<PAGE>
 
                                   FORM 10-Q

               UNITED STATES SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C.  20549

(Mark One)
[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

     For the quarterly period ended     March 31, 1998
                                    ----------------------------------------

                                       OR

[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

     For the transition period from ________________ to___________________

                        Commission file number  0-20253

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
            (Exact name of registrant as specified in its charter)

          Wisconsin                                       39-1660958
(State or other jurisdiction of                        (I.R.S.Employer
 incorporation or organization)                      Identification No.)

           101 W. 11th St., Suite 1110, Kansas City, Missouri 64105
         (Address of principal executive offices, including zip code)

                                (816) 421-7444
             (Registrant's telephone number, including area code)


       Securities registered pursuant to Section 12(b) of the Act:  None

         Securities registered pursuant to Section 12(g) of the Act:  
                         Limited Partnership Interests

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes  X   No
                                       ---     ---   
<PAGE>
 

                        PART I - FINANCIAL INFORMATION
                         Item 1. Financial Statements

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                                BALANCE SHEETS

                     March 31, 1998 and December 31, 1997
                     ------------------------------------

                                    ASSETS

<TABLE>
<CAPTION>
                                                                     (Unaudited)
                                                                      March 31,     December 31,
                                                                        1998            1997
                                                                     -----------    ------------
<S>                                                                  <C>            <C>
INVESTMENT PROPERTIES: (Note 3)
  Land                                                               $ 1,553,680     $ 2,030,982
  Buildings and improvements                                           2,650,334       3,309,464
  Accumulated depreciation                                              (651,622)       (761,861)
                                                                     -----------     -----------
    Net investment properties                                          3,552,392       4,578,585
                                                                     -----------     -----------

OTHER ASSETS:

  Cash and cash equivalents                                            1,461,639         595,420
  Cash held in Indemnification Trust (Note 8)                            295,165         290,662
  Rents and other receivables                                             14,249          23,062
  Deferred rent receivable                                                22,037          31,029
  Deferred fees                                                           21,078          21,524
  Prepaid assets                                                           2,554           3,649
                                                                     -----------     -----------

    Total other assets                                                 1,816,722         965,346
                                                                     -----------     -----------

DUE FROM FORMER AFFILIATES: (Note 2)

  Due from former general partner affiliates                           1,734,417       1,734,417
  Allowance for uncollectible amounts due from former affiliates      (1,734,417)     (1,734,417)
  Restoration cost receivable                                          5,336,536       5,181,441
  Allowance for uncollectible restoration receivable                  (5,336,536)     (5,181,441)
                                                                     -----------     -----------

    Due from former affiliates, net                                            0               0
                                                                     -----------     -----------

    Total assets                                                     $ 5,369,114     $ 5,543,931
                                                                     ===========     ===========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       2
<PAGE>
 

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                       LIABILITIES AND PARTNERS' CAPITAL

                     March 31, 1998 and December 31, 1997
                     ------------------------------------

<TABLE>
<CAPTION>
                                                                     (Unaudited)
                                                                      March 31,     December 31,
                                                                        1998            1997
                                                                     -----------    ------------
<S>                                                                  <C>            <C>
LIABILITIES:
  Accounts payable and accrued expenses                              $    28,546     $    25,331
  Due to current General Partner                                             913           1,395
  Security deposits                                                       16,635          36,819
  Unearned rental income                                                  42,528          42,254
                                                                     ------------    ------------

    Total liabilities                                                     88,622         105,799
                                                                     ------------    ------------

CONTINGENT LIABILITIES: (Note 7)

PARTNER'S CAPITAL: (Notes 1, 4 and 11)

Current General Partner -
  Cumulative net income (loss)                                            17,728          15,445
  Cumulative cash distributions                                           (7,553)         (6,640)
                                                                     ------------    ------------

                                                                          10,175           8,805
                                                                     ------------    ------------

Limited Partners (17,102.52 interests outstanding)
  Capital contributions, net of offering costs                        14,408,872      14,408,872
  Cumulative net loss                                                        (81)       (226,070)
  Cumulative cash distributions                                       (8,872,983)     (8,487,984)
  Reallocation of former general partners' deficit capital              (265,491)       (265,491)
                                                                     ------------    ------------

                                                                        5,270,317       5,429,327
                                                                     ------------    ------------

      Total partners' capital                                           5,280,492       5,438,132
                                                                     ------------    ------------

      Total liabilities and partners' capital                        $  5,369,114    $  5,543,931
                                                                     ============    ============
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       3
<PAGE>
 

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                             STATEMENTS OF INCOME

                                  (Unaudited)
                                  -----------

<TABLE>
<CAPTION>
                                                       Three Months Ended March 31,
                                                       ----------------------------
                                                         1998                1997
                                                       --------            --------
<S>                                                    <C>                 <C>
REVENUES:
  Rental income                                        $104,019            $160,999
  Interest income on direct financing leases                  0               1,150
  Interest income                                        16,369               8,715
  Other income                                               42                 294
  Gain on sale of assets                                238,698                   0
  Recovery of amounts previously written off                  0               2,571
                                                       --------            --------

