<PAGE>   1
                                                                EXHIBIT 13.1



REPORT OF INDEPENDENT AUDITORS


BOARD OF DIRECTORS

THE MILLS CORPORATION

We have audited the accompanying consolidated balance sheets of The Mills
Corporation as of December 31, 1998 and 1997, and the related consolidated
statements of operations, stockholders' equity and cash flow for each of the
three years in the period ended December 31, 1998. These financial statements
are the responsibility of the management of The Mills Corporation. 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 consolidated financial position of The Mills
Corporation as of December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles.

                                                       /s/ ERNST & YOUNG LLP

Washington, D.C.
February 18, 1999




                                                                            37
<PAGE>   2



CONSOLIDATED BALANCE SHEETS

THE MILLS CORPORATION

<TABLE>
<CAPTION>
                                                                                               December 31,
(Dollars in thousands)                                                                1998                    1997
-------------------------------------------------------------------------------------------------------------------
<S>                                                                              <C>                    <C>
ASSETS
Real estate and development assets:
Income producing property
    Land and land improvements                                                   $ 167,607               $ 167,409
    Building and improvements                                                      705,638                 703,805
    Furniture, fixtures and equipment                                               28,004                  25,253
    Less: accumulated depreciation and amortization                               (214,766)               (206,357)
                                                                               ------------------------------------
Total income producing property                                                    686,483                 690,110
Land held for investment and/or sale                                                10,606                   7,397
Construction in progress                                                            28,987                  18,904
Investment in unconsolidated joint ventures                                        145,980                  95,299
                                                                               ------------------------------------
Total real estate and development assets                                           872,056                 811,710
Cash and cash equivalents                                                           10,510                  25,263
Restricted cash                                                                     13,422                  15,623
Accounts receivable                                                                 23,017                  21,078
Notes receivable                                                                     6,291                   6,733
Deferred costs, net                                                                 44,000                  43,654
Other assets                                                                         1,066                   2,560
                                                                               ------------------------------------
TOTAL ASSETS                                                                     $ 970,362               $ 926,621
===================================================================================================================

LIABILITIES AND STOCKHOLDERS' EQUITY
Mortgages, notes, and loans payable                                              $ 782,182               $ 703,713
Accounts payable and other liabilities                                              55,210                  54,929
                                                                               ------------------------------------
Total liabilities                                                                  837,392                 758,642

Minority interests                                                                  54,052                  68,955

Stockholders' equity:
    Common stock $.01 par value, authorized 100,000,000 shares, 
        issued and outstanding 23,131,697 and 22,912,242 shares 
        in 1998 and 1997, respectively                                                 231                     229
    Additional paid-in capital                                                     439,448                 436,639
    Accumulated deficit                                                           (359,404)               (337,142)
    Deferred compensation                                                           (1,357)                   (702)
                                                                               ------------------------------------

Total stockholders' equity                                                          78,918                  99,024
                                                                               ------------------------------------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                       $ 970,362               $ 926,621
===================================================================================================================
</TABLE>


See Accompanying Notes to Consolidated Financial Statements.


38
<PAGE>   3




CONSOLIDATED STATEMENTS OF OPERATIONS

THE MILLS CORPORATION

<TABLE>
<CAPTION>
                                                                                   Year Ended December 31,
(In thousands, except per share data)                                1998                    1997                    1996
--------------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>                    <C>                     <C>
REVENUES:
    Minimum rent                                                 $101,503               $  96,370               $  94,678
    Percentage rents                                                3,832                   4,413                   4,216
    Recoveries from tenants                                        50,943                  47,350                  45,761
    Other revenue                                                   7,653                   8,150                   7,616
    Fee income                                                     10,101                   7,132                   3,639
    Interest income                                                 3,238                   2,561                   2,850
                                                               -----------------------------------------------------------
                                                                  177,270                 165,976                 158,760
EXPENSES:

    Recoverable from tenants                                       44,361                  42,025                  41,308
    Other operating                                                 5,872                   5,720                   6,170
    General and administrative                                      9,994                   9,506                   8,725
    Interest expense                                               44,044                  41,006                  45,885
    Depreciation and amortization                                  36,925                  35,487                  39,020
                                                               -----------------------------------------------------------

                                                                  141,196                 133,744                 141,108
Other income/(expense)                                               (979)                    567                   1,073
Equity in earnings of unconsolidated joint ventures
    before extraordinary items                                      8,097                   4,372                   2,661
                                                               -----------------------------------------------------------

Income before extraordinary items and minority interests           43,192                  37,171                  21,386
Extraordinary losses on debt extinguishments                         (422)                 (8,060)                 (5,301)
Equity in extraordinary losses on debt extinguishments
    of unconsolidated joint ventures                               (3,518)                   (397)                     --
                                                               -----------------------------------------------------------

Income before minority interests                                   39,252                  28,714                  16,085
Minority interests                                                (16,000)                (12,303)                 (7,904)
                                                               -----------------------------------------------------------

Net income                                                       $ 23,252               $  16,411               $   8,181
==========================================================================================================================

EARNINGS PER COMMON SHARE - BASIC:
Income before extraordinary items                                $   1.11               $    0.99               $    0.64
Extraordinary losses on debt extinguishments                        (0.10)                  (0.23)                  (0.16)
                                                               -----------------------------------------------------------

Net income                                                       $   1.01               $    0.76               $    0.48
==========================================================================================================================

EARNINGS PER SHARE - DILUTED:
Income before extraordinary items                                $   1.10               $    0.98               $    0.64
Extraordinary losses on debt extinguishments                        (0.10)                  (0.23)                  (0.16)
                                                               -----------------------------------------------------------

Net income                                                       $   1.00               $    0.75               $    0.48
==========================================================================================================================


Dividends declared per common share                              $   1.94               $    1.89               $    1.89
==========================================================================================================================

Tax treatment of dividends (unaudited):
Ordinary income                                                  $   1.14               $    0.76               $    0.66
==========================================================================================================================


Capital gains                                                    $   0.02               $      --               $      --
==========================================================================================================================

Return of capital                                                $   0.78               $    1.13               $    1.23
==========================================================================================================================
</TABLE>


See Accompanying Notes to Consolidated Financial Statements.




