Business context and reporting period
American Realty Investors, Inc. (ARL) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2014. ARL is an externally advised real estate owner and investor; it consolidates Transcontinental Realty Investors (TCI) and Income Opportunity Realty Investors (IOT). Its portfolio included 45 income-producing properties: 37 apartment communities with 6,382 units and eight commercial properties totaling about 2.1 million rentable square feet, plus 4,130 acres of land. The filing reports dollars in thousands unless stated otherwise.
Financial results and position
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Rental and other property revenue | $19.3m | $19.5m | $58.0m | $57.8m |
| Operating income (loss) | $0.5m | $(0.5)m | $0.3m | $1.3m |
| Continuing-operations net income (loss) | $(3.0)m | $(8.1)m | $(4.4)m | $(12.8)m |
| Net income (loss) applicable to common shares | $(1.7)m | $(7.0)m | $2.1m | $0.5m |
| EPS applicable to common shares | $(0.13) | $(0.62) | $0.17 | $0.04 |
- Nine-month net income included $9.3m from discontinued operations, including $14.8m in property-sale gains; the comparable 2013 figures were $15.9m and $25.4m. Continuing operations remained loss-making.
- For the nine months, interest income rose to $15.3m from $10.8m, largely reflecting acquired notes and accrued interest on related-party cash-flow notes. Mortgage and loan interest expense was $26.6m, down from $27.2m. Property operating expenses rose to $30.7m from $29.1m; depreciation and amortization rose to $13.1m from $11.8m.
- At September 30, total assets were $936.0m, total liabilities $791.2m, and total equity $144.8m. Cash and cash equivalents were $4.4m, with restricted cash of $28.8m. Notes and interest receivable, net, were $148.2m, including $18.3m of allowances.
- Balance-sheet notes and interest payable were $597.5m; additional notes related to held-for-sale properties and properties subject to sales contracts were $42.9m and $18.8m, respectively. The debt summary reports $659.1m total debt including accrued interest. Cash-flow interest paid for the nine months was $28.0m.
- Nine-month operating cash flow was negative $6.5m (versus negative $12.9m); investing cash flow was negative $2.8m (versus positive $71.1m); financing cash flow was negative $2.8m (versus negative $65.8m). Cash fell by $12.1m to $4.4m.
- Variable-rate debt was $63.4m at a 5.37% weighted-average rate. Management estimated a 1 percentage-point rate increase would reduce annual net income by about $0.6m, or $0.05 per share.
Material changes versus the prior comparable period
- Q3 common-share loss narrowed to $1.7m from $7.0m. The improvement reflected lower litigation settlement expense, higher interest and other income, and improved discontinued-operations results; revenue was slightly lower.
- Nine-month common-share income rose to $2.1m from $0.5m, but this comparison includes substantial property-sale gains. Continuing-operations loss narrowed to $4.4m from $12.8m, helped by higher interest income and a $3.7m litigation settlement credit, including forgiveness of a $3.5m balance in the Amoco matter.
- Net property-sale proceeds and related gains were lower year over year: the filing reports nine-month income-producing property sale proceeds of $41.7m versus $73.6m, and discontinued-operation sale gains of $14.8m versus $25.4m.
- Debt and refinancing activity remained substantial. Notes and interest payable on the balance sheet declined from $618.9m at year-end 2013 to $597.5m, while cash declined from $16.4m to $4.4m. Common shares issued increased, including 2.5m shares issued in a preferred-stock conversion.
Outlook, management commentary, risks and unusual items
- Management said property operations were expected to generate excess cash flow in 2014, but not enough to meet all obligations as they came due. Planned liquidity sources included property and land sales, refinancing or extending debt, and additional real-estate-secured borrowings. No earnings or revenue guidance was provided.
- Management reported apartment occupancy averaging above 93% and increasing rents, and expected recent commercial leasing efforts to benefit results over the following 12 months. These are management statements, not guarantees.
- Related-party exposure is significant: related parties owned approximately 86.8% of ARL stock. Net junior mortgage loans and accrued interest receivable from related parties totaled $132.4m; the company also reported a $22.9m related-party receivable. ARL disclosed that related-party transactions may not be on arm’s-length terms.
- Some mortgages were in default, particularly on properties transferred to related parties while sales recognition was deferred; the company said borrowers were negotiating with lenders to settle or cure defaults. Certain land mortgages were being modified or extended. Bridgewood Ranch’s reported sale was not recognized because ARL retained a repurchase option and other continuing involvement.
- Management estimated potential exposure on deficiency claims relating to foreclosed assets at no more than approximately $20m in aggregate, if any, potentially in future years. ARL also guaranteed a $22.4m outstanding loan of LK-Four Hickory and maintained reserves for possible related obligations; the filing does not quantify the company’s expected ultimate payment.
- The Clapper litigation judgment was against formerly owned ART and ART Midwest, not ARL, according to management; the appeal remanded damages for recalculation. ARL continues to fully reserve a $10m note received in the ART sale. A separate Dynex appellate ruling was favorable to TCI but remained subject to further challenges and proceedings.
- After quarter-end, TCI sold the 290-unit Blue Ridge complex on November 4, 2014, for $52.8m, repaid a $23.7m mortgage, and recorded a $26.7m gain. Sunset Lodge and adjacent land were under contract, with anticipated prices of $39.4m and $1.2m, respectively; those sales were not yet completed as of the filing.
- ARL reported a $107.2m net deferred tax asset offset by a 100% valuation allowance because management could not determine that realization was more likely than not. Management identified real-estate market, tenant, financing, interest-rate, development, sale-timing, environmental and other risks; it reported no changes to the risks in its 2013 Form 10-K.
Important facts for investors to verify
- Near-term debt maturities, defaults, extensions and refinancing availability, given low unrestricted cash and management’s stated liquidity shortfall.
- Collectability and valuation of the $148.2m net notes receivable portfolio, especially the $132.4m related-party junior loans and accrued interest.
- Actual proceeds, debt repayment and gain recognition from the Blue Ridge sale and the pending Sunset Lodge transactions.
- Potential cash exposure from deficiency claims, guarantees, deferred-sale properties, and other litigation or contingencies.
- How much reported earnings depends on property dispositions, litigation settlements and other nonrecurring items rather than recurring property operations.