**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM10-Q**

 

**(Mark One)**

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

 

**For the quarterly period ended March 31, 2004**

 

**OR**

 

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

 

**COMMISSION FILE NUMBER 001-16785**

 

**AmericanSpectrum Realty, Inc.**

(Exactname of Registrant as specified in its charter)

 

| **State of Maryland**                                                              |   | **52-2258674**                        |
|------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                               |   |                                  |
| **5850 San Felipe, Suite 450  Houston, Texas**                                     |   | **77057**                             |
| (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 checkmark whether 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 markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes o No ý

 

As of April 15, 2004,1,555,442 shares of Common Stock ($.01 par value) were outstanding.

 

 

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**TABLE OF CONTENTS**

 
| PART I  | FINANCIAL INFORMATION                                                                                           |   |
|---------|-----------------------------------------------------------------------------------------------------------------|--------|
|    |                                                                                                            |   |
| Item 1  | Financial Statements                                                                                            |   |
|    | Consolidated Balance Sheets at March 31, 2004 (unaudited) and  December 31, 2003                      |   |
|    | Consolidated Statements of Operations for  the three months ended March 31, 2004 and 2003 (unaudited)      |   |
|    | Consolidated Statement of Stockholders’  Equity for the three months ended March 31, 2004 (unaudited) |   |
|    | Consolidated Statements of Cash Flows for  the three months ended March 31, 2004 and 2003 (unaudited)      |   |
|    | Notes to Consolidated Financial Statements                                                                      |   |
| Item 2  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                     |   |
| Item 3  | Quantitative and Qualitative Disclosures  about Market Risk                                                     |   |
| Item 4  | Controls and Procedures                                                                                         |   |
|    |                                                                                                            |   |
| PART II | OTHER INFORMATION                                                                                               |   |
|    |                                                                                                            |   |
| Item 1  | Legal Proceedings                                                                                               |   |
| Item 2  | Changes in Securities and Use of Proceeds                                                                       |   |
| 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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**PARTI.  FINANCIAL INFORMATION**

 

**ITEM 1.  FINANCIALSTATEMENTS**

 

**AMERICAN SPECTRUM REALTY, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(Dollarsin thousands, except share amounts) 

 
|                                                                                                                                                              |   | **March 31,  2004** |    | **December 31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
|                                                                                                                                                              |   | **(Unaudited)**          |    |                        |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| **ASSETS**                                                                                                                                                        |   |                     |    |                        |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Real estate held for investment                                                                                                                                   |   | $                        | 204,236 |                        | $      | 201,853 |   |
| Accumulated depreciation                                                                                                                                          |   | 21,638                   |    | 19,063                      |   |
| Real estate held for investment, net                                                                                                                              |   | 182,598                  |    | 182,790                     |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Cash and cash equivalents                                                                                                                                         |   | 566                      |    | 2,937                       |   |
| Tenant and other receivables, net of  allowance for doubtful accounts of $177 and $387, respectively (including  $244 and $271, respectively, from related party) |   | 436                      |    | 553                         |   |
| Mortgage loan receivable, net of discount  of $58 and $83, respectively                                                                                           |   | 1,678                    |    | 1,667                       |   |
| Deferred rents receivable                                                                                                                                         |   | 1,295                    |    | 1,050                       |   |
| Insurance proceeds held in escrow                                                                                                                                 |   | 6,500                    |    | —                      |   |
| Insurance proceeds receivable – litigation  settlement                                                                                                       |   | —                   |    | 6,500                       |   |
| Investment in management company                                                                                                                                  |   | 4,000                    |    | 4,000                       |   |
| Prepaid and other assets, net                                                                                                                                     |   | 8,456                    |    | 8,506                       |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Total Assets                                                                                                                                                      |   | $                        | 205,529 |                        | $      | 208,003 |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                    |   |                     |    |                        |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Liabilities:                                                                                                                                                      |   |                     |    |                        |   |
| Notes payable, net of premiums of $3,022  and $3,172, respectively                                                                                                |   | $                        | 150,145 |                        | $      | 151,051 |   |
| Notes payable, litigation settlement                                                                                                                              |   | 9,750                    |    | 9,750                       |   |
| Accounts payable                                                                                                                                                  |   | 3,455                    |    | 2,252                       |   |
| Deferred tax liability                                                                                                                                            |   | 4,316                    |    | 4,316                       |   |
| Litigation settlement payable                                                                                                                                     |   | 6,500                    |    | 6,500                       |   |
| Accrued and other liabilities (including  $266 and $579, respectively, to related parties)                                                                        |   | 5,559                    |    | 6,390                       |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Total Liabilities                                                                                                                                                 |   | 179,725                  |    | 180,259                     |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Minority interest                                                                                                                                                 |   | 6,746                    |    | 7,009                       |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Commitments and Contingencies:                                                                                                                                    |   |                     |    |                        |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Redeemable Common Stock                                                                                                                                           |   | 300                      |    | 300                         |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Stockholders’ Equity:                                                                                                                                        |   |                     |    |                        |   |
| Preferred stock, $.01 par value;  authorized, 25,000,000 shares, none issued and outstanding                                                                      |   | —                   |    | —                      |   |
| Common stock, $.01 par value; authorized,  100,000,000 shares; issued, 1,555,442 at March 31, 2004 and  December 31, 2003                               |   | 16                       |    | 16                          |   |
| Additional paid-in capital                                                                                                                                        |   | 45,742                   |    | 45,742                      |   |
| Accumulated deficit                                                                                                                                               |   | (25,341                  | )       | (23,516                     | )      |
| Receivable from principal stockholders                                                                                                                            |   | (1,071                   | )       | (1,191                      | )      |
| Deferred compensation                                                                                                                                             |   | (167                     | )       | (195                        | )      |
| Treasury stock, at cost, 22,782 shares at  March 31, 2004 and December 31, 2003                                                                         |   | (421                     | )       | (421                        | )      |
|                                                                                                                                                              |   |                     |    |                        |   |
| Total Stockholders’ Equity                                                                                                                                   |   | 18,758                   |    | 20,435                      |   |
|                                                                                                                                                              |   |                     |    |                        |   |
| Total Liabilities and Stockholders’ Equity                                                                                                                   |   | $                        | 205,529 |                        | $      | 208,003 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements

 

3

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**AMERICAN SPECTRUMREALTY, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Dollars in thousands, except per share amounts)

(Unaudited)

 
|                                                           |   | **Quarter  Ended March 31,** |   |
|----------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                           |   | **2004**                          |   | **2003** |   |
| **REVENUES:**                                                  |   |                              |   |   |   |
| Rental revenue                                                 |   | $                                 | 7,373  |   | $ | 6,666 |   |
| Interest and other income                                      |   | 80                                |   | 10 |   |
| Total revenues                                                 |   | 7,453                             |   | 6,676 |   |
|                                                           |   |                              |   |   |   |
| **EXPENSES:**                                                  |   |                              |   |   |   |
| Property operating expense                                     |   | 2,766                             |   | 2,511 |   |
| General and administrative                                     |   | 1,127                             |   | 1,593 |   |
| Depreciation and amortization                                  |   | 2,685                             |   | 2,262 |   |
| Interest expense                                               |   | 2,963                             |   | 2,598 |   |
| Total expenses                                                 |   | 9,541                             |   | 8,964 |   |
|                                                           |   |                              |   |   |   |
| Net loss before minority interest and  discontinued operations |   | (2,088                            | )      | (2,288 | ) |
|                                                           |   |                              |   |   |   |
| Minority interest                                              |   | 263                               |   | 294 |   |
|                                                           |   |                              |   |   |   |
| Net loss before discontinued operations                        |   | (1,825                            | )      | (1,994 | ) |
|                                                           |   |                              |   |   |   |
| Discontinued operations:                                       |   |                              |   |   |   |
| Loss from discontinued operations                              |   | —                            |   | (282 | ) |
|                                                           |   |                              |   |   |   |
| Net loss                                                       |   | $                                 | (1,825 | ) | $ | (2,276 | ) |
|                                                           |   |                              |   |   |   |
| Basic and diluted per share data:                              |   |                              |   |   |   |
| Net loss before discontinued operations                        |   | $                                 | (1.17  | ) | $ | (1.44 | ) |
| Loss from discontinued operations                              |   | —                            |   | (0.20 | ) |
| Net loss                                                       |   | $                                 | (1.17  | ) | $ | (1.64 | ) |
|                                                           |   |                              |   |   |   |
| Basic weighted average shares used                             |   | 1,555,442                         |   | 1,384,542 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements

 

4

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**AMERICAN SPECTRUMREALTY INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

 (Dollars in thousands)

(Unaudited)

 
|                                               |   | **Common  Stock** |   | **Additional  Paid-In  Capital** |   | **Accumulated  Deficit** |   | **Deferred  Compensation** |    | **Treasury  Stock** |   | **Receivable  from  Principal  Stockholders** |   | **Total  Equity** |   |
|----------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|--------------------------|--------|----------------------------|---------|---------------------|--------|-----------------------------------------------|--------|-------------------|--------|
| Balance, December 31, 2003                    |   | $                 | 16     |                             | $      | 45,742                   |   | $                          | (23,516 | )                   | $      | (195                                          | )      | $                 | (421   | ) | $ | (1,191 | ) | $ | 20,435 |   |
| Amortization of deferred compensation              |   | —            |   | —                           |   | —                   |   | 28                         |    | —              |   | —                                        |   | 28                |   |
| Payment on receivable from principal  stockholders |   | —            |   | —                           |   | —                   |   | —                     |    | —              |   | 120                                           |   | 120               |   |
| Net loss                                           |   | —            |   | —                           |   | (1,825                   | )      | —                     |    | —              |   | —                                        |   | (1,825            | )      |
| Balance, March 31, 2004                       |   | $                 | 16     |                             | $      | 45,742                   |   | $                          | (25,341 | )                   | $      | (167                                          | )      | $                 | (421   | ) | $ | (1,071 | ) | $ | 18,758 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements

