<PAGE>
 
                                   FORM 10-K
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

(Mark One)
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

     For the fiscal year ended     December 31, 1997
                               -------------------------------------------------
                                      OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

     For the transition period from _____________ to _____________ 

                        Commission file number  0-20253

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
            (Exact name of registrant as specified in its charter)

                         Wisconsin                           39-1660958
              (State or other jurisdiction of             (I.R.S. Employer
               incorporation or organization)            Identification No.)

           101 W. 11th St., Suite 1110, Kansas City, Missouri 64105
         (Address of principal executive offices, including zip code)

                                (816) 421-7444

             (Registrant's telephone number, including area code)

  (Former name, former address and former fiscal year, if changed since last
                                   report.)

     Securities registered pursuant to Section 12(b) of the Act: None
     Securities registered pursuant to Section 12(g) of the Act: Limited
     Partnership Interests

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.   Yes   X     No
                                         -----      -----

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation  S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]

     The aggregate market value of the voting securities held by nonaffiliates
of the Registrant:  The aggregate market value of limited partnership interests
held by nonaffiliates is not determinable since there is no public trading
market for the limited partnership interests.
    
                  Index to Exhibits located on page:  34 - 35
                                                    -----------
<PAGE>
 
                                    PART I

Item 1.  Business

Background
----------

The Registrant, DiVall Income Properties 3 Limited Partnership (the
"Partnership"), is a limited partnership organized under the Wisconsin Uniform
Limited Partnership Act pursuant to an Agreement of Limited Partnership dated as
of December 12, 1989, and amended as of December 18, 1989, February 19, 1990,
April 9, 1990, February 8, 1993, May 26, 1993, June 1, 1993, and June 30, 1994.
As of December 31, 1997, the Partnership consisted of one General Partner and
1,093 Limited Partners owning an aggregate of 17,102.52 Limited Partnership D-
Interests (the "D-Interests") acquired at a public offering price of $1,000 per
Interest before volume discounts.  The Interests were sold pursuant to a
Registration Statement on Form S-11 filed under the Securities Act of 1933 dated
April 23, 1990.  On April 23, 1992, the Partnership closed the offering at
17,102.52 D-Interests ($17,102,520), providing net proceeds to the Partnership
after volume discounts and offering costs of $14,408,872.

The Partnership is currently engaged in the business of owning and operating its
investment portfolio (the "Properties") of commercial real estate. The
Properties are leased on a triple net basis to, and operated by, franchisors or
franchisees of national, regional and local retail chains under long-term
leases.  The lessees consist of fast-food, family style, and casual/theme
restaurants.  At December 31, 1997, the Partnership owned six (6) Properties and
specialty leasehold improvements for use in all six (6) of the Properties, as
more fully described in Item 2.

Prior to the disposal of the Properties, the Partnership's return on its
investment will be derived principally from rental payments received from its
lessees.  Therefore, the Partnership's return on its investment is largely
dependent upon, among other factors, the business success of its lessees.  The
business success of the Partnership's individual lessees can be adversely
affected on three general levels.  First, the tenants rely heavily on the
management contributions of a few key entrepreneurial owners.  The business
operations of such entrepreneurial tenants can be adversely affected by death,
disability or divorce of a key owner, or by such owner's poor business decisions
such as an undercapitalized business expansion.  Second, changes in a local
market area can adversely affect a lessee's business operation.  A local economy
can suffer a downturn with high unemployment.  Socioeconomic neighborhood
changes can affect retail demand at specific sites and traffic patterns may
change, or stronger competitors may enter a market. These and other local market
factors can potentially adversely affect the lessees of Partnership properties.
Finally, despite an individual lessee's solid business plans in a strong local
market, the chain concept itself can suffer reversals or changes in management
policy which can in turn affect the profitability of operations for Partnership
properties.  Therefore, there can be no assurance that any specific lessee will
have the ability to pay its rent over the entire term of its lease with the
Partnership.

Since all of the Partnership's investment in properties and equipment involves
restaurant tenants, the restaurant market is the major market segment with a
material impact on Partnership operations.  It would appear that the management
skill and potential operating efficiencies realized by Partnership lessees will
be a major ingredient for their future operating success in a very competitive
restaurant and food service marketplace.

There is no way to determine with any certainty, which, if any, tenants will
succeed or fail in their business operations over the term of their respective
leases with the Partnership.  It can be reasonably anticipated 

                                       2
<PAGE>
 
that some lessees will default on future lease payments to the Partnership which
will result in the loss of expected lease income for the Partnership. Management
will use its best efforts to vigorously pursue collection of any defaulted
amounts and to protect the Partnership assets and future rental income potential
by trying to re-lease any properties with rental defaults. External events which
could impact the Partnership's liquidity are the entrance of other competitors
into the market areas of our tenants; liquidity and working capital needs of the
leaseholders; and failure or withdrawal of any of the national franchises held
by the Partnership's tenant. Each of these events, alone or in combination,
would affect the liquidity level of leaseholders resulting in possible default
by the tenant. Since the information regarding plans for future liquidity and
expansion of closely held organizations, which are tenants of the Partnership,
tends to be of a private and proprietary nature, anticipation of individual
liquidity problems is difficult, and prediction of future events is nearly
impossible.

A preliminary investigation during 1992 by the Office of the Commissioner of
Securities for the State of Wisconsin and the Securities and Exchange Commission
(the "Investigation"), revealed that during at least the three years ended
December 31, 1992, two of the former general partners of the Partnership, Gary
J. DiVall ("DiVall") and Paul E. Magnuson ("Magnuson") had transferred
substantial cash assets of the Partnership and two affiliated publicly
registered partnerships, DiVall Insured Income Fund Limited Partnership ("DiVall
1") and DiVall Insured Income Properties 2 Limited Partnership ("DiVall 2")
(collectively the "Partnerships") to various other entities previously sponsored
by or otherwise affiliated with DiVall and Magnuson. The unauthorized transfers
were in violation of the respective Partnership Agreements. The aggregate amount
of the misappropriation, related costs and 9% interest accrued since January 1,
1993, is approximately $14,800,000, net of recoveries, of which $6,916,000 has
been allocated to the Partnership.

Subsequent to discovery, and in response to the regulatory inquiries, a third-
party Permanent Manager, The Provo Group, Inc. ("TPG"), was appointed (effective
February 8, 1993) to assume the responsibility for daily operations and assets
of the Partnerships as well as to develop and execute a plan of restoration to
the Partnerships. As reported in the Partnership's report on Form 8-K dated May
26, 1993, effective as of that date, the Limited Partners, by written consent of
a majority of interests, elected the Permanent Manager, TPG, as General Partner.
Additional results of the solicitation included the approval of the Permanent
Manager Agreement ("PMA"), the acceptance of the resignations of the former
general partners, amendments to certain provisions of the Partnership Agreement
pertaining to general partner interests and compensation, and an amendment of
the Partnership Agreement providing for an Advisory Board (the "Board").

The Permanent Manager Agreement
-------------------------------

The PMA was entered into on February 8, 1993, between the Partnership, DiVall 1,
DiVall 2, the now former general partners DiVall and Magnuson, their controlled
affiliates, and TPG, naming TPG as the Permanent Manager. The PMA contains
provisions allowing the Permanent Manager to submit the PMA, the issue of
electing the Permanent Manager as General Partner, and the issue of acceptance
of the resignations of the former general partners to a vote of the Limited
Partners through a solicitation of written consents.

TPG, as the new General Partner, has been operating and managing the affairs of
the Partnership in accordance with the provisions of the PMA and the Partnership
Agreement, as amended.

                                       3
<PAGE>
 
Advisory Board
--------------

The concept of the Advisory Board was first introduced by TPG during the
solicitation of written consents for the Partnerships, and is the only type of
oversight body known to exist for similar partnerships at this time.  The first
Advisory Board was appointed in October 1993, and held its first meeting in
November 1993.  The four person Advisory Board is empowered to, among other
functions, review operational policies and practices, review extraordinary
transactions, and advise and serve as an audit committee to the Partnership and
the General Partner.  The Advisory Board does not have the authority to direct
management decisions or policies of the Partnership or remove the General
Partner.  The powers of the Advisory Board are advisory only.  The Advisory
Board has full and free access to the Partnership's books and records, and
individual Advisory Board members have the right to communicate directly with
the Limited Partners concerning Partnership business.  Members of the Advisory
Board are compensated $3,000 annually and $1,200 for each quarterly meeting
attended.

The Advisory Board currently consists of a broker dealer representative, Steven
Carson of First Albany Corporation; and a Limited Partner from each of the three
Partnerships: Robert White from DiVall 1, Richard Otte from DiVall 2, and Albert
Gerritz from the Partnership.  For a brief description of each Advisory Board
member, refer to Item 10, Directors and Executive Officers of the Registrant.

Restoration Plan
----------------

TPG, upon commencement of its management of the Partnerships, developed a
strategy (the "Restoration Plan" or "Plan") for recovering as much of the
amounts misappropriated by the former general partners and their affiliates as
possible.  The Plan focused on recovery from the following sources:  (a)
personal property, (b) promissory notes, (c) land contracts, (d) litigation, and
(e) PMA savings.

     A.   Personal Property. DiVall and Magnuson appear to have very few
          unencumbered personal assets which would materially benefit the
          Partnerships. The Partnerships have obtained security interests in
          substantially all of DiVall and Magnuson's assets which have been
          identified. The security interests included a mortgage on DiVall's
          residence and surrounding farm land which was subsequently sold to a
          third party.

     B.   Promissory Notes. Pursuant to the PMA, DiVall, Magnuson, and entities
          owned by them, granted the Partnership a security interest in certain
          promissory notes and mortgages due from other DiVall related entities
          (the "Private Partnerships"). Recovery of amounts due under these
          notes is substantially complete, but the amount of such recoveries has
          been substantially discounted because many of the Private Partnerships
          are currently involved in bankruptcy proceedings. See Item 3, Legal
          Proceedings, for additional information regarding the bankruptcy
          proceedings of the Private Partnerships.

     C.   Land Contracts. The Partnerships were assigned two land contracts from
          the Partnership's former general partners. These contracts were not
          originally identified nor assigned in connection with the PMA and
          settlements have been received on these contracts.


     D.   Litigation. The Partnerships initiated lawsuits against the
          Partnership's former auditors, former securities counsel, former
          general partners and a former affiliate. Settlements were received
          during 1996. Refer to Item 3, Legal Proceedings, and Note 10 to the

                                       4
<PAGE>
 
          financial statements included in Item 8 below for additional
          information concerning the settlement of these lawsuits.
     
     E.   PMA Savings.  Pursuant to the terms of the PMA, The Provo Group, 
          Inc. is to account to the former general partners for all of the
          following which are avoided or reduced by implementation of the PMA:
          (i) Fees payable to the general partner or entities controlled by the
          general partner, (ii) brokerage commissions, and (iii) residuals.
          Under the PMA, all such savings shall be credited against the amounts
          due from the former general partners.

Total amounts recovered at December 31, 1997, amounted to $5,766,000, of which
approximately $2,689,000 was allocated to the Partnership.  Currently there are
few potential sources of recovery remaining.