                                                                              39
<PAGE>   4



CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

THE MILLS CORPORATION

<TABLE>
<CAPTION>
                                        Common
                                         Stock          Par         Additional      Accumulated          Deferred
(In thousands)                         (Shares)       Value    Paid-In Capital          Deficit      Compensation          Total
---------------------------------------------------------------------------------------------------------------------------------
<S>                                    <C>            <C>            <C>             <C>                <C>            <C>
Balance, December 31, 1995              16,906         $169           $309,813        $(239,574)        $      --      $  70,408

Conversion of operating
    partnership units                        1           --                 --               --                --             --
Change in ownership                         --           --                 --             (596)               --           (596)
REIT formation settlement
    adjustments                             --           --                 --             (516)               --           (516)
Dividends declared                          --           --                 --          (31,952)               --        (31,952)
Net income                                  --           --                 --            8,181                --          8,181
                                      -------------------------------------------------------------------------------------------
Balance, December 31, 1996              16,907          169            309,813         (264,457)               --         45,525

Net proceeds from additional
    equity offering                      5,325           53            121,757               --                --        121,810
Restricted stock incentive program          60            1              1,066               --            (1,067)            --
Amortization of stock incentive             --           --                 --               --               365            365
Units exchanged for common stock           572            6              2,981           (2,987)               --             --
Dividends declared                          --           --                 --          (42,924)               --        (42,924)
Net income                                  --           --                 --           16,411                --         16,411
Exercise of stock options and other         48           --              1,022               --                --          1,022
Adjustment to minority interests            --           --                 --          (43,185)               --        (43,185)
                                      -------------------------------------------------------------------------------------------

Balance, December 31, 1997              22,912          229            436,639         (337,142)             (702)        99,024

Restricted stock incentive program          55           --              1,340               --            (1,340)            --
Amortization of stock incentive             --           --                 --               --               685            685
Units exchanged for common stock           110            1                444             (445)               --             --
Dividends declared                          --           --                 --          (45,069)               --        (45,069)
Net income                                  --           --                 --           23,252                --         23,252
Exercise of stock options                   55            1              1,025               --                --          1,026
                                      -------------------------------------------------------------------------------------------

Balance, December 31, 1998              23,132         $231           $439,448        $(359,404)          $(1,357)     $  78,918
=================================================================================================================================
</TABLE>


See Accompanying Notes to Consolidated Financial Statements.



40
<PAGE>   5



CONSOLIDATED STATEMENTS OF CASH FLOW

THE MILLS CORPORATION

<TABLE>
<CAPTION>
                                                                                       Year Ended December 31,
(In thousands)                                                                1996              1998              1997
-----------------------------------------------------------------------------------------------------------------------

<S>                                                                     <C>             <C>                <C>
OPERATING ACTIVITIES:
Income before minority interests                                        $   39,252       $    28,714        $   16,085
Adjustments to reconcile income before minority
    interests to net cash provided by operating activities:
        Net accretion of note receivable                                      (700)             (700)             (700)
        Depreciation and amortization                                       36,925            36,752            42,816
        Provision for losses on accounts receivable                          1,046               591               441
        Equity in earnings of unconsolidated joint ventures, net of
            extraordinary losses on debt extinguishments                    (4,579)           (3,975)           (2,661)
        Net gain on sales of property                                           --              (992)           (1,048)
        Extraordinary loss on debt extinguishment                              422             8,060             5,301
        Amortization of restricted stock awards                                685               225                --
        Other changes in assets and liabilities:
            Increase in accounts receivable                                 (2,917)           (2,212)           (2,458)
            Decrease in notes receivable                                     1,142             1,134               890
            Decrease in other assets                                         1,426               380               242
            Increase in accounts payable and other liabilities               5,450            12,296             4,354
                                                                        -----------------------------------------------

Net cash provided by operating activities                                   78,152            80,273            63,262

INVESTING ACTIVITIES:

Investment in real estate and development assets                          (120,559)          (94,416)          (56,768)
Distributions received from unconsolidated joint ventures                   32,434            29,278                --
Proceeds from sale of property                                                  --             4,316             5,060
Deferred costs                                                              (9,486)          (14,015)          (15,760)
                                                                        -----------------------------------------------

Net cash used in investing activities                                      (97,611)          (74,837)          (67,468)

FINANCING ACTIVITIES:

Proceeds from mortgages, notes and loans payable                           208,306           196,482           423,029
Repayments of mortgages, notes and loans payable                          (129,837)         (227,582)         (369,351)
Refinancing costs                                                           (1,018)           (2,054)               --
Restricted cash                                                              2,201            (2,408)            6,139
Net proceeds from common stock offering                                         --           121,810                --
Dividends   (45,069)                                                       (42,924)          (31,952)
Distributions                                                              (30,903)          (30,506)          (31,882)
Proceeds from exercise of stock options                                      1,026               682                --
                                                                        -----------------------------------------------

Net cash provided by (used in) financing activities                          4,706            13,500            (4,017)
                                                                        -----------------------------------------------

Net increase (decrease) in cash and cash equivalents                       (14,753)           18,936            (8,223)
Cash and cash equivalents at beginning of year                              25,263             6,327            14,550
Cash and cash equivalents at end of year                                $   10,510       $    25,263        $    6,327
=======================================================================================================================


Supplemental disclosure of cash flow information:
Cash paid for interest                                                  $   52,208       $    47,953        $   52,956
=======================================================================================================================
</TABLE>


See Accompanying Notes to Consolidated Financial Statements.>




                                                                             41
<PAGE>   6



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)

NOTE 1.

