJune 30, 2004
Carrying
Value ofInvestment atJune 30, 2004
Market Value
of Investment at
June 30, 2004
IORI
ARI
Management continues to believe that the market value of each of IORI and ARI undervalues their assets and, therefore, TCI may continue to increase its ownership in these entities.
Set forth below is summarized results of operations of equity investees for the first six months of 2004 and 2003.
Revenues
Equity in loss of partnerships
Property operating expenses
Interest expense
Loss before gains on sale of real estate
NOTE 5. MARKETABLE EQUITY SECURITIES
In March 2003, TCI obtained a loan in the amount of $5.0 million to acquire equity securities of Realty Korea CR-REIT Co., Ltd. No. 1 representing approximately a 9.2% ownership interest. As of May 2003, the loan was paid in full. This investment is considered an available-for-sale security. TCI recognized an unrealized gain of $396,000 for the period ending June 30, 2004 due to an increase in market price.
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NOTE 6. RELATED PARTIES
On September 19, 2002, TCI’s Board of Directors authorized the Chief Financial Officer of TCI to advance funds either to or from TCI, through the advisor, in an amount up to $15.0 million on the condition that such advances shall be repaid in cash or transfers of assets within 90 days. These advances are unsecured and bear no interest and generally have not had specific repayment terms and have been reflected in TCI’s financial statements as other assets and other liabilities.
In June 2004, TCI purchased 17.115 acres of land from an affiliate with a net purchase price of $4.5 million, increasing the affiliate payable balance by $4.5 million.
Also in June 2004, TCI sold apartments to an affiliate with a net purchase price of $5.0 million, decreasing the affiliate payable balance by $5.0 million.
Again in June 2004, TCI refinanced an office building and two parcels of land. TCI paid-off an existing note payable for ARI for $1.9 million, decreasing the affiliate payable balance by $1.9 million.
In May 2004, TCI purchased the Treehouse Apartments from an affiliate with a net purchase price of $7.5 million for the assumption of debt and a note receivable, less cash received of $498,000. The note receivable was from the sale of the Cliffs of El Dorado Apartments to a related party in 2003. At that time, the sale of the Cliffs of El Dorado Apartments was not recorded as a sale for accounting purposes. TCI recorded the sale of the Cliffs of El Dorado in May 2004 due to payment received for the Cliffs of El Dorado note receivable.
In March 2004, a related party purchased the loans on TCI’s three Chicago hotels for $10.8 million. This amount increased the affiliate payable balance by $10.8 million.
In February 2004, TCI received a loan for $1.0 million used for the purchase of land by ARI, decreasing the affiliate payable balance by $1.0 million.
In January 2004, TCI purchased 14.216 acres of land from an affiliate with a net purchase price of $2.6 million, increasing the affiliate payable balance by $2.6 million.
In March 2003, TCI purchased two properties from an affiliate with a net purchase price of $10.7 million, reducing the affiliate receivable balance by $8.1 million after the assumption of debt of $2.65 million.
The following table reconciles the beginning and ending Affiliates receivable (payable) balances as of June 30, 2004.
Balance, December 31, 2003
Cash transfers
Cash repayments
Payments through property transfers
Repayments through property transfers
Repayment through affiliate refinance
Advance through affiliate refinancing
Advance through receipt of loan obligation
Construction fees payable to affiliate
Payables clearing thorough Prime
In April 2002, TCI sold 12 apartment properties to partnerships controlled by Metra Capital, LLC (“Metra”). Innovo Group, Inc. (“Innovo”) is a limited partner in the partnerships that purchased the properties. Joseph Mizrachi, then a Director of ARI, a related party, controlled approximately 11.67% of the outstanding common stock of Innovo. Management determined to treat the sales as financing transactions, and TCI continues to report the assets and the new debt incurred by Metra on its financial statements. The partnership agreements for each of these partnerships state that the Metra Partners, as defined, receive cash flow distributions at least quarterly in an amount sufficient to provide them with a 15% cumulative compounded annual rate of return on their invested capital, as well as a cumulative compounded annual amount of 0.50% of the average outstanding balance of the mortgage indebtedness secured by any of these properties. These distributions to the Metra Partners have priority over distributions to any other partners. At June 30, 2004, 12 of the properties remained on TCI’s balance sheet.
