<PAGE>
 
                                   FORM 10-Q

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C.  20549

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

     For the quarterly period ended September 30, 1998
                                    ---------------------------

                                       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)


     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
                                         ------     ------
<PAGE>
 
                         PART I - FINANCIAL INFORMATION
                         Item 1.  Financial Statements

                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                                 BALANCE SHEETS

                    September 30, 1998 and December 31, 1997
                    ----------------------------------------

                                     ASSETS


<TABLE>
<CAPTION>
                                                     (Unaudited)
                                                    September 30,   December 31,
                                                        1998           1997
                                                    -------------   ------------
<S>                                                 <C>             <C>
INVESTMENT PROPERTIES:  (Note 3)
     Land                                            $ 1,553,680    $ 2,030,982
     Buildings and improvements                        2,650,334      3,309,464
     Accumulated depreciation                           (692,805)      (761,861)
                                                     -----------    -----------
         Net investment properties                     3,511,209      4,578,585
                                                     -----------    -----------
OTHER ASSETS:
     Cash and cash equivalents                           229,032        595,420
     Cash held in Indemnification Trust (Note 8)         303,601        290,662
     Rents and other receivables                               0         23,062
     Deferred rent receivable                             21,197         31,029
     Deferred fees                                        20,185         21,524
     Prepaid assets                                          365          3,649
                                                     -----------    -----------
         Total other assets                              574,380        965,346
                                                     -----------    -----------
DUE FROM FORMER AFFILIATES: (Note 2)
     Due from former general partner affiliates        1,734,417      1,734,417
     Allowance for uncollectible amounts due from
      former affiliates                               (1,734,417)    (1,734,417)
     Restoration cost receivable                       5,662,696      5,181,441
     Allowance for uncollectible restoration
      receivable                                      (5,662,696)    (5,181,441)
                                                     -----------    -----------
         Due from former affiliates, net                       0              0
                                                     -----------    -----------
         Total Assets                                $ 4,085,589    $ 5,543,931
                                                     ===========    ===========
 
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       2
<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                       LIABILITIES AND PARTNERS' CAPITAL

                    September 30, 1998 and December 31, 1997
                    ----------------------------------------



<TABLE>
<CAPTION>
                                                    (Unaudited)    
                                                   September 30,    December 31,
                                                       1998             1997
                                                   -------------    ------------
<S>                                                <C>              <C>
LIABILITIES:
   Accounts payable and accrued expenses           $     25,455     $    25,331
   Due to current General Partner                            84           1,395
   Security deposits                                     16,635          36,819
   Unearned rental income                                27,254          42,254
                                                   ------------     -----------
     Total liabilities                                   69,428         105,799
                                                   ------------     -----------
CONTINGENT LIABILITIES:  (Note 7)
 
PARTNER'S CAPITAL:  (Notes 1, 4 and 11)
Current General Partner -
   Cumulative net income (loss)                          18,186          15,445
   Cumulative cash distributions                         (7,736)         (6,640)
                                                   ------------     -----------
 
                                                         10,450           8,805
                                                   ------------     -----------

Limited Partners (17,102.52 interests outstanding)
   Capital contributions, net of offering costs      14,408,872      14,408,872
   Cumulative net income (loss)                          45,314        (226,070)
   Cumulative cash distributions                    (10,182,984)     (8,487,984)
   Reallocation of former general partners'
     deficit capital                                   (265,491)       (265,491)
                                                   ------------     -----------
                                                      4,005,711       5,429,327
                                                   ------------     -----------
          Total partners' capital                     4,016,161       5,438,132
                                                   ------------     -----------
          Total liabilities and partners' capital  $  4,085,589     $ 5,543,931
                                                   ============     ===========
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       3
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                             STATEMENTS OF INCOME

                                  (Unaudited)
                                  -----------

<TABLE>
<CAPTION>
                                                        Three Months Ended           Nine Months Ended
                                                           September 30,               September 30,
                                                       ---------------------       ---------------------
                                                         1998         1997           1998         1997
                                                       --------     --------       --------     --------
<S>                                                    <C>          <C>            <C>          <C>
REVENUES:
     Rental income                                     $ 95,308     $134,359       $304,514     $452,746
     Interest income on direct financing leases               0            0              0        1,708
     Interest income                                      7,233        9,755         34,360       23,850
     Other income                                             0          250             42          631
     Gain on sale of assets                                   0        7,585        238,698        7,585
     Recovery of amounts previously written off              52           53             52       11,063
                                                       --------     --------       --------     --------
 