The total amount due the Partnerships from the former general partners and their
affiliates as of December 31, 1997, as a result of the misappropriation of
assets, approximates $14,800,000, net of recoveries, which includes the amount
of the misappropriation discovered to date, related costs, and 9% interest
accrued since January 1, 1993.

The Partnership has no employees.

All of the Partnership's business is conducted in the United States.

Item 2.  Properties

The Partnership's properties are leased under 20 year leases.  All leases are
triple net which require the tenant to pay all property operating costs
including maintenance, repairs, utilities, property taxes, and insurance.  All
leases contain percentage rent provisions which require the tenant to pay a
specified percentage (3% to 7%) of gross sales above a threshold amount.

The Partnership owned the following properties (including specialty leasehold
improvements) as of December 31, 1997:

<TABLE>
<CAPTION>
                                                                                     Lease
Acquisi-       Property Name                             Purchase     Rental Per  Expiration   Renewal
tion Date        & Address               Lessee          Price (1)      Annum        Date      Options
---------  ----------------------  ------------------  -------------  ----------  -----------  --------
<C>        <S>                     <C>                 <C>            <C>         <C>          <C>
 08/14/90  Hardee's                Hardee's Food        1,648,569(2)      92,000   01/31/2010  None
           2450 E Layton Ave       Systems, Inc.
           St Francis, WI
 
 09/11/90  Applebee's              B.T. Woodlipp,       1,297,990(2)     116,040   11/30/2009  None
           2101 Greentree Rd       Inc.
           Pittsburgh, PA
 
 02/05/91  Hardee's                Hardee's Food        1,929,472(2)      88,000   05/31/2010  None
           9505 S 13th St          Systems, Inc.
           Oak Creek, WI
</TABLE>

                                       5
<PAGE>

<TABLE>
<CAPTION>
                                                                                                Lease
Acquisi-         Property Name                                 Purchase       Rental Per     Expiration      Renewal
tion Date          & Address                Lessee            Price (1)          Annum          Date         Options
---------     --------------------     -----------------     ------------       --------     -----------     -------
<C>           <S>                      <C>                   <C>                <C>          <C>             <C>
07/01/91      Denny's                  DenAmerica, Inc.           424,187(2)      35,880      06/30/2011      None
              9060 Arapahoe Rd
              Englewood, CO

11/13/91      Denny's                  Cypress                  1,479,269(2)     140,340      01/31/2011      None
              3771 Orlando Dr          Restaurants, Inc.
              Sanford, FL

04/28/92      Denny's                  DenAmerica, Inc.           791,159(2)      77,460      05/31/2012       (3)
              4375 Sinton Rd                                   ----------       --------
              Colorado Springs, CO

                                                               $7,570,646       $549,720
                                                               ==========       ========
</TABLE>

Footnotes.

(1)  Purchase price includes all costs incurred to acquire the property.
(2)  Purchase price includes cost of specialty leasehold improvements.
(3)  Renewal options available.

During 1997, the Partnership sold its Hardee's property in Wahoo, Nebraska for
approximately $405,000, resulting in a gain, before disposition fees, of
approximately $8,000.

During January 1998, the Partnership sold its Denny's property in Sanford,
Florida to the tenant for $1,250,000, resulting in a gain, before disposition
fees, of approximately $240,000.

Item 3.  Legal Proceedings

In 1993, the Partnership, along with DiVall 1 and DiVall 2, initiated a lawsuit
against Ernst & Young LLP ("E&Y"), a certified public accounting firm, in
connection with the audits of the Partnerships performed by E &Y for the years
1989, 1990 and 1991. The Partnerships also filed claims against Magnuson,
DiVall, DiVall Real Estate Investment Corporation, David Shea, and the
Partnerships' former securities law firm, Quarles & Brady.

These matters were settled in 1996, yielding net proceeds to the Partnership,
after the payment of contingent legal fees and related costs, of approximately
$1,000,000.

As part of the Permanent Manager Agreement, DiVall, Magnuson, and entities owned
by them, granted the Partnership a security interest in certain promissory notes
and mortgages from other DiVall related entities (the "Private Partnerships").
In the aggregate, the face amount of these notes was equal to a minimum of
$8,264,932. In addition, DiVall, Magnuson, and related entities owned by them,
granted the Partnership a security interest in their general partner interests
in the Private Partnerships. The foregoing security interests were to secure the
repayment of the funds which were diverted by DiVall and Magnuson from the
Partnership. The Partnership shares such security interests with DiVall 1 and
DiVall 2. These promissory notes and mortgages are not recorded on the balance
sheets of the Partnerships, but are recorded as recoveries on a cash basis upon
settlement.

                                       6
<PAGE>
 
In 1993, nineteen (19) of the Private Partnerships sought the protection of the
Bankruptcy Court in the Eastern District of Wisconsin. Seven (7) of these
bankruptcies were voluntary and twelve (12) of these bankruptcies were
involuntary. Several of the Private Partnerships seeking bankruptcy owe
promissory notes to DiVall, Magnuson, or entities owned by them, in which the
Partnership has a security interest. These cases were subsequently transferred
to the Western District Bankruptcy Court located in Madison, Wisconsin.

The Partnership's experience in those bankruptcy cases that have concluded,
either through the approval of Plans of Reorganization, dismissal of the
bankruptcies, settlements or a combination of the foregoing, is that (i) the
value of the obligations of the Private Partnerships assigned to the
Partnerships have been at a significant discount to their face amounts, and (ii)
the General Partner interests in such Private Partnerships often have little
economic value. The Partnership's recoveries in these bankruptcies have been on
a steeply discounted basis.

Plans of reorganization have been filed in the bankruptcies, and settlement
agreements in all of the Private Partnerships have been reached. Settlements in
the bankruptcies have resulted in cash payments to the Partnerships in the
amount of $720,000 and notes secured by subordinated mortgages in the aggregate
amount of $625,000. The Partnerships subsequently sold the secured notes for a
total of $175,000.

The Partnerships have been named as defendants in certain foreclosure actions
brought in state courts in Wisconsin. In each of these actions, the plaintiff
seeks to foreclose on real property owned by one of the Private Partnerships.
The Partnerships were named as subordinate lienholders on the properties. It is
believed that none of these cases constitute a claim against the individual
Public Partnerships. However, if the foreclosures are successful, the Private
Partnerships' interest in the underlying real estate may be extinguished,
rendering individual obligations to the Partnerships uncollectible. Such a
foreclosure has occurred in one instance and is pending in at least one other
situation.

Item 4.  Submission of Matters to a Vote of Security Holders

Not applicable.

                                    PART II

Item 5.  Market Price and Dividends on Registrant's Common Equity and Related
         Stockholder Matters

(a)  Although some interests have been traded, there is no active public market
     for limited partnership interests and it is not anticipated that an active
     public market for limited partnership interests will develop.

(b)  As of December 31, 1997, there were 1,093 record holders of limited
     partnership interests in the Partnership.

(c)  The Partnership does not pay dividends. However, the Partnership Agreement,
     as amended, provides for distributable net cash receipts of the Partnership
     to be distributed on a quarterly or monthly basis, 99% to the Limited
     Partners and 1% to the General Partner, subject to the limitations on
     distributions to the General Partner described in the Amended Partnership
     Agreement. During 1997 and 1996, $1,650,000 and $1,650,000,

                                       7
<PAGE>
 
         respectively, were distributed in the aggregate to the Limited
         Partners. In 1997, the General Partner received aggregate distributions
         of $2,418, and $2,789, respectively.

Item 6.  Selected Financial Data

                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                       (a Wisconsin limited partnership)

                 December 31, 1997, 1996, 1995, 1994, and 1993
                 (not covered by Independent Auditors' Report)
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------
                       1997        1996        1995        1994         1993
-------------------------------------------------------------------------------
<S>                 <C>         <C>         <C>         <C>         <C>
Total Revenue       $  939,210  $1,812,164  $  951,189  $1,079,845  $ 1,173,258
-------------------------------------------------------------------------------
Net Income
(Loss)                 604,505     697,472      20,425     385,971     (128,731)
-------------------------------------------------------------------------------
Net Income
(Loss) per
Limited Partner
Interest                 34.99       40.37        1.18       22.34        (7.64)
-------------------------------------------------------------------------------
Total Assets         5,543,931   6,720,437   8,001,587   8,723,385   10,831,833
-------------------------------------------------------------------------------
Total Partners'
Capital              5,438,132   6,486,045   7,441,362   8,155,826    9,879,128
-------------------------------------------------------------------------------
Cash
Distributions
per Limited
Partnership
Interest                 96.48       96.48       42.98      123.24        27.00
-------------------------------------------------------------------------------
</TABLE>
(a)  The above selected financial data should be read in conjunction with the
     financial statements and the related notes appearing elsewhere in this
     annual report.

                                       8
<PAGE>
 
Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations

Liquidity and Capital Resources:

Investment Properties and Net Investment in Direct Financing Leases

The investment properties, including equipment held by the Partnership at
December 31, 1997, were originally purchased at a price, including acquisition
costs, of approximately $7,571,000.

Terratron, Inc. the lessee of two (2) Hardee's restaurants has experienced sales
difficulties over the past three years.  Effective December 31, 1995, management
entered into a one-year lease modification with the tenant which reduced base
rents for 1996 by approximately $85,000, Additionally, delinquent rent totaling
$46,000 was capitalized into a five (5)-year note accruing interest at 10% per
anum.  The amount of rent capitalized was also written off as uncollectible.
During the Fourth Quarter of 1996, management terminated the leases with
Terratron and entered into new leases with Hardee's Food Systems, Inc.  In
connection with this transaction, the capitalized rent was received.  The new
leases resulted in annual rents which are $142,000 lower than Terratron's
contract rents and $57,000 lower than 1996 adjusted rents.  In exchange for the
reduction in fixed rents, the new leases call for the payment of 8% percentage
rents on all sales over decreased breakpoints from those in the original leases.

During 1997, the Partnership sold its Hardee's property in Wahoo, Nebraska for
approximately $405,000, resulting in a gain, before disposition fees, of
approximately $8,000.

The net investment in direct financing leases, which includes the Partnership's
specialty leasehold improvement leases, were all expired or terminated at
December 31, 1997, compared to $25,000 outstanding  at December 31, 1996.  The
decrease was a result of principal payments received.

Other Assets

Cash and cash equivalents, including cash restricted for real estate taxes held
by the Partnership, were $595,000 at December 31, 1997, compared to $1,237,000
at December 31, 1996.  The Partnership designated cash of $385,000 to fund the
Fourth Quarter 1997 distributions to Limited Partners paid in February 1998;
$70,000 for the payment of year-end accounts payable and accrued expenses; and
the remainder represents reserves deemed necessary to allow the Partnership to
operate normally.  The decrease is primarily due to recoveries received during
the Fourth Quarter of 1996 and cash received from the sale of equipment which
was distributed during the First Quarter of 1997.  Cash generated through the
operations of the Partnership's investment properties, and sales of investment
properties will provide the sources for future fund liquidity and Limited
Partner distributions.

The Partnership established an Indemnification Trust (the "Trust") during the
Fourth Quarter of 1993 and deposited $130,000 in the Trust during 1994, $100,000
during 1995 and $20,000 during 1996.  The provision to establish the Trust was
included in the Permanent Manager Agreement for the indemnification of TPG, in
the absence of fraud or gross negligence, from any claims or liabilities that
may arise from TPG 

                                       9
<PAGE>
 
acting as Permanent Manager. The Trust is owned by the Partnership. For
additional information regarding the Trust, refer to Note 8 to the financial
statements included in Item 8 of this report.

