<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     September 30, 1996
                                    --------------------------

                                       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


                   SEPTEMBER 30, 1996 AND DECEMBER 31, 1995
                   ----------------------------------------


                                    ASSETS
<TABLE>
<CAPTION>

                                                                         (Unaudited)
                                                                        September 30,   December 31,
                                                                            1996            1995
                                                                        -------------   ------------
<S>                                                                      <C>             <C> 
INVESTMENT PROPERTIES:  (NOTE 3)

     Land                                                                $ 2,085,836     $ 2,085,836
     Buildings and improvements                                            3,766,226       3,766,226
     Accumulated depreciation                                               (732,432)       (644,443)
                                                                         -----------     -----------
          Net investment properties                                        5,119,630       5,207,619
                                                                         -----------     -----------
NET INVESTMENT IN DIRECT FINANCING LEASES: (NOTE 7)                          708,760         976,461
                                                                         -----------     -----------
OTHER ASSETS:
     Cash and cash equivalents                                               532,767         312,290
     Cash restricted for real estate taxes                                     2,593          42,799
     Cash held in Indemnification Trust (NOTE 10)                            273,240         242,725
     Rents and other receivables (net of allowance of $45,730 in 1995)        40,572          27,955
     Due from current General Partner                                              0             792
     Deferred rent receivable                                                 41,828          42,904
     Notes receivable                                                         44,997          79,001
     Prepaid assets                                                              646           1,902
                                                                         -----------     -----------
          Total other assets                                                 936,643         750,368
                                                                         -----------     -----------
DUE FROM FORMER AFFILIATES: (NOTE 2)
     Due from former general partner affiliates                            2,256,287       4,084,424
     Allowance for uncollectible amounts due from former affiliates       (2,256,287)     (3,017,285)
     Restoration cost receivable                                           4,339,079       3,252,676
     Allowance for uncollectible restoration receivable                   (4,339,079)     (3,252,676)
                                                                         -----------     -----------
          Due from former affiliates, net
                                                                                   0       1,067,139
          Total assets                                                   -----------     -----------

                                                                         $ 6,765,033     $ 8,001,587
                                                                         ===========     ===========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       2
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                       LIABILITIES AND PARTNERS' CAPITAL

                   SEPTEMBER 30, 1996 AND DECEMBER 31, 1995
                   ----------------------------------------

<TABLE>
<CAPTION>
 
 
                                                                (Unaudited)
                                                               September 30,   December 31,
                                                                    1996           1995
                                                               -------------   ------------
<S>                                                            <C>             <C>
LIABILITIES:
  Accounts payable and accrued expenses                          $   41,891     $  251,948
  Due to affiliated partnerships (NOTE 11)                                0        201,912
  Due to current General Partner                                        557              0
  Security deposits                                                  97,491        103,181
  Real estate taxes payable                                          16,158          3,184
                                                                 ----------     ----------
   Total liabilities                                                156,097        560,225
                                                                 ----------     ----------
CONTINGENT LIABILITIES:  (NOTE 9)
 
PARTNER'S CAPITAL:  (NOTES 1, 4 AND 13)
Former general partners -
   Capital contributions                                                200            200
   Cumulative net loss                                             (195,015)      (195,015)
   Cumulative cash distributions                                    (70,676)       (70,676)
   Reallocation of former general partners' deficit
    capital to Limited Partners                                     265,491        265,491
                                                                 ----------     ----------
                                                                          0              0
                                                                 ----------     ----------
Current General Partner -
   Cumulative net income (loss)                                       7,621          2,425
   Cumulative cash distributions                                     (3,511)        (1,433)
                                                                 ----------     ----------
 
