** **

###### **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended June 30, 2004**

 

**OR**

 

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

 

**COMMISSIONFILE NUMBER 001-16785**

 

**American Spectrum Realty, Inc.**

(Exact name of Registrant asspecified 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’s telephone number, including area code)                          |
|                                                                               |       |                                  |
|                                                                               |       |                                  |
| (Former name, 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 an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes o No ý

 

As of July 28, 2004, 1,556,897 shares of Common Stock ($.01 par value)were outstanding.

 

 

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**TABLE OFCONTENTS**

** **
| PART I  | FINANCIAL INFORMATION                                                                                                                         |   |
|---------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|    |                                                                                                                                          |   |
| Item 1  | Financial Statements                                                                                                                          |   |
|    | Consolidated Balance Sheets at June 30, 2004 and December 31, 2003                                                                            |   |
|    | Consolidated Statements of Operations for  the three months ended June 30, 2004 and 2003 and for the six months ended  June 30, 2004 and 2003 |   |
|    | Consolidated Statement of Stockholders’  Equity for the six months ended June 30, 2004                                                   |   |
|    | Consolidated Statements of Cash Flows for  the six months ended June 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 4  | Submission of Matters to a Vote of Security  Holders                                                                                          |   |
| Item 6  | Exhibits and Reports on Form 8-K                                                                                                              |   |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

**ITEM 1.  FINANCIAL STATEMENTS**

 

**AMERICAN SPECTRUM REALTY, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(Dollars in thousands,except per share amounts)

 
| ** **                                                                                                                                                        | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                        | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                        |       |              |       |                  |       |
| **ASSETS**                                                                                                                                                        |       |              |       |                  |       |
| ** **                                                                                                                                                        |       |              |       |                  |       |
| Real estate held for investment                                                                                                                                   |       | $                 | 205,149    |                  | $          | 201,853 |   |
| Accumulated depreciation                                                                                                                                          |       | 24,296            |       | 19,063                |       |
| Real estate held for investment, net                                                                                                                              |       | 180,853           |       | 182,790               |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                         |       | 1,106             |       | 2,937                 |       |
| Tenant and other receivables, net of  allowance for doubtful accounts of $207 and $387, respectively (including  $244 and $271, respectively, from related party) |       | 567               |       | 553                   |       |
| Mortgage loan receivable, net of discount  of $33 and $83, respectively                                                                                           |       | 1,689             |       | 1,667                 |       |
| Deferred rents receivable                                                                                                                                         |       | 1,445             |       | 1,050                 |       |
| Insurance proceeds held in escrow                                                                                                                                 |       | 4,860             |       | —                |       |
| Insurance proceeds receivable – litigation  settlement                                                                                                       |       | —            |       | 6,500                 |       |
| Investment in management company                                                                                                                                  |       | 4,000             |       | 4,000                 |       |
| Prepaid and other assets, net                                                                                                                                     |       | 9,290             |       | 8,506                 |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Total Assets                                                                                                                                                      |       | $                 | 203,810    |                  | $          | 208,003 |   |
|                                                                                                                                                              |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                     |       |              |       |                  |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Liabilities:                                                                                                                                                      |       |              |       |                  |       |
| Notes payable, net of premiums of $2,801  and $3,172, respectively                                                                                                |       | $                 | 154,032    |                  | $          | 151,051 |   |
| Notes payable, litigation settlement                                                                                                                              |       | 9,750             |       | 9,750                 |       |
| Accounts payable                                                                                                                                                  |       | 1,815             |       | 2,252                 |       |
| Deferred tax liability                                                                                                                                            |       | 4,316             |       | 4,316                 |       |
| Litigation settlement payable                                                                                                                                     |       | 4,860             |       | 6,500                 |       |
| Accrued and other liabilities (including  $380 and $579, respectively, to related parties)                                                                        |       | 6,559             |       | 6,390                 |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Total Liabilities                                                                                                                                                 |       | 181,332           |       | 180,259               |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Minority Interest                                                                                                                                                 |       | 6,280             |       | 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 and outstanding, 1,579,679 and 1,578,224 shares,  respectively                              |       | 16                |       | 16                    |       |
| Additional paid-in capital                                                                                                                                        |       | 45,785            |       | 45,742                |       |
| Accumulated deficit                                                                                                                                               |       | (28,272           | )          | (23,516               | )          |
| Receivable from principal stockholders                                                                                                                            |       | (1,071            | )          | (1,191                | )          |
| Deferred compensation                                                                                                                                             |       | (139              | )          | (195                  | )          |
| Treasury stock, at cost, 22,782 shares at  June 30, 2004 and December 31, 2003                                                                                    |       | (421              | )          | (421                  | )          |
|                                                                                                                                                              |       |              |       |                  |       |
| Total Stockholders’ Equity                                                                                                                                   |       | 15,898            |       | 20,435                |       |
|                                                                                                                                                              |       |              |       |                  |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                   |       | $                 | 203,810    |                  | $          | 208,003 |   |

 

The accompanying notes arean integral part of these consolidated financial statements

 

3

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**AMERICANSPECTRUM REALTY, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Dollars inthousands, except per share amounts)

(Unaudited)

 
| ** **                                                     | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES:**                                                  |       |                            |       |                          |       |   |   |   |   |
| Rental revenue                                                 |       | $                               | 7,119      |                          | $          | 6,080 |   | $ | 14,492 |   | $ | 12,746 |   |
| Interest and other income                                      |       | 82                              |       | 33                            |       | 162 |   | 43 |   |
| Total revenues                                                 |       | 7,201                           |       | 6,113                         |       | 14,654 |   | 12,789 |   |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| **EXPENSES:**                                                  |       |                            |       |                          |       |   |   |   |   |
| Property operating expense                                     |       | 2,841                           |       | 2,496                         |       | 5,607 |   | 5,007 |   |
| General and administrative                                     |       | 1,181                           |       | 1,709                         |       | 2,308 |   | 3,302 |   |
| Depreciation and amortization                                  |       | 2,776                           |       | 2,266                         |       | 5,461 |   | 4,528 |   |
| Interest expense                                               |       | 3,144                           |       | 2,652                         |       | 6,107 |   | 5,250 |   |
| Total expenses                                                 |       | 9,942                           |       | 9,123                         |       | 19,483 |   | 18,087 |   |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| **OTHER LOSS:**                                                |       |                            |       |                          |       |   |   |   |   |
| Loss on extinguishment of debt                                 |       | (613                            | )          | —                        |       | (613 | ) | — |   |
| Total other loss                                               |       | (613                            | )          | —                        |       | (613 | ) | — |   |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Net loss before minority interest and  discontinued operations |       | (3,354                          | )          | (3,010                        | )          | (5,442 | ) | (5,298 | ) |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Minority interest                                              |       | 423                             |       | 621                           |       | 686 |   | 915 |   |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Net loss before discontinued operations                        |       | (2,931                          | )          | (2,389                        | )          | (4,756 | ) | (4,383 | ) |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Discontinued operations:                                       |       |                            |       |                          |       |   |   |   |   |
| Loss from discontinued operations                              |       | —                          |       | (234                          | )          | — |   | (516 | ) |
| Gain on sale of discontinued operations                        |       | —                          |       | 2,228                         |       | — |   | 2,228 |   |
| Impairment of real estate assets held for  sale                |       | —                          |       | (4,000                        | )          | — |   | (4,000 | ) |
| Loss from discontinued operations                              |       | —                          |       | (2,006                        | )          | — |   | (2,288 | ) |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Net loss                                                       |       | $                               | (2,931     | )                             | $          | (4,395 | ) | $ | (4,756 | ) | $ | (6,671 | ) |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Basic and diluted per share data:                              |       |                            |       |                          |       |   |   |   |   |
| Net loss before discontinued operations                        |       | $                               | (1.88      | )                             | $          | (1.61 | ) | $ | (3.06 | ) | $ | (3.05 | ) |
| Loss from discontinued operations                              |       | —                          |       | (1.35                         | )          | — |   | (1.60 | ) |
| Net loss                                                       |       | $                               | (1.88      | )                             | $          | (2.96 | ) | $ | (3.06 | ) | $ | (4.65 | ) |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| Basic weighted average shares used                             |       | 1,556,250                       |       | 1,483,303                     |       | 1,555,846 |   | 1,433,922 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements

 

4

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**AMERICANSPECTRUM REALTY INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

(Dollars inthousands)

(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 |   |
| Conversion of operating partnership units  to common stock |       | —            |       | 43                               |       | —                   |       | —                     |       | —              |       | —                                        |       | 43                |       |
| Amortization of deferred compensation                      |       | —            |       | —                           |       | —                   |       | 56                         |       | —              |       | —                                        |       | 56                |       |
| Payment on receivable from principal  stockholders         |       | —            |       | —                           |       | —                   |       | —                     |       | —              |       | 120                                           |       | 120               |       |
| Net loss                                                   |       | —            |       | —                           |       | (4,756                   | )          | —                     |       | —              |       | —                                        |       | (4,756            | )          |
| Balance, June 30, 2004                                     |       | $                 | 16         |                             | $          | 45,785                   |       | $                          | (28,272    | )                   | $          | (139                                          | )          | $                 | (421       | ) | $ | (1,071 | ) | $ | 15,898 |   |

 

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)