Due From Former Affiliates, Allowance for Uncollectible Amounts Due From Former
Affiliates and Due to Affiliated Partnerships

Due from former affiliates represented misappropriated assets due from the
former general partners and their affiliates in the amount of $1,734,000 at
December 31, 1997.  The receivable decreased from the prior year due to $283,000
of recoveries received during the year from the former general partners and
their affiliates, including a settlement received from DiVall 1 as a result of a
favorable outcome in a disputed note with Boatmen's First National Bank of
Kansas City.

The Partnership maintains a record of costs incurred in identifying or
recovering the misappropriated assets.  These amounts are expensed when
incurred, and then recorded on the balance sheet as a restoration cost
receivable with a corresponding allowance for such receivable deemed
uncollectible.  These costs are considered due from the former general partners
and their affiliates.  Interest has been accrued on the misappropriated funds
since January 1, 1993, at a rate of 9% per annum and has been included in the
restoration cost receivable.  The receivable increased from approximately
$4,509,000 at December 31, 1996 to $5,181,000 at December 31, 1997, and includes
$2,814,000 of cumulative accrued interest.

In 1993, the current General Partner estimated an aggregate recovery of $3
million for the Partnerships. At that time, an allowance was established against
amounts due from former general partners and their affiliates reflecting the
estimated $3 million receivable.  This net receivable was allocated among the
Partnerships based on each Partnership's pro rata share of the total
misappropriation.  Through December 31, 1997, $5,766,000 of recoveries have been
received which exceeded the original estimate of $3 million. As a result, the
Partnership has recognized $1,283,000 as income, which represents its share of
the excess recovery.  The current General Partner continues to pursue recoveries
of the misappropriated funds, however, no further significant recoveries are
anticipated.

The restoration costs are allocated among the Partnerships based on each
Partnership's respective share of the misappropriation as discussed in Note 9 to
the financial statements included in Item 8 of this report. The allocation is
adjusted periodically to reflect any changes in the entire misappropriation.
The Partnership's percentage of the allocation was increased in 1993.

Liabilities

Accounts payable and accrued expenses at December 31, 1997, in the amount of
$25,000, primarily represented accruals of legal and auditing fees.

Due to current General Partner amounted to $49,000 at December 31, 1996, and
consisted of a true-up of the management fee for the year, leasing commissions
on the leases executed with Hardee's Food Systems, Inc.  and the Fourth Quarter
distribution.  These amounts were paid to the General Partner during the First
Quarter of 1997.  The December 31, 1997 balance of $1,395 represents the General
Partner's portion of the Fourth Quarter distribution.

                                       10
<PAGE>
 
Real estate taxes payable amounted to $81,000 at December 31, 1996, primarily
due to the collection of all 1996 taxes due in 1997 in connection with the
Terratron lease termination.  These amounts were paid in full during 1997.

Partners' Capital

Net income for the year was allocated between the General Partner and the
Limited Partners, 1% and 99%, respectively, as provided in the Partnership
Agreement and the Amendment to the Partnership Agreement, as discussed more
fully in Note 4 of the financial statements included in Item 8 of this report.
The former general partners' capital account balance was reallocated to the
Limited Partners at December 31, 1993. Refer to Note 11 to the financial
statements included in Item 8 of this report for additional information
regarding the reallocation.

Cash distributions paid to the Limited Partners and to the General Partner
during 1997, of $1,650,000 and $2,418, respectively, have also been made in
accordance with the amended Partnership Agreement.  The Fourth Quarter 1997
distribution of $385,000 was paid to the Limited Partners on February 15, 1998.

Results of Operations:

The Partnership reported  net income for the year ended December 31, 1997, in
the amount of $605,000 compared to net income for the years ended December 31,
1996 and 1995 of $697,000 and $20,000. Results for all three years were
different than would be expected from "normal" operations, primarily because of
costs associated with misappropriation of assets by the former general partners
and their affiliates.  These costs increased significantly during 1995 and 1996
as the lawsuit against the former general partner accountants and attorneys got
closer to trial as well as the payment of contingent legal fees upon settlement
of the litigation.  During 1997, Restoration Costs had only a minimal impact on
operations. Additionally, non-cash write-offs of uncollectible rent and
equipment lease losses amounted to $46,000 and $97,000, respectively, in 1995,
and equipment losses totaled $116,000 in 1996.  In addition, 1996 and 1997
results were impacted by the reversal of a portion of the former general partner
receivable write-off.

Revenues

Total revenues were $939,000, $1,812,000, and $951,000, for the years ended
December 31, 1997, 1996, and 1995, respectively.  Revenue in 1996 included a
$1,000,000 reversal of a prior year write-off of the former general partner
receivable due to recoveries received in excess of original estimates.  The 1997
reversal amounted to $283,000.

Total revenues should approximate $600,000 annually, based on leases currently
in place.  Future revenues may decrease with tenant defaults and/or sales of
Partnership properties.  They may also increase with additional rents due from
tenants, if those tenants experience sales levels which require the payment of
additional rent to the Partnership.

Expenses

For the years ended December 31, 1997, 1996, and 1995, cash expenses amounted to
approximately 24%, 48%, and 70% of total revenues, respectively.  Total
expenses, including non-cash items, amounted to 

                                       11
<PAGE>
 
36%, 62%, and 98% of total revenues for the years ended December 31, 1997, 1996,
and 1995, respectively. Items negatively impacting expenses during the last
three years are expenses incurred primarily in relation to the misappropriation
of assets by the former general partners and their affiliates, write-offs of
uncollectible rent and losses on equipment leases.

For the years ended December 31, 1997, 1996, and 1995, expenses incurred in
relation to the misappropriated assets amounted to $38,000, $609,000, and
$483,000, respectively.  Future expenses incurred in relation to the
misappropriation should have a minimal impact on the Partnership.

Additional expenses impacting operating results are restoration fees paid on
recoveries received, write-downs of equipment lease residuals, losses on
equipment lease terminations, allowances for uncollectible rent, and losses on
disposition of assets and related selling costs.   The losses, write-offs, and
depreciation are non-cash items and do not affect current operating cash flow of
the Partnership or distributions to the Limited Partners.

Inflation:

Inflation has a minimal effect on operating earnings and related cash flows from
a portfolio of triple net leases.  By their nature, such leases actually fix
revenues and are not impacted by rising costs of maintenance, insurance, or real
estate taxes.  Although the Partnership's leases have percentage rent clauses,
percentage rents represented only 3% of total rental income for 1997.  If
inflation causes operating margins to deteriorate for lessees, if expenses grow
faster than revenues, then, inflation may well negatively impact the portfolio
through tenant defaults.

It would be misleading to associate inflation with asset appreciation for real
estate, in general, and the Partnership's portfolio, specifically.  Due to the
"triple net" nature of the property leases, asset values generally move
inversely with interest rates.

Year 2000

Since the Partnership's accounting and investor relations software are not owned
by the Partnership and tenants are responsible for the operation of any
equipment located at the Partnership's properties, issues regarding preparedness
for the year 2000 should have a minimal impact on the Partnership.

                                       12
<PAGE>
 
Item 8.  Financial Statements and Supplementary Data

                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                ----------------------------------------------
                
                       (a Wisconsin limited partnership)
                       ---------------------------------

                  INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
                  -------------------------------------------

<TABLE>
<CAPTION>
                                                                         Page
                                                                         ----
<S>                                                                      <C>
 
     Report of Independent Public Accountants..........................  14
 
     Balance Sheets, December 31, 1997 and 1996........................  15 - 16
 
     Statements of Income for the Years
     Ended December 31, 1997, 1996, and 1995...........................  17
 
     Statement of Partners' Capital for the
     Years Ended December 31, 1997, 1996,
     and 1995..........................................................  18
 
     Statements of Cash Flows for the Years
     Ended December 31, 1997, 1996, and 1995...........................  19 - 20
 
     Notes to Financial Statements.....................................  21 - 30
 
     Schedule III--Real Estate and Accumulated
     Depreciation......................................................  36
</TABLE>

                                      13

<PAGE>

                              Arthur Andersen LLP


 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS




To the Partners of
Divall Income Properties 3 Limited Partnership:

We have audited the accompanying balance sheets of Divall Income Properties 3 
Limited Partnership (the Partnership) as of December 31, 1997 and 1996, and the 
related statements of income, partners' capital and cash flows for each of the 
three years in the period ended December 31, 1997. These financial statements 
are the responsibility of the Partnership'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 Divall Income Properties 3 
Limited Partnership as of December 31, 1997 and 1996, and the results of its 
operations and its cash flows for each of the three years in the period ended 
December 31, 1997, in conformity with generally accepted accounting principles.

Our audit was made for the purpose of forming an opinion on the basic financial 
statements taken as a whole. The schedule listed in the index of financial 
statements is presented for purposes of complying with the Securities and 
Exchange Commission's rules and is not part of the basic financial statements. 
This schedule has been subjected to the auditing procedures applied in the audit
of the basic financial statements and, in our opinion, fairly states in all 
material respects the financial data required to be set forth therein in 
relation to the basic financial statements taken as a whole.


/s/ Arthur Andersen LLP


Chicago, Illinois
February 26, 1998

<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                                BALANCE SHEETS
                          December 31, 1997 and 1996
                          --------------------------
                                    ASSETS
<TABLE>
<CAPTION>
                                                                     December 31,   December 31,
                                                                         1997           1996
                                                                     ------------   ------------
INVESTMENT PROPERTIES:  (Note 3)
<S>                                                                   <C>            <C>
     Land                                                             $ 2,030,982    $ 2,085,836
     Buildings and improvements                                         3,309,464      3,762,726
     Accumulated depreciation                                            (761,861)      (761,761)
                                                                      -----------    -----------
        Net investment properties                                       4,578,585      5,086,801
                                                                      -----------    -----------
NET INVESTMENT IN DIRECT FINANCING LEASES:                                      0         25,017
                                                                      -----------    -----------
OTHER ASSETS:
     Cash and cash equivalents                                            595,420      1,155,128
     Cash restricted for real estate taxes                                      0         81,447
     Cash held in indemnification trust (Note 8)                          290,662        276,248
     Rents and other receivables                                           23,062         27,186
     Deferred rent receivable                                              31,029         41,108
     Deferred fees                                                         21,524         23,310
     Prepaid assets                                                         3,649          4,192
                                                                      -----------    -----------
        Total other assets                                                965,346      1,608,619
                                                                      -----------    -----------
DUE FROM FORMER AFFILIATES: (Note 2)
     Due from former general partner affiliates                         1,734,417      2,017,488
     Allowance for uncollectible amounts due from former affiliates    (1,734,417)    (2,017,488)
     Restoration cost receivable                                        5,181,441      4,509,417
     Allowance for uncollectible restoration receivable                (5,181,441)    (4,509,417)
                                                                      -----------    -----------
        Due from former affiliates, net                                         0              0
                                                                      -----------    -----------

        Total assets                                                  $ 5,543,931    $ 6,720,437
                                                                      ===========    ===========
</TABLE>

       The accompanying notes are an integral part of these statements.

