UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
OR
FOR THE TRANSITION PERIOD FROM TO
Commission File Number 001-09240
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 (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x. No ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ¨. No x.
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 as of and for the three months ended March 31, 2005, 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 financial position, 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)
March 31,
2005
December 31,
2004
Real estate held for investment
Less—accumulated depreciation
Real estate held for sale
Real estate subject to sales contract
Notes and interest receivable
Performing (including $37,228 in 2005 and $20,925 in 2004 from affiliates and related parties)
Non-performing, non-accruing
Less—allowance for estimated losses
Investment in real estate entities
Marketable equity securities, at market value
Cash and cash equivalents
Other assets (including $7,467 in 2005 and $1,706 in 2004 from affiliates and related parties)
The accompanying notes are an integral part of these Consolidated Financial Statements.
2
CONSOLIDATED BALANCE SHEETS—Continued
Liabilities:
Notes and interest payable
Liabilities related to assets held for sale
Liabilities related to assets subject to sales contract
Other liabilities (including $1,338 in 2005 and $2,282 in 2004 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 7,900,869 shares in 2005 and 2004
Treasury stock
Paid-in capital
Accumulated deficit
Accumulated other comprehensive loss
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CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share)
For the Three Months
Ended March 31,
Property revenue:
Rents
Property expense:
Property operations (including $1,240 for three months of 2005 and $803 for three months of 2004 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 $550 for three months of 2005 and $201 for three months of 2004 from affiliates and related parties)
Equity in income (loss) of equity investees
Other expense:
Interest
Depreciation
Advisory fee to affiliate
Net income fee to affiliate
General and administrative (including $475 for three months of 2005 and $478 for three months of 2004 to affiliates and related parties)
Net loss from continuing operations before taxes
Income tax benefit
Net loss from continuing operations
Discontinued operations (See Note 9)
Less: Income tax expense
Net income from discontinued operations
Net income
Preferred dividend requirement
Net income applicable to common shares
4
Basic earnings per share:
Correction of accounting error in prior period
Discontinued operations
Diluted earnings per share:
Weighted average common shares used in computing earnings per share:
Basic
Diluted
Convertible Series C Preferred stock (173,340 shares) and options to purchase 40,000 shares of TCI’s common stock were excluded from the computation of diluted earnings per share for the three months ended March 31, 2005, because the effect of their inclusion would be antidilutive.
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CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For the Three Months Ended March 31, 2005
TreasuryStock
Paid-inCapital
AccumulatedDeficit
AccumulatedOtherComprehensiveIncome
Stockholders’Equity
Balance, January 1, 2005
Comprehensive income
Unrealized gain on foreign currency translation
Unrealized gain on marketable securities
Series C Preferred Stock cash dividends ($7.00 per share)
Balance, March 31, 2005
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities
Reconciliation of net income (loss) to net cash provided by (used in) 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
Equity in (income) loss of equity investees
Loss (income) allocated to minority interest
Decrease (increase) in interest receivable
Decrease in other assets
Decrease in interest payable
Increase in other liabilities
Net cash provided by operating activities
Cash Flows from Investing Activities
Collections on notes receivable
Funding of notes receivable
Acquisition of real estate
Real estate improvements
Real estate construction
Proceeds from sale of real estate
Distributions from equity investees, net
Deposits on pending purchases and financings
Net cash used in investing activities
Cash Flows from Financing Activities
Payments on notes payable
Proceeds from notes payable
Payments from (to) advisor
Deferred financing costs
Net cash (used in) provided by financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
7
CONSOLIDATED STATEMENTS OF CASH FLOWS—Continued
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest
Schedule of non-cash investing and financing activities:
Notes payable assumed on purchase of real estate
Notes payable assumed by buyer on sale of real estate
Notes receivable provided on the sale of real estate
Notes payable proceeds used by affiliate for the purchase of real estate
Real estate purchased from affiliate decreasing affiliate receivable
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 2004 have been reclassified to conform to the 2005 presentation.
Operating results for the three month period ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. 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, 2004 (the “2004 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 March 31, 2005, ARI owned 82.2% of the outstanding TCI common shares.