 
| ** **                                                                                | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 |       |                          |       |   |   |
| Net loss                                                                                  |       | $                             | (4,756     | ) | $ | (6,671 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:              |       |                          |       |   |   |
| Loss from discontinued operations                                                         |       | —                        |       | 2,288 |   |
| Depreciation and amortization                                                             |       | 5,461                         |       | 4,528 |   |
| Deferred rental income                                                                    |       | (395                          | )          | (225 | ) |
| Minority interest                                                                         |       | (686                          | )          | (915 | ) |
| Deferred compensation expense                                                             |       | 56                            |       | 157 |   |
| Mark to market adjustments on interest rate  protection agreements                        |       | (67                           | )          | 244 |   |
| Loss on extinguishment of debt                                                            |       | 613                           |       | — |   |
| Interest on receivable from principal  stockholders                                       |       | (34                           | )          | (21 | ) |
| Amortization of note payable premiums, included  in interest expense                      |       | (296                          | )          | (276 | ) |
| Amortization of note receivable discount,  included in interest income                    |       | (50                           | )          | — |   |
| Changes in operating assets and  liabilities:                                             |       |                          |       |   |   |
| (Increase) decrease in tenant and other  receivables                                      |       | (52                           | )          | 105 |   |
| (Decrease) increase in accounts payable                                                   |       | (437                          | )          | 333 |   |
| Increase in prepaid and other assets                                                      |       | (1,006                        | )          | (1,071 | ) |
| Increase (decrease) in accrued and other  liabilities                                     |       | 429                           |       | (493 | ) |
| Net cash used in operating activities:                                                    |       | (1,220                        | )          | (2,017 | ) |
|                                                                                      |       |                          |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 |       |                          |       |   |   |
| Proceeds received from sales of real estate  assets                                       |       | —                        |       | 4,685 |   |
| Capital improvements to real estate assets                                                |       | (3,303                        | )          | (1,417 | ) |
| Collections on mortgage loan receivable                                                   |       | 28                            |       | — |   |
| Net cash (used in) provided by investing  activities:                                     |       | (3,275                        | )          | 3,268 |   |
|                                                                                      |       |                          |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 |       |                          |       |   |   |
| Proceeds from borrowings                                                                  |       | 7,958                         |       | 758 |   |
| Repurchase of common stock                                                                |       | —                        |       | 250 |   |
| Repayment of borrowings – refinance                                                  |       | (3,820                        | )          | — |   |
| Repayment of borrowings – scheduled  payments                                        |       | (1,474                        | )          | (1,875 | ) |
| Net cash provided by (used in) by financing  activities:                                  |       | 2,664                         |       | (867 | ) |
|                                                                                      |       |                          |       |   |   |
| Cash from discontinued operations                                                         |       | —                        |       | 667 |   |
|                                                                                      |       |                          |       |   |   |
| (Decrease) increase in cash                                                               |       | (1,831                        | )          | 1,051 |   |
|                                                                                      |       |                          |       |   |   |
| Cash, beginning of period                                                                 |       | 2,937                         |       | 788 |   |
| Cash, end of period                                                                       |       | $                             | 1,106      |   | $ | 1,839 |   |
| ** **                                                                                | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:**                                   |       |                          |       |   |   |
| Cash paid for interest                                                                    |       | $                             | 5,786      |   | $ | 6,781 |   |
| Cash paid for income taxes                                                                |       | 24                            |       | 10 |   |
|                                                                                      |       |                          |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH  INVESTING AND FINANCING ACTIVITIES:**              |       |                          |       |   |   |
| Assumptions of mortgage loans in  acquisition of real estate assets                       |       | $                             | —     |   | $ | 3,644 |   |
| Conversion of debt to related parties into  common stock                                  |       | —                        |       | 2,131 |   |
| Conversion of operating partnership units  into common stock                              |       | 43                            |       | 203 |   |
| Issuance of operating partnership units in  acquisition of real estate asset              |       | —                        |       | 581 |   |
| Receivable from related party regarding  certain issues asserted by principal shareholder |       | —                        |       | 270 |   |

 

The accompanying notes arean integral part of these consolidated financial statements

 

6

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**AMERICANSPECTRUM REALTY, INC.**

### **Notesto Consolidated Financial Statemen**ts

** **

**NOTE 1. DESCRIPTION OF BUSINESS**

 

American Spectrum Realty,Inc. (“ASR” or the “Company”) is a Maryland corporation established on August8, 2000.  The Company is a full-servicereal estate corporation, which owns, manages and operates income-producingproperties.  Substantially all of the Company’sassets are held through an operating partnership (the “Operating Partnership”)in which the Company, as of June 30, 2004, held a .88% general partner interestand an 86.6% limited partnership interest. As of June 30, 2004, through its majority-owned subsidiary, theOperating Partnership, the Company owned and operated 26 properties, whichconsisted of 17 office buildings, 5 industrial properties, two shoppingcenters, one apartment complex, and one parcel of undeveloped land.  The 26 properties are located in sevenstates.

 

During the six monthsended June 30, 2004, the Company did not sell or acquire any properties.  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 Company willfocus primarily on office and industrial properties located in Texas, Californiaand Arizona.

 

The Company is the solegeneral partner of the Operating Partnership. As the sole general partner of the Operating Partnership, the Companygenerally has the exclusive power to manage and conduct the business of theOperating Partnership under its partnership agreement.  The Company’s interest as a limited partnerin the Operating Partnership entitles it to share in any cash distributionsfrom, and in profits and losses of, the Operating Partnership.  If the Company receives any distributionsfrom the Operating Partnership, it will, in turn, pay dividends to its commonstockholders so that the amount of dividends paid on each share of common stockequals four times the amount of distributions paid on each limited partnershipunit in the Operating Partnership (“OP Unit”). Most of the properties are owned by the Operating Partnership throughsubsidiary limited partnerships or limited liability companies.

 

Holdersof the OP Units have the option to redeem their units and to receive, at theoption of the Company, in exchange for each four OP Units (i) one share ofCommon Stock of the Company, or (ii) cash equal to the market value of oneshare of Common Stock of the Company at the date of conversion, but nofractional shares will be issued.

 

Management continues toconsider whether it is in the best interest of the Company to elect to betreated as a real estate investment trust (or REIT), as defined under theInternal Revenue Code of 1986, as amended. The Company currently operates in a manner that will permit it to electREIT status; however, the Company may enter into transactions which willpreclude it from electing REIT status in the future.  In general, a REIT is a company that owns orprovides financing for real estate and pays annual distributions to investorsof at least 90% of its taxable income.  AREIT typically is not subject to federal income taxation on its net income,provided applicable income tax requirements are satisfied.  For the tax year 2003, the Company was taxedas a C corporation.  It is anticipatedthat the Company will be taxed as a C corporation for the 2004 tax year.

 

**NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**BASIS OF PRESENTATION**

 

The accompanying unaudited consolidated financial statements have beenprepared pursuant to the rules and regulations of the Securities and ExchangeCommission.  In the opinion of theCompany, the accompanying interim unaudited consolidated financial statementscontain all material adjustments, consisting only of normal recurringadjustments necessary to present fairly the financial condition, the results ofoperations and changes in cash flows of the Company and its subsidiaries forinterim periods.

 

7

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The results for such interim periods are not necessarily indicative ofresults for a full year.  It is suggestedthat these consolidated financial statements be read in conjunction with theconsolidated financial statements for the year ended December 31, 2003 and therelated notes thereto included in the Company’s 2003 Annual Report on Form 10-Kfiled with the SEC.

 

All significant intercompany transactions, receivables and payableshave been eliminated in consolidation.

 

**RECLASSIFICATIONS**

 

Certain prior year balances have been reclassified to conform with thecurrent year presentation.  In accordancewith SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets”, real estate designated as held for sale are accounted for inaccordance with the provisions of SFAS No. 144 and the results of operations ofthese properties are included in income from discontinued operations.  Prior periods have been reclassified forcomparability, as required.

 

Pursuantto a one-for-four reverse stock split of the Company’s Common Stock, every fourshares of Common Stock outstanding as of the close of business on March 1, 2004became one share of new post-split Common Stock.  Share and per share data (except par value)in the consolidated financial statements and notes for all periods presentedhave been adjusted to reflect the reverse stock split.

 

**USE OF ESTIMATES**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the results of operations duringthe reporting period. Actual results could materially differ from thoseestimates.

 

**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.

 

**REAL ESTATE**

 

Rental properties are stated at cost, net of accumulated depreciation,unless circumstances indicate that cost, net of accumulated depreciation,cannot be recovered, in which case the carrying value of the property isreduced to estimated fair value. Estimated fair value (i) is based upon the Company’s plans for thecontinued operation of each property and (ii) is computed using estimated salesprice, as determined by prevailing market values for comparable propertiesand/or the use of capitalization rates multiplied by annualized net operatingincome based upon the age, construction and use of the building.  The fulfillment of the Company’s plansrelated to each of its properties is dependent upon, among other things, thepresence of economic conditions which will enable the Company to continue tohold and operate the properties prior to their eventual sale.  Due to uncertainties inherent in thevaluation process and in the economy, actual

 

8

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results of operating and disposing of the Company’s properties could bematerially different from current expectations.

 

Depreciation is provided using the straight-line method over the usefullives of the respective assets. The useful lives are as follows:

 

| 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 investments with a maturityof three months or less at the date of purchase.

 

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The Company’s financial instruments consist of cash and cashequivalents, tenant and other receivables, a mortgage loan receivable, notespayable, accounts payable and accrued expenses. Management believes that the carrying value of the Company’s financialinstruments approximate their respective fair market values at June 30, 2004and 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.

 

The Company uses interestrate swaps to hedge against fluctuations in interest rates on specificborrowings.  As of June 30, 2004, theCompany had interest rate swap contracts in notional amounts of approximately$9,600,000, which expire in December 2004. The interest rate swap contracts are reflected at fair value on theCompany’s balance sheet in accrued and other liabilities and the changes in thefair value of the hedge are recognized as adjustments to interest expense.  During the six months ended June 30, 2004 and2003, the Company recorded a benefit of $67,000 and a charge of $244,000,respectively, attributable to changes in the fair value of its derivativesfinancial instruments.

 

**DEFERRED FINANCING AND OTHER FEES**

 

Fees paid in connection with the financing and leasing of the Company’sproperties are amortized over the term of the related note payable or lease andare included in other assets.

 

## **STOCK-BASEDCOMPENSATION**

## ** **

The Financial Accounting Standards Board issued SFAS No. 123,“Accounting for Stock-Based Compensation” (“FAS 123”) in October 1995.  This standard establishes a fair valueapproach to valuing stock options awarded to employees as compensation.In December 2002, FASB issued SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure” (“FAS 148”), which amended FAS123.  FAS 148 provides alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation.  Additionally, FAS 148 amends the disclosurerequirements of FAS 123 to require prominent disclosures in the annual andinterim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reportedresults.  FAS 148 is effective forfinancial statements for fiscal years ending after

 

9

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December 15, 2002.  In compliance with FAS 148, the Company haselected to continue to follow the intrinsic value method in accounting for itsstock-based employee compensation arrangement as defined by APB No. 25“Accounting for Stock Issued to Employees”.

 

The Company has in effect its Omnibus StockIncentive Plan (the “Plan”), which is described more fully in its Form 10-Kfiled with the Securities and Exchange Commission.  The Company has elected, as permittedby FAS 123, to use the intrinsic value based method of accounting for stockoptions consistent with Accounting Principles Board Opinions No. 25,“Accounting for Stock Issued to Employees”. The intrinsic value method measures compensation cost for stock optionsas the excess, if any, of the quoted market price of the Company’s stock at themeasurement date over the exercise price. No stock-based employee compensation cost is reflected in net incomerelated to stock options, as all options granted under the Plan had an exerciseprice equal to the fair market value of the underlying common stock on the dateof grant.

