** **

###### **UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM10-Q**

 
| **(Mark  One)** |
|-----------------|
| **ý**      | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |

 

For the quarterly periodended September 30, 2004

OR

 
| **o** | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|------------------------------------------------------------------------------------------------|

* *

**CommissionFile Number 001-16785**

 

**AmericanSpectrum Realty, Inc.**

(Exact name of Registrantas specified in its charter)

 

| **State of Maryland**                                             | ** ** | **52-2258674**                          |
|-------------------------------------------------------------------|------------|-----------------------------------------|
| (State  or other jurisdiction of

incorporation  or organization) |       | (I.R.S.  Employer

Identification  No.) |
|                                                              |       |                                    |
| **5850 San Felipe, Suite 450**

**Houston, Texas 77057**          | ** ** | ** **

**77057**                   |
| (Address  of principal executive offices)                         |       | (Zip  Code)                             |
|                                                              |       |                                    |

 

 

**(713)706-6200**

(Registrant’stelephone number, including area code)

 

(Formername, former address and former fiscal year, if changed since last report

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý No o

 

Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes oNo ý

 

As of November 9, 2004 1,569,890 shares of CommonStock ($.01 par value) were outstanding.

 

 

 

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**TABLE OFCONTENTS**

 

 
|    |                                                                                                                                                     |
|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| PART  I | FINANCIAL  INFORMATION                                                                                                                                   |
|    |                                                                                                                                                     |
| Item 1  | Financial  Statements                                                                                                                                    |
|    | Consolidated Balance Sheets at September  30, 2004 and December 31, 2003                                                                                 |
|    | Consolidated  Statements of Operations for the three months ended September 30, 2004 and  2003 and for the nine months ended September 30, 2004 and 2003 |
|    | Consolidated  Statement of Stockholders’ Equity for the nine months ended September 30,  2004                                                       |
|    | Consolidated Statements of Cash Flows for  the nine months ended September 30, 2004 and 2003                                                             |
|    | Notes to Consolidated Financial Statements                                                                                                               |
| Item  2 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                              |
| Item 3  | Quantitative and  Qualitative Disclosures about Market Risk                                                                                              |
| Item  4 | Controls  and Procedures                                                                                                                                 |
|    |                                                                                                                                                     |
| PART II | OTHER INFORMATION                                                                                                                                        |
|    |                                                                                                                                                     |
| Item 1  | Legal Proceedings                                                                                                                                        |
| Item 2  | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                             |
| Item 6  | Exhibits and Reports on Form 8-K                                                                                                                         |

 

 

2

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**PARTI.  FINANCIALINFORMATION**

 

**                ITEM1.  FINANCIALSTATEMENTS**

 

**AMERICANSPECTRUM REALTY, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(Dollars in thousands,except per share amounts) 

 
| **ASSETS**                                                                                                                                                        | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
|                                                                                                                                                              |       | **(Unaudited)**        |       |                  |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Real estate held for investment                                                                                                                                   |       | $                      | 192,193    |                  | $          | 186,208 |   |
| Accumulated depreciation                                                                                                                                          |       | 25,055                 |       | 17,668                |       |
| Real estate held for investment, net                                                                                                                              |       | 167,138                |       | 168,540               |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Real estate held for sale                                                                                                                                         |       | —                 |       | 14,574                |       |
| Cash and cash equivalents                                                                                                                                         |       | 2,007                  |       | 2,937                 |       |
| Tenant and other receivables, net of allowance for doubtful accounts  of $202 and $352, respectively (including $244 and $271, respectively, from  related party) |       | 466                    |       | 420                   |       |
| Mortgage loan receivable, net of discount of $83 at December 31, 2003                                                                                             |       | —                 |       | 1,667                 |       |
| Deferred rents receivable                                                                                                                                         |       | 1,488                  |       | 1,045                 |       |
| Insurance proceeds receivable — litigation settlement                                                                                                        |       | —                 |       | 6,500                 |       |
| Deposit held in escrow                                                                                                                                            |       | 1,365                  |       | —                |       |
| Investment in management company                                                                                                                                  |       | 4,000                  |       | 4,000                 |       |
| Prepaid and other assets, net                                                                                                                                     |       | 10,453                 |       | 8,320                 |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Total Assets                                                                                                                                                      |       | $                      | 186,917    |                  | $          | 208,003 |   |
|                                                                                                                                                              |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                     |       |                   |       |                  |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Liabilities:                                                                                                                                                      |       |                   |       |                  |       |
| Notes payable, net of premiums of $2,603 and $3,089, respectively                                                                                                 |       | $                      | 146,784    |                  | $          | 143,742 |   |
| Notes payable, litigation settlement                                                                                                                              |       | 9,750                  |       | 9,750                 |       |
| Liabilities related to real estate held for sale                                                                                                                  |       | —                 |       | 8,018                 |       |
| Accounts payable                                                                                                                                                  |       | 2,345                  |       | 2,048                 |       |
| Deferred tax liability                                                                                                                                            |       | 4,316                  |       | 4,316                 |       |
| Litigation settlement payable                                                                                                                                     |       | —                 |       | 6,500                 |       |
| Accrued and other liabilities (including $437 and $579, respectively,  to related parties)                                                                        |       | 6,810                  |       | 5,885                 |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Total Liabilities                                                                                                                                                 |       | 170,005                |       | 180,259               |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Minority Interest                                                                                                                                                 |       | 5,527                  |       | 7,009                 |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Commitments and Contingencies:                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Redeemable Common Stock                                                                                                                                           |       | 300                    |       | 300                   |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Stockholders’ Equity:                                                                                                                                        |       |                   |       |                  |       |
| Preferred stock, $.01 par value; authorized, 25,000,000 shares, none  issued and outstanding                                                                      |       | —                 |       | —                |       |
| Common stock, $.01 par value; authorized, 100,000,000 shares; issued,  1,592,710 and 1,578,224 shares, respectively                                               |       | 16                     |       | 16                    |       |
| Additional paid-in capital                                                                                                                                        |       | 45,905                 |       | 45,742                |       |
| Accumulated deficit                                                                                                                                               |       | (33,232                | )          | (23,516               | )          |
| Receivable from principal stockholders                                                                                                                            |       | (1,071                 | )          | (1,191                | )          |
| Deferred compensation                                                                                                                                             |       | (73                    | )          | (195                  | )          |
| Treasury stock, at cost, 24,032 and 22,782 share, respectively                                                                                                    |       | (460                   | )          | (421                  | )          |
|                                                                                                                                                              |       |                   |       |                  |       |
| Total Stockholders’ Equity                                                                                                                                   |       | 11,085                 |       | 20,435                |       |
|                                                                                                                                                              |       |                   |       |                  |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                   |       | $                      | 186,917    |                  | $          | 208,003 |   |
|                                                                                                                                                                   |            |                        |            |                       |            |  |  |  |

 

The accompanying notesare an integral part of these consolidated financial statements

 

 

3

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**AMERICANSPECTRUM REALTY, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Dollarsin thousands, except per share amounts)

(Unaudited)

 
| ** **                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES:**                                                 | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Rental revenue**                                            |       | $                                    | 6,520      |                                | $          | 5,734 |   | $ | 20,006 |   | $ | 17,475 |   |
| Interest and other income                                     |       | 49                                   |       | 34                                  |       | 211 |   | 77 |   |
| Total revenues                                                |       | 6,569                                |       | 5,768                               |       | 20,217 |   | 17,552 |   |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| **EXPENSES:**                                                 |       |                                 |       |                                |       |   |   |   |   |
| Property operating expense                                    |       | 2,758                                |       | 2,578                               |       | 7,851 |   | 7,054 |   |
| General and administrative                                    |       | 1,243                                |       | 1,650                               |       | 3,551 |   | 4,952 |   |
| Depreciation and amortization                                 |       | 2,606                                |       | 2,212                               |       | 7,735 |   | 6,397 |   |
| Interest expense                                              |       | 3,139                                |       | 2,452                               |       | 8,998 |   | 7,456 |   |
| Total expenses                                                |       | 9,746                                |       | 8,892                               |       | 28,135 |   | 25,859 |   |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| **OTHER LOSS:**                                               |       |                                 |       |                                |       |   |   |   |   |
| Loss on extinguishment of debt                                |       | (214                                 | )          | —                              |       | (827 | ) | — |   |
| Total other loss                                              |       | (214                                 | )          | —                              |       | (827 | ) | — |   |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Net loss before minority interest and discontinued operations |       | (3,391                               | )          | (3,124                              | )          | (8,745 | ) | (8,307 | ) |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Minority interest                                             |       | 704                                  |       | 930                                 |       | 1,390 |   | 1,845 |   |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Net loss before discontinued operations                       |       | (2,687                               | )          | (2,194                              | )          | (7,355 | ) | (6,462 | ) |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Discontinued operations:                                      |       |                                 |       |                                |       |   |   |   |   |
| Income (loss) from discontinued operations                    |       | 25                                   |       | (443                                | )          | (63 | ) | (1,074 | ) |
| (Loss) gain on sale of discontinued operations                |       | (2,298                               | )          | 51                                  |       | (2,298 | ) | 2,279 |   |
| Impairment of real estate assets held for sale                |       | —                               |       | (3,500                              | )          | — |   | (7,500 | ) |
| Loss from discontinued operations                             |       | (2,273                               | )          | (3,892                              | )          | (2,361 | ) | (6,295 | ) |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Net loss                                                      |       | $                                    | (4,960     | )                                   | $          | (6,086 | ) | $ | (9,716 | ) | $ | (12,757 | ) |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Basic and diluted per share data:                             |       |                                 |       |                                |       |   |   |   |   |
| Net loss before discontinued operations                       |       | $                                    | (1.72      | )                                   | $          | (1.43 | ) | $ | (4.72 | ) | $ | (4.41 | ) |
| Loss from discontinued operations                             |       | (1.45                                | )          | (2.54                               | )          | (1.51 | ) | (4.29 | ) |
| Net loss                                                      |       | $                                    | (3.17      | )                                   | $          | (3.98 | ) | $ | (6.23 | ) | $ | (8.70 | ) |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| Basic weighted average shares used                            |       | 1,564,885                            |       | 1,529,702                           |       | 1,558,859 |   | 1,465,849 |   |

 

 

Theaccompanying notes are an integral part of these consolidated financial statements

 

4

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**AMERICANSPECTRUM REALTY INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

 (Dollars in thousands)

(Unaudited)

 
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Additional Paid-In Capital** | ** ** | **Accumulated Deficit** | ** ** | **Deferred Compensation** | ** ** | **Treasury Stock** | ** ** | **Receivable from Principal Stockholders** | ** ** | **Total Equity** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|--------------------------------|------------|-------------------------|------------|---------------------------|------------|--------------------|------------|--------------------------------------------|------------|------------------|------------|
| ** **                                                 | ** ** | ** **       | ** ** | ** **                     | ** ** | ** **              | ** ** | ** **                | ** ** | ** **         | ** ** | ** **                                 | ** ** | ** **       | ** ** |
| Balance,  December 31, 2003                                |       | $                | 16         |                           | $          | 45,742                  |       | $                         | (23,516)   |               | $          | (195)                                      |       | $                | (421)      |   | $ | (1,191) |   | $ | 20,435 |   |
| Issuance of  common stock                                  |       | —           |       | 71                             |       | —                  |       | —                    |       | —             |       | —                                     |       | 71               |       |
| Conversion of  operating partnership units to common stock |       | —           |       | 92                             |       | —                  |       | —                    |       | —             |       | —                                     |       | 92               |       |
| Restricted stock forfeited                                 |       | —           |       | —                         |       | —                  |       | 39                        |       | (39                | )          | —                                     |       | —           |       |
| Amortization of deferred compensation                      |       | —           |       | —                         |       | —                  |       | 83                        |       | —             |       | —                                     |       | 83               |       |
| Payment on receivable from principal stockholders          |       | —           |       | —                         |       | —                  |       | —                    |       | —             |       | 120                                        |       | 120              |       |
| Net loss                                                   |       | —           |       | —                         |       | (9,716                  | )          | —                    |       | —             |       | —                                     |       | (9,716           | )          |
| Balance, September 30, 2004                                |       | $                | 16         |                           | $          | 45,905                  |       | $                         | (33,232    | )                  | $          | (73                                        | )          | $                | (460       | ) | $ | (1,071 | ) | $ | 11,085 |   |
|                                                            |            |                  |            |                                |            |                         |            |                           |            |                    |            |                                            |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

Theaccompanying notes are an integral part of these consolidated financialstatements

 

 

5

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**AMERICANSPECTRUM REALTY, INC**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Dollars in thousands)

(Unaudited)

