ITEM 1. "BUSINESS--Business Plan."
To qualify for federal taxation as a REIT under the Code, IORI is required, among other things, to hold at least 75% of the value of its total assets in real estate assets, government securities, cash and cash equivalents at the close of each quarter of each taxable year.
Geographic Regions
IORI has divided the continental United States into the following geographic regions.
[MAP]
Northeast region comprised of the states of Connecticut, Delaware, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont, and the District of Columbia. IORI has no properties in this region.
Southeast region comprised of the states of Alabama, Florida, Georgia, Mississippi, North Carolina, South Carolina, Tennessee and Virginia. IORI has 1 commercial property in this region.
Southwest region comprised of the states of Arizona, Arkansas, Louisiana, New Mexico, Oklahoma and Texas. IORI has 7 apartments and 2 commercial properties in this region.
Midwest region comprised of the states of Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, West Virginia and Wisconsin. IORI has no properties in this region.
Mountain region comprised of the states of Colorado, Idaho, Montana, Nevada, Utah and Wyoming. IORI has no properties in this region.
Pacific region comprised of the states of California, Oregon and Washington. IORI has 2 commercial properties in this region.
Excluded from above are two parcels of unimproved land in the Southwest Region, as described below.
Real Estate
At December 31, 2002, 84% of IORI's assets were invested in real estate, on a leveraged basis, in the Pacific, Southeast and Southwest regions of the continental United States. IORI's real estate portfolio consists of 14 owned properties and an investment in a partnership which owns a commercial property.
Types of Real Estate Investments. IORI's real estate consists of apartments and commercial properties (office buildings) having established income-producing capabilities. In selecting real estate for investment, the location, age and type of property; gross rents; lease terms; financial and business standing of tenants; operating expenses; fixed charges; land values and physical condition are considered. IORI may acquire properties subject to, or assume, existing debt and may mortgage, pledge or otherwise obtain financing for its properties. The IORI Board may alter the types of and criteria for selecting new real estate investments and for obtaining financing without a vote of stockholders.
IORI has typically invested in developed real estate, although it also may invest in new construction or development either directly or in partnership with nonaffiliated parties or affiliates (subject to approval by the Board). To the extent that IORI invests in construction and development projects, it will be subject to business risks, such as cost overruns and construction delays, associated with such higher risk projects.
In the opinion of management, IORI's properties are adequately covered by insurance.
The following table sets forth the percentages, by property type and geographic region, (other than two parcels of unimproved land, as described below) of IORI's owned real estate at December 31, 2002.
The foregoing table is based solely on the number of apartment units and commercial square footage owned and does not reflect the value of IORI's investment in each region. IORI owns two parcels of unimproved land, 1.01 acres and 204 acres, both in the Southwest region. See Schedule III to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for a detailed description of IORI's real estate.
A summary of the activity in IORI's owned real estate portfolio during 2002 is as follows:
Properties Held for Investment. Set forth below are IORI's owned properties at December 31, 2002, all of which were held for investment and the monthly rental rate for apartments and the average annual rental rate for office buildings and occupancy thereof at December 31, 2002, 2001 and 2000:
Partnership Properties. Set forth below is the commercial property owned by each of the two partnerships in which IORI is an equity investor and the average annual rental rate and occupancy thereof at December 31, 2002, 2001 and 2000:
IORI owned a 36.3% general partner interest and TCI owned a 63.7% limited partner interest in Tri-City Limited Partnership ("Tri-City") which in turn owned Chelsea Square Shopping Center. In February 2000, Tri-City obtained mortgage financing of $2.1 million secured by the previously unencumbered shopping center. Tri-City received net cash of $2.0 million after the funding of required escrows and the payment of various closing costs. The mortgage bore interest at a fixed rate of 10.24% per annum until February 2001 and a variable rate thereafter, required monthly payments of principal and interest of $20,601 and matured in February 2005. IORI received a distribution of $739,000 of the net financing proceeds. In November 2002, Tri-City sold the Chelsea Square Shopping Center. Tri-City received net cash of $1.9 million after the payment of debt and closing costs. IORI received a distribution of $704,000 of the sale proceeds. Tri-City recognized a gain of $1.1 million of which $383,000 was IORI's equity share.
IORI owns a 10% limited partner interest and TCI owns a 90% general partner interest in TCI Eton Square, L.P., which owns the Eton Square Building in Tulsa, Oklahoma.
Mortgage Loans
Prior to 1991, a substantial portion of IORI's assets had been invested in mortgage notes secured by income-producing real estate. IORI's mortgage notes had included first, wraparound and junior mortgage loans. Prior to the third quarter of 2000, management had not been seeking to fund or acquire new mortgage loans, other than those which may have originated in conjunction with IORI's providing purchase money financing of a property sale. See ITEM 1. "BUSINESS." BCM, in its capacity as a mortgage servicer, services the mortgage notes.
Junior Mortgage Loans. Junior mortgage loans are loans secured by mortgages that are subordinate to one or more prior liens either on the fee or a leasehold interest in real estate. Recourse on the loans ordinarily includes the real estate which secures the loan, other collateral and personal guarantees of the borrower.
The following discussion briefly describes the junior mortgage loans that IORI originated as well as events that affected previously funded junior mortgage loans during 2002.
In September 2000, IORI funded a $1.5 million loan, secured by a second lien on 165 acres of unimproved land in The Colony, Texas. In May 2001, IORI received $1.0 million as a partial principal paydown. The loan bore interest at 18.0% per annum, required monthly payments of interest only and matured in January 2002. In January 2002, the loan was extended to April 2002. In April 2002, the loan was paid off, including accrued but unpaid interest.
In January 2002, IORI purchased 100% of the outstanding common shares of Rosedale Corporation ("Rosedale"), a wholly-owned subsidiary of American Realty Investors, Inc. ("ARI"), a related party, for $5.1 million cash. Rosedale owned the 83,331 sq. ft. Rosedale Towers Office Building in Roseville, Minnesota. ARI guaranteed that the asset would produce at least a 12% return annually of the purchase price for a period of three years from the purchase date. If the asset failed to produce the 12% return, ARI shall pay IORI any shortfall. Management classified this related party transaction as a note receivable from ARI. In the first quarter of 2002, after reviewing the property's fair value after costs to sell, even though ARI guaranteed the 12% return, IORI recognized a provision for loss on the note receivable of $767,000. In December 2002, the Rosedale Towers Office Building was sold for $7.2 million. ARI received $3.5 million of the proceeds after the payment of the first lien debt and various closing costs and IORI recognized an additional loss of $801,000 on its note. The $3.5 million received by ARI is included within other assets in the accompanying Consolidated Balance Sheet.
In February 2002, IORI funded a $2.0 million mortgage loan as a participation agreement with Transcontinental Realty Investors, Inc. ("TCI"), a related party. The loan was secured by a second lien on a retail center in Montgomery County, Texas. The note receivable bore interest at 16.0% per annum, required monthly interest only payments of $47,000 and matured in February 2002. In February 2002, the loan was extended until April 2002. In April 2002, IORI extended the loan until July 2002, receiving $8,500 as an extension fee. In July 2002, the loan was extended until September 2002, with IORI receiving $8,500 as an extension fee. Of the $2.0 million in principal payments, $1.5 million was received by TCI and $500,000 was received by Basic Capital Management, Inc. ("BCM"), an affiliate and the advisor to IORI. These amounts are included within receivable from affiliates in the accompanying Consolidated Balance Sheet.
Partnership mortgage loans. IORI owns a 40% general partner interest and TCI owns a 60% general partner interest in Nakash Income Associates ("NIA"), which holds a wraparound mortgage note receivable secured by a building occupied by a Wal-Mart in Maulden, Missouri.
ITEM 3. LEGAL PROCEEDINGS
Olive Litigation
In February 1990, IORI, together with National Income Realty Trust, Continental Mortgage and Equity Trust ("CMET") and TCI, three real estate entities with, at the time, the same officers, directors or trustees and advisor as IORI, entered into a settlement (the "Settlement") of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al. (the "Olive Litigation"), relating to the operation and management of each of the entities. On April 23, 1990, the Court granted final approval of the terms of the Settlement. The Settlement was modified in 1994 (the "Modification").
On January 27, 1997, the parties entered into an Amendment to the Modification effective January 9, 1997 (the "First Amendment"). The First Amendment provided for the settlement of additional matters raised by plaintiffs' counsel in 1996. The Court issued an order approving the First Amendment on July 3, 1997.
The First Amendment provided that IORI's Board retain a management/compensation consultant or consultants to evaluate the fairness of the BCM advisory contract and any contract of its affiliates with IORI, CMET and TCI, including, but not limited to, the fairness to IORI, CMET and TCI of such contracts relative to other means of administration. In 1998, the Board engaged a management/compensation consultant to perform the evaluation which was completed in September 1998.