                                      15

<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                                 BALANCE SHEETS
                           December 31, 1997 and 1996
                           --------------------------
                       LIABILITIES AND PARTNERS' CAPITAL
<TABLE>
<CAPTION>
                                                                         December 31   December 31, 
                                                                             1997          1996     
                                                                         ------------  -------------
LIABILITIES:                                                                                        
<S>                                                                      <C>           <C>          
   Accounts payable and accrued expenses                                 $    25,331    $    30,280 
   Due to current General Partner                                              1,395         49,327 
   Security deposits                                                          36,819         46,979 
   Real estate taxes payable                                                       0         81,217 
   Unearned rental income                                                     42,254         26,589 
                                                                         -----------    ----------- 
     Total liabilities                                                       105,799        234,392 
                                                                         -----------    ----------- 
CONTINGENT LIABILITIES: (Note 7)                                                                    
                                                                                                    
PARTNERS' CAPITAL: (Notes 1, 4 and 11)                                                              
   Current General Partner -                                                                        
     Cumulative net income                                                    15,445          9,400 
     Cumulative cash distributions                                            (6,640)        (4,222)
                                                                         -----------    ----------- 
                                                                                                    
                                                                               8,805          5,178 
                                                                         -----------    ----------- 
   Limited Partners (17,102.52 interests outstanding)                                               
     Capital contributions, net of offering costs                         14,408,872     14,408,872 
     Cumulative net loss                                                    (226,070)      (824,530)
     Cumulative cash distributions                                        (8,487,984)    (6,837,984)
     Reallocation of former general partners' deficit capital               (265,491)      (265,491)
                                                                         -----------    ----------- 
                                                                           5,429,327      6,480,867 
                                                                         -----------    ----------- 
       Total partners' capital                                             5,438,132      6,486,045 
                                                                         -----------    ----------- 
       Total liabilities and partners' capital                           $ 5,543,931    $ 6,720,437 
                                                                         ===========    =========== 
</TABLE>

       The accompanying notes are an integral part of these statements.

                                      16

<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                              STATEMENTS OF INCOME
             For the Years Ended December 31, 1997, 1996, and 1995
             -----------------------------------------------------
<TABLE>
<CAPTION>
 
                                                              1997       1996       1995  
                                                            --------  ----------  --------
<S>                                                         <C>       <C>         <C>     
REVENUES:                                                                                 
  Rental income                                             $597,697  $  674,703  $758,852
  Interest income on direct financing leases                   1,708      85,204   118,763
  Interest income                                             31,435      51,243    57,163
  Other income                                                17,714       1,217    16,411
  Gain on sale of assets                                       7,585           0         0
  Recovery of amounts previously written off                                           
  (Notes 9 and 10)                                           283,071     999,797         0
                                                            --------  ----------  --------
                                                             939,210   1,812,164   951,189
                                                            --------  ----------  --------
                                                                                          
EXPENSES:                                                                                 
                                                                                          
  Management fees (Note 6)                                    52,177      86,826    56,829
  Disposition fees (Note 6)                                   12,150           0         0
  Restoration fees (Note 6)                                   11,323      63,163     3,028
  Insurance                                                    4,925       5,112     4,843
  General and administrative                                  39,119      43,875    40,092
  Advisory Board fees and expenses                            14,752      16,332    18,603
  Interest                                                         0           0     3,293
  Professional services                                       49,768      53,761    53,511
  Professional services related to Investigation              37,754     609,079   483,320
  Depreciation                                               110,951     117,318   117,318
  Amortization                                                 1,786           0     7,566
  Loss on equipment leases                                         0     115,726    96,631
  Allowance for Uncollectible Rent                                 0           0    45,730
  Write-down of property to net realizable value                   0       3,500         0
                                                            --------  ----------  --------
                                                             334,705   1,114,692   930,764
                                                            --------  ----------  --------
NET INCOME                                                  $604,505  $  697,472  $ 20,425
                                                            ========  ==========  ========
NET INCOME - CURRENT GENERAL PARTNER                        $  6,045  $    6,975  $    204
NET INCOME  - LIMITED PARTNERS                               598,460     690,497    20,221
                                                            --------  ----------  --------
                                                            $604,505  $  697,472  $ 20,425
                                                            ========  ==========  ========
NET INCOME PER LIMITED                                                                   
  PARTNERSHIP INTEREST, based on 17,102.52                                                
  interests outstanding                                     $  34.99  $    40.37  $   1.18
                                                            ========  ==========  ======== 
</TABLE>

       The accompanying notes are an integral part of these statements.

                                      17

<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                        STATEMENTS OF PARTNERS' CAPITAL

              For the years ended December 31, 1997, 1996 and 1995
              ----------------------------------------------------
<TABLE>
<CAPTION>
                                Current General Partner                                 Limited Partners
                            --------------------------------- ---------------------------------------------------------------------
                                                                 Capital
                                          Cumulative          Contributions,  Cumulative     Cumulative
                            Cumulative      Cash                  Net of      Net Income       Cash
                            Net Income  Distributions  Total  Offering Costs    (Loss)     Distributions  Reallocation     Total
                            ----------  ------------- ------- -------------- ------------  -------------  ------------ ------------
<S>                         <C>         <C>           <C>     <C>            <C>           <C>            <C>           <C>
BALANCE AT DECEMBER 31,
 1994                        $ 2,221       $(1,544)   $   677  $14,408,872    $(1,535,248)  $(4,452,984)   $(265,491)  $ 8,155,149
Cash Distributions
   ($42.98 per limited
    partnership interest
    outstanding)                               111        111                                  (735,000)                  (735,000)
Net Income                       204                      204                      20,221                                   20,221
                             -------       -------    -------  -----------    -----------   -----------    ---------   -----------
BALANCE AT DECEMBER 31,
 1995                        $ 2,425       $(1,433)   $   992  $14,408,872    $(1,515,027)  $(5,187,984)   $(265,491)  $ 7,440,370
Cash Distributions
   ($96.48 per limited
    partnership interest
    outstanding)                            (2,789)    (2,789)                               (1,650,000)                (1,650,000)
Net Income                     6,975                    6,975                     690,497                                  690,497
                             -------       -------    -------  -----------    -----------   -----------    ---------   -----------
BALANCE AT DECEMBER 31,
 1996                        $ 9,400       $(4,222)   $ 5,178  $14,408,872    $  (824,530)  $(6,837,984)   $(265,491)  $ 6,480,867
Cash Distributions
    ($96.48 per limited
     partnership
     interest outstanding)                  (2,418)    (2,418)                               (1,650,000)                (1,650,000)
Net Income                     6,045                    6,045                     598,460                                  598,460
                             -------       -------    -------  -----------    -----------   -----------    ---------   -----------
BALANCE AT DECEMBER 31,
 1997                        $15,445       $(6,640)   $ 8,805  $14,408,872    $  (226,070)  $(8,487,984)   $(265,491)  $ 5,429,327
                             =======       =======    =======  ===========    ===========   ===========    =========   ===========
</TABLE>
        The accompanying notes are an integral part of these statements.

                                       18
<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
                            STATEMENTS OF CASH FLOWS
             For the Years Ended December 31, 1997, 1996, and 1995
             -----------------------------------------------------

<TABLE>
<CAPTION>
 
                                                                                                  1997          1996         1995
                                                                                              ------------  ------------  ----------
<S>                                                                                           <C>           <C>           <C>
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
     Net income                                                                               $   604,505   $   697,472   $  20,425
     Adjustments to reconcile net income to net cash from (used in) operating activities -
          Depreciation and amortization                                                           112,737       117,318     124,884
          Write-down of property to net realizable value                                                0         3,500           0
          Net gain on disposition                                                                  (7,585)            0           0
          Recovery of amounts previously written off                                             (283,071)     (999,797)          0
          Provision for uncollectible rent                                                              0             0      45,730
          Loss on equipment leases                                                                      0       115,726      96,631
          Interest applied to Indemnification Trust Account                                       (14,414)      (13,523)    (12,438)
          (Increase) Decrease in rents, other receivables and prepaid assets                        4,667          (729)    (50,408)
          (Increase)/Decrease in deferred rent receivable                                          10,079         1,796      (1,829)
          Deposits (received) applied for real estate taxes                                        81,447       (38,648)      8,314
          Increase/(Decrease) in accounts payable and accrued expenses                             (4,949)     (221,668)    176,024
          Increase/(Decrease) in due to General Partner                                           (47,932)       26,017        (358)
          (Decrease) in security deposits                                                         (10,160)      (10,614)          0
          Increase/(Decrease) in real estate taxes payable                                        (81,217)       78,033     (47,834)
          Increase/(Decrease) in unearned rental income                                            15,665        26,589      (5,690)
                                                                                              -----------   -----------   ---------

               Net cash provided from (used in) operating activities                              379,772      (218,528)    353,451
                                                                                              -----------   -----------   ---------
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
     Principal payments received on direct financing leases                                        25,017       753,954     332,797
     Deposit to Indemnification Trust Account                                                           0       (20,000)   (100,000)
     Recoveries from former G.P. affiliates                                                       283,071     2,066,936      75,697
     Proceeds from sale of land and buildings                                                     404,850        36,176           0
     Proceeds from land easement                                                                        0             0      17,000
     Principal receipts from note                                                                       0        79,001     115,105
                                                                                              -----------   -----------   ---------

               Net cash provided from investing activities                                        712,938     2,916,067     440,599
                                                                                              -----------   -----------   ---------
 
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES:
     Principal payments on mortgage note                                                                0             0     (79,298)
     Payments of amounts due to affiliated partnerships                                                 0      (201,912)    (50,178)
     Cash distributions (to) from General Partner                                                  (2,418)       (2,789)        111
     Cash distributions (to) Limited Partners                                                  (1,650,000)   (1,650,000)   (735,000)
                                                                                              -----------   -----------   ---------

               Net cash (used in) financing activities                                         (1,652,418)   (1,854,701)   (864,365)
                                                                                              -----------   -----------   ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                             (559,708)      842,838     (70,315)

CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                                  1,155,128       312,290     382,605
                                                                                              -----------   -----------   ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR                                                      $   595,420   $ 1,155,128   $ 312,290
                                                                                              ===========   ===========   =========
SUPPLEMENTAL DISCLOSURE--cash paid for interest                                               $         0   $         0   $   3,293
                                                                                              ===========   ===========   =========
</TABLE>
 
       The accompanying notes are an integral part of these statements.

                                       19
<PAGE>
 
            Supplemental Information to the Statements of Cash Flows
            --------------------------------------------------------

The following significant non-cash transactions occurred during the three years
affecting the Partnership's financial statements:

     1.   During 1996, the Partnership was deeded land with a value of $36,176
          in exchange for a note receivable from a tenant.

     2.   During 1996, security deposits totaling $45,588 were applied as
          equipment lease payments for a tenant.

     3.   During 1996, the Partnership incurred leasing commissions totaling
          $23,310 which were unpaid at year-end. The amount was paid in full
          during 1997.

       The accompanying notes are an integral part of these statements.