 

5

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**AMERICAN SPECTRUM REALTY, INC**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Dollarsin thousands)

(Unaudited)

 
|                                                                                      |   | **Quarter  Ended March 31,** |   |
|-------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                      |   | **2004**                          |   | **2003** |   |
| **CASH FLOWS FROM  OPERATING ACTIVITIES:**                                                |   |                              |   |   |   |
| Net loss                                                                                  |   | $                                 | (1,825 | ) | $ | (2,276 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities:          |   |                              |   |   |   |
| Loss from discontinued operations                                                         |   | —                            |   | 282 |   |
| Depreciation and amortization                                                             |   | 2,685                             |   | 2,262 |   |
| Deferred rental income                                                                    |   | (245                              | )      | (120 | ) |
| Minority interest                                                                         |   | (263                              | )      | (294 | ) |
| Deferred compensation expense                                                             |   | 28                                |   | 79 |   |
| Mark to market adjustments on interest rate  protection agreements                        |   | (10                               | )      | 222 |   |
| Interest on receivable from principal  stockholders                                       |   | (18                               | )      | — |   |
| Amortization of note payable premiums,  included in interest expense                      |   | (149                              | )      | (140 | ) |
| Amortization of note receivable discount,  included in interest income                    |   | (25                               | )      | — |   |
| Changes in operating assets and  liabilities:                                             |   |                              |   |   |   |
| Decrease (increase) in tenant and other  receivables                                      |   | 83                                |   | (8 | ) |
| Increase in accounts payable                                                              |   | 1,203                             |   | 1,421 |   |
| Increase in prepaid and other assets                                                      |   | (53                               | )      | (353 | ) |
| Decrease in accrued and other liabilities                                                 |   | (649                              | )      | (596 | ) |
| Net cash provided by operating activities:                                                |   | 762                               |   | 479 |   |
|                                                                                      |   |                              |   |   |   |
| **CASH FLOWS FROM  INVESTING ACTIVITIES:**                                                |   |                              |   |   |   |
| Capital improvements to real estate assets                                                |   | (2,390                            | )      | (652 | ) |
| Collections on mortgage loan receivable                                                   |   | 14                                |   | — |   |
| Net cash used in investing activities:                                                    |   | (2,376                            | )      | (652 | ) |
|                                                                                      |   |                              |   |   |   |
| **CASH FLOWS FROM  FINANCING ACTIVITIES:**                                                |   |                              |   |   |   |
| Proceeds from borrowings                                                                  |   | —                            |   | 30 |   |
| Repayment of borrowings                                                                   |   | (757                              | )      | (810 | ) |
| Net cash used in by financing activities:                                                 |   | (757                              | )      | (780 | ) |
|                                                                                      |   |                              |   |   |   |
| Cash from discontinued operations                                                         |   | —                            |   | 920 |   |
|                                                                                      |   |                              |   |   |   |
| Decrease in cash                                                                          |   | (2,371                            | )      | (33 | ) |
|                                                                                      |   |                              |   |   |   |
| Cash, beginning of period                                                                 |   | 2,937                             |   | 788 |   |
|                                                                                      |   |                              |   |   |   |
| Cash, end of period                                                                       |   | $                                 | 566    |   | $ | 755 |   |
|                                                                                      |   |                              |   |   |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:**                                   |   |                              |   |   |   |
| Cash paid for interest                                                                    |   | $                                 | 2,876  |   | $ | 3,207 |   |
| Cash paid for income taxes                                                                |   | 21                                |   | 4 |   |
|                                                                                      |   |                              |   |   |   |
| **SUPPLEMENTAL  DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:**              |   |                              |   |   |   |
| Conversion of operating partnership units  into common stock                              |   | $                                 | — |   | $ | 130 |   |
| Receivable from related party regarding  certain issues asserted by principal shareholder |   | —                            |   | 270 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements

 

6

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**AMERICAN SPECTRUM REALTY, INC.**

### **Notes to Consolidated Financial Statements**

 

**NOTE1.  DESCRIPTION OF BUSINESS**

 

American SpectrumRealty, Inc. (“ASR” or the “Company”) is a Maryland corporation established onAugust 8, 2000.  The Company is afull-service real estate corporation, which owns, manages and operatesincome-producing properties. Substantially all of the Company’s assets are held through an operatingpartnership (the “Operating Partnership”) in which the Company, as ofMarch 31, 2004, held a .88% general partner interest and an 86.51% limitedpartnership interest.  As ofMarch 31, 2004, through its majority-owned subsidiary, the OperatingPartnership, the Company owned and operated 26 properties, which consisted of17 office buildings, 5 industrial properties, two shopping centers, oneapartment complex, and one parcel of undeveloped land.  The 26 properties are located in sevenstates.

 

During the firstquarter 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 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 South Carolina,its non-core markets.  The Company willfocus primarily on office and industrial properties located in Texas,California and Arizona.

 

The Company is thesole general partner of the Operating Partnership.  As the sole general partner of the Operating Partnership, theCompany generally has the exclusive power to manage and conduct the business ofthe Operating 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.  Any distribution received by the Companyfrom the Operating Partnership will be used to pay dividends on the Company’scommon stock.  .  Most of the properties are owned by theOperating Partnership through subsidiary limited partnerships or limitedliability companies.

 

Holders of limited partnership units in the Operating Partnership (“OPUnits”) have the option to redeem their units and to receive, at the option ofthe Company, in exchange for each four OP Units (i) one share of Common Stockof the Company, or (ii) cash equal to the market value of one share of CommonStock of the Company at the date of conversion, but no fractional shares willbe issued.

 

Management continuesto consider 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 plans to operate in a manner that will permit it to electREIT status in the future.  In general,a REIT is a company that owns or provides financing for real estate and paysannual distributions to 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.

 

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

 

**BASIS OFPRESENTATION**

 

The accompanying unauditedconsolidated financial statements have been prepared pursuant to the rules andregulations of the SEC.  In the opinionof the Company, the accompanying interim unaudited consolidated financialstatements contain all material adjustments, consisting only of normalrecurring adjustments necessary to present fairly the financial condition, theresults of operations and changes in cash flows of the Company and itssubsidiaries for interim periods.

 

The results for such interimperiods are not necessarily indicative of results for a full year.  It is suggested that these consolidatedfinancial statements be read in conjunction with the consolidated financialstatements for the year ended December 31, 2003 and the related notesthereto included in the Company’s 2003 Annual Report on Form 10-K filed withthe SEC.

 

7

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All significant intercompanytransactions, receivables and payables have been eliminated in consolidation.

 

**RECLASSIFICATIONS**

** **

Certain prior year balanceshave been reclassified to conform with the current year presentation.   In accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”, real estateassets designated as held for sale are accounted for in accordance with theprovisions of SFAS No. 144 and the results of operations of these propertiesare included in income from discontinued operations.  Prior periods have been reclassified for comparability, asrequired.

 

Pursuant to a one-for-fourreverse stock split of the Company’s Common Stock, every four shares of CommonStock outstanding as of the close of business on March 1, 2004 became one shareof new post-split Common Stock.  Shareand per share data (except par value) in the consolidated financial statementsand notes for all periods presented have been adjusted to reflect the reversestock split.

 

**USE OF ESTIMATES**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America 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 materially differ from those estimates.

 

**NEWACCOUNTING 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.

 

InApril 2003, FASB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities” (“FAS 149”).  FAS 149 amends and clarifies certainderivative instruments embedded in other contracts, and for hedging activitiesunder SFAS No. 133.  FAS 149is effective for certain contracts entered into or modified by the Companyafter June 30, 2003.  The adoptionof FAS 149 did not have a material impact on the Company’s consolidatedfinancial position or results of operations.

 

**REAL ESTATE**

 

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

 

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

 

8

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

 

**CASHEQUIVALENTS**

 

Cash equivalents include allhighly liquid investments with a maturity of three months or less at the dateof purchase.

 

**FAIR VALUEOF FINANCIAL INSTRUMENTS**

 

The Company’s financialinstruments consist of cash and cash equivalents, tenant and other receivables,a mortgage loan receivable, notes payable, accounts payable and accruedexpenses.  Management believes that thecarrying value of the Company’s financial instruments approximate theirrespective fair market values at March 31, 2004 and December 31,2003.

 

**DERIVATIVEFINANCIAL INSTRUMENTS**

 

The Companyfollows Statement 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, thechanges in the fair value of the derivative and of the hedged item attributableto the hedged 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 usesinterest rate swaps to hedge against fluctuations in interest rates on specificborrowings.  As of March 31, 2004,the Company 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 onthe Company’s balance sheet in accrued and other liabilities and the changes inthe fair value of the hedge are recognized as adjustments to interestexpense.  During the three months endedMarch 31, 2004 and 2003, the Company recorded a benefit of $10,000 and acharge of $222,000, respectively, attributable to changes in the fair value ofits derivatives financial instruments.

