<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC  20549

                                 FORM 10-KSB/A
                                AMENDMENT NO. 1


[X]  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 (fee required) for the Fiscal Year Ended December 31, 1996.

[ ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 (no fee required) for the Transition Period from
     _______________ to _______________.


                         COMMISSION FILE NUMBER 1-12514



                  AMERICAN REAL ESTATE INVESTMENT CORPORATION
                 (Name of small business issuer in its charter)



            MARYLAND                               84-1246585
-----------------------------------------------------------------------------
(State or other jurisdiction of            (IRS Employer Identification
 incorporation or organization)                       Number)


1670 BROADWAY, SUITE 3350, DENVER, COLORADO                 80202
-----------------------------------------------------------------------------
(Address of principal executive offices)                (Zip Code)


        Issuer's Telephone Number (including Area Code):  (303) 869-4700

         Securities registered under Section 12(b) of the Exchange Act:
              Title of each Class:  COMMON STOCK, $.001 PAR VALUE
      Name of each Exchange on which Registered:  AMERICAN STOCK EXCHANGE



         Securities registered under Section 12(g) of the Exchange Act:
                                      NONE



Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act of 1934 during the past 12 months (or for such
shorter period that the Issuer was required to file such reports), and (2) and
been subject to such filing requirements for the past 90 days. [X] Yes  [ ] No

Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of the Issuer's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [X]

The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of February 6, 1997 was $9,798,340.

The number of shares outstanding of each of the Issuer's common equity, as of
December 31, 1996, was 1,121,630 shares of Common Stock



                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Issuer's Annual Meeting of Stockholders
to be held on May 7, 1997 are incorporated by reference herein as portions of
Part III of this Form 10-KSB.
<PAGE>
 
                                    PART II



ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
--------------------------------------------------------------------------------
OF OPERATION.
-------------

RESULTS OF 0PERATIONS

YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995

  The following discussion relates to 1996 and 1995 amounts which represent
the twelve months ended December 31, 1996 and December 31, 1995, respectively.

  Rents and fees revenues increased in 1996 to $9,943,156 from $9,629,446 in
1995, or by $313,710, primarily due to increased rents at Quadrangles Village
apartments ("Quadrangles") and Timberleaf apartments ("Timberleaf") combined
with lower vacancies at Quadrangles.  Other income decreased to $297,138 in 1996
from $336,553 in 1995 due to more revenues in 1995 from a cable and telephone
agreement relating to the properties, excluding Emerald Pointe apartments
("Emerald"), which was executed during the first calendar quarter of 1995.

  Repairs and maintenance increased from $695,243 in 1995 to $707,870 in 1996
primarily as a result of additional general repairs performed on Sedona
apartments ("Sedona") and Timberleaf during 1996, which were partially offset by
slightly lower repair expenditures for Americana Lakewood apartments
("Americana") and Quadrangles in 1996.  The Company has maintained its policy
regarding the expenditure of the requisite amount of funds on each property to
maintain the overall quality of all properties included in its portfolio.

  Property taxes decreased to $417,281 in 1996 from $447,063 in 1995 primarily
due to a slightly lower property assessment for Americana, Sedona and
Quadrangles even though the assessed property values remained fairly stable from
1995 to 1996.

  Property management fees increased from $339,899 in 1995 to $352,721 in 1996
primarily due to higher net revenues for Quadrangles in 1996.

                                     - 1 -
<PAGE>
 
  Utilities increased to $1,033,955 in 1996 from $912,361 in 1995 primarily as a
result of higher utility costs incurred by Sedona, International apartments
("International") and Timberleaf, all of which were properties constructed in
the 1970s.

  Payroll increased from $799,025 in 1995 to $893,555 in 1996 as a result of
employee turnover costs for on site management personnel at all Denver
properties, in addition to salary and wage increases.

  Other property operations increased from $913,518 in 1995 to $1,005,182 in
1996 due to several factors.  Higher advertising expenses and commissions were
incurred by Sedona in 1996 related to additional marketing efforts to potential
new tenants.  Timberleaf also incurred additional advertising expenses in 1996
to target a wider base of potential new tenants.  Finally, added security
services for Timberleaf and Quadrangles led to higher security expenses for
these two properties in 1996 as compared to 1995.

  The Company incurred general and administrative expenses aggregating $652,485
in 1995 as compared to $515,093 in 1996.  The decrease in general and
administrative expenses in 1996 was attributable primarily to the significant
decrease in legal fee expenses during 1996.  Legal fees were incurred during
1995 in conjunction with the prior engagement of PaineWebber, Inc. and the
related due diligence procedures and correspondence with respect to certain
potential opportunities for the Company generated by PaineWebber, Inc., none of
which came to fruition. Additionally, a significant level of legal fees were
recorded in 1995 in connection with the Emerald Pointe lawsuit and the estimated
costs associated with this lawsuit.  Additional factors leading to the decrease
in general and administrative expenses in 1996 were lower acquisition related
expenses and lower accounting and tax related research expenses, lower personnel
costs and reduced telephone expenses.  The overall decrease in general and
administrative expenses was partially offset by an increase in salaries and
wages in 1996 and an increase in insurance expenses related to the Company's D &
0 insurance policy originally implemented by the Company on February 27, 1995.
The Company incurred D & 0 insurance expense for a full year in 1996 as opposed
to a partial year in 1995, in addition to an increase in the policy's premiums
upon renewal at the annual anniversary date of this policy.

  Depreciation and amortization expenses increased slightly from $1,304,215 in
1995 to $1,306,039 in 1996.  Depreciation increased in 1996 as a result of the
additional depreciation associated with property improvements during the year.
This 

                                     - 2 -
<PAGE>
 
increase in depreciation expense was substantially offset by the decrease
in amortization expense, primarily resulting from the write-off of all remaining
loan costs associated with the mortgage loan refinancing for Americana in 1995.

  Financing expenses decreased from $4,172,501 in 1995 to $3,897,105 in 1996.
The decrease in financing expenses was a result of many factors.  Lower interest
rates were experienced on the Company's bank loan facilities resulting from the
50 basis point reduction recognized upon renewal of such loan facilities in
August of 1995 in addition to the decrease in the prime rate since the 1995
periods.  The Company's line of credit was repaid in full, and a portion of the
bank term loan was repaid, with proceeds from the sale of International in
December 1996. In addition, the bridge loan which was originally obtained from a
related party to provide a portion of the financing to acquire Quadrangles was
paid off in its entirety in 1995 with proceeds from the Americana first mortgage
loan refinancing. This refinancing is also the reason for the decrease in
related party interest expense from $200,959 to zero in 1996.  Finally, the
principal balances of all mortgage loans have been regularly amortized in the
normal course of business during 1996, resulting in lower interest expense on
the reduced loan amounts.

  Equity in earnings of investment in partnership decreased from $596,950 in
1995 to $570,401 in 1996 as a result of a reduction in net income of Emerald
Vista Associates, L.P. ("Emerald Vista") in 1996, a portion of which is
recognized by the Company in conjunction with its ownership of a general partner
interest in Emerald Vista.  The Company uses the equity method of accounting to
account for the Company's interest in non-controlled joint ventures such as
Emerald Vista.

  The minority interest allocation was $1,364,323 in 1996 as compared to
($16,185) in 1995.  Net income increased in 1996 as a result of higher revenues,
lower financing expenses and a gain on the sale of one of the Company's
properties.  Therefore, the Company allocated the proportionate share of such
net income to minority interest in accordance with the terms of the partnership
agreement for the Operating Partnership.  The appropriate amount of net income
was allocated to "catch up" prior years' allocations to minority interest which
were not previously allocated due to net income not exceeding certain levels, in
addition to the proportionate share of the remaining net income in 1996 after
the preferred allocation to the Company.

                                     - 3 -
<PAGE>
 
  An extraordinary loss from debt refinancing of $371,093 was recognized in 1995
in conjunction with the April 1995 repayment of the previously existing first
mortgage loan secured by Americana with proceeds from the first mortgage loan
secured by the same property through a refinancing.  The loss resulted from a
prepayment penalty and the remaining unamortized loan costs.

  Net income was $1,103,650 in 1996 as COMPARED TO A NET LOSS OF $(28,269) IN
1995.  The increase in net income primarily resulted from the gain on the sale
of international in 1996. In addition, the prepayment penalty and write-off of
unamortized loan costs relating to the Americana mortgage loan refinancing were
reflected in 1995, whereas no such expenses were incurred in 1996.