Stock-based employee compensation. 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:
For the Three
Months
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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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—Continued
NOTE 2. REAL ESTATE
In 2005, TCI purchased the following properties:
Property
Purchase
Price
Rate
Maturity
Date
First Quarter
Office Buildings
Two Hickory(3)
Land
Mandahl Bay
Mandahl Bay (Gilmore)
Mandahl Bay (Chung)
Second Quarter
Apartments
Foxwood(3)
Parc at Metro Center(4)
Park West
Centurion
In 2004, TCI purchased the following properties:
288 City Park(1)
Blue Lake Villas II(1)
Bridges on Kinsey(1)
Dakota Arms(1)
Lake Forest(1)
Vistas of Vance Jackson(1)
Lubbock
Railroad
Vista Ridge(2)
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In 2005, TCI sold the following properties:
Location
Net Cash
Received
Debt
Discharged
Gain
on Sale
Office Building
Institute Place
Industrial Warehouse
5700 Tulane
Granbury Station
Alamo Springs/Lemmon Carlisle
In 2004, TCI sold the following properties:
Extinguished
Countryside Harmon
Countryside Retail
Kelly (Pinewood)
Ogden Industrial
Texstar Warehouse(2)
Shopping Center
K-Mart(2)
Allen
Marine Creek(7)
Red Cross
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At March 31, 2005, TCI had the following properties under construction:
Units
Amount
Expended
Additional
to Expend
Construction
Loan
Funding
Bluffs at Vista Ridge
Bridges on Kinsey
Dakota Arms
Kingsland Ranch
Laguna Vista
Lake Forest
Parc at Maumelle
Stonebridge at City Park (formerly 288 City Park)
Vistas of Vance Jackson
Wildflower Villas
For the three months ended March 31, 2005, TCI completed the 70 unit Blue Lake Villas II in Waxahachie, Texas.
NOTE 3. NOTES AND INTEREST RECEIVABLE
In March 2005, TCI entered into an agreement to advance a third party $3.2 million for development costs relating to land lots in Austin, Texas. These advances are secured by stock in the borrower and hold a second lien on the undeveloped land. The secured note bears interest at 10%, requires semi-annual payments and matures in March 2008. As of March 31, 2005, TCI had not advanced any funds to the borrower. TCI also guaranteed, with full recourse to TCI, an $18 million loan for the borrower which loan is secured by a first lien on the undeveloped land.
In October 2004, TCI sold the In The Pines apartments to a third party and provided $1.0 million of the purchase price as seller financing in the form of two notes. The first note bears interest at 7.0% per annum, requires monthly interest payments and matured in January 2005. The Purchaser extended this note to March 2005 by paying 1.0% of the outstanding principal balance as an extension fee and then extended the note an additional 30 days to April 2005 by paying an extension fee of 0.5% of the outstanding principal balance. In the event of a default, the note is also secured by membership rights in the purchaser’s entity. The second note is unsecured, bears interest at 8.5% per annum, requires monthly interest payments and matured in January 2005. The Purchaser extended this note to March 2005 by paying 1.0% of the outstanding principal balance as an extension fee and extended the note an additional 30 days to April 2005 by paying an extension fee of 0.5% of the outstanding principal balance. Both loans were extended to October 2005 with the payment to TCI of a 2.0% extension fee.
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 secured note bore interest at 7% and matured in September 2004. The purchaser extended the note to December 2004 with a $1.1 million principal payment in September 2004. This note, including accrued but unpaid interest, was paid in December 2004.
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 bore interest at a fixed rate of 5.0% and required all interest and principal payments be paid at maturity on 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 discounted the note $2,000 and recognized a loss of $2,000.
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 (then 9.0% per annum), required monthly interest only payments and originally matured in January 2003. As of March 2004, TCI had funded a total of $4.3 million. On January 22, 2003, TCI agreed to extend the maturity date until May 1, 2003. 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 additional security for the note. In December 2004, TCI agreed to a Modification Agreement with the borrower, which was effective November 1, 2003. As of the modified effective date, accrued interest of $582,000 was added to the principal balance of the note, the interest rate fixed at 9.0% per annum and all principal and interest is due November 2005. TCI also received Pledge and Security Agreements in various partnership interests belonging to the borrower and received various Assignments of Proceeds from sales in certain entities owned by the borrower. TCI reduced accrued interest and principal by $1.5 million from the receipt of notes receivable assigned to TCI by borrower and by $605,000 from cash received. TCI also received $1.4 million in January 2005 that was applied to accrued interest and principal effective December 30, 2004.