                                                                      4,110            992
                                                                 ----------     ----------
Limited Partners (17,102.52 interests outstanding)
   Capital contributions, net of offering costs                  14,408,872     14,408,872
   Cumulative net loss                                           (1,000,571)    (1,515,027)
   Cumulative cash distributions                                 (6,537,984)    (5,187,984)
   Reallocation of former general partners' deficit capital        (265,491)      (265,491)
                                                                 ----------     ----------
                                                                  6,604,826      7,440,370
                                                                 ----------     ----------
          Total partners' capital                                 6,608,936      7,441,362
                                                                 ----------     ----------
          Total liabilities and partners' capital                $6,765,033     $8,001,587
                                                                 ==========     ========== 
</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           Nine Months Ended
                                                       ------------------           -----------------
                                                         September 30,                September 30,
                                                         -------------                -------------
                                                       1996          1995           1996         1995
                                                      ------        ------         ------       ------
<S>                                                  <C>           <C>           <C>             <C>
REVENUES:
  Rental income                                      $167,149      $192,557      $  510,765      $563,109
  Interest income on direct financing leases           20,566        33,687          71,454        88,284
  Interest income                                      14,094         5,697          41,429        46,533
  Other income                                            222         1,287             870         2,874
  Recovery of amounts previously written off           18,259             0         764,298             0
                                                     --------      --------      ----------      --------
                                                      220,290       233,228       1,388,816       700,800
                                                     --------      --------      ----------      --------
EXPENSES:
  Partnership management fees                          15,450        14,787          46,070        42,117
  Restoration fees                                        598           243          53,610         2,710
  Insurance                                             1,181         1,281           3,827         3,569
  General and administrative (NOTE 8)                   8,821         8,705          34,056        31,100
  Advisory Board fees and expenses                      4,163         5,087          12,752        15,415
  Interest                                                  0           168               0         3,260
  Professional services                                11,106        12,647          37,354        50,622
  Professional services related to investigation       10,296       150,233         593,505       311,695
  Loss on equipment lease                                   0             0               0         5,809
  Depreciation                                         29,331        29,330          87,990        87,989
  Amortization                                              0             0               0         7,565
                                                     --------      --------      ----------      --------
                                                       80,946       228,481         869,164       561,851
                                                     --------      --------      ----------      --------
NET INCOME                                           $139,344      $ 10,747      $  519,652      $138,949
                                                     ========      ========      ==========      ========

NET INCOME - GENERAL PARTNER                         $  1,393      $    107      $    5,197      $  1,389

NET INCOME - LIMITED PARTNERS                         137,951        10,640         514,455       137,560
                                                     --------      --------      ----------      --------
                                                     $139,344      $ 10,747      $  519,652      $138,949
                                                     ========      ========      ==========      ========
NET INCOME PER LIMITED PARTNERSHIP
 INTEREST, based on 17,102.52 interests
 outstanding                                            $8.07         $0.62          $30.08         $8.04
                                                        =====         =====          ======         =====
</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>

                                                                            Nine Months Ended
                                                                            -----------------
                                                                              September 30,
                                                                              -------------
                                                                            1996        1995
                                                                            ----        ----
<S>                                                                      <C>          <C> 
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
  Net income                                                             $  519,652   $ 138,949
  Adjustments to reconcile net income to net cash from (used in)
   operating activities -
    Depreciation and amortization                                            87,990      95,554
    Recovery of amounts previously written off                             (764,298)          0
    Loss on equipment lease                                                       0       5,809
    Interest applied to Indemnification Trust Account                       (10,515)     (6,866)
    (Increase) in rents, other receivables and prepaid assets               (10,569)    (27,373)
    (Increase)/Decrease in deferred rent receivable                           1,076      (1,898)
    Deposits applied for real estate taxes                                   40,206      21,588
    Increase/(Decrease) in accounts payable and accrued expenses           (210,057)    113,235
    Decrease in security deposits                                            (5,690)          0
    Increase in due to General Partner                                          557       1,443
    Increase/(Decrease) in real estate taxes payable                         12,974     (21,493)
                                                                         ----------   ---------
          Net cash provided from (used in) operating activities            (338,674)    318,948
                                                                         ----------   ---------

CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
  Principal payments received on direct financing leases                    271,000     270,260
  Deposit to Indemnification Trust Account                                  (20,000)    (75,000)
  Recoveries from former affiliates                                       1,828,137      67,740
  Proceeds from land easement                                                     0      17,000
  Principal receipts from note                                               34,004     104,601
                                                                         ----------   ---------
          Net cash provided from investing activities                     2,113,141     384,601
                                                                         ----------   ---------
CASH FLOWS (USED IN) FINANCING ACTIVITIES:
  Principal payments on mortgage note                                             0     (77,740)
  Payments of amounts due to affiliated partnerships                       (201,912)    (65,031)
  Cash distributions to General Partner                                      (2,078)       (556)
  Cash distributions to Limited Partners                                 (1,350,000)   (560,000)
                                                                         ----------   ---------
          Net cash (used in) financing activities                        (1,553,990)   (703,327)
                                                                         ----------   ---------

NET INCREASE (DECREASE) IN CASH AND CASH
 EQUIVALENTS                                                                220,477         222 
                                                                            
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                            312,290     382,605
                                                                         ----------   ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD                               $  532,767   $ 382,827
                                                                         ==========   =========
SUPPLEMENTAL DISCLOSURE--cash paid for interest                          $        0   $   3,260
                                                                         ==========   =========
</TABLE> 

       The accompanying notes are an integral part of these statements.