NOTE 7. NOTES AND INTEREST PAYABLE
In March 2004, a related party to TCI purchased the loans on TCI’s three Chicago hotels, the City Suites hotel, the Willows hotel and The Majestic hotel. The loans, including accrued but unpaid interest, were purchased for $10.8 million dollars. The purchased loans were applied as an affiliate payable to the Prime affiliate balance. In August 2004, the City Suites hotel was released from bankruptcy protection.
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In February 2004, the Brandeis office building was returned to the lender via a Deed in Lieu of Foreclosure process. The outstanding debt and accrued interest was $8.8 million. TCI recorded a net impairment of $4.4 million in the fourth quarter of 2003 for this transaction.
In February 2004, TCI received a loan for $1.0 million that is cross defaulted and cross collateralized with ARI’s purchase of land in Portage County, Ohio. The loan bears interest at the prime rate plus .5%, which is currently 5.0%, requires monthly principal and interest payments, and matures in February 2005.
In 2004, TCI refinanced or financed the following properties:
Incurred
Discharged
Received/(Paid)
Centura Tower
Centura Land
Hollywood, Dominion & Mira Lago(2)
Marine Creek(3)
Paramount Terrace
Treehouse
1010 Common
Marine Creek
Lacy Longhorn
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In 2003, TCI refinanced or financed the following properties:
Mountain Plaza
Stone Oak
Bonita Plaza
Plantation
Bridgeview
Cullman
NOTE 8. OPERATING SEGMENTS
Significant differences among the accounting policies of the operating segments as compared to the Consolidated Financial Statements principally involve the calculation and allocation of administrative expenses. Management evaluates the performance of each of the operating segments and allocates resources to them based on their operating income and cash flow. Items of income that are not reflected in the segments are interest, gain on foreign currency transaction, equity in loss of equity investees and equity in investees gains on sales of real estate which totaled $1.9 million and $2.8 million for the three and six months ended June 30, 2004 and $607,000 and $1.7 million for the three and six months ended June 30, 2003, respectively. Expenses that are not reflected in the segments are general and administrative expenses, discount on sale of note receivable, minority interest, advisory and net income fees which totaled $2.9 million and $7.9 million for the three and six months ended June 30, 2004 and $2.9 million and $6.3 million for the three and six months ended June 30, 2003, respectively. Also excluded from segment assets are assets of $98.7 million at June 30, 2004, and $95.0 million at June 30, 2003, which are not identifiable with an operating segment. There are no intersegment revenues and expenses.
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NOTE 8. OPERATING SEGMENTS (Continued)
Presented below is the operating income of each operating segment for the three and six months ended June 30, 2004 and 2003, and each segment’s assets at June 30.
Three Months Ended June 30, 2004
Commercial
Properties
Operating income (loss)
Assets
Property Sales:
Sales price
Cost of sales
Deferred current gain
Gain on sale
Six Months Ended June 30, 2004
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Three Months Ended June 30, 2003
Six Months Ended June 30, 2003
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NOTE 9. DISCONTINUED OPERATIONS
Effective January 1, 2002, TCI adopted Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which established a single accounting model for the impairment or disposal of long-lived assets, including discontinued operations. This statement requires that the operations related to properties that have been sold or properties that are intended to be sold be presented as discontinued operations in the statement of operations for all periods presented, and properties intended to be sold are to be designated as “held-for-sale” on the balance sheet. In the event of a future sale, TCI is required to reclassify portions of previously reported operations to discontinued operations within the Statement of Operations.
For the three and six months ended June 30, 2004 and 2003, income from discontinued operations relates to 13 properties that TCI sold during 2004 and 14 properties that TCI sold during 2003. The following table summarizes revenue and expense information for these properties sold and held-for-sale.