** **
| ** **                                                                                | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Net loss                                                                                  |       | $                                   | (9,716     | ) | $ | (12,757 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:              |       |                                |       |   |   |
| Loss from discontinued operations                                                         |       | 2,361                               |       | 6,295 |   |
| Depreciation and amortization                                                             |       | 7,735                               |       | 6,397 |   |
| Deferred rental income                                                                    |       | (447                                | )          | (305 | ) |
| Minority interest                                                                         |       | (1,390                              | )          | (1,845 | ) |
| Deferred compensation expense                                                             |       | 83                                  |       | 233 |   |
| Mark to market adjustments on interest rate protection agreements                         |       | (65                                 | )          | 202 |   |
| Loss on extinguishment of debt                                                            |       | 827                                 |       | — |   |
| Interest on receivable from principal stockholders                                        |       | (50                                 | )          | (39 | ) |
| Amortization of note payable premiums, included in interest expense                       |       | (411                                | )          | (384 | ) |
| Amortization of note receivable discount, included in interest income                     |       | (58                                 | )          | — |   |
| Changes in operating assets and liabilities:                                              |       |                                |       |   |   |
| (Increase) decrease in tenant and other receivables                                       |       | (129                                | )          | 64 |   |
| Decrease (increase) in accounts payable                                                   |       | 297                                 |       | (62 | ) |
| Increase in prepaid and other assets                                                      |       | (2,692                              | )          | (1,820 | ) |
| Increase (decrease) in accrued and other liabilities                                      |       | 1,379                               |       | (305 | ) |
| Net cash used in operating activities:                                                    |       | (2,276                              | )          | (4,326 | ) |
|                                                                                      |       |                                |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Proceeds received from sales of real estate assets                                        |       | 9,992                               |       | 32,283 |   |
| Capital improvements to real estate assets                                                |       | (3,929                              | )          | (2,824 | ) |
| Collections on mortgage loan receivable                                                   |       | 28                                  |       | — |   |
| Real estate acquisitions                                                                  |       | (138                                | )          | (281 | ) |
| Net cash provided by investing activities:                                                |       | 5,953                               |       | 29,178 |   |
|                                                                                      |       |                                |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 |       |                                |       |   |   |
| Proceeds from borrowings — refinances                                                |       | 18,750                              |       | 1,340 |   |
| Proceeds from borrowings — other                                                     |       | 458                                 |       | 758 |   |
| Issuance of common stock                                                                  |       | —                              |       | 250 |   |
| Repurchase of common stock                                                                |       | —                              |       | (69 | ) |
| Note payments on litigation settlement                                                    |       | —                              |       | (250 | ) |
| Acquisition of minority interest in operating partnership                                 |       | —                              |       | (223 | ) |
| Repayment of borrowings — property sales                                             |       | (7,041                              | )          | (20,947 | ) |
| Repayment of borrowings — refinances                                                 |       | (14,620                             | )          | (1,300 | ) |
| Repayment of borrowings — scheduled payments                                         |       | (2,063                              | )          | (3,198 | ) |
| Net cash used in financing activities:                                                    |       | (4,516                              | )          | (23,639 | ) |
|                                                                                      |       |                                |       |   |   |
| Cash from discontinued operations                                                         |       | (91                                 | )          | 1,463 |   |
|                                                                                      |       |                                |       |   |   |
| (Decrease) increase in cash                                                               |       | (930                                | )          | 2,676 |   |
|                                                                                      |       |                                |       |   |   |
| Cash, beginning of period                                                                 |       | 2,937                               |       | 788 |   |
| Cash, end of period                                                                       |       | $                                   | 2,007      |   | $ | 3,464 |   |
|                                                                                      |       |                                |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:**                                    |       |                                |       |   |   |
| Cash paid for interest                                                                    |       | $                                   | 8,788      |   | $ | 10,114 |   |
| Cash paid for income taxes                                                                |       | 25                                  |       | 17 |   |
|                                                                                      |       |                                |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING  AND FINANCING ACTIVITIES:**              |       |                                |       |   |   |
| Assumptions of mortgage loans in acquisition of real estate assets                        |       | $                                   | —     |   | $ | 6,077 |   |
| Note receivable settled through acquisition of real estate asset                          |       | 1,722                               |       | — |   |
| Deposit held in escrow for acquisition of real estate asset                               |       | 1,365                               |       | — |   |
| Financing settled through divestitures                                                    |       | —                              |       | 16,885 |   |
| Conversion of debt to related parties into common stock                                   |       | —                              |       | 2,131 |   |
| Conversion of operating partnership units into common stock                               |       | 92                                  |       | 232 |   |
| Issuance of common stock in acquisition of real estate asset                              |       | 71                                  |       | — |   |
| Issuance of operating partnership units in acquisition of real estate  assets             |       | —                              |       | 1,010 |   |
| Receivable from related party regarding certain issues asserted by  principal shareholder |       | —                              |       | 270 |   |

 

The accompanying notesare an integral part of these consolidated financial statements

 

 

6

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**AMERICANSPECTRUM REALTY, INC.**

### **Notes to**ConsolidatedFinancial Statements

 

**NOTE 1.  DESCRIPTION OF BUSINESS**

 

American SpectrumRealty, Inc. (“ASR” or the “Company”) is a Maryland corporation established onAugust 8, 2000.  The Company is afull-service real estate corporation, which owns, manages and operatesincome-producing properties. Substantially all of the Company’s assets are held through an operatingpartnership (the “Operating Partnership”) in which the Company, as of September30, 2004, held the sole general partner interest of .87% and a limitedpartnership interest totaling 86.83%.  Asof September 30, 2004, through its majority-owned subsidiary, the OperatingPartnership, the Company owned and operated 24 properties, which consisted of17 office buildings, four industrial properties, two shopping centers and oneapartment complex.  The 24 properties arelocated in seven states.  In October 2004, the Company acquired an additionaloffice building located in Houston, Texas consisting of 81,587 rentable squarefeet.

 

During the ninemonths ended September 30, 2004, the Company sold three properties, whichconsisted of one office building, one industrial property and a parcel ofundeveloped land, and acquired one office building in Houston, Texas.  During 2003, the Company sold elevenproperties, which consisted of two apartment complexes, two office buildings,six industrial properties and one shopping center, and acquired four officebuildings in Houston, Texas.  During2002, the Company sold two shopping center properties and one apartmentproperty, and purchased three office properties in the Houston area.  The property sales are part of the Company’sstrategy to sell its non-core property types — apartment and shopping centerproperties — and to sell its properties located in the Midwest and Carolina’s,its non-core markets.  The Companyintends to focus primarily on office and industrial properties located inTexas, California and Arizona.

 

The Company is thesole general partner of the Operating Partnership.  As the sole general partner of the OperatingPartnership, the Company generally has the exclusive power to manage andconduct the business of the Operating Partnership under its partnershipagreement.  The Company’s interest as alimited partner in the Operating Partnership entitles it to share in any cashdistributions from, and in profits and losses of, the Operating Partnership.  If the Company receives any distributionsfrom the Operating Partnership, it intends, in turn, pay dividends to itscommon stockholders so that the amount of dividends paid on each share ofcommon stock equals four times the amount of distributions paid on each limitedpartnership unit in the Operating Partnership (“OP Unit”).  Most of the properties are owned by theOperating Partnership through subsidiary limited partnerships or limitedliability companies.

 

Holders of the OP Units have the option to redeem their units and toreceive, at the option of the Company, in exchange for each four OP Units (i)one share of Common Stock of the Company, or (ii) cash equal to the marketvalue of one share of Common Stock of the Company at the date of conversion,but no fractional shares will be issued.

 

Managementcontinues to consider whether it is in the best interest of the Company toelect to be treated as a real estate investment trust (or REIT), as definedunder the Internal Revenue Code of 1986, as amended.  The Company currently operates in a mannerthat will permit it to elect REIT status; however, the Company may enter intotransactions which will preclude it from electing REIT status in thefuture.  In general, a REIT is a companythat owns or provides financing for real estate and pays annual distributionsto investors of at least 90% of its taxable income.  A REIT typically is not subject to federalincome taxation on its net income, provided applicable income tax requirementsare satisfied.   For the tax year 2003,the Company was taxed as a C corporation. It is anticipated that the Company will be taxed as a C corporation forthe 2004 tax year.

 

 

7

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**NOTE 2. SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

 

**BASIS OF PRESENTATION**

 

The accompanying unaudited consolidated financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission.  Inthe opinion of the Company, the accompanying interim unaudited consolidatedfinancial statements contain all material adjustments, consisting only ofnormal recurring adjustments necessary to present fairly the financialcondition, the results of operations and changes in cash flows of the Companyand its subsidiaries for interim periods.

 

The results for such interim periods are notnecessarily indicative of results for a full year.  It is suggested that these consolidatedfinancial statements be read in conjunction with the consolidated financialstatements for the year ended December 31, 2003 and the related notes theretoincluded in the Company’s 2003 Annual Report on Form 10-K filed with the SEC.

 

All significant intercompany transactions, receivablesand payables have been eliminated in consolidation.

 

**RECLASSIFICATIONS**

## ** **

Certain prior year balances have been reclassified toconform with the current year presentation.  In accordance with SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets”, real estate designated asheld for sale are accounted for in accordance with the provisions of SFAS No.144 and the results of operations of these properties are included in incomefrom discontinued operations.  Priorperiods have been reclassified for comparability, as required.

 

Pursuant to a one-for-four reverse stock split of theCompany’s Common Stock, every four shares of Common Stock outstanding as of theclose of business on March 1, 2004 became one share of new post-split CommonStock.  Share and per share data (exceptpar value) in the consolidated financial statements and notes for all periodspresented have been adjusted to reflect the reverse stock split.

 

**USE OF ESTIMATES**

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the results ofoperations during the reporting period. Actual results could materially differfrom those estimates.

 

**NEW ACCOUNTING PRONOUNCEMENTS**

 

In May 2003, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 150*,*“Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity” (“FAS 150”). * *FAS150 specifies that certain financial instruments within its scope constituteobligations of the issuer and that, therefore, the issuer must classify them asliabilities.  Such financial instrumentsinclude mandatorily redeemable financial instruments, obligations to repurchasethe issuer’s equity shares by transferring assets, and certain obligations toissue a variable number of shares.  SFASNo. 150 is effective immediately for all financial instruments enteredinto or modified after May 31, 2003. For all other instruments, FAS 150 is effective at the beginning ofthe third quarter of 2003.  The adoptionof FAS 150 did not have a material impact on the Company’s consolidatedfinancial position or results of operations.

 

In April 2003, FASBissued SFAS No. 149, “Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities” (“FAS 149”).  FAS149 amends and clarifies certain derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133.  FAS 149 is effective for certaincontracts entered into or modified by the Company after June 30,2003.  The adoption of FAS 149 did nothave a material impact on the Company’s consolidated financial position orresults of operations.

 

 

8

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**REAL ESTATE**

 

Rental properties are stated at cost, net ofaccumulated depreciation, unless circumstances indicate that cost, net ofaccumulated depreciation, cannot be recovered, in which case the carrying valueof the property is reduced to estimated fair value.  Estimated fair value (i) is based upon theCompany’s plans for the continued operation of each property and (ii) iscomputed using estimated sales price, as determined by prevailing market valuesfor comparable properties and/or the use of capitalization rates multiplied byannualized net operating income based upon the age, construction and use of thebuilding.  The fulfillment of theCompany’s plans related to each of its properties is dependent upon, amongother things, the presence of economic conditions which will enable the Companyto continue to hold and operate the properties prior to their eventualsale.  Due to uncertainties inherent inthe valuation process and in the economy, actual results of operating anddisposing of the Company’s properties could be materially different fromcurrent expectations.

 

Depreciation is provided using the straight-linemethod over the useful lives of the respective assets. The useful lives are asfollows:

 

| Building and Improvements |   | 5 to 40 years             |
|---------------------------|--------|---------------------------|
| Tenant Improvements       |   | Term of the related lease |
| Furniture and Equipment   |   | 3 to 5 years              |

 

**CASH EQUIVALENTS**

 

Cash equivalents include all highly liquid investmentswith a maturity of three months or less at the date of purchase.

 

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The Company’s financial instruments consist of cashand cash equivalents, an escrow deposit, tenant and other receivables, notespayable, accounts payable and accrued expenses. Management believes that the carrying value of the Company’s financialinstruments approximate their respective fair market values at September 30,2004 and December 31, 2003.

 

**DERIVATIVE FINANCIAL INSTRUMENTS**

 

The Company followsStatement of Financial Accounting Standard No. 133, as amended, whichestablishes accounting and reporting standards for derivative financialinstruments, including certain derivative instruments embedded in othercontracts and hedging activities.  Allderivatives, whether designed as hedging relationships or not, are required tobe recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes inthe fair value of the derivative and of the hedged item attributable to thehedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effectiveportions of changes in the fair value of the derivative are recorded in othercomprehensive income and ineffective portions of changes in the fair value ofcash flow hedges are recognized in earnings.

 

As of December 31, 2003,the Company had interest rate swap contracts in notional amounts ofapproximately $9,600,000.  The interestrate swap contracts were reflected at fair value on the Company’s balance sheetat December 31, 2003 in accrued and other liabilities and the changes in thefair value of the hedge were recognized as adjustments to interest expense.  The Company had no swap contacts at September30, 2004.  During the nine months endedSeptember 30, 2004 and 2003, the Company recorded a benefit of $65,000 and acharge of $202,000, respectively, attributable to changes in the fair value ofits derivatives financial instruments.

 

**DEFERRED FINANCING AND OTHER FEES**

 

Fees paid in connection with the financing and leasingof the Company’s properties are amortized over the term of the related notepayable or lease and are included in other assets.

 

 

9

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## **STOCK-BASEDCOMPENSATION**

 

The Financial Accounting Standards Board issued SFASNo. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) in October1995.  This standard establishes a fairvalue approach to valuing stock options awarded to employees as compensation. In December2002, FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation -Transition and Disclosure” (“FAS 148”), which amended FAS 123.  FAS 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. Additionally, FAS 148 amends the disclosure requirements of FAS 123 torequire prominent disclosures in the annual and interim financial statements aboutthe method of accounting for stock-based employee compensation and the effectof the method used on reported results. FAS 148 is effective for financial statements for fiscal years endingafter December 15, 2002.  In compliancewith FAS 148, the Company has elected to continue to follow the intrinsic valuemethod in accounting for its stock-based employee compensation arrangement asdefined by APB No. 25 “Accounting for Stock Issued to Employees”.

