<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, 1997
                                     ---------------------------

                                                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, 1997 AND DECEMBER 31, 1996
                      ------------------------------------

<TABLE> 
<CAPTION> 
                                     ASSETS
 
                                                                     (Unaudited)
                                                                      March 31,    December 31,
                                                                         1997          1996
                                                                     ------------  -------------
<S>                                                                  <C>           <C>
INVESTMENT PROPERTIES:  (NOTE 3)
     Land                                                            $ 2,085,836    $ 2,085,836
     Buildings and improvements                                        3,762,726      3,762,726
     Accumulated depreciation                                           (791,091)      (761,761)
                                                                     -----------    -----------
     Net investment properties                                         5,057,471      5,086,801
                                                                     -----------    -----------
NET INVESTMENT IN DIRECT FINANCING LEASES: (NOTE 7)                       12,787         25,017
                                                                     -----------    -----------

OTHER ASSETS:

     Cash and cash equivalents                                           313,774      1,155,128
     Cash restricted for real estate taxes                                 7,217         81,477
     Cash held in Indemnification Trust (NOTE 9)                         280,184        276,248
     Rents and other receivables                                          23,151         27,186
     Deferred rent receivable                                             40,379         41,108
     Deferred fees                                                        22,864         23,310
     Prepaid assets                                                        2,868          4,192
                                                                     -----------    -----------

     Total other assets                                                  690,437      1,608,619
                                                                     -----------    -----------

DUE FROM FORMER AFFILIATES: (NOTE 2)

     Due from former general partner affiliates                        2,014,917      2,017,488
     Allowance for uncollectible amounts due from former affiliates   (2,014,917)    (2,017,488)
     Restoration cost receivable                                       4,627,244      4,509,417
     Allowance for uncollectible restoration receivable               (4,627,244)    (4,509,417)
                                                                     -----------    -----------
     Due from former affiliates, net                                           0              0
                                                                     -----------    -----------
 
     Total assets                                                    $ 5,760,695    $ 6,720,437
                                                                     ===========    ===========
</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, 1997 AND DECEMBER 31, 1996
                      ------------------------------------

<TABLE>
<CAPTION>
                                                               (Unaudited)
                                                                March 31,    December 31,
                                                                   1997          1996
                                                               ------------  -------------
<S>                                                            <C>           <C>
LIABILITIES:

   Accounts payable and accrued expenses                       $    22,769    $    30,280
   Due to current General Partner                                      324         49,327
   Security deposits                                                46,979         46,979
   Unearned rental income                                           48,846         26,589
   Real estate taxes payable                                             0         81,217
                                                               -----------    -----------

     Total liabilities                                             118,918        234,392
                                                               -----------    -----------

CONTINGENET LIABILITIES:  (NOTE 8)
 
PARTNER'S CAPITAL:  (NOTES 1, 4 AND 12)

Current General Partner -
   Cumulative net income (loss)                                     10,211          9,400
   Cumulative cash distributions                                    (4,546)        (4,222)
                                                               -----------    -----------
 
                                                                     5,665          5,178
                                                               -----------    -----------

Limited Partners (17,102.52 interests outstanding)
   Capital contributions, net of offering costs                 14,408,872     14,408,872
   Cumulative net loss                                            (744,285)      (824,530)
   Cumulative cash distributions                                (7,762,984)    (6,837,984)
   Reallocation of former general partners' deficit capital       (265,491)      (265,491)
                                                               -----------    -----------

                                                                 5,636,112      6,480,867
                                                               -----------    -----------

          Total partners' capital                                5,641,777      6,486,045
                                                               -----------    -----------

          Total liabilities and partners' capital              $ 5,760,695    $ 6,720,437
                                                               ===========    ===========
</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,
                                                       ----------------------------
                                                           1997           1996
                                                       -------------  -------------
<S>                                                    <C>            <C>
REVENUES:
     Rental income                                          $160,999       $170,578
     Interest income on direct financing leases                1,150         27,053
     Interest income                                           8,715          8,053
     Other income                                                294            277
     Recovery of amounts previously written off                2,571        729,091
                                                            --------       --------
 