 

**DEFERREDFINANCING AND OTHER FEES**

 

Fees paid in connection withthe financing and leasing of the Company’s properties are amortized over theterm of the related note payable or lease and are included in other assets.

 

**STOCK-BASED COMPENSATION**

 

The Financial AccountingStandards Board issued SFAS No. 123, “Accounting for Stock-Based Compensation”(“FAS 123”) in October 1995.  Thisstandard establishes a fair value approach to valuing stock options awarded toemployees as compensation. In December 2002, FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation - Transition and Disclosure” (“FAS148”), which amended FAS 123.  FAS 148provides alternative methods of transition for a voluntary change to the fairvalue based method of accounting 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 reported results.  FAS 148 is effective for financialstatements for fiscal years ending after 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 Companyhas in effect its Omnibus Stock Incentive Plan (the “Plan”), which is describedmore fully in

 

9

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Note 19.  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 followingtable illustrates the effect on net income (loss) and earnings per share if theCompany had applied the fair value recognition of the provisions of FAS 123 tostock-based employee compensation (thousands of dollars):

 
|                                                                                                                      |   | **Three  Months Ended** |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                                                      |   | **2004**                |   | **2003** |   |
| Net loss, as reported                                                                                                     |   | $                       | (1,825 | ) | $ | (2,276 | ) |
| Deduct:   Employee compensation expense for stock option grants under fair value  method, net of related tax effects |   | (68                     | )      | (62 | ) |
| Pro forma net loss                                                                                                        |   | $                       | (1,893 | ) | $ | (2,338 | ) |
|                                                                                                                      |   |                    |   |   |   |
| Per share data:                                                                                                           |   |                    |   |   |   |
| Basic and diluted, as reported                                                                                            |   | $                       | (1.17  | ) | $ | (1.64 | ) |
| Basic and diluted, proforma                                                                                               |   | $                       | (1.22  | ) | $ | (1.69 | ) |

 

**MINORITY INTEREST**

 

Unit holders inthe Operating Partnership (other than the Company) held a 12.61% limitedpartnership interest in the Operating Partnership at March 31, 2004 andDecember 31, 2003.  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.

 

**RENTALREVENUE**

 

Certain leases provide fortenant occupancy during periods for which no rent is due or where minimum rentpayments increase during the term of the lease.  The Company records rental income for the full term of each leaseon a straight-line basis.  Accordingly,a receivable 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.

 

The Company’s portfolio ofleases turns over continuously, with the number and value of expiring leasesvarying from year to year.  TheCompany’s ability to re-lease the space to existing or new tenants at rates equalto or greater than those realized historically is impacted by, among otherthings, the economic conditions of the market in which a property is located,the availability of competing space, and the level of improvements which may berequired at the property.  No assurancecan be given that the rental rates that the Company will obtain in the futurewill be equal to or greater than those obtained under existing contractualcommitments.

 

**NET LOSS PER SHARE**

 

Net loss per share is calculated based on the weighted average numberof common shares outstanding.  Stockoptions outstanding of 56,125 at March 31, 2004 and OP Units (other thanthose held by the Company) outstanding of 898,757 at March 31, 2004 havenot been included in the net loss per share calculation since their effectwould be antidilutive.  See “MinorityInterests” paragraph above.

 

10

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**INCOMETAXES**

 

In preparing the Company’sconsolidated financial statements, management estimates the income tax in eachof the jurisdictions in which the Company operates.  This process includes an assessment of current tax expense, theresults of tax examinations, and the effects of temporary differences resultingfrom the different treatment of transactions for tax and financial accountingpurposes.  These differences may resultin deferred tax assets or liabilities which are included in the consolidatedbalance sheet.  The realization ofdeferred tax assets as a result of future taxable income must be assessed andto the extent that the realization is doubtful, a valuation allowance isestablished.  The Company’s income taxprovision is based on calculations and assumptions that will be subject toexamination by the taxing authorities in the jurisdictions in which the Companyoperates.  Should the actual resultsdiffer from the Company’s estimates, the Company would have to adjust theincome tax provision in the period in which the facts and circumstances thatgive rise to the revision become known. Tax law and rate changes are reflected in the income tax provision inthe period in which such changes are enacted.

 

**NOTE 3. REAL ESTATE**

 

**ACQUISITIONS**

 

Noreal estate acquisitions were made during the first quarters of 2004 and 2003.

 

On November 13, 2003, the Company acquired an office property inHouston, Texas, consisting of approximately 89,695 rentable square feet.  Acquisition costs of approximately$3,476,000 were primarily funded with a new mortgage loan with the remainder incash.

 

Between May 7, 2003 and October 27, 2003, the Company acquiredthree office properties from an affiliated entity.  The properties are located in Houston, Texas and consist ofapproximately 160,742 rentable square feet. Acquisition costs of approximately $10,703,000 included assumed or newmortgage indebtedness, the issuance of 382,537 OP Units (valued for thispurpose at $4.11 per unit), deferred payments and cash.

 

Rentalrevenue and related expenses from the acquired properties was included in theCompany’s results since their respective dates of acquisition. Therefore, theresults of operations for the first quarter of 2004 include results from theabove acquisitions, whereas, the results of operations for the first quarter of2003 do not.

 

**DISPOSITIONS**

 

Noreal estate dispositions were made during the first quarters of 2004 and 2003.

 

On December 5, 2003, the Company sold Marketplace, a 105,289square foot shopping center property located in South Carolina, for $4,250,000.

 

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

 

OnSeptember 30, 2003, the Company sold Emerald Pointe, a 366-unit apartmentproperty located in Texas, for $10,100,000.

 

OnSeptember 12, 2003, the Company sold two properties:  Park Plaza, a 95,080 square foot industrialproperty located in Indiana, was sold for $3,225,000; and Oak Grove Commons, a137,678 square foot industrial property located in Illinois, was sold for$5,921,000.

 

On July 18,2003, the Company sold Northeast Commerce Center, a 100,000 square footindustrial property located in Ohio, for $4,771,000.

 

On July 9,2003, the Company sold three properties: Northcreek, a 92,282 square footoffice property located in Ohio, was sold for $5,620,000; Business Center, a64,387 square foot industrial property located

 

11

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in Missouri, wassold for $3,655,000; and Jackson, a 320,000 square foot industrial property inIndiana, was sold for $4,000,000.

 

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

 

On April 10,2003, the Company sold Valencia, an 82,560 square foot industrial propertylocated in Arizona, for $4,100,000.

 

In theaccompanying consolidated statement of operations for the quarter endedMarch 31, 2003, the results of operations for properties mentioned aboveare shown in the section “Discontinued operations”.

 

**INTANGIBLEASSETS PURCHASED**

 

Upon acquisitionsof real estate, the Company assesses the fair value of acquired tangible andintangible assets (including land, buildings, tenant improvements, above andbelow market leases, origination costs, acquired in-place leases, otheridentified intangible assets and assumed liabilities in accordance withStatement of Financial Accounting Standards No. 141), and allocates thepurchase price to the acquired assets and assumed liabilities.  The Company also considers an allocation ofpurchase price of other acquired intangibles, including acquired in-placeleases.

 

The Companyevaluates acquired “above and below” market leases at their fair value (using adiscount rate which reflects the risks associated with the leases acquired)equal to the difference between (i) the contractual amounts to be paid pursuantto each in-place lease and (ii) management’s estimate of fair market leaserates for each corresponding in-place lease, measured over a period equal tothe remaining term of the lease for above-market leases and the initial termplus the 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**

 

The Company recorded a loss from discontinued operations of $282,000for the three months ended March 31, 2003 related to the eleven propertiessold in 2003.  The properties were soldduring the second, third and fourth quarters of 2003.  No properties were sold during the three months endedMarch 31, 2004 and no properties were classified as held for sale as ofMarch 31, 2004 and December 31, 2003.

 

The condensed consolidated statements of operations of discontinuedoperations are summarized below (dollars in thousands):

 

**Condensed Consolidated Statement ofOperations**

 
|                                  |   | **Three  Months Ended  March 31, 2003** |   |
|---------------------------------------|--------|----------------------------------------------|--------|
| Rental revenue                        |   | $                                            | 2,809  |   |
| Total expenses                        |   | 3,091                                        |   |
| Net loss from discontinued operations |   | $                                            | (282   | ) |

 

**NOTE 5.MORTGAGE LOAN RECEIVABLE**

 

On October 27, 2003, the Company acquired a note secured by aproperty adjacent to an office property owned by the Company.  The note bears interest at 7.5% per annumand matures in November 2004.  Thereceivable balance of the note as of March 31, 2004 and December 31,2003 was $1,677,724 and $1,666,504, respectively, net of discount of $58,277and $83,253, respectively.  The purchaseof this note was funded with a new loan to the Company from the lender thatowned the note.  Loan costs ofapproximately $41,000 were incurred in connection with the transaction.