ORGANIZATION AND BASIS OF PRESENTATION


ORGANIZATION

The Mills Corporation (the "Company") is a fully-integrated, self-managed real
estate investment trust ("REIT").

      The Company conducts all of its business through The Mills Limited
Partnership ("the Operating Partnership"), in which it owns, as of December 31,
1998, a 1% interest as the sole general partner and a 58.35% interest as a
limited partner. The Company, through the Operating Partnership, is engaged in
the ownership, development, redevelopment, leasing, acquisition, expansion, and
management of super-regional, retail and entertainment-oriented centers (the
"Mills" and "Block" projects) and community shopping centers (the "Community
Centers"). As of December 31, 1998, the Operating Partnership owns or holds an
interest in the following operating properties:

<TABLE>
<CAPTION>
MILLS                                       LOCATION
-----------------------------------------------------------------------------
<S>                                         <C>
Franklin Mills                              Philadelphia, PA
Gurnee Mills                                Gurnee, IL (Chicago)
Potomac Mills                               Woodbridge, VA (Washington, DC)
Sawgrass Mills                              Sunrise, FL (Ft. Lauderdale)
Ontario Mills                               Ontario, CA (Los Angeles)
Grapevine Mills                             Grapevine, TX (Dallas/Fort Worth)
Arizona Mills                               Tempe, AZ (Phoenix)

<CAPTION>
BLOCK
-----------------------------------------------------------------------------
<S>                                         <C>
The Block at Orange                         Orange, CA (Los Angeles)

<CAPTION>
COMMUNITY CENTERS
-----------------------------------------------------------------------------
<S>                                         <C>
Butterfield Plaza                           Downers Grove, IL
Cooper's Plaza                              Voorhees, NJ
Crosswinds Center                           St. Petersburg, FL
Fashion Place                               Columbia, SC
Germantown Commons                          Germantown, MD
Gwinnett Marketfair                         Duluth, GA
Liberty Plaza                               Philadelphia, PA
Montgomery Village                          Gaithersburg, MD
Mount Prospect Plaza                        Mount Prospect, IL
West Falls Church Outlet Center             Falls Church, VA
Western Hills Plaza                         Cincinnati, OH
</TABLE>

In addition to the operating properties, the Company is actively involved in the
development of a number of new Mills.

BASIS OF PRESENTATION

The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries, including its majority owned subsidiary, the
Operating Partnership. The accounts of the Operating Partnership include the
accounts of all Properties which are wholly-owned or controlled by the Operating
Partnership, as well as its wholly-owned subsidiaries Mills Management LLC
("Mills Management") and Management Associates Limited Partnership ("MALP"). In
addition, the Operating Partnership owns 5% of the voting common stock and 99%
of the preferred stock of the Mills Services Corporation ("MSC"), an entity
formed in connection with the Company's initial public offering to provide
development, management, leasing and financing services to the Company and other
entities owned by affiliates of the Company. As a result of the Operating
Partnership's ownership of 99% of the economic interests, MSC is consolidated
with the Operating Partnership. The Company's ownership in certain Mills and
Block operating properties, as well as certain properties under development




42
<PAGE>   7



are through investments in the partnerships that own Ontario Mills, Ontario
Mills Residual, Grapevine Mills, Grapevine Mills Residual, Arizona Mills,
Sawgrass Mills Phase III, The Block at Orange, Concord Mills, Katy Mills, Opry
Mills, Vaughan Mills and Meadowlands Mills. Such investments are accounted for
using the equity method of accounting (see Note 4).

      All significant intercompany transactions and balances have been
eliminated in consolidation. Minority interests represent the ownership
interests in the Operating Partnership not held by the Company.

NOTE 2.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


INCOME PRODUCING PROPERTY

Income producing property is stated at the lower of cost or fair value and
includes all costs related to acquisition, development, leasing and
construction, including tenant improvements, interest incurred during
construction and certain direct and indirect costs of development. Land held for
sale is carried at the lower of cost or fair value less costs to sell.
Maintenance and repairs are charged to expense as incurred. Depreciation expense
is computed using the straight-line method over the estimated useful lives of
the assets, as follows:

<TABLE>
<S>                                                     <C>
Buildings and improvements                              40 years
Land improvements                                       20 years
Furniture, fixtures and equipment                        7 years
----------------------------------------------------------------
</TABLE>


Total interest expense capitalized to real estate and development assets,
including investment in joint ventures under development, was $8,761, $8,890 and
$7,171 for the years ended December 31, 1998, 1997 and 1996, respectively.

INCOME RECOGNITION

The Company, as lessor, has retained substantially all the risks and benefits of
ownership and accounts for its leases as operating leases. Minimum rent from
income producing property are recognized on a straight-line basis over the terms
of the respective leases. Commencing in the second quarter of 1998, percentage
rents are recognized when tenants' sales have reached breakpoints stipulated in
the respective leases. For periods prior to the second quarter of 1998, such
rents were recognized on an accrual basis. The impact of this change on 1998
operations was not material. Recoveries from tenants for real estate taxes and
other operating expenses are recognized as revenue in the period the applicable
costs are incurred.

      Management, leasing and development fees relating to entities not
controlled by the Company are recognized as revenue as they are earned.

DEFERRED COSTS

Deferred costs consist of loan fees and related expenses which are amortized on
a straight-line basis that approximates the interest method over the terms of
the related notes. In addition, deferred costs include leasing charges,
including tenant construction allowances and direct salaries and other costs
incurred by the Company to originate a lease, which are amortized on a
straight-line basis over the terms of the related leases.

      Total accumulated amortization of deferred costs was $60,352 and $51,743
at December 31, 1998 and 1997, respectively.

      In connection with the refinancing of certain debt during 1998, the
Company wrote off $422 of unamortized loan costs. Such amounts are reflected as
extraordinary losses on debt extinguishments.