 

The Company has in effectits Omnibus Stock Incentive Plan (the “Plan”), which is described more fully inits Form 10-K filed with the Securities and Exchange Commission.  The Company has elected, as permitted by FAS 123, touse the intrinsic value based method of accounting for stock options consistentwith Accounting Principles Board Opinions No. 25, “Accounting for Stock Issuedto Employees”.  The intrinsic valuemethod measures compensation cost for stock options as the excess, if any, ofthe quoted market price of the Company’s stock at the measurement date over theexercise price.  No stock-based employeecompensation cost is reflected in net income related to stock options, as alloptions granted under the Plan had an exercise price equal to the average ofthe high and low sales prices of the underlying common stock on the date ofgrant.

 

The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition of the provisions of FAS 123 to stock-basedemployee compensation (thousands of dollars):

 
| ** **                                                                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                         | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
|                                                                                                               |       | **2004**               |       | **2003**              |       | **2004** |   | **2003** |   |
| Net loss, as reported                                                                                              |       | $                      | (4,960     | )                     | $          | (6,086 | ) | $ | (9,716 | ) | $ | (12,757 | ) |
| Deduct: Employee compensation expense for stock option grants under  fair value method, net of related tax effects |       | (44                    | )          | (68                   | )          | (141 | ) | (212 | ) |
| Pro forma net loss                                                                                                 |       | $                      | (5,004     | )                     | $          | (6,154 | ) | $ | (9,857 | ) | $ | (12,969 | ) |
|                                                                                                               |       |                   |       |                  |       |   |   |   |   |
| Per share data:                                                                                                    |       |                   |       |                  |       |   |   |   |   |
| Basic and diluted, as reported                                                                                     |       | $                      | (3.17      | )                     | $          | (3.98 | ) | $ | (6.23 | ) | $ | (8.70 | ) |
| Basic and diluted, proforma                                                                                        |       | $                      | (3.20      | )                     | $          | (4.02 | ) | $ | (6.32 | ) | $ | (8.85 | ) |
|                                                                                                                    |            |                        |            |                       |            |  |  |  |  |  |  |  |  |  |

# ** **

# **MINORITY INTEREST**

 

Unit holders inthe Operating Partnership (other than the Company) held a 12.30% and 12.61%limited partnership interest in the Operating Partnership at September 30, 2004and December 31, 2003, respectively. Each of the holders of the interests in the Operating Partnership (otherthan the Company) has the option (exercisable after the first anniversary ofthe issuance of the OP Units) to redeem its OP Units and to receive, at theoption of the Company, in exchange for each four OP Units, either (i) one shareof Common Stock of the Company, or (ii) cash equal to the value of one share ofCommon Stock of the Company at the date of conversion, but no fractional shareswill be issued.

 

**RENTAL REVENUE**

 

Certain leases provide for tenant occupancy duringperiods for which no rent is due or where minimum rent payments increase duringthe term of the lease.  The Companyrecords rental income for the full term of each lease on a straight-linebasis.  Accordingly, a receivable isrecorded from tenants equal to the excess 

 

 

10

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of the amount that would have been collected on astraight-line basis over the amount collected and currently due (Deferred RentReceivable).  When a property isacquired, the term of existing leases is considered to commence as of theacquisition date for purposes of this calculation.

 

The Company’s portfolio of leases turns overcontinuously, with the number and value of expiring leases varying from year toyear.  The Company’s ability to re-leasethe space to existing or new tenants at rates equal to or greater than thoserealized historically is impacted by, among other things, the economicconditions of the market in which a property is located, the availability ofcompeting space, and the level of improvements which may be required at theproperty.  No assurance can be given thatthe rental rates that the Company will obtain in the future will be equal to orgreater than those obtained under existing contractual commitments.

 

# **NET LOSS PER SHARE**

 

Netloss per share is calculated based on the weighted average number of commonshares outstanding.  Stock optionsoutstanding of 46,125 at September 30, 2004 and OP Units (other than those heldby the Company) outstanding of 880,794 (convertible into approximately 220,198shares of common stock) at September 30, 2004 have not been included in the netloss per share calculation since their effect would be antidilutive.  See “Minority Interests” paragraph above.

 

**INCOME TAXES**

 

In preparing the Company’s consolidated financialstatements, management estimates the income tax in each of the jurisdictions inwhich the Company operates.  This processincludes an assessment of current tax expense, the results of tax examinations,and the effects of temporary differences resulting from the different treatmentof transactions for tax and financial accounting purposes.  These differences may result in deferred taxassets or liabilities which are included in the consolidated balance sheet.  The realization of deferred tax assets as aresult of future taxable income must be assessed and to the extent that therealization is doubtful, a valuation allowance is established.  The Company’s income tax provision is basedon calculations and assumptions that will be subject to examination by thetaxing authorities in the jurisdictions in which the Company operates.  Should the actual results differ from theCompany’s estimates, the Company would have to adjust the income tax provisionin the period in which the facts and circumstances that give rise to therevision become known.  Tax law and ratechanges are reflected in the income tax provision in the period in which suchchanges are enacted.

 

## **NOTE 3.  REAL ESTATE**

## ** **

# **ACQUISITIONS**

 

*2004.*

 

OnAugust 2, 2004, the Company acquired a 42,860 square foot office property inHouston, Texas, which is adjacent to an office property owned by theCompany.  The Company owned thepromissory note secured by the property, representing the debt from the owner.  Acquisition costs of approximately $2,084,000included the settlement of the note, the issuance of 10,000 shares ofrestricted Common Stock (valued for this purpose at $7.50 per share) and cash.

 

*2003.*

 

During 2003, the Company acquired four officeproperties, three of which were from an affiliated entity.  The properties are located in Houston, Texasand consist of approximately 250,437 rentable square feet.  Acquisition costs of approximately$16,088,000 included assumed or new mortgage indebtedness of $13,465,000, theissuance of 382,537 OP Units (valued for this purpose at $4.11 per unit),proceeds from a tax deferred exchange of $543,000, deferred payments of$191,000 with the remainder in cash.

 

Rental revenue and related expenses from the acquired properties wasincluded in the Company’s results since their respective dates ofacquisition.  Therefore, the results ofoperations for the three and nine months ended September 30, 2004 includeresults from all of the above acquisitions, whereas, the results of 

 

 

11

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operations for the three and nine months ended September 30, 2003contain limited results related to these acquisitions.

 

## **DISPOSITIONS**

 

*2004.*

 

On September 30, 2004, the Company sold VanBuren, a 16.65 acre parcel of undeveloped land located in Phoenix, Arizona, for$3,111,000.

 

On August 24, 2004, the Company sold ParkadeCenter, a 220,684 square foot office property located in Columbia, Missouri,for $4,127,000.

 

On July 30, 2004, the Company sold Westlakes,a 95,370 square foot industrial property located in San Antonio, Texas, for $4,975,000.

 

The three properties sold during the ninemonths ended September 30, 2004 produced net proceeds of approximately$4,316,000 of which $1,365,000 was held in escrow at September 30, 2004 as asource to facilitate the funding of a future acquisition in a tax-deferredexchange.  A net loss of $2,298,000 wasincurred in connection with the transactions, which is reflected asdiscontinued operations in the consolidated statements of operations.

 

*2003.*

 

During 2003, the Company sold elevenproperties for an aggregate sales price of $61,162,000.  The properties, which totaled 1,477,833square feet, consisted of six industrial properties, two office buildings, twoapartment complexes and one shopping center property.  Reference is made to the Company’s AnnualReport on Form 10-K for 2003 for more information with respect to the 2003property dispositions.

 

In the accompanyingconsolidated statement of operations for the three and nine months endedSeptember 30, 2004 and 2003, the results of operations for properties mentionedabove are shown in the section “Discontinued operations” through theirrespective sale date.

 

**INTANGIBLEASSETS PURCHASED**

 

Upon acquisitions of realestate, the Company assesses the fair value of acquired tangible and intangibleassets (including land, buildings, tenant improvements, above and below marketleases, origination costs, acquired in-place leases, other identifiedintangible assets and assumed liabilities in accordance with Statement ofFinancial Accounting Standards No. 141), and allocates the purchase price tothe acquired assets and assumed liabilities. The Company also considers an allocation of purchase price of otheracquired intangibles, including acquired in-place leases.

 

## **The Company evaluates acquired“above and below” market leases at their fair value (using a discount ratewhich reflects the risks associated with the leases acquired) equal to thedifference between (i) the contractual amounts to be paid pursuant to eachin-place lease and (ii) management’s estimate of fair market lease rates foreach corresponding in-place lease, measured over a period equal to theremaining term of the lease for above-market leases and the initial term plusthe term of any below-market fixed rate renewal options for below-market leases.  Based on its acquisitions to date, theCompany’s allocation to intangible assets for assets purchased has beenimmaterial.**

 

## **NOTE 4.  DISCONTINUED OPERATIONS**

 

*Realestate assets held for sale.*

 

As of December 31, 2003, three propertieswere classified as “Real estate held for sale”. These three properties were sold during the third quarter of 2004.  The properties consisted of a 220,684 squarefoot office property located in Columbia, Missouri, a 95,370 square footindustrial property located in San Antonio, Texas and a 16.65 acre parcel ofundeveloped land located in Phoenix, Arizona. The sales 

 

 

12

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produced net proceeds of approximately$4,316,000 of which $1,365,000 was held in escrow at September 30, 2004 as asource to facilitate the funding of a future acquisition in a tax-deferredexchange.

 

 
| **Condensed Consolidated Balance Sheet**         | ** ** | **December 31, 2003** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
|                                             |       |                  |       |
| Real estate                                      |       | $                     | 14,250     |   |
| Other                                            |       | 324                   |       |
| Real estate assets held for sale                 |       | $                     | 14,574     |   |
|                                             |       |                  |       |
| Notes payable, net                               |       | $                     | 7,309      |   |
| Accounts payable                                 |       | 204                   |       |
| Accrued and other liabilities                    |       | 505                   |       |
| Liabilities related to real estate held for sale |       | $                     | 8,018      |   |

 

All real estate assets held by the Company onSeptember 30, 2004 are considered held for investment.  No real estate was classified as held for saleby the Company at September 30, 2004.

 

*Net lossfrom discontinued operations.*

 

Net loss from discontinued operations for thethree and nine months ended September 30, 2004 includes the results ofoperations of the three properties sold during the third quarter of 2004.   A net loss on sale of discontinuedoperations totaling $2,298,000 was incurred in connection with thetransactions.

 

The condensed consolidated statements ofoperations of discontinued operations for the three and nine months ended September30, 2004 are summarized below (dollars in thousands):

 
| **Condensed Consolidated Statements of Operations**                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **September 30, 2004** | ** ** | **September 30, 2004** | ** ** |
| Rental revenue                                                     |       | $                      | 305        |                   | $          | 1,311 |   |
| Total expenses                                                     |       | 280                    |       | 1,374                  |       |
| Net income (loss) from discontinued operations before loss on sale |       | 25                     |       | (63                    | )          |
| Loss on sale of discontinued operations                            |       | (2,298                 | )          | (2,298                 | )          |
| Net loss from discontinued operations                              |       | $                      | (2,273     | )                      | $          | (2,361 | ) |

 

Net loss from discontinued operations for thethree and nine months ended September 30, 2003 includes the results ofoperations of eleven properties sold in 2003 and three properties sold in2004.   Seven of the eleven properties,which were sold during the third quarter of 2003, generated a net gain on saleof discontinued operations of $51,000.  The net loss from discontinued operations for the quarter endedSeptember 30, 2003 included an impairment charge of $3,500,000 related to anoffice property subsequently sold in the fourth quarter of 2003.  Nine of the eleven properties, which weresold during the nine months ended September 30, 2003, generated a net gain onsale of discontinued operations of $2,279,000.  The net gainrecognized for the nine months was after taking into consideration animpairment charge totaling $4,000,000 recorded in the second quarter of 2003related to three of the nine properties. Impairment charges for the nine months ended September 30, 2003, whichtotaled $7,500,000, were related to four properties sold during 2003.  The impairments were based on the anticipatedsales price less cost to sell as compared to the carrying value of the assets.

 

The condensed consolidated statements ofoperations of discontinued operations for the three and nine months endedSeptember 30, 2003 are summarized below (dollars in thousands):

 
| **Condensed Consolidated Statements of Operations**                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                | ** ** | **September 30, 2003** | ** ** | **September 30, 2003** | ** ** |
| Rental revenue                                                            |       | $                      | 1,790      |                   | $          | 7,964 |   |
| Total expenses                                                            |       | 2,233                  |       | 9,038                  |       |
| Net loss from discontinued operations before gain on sale and  impairment |       | (443                   | )          | (1,074                 | )          |
| Gain on sale of discontinued operations                                   |       | 51                     |       | 2,279                  |       |
| Impairment of real estate assets held for sale                            |       | (3,500                 | )          | (7,500                 | )          |
| Net loss from discontinued operations                                     |       | $                      | (3,892     | )                      | $          | (6,295 | ) |

 

 

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**NOTE 5. MORTGAGE LOAN RECEIVABLE**

 

On October 27, 2003, the Company acquired a note secured by a propertyadjacent to an office property owned by the Company.  The property consists of 42,860 square feetand is located in Houston, Texas.  Thepurchase of this note was funded with a new loan to the Company from the lenderthat owned the note.  Loan costs ofapproximately $41,000 were incurred in connection with the transaction.  The note bore interest at 7.5% perannum.  The receivable balance of thenote at December 31, 2003 was $1,666,504, net of discount of $83,253.  On August 2, 2004 the Company acquired theproperty.  Acquisition costs ofapproximately $2,084,000 included the settlement of the note, the issuance of10,000 shares of restricted Common Stock (valued for this purpose at $7.50 pershare) and cash.