 

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 June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss, as reported                                                                                                     |       | $                               | (2,931     | )                             | $          | (4,395 | ) | $ | (4,756 | ) | $ | (6,671 | ) |
| Deduct:   Employee compensation expense for stock option grants under fair value  method, net of related tax effects |       | (79                             | )          | (81                           | )          | (147 | ) | (145 | ) |
| Pro forma net loss                                                                                                        |       | $                               | (3,010     | )                             | $          | (4,476 | ) | $ | (4,903 | ) | $ | (6,816 | ) |
|                                                                                                                      |       |                            |       |                          |       |   |   |   |   |
| Per share data:                                                                                                           |       |                            |       |                          |       |   |   |   |   |
| Basic and diluted, as reported                                                                                            |       | $                               | (1.88      | )                             | $          | (2.96 | ) | $ | (3.06 | ) | $ | (4.65 | ) |
| Basic and diluted, proforma                                                                                               |       | $                               | (1.93      | )                             | $          | (3.02 | ) | $ | (3.15 | ) | $ | (4.75 | ) |

# ** **

# **MINORITY INTEREST**

# ** **

Unit holders in theOperating Partnership (other than the Company) held a 12.52% and 12.61% limitedpartnership interest in the Operating Partnership at June 30, 2004 and December31, 2003, respectively.  Each of theholders of the interests in the Operating Partnership (other than the Company)has the option (exercisable after the first anniversary of the issuance of theOP Units) to redeem its OP Units and to receive, at the option of the Company,in exchange for each four OP Units, either (i) one share of Common Stock of theCompany, or (ii) cash equal to the value of one share of Common Stock of the Companyat the date of conversion, but no fractional shares will be issued.

 

**RENTAL REVENUE**

 

Certain leases provide for tenant occupancy during periods for which norent is due or where minimum rent payments increase during the term of thelease.  The Company records rental incomefor the full term of each lease on a straight-line basis.  Accordingly, a receivable is recorded fromtenants equal to the excess 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 over continuously, with the numberand value of expiring leases varying from year to year.  The Company’s ability to re-lease the spaceto existing or new tenants at rates equal to or greater than those realizedhistorically is impacted by, among other things, the economic conditions of themarket in which a property is located, the availability of competing space, andthe level of improvements which may be required at the property.  No assurance can be given that the rentalrates that the Company will obtain in the future will be equal to or greaterthan those obtained under existing contractual commitments.

 

10

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# **NET LOSS PER SHARE**

# ** **

Netloss per share is calculated based on the weighted average number of commonshares outstanding.  Stock optionsoutstanding of 62,375 at June 30, 2004 and OP Units (other than those held bythe Company) outstanding of 892,931 (convertible into approximately 223,232shares of common stock)  at June 30, 2004have not been included in the net loss per share calculation since their effectwould be antidilutive.  See “MinorityInterests” paragraph above.

 

**INCOME TAXES**

 

In preparing the Company’s consolidated financial statements,management estimates the income tax in each of the jurisdictions in which theCompany operates.  This process includesan assessment of current tax expense, the results of tax examinations, and theeffects of temporary differences resulting from the different treatment oftransactions for tax and financial accounting purposes.  These differences may result in deferred taxassets or liabilities which are included in the consolidated balancesheet.  The realization of deferred taxassets as a result of future taxable income must be assessed and to the extentthat the realization 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**

# ** **

No real estate acquisitions were made during the six months ended June30, 2004.  During 2003, the Companyacquired four properties, as discussed below.

 

On November 13, 2003, theCompany acquired an office property in Houston, Texas, consisting ofapproximately 89,695 rentable square feet. Acquisition costs of approximately $3,476,000 were primarily funded witha new mortgage loan with the remainder in cash.

 

Between May 7, 2003 and October27, 2003, the Company acquired three office properties from an affiliatedentity.  The properties are located inHouston, Texas and consist of approximately 160,742 rentable square feet.  Acquisition costs of approximately $10,703,000included assumed or new mortgage indebtedness, the issuance of 382,537 OP Units(valued for this purpose at $4.11 per unit), deferred payments and cash.

 

Rental revenue and related expenses from theacquired properties was included in the Company’s results since theirrespective dates of acquisition. Therefore, the results of operations for the three and six months endedJune 30, 2004 include results from all of the above acquisitions, whereas, theresults of operations for the three and six months ended June 30, 2003 containlimited results related to these acquisitions.

 

## **DISPOSITIONS**

## ** **

No real estate dispositions were made during the six months ended June30, 2004.  During 2003, the Company soldeleven properties, as discussed below.

 

On December 5, 2003, theCompany sold Marketplace, a 105,289 square foot shopping center propertylocated in South Carolina, for $4,250,000.

 

On October 31, 2003, the Company sold Leawood Fountain Plaza, an 86,355square foot office property located in Kansas, for $3,020,000.

 

On September 30, 2003,the Company sold Emerald Pointe, a 366-unit apartment property located inTexas, for $10,100,000.

 

11

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On September 12, 2003,the Company sold two properties:  ParkPlaza, a 95,080 square foot industrial property located in Indiana, was soldfor $3,225,000; and Oak Grove Commons, a 137,678 square foot industrialproperty located in Illinois, was sold for $5,921,000.

 

On July 18, 2003, theCompany sold Northeast Commerce Center, a 100,000 square foot industrialproperty located in Ohio, for $4,771,000.

 

On July 9, 2003, theCompany sold three properties: Northcreek, a 92,282 square foot office propertylocated in Ohio, was sold for $5,620,000; Business Center, a 64,387 square footindustrial property located in Missouri, was sold for $3,655,000; and Jackson,a 320,000 square foot industrial property in Indiana, was sold for $4,000,000.

 

On May 15, 2003, theCompany sold Villa Redondo, a 125-unit apartment property in California, for$12,500,000.

 

On April 10, 2003, theCompany sold Valencia, an 82,560 square foot industrial property located inArizona, for $4,100,000.

 

In the accompanyingconsolidated statement of operations for the three and six months ended June30, 2003, the results of operations for properties mentioned above are shown inthe section “Discontinued operations”.

 

**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-marketleases.  Based on its acquisitions todate, the Company’s allocation to intangible assets for assets purchased hasbeen immaterial.**

## ** **

## **NOTE 4.  DISCONTINUED OPERATIONS**

## ** **

No properties were sold duringthe six months ended June 30, 2004 and no properties were classified as held forsale as of June 30, 2004 and December 31, 2003.

 

Net loss from discontinuedoperations for the three and six months ended June 30, 2003 includes theoperations of the eleven properties sold in 2003.  A gain on sale of discontinued operations of$2,228,000 on the disposition Valencia and Villa Redondo was recognized duringthe second quarter of 2003.  Animpairment totaling $4,000,000 was recognized on three other properties duringthe second quarter of 2003.  Theimpairment was based on the anticipated sales price less cost to sell ascompared to the carrying value of the assets. The three properties, which were sold in the third quarter of 2003,consisted of one office and two industrial properties.

 

12

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The condensed consolidatedstatements of operations of discontinued operations for the three and sixmonths ended June 30, 2003 are summarized below (dollars in thousands):

 

**CondensedConsolidated Statements of Operations**

 
| ** **                                                                | ** ** | **Three Months Ended  June 30, 2003** | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Rental revenue                                                            |       | $                                     | 2,360      |                                | $          | 5,169 |   |
| Total expenses                                                            |       | 2,594                                 |       | 5,685                               |       |
| Net loss from discontinued operations  before gain on sale and impairment |       | (234                                  | )          | (516                                | )          |
| Gain on sale of discontinued operations                                   |       | 2,228                                 |       | 2,228                               |       |
| Impairment of real estate assets held for  sale                           |       | (4,000                                | )          | (4,000                              | )          |
| Net loss from discontinued operations                                     |       | $                                     | (2,006     | )                                   | $          | (2,288 | ) |

 

**NOTE 5. MORTGAGE LOAN RECEIVABLE**

 

On October 27, 2003, theCompany acquired a note secured by a property adjacent to an office propertyowned by the Company.  The note bearsinterest at 7.5% per annum and matures in November 2004.  The receivable balance of the note as of June30, 2004 and December 31, 2003 was $1,689,684 and $1,666,504, respectively, netof discount of $33,301 and $83,253, respectively.  The purchase of this note was funded with anew loan to the Company from the lender that owned the note.  Loan costs of approximately $41,000 wereincurred in connection with the transaction. The Company is negotiating with the current owner to purchase thebuilding.

 

**NOTE 6.  NOTESPAYABLE, NET OF PREMIUMS**

 

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

 
| ** **                                                                                                                                                                                                                                                                                                                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Secured loans with various lenders, net of  unamortized premiums of $2,801 at June 30, 2004 and $3,172 at December 31,  2003, bearing interest at fixed rates between 5.00% and 12.00%, with monthly  principal and interest payments ranging between $3 and $269 at June 30, 2004  and December 31, 2003, and maturing at various dates through August 11, 2012. |       | $        | 127,885    |     | $          | 124,575 |   |
|                                                                                                                                                                                                                                                                                                                                                              |       |     |       |     |       |
| Secured loans with various banks bearing  interest at variable rates ranging between 5.28% and 6.50% at June 30, 2004,  and 5.14% and 6.50% December 31, 2003, and maturing at various dates through  May 1, 2008.                                                                                                                                                |       | 13,381   |       | 13,659   |       |
|                                                                                                                                                                                                                                                                                                                                                              |       |     |       |     |       |
| Secured Series A & B Bonds with a fixed  interest rate of 6.39%, monthly principal and interest payments of $74,  maturing September 30, 2031.                                                                                                                                                                                                                |       | 11,456   |       | 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 June 30, 2004 and  between 4.99% and 20.00% at December 31, 2003, and maturing at various dates  through February 19, 2005.                                                                                                                                    |       | 910      |       | 810      |       |
|                                                                                                                                                                                                                                                                                                                                                              |       |     |       |     |       |
| Total                                                                                                                                                                                                                                                                                                                                                             |       | $        | 154,032    |     | $          | 151,051 |   |

 

Debt premiums are amortizedinto interest expense over the terms of the related mortgages using theeffective interest method.  As of June30, 2004 and December 31, 2003, the unamortized debt premiums included in theabove schedule were $2,801,000 and $3,172,000 respectively.

 

InMay 2004, the Company refinanced a $3,132,000 loan on Mira Mesa, one of itsoffice 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.

 

13

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In May 2004, the Companyfinanced insurance premiums of $373,000 on its properties and agreed to pay aservice fee of $85,000 over one year.

 

InDecember 2003, the Company refinanced a $3,000,000 loan on San Felipe, one ofits office properties, with a new one-year loan agreement in the amount of$5,350,000.  The new loan, which containstwo six-month extension options, bears interest at a fixed rate of 7.95% perannum.  Net proceeds of $2,059,000 werereceived as a result of the refinance.

 

InNovember 2003, in connection with the acquisition of an office property inHouston, Texas, the Company obtained a loan in the amount of $4,574,000.  The loan, which matures in May 2004 may beextended, at the Company’s option, to November 2004.  The loan bears interest at a fixed rate of 5%per annum.

 

InOctober 2003, the Company entered into a $4,100,000 loan agreement inconnection with the acquisition of an office property in Houston, Texas and theacquisition of a note secured by another office property in Houston.  The loan, of which $3,700,000 had been fundedas of December 31, 2003, matures in November 2005 and bears interest at a fixedrate of 6% per annum.

 

InSeptember 2003, a note payable in the amount of $510,000 was repaid with theproceeds from the sale of Emerald Pointe. The note bore interest at prime plus 1%.