      In connection with the refinancing of certain debt during 1997, the
Company wrote off $6,006 of unamortized loan costs and paid a prepayment penalty
of $2,054. Such amounts are reflected as an extraordinary loss on debt
extinguishment.

      In connection with the refinancing of certain debt during 1996,
unamortized loan costs of $6,829 and a prepayment penalty of $600, net of the
proceeds from the sale of interest rate cap agreements of $557 and the reversal
of straight-line interest expense of $1,571, were written off and are included
as an extraordinary loss on debt extinguishment.


                                                                              43
<PAGE>   8




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)


CASH AND CASH EQUIVALENTS

All highly liquid investments with an original maturity of three months or less
are considered to be cash equivalents.

RESTRICTED CASH

Restricted cash primarily consists of funds invested in cash collateral
accounts. The purpose of the cash collateral accounts is to hold proceeds from
certain transactions and to fund maintenance reserves, interest, taxes and
payments on debt. The cash collateral accounts are controlled by the lenders.

INCOME TAXES

Federal income taxes are not provided for because the Company believes it
qualifies as a REIT under the provisions of the Internal Revenue Code ("IRC")
and will distribute in excess of its taxable income to its shareholders. As a
REIT, the Company is required to distribute at least 95% of its taxable income
to shareholders and to meet certain other requirements. The differences between
net income available to common shareholders for financial reporting purposes and
taxable income before dividend deductions relate primarily to temporary
differences, principally real estate depreciation.

      MSC, the Company's consolidated IRC subchapter C corporate subsidiary, is
subject to federal income taxes at the prevailing tax rates. MSC has a federal
net operating loss carryforward of approximately $13.7 million and $9.0 million
at December 31, 1998 and 1997, respectively. A valuation allowance has been
established for deferred tax assets principally relating to the loss
carryforward as there can be no assurance that MSC will generate taxable income
in future years. MSC has recorded a $165 provision for the alternative minimum
tax for the year ended December 31, 1998.

SEGMENT REPORTING

Effective January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" (SFAS 131). SFAS 131 defines an operating segment as a component of
an enterprise that engages in business activities that generate revenues and
incur expenses, whose operating results are reviewed by the chief operating
decision maker in the determination of resource allocation and performance, and
for which discrete financial information is available. The Company operates in
one reportable segment, the development, ownership and operation of retail
properties. These properties consist of "Mills" superregional value and
entertainment oriented malls, "Block" retail and entertainment properties and
community center retail shopping centers. Substantially all the Company's
assets, revenues and income are derived from this segment. The Company currently
has no operations in foreign countries.

REPORTING ON THE COSTS OF START-UP ACTIVITIES

In April 1998, the Accounting Standards Executive Committee issued Statement of
Position 98-5, "Reporting on Costs of Start-Up Activities" (SOP 98-5), which is
effective for fiscal years beginning after December 15, 1998. SOP 98-5 requires
costs of start-up activities and organization costs to be expensed as incurred.
It is the Company's policy to capitalize certain costs incurred to develop and
rent its projects in accordance with SFAS No. 67, "Accounting for Costs and
Initial Rental Operations of Real Estate Projects" and SFAS No. 91, "Accounting
for Non-Refundable Fees and Costs Associated with Originating and or Acquiring
Loans and Initial Direct Costs of Leases." All costs of the Company's
development and leasing activities which are not considered to be within the
scope of SFAS No. 67 or SFAS No. 91 are expensed as incurred. SOP 98-5 states
that the guidance provided by SFAS No. 67 and SFAS No. 91 is not affected by the
provisions of SOP 98-5. Therefore, the adoption of SOP 98-5 is not anticipated
to have a material effect on results of operations or the financial position of
the Company.




44
<PAGE>   9



EARNINGS PER SHARE

The Company accounts for earnings per share pursuant to SFAS 128. Basic EPS is
calculated by dividing income available to common shareholders by the weighted
number of common shares outstanding during the period. Diluted EPS is calculated
by adjusting net income for the period for the effects on minority interests
resulting from issuance of stock pursuant to restricted stock or option grants
and dividing the resulting adjusted net income by the weighted average shares
outstanding during the period, adjusted for the dilutive effect of options and
stock grants.

      The following table sets forth the computation of basic and diluted
earnings per share:

<TABLE>
<CAPTION>

                                                                                   1998                    1997            1996
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                                             <C>                     <C>            <C>
Numerator for basic earnings per share                                          $23,232                 $16,411        $  8,181
================================================================================================================================

Numerator for diluted earnings per share                                        $23,374                 $16,411        $  8,181
================================================================================================================================

Denominator:
Denominator for basic earnings per share -
    weighted average shares                                                      23,062                  21,517          16,917
Unvested Restricted Stock Awards -
    weighted average shares                                                         (51)                    (17)             --
                                                                               -------------------------------------------------

Denominator for basic earnings per share
    adjusted weighted average shares                                             23,011                  21,500          16,917
Effect of dilutive securities:
Employee stock options and restricted stock awards                                  350                     431              81
                                                                               -------------------------------------------------

Denominator for diluted earnings per
    share-adjusted weighted-average shares                                       23,361                  21,931          16,998
================================================================================================================================

Basic earnings per share                                                        $  1.01                 $  0.76        $   0.48
Diluted earnings per share                                                      $  1.00                 $  0.75        $   0.48
</TABLE>

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 amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.

MINORITY INTERESTS

Minority interests represent the interests of the unitholders in the Operating
Partnership. The unitholder interest is adjusted at each period end to reflect
the ownership percentage at that particular time. The unitholder interest was
40.65%, 41.05% and 49.10% at December 31, 1998, 1997 and 1996, respectively.

RECLASSIFICATIONS

Certain previously reported amounts have been reclassified to conform with the
current year presentation.

NOTE 3.