                                                        359,128             173,729
                                                       --------            --------

EXPENSES:                                                          
  Partnership management fees                            16,045              15,620
  Disposition fees                                       37,500                   0
  Restoration fees                                            0                 103
  Insurance                                               1,095               1,327
  General and administrative                             12,115              10,216
  Advisory Board fees and expenses                        4,358               3,422
  Professional services                                  22,589              12,280
  Professional services related to investigation            479              19,930
  Appraisal fees                                         13,900                   0
  Depreciation                                           22,329              29,330
  Amortization                                              446                 446
                                                       --------            --------

                                                        130,856              92,674
                                                       --------            --------

NET INCOME                                             $228,272            $ 81,055
                                                       ========            ========

NET INCOME - GENERAL PARTNER                           $  2,283            $    811

NET INCOME - LIMITED PARTNERS                           225,989              80,244
                                                       --------            --------

                                                       $228,272            $ 81,055
                                                       ========            ========

NET INCOME PER LIMITED PARTNERSHIP                                   
INTEREST, based on 17,102.52 interests outstanding       $13.21               $4.69
                                                         ======               =====
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       4
<PAGE>
 

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                           STATEMENTS OF CASH FLOWS

                                  (Unaudited)
                                  -----------

<TABLE>
<CAPTION>
                                                                        Three Months Ended March 31,
                                                                        ----------------------------
                                                                           1998              1997
                                                                        ----------        ----------
<S>                                                                     <C>               <C>
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
  Net income                                                            $  228,272        $   81,055
  Adjustments to reconcile net income to net cash from (used in)
   operating activities -
    Depreciation and amortization                                           22,775            29,776
    Gain on sale of assets                                                (238,698)                0
    Recovery of amounts previously written off                                   0            (2,571)
    Interest applied to Indemnification Trust Account                       (4,503)           (3,936)
    Decrease in rents, other receivables and prepaid assets                  9,908             5,330
    Decrease in deferred rent receivable                                     8,992               729
    Deposits applied for real estate taxes                                       0            74,260
    Increase/(Decrease) in accounts payable and accrued expenses             3,216            (7,511)
    (Decrease) in due to General Partner                                      (482)          (49,003)
    Increase in unearned rental income                                         274            22,257
    (Decrease in security deposits                                         (20,184)                0
    (Decrease) in real estate taxes payable                                      0           (81,217)
                                                                        ----------        ----------

        Net cash provided from operating activities                          9,570            69,169
                                                                        ----------        ----------

CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:                                         
  Principal payments received on direct financing leases                         0            12,230
  Recoveries from former affiliates                                              0             2,571
  Proceeds from sale of assets                                           1,242,562                 0
                                                                        ----------        ----------

        Net cash provided from investing activities                      1,242,562            14,801
                                                                        ----------        ----------

CASH FLOWS (USED IN) FINANCING ACTIVITIES:                                              
  Cash distributions to General Partner                                       (913)             (324)
  Cash distributions to Limited Partners                                  (385,000)         (925,000)
                                                                        ----------        ----------

        Net cash (used in) financing activities                           (385,913)         (925,324)
                                                                        ----------        ----------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                       866,219          (841,354)

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                           595,420         1,155,128
                                                                        ----------        ----------

CASH AND CASH EQUIVALENTS AT END OF PERIOD                              $1,461,639        $  313,774
                                                                        ==========        ==========
</TABLE> 

       The accompanying notes are an integral part of these statements.
 
                                      5 
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                         NOTES TO FINANCIAL STATEMENTS


These unaudited interim financial statements should be read in conjunction with
DiVall Income Properties 3, Limited Partnership's (the "Partnership") 1997
annual audited financial statements within Form 10-K.

These unaudited financial statements include all adjustments which are, in the
opinion of management, necessary to present a fair statement of financial
position as of March 31, 1998, and the results of operations for the three-month
periods ended March 31, 1998, and 1997, and cash flows for the three-month
periods ended March 31, 1998 and 1997. Results of operations for the periods are
not necessarily indicative of the results to be expected for the full year.

The following significant event(s) have occured subsequent to fiscal year 1997,
which require disclosure in this interim report per Regulation S-X, Rule 10-01,
Paragraph (a) (5):

During the first quarter of 1998, the Partnership sold its Denny's property in
Sanford, Florida for $1,250,000. The sale took place in January 1998, resulting
in a gain, before disposition fees of approximately $240,000.

1.   ORGANIZATION AND BASIS OF ACCOUNTING:
 
DiVall Income Properties 3 Limited Partnership (the "Partnership") was formed on
December 12, 1989, pursuant to the Uniform Limited Partnership Act of the State
of Wisconsin. The initial capital which was contributed during 1989, consisted
of $300, representing aggregate capital contributions of $200 by the former
general partners and $100 by the Initial Limited Partner.