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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 7.5% per annum, requires monthly interest only payments and matures in March 2007. As of March 2005, TCI has funded $768,000 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, requires monthly interest only payments, and matures in June 2005. As of March 2005, TCI has funded $300,000 of the line of credit.
Related Parties. 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 unsecured note bears interest at the prime rate plus 2% (which is currently 8.0%), and matured in April 2005. This note was extended to April 2008.
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 unsecured note bears interest at the prime rate plus 2% (which is currently 8.0%), and matured in April 2005. This note was extended to April 2008.
In January 2002, TCI purchased 100% of the outstanding common shares of ART Two Hickory Corporation (“Two Hickory”), a wholly-owned subsidiary of ARI for $4.4 million cash. Two Hickory owns the 96,217 sq. ft. Two Hickory Centre Office Building in Farmers Branch, Texas. ARI guaranteed that the asset shall produce at least a 12.0% annual return of the purchase price for a period of three years from the purchase date. If the asset fails to produce the 12.0% annual return, ARI shall pay TCI any shortfall. In addition, if the asset fails to produce the 12.0% return for a calendar year and ARI fails to pay the shortfall, TCI may require ARI to repurchase the shares of Two Hickory for the purchase price. Because ARI guaranteed the 12.0% return and TCI has the option of requiring ARI to repurchase the entities, management has classified this related party transaction as a note receivable from ARI. In June 2002, the asset was refinanced. TCI received $1.3 million of the proceeds as a principal reduction on its note receivable from ARI. In January 2005, TCI completed the purchase of Two Hickory by recording the asset and removing the note receivable from ARI.
In April 2002, TCI purchased 100% of the following entities: ART One Hickory Corporation (“One Hickory”), Garden Confederate Point, LP (“Confederate Point”), Garden Foxwood, LP (“Foxwood”), and Garden Woodsong, LP (“Woodsong”), all previously wholly-owned subsidiaries of ARI for $10.0 million. One Hickory owns the 120,615 sq. ft. One Hickory Centre Office Building in Farmers Branch, Texas. Confederate Point owns the 206 unit Confederate Apartments in Jacksonville, Florida. Foxwood owns the 220 unit Foxwood Apartments in Memphis, Tennessee. Woodsong owned the 190 unit Woodsong Apartments in Smyrna, Georgia. ARI guaranteed that these assets shall produce at least a 12.0% return annually of the purchase price for a period of three years from the purchase date. If the assets collectively fail to produce the 12.0% return, ARI shall pay TCI any shortfall. In addition, if the assets fail to produce the 12.0% return for a calendar year and ARI fails to pay the shortfall, TCI may require ARI to repurchase the entities for the purchase price. Because ARI guaranteed the 12.0% return and TCI has the option of requiring ARI to repurchase the entities, management has classified this related party transaction as a note receivable from ARI. In July 2002, the Woodsong Apartments were sold. TCI received $2.8 million from the proceeds as payment of principal and accrued but unpaid interest on the note receivable. In October 2003, TCI sold One Hickory to IORI for $12.2 million, less prorations, for a wraparound promissory note of $12.0 million. This note bears interest at 5.49% interest, requires monthly interest and principal payments and matures in June 2006. This transaction effectively discharged the note receivable TCI had from ARI for the financing of One Hickory. Also, in November 2003, Confederate Point sold the Confederate Apartments and paid $2.1 million to TCI to pay off the loan and accrued but unpaid interest. In April 2005, TCI completed the purchase of the Foxwood Apartments by recording the asset and removing the note receivable from ARI.
NOTE 4. INVESTMENT IN REAL ESTATE ENTITIES
Real estate entities. TCI’s investment in real estate entities at March 31, 2005 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. ARI is a related party that owns 82.2% 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. Garden Centura, L.P. is accounted for on the cost method.
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TCI’s investment in real estate entities at March 31, 2005, was as follows:
Investee
Percentage
of TCI’s
Ownership at
March 31, 2005
Carrying
Value of
Investment at
Market Value
of Investment at
IORI
ARI
Garden Centura, L.P.
Other
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 method investees for the first three months of 2005 and 2004.