In 1999, plaintiffs' counsel asserted that the Board did not comply with the provision requiring such engagement and requested that the Court exercise its retained jurisdiction to determine whether there was a breach of this provision of the First Amendment. In January 2000, the Board engaged another management/compensation consultant to perform the required evaluation again. This evaluation was completed in April 2000 and was provided to plaintiffs' counsel. The Board believes that any alleged breach of the First Amendment has been fully remedied by the Board's engagement of the second consultant. Although several status conferences on this matter have been held, there has been no court order resolving whether there was any breach of the First Amendment.
In October 2000, plaintiffs' counsel asserted that the stock option agreement to purchase TCI shares, which was entered into by IORI and ARI, an affiliate of IORI, in October 2000 with an investment fund, breached a provision of the Modification. As a result of this assertion, IORI assigned all of its rights to purchase the TCI shares under this stock option agreement to ARI.
The Board believes that the provisions of the Settlement, Modification and the First Amendment terminated on April 28, 1999. However, in September 2000, the Court ruled that certain provisions of the Modification continue to be effective after the termination date. This ruling was appealed to the United States Court of Appeals for the Ninth Circuit by IORI and TCI.
On October 23, 2001, TCI, IORI and ARI jointly announced a preliminary agreement with the plaintiff's legal counsel for complete settlement of all disputes in the lawsuit. For further information, refer to ITEM 1. "LEGAL PROCEEDINGS" included in TCI's Second Quarter Report on Form 10-Q for the six months ended June 30, 2002.
On November 15, 2002, ARI commenced the tender offer for the IORI and TCI shares. The tender offer was completed on March 19, 2003.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S SHARES OF COMMON STOCK AND RELATED SHAREHOLDER MATTERS
IORI's Common Stock is traded on the American Stock Exchange ("AMEX") under the symbol "IOT". The foll owing table sets forth the high and low prices for IORI's Common Stock as reported on the AMEX.
As of March 19, 2003, the closing price of IORI's Common Stock on the AMEX was $18.75 per share.
As of March 19, 2003, IORI's Common Stock was held by 920 holders of record.
IORI paid no dividends in 2002 or 2001 and management does not intend to pay dividends in 2003. See ITEM 7. "MANAGEMENT DISCUSSION AND ANALYSIS--Liquidity and Capital Resources."
On December 5, 1989, the Board of Directors approved a share repurchase program, authorizing the repurchase of a total of 200,000 shares of IORI's Common Stock. In June 2000, the Board increased this authorization to 300,000 shares. Through December 31, 2002, a total of 218,804 shares had been repurchased at a cost of $1.9 million. In September 2001, the Board approved separately a private block purchase of 75,100 shares of IORI Common Stock for a total cost of $1.3 million.
ITEM 6. SELECTED FINANCIAL DATA
IORI purchased nine properties for a total of $46.5 million in 2000, and one property for $5.4 million in 1999. IORI sold two properties for a total of $19.2 million in 2002, seven properties for a total of $66.6 million in 2000, and one property for $3.2 million in 1999. See ITEM 2.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
IORI invests in equity interests in real estate through acquisitions, leases, partnerships and in mortgage loans. IORI is the successor to a California business trust organized on December 14, 1984, which commenced operations on April 10, 1985.
Critical Accounting Policies
Critical accounting policies are those that are both important to the presentation of IORI's financial condition and results of operations and require management's most difficult, complex or subjective judgements. IORI's critical accounting policies relate to the evaluation of impairment of long-lived assets and the evaluation of the collectibility of accounts and notes receivable.
If events or changes in circumstances indicate that the carrying value of a rental property to be held and used or land held for development may be impaired, management performs a recoverability analysis based on estimated undiscounted cash flows to be generated from the property in the future. If the analysis indicates that the carrying value is not recoverable from future cash flows, the property is written down to estimated fair value and an impairment loss is recognized. If management decides to sell rental properties or land held for development, management evaluates the recoverability of the carrying amounts of the assets. If the evaluation indicates that the carrying value is not recoverable from estimated net sales proceeds, the property is written down to estimated fair value less costs to sell and an impairment loss is recognized within income from continuing operations. IORI's estimates of cash flow and fair values of the properties are based on current market conditions and considers matters such as rental rates and occupancies for comparable properties, recent sales data for comparable properties and, where applicable, contracts or the results of negotiations with purchasers or prospective purchasers. IORI's estimates are subject to revision as market conditions and IORI's assessments of them change.
IORI's allowance for doubtful accounts receivable and notes receivable is established based on analysis of the risk of loss on specific accounts. The analysis places particular emphasis on past due accounts. Management considers such information as the nature and age of the receivable, the payment history of the tenant or other debtor, the financial condition of the tenant or other debtor and IORI's assessment of its ability to meet its lease or interest obligations. IORI's estimate of the required allowance, which is reviewed on a quarterly basis, is subject to revision as these factors change and is sensitive to the effects of economic and market conditions.
Obligations and Commitments
IORI has contractual obligations and commitments primarily with regards to the payment of mortgages.
The following table aggregates IORI's expected contractual obligations and commitments subsequent to December 31, 2002. (Dollars in thousands.)
Liquidity and Capital Resources
Cash and cash equivalents totaled $10,000, $66,000 and $2.1 million at December 31, 2002, 2001 and 2000. IORI's principal sources of cash have been and will continue to be property operations, proceeds from property
sales and refinancings and partnership distributions. Although management anticipates that IORI will generate excess cash from operations in 2003 due to increased rental rates and occupancy at its properties, such excess, however, will not be sufficient to discharge all of IORI's debt obligations as they mature. Management intends to selectively sell income producing real estate, refinance real estate and incur additional borrowings against real estate to meet its cash requirements.
Net cash used in operating activities was $2.5 million in 2002, $2.0 million in 2001, and $1.9 million in 2000. The primary factors affecting cash flow from operating activities are discussed in the following paragraphs.
Cash flow from property operations (rents collected less payments for property operating expenses) was $3.4 million in 2002, $6.0 million in 2001, and $6.6 million in 2000. In 2002, a decrease of $1.7 million was due to the sale of two office buildings in 2002 and $900,000 was due to decreased occupancies at IORI's commercial properties. Of the decrease in 2001 from 2000, $2.0 million was due to the sale of three apartments and two office buildings in 2000. The decrease was offset in part by an increase of $721,000 from the purchase of five apartments in 2000 and an increase of $700,000 due to increased rental rates and occupancies at IORI's apartment and commercial properties.
Interest collected was $291,000 in 2002, $148,000 in 2001, and $310,000 in 2000. The increase in 2002 was due to the funding of two notes. The decrease in 2001 from 2000 was due to a decrease in short-term investment income and the partial paydown of one mortgage note receivable in 2001.
Interest paid on notes payable was $4.3 million in 2002, $5.5 million in 2001, and $5.0 million in 2000. Of the decrease in 2002 from 2001, $600,000 was due to the sale of two commercial properties, $600,000 was due to the refinancing of Travelers land, $200,000 was due to decreased variable rates and principal reductions and a $200,000 increase was due to the refinancing of apartments. Of the increase in 2001 from 2000, $427,000 was due to the purchase of five apartments in 2000 and $1.6 million was due to the purchase of one parcel of unimproved land in 2000. The increase also was due to a $188,000 increase from a loan refinancing for a commercial property in 2001. This increase was offset by a decrease of $883,000 from the sale of three apartments in 2000, $496,000 from the sale of two commercial properties in 2000, and $135,000 from the sale of two unimproved land parcels in 2000. A decrease of $200,000 was due to variable interest rates decreasing during 2001 for several of IORI's variable rate notes.
Advisory and net income fee paid to affiliate was $868,000 in 2002, $1.1 million in 2001, and $2.6 million in 2000. The decrease in 2002 from 2001, was due to a decrease in gross assets. Of the decrease in 2001 from 2000, $1.4 million was due to a decrease in the net income fee paid which is due to a decrease in IORI's net income, the basis for such fee. The remaining decrease was due to a decrease in gross assets. See NOTE 8. "ADVISORY AGREEMENT."
General and administrative expenses paid was $1.0 million in 2002, $1.6 million in 2001, and $1.2 million in 2000. The decrease in 2002 from 2001, was due to decreases in franchise taxes paid. The increase in 2001 from 2000, was due to increases in taxes accrued in 2000 and paid in 2001.
IORI made improvements to its properties totaling $365,000 in 2002, $3.5 million in 2001, and $1.9 million in 2000. The variance was primarily due to improvements made to IORI's unimproved land.
IORI received cash of $500,000 in 2002 and $1.0 million from mortgage receivable principal payments in 2001, and net cash of $22.9 million in 2002 and $14.1 million from refinancings in 2001. In 2002, $26.3 million was expended in principal payments on mortgage debt, $14.8 million was expended in 2001, and $18.2 million was expended in 2000.