 

InAugust 2003, the Company refinanced a $1,300,000 loan secured by Van Buren, aparcel of undeveloped land, and entered into a new two-year loan agreement inthe amount of $1,340,000.  The new loanbears interest at a fixed rate of 12% per annum and matures August 1, 2005.

 

InJuly 2003, in connection with the acquisition of an office property in 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 2012. 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.

 

InMay 2003, in connection with the acquisition of an office property in 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 Parkerand Leahy, LLP cancelled its $199,180 note, plus $45,891 of accrued interestthereon, in exchange for 14,943 shares of the Company’s common stock.

 

In May 2003, John N. Galardicancelled his $1,600,000 note, plus $286,036 of accrued interest thereon, inexchange for 115,002 shares of the Company’s common stock.

 

In May 2003, the Company financed insurance premiums of $643,000 on itsproperties and agreed to pay a service fee of $85,000 over one year.  The insurance premium note was paid in fullin February 2004.  The Company financedan additional insurance premium during 2003 of $130,000, which was paid in fullin June 2004.

 

InJuly 2002, the lender under a loan agreement related to the South Carolinashopping center properties notified the Company it was technically in defaultunder its loan agreement for non-compliance with certain covenants, includingcovenants 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 June 30, 2004, the remaining balance ofthe loan was approximately $2,756,000. The Company continues to discuss the non-compliance matter with the newlender.  The new lender has notaccelerated the loan.

 

14

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

# ** **

As the result of the settlement of the Teachout litigation, which wasdocumented in the third quarter of 2003, the Company reaffirmed its previouslyannounced obligation to pay the former limited partners of Sierra PacificDevelopment Fund II (“Fund II”) as of the date of the Company’s 2001consolidation transaction (the “Consolidation”), or their assignees ortransferees, the loans which were made and called by the former general partnerof Fund II as part of the Consolidation. Pursuant to the settlement, the Company established a repayment plan andsecured the debt with a second deed of trust on an office property owned by theCompany.  This repayment plan consists ofa promissory note in the amount of $8,800,000, which bears interest at 6% perannum and matures in March 2006. Interest-only payments, which are payable quarterly, commenced June 2,2003.  The note may be prepaid in wholeor in part at any time without penalty.

 

As part of the settlement, the Company agreed to pay legal feestotaling $1,200,000 to the plaintiff’s counsel. The Company made a scheduled payment of $250,000 in the third quarter of2003 with the remaining $950,000 consisting of two promissory notes.  The first note, in the amount of $700,000,bears interest at 6% per annum and matures in March 2006.  Interest-only payments, which are payablequarterly, commenced June 2, 2003.  Thesecond promissory note, in the amount of $250,000, bears no interest andmatures in March 2006.  The notes, whichare 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.

 

Inconnection 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 was paid.  The payment was made with certain funds owedto Mr. Carden and Mr. Galardi by the Company related to a guarantee fee.  See Note 12 – Related Party Transactions.

 

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

## ** **

In May 2004, in connection with the refinanceof Mira Mesa, the Company recorded a loss on early extinguishment of debt of$613,000 due to a prepayment penalty of $687,000, which was offset in part bythe write-off of an unamortized loan premium of $74,000.  The loss on early extinguishment of debt inincluded in other loss in the consolidated statements of operations.

 

## **NOTE 9.  MINORITY INTEREST**

## ** **

Unit holders in theOperating Partnership (other than the Company) held a 12.52% and 12.61% limitedpartnership interest in the Operating Partnership at June 30, 2004 and December31, 2003, respectively.  Each of theholders of the interests in the Operating Partnership (other than the Company)has the option (exercisable after the first anniversary of the issuance of theOP Units) to redeem its OP Units and to receive, at the option of the Company,in exchange for each four OP Units, either (i) one share of Common Stock of theCompany, or (ii) cash equal to the value of one share of Common Stock of theCompany at the date of conversion, but no fractional shares will be issued.

 

During the second quarter of2004, a total of 5,826 OP Units were exchanged for 1,455 shares of CommonStock.

 

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

 

15

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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 December31, 2003, a total of 202,056 OP Units were exchanged for 50,514 shares ofCommon 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 May 2003, the Company’sBoard of Directors authorized the repurchase of up to 75,000 shares of its commonstock from the proceeds of property sales. Such purchases would be made from time to time in open markettransactions.

 

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.

 

Pursuantto the settlement of the Teachout litigation, the Company repurchased 45 sharesfrom a former limited partner of Fund II for $2,457, or $54.00 per share,during the third quarter of 2003.

 

InDecember 2003, the Company repurchased 6,563 shares of restricted stock from anemployee for cash of $59,750 and the reversal of deferred compensation 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 in2003 and is included in interest expense on the results of operations.  For the first six months ended June 30, 2004,the Company has accrued $114,000 related to the guarantee fee payable for the2004 year.

 

During 2003, the Company madepayments totaling $1,000,000, on its indebtedness to an affiliated entity,reducing the balance due to $251,321. The Company has a balance due of $14,800 to another affiliated entity asof June 30, 2004.

 

During 2003, the Companyacquired three office properties from an affiliated entity.  The properties are located in Houston, Texasand consist of approximately 160,742 rentable square feet.  Acquisition costs of approximately$10,703,000 included assumed or new mortgage indebtedness, the issuance of382,537 OP Units, deferred payments of $190,469 and cash.

 

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

 

16

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In May 2003, Mr. Galardicancelled his $1,600,000 note, plus $286,036 of accrued interest thereon, inexchange for 115,002 shares of the Company’s common stock.

 

In May 2003, Mr. Galardipurchased a total of 15,243 shares of the Company’s common stock for $16.40 pershare.

 

In February 2003, the Companyreached an agreement with CGS Real Estate Company, Inc. whereby CGSacknowledged that it owed the Company a net amount of $270,375 which related toseveral issues asserted by William J. Carden that were owed by CGS to theCompany and by the Company to CGS.  Thisamount is payable on March 15, 2006 with interest accruing from March 15, 2003at an annual rate of 6% and payable quarterly commencing on June 15, 2003.  An affiliate of Mr. Carden is a principalstockholder of CGS.  Mr. Carden is anofficer and a director of CGS, and an affiliate of Mr. Galardi is a principalstockholder of CGS.  Mr. Carden and Mr.Galardi have agreed to guarantee this obligation of CGS, and they have securedthis guarantee with an assignment to the Company of their right to receive$270,375 of principal payments on the notes payable to them and theiraffiliates by reason of the settlement of the Teachout litigation, plus allinterest payable on such principal amount of notes. In March 2004, as part ofthe payment of the Guarantee Fee, interest due on this obligation for 2004 waspaid in advance and $26,606 was applied to the principal due on thisobligation.  The principal balance due asof June 30, 2004 is $243,858.

 

In connection with thesettlement of the Teachout litigation, Mr. Galardi and Mr. Carden acknowledgedthat they owe the Company the sum of $1,187,695 as indemnification against aportion of the Company’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 June 30, 2004 is $1,070,820.

 

During2002, the Company made payments totaling $521,808 on its obligation to ASJ,Ltd., which is owned by Mr. Carden, his wife and a trust for his children.  The payments reduced the balance due to ASJ,Ltd. to $200,000 as of December 31, 2002. During 2003, the obligation 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 six months ended June 30, 2004, the Company paid $70,118 for real estaterelated services to a firm in which Patricia A. Nooney, an executive officer ofthe Company, holds an ownership interest. For the year ended December 31, 2003, the Company paid $98,763 to thisfirm.

 

**NOTE13.  SEGMENT INFORMATION**

 

As of June 30, 2004, the Company owned a portfolio of propertiescomprising office, industrial, shopping center properties, an apartmentproperty, and a parcel of undeveloped land. 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 toresidential tenants on either a month-by-month basis or for terms generally ofone year or less.

 

The accounting policies of the segments are the same as those describedin the summary of significant accounting policies.  The Company evaluates performance of itsproperty types based on net operating

 

17

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income derived by subtracting property operating expenses from rentalrevenue.  Significant information used bythe Company for its reportable segments as of and for the three months and sixmonths ended June 30, 2004 and 2003 is as follows (dollars in thousands):

 
| ** **                           | ** ** | **Office** | ** ** | **Industrial** | ** ** | **Shopping  Center** | ** ** | **Apartment** | ** ** | **Undeveloped  Land and  Other** | ** ** | **Property  Total** | ** ** |
|--------------------------------------|------------|------------|------------|----------------|------------|----------------------|------------|---------------|------------|----------------------------------|------------|---------------------|------------|
| **Three Months Ended June 30,**      | ** ** | ** ** | ** ** | ** **     | ** ** | ** **           | ** ** | ** **    | ** ** | ** **                       | ** ** | ** **          | ** ** |
| **2004**                             |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| Rental revenue                       |       | $          | 5,449      |           | $          | 720                  |       | $             | 280        |                             | $          | 670                 |       | $ | — |   | $ | 7,119 |   |
| Property operating expenses          |       | 2,114      |       | 198            |       | 87                   |       | 413           |       | 29                               |       | 2,841               |       |
| Net operating income (NOI)           |       | $          | 3,335      |           | $          | 522                  |       | $             | 193        |                             | $          | 257                 |       | $ | (29 | ) | $ | 4,278 |   |
| Real estate held for investment, net |       | $          | 136,214    |           | $          | 21,768               |       | $             | 5,271      |                             | $          | 13,623              |       | $ | 3,977 |   | $ | 180,853 |   |
|                                 |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| **2003**                             |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| Rental revenue                       |       | $          | 4,411      |           | $          | 693                  |       | $             | 254        |                             | $          | 714                 |       | $ | 8 |   | $ | 6,080 |   |
| Property operating expenses          |       | 1,857      |       | 189            |       | 57                   |       | 358           |       | 35                               |       | 2,496               |       |
| Net operating income (NOI)           |       | $          | 2,554      |           | $          | 504                  |       | $             | 197        |                             | $          | 356                 |       | $ | (27 | ) | $ | 3,584 |   |
| Real estate held for investment, net |       | $          | 128,939    |           | $          | 22,901               |       | $             | 5,648      |                             | $          | 14,195              |       | $ | 2,089 |   | $ | 173,772 |   |

 
| ** **                           | ** ** | **Office** | ** ** | **Industrial** | ** ** | **Shopping  Center** | ** ** | **Apartment** | ** ** | **Undeveloped  Land and  Other** | ** ** | **Property  Total** | ** ** |
|--------------------------------------|------------|------------|------------|----------------|------------|----------------------|------------|---------------|------------|----------------------------------|------------|---------------------|------------|
| **Six Months Ended June 30,**        |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| **2004**                             |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| Rental revenue                       |       | $          | 11,161     |           | $          | 1,476                |       | $             | 527        |                             | $          | 1,328               |       | — |   | $ | 14,492 |   |
| Property operating expenses          |       | 4,205      |       | 424            |       | 139                  |       | 789           |       | $                                | 50         |                | 5,607      |   |
| Net operating income (NOI)           |       | $          | 6,956      |           | $          | 1,052                |       | $             | 388        |                             | $          | 539                 |       | $ | (50 | ) | $ | 8,885 |   |
| Real estate held for investment, net |       | $          | 136,214    |           | $          | 21,768               |       | $             | 5,271      |                             | $          | 13,623              |       | $ | 3,977 |   | $ | 180,853 |   |
|                                 |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| **2003**                             |       |       |       |           |       |                 |       |          |       |                             |       |                |       |
| Rental revenue                       |       | $          | 9,399      |           | $          | 1,422                |       | $             | 484        |                             | $          | 1,391               |       | $ | 50 |   | $ | 12,746 |   |
| Property operating expenses          |       | 3,586      |       | 533            |       | 154                  |       | 652           |       | 82                               |       | 5,007               |       |
| Net operating income (NOI)           |       | $          | 5,813      |           | $          | 889                  |       | $             | 330        |                             | $          | 739                 |       | $ | (32 | ) | $ | 7,739 |   |
| Real estate held for investment, net |       | $          | 128,939    |           | $          | 22,901               |       | $             | 5,648      |                             | $          | 14,195              |       | $ | 2,089 |   | $ | 173,772 |   |