LIQUIDITY AND CAPITAL RESOURCES

  The primary sources of cash during 1996 were proceeds from the sale of
International and cash from operations.  The primary cash outflows related to
the repayment in full of the Company's bank line of credit, the partial
repayment of the bank installment loan, the amortization of mortgage notes
principal payable and the bank installment loan and the payment of cash
dividends and cash distributions to the Company's shareholders and the Operating
Partnership's limited partners, respectively.

  The primary sources of cash during 1995 were proceeds from a new mortgage loan
secured by Americana and cash from operations. The primary cash outflows related
to the repayment in full of the previously existing mortgage loan secured by
Americana, the repayment in full of the bridge loan secured in connection with
the acquisition of Quadrangles, the amortization of principal of mortgage notes
payable and the bank installment loan and the payment of cash dividends and cash
distributions to the Company's shareholders and the Operating Partnership's
limited partners, respectively.

CASH FLOWS FROM OPERATING ACTIVITIES

  Net cash provided by operating activities in 1996 was $2,253,680 as compared
to $1,493,255 in 1995.  The increase in 1996 net cash flows is a primary result
of the increase in rents and fees and operating income for Quadrangles, and
reduced financing expenses.

                                     - 4 -
<PAGE>
 
CAPITAL EXPENDITURES AND COMMITMENTS


  Investing activities in 1996 provided cash of $2,570,606 compared to net cash
outlays of $575,878 for investing activities in 1995.  The significant increase
in 1996 resulted from the proceeds from the sale of property in 1996.  The
amounts for both years included expenditures for property improvements or
enhancements offset by cash distributions resulting from the Company's
investment in Emerald Vista.

  Except for certain capital improvements proposed to be made to the Sedona
apartments, the aggregate cost of which is not expected to exceed $1,000,000,
the Company has no plans to make any material renovations or improvements to any
of the Properties.

CAPITAL RESOURCES

  The primary sources of cash in 1996 were the proceeds from the sale of
International and the Company's cash from operations. Principal cash outflows
for the year 1996 were the repayment of the Company's line of credit, the
partial repayment of the bank installment loan, dividends paid to holders of
common stock, distributions to limited partners of the Operating Partnership
(i.e. minority interest distributions) and payment of interest on existing
indebtedness.  The cash sources in 1995 included net proceeds from the General
Electric Capital Corporation ("GECC") $10,500,000 first mortgage loan
collateralized by Americana and the Company's cash from operations.  The primary
cash outflows were the repayment of the previously existing first mortgage loan
secured by Americana and the prepayment penalty related thereto, the repayment
of the Quadrangles bridge loan and all accrued interest through the payoff date,
dividends paid to holders of common stock, distributions to limited partners of
the Operating Partnership (i.e. minority interest distributions) and payment of
interest on existing indebtedness.

  The Company expects to meet its short term liquidity requirements generally
through its cash flow provided by operations.  The Company believes that its
cash from operations will be sufficient to meet operating requirements and to
make dividend payments to stockholders in accordance with REIT qualification
requirements.

                                     - 5 -
<PAGE>
 
  The Company had outstanding indebtedness of approximately $37,239,000 as of
December 31, 1996, representing three non-recourse mortgage notes payable
aggregating approximately $33,027,000 and a bank installment loan with a balance
of approximately $4,212,000.

  A non-recourse mortgage note payable collateralized by Americana, which was
refinanced in 1995 with GECC, had an outstanding principal balance of
approximately $10,206,000 as of December 31, 1996, bears interest at GECC's
composite commercial paper rate plus 3.75%, adjusted on a monthly basis.  The
mortgage note payable requires monthly interest payments, in addition to
quarterly principal payments based on a stipulated percentage of the excess cash
flow, as defined, from Americana.  The note requires a balloon payment in the
amount of the outstanding principal balance on April 30, 2000, the maturity
date, and contains a 1% prepayment penalty through April 26, 1997.  There is no
prepayment penalty from April 27, 1997 to maturity.  Proceeds from the GECC loan
were used to repay the previously existing first mortgage loan collateralized by
Americana and the bridge loan which was originally obtained from a related party
to provide a portion of the financing to acquire Quadrangles.  GECC loan
proceeds were also used to pay the prepayment penalty of $242,605 relating to
this first mortgage loan refinancing.

  A non-recourse mortgage note payable collateralized by Timberleaf had an
outstanding principal balance of approximately $6,372,000 as of December 31,
1996, bears interest at 9.0% per annum payable monthly and matures in 2004.
Through March 20, 2003, such note may only be prepaid upon payment of all
principal and accrued interest and a prepayment penalty calculated in accordance
with a formula based on the yield rate of a certain U.S. Treasury security.  As
of December 31, 1996, if such indebtedness had been prepaid, such penalty would
have been approximately $591,000 or 9.3% of the principal outstanding on that
date.  At maturity on April 1, 2004, a balloon payment of approximately
$5,822,000 will be payable.

  A non-recourse mortgage note payable collateralized by Quadrangles had an
outstanding principal balance of approximately $16,449,000 as of December 31,
1996, bears interest at 6.35% per annum payable monthly and matures in 2026, at
which time the note will be fully amortized.  The note cannot be prepaid prior
to June 2003, and thereafter contains a prepayment penalty as follows: 2% from
June 2003 to May 2004; 1% from June 2004 to May 2005; 0% from June 2005 to May
2026.

                                     - 6 -
<PAGE>
 
  The Company repaid the bank line of credit in full with proceeds from the sale
of International.  The installment loan, which was then collateralized by
Sedona, was also partially repaid with proceeds from the sale of International
and had an outstanding principal balance of approximately $4,212,000 as of
December 31, 1996.  This bank loan facility bears interest at the bank's prime
rate plus 0.5%, adjusted on a daily basis, and can be prepaid at any time
without penalty.  Monthly interest payments are required on this bank
installment loan, in addition to monthly principal payments based on a 25-year
amortization period.  The installment loan matures on August 31, 1998.  The loan
agreement contains various affirmative and negative covenants, including
requirements to maintain certain financial ratios, and a breach of those
covenants, unless waived, could result in the entire loan becoming immediately
due and payable.

  The Company refinanced the installment note payable collateralized by Sedona
apartments in the form of a $5,700,000 mortgage loan from GMAC Commercial
Mortgage Corporation ("GMAC") on January 31, 1997.  The GMAC mortgage note
payable bears interest at 250 basis points over the one month LIBOR rate rounded
up to the nearest eighth of one percent and adjusts on a monthly basis (8.00% at
January 31, 1997).  The mortgage note payable requires monthly principal and
interest payments based on a 25-year amortization.  The note requires a balloon
payment in the amount of the outstanding principal balance on August 1, 1998 and
contains a 1% prepayment penalty/exit fee which is waived if GMAC places the
permanent loan on this property.  In addition, the note payable requires the
Company to escrow cash for the payment of property taxes, insurance and capital
improvements.  Proceeds from the GMAC loan were used to repay the previously
existing installment loan collateralized by Sedona apartments and to establish a
completion repair escrow for proposed capital improvements on the property.

     The Company and an affiliated entity are defendants in a lawsuit commenced
in December 1995 in the Superior Court of the State of California, County of San
Diego, by Emerald Vista, Inc., Emerald Vista Associates, L.P., and Schickler
Meringoff Properties.  Emerald Vista Associates, L.P. owns the Emerald Pointe
Apartments.  Emerald Vista, Inc. is one of the co-general partners and an
affiliate of the Company is a co-general partner. Schickler Meringoff Properties
provides on-site management of the properties.  The plaintiffs allege that the
defendants, in connection with an inspection of the partnership's apartment
property in June 1995, breached their fiduciary duties to the plaintiffs and
both negligently and intentionally interfered with contracts of employment
between the manager of the property and certain of its employees.  Plaintiffs
are seeking damages, declaratory and injunctive relief among 

                                     - 7 -
<PAGE>
 
other remedies, including a declaratory judgment that all cash flow from the
property after payment of the first mortgage debt service may be placed in an
escrow account to cover any cash shortfall pending the outcome of the
litigation. Management of the Company and its legal counsel believe that the
Company has meritorious defenses to the claims asserted, that the claims are
substantially without merit and that liability, if any, related to this matter
will not have a material impact upon the financial position or results of
operations of the Company.