Revenue:
Rental
Property operations
Expenses:
Net income (loss) from discontinued operations before gains on sale of real estate
Net income from discontinued operations
Discontinued operations have not been segregated in the consolidated statements of cash flows. Therefore, amounts for certain captions will not agree with respective consolidated statements of operations.
NOTE 10. CORRECTION OF ACCOUNTING ERROR IN PRIOR PERIOD
Subsequent to March 31, 2004, but prior to filing this form 10-Q, TCI discovered an error in the depreciation calculation for a shopping center TCI had purchased in March 2003 for $8.7 million. The amount subject to depreciation was $7.8 million and was to be depreciated straight-line over 40 years or 480 months. Instead, the property was depreciated over 40 months instead of 480 months, resulting in depreciation expense being overstated by $1.8 million for 2003 and $1.1 million for 2004. The Consolidated Balance Sheet as of December 31, 2003 has been revised to reflect the correction of the error through a decrease in accumulated depreciation of $1.8 million and an increase in retained earnings and total stockholders’ equity of $1.8 million. The unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2003, reflect the correction of the impact of this error on depreciation expense of $538,000 and $718,000, respectively. The Consolidated Statement of Stockholders’ Equity for December 31, 2003 has been revised to reflect the correction of the error through a decrease in the December 31, 2003 balance of accumulated deficit and total stockholders’ equity of $1.8 million. TCI does not intend to restate any previously issued Form 10-Q’s or Form 10-K’s for previous periods because, in the opinion of management, the effect is not material to the results of operations for any period previously reported on.
NOTE 11. SUBSEQUENT EVENTS
Activity subsequent to June 30, 2004 not already reflected elsewhere in this 10-Q are disclosed below.
In July 2004, TCI received an advance of $3.8 million, less fees, on a $10.0 million second lien note on the Centura Tower building. This note bears interest at the prime rate plus 1%, which is currently 5.5%, requires interest only payments until all of the note is advanced, and matures in April 2006.
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Also in July 2004, TCI received a loan of $2.5 million, less fees, that is secured by TCI’s $7.2 million note receivable from the sale of 492 acres of land in Allen, Texas earlier in 2004. This loan bears interest at the prime rate plus 1.5%, which is currently 6.0%, requires interest only payments, and matures in December 2004.
NOTE 12. COMMITMENTS AND CONTINGENCIES
Liquidity. Management anticipates that TCI will generate excess cash from operations in 2004 due to increased rental rates and occupancy at its properties, however, such excess will not be sufficient to discharge all of TCI’s debt obligations as they mature. Management intends to selectively sell income producing real estate, refinance real estate and incur additional borrowings against real estate to meet its cash requirements.
Partnership Buyouts. TCI is the limited partner in 12 partnerships formed to construct residential properties. As permitted in the respective partnership agreements, TCI intends to purchase the interests of the general and any other limited partners in these partnerships subsequent to the completion of these projects. The amounts paid to buyout the nonaffiliated partners are limited to development fees earned by the nonaffiliated partners, and are set forth in the respective partnership agreements. The total amount of the expected buyouts as of June 30, 2004 is approximately $2.4 million.
Litigation. TCI is involved in various lawsuits arising in the ordinary course of business. Management is of the opinion that the outcome of these lawsuits will have no material impact on TCI’s financial condition, results of operations or liquidity.
Guarantees. In April 2004, TCI guaranteed a $7.5 million note payable for a subsidiary of its parent, ARI. TCI pledged certain tracts of land as collateral and has guaranteed the payment of 50% of the note balance, all interest accrued and payable, all other costs and fees associated with the note and any future collection expenses.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
TCI invests in real estate through acquisitions, leases and partnerships. TCI also invests in mortgage loans. TCI is the successor to a business trust organized on September 6, 1983, and commenced operations on January 31, 1984.
Critical Accounting Policies
Critical accounting policies are those that are both important to the presentation of TCI’s financial condition and results of operations and require management’s most difficult, complex or subjective judgments. TCI’s critical accounting policies relate to the evaluation of impairment of long-lived assets and the evaluation of the collectibility of accounts and notes receivable.