Revenues
Equity in loss of partnerships
Property operating expenses
Interest expense
Income/(loss) before gains on sale of real estate
NOTE 5. MARKETABLE EQUITY SECURITIES
TCI owns equity securities of Realty Korea CR-REIT Co., Ltd. No. 1 representing approximately a 9.2% ownership interest. This investment is considered an available-for-sale security. TCI recognized an unrealized gain of $669,000 for the period ending March 31, 2005 due to an increase in market price.
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 February 2004, TCI received a loan for $1.0 million used for the purchase of land by ARI, increasing the affiliate receivable balance by $1.0 million.
In February 2004, TCI recorded the sale of a tract of Marine Creek land originally sold to a related party in December 2003. This transaction was not recorded as a sale for accounting purposes in December 2003 and was recorded as a TCI refinancing transaction in February 2004. TCI received $1.2 million in cash from the related party in February 2004 as payment on the land. TCI still has a note receivable balance of $270,000 that bears interest at 12.0% and matures in April 2009. TCI recorded the sale of the Marine Creek land tract due to the payment received on the note receivable.
In January 2004, TCI purchased 14.216 acres of land from an affiliate with a net purchase price of $2.6 million, decreasing the affiliate receivable balance by $2.6 million.
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The following table reconciles the beginning and ending Affiliates receivable (payable) balances as of March 31, 2005.
Balance, December 31, 2004
Cash transfers
Cash repayments
Repayments through property transfers
Fees payable to affiliate
Payables clearing through Prime
Returns on Metra Properties. 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 March 31, 2005, 12 of the properties remained on TCI’s balance sheet. During April 2005, resolution of the litigation occurred, settling all liabilities remaining from the original partnership arrangements which included a return of investor equity, prospective asset management fees and miscellaneous fees and transactions costs from the Plaintiffs as a prepayment of a preferred return, along with a delegation of management to another entity, and a motion to dismiss the action as a part of the resolution. Of the prepayment, the Company will recognize expenses of $462,000 and a reduction in liabilities of $2.1 million during the second quarter of 2005.
NOTE 7. NOTES AND INTEREST PAYABLE
In February 2005, TCI received a loan in the amount of $5.0 million. The note bears interest at 8.0% per annum, requires semi-annual interest payments and matures in July 2006. The loan is collateralized by certain partnership interests that hold apartments owned by TCI. At maturity, the lender has the option to convert the outstanding loan balance into general and limited partnership units in each of the partnerships, subject to HUD approval.
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 6.5%, requires monthly principal and interest payments, and matured in February 2005. This loan was extended to August 2005.
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In 2005, TCI refinanced or financed the following properties:
Incurred
Bridgeview Plaza
Shopping Centers
Dunes Plaza
Autumn Chase
Courtyard
Southgate
In 2004, TCI refinanced or financed the following properties:
Received/(Paid)
Centura Tower
Centura Land
Hollywood, Dominion & Mira Lago(2)
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, equity in loss of equity investees and equity in investees gains on sales of real estate which totaled $2.0 million and $856,000 for the three months ended March 31, 2005 and 2004, respectively. Expenses that are not reflected in the segments are general and administrative expenses, minority interest, advisory and net income fees which totaled $3.4 million and $5.0 million for the three months ended March 31, 2005 and 2004, respectively. Also excluded from segment assets are assets of $132.6 million at March 31, 2005, and $105.5 million at March 31, 2004, which are not identifiable with an operating segment. There are no intersegment revenues and expenses.
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Presented below is the operating income of each operating segment for the three months ended March 31, 2005 and 2004, and each segment’s assets at March 31.
Three Months Ended March 31, 2005
Commercial
Properties
Operating income (loss)
Assets
Property Sales:
Sales price
Gain on sale
Three Months Ended March 31, 2004 (As Restated)
Deferred current gain
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NOTE 9. DISCONTINUED OPERATIONS
For the three months ended March 31, 2005 and 2004, income from discontinued operations relates to 9 properties that TCI sold or are to be sold in 2005 and 22 properties that TCI sold during 2004. The following table summarizes revenue and expense information for these properties sold and held-for-sale.
For the
Three Months
Revenue
Rental
Property operations
Expenses
Net loss from discontinued operations before gains on sale of real estate
Gain on sale of operations
Equity in investees gain on sale of real estate
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
During the second quarter of 2004, 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 since March 2003. The unaudited Consolidated Statements of Operations for the three months ended March 31, 2004, reflect the correction of the impact of this error on depreciation expense of $538,000. 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.