                                                             173,729        935,052
                                                            --------       --------
EXPENSES:
     Partnership management fees                              15,620         15,170
     Restoration fees                                            103         52,335
     Insurance                                                 1,327          1,268
     General and administrative (NOTE 8)                      10,216          8,930
     Advisory Board fees and expenses                          3,422          4,942
     Professional services                                    12,280         13,187
     Professional services related to investigation           19,930        650,670
     Depreciation                                             29,330         29,330
     Amortization                                                446              0
                                                            --------       --------
                                                              92,674        775,832
                                                            --------       --------
NET INCOME                                                  $ 81,055       $159,220
                                                            ========       ========
NET INCOME - GENERAL PARTNER                                $    811       $  1,592
NET INCOME - LIMITED PARTNERS                                 80,244        157,628
                                                            --------       --------
                                                            $ 81,055       $159,220
                                                            ========       ========
NET INCOME PER LIMITED PARTNERSHIP
 INTEREST, based on 17,102.52 interests outstanding            $4.69          $9.22
                                                            ========       ========
</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,
                                                                                ------------------------------
                                                                                     1997            1996
                                                                                --------------  --------------
<S>                                                                             <C>             <C>
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
     Net income                                                                    $   81,055      $  159,220
     Adjustments to reconcile net income to net cash from (used in)
        operating activities -
          Depreciation and amortization                                                29,776          29,330
          Recovery of amounts previously written off                                   (2,571)       (729,091)
          Interest applied to Indemnification Trust Account                            (3,936)         (3,131)
          (Increase)/Decrease in rents, other receivables and prepaid assets            5,330         (11,791)
          (Increase)/Decrease in deferred rent receivable                                 729              58
          Deposits applied for real estate taxes                                       74,260          42,714
          (Decrease) in accounts payable and accrued expenses                          (7,511)       (104,878)
          Increase/(Decrease) in due to General Partner                               (49,003)            637
          Increase in unearned rental income                                           22,257               0
          (Decrease) in real estate taxes payable                                     (81,217)           (513)
                                                                                   ----------      ----------
               Net cash provided from operating activities                             69,169         617,445
                                                                                   ----------      ----------
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
     Principal payments received on direct financing leases                            12,230          83,254
     Deposit to Indemnification Trust Account                                               0         (20,000)
     Deposit to restoration escrow account                                                  0        (826,160)
     Recoveries from former affiliates                                                  2,571       1,796,230
     Principal receipts from note                                                           0           5,961
                                                                                   ----------      ----------
               Net cash provided from investing activities                             14,801       1,039,285
                                                                                   ----------      ----------
CASH FLOWS (USED IN) FINANCING ACTIVITIES:
     Payments of amounts due to affiliated partnerships                                     0        (201,912)
     Cash distributions to General Partner                                               (324)           (637)
     Cash distributions to Limited Partners                                          (925,000)        (50,000)
                                                                                   ----------      ----------
               Net cash (used in) financing activities                               (925,324)       (252,549)
                                                                                   ----------      ----------
NET INCREASE (DECREASE) IN CASH AND CASH
   EQUIVALENTS                                                                       (841,354)        169,291
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                    1,155,128         312,290
                                                                                   ----------      ----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD                                         $  313,774      $  481,581
                                                                                   ==========      ==========
SUPPLEMENTAL DISCLOSURE--cash paid for interest                                    $        0      $        0
                                                                                   ==========      ==========
</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 March 31, 1997, 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.

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.

                                       6
<PAGE>
 
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, 1995, 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 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 $14,300,000, of which
approximately $6,700,000 has been attributed to the Partnership and is reflected
as due from former affiliates on the balance sheet at March 31, 1997.  The 9%
interest accrued as of March 31, 1997, amounted to approximately $2,348,000 and
is not reflected in the accompanying income statement.  As of December 31, 1996,
$6,527,000 was reflected as due from former affiliates based on an estimated
overall misappropriation and related costs of $14,000,000.

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

                                       7
<PAGE>
 
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, 1997, $5,166,000 of recoveries
have been received which exceeded the original estimate of $3 million.  As a
result, the Partnership has recognized $1,003,000 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, 1997, 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 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 Partnership Agreement, TPG continues to
provide management services for the same fee structure as provided in the PMA
mentioned above.  Effective March 1, 1997, the minimum management fee and the
maximum reimbursement for office rent and overhead increased by 3.3%
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 $76,677 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.

                                       8
<PAGE>
 
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 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

                                       9
<PAGE>
 
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>
             1997                                     $  618,000
             1998                                        618,000
             1999                                        618,000
             2000                                        618,000
             2001                                        618,000
       Thereafter                                      5,400,163
                                                      ----------
                                                      $8,490,163
                                                      ==========
</TABLE>

Three (3) of the Partnership's properties are leased to a Denny's franchise.
Base rent from these properties amounted to approximately 38% of total base rent
in 1996.

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, 1997, the Partnership has leased two of its properties to Hardees Food
Systems, Inc., which constitute 21% of the aggregate gross proceeds.