If events or changes in circumstances indicate that the carrying value of a rental property to be held and used or land held for development may be impaired, management performs a recoverability analysis based on estimated undiscounted cash flows to be generated from the property in the future. If the analysis indicates that the carrying value is not recoverable from future cash flows, the property is written down to estimated fair value and an impairment loss is recognized. If management decides to sell rental properties or land held for development, management evaluates the recoverability of the carrying amounts of the assets. If the evaluation indicates that the carrying value is not recoverable from estimated net sales proceeds, the property is written down to estimated fair value less costs to sell and an impairment loss is recognized within income from continuing operations. TCI’s estimates of cash flow and fair values of the properties are based on current market conditions and consider matters such as rental rates and occupancies for comparable properties, recent sales data for comparable properties and, where applicable, contracts or the results of negotiations with purchasers or prospective purchasers. TCI’s estimates are subject to revision as market conditions and TCI’s assessments of them change.
TCI’s allowance for doubtful accounts receivable and notes receivable is established based on analysis of the risk of loss on specific accounts. The analysis places particular emphasis on past due accounts. Management considers such information as the nature and age of the receivable, the payment history of the tenant or other debtor, the financial condition of the tenant or other debtor and TCI’s assessment of its ability to meet its lease or interest obligations. TCI’s estimate of the required allowance, which is reviewed on a quarterly basis, is subject to revision as these factors change and is sensitive to the effects of economic and market conditions.
TCI’s management periodically discusses criteria for estimates and disclosures of its estimates with the Audit Committee of its Board of Directors.
Liquidity and Capital Resources
TCI reported a net loss of $3.0 million for the three months ended June 30, 2004, which included the following non-cash charges: depreciation and amortization of $5.1 million, equity loss of equity investees of $939,000, gain on foreign currency transaction of $1.2 million, equity investees gain on sale of real estate of $436,000 and gain on sale of operations of $1.8 million. For the six months ended June 30, 2004, TCI reported a net loss of $1.0 million, which included the following non-cash charges: depreciation and amortization of $10.9 million, equity loss of equity investees of $1.5 million, gain on foreign currency transaction of $1.2 million, equity investees gain on sale of real estate of $1.5 million and gain on sale of operations of $12.7 million.
For the six months ended June 30, 2004, net cash provided by operating activities amounted to $2.6 million, interest receivable increased by $846,000 due to additional notes receivable fundings, other assets increased by $7.4 million due to decreased rent receivables and deposits, interest payable decreased by $1.4 million due to notes paid or lower financing rates and other liabilities decreased by $840,000.
Also for the six months ended June 30, 2004, net cash used in investing activities was $46.5 million primarily due to real estate construction and improvements of $101.5 million, payments for real estate acquisitions of $19.0 million, deposits on pending purchases of $3.0 million, and additional fundings of notes receivable of $55,000. These outflows for investing activities were offset by the collection of $79,000 on notes receivable, payments from the advisor of $6.5 million and proceeds from sale of real estate of $70.4 million.
Net cash provided by financing activities of $42.2 million was due to proceeds received from the funding or refinancing of notes payable of $175.2 million; offset by cash payments of $131.3 million to paydown existing notes payable, dividends paid to preferred stockholders of $60,000 and $1.6 million for financing costs.
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In the first six months of 2004, TCI sold one shopping center, three industrial warehouses, two land parcels, three apartments and four office buildings for a total of $105.8 million, receiving $22.4 million in cash and extinguishing debt of $61.1 million after the payment of various closing costs.
Also in the first six months of 2004, TCI financed or refinanced two office buildings, two apartments and five parcels of land, incurring new debt of $75.7 million and receiving $5.5 million in cash, after paying various closing costs.