NOTE 11.COMMITMENTS AND CONTINGENCIES
Partnership Obligations. TCI is the limited partner in 11 partnerships that are currently constructing 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 non-affiliated partners are limited to development fees earned by the non-affiliated partners, and are set forth in the respective partnership agreements. The total amount of the expected buyouts as of March 31, 2005 is approximately $2.1 million. TCI is a non-controlling general and limited partner in a real estate partnership and is obligated to fund approximately $2.3 million through March 31, 2006 for certain partnership obligations.
Liquidity. Although management anticipates that TCI will generate excess cash from operations in 2005, such excess, however, 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.
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 February 2004, various subsidiaries of TCI guaranteed a $10 million line of credit for its parent, ARI. The subsidiaries of TCI also pledged and assigned assets, in the form of securities and partnership interests in construction properties, as additional collateral for this line of credit.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
WARNING CONCERNING FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q and TCI’s 2004 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 which 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.
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.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)
Liquidity and Capital Resources
TCI reported net income of $4.3 million for the three months ended March 31, 2005, which included the following non-cash charges: depreciation and amortization of $5.0 million, equity income of equity investees of $1.2 million, and gain on sale of real estate of $10.4 million. For the three months ended March 31, 2004, TCI reported net income of $2.1 million, which included the following non-cash charges: depreciation and amortization of $6.1 million, equity loss of equity investees of $570,000 and gain on sale of real estate of $11.9 million.
For the three months ended March 31, 2005, net cash provided by operating activities amounted to $384,000, due to other assets increased by $2.4 million primarily due to a reduction in escrows and deposits, interest payable decreased by $818,000 and other liabilities increased by $1.1 million due to an increase in accrued expenses.
Also for the three months ended March 31, 2005, net cash used in investing activities was $8.7 million primarily due to real estate construction and improvements of $15.0 million, payments for real estate acquisitions of $7.8 million, deposits on pending purchases of $671,000 and additional fundings on notes receivable of $647,000. These outflows for investing activities were offset by the collection of $1.4 million on notes receivable and proceeds from sale of real estate of $13.6 million.
Net cash used in financing activities of $3.7 million was due to proceeds received from the funding or refinancing of notes payable of $31.7 million; offset by cash payments of $26.6 million to paydown existing notes payable, $308,000 for financing costs and $8.5 million in payments made to the advisor.
In the first three months of 2005, TCI sold one office building, one industrial warehouse and one land parcel for a total of $16.3 million, receiving $5.8 million in cash and discharging debt of $8.5 million after the payment of various closing costs.
Also in the first three months of 2005, TCI financed or refinanced two shopping centers for a total of $10.9 million, discharging $9.0 million in debt and receiving $1.3 million in cash.
Further in the first three months of 2005, TCI purchased three parcels of unimproved land and one office building for $18.7 million. TCI paid $4.3 million in cash, including various closing costs and incurred or assumed $10.9 million in debt. TCI also incurred $13.8 million on property construction, of which $12.3 million was funded by debt. For the remainder of 2005 and the first half of 2006, TCI expects to spend an additional $42.5 million on property construction projects, of which $42.1 million will be funded by debt.
Management reviews the carrying values of TCI’s properties and mortgage notes receivable at least annually and whenever events or a change in circumstances indicate that impairment may exist. Impairment is considered to exist if, in the case of a property, the future cash flow from the property (undiscounted and without interest) is less than the carrying amount of the property. For notes receivable, impairment is considered to exist if it is probable that all amounts due under the terms of the note will not be collected. If impairment is found to exist, a provision for loss is recorded by a charge against earnings. The mortgage note receivable review includes an evaluation of the collateral property securing each note. The property review generally includes: (1) selective property inspections; (2) a review of the property’s current rents compared to market rents; (3) a review of the property’s expenses; (4) a review of maintenance requirements; (5) a review of the property’s cash flow; (6) discussions with the manager of the property; and (7) a review of properties in the surrounding area.
