American Realty Investors, Inc. — Q2 2015 Form 10-Q
Reporting period: Three and six months ended June 30, 2015; filed August 13, 2015. Unless noted otherwise, dollar amounts below are in millions. The company owns and develops real estate and invests in mortgage notes. At quarter-end, its portfolio included 53 income-producing properties, 7,085 apartment units, approximately 2.2 million rentable square feet of commercial space, and 4,159 acres of land. ARL has no employees and is externally advised by Pillar Income Asset Management. Approximately 86.7% of ARL shares were owned by related parties.
Financial performance
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Rental and other property revenue | $24.2 | $19.5 | $47.4 | $38.7 |
| Operating expenses | $20.4 | $19.9 | $41.5 | $38.9 |
| Net operating income (loss), as presented | $3.9 | $(0.4) | $5.9 | $(0.2) |
| Income (loss) from continuing operations | $1.7 | $(2.0) | $4.4 | $(1.4) |
| Net income | $1.7 | $2.1 | $4.5 | $6.4 |
| Net income applicable to common shares | $0.9 | $0.9 | $3.8 | $3.8 |
| Diluted earnings per share | $0.05 | $0.07 | $0.22 | $0.33 |
Property revenue less property operating expense was $12.9 million in Q2 2015, or approximately 53% of revenue, compared with $9.5 million, or 49%, in Q2 2014. For the six-month periods, the comparable figures were $24.4 million (about 52%) and $18.7 million (about 49%). These are simple calculated property-level measures, not a company-reported margin.
Revenue growth reflected acquisitions and improved same-property results. Management reported apartment occupancy averaging above 95%. Q2 revenue increased $4.7 million year over year; six-month revenue increased $8.7 million. Operating costs and depreciation also rose, partly due to acquired properties. General and administrative expense declined, while mortgage and loan interest expense increased to $21.4 million for the first half from $20.3 million.
Six-month 2015 results included $5.9 million of gains on land sales, including recognition of a previously deferred gain. Other income was $4.1 million, primarily from a settlement agreement with a lender. In 2014, discontinued operations included $13.1 million of gains on sales of income-producing properties. Net income applicable to common shares was unchanged at $3.8 million for the six-month comparisons, but diluted EPS fell from $0.33 to $0.22, alongside a higher diluted weighted-average share count.
Balance sheet, debt and liquidity
- Total assets were $1,076.6 million at June 30, 2015, up from $965.5 million at December 31, 2014. Net real estate was $801.9 million; notes and interest receivable, net, were $125.4 million.
- Cash and cash equivalents were $19.2 million and restricted cash was $52.2 million. Restricted cash is not equivalent to unrestricted operating liquidity.
- Debt was $794.7 million before $20.0 million of unamortized deferred borrowing costs; balance-sheet debt-related liabilities, net of those costs, totaled approximately $774.7 million. Notes and interest payable on the balance sheet increased to $755.5 million from $638.9 million at year-end.
- Total shareholders’ equity was $185.4 million. The company reported $37.4 million receivable from a related party.
- Variable-rate debt totaled $143.8 million, with a weighted-average rate of 8.66%. Management estimated a 1% increase in base rates would reduce annual net income by $1.4 million, or about $0.09 per share. It cited fixed-rate HUD financing with a 3.78% weighted-average rate as a partial offset.
- Operating cash flow was negative $26.6 million, versus negative $5.7 million in the first half of 2014. Investing cash flow was negative $95.7 million, primarily reflecting $105.7 million of income-producing property acquisitions. Financing cash flow was positive $129.1 million, including $203.3 million of note proceeds. Cash increased $6.9 million to $19.2 million.
Management said cash generated by property operations would not be sufficient to meet all obligations as they come due. It plans to sell land and income-producing properties, refinance or extend debt, and seek additional real-estate-secured borrowing. Operating cash use included a $15.9 million increase in related-party receivables; investors should assess the timing and collectability of these balances.
Material transactions, outlook and risks
- Acquisitions and dispositions: During the first half, ARL acquired five apartment complexes, adding 727 units for a combined $42.1 million, and an office building for $16.8 million. It sold about 43 acres of land for $9.1 million and recorded a $4.1 million gain. No income-producing properties were sold in the first half of 2015.
- Financing: In May, the company obtained a $120 million financing commitment, of which $84.4 million was advanced at closing. The five-year, interest-only loan bears interest at 30-day LIBOR plus 10.75% and is secured by equity interests in residential properties. The company also refinanced or modified property loans at lower rates. It stated that it was in compliance with applicable financial covenants at June 30.
- Debt and sale-related concerns: Certain land mortgages were being modified or extended. Mortgages on properties transferred to a related party under deferred sale accounting were in default, primarily for nonpayment; ARL said discussions with lenders were ongoing. The transfers were not recognized as sales because of continuing involvement and uncertainty over recovery of the company’s investment.
- Management outlook: No numerical earnings or revenue guidance was provided. Management expected excess cash flow from property operations in 2015, but explicitly said it would not cover all obligations as due. It cited asset sales, refinancing and additional borrowing as intended liquidity sources.
- Litigation and contingencies: A July 20, 2015 judgment awarded ART $24.9 million, TCI $19.5 million and Basic $0.4 million, plus post-judgment interest and collectively $1.6 million in attorneys’ fees, against Dynex Commercial. ARL said it was reviewing next steps; collection and the effect on ARL are not established in the filing. ARL also disclosed a guarantee of a $22.1 million LK-Four Hickory loan and potential related obligations. Other litigation includes the Clapper matter; management denied ARL liability but reported that a $10 million note receivable connected with the sale of ART remained fully reserved.
- Related parties and reporting: Related-party transactions include substantial mortgage-note interest income, advisory fees and property transactions. ARL adopted the revised discontinued-operations standard in 2015, which changes which property sales qualify for discontinued-operations presentation and affects comparability. Management reported effective disclosure controls and no material change in internal control over financial reporting.
- Key risks: Financing availability and cost, substantial debt and refinancing needs, variable interest rates, property occupancy and rents, development execution, asset-sale timing, related-party exposures, and the collection of notes and receivables. The company’s $97.1 million net deferred tax asset was fully offset by a valuation allowance because realization was not considered more likely than not.
Important facts for investors to verify
- Availability, terms and covenant compliance of financing, including how much of the $120 million facility was ultimately funded and the effect of its LIBOR-plus-10.75% rate.
- Debt maturities, extension or modification outcomes, and the company’s capacity to meet obligations given negative operating cash flow and management’s stated liquidity shortfall.
- Collectability and settlement of related-party receivables and mortgage notes, including the $37.4 million related-party receivable and the concentration of related-party notes.
- Status and potential recovery from the Dynex judgment, and the exposure under the LK-Four Hickory guarantee and other litigation.
- Default status and resolution of mortgages associated with properties subject to related-party sales contracts, including any cash support or guarantee obligations.
- Whether acquisitions, occupancy above 95%, same-property improvements and land-sale gains translate into sustainable operating cash flow and earnings, excluding unusual gains and presentation changes.