 

**NOTE 6.  NOTES PAYABLE, NET OF PREMIUMS**

 

The Company had the following notes payableoutstanding as of September 30, 2004 and December 31, 2003 (dollars inthousands):

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Secured loans with various lenders, net of unamortized premiums of  $2,603 at September 30, 2004 and $3,089 at December 31, 2003, bearing  interest at fixed rates between 5.00% and 10.50% at September 30, 2004 and  December 31, 2003, with monthly principal and interest payments ranging  between $3 and $269 at September 30, 2004 and December 31, 2003, and maturing  at various dates through August 1, 2014. |       | $        | 130,264    |     | $          | 121,391 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Secured loans with various banks bearing interest at variable rates  ranging between 5.61% and 7.00% at September 30, 2004, and 5.14% and 6.50%  December 31, 2003, and maturing at various dates through May 1, 2008.                                                                                                                                                                                                  |       | 3,988    |       | 9,534    |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Secured Series A & B Bonds with a fixed interest rate of 6.39%,  monthly principal and interest payments of $74, maturing September 30, 2031.                                                                                                                                                                                                                                                                       |       | 11,416   |       | 11,532   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Secured Series C Bonds with a fixed interest rate of 9.50%,  semi-annual principal and interest payments of $97, maturing November 1,  2006.                                                                                                                                                                                                                                                                            |       | 400      |       | 475      |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Unsecured loans with various lenders, bearing interest at fixed rates  between 5.45% and 20.00% at September 30, 2004 and between 4.99% and 20.00%  at December 31, 2003, and maturing at various dates through February 19,  2005.                                                                                                                                                                                     |       | 716      |       | 810      |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Total                                                                                                                                                                                                                                                                                                                                                                                                                   |       | $        | 146,784    |     | $          | 143,742 |   |

 

Debt premiums are amortized into interestexpense over the terms of the related mortgages using the effective interestmethod.  As of September 30, 2004 andDecember 31, 2003, the unamortized debt premiums included in the above schedulewere $2,603,000 and $3,089,000 respectively.

 

In August 2004, the Company refinanced a $5,350,000 loan on San Felipe,one of its office properties with a new loan agreement in the amount of$5,500,000.  The new loan bears interestat a fixed rate of 5.65% per annum and matures in August 2014.   The Company funded closing costs ofapproximately $178,000 and escrowed $327,000 for future capital expenditures,real estate taxes and insurance related to the August 2004 refinance.  Net proceeds of $2,059,000 were received inDecember 2003 related to the December 2003 refinance of the original $3,000,000loan on the property.

 

In August 2004, Company financed costs of $8,750 related to theacquisition of an office property in Houston, Texas.  The note bears interest at 10% per annum andmatures in November 2004.

 

In July 2004, the Company refinanced a $5,330,000 loan on NorthwestCorporate Center, one of its office properties, with a new loan agreement inthe amount of $5,750,000.  The new loanbears interest at a fixed rate of 6.26% per annum and matures in August2014.  No proceeds were received directlyas a result of the 

 

 

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refinance, however $350,000 is being held in escrow by the lender toassist the funding of future capital expenditures at the property.

 

In May 2004, the Company refinanced a $3,132,000 loan on Mira Mesa, oneof its office properties, with a new one-year loan agreement in the amount of$7,500,000.  The new loan, which containstwo six-month extension options, bears interest at a fixed rate of 7.95% perannum.  Net proceeds of $3,440,000 werereceived as a result of the refinance.

 

In May 2004, theCompany financed insurance premiums of $373,000 on its properties and agreed topay a service fee of $85,000 over one year.

 

In November 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company obtained a loan in the amount of$4,574,000.  The loan, which was due tomature in November 2004, bore interest at a fixed rate of 5% per annum.  In October 2004, the maturity date of theloan was extended to November 2005.  Theloan will bear interest at a fixed rate of 8% under the terms of the extension.

 

In October 2003, the Company entered into a $4,100,000 loan agreementin connection with the acquisition of an office property in Houston, Texas andthe acquisition of a note secured by another office property in Houston.  The loan, of which $3,700,000 had been fundedas of September 30, 2004, matures in November 2005 and bears interest at afixed rate of 6% per annum.

 

In September 2003, a note payable in the amount of $510,000 was repaidwith the proceeds from the sale of Emerald Pointe.  The note bore interest at prime plus 1%.

 

In August 2003, the Company refinanced a $1,300,000 loan secured by VanBuren, a parcel of undeveloped land, and entered into a two-year loan agreementin the amount of $1,340,000.  The loanbore interest at a fixed rate of 12% per annum and matured August 1, 2005.  In September 2004, the loan was paid inconnection with the sale of the property.

 

In July 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $1,723,000.  The loan bears interest at a fixed rate of7.41% per annum and matures in May 2005. The Company also entered into an agreement that provided for sellerfinancing of $710,000, bearing interest at a fixed rate of 7.41% per annum andmaturing in July 2005.

 

In May 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $3,180,000.  The loan bears interest at a fixed rate of6.80% per annum and matures in August 2012. The Company also entered into an agreement that provided for sellerfinancing of $464,000, bearing interest at a fixed rate of 6.80% per annum andmaturing in May 2005.

 

In May 2003, the successor of Brown Parker and Leahy, LLP cancelled its$199,180 note, plus $45,891 of accrued interest thereon, in exchange for 14,943shares of the Company’s common stock.

 

In May 2003, John N. Galardi cancelled his$1,600,000 note, plus $286,036 of accrued interest thereon, in exchange for115,002 shares of the Company’s common stock.

 

In May 2003, the Company financed insurance premiumsof $643,000 on its properties and agreed to pay a service fee of $85,000 overone year.  The insurance premium note waspaid in full in February 2004.  TheCompany financed an additional insurance premium during 2003 of $130,000, whichwas paid in full in June 2004.

 

In July 2002, the lender under a loan agreement related to the SouthCarolina shopping center properties notified the Company it was technically indefault under its loan agreement for non-compliance with certain covenants,including covenants requiring improvements to shopping center properties.  Thereafter, the lender notified the Companythat it was in default for failure to pay a matured portion of the loan, whichmatured in November 2002.  In early 2003,the lender sold the loan to the major tenant in two of the shoppingcenters.  In December 2003, the Companysold one of the shopping center properties and repaid $3,935,000, whichincluded the pay-off of the matured portion of the loan.  As of September 30, 2004, the 

 

 

15

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remaining balance of the loan was approximately $2,756,000.   The Company continues to discuss thenon-compliance matter with the new lender. The new lender has not accelerated the loan.

# ** **

# **NOTE 7.  NOTESPAYABLE, LITIGATION SETTLEMENT**

 

As the result of the settlement of the Teachoutlitigation, which was documented in the third quarter of 2003, the Companyreaffirmed its previously announced obligation to pay the former limitedpartners of Sierra Pacific Development Fund II (“Fund II”) as of the date ofthe Company’s 2001 consolidation transaction (the “Consolidation”), or their assigneesor transferees, the loans which were made and called by the former generalpartner of Fund II as part of the Consolidation.  Pursuant to the settlement, the Companyestablished a repayment plan and secured the debt with a second deed of truston an office property owned by the Company. This repayment plan consists of a promissory note in the amount of$8,800,000, which bears interest at 6% per annum and matures in March2006.  Interest-only payments, which arepayable quarterly, commenced June 2, 2003. The note may be prepaid in whole or in part at any time without penalty.

 

As part of the settlement, the Company agreed to paylegal fees totaling $1,200,000 to the plaintiff’s counsel.  The Company made a scheduled payment of$250,000 in the third quarter of 2003 with the remaining $950,000 consisting oftwo promissory notes.  The first note, inthe amount of $700,000, bears interest at 6% per annum and matures in March2006.  Interest-only payments, which arepayable quarterly, commenced June 2, 2003.  The second promissory note, in the amount of $250,000, bears no interestand matures in March 2006.  The notes,which are secured by a second deed of trust on an office property owned by theCompany, may be prepaid in whole or in part at any time without penalty.

 

In connection with the agreement, William J. Carden and John N. Galardiacknowledged that they owe the Company the sum of $1,187,695 as indemnificationagainst a portion of the Company’s settlement obligation.  Mr. Carden is the Chief Executive Officer, adirector and a principal stockholder of the Company.  Mr. Galardi is a director and principalstockholder of the Company.  Mr. Galardiand certain affiliates of Mr. Carden and/or Mr. Galardi are beneficiaries, inpart, of the settlement of the Teachout litigation and are owed an amount inexcess of this obligation pursuant to that settlement.  Mr. Galardi and Mr. Carden have agreed to paythe Company the principal sum of this obligation, plus interest thereon at theannual rate of 6% from March 15, 2003, in the form of an assignment to theCompany of their right to receive $1,187,695 of principal payments on the notespayable to them and their affiliates by reason of the settlement of theTeachout litigation, plus all interest payable on such principal amount ofnotes.  The receivable of $1,187,695 andaccrued interest are reflected as a component of equity in the Company’sconsolidated financial statements.  InMarch, the interest due for all of 2004 and $116,875 in principal waspaid.  The payment was made with certainfunds owed to Mr. Carden and Mr. Galardi by the Company related to a guaranteefee.  See Note 12 — Related PartyTransactions.

 

## **NOTE 8.  LOSS ON EARLY EXTINGUISHMENT OF DEBT**

 

In August 2004, inconnection with the refinance of San Felipe, the Company recorded a loss onearly extinguishment of debt of $214,000 due to a prepayment penalty of$120,000 and the write-off of unamortized loan costs of $94,000.

 

In May 2004, in connectionwith the refinance of Mira Mesa, the Company recorded a loss on earlyextinguishment of debt of $613,000 due to a prepayment penalty of $687,000,which was offset in part by the write-off of an unamortized loan premium of$74,000.

 

The loss on earlyextinguishment of debt is included in other loss in the consolidated statementsof operations.

 

## **NOTE 9.  MINORITY INTEREST**

 

Unit holders inthe Operating Partnership (other than the Company) held a 12.30% and 12.61%limited partnership interest in the Operating Partnership at September 30, 2004and December 31, 2003, respectively. Each of the holders of the interests in the Operating Partnership (otherthan the Company) has the option (exercisable after the first anniversary ofthe issuance of the OP Units) to redeem its OP Units 

 

 

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and to receive, atthe option of the Company, in exchange for each four OP Units, either (i) oneshare of Common Stock of the Company, or (ii) cash equal to the value of oneshare of Common Stock of the Company at the date of conversion, but nofractional shares will be issued.

 

During the nine months ended September 30,2004, a total of 17,963 OP Units were exchanged for 4,486 shares of CommonStock.

 

In July 2003, the Company purchased 7,329 OP Unitsfrom Nooney Development Partners, L.P. for $223,000 pursuant to an agreement enteredinto at the time of the Consolidation.

 

During the year ended December 31, 2003, the Companyissued a total of 382,537 OP Units to an affiliated entity in connection withthe acquisition of three office properties in Houston, Texas.

 

During the year ended December 31, 2003, atotal of 202,056 OP Units were exchanged for 50,514 shares of Common Stock.

 

# **NOTE 10.  REDEEMABLE COMMON STOCK**

 

On October 23, 2001, theCompany issued 5,000 shares of its Common Stock, $.01 par value per share, withthe holder’s right to compel the sale of the stock back to the Company (the“Put”) at a fixed price of $60.00 per share during the period from October 31,2002 to November 30, 2002.  In November2002, the Company and holder agreed to extend the put exercise period to May30, 2003 through June 30, 2003.  In May2003, the Company received notice that the holder exercised its right to sellthe Common Stock back to the Company for $60.00 per share or a total of$300,000 and subsequently agreed to a payment schedule.  In January 2004, the Company and holderagreed to extend the put exercise period to November 30, 2004 through December31, 2004.

 

**NOTE11.  REPURCHASE OF COMMON STOCK**

 

In October 2004,the Company announced that it will go forward with an odd lot buy back programpreviously postponed.  The Company hasoffered to purchase up to 250,000 shares and intends to offer $8.25 per shareto holders of fewer than 100 shares.

 

In September 2004, inconjunction with a resignation agreement, an employee relinquished 1,250 sharesof restricted common stock.

 

In May 2003, the Company’sBoard of Directors authorized the repurchase of up to 75,000 shares of itscommon stock from the proceeds of property sales.  Such purchases would be made from time totime in open market transactions.

 

During 2003, the Companyrepurchased a total of 16,174 shares at an average price of $14.04 per share inopen market transactions.  The total costof the stock repurchases amounted to $234,268.

 

Pursuant to the settlement of the Teachout litigation, the Companyrepurchased 45 shares from a former limited partner of Fund II for $2,457, or$54.00 per share, during the third quarter of 2003.

 

In December 2003, the Company repurchased 6,563 shares of restrictedstock from an employee for cash of $59,750 and the reversal of deferredcompensation of $124,605.