                                                        102,593      152,002        577,666      497,583
                                                       --------     --------       --------     --------
EXPENSES:
     Partnership management fees                         16,215       15,960         48,475       47,540
     Restoration fees                                         0            0              0          103
     Insurance                                            1,094        1,218          3,284        3,784
     General and administrative                           5,649        6,510         32,186       32,833
     Advisory Board fees and expenses                     4,578        4,178         13,489       10,200
     Professional services                               20,881       13,611         68,300       38,180
     Professional services related to investigation         194        4,957          1,480       36,318
     Appraisals                                               0            0         13,776            0
     Environmental inspections                                0            0          8,250            0
     Land title surveys                                  11,950            0         11,950            0
     Disposition fees                                         0       12,150         37,500       12,150
     Depreciation                                        20,591       26,487         63,512       85,146
     Amortization                                           446          446          1,339        1,339
                                                       --------     --------       --------     --------
                                                         81,598       85,517        303,541      267,593
                                                       --------     --------       --------     --------
NET INCOME                                             $ 20,995     $ 66,485       $274,125     $229,990
                                                       ========     ========       ========     ========
NET INCOME - GENERAL PARTNER                           $    210     $    665       $  2,741     $  2,300
NET INCOME - LIMITED PARTNERS                            20,785       65,820        271,384      227,690
                                                       --------     --------       --------     --------
                                                       $ 20,995     $ 66,485       $274,125     $229,990
                                                       ========     ========       ========     ========
NET INCOME PER LIMITED PARTNERSHIP  
 INTEREST, based on 17,102.52 interests                $   1.22     $   3.85       $  15.87     $  13.31
 outstanding                                           ========     ========       ========     ========
 
</TABLE>
       The accompanying notes are an integral part of these statements.

                                       4
<PAGE>
 
                DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                           STATEMENTS OF CASH FLOWS

                                  (Unaudited)
                                  -----------



<TABLE>
<CAPTION>
                                                                        Nine Months Ended September 30,
                                                                       --------------------------------
                                                                             1998             1997
                                                                       ---------------   --------------
<S>                                                                     <C>                 <C>
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:
     Net income                                                            $   274,125      $   229,990
     Adjustments to reconcile net income to net cash from (used in)
        operating activities -
          Depreciation and amortization                                         64,851           86,485
          Gain on sale of assets                                              (238,698)          (7,585)
          Recovery of amounts previously written off                                 0          (11,063)
          Interest applied to Indemnification Trust Account                    (12,939)         (11,427)
          Decrease in rents, other receivables and prepaid assets               26,346            9,554
          Decrease in deferred rent receivable                                   9,832            9,499
          Deposits applied for real estate taxes                                     0           81,477
          Increase in accounts payable and accrued expenses                        124            5,250
          Decrease in security deposits                                        (20,184)          (9,450)
          (Decrease) in due to General Partner                                  (1,311)         (49,061)
          Increase/(Decrease) in unearned rental income                        (15,000)             665
          (Decrease) in real estate taxes payable                                    0          (81,217)
                                                                           -----------      -----------

               Net cash provided from operating activities                      87,146          253,117
                                                                           -----------      -----------
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
     Principal payments received on direct financing leases                          0           30,886
     Recoveries from former affiliates                                               0            2,571
     Proceeds from sale of assets                                            1,242,562          404,851
                                                                           -----------      -----------

               Net cash provided from investing activities                   1,242,562          438,308
                                                                           -----------      -----------
CASH FLOWS (USED IN) FINANCING ACTIVITIES:
     Cash distributions to General Partner                                      (1,096)            (920)
     Cash distributions to Limited Partners                                 (1,695,000)      (1,150,000)
                                                                           -----------      -----------

               Net cash (used in) financing activities                      (1,696,096)      (1,150,920)
                                                                           -----------      -----------
NET (DECREASE) IN CASH AND CASH
   EQUIVALENTS                                                                (366,388)        (459,495)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                               595,420        1,155,128
                                                                           -----------      -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD                                 $   229,032      $   695,633
                                                                           ===========      ===========
</TABLE> 
 
 
       The accompanying notes are an integral part of these statements.

                                       5
<PAGE>
 
                 DIVALL INCOME PROPERTIES 3 LIMITED PARTNERSHIP

                         NOTES TO FINANCIAL STATEMENTS


These unaudited interim financial statements should be read in conjunction with
DiVall Income Properties 3 Limited Partnership's (the "Partnership") 1997 annual
audited financial statements within Form 10-K.

These unaudited financial statements include all adjustments which are, in the
opinion of management, necessary to present a fair statement of financial
position as of September 30, 1998, and the results of operations for the three-
and nine-month periods ended September 30, 1998, and 1997, and cash flows for
the nine-month periods ended September 30, 1998 and 1997.  Results of operations
for the periods are not necessarily indicative of the results to be expected for
the full year.