The Partnership initially offered two classes of Limited Partnership interests
for sale: Distribution interests ("D-interests") and Retention interests 
("R-interests"). Each class was offered at a price (before volume discounts) of
$1,000 per interest. The Partnership offered the two classes of interests
simultaneously up to an aggregate of 25,000 interests.

The minimum offering requirements for the D-interests were met and escrowed
subscription funds were released to the Partnership as of July 13, 1990. The
offering closed on April 23, 1992, at which point 17,102.52 D-interests had been
issued, resulting in aggregate proceeds, net of discounts and offering costs, of
$14,408,872.

The minimum offering requirements for R-interests were not met. During 1991,
680.9 R-interests were converted to D-interests and were reflected as
Partnership issuances in 1991.

The Partnership is currently engaged in the business of owning and operating its
investment portfolio (the "Properties") of commercial real estate. The
Properties are leased on a triple net basis to, and operated by, franchisors or
franchisees of national, regional and local retail chains under long-term
leases. The lessees consist of fast-food, family style, and casual/theme
restaurants. At March 31, 1998, the Partnership owned five (5) properties and
specialty leasehold improvements for use in all five (5) of the Properties.

                                       6
<PAGE>
 
Rental revenue from investment properties is recognized on the straight-line
basis over the life of the respective lease. Revenue from direct financing
leases is recognized at level rates of return over the term of the lease.

Depreciation of the properties is provided on a straight-line basis over 31.5
years, which is the estimated useful lives of the buildings and improvements.

Deferred charges consist of leasing commissions paid when properties are leased
to tenants other than the original tenant. Leasing commissions are capitalized
and amortized over the life of the lease.

Real estate taxes on the Partnership's investment properties are the
responsibility of the tenant. However, when a tenant fails to make the required
tax payments or when a property becomes vacant, the Partnership makes the
appropriate payment to avoid possible foreclosure of the property. Taxes are
accrued in the period for which the liability is incurred.

Cash and cash equivalents include cash on deposit in financial institutions and
highly liquid temporary investments with initial maturities of 90 days or less.

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities (and disclosure of
contingent assets and liabilities) at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

The Partnership will be dissolved on December 1, 2015, or earlier upon the prior
occurrence of any of the following events: (a) the disposition of all interests
in real estate and other Partnership assets; (b) the decision by Majority Vote
of the Limited Partners to dissolve the Partnership or to compel the sale of all
or substantially all of the Partnership's assets; (c) the failure to elect a
successor General Partner within six months after removal of the last remaining
General Partner; or (d) the date of the death or the effective date of
dissolution, removal, withdrawal, bankruptcy, or incompetency of the last
remaining General Partner, unless the Partnership is continued by vote of all
Limited Partners and a replacement General Partner is previously elected by a
majority of the Limited Partners.

No provision for Federal income taxes has been made, as any liability for such
taxes would be that of the individual partners rather than the Partnership. At
December 31, 1998, the tax basis of the Partnership's assets exceeded the
amounts reported in the accompanying financial statements by approximately
$2,800,000.

2.   REGULATORY INVESTIGATION:

A preliminary investigation during 1992 by the Office of the Commissioner of
Securities for the State of Wisconsin and the Securities and Exchange Commission
(the "Investigation") revealed that during at least the three years ended
December 31, 1992, the former general partners of the Partnership, Gary J.
DiVall ("DiVall") and Paul E. Magnuson ("Magnuson") had transferred substantial
cash assets of the Partnership and two affiliated publicly registered
partnerships, DiVall Insured Income Fund Limited Partnership ("DiVall 1") and
DiVall Insured Income Properties 2 Limited Partnership ("DiVall 2")
(collectively the "Partnerships") to various other entities previously sponsored
by or otherwise affiliated with DiVall and

                                       7
<PAGE>
 
Magnuson. The unauthorized transfers were in violation of the respective
Partnership Agreements and resulted, in part, from material weaknesses in the
internal control system of the Partnerships. The aggregate amount of the
misappropriation, related costs, and 9% interest accrued since January 1, 1993,
is in excess of $15,100,000, of which approximately $7,071,000 has been
attributed to the Partnership and is reflected as due from former affiliates on
the balance sheet at March 31, 1998. The 9% interest accrued as of March 31,
1998, amounted to approximately $2,969,000 and is not reflected in the
accompanying income statement. As of December 31, 1997, $6,916,000 was reflected
as due from former affiliates based on an estimated overall misappropriation and
related costs of $14,800,000.

Subsequent to discovery, and in response to the regulatory inquiries, a third-
party Permanent Manager, The Provo Group, Inc. ("TPG"), was appointed (effective
February 8, 1993) to assume responsibility for daily operations and assets of
the Partnerships as well as to develop and execute a plan of restoration for the
Partnerships. Effective May 26, 1993, the Limited Partners, by written consent
of a majority of interests, elected the Permanent Manager, TPG, as General
Partner. TPG terminated the former general partners by accepting their tendered
resignations.