                                       5
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                         NOTES TO FINANCIAL STATEMENTS


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 and recovering
the assets misappropriated by the former general partners and their affiliates.
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 September 30, 1996, the Partnership owned seven (7) properties
and specialty leasehold improvements for use in all seven (7) of the Properties.

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.

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.

                                       6
<PAGE>
 
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, 1995, the tax basis of the Partnership's assets exceeded the
amounts reported in the accompanying financial statements by approximately
$3,100,000.

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 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 $14,000,000, of which
approximately $6,595,000 has been attributed to the Partnership and is reflected
as due from former affiliates on the balance sheet at September 30, 1996.  The
9% interest accrued as of September 30, 1996, amounted to approximately
$2,046,000 and is not reflected in the accompanying income statement.  As of
December 31, 1995, $7,337,000 was reflected as due from former affiliates based
on an estimated overall misappropriation and related costs of $15,700,000.
Permanent Manager Agreement ("PMA") savings, representing cost savings to the
Partnerships as a result of the implementation of the PMA, are not credited
against the due from former affiliates account on the financial statements of
the Partnership.

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.

The current General Partner is vigorously pursuing recovery of the
misappropriated funds from the various sources and initially estimated an
aggregate recovery of $3 million for the Partnerships, of which approximately
$1.4 million was allocated to the Partnership.  As such, an allowance has been
established against amounts due

                                       7
<PAGE>
 
from former general partner affiliates reflecting the current General Partner's
best estimate of probable loss from misappropriated amounts.  This allowance has
been allocated among the Partnerships based on each Partnership's pro rata share
of the total misappropriation.  The amount of the Partnership's allowance was
reduced by approximately $761,000 during the first nine months of 1996 as a
result of recoveries received in excess of the original estimate.  Pending
resolution of all sources of potential recovery, it is not possible to determine
the amount that will ultimately be recovered.

As mentioned above, material weaknesses were identified in the Partnership's
internal control structure.  The internal control structure was not adequate to
assure that all transactions of the Partnership were properly recorded and
reflected in the books and records and financial statements of the Partnership.
Significant transactions affecting the Partnership were apparently initiated by
the former general partners during the three years ended December 31, 1992,
which initially either were not recorded on the books and records of the
Partnership or were improperly recorded and characterized.  Such transactions
included unsupported disbursements or improper disbursements under the terms of
the Partnership Agreement and the encumbrance of Partnership assets.  All such
transactions identified during the regulatory Investigation and concurrent
reviews have been reflected in the Partnership's financial statements as of
September 30, 1996.

3.   INVESTMENT PROPERTIES:
     ----------------------

As of September 30, 1996, the Partnership owned seven (7) fast-food restaurants
comprised of:  three (3) Hardee's restaurants, one (1) Applebee's restaurant,
and three (3) Denny's restaurants.  The seven (7) properties are located in five
(5) 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.

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 Partnership's investment properties had been managed by an affiliate of the
former general partners pursuant to a management agreement which provided for a
fee equal to 1% of gross receipts amounting to approximately $2,000 through
February 28, 1993.  In addition, the former general partner affiliate was
entitled to receive reimbursements of general and administrative costs, either
direct or indirect, amounting to approximately $12,000 through February 28,
1993.  As a result of the Investigation, the Partnership engaged a third party
as Interim Manager in October 1992.  The Interim Manager received approximately
$19,000 through February 28, 1993, for management services.  Subsequent to the
appointment of the Permanent Manager, effective February 8, 1993, these services
were being provided by the Permanent Manager for an overall fee 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 Partnership Agreement, TPG continues to provide
management services for the same fee structure as provided in the PMA mentioned
above. The minimum management fee and the maximum reimbursement for office rent
and overhead have increased annually by the allowable annual Consumer Price
Index adjustment per the PMA.  For purposes of computing

                                       8
<PAGE>
 
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 $67,022 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
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 10.)
                                       
                                       9
<PAGE>
 
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>
                      1996                 $   670,900
                      1997                     742,860
                      1998                     742,860
                      1999                     742,860
                      2000                     742,860
                Thereafter                   7,175,975
                                           -----------
                                           $10,818,315
                                           ===========
</TABLE>
Three (3) of the Partnership's properties are leased to a Denny's franchise.
Base rent from these properties amounted to approximately 34% of total base rent
in 1995.