  See the accompanying Consolidated Statements of Cash Flows included in the
financial statements for a reconciliation of cash for the periods described
therein.


FUNDS FROM OPERATIONS

  Funds From Operations ("FFO"), which is a commonly used measurement of the
performance of an equity real estate investment trust ("REIT"), as defined by
the National Association of Real Estate Investment Trusts, Inc. ("NAREIT"), is
net income (computed in accordance with generally accepted accounting
principles), excluding gains (or losses) from debt restructuring and sales of
property, plus depreciation and amortization, and after adjustments for
unconsolidated partnerships and joint ventures.  Adjustments for unconsolidated
partnerships and joint ventures will be calculated to reflect funds from
operations on the same basis.  Management believes the presentation of FFO is a
useful disclosure as a general measurement of its performance in the real estate
industry, although the Company's FFO may not necessarily be comparable to
similarly titled measures of other REITs.  NAREIT recently clarified the
application of its FFO definition and recommended the implementation of the new
application of its FFO definition no later than for fiscal periods beginning in
1996.  The Company implemented the new application of the NAREIT FFO definition
in the first quarter of 1996, and all amounts have been restated to conform to
the new NAREIT definition wherein amortization of loan costs aggregating $71,358
and $188,468, respectively, have not been included in FFO for the years ended
December 31, 1996 and December 31, 1995.  FFO does not represent cash generated
from operating activities in accordance with generally accepted accounting
principles, and is not necessarily indicative of cash available to fund cash
needs and should not be considered as an alternative to net income as an
indicator of the Company's operating performance or as an alternative to cash
flow as a measure of liquidity.  The Company's FFO increased to $2,165,278 for
the year ended December 31, 1996 from $1,820,564 for the year ended December 31,
1995 primarily 

                                     - 8 -
<PAGE>
 
due to the impact of higher rents and fees revenues, lower interest expense and
lower loan amortization costs in 1996. FFO for the year ended 1996 was
calculated by deducting the gain on sale of property of $1,786,079 and deducting
the Company's equity in earnings from investment in partnership of $570,401 from
net income before minority interest of $2,467,973, and then adding depreciation
and amortization of $1,306,039 and adding the Company's FFO allocation from
Emerald Vista Associates, L.P. of $747,746. FFO for the year ended 1995 was
calculated by deducting the Company's equity in earnings from investment in
partnership (i.e., the Company's unconsolidated investment in Emerald Vista
Associates, L.P.) of $596,950 from net loss before minority interests of
$(44,454), and then adding depreciation and amortization of $1,304,215, adding
the costs associated with debt refinancing of $371,093 related to the first
mortgage loan refinancing completed for Americana in April 1995, and adding the
Company's FFO allocation from Emerald Vista Associates, L.P. of $786,660.


INFLATION

     Substantially all of the leases at the Properties are for a term of one
year or less which may enable the Company to seek increased rents upon renewal
or reletting of apartment units.  Such short-term leases generally minimize the
risk to the Company of the adverse effects of inflation.

ITEM 7.  FINANCIAL STATEMENTS.
------------------------------

      The response to this Item is included in a separate section of this
Report. See page F-1.

                                     - 9 -
<PAGE>
 
                                   SIGNATURES


  Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                     AMERICAN REAL ESTATE INVESTMENT CORPORATION


                                By:   /s/ Evan Zucker
                                     -------------------------------------------
                                     Evan Zucker, President

  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<TABLE> 
<CAPTION> 

SIGNATURE                      TITLE                         DATE           
<S>                           <C>                            <C>            
 /s/ Evan Zucker                                                            
____________________________  President and Director         August 26, 1997
Evan Zucker                   (Principal Executive Officer)                 
                                                                            
 /s/ Rick A. Burger                                                         
____________________________  Treasurer (Principal Financial August 26, 1997
Rick A. Burger                and Accounting Officer)                       
                                                                            
 /s/ James Mulvihill                                                        
____________________________  Director                       August 26, 1997
James Mulvihill                                                             
                                                                            
 /s/ Hord Hardin, III                                                       
____________________________  Director                       August 26, 1997
Hord Hardin, III                                                            
                                                                            
 /s/ J. Christopher O'Keeffe                                                 
____________________________  Director                       August 26, 1997
J. Christopher O'Keeffe                                                     
                                                                            
 /s/ Michael Rotchford                                                      
____________________________  Director                       August 26, 1997 
Michael Rotchford
</TABLE> 

                                     - 10 -
<PAGE>
 
                  AMERICAN REAL ESTATE INVESTMENT CORPORATION

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



<TABLE>
<CAPTION>
 
     <S>                                                             <C> 
     Report of Independent Public Accountants                         F-2
 
     Consolidated Balance Sheet as of December 31, 1996               F-3
 
     Consolidated Statements of Operations for the years ended
     December 31, 1996 and 1995                                       F-4
 
     Consolidated Statements of Shareholders' Equity for the years
     ended December 31, 1996 and 1995                                 F-5
 
     Consolidated Statements of Cash Flows for the years ended
     December 31, 1996 and 1995                                       F-6
 
     Notes to Consolidated Financial Statements                       F-8
</TABLE>

                                      F-1
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To the Shareholders of
     American Real Estate Investment Corporation:

We have audited the accompanying consolidated balance sheet of AMERICAN REAL
ESTATE INVESTMENT CORPORATION (a Maryland corporation) and subsidiaries as of
December 31, 1996, and the related consolidated statements of operations,
shareholders' equity and cash flows for the years ended December 31, 1996 and
1995 as revised - see Note 2.  These financial statements are the responsibility
of the Company's management.  Our responsibility is to express an opinion on
these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of American Real Estate Investment
Corporation and subsidiaries as of December 31, 1996, and the results of their
operations and their cash flows for the years ended December 31, 1996 and 1995,
in conformity with generally accepted accounting principles.


                                                             ARTHUR ANDERSEN LLP



Denver, Colorado,
 January 31, 1997.

                                      F-2
<PAGE>
 
                   AMERICAN REAL ESTATE INVESTMENT CORPORATION
                           CONSOLIDATED BALANCE SHEET
<TABLE> 
<CAPTION> 

                                                                   December 31,
                                                                       1996
                                                                ------------------
<S>                                                             <C> 
ASSETS
Investment in real estate:
    Land                                                        $        8,482,659
    Buildings and improvements                                          37,709,943
                                                                ------------------
                                                                        46,192,602
    Less: Accumulated depreciation                                      (3,827,829)
                                                                ------------------
                                                                        42,364,773
    Investment in partnership                                            1,190,611
                                                                ------------------
        Total investment in real estate, net                            43,555,384

Cash & cash equivalents                                                  1,341,590
Restricted cash                                                            741,285
Accounts receivable                                                        120,603
Other assets, net                                                          464,823
                                                                ------------------
        Total assets                                            $       46,223,685
                                                                ==================

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
    Mortgage notes payable                                      $       33,026,544
    Other notes payable                                                  4,212,493
    Accrued interest                                                       257,104
    Accrued property taxes                                                 307,657
    Accrued expenses and other liabilities                                 419,560
    Security deposits                                                      246,021
                                                                ------------------
        Total liabilities                                               38,469,379
                                                                ------------------
Minority interest                                                        3,125,049

Commitments and contingencies (Note 7)

Shareholders' equity:
    Preferred stock, $.01 par value; 5,000,000 
     shares authorized; no preferred shares issued 
     and outstanding                                                             0 
    Common stock, $.001 par value; 30,000,000 shares 
     authorized; 1,121,630 common shares issued and 
     outstanding                                                             1,122
    Additional paid-in capital                                           5,373,919
    Cumulative net income                                                1,874,551
    Cumulative dividends                                                (2,620,335)
                                                                ------------------
        Total shareholders' equity                                       4,629,257
                                                                ------------------
        Total liabilities and shareholders' equity              $       46,223,685
                                                                ==================
</TABLE> 


      The accompanying notes to consolidated financial statements are an 
                     integral part of this balance sheet.