Scheduled principal payments on notes payable of $12.6 million are due in 2003. For those mortgages that come due in 2003, it is management's intent to either seek an extension of the due dates by one or more years, or
refinance the debt on a long-term basis, or pay off the debt at maturity, or selectively sell income producing real estate. Management believes it will continue to be successful in obtaining loan extensions and/or refinancings.
Management expects that funds from existing cash resources, selective sales of income producing properties, refinancing of real estate, and additional borrowings against real estate will be sufficient to meet IORI's cash requirements associated with its current and anticipated level of operations, maturing debt obligations and existing commitments. To the extent that IORI's liquidity permits or financing sources are available, management intends to make new real estate investments.
IORI owned a 36.3% general partner interest in the Tri-City partnership. IORI received a distribution of $25,000 in 2002, $18,000 in 2001, and $25,000 in 2000 from Tri-City's operating cash flow. In 2002, IORI received $752,000 as a distribution from the sales proceeds. IORI owns a 40% general partner interest in the NIA partnership. In 2002 and 2001, IORI received no distributions from NIA and made a $24,000 contribution in 2001 to the partnership. IORI owns a 10% limited partnership interest in the TCI Eton Square partnership. IORI received no distributions and made no contributions to the partnership in 2002 or 2001. See NOTE 4. "INVESTMENT IN EQUITY METHOD PARTNERSHIPS."
IORI paid no dividends in 2002 and 2001. In December 2000, the Board of Directors determined not to pay a fourth quarter dividend to holders of IORI's Common Stock. The non-payment decision was based on the Board determining that IORI needed to retain cash for acquisitions that were anticipated in 2001 and that IORI had no REIT taxable income that required a distribution. Management does not plan to pay quarterly dividends for 2003.
In 2001, IORI repurchased 75,100 shares of Common Stock in a private block purchase for a total of $1.3 million.
Management reviews the carrying values of IORI's properties at least annually and whenever events or a change in circumstances indicate that impairment may exist. Impairment is considered to exist if the future cash flow from a property (undiscounted and without interest) is less than the carrying amount of the property. If impairment is found to exist, a provision for loss is recorded by a charge against earnings. The property review generally includes selective property inspections, discussions with the manager of the property and visits to selected properties in the area and a review of (1) the property's current rents compared to market rents, (2) the property's expenses, (3) the property's maintenance requirements and (4) the property's cash flows.
Results of Operations
IORI reported net income of $2.1 million in 2002, a net loss of $3.5 million in 2001 and net income of $16.8 million in 2000. Fluctuations in these and the other components of revenue and expense are discussed in the following paragraphs.
Rents were $9.9 million in 2002, $10.2 million in 2001 and $8.1 million in 2000. The decrease in 2002 from 2001 was due to decreased occupancies at IORI's commercial properties. Of the increase in 2001 from 2000, $1.4 million was due to the purchase of five apartment properties in 2000 and $500,000 and $169,000 was due to increased rental rates at IORI's commercial and apartment properties, respectively. Rents in 2003 are expected to decrease as IORI selectively sells properties.
Property operations expense was $5.6 million in 2002, $5.4 million in 2001, and $4.4 million in 2000. Of the increase in 2002 from 2001, $100,000 was due to an increase in property taxes for IORI's land and $100,000 was due to increased utility and insurance expenses. Of the increase in 2001 from 2000, $598,000 was due to the purchase of five apartments in 2000, $235,000 was due to the increased utility, cleaning, repairs and insurance expense at IORI's commercial properties and $250,000 was due to an increase in property taxes for IORI's land. Property operations expense is expected to decrease in 2003 as IORI selectively sells properties.
Interest income was $270,000 in 2002, $194,000 in 2001, and $319,000 in 2000. This increase was due to an increase in short term notes receivable which were paid off by the end of 2002. The decrease in 2001 from 2000, was due to a decrease in short-term investments, and from a $1.0 million principal paydown received in May 2001 on IORI's only note receivable. Interest income is expected to decrease as all of IORI's notes have been paid off.
Interest expense was $4.7 million in 2002, $5.2 million in 2001, and $2.7 million in 2000. Of the decrease in 2002 from 2001, $569,000 was due to the refinancing of Travelers land, and $219,000 was due to lower variable interest rate and principal paydowns. This decrease was offset by an increase of $300,000 due to the refinancing of the apartments. Of the increase in 2001 from 2000, $345,000 and $2.0 million was due to the purchase of five apartments and one unimproved land parcel in 2000, respectively, and $174,000 was due to one loan refinanced in 2001. The remaining decrease of $156,000 was due to lower variable interest rates at IORI's apartment and commercial properties. Interest expense in 2003 is expected to remain constant or decrease as IORI selectively sells properties.
Depreciation expense was $1.8 million in 2002, $1.9 million in 2001, and $1.5 million in 2000. The decrease was due to fully depreciated tenant improvements. Of the increase in 2001 from 2000, $138,000 was from the purchase of five properties in 2000 and an increase of $200,000 was from tenant improvements. Depreciation expense in 2003 is expected to approximate 2002.
Advisory fee to affiliate was $714,000 in 2002, $817,000 in 2001, and $664,000 in 2000. The change was due to changes in gross assets, the basis of the fee. The advisory fee in 2003 is expected to decrease due to property sales in 2002. See NOTE 8. "ADVISORY AGREEMENT."
IORI paid a net income fee of $169,000 in 2002. IORI paid no net income fee in 2001 compared to $1.4 million in 2000. The net income fee is based on 7.5% of IORI's net income.
General and administrative expense was $1.0 million in 2002, $739,000 in 2001, and $1.5 million in 2000. The increase in 2002 from 2001, was primarily due to an increase in Director's and Officer's insurance. The decrease in 2001 from 2000, was primarily due to a decrease in franchise taxes.
Equity gains of partnerships was $862,000 in 2002 and equity losses were $9,000 in 2001, and $61,000 in 2000. The increase in 2002 was due to dissolving of the Tri-City partnership. The decrease in 2001 was primarily due to a decrease in operating expenses at Eton Square Office Building.
IORI realized gains on the sale of real estate of $7.1 million in 2002 and $20.9 million in 2000. In 2002, gains on sale of real estate represented the gain on the sale of Daley Corporate Center.
In 2000, gains on sale of real estate totaling $20.9 million were realized: $903,000 on the sale of La Monte Park Apartments, $1.2 million on the sale of Renaissance Parc Apartments, $1.9 million on the sale of Olympic Office Building, $13.1 million on the sale of Saratoga Office Building, $2.2 million on the sale of Eastpoint Apartments, $388,000 on the sale of Etheredge and Fambrough land and a $1.3 million recognition of a deferred gain.
IORI realized net income (loss) on discontinued operations of $6.7 million, $228,000 and $(295,000) in 2002, 2001 and 2000. The income (loss) relates to two properties that IORI sold during 2002. The following table summarizes revenue and expense information for the properties sold.
Environmental Matters
Under various federal, state and local environmental laws, ordinances and regulations, IORI may be potentially liable for removal or remediation costs, as well as certain other potential costs, relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos-containing materials into the air, and third parties may seek recovery for personal injury associated with such materials.
Management is not aware of any environmental liability relating to the above matters that would have a material adverse effect on IORI's business, assets or results of operations.
Inflation
The effects of inflation on IORI's operations are not quantifiable. Revenues from property operations tend to fluctuate proportionately with inflationary increases and decreases in housing costs. Fluctuations in the rate of inflation also affect the sales values of properties and the ultimate gain to be realized from property sales. To the extent that inflation affects interest rates, earnings from short-term investments and the cost of new financings as well as the cost of variable interest rate debt will be affected.
Taxes
For the years 2002, 2001 and 2000, IORI elected and in the opinion of management qualified to be taxed as a REIT as defined under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended. To continue to qualify for federal taxation as a REIT, IORI is required to hold at least 75% of the value of its total assets in real estate assets, government securities, cash and cash equivalents at the close of each quarter of each taxable year. As a REIT, IORI is also required to distribute at least 90% (95% in 2000) of its REIT taxable income plus 90% (95% in 2000) of its net income from foreclosure property on an annual basis to stockholders.
Due to the completion of the tender offer by ARI on March 19, 2003, and the resulting concentration of ownership, IORI no longer met the requirement for tax treatment as a REIT as of January 1, 2003. IORI cannot re-qualify for tax treatment as a REIT for at least five years.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES REGARDING MARKET RISK
IORI's future operations, cash flow and fair values of financial instruments are partially dependent upon the then existing market interest rates and market equity prices. Market risk is the changes in the market rates and prices and the affect of the changes on future operations. Market risk is managed by matching the property's anticipated net operating income to an appropriate financing.