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
September 30, 1996, the Partnership has leased two of its properties to
Terratron, Inc., which constitute 21% of the aggregate gross proceeds.  Due to
sales difficulties in the stores leased by Terratron, a one (1) year lease
modification was entered into with the tenant, reducing 1996 base rents by
approximately $85,000. Additionally, delinquent rents totaling $46,000 were
capitalized into a five (5) year note accruing interest at 10% per annum.  The
amount of the rent capitalized was written off as uncollectible at December 31,
1995.  During September 1996, management began negotiating new leases with
Hardee's Food Systems, Inc., whereby all payments due from Terratron for 1996
under their modified lease terms would be received.  Management anticipates
execution of these leases during the Fourth Quarter of 1996.

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

Amounts paid to the current General Partner for the nine months ended September
30, 1996 and 1995, are as follow:
<TABLE>
<CAPTION>
Current General Partner                 Incurred as of      Incurred as of
-----------------------               September 30, 1996  September 30, 1995
                                      ------------------  ------------------

<S>                                    <C>                 <C>
Management fees                        $ 46,070            $42,117
Restoration fees                         53,610              2,710
Cash distribution                         2,078                556
Overhead allowance                        3,839              3,736
Reimbursement for out-of-pocket
  expenses                                6,863              7,537
                                       --------            -------
                                       $112,460            $56,656
                                       ========            =======
</TABLE>

 
7.   NET INVESTMENT IN DIRECT FINANCING LEASES:
     ------------------------------------------

The net investment in direct financing leases, which includes the Partnership's
specialty leasehold improvement leases, is comprised of the following as of
September 30, 1996:
<TABLE>
<CAPTION> 
      <S>                                               <C>
       Minimum lease payments receivable                 $ 778,662
       Estimated residual values of leased
         property (non-recourse)                            47,356

       Less - Unearned income                             (117,258)
                                                         ---------

        Net investment in direct financing leases        $ 708,760
                                                         =========
</TABLE>

Scheduled future minimum lease payments are as follows:

<TABLE>
<CAPTION> 
              <S>                   <C>
               Year ending
               December 31,
                       1996          $104,187
                       1997           312,561
                       1998           225,470
                       1999           183,800
                                     --------
                                     $826,018
                                     ========
</TABLE>

During 1995, it was determined that the residual amounts of the leases were
overstated.  Accordingly, a write-down of residual amounts to their estimated
net realizable values was recorded.  The total amount of the write-down was
approximately $96,000.

                                      11
<PAGE>
 
8.   GENERAL AND ADMINISTRATIVE EXPENSES:
     ------------------------------------

For the periods  ended September 30, 1996 and 1995, general and administrative
expenses incurred by the Partnership were as follows:
<TABLE>
<CAPTION>
 
                                 Three Months Ended       Nine Months Ended
                                 ------------------       -----------------
                                   September 30,            September 30,
                                   -------------            -------------
                                 1996          1995       1996         1995
                                ------        ------     ------       ------
<S>                            <C>           <C>        <C>          <C>
Communication costs             $5,825        $5,833     $22,858      $21,054
Overhead allowance               1,287         1,252       3,839        3,736
Income tax expense                   0             0       1,065        1,725
Other administration             1,709         1,619       6,294        4,585
                                ------        ------     -------      -------
                                $8,821        $8,705     $34,056      $31,100
                                ======        ======     =======      =======
</TABLE>

9.   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 exceeding 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 September 30, 1996, 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.

10.  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 September 30, 1996.  Funds are invested in U.S.
Treasury securities.  In addition, interest totaling $23,240 has been credited
to the Trust as of September 30, 1996.  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

                                       12
<PAGE>
 
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.