Further in the first six months of 2004, TCI purchased five parcels of unimproved land, one apartment and eight parcels of unimproved land for apartment construction for $34.9 million. TCI paid $4.2 million in cash, including various closing costs and incurred $19.9 million in debt. TCI also incurred $99.1 million on property construction, of which $94.3 million was funded by debt. For the remainder of 2004 and the first half of 2005, TCI expects to spend an additional $71.5 million on property construction projects, of which $67.3 million will be funded by debt.
Results of Operations
TCI had a net loss of $3.0 million and $1.0 million in the three and six months ended June 30, 2004, including gains on the sale of real estate totaling $1.8 million and $12.7 million, income from discontinued operations of $14,000 and a loss from discontinued operations of $315,000 and gain on the sale of real estate by equity investees of $436,000 and $1.5 million, respectively, compared to net income of $2.1 million and a net loss of $5.2 million in the corresponding periods in 2003, which include gains on the sale of real estate totaling $8.5 million for both periods in 2003, losses from discontinued operations of $616,000 and $656,000 and gain on sale of real estate by equity investees of $244,000 and $1.8 million, respectively. Fluctuations in this and other components of revenues and expense between the 2004 and 2003 periods are discussed below.
Rents in the three months ended June 30, 2004 increased to $28.3 million compared to $23.5 million in 2003. This increase is mainly due to new rental income from the completion of ten apartments in 2004 and 2003 and higher hotel revenues in 2004.
Rents in the six months ended June 30, 2004 increased to $57.9 million compared to $47.9 million in 2003. This increase is mainly due to new rental income from the completion of ten apartments in 2004 and 2003 and higher hotel revenues in 2004.
Property operations expense increased to $17.8 million in the three months ended June 30, 2004, compared to $14.8 million in 2003. This increase is mainly due to the completion of ten apartments in 2004 and 2003. Property operations expenses for the remaining quarters of 2004 are expected to increase as TCI continues to finish construction of new apartment properties.
Property operations expense increased to $36.0 million in the six months ended June 30, 2004, compared to $31.4 million in 2003. This increase is mainly due to the completion of ten apartments in 2004 and 2003. Property operations expenses for the remaining quarters of 2004 are expected to increase as TCI continues to finish construction of new apartment properties.
Interest income increased to $1.2 million in the three months ended June 30, 2004, compared to $660,000 in 2003. The increase was primarily due to new notes receivables added in the second half of 2003.
TCI recognized a gain on foreign currency transaction due to a strengthening of the Polish Zloty against the Euro for Hotel Akademia during 2004. Hotel Akademia’s long-term debt is denominated in Euros and the translation of Euros into Polish Zlotys prior to being translated into US Dollars is recorded as a gain or loss on TCI’s income statement.
Equity in losses of investees was $939,000 in the three months ended June 30, 2004 compared to $297,000 in 2003. ARI and IORI both had larger losses in the second quarter of 2004 as compared to the second quarter of 2003.
Interest expense increased to $9.2 million in the three months ended June 30, 2004, from $7.8 million in 2003. This increase is due to the completion of ten apartments in 2003 and 2004, which was offset by lower commercial interest due to sales and refinancings with lower rates in 2003 and 2004.
Interest expense increased to $19.8 million in the six months ended June 30, 2004, from $16.3 million in 2003. This increase is due to the completion of ten apartments in 2003 and 2004, which was offset by lower commercial interest due to sales and refinancings with lower rates in 2003 and 2004.
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Depreciation expense increased to $5.1 million in the three months ended June 30, 2004 from $4.4 million in 2003. This increase is due to depreciation from ten completed apartments in 2003 and 2004. Depreciation expense for the remaining quarters of 2004 may continue to increase as TCI completes its apartment construction projects.
Depreciation expense increased to $10.3 million in the six months ended June 30, 2004 from $8.6 million in 2003. This increase is due to depreciation from ten completed apartments in 2003 and 2004. Depreciation expense for the remaining quarters of 2004 may continue to increase as TCI completes its apartment construction projects.