In 1993, the current General Partner estimated an aggregate recovery of $3
million for the Partnerships. At that time, an allowance was established against
amounts due from former general partners and their affiliates reflecting the
estimated $3 million receivable. This net receivable was allocated among the
Partnerships based on each Partnership's pro rata share of the total
misappropriation. Through March 31, 1998, $5,766,000 of recoveries have been
received which exceeded the original estimate of $3 million. As a result, the
Partnership has recognized $1,283,000 as income, which represents its share of
the excess recovery. The current General Partner continues to pursue recoveries
of the misappropriated funds, however no further significant recoveries are
anticipated.

3.   INVESTMENT PROPERTIES:

As of March 31, 1998, the Partnership owned five (5) fast-food restaurants
comprised of: two (2) Hardee's restaurants, one (1) Applebee's restaurant, and
two (2) Denny's restaurants. The five (5) properties are located in three (3)
states.

The total cost of the investment properties includes the original purchase price
plus acquisition fees and other capitalized costs paid to an affiliate of the
former general partners.

During January 1998, the Partnership sold its Denny's property in Sanford,
Florida, to the tenant for $1,250,000, resulting in a gain, before disposition
fees, of approximately $239,000.

According to the Partnership Agreement, the former general partners were to
commit 82% of the original offering proceeds to the acquisition of investment
properties. Upon full investment of the net proceeds of the offering,
approximately 57% of the original offering proceeds was invested in the
Partnership's properties.

The current General Partner receives a fee for managing the Partnership equal to
4% of gross receipts, with a maximum reimbursement for office rent and related
overhead of $25,000 between the three affiliated Partnerships as provided in the
Permanent Manager Agreement ("PMA"). On May 26, 1993, the Permanent Manager,
TPG, replaced the former general partners as the new General Partner, as
provided for in an amendment to the Partnership Agreement dated May 26, 1993.
Pursuant to amendments to the

                                       8
<PAGE>
 
Partnership Agreement, TPG continues to provide management services for the same
fee structure as provided in the PMA mentioned above. Effective March 1, 1998,
the minimum management fee and the maximum reimbursement for office rent and
overhead increased by 1.6% representing the allowable annual Consumer Price
Index adjustment per the PMA. For purposes of computing the 4% overall fee,
gross receipts includes amounts recovered in connection with the
misappropriation of assets by the former general partners and their affiliates.
TPG has received fees from the Partnership totaling $87,897 to date on the
amounts recovered, which has been offset against the 4% minimum fee.

Several of the Partnership's property leases contain purchase option provisions
with stated purchase prices in excess of the original cost of the properties.
The current General Partner is unaware of any unfavorable purchase options in
relation to original cost.

4.   PARTNERSHIP AGREEMENT:

The Partnership Agreement, prior to an amendment effective May 26, 1993,
provided that, for financial reporting and income tax purposes, net profits or
losses from operations were allocated 90% to the Limited Partners and 10% to the
former general partners. The Partnership Agreement also provided that Net Cash
Receipts, as defined, would be distributed 90% to the Limited Partners and 10%
to the former general partners, except that distributions to the former general
partners in excess of 1% in any calendar year would be subordinated to
distributions to the Limited Partners in an amount equal to their Original
Property Distribution Preference, as defined.

Net proceeds, as defined, were to be distributed as follows: (a) 1% to the
General Partners and 99% to the Limited Partners, until distributions to the
Limited Partners equal their Original Capital, as defined, plus their Original
Property Liquidation Preference, as defined, and (b) the remainder 90% to the
Limited Partners and 10% to the General Partners. Such distributions were to be
made as soon as practicable following the sale, financing or refinancing of an
original property.

On May 26, 1993, pursuant to the results of a solicitation of written consents
from the Limited Partners, the Partnership Agreement was amended to replace the
former general partners and amend various sections of the agreement. The former
general partners were replaced as General Partner, by The Provo Group, Inc., an
Illinois corporation. Under the terms of the amendment, net profits or losses
from operations are allocated 99% to the Limited Partners and 1% to the current
General Partner. The amendment also provided for distributions from Net Cash
Receipts to be made 99% to the Limited Partners and 1% to its current General
Partner. Pursuant to the amendments to the Partnership Agreement effective June
30, 1994, distributions of Net Cash Receipts will not be made to the General
Partner unless and until each Limited Partner has received a distribution from
Net Cash Receipts in an amount equal to 10% per annum, cumulative simple return
on his or her Adjusted Original Capital, as defined, from the Return Calculation
Date, as defined, except to the extent needed by the General Partner to pay its
federal and state incomes taxes on the income allocated to it attributable to
such year. Distributions paid to the General Partner are based on the estimated
tax liability as a result of allocated income. Subsequent to the filing of the
General Partner's income tax returns, a true-up of actual distributions is made.
Net proceeds, as defined, was also amended to be distributed 1% to the current
General Partner and 99% to the Limited Partners.