11.  RESTORATION TRUST ACCOUNT; EXPENSE ALLOCATIONS; AND RELATED INTER-
     ----------------------------------------------------------- -----
     PARTNERSHIP RECEIVABLES:
     ------------------------

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.  Based on modified allocations adjusted as of
December 31, 1993, the Partnership owed $295,053 and $192,359 to DiVall 1 and
DiVall 2, respectively, for amounts paid on its behalf.  Amounts recovered from
former general partner affiliates have been used to partially repay the amounts
due to DiVall 1 and DiVall 2.  At December 31, 1995, the remaining amounts due
to DiVall 1 and DiVall 2 totaled $105,824 and $73,588, respectively.  Such
amounts are reflected on the balance sheet as due to affiliated partnerships.
These amount were fully repaid during March 1996 from recoveries received.

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.  Any available recovery funds are being
utilized first to satisfy amounts due other partnerships for amounts advanced
under prior allocation methods.  As of September 30, 1996, the Partnerships
recovered a total of approximately $4,609,000 from the former general partners
and their affiliates, accountants and attorneys.  Of this amount, the
Partnership received its pro-rata share in the amount of $2,149,000.
Additionally, $40,347, representing 50% of all previously escrowed disposition
fees earned by the General Partner, is reflected as a 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 9.

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.

On March 24, 1994, an affiliated partnership, DiVall 1, filed a complaint in the
United States District Court for the Western District of Missouri against
Boatmen's First National Bank of Kansas City ("Boatmen's) seeking a declaratory
judgment that Boatmen's has no right or interest in a promissory note executed
in the name of DiVall 1 by the former general partners (the "Note") secured by
mortgages on five DiVall 1 properties, and further

                                      13
<PAGE>
 
seeking an injunction against foreclosure proceedings instituted against a
DiVall 1 property located in Dallas, Texas under a first deed of trust and
security agreement given to secure the Note (the "Foreclosure").  The former
general partners borrowed $600,000 during or before 1991 from Metro North State
Bank (now Boatmen's).  The proceeds of the Note were not received by DiVall 1.
As of September 30, 1996, DiVall 1 had not paid debt service on the Note.
DiVall 1 received a notice of default on the Note in October 1993, and the
Foreclosure Action was filed in February 1994.  As of September 30, 1996,
interest in the amount of $213,000 had accrued but was unpaid on the Note.
Interest is accrued at the face rate of the Note.  If DiVall 1 loses the case
against Boatmen's, additional interest totaling approximately $232,000,
representing the default rate of interest may be due.  Boatmen's has agreed to
stay its foreclosure proceedings pending the outcome of the litigation.
Boatmen's answered the complaint and filed a motion for summary judgment to
which DiVall 1 responded.  The District Court granted Boatmen's motion for
summary judgement.  DiVall 1 appealed and the Eighth Circuit Court of Appeals
reversed the District Court's ruling.  The case was sent back to the District
Court for further discovery and trial.  Pursuant to the Restoration Trust
Account procedures described above, all of the Partnerships are sharing the
expenses of this litigation and any recoveries resulting effectively from the
partial or full cancellation of the alleged indebtedness will be allocated among
the three Partnerships on the same basis as the restoration costs are currently
being allocated.

12.  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 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.

On July 23, 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, to date, been on a
steeply discounted basis. Management anticipates that the recoveries in the
remaining unresolved bankruptcies are likely to also be on a deeply discounted
basis.

Plans of reorganization have been filed in some of the bankruptcies, and
settlement agreements in many of the Private Partnerships have been reached.
Settlements in eighteen (18) of the bankruptcies to date have resulted in cash
payments to the Partnerships of a total of $580,000 and notes secured by
subordinated mortgages in the

                                       14
<PAGE>
 
aggregate amount of $625,000.  Two of the settlement notes have subsequently
been sold for a total of $50,000, and an option has been granted to purchase the
remaining note for $125,000.   The Partnership is continuing to vigorously
defend its interests in the remaining bankruptcies.

13.  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.

14.  SUBSEQUENT EVENTS:
     ------------------

On November 15, 1996, the Partnership made a distribution to the Limited
Partners for the Third Quarter 1996 of $300,000 amounting to approximately
$17.54 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
September 30, 1996, were originally purchased at a price, including acquisition
costs, of approximately $5,869,000.