Related Party Transactions
In February 2004, TCI recorded the sale of a tract of Marine Creek land originally sold to a related party in December 2003. This transaction was not recorded as a sale for accounting purposes in December 2003 and was recorded as a TCI refinancing transaction in February 2004. TCI received $1.2 million in cash from the related party in February 2004 as payment on the land. TCI still has a note receivable balance of $270,000 remaining that bears interest at 12.0% and matures in April 2009. TCI recorded the sale of the Marine Creek land tract due to the payment received on the note receivable.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Continued)
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 March 31, 2005, 12 of the properties remained on TCI’s balance sheet.
Results of Operations
TCI had net income of $4.3 million in the period ended March 31, 2005, including gains on the sale of real estate totaling $10.4 million and a loss from discontinued operations of $449,000, compared to net income of $2.0 million in the corresponding period in 2004, including gains on real estate of $10.9 million, a loss from discontinued operations of $771,000 and $1.0 million gain on sale of real estate by equity investees. Fluctuations in this and other components of revenues and expense between the 2005 and 2004 periods are discussed below.
Rents in the period ended March 31, 2005, increased to $23.6 million compared to $21.1 million in 2004. This increase is mainly due to additional rental income from the completion of apartment construction projects over the past four years and from slightly higher room revenues from TCI’s hotels. These gains were offset by a decrease in commercial revenues due to lower occupancies.
Property operations expense increased to $15.2 million in the period ended March 31, 2005, compared to $13.5 million in 2004. This increase is mainly due to the completion of apartment construction projects over the past four years, offset by lower commercial expenses due to lower occupancies. Property operations expenses for the remaining quarters of 2005 may continue to increase as TCI continues to finish construction of new apartment projects.
Interest income increased to $845,000 in the period ended March 31, 2005, compared to $398,000 in 2004. The increase is primarily due to additional interest from an increase in the outstanding notes receivable balances from March 2004 and from additional interest on variable rate notes due to increases in the prime rate during 2004 and 2005.
Equity income of investees was $1.2 million in the period ended March 31, 2005, compared to equity in loss of equity investees of $570,000 in 2004. ARI and IORI both recognized income from operations in the first quarter of 2005 compared to losses in the first quarter of 2004.
Interest expense increased to $8.8 million in the period ended March 31, 2005, from $7.5 million in 2004. This increase is mainly due to the completion of apartment construction projects over the past four years, plus additional interest from land loans due to new land purchases in 2004 and 2005.
Net income fee due to affiliate in the period ended March 31, 2005 was $325,000, as compared to $79,000 in 2004. The net income fee is payable to TCI’s advisor based on 7.5% of TCI’s net income. TCI had higher net income for the three months ended March 31, 2005 compared to the same period in 2004.
General and administrative expenses decreased to $1.5 million in the period ended March 31, 2005, from $3.0 million in 2004. The decrease was mainly due to lower spending on legal fees, lower state and franchise income taxes and lower cost reimbursements to Prime.
In the three months of 2005, gains on sale of real estate totaling $10.4 million were recognized, including $10.1 million on the sale of Institute Place, $294,000 on the sale of the 5700 Tulane industrial warehouse and $10,000 on the sale of Granbury Station land.
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 three months of 2005 and the first three months of 2004; therefore, it recorded no provision for income taxes.
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At March 31, 2005, TCI had a net deferred tax asset of $45.7 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.
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 March 31, 2005, 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 March 31, 2005, that have materially affected, or are reasonably likely to materially affect, TCI’s internal control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Innovo Realty, Inc. On August 10, 2004, three entities, including Transcontinental Realty Investors, Inc. (the “Company”), 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, Inc., Metra Capital LLC, Innovo Group, Inc., Joseph Mizrachi, Simon Mizrachi, Herbert Guez, Third Millennium Partners LLC, Third Millennium Partners, Inc., Third Millennium Group LLC and Sunridge Management, Inc., Defendants. The Plaintiffs’ complaint alleges that a former director of American Realty Investors, Inc. (“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 were affiliates of, or are controlled by, the former director of the Company. During April 2005, resolution of the litigation occurred, settling all liabilities remaining from the original partnership arrangements which included a return of investor equity, prospective asset management fees and miscellaneous fees and transactions costs from the Plaintiffs as a prepayment of a preferred return, along with a delegation of management to another entity, and a motion to dismiss the action as a part of the resolution. Of the prepayment, the Company will recognize expenses of $462,000 and a reduction in liabilities of $2.1 million during the second quarter of 2005.