NOTES RECEIVABLE

Notes receivable include $5,980 and $6,639 at December 31, 1998 and 1997,
respectively, relating to a reimbursement and annexation agreement with the
Village of Gurnee ("Village") to reimburse the owner of Gurnee Mills for the
cost of certain public improvements. The Village has executed a non-interest
bearing note for $15,000 to be paid from taxes collected from tenants of Gurnee
Mills during a ten-year period beginning one year after Gurnee Mills opened in
August 1991. In 1996, the note was amended and the note amount increased to
$17,500 to be paid over a thirteen year period. The note was recorded in 1991 at
its net present value, based on the estimated taxes to be collected by the
Village using a discount rate of 10%. Interest income accreted was $700 for each
of the years ended December 31, 1998, 1997 and 1996, respectively. For the years
ended December 31, 1998, 1997 and 1996, collections from the Village totaled
$1,359, $988 and $908, respectively.




                                                                              45
<PAGE>   10


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)

NOTE 4.

INVESTMENT IN UNCONSOLIDATED JOINT VENTURES


Certain operating properties and properties under development are partially
owned through joint ventures ("Joint Ventures") in which the Company is also a
co-general and co-managing partner. The Company's interest in each Joint Venture
is as follows:

<TABLE>
<CAPTION>

                                                     Ownership %
Joint Venture                                     as of 12/31/98
----------------------------------------------------------------

<S>                                                        <C>
Ontario Mills                                              50.0%
Grapevine Mills                                            37.5%
Arizona Mills                                              36.8%
Sawgrass Mills Phase III                                   50.0%
Katy Mills                                                 62.5%
Concord Mills                                              37.5%
Meadowlands Mills                                          66.7%
Opry Mills                                                 66.7%
The Block at Orange                                        50.0%
</TABLE>

      As major business decisions require the approval of at least one other
general partner, the Company does not control these Joint Ventures pursuant to
Statement of Position No. 78-9. As a result, the investments are accounted for
under the equity method, where the investments are recorded at cost and
subsequently adjusted for net equity in income (loss) and cash contributions and
distributions. The Company eliminates intercompany profits on sales of services
that are capitalized by the Joint Ventures.

      In connection with the Joint Venture agreements, the Company is committed
to providing certain levels of equity in addition to the amounts invested to
date. The Company has guaranteed repayment of $148.6 million of the Joint
Venture debt until certain debt service coverage tests are met. In addition, the
Company is contingently liable for property taxes and assessments levied against
Ontario Mills Limited Partnership by the City of Ontario Special Assessment
District. The remaining aggregate amount of the special tax assessment is
approximately $18.8 million and will be collected over a 25 year period through
2020 to fund debt service on bonds issued by the City to fund infrastructure
improvements.

      Certain of the Company's joint venture agreements contain buy-sell
provisions whereby certain partners can require the purchase or sale of
ownership interests among the partners.

      Condensed combined balance sheet as of December 31, 1998 and 1997 and
condensed combined results of operations for each of the three years in the
period ended December 31, 1998 are presented below for all Joint Ventures.

<TABLE>
<CAPTION>
                                                                          December 31,
                                                                        1998            1997
---------------------------------------------------------------------------------------------

<S>                                                              <C>               <C>
ASSETS:
    Income producing assets                                      $   522,174       $ 465,316
    Construction in progress                                         299,221         112,495
    Other                                                            242,017         122,458
                                                                -----------------------------
                                                                  $1,063,412       $ 700,269
---------------------------------------------------------------------------------------------

LIABILITIES AND PARTNERS' EQUITY:
    Debt                                                         $   583,296       $ 358,538
    Other liabilities                                                118,176          71,849
    Operating Partnership's accumulated equity                       106,875          75,600
    Joint Venture partners' accumulated equity                       255,065         194,282
                                                                -----------------------------
                                                                  $1,063,412       $ 700,269
---------------------------------------------------------------------------------------------
</TABLE>



46
<PAGE>   11

<TABLE>
<CAPTION>
                                                                      Year Ended December 31,
                                                                 1998            1997            1996
------------------------------------------------------------------------------------------------------
<S>                                                          <C>             <C>              <C>
Revenues                                                     $ 98,342        $ 40,367         $ 3,720
Recoverable and other property expenses                       (30,010)        (17,020)         (1,085)
Interest expense                                              (28,456)        (10,537)           (523)
Depreciation and amortization                                 (25,695)        (10,693)         (1,268)
Other                                                           7,253           6,711           5,489
Extraordinary losses on debt extinguishments                   (8,878)           (961)             --
                                                           -------------------------------------------

Net income                                                   $ 12,556        $  7,867         $ 6,333
======================================================================================================

Equity in earnings of unconsolidated joint ventures
    before extraordinary losses                              $  8,097        $  4,372         $ 2,661
======================================================================================================

Equity in extraordinary losses on debt extinguishments
    of unconsolidated joint ventures                         $ (3,518)       $   (397)        $    --
======================================================================================================
</TABLE>


      The primary difference between the carrying value of the Company's
investment in unconsolidated joint ventures and the Operating Partnership's
accumulated equity noted above is due to capitalized interest on the investment
balance, capitalized development and leasing costs which are recovered by the
Operating Partnership through fees during construction and loans and advances to
the Joint Ventures included in other liabilities above.

      In connection with refinancing of debt, the Grapevine Mills and Ontario
Mills joint ventures recognized extraordinary losses on debt extinguishments
totalling $8.9 million due to the write-off of unamortized deferred loan costs
of $3.4 million and the payment of a prepayment penalty of $5.5 million. The
Company's share of the losses was $3.5 million.