 

## **NOTE 12.  RELATED PARTY TRANSACTIONS**

 

InMarch 2004, the Company paid a total of $224,520 (“Guarantee Fee”) to WilliamJ. Carden, John N. Galardi and CGS Real Estate Company, Inc. (“the Guarantors”)in consideration for their guarantees of certain obligations of the Company asof December 31, 2003.  The payment was made in the form of an offsetagainst certain sums owed to the Company by the Guarantors.  The Company has agreed to pay the Guarantorsan annual guarantee fee equal to between .25% and .75% (depending on the natureof the guaranty) of the outstanding balance as of December 31 of the guaranteedobligations.  The guaranty fee is to bepaid for a maximum of 3 years on any particular obligation.  The charge for this guaranty was accrued 

 

 

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in2003 and is included in interest expense on the results of operations.  For the first nine months ended September 30,2004, the Company has accrued $171,000 related to the guarantee fee payable forthe 2004 year.

 

During 2003, the Company made paymentstotaling $1,000,000, on its indebtedness to an affiliated entity, reducing thebalance due to $251,321.  The Company hasa balance due of $14,800 to an affiliated entity as of September 30, 2004.

 

During 2003, the Company acquired threeoffice properties from an affiliated entity. The properties are located in Houston, Texas and consist ofapproximately 160,742 rentable square feet. Acquisition costs of approximately $10,703,000 included assumed or new mortgageindebtedness, the issuance of 382,537 OP Units, deferred payments of $190,469and cash.

 

In May 2003, the successor of Brown Parker and Leahy, LLP cancelled its$199,180 note, plus $45,891 of accrued interest thereon, in exchange for 14,943shares of the Company’s common stock. Timothy Brown, a director of the Company, was a partner of Brown ParkerLeahy, LLP.

 

In May 2003, Mr. Galardi cancelled his$1,600,000 note, plus $286,036 of accrued interest thereon, in exchange for115,002 shares of the Company’s common stock.

 

In May 2003, Mr. Galardi purchased a total of15,243 shares of the Company’s common stock for $16.40 per share.

 

In February 2003, the Company reached anagreement with CGS Real Estate Company, Inc. whereby CGS acknowledged that it owedthe Company a net amount of $270,375 which related to several issues assertedby William J. Carden that were owed by CGS to the Company and by the Company toCGS.    This amount is payable on March15, 2006 with interest accruing from March 15, 2003 at an annual rate of 6% andpayable quarterly commencing on June 15, 2003. An affiliate of Mr. Carden is a principal stockholder of CGS.  Mr. Carden is an officer and a director ofCGS, and an affiliate of Mr. Galardi is a principal stockholder of CGS.  Mr. Carden and Mr. Galardi have agreed toguarantee this obligation of CGS, and they have secured this guarantee with anassignment to the Company of their right to receive $270,375 of principalpayments on the notes payable to them and their affiliates by reason of thesettlement of the Teachout litigation, plus all interest payable on suchprincipal amount of notes. In March 2004, as part of the payment of theGuarantee Fee, interest due on this obligation for 2004 was paid in advance and$26,606 was applied to the principal due on this obligation.  The principal balance due as of September 30,2004 is $243,858.

 

In connection with the settlement of theTeachout litigation, Mr. Galardi and Mr. Carden acknowledged that they owe theCompany the sum of $1,187,695 as indemnification against a portion of theCompany’s settlement obligation.  Mr.Galardi and certain affiliates of Mr. Carden and/or Mr. Galardi arebeneficiaries, in part, of the settlement of the Teachout litigation and areowed an amount in excess of this obligation pursuant to that settlement.  Mr. Galardi and Mr. Carden have agreed to paythe Company the principal sum of this obligation, plus interest thereon at theannual rate of 6% from March 15, 2003, in the form of an assignment to theCompany of their right to receive $1,187,695 of principal payments on the notespayable to them and their affiliates by reason of the settlement of theTeachout litigation, plus all interest payable on such principal amount ofnotes.  The receivable of $1,187,695 andaccrued interest are reflected as a component of equity in the Company’sconsolidated financial statements.  InMarch 2004, as part of the payment of the Guarantee Fee, interest due on thisobligation for 2004 was paid in advance and $116,875 was applied to theprincipal due on this obligation.  Thebalance due as of September 30, 2004 is $1,070,820.

 

During2003, the Company’s obligation to ASJ, Ltd., which is owned by Mr. Carden, hiswife and a trust for his children, was reduced by $111,321 to offset certainamounts which became payable from the related party.  In January 2004, the Company paid theremaining balance due of $88,679.

 

Duringthe nine months ended September 30, 2004, the Company paid $158,237 for realestate related services to a firm in which Patricia A. Nooney, an executiveofficer of the Company, holds an ownership interest.  For the year ended December 31, 2003, theCompany paid $98,763 to this firm.

 

 

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InSeptember 2004, the Company began managing an apartment complex owned by anaffiliated entity of Mr. Carden.  Duringthe nine months ended September 30, 2004, the Company received management feesof $8,000 from this entity.

 

**NOTE 13.  SEGMENT INFORMATION**

 

As of September 30, 2004, the Company owned aportfolio of properties comprising office, industrial, shopping centerproperties, and an apartment property. Each of these property types represents a reportable segment withdistinct uses and tenant types and requires the Company to employ differentmanagement strategies.  The propertiescontained in the segments are located in various regions and markets within theUnited States.  The office portfolioconsists primarily of suburban office buildings.  The industrial portfolio consists ofproperties designed for warehouse, distribution and light manufacturing forsingle-tenant or multi-tenant use.  Theshopping center portfolio consists of community shopping centers located inSouth Carolina.  The Company’s soleremaining apartment property is located in Missouri and is rented to residentialtenants on either a month-by-month basis or for terms generally of one year orless.

 

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies.  The Company evaluates performance of itsproperty types based on net operating income derived by subtracting propertyoperating expenses from rental revenue. Significant information used by the Company for its reportable segmentsas of and for the three months and nine months ended September 30, 2004 and2003 is as follows (dollars in thousands):

 
| **Three Months Ended September 30,** | ** ** | **Office** | ** ** | **Industrial** | ** ** | **Shopping  Center** | ** ** | **Apartment** | ** ** | **Other**  | ** ** | **Property  Total** | ** ** |
|--------------------------------------|------------|------------|------------|----------------|------------|----------------------|------------|---------------|------------|------------|------------|---------------------|------------|
| **2004**                             | ** ** | ** ** | ** ** | ** **     | ** ** | ** **           | ** ** | ** **    | ** ** | ** ** | ** ** | ** **          | ** ** |
| Rental revenue                       |       | $          | 4,846      |           | $          | 748                  |       | $             | 222        |       | $          | 704                 |       | — |   | $ | 6,520 |   |
| Property operating expenses          |       | 2,099      |       | 141            |       | 45                   |       | 473           |       | —     |       | 2,758               |       |
| Net operating income (NOI)           |       | $          | 2,747      |           | $          | 607                  |       | $             | 177        |       | $          | 231                 |       | $ | — |   | $ | 3,762 |   |
| Real estate held for investment, net |       | $          | 131,280    |           | $          | 17,160               |       | $             | 5,153      |       | $          | 13,482              |       | $ | 63 |   | $ | 167,138 |   |
|                                 |       |       |       |           |       |                 |       |          |       |       |       |                |       |
| **2003**                             |       |       |       |           |       |                 |       |          |       |       |       |                |       |
| Rental revenue                       |       | $          | 4,127      |           | $          | 708                  |       | $             | 221        |       | $          | 671                 |       | $ | 7 |   | $ | 5,734 |   |
| Property operating expenses          |       | 1,939      |       | 166            |       | 70                   |       | 403           |       | —     |       | 2,578               |       |
| Net operating income (NOI)           |       | $          | 2,188      |           | $          | 542                  |       | $             | 151        |       | $          | 268                 |       | $ | 7 |   | $ | 3,156 |   |
| Real estate held for investment, net |       | $          | 123,852    |           | $          | 27,477               |       | $             | 5,549      |       | $          | 14,050              |       | $ | 116 |   | $ | 161,044 |   |
|                                      |            |            |            |                |            |                      |            |               |            |            |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |

 
| **Nine Months Ended September 30,**  | ** ** | **Office** | ** ** | **Industrial** | ** ** | **Shopping  Center** | ** ** | **Apartment** | ** ** | **Other** | ** ** | **Property**

**Total** | ** ** |
|--------------------------------------|------------|------------|------------|----------------|------------|----------------------|------------|---------------|------------|-----------|------------|-------------------------|------------|
| **2004**                             |       |       |       |           |       |                 |       |          |       |      |       |                    |       |
| Rental revenue                       |       | $          | 15,263     |           | $          | 1,962                |       | $             | 749        |      | $          | 2,032                   |       | — |   | $ | 20,006 |   |
| Property operating expenses          |       | 5,912      |       | 468            |       | 184                  |       | 1,262         |       | $         | 25         |                    | 7,851      |   |
| Net operating income (NOI)           |       | $          | 9,351      |           | $          | 1,494                |       | $             | 565        |      | $          | 770                     |       | $ | (25 | ) | $ | 12,155 |   |
| Real estate held for investment, net |       | $          | 131,280    |           | $          | 17,160               |       | $             | 5,153      |      | $          | 13,482                  |       | $ | 63 |   | $ | 167,138 |   |
|                                 |       |       |       |           |       |                 |       |          |       |      |       |                    |       |
| **2003**                             |       |       |       |           |       |                 |       |          |       |      |       |                    |       |
| Rental revenue                       |       | $          | 12,785     |           | $          | 1,866                |       | $             | 705        |      | $          | 2,062                   |       | $ | 57 |   | $ | 17,475 |   |
| Property operating expenses          |       | 5,129      |       | 584            |       | 224                  |       | 1,055         |       | 62        |       | 7,054                   |       |
| Net operating income (NOI)           |       | $          | 7,656      |           | $          | 1,282                |       | $             | 481        |      | $          | 1,007                   |       | $ | (5 | ) | $ | 10,421 |   |
| Real estate held for investment, net |       | $          | 123,852    |           | $          | 17,477               |       | $             | 5,549      |      | $          | 14,050                  |       | $ | 116 |   | $ | 161,044 |   |
|                                      |            |            |            |                |            |                      |            |               |            |           |            |                         |            |  |  |  |  |  |  |  |

 

The following is areconciliation of segment revenues, income and assets to consolidated revenues,income and assets for the periods presented above (dollars in thousands):

 
| ** **                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES**                                                  |       |                                 |       |                                |       |   |   |   |   |
| Total revenues for reportable segments                        |       | $                                    | 6,520      |                                | $          | 5,734 |   | $ | 20,006 |   | $ | 17,475 |   |
| Other revenues                                                |       | 49                                   |       | 34                                  |       | 211 |   | 77 |   |
| Total consolidated revenues                                   |       | $                                    | 6,569      |                                | $          | 5,768 |   | $ | 20,217 |   | $ | 17,552 |   |
|                                                          |       |                                 |       |                                |       |   |   |   |   |
| **NET (LOSS) INCOME**                                         |       |                                 |       |                                |       |   |   |   |   |
| NOI for reportable segments                                   |       | $                                    | 3,762      |                                | $          | 3,156 |   | $ | 12,155 |   | $ | 10,421 |   |
| Unallocated amounts:                                          |       |                                 |       |                                |       |   |   |   |   |
| Interest and other income                                     |       | 49                                   |       | 34                                  |       | 211 |   | 77 |   |
| General and administrative expenses                           |       | (1,243                               | )          | (1,650                              | )          | (3,551 | ) | (4,952 | ) |
| Depreciation and amortization                                 |       | (2,606                               | )          | (2,212                              | )          | (7,735 | ) | (6,397 | ) |
| Interest expense                                              |       | (3,139                               | )          | (2,452                              | )          | (8,998 | ) | (7,456 | ) |
| Loss on extinguishment of debt                                |       | (214                                 | )          | —                              |       | (827 | ) | — |   |
| Net loss before minority interest and discontinued operations |       | $                                    | (3,391     | )                                   | $          | (3,124 | ) | $ | (8,745 | ) | $ | (8,307 | ) |
|                                                               |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

 

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| ** **                           | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|-------------------|------------|
| ** **                           | ** ** | **2004**          | ** ** | **2003** | ** ** |
| **ASSETS**                           | ** ** | ** **        | ** ** | ** ** | ** ** |
| Total assets for reportable segments |       | $                 | 167,138    |   | $ | 161,044 |   |
| Real estate held for sale            |       | —            |       | 22,412 |   |
| Cash and cash equivalents            |       | 2,007             |       | 3,464 |   |
| Tenant and other receivables, net    |       | 466               |       | 391 |   |
| Deferred rent receivable             |       | 1,488             |       | 722 |   |
| Deposits held in escrow              |       | 1,365             |       | 560 |   |
| Investment in management company     |       | 4,000             |       | 4,000 |   |
| Prepaid and other assets, net        |       | 10,453            |       | 9,371 |   |
| Total consolidated assets            |       | $                 | 186,917    |   | $ | 201,964 |   |

 

# **NOTE 14.  COMMITMENTS AND CONTINGENCIES**

 

The following is information concerning legalproceedings to which the Company or its subsidiaries is a party or of which anyof their property is subject:

 

Lewis Matter

OnAugust 2, 2004, the Orange County Superior Court approved the final accountingin the Robert L. Lewis matter.  Thismatter, initiated on or about September 27, 2001 by Robert L. Lewis, MadisonLiquidity Investors 103 LLC and Madison Liquidity Investors 112 LLC, allegedclaims against the Company and others for breach of fiduciary duty, breach ofcontract, intentional interference with prospective economic advantage, andintentional interference with contractual relations related to the Company’s2001 consolidation transaction, although the consolidation was disclosed in aProspectus/Consent Solicitation filed with the Securities and ExchangeCommission and was approved by a majority vote of the limited partners of thepartnerships.  In October 2003, counselfor the plaintiffs and counsel for the defendants executed a Memorandum ofUnderstanding regarding a proposed settlement in this matter.  By the terms of that Memorandum, thedefendants agreed to pay a total of $6,500,000 to settle this action and allother claims known and unknown relating to the facts set forth in theplaintiff’s complaints.  The settlementwas funded, in its entirety, by insurance coverage.  In 2004, the Court approved the settlement asfair, adequate and reasonable and the defendants’ insurers deposited $6,500,000into an escrow account for the purposes of settlement.  Subsequently, $1,640,000 was disbursed forattorney fees and expenses, while the remaining $4,860,000 was distributed tothe plaintiffs.  Reference is made to theCompany’s annual report on Form 10-K for 2003 for more information with respectto this matter.