 

12

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**NOTE6.  NOTES PAYABLE, NET OF PREMIUMS**

 

The Company had thefollowing mortgage loans, bank lines, and notes payable outstanding related tocontinuing operations as of March 31, 2004 and December 31, 2003(dollars in thousands):

 
|                                                                                                                                                                                                                                                                                                                                                                                          |   | **2004** |    | **2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|
| Secured loans with various lenders, net of  unamortized premiums of $3,022 at March 31, 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 March 31, 2004 and December 31, 2003, and maturing at  various dates through August 11, 2012. |   | $        | 124,061 |     | $      | 124,575 |   |
|                                                                                                                                                                                                                                                                                                                                                                                          |   |     |    |     |   |
| Secured loans with various banks bearing  interest at variable rates ranging between 5.09% and 6.50% at March 31,  2004, and 5.14% and 6.50% December 31, 2003, and maturing at various  dates through May 1, 2008.                                                                                                                                                                 |   | 13,520   |    | 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.                                                                                                                                                                                                                                       |   | 11,494   |    | 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.                                                                                                                                                                                                                                             |   | 475      |    | 475      |   |
|                                                                                                                                                                                                                                                                                                                                                                                          |   |     |    |     |   |
| Unsecured loans with various lenders,  bearing interest at fixed rates between 4.99% and 20.00% at March 31,  2004 and December 31, 2003, and maturing at various dates through  October 1, 2004.                                                                                                                                                                              |   | 595      |    | 810      |   |
|                                                                                                                                                                                                                                                                                                                                                                                          |   |     |    |     |   |
| Total                                                                                                                                                                                                                                                                                                                                                                                         |   | $        | 150,145 |     | $      | 151,051 |   |

 

Debt premiums are amortized into interest expense over the terms of therelated mortgages using the effective interest method.  As of March 31, 2004 andDecember 31, 2003, the unamortized debt premiums included in the aboveschedule were $3,022,000 and $3,172,000 respectively.

 

In December 2003, the Company refinanced a $3,000,000 loan on SanFelipe, one of its office properties, with a new one-year loan in the amount of$5,350,000.  The new loan, whichcontains two six-month extension options, bears interest at a fixed rate of7.95% per annum.  Proceeds of $2,059,000were received as a result of the refinance.

 

In November 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company obtained a loan in the amount of$4,574,000.  The loan, which matures inMay 2004 may be extended, at the Company’s option, to November 2004.  The loan bears interest at a fixed rate of5% per annum.

 

In October 2003, the Company entered into a $4,100,000 loanagreement in connection with the acquisition of an office property in Houston,Texas and the acquisition of a note secured by another office property inHouston.  The loan, of which $3,700,000had been funded as of December 31, 2003, matures in November 2005 andbears interest at a fixed rate of 6% per annum.

 

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

 

In August 2003, the Company refinanced a $1,300,000 loan securedby Van Buren, a parcel of undeveloped land, and entered into a new two-yearloan agreement in the amount of $1,340,000. The new loan bears interest at a fixed rate of 12% per annum and maturesAugust 1, 2005.

 

In July 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company assumed a loan in the amount of$1,723,000.  The loan bears interest ata fixed rate of 7.41% per annum and matures in May 2012.  The Company also entered into an agreementthat provided for seller financing of $710,000, bearing interest at a fixedrate of 7.41% per annum and maturing in July 2005.

 

In May 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $3,180,000.  The loan bears interest at a fixed rate of6.80% per annum

 

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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.

 

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

 

In May 2003, John N. Galardi cancelled his $1,600,000 note, plus$286,036 of accrued interest thereon, in exchange for 115,002 shares of theCompany’s common stock.

 

In May 2003, the Companyfinanced insurance premiums of $643,000 on its properties and agreed to pay aservice fee of $85,000 over one year. The insurance premium note was paid in full during the first quarter of2004.  The Company financed anadditional insurance premium during 2003 of $130,000, with scheduled paymentsthrough June 2004.

 

In July 2002, the lender under a loan agreement related to theSouth Carolina shopping center properties notified the Company it wastechnically in default under its loan agreement for non-compliance with certaincovenants, including covenants requiring improvements to shopping centerproperties.  Thereafter, the lendernotified the Company that it was in default for failure to pay a maturedportion 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 the shopping centerproperties and repaid $3,935,000, which included the pay-off of the maturedportion of the loan.  As ofMarch 31, 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.

 

**NOTE 7. NOTES PAYABLE, LITIGATION SETTLEMENT**

 

As the result of thesettlement of the Teachout litigation, which was documented in the thirdquarter of 2003, the Company reaffirmed its previously announced obligation topay the former limited partners of Sierra Pacific Development Fund II("Fund II") as of the date of the Company’s 2001 consolidationtransaction (the “Consolidation”), or their assignees or transferees, the loanswhich were made and called by the former general partner of Fund II as part ofthe Consolidation.  Pursuant to thesettlement, the Company established a repayment plan and secured the debt witha second deed of trust on an office property owned by the Company.  This repayment plan consists of a promissorynote in the amount of $8,800,000, which bears interest at 6% per annum andmatures in March 2006. Interest-only payments, which are payable quarterly, commencedJune 2, 2003.  The note may beprepaid in whole or in part at any time without penalty.

 

As part of the settlement,the Company agreed to pay legal fees totaling $1,200,000 to the plaintiff’scounsel.  The Company made a scheduledpayment of $250,000 in the third quarter of 2003 with the remaining $950,000consisting of two promissory notes.  Thefirst note, in the amount of $700,000, bears interest at 6% per annum andmatures in March 2006. Interest-only payments, which are payable quarterly, commencedJune 2, 2003.   The secondpromissory note, in the amount of $250,000, bears no interest and matures inMarch 2006.  The notes, which aresecured by a second deed of trust on an office property owned by the Company,may be prepaid in whole or in part at any time without penalty.

 

In connection with the agreement, William J. Carden and John N. Galardiacknowledged that they owe the Company the sum of $1,187,695 as indemnificationagainst a portion of the Company’s settlement obligation.  Mr. Carden is the Chief Executive Officer, adirector and a principal stockholder of the Company.  Mr. Galardi is a director and principal stockholder of theCompany.  Mr. Galardi and certainaffiliates of Mr. Carden and/or Mr. Galardi are beneficiaries, in part, of thesettlement of the Teachout litigation and are owed an amount in excess of thisobligation pursuant to that settlement. Mr. Galardi and Mr. Carden have agreed to pay the Company the principalsum of this obligation, plus interest thereon at the annual rate of 6% fromMarch 15, 2003, and secured with an assignment to the Company of theirright to receive $1,187,695 of principal payments on the notes payable to themand their affiliates by reason of the settlement of the Teachout litigation,plus all interest payable on such principal amount of notes.  The receivable of $1,187,695 and accruedinterest are reflected as a component of equity in the Company’s consolidatedfinancial statements.  In March, theinterest due for all of 2004 and $116,875 in principal was

 

14

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paid.  The payment was made withcertain funds owed to Mr. Carden and Mr. Galardi by the Company related to aguarantee fee.  See Note 11 – RelatedParty Transactions.

 

**NOTE 8. MINORITY INTEREST**

 

Unit holders inthe Operating Partnership (other than the Company) held a 12.61% limitedpartnership interest in the Operating Partnership at March 31, 2004 andDecember 31, 2003.  Each of theholders of the interests in the Operating Partnership (other than the Company) hasthe option (exercisable after the first anniversary of the issuance of the OPUnits) to redeem its OP Units and to receive, at the option of the Company, inexchange 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.

 

In July 2003, theCompany purchased 7,329 OP Units from Nooney Development Partners, L.P. for$223,000 pursuant to an agreement entered into at the time of the Consolidation.

 

During the year endedDecember 31, 2003, the Company issued a total of 382,537 OP Units to anaffiliated entity in connection with the acquisition of three office propertiesin Houston, Texas.

 

During the year ended December 31, 2003, a total of 202,056 OPUnits were exchanged for 50,514 shares of Common Stock.

 

**NOTE 9. REDEEMABLE COMMON STOCK**

 

OnOctober 23, 2001, the Company issued 5,000 shares of its common stock (ona post-split basis),  with the holder’sright to compel the sale of the stock back to the Company (the “Put”) at afixed price of $60.00 per share during the period from October 31, 2002 toNovember 30, 2002.  InNovember 2002, the Company and holder agreed to extend the put exerciseperiod to May 30, 2003 through June 30, 2003.  In May 2003, the Company received notice that the holderexercised its right to sell the common stock back to the Company for $60.00 pershare or a total of $300,000 and subsequently agreed to a paymentschedule.  In January 2004, theCompany and holder agreed to extend the put exercise period toNovember 30, 2004 through December 31, 2004.

 

**NOTE 10. REPURCHASE OF COMMON STOCK**

 

In May 2003, the Company’s Board of Directors authorized the repurchaseof up to 75,000 shares of its common stock from the proceeds of propertysales.  Such purchases would be madefrom time to time in open market transactions.

 

During 2003, the Company repurchased a total of 16,174 shares at anaverage price of $14.04 per share in open market transactions.  The total cost of the stock repurchasesamounted to $234,268.

 

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

 

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

 

**NOTE 11. RELATED PARTY TRANSACTIONS**

 

In March 2004, the Company paida total of $224,520 (“Guarantee Fee”) to William J. Carden, John N. Galardi andCGS Real Estate Company, Inc. (“the Guarantors”) in consideration for theirguarantees of certain obligations of the Company as of December 31, 2003.  The payment was made in the form of anoffset against 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 is accrued in2003 and is included in interest expense on the results of operations.

 

15

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During 2003, the Company made payments totaling $1,000,000, on itsindebtedness to an affiliated entity, reducing the balance due to $251,321,inclusive of deferred payments of $190,469 mentioned below.

 

During 2003, the Company acquired three office properties from anaffiliated entity.  The properties arelocated in Houston, Texas and consist of approximately 160,742 rentable squarefeet.  Acquisition costs ofapproximately $10,703,000 included assumed or new mortgage indebtedness, theissuance of 382,537 OP Units, deferred payments of $190,469 and cash.