Net income fee due to affiliate in the six months ended June 30, 2004 was reduced by $79,000. The net income fee is payable to TCI’s advisor based on 7.5% of TCI’s net income. Due to TCI having a loss for the six months ended June 30, 2004, the fee recorded for the first quarter of 2004 was reversed. TCI had a net loss for the six months ended June 30, 2003 and no fee was recorded.
General and administrative expenses decreased to $1.0 million in the three months ended June 30, 2004, from $1.3 million in 2003. This decrease was mainly due to a reduction in legal fees for the quarter.
General and administrative expenses increased to $4.0 million in the six months ended June 30, 2004, from $3.0 million in 2003. These increases were mainly due to higher legal fees, estimated state income and franchise taxes, rent expense and cost reimbursements to Prime.
In the six months of 2004, gains on sale of real estate totaling $12.7 million were recognized, including $5.5 million on the sale of Countryside Retail center, $1.9 million on the sale of Countryside Harmon, $1.4 million on the sale of Ogden Industrial Warehouse, $153,000 on the sale of the Pinewood Kelly Warehouse, $2.1 million on the sale of the 492.531 acres of Allen land, $1.1 million on the sale of the Sandstone Apartments, $328,000 on the sale of the Atrium office building and $345,000 on the sale of 4135 Beltline.
Tax Matters
Financial statement income varies from taxable income principally due to the accounting for income and losses of investees, gains and losses from asset sales, depreciation on owned properties, amortization of discounts on notes receivable and payable and the difference in the allowance for estimated losses. TCI had a loss for federal income tax purposes after the use of net operating loss carryforwards in the first six months of 2004 and a loss for federal income tax purposes in the first six months of 2003; therefore, it recorded no provision for income taxes.
At June 30, 2004, TCI had a net deferred tax asset of $21.2 million due to tax deductions available to it in future years. However, as management cannot determine that it is more likely than not that TCI will realize the benefit of the deferred tax assets, a 100% valuation allowance has been established.
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Inflation
The effects of inflation on TCI’s operations are not quantifiable. Revenues from property operations tend to fluctuate proportionately with inflationary increases and decreases in housing costs. Fluctuations in the rate of inflation also affect sales values of properties and the ultimate gain to be realized from property sales. To the extent that inflation affects interest rates, TCI’s earnings from short-term investments and the cost of new financings as well as the cost of variable interest rate debt, will be affected.
Environmental Matters
Under various federal, state and local environmental laws, ordinances and regulations, TCI may be potentially liable for removal or remediation costs, as well as certain other potential costs, relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos-containing materials into the air, and third parties may seek recovery for personal injury associated with such materials.
Management is not aware of any environmental liability relating to the above matters that would have a material adverse effect on TCI’s business, assets or results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
At June 30, 2004, TCI’s exposure to a change in interest rates on its debt is as follows:
Weighted Average
Interest Rate
Effect of 1%Increase In
Base Rates
Notes payable:
Variable rate
Total decrease in TCI’s annual net income
Per share
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, TCI carried out an evaluation, under the supervision and with the participation of TCI’s Acting Principal Executive Officer and principal accounting officer, of TCI’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that evaluation, TCI’s Acting Principal Executive Officer and principal accounting officer concluded that TCI’s disclosure controls and procedures are effective.
There have been no significant changes in TCI’s internal controls over financial reporting during the quarter ending June 30, 2004, that have materially affected, or are reasonably likely to materially affect, TCI’s internal control over financial reporting.