IORI is exposed to interest rate risk associated with variable rate notes payable and maturing debt that has to be refinanced. IORI does not hold financial instruments for trading or other speculative purposes, but rather issues these financial instruments to finance its portfolio of real estate assets. IORI's interest rate sensitivity position is managed by IORI's finance department. Interest rate sensitivity is the relationship between changes in market interest rates and the fair value of market rate sensitive assets and liabilities. IORI's earnings are affected as changes in short-term interest rates impact its cost of variable rate debt and maturing fixed rate debt. A large portion of IORI's market risk is exposure to short-term interest rates from variable rate borrowings. The impact on IORI's financial statements of refinancing fixed debt that matured during 2002 was not material. As permitted, management intends to convert a significant portion of variable rates borrowings to fixed rates in 2003. If market interest rates for variable rate debt average 100 basis points more in 2003 than they did during 2002, IORI's interest expense would increase and income would decrease by $417,000. This amount is determined by considering the impact of hypothetical interest rates on IORI's borrowing cost. This analysis did not consider the effects of the reduced level of overall economic activity that could exist in such an environment. Further, in the event of a change of such magnitude, management would likely take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no change in IORI's financial structure.
The following table contains only those exposures that existed at December 31, 2002. Anticipation of exposures or risk on positions that could possibly arise was not considered. IORI's ultimate interest rate risk and its affect on operations will depend on future capital market exposures, which cannot be anticipated with a probable assurance level. (Dollars in thousands.)
Liabilities
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
All other schedules are omitted because they are not required, are not applicable or the information required is included in the Financial Statements or the notes thereto.
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors of Income Opportunity Realty Investors, Inc.
We have audited the accompanying consolidated balance sheets of Income Opportunity Realty Investors, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2002. We have also audited the schedules listed in the accompanying index. These financial statements and the schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe our audits provide a reasonable basis for our opinion.
As described in Note 17, Income Opportunity Realty Investors, Inc.'s management has indicated its intent to both sell income producing properties and refinance or extend debt secured by real estate, to meet its liquidity needs.
As discussed in Note 1, IORI adopted the provisions of SFAS 144, Accounting for Impairment of Long Lived Assets, in 2001.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Income Opportunity Realty Investors, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the schedules referred to above presents fairly, in all material respects, the information set forth therein.
BDO SEIDMAN, LLP
Dallas, Texas March 21, 2003
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these Consolidated Financial Statements.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these Consolidated Financial Statements.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these Consolidated Financial Statements.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these Consolidated Financial Statements.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)
The accompanying notes are an integral part of these Consolidated Financial Statements.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The accompanying Consolidated Financial Statements of Income Opportunity Realty Investors, Inc. and consolidated entities were prepared in conformity with accounting principles generally accepted in the United States of America, the most significant of which are described in NOTE 1. "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES." The Notes to Consolidated Financial Statements are an integral part of these Consolidated Financial Statements. The data presented in the Notes to Consolidated Financial Statements are as of December 31 of each year and for the year then ended, unless otherwise indicated. Dollar amounts in tables are in thousands, except per share amounts.
Certain balances for 2001 and 2000 have been reclassified to conform to the 2002 presentation.
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and business. Income Opportunity Realty Investors, Inc. ("IORI") is the successor to a California business trust organized on December 14, 1984, which commenced operations on April 10, 1985. IORI invests in real estate through direct ownership, leases and partnerships and it also may invest in mortgage loans on real estate.
In October 2001, IORI announced a preliminary agreement for the acquisition of IORI by American Realty Investors, Inc. ("ARI"), a related party. See NOTE 17. "COMMITMENTS AND CONTINGENCIES AND LIQUIDITY."
Basis of consolidation. The Consolidated Financial Statements include the accounts of IORI and controlled subsidiaries and partnerships. All significant intercompany transactions and balances have been eliminated.
Accounting estimates. In the preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, it is necessary for 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 Consolidated Financial Statements and the reported amounts of revenues and expenses for the year then ended. Actual results could differ from those estimates.
Recent accounting pronouncements. In April 2002, the FASB issued Statement 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Correction" ("SFAS No. 145"). Statement 4, "Reporting Gains and Losses from Extinguishment of Debt" ("SFAS No. 4"), required that gains and losses from the extinguishment of debt that were included in the determination of net income be aggregated and, if material, classified as an extraordinary item. The provisions of SFAS No. 145 related to the rescission of SFAS No. 4 will require IORI to reclassify prior period items that do not meet the extraordinary classification. The provisions of SFAS No. 145 that relates to the rescission of SFAS No. 4 become effective in fiscal years beginning after May 15, 2002. The adoption of SFAS No. 145 is not expected to have a material impact on the consolidated financial position or results of operations of IORI.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force ("EITF") Issue No. 94-3. IORI will adopt the provisions of SFAS No. 146 for restructuring activities initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at the date of a company's commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amount recognized.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation. Finally, this Statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. Management currently believes that the adoption of SFAS No. 148 will not have a material impact on the financial statements.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," which disclosures are effective for financial statements issued after December 15, 2002. While IORI has various guarantees included in contracts in the normal course of business, these guarantees do not represent significant commitments or contingent liabilities of the indebtedness of entities outside of the consolidated company.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46") which requires the consolidation of variable interest entities, as defined. FIN 46 is applicable to financial statements to be issued by IORI after 2002, however, disclosures are required currently if IORI expects to consolidate any variable interest entities. IORI does not currently believe that any entities will be consolidated as a result of FIN 46.
Real estate held for investment and depreciation. Real estate held for investment is carried at cost. Statement of Financial Accounting Standards No. 144 ("SFAS No. 144") requires that a property be considered impaired, if the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the property. If impairment exists, an impairment loss is recognized by a charge against earnings equal to the amount by which the carrying amount of the property exceeds the fair value of the property. If impairment of a property is recognized, the carrying amount of the property is reduced by the amount of the impairment and a new cost for the property is established. Such new cost is depreciated over the property's remaining useful life. Depreciation is provided by the straight-line method over estimated useful lives, which range from 2 to 40 years.
Revenue recognition on the sale of real estate. Sales of real estate are recognized when and to the extent permitted by Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("SFAS No. 66"). Until the requirements of SFAS No. 66 for full profit recognition have been met, transactions are accounted for using either the deposit, the installment sale, the cost recovery or the financing method, whichever is appropriate. See NOTE 2. "REAL ESTATE."
Investment in noncontrolled partnerships. The equity method is used to account for investments in partnerships which IORI does not control. Under the equity method, an initial investment, recorded at cost, is increased by a proportionate share of the partnership's operating income and any additional advances and decreased by a proportionate share of the partnership's operating losses and distributions received.
Operating segments. Management has determined reportable operating segments to be those that are used for internal reporting purposes which disaggregates operations by type of real estate.
Fair value of financial instruments. The following assumptions were used in estimating the fair value of notes receivable and payable. For notes receivable the fair value was estimated by discounting future cash flows using current interest rates for similar loans. For notes payable the fair value was estimated using year end interest rates for mortgages with similar terms and maturities.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Cash equivalents. For purposes of the Consolidated Statements of Cash Flows, all highly liquid investments purchased with an original maturity of three months or less are considered cash equivalents.
Earnings per share. Income (loss) per share is presented in accordance with Statement of Financial Accounting Standards No. 128 "Earnings Per Share." Income (loss) per share is computed based upon the weighted average number of shares of Common Stock outstanding during each year.
NOTE 2. REAL ESTATE
In 2002, IORI sold the following properties:
Concentration of investment risk. IORI has a high concentration of investment risk on properties in the Southwest region of the United States. This risk includes, but is not limited to changes in local economic conditions, changes in real estate and zoning laws, increases in real estate taxes, floods, tornados and other acts of God and other factors beyond the control of management. In the opinion of management, this investment risk is partially mitigated by the diversification of property types in other geographical regions of the United States, management's review of additional investments, acquisitions in other areas and by insurance.
NOTE 3. NOTES AND INTEREST RECEIVABLE
Junior Mortgage Loans. Junior mortgage loans are loans secured by mortgages that are subordinate to one or more prior liens either on the fee or a leasehold interest in real estate. Recourse on the loans ordinarily includes the real estate which secures the loan, other collateral and personal guarantees of the borrower.
In September 2000, IORI funded a $1.5 million loan secured by a second lien on 165 acres of unimproved land in The Colony, Texas. In May 2001, IORI received $1.0 million as a partial principal paydown. The loan bore interest at 18.0% per annum, required monthly payments of interest only and matured in January 2002. In January 2002, the loan was extended to April 2002. In April 2002, the loan was paid off including accrued but unpaid interest.