                                      F-3
<PAGE>
 
                  AMERICAN REAL ESTATE INVESTMENT CORPORATION
                     CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE> 
<CAPTION> 

                                                               Year ended                      Year ended
                                                              December 31,                    December 31,
                                                                  1996                            1995
                                                            ------------------            ---------------------
<S>                                                         <C>                            <C> 
Revenues:
    Rents and fees                                          $       9,943,156             $          9,629,446
    Other income                                                      297,138                          336,553
                                                            ------------------            ---------------------
        Total revenues                                             10,240,294                        9,965,999
                                                            ------------------            ---------------------

Operating expenses:
    Repairs and maintenance                                           707,870                          695,243
    Property taxes                                                    417,281                          447,063
    Property management fees                                          352,721                          339,899
    Utilities                                                       1,033,955                          912,361
    Payroll                                                           893,555                          799,025
    Other property operations                                       1,005,182                          913,518
    General and administrative                                        515,093                          652,485
    Depreciation and amortization                                   1,306,039                        1,304,215
                                                            ------------------            ---------------------
        Total operating expenses                                    6,231,696                        6,063,809
                                                            ------------------            ---------------------

Financing expenses:
    Non-related party interest expense                              3,897,105                        3,971,542
    Related party interest expense                                          0                          200,959
                                                            ------------------            ---------------------
        Total financing expenses                                    3,897,105                        4,172,501
                                                            ------------------            ---------------------

Minority interest                                                   1,364,323                          (16,185)

Equity in earnings from investment
    in partnership                                                    570,401                          596,950
                                                            ------------------            ---------------------

Income (loss) before gain on sale of property
    and extraordinary item                                           (682,429)                         342,824

Gain on sale of property                                            1,786,079                                0
                                                            ------------------            ---------------------

Income before extraordinary item                                    1,103,650                          342,824

Extraordinary loss from debt refinancing                                    0                          371,093
                                                            ------------------            ---------------------

Net income (loss)                                           $       1,103,650             $            (28,269)
                                                            ==================            =====================

Primary earnings (loss) per share:
    Income before extraordinary item                        $            1.00             $               0.31
    Extradordinary loss                                                  0.00                            (0.34)
                                                            ------------------            ---------------------
    Primary earnings (loss)                                 $            1.00             $              (0.03)
                                                            ==================            =====================

Fully diluted earnings (loss) per share:
    Income before extraordinary item                        $            1.00             $               0.18
    Extradordinary loss                                                  0.00                            (0.21)
                                                            ------------------            ---------------------
    Fully diluted earnings (loss)                           $            1.00             $              (0.03)
                                                            ==================            =====================
</TABLE> 

  The accompanying notes to consolidated financial statements are an integral
                           part of these statements.

                                      F-4
<PAGE>
 
<TABLE>
<CAPTION>
                                            AMERICAN REAL ESTATE INVESTMENT CORPORATION
                                          CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY



                                            Preferred Stock                Common Stock                Additional
                                        -------------------------  ------------------------------       Paid-in
                                          Shares        Amount        Shares           Amount           Capital
                                        ----------  -------------  -------------  ---------------  ----------------
<S>                                      <C>         <C>            <C>            <C>              <C>

Balances, December 31, 1994                     0   $          0     1,075,000      $      1,075     $    5,022,368

  Net loss                                      -              -             -                -                   -

  Dividends paid ($.83 per share)               -              -             -                -                   -

  Common stock issued to     
    officers and directors (Note 5)             -              -        21,004               21             161,978

                                        ----------  -------------  -------------  ---------------  ----------------
Balances, December 31, 1995                     0              0     1,096,004            1,096           5,159,445

  Net income                                    -              -             -                -                 -

  Dividends paid ($.85 per share)               -              -             -                -                 -

  Common stock issued for
    services provided (Note 5)                  -              -         6,176                6            52,494

  Common stock issued to
    officers and directors (Note 5)             -              -        19,450               20           161,980

                                        ==========  =============  =============  ===============  ================
Balances, December 31, 1996                     0   $          0     1,121,630    $       1,122     $   5,373,919
                                        ==========  =============  =============  ===============  ================

                                              Retained
                                              Earnings /            Total
                                             (Accumulated       Shareholders'
                                                Deficit)            Equity
                                           ----------------  -------------------

Balances, December 31, 1994                $     23,826      $     5,022,368        

  Net loss                                      (28,269)             (28,269)

  Dividends paid ($.83 per share)              (901,734)            (901,734)
  Common stock issued to
    officers and directors (Note 5)                   -              161,999
                                         ----------------  -------------------
Balances, December 31, 1995                    (906,177)           4,254,364        

  Net income                                  1,103,650            1,103,650

  Dividends paid ($.85 per share)              (943,257)            (943,257)

  Common stock issued for                            
    services provided (Note 5)                       -                52,500
                                                     
  Common stock issued to
    officers and directors (Note 5)                  -               162,000
                                         ================  ===================
Balances, December 31, 1996               $    (745,784)    $      4,629,257        
                                         ================  ===================


      The accompanying notes to consolidated financial statements are an integral part of these statements.


</TABLE> 
                                      F-5
<PAGE>
 
                   AMERICAN REAL ESTATE INVESTMENT CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
                                                                                                   Page 1 of 2

                                                               Year ended                      Year ended
                                                              December 31,                    December 31,
                                                                  1996                            1995
                                                            ------------------            ---------------------
<S>                                                          <C>                            <C> 
OPERATING ACTIVITIES:
  Net income (loss)                                         $       1,103,650             $            (28,269)
  Adjustments to reconcile net income (loss) to cash
    provided by operating activities:
      Depreciation                                                  1,361,394                        1,372,978
      Amortization                                                      5,470                            6,305
      Gain on sale of property                                     (1,786,079)                               0
      Equity in earnings from investment in partnership              (570,401)                        (596,950)
      Amortization of investment in partnership in
        excess of underlying equity                                   530,105                          524,524
      Common stock compensation                                       162,000                          161,999
      Minority interest allocation                                  1,364,323                          (16,185)
      Cash provided by (used in):
        Restricted cash                                                49,752                          496,540
        Accounts receivable                                            17,257                           32,564
        Other assets                                                   44,852                           10,758
        Accrued interest                                               68,954                          (87,243)
        Accrued property taxes                                        (43,320)                         (11,721)
        Accrued expenses and other liabilities                        (33,016)                        (383,591)
        Security deposits                                             (21,261)                          11,546
                                                            ------------------            ---------------------
Net cash provided by operating activities                           2,253,680                        1,493,255
                                                            ------------------            ---------------------

INVESTING ACTIVITIES:
  Investment in real estate                                          (565,846)                        (678,102)
  Proceeds from sale of property                                    2,907,024                                0
  Partnership cash distributions received                             229,428                          102,224
                                                            ------------------            ---------------------
Net cash provided by (used in) investing activities                 2,570,606                         (575,878)
                                                            ------------------            ---------------------

FINANCING ACTIVITIES:
  Dividends paid                                                     (943,257)                        (901,734)
  Minority interest distributions                                    (675,186)                        (659,345)
  Proceeds from mortgage notes payable                                      0                       10,310,000
  Repayment of mortgage notes payable                                (322,293)                      (6,530,062)
  Repayment of other note payable                                     (82,407)                         (61,334)
  Repayment of other note payable from sale                        (2,095,511)                               0
  Repayment of note payable to related party                                0                       (3,500,000)
                                                            ------------------            ---------------------
Net cash used in financing activities                              (4,118,654)                      (1,342,475)
                                                            ------------------            ---------------------
Net increase (decrease) in cash and cash equivalents                  705,632                         (425,098)
Cash and cash equivalents, beginning of year                          635,958                        1,061,056
                                                            ------------------            ---------------------
Cash and cash equivalents, end of year                      $       1,341,590             $            635,958
                                                            ==================            =====================
</TABLE> 

The accompanying notes to consolidated financial statements are an integral part
                             of these statements.

                                      F-6
<PAGE>
 
                   AMERICAN REAL ESTATE INVESTMENT CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                     Page 2 of 2

                                             Year ended           Year ended
                                            December 31,          December 31,
                                                 1996                  1995
                                           --------------        -------------
SUPPLEMENTAL DISCLOSURE OF CASH
FLOW INFORMATION:

  Cash paid for interest                    $   3,083,734         $  3,389,010
                                            =============         ============



SUPPLEMENTAL DISCLOSURE OF NON-CASH
INVESTING AND FINANCING ACTIVITIES:

    The Company recorded a decrease (increase) in accounts receivable and a
    corresponding increase (decrease) in investment in partnership for its
    preferred cash return on its investment in 1996 and 1995 of $26,929 and
    $(104,919), respectively.