Additionally, as per the amendment of the Partnership Agreement dated May 26,
1993, the total compensation paid to all persons for the sale of the investment
properties shall be limited to a competitive real estate commission, not to
exceed 6% of the contract price for the sale of the property. The General

                                       9
<PAGE>
 
Partner may receive up to one-half of the competitive real estate commission,
not to exceed 3%, provided that the General Partner provides a substantial
amount of services in the sales effort. It is further provided that a portion of
the amount of such fees payable to the General Partner is subordinated to its
success at recovering the funds misappropriated by the former general partners.
(See Note 8.)

Effective June 1, 1993, the Partnership Agreement was amended to (i) change the
definition of "Distribution Quarter" to be consistent with calendar quarters,
and (ii) change the distribution provisions to subordinate the General Partner's
share of distributions from Net Cash Receipts and Net Proceeds, except to the
extent necessary for the General Partner to pay its federal and state income
taxes on Partnership income allocated to the General Partner. Because these
amendments do not adversely affect the rights of the Limited Partners, pursuant
to section 10.2 of the Partnership Agreement, the amendments were made by the
General Partner without a vote of the Limited Partners.

5.   LEASES:

Lease terms for the investment properties are 20 years from their inception. The
leases provide for minimum rents and additional rents based upon percentages of
gross sales in excess of specified breakpoints. The lessee is responsible for
occupancy costs such as maintenance, insurance, real estate taxes, and
utilities. Accordingly, these amounts are not reflected in the statements of
income, except in circumstances where, in management's opinion, the Partnership
will be required to pay such costs to preserve assets (i.e., payment of past-due
real estate taxes). Management has determined that the leases are properly
classified as operating leases; therefore, rental income is reported when earned
and the cost of the property, excluding the cost of the land, is depreciated
over its estimated useful life.

Aggregate minimum lease payments to be received under the leases for the
Partnership's properties are as follows:

<TABLE>
<CAPTION>

          Year ending
          December 31,
<S>                                                             <C>
 
             1998                                               $  409,380
             1999                                                  409,380   
             2000                                                  409,380
             2001                                                  409,380
             2002                                                  409,380
          Thereafter                                             3,141,338 
                                                                ----------
                                                                $5,188,238
                                                                ==========
</TABLE>

Two (2) of the Partnership's properties are leased to a Denny's franchisee. Base
rent from these properties amounted to approximately 21% of total base rent in
1997.

The original offering document required the Partnership to lease its properties
to a single tenant as long as the properties so leased do not constitute; in the
aggregate, more than 20% of the aggregate gross proceeds of the offering. As of
March 31, 1998, the Partnership has leased two of its properties to Hardees Food
Systems, Inc., which constitute 21% of the aggregate gross proceeds.

                                      10
<PAGE>
 
6.   TRANSACTIONS WITH CURRENT GENERAL PARTNER:

Amounts paid to the current General Partner for the quarters ended March 31,
1998 and 1997, are as follow:

<TABLE>
<CAPTION>
                                               Incurred as of  Incurred as of
     Current General Partner                   March 31, 1998  March 31, 1997
     ----------------------                    --------------  --------------
     <S>                                       <C>             <C>           
     Management fees                                  $16,045         $15,620
     Disposition fees                                  37,500               0
     Restoration fees                                       0             103
     Cash distribution                                    913             324
     Overhead allowance                                 1,294           1,288
     Reimbursement for out-of-pocket expenses           3,161           2,432
                                                      -------         -------
                                                      $58,913         $19,767
                                                      =======         ======= 
</TABLE>

7.   CONTINGENT LIABILITIES:

According to the Partnership Agreement, as amended, the current General Partner
may receive a disposition fee not to exceed 3% of the contract price of the sale
of investment properties. Fifty percent (50%) of all such disposition fees
earned by the current General Partner is to be escrowed until the aggregate
amount of recovery of the funds misappropriated from the Partnerships by the
former general partners is greater than $4,500,000. Upon reaching such recovery
level, full disposition fees will thereafter be payable and fifty percent (50%)
of the previously escrowed amounts will be paid to the current General Partner.
At such time as the recovery exceeds $6,000,000 in the aggregate, the remaining
escrowed disposition fees shall be paid to the current General Partner. If such
levels of recovery are not achieved, the current General Partner will contribute
the amounts escrowed towards the recovery. In lieu of an escrow, 50% of all such
disposition fees have been paid directly to the restoration account and then
distributed among the three Partnerships. After surpassing the $4,500,000
recovery level during March 1996, 50% of the amounts previously escrowed was
refunded to the current General Partner. The remaining amount allocated to the
Partnerships may be owed to the current General Partner if the $6,000,000
recovery level is met. As of March 31, 1998, the Partnership may owe the current
General Partner $18,862, which is currently reflected as a recovery, if the
$6,000,000 recovery level is achieved, which is unlikely.