In January 2002, IORI purchased 100% of the outstanding common shares of Rosedale Corporation ("Rosedale"), a wholly-owned subsidiary of American Realty Investors, Inc. ("ARI"), a related party, for $5.1 million cash. Rosedale owned the 83,331 sq. ft. Rosedale Towers Office Building in Roseville, Minnesota. ARI guaranteed that the asset would produce at least a 12% return annually of the purchase price for a period of three years from the purchase date. If the asset failed to produce the 12% return, ARI agreed to pay IORI any shortfall. Management recorded this related party transaction as a note receivable from ARI. In the first quarter of 2002, after reviewing the property's fair value after costs to sell, even though ARI has guaranteed the 12% return, IORI recognized a provision for loss on the note receivable of $767,000. In December 2002, the Rosedale Towers Office Building was sold for $7.2 million. ARI received $3.5 million of the proceeds after the payment of the first lien debt and various closing costs, and IORI recognized an additional loss of $801,000 on this note. The $3.5 million received by ARI is included within other assets in the accompanying Consolidated Balance Sheet.
In February 2002, IORI funded a $2.0 million mortgage loan as a participation agreement with Transcontinental Realty Investors, Inc. ("TCI"), a related party. The loan was secured by a second lien on a retail
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
center in Montgomery County, Texas. The note receivable bore interest at 16.0% per annum, required monthly interest only payments of $47,000 and matured in February 2002. In February 2002, the loan was extended until April 2002. In April 2002, IORI extended the loan until July 2002, receiving $8,500 as an extension fee. In July 2002, the loan was extended until September 2002, with IORI receiving an additional $8,500 as an extension fee. Also in July 2002, $500,000 in principal was paid on the note. In August 2002, the note was paid off including accrued but unpaid interest. Of the $2.0 million in principal payments, $1.5 million was received by TCI and $500,000 was received by Basic Capital Management, Inc. ("BCM"), an affiliate and the advisor to IORI. These amounts are included within receivables from affiliates in the accompanying Consolidated Balance Sheet.
NOTE 4. INVESTMENT IN EQUITY METHOD PARTNERSHIPS
Investments in equity method partnerships consisted of the following:
IORI owned a 36.3% general partner interest in Tri-City, which in turn owned a shopping center in Houston, Texas. TCI owned a 63.7% limited partner interest in Tri-City. In November 2002, the shopping center was sold for $4.2 million. Tri-City received net cash of $1.9 million after the payment of various closing costs. IORI received a distribution of $704,000 of the net proceeds and recognized a gain of $1.3 million on its investment in Tri-City.
IORI also owns a 40% general partner interest in NIA. NIA's only asset is a wraparound mortgage note receivable secured by a shopping center in Maulden, Missouri. TCI owns the remaining 60% general partner interest in NIA.
IORI further owns a 10% limited partner interest in Eton Square, which at December 31, 2002, owned the Eton Square Building in Tulsa, Oklahoma. TCI owns a 90% general partner interest in Eton Square.
Set forth below are summarized financial data for the partnerships accounted for using the equity method:
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
IORI's equity share of:
- -------- * Includes the $1.3 million gain from the sale of IORI's investment in Tri-City.
NOTE 5. NOTES AND INTEREST PAYABLE
Notes and interest payable consisted of the following:
Scheduled notes payable principal payments are due as follows:
Notes payable at December 31, 2002, bear interest at rates ranging from 4.25% to 10.5% and mature between 2003 and 2025. The mortgages are collateralized by deeds of trust on real estate with a net carrying value of $74.7 million.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In April 2002, IORI sold all of its residential properties to partnerships controlled by Metra Capital, LLC ("Metra"). These properties include: the 60 unit Brighton Court, the 92 unit Del Mar, the 68 unit Enclave, the 280 unit Meridian, the 57 unit Signature, the 114 unit Sinclair, located in Midland, Texas, and the 106 unit Treehouse, located in San Antonio, Texas. Innovo Realty, Inc., a subsidiary of Innovo Group, Inc. ("Innovo") is a limited partner in the partnerships that purchased the properties. Joseph Mizrachi, a director of ARI, a related party, controls approximately 11.67% of the outstanding common stock of Innovo. The sale constituted 23% of the total assets of IORI as of December 31, 2001. The sales price for the properties totaled $26.2 million. IORI received $5.4 million in cash after the payoff of $16.1 million in debt and various closing costs. Management has determined to account for this sale as a refinancing transaction, in accordance with SFAS No. 66, "Accounting for Sales of Real Estate." IORI will continue to report the assets and the new debt incurred by the Metra partnerships on the IORI financial statements. The new debt on the properties totals $21.4 million, bears interest at 7.57% per annum, requires monthly interest only payments of $135,000 and matures in May 2012. IORI also received $5.2 million of 8% non-recourse, non-convertible Series A Preferred Stock ("Preferred Shares") of Innovo.
The dividend on the Preferred Shares will be funded entirely and solely through member distributions from cash flows generated by the operation and subsequent sale of the sold properties. In the event the cash flows for the properties are insufficient to cover the 8% annual dividend, Innovo will have no obligation to cover any shortfall.
The Preferred Shares have a mandatory redemption feature and are redeemable from the cash proceeds received by Innovo from the operation and sale of the properties. All member distributions that are in excess of current and accrued 8% dividends must be used by Innovo to redeem the Preferred Shares. Since redemption of these shares is subject to the above future events, management has not recorded any basis in the Preferred Shares.
In 2001, IORI refinanced the following properties:
- -------- (1) Variable rate.
NOTE 6. RELATED PARTY TRANSACTIONS
In January 2002, IORI purchased 100% of the outstanding common shares of Rosedale Corporation ("Rosedale"), a wholly-owned subsidiary of American Realty Investors, Inc. ("ARI"), a related party, for $5.1 million cash. Rosedale owned the 83,331 sq. ft. Rosedale Towers Office Building in Roseville, Minnesota. ARI guaranteed that the asset would produce at least a 12% return annually of the purchase price for a period of three years from the purchase date. If the asset failed to produce the 12% return, ARI shall pay IORI any shortfall. Management has classified this related party transaction as a note receivable from ARI. In the first quarter of 2002, after reviewing the property's fair value after costs to sell, even though ARI has guaranteed the 12% return, IORI recognized a provision for loss on the note receivable of $767,000. In December 2002, the Rosedale Towers Office Building was sold for $7.2 million. ARI received $3.5 million of the proceeds after the payment of the first lien debt and various closing costs and IORI recognized an additional loss of $801,000 on its note. The $3.5 million received by ARI is included within other assets in the accompanying Consolidated Balance Sheet.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In February 2002, IORI funded a $2.0 million mortgage loan as a participation agreement with Transcontinental Realty Investors, Inc. ("TCI"), a related party. The loan was secured by a second lien on a retail center in Montgomery County, Texas. The note receivable bore interest at 16.0% per annum, required monthly interest only payments of $47,000 and matured in February 2002. In February 2002, the loan was extended until April 2002. In April 2002, IORI extended the loan until July 2002, receiving $8,500 as an extension fee. In July 2002, the loan was extended until September 2002, with IORI receiving $8,500 as an extension fee. Also in July 2002, IORI received a $500,000 principal paydown on the note. In August 2002, the note was paid off including accrued but unpaid interest. Of the $2.0 million in principal payments, $1.5 million was received by TCI and $500,000 was received by Basic Capital Management, Inc. ("BCM"), an affiliate and the advisor to IORI. These amounts are included within receivable from affiliates in the accompanying Consolidated Balance Sheet.
During 2002, IORI's Board of Directors authorized IORI's Chief Financial Officer to advance funds either to or from IORI, through BCM, in an amount up to $5.0 million, on the condition that such advances shall be repaid in cash or transfers of assets within 90 days.
The following table reconciles the beginning and ending balances of Accounts Receivable from Affiliates as of December 31, 2002.
Returns on Metra Properties. As described more fully in Note 5, IORI sold all of its residential properties during 2002 to partnerships controlled by Metra. The partnership agreement for each of these partnerships states that the Metra Partners, as defined, receive cash flow distributions at least quarterly in an amount sufficient to provide them with a fifteen percent cumulative compounded annual rate of return on their invested capital, as well as a cumulative annual amount of 0.50% of the average outstanding balance of the mortgage indebtedness secured by any of these residential properties. These distributions to the Metra Partners have priority over distributions to any of the other partners.
NOTE 7. DIVIDENDS
Dividends of $685,000 ($.45 per share) were paid in 2000.
It was reported to the Internal Revenue Service that 100% of the dividends paid in 2000 represented capital gains.
In December 2000, the Board of Directors determined not to pay a fourth quarter dividend to holders of IORI's Common Stock. The non-payment decision was based on the Board determining that IORI needed to retain cash for acquisitions that were anticipated in 2001 and that IORI had no REIT taxable income that required a distribution.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
No dividends were declared or paid in 2002 or 2001. Management expects to pay no dividends in 2003.
NOTE 8. RENTS UNDER OPERATING LEASES
Operations include the leasing of office buildings. The leases thereon expire at various dates through 2011. The following is a schedule of minimum future rents on non-cancelable operating leases as of December 31, 2002:
NOTE 9. ADVISORY AGREEMENT
BCM is indirectly owned by a trust for the children of Gene E. Phillips. Mr. Phillips is not an officer or director of BCM, but serves as a representative of the trust, and is indirectly involved in daily consultation with the officers of BCM and has significant influence over the conduct of BCM's business, including the rendering of advisory services and the making of investment decisions for itself and for IORI.