Sunset Management LLC. On October 5, 2004, Sunset Management LLC (“Sunset”) filed a complaint as a purported stockholder’s derivative action on behalf of Transcontinental Realty Investors, Inc. in the United States District Court for the Northern District of Texas, Dallas Division, against American Realty Investors, Inc., Basic Capital Management, Inc., Prime Income Asset Management, Inc., Prime Income Asset Management LLC, Income Opportunity Realty Investors, Inc., United Housing Foundation (“United”), Inc., Regis Realty, Inc., the Company, the Company’s current directors and officers and others. Sunset’s complaint filed as Case No. 304CV02162-B styled Sunset Management LLC, derivatively on behalf of Transcontinental Realty Investors, Inc. v. American Realty Investors, Inc., et al., raises a number of allegations previously raised by Sunset in four other cases which, as rulings have occurred, have resulted in a denial of Sunset’s requested relief. The Defendants on November 8, 2004 filed a Motion to Dismiss pursuant to Rules 12 and 23.1 of the Federal Rules of Civil Procedure on the basis that Sunset’s allegations are insufficient to evade the stringent demand requirement under the futility exceptions for stockholder derivative actions, and that Sunset cannot fairly and adequately represent the interests of other stockholders. One of the individual Defendants also filed on January 4, 2005 a Motion to Disqualify Sunset’s Counsel. On January 4, 2005, the Defendants filed a Motion to Stay Discovery and for Protective Order, which Motion was granted on March 30, 2005 by the issuance of an Order of the Court granting the Motion for Protective Order and staying all discovery in the action pending further Order of the Court, if appropriate, following the Court’s ruling on the Defendants’ Motion to Dismiss. On March 28, 2005, Sunset also filed a Petition for Writ of Mandamus in the United States District Court for the Eastern District of Texas, Sherman Division, seeking a Writ of Mandamus to be issued by the Court directing the bankruptcy judge in the United States Bankruptcy Court for the Eastern District of Texas, Sherman Division, in the case styled In Re: ART Williamsburg, Inc., Case No. 03-43909BTR-11, and American Realty Trust, Inc., et al. v. Sunset Management LLC, Adversary Proceeding No. 03-4256, to rule on pending Motions for Summary Judgment within twenty days thereof. On April 11, 2005, the United States District Court for the Eastern District of Texas, Sherman Division, entered its Order denying Sunset’s Petition for Writ of Mandamus. On May 6, 2005, in the bankruptcy case styled In Re: ART Williamsburg, Inc., Case No. 03-43909BTR-11 pending in the United States Bankruptcy Court for the Eastern District of Texas, Sherman Division, Sunset filed a Motion for Allowance of Claim, Determination of the Value of its Lien, Allowance of Deficiency as an Unsecured Claim and Abandonment of Cash Collateral to Sunset. Such Motion seeks an Order (i) estimating and determining the allowed amount of Sunset’s claim for purposes of distribution, (ii) determining the method of value in Sunset’s secured claim, (iii) determining the value of the lien held by Sunset, (iv) declaring that Sunset’s claim is secured in the amount determined, (v) allowing Sunset a deficiency claim for the unsecured portion of its claim, and (vi) ordering a distribution to Sunset of the proceeds received by the Debtor from a specified note.
The ownership of property and provision of services to the public as tenants entails an inherent risk of liability. Although the Company and its subsidiaries are involved in various items of litigation incidental to and in the ordinary course of its business, in the opinion of management, the outcome of such litigation will not have a material adverse impact upon the Company’s financial condition, results of operations or liquidity.
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the period covered by this report, Registrant did not purchase any of its equity securities. The following table sets forth a summary by month for the quarter the items described and the number of shares remaining to be purchased under a share repurchase program of the Registrant as of the end of each month.
Period
Total Number of
Shares Purchased
Average Price
Paid per Share
Shares Purchased as
Part of Publicaly
Announced Program
Maximum Number of
Shares that May
Yet be Purchased
Under the Program(a)
Balance as of December 31, 2004
January 1-31, 2005
February 1-28, 2005
March 1-31, 2005
Total
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ITEM 6. EXHIBITS
Description
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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.
/s/ Ted P. Stokely
/s/ Samuel C. Perry
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EXHIBITS TO
QUARTERLY REPORT ON FORM 10-Q
For the Quarter ended March 31, 2005
Exhibit
Number
Page
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