 

The followingis a reconciliation of segment revenues, income and assets to consolidatedrevenues, income and assets for the periods presented above (dollars inthousands):

 
| ** **                                                     | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **REVENUES**                                                   |       |                            |       |                          |       |   |   |   |   |
| Total revenues for reportable segments                         |       | $                               | 7,119      |                          | $          | 6,080 |   | $ | 14,492 |   | $ | 12,746 |   |
| Other revenues                                                 |       | 82                              |       | 33                            |       | 162 |   | 43 |   |
| Total consolidated revenues                                    |       | $                               | 7,201      |                          | $          | 6,113 |   | $ | 14,654 |   | $ | 12,789 |   |
|                                                           |       |                            |       |                          |       |   |   |   |   |
| **NET (LOSS) INCOME**                                          |       |                            |       |                          |       |   |   |   |   |
| NOI for reportable segments                                    |       | $                               | 4,278      |                          | $          | 3,584 |   | $ | 8,885 |   | $ | 7,739 |   |
| Unallocated amounts:                                           |       |                            |       |                          |       |   |   |   |   |
| Interest and other income                                      |       | 82                              |       | 33                            |       | 162 |   | 43 |   |
| General and administrative expenses                            |       | (1,181                          | )          | (1,709                        | )          | (2,308 | ) | (3,302 | ) |
| Depreciation and amortization                                  |       | (2,776                          | )          | (2,266                        | )          | (5,461 | ) | (4,528 | ) |
| Interest expense                                               |       | (3,144                          | )          | (2,652                        | )          | (6,107 | ) | (5,250 | ) |
| Loss on extinguishment of debt                                 |       | (613                            | )          | —                        |       | (613 | ) | — |   |
| Net loss before minority interest and  discontinued operations |       | $                               | (3,354     | )                             | $          | (3,010 | ) | $ | (5,442 | ) | $ | (5,298 | ) |

 

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| ** **                           | ** ** | **June 30,** | ** ** |
|--------------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2004**     | ** ** | **2003** | ** ** |
| **ASSETS**                           |       |         |       |   |   |
| Total assets for reportable segments |       | $            | 180,853    |   | $ | 173,772 |   |
| Real estate held for sale            |       | —       |       | 48,746 |   |
| Cash and cash equivalents            |       | 1,106        |       | 1,839 |   |
| Tenant and other receivables, net    |       | 567          |       | 515 |   |
| Mortgage loan receivable, net        |       | 1,689        |       | — |   |
| Deferred rent receivable             |       | 1,445        |       | 644 |   |
| Insurance proceeds held in escrow    |       | 4,860        |       | — |   |
| Investment in management company     |       | 4,000        |       | 4,000 |   |
| Prepaid and other assets, net        |       | 9,290        |       | 8,543 |   |
| Total consolidated assets            |       | $            | 203,810    |   | $ | 238,059 |   |

 

# **NOTE 14.  COMMITMENTS ANDCONTINGENCIES**

# ** **

The following is informationconcerning material, pending legal proceedings to which the Company or itssubsidiaries is a party or of which any of their property is subject:

 

Lewis Matter

 

Onor about September 27, 2001, Robert L. Lewis, Madison Liquidity Investors 103LLC and Madison Liquidity Investors 112 LLC, purporting to represent themselvesand all others similarly situated, initiated an action against the Company,CGS, William J. Carden, John N. Galardi and S-P Properties, Inc. in the OrangeCounty Superior Court, Case No. 01 CC 000394.

 

Plaintiffs’complaint in this action alleged claims against the Company and others forbreach of fiduciary duty and breach of contract.  Plaintiffs’ complaint challenged theConsolidation, although the Consolidation was disclosed in a Prospectus/ConsentSolicitation filed with the Securities and Exchange Commission and was approvedby a majority vote of the limited partners of the partnerships. Plaintiffsalleged that the approval was invalid and that the Consolidation constituted abreach of fiduciary duty by each of the defendants.  Plaintiffs further alleged that theConsolidation constituted breach of the partnership agreements governing thepartnerships.

 

Plaintiffs’ prayer for relief sought the following: 1)an injunction prohibiting the defendants from commingling; 2) imposition of aconstructive trust providing for liquidation of the assets of the partnershipsand a distribution of the assets to the former limited partners therein; 3) ajudicial declaration that the action may be maintained as a class action; 4)monetary/compensatory damages; 5) plaintiffs’ costs of suit, includingattorneys’, accountants’ and expert fees; and 6) a judicial order ofdissolution of the partnerships and appointment of a liquidating trustee.  On March 15, 2002, the Court sustained theCompany’s demurrer to plaintiffs’ complaint and held that the complaint failedto state a cause of action for either breach of fiduciary duty or breach ofcontract against the Company.  The Courtgave the plaintiffs twenty days leave to amend.

 

Subsequently, plaintiffs filedand served a Second Amended Complaint alleging claims against the Company forbreach of fiduciary duty, breach of contract, intentional interference withprospective economic advantage, and intentional interference with contractualrelations.  On June 14, 2002, the Courtsustained the Company’s demurrer on the grounds that Plaintiffs’ Second AmendedComplaint failed to state a cause of action against the Company forinterference with contract or interference with prospective economicadvantage.  The Court gave Plaintiffstwenty days leave to amend.

 

Subsequently,the plaintiffs filed and served a Third Amended Complaint on the Companyalleging claims against the Company for breach of fiduciary duty, breach ofcontract, intentional interference with prospective economic advantage, andintentional interference with contractual relations.  On September 6, 2002, the Court sustained theCompany’s demurrer on the grounds that the Plaintiffs’ Third Amended Compliantfailed to state a cause of action for either interference with contract orinterference with prospective economic advantage against the Company.  The Court gave the Plaintiffs twenty days toamend.

 

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OnSeptember 25, 2002, the plaintiffs filed and served a Fourth Amended Complainton the Company alleging claims against the Company for breach of fiduciaryduty, breach of contract, intentional interference with prospective economicadvantage, and intentional interference with contractual relations.  The plaintiffs’ prayer for relief on itsFourth Amended Compliant seeks the following: 1) an injunction prohibiting the defendants from commingling; 2)imposition of a constructive trust providing for liquidation of the assets ofthe partnerships and a distribution of the assets to the former limitedpartners therein; 3) a judicial declaration that the action may be maintainedas a class action; 4) monetary/compensatory damages; 5) plaintiffs’ costs ofsuit, including attorneys’, accountants’ and expert fees; and 6) a judicialorder of dissolution of the partnerships and appointment of a liquidatingtrustee.  On October 29, 2002, theCompany responded by answer and asserted general and specific affirmative defensesto the allegations in the Fourth Amended Complaint.

 

On January 10, 2003,plaintiffs filed and served a Notice of Motion and Motion for ClassCertification.  On January 31, 2003, theCompany filed an Opposition to Plaintiffs’ Motion for Class Certification.  On March 7, 2003, the Court grantedplaintiffs’ Motion for Class Certification but expressly reserved the right tovisit the issue of certification should rescission be chosen as a remedy todetermine whether it is still a viable procedure in the class setting.

 

On October 16, 2003,counsel for the plaintiffs and counsel for the defendants executed a Memorandumof Understanding regarding the 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 the FourthAmended Complaint.  Plaintiffs haveagreed to release such claims, pursuant to the Memorandum.  As this matter is a class action, the partiesneed to obtain court approval to complete the settlement and to administer thepayment of the settlement amounts to the class members.  The settlement is funded, in its entirety, byinsurance coverage.

 

On January 14, 2004, the Court granted preliminaryapproval of the settlement, directed notice to the Class, and set a fairnesshearing for March 23, 2004.  On February26, 2004, the defendants’ insurers deposited $6,500,000 into an escrow accountfor the purposes of settlement.  On April12, 2004, the Court ruled that the settlement is fair, adequate andreasonable.  On April 15, 2004,$1,640,000 was disbursed from the escrow account for attorney fees andexpenses, reducing the escrow balance to $4,860,000.  The remaining balance will be distributed tothe plaintiffs following a final accounting in the matter.

 

Other Matters

 

Certain claims and lawsuits have arisen against the Company in itsnormal course of business. The Company believes that such claims and lawsuitswill not have a material adverse effect on the Company’s financial position,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.

 

ContractualObligations and Commitments

 

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

 
| ** **                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt (1)             |       | $        | 22,823     |     | $          | 18,998   |       | $        | 5,892      |     | $          | 1,453          |       | $         | 4,744      |   | $ | 97,321 |   | $ | 151,231 |   |
| Litigation settlement (2)      |       | —   |       | —   |       | 9,750    |       | —   |       | —   |       | —         |       | 9,750     |       |
| Capital lease expenditures (3) |       | 720      |       |     |       | —   |       | —   |       | —   |       | —         |       | 720       |       |
| Employee obligations (4)       |       | 403      |       | 580      |       |     |       |     |       |     |       |           |       | 983       |       |
| Total                          |       | $        | 23,946     |     | $          | 19,578   |       | $        | 15,642     |     | $          | 1,453          |       | $         | 4,744      |   | $ | 97,321 |   | $ | 162,684 |   |

 

----

(1) See Note 6 – Notes Payable.

(2) Represents obligations related to thesettlement of the Teachout litigation. See Note 7 – Notes Payable, Litigation Settlement.

 

20

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(3) Representscommitments for tenant improvements and lease commissions related to theleasing of space to new or renewing tenants.

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

 

**NOTE15.  SUBSEQUENT EVENTS**

** **

OnJuly 21, 2004, the Company refinanced a $5,320,000 loan on Northwest CorporateCenter, one of its office properties, with a new loan agreement in the amountof $5,750,000.  The new loan bearsinterest 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.