Under the Advisory Agreement, BCM is required to annually formulate and submit for Board approval a budget and business plan containing a twelve-month forecast of operations and cash flow, a general plan for asset sales and purchases, borrowing activity and other investments. BCM is required to report quarterly to the Board on IORI's performance against the business plan. In addition, all transactions require prior Board approval, unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to BCM by the Board.
The Advisory Agreement also requires prior Board approval for the retention of all consultants and third party professionals other than legal counsel. The Advisory Agreement provides that BCM shall be deemed to be in a fiduciary relationship to the stockholders and contains a broad standard governing BCM's liability for losses incurred by IORI.
The Advisory Agreement provides for BCM to be responsible for IORI's day-to-day operations and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% per annum of net income.
The Advisory Agreement also provides for BCM to receive an annual incentive sales fee. BCM or an affiliate of BCM is to receive an acquisition commission for supervising the purchase or long-term lease of real estate. BCM or an affiliate of BCM is to receive a mortgage or loan acquisition fee with respect to the purchase of any existing mortgage loan. BCM or an affiliate of BCM also is to receive a mortgage brokerage and equity refinancing fee for obtaining loans or refinancing of IORI's properties. In addition, BCM receives reimbursement of certain expenses incurred by it, in the performance of advisory services for IORI.
The Advisory Agreement requires BCM or any affiliate of BCM to pay to IORI one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by IORI.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Under the Advisory Agreement all or a portion of the annual advisory fee must be refunded by BCM if the Operating Expenses of IORI (as defined in the Advisory Agreement) exceed certain limits specified in the Advisory Agreement. The effect of this limitation was to require BCM to refund $68,000 of the 2002 annual advisory fee and $256,000 of the 2001 annual advisory fee. BCM was not required to refund any of its 2000 advisory fees.
Additionally, if management was to request that BCM render services other than those required by the Advisory Agreement, BCM or an affiliate of BCM would be separately compensated for such additional services on terms to be agreed upon from time to time. As discussed in NOTE 9. "PROPERTY MANAGEMENT," Triad Realty Services, Ltd. ("Triad"), an affiliate of BCM, provides property management services and, as discussed in NOTE 10. "REAL ESTATE BROKERAGE," Regis Realty, Inc. ("Regis"), a related party, provided, on a non-exclusive basis, brokerage services.
BCM may assign the Advisory Agreement only with the prior consent of IORI.
NOTE 10. PROPERTY MANAGEMENT
Triad provides property management services for a fee of 5% or less of the monthly gross rents collected on residential properties and 3% or less of the monthly gross rents collected on commercial properties under its management. Triad subcontracts with other entities for property-level management services at various rates. The general partner of Triad is BCM. The limited partner of Triad is Highland Realty Services, Inc. ("Highland"), a related party. Triad subcontracted to Regis, which is owned by Highland, the property-level management and leasing of IORI's five office buildings and the commercial property owned by Eton Square, until December 2002. Since January 1, 2003, Regis Realty I, LLC, which is owned by Highland, provided property management services. Regis was and Regis Realty I, LLC is entitled to receive property and construction management fees and leasing commissions in accordance with the terms of its property-level management agreement with Triad.
NOTE 11. REAL ESTATE BROKERAGE
Regis also provided brokerage services on a non-exclusive basis until December 2002. Regis was and Regis Realty I, LLC is entitled to receive a commission for property purchases and sales in accordance with a sliding scale of total brokerage fees to be paid by IORI.
NOTE 12. ADVISORY FEES, PROPERTY MANAGEMENT FEES, ETC.
Fees and cost reimbursements to BCM and its affiliates:
Costs incurred by BCM related to IORI, ARI and TCI are allocated based on the relative book values of each company's assets.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Fees paid to GS Realty, a related party to IORI:
- -------- * Net of property management fees paid to subcontractors, other than Regis.
NOTE 13. INCOME TAXES
For the years 2002, 2001 and 2000, IORI elected and qualified to be treated as a Real Estate Investment Trust ("REIT"), as defined in Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"), and as such, was not taxed for federal income tax purposes on that portion of its taxable income which is distributed to stockholders. Due to the completion of the tender offer by ARI, an affiliate, and the resulting concentration of ownership, IORI no longer met the requirements for tax treatment as a REIT under the Code as of January 1, 2003, and is prohibited for re-qualifying for REIT status for at least five years.
IORI had net income for federal income tax purposes before the application of operating loss carryforwards in 2002 and 2000 and had a net loss for federal income tax purposes in 2001. Therefore, IORI recorded no provision for income taxes. IORI's tax basis in its net assets differs from the amount at which its net assets are reported for financial statement purposes, principally due to the accounting for gains and losses on property sales, depreciation on owned properties and investments in joint venture partnerships. At December 31, 2002, IORI's tax basis in its net assets was exceeded by their net basis for financial statement purposes by approximately $20 million and IORI's tax basis in its net mortgage liabilities was exceeded by their net basis for financial statement purposes by approximately $23.0 million. As a result, aggregate future income for income tax purposes will be less than such amount for financial statement purposes and IORI would be able to maintain its REIT status without distributing 90% of its financial statement income. Additionally, at December 31, 2002, IORI has current and prior tax net operating loss carryforwards of $2.4 million expiring through the year 2021.
As a result of IORI's election to be treated as a REIT for income tax purposes for years 2001 and 2000 and its then intention to distribute its REIT taxable income, if any, in future years, no deferred tax asset, liability or valuation allowance was recorded. In anticipation of its January 1, 2003 loss of REIT status, it was determined that at December 31, 2002 that IORI had a net deferred tax asset of $4.0 million due to tax deductions available to it in future years. However, as management cannot determine that it is more likely than not that IORI will relaize the benefit of the deferred tax asset, a 100% valuation allowance has been established.
NOTE 14. OPERATING SEGMENTS
Significant differences among the accounting policies of the operating segments as compared to the Consolidated Financial Statements principally involve the calculation and allocation of general and administrative expenses. Management evaluates the performance of the operating segments and allocates resources to each of them based on their operating income and cash flow. Items of income that are not reflected in the segments are interest, and equity in partnerships totaling $1.1 million, $185,000 and $258,000 for 2002, 2001 and 2000, respectively. Expenses that are not reflected in the segments are general and administrative expenses, advisory and net income fees and provision for losses totaling $3.5 million, $1.6 million and $3.6 million for 2002, 2001 and 2000, respectively. Excluded from operating segment assets are assets of $15.4 million at December 31, 2002, and $4.4 million at December 31, 2001, which are not identifiable with an operating segment. There are no intersegment revenues and expenses and all business is conducted in the United States.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Presented below is the operating income of each operating segment.
- -------- * Excludes a $1.3 million deferred gain on the sale of a property to an affiliate, recognized by IORI upon the affiliate's subsequent resale of the property.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NOTE 15. DISCONTINUED OPERATIONS
Effective January 1, 2002, IORI adopted Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which established a single accounting model for the impairment or disposal of long-lived assets, including discontinued operations. This statement requires that the operations related to properties that have been sold or properties that are intended to be sold be presented as discontinued operations in the statement of operations for all periods presented, and properties intended to be sold are to be designated as "held-for-sale" on the balance sheet.
For 2002, 2001 and 2000, income (loss) from discontinued operations relates to two properties that IORI sold during 2002. The following table summarizes revenue and expense information for these properties sold.
NOTE 16. QUARTERLY DATA
The following is a tabulation of quarterly results of operations for the years 2002, 2001 and 2000 (unaudited).
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In the first quarter of 2002, the Daley Corporate Center office building was sold, and a gain on sale of real estate of $7.1 million was recognized. In the third quarter of 2002, the Westlake Village Office Building was sold at a loss of $336,000. In the fourth quarter of 2002, IORI recognized a gain of $383,000, IORI's share of gain on sale of real estate from an equity investee.
NOTE 17. COMMITMENTS AND CONTINGENCIES AND LIQUIDITY
Olive Litigation. In February 1990, IORI, together with National Income Realty Trust, Continental Mortgage and Equity Trust ("CMET") and TCI, three real estate entities with, at the time, the same officers, directors or trustees and advisor as IORI, entered into a settlement (the "Settlement") of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al. (the "Olive Litigation"), relating to the operation and management of each of the entities. On April 23, 1990, the Court granted final approval of the terms of the Settlement. The Settlement was modified in 1994 (the "Modification").
On January 27, 1997, the parties entered into an Amendment to the Modification effective January 9, 1997 (the "First Amendment"). The First Amendment provided for the settlement of additional matters raised by plaintiffs' counsel in 1996. The Court issued an order approving the First Amendment on July 3, 1997.