The net investment in direct financing leases, which includes the Partnership's
specialty leasehold improvement leases, amounted to $709,000 at September 30,
1996, compared to $976,000 at December 31, 1995.  The decrease of $267,000 was a
result of principal and residual payment received.

OTHER ASSETS
------------

Cash and cash equivalents, including cash restricted for real estate taxes  held
by the Partnership, were $535,000 at September 30, 1996, compared to $355,000 at
December 31, 1995.  The Partnership designated cash of $300,000 to fund the
Third Quarter 1996 distributions to Limited Partners; $90,000 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 11
to the financial statements.

                                       15
<PAGE>
 
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 $2,256,000 at
September 30, 1996.  The receivable decreased from December 31, 1995, due to
$1,813,000 of recoveries received from the former general partners and their
affiliates, including the settlement received in the litigation against the
Partnerships' former accountants and attorneys.

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 $3,253,000 at December 31, 1995 to
$4,339,000 at September 30, 1996, and includes $2,046,000 of cumulative accrued
interest.

The current General Partner is vigorously pursuing recovery of the
misappropriated funds from the various sources, and initially estimated an
aggregate recovery of $3 million for the Partnerships, of which approximately
$1.4 million was allocated to the Partnership.  As such, an allowance was
established against amounts due from the former general partners and their
affiliates reflecting the current General Partner's original estimate of
probable loss from misappropriated amounts.  This allowance was allocated among
the Partnerships based on each Partnership's pro rata share of the total
misappropriation.  The amount of the Partnership's allowance was reduced by
approximately $761,000 during the first nine months of 1996, due to recoveries
received in excess of the original estimate.

The restoration costs are allocated among the Partnerships based on each
Partnership's respective share of the misappropriation as discussed in Note 12
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.  Consequently, the Partnership had not been
paying its pro rata share of the costs.  Accordingly, the Partnership recorded
payables at December 31, 1993, in the amount of $295,000 and $192,000, due to
DiVall 1 and DiVall 2, respectively, with corresponding amounts reflected as
professional expenses related to the Investigation.  Recoveries allocated to the
Partnership have been used to repay the amounts owed to DiVall 1 and DiVall 2.
At December 31, 1995, the remaining amounts due to DiVall 1 and DiVall 2 for
restoration costs totaled $106,000 and $74,000, respectively.  During March
1996, these amounts were fully repaid from recoveries received.

As a result of the misappropriation and material weaknesses in the internal
control structure of the Partnership prior to February 8, 1993, there can be no
assurance that all transactions recorded by the Partnership prior to February 8,
1993, were appropriate transactions of the Partnership and properly reflected in
the accompanying financial statements of the Partnership or that all
transactions of the Partnership prior to February 8, 1993, including improper
and unsupported transactions, have been identified and reflected in the
accompanying financial statements of the Partnership as of September 30, 1996.

LIABILITIES
-----------

Accounts payable and accrued expenses at September 30, 1996, in the amount of
$42,000, primarily represented the accrual of legal and auditing fees.

                                       16
<PAGE>
 
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 14 to the financial statements for additional information
regarding the reallocation.

Cash distributions paid to the Limited Partners and to the General Partner
during 1996, of $1,350,000 and $2,078, respectively, have also been made in
accordance with the amended Partnership Agreement.  The Third Quarter 1996
distribution of $300,000 was paid to the Limited Partners on November 15, 1996.

RESULTS OF OPERATIONS:
----------------------

Management believes that the financial results are not indicative of "normal"
Partnership operations.  There are many events which occurred since the
discovery of the misappropriations in 1992 which have had a negative impact on
financial results.  Some of these events will continue to have a negative impact
on the Partnership in the future.  However, the settlement of litigation against
the Partnership's former accountants and attorneys should result in operating
results going forward which more closely represent "normal" operations than what
has been experienced during the past three years.

The Partnership reported  net income for the quarter ended September 30, 1996,
in the amount of $139,000 compared to net income for the quarter ended September
30, 1995 of $11,000.  For the nine months ended September 30, 1996 and 1995, net
income totaled $520,000 and $139,000, respectively.  Results for both years were
less than would be expected from "normal" operations, primarily because of costs
associated with misappropriation of assets by the former general partners and
their affiliates.  These costs increased significantly during the First Quarter
of 1996 as the lawsuit against the former general partner accountants and
attorneys got closer to trial and as a result of contingent fee payments made
upon settlements of the litigation.  These costs decreased during the remainder
of 1996 due to the settlement of the litigation.