 

Other Matters

Certain claims and lawsuits have arisen against theCompany in its normal course of business. The Company believes that such claimsand lawsuits will not have a material adverse effect on the Company’s financialposition, cash flow or results of operations.

 

The Company has becomeaware that two of its properties may contain hazardous substances abovereportable levels.  The Company iscurrently evaluating this situation to determine an appropriate course ofaction.

 

 

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Contractual Obligations andCommitments

 

Thefollowing table aggregates the Company’s contractual obligations subsequent toSeptember 30, 2004 (dollars in thousands):

 

 
| ** **                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt (1) (2)         |       | $        | 3,070      |     | $          | 21,146   |       | $        | 5,544      |     | $          | 1,605          |       | $         | 4,903      |   | $ | 107,913 |   | $ | 144,181 |   |
| Litigation settlement (3)      |       | —   |       | —   |       | 9,750    |       | —   |       | —   |       | —         |       | 9,750     |       |
| Capital lease expenditures (4) |       | 2,240    |       | —   |       | —   |       | —   |       | —   |       | —         |       | 2,240     |       |
| Employee obligations (5)       |       | 50       |       | 167      |       | —   |       | —   |       | —   |       | —         |       | 217       |       |
| Total                          |       | $        | 5,360      |     | $          | 21,313   |       | $        | 15,294     |     | $          | 1,605          |       | $         | 4,903      |   | $ | 107,913 |   | $ | 156,388 |   |

 

(1) See Note 6 — NotesPayable.

(2) Includes debt of$7,500,000 with two 6-month extension options to May 2006.

(3)Represents obligations related to the settlement of the Teachout litigation.  See Note 7 — Notes Payable, Litigation Settlement.

(4)Represents commitments for tenant improvements and lease commissions related tothe leasing of spaceto new or renewing tenants.

(5)Represents employment agreement commitments for officers of the Company.

 

**NOTE15.  SUBSEQUENT EVENTS**

 

On October 29, 2004, the Company refinanced a $1,175,800 loan on one ofits office properties due to mature in May 2005 and entered into a revolvingcredit promissory note in the amount of $2,250,000, of which $1,226,000 hasbeen drawn to cover the repayment of existing debt and financing costs.  The note bears interest at prime plus 1% perannum and matures in November 2006.

 

On October 20, 2004, the Company acquired an office property inHouston, Texas consisting of 81,587 rentable square feet.  Acquisition costs of approximately $5,900,000included proceeds from a tax-deferred exchange, the assumption of existing debtand seller financing.

 

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

ASR is a full-servicereal estate corporation, which owns, manages and operates income-producingproperties.  Substantially all of theCompany’s assets are held through its Operating Partnership in which theCompany, as of September 30, 2004, held the sole general partner interest of..87% and a limited partnership interest totaling 86.83%.  As of September 30, 2004, through itsmajority-owned subsidiary, the Operating Partnership, the Company owned andoperated 24 properties, which consisted of 17 office buildings, four industrialproperties, two shopping centers and one apartment complex.  The 24 properties are located in sevenstates.

 

During the firstnine months of 2004, the Company sold three properties, which consisted of oneoffice building, one industrial property and a parcel of undeveloped land, andacquired one office building in Houston, Texas. During 2003, the Company sold eleven properties, which consisted of twoapartment complexes, two office buildings, six industrial properties and oneshopping center, and acquired four office buildings in Houston, Texas.  During 2002, the Company sold two shoppingcenter properties and one apartment property, and purchased three officeproperties in the Houston area.  Theproperty sales and acquisitions were part of the Company’s strategy to sellcertain of its properties in its non-core markets and acquire additionalproperties in its core property types and core geographic markets.  The Company intends to continue to focus primarilyon office and industrial properties located in Texas, California and Arizona.

 

On September 30,2004, the properties owned by the Company were 86% occupied compared to 78%occupied on September 30, 2003.  TheCompany continues to aggressively pursue prospective tenants to increase itsoccupancy, which is expected to improve operational results.

 

In the accompanyingconsolidated statement of operations, the results of operations for propertiessold are shown in the section “Discontinued operations”.  Therefore the revenues and expenses reportedfor the quarters and nine months ended September 30, 2004 and 2003 reflectresults from properties currently owned by the Company.   As of December 31, 2003, three propertieswere classified on the balance sheet as real estate held for sale.  These three properties were sold during thethird quarter of 2004.  All real estateassets held by the Company on September 30, 2004 are considered held forinvestment.  No real estate wasclassified as held for sale by the Company at September 30, 2004.

 

The share data in this Item 2 has been adjusted togive effect to the one-for-four reverse stock split which became effectiveMarch 2, 2004.

 

**CRITICALACCOUNTING ESTIMATES**

 

The majoraccounting policies followed by the Company are listed in Note 2 — Summary ofSignificant Accounting Policies. — of the Notes to the Consolidated FinancialStatements.  The consolidated financialstatements of the Company are prepared in accordance with accounting principlesgenerally accepted in the United States of America, which requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the results of operations during the reportingperiod. Actual results could differ materially from those estimates.

 

The Companybelieves the following critical accounting policies affect its more significantjudgments and estimates used in the preparation of its consolidated financialstatements:

 

•                  Certain leasesprovide for tenant occupancy during periods for which no rent is due or whereminimum rent payments increase during the term of the lease.  The Company records rental income for thefull term of each lease on a straight-line basis.  Accordingly, a receivable, if deemedcollectible, is recorded from tenants equal to the excess of the amount thatwould have been collected on a straight-line basis over the amount collectedand currently due (Deferred Rent Receivable). When a property is acquired, the term of existing leases is consideredto commence as of the acquisition date for purposes of this calculation.

 

 

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•                  Rental properties are stated at cost, netof accumulated depreciation, unless circumstances indicate that cost, net ofaccumulated depreciation, cannot be recovered, in which case the carrying valueof the property is reduced to estimated fair value. Estimated fair value (i) isbased upon the Company’s plans for the continued operation of each property and(ii) is computed using estimated sales price, as determined by prevailingmarket values for comparable properties and/or the use of capitalization ratesmultiplied by annualized net operating income based upon the age, constructionand use of the building.  The fulfillmentof the Company’s plans related to each of its properties is dependent upon,among other things, the presence of economic conditions which will enable theCompany to continue to hold and operate the properties prior to their eventualsale. Due to uncertainties inherent in the valuation process and in theeconomy, the actual results of operating and disposing of the Company’sproperties could be materially different than current expectations.

 

•                  Gains on property sales are accounted forin accordance with the provisions of SFAS No. 66, “Accounting for Sales of RealEstate”.  Gains are recognized in fullwhen real estate is sold, provided (i) the gain is determinable, that is, thecollectibility of the sales price is reasonably assured or the amount that willnot be collectible can be estimated, and (ii) the earnings process is virtuallycomplete, that is, the Company is not obligated to perform significantactivities after the sale to earn the gain. Losses on property sales are recognized immediately.

 

•                  Managementcontinues to consider whether it is in the best interest of the Company toelect to be treated as a real estate investment trust (or REIT), as definedunder the Internal Revenue Code of 1986, as amended.  The Company currently operates in a mannerthat will permit it to elect REIT status; however, the Company may enter intotransactions which will preclude it from electing REIT status in thefuture.  In general, a REIT is a companythat owns or provides financing for real estate and pays annual distributionsto investors of at least 90% of its taxable income.  A REIT typically is not subject to federalincome taxation on its net income, provided applicable income tax requirementsare satisfied.   For the tax year 2003,the Company was taxed as a C corporation. It is anticipated that the Company will be taxed as a C corporation forthe 2004 tax year.

# ** **

# **RESULTS OF OPERATIONS**

 

In accordance with generally accepted accountingprinciples, the operating results of the eleven properties sold in 2003 and thethree properties sold in 2004 are reported as discontinued operations in theresults of operations.  See Note 4 —Discontinued Operations — of the Notes to Consolidated FinancialStatements.  Unless otherwise indicated,the following discussion reflects the results from continuing operations, whichinclude the real estate assets held for investment.

 

***Discussion of the three months ended September 30, 2004 and 2003.***

 

The following table shows acomparison of rental revenues and certain expenses for the quarters ended September30:

 
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                    | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**        | ** ** | **%** | ** ** |
| Rental revenue                |       | $          | 6,520,000  |       | $          | 5,734,000    |       | 786,000 |   | 13.7 | % |
| Operating expenses:           |       |       |       |       |       |         |       |   |   |
| Property operating expenses   |       | 2,758,000  |       | 2,578,000  |       | 180,000      |       | 7.0 | % |
| General and administrative    |       | 1,243,000  |       | 1,650,000  |       | (407,000     | )          | (24.7 | )% |
| Depreciation and amortization |       | 2,606,000  |       | 2,212,000  |       | 394,000      |       | 17.8 | % |
| Interest expense              |       | 3,139,000  |       | 2,452,000  |       | 687,000      |       | 28.0 | % |
|                               |            |            |            |            |            |              |            |  |  |  |  |

 

*Rental revenue*. The increase of $786,000, or 13.7%, wasattributable to $456,000 in revenue generated from three office propertiesacquired subsequent to the third quarter of 2003 and $330,000 in higherrevenues from properties owned on September 30, 2004 and September 30, 2003(“Same Properties”). Two of the properties were acquired during the fourthquarter of 2003 and one was acquired during the third 

 

 

23

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quarter of 2004. Rental revenue from the acquired properties was included in theCompany’s results since their respective dates of acquisition.  The weighted average occupancy of propertiesheld for investment increased to 86% on September 30, 2004 from 78% onSeptember 30, 2003.

 

*Property operating expenses*. The increase of $180,000, or 7.0%, was due primarily to expenses relatedto the three acquired properties mentioned above.

 

*Generaland administrative*. The decrease of $407,000 was in large part due to a decrease incompensation expense, primarily due tothe closure of the Company’s office in New York and the downsizing of itsadministrative staff, especially in the St. Louis and San Diego offices.  Further, professional fees decreaseddue to the settlement of two major lawsuits in 2003 and the hiring of in-houselegal counsel.  Both of these factors contributed to the reduced fees for outside legalservices incurred in the first nine months of 2004 compared to the first ninemonths of 2003.

 

*Depreciation and amortization*. The increase of $394,000 was related to depreciation of capitalimprovements and amortization of capitalized lease costs incurred in 2002 and2003 and also the depreciation related to the three above mentioned acquiredproperties.  During the last two years,2002 and 2003, the Company spent approximately $8,186,000 in capitalimprovements on its existing properties, primarily for renovations and tenantimprovements.

 

*Interest expense*. The increase of $687,000 was due to (i) the higher interest expense andfees on increased debt on three of its properties, (ii) the interest expenseassociated with the three acquired properties mentioned above, (iii) theCompany recording interest at the default rate on debt related to one of itsshopping center properties and (iv) the accrual of a loan guarantee fee.

 

In July 2004, the Company refinanced a $5,330,000 loan on NorthwestCorporate Center, one of its office properties, with a new loan agreement inthe amount of $5,750,000.  The new loanbears interest at a fixed rate of 6.26% per annum and matures in August2014.  In May 2004, the Companyrefinanced a $3,132,000 loan on Mira Mesa, one of its office properties, with anew one-year loan agreement in the amount of $7,500,000 bearing interest at7.95%.   In December 2003, the Companyrefinanced a $3,000,000 loan on San Felipe, one of its office properties, witha one-year loan in the amount of $5,350,000 bearing interest at 7.95%.  InAugust 2004, the loan was refinanced again with a new loan agreement in theamount of $5,500,000.   The new loanbears interest at a fixed rate of 5.65% per annum and matures in August 2014.

 

In July 2002, the lender under a loanagreement related to the South Carolina shopping center properties notified theCompany it was technically in default under its loan agreement fornon-compliance with certain covenants, including covenants requiringimprovements to shopping center properties. Thereafter, the lender notified the Company that it was in default forfailure to pay a matured portion of the loan, which matured in November2002.  In early 2003, the lender sold theloan to the major tenant in two of the shopping centers.  In December 2003, the Company sold one of theshopping center properties and repaid $3,935,000, which included the pay-off ofthe matured portion of the loan.  As ofSeptember 30, 2004, the remaining balance of the loan was approximately $2,756,000.   The Company continues to discuss thenon-compliance matter with the new lender. The new lender has not accelerated the loan.

 

The loan guarantee fee, which is payable to two of the Company’sdirectors and their affiliated entity, is in consideration of their guaranteesof certain indebtedness of the Company. In 2004, effective in 2003, the Company agreed to pay an annualguarantee fee equal to between .25% and .75% (depending on the nature of theguaranty) of the outstanding balance as of December 31 of each year of theguaranteed obligations.  The guaranty feeis to be paid for a maximum of 3 years on any particular obligation.  For the third quarter of 2004, the Companyaccrued $57,000 related to this guarantee fee. The fee for 2003 was accrued in the fourth quarter of 2003.