8.   PMA INDEMNIFICATION TRUST:

The Permanent Manager Agreement ("PMA") provides that the Permanent Manager will
be indemnified from any claims or expenses arising out of or relating to the
Permanent Manager serving in such capacity or as substitute general partner, so
long as such claims do not arise from fraudulent or criminal misconduct by the
Permanent Manager. The PMA provides that the Partnership fund this
indemnification obligation by establishing a reserve of up to $250,000 of
Partnership assets which would not be subject to the claims of the Partnership's
creditors. An Indemnification Trust ("Trust") serving such purposes has been
established at United Missouri Bank, N.A. The Trust has been fully funded with
Partnership assets as of

                                      11
<PAGE>
 
March 31, 1998. Funds are invested in U.S. Treasury securities. In addition,
interest totaling $45,165 has been credited to the Trust as of March 31, 1998.
The rights of the Permanent Manager to the Trust shall be terminated upon the
earliest to occur of the following events: (i) the written release by the
Permanent Manager of any and all interest in the Trust; (ii) the expiration of
the longest statute of limitations relating to a potential claim which might be
brought against the Permanent Manager and which is subject to indemnification;
or (iii) a determination by a court of competent jurisdiction that the Permanent
Manager shall have no liability to any person with respect to a claim which is
subject to indemnification under the PMA. At such time as the indemnity
provisions expire or the full indemnity is paid, any funds remaining in the
Trust will revert back to the general funds of the Partnership.

9.   RESTORATION TRUST ACCOUNT AND EXPENSE ALLOCATIONS:

Restoration costs represent expenses incurred by the Partnership in relation to
the misappropriated assets by the former general partners and their affiliates.
These costs are allocated among the Partnerships based on each partnership's
respective share of the entire misappropriation, as currently quantified. The
amount of misappropriation for each partnership is adjusted annually to reflect
new discoveries and more accurate quantification of amounts based on the
continuing investigation. Such adjustments will result in periodic adjustments
to prior allocations of recovery costs to reflect updated information.
Consequently, previous payments for restoration expenses may not be consistent
with modified allocations.

Recoveries realized by the Partnerships are being distributed to each respective
partnership on the same basis as the restoration costs are currently being
allocated, adjusted for any future changes in the entire misappropriation, as a
result of the continuing investigation. As of March 31, 1997, the Partnerships
recovered a total of approximately $5,126,000 from the former general partners
and their affiliates. Of this amount, the Partnership received its pro-rata
share in the amount of $2,390,000. Additionally, $40,347, representing 50% of
all previously escrowed disposition fees earned by the General Partner, have
been paid to the recovery. Of that amount, $18,862 was allocated to the
Partnership and is contingently payable to the General Partner upon achievement
of the final recovery level as described in Note 7.

The PMA contemplated that the Permanent Manager could establish a separate and
distinct Restoration Trust Fund which would hold all recoveries until a final
independent adjudication by a court of competent jurisdiction or vote of the
Limited Partners ratified the allocation of proceeds to each respective
partnership. Management has concluded that a fair and reasonable interim
accounting for recovery proceeds can be accomplished at the partnership level in
a manner similar to restoration costs which are paid directly by the
Partnerships. Management reserves the right to cause the final allocation of
such costs and recoveries to be determined either by a vote of the Limited
Partners or a court of competent jurisdiction. Potential sources of recoveries
include third party litigation, promissory notes, land contracts, and personal
assets of the former general partners and their affiliates.

10.  LITIGATION:

As part of the Permanent Manager Agreement, DiVall, Magnuson, and entities owned
by them, granted the Partnership a security interest in certain promissory notes
and mortgages from other DiVall related entities (the "Private Partnerships").
In the aggregate, the face amount of these notes were equal to a minimum of
$8,264,932. In addition, DiVall, Magnuson, and related entities owned by them,
granted the Partnership a security interest in their general partner interests
in the Private Partnerships. The foregoing security interests were to secure the
repayment of the funds which were diverted by DiVall and Magnuson

                                      12
<PAGE>
 
from the Partnership. The Partnership shares such security interests with DiVall
1 and DiVall 2. These promissory notes and mortgages are not recorded on the
balance sheets of the Partnerships, but are recorded as recoveries on a cash
basis upon settlement.

In 1993, nineteen (19) of the Private Partnerships sought the protection of the
Bankruptcy Court in the Eastern District of Wisconsin. Seven (7) of these
bankruptcies were voluntary and twelve (12) of these bankruptcies were
involuntary. Several of the Private Partnerships seeking bankruptcy owe
promissory notes to DiVall, Magnuson, or entities owned by them, in which the
Partnership has a security interest. These cases were subsequently transferred
to the Western District Bankruptcy Court located in Madison, Wisconsin.

The Partnership's experience in those bankruptcy cases that have concluded,
either through the approval of Plans of Reorganization, dismissal of the
bankruptcies, settlements or a combination of the foregoing, is that (i) the
value of the obligations of the Private Partnerships assigned to the Partnership
has been at a significant discount to their face amounts, and (ii) the General
Partner interests in such Private Partnerships often have little economic value.
The Partnership's recoveries in these bankruptcies have been on a steeply
discounted basis.