REVENUES
--------

Total revenues were $220,000, and $233,000, for the quarters ended September 30,
1996, and 1995, respectively, and were $1,389,000 and $701,000 for the nine
months ended September 30, 1996 and 1995, respectively.  The increase in income
in 1996 is attributable to the recovery of amounts from the Partnerships' former
accountants and attorneys which had been previously been written-off.

Total revenues, should approximate $750,000 annually or $187,000 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.  The decrease
in estimated recurring revenues from 1995 to projected 1996 levels is primarily
a result of the one (1) year lease modification entered into with Terratron, the
tenant of two (2) of the Partnership's Hardee's restaurants.

                                       17
<PAGE>
 
EXPENSES
--------

For the quarters ended September 30, 1996 and 1995, cash expenses amounted to
approximately 23% and 83% of total revenues, respectively.  For the nine months
ended September 30, 1996 and 1995, cash expenses totaled approximately 56% and
67%, respectively.  Total expenses, including non-cash items, amounted to 37%
and 95% of total revenues for the quarters ended September 30, 1996 and 1995,
respectively, and 63% and 80% for the nine months ended September 30, 1996 and
1995.  Items negatively impacting expenses are expenses incurred primarily in
relation to the misappropriation of assets by the former general partners and
their affiliates.  The reversal of an over accrual of these expenses favorably
impacted the Second Quarter of 1996 results.

For the nine months ended September 30, 1996 and 1995, expenses incurred in
relation to the misappropriated assets amounted to $594,000 and $312,000,
respectively.  These costs increased significantly during the First Quarter of
1996 due to the payment of contingent fees and litigation expenses in relation
to the settlement of litigation against the Partnerships' former accountants and
attorneys.  Future expenses incurred in relation to the misappropriation should
have a minimal impact on the Partnership.

As noted above, management believes the Partnership's operations have yet to
stabilize to what could be considered normal, due to the negative impact of the
costs related to the recovery of the misappropriated assets. However, these
"recovery costs" should be minimized in the future.

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
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.


                          PART II - OTHER INFORMATION


Item 1.  Legal Proceedings

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 was 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 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.

                                       18
<PAGE>
 
On July 23, 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
Partnerships have 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, to
date, been on a steeply discounted basis. Management anticipates that the
recoveries in the remaining unresolved bankruptcies are likely to also be on a
deeply discounted basis.

Plans of reorganization have been filed in some of the bankruptcies, and
settlement agreements in many of the Private Partnerships have been reached.
Settlements in eighteen (18) of the bankruptcies to date have resulted in cash
payments to the Partnerships of a total of $580,000 and notes secured by
subordinated mortgages in the aggregate amount of $625,000. Two of the
settlement notes have subsequently been sold for a total of $50,000, and an
option has been granted to purchase the remaining note for $125,000. The
Partnership is continuing to vigorously defend its interests in the remaining
bankruptcies.

The Partnerships have been named as defendants in certain foreclosure actions
brought in state courts in Wisconsin. In each of these actions, the plaintiff
seeks to foreclose on real property owned by one of the Private Partnerships.
The Partnerships were named as subordinate lienholders on the properties. It is
believed that none of these cases constitute a claim against the individual
Public Partnerships. However, if the foreclosures are successful, the Private
Partnerships' interest in the underlying real estate may be extinguished,
rendering individual obligations to the Partnerships uncollectible. Such a
foreclosure has occurred in one instance and is pending in at least one other
situation.

The Partnership is also pursuing collection actions against former tenants of
the Partnership and/or guarantors of former tenants of the Partnership arising
from defaults on their leases. Although the Partnership believes its claims are
valid, it is currently unknown whether the Partnerships will receive favorable
verdicts or whether any such verdicts will ultimately prove collectible.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)  Listing of Exhibits:

     28.0  Correspondence to the Limited Partners dated November 15, 1996,
           regarding the Third Quarter 1996 distribution.

(b)  Report on Form 8-K:

     The Registrant filed no reports on Form 8-K during the third quarter of
     fiscal year 1996.

                                      19
<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: November 13, 1996


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: November 13, 1996



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


Date: November 13, 1996

                                      20