 

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

 

In May 2003, Mr. Galardi cancelled his $1,600,000 note, plus $286,036of accrued interest thereon, in exchange for 115,002 shares of the Company’scommon stock.

 

In May 2003, Mr. Galardi purchased a total of 15,243 shares of theCompany’s common stock for $16.40 per share.

 

In February 2003, the Company reached an agreement with CGS RealEstate Company, Inc. whereby CGS acknowledged that it owed the Company a netamount of $270,375 which related to several issues asserted by William J.Carden that were owed by CGS to the Company and by the Company to CGS.    This amount is payable on March 15,2006 with interest accruing from March 15, 2003 at 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, inconnection with the payment of the Guarantee Fee, interest due on thisobligation for 2004 was paid in advance and $26,606 was applied to theprincipal due on this obligation.  Theprincipal balance due as of March 31, 2004 is $243,769.

 

In connection with the settlement of the Teachout litigation, Mr.Galardi and Mr. Carden acknowledged that they owe the Company the sum of$1,187,695 as indemnification against a portion of the Company’s settlementobligation.  Mr. Galardi and certainaffiliates of Mr. Carden and/or Mr. Galardi are beneficiaries, in part, of thesettlement of the Teachout litigation and are owed an amount in excess of thisobligation pursuant to that settlement. Mr. Galardi and Mr. Carden have agreed to pay the Company the principalsum of this obligation, plus interest thereon at the annual rate of 6% fromMarch 15, 2003, and secured this obligation with 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, in connection with the payment of the Guarantee Fee, interestdue on this obligation for 2004 was paid in advance and $116,875 was applied tothe principal due on this obligation. The balance due as of March 31, 2004 is $1,070,820.

 

During 2002, the Company made payments totaling $521,808 on itsobligation to ASJ, Ltd., which is owned by Mr. Carden, his wife and a trust forhis children.  The payments reduced thebalance due to ASJ, Ltd. to $200,000 as of December 31, 2002.  During 2003, the obligation was reduced by$111,321 to offset certain amounts which became payable from the related party.  In January 2004, the Company paid theremaining balance due of $88,679.

 

**NOTE 12.  SEGMENTINFORMATION**

 

As of March 31, 2004,the Company owned a portfolio of properties comprising office, industrial,shopping center properties, an apartment property, and a parcel of undevelopedland.  Each of these property typesrepresents a reportable segment with distinct uses and tenant types andrequires the Company to employ

 

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different managementstrategies.  The properties contained inthe segments are located in various regions and markets within the UnitedStates.  The office portfolio consistsprimarily of suburban office buildings. The industrial portfolio consists of properties designed for warehouse,distribution and light manufacturing for single-tenant or multi-tenantuse.  The shopping center portfolioconsists of community shopping centers located in South Carolina.  The Company’s sole remaining apartmentproperty is located in Missouri and is rented to residential tenants on eithera month-by-month basis or for terms generally of one year or less.

 

The accounting policies ofthe segments are the same as those described in the summary of significantaccounting policies.  The Companyevaluates performance of its property types based on net operating income derivedby subtracting property operating expenses from rental revenue.  Significant information used by the Companyfor its reportable segments as of and for the three months ended March 31,2004 and 2003 is as follows (dollars in thousands):

 
| **Three Months Ended March 31,** |   | **Office** |    | **Industrial** |   | **Shopping  Center** |   | **Apartment** |   | **Undeveloped  Land and  Other** |   | **Property  Total** |   |
|---------------------------------------|--------|------------|---------|----------------|--------|----------------------|--------|---------------|--------|----------------------------------|--------|---------------------|--------|
| **2004**                              |   |       |    |           |   |                 |   |          |   |                             |   |                |   |
| Rental revenue                        |   | $          | 5,712   |           | $      | 756                  |   | $             | 247    |                             | $      | 658                 |   | — |   | $ | 7,373 |   |
| Property operating expenses           |   | 2,091      |    | 226            |   | 52                   |   | 376           |   | $                                | 21     |                | 2,766  |   |
| Net operating income (NOI)            |   | $          | 3,621   |           | $      | 530                  |   | $             | 195    |                             | $      | 282                 |   | $ | (21 | ) | $ | 4,607 |   |
| Real estate held for investment, net  |   | $          | 137,465 |           | $      | 22,033               |   | $             | 5,352  |                             | $      | 13,761              |   | $ | 3,987 |   | $ | 182,598 |   |
|                                  |   |       |    |           |   |                 |   |          |   |                             |   |                |   |
| **2003**                              |   |       |    |           |   |                 |   |          |   |                             |   |                |   |
| Rental revenue                        |   | $          | 4,988   |           | $      | 729                  |   | $             | 230    |                             | $      | 677                 |   | $ | 42 |   | $ | 6,666 |   |
| Property operating expenses           |   | 1,729      |    | 344            |   | 97                   |   | 294           |   | 47                               |   | 2,511               |   |
| Net operating income (NOI)            |   | $          | 3,259   |           | $      | 385                  |   | $             | 133    |                             | $      | 383                 |   | $ | (5 | ) | $ | 4,155 |   |
| Real estate held for investment, net  |   | $          | 123,854 |           | $      | 23,163               |   | $             | 5,747  |                             | $      | 14,339              |   | $ | 4,028 |   | $ | 171,131 |   |

 

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 March 31,** |       |
|----------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                           |   | **2004**                               |       | **2003** |   |
| **REVENUES**                                                   |   |                                   |       |   |   |
| Total revenues for reportable segments                         |   | $                                      | 7,373      |   | $ | 6,666 |   |
| Other revenues                                                 |   | 80                                     |       | 10 |   |
| Total consolidated revenues                                    |   | $                                      | 7,453      |   | $ | 6,676 |   |
|                                                           |   |                                   |       |   |   |
| **NET LOSS**                                                   |   |                                   |       |   |   |
| NOI for reportable segments                                    |   | $                                      | 4,607      |   | $ | 4,155 |   |
| Unallocated amounts:                                           |   |                                   |       |   |   |
| Interest and other income                                      |   | 80                                     |       | 10 |   |
| General and administrative expenses                            |   | (1,127                                 | )          | (1,593 | ) |
| Depreciation and amortization                                  |   | (2,685                                 | )          | (2,262 | ) |
| Interest expense                                               |   | (2,963                                 | )          | (2,598 | ) |
| Net loss before minority interest and  discontinued operations |   | $                                      | (2,088     | ) | $ | (2,288 | ) |
|                                                           |   |                                   |       |   |   |
|                                                           |   | **March 31,**                     | ** ** |
|                                                           |   | **2004**                               |       | **2003** | ** ** |
| **ASSETS**                                                     |   |                                   |       |   |   |
| Total assets for reportable segments                           |   | $                                      | 182,598    |   | $ | 171,131 |   |
| Real estate assets held for sale                               |   | —                                 |       | 66,895 |   |
| Cash and cash equivalents                                      |   | 566                                    |       | 755 |   |
| Tenant and other receivables, net                              |   | 436                                    |       | 635 |   |
| Deferred rent receivable                                       |   | 1,295                                  |       | 539 |   |
| Insurance proceeds held in escrow                              |   | 6,500                                  |       | — |   |
| Deposits held in escrow                                        |   | —                                 |       | 279 |   |
| Mortgage loan receivable                                       |   | 1,678                                  |       | — |   |
| Investment in management company                               |   | 4,000                                  |       | 4,000 |   |
| Prepaid and other assets, net                                  |   | 8,456                                  |       | 7,345 |   |
| Total consolidated assets                                      |   | $                                      | 205,529    |   | $ | 251,579 |   |

 

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**NOTE 13. COMMITMENTS AND CONTINGENCIES**

 

The following is information concerning material, pending legal proceedingsto which the Company or its subsidiaries is a party or of which any of theirproperty is subject:

 

Lewis Matter

 

On or about September 27, 2001, Robert L. Lewis, Madison LiquidityInvestors 103 LLC and Madison Liquidity Investors 112 LLC, purporting torepresent themselves and all others similarly situated, initiated an actionagainst the Company, CGS, William J. Carden, John N. Galardi and S-PProperties, Inc. in the Orange County Superior Court, Case No. 01 CC 000394.

 

Plaintiffs’ complaint in this action alleged claims against the Companyand others for breach 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 the Consolidation constitutedbreach of the partnership agreements governing the partnerships.

 

Plaintiffs’ prayer forrelief sought the following: 1) an injunction prohibiting the defendants fromcommingling; 2) imposition of a constructive trust providing for liquidation ofthe assets of the partnerships and a distribution of the assets to the formerlimited partners therein; 3) a judicial declaration that the action may bemaintained as a class action; 4) monetary/compensatory damages; 5) plaintiffs’costs of suit, including attorneys’, accountants’ and expert fees; and 6) ajudicial order of dissolution of the partnerships and appointment of aliquidating trustee.  On March 15,2002, the Court sustained the Company’s demurrer to plaintiffs’ complaint andheld that the complaint failed to state a cause of action for either breach offiduciary duty or breach of contract against the Company.  The Court gave the plaintiffs twenty daysleave to amend.

 

Subsequently, plaintiffs filed and served a Second Amended Complaintalleging claims against the Company for breach of fiduciary duty, breach ofcontract, intentional interference with prospective economic advantage, andintentional interference with contractual relations.  On June 14, 2002, the Court sustained the Company’s demurreron the grounds that Plaintiffs’ Second Amended Complaint failed to state acause of action against the Company for interference with contract orinterference with prospective economic advantage.  The Court gave Plaintiffs twenty days leave to amend.