    The Company issued common stock during 1996 in the amount of $52,500 to an
    entity, of which a limited partner of the Operating Partnership is Chief
    Executive Manager, in payment of the balance of its fee earned for securing
    the Company's mortgage loan with GECC which was expensed and accrued as of
    December 31, 1995.


  The accompanying notes to consolidated financial statements are an integral
                           part of these statements.

                                      F-7
<PAGE>
 
                  AMERICAN REAL ESTATE INVESTMENT CORPORATION
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 1996 AND 1995



1. ORGANIZATION AND OPERATIONS

     American Real Estate Investment Corporation (the "Company"), which is a
self administered equity real estate investment trust ("REIT"), is currently
engaged in the ownership and operation of multifamily residential properties
located in certain markets within the Southwestern United States, including the
Denver, Phoenix and San Diego metropolitan areas.  The Company presently owns
either a full or partial interest in multifamily residential properties which
comprise an aggregate of 1,992 units.

     The Company has from time to time engaged in negotiations with respect to
the sale of one or more of its properties and such negotiations are expected to
continue on an ongoing basis.  The Company sold a 150 unit multifamily
residential property constructed in 1973 known as the International apartments
located at 909 South Peoria Street in the Denver, Colorado metropolitan area on
December 20, 1996 for a gross sales price of $3,050,000 to a European based
investor.  The Company is analyzing certain industry, economic and other
conditions to determine how the proceeds of such sale or future sale will be re-
deployed and is presently considering various alternatives.



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


 Basis of Presentation

     The accompanying consolidated financial statements include the account
balances as of December 31, 1996 and the activity for the years ended December
31, 1996 and December 31, 1995 for the Company on a consolidated basis.  Certain
prior year balances have been reclassified to conform with the current year
presentation.

     The accompanying consolidated statement of operations for the year ended
December 31, 1995 includes an extraordinary loss of $371,093 from debt which was
refinanced.  This presentation of the extraordinary loss is different than the
presentation which was used in the original filing of the Company's Form 10-KSB
for the year ended December 31, 1996.  The loss incurred from the refinancing of
debt was originally recorded as a component of financing expenses.  This
reclassification has no impact on the Company's net loss or primary and fully
diluted net loss per share as originally reported.


                                      F-8
<PAGE>
 
 Principles of Consolidation

     The consolidated financial statements include the accounts of the Company
and all majority-owned subsidiaries, including American Real Estate Investment,
L.P. (the "Operating Partnership").  All significant intercompany accounts and
transactions have been eliminated in consolidation.


 Allocations of Income and Distributions of Cash

     The net income of the Operating Partnership for each year will be allocated
as follows: First, the dollar amount representing 80% of the number of shares of
the Company's common stock outstanding at the end of each calendar year
(equivalent to approximately $897,000 and $877,000, respectively for 1996 and
1995) is allocated to the Company.  Any remaining net income for each such year
will then be allocated to the limited partners until the cumulative net income
allocated to the limited partners for the current and all prior years is equal
to approximately 42% of total cumulative net income since inception.
Thereafter, all net income will be allocated to the Company and the limited
partners in accordance with their percentage interests.  Net losses of the
Operating Partnership will be allocated to all the partners in proportion to
their capital account balances or percentage interests in accordance with the
terms of the partnership agreement.  All such allocations of net income and net
loss will be made subject to compliance with the provisions of Section 704(b)
and 704(c) of the Internal Revenue Code and the Treasury Regulations promulgated
thereunder.  During the year ended December 31, 1995 a net loss of $(16,185) was
allocated to minority interest.  During the year ended December 31, 1996, net
income of $1,364,323 was allocated to the minority interest.  As a result of the
additional amounts allocated to minority interest during 1996, no additional
amounts of cumulative net income need to be allocated to the minority interest
as of December 31, 1996.

     The Company has the right to cause the Operating Partnership to distribute
all or any portion of its "net operating cash flow" (as defined) to the partners
as determined from time to time.  The Company, in its capacity as general
partner, will make this determination.  The Company is required to use its best
efforts to cause the Operating Partnership to distribute sufficient amounts to
enable the Company to pay shareholders' dividends that will satisfy the REIT
requirements and avoid any Federal income or excise tax liabilities of the
Company.

     In the event of liquidation of the Operating Partnership, the assets of the
Operating Partnership will be distributed in accordance with all the partners'
capital accounts.  Liquidating distributions to the limited partners will be
adversely affected to the extent profits were allocated to the Company rather
than the limited partners.  In certain instances in which cash distributions by
the Operating Partnership exceed its net income, distributions to holders of
common stock may be taxed as dividends whereas distributions to limited partners
may constitute a return of capital.

                                      F-9
<PAGE>
 
 Investment in Real Estate

     Investment in real estate is recorded at cost and depreciated over the
estimated useful lives of the related assets.  Expenditures for additions,
renewals and betterments which extend the useful life of the properties are
capitalized.  Routine maintenance and repairs are charged to expense as
incurred.  Furnishings and equipment are included in buildings and improvements
in the accompanying consolidated balance sheet.  The estimated useful lives of
the assets are as follows:
 
                                        Years
                                        -----
          Buildings and improvements    10-35
          Land improvements                15
          Furnishings and equipment      3-10

     The Company accounts for an asset as an asset to be disposed of when they
have committed to a formal plan of disposition and it is probable that a buyer
will purchase the asset due to the occurrence of a significant economic penalty
to the buyer if the asset is not purchased.  The Company reports its assets to
be disposed of at the lower of carrying value or fair value less the cost to
sell the related asset.

     The equity method of accounting is used to account for the Company's
interest in non-controlled joint ventures.  Accordingly, the carrying amount of
the Company's investment in real estate joint ventures is increased or decreased
by the Company's share of joint venture income or loss and cash contributions or
distributions.


 Fair Value of Financial Instruments

     Fair values of cash equivalents and other current amounts receivable and
payable approximated the carrying amount due to their short-term nature.

     Debt carried on the Company's consolidated balance sheet at amortized cost
of approximately $37,239,000 at December 31, 1996 has an estimated fair value of
approximately $34,860,000.  The fair value of the long-term portion of the
Company's fixed rate debt is based on quoted market prices where available or,
if not available, is based on discounting future cash flows using current
interest rates adjusted for risk.  The fair value of the long-term variable rate
debt approximates its recorded value since interest rates fluctuate based on
market conditions.  The fair value of the short-term debt approximates its
recorded value due to its short-term nature.


 Revenue Recognition

     Revenues, consisting primarily of rentals for apartments, are recognized on
the accrual basis of accounting.
                                     F-10
<PAGE>
 
 Use of Estimates

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods.  Actual results could differ from those
estimates.



 Income Taxes and Other

     The Company elected to be taxed as a REIT under Sections 856 through 860 of
the Internal Revenue Code and applicable Treasury Regulations, commencing with
its taxable year ending December 31, 1993.  The Company believes that it is
organized and will continue to operate in such a manner as to qualify for
taxation as a REIT under the Internal Revenue Code.

     A REIT is generally not subject to Federal corporate income taxes on that
portion of its ordinary income or capital gain that is currently distributed to
shareholders because the REIT provisions of the Code generally allow a REIT to
deduct dividends paid to its shareholders.  This deduction substantially
eliminates the Federal "double taxation" on earnings that generally results from
an investment in a corporation.  The Company's dividends of approximately $0.85
per share paid in 1996 were allocated to the shareholders on the following
basis: approximately $0.52 per share represented ordinary income and
approximately $0.33 per share represented long term capital gain.

     There are differences in the Company's bases of assets and liabilities,
specifically relating to minority interests, between financial statements
prepared in accordance with generally accepted accounting principles and
financial statements prepared on a tax basis for completion of annual federal
and state income tax returns.  This is typical for an umbrella partnership real
estate investment trust, the existing organizational structure of the Company in
conjunction with the Operating Partnership.



 Deferred Loan Costs

     The Company capitalizes costs related to the issuance of debt and amortizes
the amounts over the life of the related loans.  The annual amortization is
included in interest expense in the accompanying statements of operations.  The
amount of accumulated amortization related to deferred loan costs is $128,030 as
of December 31, 1996, and the net deferred loan costs are shown in other assets,
net in the accompanying consolidated balance sheet.