The following significant event(s) have occurred subsequent to fiscal year 1997,
which require disclosure in this interim report per Regulation S-X, Rule 10-01,
Paragraph (a) (5):

During the First Quarter of 1998, the Partnership sold its Denny's property in
Sanford, Florida for $1,250,000.  The sale took place in January 1998, resulting
in a gain, before disposition fees of approximately $239,000.

1.   ORGANIZATION AND BASIS OF ACCOUNTING:
     
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 September 30, 1998, the

                                       6
<PAGE>
 
Partnership owned five (5) properties and specialty leasehold improvements for
use in all five (5) 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 consist of 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 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.

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, as defined, 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.

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

                                       7
<PAGE>
 
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 in excess of $15,800,000, of which approximately $7,397,000 has been
attributed to the Partnership and is reflected as due from former affiliates on
the balance sheet at September 30, 1998.  The 9% interest accrued as of
September 30, 1998, amounted to approximately $3,294,000 and is not reflected in
the accompanying income statement.  As of December 31, 1997, $6,916,000 was
reflected as due from former affiliates based on an estimated overall
misappropriation and related costs of $14,800,000.

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 September 30, 1998, $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 September 30, 1998, the Partnership owned five (5) fast-food restaurants
comprised of:  two (2) Hardee's restaurants, one (1) Applebee's restaurant, and
two (2) Denny's restaurants.  The five (5) properties are located in three (3)
states.

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.

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 $239,000.

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 full investment of the net proceeds 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 overhead of $25,000 between the three affiliated

                                       8
<PAGE>
 
Partnerships as provided in the Permanent Manager Agreement ("PMA").  On May 26,
1993, the Permanent Manager, TPG, replaced the former general partners as the
new General Partner, as provided for in an amendment to the Partnership
Agreement dated May 26, 1993.  Pursuant to amendments to the Partnership
Agreement, TPG continues to provide management services for the same fee
structure as provided in the PMA mentioned above.  Effective March 1, 1998, the
minimum management fee and the maximum reimbursement for office rent and
overhead increased by 1.6% representing the allowable annual Consumer Price
Index adjustment per the 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 current book value.

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 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 TPG.  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 in
the Partnership Agreement, was also amended to be distributed 1% to the current
General Partner and 99% to the Limited Partners.

                                       9
<PAGE>
 
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.

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>

Two (2) of the Partnership's properties are leased to a Denny's franchise.  Base
rent from these properties amounted to approximately 21% of total base rent in
1997.

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
September 30, 1998, the Partnership has leased two of its properties to Hardees
Food Systems, Inc., which constitute 21% of the aggregate gross proceeds.

                                       10
<PAGE>
 
6.   TRANSACTIONS WITH CURRENT GENERAL PARTNER:

Amounts paid to the current General Partner for the nine months ended September
30, 1998 and 1997, are as follow:

<TABLE>
<CAPTION>
                                            Incurred as of  Incurred as of      
                                             September 30,   September 30,
Current General Partner                          1998            1997
-----------------------                     --------------  --------------
<S>                                         <C>             <C>
Management fees                                 $48,475         $47,540
Disposition fees                                 37,500          12,150
Restoration fees                                      0             103
Cash distribution                                 1,096             920
Overhead allowance                                3,911           3,863
Reimbursement for out-of-pocket expenses          8,954           9,034
                                                -------         -------
                                                $99,936         $73,610
                                                =======         =======
</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.  After surpassing the $4,500,000
recovery level during March 1996, 50% of the amounts previously escrowed was
refunded to the current General Partner.  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 September 30, 1998, 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, which is considered unlikely.

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

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<PAGE>
 
September 30, 1998.  Funds are invested in U.S. Treasury securities.  In
addition, interest totaling $53,601 has been credited to the Trust as of
September 30, 1998.  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 AND EXPENSE ALLOCATIONS:

Restoration costs represent expenses incurred by the Partnership in relation to
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 will 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 September 30, 1998, 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 $2,677,000.  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 the final recovery level 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 interim
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.

10.  LITIGATION:

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

                                       12
<PAGE>
 
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.

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:

On November 15, 1998, the Partnership made a distribution to the Limited
Partners for the Third Quarter 1998 of $50,000 amounting to approximately $2.92
per limited partnership interest.

Item 2.  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
September 30, 1998, were originally purchased at a price, including acquisition
costs, of approximately $6,091,000.

                                       13
<PAGE>
 
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.