 

Subsequently, the plaintiffs filed and served a Third 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.   On September 6, 2002, the Courtsustained the Company’s demurrer on the grounds that the Plaintiffs’ ThirdAmended Compliant failed to state a cause of action for either interferencewith contract or interference with prospective economic advantage against theCompany.  The Court gave the Plaintiffstwenty days to amend.

 

On September 25, 2002, theplaintiffs filed and served a Fourth 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. The plaintiffs’ prayer for relief on its Fourth Amended Compliant seeksthe following:  1) an injunctionprohibiting the defendants from commingling; 2) imposition of a constructivetrust providing for liquidation of the assets of the partnerships and adistribution 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 October 29, 2002, the Company respondedby answer and asserted general and specific affirmative defenses to theallegations in the Fourth Amended Complaint.

 

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OnJanuary 10, 2003, plaintiffs filed and served a Notice of Motion andMotion for Class Certification.  OnJanuary 31, 2003, the Company filed an Opposition to Plaintiffs’ Motionfor Class Certification.  OnMarch 7, 2003, the Court granted plaintiffs’ Motion for ClassCertification but expressly reserved the right to visit the issue ofcertification should rescission be chosen as a remedy to determine whether itis still a viable procedure in the class setting.

 

OnOctober 16, 2003, counsel for the plaintiffs and counsel for thedefendants executed a Memorandum of Understanding regarding the settlement inthis matter.   By the terms of thatMemorandum, the defendants agreed to pay a total of $6,500,000 to settle thisaction and all other claims known and unknown relating to the facts set forthin the Fourth Amended Complaint. Plaintiffs have agreed to release such claims, pursuant to theMemorandum.  As this matter is a classaction, the parties need to obtain court approval to complete the settlementand to administer the payment of the settlement amounts to the classmembers.  The settlement is funded, inits entirety, by insurance coverage.

 

On January 14, 2004,the Court granted preliminary approval of the settlement, directed notice tothe Class, and set a fairness hearing for March 23, 2004.  On February 26, 2004, the defendants’insurers deposited $6,500,000 into an escrow account for the purposes ofsettlement.  On April 12, 2004, theCourt ruled that the settlement is fair, adequate and reasonable.

 

Other Matters

 

Certain claims and lawsuitshave arisen against the Company in its normal course of business. The Companybelieves that such claims and lawsuits will not have a material adverse effecton the Company’s financial position, cash flow or results of operations.

 

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

 

Contractual Obligations and Commitments

 

The following table aggregates the Company’s contractual obligationssubsequent to March 31, 2004 (dollars in thousands):

 
|                           |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|
| Long-term debt (1)             |   | $        | 23,426 |     | $      | 11,801   |   | $        | 6,335  |     | $      | 1,932          |   | $         | 5,261  |   | $ | 98,368 |   | $ | 147,123 |   |
| Litigation settlement (2)      |   | —   |   | —   |   | —   |   | 9,750    |   | —   |   | —         |   | 9,750     |   |
| Capital lease expenditures (3) |   | 958      |   |     |   | —   |   | —   |   | —   |   | —         |   | 958       |   |
| Employee obligations (4)       |   | 505      |   | 198      |   |     |   |     |   |     |   |           |   | 703       |   |
| Total                          |   | $        | 24,889 |     | $      | 11,999   |   | $        | 6,335  |     | $      | 11,682         |   | $         | 5,261  |   | $ | 98,368 |   | $ | 158,534 |   |

 

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(1)          SeeNote 6 – Notes Payable.

(2)          Representsobligations related to the settlement of the Teachout litigation.  See Note 7 – Notes Payable, LitigationSettlement.

(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.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

ASR is afull-service real estate corporation, which owns, manages and operatesincome-producing properties. Substantially all of the Company’s assets are held through its OperatingPartnership in which the Company, as of March 31, 2004, held a .88%general partner interest and an 86.51% limited partnership interest. As ofMarch 31, 2004, through its majority-owned subsidiary, the OperatingPartnership, the Company owned and operated 26 properties, which consisted of17 office buildings, 5 industrial properties, two shopping centers, oneapartment complex, and one parcel of undeveloped land.  The 26 properties are located in sevenstates.

 

During the firstquarter 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 werepart of the Company’s strategy to sell certain of its properties in itsnon-core markets and acquire additional properties in its core property typesand core geographic markets.  TheCompany will continue to focus primarily on office and industrial propertieslocated in Texas, California and Arizona.

 

On March 31,2004, the properties owned by the Company were 81% occupied.  The Company is aggressively pursuingprospective tenants to increase its occupancy, which should have the effect ofimproving operational results.

 

In theaccompanying consolidated statement of operations, the results of operationsfor properties sold are shown in the section “Discontinuedoperations”.  Therefore the revenues andexpenses reported for the quarters ended March 31, 2003 and 2004 reflectresults from properties currently owned by the Company.   As of December 31, 2003 andMarch 31, 2004, there were no properties classified in the balance sheetas held for sale.

 

The share data in this Item2 has been adjusted to give effect to the one-for-four reverse stock splitwhich became effective March 2, 2004.

 

**CRITICALACCOUNTING ESTIMATES**

 

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

 

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

 

•                  Certain leases provide for tenantoccupancy during periods for which no rent is due or where minimum rent paymentsincrease during the term of the lease. The Company records rental income for the full term of each lease on astraight-line basis.  Accordingly, areceivable, if deemed collectible, is recorded from tenants equal to the excessof the amount that would have been collected on a straight-line basis over theamount collected and currently due (Deferred Rent Receivable).  When a property is acquired, the term ofexisting leases is considered to commence as of the acquisition date forpurposes 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

 

20

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ofthe property is reduced to estimated fair value. Estimated fair value (i) isbased upon the Company’s plans for the continued operation of each property and(ii) is computed using estimated sales price, as determined by prevailingmarket values for comparable properties and/or the use of capitalization ratesmultiplied by annualized net operating income based upon the age, constructionand use of the building.  Thefulfillment of the Company’s plans related to each of its properties isdependent upon, among other things, the presence of economic conditions whichwill enable the Company to continue to hold and operate the properties prior totheir eventual sale. Due to uncertainties inherent in the valuation process andin the economy, the actual results of operating and disposing of the Company’sproperties could be materially different 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.  However, the Company plans to operate in a manner that willpermit it to elect REIT status in the future. In general, a REIT is a company that owns or provides financing for realestate and pays annual distributions to investors of at least 90% of itstaxable income.  A REIT typically is notsubject to federal income taxation on its net income, provided applicable incometax requirements are satisfied.   Forthe tax year 2003, the Company was taxed as a C corporation.

 

**RESULTS OF OPERATIONS**

 

In accordance with generallyaccepted accounting principles, the operating results of the eleven propertiessold in 2003 were reported as discontinued operations in the results ofoperations for the first quarter of 2003. See Note 4 – Discontinued Operations – of the Notes to ConsolidatedFinancial Statements.  Unless otherwiseindicated, the following discussion reflects the results from continuingoperations, which include the real estate assets held for investment.

 

***Discussion of the three months endedMarch 31, 2004 and 2003.***

 

The followingtable shows a comparison of rental revenues and certain expenses for thequarters ended March 31:

 
|                          |   | **2004**  |      | **2003**  |   | **Variance** |   |
|-------------------------------|--------|-----------|-----------|-----------|--------|--------------|--------|
| **$**                         |   | **%**     |
| Rental revenue                |   | $         | 7,373,000 |      | $      | 6,666,000    |   | 707,000 |   | 10.6 | % |
| Operating expenses:           |   |      |      |      |   |         |   |   |   |
| Property operating expenses   |   | 2,766,000 |      | 2,511,000 |   | 255,000      |   | 10.2 | % |
| General and administrative    |   | 1,127,000 |      | 1,593,000 |   | (466,000     | )      | (29.3 | )% |
| Depreciation and amortization |   | 2,685,000 |      | 2,262,000 |   | 423,000      |   | 18.7 | % |
| Interest expense              |   | 2,963,000 |      | 2,598,000 |   | 365,000      |   | 14.0 | % |
|                               |        |           |           |           |        |              |        |  |  |  |  |

 

*Rentalrevenue*. The increaseof $707,000, or 10.6%, was attributable to $749,000 in revenue generated fromfour office properties acquired subsequent to the first quarter of 2003 and a$196,000 payment received from the owner of a neighboring property for past useof common parking areas.  These amountswere offset, to an extent, by lower revenues from a property in San Diego,California due to the expiration of the lease of a major tenant inFebruary 2003.  The four officeproperties were acquired between May 7, 2003 and November 13, 2003.  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 81% at March 31, 2004 and79% at March 31, 2003.

 

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*Propertyoperating expenses*.  The increase of $255,000, or 10.2%, was dueto the expenses related to the four above mentioned acquired properties, offsetin part by a $123,000 reduction in operating expenses for other propertiesowned by the Company.  This reduction isprimarily due to lower insurance and real estate tax expense.  In May 2003, the Company renewed itsinsurance coverage at rates lower than those in the previous policy year.  In the first quarter of 2003, the Companyaccrued for late fees related to real estate tax payments.  In the first quarter of 2004, all realestate taxes that were due were paid timely, therefore no late fees wereincurred.