                                      20
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                         NOTES TO FINANCIAL STATEMENTS

                       DECEMBER 31, 1997, 1996, AND 1995

1.   ORGANIZATION AND BASIS OF ACCOUNTING:
     -------------------------------------

DiVall Income Properties 3 Limited Partnership (the "Partnership") was formed on
December 12, 1989, pursuant to the Uniform Limited Partnership Act of the State
of Wisconsin.  The initial capital which was contributed during 1989, consisted
of $300, representing aggregate capital contributions of $200 by the former
general partners and $100 by the Initial Limited Partner.

The Partnership initially offered two classes of Limited Partnership interests
for sale:  Distribution interests ("D-interests") and Retention interests ("R-
interests").  Each class was offered at a price (before volume discounts) of
$1,000 per interest.  The Partnership offered the two classes of interests
simultaneously up to an aggregate of 25,000 interests.

The minimum offering requirements for the D-interests were met and escrowed
subscription funds were released to the Partnership as of July 13, 1990.  The
offering closed on April 23, 1992, at which point 17,102.52 D-interests had been
issued, resulting in aggregate proceeds, net of discounts and offering costs, of
$14,408,872.

The minimum offering requirements for R-interests were not met.   During 1991,
680.9 R-interests were converted to D-interests and were reflected as
Partnership issuances in 1991.

The Partnership is currently engaged in the business of owning and operating its
investment portfolio (the "Properties") of commercial real estate.  The
Properties are leased on a triple net basis to, and operated by, franchisors or
franchisees of national, regional and local retail chains under long-term
leases.  The lessees consist of fast-food, family style, and casual/theme
restaurants.  At December 31, 1997, the Partnership owned six (6) properties and
specialty leasehold improvements for use in all six (6) of the Properties.

Rental revenue from investment properties is recognized on the straight-line
basis over the life of the respective lease.  Revenue from direct financing
leases is recognized at level rates of return over the term of the lease.

Depreciation of the properties is provided on a straight-line basis over 31.5
years, which is the estimated useful lives of the buildings and improvements.

Deferred charges represent leasing commissions paid when properties are leased
to tenants other than the original tenant.  Leasing commissions are capitalized
and amortized over the life of the lease.

Real estate taxes on the Partnership's investment properties are the
responsibility of the tenant.  However, when a tenant fails to make the required
tax payments or when a property becomes vacant, the Partnership 

                                      21
<PAGE>
 
makes the appropriate payment to avoid possible foreclosure of the property.
Taxes are accrued in the period for which the liability is incurred.

Cash and cash equivalents include cash on deposit in financial institutions and
highly liquid temporary investments with initial maturities of 90 days or less.

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 (and disclosure of
contingent assets and liabilities) at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

During 1996, the Partnership adopted Statement of Financial Accounting Standards
No.121 ("SFAS 121"), Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of, which requires that all long-lived assets
be reviewed for impairment in value whenever changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.  The adoption of
SFAS 121 had no impact on the Partnership's financial statements in 1996 or
1997.

The Partnership will be dissolved on December 1, 2015, or earlier upon the prior
occurrence of any of the following events:  (a)  the disposition of all
interests in real estate and other Partnership assets; (b)  the decision by
Majority Vote of the Limited Partners to dissolve the Partnership or to compel
the sale of all or substantially all of the Partnership's assets; (c)  the
failure to elect a successor General Partner within six months after removal of
the last remaining General Partner; or (d) the date of the death or the
effective date of dissolution, removal, withdrawal, bankruptcy, or incompetency
of the last remaining General Partner, unless the Partnership is continued by
vote of all Limited Partners and a replacement General Partner is previously
elected by a majority of the Limited Partners.

No provision for Federal income taxes has been made, as any liability for such
taxes would be that of the individual partners rather than the Partnership.  At
December 31, 1997, the tax basis of the Partnership's assets exceeded the
amounts reported in the accompanying financial statements by approximately
$2,800,000.

The following represents a reconciliation of net income as stated on the
Partnership's statements of income to net income for tax reporting purposes:
<TABLE>
<CAPTION>
                                                1997       1996       1995
                                             ---------  ----------  ---------
     <S>                                      <C>        <C>         <C>
     Net income per statements of income      $604,505   $ 697,472   $ 20,425

     Book to tax depreciation difference         8,014       8,491      8,525

     Straight line rent adjustment             (10,079)     (1,796)    (1,829)

     Allowance for receivables                       0     (45,730)    45,730

     Loss on equipment leases                        0     (53,288)    90,822

     Other, net                                  5,231    (168,552)    (5,510)
                                              --------   ---------   --------
     Net income for tax reporting purposes    $607,671   $ 436,597   $158,163
                                              ========   =========   ========
</TABLE>
                                      22
<PAGE>
 
2.   REGULATORY INVESTIGATION:
     -------------------------

A preliminary investigation during 1992 by the Office of the Commissioner of
Securities for the State of Wisconsin and the Securities and Exchange Commission
(the "Investigation") revealed that during at least the three years ended
December 31, 1992, the former general partners of the Partnership, Gary J.
DiVall ("DiVall") and Paul E. Magnuson ("Magnuson") had transferred substantial
cash assets of the Partnership and two affiliated publicly registered
partnerships, DiVall Insured Income Fund Limited Partnership ("DiVall 1") and
DiVall Insured Income Properties 2 Limited Partnership ("DiVall 2")
(collectively the "Partnerships") to various other entities previously sponsored
by or otherwise affiliated with DiVall and Magnuson.  The unauthorized transfers
were in violation of the respective Partnership Agreements and resulted, in
part, from material weaknesses in the internal control system of the
Partnerships.  The aggregate amount of the misappropriation, related costs, and
9% interest accrued since January 1, 1993, is approximately $14,800,000, of
which approximately $6,916,000 has been attributed to the Partnership and is
reflected as due from former affiliates on the balance sheet at December 31,
1997.  The 9% interest accrued as of December 31, 1997, amounted to
approximately $2,814,000 and is not reflected in the accompanying income
statement.  As of December 31, 1996, $6,527,000 was reflected as due from former
affiliates based on an estimated overall misappropriation and related costs of
$14,000,000.

Subsequent to discovery, and in response to the regulatory inquiries, a third-
party Permanent Manager, The Provo Group, Inc. ("TPG"), was appointed (effective
February 8, 1993) to assume responsibility for daily operations and assets of
the Partnerships as well as to develop and execute a plan of restoration for the
Partnerships.  Effective May 26, 1993, the Limited Partners, by written consent
of a majority of interests, elected the Permanent Manager, TPG, as General
Partner.  TPG terminated the former general partners by accepting their tendered
resignations.

In 1993, the current General Partner estimated an aggregate recovery of $3
million for the Partnerships. At that time, an allowance was established against
amounts due from former general partners and their affiliates reflecting the
estimated $3 million receivable.  This net receivable was allocated among the
Partnerships based on each Partnership's pro rata share of the total
misappropriation.  Through December 31, 1997, $5,766,000 of recoveries have been
received which exceeded the original estimate of $3 million. As a result, the
Partnership has recognized $1,283,000 as income, which represents its share of
the excess recovery.  The current General Partner continues to pursue recoveries
of the misappropriated funds, however, no further significant recoveries are
anticipated.

3.   INVESTMENT PROPERTIES:
     ----------------------

As of December 31, 1997, the Partnership owned six (6) fast-food restaurants
comprised of:  two (2) Hardee's restaurants, one (1) Applebee's restaurant, and
three (3) Denny's restaurants.  The six (6) properties are located in four (4)
states.

Terratron, Inc. the former lessee of the two (2) Hardee's restaurants has
experienced sales difficulties over the past three years.  Effective December
31, 1995, management entered into a one-year lease modification with the tenant
which reduced base rents for 1996 by approximately $85,000.  Additionally,
delinquent rent totaling $46,000 was capitalized into a five (5)-year note
accruing interest at 10% per anum.  The amount of rent capitalized was also
written off as uncollectible.

                                      23
<PAGE>
 
During the Fourth Quarter of 1996, management terminated the leases with
Terratron and entered into new leases with Hardee's Food Systems, Inc.  In
connection with this transaction, the capitalized rent was received.  The new
leases resulted in annual rents which are $142,000 lower than Terratron's
contract rents and $57,000 lower than 1996 adjusted rents.  In connection with
the transaction, Terratron terminated their equipment leases and the equipment
was sold to the new tenant for $380,000, resulting in a loss to the Partnership
of $93,000.

During 1997, the Partnership sold its Hardee's property in Wahoo, Nebraska, for
approximately $405,000, resulting in a gain, before disposition fees, of
approximately $8,000.

During January 1998, the Partnership sold its Denny's property in Sanford,
Florida, to the tenant for $1,250,000, resulting in a gain, before disposition
fees, of approximately $240,000.

The total cost of the investment properties includes the original purchase price
plus acquisition fees and other capitalized costs paid to an affiliate of the
former general partners.

According to the Partnership Agreement, the former general partners were to
commit 82% of the original offering proceeds to the acquisition of investment
properties.  Upon the close of the offering, approximately 57% of the original
offering proceeds was invested in the Partnership's properties.

The current General Partner receives a fee for managing the Partnership equal to
4% of gross receipts, with a maximum reimbursement for office rent and related
office overhead of $25,000 between the three affiliated Partnerships.  Effective
March 1, 1997, the minimum management fee and the maximum reimbursement for
office rent and overhead increased by 3.3% representing the allowable annual
Consumer Price Index adjustment per the Permanent Manager Agreement ("PMA").
For purposes of computing the 4% overall fee, gross receipts  includes amounts
recovered in connection with the misappropriation of assets by the former
general partners and their affiliates.  TPG has received fees from the
Partnership totaling $87,897 to date on the amounts recovered,  which has been
offset against the 4% minimum fee.

Several of the Partnership's property leases contain purchase option provisions
with stated purchase prices in excess of the original cost of the properties.
The current General Partner is unaware of any unfavorable purchase options in
relation to original cost.

4.   PARTNERSHIP AGREEMENT:
     ----------------------

The Partnership Agreement, prior to an amendment effective May 26, 1993,
provided that, for financial reporting and income tax purposes, net profits or
losses from operations were allocated 90% to the Limited Partners and 10% to the
former general partners.  The Partnership Agreement also provided that Net Cash
Receipts, as defined, would be distributed 90% to the Limited Partners and 10%
to the former general partners, except that distributions to the former general
partners in excess of 1% in any calendar year would be subordinated to
distributions to the Limited Partners in an amount equal to their Original
Property Distribution Preference, as defined.

Net proceeds, as defined, were to be distributed as follows:  (a)  1% to the
General Partners and 99% to the Limited Partners, until distributions to the
Limited Partners equal their Original Capital, as defined, plus their Original
Property Liquidation Preference, as defined, and (b) the remainder 90% to the
Limited 

                                      24
<PAGE>
 
Partners and 10% to the General Partners.  Such distributions were to be
made as soon as practicable following the sale, financing or refinancing of an
original property.