Other Assets

Cash and cash equivalents  held by the Partnership, were $229,000 at September
30, 1998, compared to $595,000 at December 31, 1997.  The Partnership designated
cash of $50,000 to fund the Third Quarter 1998 distributions to Limited
Partners; $55,000 for the payment of accounts payable and accrued expenses; and
the remainder represents reserves deemed necessary to allow the Partnership to
operate normally. 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 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.

Due From Former Affiliates and Allowance for Uncollectible Amounts Due From
Former Affiliates

Due from former affiliates represented misappropriated assets due from the
former general partners and their affiliates in the amount of $1,734,000 at
September 30, 1998 and December 31, 1997.  No further material recoveries are
anticipated.

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
$5,181,000 at December 31, 1997 to $5,663,000 at September 30, 1998, and
includes $3,294,000 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 September 30, 1998, $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.  The allocation is adjusted periodically to reflect
any changes in the entire misappropriation.  The Partnership's percentage of the
allocation was increased in 1993.

                                       14
<PAGE>
 
Liabilities

Accounts payable and accrued expenses at September 30, 1998, in the amount of
$25,000, primarily represented the accrual of legal and auditing fees.

Partners' Capital

Net income for the quarter 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.  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 for additional information
regarding the reallocation.

Cash distributions paid to the Limited Partners and to the General Partner
during 1998, of $1,695,000 and $1,096, respectively, have also been made in
accordance with the amended Partnership Agreement.  The Third Quarter 1998
distribution of $50,000 was paid to the Limited Partners on November 15, 1998.

Results of Operations:

The Partnership reported  net income for the quarter ended September 30, 1998,
in the amount of $21,000 compared to net income for the quarter ended September
30, 1997 of $66,000.  Net income for the nine months ended September 30, 1998
and 1997 totaled $274,000 and $230,000, respectively.

Revenues

Total revenues were $103,000, and $152,000, for the quarters ended September 30,
1998, and 1997, respectively and were $578,000 and $498,000 for the nine months
ended September 30, 1998 and 1997, respectively.  The increase in income in 1998
is attributable to a gain recognized on the sale of a Denny's property to the
tenant in the amount of $239,000, partially offset by a reduction in rental
income due to properties which have been sold.

Total revenues, should approximate $400,000 annually or $100,000 quarterly,
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 quarters ended September 30, 1998 and 1997, cash expenses amounted to
approximately 59% and 39% of total revenues, respectively.  For the nine months
ended September 30, 1998 and 1997, cash expenses totaled 41% and 36% of total
revenues, respectively.  Total expenses, including non-cash items, amounted to
80% and 56% of total revenues for the quarters ended September 30, 1998 and
1997, respectively and totaled 53% and 54% of total revenues for the nine months
ended September 30, 1998 and 1997, respectively.  Items negatively impacting
expenses during 1998 included disposition fees of $37,500 on the sale of the
Denny's property in Sanford, Florida, in addition to fees incurred for the
appraisal,  environmental inspection and survey of the Partnership properties
totaling $34,000 and legal fees totaling $25,000, in relation to the proposed
liquidation.

                                       15
<PAGE>
 
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.  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

The Partnership's operations are not dependent on date sensitive software.  The
Partnership is not aware of any Year 2000 problems with its current software.
Accounting and Partnership records software are owned and operated by third
parties who provide services to the Partnership under contract.  The Partnership
is currently in the process of evaluating Year 2000 issues with these third
party providers. The Partnership believes, however, that even if any Year 2000
problems are not corrected on schedule, the cost and disruption to operations of
the Partnership are expected to be minimal.

Tenants are responsible for the operation of any equipment located at the
Partnership's properties.  While the Partnership is not fully aware of the
compliance attainment efforts of its tenants, tenant preparedness for the Year
2000 should have minimal impact on the Partnership and are not expected to be
material to the Partnership's operations, financial condition or liquidity.


Item 3.  Quantitative and Qualitative Disclosures About Market Risk

Not Applicable.

                                       16
<PAGE>
 
                          PART II - OTHER INFORMATION

Item 1 - 5.

Not Applicable.

Item 6.  Exhibits and Reports on Form 8-K

(a)  Listing of Exhibits:

     99.0  Correspondence to the Limited Partners dated November 15, 1998,
           regarding the Third Quarter 1998 distribution.

(b)  Report on Form 8-K:

     The Registrant filed no reports on Form 8-K during the third quarter of
     fiscal year 1998.

                                       17
<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:  __________________________________________________
     Bruce A. Provo, President


Date:  November 14, 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:  __________________________________________________
     Bruce A. Provo, President


Date:  November 14, 1998



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


Date:  November 14, 1998

                                       18
<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:  November 14, 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:  November 14, 1998



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


Date:  November 14, 1998

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