 

*Generaland administrative*. The decrease of $466,000 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, New York, the downsizing of its San Diego, California office and thedownsizing of its administrative staff in the St. Louis, Missouri office.  In 2003, the Company settled two majorlawsuits and hired an in-house legal counsel. Both of these factors contributed to the reduced fees for outside legalservices incurred in the first quarter of 2004 compared to the first quarter of2003.

 

*Depreciationand amortization*.  The increase of $423,000 was related todepreciation of capital improvements and amortization of capitalized leasecosts incurred in 2002 and 2003 and also the depreciation related to the fourabove mentioned acquired properties. During the last two years, 2002 and 2003,the Company has spent approximately $8,186,000 in capital improvements on itsexisting properties, namely for renovations and tenant improvements.

 

*Interest expense*.  The increase of $365,000 isprimarily due to the interest of $223,000 related to debt incurred and/orassumed related to the above mentioned four office properties acquired, theinterest related to the note payable for the Teachout litigation settlement andthe accrual of a loan guarantee fee. The $8,800,000 note payable for the litigation settlement began accruinginterest at 6% on March 2, 2003. The loan guarantee fee, which is payableto two 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 ofDecember 31 of each year of the guaranteed obligations.  The guaranty fee is to be paid for a maximumof 3 years on any particular obligation.  For the first quarter of 2004, the Company accrued $57,000related to this guarantee fee.  The feefor 2003 was accrued in the fourth quarter of 2003.

 

*Discontinued operations*.  TheCompany recorded a loss from discontinued operations of $282,000 for the threemonths ended March 31, 2003 related to the eleven properties sold in 2003.  See Note 4 – Discontinued Operations – ofthe Notes to Consolidated Financial Statements. No results of operations wereclassified as discontinued in the first quarter of 2004.

 

The loss from discontinued operations is summarized below.

 

**Condensed Consolidated Statement ofOperations**

 
|                                  |   | **Three  Months Ended  March 31, 2003** |   |
|---------------------------------------|--------|----------------------------------------------|--------|
| Rental revenue                        |   | $                                            | 2,809  |   |
| Total expenses                        |   | 3,091                                        |   |
| Net loss from discontinued operations |   | $                                            | (282   | ) |

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

During 2004, the Company derived cash from collection of rents.  Major uses of cash included capitalimprovements to real estate assets, primarily for tenant improvements, paymentof operational expenses and repayment of borrowings.

 

The Company reported a net loss of $1,825,000 for the three monthsended March 31, 2004 compared to a net loss of $2,276,000 for the threemonths ended March 31, 2003.  Theseresults include the following non-cash items:

 

22

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|                                                                |   | **Three  Months Ended  March 31,** |   |
|---------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                |   | **2004**                                |   | **2003** |   |
| Non-Cash Charges:                                                   |   |                                    |   |   |   |
| Depreciation and amortization from real  estate held for investment |   | $                                       | 2,685  |   | $ | 2,262 |   |
| Deferred compensation expense                                       |   | 28                                      |   | 79 |   |
| Mark to market adjustments on interest rate  protection agreements  |   | —                                  |   | 222 |   |
|                                                                |   |                                    |   |   |   |
| Non-Cash Items:                                                     |   |                                    |   |   |   |
| Deferred rental income                                              |   | 245                                     |   | 120 |   |
| Minority interest                                                   |   | 263                                     |   | 294 |   |
| Amortization of note payable premiums                               |   | 149                                     |   | 140 |   |
| Amortization of note receivable discount                            |   | 25                                      |   | — |   |
| Interest on receivable from principal  stockholders                 |   | 18                                      |   | — |   |
| Mark to market adjustments on interest rate  protection agreements  |   | 10                                      |   | — |   |
|                                                                     |        |                                         |        |  |  |  |  |

 

Net cash used in investing activities for three months endedMarch 31, 2004 amounted to $2,376,000. This amount was primarily attributable to the funding of capitalexpenditures of $2,390,000.  Net cashused in investing activities of $652,000 for the three months endedMarch 31, 2003 was due to the funding of capital expenditures.

 

Net cash used in financing activities of $757,000 for the quarter endedMarch 31, 2004 consisted of scheduled principal payments on debt.  Net cash used in financing activities amountedto $780,000 for the quarter ended March 31, 2003.  This amount was comprised of scheduledinterest payments on debt of  $810,000,offset by proceeds from borrowings of $30,000 from an affiliate of a relatedparty which completed the funding of an $830,000 loan on Valencia entered intoin December 2002.  The mortgage of$830,000 was repaid in conjunction with the sale of the property inApril 2003.

 

In December 2003, the Company refinanced a $3,000,000 loan on SanFelipe, one of its office properties, with a new one-year loan in the amount of$5,350,000.  The new loan, whichcontains two six-month extension options, bears interest at a fixed rate of7.95% per annum.  Net proceeds of$2,059,000 were received as a result of the refinance.

 

In November 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company obtained a loan in the amount of$4,574,000.  The loan, which matures inMay 2004, may be extended, at the option of the Company toNovember 2004.  The loan bearsinterest at a fixed rate of 5% per annum.

 

In October 2003, the Company entered into a $4,100,000 loanagreement in connection with the acquisition of an office property in Houston,Texas and the acquisition of a note secured by another office property in Houston.  The loan, of which $3,700,000 had beenfunded as of December 31, 2003, matures in November 2005 and bearsinterest at a fixed rate of 6% per annum.

 

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

 

In August 2003, the Company refinanced a $1,300,000 loan securedby Van Buren, a parcel of undeveloped land, and entered into a new two-yearloan agreement in the amount of $1,340,000. The new loan bears interest at a fixed rate of 12% per annum and maturesAugust 1, 2005.

 

In July 2003, in connection with the acquisition of an officeproperty in Houston, Texas, the Company assumed a loan in the amount of$1,723,000.  The loan bears interest ata fixed rate of 7.41% per annum and matures in May 2012.  The Company also entered into an agreementthat provided for seller financing of $710,000, bearing interest at a fixedrate of 7.41% per annum and maturing in July 2005.

 

In May 2003, in connection with the acquisition of an office propertyin Houston, Texas, the Company assumed a loan in the amount of $3,180,000.  The loan bears interest at a fixed rate of6.80% per annum

 

23

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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.

 

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

 

In May 2003, John N. Galardi cancelled his $1,600,000 note, plus$286,036 of accrued interest thereon, in exchange for 115,002 shares of theCompany’s common stock.

 

In May 2003, the Companyfinanced insurance premiums of $643,000 on its properties and agreed to pay aservice fee of $85,000 over one year. The insurance premium note was paid in full in February 2004.  The Company financed an additional insurancepremium during 2003 of $130,000, with scheduled payments throughJune 2004.

 

In July 2002, the lender under a loan agreement related to theSouth Carolina shopping center properties notified the Company it wastechnically in default under its loan agreement for non-compliance with certaincovenants, including covenants requiring improvements to shopping centerproperties.  Thereafter, the lendernotified the Company that it was in default for failure to pay a maturedportion 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 the shoppingcenter properties and repaid $3,935,000, which included the pay-off of the maturedportion of the loan.  As ofMarch 31, 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 Companyexpects to meet its short-term liquidity requirements for normal propertyoperating expenses and general and administrative expenses from cash generatedby operations and cash currently held. In addition, the Company anticipates capital costs to be incurred relatedto re-leasing space and improvements to properties, litigation settlement costsand other fees for professional services. The funds to meet these obligations will be obtained from proceeds ofthe sale of assets, lender held funds and refinancings of properties.  Based on current analysis, the Companybelieves that the cash generated by these anticipated activities will beadequate to meet these obligations. There can be no assurance, however, that these activities will occur andthat substantial cash will be generated. If these activities do not occur, the Company will not have sufficientcash to meet its obligations.

 

**CONTRACTUALOBLIGATIONS AND COMMITMENTS**

 

The following table aggregates the Company’s contractual obligationssubsequent to March 31, 2004 (dollars in thousands):

 
|                           |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|
| Long-term debt (1)             |   | $        | 23,426 |     | $      | 11,801   |   | $        | 6,335  |     | $      | 1,932          |   | $         | 5,261  |   | $ | 98,368 |   | $ | 147,123 |   |
| Litigation settlement (2)      |   | —   |   | —   |   | —   |   | 9,750    |   | —   |   | —         |   | 9,750     |   |
| Capital lease expenditures (3) |   | 958      |   |     |   | —   |   | —   |   | —   |   | —         |   | 958       |   |
| Employee obligations (4)       |   | 505      |   | 198      |   |     |   |     |   |     |   |           |   | 703       |   |
| Total                          |   | $        | 24,889 |     | $      | 11,999   |   | $        | 6,335  |     | $      | 11,682         |   | $         | 5,261  |   | $ | 98,368 |   | $ | 158,534 |   |

 

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(1)          SeeNote 6 – Notes Payable – in the accompanying consolidated financial statementsof the Company.

(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 theleases at the industrial and retail properties provide for pass-through totenants of certain operating costs, including real estate taxes, common areamaintenance expenses, and insurance. Leases at the apartment property generallyprovide for an initial term of one month to one year and allow

 

24

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for rent adjustments at thetime of renewal.  Leases at the officeproperties typically provide for rent adjustments and pass-through of increasesin operating expenses during the term of the lease.  All of these provisions may permit the Company to increase rentalrates or other charges to tenants in response to rising prices and, therefore,serve to reduce the Company’s exposure to the adverse effects of inflation.