On May 26, 1993, pursuant to the results of a solicitation of written consents
from the Limited Partners, the Partnership Agreement was amended to replace the
former general partners and amend various sections of the agreement.  The former
general partners were replaced as General Partner, by The Provo Group, Inc., an
Illinois Corporation.  Under the terms of the amendment, net profits or losses
from operations are allocated 99% to the Limited Partners and 1% to the current
General Partner.  The amendment also provided for distributions from Net Cash
Receipts to be made 99% to the Limited Partners and 1% to its current General
Partner.  Pursuant to the amendments to the Partnership Agreement effective June
30, 1994, distributions of Net Cash Receipts will not be made to the General
Partner unless and until each Limited Partner has received a distribution from
Net Cash Receipts in an amount equal to 10% per annum, cumulative simple return
on his or her Adjusted Original Capital, as defined, from the Return Calculation
Date, as defined, except to the extent needed by the General Partner to pay its
federal and state incomes taxes on the income allocated to it attributable to
such year.  Distributions paid to the General Partner are based on the estimated
tax liability as a result of allocated income.  Subsequent to the filing of the
General Partner's income tax returns, a true-up of actual distributions is made.
Net proceeds, as defined, was also amended to be distributed 1% to the current
General Partner and 99% to the Limited Partners.

Additionally, as per the amendment of the Partnership Agreement dated May 26,
1993, the total compensation paid to all persons for the sale of the investment
properties shall be limited to a competitive real estate commission, not to
exceed 6% of the contract price for the sale of the property.  The General
Partner may receive up to one-half of the competitive real estate commission,
not to exceed 3%, provided that the General Partner provides a substantial
amount of services in the sales effort.  It is further provided that a portion
of the amount of such fees payable to the General Partner is subordinated to its
success at recovering the funds misappropriated by the former general partners.
(See Note 7.)

Effective June 1, 1993, the Partnership Agreement was amended to (i) change the
definition of "Distribution Quarter" to be consistent with calendar quarters,
and (ii) change the distribution provisions to subordinate the General Partner's
share of distributions from Net Cash Receipts and Net Proceeds, except to the
extent necessary for the General Partner to pay its federal and state income
taxes on Partnership income allocated to the General Partner.  Because these
amendments do not adversely affect the rights of the Limited Partners, pursuant
to section 10.2 of the Partnership Agreement, the amendments were made by the
General Partner without a vote of the Limited Partners.

5.   LEASES:
     -------

Lease terms for the investment properties are 20 years from their inception.
The leases provide for minimum rents and additional rents based upon percentages
of gross sales in excess of specified breakpoints.  The lessee is responsible
for occupancy costs such as maintenance, insurance, real estate taxes, and
utilities.

Accordingly, these amounts are not reflected in the statements of income, except
in circumstances where, in management's opinion, the Partnership will be
required to pay such costs to preserve assets (i.e., payment of past-due real
estate taxes).  Management has determined that the leases are properly
classified as operating leases; therefore, rental income is reported when earned
and the cost of the property, excluding the cost of the land, is depreciated
over its estimated useful life.

                                      25
<PAGE>
 
Aggregate minimum lease payments to be received under the leases for the
Partnership's properties are as follows:
<TABLE>
<CAPTION>
          Year ending
          December 31,
<S>                                                           <C>
                1998                                          $  409,380
                1999                                             409,380
                2000                                             409,380
                2001                                             409,380
                2002                                             409,380
        Thereafter                                             3,141,338
                                                              ----------
                                                              $5,188,238
                                                              ==========
</TABLE>
Percentage rentals included in rental income in 1997, 1996, and 1995 were
$20,658, $13,399, and $18,923, respectively.

Three (3) of the Partnership's properties are leased to a Denny's franchise.
Base rent from these properties amounted to approximately 43% of total base rent
in 1997.

Two (2) of the Partnership's properties are leased to a Hardee's franchise.
Base rent from these properties is approximately 31% of total base rents.

The original offering document required the Partnership to lease its properties
to a single tenant as long as the properties so leased do not constitute; in the
aggregate, more than 20% of the aggregate gross proceeds of the offering.  As of
December 31, 1995, the Partnership had leased two of its properties to
Terratron, Inc., which constituted 21% of the aggregate gross proceeds.  Due to
sales difficulties in the stores leased by Terratron, a one (1)-year lease
modification was entered into with the tenant, reducing 1996 base rents by
approximately $85,000.  Additionally, delinquent rents totaling $46,000 were
capitalized into a five (5)-year note accruing interest at 10% per annum.  The
amount of the rent capitalized was written off as uncollectible at December 31,
1995.  During the Fourth Quarter of 1996, the leases with Terratron were
terminated and new leases were entered into for the properties with Hardee's
Food Systems, Inc.  In connection with this transaction, the capitalized rent
was received.  The new leases resulted in annual rents which are $142,000 lower
than Terratron's contract rents and $57,000 lower than 1996 adjusted rents.

                                       26
<PAGE>
 
6. TRANSACTIONS WITH CURRENT GENERAL PARTNER:
   ------------------------------------------

Amounts incurred to the current General Partner for the years ended December 31,
1997, 1996, and 1995, are as follows:

<TABLE>
<CAPTION>

Current General Partner                              Incurred               Incurred          Incurred for the
-----------------------                         for the year ended     for the year ended        year ended
                                                December 31, 1997      December 31, 1996      December 31, 1995
                                                ------------------     ------------------     -----------------

<S>                                                        <C>                   <C>                    <C>
Management fees                                            $52,177               $ 86,826               $56,829
Disposition fees                                            12,150                      0                     0
Restoration fees                                            11,323                 63,163                 3,028
Leasing commissions                                              0                 23,310                     0
Cash distribution                                            2,418                  2,789                  (111)
Overhead allowance                                           5,150                  5,127                 4,988
Reimbursement for out-of-pocket expenses                    11,493                  9,118                10,542
                                                           -------               --------               -------
                                                           $94,711               $190,333               $75,276
                                                           =======               ========               =======
</TABLE>

7.  CONTINGENT LIABILITIES:
    ----------------------- 

According to the Partnership Agreement, as amended, the current General Partner
may receive a disposition fee not to exceed 3% of the contract price of the sale
of investment properties. Fifty percent (50%) of all such disposition fees
earned by the current General Partner is to be escrowed until the aggregate
amount of recovery of the funds misappropriated from the Partnerships by the
former general partners is greater than $4,500,000. Upon reaching such recovery
level, full disposition fees will thereafter be payable and fifty percent (50%)
of the previously escrowed amounts will be paid to the current General Partner.
At such time as the recovery exceeds $6,000,000 in the aggregate, the remaining
escrowed disposition fees shall be paid to the current General Partner. If such
levels of recovery are not achieved, the current General Partner will contribute
the amounts escrowed towards the recovery. In lieu of an escrow, 50% of all such
disposition fees have been paid directly to the restoration account and then
distributed among the three Partnerships. Fifty percent (50%) of the total
amount paid to the recovery was refunded to the current General Partner during
1996, after exceeding the $4,500,000 recovery level. The remaining amount
allocated to the Partnerships may be owed to the current General Partner if the
$6,000,000 recovery level is met. As of December 31, 1997, the Partnership may
owe the current General Partner $18,862, which is currently reflected as a
recovery, if the $6,000,000 recovery level is achieved. Management believes it
is unlikely that this recovery level will be achieved.

8.  PMA INDEMNIFICATION TRUST:
    --------------------------

The Permanent Manager Agreement ("PMA") provides that the Permanent Manager will
be indemnified from any claims or expenses arising out of or relating to the
Permanent Manager serving in such capacity or as substitute general partner, so
long as such claims do not arise from fraudulent or criminal misconduct by the
Permanent Manager. The PMA provides that the Partnership fund this
indemnification obligation by establishing a reserve of up to $250,000 of
Partnership assets which would not be subject to the claims of the Partnership's
creditors. An Indemnification Trust ("Trust") serving such purposes has been
established at United Missouri Bank, N.A. The Trust has been fully funded with
Partnership assets as of
                                       27
<PAGE>
 
December 31, 1997. Funds are invested in U.S. Treasury securities. In addition,
interest totaling $40,662 has been credited to the Trust as of December 31,
1997. The rights of the Permanent Manager to the Trust shall be terminated upon
the earliest to occur of the following events: (i) the written release by the
Permanent Manager of any and all interest in the Trust; (ii) the expiration of
the longest statute of limitations relating to a potential claim which might be
brought against the Permanent Manager and which is subject to indemnification;
or (iii) a determination by a court of competent jurisdiction that the Permanent
Manager shall have no liability to any person with respect to a claim which is
subject to indemnification under the PMA. At such time as the indemnity
provisions expire or the full indemnity is paid, any funds remaining in the
Trust will revert back to the general funds of the Partnership.

9.  RESTORATION TRUST ACCOUNT; EXPENSE ALLOCATIONS; AND RELATED 
    -----------------------------------------------------------
    INTER-PARTNERSHIP RECEIVABLES:
    ------------------------------

Restoration costs represent expenses incurred by the Partnership associated
with the misappropriated assets by the former general partners and their
affiliates. These costs are allocated among the Partnerships based on each
partnership's respective share of the entire misappropriation, as currently
quantified. The amount of misappropriation for each partnership is adjusted
annually to reflect new discoveries and more accurate quantification of amounts
based on the continuing Investigation. Such adjustments may result in periodic
adjustments to prior allocations of recovery costs to reflect updated
information. Consequently, previous payments for restoration expenses may not be
consistent with modified allocations.

Recoveries realized by the Partnerships are being distributed to each respective
partnership on the same basis as the restoration costs are currently being
allocated, adjusted for any future changes in the entire misappropriation, as a
result of the continuing investigation. As of December 31, 1997, the
Partnerships recovered a total of approximately $5,726,000 from the former
general partners and their affiliates. Of this amount, the Partnership received
its pro-rata share in the amount of $2,670,660. Additionally, $40,347,
representing 50% of all previously escrowed disposition fees earned by the
General Partner, have been paid to the recovery. Of that amount, $18,862 was
allocated to the Partnership and is contingently payable to the General Partner
upon achievement of certain recovery levels as described in Note 7.

The PMA contemplated that the Permanent Manager could establish a separate and
distinct Restoration Trust Fund which would hold all recoveries until a final
independent adjudication by a court of competent jurisdiction or vote of the
Limited Partners ratified the allocation of proceeds to each respective
partnership. Management has concluded that a fair and reasonable accounting for
recovery proceeds can be accomplished at the partnership level in a manner
similar to restoration costs which are paid directly by the Partnerships.
Management reserves the right to cause the final allocation of such costs and
recoveries to be determined either by a vote of the Limited Partners or a court
of competent jurisdiction. Potential sources of recoveries include third party
litigation, promissory notes, land contracts, and personal assets of the former
general partners and their affiliates.

In 1994, an affiliated partnership, DiVall 1, filed a complaint in the United
States District Court for the Western District of Missouri against Boatmen's
First National Bank of Kansas City ("Boatmen's") seeking a declaratory judgment
that Boatmen's has no right or interest in a promissory note executed in the
name of DiVall 1 by the former general partners (the "Note") secured by
mortgages on five DiVall 1 properties, and further seeking an injunction against
foreclosure proceedings instituted against a DiVall 1 property located in
Dallas, Texas under a first deed of trust and security agreement given to secure
the Note (the "Foreclosure"). Trial of the case took place on June 23, 1997. The
judge ruled in favor of DiVall 1 on

                                      28
<PAGE>
 
August 21, 1997, that the note was not enforceable. An appeal by Boatmen's was
subsequently dropped, so the full $600,000 recovery has been recorded. Pursuant
to the Restoration Trust Account procedures described above, all of the
Partnerships are sharing the expenses of this litigation and the recovery
resulting from the full cancellation of the alleged indebtedness was allocated
among the three Partnerships on the same basis as the restoration costs are
being allocated. The Partnership's share of the recovery amounted to $280,500.