Plans of reorganization have been filed in the bankruptcies, and settlement
agreements in all of the Private Partnerships have been reached. Settlements in
the bankruptcies have resulted in cash payments to the Partnerships of a total
of $720,000 and notes secured by subordinated mortgages in the aggregate amount
of $625,000. The Partnerships subsequently sold the secured notes for a total of
$175,000.

11.  FORMER GENERAL PARTNERS' CAPITAL ACCOUNTS:

The capital account balance of the former general partners as of May 26, 1993,
the date of their removal as general partners pursuant to the results of a
solicitation of written consents from the Limited Partners, was a deficit of
$265,491. At December 31, 1993, the former general partners' deficit capital
account balance in the amount of $265,491 was reallocated to the Limited
Partners.

12.  SUBSEQUENT EVENTS:

On May 15, 1998, the Partnership made a distribution to the Limited Partners for
the First Quarter 1998 of $1,270,000 amounting to approximately $74.26 per
limited partnership interest.

Item 2.   Management's Discussion and Analysis of Financial Condition and
Results of Operations

Liquidity and Capital Resources:

Investment Properties and Net Investment in Direct Financing Leases

The investment properties, including equipment held by the Partnership at March
31, 1998, were originally purchased at a price, including acquisition costs, of
approximately $6,091,000.

During January 1998, the Partnership sold its Denny's property in Sanford,
Florida, to the tenant for $1,250,000, resulting in a gain, before disposition
fees of approxiately $240,000.

                                      13
<PAGE>
 
Other Assets

Cash and cash equivalents were $1,462,000 at March 31, 1998, compared to
$595,000 at December 31, 1997. The Partnership designated cash of $1,270,000 to
fund the First Quarter 1998 distributions to Limited Partners; $52,000 for the
payment of accounts payable and accrued expenses; and the remainder represents
reserves deemed necessary to allow the Partnership to operate normally. Cash
generated through the operations of the Partnership's investment properties,
sales of investment properties, and any recoveries of misappropriated funds by
the former general partners will provide the sources for future fund liquidity
and Limited Partner distributions.

The Partnership established an Indemnification Trust (the "Trust") during the
Fourth Quarter of 1993 and deposited $130,000 in the Trust during 1994, $100,000
during 1995, and $20,000 during 1996. The provision to establish the Trust was
included in the Permanent Manager Agreement for the indemnification of TPG, in
the absence of fraud or gross negligence, from any claims or liabilities that
may arise from TPG acting as Permanent Manager. The Trust is owned by the
Partnership. For additional information regarding the Trust, refer to Note 8 to
the financial statements.

Due From Former Affiliates, Allowance for Uncollectible Amounts Due From Former
Affiliates and Due to Affiliated Partnerships

Due from former affiliates represented misappropriated assets due from the
former general partners and their affiliates in the amount of $1,734,000 at
March 31, 1998 and December 31,1997. It is not anticipated that any further
material recoveries will be received.

The Partnership maintains a record of costs incurred in identifying or
recovering the misappropriated assets. These amounts are expensed when incurred,
and then recorded on the balance sheet as a restoration cost receivable with a
corresponding allowance for such receivable deemed uncollectible. These costs
are considered due from the former general partners and their affiliates.
Interest has been accrued on the misappropriated funds since January 1, 1993, at
a rate of 9% per annum and has been included in the restoration cost receivable.
The receivable increased from approximately $5,181,000 at December 31, 1997 to
$5,337,000 at March 31, 1998, and includes $2,969,000 of cumulative accrued
interest.

In 1993, the current General Partner estimated an aggregate recovery of $3
million for the Partnerships. At that time, an allowance was established against
amounts due from former general partners and their affiliates reflecting the
estimated $3 million receivable. This net receivable was allocated among the
Partnerships based on each Partnership's pro rata share of the total
misappropriation. Through March 31, 1998, $5,766,000 of recoveries have been
received which exceeded the original estimate of $3 million. As a result, the
Partnership has recognized $1,283,000 as income, which represents its share of
the excess recovery. The current General Partner continues to pursue recoveries
of the misappropriated funds, however no further significant recoveries are
anticipated.

The restoration costs are allocated among the Partnerships based on each
Partnership's respective share of the misappropriation as discussed in Note 9 to
the financial statements. The allocation is adjusted periodically to reflect any
changes in the entire misappropriation. The Partnership's percentage of the
allocation was increased in 1993.

                                      14
<PAGE>
 
Liabilities

Accounts payable and accrued expenses at March 31, 1998, in the amount of
$29,000, primarily represented the accrual of legal and auditing fees.

Partners' Capital

Net income for the quarter was allocated between the General Partner and the
Limited Partners, 1% and 99%, respectively, as provided in the Partnership
Agreement and the Amendment to the Partnership Agreement, as discussed more
fully in Note 4 of the financial statements. The former general partners'
capital account balance was reallocated to the Limited Partners at December 31,
1993. Refer to Note 11 to the financial statements for additional information
regarding the reallocation.