                                     F-11
<PAGE>
 
 Earnings per Share

     Primary earnings per share were calculated based on the weighted average
shares outstanding of 1,106,379 and 1,083,233 for the periods ended December 31,
1996 and December 31, 1995, respectively.  Fully diluted earnings per share were
calculated based on the greater of the number of fully diluted shares
outstanding at year end or the weighted average shares outstanding upon assumed
conversion of the limited partner interests, or a total of 1,831,443 shares for
the year ended December 31, 1996 and 1,756,988 shares for the year ended
December 31, 1995, unless the effect of the conversion is anti-dilutive and then
such shares are assumed not to be exercised, as is the case for the year ended
December 31, 1996.  The fully diluted earnings per share is also calculated on
earnings before minority interest as if the conversion of the limited partner
interests occurred at the beginning of the year.  As discussed further in Note
6, the number of shares obtainable upon conversion of the limited partner
interests and, therefore, fully diluted earnings per share, will fluctuate based
upon the amount of income allocated and distributions paid to the limited
partners.


 Cash and Cash Equivalents and Restricted Cash

     For purposes of reporting cash flows, the Company considers all highly
liquid investments purchased with an original maturity of three months or less
to be cash equivalents.  Restricted  cash represents security deposits from
tenants and amounts in escrow for payment of property taxes, insurance and
capital improvements, most of which is required by the Company's lenders.


 Asset Impairment

     The Company assesses the impairment of its assets whenever events or
changes in circumstances indicate that the carrying amount of an asset that the
Company expects to hold and use may not be recoverable.  In performing the
review for recoverability, the Company estimates the future cash flows expected
to result from the use of the asset and its eventual disposition.  If the sum of
the expected future cash flows (undiscounted and without interest charges) is
less than the carrying amount of the asset, the Company will recognize an
impairment loss.  The impairment loss is measured as the amount that the
carrying value of the asset exceeds the fair value of the asset.  The estimate
of the fair value of the asset is based on quoted market prices in active
markets or, if quoted market prices are not available, the best information
available in the circumstances, such as the present value of estimated expected
future cash flows.



3. MULTIFAMILY PROPERTIES

     In connection with the initial public offering, three properties owned
previously by

                                     F-12
<PAGE>
 
Parker, Virginia and Peoria were transferred to the Company.  The general and
limited partner interests of the three limited partnerships (the predecessor
owners of the properties), which are Parker Road Associates, Ltd. ("Parker"),
Virginia Street Associates Limited Partnership ("Virginia") and Peoria Street
Associates Limited Partnership ("Peoria"), were exchanged for limited
partnership interests in the Operating Partnership on November 10, 1993.  The
assets and liabilities of the three predecessor partnerships were recorded by
the Operating Partnership at historical amounts.

     Parker acquired, from an unrelated entity, a 276 unit apartment complex
known as Sedona, located in Aurora, Colorado on September 11, 1991.  A mortgage
with a bank and loans from the limited partners were used to fund the $4,700,000
purchase price, closing costs and certain improvements.  The mortgage and
limited partner loans were paid in full with proceeds from the public offering.

     Peoria acquired, from an unrelated entity, a 150 unit apartment complex
known as the International on  February 26, 1992.  The purchase price, which
totalled approximately $788,000, was funded through a loan from a limited
partner.  This loan was paid in full with proceeds from the public offering.
This property was sold by the Company on December 20, 1996 for a gross sales
price of $3,050,000.

     Virginia acquired, from an unrelated entity, a 300 unit apartment complex
known as Americana Lakewood on April 13, 1992.  The purchase price, which
totalled approximately $8,317,000 plus closing costs and certain improvements
were funded through a mortgage with a bank and a loan from an affiliate.  The
loan from the affiliate was paid in full with proceeds from the public offering
and the mortgage loan was paid in full during 1995 with proceeds from a new
mortgage loan (see Note 4).

     The Company acquired a general partner interest in Emerald Vista
Associates, L.P. ("Emerald Vista"), for $1,350,000 plus closing costs on June
16, 1994 through a newly formed limited partnership (American Emerald Partners,
L.P.).  Emerald Vista is an existing partnership that owns the 456 unit Emerald
Pointe multifamily residential property.  In accordance with the terms of the
amended partnership agreement of Emerald Vista, American Emerald Partners, L.P.
is entitled to receive 50% of the excess cash flow available for distribution
after the payment of a 15% cumulative preferential return on its net equity
investment.  The first mortgage indebtedness of the partnership was restructured
as part of the acquisition transaction, resulting in an outstanding principal
amount of $16,500,000.  See Notes 7 and 9 for further information on Emerald
Vista.

     The Company acquired a 450 unit multifamily residential property known as
Timberleaf apartments on June 30, 1994 for a purchase price of $8,500,000 plus
closing costs.  As part of the purchase price, the Company assumed the existing
first mortgage indebtedness on the property with an outstanding principal
balance of $6,492,872.

     The Company acquired a 510 unit multifamily residential property known as
Quadrangles Village apartments on December 2, 1994 for a purchase price of
$21,100,000 plus closing costs.

                                     F-13
<PAGE>
 
As part of the purchase price, the Company assumed the existing first mortgage
indebtedness on the property with an outstanding principal balance of
$16,808,175.



4. NOTES PAYABLE

     The Company refinanced the mortgage note payable collateralized by
Americana Lakewood apartments in the form of a $10,500,000 mortgage loan from
General Electric Capital Corporation ("GECC") on April 27, 1995.  The debt
refinancing costs are included as an extraordinary loss in the accompanying
consolidated statements of operations.  The GECC mortgage note payable had a
principal balance of $10,205,752 as of December 31, 1996 and bears interest at
GECC's composite commercial paper rate plus 3.75% (9.26% at December 31, 1996).
The mortgage note payable requires monthly interest payments through April 2000.
In addition, quarterly principal payments are required based on a stipulated
percentage of the excess cash flow, as defined, from Americana Lakewood
apartments.  The note requires a balloon payment in the amount of the
outstanding principal balance on April 30, 2000 and contains a 1% prepayment
penalty through April 26, 1997.  There is no prepayment penalty from April 27,
1997 to maturity.  In addition, the note payable requires the Company to escrow
cash for the payment of capital improvements.  Proceeds from the GECC loan were
used to repay the previously existing first mortgage loan collateralized by
Americana Lakewood apartments and the bridge loan which was originally obtained
from a related party to provide a portion of the financing to acquire the
Quadrangles Village apartments.  GECC loan proceeds were also used to pay the
prepayment penalty of $242,605 relating to this first mortgage loan refinancing.

     The mortgage note payable collateralized by the Timberleaf apartments
property had a principal balance of $6,372,130 as of December 31, 1996 and bears
interest at 9.0%.  The note payable requires monthly principal and interest
payments of $52,300 through March 2004.  The note requires a balloon payment of
approximately $5,822,000 due April 1, 2004 and contains a prepayment penalty
based upon a formula on the yield rate of a certain U.S. Treasury Security.  At
December 31, 1996 such prepayment penalty would have amounted to approximately
$591,000.  The yield maintenance prepayment penalty provision expires March 20,
2003, at which time the prepayment penalty becomes 1% of the outstanding
principal balance through maturity.  In addition, the note payable requires the
Company to escrow cash for the payment of property taxes and insurance.

     The mortgage note payable collateralized by the Quadrangles Village
apartments property had a principal balance of $16,448,662 as of December 31,
1996 and bears interest at 6.35%.  The note payable requires monthly principal
and interest payments of $103,031 through May 1, 2026.  The note cannot be
prepaid prior to June 2003, and thereafter contains a prepayment penalty as
follows:  2% from June 2003 to May 2004; 1% from June 2004 to May 2005; 0%
thereafter.  In addition, the note payable requires the Company to escrow cash
for the payment of property taxes, insurance and capital improvements.
Quadrangles Village apartments is a property financed by the Department of
Housing and Urban Development.

                                     F-14
<PAGE>
 
     The installment loan collateralized by Sedona apartments had a principal
balance of $4,212,493 as of December 31, 1996 and is included in other notes
payable in the accompanying consolidated balance sheet.  This loan represents a
bank loan which bears interest at the bank's prime rate plus 0.5% (8.75% at
December 31, 1996) and is due on August 31, 1998.  This loan requires monthly
principal and interest payments based on a 25 year amortization period and can
be prepaid at any time without penalty.  The Company's fully funded $500,000
bank revolving line of credit was paid in full with proceeds from the sale of
International apartments.