WARNING CONCERNING FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q and TCI’s 2003 Form 10-K, referred to herein, contain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and federal securities laws. These statements concern the intent, belief or expectations of TCI’s officers with respect to TCI’s ability to lease its properties, tenant’s ability to pay rents, purchase of additional properties, ability to pay interest and debt principal and make distributions, policies and plans regarding investments and financings, and other matters. Also, words such as “believe”, “expect”, “anticipate”, “intend”, “plan”, “estimate”, or similar expressions identify forward looking statements. Actual results may differ materially from those contained in or implied by the forward looking statements as a result of various factors. Such factors include, without limitation, the impact of changes in the economy and the capital markets on TCI and its tenants, competition within the real estate industry or those industries in with its tenants operate, and changes in federal, state and local legislation. For example: Some of TCI’s tenants may not renew expiring leases and TCI may be unable to locate new tenants to maintain the historical occupancy rates of the properties; rents which TCI can achieve at its properties may decline; tenants may experience losses and become unable to pay rents; and TCI may be unable to identify or to negotiate acceptable purchase prices for new properties. These results could occur due to many different circumstances, some of which, such as changes in TCI’s tenants’ financial conditions or needs for leased space, or changes in the capital markets or the economy, generally, are beyond TCI’s control. Forward looking statements are only expressions of TCI’s present expectations and intentions. Forward looking statements are not guaranteed to occur, and they may not occur. You should not place undue reliance upon forward looking statements.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On August 10, 2004, American Realty Investors, Inc., Transcontinental Realty Investors, Inc. and Income Opportunity Realty Investors, Inc. instituted an action in Texas State District Court as Cause No. 2004-60231-393 styled American Realty Investors, Inc., Transcontinental Realty Investors, Inc. and Income Opportunity Realty Investors, Inc., Plaintiffs v. Innovo Realty, Inc. and Innovo Group, Inc., Involuntary Plaintiffs v. Innovo Realty, Metra Capital LLC, Innovo Group, Inc., Joseph Mizrachi, Simon Mizrachi, Hurbert Guez, Third Millennium Partners LLC, Third Millennium Partners, Inc., Third Millennium Group LLC and Sunridge Management Group, Inc., Defendants. Plaintiffs’ complaint alleges that Joseph Mizrachi, a former director of ARI and others, offered a plan to the Plaintiffs to create one or more joint venture arrangements with one or more of the Plaintiffs to pursue alternative forms of financing or refinancing portions of Plaintiffs’ real estate portfolios, which entailed the creation of 22 separate limited partnerships to acquire 28 separate apartment complexes in three states (Texas, Florida and Louisiana), the general partners of which are affiliates of, or controlled by, Joseph Mizrachi. Plaintiffs’ complaint alleges that the overall transaction required the establishment of a sinking fund by the Defendants and the 22 limited partnerships as a trust for the benefit of certain preferred shareholders of Innovo Group, Inc. and the payment of certain proceeds to the Plaintiffs. Plaintiffs assert that payments have not been made pursuant to the agreement of the parties. Plaintiffs allege that Defendants’ conduct constituted a common business enterprise, alleges breach of contract and derivative claims on behalf of Innovo Group, Inc. against Joseph Mizrachi and others and requests declaratory relief involving the Plaintiffs’ rights in the partnerships, an accounting of proceeds, and the creation of a constructive trust. Plaintiffs’ complaint also alleges that Joseph Mizrachi engaged in fraud, negligent misrepresentation and/or breach of fiduciary duty and seeks unspecified damages, attorneys’ fees, a constructive trust be established, and other relief.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
Period
Average Price
Paid per Share
Maximum Number ofShares that May
Yet be Purchased
Under the Program(a)
April 1-30, 2004
May 1-31, 2004
June 1-30, 2004
Total
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Description
Current Report on Form 8-K, dated May 31, 2004, was filed with respect to Item 4 “Changes in Registrant’s Certifying Accountant”, Item 5 “Other Events and Regulation FD Disclosure” and Item 7. “Financial Statements and Exhibits” which reports a change in TCI’s certifying accountant, effective June 1, 2004, and the resignation of Ronald E. Kimbrough, TCI’s acting principal executive officer, Executive Vice President and Chief Financial Officer.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 16, 2004
By:
/s/ J. C. Lowenberg III
J. C. Lowenberg III
Executive Vice President and Chief Financial Officer
(Principal Financial Officer and Acting Principal Executive Officer)
/s/ Scott T. Lewis
Scott T. Lewis
Vice President and Chief Accounting Officer
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EXHIBITS TO
QUARTERLY REPORT ON FORM 10-Q
For the Quarter ended June 30, 2004
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