6.   TRANSACTIONS WITH CURRENT GENERAL PARTNER:
     ------------------------------------------

Amounts paid to the current General Partner for the quarters ended March 31,
1997 and 1996, are as follow:

<TABLE>
<CAPTION>
     Current General Partner                     Incurred as of  Incurred as of 
     -----------------------                     March 31, 1997  March 31, 1996
                                                 --------------  --------------
     <S>                                         <C>             <C>           
     Management fees                                    $15,620         $15,170
     Restoration fees                                       103          52,335
     Cash distribution                                      324             637
     Overhead allowance                                   1,288           1,264
     Reimbursement for out-of-pocket expenses             2,432           1,826
                                                        -------         -------
                                                        $19,767         $71,232
                                                        =======         ======= 
</TABLE>

                                       10
<PAGE>
 
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
March 31, 1997:

<TABLE>
<S>                                                        <C>
Minimum lease payments receivable                               $   686

Estimated residual values of leased                        
  property (non-recourse)                                        12,659

Less - Unearned income                                             (558)
                                                                -------
     Net investment in direct financing leases                  $12,787
                                                                =======
 
Scheduled future minimum lease payments are as follows:
 
               Year ending
               December 31,
 
                  1997                                          $13,345
                                                                =======
</TABLE> 

8.   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, 1997, 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.

9.   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 March 31, 1997.

                                       11
<PAGE>
 
Funds are invested in U.S. Treasury securities.  In addition, interest totaling
$30,184 has been credited to the Trust as of March 31, 1997.  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.

10.  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 8.

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 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 March

                                       12
<PAGE>
 
31, 1997, 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 March 31, 1997, interest in the amount of
$239,000 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 $260,000, 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.  Trial of
the case is scheduled to begin on June 23, 1997.  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.

11.  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 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.

                                       13
<PAGE>
 
12.  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.

13.  SUBSEQUENT EVENTS:
     ------------------

On May 15, 1997, the Partnership made a distribution to the Limited Partners for
the First Quarter 1997 of $100,000 amounting to approximately $5.85 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, 1997, 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 $13,000 at March 31, 1997,
compared to $25,000 at December 31, 1996.  The decrease of $12,000 was a result
of principal payments received during the quarter as well as the termination of
the equipment lease with the Hardee's in Wahoo, Nebraska.

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

Cash and cash equivalents, including cash restricted for real estate taxes held
by the Partnership, were $314,000 at March 31, 1997, compared to $1,237,000 at
December 31, 1996.  The Partnership designated cash of $100,000 to fund the
First Quarter 1997 distributions to Limited Partners; $75,000 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 9 to
the financial statements.

                                       14
<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 $2,015,000 at
March 31, 1997.  The receivable decreased from December 31, 1996, due to $2,600
of recoveries received during the quarter from the former general partners and
their affiliates.

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 $4,509,000 at December 31, 1996 to
$4,627,000 at March 31, 1997, and includes $2,348,000 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, 1997, $5,166,000 of recoveries have been
received which exceeded the original estimate of $3 million.  As a result, the
Partnership has recognized $1,003,000 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 10
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.

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

Accounts payable and accrued expenses at March 31, 1997, in the amount of
$23,000, 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 12 to the financial statements for additional information
regarding the reallocation.

Cash distributions paid to the Limited Partners and to the General Partner
during 1997, of $925,000 and $324, respectively, have also been made in
accordance with the amended Partnership Agreement.  The First Quarter 1997
distribution of $100,000 was paid to the Limited Partners on May 15, 1997.

                                       15
<PAGE>
 
RESULTS OF OPERATIONS:
----------------------

The Partnership reported  net income for the quarter ended March 31, 1997, in
the amount of $81,000 compared to net income for the quarter ended March 31,
1996 of $159,000.  Costs increased significantly during 1996 as the lawsuit
against the former general partner accountants and attorneys got closer to trial
and as a result of contigent fee payments made upon settlements of the
litigation.  During 1997, these costs had a minimal impact on operations.
Additionally, revenue for 1996 included a recovery of amounts previously written
off as a result of amounts received from the Partnership's former accountants
and attorneys.

REVENUES
--------

Total revenues were $174,000, and $935,000, for the quarters ended March 31,
1997, and 1996, 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 $600,000 annually or $150,000 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, 1997 and 1996, cash expenses amounted to
approximately 36% and 80% of total revenues, respectively.  Total expenses,
including non-cash items, amounted to 53% and 83% of total revenues for the
quarters ended March 31, 1997 and 1996, respectively.  Items negatively
impacting expenses during the First Quarter of 1996, are expenses incurred
primarily in relation to the misappropriation of assets by the former general
partners and their affiliates.

For the quarters ended March 31, 1997 and 1996, expenses incurred in relation to
the misappropriated assets amounted to $20,000 and $651,000, 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.

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.

                                       16
<PAGE>
 
                          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.

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 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.

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.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(a)  Listing of Exhibits:

     99.0 Correspondence to the Limited Partners dated May 15, 1997, regarding
          the First Quarter 1997 distribution.

(b)  Report on Form 8-K:

     The Registrant filed no reports on Form 8-K during the first quarter of
     fiscal year 1997.

                                       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, 1997


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, 1997



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


Date:  May 14, 1997

                                       18