     Under the provisions of the installment loan, the Company is required,
among other restrictions, to maintain a minimum debt service coverage ratio of
1.5 times.  As of December 31, 1996, the minimum debt service coverage ratios
required under the bank line of credit have been met by the Company.

     Maturities of the aggregate notes payable as of December 31, 1996 are as
follows (principal payments for the mortgage loan collateralized by Americana
Lakewood apartments are reflected in the year 2000 only, since the annual
principal payments are based on the cash flow from this property and therefore
are not yet known):
 
 
                     Year              Amount
                    ------           ----------
                     1997          $   253,975
                     1998            4,484,676
                     1999              291,732
                     2000           10,518,476
                     2001              335,268
                  Thereafter        21,354,910
                                   -----------
                                   $37,239,037
                                    ==========                        


5. RELATED PARTY TRANSACTIONS

     The Company subleases its office space from Black Creek Capital, LLC to
serve as its headquarters.  The lease agreement contains provisions for a
monthly lease payment of $1,346 payable by the first of each month and expires
December 31, 1999.  A principal of the Company is a principal officer of Black
Creek Capital, LLC.

     The President and Chief Executive Officer and the Treasurer and Chief
Financial Officer of the Company each earned a bonus of $25,000 during 1996 and
1995 for achieving the funds from operations benchmark which was stipulated in
the Company's original prospectus dated November 3, 1993.

     The President and Chief Executive Officer, and the Chairman of the Company
each received compensation, commencing January 1, 1995, on a quarterly basis in
the form of

                                     F-15
<PAGE>
 
common stock issued by the Company.  Members of the Board of Directors who are
not officers of the Company received compensation, commencing January 1, 1995,
on a quarterly basis in the form of common stock issued by the Company.  Total
common stock compensation was approximately $162,000 to officers and directors
of the Company for the years ended December 31, 1996 and December 31, 1995.

     The Company issued common stock during 1996 in the amount of $52,500 at its
then current market price to an entity, of which a limited partner of the
Operating Partnership is Chief Executive Manager, in settlement of the balance
of its fee earned for securing the Company's mortgage loan with GECC which was
accrued as of December 31, 1995.



6. STOCK OPTIONS, STOCK WARRANTS AND CONVERSION RIGHTS

     The Company has established stock option plans whereby options to purchase
shares may be granted to certain directors, officers and employees.  The plans
allow for the granting of "incentive" and "non-qualified" options.  The plans
are to be administered by a committee of the Company's directors who will have
the authority to determine the terms of the options.  However, for the incentive
options, the options are to be granted at not less than the fair market value of
the Company's stock on the date of the grant and the term cannot exceed ten
years.  Also, incentive options granted to 10% or more shareholders cannot be at
less than 110% of the fair market value of the Company's stock on the date of
the grant and the term cannot exceed ten years.  At August 24, 1993, the Board
of Directors reserved 250,000 shares for issuance to certain officers and
employees under the initial plan.    As of December 31, 1996, the Board of
Directors had granted certain officers of the Company 82,000 10-year options at
an exercise price of $10.00 per share.  Of the 82,000 options, 35,000 were
granted during 1996, 35,000 were granted during 1995 and 12,000 were granted
during 1994 under this plan.

     On August 31, 1994 the Company adopted, subject to shareholder approval, a
non-employee stock option plan and 150,000 shares were reserved thereunder in
the form of stock options for issuance to certain directors or consultants under
the newly adopted plan.  Such plan was approved by the shareholders of the
Company at its annual shareholder meeting held on June 7, 1995.  As of December
31, 1996, the Board of Directors had granted to certain directors of the Company
104,000 10-year options at an exercise price of $10.00 per share.  Of the
104,000 options, 40,000 were granted during 1996, 40,000 were granted during
1995 and 24,000 were granted during 1994 under this plan.

     In conjunction with the initial public offering, certain officers and
directors received 186,700 10-year options at an exercise price of $10.00 per
share, all of which remained outstanding as of December 31, 1996 and 1995.

     All options were exercisable at December 31, 1996.  No options were
exercised during the years ended December 31, 1996 or 1995.  The fair value of
each option grant is estimated, for disclosure purposes, on the date of grant
using an option pricing model with the following

                                     F-16
<PAGE>
 
assumptions for 1996 and 1995: 7.78% dividend yield; an expected life of 10
years; expected volatility of 20.03%; and a risk free interest rate of 6.423%.
The weighted average fair value of those shares granted in 1996 and 1995 was
$.59 and $.44, respectively, per share.  The weighted average remaining
contractual life for the options granted in 1995 and 1996 that were outstanding
at December 31, 1996 was 8.5 years.

     The Company accounts for its stock-based options under Accounting
Principles Board Opinion No. 25, under which no compensation expense related to
options has been recognized, as all options have been granted with an exercise
price equal to or greater than the fair value of the Company's common stock on
the date of grant.  The Company adopted Statement of Financial Accounting
Standards ("SFAS") 123 for disclosure purposes in 1996.  For SFAS 123 purposes,
the fair value of each option grant and stock purchase right has been estimated
as of the date of grant using an option pricing model with the assumptions
outlined in the preceding paragraph.

     Using these assumptions, the fair value of the stock options granted in
1996 and 1995 was approximately $44,000 and $33,000, respectively.  Had
compensation cost been determined consistent with SFAS 123, utilizing the
assumptions detailed above, the Company's net income (loss) would have been
reduced to the following pro forma amounts:
<TABLE>
<CAPTION>
 
                                           Year Ended     Year Ended
                                          December 31,    December 31,
                                             1996            1995
                                          ------------   -------------
 <S>                                       <C>            <C> 
   Net income (loss):
           As reported                     $ 1,103,650     $  (28,269)
           Pro forma                       $ 1,077,860     $  (47,426)

   Primary earnings (loss) per share:
           As reported                         $  1.00        $  (.03) 
           Pro forma                           $   .97        $  (.04)
 
   Fully diluted earnings (loss) per share:
           As reported                         $  1.00        $  (.03)
           Pro forma                           $   .97        $  (.04)

</TABLE> 
 


     In conjunction with the initial public offering, Dickinson & Co. received a
warrant to purchase up to 107,500 shares of common stock, par value $.001, of
the Company at an exercise price of $16.50 per share at any time during the
period from November 3, 1993 to November 2, 1998, at which time the warrant
expires.

     In conjunction with the acquisition of Quadrangles Village apartments, D.H.
Blair

                                     F-17

<PAGE>
 
Holdings, Inc. received a warrant to purchase 175,000 shares of common stock,
par value $.001, of the Company at a price of $10.00 per share at any time
during the period from December 2, 1994 to December 2, 1999, at which time the
warrant expires.  The warrant was transferred to a limited partner of the
Operating Partnership at the time the note was purchased.

     Pursuant to the Partnership Agreement, the limited partners of the
Operating Partnership received a Conversion Right, which enables each limited
partner, commencing November 3, 1994, to convert their interests in the
Operating Partnership into shares of common stock of the Company.  The
Conversion Right enables the limited partners of the Operating Partnership to
convert their partnership interest in the Operating Partnership into a maximum
aggregate ownership of up to 42.42% of the shares of common stock outstanding
immediately after the initial public offering.  The number of shares of common
stock into which limited partners in the aggregate could convert their
partnership interests was initially established at 792,007.  The number of
shares relating to the Conversion Right remains stable irrespective of the
market price of the Company's common stock, except that such number of shares
may be subject to reduction for cash distributions made to the limited partners
in excess of net income allocated to the limited partners.  The limited
partners, in the aggregate, could convert their partnership interests in the
Operating Partnership into 725,064 shares of common stock as of December 31,
1996 and 636,185 shares of common stock as of December 31, 1995.

     The Conversion Right, which became exercisable on November 10, 1994, may be
exercised from time to time in whole or in part prior to November 10, 1998, at
which time the Conversion Right expires.  No limited partner interests were
converted during 1996.

     The purchase price payable upon exercise of the Conversion Right is payable
by the Company's issuance of the appropriate number of shares of common stock.
Limited partners may exercise their Conversion Right only once during each
calendar quarter period.