 

*Loss onextinguishment of debt*.  InAugust 2004, in connection with the refinance of San Felipe, the Companyrecorded a loss on early extinguishment of debt of $214,000 due to a prepaymentpenalty of $120,000 and the write-off of unamortized loan costs of $94,000.

 

*Discontinued operations*.  TheCompany recorded income from discontinued operations of $25,000 for the threemonths ended September 30, 2004 related to the three properties sold during thethird quarter of 2004.

 

 

24

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The Company recorded a loss from discontinued operations of $443,000for the quarter ended September 30, 2003.  No properties were classified as held forsale as of September 30, 2004.  See Note4 — Discontinued Operations — of the Notes to Consolidated FinancialStatements.

 

The income (loss) from discontinued operations is summarized below.

 
| **Condensed Consolidated Statements of Operations** | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Rental revenue                                      |       | $                      | 305        |                   | $          | 1,790 |   |
| Total expenses                                      |       | 280                    |       | 2,233                  |       |
| Net income (loss) from discontinued operations      |       | $                      | 25         |                   | $          | (443 | ) |
|                                                     |            |                        |            |                        |            |  |  |  |

 

*Loss on sale of discontinuedoperations*.       TheCompany sold three properties — one office building, one industrial propertyand a parcel of undeveloped land - during the third quarter of 2004 for anaggregate of $12,214,000.  Lossestotaling $2,597,000 were recorded on the sale of the office building and theparcel of undeveloped land.  The sale ofthe industrial property generated a gain of $299,000.  The Company sold seven properties during the third quarter of2003 for an aggregate of $37,292,000 and recognized a net gain of $51,000,after taking into consideration an impairment charge totaling $4,000,000recorded in the second quarter of 2003 related to three of the sevenproperties.  The impairment was based onthe anticipated sales price less cost to sell as compared to the carrying valueof the assets.

 

*Impairment of real estate assetsheld for sale**.*  The Company recorded an impairment of $3,500,000during the third quarter of 2003 on an office property, which was sold in thefourth quarter of 2003.  The impairmentwas based on the anticipated sales price less cost to sell as compared to thecarrying value of the asset.

 

***Discussion of the nine months ended September 30, 2004 and 2003.***

 

The following table shows acomparison of rental revenues and certain expenses for the nine months endedSeptember 30:

 
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                    | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**        | ** ** | **%** | ** ** |
| Rental revenue                |       | $          | 20,006,000 |       | $          | 17,475,000   |       | 2,531,000 |   | 14.5 | % |
| Operating expenses:           |       |       |       |       |       |         |       |   |   |
| Property operating expenses   |       | 7,851,000  |       | 7,054,000  |       | 797,000      |       | 11.3 | % |
| General and administrative    |       | 3,551,000  |       | 4,952,000  |       | (1,401,000   | )          | (28.3 | )% |
| Depreciation and amortization |       | 7,735,000  |       | 6,397,000  |       | 1,338,000    |       | 20.1 | % |
| Interest expense              |       | 8,998,000  |       | 7,456,000  |       | 1,542,000    |       | 20.1 | % |
|                               |            |            |            |            |            |              |            |  |  |  |  |

 

*Rental revenue*. The increase of $2,531,000, or 14.5%,was attributable to  (i) $1,798,000 inrevenue generated from five office properties acquired in May 2003 throughAugust 2004, (ii) a $196,000 payment received from the owner of a neighboringproperty for past use of common parking areas and (iii) higher revenues of$537,000 for Same Properties.  Rentalrevenue from the acquired properties was included in the Company’s resultssince their respective dates of acquisition. The weighted average occupancy of properties held for investment was 86%at September 30, 2004 and 78% at September 30, 2003.

 

*Property operating expenses*. The increase of $797,000, or 11.3%, was due to the expenses related tothe five acquired properties mentioned above, offset in part by an $190,000reduction in operating expenses for other properties owned by the Company.

 

*Generaland administrative*. The decrease of $1,401,000 was in large part due to a decrease incompensation expense, primarily due to theclosure of the Company’s office in New York and the downsizing of itsadministrative staff, especially in the St. Louis and San Diego offices.  Further, professional fees decreaseddue to the settlement of two major lawsuits in 2003 and the hiring of in-houselegal counsel.  Both of these factors contributed to thereduced fees for outside legal services incurred in the first nine months of2004 compared to the first nine months of 2003.

 

 

25

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*Depreciation and amortization*. The increase of $1,338,000 was related to depreciation of capitalimprovements and amortization of capitalized lease costs incurred in 2002 and2003 and also the depreciation related to the five acquired propertiesmentioned above.  During the last twoyears, 2002 and 2003, the Company has approximately $8,186,000 in capitalimprovements on its existing properties, primarily for renovations and tenantimprovements.

 

*Interest expense*. The increase of $1,542,000 was due to (i) the higher interest expenseand fees on increased debt on three of its properties, (ii) the interestexpense associated with the five acquired properties mentioned above, (iii) theCompany recording interest at the default rate on debt related to one of itsshopping center properties and (iv) the accrual of a loan guarantee fee.

 

In July 2004, the Company refinanced a $5,330,000 loan on NorthwestCorporate Center, one of its office properties, with a new loan agreement inthe amount of $5,750,000.  The new loanbears interest at a fixed rate of 6.26% per annum and matures in August2014.  In May 2004, the Companyrefinanced a $3,132,000 loan on Mira Mesa, one of its office properties, with anew one-year loan agreement in the amount of $7,500,000 bearing interest at7.95%.   In December 2003, the Companyrefinanced a $3,000,000 loan on San Felipe, one of its office properties, witha one-year loan in the amount of $5,350,000 bearing interest at 7.95%.  InAugust 2004, the loan was refinanced again with a new loan agreement in theamount of $5,500,000.   The new loanbears interest at a fixed rate of 5.65% per annum and matures in August 2014.

 

In July 2002, the lender under a loanagreement related to the South Carolina shopping center properties notified theCompany it was technically in default under its loan agreement fornon-compliance with certain covenants, including covenants requiringimprovements to shopping center properties. Thereafter, the lender notified the Company that it was in default forfailure to pay a matured portion of the loan, which matured in November2002.  In early 2003, the lender sold theloan to the major tenant in two of the shopping centers.  In December 2003, the Company sold one of theshopping center properties and repaid $3,935,000, which included the pay-off ofthe matured portion of the loan.  As ofSeptember 30, 2004, the remaining balance of the loan was approximately$2,756,000.   The Company continues todiscuss the non-compliance matter with the new lender.  The new lender has not accelerated the loan.

 

The loan guarantee fee, which is payable to two of the Company’sdirectors and their affiliated entity, is in consideration of their guaranteesof certain indebtedness of the Company. In 2004, effective in 2003, the Company agreed to pay an annualguarantee fee equal to between .25% and .75% (depending on the nature of theguaranty) of the outstanding balance as of December 31 of each year of theguaranteed obligations.  The guaranty feeis to be paid for a maximum of 3 years on any particular obligation.  For the first nine months of 2004, theCompany accrued $171,000 related to this guarantee fee.  The fee for 2003 was accrued in the fourthquarter of 2003.

 

*Loss onextinguishment of debt*.  TheCompany recorded a loss on extinguishment of debt of $827,000 during the ninemonths ended September 30, 2004.  In May2004, in connection with the refinance of Mira Mesa, the Company recorded aloss on early extinguishment of debt of $613,000 due to a prepayment penalty of$687,000, which was offset in part by the write-off of an unamortized loanpremium of $74,000.  In August 2004, inconnection with the refinance of San Felipe, the Company recorded a loss onearly extinguishment of debt of $214,000 due to a prepayment penalty of$120,000 and the write-off of unamortized loan costs of $94,000.

 

*Discontinued operations*.  TheCompany recorded a loss from discontinued operations of $63,000 for the ninemonths ended September 30, 2004 related to the three properties sold in thethird quarter.  The Company recorded aloss from discontinued operations of $1,074,000 for the nine months endedSeptember 30, 2003 related to the eleven properties sold in 2003 and threeproperties sold in 2004. See Note 4 — Discontinued Operations — of theNotes to Consolidated Financial Statements.

 

The loss from discontinued operations is summarized below.

 
| **Condensed Consolidated Statements of Operations** | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Rental revenue                                      |       | $                      | 1,311      |                   | $          | 7,964 |   |
| Total expenses                                      |       | 1,374                  |       | 9,038                  |       |
| Net loss from discontinued operations               |       | $                      | (63        | )                      | $          | (1,074 | ) |

 

 

26

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*Gain on sale of discontinuedoperations*.    The Companysold three properties — one office building, one industrial property and aparcel of undeveloped land - during the first nine months of 2004 for anaggregate of $12,214,000.  Lossestotaling $2,597,000 were recorded on the sale of the office building and theparcel of undeveloped land.  The sale ofthe industrial property generated a gain of $299,000.  The Company sold nine properties during the first nine monthsof 2003 for an aggregate of $53,892,000 and recognized a net gain of$2,279,000, after taking into consideration an impairment charge totaling$7,500,000 of which $4,000,000 was recorded in the second quarter of 2003 and$3,500,000 related to an office property subsequently sold in the fourthquarter of 2003.  The impairment chargeswere based on the anticipated sales prices less costs to sell as compared tothe carrying value of the assets.

 

*Impairmentof real estate assets held for sale.*  The Company recorded an impairment of$7,500,000 on four properties held for sale in 2003.  The impairment was based on the anticipatedsales price less cost to sell as compared to the carrying value of theassets.  The four properties, which weresold in 2003, consisted of two office and two industrial properties.

 

# **LIQUIDITY AND CAPITAL RESOURCES**

 

During first nine months of 2004, the Company derived cash fromcollection of rents, sale of an industrial property and proceeds fromrefinancing of debt on an office property in California.  Major uses of cash included payment forcapital improvements to real estate assets, primarily for tenant improvements,payment of operational expenses, repayment of borrowings and purchase of anoffice building in Houston, Texas.

 

The Company reported a net loss of $9,716,000 for the nine months endedSeptember 30, 2004 compared to a net loss of $12,757,000 for the nine monthsended September 30, 2003.  These resultsinclude the following non-cash items:

 
| ** **                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Non-Cash Charges:                                                  |       |                                |       |   |   |
| Depreciation and amortization from real estate held for investment |       | $                                   | 7,735      |   | $ | 6,397 |   |
| Mark-to-market adjustments on interest rate protection agreements  |       | —                              |       | 202 |   |
| Deferred compensation expense                                      |       | 83                                  |       | 233 |   |
| Non-Cash Items:                                                    |       |                                |       |   |   |
| Deferred rental income                                             |       | (447                                | )          | (305 | ) |
| Minority interest                                                  |       | (1,390                              | )          | (1,845 | ) |
| Interest on receivable from principal stockholders                 |       | (50                                 | )          | (39 | ) |
| Amortization of loan premiums                                      |       | (411                                | )          | (384 | ) |
| Amortization of note receivable discount                           |       | (58                                 | )          | — |   |
| Mark-to-market adjustments on interest rate protection agreements  |       | (65                                 | )          | — |   |
|                                                                    |            |                                     |            |  |  |  |  |

 

Net cash provided by investing activities fornine months ended September 30, 2004 amounted to $5,953,000.  This amount was primarily attributableproceeds received from the sale of three properties during the period.    Funds were used for capital expenditures,primarily for tenant improvements.  Netcash provided from investing activities for the nine months ended September 30,2003 was $29,178,000 primarily from proceeds from the sales of properties.  Funds used for capital improvements for thenine months ended September 30, 2003 amounted to $2,824,000, primarily fortenant improvements.

 

Net cash used byfinancing activities amounted to $4,516,000 for the nine months ended September30, 2004.  Net funds provided fromborrowings of $19,208,000 were primarily due to the refinancing the debt onthree properties as discussed below.  Scheduledprincipal payments for the nine months ended September 30, 2004 amounted to$2,063,000.  Net cash used in financingactivities amounted to $23,639,000 for the nine months ended September 30, 2003primarily to repay debt on properties sold during the period.  Repayments of borrowings of  $3,198,000 consisted of scheduled principalpayments made during the nine months ended September 30, 2003.  Proceeds from borrowings, which totaled 

 

 

27

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$2,098,000 for thenine months ended September 30, 2003, consisted of (i) $1,340,000 related tothe refinancing of debt on a property, (ii) $728,000 to fund property insurancepremiums and service fee and (iii) $30,000 from an affiliate of a related partywhich completed the funding of an $830,000 loan on Valencia entered into inDecember of 2002.  The mortgage wasrepaid in conjunction with the sale of the property in April 2003.  In addition, funds were used to pay amountsdue related to the Teachout settlement, to acquire units in the OperatingPartnership, and to purchase 17,500 shares of common stock of the Companypursuant to a stock repurchase plan previously disclosed.  Also, John N. Galardi purchased 60,975 sharesof the Company’s common stock for $250,000 in May 2003.

 

In August 2004, the Company refinanced a $5,350,000 loan on San Felipe,one of its office properties with a new loan agreement in the amount of$5,500,000.  The new loan bears interestat a fixed rate of 5.65% per annum and matures in August 2014.  The Company funded closing costs of approximately$178,000 and escrowed $327,000 for future capital expenditures, real estatetaxes and insurance related to the August 2004 refinance.  Net proceeds of $2,059,000 were received inDecember 2003 related to the December 2003 refinance of the original $3,000,000loan on the property.