** **

OnJuly 30, 2004, the Company sold Westlakes, a 95,370 square foot industrialproperty located in Texas for $4,975,000. The sale produced net proceeds of approximately $2,780,000, of which$2,530,000 is being held in escrow as a source to facilitate the funding of afuture acquisition in a tax-deferred exchange. The Company anticipates a gain will be recognized in the third quarterof 2004 on the transaction.

 

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 held the note onthe property.   See Note 5 – MortgageLoan Receivable.

 

21

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL 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 June 30, 2004, held a .88% general partner interest and an 86.6%limited partnership interest. As of June 30, 2004, through its majority-ownedsubsidiary, the Operating Partnership, the Company owned and operated 26properties, which consisted of 17 office buildings, 5 industrial properties,two shopping centers, one apartment complex, and one parcel of undevelopedland.  The 26 properties are located inseven states.

 

During the first sixmonths of 2004, the Company did not sell or acquire any properties.  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 and acquisitions were partof the Company’s strategy to sell certain of its properties in its non-coremarkets and acquire additional properties in its core property types and coregeographic markets.  The Company willcontinue to focus primarily on office and industrial properties located inTexas, California and Arizona.

 

On June 30, 2004, theproperties owned by the Company were 83% occupied compared to 75% occupied onJune 30, 2003.  The Company continues toaggressively pursue prospective tenants to increase its occupancy, which shouldhave the effect of improving operational results.

 

In the accompanying consolidated statement ofoperations, the results of operations for properties sold are shown in thesection “Discontinued operations”. Therefore the revenues and expenses reported for the quarters and sixmonths ended June 30, 2004 and 2003 reflect results from properties currentlyowned by the Company.  As ofDecember 31, 2003 and June 30, 2004, there were no properties classified on thebalance sheet as held for sale.

 

The share data in this Item 2 has been adjusted to give effect to theone-for-four reverse stock split which became effective March 2, 2004.

 

**CRITICALACCOUNTING ESTIMATES**

 

The major accountingpolicies followed by the Company are listed in Note 2 – Summary of SignificantAccounting 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 Company believes thefollowing critical accounting policies affect its more significant judgmentsand estimates used in the preparation of its consolidated financial statements:

 

•                  Certainleases provide for tenant occupancy during periods for which no rent is due orwhere minimum 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.

 

•                  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 value

 

22

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of the property is reducedto estimated fair value. Estimated fair value (i) is based upon the Company’splans for the continued operation of each property and (ii) is computed usingestimated sales price, as determined by prevailing market values for comparableproperties and/or the use of capitalization rates multiplied by annualized netoperating income based upon the age, construction and use of the building.  The fulfillment of the Company’s plans relatedto each of its properties is dependent upon, among other things, the presenceof economic conditions which will enable the Company to continue to hold andoperate the properties prior to their eventual sale. Due to uncertaintiesinherent in the valuation process and in the economy, the actual results ofoperating and disposing of the Company’s properties could be materiallydifferent than current expectations.

 

•                  Gains on property sales are accounted for inaccordance 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 tax year 2004.

 

# **RESULTS OF OPERATIONS**

# ** **

In accordance with generally accepted accounting principles, theoperating results of the eleven properties sold in 2003 were reported asdiscontinued operations in the results of operations for the second quarter andsix months ended June 2003.  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 thethree months ended June 30, 2004 and 2003.***

 

The following table shows a comparison ofrental revenues and certain expenses for the quarters ended June 30:

 
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                    | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$$**       | ** ** | **%** | ** ** |
| Rental revenue                |       | $          | 7,119,000  |       | $          | 6,080,000    |       | 1,039,000 |   | 17.1 | % |
| Operating expenses:           |       |       |       |       |       |         |       |   |   |
| Property operating expenses   |       | 2,841,000  |       | 2,496,000  |       | 345,000      |       | 13.8 | % |
| General and administrative    |       | 1,181,000  |       | 1,709,000  |       | (528,000     | )          | (30.9 | )% |
| Depreciation and amortization |       | 2,776,000  |       | 2,266,000  |       | 510,000      |       | 22.5 | % |
| Interest expense              |       | 3,144,000  |       | 2,652,000  |       | 492,000      |       | 18.6 | % |
|                               |            |            |            |            |            |              |            |  |  |  |  |

 

*Rental revenue*. The increase of $1,039,000, or 17.1%, wasattributable to $532,000 in revenue generated from three office propertiesacquired subsequent to the second quarter of 2003 and $507,000 in higherrevenues from properties owned on June 30, 2004 and June 30, 2003 (“SameProperties”). The three office properties were acquired between July 30, 2003and November 13, 2003.  Rental revenuefrom the acquired properties was included in the Company’s results since theirrespective dates of acquisition.  Theweighted average occupancy of Same Properties increased to 83% on June 30, 2004from 75% on June 30, 2003 and 79% on March 31, 2003.  The weighted average occupancy of allproperties held as of June 30, 2004 was 83%.

 

23

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*Property operating expenses*.  Theincrease of $345,000, or 13.8%, was due primarily to expenses related to thethree acquired properties mentioned above.

 

*Generaland administrative*. The decrease of $528,000 was due to lower professional fees, especiallylegal services, and a decrease in compensation expense, primarily due to the closure of the Company’s office in NewYork and the downsizing of its administrative staff, especially in the St.Louis and San Diego offices.  In 2003,the Company settled two major lawsuits and hired an in-house legal counsel.  Both of these factors contributed to thereduced fees for legal services incurred in the second quarter of 2004 comparedto the second quarter of 2003.

 

*Depreciation and amortization*.  Theincrease of $510,000 was related to depreciation of capital improvements andamortization of capitalized lease costs incurred in 2002 and 2003 and also thedepreciation related to the three above mentioned acquired properties. Duringthe last two years, 2002 and 2003, the Company has spent approximately$8,186,000 in capital improvements on its existing properties, namely forrenovations and tenant improvements.

 

*Interestexpense*.  The increase of $492,000 was due to (i) thehigher interest expense and fees on increased debt on two of its properties,(ii) the interest expense associated with the three acquired propertiesmentioned above, (iii) the Company recording interest at the default rate ondebt related to one of its shopping center properties and (iv) the accrual of aloan guarantee fee.

 

In December 2003, the Company refinanced a$3,000,000 loan on San Felipe, one of its office properties, with a newone-year loan in the amount of $5,350,000 bearing interest at 7.95%.  In May 2004, the Company refinanced a$3,132,000 loan on Mira Mesa, one of its office properties, with a new one-yearloan agreement in the amount of $7,500,000 bearing interest at 7.95%.

 

In July 2002, the lender undera loan agreement related to the South Carolina shopping center propertiesnotified the Company 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 November 2002.  In early 2003, the lender sold the loan tothe 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 ofJune 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 totwo of the Company’s directors and a company they are affiliated with, is inconsideration of their guarantees of certain indebtedness of the Company.  In 2004, effective in 2003, the Companyagreed to pay an annual guarantee fee equal to between .25% and .75% (dependingon the nature of the guaranty) of the outstanding balance as of December 31 ofeach year of the guaranteed obligations. The guaranty fee is to be paid for a maximum of 3 years on anyparticular obligation.  For thesecond quarter of 2004, the Company accrued $57,000 related to this guaranteefee.  The fee for 2003 was accrued in thefourth quarter of 2003.

 

*Loss on extinguishment of debt*.  In May 2004, in connection with the refinanceof Mira Mesa, the Company recorded a loss on early extinguishment of debt of$613,000 due to a prepayment penalty of $687,000, which was offset in part bythe write-off of an unamortized loan premium of $74,000.

 

*Discontinued operations*.  TheCompany recorded a loss from discontinued operations of $234,000 for the threemonths ended June 30, 2003 related to the eleven properties sold in 2003.  No properties were sold during the first sixmonths of 2004 and no properties were classified as held for sale as of June30, 2004.  See Note 4 – DiscontinuedOperations – of the Notes to Consolidated Financial Statements.

 

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Theloss from discontinued operations is summarized below.

 

**CondensedConsolidated Statements of Operations**

 
| ** **                            | ** ** | **Three Months Ended  June 30, 2003** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| Rental revenue                        |       | $                                     | 2,360      |   |
| Total expenses                        |       | 2,594                                 |       |
| Net loss from discontinued operations |       | (234                                  | )          |
|                                       |            |                                       |            |  |

 

*Gain onsale of discontinued operations*.  The Company sold one industrial property and one apartment property inthe second quarter of 2003 for an aggregate of $16,600,000 and recognized again of $2,228,000.  The sales generatednet proceeds of $4,685,000.

 

*Impairmentof real estate assets held for sale.*  TheCompany recorded an impairment of $4,000,000 on three properties held for salein the second quarter of 2003.  Theimpairment was based on the anticipated sales price less cost to sell ascompared to the carrying value of the assets. The three properties consist of one office and two industrialproperties.

 

***Discussion of thesix months ended June 30, 2004 and 2003.***

 

The following table shows a comparison ofrental revenues and certain expenses for the six months ended June 30:

 
| ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                    | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**        | ** ** | **%** | ** ** |
| Rental revenue                |       | $          | 14,492,000 |       | $          | 12,746,000   |       | 1,746,000 |   | 13.7 | % |
| Operating expenses:           |       |       |       |       |       |         |       |   |   |
| Property operating expenses   |       | 5,607,000  |       | 5,007,000  |       | 600,000      |       | 12.0 | % |
| General and administrative    |       | 2,308,000  |       | 3,302,000  |       | (994,000     | )          | (30.1 | )% |
| Depreciation and amortization |       | 5,461,000  |       | 4,528,000  |       | 933,000      |       | 20.6 | % |
| Interest expense              |       | 6,107,000  |       | 5,250,000  |       | 857,000      |       | 16.3 | % |
|                               |            |            |            |            |            |              |            |  |  |  |  |

 

*Rental revenue*. The increase of $1,746,000, or 13.7%, wasattributable to (i) $1,317,000 in revenue generated from four office propertiesacquired in May 2003 through November 2003, (ii) a $196,000 payment receivedfrom the owner of a neighboring property for past use of common parking areasand (iii) higher revenues of $232,000 for Same Properties.  Rental revenue from the acquired propertieswas included in the Company’s results since their respective dates ofacquisition.  The weighted averageoccupancy of properties held for investment was 83% at June 30, 2004 and 75% atJune 30, 2003.

 

*Property operating expenses*.  Theincrease of $600,000, or 12.0%, was due to the expenses related to the fouracquired properties mentioned above, offset in part by an $83,000 reduction inoperating expenses for other properties owned by the Company.

 

*Generaland administrative*. The decrease of $994,000 was due to lower professional fees, especiallylegal services, and a decrease in compensation expense, primarily due to the closure of the Company’s office in NewYork and the downsizing of its administrative staff, especially in the St.Louis and San Diego offices.  In 2003,the Company settled two major lawsuits and hired an in-house legal counsel.  Both of these factors contributed to thereduced fees for outside legal services incurred in the first six months of2004 compared to the first six months of 2003.