The First Amendment provided that IORI's Board retain a management/compensation consultant or consultants to evaluate the fairness of the BCM advisory contract and any contract of its affiliates with IORI, CMET and TCI, including, but not limited to, the fairness to IORI, CMET and TCI of such contracts relative to other means of administration. In 1998, the Board engaged a management/compensation consultant to perform the evaluation which was completed in September 1998.
In 1999, plaintiffs' counsel asserted that the Board did not comply with the provision requiring such engagement and requested that the Court exercise its retained jurisdiction to determine whether there was a breach of this provision of the First Amendment. In January 2000, the Board engaged another management/compensation consultant to perform the required evaluation again. This evaluation was completed in April 2000 and was provided to plaintiffs' counsel. The Board believes that any alleged breach of the First Amendment has been fully remedied by the Board's engagement of the second consultant. Although several status conferences have been held on this matter, there has been no Court order resolving whether there was any breach of the First Amendment.
In October 2000, plaintiffs' counsel asserted that the stock option agreement to purchase TCI shares, which was entered into by IORI and an affiliate of IORI, American Realty Investors, Inc. ("ARI"), in October 2000 with an investment fund, breached a provision of the Modification. As a result of this assertion, IORI assigned all of its rights to purchase the TCI shares under this stock option agreement to ARI.
The Board believes that all provisions of the Settlement, the Modification and First Amendment terminated on April 28, 1999. However, in September 2000, the Court ruled that certain provisions of the Modification continue to be effective after the termination date. This ruling was appealed to the United States Court of Appeals for the Ninth Circuit by IORI and TCI.
On October 23, 2001, IORI, TCI and ARI jointly announced a preliminary agreement with the plaintiff's legal counsel for complete settlement of all disputes in the lawsuit. In February 2002, the court granted final approval of the proposed settlement (the "Second Amendment"). Under the Second Amendment, the appeal has been dismissed and ARI agreed to either (i) acquire all of the outstanding shares of IORI and TCI not currently owned by ARI for a cash payment or shares of ARI preferred stock or (ii) make a tender offer for all of the
INCOME OPPORTUNITY REALTY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
outstanding common shares of IORI and TCI not currently owned by ARI. Under the merger, ARI would pay $19.00 cash per IORI share and $17.50 cash per TCI share for the stock held by non-affiliated stockholders. ARI would issue one share of Series H Redeemable Convertible Preferred Stock with a liquidation value of $21.50 per share for each share of IORI Common Stock for stockholders who elect to receive ARI preferred stock in lieu of cash. ARI would issue one share of Series G Redeemable Convertible Preferred Stock with a liquidation value of $20.00 per share for each share of TCI Common Stock for stockholders who elect to receive ARI preferred stock in lieu of cash. Each share of Series H Redeemable Convertible Preferred Stock will be convertible into 2.25 shares of ARI Common Stock during a 75-day period that commences fifteen days after the date of the first ARI Form 10-Q filing that occurs after the closing of the merger transaction. Upon the acquisition of the IORI and TCI shares, IORI and TCI would become wholly-owned subsidiaries of ARI. The transaction was subject to the negotiation of a definitive merger agreement, and a vote of the shareholders of all three entities. IORI has the same board as TCI and the same advisor as TCI and ARI. Earl D. Cecil and Ted P. Stokely who serve as Directors of IORI and TCI, are also directors of ARI.
On November 15, 2002, ARI commenced, through subsidiaries, a tender offer for shares of common stock of TCI and IORI. The price per share was $17.50 for TCI shares and $19.00 for IORI shares. The tender offers were made to cure a default under the settlement resulting from ARI's failure to timely complete the SEC review process of the registration statement for the proposed mergers with TCI and IORI. The tender offers were completed on March 19, 2003. ARI acquired 265,036 shares of IORI and 1,213,226 TCI shares. The completion of the tender offer fulfills the obligations under the Second Amendment and the Olive Litigation has been dismissed with prejudice. ARI has deferred further action on the mergers.
Liquidity. Although management anticipates that IORI will generate excess cash from operations in 2002, due to increased rental rates and occupancy at its properties, however, such excess will not be sufficient to discharge all of IORI's debt obligations as they mature. Management intends to selectively sell income producing real estate, refinance real estate and incur additional borrowings against real estate to meet its cash requirements.
Other Litigation. IORI is also involved in various other lawsuits arising in the ordinary course of business. Management is of the opinion that the outcome of these lawsuits will have no material impact on the Company's financial condition, results of operations or liquidity.
SCHEDULE III
INCOME OPPORTUNITY REALTY INVESTORS, INC.
REAL ESTATE AND ACCUMULATED DEPRECIATION
December 31, 2002
- -------- (1) The aggregate cost for Federal income tax purposes is $60.0 million.
SCHEDULE III (Continued)
INCOME OPPORTUNITY REALTY INVESTORS, INC.
REAL ESTATE AND ACCUMULATED DEPRECIATION
SCHEDULE IV (Continued)
INCOME OPPORTUNITY REALTY INVESTORS, INC.
MORTGAGE LOANS ON REAL ESTATE
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
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PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT
Directors
The affairs of Income Opportunity Realty Investors, Inc. ("IORI") are managed by a Board of Directors. The Directors are elected at the annual meeting of stockholders or appointed by the incumbent Board and serve until the next annual meeting of stockholders or until a successor has been elected or approved.
The Directors of IORI are listed below, together with their ages, terms of service, all positions and offices with IORI or its advisor, Basic Capital Management, Inc. ("BCM"), their principal occupations, business experience and directorships with other companies during the last five years or more. The designation "Affiliated", when used below with respect to a Director, means that the Director is an officer, director or employee of BCM or an officer of IORI. The designation "Independent" when used below with respect to a Director, means that the Director is neither an officer of IORI nor a director, officer or employee of BCM, although IORI may have certain business or professional relationships with the Director as discussed in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS--Certain Business Relationships."
TED P. STOKELY: Age 69, Director (Independent) (since April 1990) and Chairman of the Board (since January 1995).
General Manager (since January 1995) of ECF Senior Housing Corporation, a nonprofit corporation; General Manager (since January 1993) of Housing Assistance Foundation, Inc., a nonprofit corporation; Part-time unpaid consultant (since January 1993) of Eldercare Housing Foundation ("Eldercare"), a nonprofit corporation; General Manager (since April 2002) of Unified Housing Foundation, Inc., a nonprofit corporation; Director and Chairman of the Board of ARI (since November 2002); and Director (since April 1990) and Chairman of the Board (since January 1995) of Transcontinental Realty Investors, Inc. ("TCI").
HENRY A. BUTLER: Age 52, Director (Affiliated) (since December 2001).
Broker--Land Sales (since 1992) of Basic Capital Management, Inc. ("BCM"); Owner/Operator (1989 to 1991) of Butler Interests, Inc.; and Director (since December 2001) of TCI.
EARL D. CECIL: Age 73, Director (Independent) (since March 2002).
Financial and business consultant (since January 1994); Division Vice President (February 1987 to December 1993) of James Mitchell & Company, a financial services marketing organization; Director (since November 2001) of ARI; and Director (since March 2002) of TCI.
MARTIN L. WHITE: Age 63, Director (Independent) (since January 1995).
Chief Executive Officer (since 1995) of Builders Emporium, Inc.; Chairman and Chief Executive Officer (since 1993) of North American Trading Company Ltd.; President and Chief Operating Officer (since 1992) of Community Based Developers, Inc.; and Director (since January 1995) of TCI.
Board Committees
The Board of Directors held 10 meetings during 2002. For such year, no incumbent Director attended fewer than 75% of the aggregate of (1) the total number of meetings held by the Board during the period for which he had been a Director and (2) the total number of meetings held by all committees of the Board on which he served during the period that he served.
The Board of Directors has an Audit Committee, the function of which is to review IORI's operating and accounting procedures. The current members of the Audit Committee, all of whom are Independent Directors, are Messrs. Cecil, Stokely and White. The Audit Committee met four times during 2002.
The Board of Directors does not have Nominating or Compensation Committees.
Executive Officers
The following persons currently serve as executive officers of IORI: Mark Branigan, Executive Vice President--Residential; Louis J. Corna Executive Vice President--Tax; and Ronald E. Kimbrough, Acting Principal Executive Officer, Executive Vice President and Chief Financial Officer. Their positions with IORI are not subject to a vote of stockholders. Their ages, terms of service, all positions and offices with IORI or BCM, other principal occupations, business experience and directorships with other companies during the last five years or more are set forth below.
MARK W. BRANIGAN: Age 48, Executive Vice President--Residential (since June 2001); Executive Vice President and Chief Financial Officer (August 2000 to June 2001), Vice President--Director of Construction (August 1999 to August 2000) and Executive Vice President--Residential Asset Management (January 1992 to October 1997).