      In October 1998, the Company and the Katy Mills joint venture entered into
a settlement agreement with Chelsea GCA Realty, Inc., Simon Property Group,
L.P., and certain of their affiliates by which the parties settled litigation
concerning efforts by Chelsea and Simon to develop a shopping center in the
Houston, Texas area within close proximity to the Katy Mills project. In order
to protect the investment in the Katy Mills project, the Company and the Katy
Mills joint venture purchased Chelsea's interest in the proposed project by
reimbursing Chelsea for its share of land costs, development costs and fees
related to the project and agreed to make $21.4 million of additional payments
to Chelsea over a four-year period. Of this amount, the Katy Mills joint venture
paid $3.0 million in October 1998 and $4.6 million in January 1999. The Company
and its joint venture partners anticipate that the construction loan and equity
contributions for Katy Mills would be sufficient to cover the joint venture's
obligations to make the deferred payments. Katy Mills' future payment
obligations under the settlement agreements are secured by a pledge of 1,007,620
shares of the Company's common stock. The number of shares will be reduced pro
rata as payments are made. The obligation was reduced to $13.8 million and the
number of shares pledged was reduced by 244,529 with the January 1999 payment.

      In 1997, the Company and its joint venture partner associated with a
Columbus, Ohio project decided not to pursue a Mills-type project in this area
and to focus the Company's efforts in those areas where market dynamics are more
favorable. In conjunction with this decision, the partnership expensed all
previously capitalized preacquisition and predevelopment costs related to this
project. Pursuant to the terms of the joint venture agreement, and through a
separate agreement with the owner of the full-retail regional mall site, the
Company was reimbursed for all its costs incurred in connection with the
Columbus project.




                                                                              47
<PAGE>   12



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)

NOTE 5.

BORROWINGS

Mortgages, notes, and loans payable, which are secured by the Company's income
producing properties, consist of the following at December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                                                                           1998            1997
--------------------------------------------------------------------------------------------------------------------------------

<S>                                                                                                  <C>              <C>
Potomac Mills/Gurnee Mills securitized bonds - principal and interest payments
    based on 30 year amortization with an anticipated balloon payment in
    December 2003 and required maturity in 2026; weighted average fixed interest
    rate of 7.02%                                                                                      $278,022        $281,117

Sawgrass Mills securitized bonds - interest only payments through maturity in
    January 2001; fixed interest rate of 6.45% on $115,000; variable interest
    rates on remaining amounts from LIBOR + .85% to LIBOR + 2.30%
    (LIBOR was 5.06% at December 31, 1998)                                                              145,000         145,000

Sawgrass Mills Phase II mortgage loan - interest only payments through maturity
    in July 1998; variable interest rate at LIBOR plus 2.35%                                                 --          12,000

Sawgrass Mills Phase II mortgage loan - interest only payments
    through maturity in January 2001; fixed interest rate of 6.97%.                                      18,000              --

Franklin Mills and Liberty Plaza mortgage loan - principal and interest payments
    based on 30 year amortization with an anticipated balloon payment in May
    2007 and required maturity in 2027; fixed interest rate at 7.88% per annum
    on $110 million, 7.44% on $20 million, and 6.22% on $13 million.                                    141,298         129,495

Western Hills mortgage loan - interest only payments through maturity in January
    1999; fixed interest rates at blended rate of 7.675% (see Note 12)                                   14,949          14,949

Community Centers' mortgage loan - principal and interest payments through
    maturity in January 2001; fixed interest rate of 7.16% (see Note 12)                                 66,833          71,943

The Mills Limited Partnership $60.0 million revolving line of credit - interest
    only payments through maturity in October 1998 (with a one year extension
    option); variable interest rate at LIBOR plus 3.00%                                                      --          41,000

The Mills Limited Partnership $100 million revolving line of credit - interest
    only payments through maturity in April 2000 (with a one year extension
    option); variable interest rate at LIBOR plus 1.40%                                                  89,000              --

The Mills Limited Partnership $15 million promissory note interest only
    payments; through maturity in January 2000 (with a one year extension
    option); variable interest rate at LIBOR plus 1.25%                                                  15,000              --

Other notes and loans payable                                                                            14,080           8,209
                                                                                                      --------------------------
                                                                                                       $782,182        $703,713
================================================================================================================================
</TABLE>

      The weighted average interest rate at December 31, 1998 and 1997, was
6.98% and 7.24%, respectively. Of the Company's approximately $782.2 million of
consolidated debt, $637.3 million was fixed rate at December 31, 1998.

      In January 1992, in conjunction with improvements to one of the Mills, a
Mills entity obtained from a bank a 10 year letter of credit in the amount of
$30,249 which serves as a credit enhancement for bonds sold by a municipality to
the public. Proceeds from the bonds were used to reimburse the Mills entity for
the costs of public works, which amounted to approximately $21,000. This
reimbursement was recorded as a reduction of the costs previously capitalized to
the income producing property. The bonds are payable from ad valorem




48
<PAGE>   13



taxes levied by the municipality against the assessed value of the real property
owned by the Partnership and real property owned by outside parties. Funds can
be drawn on the letter of credit for the purpose of repaying principal and
interest on the bonds.

      The aggregate maturities of the Company's borrowings at December 31, 1998
is as follows:

<TABLE>
<S>                                      <C>
1999                                      $ 25,350
2000                                       121,342
2001                                       231,488
2002                                         5,887
2003                                         6,325
Thereafter                                 391,790
                                          --------
                                          $782,182
==================================================
</TABLE>


NOTE 6.