 

In July 2004, the Company refinanced a $5,330,000 loan on NorthwestCorporate Center, one of its office properties, with a new loan agreement inthe amount of $5,750,000.  The new loanbears interest at a fixed rate of 6.26% per annum and matures in August 2014.  No proceeds were received directly as aresult of the refinance, however $350,000 is being held in escrow by the lenderto assist the funding of future capital expenditures at the property.

 

In May 2004, the Company refinanced a $3,132,000 loan on Mira Mesa, oneof its office properties, with a new one-year loan agreement in the amount of$7,500,000.  The new loan, which containstwo six-month extension options, bears interest at a fixed rate of 7.95% perannum.

 

In May 2004, theCompany financed insurance premiums of $373,000 on its properties and agreed topay a service fee of $85,000 over one year.

 

In November 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company obtained a loan in the amount of$4,574,000.  The loan, which was due tomature in November 2004, bore interest at a fixed rate of 5% per annum.  In October 2004, the maturity date of theloan was extended to November 2005.  Theloan will bear interest at a fixed rate of 8% under the terms of the extension.

 

In October 2003, the Company entered into a $4,100,000 loan agreementin connection with the acquisition of an office property in Houston, Texas andthe acquisition of a note secured by another office property in Houston.  The loan, of which $3,700,000 had been fundedas of September 30, 2004, matures in November 2005 and bears interest at afixed rate of 6% per annum.

 

In August 2003, the Company refinanced a $1,300,000 loan secured by VanBuren, a parcel of undeveloped land, and entered into a two-year loan agreementin the amount of $1,340,000.  The loanbore interest at a fixed rate of 12% per annum and matured August 1, 2005.  In September 2004, the loan was paid inconnection with the sale of the property.

 

In July 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $1,723,000.  The loan bears interest at a fixed rate of7.41% per annum and matures in May 2005. The Company also entered into an agreement that provided for sellerfinancing of $710,000, bearing interest at a fixed rate of 7.41% per annum andmaturing in July 2005.

 

In May 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $3,180,000.  The loan bears interest at a fixed rate of 6.80%per annum and matures in August 2012. The Company also entered into an agreement that provided for sellerfinancing of $464,000, bearing interest at a fixed rate of 6.80% per annum andmaturing in May 2005.

 

In May 2003, the successor of Brown Parker and Leahy, LLP cancelled its$199,180 note, plus $45,891 of accrued interest thereon, in exchange for 14,943shares of the Company’s common stock.

 

 

28

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In May 2003, John N. Galardi cancelled his$1,600,000 note, plus $286,036 of accrued interest thereon, in exchange for115,002 shares of the Company’s common stock.

 

In July 2002, the lender under a loan agreement related to the SouthCarolina shopping center properties notified the Company it was technically indefault under its loan agreement for non-compliance with certain covenants,including covenants requiring improvements to shopping center properties.  Thereafter, the lender notified the Companythat it was in default for failure to pay a matured portion of the loan, whichmatured in November 2002.  In early 2003,the lender sold the loan to the major tenant in two of the shoppingcenters.  In December 2003, the Companysold one of the shopping center properties and repaid $3,935,000, whichincluded the pay-off of the matured portion of the loan.  As of September 30, 2004, the remainingbalance of the loan was approximately $2,756,000.   The Company continues to discuss thenon-compliance matter with the new lender. The new lender has not accelerated the loan.

 

TheCompany expects to meet its short-term liquidity requirements for normalproperty operating expenses and general and administrative expenses from cashgenerated by operations and cash currently held.  In addition, the Company anticipates capitalcosts to be incurred related to re-leasing space and improvements toproperties, litigation settlement costs, state income taxes and other fees forprofessional services.  The funds to meetthese obligations will be obtained from proceeds of the sale of assets andlender held funds.  Based on currentanalysis, the Company believes that the cash generated by these anticipatedactivities will be adequate to meet these obligations.  There can be no assurance, however, thatthese activities will occur and that substantial cash will be generated.  If these activities do not occur, the Companywill not have sufficient cash to meet its obligations.

 

Inaddition, as of September 30, 2004, the Company has substantial debt becomingdue in 2004, 2005 and 2006.  Based on theCompany’s historical losses and current debt level, there can be no assurancesas to the Company’s ability to obtain funds necessary for the refinancing ofthese maturing debts.  If refinancingtransactions are not consummated, the Company will seek extensions and/ormodifications from the existing lenders. If these refinancings do not occur, the Company will not have sufficientcash to meet its obligations.

 

**CONTRACTUALOBLIGATIONS AND COMMITMENTS**

 

Thefollowing table aggregates the Company’s contractual obligations subsequent toSeptember 30, 2004 (dollars in thousands):

 
| ** **                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt (1) (2)         |       | $        | 3,070      |     | $          | 21,146   |       | $        | 5,544      |     | $          | 1,605          |       | $         | 4,903      |   | $ | 107,913 |   | $ | 144,181 |   |
| Litigation settlement (3)      |       | —   |       | —   |       | 9,750    |       | —   |       | —   |       | —         |       | 9,750     |       |
| Capital lease expenditures (4) |       | 2,240    |       | —   |       | —   |       | —   |       | —   |       | —         |       | 2,240     |       |
| Employee obligations (5)       |       | 50       |       | 167      |       | —   |       | —   |       | —   |       | —         |       | 217       |       |
| Total                          |       | $        | 5,360      |     | $          | 21,313   |       | $        | 15,294     |     | $          | 1,605          |       | $         | 4,903      |   | $ | 107,913 |   | $ | 156,388 |   |
|                                |            |          |            |          |            |          |            |          |            |          |            |                |            |           |            |  |  |  |  |  |  |  |  |  |  |  |

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(1) See Note 6 —Notes Payable — in the accompanying consolidated financial statements of theCompany.

(2) Includes debt of$7,500,000 with two 6-month extension options to May 2006.

(3)Represents obligations related to the settlement of the Teachoutlitigation.  See Note 7 — Notes Payable,Litigation Settlement — in the accompanying consolidated financial statementsof the Company.

(4)Represents commitments for tenant improvements and lease commissions related tothe leasing of space to new or renewing tenants.

(5) Represents employmentagreement commitments for officers of the Company.

 

**INFLATION**

 

Substantially all of the leases at the industrial andretail properties provide for pass-through to tenants of certain operatingcosts, including real estate taxes, common area maintenance expenses, and insurance.Leases at the apartment property generally provide for an initial term of onemonth to one year and allow for rent adjustments at the time of renewal.  Leases at the office properties typicallyprovide for rent adjustments and pass-through of increases in operatingexpenses during the term of the lease. All of these 

 

 

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provisions may permit the Company to increase rentalrates or other charges to tenants in response to rising prices and, therefore,serve to reduce the Company’s exposure to the adverse effects of inflation.

 

**FORWARD-LOOKING STATEMENTS**

 

ThisReport on Form 10-Q contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of the Securities andExchange Act of 1934.  These forward-lookingstatements are based on management’s beliefs and expectations, which may not becorrect.  Important factors that couldcause actual results to differ materially from the expectations reflected inthese forward-looking statements include the following: the Company’s level ofindebtedness and ability to refinance its debt; the fact that the Company’spredecessors have had a history of losses in the past; unforeseen liabilitieswhich could arise as a result of the prior operations of companies acquired inthe 2001 consolidation transaction; risks inherent in the Company’s acquisitionand development of properties in the future, including risks associated withthe Company’s strategy of investing in under-valued assets; general economic,business and market conditions, including the impact of the current economicdownturn; changes in federal and local laws, and regulations; increasedcompetitive pressures; and other factors, including the factors set forthbelow, as well as factors set forth elsewhere in this Report on Form 10-Q.

 

**RISK FACTORS**

 

Stockholders or potential stockholders should read the“Risk Factors” section of the Company’s latest annual report on Form 10-K filedwith the Securities and Exchange Commission in conjunction with this quarterlyreport on Form 10-Q to better understand the factors affecting the Company’sfinancial condition and results of operations.

 

**ITEM3.  QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

**INTEREST RATES**

 

One of the Company’s primary market risk exposure isto changes in interest rates on its borrowings.

 

It is the Company’spolicy to manage its exposure to fluctuations in market interest rates for itsborrowings through the use of fixed rate debt instruments to the extent thatreasonably favorable rates are obtainable with such arrangements.  In order to maximize financial flexibilitywhen selling properties and minimize potential prepayment penalties on fixedrate loans, the Company has also entered into variable rate debt arrangements.

 

At September 30, 2004, the Company’s totalindebtedness included fixed-rate debt of approximately $152,546,000 andfloating-rate indebtedness of approximately $3,988,000. The Company continuallyreviews the portfolio’s interest rate exposure in an effort to minimize therisk of interest rate fluctuations.  TheCompany does not have any other material market-sensitive financialinstruments.

 

A change of 1.00% in the index rate to which theCompany’s variable rate debt is tied would change the annual interest incurred bythe Company by approximately $39,875, or $0.03 per share, based upon thebalances outstanding on variable rate instruments at September 30, 2004.

 

**ITEM4.  CONTROLSAND PROCEDURES**

 

Management, including the Company’s Chief ExecutiveOfficer and Acting Chief Financial Officer, have evaluated the effectiveness ofthe Company’s disclosure controls and procedures as of the end of the quartercovered by this report.  Based on, and asof the date of, that evaluation, the Chief Executive Officer and Acting ChiefFinancial Officer concluded that the disclosure controls and procedures wereeffective, in all material respects, to ensure that information required to bedisclosed in the reports the Company files and submits under the Exchange Actis recorded, processed, summarized and reported as and when required.

 

There have been no significant changes in theCompany’s internal controls or in other factors that could significantly affectinternal controls subsequent to the date of the evaluation referred to above.

 

 

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**PART II.  OTHER INFORMATION**

 

**ITEM1.  LEGALPROCEEDINGS**

 

The following is information concerning legalproceedings to which the Company or its subsidiaries is a party or of which anyof their property is subject:

 

Lewis Matter

On August 2, 2004, the Orange County Superior Court approved the finalaccounting in the Robert L. Lewis matter. This matter, initiated on or about September 27, 2001 by RobertL. Lewis, Madison Liquidity Investors 103 LLC and Madison Liquidity Investors112 LLC, alleged claims against the Company and others for breach of fiduciaryduty, breach of contract, intentional interference with prospective economicadvantage, and intentional interference with contractual relations related tothe Company’s 2001 consolidation transaction, although the consolidation wasdisclosed in a Prospectus/Consent Solicitation filed with the Securities andExchange Commission and was approved by a majority vote of the limited partnersof the partnerships.  In October 2003,counsel for the plaintiffs and counsel for the defendants executed a Memorandumof Understanding regarding a proposed settlement in this matter.  By the terms of that Memorandum, thedefendants agreed to pay a total of $6,500,000 to settle this action and allother claims known and unknown relating to the facts set forth in theplaintiff’s complaints.  The settlementwas funded, in its entirety, by insurance coverage.  In 2004, the Court approved the settlement asfair, adequate and reasonable and the defendants’ insurers deposited $6,500,000into an escrow account for the purposes of settlement.  Subsequently, $1,640,000 was disbursed forattorney fees and expenses, while the remaining $4,860,000 was distributed tothe plaintiffs.  Reference is made to theCompany’s annual report on Form 10-K for 2003 for more information with respectto this matter.

 

Other Matters

Certain claims and lawsuits have arisen against theCompany in its normal course of business. The Company believes that such claimsand lawsuits will not have a material adverse effect on the Company’s financialposition, cash flow or results of operations.

 

# **ITEM 2. UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

In August 2004, the Company issued 10,000 shares ofunregistered Common Stock.  The shareswere issued to the seller of an office property located in Houston, Texas aspart of the Company’s consideration for the acquisition of the property.  The consideration related to the issuedshares amounted to $75,000 (valued for this purpose at $7.50 per share).

 

**ITEM6.  EXHIBITS ANDREPORTS ON FORM 8-K**

 

(a)  Exhibits:

 

The Exhibit Index attached hereto is herebyincorporated by reference this item.

 

(b)  Reports onForm 8-K:

 

On September 8, 2004, a report on Form 8-K was filedwith respect to Item 8.01.

On September 3, 2004, a report on Form 8-K was filedwith respect to Item 8.01.

On August 31, 2004, a report on Form 8-K was filedwith respect to Item 8.01.

On August 27, 2004, a report on Form 8-K was filedwith respect to Item 8.01.

On August 4, 2004, a report on Form 8-K was filed withrespect to Item 12.

 

 

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**SIGNATURES**

 

Pursuant to the requirements of Section l3 or l5(d) ofthe Securities Exchange Act of l934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

**AMERICANSPECTRUM REALTY, INC.**

 

 

 

 
| Date: November 12, 2004 | By:      | */s/ William J. Carden*            |
|-------------------------|----------|------------------------------------|
| * *                | * * | William J. Carden                  |
|                    |     | Chairman of the Board, President,  |
|                    |     | Chief Executive Officer and Acting |
|                    |     | Chief Financial Officer            |
|                    |     |                               |

##### * *

| Date: November 12, 2004 | By:    | */s/ Patricia A. Nooney*                         |
|-------------------------|--------|--------------------------------------------------|
| * *                |   | Patricia A. Nooney                               |
|                    |   | Senior Vice President and Director of Accounting |
|                    |   | (Principal Accounting Officer)                   |

 

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit  Title**                                                                                                      |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                    |
| 31              |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                |
|            |       |                                                                                                                    |
| 32              |       | Certification pursuant to  18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

 

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