American Realty Investors, Inc. — Q2 2014 Form 10-Q
Reporting period: Three and six months ended June 30, 2014; comparisons are with the corresponding 2013 periods. Amounts below are in U.S. dollars; financial figures are in millions unless stated otherwise.
Business context
ARL is an externally advised real estate owner and investor, with residential apartments, commercial properties, land and mortgage notes receivable. At June 30, 2014, its portfolio included 36 apartment communities with 6,166 units, nine commercial properties totaling approximately 2.1 million rentable square feet, and 4,155 acres of land. ARL reported that it had no employees.
Financial results and liquidity
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Rental and other property revenue | $20.8 | $20.4 | $41.3 | $40.6 |
| Operating income | $0.4 | $1.3 | $1.5 | $3.2 |
| Net income (loss) from continuing operations | $(1.7) | $0.8 | $(0.8) | $(4.2) |
| Net income attributable to ARL | $1.5 | $8.4 | $5.1 | $8.7 |
| Net income applicable to common shares | $0.9 | $7.7 | $3.8 | $7.5 |
| Basic and diluted EPS | $0.08 | $0.67 | $0.33 | $0.65 |
Operating margin, calculated as operating income divided by property revenue, was approximately 2.1% in Q2 2014 versus 6.3% in Q2 2013, and 3.5% for the first half of 2014 versus 7.9% a year earlier. Common-share earnings included substantial gains from discontinued property operations: $3.8 million in Q2 and $7.3 million for the first half of 2014. Continuing operations remained loss-making in both 2014 periods.
- Cash flow: Operating activities used $5.7 million in the first half, compared with $12.6 million used in 2013. Investing activities provided $25.6 million, down from $72.8 million, principally reflecting lower property-sale proceeds. Financing activities used $22.6 million, versus $68.0 million. Cash and cash equivalents decreased $2.7 million to $13.7 million; restricted cash was $26.2 million.
- Debt and balance sheet: Total debt shown in the debt note was $645.4 million, including accrued interest. Total assets were $922.2 million, total liabilities $782.3 million and total equity $139.9 million. Notes and interest receivable, net of allowance, totaled $138.0 million; $146.8 million of performing notes were from related parties before allowance and other adjustments.
- Debt sensitivity: $68.9 million of notes payable carried variable rates; management estimated a 1 percentage-point rate increase would reduce annual net income by about $0.7 million, or $0.06 per share.
Material changes and significant items
- First-half property revenue rose $0.7 million, as apartment revenue increased $1.5 million while commercial revenue declined $0.8 million. Management reported apartment occupancy averaging above 95%; it cited commercial leasing efforts and expected benefits from new leases over the following 12 months.
- First-half property operating costs increased $1.3 million, with higher real estate taxes and non-recurring repair work cited. General and administrative costs rose $1.1 million, mainly from professional fees and franchise taxes. First-half net income was also affected by $3.8 million in litigation settlement income/expense presentation, primarily related to the Amoco Building settlement, and $1.6 million of loan charges and prepayment penalties.
- Property sales included Pecan Pointe, a 232-unit apartment complex sold for $23.1 million with a $6.1 million gain, and 1010 Common, a commercial building sold for $16.6 million with a $7.0 million gain. The first-half statements report $13.1 million of gains on sales in discontinued operations.
- ARL reported a $40 million financing secured by residential apartment equity interests, bearing 12% interest, interest-only for the first year, and with quarterly principal payments beginning in April 2015. It also reported various land mortgages being modified or extended as loans approached expiry.
- At June 30, the company had $76.1 million in deferred revenue associated with related-party sales. Properties classified as subject to sales contracts were not recognized as completed sales because of continuing involvement; related mortgage defaults were attributed primarily to lack of payment, and the borrowers were in discussions with lenders.
- Related-party exposure is significant: approximately 87.4% of ARL stock was owned by related parties. Related-party notes generated $10.0 million of first-half interest income, and the company reported a $26.1 million receivable from a related party at quarter-end.
- After quarter-end, a July 17 conversion of 890,797 Series A preferred shares resulted in issuance of 2,502,230 common shares at $6.07 per share. The filing reports 14,027,619 common shares outstanding at August 5, versus 11,525,389 at June 30.
Outlook, risks and contingencies
Management expected property operations to generate excess cash flow in 2014, but stated it would not be sufficient to meet all obligations as they came due. Its plans included selling land and income-producing properties, refinancing or extending debt, and obtaining additional real-estate-secured borrowings. No quantified earnings or revenue guidance was provided.
- The company described deficiency claims related to foreclosed assets and estimated aggregate maximum exposure, if any, of approximately $20 million, potentially in future years.
- ARL had guaranteed a $28 million LK-Four Hickory loan, with a reported outstanding balance of $23.4 million, and maintained reserves for possible obligations connected with related parties’ ability to meet their commitments.
- Management reported no material environmental liability known to it. It also stated that previously disclosed risk factors had not changed.
- ARL had a $123.2 million net deferred tax asset, fully offset by a valuation allowance because management could not determine that realization was more likely than not.
- Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Debt maturities, covenant status and the progress of land-loan modifications, given management’s statement that operating cash flow would not cover all obligations.
- Cash conversion and the sustainability of reported earnings, particularly the continuing-operations losses and reliance on property-sale gains.
- Collectability, payment terms and collateral support for related-party notes and receivables, including notes tied to Unified Housing Foundation and other related entities.
- Status of mortgages in default on properties subject to sales contracts, and whether those transactions will ultimately close or be reversed.
- Potential cash exposure from deficiency claims and guarantees, and developments in the disclosed litigation matters.
- The effects of the July preferred-stock conversion on common-share dilution, dividends and voting ownership.