LEASING ACTIVITIES

The Company has noncancellable leases with tenants with remaining terms ranging
from one to 25 years and requiring monthly payments of specified minimum rents.
A majority of the leases require reimbursement by the tenant of substantially
all operating expenses of the properties. In addition, many of the leases
provide for additional rental payments based on gross revenues of the tenant in
excess of specified amounts. Future minimum rental commitments to be received
under noncancellable leases for the Mills (excluding Ontario Mills, Grapevine
Mills, Arizona Mills and The Block at Orange which are joint ventures) and the
Community Centers are as follows:

<TABLE>
<CAPTION>
Year ending December 31
---------------------------------------------------

<S>                                      <C>
1999                                      $ 95,899
2000                                        89,663
2001                                        71,289
2002                                        56,504
2003                                        44,346
Thereafter                                 145,178
                                          --------
                                          $502,879
==================================================
</TABLE>


      The Company has a noncancellable operating lease for its corporate
headquarters in Arlington, Virginia. The lease commenced April 1, 1996 for a
term of ten years. Minimum rental payments under this lease subsequent to
December 31, 1998, are as follows:

<TABLE>
<CAPTION>
Year ending December 31
-------------------------------------------------

<S>                                      <C>
1999                                      $ 1,570
2000                                        1,610
2001                                        1,732
2002                                        1,804
2003                                        1,849
Thereafter                                  4,354
                                          -------
                                          $12,919
=================================================
</TABLE>
NOTE 7.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The following disclosures of estimated fair value were determined by management,
using available market information and appropriate valuation methodologies.
Considerable judgment is necessary to interpret market data and develop
estimated fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize on disposition
of the financial instruments. The use of different market assumptions and/or
estimation methodologies could have a material effect on the estimated fair
value amounts.

      Cash equivalents, accounts receivable, accounts payable and accrued
expenses and other liabilities are carried at amounts which reasonably
approximate their fair values.

      Fixed rate debt with an aggregate carrying value of approximately $637.3
million has an estimated aggregate fair value of $643.6 million at December 31,
1998. Estimated fair value of fixed rate debt is based on interest rates
currently available to the Company for issuance of




                                                                              49
<PAGE>   14



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)


debt with similar terms, credit risk and remaining maturities. The estimated
fair value of the Company's variable rate debt is estimated to be approximately
equal to its carrying value of $144.9 million at December 31, 1998.

      Disclosure about fair value of financial instruments is based on pertinent
information available to management at December 31, 1998. Although management is
not aware of any factors that would significantly affect the reasonable fair
value amounts, such amounts have not been comprehensively revalued for purposes
of these financial statements since December 31, 1998, and current estimates of
fair value may differ significantly from the amounts presented herein.

NOTE 8.

EMPLOYEE BENEFIT PLANS

The Company has a 401(k) defined contribution benefit plan that covers all
employees who are age 21 or older and have at least one year of service.
Contributions made by employees electing to participate in the plan under salary
reduction agreements are recorded when paid into the plan, or alternatively,
accrued if unpaid. Employer contributions are accrued and paid into the plan
periodically. Employer contributions were $790, $372 and $282 in 1998, 1997 and
1996, respectively.

NOTE 9.

STOCK OPTION PLAN

The Company has an Executive Equity Incentive Plan ("Plan") for the purpose of
attracting and retaining directors, executive officers and other key personnel
for the Company, the Operating Partnership and their subsidiaries. Pursuant to
the Plan, 4,500,000 shares of common stock have been reserved for issuance of
stock options at a price not less than 100% of fair market value at the date of
grant and restricted stock. The options expire 10 years from the date of grant
and will contain such other terms and conditions (including, without limitation,
conditions to vesting) as may be determined by the Company's Executive
Compensation Committee.

      In 1996, the Company adopted pursuant to the Plan, its 1996 long-term
Incentive Plan which granted restricted stock and certain options to the
Company's executive officers and provided that such restricted stock and stock
options would vest in 20% increments over a five-year period. Generally, other
options granted under the Plan vest 50% and 100% on the third and fourth
anniversaries, respectively, of the date of grant.

      A summary of the Company's stock option activity, and related information
for the years ended December 31 follows:

<TABLE>
<CAPTION>
                                              1998                  1997                       1996
----------------------------------------------------------------------------------------------------------------
                                                  Weighted-                 Weighted-                 Weighted-
                                     Options        Average  Options         Average  Options           Average
                                       (000) Exercise Price    (000)  Exercise Price    (000)    Exercise Price
----------------------------------------------------------------------------------------------------------------

<S>                                   <C>        <C>          <C>         <C>            <C>          <C>
Outstanding -
    beginning of year                 1,892      $21.53       1,461       $19.57         824          $22.28
Granted                               2,362       25.19         653        25.38         858           17.73
Exercised                               (55)      18.56         (34)       20.66         -0-             -0-
Forfeited                              (138)      22.91        (188)       19.78        (221)          22.54
                                     -------    --------    --------     --------     -------         -------
Outstanding - end of year             4,061       23.62       1,892        21.53       1,461           19.57
                                     =======    ========    ========     ========     =======         =======

Exercisable at end of year              834       21.71         403        21.28         -0-             -0-
Weighted-average fair
    value of options granted
    during the year                              $ 1.90                   $ 2.78                      $ 0.92
</TABLE>

      The range of exercise prices of options outstanding at December 31, 1998
was $17.27 to $26.19. The weighted average remaining contractual life of options
outstanding at December 31, 1998 was 8.20 years.

      The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," (SFAS 123)
requires use of option valuation models that were not developed




50
<PAGE>   15



for use in valuing employee stock options. Under APB 25, when the exercise price
of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.

      Pro forma information regarding net income and earnings per share is
required by SFAS 123 which also requires that the information be determined as
if the Company has accounted for its employee stock options granted subsequent
to December 31, 1994 under the fair value method of that Statement. The fair
value for these options was estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted-average assumptions for 1998,
1997 and 1996, respectively: risk-free interest of 5.25%, 6.71% and 6.25%;
expected life of the option of 4.5 years, 4.96 and 4.83 years; a dividend yield
of 9.0%, 7.0% and 7.0%; and volatility factors of the expected market price of
the Company's common stock of .210, .210 and .138.

      The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

      For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information follows (in thousands except for earnings per share
information):

<TABLE>
<CAPTION>
                                                1998            1997            1996
-------------------------------------------------------------------------------------
<S>                                          <C>             <C>             <C>
Pro forma income before minority interest    $37,899         $28,445         $15,937
Pro forma net income per share - diluted     $   .97         $   .75         $   .48
</TABLE>


NOTE 10.

