AMERICAN REALTY INVESTORS INC quarterly report, Q3 FY2013

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American Realty Investors, Inc. — Q3 2013 Form 10-Q

Business context and period. This unaudited filing covers the three and nine months ended September 30, 2013, compared with the same 2012 periods. ARL is an externally advised real estate investor consolidating TCI and IOT. Its portfolio included 46 apartment communities with 8,353 units, 11 commercial properties, and 4,623 acres of land. The company reported that related parties owned approximately 87.4% of ARL.

Key financial results

  • Revenue: Rental and other property revenue was $27.5 million in Q3, down 1.0% from $27.8 million. Nine-month revenue was $81.5 million, down 0.3% from $81.7 million.
  • Operating results: Operating income was $2.5 million in Q3 versus $5.3 million a year earlier; nine-month operating income was $10.5 million versus $14.1 million. The corresponding operating margins were approximately 9.1% and 12.9% in 2013, respectively.
  • Net income and EPS: Q3 net loss applicable to common shares was $7.0 million, or $0.62 per share, compared with a $49,000 loss, or effectively break-even per share, in Q3 2012. Nine-month common income was $463,000, or $0.04 per share, versus a $2.9 million loss, or $0.25 per share, in 2012.
  • Drivers of nine-month earnings: Net income included $25.4 million of gains from discontinued-operation property sales. Continuing operations generated a $13.3 million net loss. Discontinued operations contributed $16.4 million after $8.8 million of related tax expense.
  • Cash flow: Nine-month operating cash flow was negative $12.9 million, an improvement from negative $31.6 million in 2012. Investing activities provided $71.1 million, principally reflecting property-sale proceeds; financing activities used $65.8 million. Cash declined $7.7 million to $9.4 million.
  • Debt and equity: Notes and interest payable totaled $781.5 million at September 30; stock-secured notes and margin debt added $24.3 million. Total liabilities were $979.2 million and shareholders’ equity was $86.2 million. Total assets were $1.065 billion, down from $1.135 billion at year-end 2012.
  • Receivables and related-party exposure: Net notes and interest receivable were $105.1 million, including $20.1 million of allowance for doubtful accounts. Performing notes included $114.2 million gross from related parties. Q3 interest income was $3.8 million, including $3.7 million from related parties.

Material changes versus prior periods

  • Apartment revenue increased, while commercial revenue declined. Management reported apartment occupancy averaging nearly 94%; commercial same-property revenue was weaker.
  • Q3 expenses included a $1.1 million impairment provision and $2.8 million litigation-settlement expense; neither category had a comparable Q3 2012 charge. Nine-month impairment expense was $1.9 million.
  • Nine-month mortgage and loan interest fell to $32.9 million from $35.4 million, primarily because of apartment refinancings at lower rates. However, deferred borrowing-cost amortization rose to $3.7 million and loan charges and prepayment penalties rose to $7.4 million.
  • Property dispositions and lower land-sale gains affected comparability: nine-month gain on land sales was $0.6 million versus $6.6 million in 2012. Discontinued-operation gains were higher, largely reflecting 2013 sales including the Amoco property.
  • Real estate, net, declined to $870.8 million from $930.4 million at December 31, 2012. Notes and interest payable declined from $769.2 million to $751.0 million, before separately reported debt tied to held-for-sale and sales-contract properties and stock-secured borrowings.

Outlook, risks and unusual items

  • Liquidity outlook: Management expected excess cash flow from property operations in 2013 but stated it would not be sufficient to meet all obligations as they came due. Planned sources included property and land sales, refinancing or extending debt, and additional real-estate-secured borrowing. No quantified earnings or revenue guidance was provided.
  • Debt and rate exposure: Management was negotiating modifications or extensions for certain land mortgages. The filing estimates that a 1 percentage-point increase in base rates would reduce annual net income by $1.135 million, based on $113.5 million of variable-rate debt.
  • Contingencies: ARL reported deficiency claims relating to foreclosed assets, with estimated aggregate maximum exposure of approximately $20 million, if any, potentially arising in future years. A separate $74 million Clapper judgment was against ART and ART Midwest, not ARL or its subsidiaries; ART was appealing, and ARL said it had not guaranteed or indemnified those entities.
  • Litigation and settlements: A Texas appellate ruling in the long-running Dynex dispute was favorable to TCI, but further challenges, a damages judgment, and attorney-fee proceedings remained possible. ARL also agreed to a $3.7 million settlement with Far East National Bank, payable in monthly installments.
  • Related parties and governance: The company has no employees and relies on external advisor Pillar. Nine-month advisory fees were $7.6 million. Significant related-party balances and transactions, including loans and deferred property sales, warrant attention because management acknowledged they may not be on arm’s-length terms.
  • Development and asset risks: A 420-acre German resort project faced partner mismanagement and insolvency proceedings. The company was cooperating with an insolvency manager and believed the project value could satisfy creditors and return its investment; that outcome was uncertain. A proposed sale of nine apartment properties remained subject to HUD approval and was not classified as held for sale at quarter-end.
  • Subsequent events: In October 2013, the company refinanced 600 Las Colinas with a $41.0 million mortgage and transferred the Ergon building and adjacent land to a lender for a $3.7 million settlement price.

Important facts for investors to verify

  1. Near-term debt maturities, lender extensions, refinancing terms, and the company’s ability to meet obligations given negative operating cash flow and $9.4 million of cash.
  2. Whether planned asset sales—including the nine-property transaction subject to HUD approval—close on expected terms and generate usable cash after debt repayment.
  3. Collectability and recoverable value of notes receivable, especially related-party and non-performing balances, and the adequacy of the $20.1 million allowance.
  4. Final exposure and payment timing for deficiency claims, the Far East National Bank settlement, and other litigation; distinguish ARL obligations from those of ART and its subsidiaries.
  5. Performance of commercial properties, sustainability of apartment occupancy and rents, and the effect of asset sales on recurring revenue and earnings.
  6. Progress and potential impairment or recovery of the German resort investment, and the extent of future funding needs.
  7. Related-party transactions, advisory costs, and the terms and repayment prospects of related-party loans and deferred sales.