 

*Depreciation and amortization*.  Theincrease of $933,000 was related to depreciation of capital improvements andamortization of capitalized lease costs incurred in 2002 and 2003 and also thedepreciation related to the four acquired properties mentioned above.  During the last two years, 2002 and 2003, theCompany has spent approximately $8,186,000 in capital improvements on itsexisting properties, namely for renovations and tenant improvements.

 

*Interestexpense*.  The increase of $857,000 was due to (i) thehigher interest expense and fees on increased debt on two of its properties,(ii) the interest expense associated with the four acquired propertiesmentioned above, (iii) the Company recording interest at the default rate ondebt related to one of its shopping center properties and (iv) the accrual of aloan guarantee fee.

 

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In December 2003, the Company refinanced a$3,000,000 loan on San Felipe, one of its office properties, with a newone-year loan in the amount of $5,350,000 bearing interest at 7.95%.  In May 2004, the Company refinanced a$3,132,000 loan on Mira Mesa, one of its office properties, with a new one-yearloan agreement in the amount of $7,500,000 bearing interest at 7.95%.

 

In July 2002, the lender undera loan agreement related to the South Carolina shopping center propertiesnotified the Company 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 ofJune 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.

 

Theloan guarantee fee, which is payable to two of the Company’s directors and acompany they are affiliated with, is in consideration of their guarantees ofcertain indebtedness of the Company.  In2004, effective in 2003, the Company agreed to pay an annual guarantee feeequal to between .25% and .75% (depending on the nature of the guaranty) of theoutstanding balance as of December 31 of each year of the guaranteedobligations.  The guaranty fee is to bepaid for a maximum of 3 years on any particular obligation.  For the first six months of 2004, the Companyaccrued $114,000 related to this guarantee fee. The fee for 2003 was accrued in the fourth quarter of 2003.

 

*Loss on extinguishment of debt*.  In May 2004, in connection with the refinanceof Mira Mesa, the Company recorded a loss on early extinguishment of debt of$613,000 due to a prepayment penalty of $687,000, which was offset in part bythe write-off of an unamortized loan premium of $74,000.

 

*Discontinued operations*.  TheCompany recorded a loss from discontinued operations of $516,000 for the sixmonths ended June 30, 2003 related to the eleven properties sold in 2003.No properties were sold during the first six months of 2004 and no propertieswere classified as held for sale as of June 30, 2004. See Note 4 – DiscontinuedOperations – of the Notes to Consolidated Financial Statements. No results ofoperations were classified as discontinued in the first six months of 2004.

 

Theloss from discontinued operations is summarized below.

 

**CondensedConsolidated Statements of Operations**

 
| ** **                            | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| Rental revenue                        |       | $                                   | 5,169      |   |
| Total expenses                        |       | 5,685                               |       |
| Net loss from discontinued operations |       | (516                                | )          |
|                                       |            |                                     |            |  |

 

*Gain onsale of discontinued operations*.  The Company sold one industrial property and one apartment property inthe second quarter of 2003 for an aggregate of $16,600,000 and recognized again of $2,228,000.  The sales generatednet proceeds of $4,685,000.

 

*Impairmentof real estate assets held for sale.*  The Company recorded an impairment of$4,000,000 on three properties held for sale in the second quarter of2003.  The impairment was based on theanticipated sales price less cost to sell as compared to the carrying value ofthe assets.  The three properties consistof one office and two industrial properties.

 

# **LIQUIDITY AND CAPITAL RESOURCES**

# ** **

During2004, the Company derived cash from collection of rents and proceeds fromrefinancing of debt on an office property in California.  Major uses of cash included capital improvementsto real estate assets, primarily for tenant improvements, payment ofoperational expenses and repayment of borrowings.

 

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TheCompany reported a net loss of $4,756,000 for the six months ended June 30,2004 compared to a net loss of $6,671,000 for the six months ended June 30,2003.  These results include thefollowing non-cash items:

 
| ** **                                                          | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **2004**                       |       | **2003** | ** ** |
| Non-Cash Charges:                                                   |       |                           |       |   |   |
| Depreciation and amortization from real  estate held for investment |       | $                              | 5,461      |   | $ | 4,528 |   |
| Mark-to-market adjustments on interest rate  protection agreements  |       | —                         |       | 244 |   |
| Deferred compensation expense                                       |       | 56                             |       | 157 |   |
| Non-Cash Items:                                                     |       |                           |       |   |   |
| Deferred rental income                                              |       | (395                           | )          | (225 | ) |
| Minority interest                                                   |       | (686                           | )          | (915 | ) |
| Interest on receivable from principal  stockholders                 |       | (34                            | )          | (21 | ) |
| Amortization of loan premiums                                       |       | (296                           | )          | (276 | ) |
| Amortization of note receivable discount                            |       | (50                            | )          | — |   |
| Mark-to-market adjustments on interest rate  protection agreements  |       | (67                            | )     | — |   |
|                                                                     |            |                                |            |  |  |  |  |

 

Net cash used in investingactivities for six months ended June 30, 2004 amounted to $3,275,000.  This amount was primarily attributable to thefunding of capital expenditures, primarily for tenant improvements.  Net cash provided from investing activitiesfor the six months ended June 30, 2003 was $3,268,000.  Proceeds from the sales of properties for thesix months ended June 30, 2003 amounted to $4,685,000, which was derived fromthe sale of an office property located in Arizona and an apartment propertylocated in California.  Funds used forcapital improvements for the six months ended June 30, 2003 amounted to$1,417,000, primarily for tenant improvements.

 

Net cash provided byfinancing activities amounted to $2,664,000 for the six months ended June 30,2004.  Net funds provided fromrefinancing the debt on an office building in San Diego, California amounted to$3,680,000.  In May 2004, the Company refinanced a$3,132,000 loan on Mira Mesa, one of its office properties, with a new one-yearloan agreement in the amount of $7,500,000. The new loan, which contains two six-month extension options, bearsinterest at a fixed rate of 7.95% per annum. In May 2004, the Company financed insurance premiums of $373,000on its properties and agreed to pay a service fee of $85,000 over oneyear.  Scheduled principal payments forthe six months ended June 30, 2004 amounted to $1,474,000.  Net cash used in financing activitiesamounted to $867,000 for the six months ended June 30, 2003.  Repayments of borrowings of $1,875,000consisted of scheduled principal payments made during the six months ended June30, 2003.  Proceeds from borrowings,which totaled $758,000 for the six months ended June 30, 2003, consisted of (i)$728,000 to fund property insurance premiums and service fee and (ii) $30,000from an affiliate of a related party which completed the funding of an $830,000loan on Valencia entered into in December of 2002.  The mortgage was repaid in conjunction withthe sale of the property in April 2003. In addition, John N. Galardi purchased 60,975 shares of the Company’scommon stock for $250,000 in May 2003.

 

InDecember 2003, the Company refinanced a $3,000,000 loan on San Felipe, one ofits office properties, with a new one-year loan agreement in the amount of$5,350,000.  The new loan, which containstwo six-month extension options, bears interest at a fixed rate of 7.95% perannum.  Net proceeds of $2,059,000 werereceived as a result of the refinance.

 

InNovember 2003, in connection with the acquisition of an office property inHouston, Texas, the Company obtained a loan in the amount of $4,574,000.  The loan, which matures in May 2004, may beextended, at the option of the Company to November 2004.  The loan bears interest at a fixed rate of 5%per annum.

 

InOctober 2003, the Company entered into a $4,100,000 loan agreement inconnection with the acquisition of an office property in Houston, Texas and theacquisition of a note secured by another office property in

 

27

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Houston.  The loan, of which $3,700,000 had been fundedas of December 31, 2003, matures in November 2005 and bears interest at a fixedrate of 6% per annum.

 

InSeptember 2003, a note payable in the amount of $510,000 was repaid with theproceeds from the sale of Emerald Pointe. The note bore interest at prime plus 1%.

 

InAugust 2003, the Company refinanced a $1,300,000 loan secured by Van Buren, aparcel of undeveloped land, and entered into a new two-year loan agreement inthe amount of $1,340,000.  The new loanbears interest at a fixed rate of 12% per annum and matures August 1, 2005.

 

InJuly 2003, in connection with the acquisition of an office property in 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 2012. 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.

 

InMay 2003, in connection with the acquisition of an office property in 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 Parkerand Leahy, LLP cancelled its $199,180 note, plus $45,891 of accrued interestthereon, in exchange for 14,943 shares of the Company’s common stock.

 

In May 2003, John N. Galardicancelled his $1,600,000 note, plus $286,036 of accrued interest thereon, inexchange for 115,002 shares of the Company’s common stock.

 

In May 2003, the Company financed insurance premiums of $643,000 on itsproperties and agreed to pay a service fee of $85,000 over one year.  The insurance premium note was paid in fullin February 2004.  The Company financedan additional insurance premium during 2003 of $130,000, which was paid in fullin June 2004.

 

InJuly 2002, the lender under a loan agreement related to the South Carolinashopping center properties notified the Company it was technically in defaultunder its loan agreement for non-compliance with certain covenants, includingcovenants 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 June 30, 2004, the remaining balance ofthe loan was approximately $2,756,000. The Company continues to discuss the non-compliance matter with the newlender.  The new lender has notaccelerated the loan.

 

The Company expects to meet its short-termliquidity requirements for normal property operating expenses and general andadministrative expenses from cash generated by operations and cash currentlyheld.  In addition, the Companyanticipates capital costs to be incurred related to re-leasing space andimprovements to properties, litigation settlement costs, state income taxes andother fees for professional services. The funds to meet these obligations will be obtained from proceeds ofthe sale of assets and lender held funds. Based on current analysis, the Company believes that the cash generatedby these anticipated activities will be adequate to meet theseobligations.  There can be no assurance,however, that these activities will occur and that substantial cash will begenerated.  If these activities do notoccur, the Company will not have sufficient cash to meet its obligations.

 

In addition, as of June 30, 2004, the Companyhas substantial debt becoming due in 2004, 2005 and 2006.  Based on the Company’s historical losses andcurrent debt level, there can be no assurances as to the Company’s ability toobtain funds necessary for the refinancing of these maturing debts.  If refinancing transactions are notconsummated, the Company will seek extensions and/or modifications from the existinglenders.

 

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**CONTRACTUALOBLIGATIONS AND COMMITMENTS**

 

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

 
| ** **                     | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt (1)             |       | $        | 22,823     |     | $          | 18,998   |       | $        | 5,892      |     | $          | 1,453          |       | $         | 4,744      |   | $ | 97,321 |   | $ | 151,231 |   |
| Litigation settlement (2)      |       | —   |       | —   |       | 9,750    |       | —   |       | —   |       | —         |       | 9,750     |       |
| Capital lease expenditures (3) |       | 720      |       |     |       | —   |       | —   |       | —   |       | —         |       | 720       |       |
| Employee obligations (4)       |       | 403      |       | 580      |       |     |       |     |       |     |       |           |       | 983       |       |
| Total                          |       | $        | 23,946     |     | $          | 19,578   |       | $        | 15,642     |     | $          | 1,453          |       | $         | 4,744      |   | $ | 97,321 |   | $ | 162,684 |   |

 

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

(2) Representsobligations related to the settlement of the Teachout litigation.  See Note 7 – Notes Payable, LitigationSettlement – in the accompanying consolidated financial statements of theCompany.