 

**FORWARD-LOOKINGSTATEMENTS**

 

This Report on Form 10-Q contains forward-looking statements within themeaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities and Exchange Act of 1934. These forward-looking statements are based on management’s beliefs andexpectations, which may not be correct. Important factors that could cause actual results to differ materiallyfrom the expectations 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 filed with theSecurities and Exchange Commission in conjunction with this quarterly report onForm 10-Q to better understand the factors affecting the Company’s financialcondition and results of operations.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK**

 

**INTEREST RATES**

 

One of the Company’s primarymarket risk exposure is to changes in interest rates on its borrowings.

 

It is theCompany’s policy to manage its exposure to fluctuations in market interestrates for its borrowings through the use of fixed rate debt instruments to theextent that reasonably 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 intointerest rate swap agreements to manage its interest rate risk.  The agreements, in notional amounts totalingapproximately $9,600,000 at March 31, 2004, effectively fix the interestrate at 2.42% plus the applicable variable rate margin (effective rate of 6.42%at March 31, 2004).

 

At March 31, 2004, theCompany’s total indebtedness included fixed-rate debt of approximately$146,375,000 and floating-rate indebtedness of approximately $13,520,000. TheCompany continually reviews the portfolio’s interest rate exposure in an effortto minimize the risk of interest rate fluctuations.  The Company does not have any other material market-sensitivefinancial instruments.

 

A change of 1.00% in theindex rate to which the Company’s variable rate debt is tied would change theannual interest incurred by the Company by approximately $135,200, or $0.09 pershare, based upon the balances outstanding on variable rate instruments atMarch 31, 2004.

 

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**ITEM4.  CONTROLS AND PROCEDURES**

 

Management, including the Company’s Chief Executive Officer and ActingChief Financial Officer, have evaluated the effectiveness of the Company’sdisclosure controls and procedures as of the end of the quarter covered by thisreport.  Based on, and as of the dateof, that evaluation, the Chief Executive Officer and Acting Chief FinancialOfficer concluded that the disclosure controls and procedures were effective,in all material respects, to ensure that information required to be disclosedin the reports the Company files and submits under the Exchange Act isrecorded, processed, summarized and reported as and when required.

 

There have been no significant changes in the Company’s internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of the evaluation referred to above.

 

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**PART II. OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

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

 

Lewis Matter

On or about September 27, 2001, Robert L. Lewis, Madison LiquidityInvestors 103 LLC and Madison Liquidity Investors 112 LLC, purporting torepresent themselves and all others similarly situated, initiated an actionagainst the Company, CGS, William J. Carden, John N. Galardi and S-PProperties, Inc. in the Orange County Superior Court, Case No. 01 CC 000394.

 

Plaintiffs’ complaint in this action alleged claims against the Companyand others for breach of fiduciary duty and breach of contract.  Plaintiffs’ complaint challenged the 2001consolidation transaction (the “Consolidation”), although the Consolidation wasdisclosed in a Prospectus/Consent Solicitation filed with the Securities andExchange Commission and was approved by a majority vote of the limited partnersof the partnerships. Plaintiffs alleged that the approval was invalid and thatthe Consolidation constituted a breach of fiduciary duty by each of thedefendants.  Plaintiffs further allegedthat the Consolidation constituted breach of the partnership agreementsgoverning the partnerships.

 

Plaintiffs’ prayer forrelief sought the following: 1) an injunction prohibiting the defendants fromcommingling; 2) imposition of a constructive trust providing for liquidation ofthe assets of the partnerships and a distribution of the assets to the formerlimited partners therein; 3) a judicial declaration that the action may bemaintained as a class action; 4) monetary/compensatory damages; 5) plaintiffs’costs of suit, including attorneys’, accountants’ and expert fees; and 6) ajudicial order of dissolution of the partnerships and appointment of aliquidating trustee.  On March 15,2002, the Court sustained the Company’s demurrer to plaintiffs’ complaint andheld that the complaint failed to state a cause of action for either breach offiduciary duty or breach of contract against the Company.  The Court gave the plaintiffs twenty daysleave to amend.

 

Subsequently, plaintiffs filed and served a Second Amended Complaintalleging claims against the Company for breach of fiduciary duty, breach ofcontract, intentional interference with prospective economic advantage, andintentional interference with contractual relations.  On June 14, 2002, the Court sustained the Company’s demurreron the grounds that Plaintiffs’ Second Amended Complaint failed to state acause of action against the Company for interference with contract orinterference with prospective economic advantage.  The Court gave Plaintiffs twenty days leave to amend.

 

Subsequently, the plaintiffs filed and served a Third 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.   On September 6, 2002, the Courtsustained the Company’s demurrer on the grounds that the Plaintiffs’ ThirdAmended Compliant failed to state a cause of action for either interferencewith contract or interference with prospective economic advantage against theCompany.  The Court gave the Plaintiffstwenty days to amend.

 

On September 25, 2002, theplaintiffs filed and served a Fourth 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. The plaintiffs’ prayer for relief on its Fourth Amended Compliant seeksthe following:  1) an injunctionprohibiting the defendants from commingling; 2) imposition of a constructivetrust providing for liquidation of the assets of the partnerships and adistribution 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 of dissolutionof the partnerships and appointment of a liquidating trustee.  On October 29, 2002, the Company respondedby answer and asserted general and specific affirmative defenses to theallegations in the Fourth Amended Complaint.

 

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OnJanuary 10, 2003, plaintiffs filed and served a Notice of Motion andMotion for Class Certification.  OnJanuary 31, 2003, the Company filed an Opposition to Plaintiffs’ Motionfor Class Certification.  OnMarch 7, 2003, the Court granted plaintiffs’ Motion for ClassCertification but expressly reserved the right to visit the issue ofcertification should rescission be chosen as a remedy to determine whether itis still a viable procedure in the class setting.

 

OnOctober 16, 2003, counsel for the plaintiffs and counsel for thedefendants executed a Memorandum of Understanding regarding the settlement inthis matter.   By the terms of thatMemorandum, the defendants agreed to pay a total of $6,500,000 to settle thisaction and all other claims known and unknown relating to the facts set forthin the Fourth Amended Complaint. Plaintiffs have agreed to release such claims, pursuant to theMemorandum.  As this matter is a classaction, the parties need to obtain court approval to complete the settlementand to administer the payment of the settlement amounts to the classmembers.  The settlement is funded, inits entirety, by insurance coverage.

 

On January 14, 2004,the Court granted preliminary approval of the settlement, directed notice tothe Class, and set a fairness hearing for March 23, 2004.  On February 26, 2004, the defendants’insurers deposited $6,500,000 into an escrow account for the purposes ofsettlement.  On April 12, 2004, theCourt ruled that the settlement is fair, adequate and reasonable.

 

Other Matters

Certain claims and lawsuitshave arisen against the Company in its normal course of business. The Companybelieves that such claims and lawsuits will not have a material adverse effecton the Company’s financial position, cash flow or results of operations.

 

The Companyhas become aware that two of its properties may contain hazardous substancesabove reportable levels.  The Company iscurrently evaluating this situation to determine an appropriate course ofaction.

 

**ITEM2. CHANGES IN SECURITIES AND USE OF PROCEEDS**

 

On February 27, 2004, the Company’s stockholders approved aone-for-four reverse stock split of the Company’s Common Stock.  Pursuant to that reverse split, every fourshares of Common Stock outstanding as of the close of business on March 1,2004 became one share of new post-split Common Stock.

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

A special meeting of stockholders was held on February 27, 2004.The matters on which the stockholders voted, in person or by proxy, were i) toamend the Company’s charter to effect a one-for-four reverse stock split of alloutstanding (but not all authorized) shares of the Company’s common stock, andii) to approve the issuance by the Company of up to 382,537 shares of CommonStock (calculated on a pre-split basis) upon the exchange of 382,537 units oflimited partnership interest in the Company’s operating partnership which wereissued during 2003.  The results of thevoting are shown below:

 

Amend charter to effect a one-for-four reverse stock split:

 
| For     |   | 4,425,165 |   |
|---------|--------|-----------|--------|
| Against |   | 192,955   |   |
| Abstain |   | 56,518    |   |

 

Approve issuance of up to 382,537 shares of Common Stock:

 
| For     |   | 2,671,653 |   |
|---------|--------|-----------|--------|
| Against |   | 195,917   |   |
| Abstain |   | 61,265    |   |

 

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**ITEM6.  EXHIBITS AND REPORTS ON FORM 8-K**

 

(a)  Exhibits:

 

The Exhibit Index attached hereto is hereby incorporated by referencethis item.

 

(b)  Reports on Form 8-K:

 

On March 4, 2004, a report on Form 8-K was filed with respect toItem 5.

 

On March 17, 2004, a report on Form 8-K was filed with respect toItem 12.

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section l3 or l5(d) of the Securities Exchange Act of l934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

**AMERICAN SPECTRUM REALTY, INC.**

 

 
| Date: April 29, 2004 |   |                                                                                            |
|---------------------------|--------|-------------------------------------------------------------------------------------------------|
|                      | By:    | */s/ William J.  Carden*                                                                        |   |
|                      |   | William  J. Carden                                                                              |
|                      |   | Chairman  of the Board, President,  Chief Executive Officer and Acting  Chief Financial Officer |
|                      |   |                                                                                            |
| Date: April 29, 2004 |   |                                                                                            |
|                      | By:    | */s/ Patricia A.  Nooney*                                                                       |   |
|                      |   | Patricia  A. Nooney                                                                             |
|                      |   | Senior Vice President and Director of Accounting(Principal Accounting Officer)                  |

 

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**EXHIBIT INDEX**

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

 

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