10.  LITIGATION:
     -----------

In 1993, the Partnership, along with DiVall 1 and DiVall 2 initiated a lawsuit
against Ernst & Young LLP ("E & Y"), a certified public accounting firm, in
connection with the audits of the Partnerships performed by E & Y for the years
1989, 1990 and 1991. The Partnerships also filed claims against Magnuson,
DiVall, DiVall Real Estate Investment Corporation, David Shea, and the
Partnerships' former securities law firm, Quarles & Brady.

These matters were settled in 1996, yielding net proceeds to the Partnership,
after the payment of contingent legal fees and related costs, of approximately
$1,000,000.

As part of the Permanent Manager Agreement, DiVall, Magnuson, and entities owned
by them, granted the Partnership a security interest in certain promissory notes
and mortgages from other DiVall related entities (the "Private Partnerships").
In the aggregate, the face amount of these notes were equal to a minimum of
$8,264,932. In addition, DiVall, Magnuson, and related entities owned by them,
granted the Partnership a security interest in their general partner interests
in the Private Partnerships. The foregoing security interests were to secure the
repayment of the funds which were diverted by DiVall and Magnuson from the
Partnership. The Partnership shares such security interests with DiVall 1 and
DiVall 2. These promissory notes and mortgages are not recorded on the balance
sheets of the Partnerships, but are recorded as recoveries on a cash basis upon
settlement.

In 1993, nineteen (19) of the Private Partnerships sought the protection of the
Bankruptcy Court in the Eastern District of Wisconsin. Seven (7) of these
bankruptcies were voluntary and twelve (12) of these bankruptcies were
involuntary. Several of the Private Partnerships seeking bankruptcy owe
promissory notes to DiVall, Magnuson, or entities owned by them, in which the
Partnership has a security interest. These cases were subsequently transferred
to the Western District Bankruptcy Court located in Madison, Wisconsin.

The Partnership's experience in those bankruptcy cases that have concluded,
either through the approval of Plans of Reorganization, dismissal of the
bankruptcies, settlements or a combination of the foregoing, is that (i) the
value of the obligations of the Private Partnerships assigned to the Partnership
has been at a significant discount to their face amounts, and (ii) the General
Partner interests in such Private Partnerships often have little economic value.
The Partnership's recoveries in these bankruptcies have been on a steeply
discounted basis.

Plans of reorganization have been filed in the bankruptcies, and settlement
agreements in all of the Private Partnerships have been reached. Settlements in
the bankruptcies have resulted in cash payments to the Partnerships of a total
of $720,000 and notes secured by subordinated mortgages in the aggregate amount
of $625,000. The Partnerships subsequently sold the secured notes for a total of
$175,000.

                                      29
<PAGE>
 
11.  FORMER GENERAL PARTNERS' CAPITAL ACCOUNTS:
     ------------------------------------------

The capital account balance of the former general partners as of May 26, 1993,
the date of their removal as general partners pursuant to the results of a
solicitation of written consents from the Limited Partners, was a deficit of
$265,491. At December 31, 1993, the former general partners' deficit capital
account balance in the amount of $265,491 was reallocated to the Limited
Partners.

12.  SUBSEQUENT EVENTS:
     ------------------

In February 1998, the Partnership made a distribution to the Limited Partners
from operations for the Fourth Quarter 1997 of $385,000 amounting to $22.51 per
limited partnership interest.

Item 9.  Changes in and Disagreements With Accountants on Accounting and
         Financial Disclosure

None

                                   PART III

Item 10.  Directors and Executive Officers of the Registrant

The General Partner of the Partnership is The Provo Group, Inc., an Illinois
corporation ("TPG") with its principal office at 101 West 11th Street, Suite
1110, Kansas City, Missouri 64105. TPG was elected General Partner by vote of
the Limited Partners effective May 26, 1993. TPG had been managing the
Partnership since February 8, 1993, under the terms of the Permanent Manager
Agreement ("PMA"), which remains in effect. TPG also serves as the corporate
general partner for DiVall 1 and DiVall 2. See Items 1 and 13 hereof for
additional information about the PMA and the election of TPG as the General
Partner.

The executive officers and director of the General Partner who control the
affairs of the Partnership are as follows:

     Bruce A. Provo, Age 47 - President, Founder and Director.  Mr. Provo has
     been involved in the management of real estate and other asset portfolios
     since 1979. Since he founded the company in 1985, Mr. Provo has been
     President of TPG. From 1982 to 1986, Mr. Provo served as President and
     Chief Operating Officer of the North Kansas City Development Company
     ("NKCDC"), North Kansas City, Missouri. NKCDC was founded in 1903 and the
     assets of the company were sold in December, 1985 for $102,500,000. NKCDC
     owned commercial and industrial properties, including an office park and a
     retail district, as well as apartment complexes, motels, recreational
     facilities, fast food restaurants, and other properties. NKCDC's holdings
     consisted of over 100 separate properties and constituted approximately 20%
     of the privately held real property in North Kansas City, Missouri (a four
     square mile municipality). Following the sale of the company's real estate,
     Mr. Provo served as the President and Chief Executive Officer and
     Liquidating Trustee of NKCDC from 1986 to 1991.

                                      30
<PAGE>
 
     Mr. Provo graduated from Miami University, Oxford, Ohio in 1972 with a B.S.
     in Accounting. He became a Certified Public Accountant in 1974 and was a
     manager in the banking and financial services division of Arthur Andersen
     LLP prior to joining Rubloff Development Corporation in 1979. From 1979
     through 1985, Mr. Provo served as Vice President - Finance and then as
     President of Rubloff Development Corporation. Mr. Provo has previously
     served on the Board of Directors of the National Realty Committee, a
     legislative "watchdog" organization for the commercial real estate industry
     headquartered in Washington, DC.

     Kristin J. Atkinson, Age 35 - Vice President - Finance and Administration.
     Ms. Atkinson joined The Provo Group, Inc. in September 1994, to provide
     management expertise in the areas of financial controls and management
     accounting services for four limited partnerships managed by TPG. Prior to
     joining TPG, Ms. Atkinson was Manager of Financial Reporting for Farm &
     Home Savings Association (a $4 billion savings and loan association) for
     nine years where she was responsible for supervision of the preparation of
     internal and external financial documentation, including regulatory filings
     for the savings association and its parent company. Ms. Atkinson graduated
     Magna Cum Laude with a B.S. in Accounting from Missouri Southern State
     College in Joplin, Missouri and worked as an accountant for James P. Arthur
     and Company for one year before joining Farm & Home Savings Association.

     Brenda Bloesch, Age 36 - Director of Investor Relations. Ms. Bloesch joined
     The Provo Group, Inc. in March 1993, to oversee and provide various levels
     of client support for more than 8,000 broker dealers, registered
     representatives, custodians and investors. Primarily responsible for all
     communications regarding four limited partnerships managed by TPG, Ms.
     Bloesch is also involved with database management and partnership
     compliance issues. Prior to joining TPG, Ms. Bloesch was Manager of
     Investment Services at DiVall Real Estate Investment Corporation ("DREIC")
     for four years and Publisher Services Manager at NewsNet, Inc. for five
     years. Her role at DREIC allowed Ms. Bloesch to obtain extensive knowledge
     of limited partnerships and gain familiarity with the broker and investor
     communities. Ms. Bloesch is a graduate of Lock Haven University in Lock
     Haven, Pennsylvania, where she received her B.A. in Journalism and Media
     Studies.

The Advisory Board, although its members are not "Directors" or "Executive
Officers" of the Partnership, provides advisory oversight to management of the
Partnership and consists of:

     Steve Carson - Vice President/Investments at First Albany Corporation. Mr.
     Carson's primary client concentration includes labor union, pension, and
     annuity funds. Mr. Carson has worked for First Albany for 11 years. He
     began his career as a retail broker at E.F Hutton & Company and served as
     Vice President, Shearson American Express from 1980-1986. Mr. Carson
     attended Northrup University in Los Angeles, California. He has served as
     Board Member and President on various Civic Boards in Syracuse, New York.
     Mr. Carson represents the broker-dealer community.

                                      31
<PAGE>
 
     Robert White - President of Chevron, TCI. Mr. White has worked for Chevron
     in various positions over the past 38 years. This company specializes in
     acquiring real estate that has been allocated as either Low-Income Housing
     or Historic Rehabilitation tax credits. Most of the acquisitions are made
     using limited partnership structures -- with TCI as the limited partner.
     Mr. White started his career as a research chemist with Chevron Research
     Company in 1959, after receiving a B.S Degree in Chemistry from the
     University of California at Berkeley. In 1977, Mr. White received a M.B.A
     Degree in Financial Analysis and subsequently transferred to Chevron
     Corporation's Planning and Analysis Department in San Francisco. In 1991,
     Mr. White became Vice-President of Chevron Land. After this company was
     sold in 1995, he assumed the position as President of the new Chevron
     subsidiary, Chevron TCI, Inc. Mr. White is a Limited Partner representing
     DiVall 1.

     Richard W. Otte - Editorial Writer. Mr. Otte is in his sixth year as an
     Editorial Board Member and editorial writer for The Volusion, a DeLand,
     Florida, subsidiary of the News-Journal Corporation in Daytona Beach,
     Florida. Mr. Otte retired in 1988 after 34 years with the Dispatch Printing
     Co., serving his last eight years as Managing Editor of the Columbus
     Dispatch and as a member of its Operating Committee. He previously was the
     executive sports editor of the newspaper in Ohio's capital city. Mr. Otte's
     49 years in professional journalism also include news reporting, editing
     and sports assignments with the Daytona Journal Herald and Springfield 
     News-Sun. Mr. Otte is a Limited Partner representing DiVall 2.
 
     Albert Gerritz - Perinton Volunteer Ambulance Corps. Mr. Gerritz has held
     various offices in Finance and Administration, including President. Mr.
     Gerritz retired in 1986 after 36 years with Eastman Kodak Co. where he was
     Supervisor of Engineering Services, Research Labs. Mr. Gerritz was
     instrumental in identifying the need and pursuing the development of a
     unique research complex for Kodak, which became the case study for his
     consulting activities on research facilities nationwide. Mr. Gerritz also
     worked for forty years in the Bushnell's Basin Fire Department and served
     five years as Chief. Mr. Gerritz has a life membership in National Society
     of Professional Engineers. Mr. Gerritz is a Limited Partner representing
     DiVall 3.

Item 11.  Executive Compensation

The Partnership has not paid any "executive compensation" to the corporate
General Partner or to the directors and officers of the General Partner. The
General Partner's participation in the income of the Partnership is set forth in
the Agreement of Limited Partnership and amendments thereto, which are filed as
Exhibits 3.1, 3.2, 3.3, 3.4 and 3.5 hereto. The current General Partner received
management fees and expense reimbursements during the year.

See Item 13 below, and Note 6 to the financial statements in Item 8 hereof, for
further discussion of payments by the Partnership to the General Partner and
former general partners.