(3) Representscommitments for tenant improvements and lease commissions related to theleasing of space to new or renewing tenants.

(4) Representsemployment agreement commitments for officers of the Company.

 

**INFLATION**

 

Substantially all of the leases at the industrial and retail propertiesprovide for pass-through to tenants of certain operating costs, including realestate taxes, common area maintenance expenses, and insurance. Leases at theapartment property generally provide for an initial term of one month to oneyear 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 provisions may permit the Company to increase rental ratesor other charges to tenants in response to rising prices and, therefore, serveto 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.  Theseforward-looking statements are based on management’s beliefs and expectations,which may not be correct.  Importantfactors that could cause actual results to differ materially from theexpectations reflected in these forward-looking statements include thefollowing: the Company’s level of indebtedness and ability to refinance itsdebt; the fact that the Company’s predecessors have had a history of losses inthe past; unforeseen liabilities which could arise as a result of the prioroperations of companies acquired in the 2001 consolidation transaction; risksinherent in the Company’s acquisition and development of properties in thefuture, including risks associated with the Company’s strategy of investing inunder-valued assets; general economic, business and market conditions,including the impact of the current economic downturn; changes in federal andlocal laws, and regulations; increased competitive pressures; and otherfactors, including the factors set forth below, as well as factors set forthelsewhere 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.

 

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**ITEM 3.  QUANTITATIVE AND Q****UALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

**INTEREST RATES**

 

One of the Company’s primary market risk exposure is to changes ininterest 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.

 

The Company has entered into interest rate swap agreements to manageits interest rate risk.  The agreements,in notional amounts totaling approximately $9,600,000 at June 30, 2004,effectively fix the interest rate at 2.42% plus the applicable variable ratemargin (effective rate of 6.42% at June 30, 2004).

 

At June 30, 2004, the Company’s total indebtedness included fixed-ratedebt of approximately $150,400,000 and floating-rate indebtedness ofapproximately $13,380,000. The Company continually reviews the portfolio’sinterest rate exposure in an effort to minimize the risk of interest ratefluctuations.  The Company does not haveany other material market-sensitive financial instruments.

 

A change of 1.00% in the index rate to which the Company’s variablerate debt is tied would change the annual interest incurred by the Company byapproximately $133,800, or $0.09 per share, based upon the balances outstandingon variable rate instruments at June 30, 2004.

 

**ITEM 4.  CONTROLS ANDPROCEDURES**

 

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 the Company’sinternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of the evaluation referred to above.

 

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**PARTII.  OTHERINFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

The following is informationconcerning material, pending legal proceedings to which the Company or itssubsidiaries is a party or of which any of their property is subject:

 

Lewis Matter

On or about September 27, 2001,Robert L. Lewis, Madison Liquidity Investors 103 LLC and Madison LiquidityInvestors 112 LLC, purporting to represent themselves and all others similarlysituated, initiated an action against the Company, CGS, William J. Carden, JohnN. Galardi and S-P Properties, Inc. in the Orange County Superior Court, CaseNo. 01 CC 000394.

 

Plaintiffs’ complaint in thisaction alleged claims against the Company and others for breach of fiduciaryduty and breach of contract.  Plaintiffs’complaint challenged the 2001 consolidation transaction, (the “Consolidation”)although the Consolidation was disclosed in a Prospectus/Consent Solicitationfiled with the Securities and Exchange Commission and was approved by amajority vote of the limited partners of the partnerships. Plaintiffs allegedthat the approval was invalid and that the Consolidation constituted a breachof fiduciary duty by each of the defendants. Plaintiffs further alleged that the Consolidation constituted breach ofthe partnership agreements governing the partnerships.

 

Plaintiffs’ prayer for relief sought the following: 1)an injunction prohibiting the defendants from commingling; 2) imposition of aconstructive trust providing for liquidation of the assets of the partnershipsand a distribution of the assets to the former limited partners therein; 3) ajudicial declaration that the action may be maintained as a class action; 4)monetary/compensatory damages; 5) plaintiffs’ costs of suit, includingattorneys’, accountants’ and expert fees; and 6) a judicial order ofdissolution of the partnerships and appointment of a liquidating trustee.  On March 15, 2002, the Court sustained theCompany’s demurrer to plaintiffs’ complaint and held that the complaint failedto state a cause of action for either breach of fiduciary duty or breach ofcontract against the Company.  The Courtgave the plaintiffs twenty days leave to amend.

 

Subsequently, plaintiffs filedand served a Second Amended Complaint alleging claims against the Company forbreach of fiduciary duty, breach of contract, intentional interference withprospective economic advantage, and intentional interference with contractualrelations.  On June 14, 2002, the Courtsustained the Company’s demurrer on the grounds that Plaintiffs’ Second AmendedComplaint failed to state a cause of action against the Company forinterference with contract or interference with prospective economicadvantage.  The Court gave Plaintiffstwenty days leave to amend.

 

Subsequently,the plaintiffs filed and served a Third Amended Complaint on the Company allegingclaims against the Company for breach of fiduciary duty, breach of contract,intentional interference with prospective economic advantage, and intentionalinterference with contractual relations. On September 6, 2002, the Court sustained the Company’s demurrer on thegrounds that the Plaintiffs’ Third Amended Compliant failed to state a cause ofaction for either interference with contract or interference with prospectiveeconomic advantage against the Company. The Court gave the Plaintiffs twenty days to amend.

 

OnSeptember 25, 2002, the plaintiffs filed and served a Fourth Amended Complainton the Company alleging claims against the Company for breach of fiduciaryduty, breach of contract, intentional interference with prospective economicadvantage, and intentional interference with contractual relations.  The plaintiffs’ prayer for relief on itsFourth Amended Compliant seeks the following: 1) an injunction prohibiting the defendants from commingling; 2)imposition of a constructive trust providing for liquidation of the assets ofthe partnerships and a distribution of the assets to the former limitedpartners therein; 3) a judicial declaration that the action may be maintainedas a class action; 4) monetary/compensatory damages; 5) plaintiffs’ costs ofsuit, including attorneys’, accountants’ and expert fees; and 6) a judicialorder of dissolution of the partnerships and appointment of a liquidatingtrustee.  On October 29, 2002, theCompany responded by answer and asserted general and specific affirmativedefenses to the allegations in the Fourth Amended Complaint.

 

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On January 10, 2003,plaintiffs filed and served a Notice of Motion and Motion for ClassCertification.  On January 31, 2003, theCompany filed an Opposition to Plaintiffs’ Motion for Class Certification.  On March 7, 2003, the Court grantedplaintiffs’ Motion for Class Certification but expressly reserved the right tovisit the issue of certification should rescission be chosen as a remedy todetermine whether it is still a viable procedure in the class setting.

 

On October 16, 2003,counsel for the plaintiffs and counsel for the defendants executed a Memorandumof Understanding regarding the 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 the FourthAmended Complaint.  Plaintiffs haveagreed to release such claims, pursuant to the Memorandum.  As this matter is a class action, the partiesneed to obtain court approval to complete the settlement and to administer thepayment of the settlement amounts to the class members.  The settlement is funded, in its entirety, byinsurance coverage.

 

On January 14, 2004, the Court granted preliminaryapproval of the settlement, directed notice to the Class, and set a fairnesshearing for March 23, 2004.  On February26, 2004, the defendants’ insurers deposited $6,500,000 into an escrow accountfor the purposes of settlement.  On April12, 2004, the Court ruled that the settlement is fair, adequate andreasonable.  On April 15, 2004,$1,640,000 was disbursed from the escrow account for attorney fees andexpenses, reducing the escrow balance to $4,860,000.  The remaining balance will be distributed tothe plaintiffs following a final accounting in the matter.

 

Other Matters

Certain claims and lawsuits have arisen against the Company in itsnormal course of business. The Company believes that such claims and lawsuitswill not have a material adverse effect on the Company’s financial position,cash flow or results of operations.

 

**ITEM 4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

The 2004 annual meeting of stockholders was held on April 28,2004.  The matters on which thestockholders voted, in person or by proxy, were (i) to elect six directors toserve until the Company’s next annual meeting of stockholders and until theirsuccessors are duly elected and qualified, and (ii) to ratify the selection ofBDO Seidman, LLP, as the Company’s independent auditors for the fiscal yearended December 31, 2004.  The results ofthe voting are shown below:

 

Election of directors:

 
| **Name  of  Nominee** | ** ** | **Number of  Votes For** | ** ** | **Number of  Votes Withheld** | ** ** |
|-----------------------|------------|--------------------------|------------|-------------------------------|------------|
| Timothy R. Brown      |       | 1,079,739                |       | 29,299                        |       |
| William J. Carden     |       | 1,080,477                |       | 28,561                        |       |
| Lawrence E. Fiedler   |       | 1,080,818                |       | 28,220                        |       |
| John N. Galardi       |       | 1,080,209                |       | 28,829                        |       |
| William W. Geary, Jr. |       | 1,080,815                |       | 28,223                        |       |
| John F. Itzel         |       | 1,080,889                |       | 28,149                        |       |

 

Ratify the selection of BDO Seidman, LLP as independent auditors:

 
| **Number  of  Votes For** | ** ** | **Number of  Votes Against** | ** ** | **Number of  Votes Abstaining** | ** ** |
|---------------------------|------------|------------------------------|------------|---------------------------------|------------|
| 1,094,388                 |       | 6,227                        |       | 8,423                           |       |

 

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**ITEM 6.  EXHIBITSAND REPORTS ON FORM 8-K**

 

(a)  Exhibits:

 

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

 

(b)  Reports onForm 8-K:

 

On April 29, 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) of the SecuritiesExchange Act of l934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

**AMERICANSPECTRUM REALTY, INC.**

 

 
| Date: August  3, 2004 | By:      | */s/ William J. Carden*                           | * * |
|-----------------------|----------|---------------------------------------------------|----------|
|                  |     | William J. Carden                                 |
|                  |     | Chairman of the Board,  President,                |
|                  |     | Chief Executive Officer  and Acting               |
|                  |     | Chief Financial Officer                           |
| * *              | * * | * *                                          |
| * *              | * * | * *                                          |
| Date: August  3, 2004 | By:      | */s/ Patricia A. Nooney*                          | * * |
|                  |     | Patricia A. Nooney                                |
|                  |     | Senior Vice President  and Director of Accounting |
|                  |     | (Principal Accounting  Officer)                   |

 

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**EXHIBITINDEX**

 
| **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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