7. COMMITMENTS AND CONTINGENCIES

     The Company and an affiliated entity are defendants in a lawsuit commenced
in December 1995 in the Superior Court of the State of California, County of San
Diego, by Emerald Vista, Inc., Emerald Vista Associates, L.P., and Schickler
Meringoff Properties.  Emerald Vista Associates, L.P. owns the Emerald Pointe
apartments.  Emerald Vista, Inc. is one of the co-general partners and an
affiliate of the Company is a co-general partner.  Schickler Meringoff
Properties provides on-site management of the properties.  The plaintiffs allege
that the defendants, in connection with an inspection of the partnership's
apartment property in June 1995, breached their fiduciary duties to the
plaintiffs and both negligently and intentionally interfered with contracts of
employment between the manager of the property and certain of its employees.
Plaintiffs are seeking damages, declaratory and injunctive relief among other
remedies, including a declaratory judgment that all cash flow from the property
after payment of the first mortgage debt service may be placed in an escrow
account to cover any cash shortfall pending the outcome of the litigation.
Management and its legal counsel believe that the


                                     F-18
<PAGE>
 
Company and its subsidiary have meritorious defenses to the plaintiff's claims.
The Company has filed an answer in the litigation and believes that liability,
if any, related to this matter will not have a material impact upon the
financial position or results of operations of the Company.  Trial is scheduled
for June 2, 1997.

     The Company also received notification dated October 26, 1995 from a
representative of the managing general partner of Emerald Pointe apartments that
the quarterly cash flow from such property distributable to the partners has
been deposited into a special reserve account until further notice in relation
to a dispute between the Company and the managing general partner, which the
Company is presently attempting to resolve.  Cash flow from Emerald Pointe
apartments was reported as $41,682 and $45,010 for the period from June 1, 1995
to September 30, 1995 and the period from October 1, 1995 to December 31, 1995,
respectively, and such amounts were initially deposited into a separate escrow
account.  During 1996, the Company received the reported cash flow of $86,692
from Emerald Pointe apartments for the period from June 1, 1995 to December 31,
1995, and also received all reported cash flows for 1996.

     The Company entered into employment agreements with two officers of the
Company in conjunction with the initial public offering pursuant to which one
officer served as President and Chief Executive Officer of the Company and
another officer served as Treasurer and Chief Financial Officer of the Company.
The agreements were for an initial term of three years ending in November 1996.
Employment agreements for these two officers of the Company were extended
through December 31, 1999 at specified compensation levels, including stipulated
severance packages upon termination of either agreement prior to December 31,
1999.  Each executive may receive salary, bonuses and additional compensation or
benefits as the Company may, in its discretion, award to the employee.



8. OWNERSHIP LIMIT AND BOARD OF DIRECTORS TERMS

     In order to maintain its qualification as a REIT, not more than 50% in
value of the outstanding shares of the Company may be owned, directly or
indirectly, by five or fewer individuals (as defined in the Code to include
certain entities).  To ensure that the Company will not fail to qualify as a
REIT under this test, the Certificate of Incorporation of the Company authorizes
the Directors to take such action as may be required to preserve its
qualification as a REIT and to limit any person, subject to certain exceptions
and other than any person approved by the Directors, to direct or indirect
ownership of 4.75% of the lesser of the number or value of the outstanding
shares of the Company; provided, however, the Directors may not grant an
exemption from the foregoing ownership limitation to any Director, employee or
other person whose ownership, direct or indirect, of in excess of 4.75% of the
lesser of the number or value of the outstanding common stock would result in
the termination of the Company's status as a REIT.  The Company also has the
ability to issue other classes of common and preferred shares of stock.

     Pursuant to the terms of the Company's Certificate of Incorporation, the
Directors are


                                     F-19
<PAGE>
 
divided into three classes.  One class holds office initially for a term
expiring at the annual meeting of shareholders to be held in 1997, another class
holds office for a term expiring at the annual meeting of shareholders to be
held in 1998 and another class holds office for a term expiring at the annual
meeting of shareholders to be held in 1999.  The members of each class of
Directors will hold office until their successors are duly elected and
qualified.  At each annual meeting of the shareholders of the Company, the
successors to the class of Directors whose term expires at such meeting will be
elected to hold office for a term expiring at the annual meeting of shareholders
held in the third year following the year of their election.



9. INVESTMENT IN PARTNERSHIP

     During 1994, the Company acquired a 50% general partnership interest in
Emerald Vista.  The Company is entitled to receive 50% of the excess cash flow
available for distribution, as defined, after the payment of a 15% cumulative
preferential return on its net equity investment.  The Company is a co-general
partner and, based on the partnership agreement which states that the other
general partner is the managing general partner, does not control Emerald Vista.
Accordingly, the Company records its investment in Emerald Vista under the
equity method and records its equity in earnings based on its allocable share of
the net income or loss from Emerald Vista.

     The Company established receivables on its books for the Company's
preferred return on its investment in Emerald Vista for the amounts owed to the
Company as of December 31, 1996 and December 31, 1995.



 Significant Accounting Policies

     Emerald Vista accounts for its investment in real estate at cost.  Costs
related to the acquisition of real estate by Emerald Vista, including
commissions, closing costs and direct and indirect acquisition costs have been
capitalized.  Capitalized costs are depreciated over their estimated useful
lives ranging from 5 to 35 years.  Costs of repairs and maintenance are expensed
as incurred.

     Costs incurred in connection with Emerald Vista's financing are deferred
and amortized over the life of the related mortgage note payable.  Such costs
are included in other assets on its balance sheet and the accumulated
amortization at December 31, 1996 was approximately $44,000.

     Provision for Federal and state income taxes has not been made in Emerald
Vista's financial statements as the tax effects of Emerald Vista's activities
will be reflected in the individual tax returns of the partners.


                                     F-20
<PAGE>
 
 Amortization of Investment in Excess of Underlying Equity

     The Company's investment in Emerald Vista ($1,190,611 at December 31, 1996)
was in excess of its share in the existing equity as of the date of its
acquisition of the general partner interest in Emerald Vista.  The Company is
amortizing the amount of its investment in excess of its share in the underlying
equity using the straight-line method.  The amortization is recorded on a pro
rata basis to interest expense and depreciation expense on the financial
statements.  The unamortized investment in excess of its share in the underlying
equity was approximately $2,000,000 as of December 31, 1996.


 Summarized Financial Data

     The following is a summary of Emerald Vista's balance sheet as of December
31, 1996 and the statement of operations for the years ended December 31, 1996
and 1995:

<TABLE>
<CAPTION>
 
 
               Balance Sheet:                                    1996
               ---------------                                 --------
                                                              (Unaudited)
                                                                (000's)
               <S>                                             <C>
 
               Investment in real estate, net                    $19,566
               Cash                                                  157
               Other assets, net                                     208
                                                                 -------
               Total assets                                      $19,931
                                                                 =======
 
               Mortgage note payable                             $21,090
               Other liabilities                                     382
               Partners' deficit                                  (1,541)
                                                                 -------
               Total liabilities and partners' deficit           $19,931
                                                                 =======
 
 
               Statements of Operations:             1996         1995
               ------------------------             -------      -------
                                                  (Unaudited)  (Unaudited)
                                                    (000's)      (000's)
 
               Revenues                             $ 2,886      $ 2,941
               Operating expenses                    (1,837)      (1,832)
               Interest expense                        (111)        (118)
                                                    -------      -------
               Net income                           $   938      $   991
                                                    ========     =======
</TABLE>

                                     F-21

<PAGE>
 
10. SUBSEQUENT EVENTS

     The Company refinanced the installment note payable collateralized by
Sedona apartments in the form of a $5,700,000 mortgage loan from GMAC Commercial
Mortgage Corporation ("GMAC") on January 31, 1997.  The GMAC mortgage note
payable bears interest at 250 basis points over the one month LIBOR rate rounded
up to the nearest eighth of one percent and adjusts on a monthly basis (8.00% at
January 31, 1997).  The mortgage note payable requires monthly principal and
interest payments based on a 25 year amortization.  The note requires a balloon
payment in the amount of the outstanding principal balance on August 1, 1998 and
contains a 1% prepayment penalty/exit fee which is waived if GMAC places the
permanent loan on this property.  In addition, the note payable requires the
Company to escrow cash for the payment of property taxes, insurance and capital
improvements.  Proceeds from the GMAC loan were used to repay the previously
existing installment loan collateralized by Sedona apartments and to establish a
completion repair escrow for designated capital improvements on the property.

     The Company announced on February 5, 1997 that it had declared a cash
dividend of $0.21625 per share for operations relating to the quarter ending
December 31, 1996 payable on March 4, 1997 to shareholders of record on February
21, 1997.


                                     F-22