                                      32
<PAGE>
 
Item 12.  Security Ownership of Certain Beneficial Owners and Management

(a)  As of December 31, 1997, the following entity is known to beneficially own
5% or more of the outstanding Limited Partnership Interests as follows:

<TABLE>
<CAPTION>
                                                          Interests    Percentage of
Title of                     Name and Address of         Beneficially   Interests of
 Class                         Beneficial Owner             Owned       Outstanding
---------------------  --------------------------------  ------------  --------------
<S>                    <C>                               <C>           <C>
Limited Partnership    The Engineers Joint Pension Fund      1,500         8.77%
Interests              4325 S. Salina Street
                       Syracuse, NY 13205
 
</TABLE>
(b)  As of December 31, 1997, neither the General Partner nor any of its
affiliates owned any Limited Partnership Interests in the Partnership.

Item 13.  Certain Relationships and Related Transactions

The compensation to be paid to TPG is governed by the Partnership Agreement, as
amended by vote of the Limited Partners to reflect the terms of the PMA.  TPG's
compensation includes a base fee equal to 4% of the Partnership's gross
collected receipts, subject to a minimum of $57,000 per year.  For this purpose,
"gross collected receipts" means all cash revenues arising from operations and
reserves of the Partnerships, including any proceeds recovered with respect to
the obligations of the former general partners.  The portion of such fee
resulting from recoveries from former general partners is designated as
restoration fees.  TPG is also entitled to reimbursement for office rent and
utilities not to exceed $4,750 per year.  TPG is entitled to reimbursement of
reasonable direct costs and expenses, such as travel, lodging, overnight
delivery and postage, but has no right to be reimbursed for administrative
expenses such as payroll, payroll taxes, insurance, retirement and other
benefits, base phone and fax charges, office furniture and equipment, copier
rent, and the like.  Between the three Partnerships, TPG is entitled to an
aggregate minimum base management fee of $300,000 per year and reimbursement for
office rent in the maximum amount of $25,000 per year.  The Partnership shall
only be responsible for its allocable share of such minimum and maximum amounts
as indicated above ($57,000 minimum base fee and $4,750 maximum rent
reimbursement).  TPG is entitled to an annual increase in the minimum base
management fee and maximum office overhead reimbursement in an amount not to
exceed the percentage increase in the Consumer Price Index ("CPI") for the
immediately preceding calendar year.  Effective March 1, 1997, the minimum
management fee and the maximum reimbursement for office rent and overhead
increased by 3.3% representing the allowable annual CPI adjustment.
Additionally, TPG is allowed up to one-half of the Competitive Real Estate
Commission, not to exceed 3% upon the disposition of assets.  The payment of a
portion of such fees is subordinated to TPG's success at recovering the funds
misappropriated by the former general partners.

The PMA has an expiration date of December 31, 2002, but may be terminated
earlier (a) by a vote at any time by a majority in interest of the Limited
Partners, (b) upon the dissolution and winding up of the Partnership, (c) upon
the entry of an order of a court finding that the Permanent Manager has engaged
in fraud or other like misconduct or has shown itself to be incompetent in
carrying out its duties under the Partnership Agreement, or (d) upon sixty (60)
days written notice from the Permanent Manager to the Limited Partners of the
Partnership.  Upon termination of the PMA, other than by the voluntary action of
TPG, TPG shall be paid a termination fee of one month's Base Fee allocable to
the Partnership, subject 

                                       33
<PAGE>
 
to a minimum of $4,750. In the event that TPG is terminated by action of a
substitute general partner, TPG shall also receive, as part of this termination
fee, 4% of any proceeds recovered with respect to the obligations of the former
general partners, whenever such proceeds are collected.

Under the PMA, TPG shall be indemnified by the Partnership, DiVall and Magnuson,
and their controlled affiliates, and shall be held harmless from all claims of
any party to the Partnership Agreement and from any third party including,
without limitation, the Limited Partners of the Partnership, for any and all
liabilities, damages, costs, and expenses, including reasonable attorneys' fees,
arising from or related to claims relating to or arising from the PMA or its
status as Permanent Manager.  The indemnification does not extend to claims
arising from fraud or criminal misconduct of TPG as established by court
findings. To the extent possible, the Partnership is to provide TPG with
appropriate errors and omissions, officers liability or similar insurance
coverage, at no cost to TPG.  In addition, TPG is granted the right to establish
and segregate Partnership assets in an amount not to exceed $250,000, solely for
the purpose of funding such indemnification obligations (the "Indemnification
Trust").  Once a determination has been made that no such claims can or will be
made against TPG, the balance of the Indemnification Trust will become
unrestricted cash of the Partnership.  As of December 31, 1997, the Partnership
had fully funded to the Indemnification Trust.

The following fees and reimbursements from the Partnership were incurred to
management in 1997:
<TABLE>
<CAPTION>

The Provo Group, Inc.
---------------------
<S>                                              <C>
 
     Management Fees                             $52,177
     Restoration Fees                             11,323
     Office Overhead Allowance                     5,150
     Direct Cost Reimbursements                   11,493
                                                 -------
       1997 Total                                $80,143
                                                 =======
</TABLE>
                                    PART IV
Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K
 
 
(a)    1. Financial Statements

          The following financial statements of DiVall Income Properties 3
          Limited Partnership are included in Part II, Item 8:
          
          Report of Independent Public Accountants

          Balance Sheets, December 31, 1997 and 1996
          Statements of Income for the Years Ended December 31, 1997, 1996 and
          1995

                                       34
<PAGE>
          Statements of Partners' Capital for the Years Ended December 31, 1997,
          1996 and 1995

          Statements of Cash Flows for the Years Ended December 31, 1997, 1996
          and 1995
 
          Notes to Financial Statements

     2.   Financial Statement Schedules

          Schedule III - Real Estate and Accumulated Depreciation

     All other schedules for which provision is made in the applicable
     accounting regulation of the Securities and Exchange Commission are not
     required under the related instruction or are inapplicable and, therefore,
     have been omitted.

     3.   Listing of Exhibits

          3.1   Agreement of Limited Partnership dated as of December 12, 1989,
                and amended as of December 18, 1989, February 19, 1990, and
                April 9, 1990, filed as Exhibit 3A to Amendment No.2 to the
                Partnership's Registration Statement on Form S-11 dated April
                23, 1990, incorporated herein by reference.

          3.2   Amendment to Amended Agreement of Limited Partnership dated as
                of February 8, 1993, filed as Exhibit 3.3 to the Partnership's
                10-K for the year ended December 31, 1992, and incorporated
                herein by reference.

          3.3   Amendment to Amended Agreement of Limited Partnership dated as
                of May 26, 1993, filed as Exhibit 3.3 to the Partnership's 10-K
                for the year ended December 31, 1993, and incorporated herein by
                reference.

          3.4   Amendment to Amended Agreement of Limited Partnership dated as
                of June 1, 1993, filed as Exhibit 3.4 to the Partnership's 10-K
                for the year ended December 31, 1993, and incorporated herein by
                reference.

          3.5   Amendment to Amended Agreement of Limited Partnership dated as
                of June 30, 1994, filed as Exhibit 3.5 to the Partnership's 10-K
                for the year ended December 31, 1994, and incorporated herein by
                reference.

         10.0   Permanent Manager Agreement filed as an exhibit to the Current
                Report on Form 8-K dated January 22, 1993, incorporated herein
                by reference.

         28.0   Correspondence to the Limited Partners dated February 15, 1998,
                regarding the Fourth Quarter 1997 distribution.

(b)    Report on Form 8-K:

       The Registrant filed no reports on Form 8-K during the fourth quarter of
       fiscal year 1997.

                                       35
<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP
            SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION
                               DECEMBER 31, 1997
<TABLE>
<CAPTION>

                                                                                Gross amount at which
                                                 Initial cost to Partnership  carried at end of year (A)
                                                 ---------------------------  --------------------------



                                                                Building                    Building
                                                                  and                         and                     Accumulated
         Property              Encumbrances         Land      Improvements      Land      Improvements    Total       depreciation
----------------------------------------------------------------------------------------------------------------------------------
<S>                            <C>               <C>           <C>           <C>          <C>           <C>           <C>
Pittsburgh, Pennsylvania                 $-      $  274,467    $  616,866    $  274,467    $  616,866   $  891,333      $156,920
St. Francis, Wisconsin                    -         485,354       709,028       468,354       709,028    1,177,382       182,650
Oak Creek, Wisconsin                      -         496,505       845,400       496,505       845,400    1,341,905       198,074
Englewood, Colorado                       -               -       213,210             -       213,210      213,210        45,565
Sanford, Florida                          -         477,302       659,131       477,302       659,131    1,136,433       130,830
Colorado Springs, Colorado                -         314,354       265,829       314,354       265,829      580,183        47,822
                               ---------------------------------------------------------------------------------------------------


                                         $0       2,047,982     3,309,464     2,030,982     3,309,464    5,340,446       761,861
                               ===================================================================================================


                                                                     Life on which
                                                                      depreciation
                                                                   in latest statement
                                                                      of operations
                                      Date of         Date            is computed
         Property                   construction    acquired            (years)
-------------------------------------------------------------------------------------

Pittsburgh, Pennsylvania               1990          9/11/90              31.5
St. Francis, Wisconsin                 1990          8/14/90              31.5
Oak Creek, Wisconsin                   1991           2/5/91              31.5
Englewood, Colorado                    1991           7/1/91              31.5
Sanford, Florida                       1991         11/13/91              31.5
Colorado Springs, Colorado                -          4/28/92              31.5
</TABLE>

(A) Represents aggregate costs for federal income tax purposes.

(B) Reconciliation of "Real Estate and Accumulated Depreciation":

<TABLE>
<CAPTION>

                                     Year ended                 Year ended
Investments in Real Estate        December 31, 1997          December 31, 1996
-------------------------------------------------------------------------------
<S>                                <C>                        <C>
Balance at beginning of year             $5,848,562                 $5,852,062
Property write-down                               0                     (3,500)


Sale of Property                           (508,116)                         0
                                         ----------                 ----------

Balance at end of year                   $5,340,446                 $5,848,562
                                         ==========                 ==========
</TABLE>

<TABLE> 
<CAPTION> 

                                      Year ended                 Year ended
Accumulated Depreciation           December 31, 1997          December 31, 1996
-------------------------------------------------------------------------------
<S>                                <C>                        <C>
Balance at beginning of year               $ 761,761                   $644,448
Additions charged to costs                          
 and expenses                                110,951                    117,318

Sale of Property                            (110,851)                         0
                                           ---------                   --------

Balance at end of year                     $ 761,861                   $761,761
                                           =========                   ========
</TABLE> 
                                       36
<PAGE>
 
                                  SIGNATURES

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


DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP


By:  The Provo Group, Inc., General Partner

By:  /s/Bruce A. Provo
     ---------------------------------------------
     Bruce A. Provo, President


Date:  March 27, 1998


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.


By:  The Provo Group, Inc., General Partner


By:  /s/Bruce A. Provo
     ---------------------------------------------
     Bruce A. Provo, President


Date:  March 27, 1998


By:  /s/Kristin J. Atkinson
     --------------------------------------------
     Kristin J. Atkinson
     Vice President - Finance and Administration


Date:  March 27, 1998

                                      37