Cash distributions paid to the Limited Partners and to the General Partner
during 1998, of $385,000 and $913, respectively, have also been made in
accordance with the amended Partnership Agreement. The First Quarter 1998
distribution of $1,270,000 was paid to the Limited Partners on May 15, 1998.

Results of Operations:

The Partnership reported net income for the quarter ended March 31, 1998, in the
amount of $228,000 compared to net income for the quarter ended March 31, 1997
of $81,000.

Revenues

Total revenues were $359,000, and $174,000, for the quarters ended March 31,
1998, and 1997, respectively. The increase in income in 1998 is attributable to
a gain recognized on the sale of a Denny's property to the tenant.

Total revenues, should approximate $400,000 annually or $100,000 quarterly,
based on leases currently in place. Future revenues may decrease with tenant
defaults and/or sales of Partnership properties. They may also increase with
additional rents due from tenants, if those tenants experience sales levels
which require the payment of additional rent to the Partnership.

Expenses

For the quarters ended March 31, 1998 and 1997, cash expenses amounted to
approximately 30% and 36% of total revenues, respectively. Total expenses,
including non-cash items, amounted to 36% and 53% of total revenues for the
quarters ended March 31, 1998 and 1997, respectively. During 1998, disposition
fees of $37,500 on the sale of the Denny's property in Sanford, Florida, and
fees incurred for the appraisal of the Partnership's properties totaling $13,900
had a negative impact on expenses.

Inflation:

Inflation has a minimal effect on operating earnings and related cash flows from
a portfolio of triple net leases. By their nature, such leases actually fix
revenues and are not impacted by rising costs of maintenance, insurance, or real
estate taxes. If inflation causes operating margins to deteriorate for lessees

                                      15
<PAGE>
 
if expenses grow faster than revenues, then, inflation may well negatively
impact the portfolio through tenant defaults.

It would be misleading to associate inflation with asset appreciation for real
estate, in general, and the Partnership's portfolio, specifically. Due to the
"triple net" nature of the property leases, asset values generally move
inversely with interest rates.

Year 2000

The Partnership's operations are not dependent on date sensitive software. The
Partnership is not aware of any Year 2000 problems with its current software.
Accounting and Partnership records software are owned and operated by third
parties who provide services to the Partnership under contract. The Partnership
is currently in the process of evaluating Year 2000 issues with these third
party providers. The Partnership believes, however, that even if any Year 2000
problems are not corrected on schedule, the cost and disruption to operations of
the Partnership are expected to be minimal.

Tenants are responsible for the operation of any equipment located at the
Partnership's properties. While the Partnership is not fully aware of the
compliance attainment efforts of its tenants, tenant preparedness for the Year
2000 should have minimal impact on the Partnership and are not expected to be
material to the Partnership's operations, financial condition or liquidity.

                                      16
<PAGE>
 
                          PART II - OTHER INFORMATION

Items 1 - 4.

Not Applicable.

Item 5.  Other Information

On April 17, 1998, the Partnership filed a Definitive Consent Statement on
Schedule 14A with the Securities and Exchange Commission in connection with the
solicitation of consents by the Partnership to approve the sale of all the
Partnership's properties and to subsequently liquidate the Partnership. If the
proposed liquidation of the Partnership is approved by a majority of limited
partners, it is expected to be completed prior to the end of 1998.

Item 6.  Exhibits and Reports on Form 8-K

(a)  Listing of Exhibits:

     99.0  Correspondence to the Limited Partners dated May 15, 1998, regarding
           the First Quarter 1998 distribution.

(b)  Report on Form 8-K:

     The Registrant filed no reports on Form 8-K during the first quarter of
     fiscal year 1998.

                                      17
<PAGE>
 
                                  SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.


DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP



By:    The Provo Group, Inc., General Partner             
                                                          
                                                          
                                                          
By:    /s/ Bruce A. Provo                                 
       -------------------------------------------------- 
       Bruce A. Provo, President                           


Date:  May 14, 1998


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.


By:    The Provo Group, Inc., General Partner           
                                                        
                                                        
                                                        
By:    /s/ Bruce A. Provo                                 
       --------------------------------------------------
       Bruce A. Provo, President                         


Date:  May 14, 1998



By:    /s/ Kristin J. Atkinson                             
       -------------------------------------------------- 
       Kristin J. Atkinson                               
       Vice President - Finance and Administration        


Date:  May 14, 1998

                                      18
<PAGE>
 
                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.


DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP


By:  The Provo Group, Inc., General Partner



By:  /s/   
     ---------------------------------------------
     Bruce A. Provo, President


Date:  May 14, 1998


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.



By:  The Provo Group, Inc., General Partner



By:  /s/   
     ---------------------------------------------
     Bruce A. Provo, President


Date:  May 14, 1998



By:  /s/ 
     --------------------------------------------
     Kristin J. Atkinson
     Vice President - Finance and Administration


Date:  May 14, 1998

                                       19