LEGAL MATTERS

On March 3, 1998, the Company received a payment of $2.0 million from the A.J.
1989 Trust (the "A.J. Trust"), in payment of a judgement obtained in an action
originally filed on April 27, 1994, by the A.J. Trust, Mr. Richard Kramer and a
partnership affiliated with Mr. Kramer against the Operating Partnership,
Herbert S. Miller, and certain other parties. Concurrently with the payment, the
parties to such litigation dismissed with prejudice the remaining claims in the
suit.

      The Company is involved in other litigation incident to the operations of
its income producing properties, the outcome of which is not expected to have a
material effect on the consolidated financial position or results of operations
of the Company.

NOTE 11.

TRANSACTIONS WITH AFFILIATES

MSC provides management, leasing, commissioned land sales, and related services
to entities owned by partners of the Operating Partnership. Fees earned for the
years ended December 31, 1998, 1997, and 1996, were $867, $1,214 and $1,166,
respectively.

      In addition, MSC provides development and leasing, financing and
management services for Joint Ventures. Fees earned during 1998, 1997 and 1996,
net of amounts eliminated, were $9,234, $5,918 and $2,473, respectively.

      The Company is the lessor of a ground lease with the Sawgrass Mills Phase
III Joint Venture. The lease commenced January 1, 1997 and expires on December
31, 2046. Annual rent was $800 for 1998 and 1997.

      During 1997, MSC purchased land from an entity owned by certain partners
of the Operating Partnership for $2,300 and the assumption of debt of $4,700.
The assumption of debt has been treated as non-cash financing activity for the
Consolidated Statements of Cash Flow.

NOTE 12.

SUBSEQUENT EVENTS

On January 27, 1999, the Company refinanced ten community centers with a new
$112.5 million permanent loan. The proceeds were used to repay a $14.9 million
mortgage loan on Western Hills and to repay a $66.8 million loan on nine other
community centers. The remaining proceeds will be used to fund development costs
and capital requirements of the




                                                                            51
<PAGE>   16



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

THE MILLS CORPORATION December 31, 1998 (Dollars in thousands, unless otherwise
indicated)


Company. The indebtedness is a thirty-year amortizing loan with an anticipated
balloon repayment in February 2009. The loan bears a fixed interest rate of
7.30% and is guaranteed by the Company.

      On February 4, 1999, the Company received a five-year, $750 million
capital commitment from Kan Am, a significant unitholder of the Operating
Partnership and joint venture partner, to fund future development projects.
Subject to terms and conditions, Kan Am will continue to fund certain project
level capital as they have on several of the Company's prior projects.
Approximately $300 million is to be funded in specifically identified projects
over the next two years. In addition, Kan Am has agreed to work with the Company
to identify such other projects, and to use best efforts to provide funding for
such projects, in the approximate amount of $150.0 million in each of 2001, 2002
and 2003. Consistent with prior partnerships, Kan Am will fund up to 100% of a
specific project's equity requirements and receive a percentage of ownership
interest equal to half of the percentage that they have funded.

NOTE 13.

UNAUDITED QUARTERLY RESULTS OF OPERATIONS

The following is a summary of results of operations for each of the fiscal
quarters during 1998:



<TABLE>
<CAPTION>
                                                                                        Three Months Ended
                                                                       March 31         June 30    September 30     December 31
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>             <C>             <C>             <C>
Total revenues                                                      $    41,745     $    42,910     $    43,683     $    48,932
Income before extraordinary items and
    minority interests                                                    8,678           9,920           9,579          15,015
Income before minority interests                                          8,678           9,498           8,906          12,170
Net income                                                                5,120           5,628           5,285           7,219

EARNINGS PER SHARE - BASIC:

Income per share before extraordinary items                                0.22            0.26            0.24           0 .39
Extraordinary loss on debt extinguishment                                    --           (0.01)          (0.01)          (0.08)
                                                                   -------------------------------------------------------------

Net income per share                                                     $ 0.22          $ 0.25          $ 0.23          $ 0.31
================================================================================================================================


EARNINGS PER SHARE - DILUTED:

Income per share before extraordinary items                                0.22            0.25            0.24           0 .39
Extraordinary loss on debt extinguishment                                    --           (0.01)          (0.01)          (0.08)
                                                                   -------------------------------------------------------------

Net income per share                                                $      0.22     $      0.24     $      0.23     $      0.31
================================================================================================================================


Basic Shares                                                         22,909,523      22,986,131      23,039,036      23,081,737
Diluted Shares                                                       23,338,880      23,589,291      23,385,907      23,313,807
</TABLE>

      The following is a summary of results of operations for each of the fiscal
quarters during 1997:

<TABLE>
<CAPTION>
                                                                                        Three Months Ended
                                                                       March 31         June 30    September 30     December 31
--------------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>             <C>             <C>             <C>
Total revenues                                                      $    40,224     $    40,516     $    41,705     $    43,531
Income before extraordinary items and
    minority interests                                                    6,474           8,849           9,434          12,414
Income before minority interests                                          6,077             789           9,434          12,414
Net income                                                                3,020             461           5,614           7,316

EARNINGS PER SHARE - BASIC:

Income per share before extraordinary items                                0.19            0.24            0.24           0 .32
Extraordinary loss on debt extinguishment                                 (0.01)          (0.22)             --              --
                                                                   -------------------------------------------------------------

Net income per share                                                $      0.18     $      0.02     $      0.24     $      0.32
================================================================================================================================


EARNINGS PER SHARE - DILUTED:

Income per share before extraordinary items                                0.19            0.24            0.24           0 .31
Extraordinary loss on debt extinguishment                                 (0.01)          (0.22)             --              --
                                                                   -------------------------------------------------------------

Net income per share                                                $      0.18     $      0.02     $      0.24     $      0.31
================================================================================================================================


Basic Shares                                                         17,559,879      23,015,641      22,854,497      22,866,531
Diluted Shares                                                       17,908,715      23,443,536      23,382,238      23,352,969
</TABLE>



52