AMERICAN REALTY INVESTORS INC annual report, FY2013

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Business context and reporting period

American Realty Investors, Inc. (ARL) filed this Form 10-K for the fiscal year ended December 31, 2013. ARL is an externally advised real estate company and consolidates Transcontinental Realty Investors, Inc. (TCI) and Income Opportunity Realty Investors, Inc. (IOT). Its portfolio at year-end included 37 apartment communities with 6,398 units, 10 commercial properties totaling about 2.6 million square feet, and approximately 4,198 acres of land. Apartment occupancy averaged 95.61%; commercial occupancy varied substantially by property.

Financial performance and condition

  • Revenue: Rental and other property revenue was $89.6 million, down $0.5 million from $90.1 million in 2012. Apartment revenue increased $3.4 million, offset by a $3.9 million decline in commercial revenue, which management attributed partly to tenants downsizing or leaving.
  • Profit: Operating expenses were $102.1 million and operating loss was $12.4 million, compared with operating income of $10.7 million in 2012. Net loss from continuing operations was $10.0 million. Net income attributable to ARL was $41.3 million; income applicable to common shares was $38.8 million, or $3.37 per diluted share, versus a $8.0 million common loss in 2012. The improvement was primarily driven by $61.7 million of after-tax income from discontinued operations, including large property-sale gains, and a $40.0 million income-tax benefit from continuing operations—not by continuing operating profit.
  • Significant expenses and gains: Impairment provisions were $19.0 million, up from $2.3 million in 2012. Litigation settlement expense was $20.3 million, compared with $0.2 million. Discontinued operations included $99.0 million of property-sale gains before tax. The December sale of nine apartment complexes for $189.6 million generated a reported $73.5 million gain.
  • Cash flow: Operating activities used $42.2 million, versus $26.9 million used in 2012. Investing activities provided $251.8 million, largely from property sales; financing activities used $206.6 million. Cash and cash equivalents ended the year at $16.4 million, with a further $32.9 million classified as restricted cash.
  • Assets, debt and equity: Total assets were $943.3 million, down from $1.135 billion; net real estate was $700.3 million. Notes and interest receivable, net, totaled $136.8 million, including substantial related-party balances. Total indebtedness was reported as approximately $659.0 million, compared with $869.9 million at year-end 2012. Shareholders’ equity was $134.9 million, including non-controlling interests; ARL shareholders’ equity was $89.8 million. Book value per share was $11.70.
  • Debt profile and liquidity: The debt schedule reports $655.6 million of notes payable, including $85.4 million variable-rate and $570.2 million fixed-rate debt; the weighted-average rate was 5.81%, up from 5.09%. Scheduled principal payments were $151.4 million in 2014. Management said available cash plus expected 2014 property cash flow would not cover all requirements and planned asset sales, refinancing, extensions and additional property-secured borrowing. The filing also presents contractual obligations of $1.058 billion including interest and operating leases.

Material changes versus 2012

  • Rental revenue was nearly flat, but commercial same-property revenue declined while apartment revenue grew; management said apartment occupancy remained above 95%.
  • Operating results deteriorated to a loss, reflecting higher impairment, depreciation, general and administrative expense, and advisory-related fees. Mortgage and loan interest expense declined to $38.1 million from $40.1 million, partly due to refinancing at lower rates.
  • Asset-sale activity rose sharply. The company reported $259.1 million of proceeds from income-producing property sales and $14.8 million from land sales in 2013. Real estate net book value fell from $930.4 million to $700.3 million.
  • Debt declined, but cash from operations remained negative and management warned that liquidity would not meet all obligations without further financing or dispositions.

Outlook, risks and unusual items

  • Outlook: No quantified earnings or revenue guidance was provided. Management’s stated liquidity plan relies on selling land and income-producing properties, refinancing or extending debt, and seeking additional secured borrowing. The filing cautions that these actions may not be available on acceptable terms.
  • Near-term financing: Subsequent to year-end, TCI obtained a $40 million loan at 12% interest, with quarterly principal payments after the first year and security over residential-apartment equity interests. This is a material financing cost and collateral commitment.
  • Related parties and governance: Approximately 87.4% of ARL stock was held by related entities. ARL reported $145.7 million of notes and interest receivable due from related parties and $15.6 million of related-party note interest income. Pillar received $10.2 million in advisory fees, $4.1 million in net-income fees and other fees and reimbursements. The filing acknowledges related-party transactions may not be on arm’s-length terms; management and directors also serve TCI and IOT.
  • Defaults, claims and litigation: ARL disclosed deficiency claims related to foreclosed assets, with management estimating aggregate maximum exposure of approximately $20 million. Properties classified as subject to sales contracts include assets whose buyers’ mortgage loans were in default; ARL retained the assets and related obligations in its accounts because sale-recognition criteria were not met. The Port Olpenitz project resulted in a $5.3 million write-off, with recovery litigation ongoing. A favorable appellate ruling in the Dynex case could result in damages for TCI, but the outcome remained subject to further proceedings. A separate judgment involving formerly owned ART was remanded for recalculation; ARL says it has no liability, while its $10 million note receivable from the purchaser of ART remains fully reserved.
  • Other items: Common dividends were not declared for 2013, 2012 or 2011. The auditor issued an unqualified opinion on the financial statements, but did not audit or opine on internal control effectiveness. The filing states disclosure controls were effective; its internal-control discussion refers to management’s assessment as of December 31, 2012, so the period addressed should be checked.

Most important facts for investors to verify

  1. Whether the 2013 common-share profit is sustainable: continuing operations lost $10.0 million, while discontinued operations and asset-sale gains drove reported earnings.
  2. ARL’s ability to meet the $151.4 million of scheduled 2014 principal and other obligations, given negative operating cash flow and management’s stated funding shortfall.
  3. The terms, collateral and repayment capacity associated with the subsequent $40 million, 12% loan, and progress on other refinancing and asset-sale plans.
  4. Collectability and concentration of related-party receivables, especially UHF-related notes, and whether related-party fees and transactions serve ARL’s interests.
  5. Potential exposure from mortgage defaults, deficiency claims, guarantees and unresolved litigation, including the retained assets subject to sales contracts.
  6. The composition and cash/tax effects of the $40.0 million tax benefit and the $33.2 million tax expense reported in discontinued operations.