AMERICAN REALTY INVESTORS INC quarterly report, Q1 FY2014

Business context and reporting period

American Realty Investors, Inc. (ARL) filed this unaudited Form 10-Q for the three months ended March 31, 2014. ARL is an externally advised real estate owner and investor; it consolidates subsidiaries TCI and IOT. At quarter-end, its portfolio included 36 apartment communities with 6,166 units, 10 commercial properties totaling approximately 2.6 million rentable square feet, and 4,209 acres of land. ARL reported 46 income-producing properties, including assets held for sale or subsequently sold.

Financial performance and position

At March 31, 2014, total assets were $940.2 million, total equity $138.5 million, and cash and cash equivalents $18.4 million; restricted cash was an additional $27.7 million. Notes and interest payable totaled $629.4 million on the balance sheet, with another $36.7 million associated with assets held for sale and properties subject to sales contracts. The debt schedule reports total debt, including accrued interest, of $666.1 million. Variable-rate notes totaled $59.2 million at a weighted average 4.73%; management estimated a 1 percentage-point rate increase would reduce annual net income by $0.6 million, or $0.05 per share.

Property operating expenses were $10.3 million and depreciation and amortization was $4.5 million. Rental revenue less property operating expenses was approximately $10.3 million, compared with $10.4 million in Q1 2013; operating income fell to $1.1 million from $2.0 million. Related-party notes and interest receivable were a significant concentration: the filing reports $122.3 million of junior mortgage loans and accrued interest, net of allowances, and $3.1 million of related interest income.

Material changes versus the prior comparable period

• Rental revenue increased $0.2 million, reflecting a $0.7 million increase in apartments partly offset by a $0.5 million decline in commercial properties. Management cited average apartment occupancy of 95% and commercial tenant vacancies.
• Operating expenses rose $0.3 million, depreciation and amortization rose $0.7 million, and related-party net income fees rose from $0.1 million to $0.5 million. These contributed to lower operating income.
• Interest income increased $0.6 million, primarily from new Unified Housing Foundation notes. Mortgage and loan interest expense declined $1.0 million; deferred borrowing-cost amortization declined $1.5 million and loan charges and prepayment penalties declined $2.4 million.
• Q1 2014 included $3.8 million of litigation settlement income and a $0.8 million land-sale gain. Discontinued operations included a $6.1 million gain on the Pecan Pointe apartment sale; the prior-year discontinued-operations gain was $7.2 million. Accordingly, the swing to positive common-share earnings was substantially supported by property-sale gains and other non-recurring items, not stronger operating income.
• Operating cash use increased year over year, while financing cash flow improved from a net outflow to a net inflow. The cash flow statement reports Q1 2013 operating cash use of $9.9 million, whereas MD&A gives $9.1 million; the filing does not reconcile this difference.

Outlook, risks, contingencies, and unusual items

Management expected property operations to generate excess cash flow in 2014 but stated that it would not be sufficient to meet all obligations as they come due. Its stated plan was to sell land and income-producing properties, refinance or extend debt, and obtain additional real-estate-secured borrowings. No earnings or revenue guidance was provided. Management also reported that it was in discussions with lenders regarding certain land mortgages requiring modification or extension.

• On March 28, TCI obtained $40.0 million of financing at 12% for five years, secured by equity interests in residential apartments; it is interest-only for the first year, with quarterly principal payments beginning in April 2015.
• Some mortgages on properties transferred to related parties without recognition of a completed sale are in default, primarily for nonpayment. ARL/TCI may remain exposed through continuing involvement, guarantees, or potential cash shortfalls.
• ARL and a related party guaranteed a $28.0 million LK-Four Hickory loan with a reported outstanding balance of $23.4 million. Separately, management estimated potential exposure from deficiency claims on foreclosed assets at up to approximately $20.0 million in aggregate, if any, in future years.
• The company reported a $122.9 million net deferred tax asset with a 100% valuation allowance. It also stated that ARL had a tax loss after net operating loss carryforwards and recorded no tax provision for federal income tax purposes; the reported financial statements nevertheless include income tax benefits and expense allocations.
• In February, TCI settled the Amoco Building matter by paying $1.2 million; a remaining $3.5 million note balance and accrued interest were forgiven. The quarter also included $3.8 million of litigation settlement income.
• In a legacy Clapper-related case against formerly owned ART entities, an appellate court affirmed part of a judgment but remanded damages for recalculation. ARL management said it believes ARL has no liability; ARL’s $10 million note receivable from the buyer of ART remains fully reserved. A separate Dynex appeal was favorable to TCI, but further challenges and proceedings were expected.
• On April 3, 2014, TCI sold the 1010 Common commercial building for $16.6 million; ARL estimated a $4.1 million gain. Management cautioned that forward-looking statements are subject to risks, including financing availability, interest rates, occupancy, property sales, and development conditions.

Important facts for investors to verify

• Debt maturities, covenant compliance, lender negotiations, and the ability to refinance or sell assets in time to meet obligations.
• Cash conversion and recurring property profitability, given negative operating cash flow and earnings materially affected by sales and settlement items.
• Collectability and collateral support for the large related-party notes receivable, including amounts involving Unified Housing Foundation and other affiliates.
• Potential exposure from guarantees, defaulted mortgages on related-party transactions, deficiency claims, and other litigation.
• The Q1 2013 operating-cash-flow discrepancy between the cash flow statement and MD&A, and the treatment of income taxes and the fully reserved deferred tax asset.
• Related-party governance and transaction terms: approximately 87.4% of ARL stock was owned by related parties, and Pillar is its external advisor and cash manager.