Executive Vice President--Residential (since June 2001), Executive Vice President and Chief Financial Officer (August 2000 to June 2001), Vice President--Director of Construction (August 1999 to August 2000) and Executive Vice President--Residential Management (January 1992 to October 1997) of BCM, American Realty Trust, Inc, ("ART") and TCI; Executive Vice President and Chief Financial Officer (August 2000 to June 2001) and Director (September 2000 to June 2001) of ARI; and real estate consultant (November 1997 to July 1999).
LOUIS J. CORNA: Age 55, Executive Vice President--Tax (since October 2001), Executive Vice President and Chief Financial Officer (June 2001 to October 2001), and Senior Vice President--Tax (December 2001 to June 2001).
Executive Vice President--Tax (since October 2001), Executive Vice President and Chief Financial Officer (June 2001 to October 2001), and Senior Vice President--Tax (December 2000 to June 2001) of BCM, ARI and TCI; Private Attorney (January 2000 to December 2000); Vice President--Taxes and Assistant Treasurer (March 1998 to January 2000) of IMC Global, Inc.; and Vice President--Taxes (July 1991 to February 1998) of Whitman Corporation.
RONALD E. KIMBROUGH: Age 50, Acting Principal Executive Officer, Executive Vice President and Chief Financial Officer (since January 2002).
Acting Principal Executive Officer, Executive Vice President and Chief Financial Officer (since January 2002) of BCM, ARI and TCI; Controller (from September 2000 to January 2002) of BCM; Vice President and Treasurer (from January 1998 to September 2000) of Syntek West, Inc. and One Realco Corporation; and Consultant (1997).
Officers
Although not an executive officer, Robert A. Waldman currently serves as Senior Vice President, Secretary and General Counsel. His position with IORI is not subject to a vote of stockholders. His age, term of service, all positions and offices with IORI or BCM, other principal occupations, business experience and directorships with other companies during the last five years or more is set forth below.
ROBERT A. WALDMAN: Age 50, Senior Vice President and General Counsel (since January 1995); Vice President (December 1990 to January 1995) and Secretary (December 1993 to February 1997 and since June 1999).
Senior Vice President and General Counsel (since January 1995), Vice President (December 1990 to January 1995) and Secretary (December 1993 to February 1997 and since June 1999 ) of TCI; Senior Vice President and General Counsel (since January 1995), Vice President (January 1993 to January 1995) and Secretary (since December 1989) of ART; Senior Vice President and General Counsel (since November 1994), Vice President and Corporate Counsel (November 1989 to November 1994), and Secretary (since November 1989) of BCM; and Senior Vice President, Secretary and General Counsel (since August 2000) of ARI.
In addition to the foregoing officers, IORI has several vice presidents and assistant secretaries who are not listed herein.
Compliance with Section 16(a) of the Securities Exchange Act of 1934
Under the securities laws of the United States, IORI's Directors, executive officers, and any persons holding more than ten percent of IORI's shares of Common Stock are required to report their share ownership and any changes in that ownership to the Securities and Exchange Commission (the "Commission"). Specific due dates for these reports have been established and IORI is required to report any failure to file by these dates during 2002. All of these filing requirements were satisfied by IORI's Directors and executive officers and ten percent holders. In making these statements, IORI has relied on the written representations of its incumbent Directors and executive officers and its ten percent holders and copies of the reports that they have filed with the Commission.
The Advisor
Although the Board of Directors is directly responsible for managing the affairs of IORI and for setting the policies which guide it, day-to-day operations are performed by a contractual advisor under the supervision of the Board. The duties of the advisor include, among other things, locating, investigating, evaluating and recommending real estate and mortgage note investment and sales opportunities as well as financing and refinancing sources. The advisor also serves as a consultant to the Board in connection with the business plan and investment decisions made by the Board.
BCM has served as IORI's advisor since March 1989. BCM is a company of which Messrs. Branigan, Corna and Kimbrough serve as executive officers. BCM is indirectly owned by a trust for the children of Gene E. Phillips. Mr. Phillips is not an officer or director of BCM, but serves as a representative of trust, is indirectly involved in daily consultation with the officers of BCM and has significant influence over the conduct of BCM's business, including the rendering of advisory services and the making of investment decisions for itself and for IORI.
Under the Advisory Agreement, BCM is required to annually formulate and submit for Board approval a budget and business plan containing a twelve-month forecast of operations and cash flow, a general plan for asset sales and purchases, borrowing activity, and other investments. BCM is required to report quarterly to the Board on IORI's performance against the business plan. In addition, all transactions require prior Board approval, unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to BCM by the Board.
The Advisory Agreement also requires prior approval of the Board for the retention of all consultants and third party professionals, other than legal counsel. The Advisory Agreement provides that BCM shall be deemed to be in a fiduciary relationship to the stockholders; contains a broad standard governing BCM's liability for losses by IORI; and contains guidelines for BCM's allocation of investment opportunities as among itself, IORI and other entities it advises.
The Advisory Agreement provides for BCM to be responsible for the day-to-day operations of IORI and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% of IORI's net income.
The Advisory Agreement also provides for BCM to receive an annual incentive sales fee equal to 10% of the amount, if any, by which the aggregate sales consideration for all real estate sold by IORI during the fiscal year exceeds the sum of: (1) the cost of each property as originally recorded in IORI's books for tax purposes (without deduction for depreciation, amortization or reserve for losses), (2) capital improvements made to such assets during the period owned, and (3) all closing costs, (including real estate commissions) incurred in the sale of such real estate. However, no incentive fee shall be paid unless (a) such real estate sold in such fiscal year, in the aggregate, has produced an 8% simple annual return on the net investment, including capital improvements, calculated over the holding period before depreciation and inclusive of operating income and sales consideration and (b) the aggregate net operating income from all real estate owned for each of the prior and current fiscal years shall be at least 5% higher in the current fiscal year than in the prior fiscal year.
Additionally, pursuant to the Advisory Agreement, BCM or an affiliate of BCM is to receive an acquisition commission for supervising the acquisition, purchase or long-term lease of real estate equal to the lesser of (1) up to 1% of the cost of acquisition, inclusive of commissions, if any, paid to nonaffiliated brokers, or (2) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services as an ongoing public activity in the same geographical location and for comparable property, provided that the aggregate purchase price of each property (including acquisition fees and real estate brokerage commissions) may not exceed such property's appraised value at acquisition.
The Advisory Agreement requires BCM or any affiliate of BCM to pay IORI one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by IORI. However, the compensation retained by BCM or any affiliate of BCM shall not exceed the lesser of (1) 2% of the amount of the loan commitment or (2) a loan brokerage and commitment fee which is reasonable and fair under the circumstances.
The Advisory Agreement also provides that BCM or an affiliate of BCM is to receive a mortgage or loan acquisition fee with respect to the purchase of any existing mortgage loan equal to the lesser of (1) 1% of the amount of the loan purchased or (2) a brokerage or commitment fee which is reasonable and fair under the circumstances. Such fee will not be paid in connection with the origination or funding of any mortgage loan by IORI.
Under the Advisory Agreement, BCM or an affiliate of BCM also is to receive a mortgage brokerage and equity refinancing fee for obtaining loans or refinancing on properties equal to the lesser of (1) 1% of the amount of the loan or the amount refinanced or (2) a brokerage or refinancing fee which is reasonable and fair under the circumstances. However, no such fee shall be paid on loans from BCM or an affiliate of BCM without the approval of the Board of Directors. No fee shall be paid on loan extensions.
Under the Advisory Agreement, BCM is to receive reimbursement of certain expenses incurred by it, in the performance of advisory services to IORI.
Under the Advisory Agreement all or a portion of the annual advisory fee must be refunded by BCM if the Operating Expenses of IORI (as defined in the Advisory Agreement) exceed certain limits specified in the
Advisory Agreement based on the book value, net asset value and net income of IORI during the fiscal year. BCM was required to refund $256,000 of the 2001 advisory fee under this provision.
Additionally, if management were to request that BCM render services other than those required by the Advisory Agreement, BCM or an affiliate of BCM is separately compensated for such additional services on terms to be agreed upon from time to time. As discussed below, under Property Management, IORI has hired Triad Realty Services, Ltd. ("Triad"), an affiliate of BCM, to provide management for IORI's properties and, as discussed below, under Real Estate Brokerage IORI has engaged Regis Realty I, LLC, a related party, on a non-exclusive basis to provide brokerage services for IORI.
BCM may assign the Advisory Agreement only with the prior consent of IORI.
The directors and principal officers of BCM are set forth below.
Mickey N. Phillips is Gene E. Phillips' brother and Ryan T. Phillips is Gene E. Phillips' son. Gene E. Phillips serves as a representative of the trust, established for the benefit of his children, which indirectly owns BCM and, in such capacity has substantial contact with the management of BCM and input with respect to its performance of advisory services to IORI.
Property Management
Since February 1, 1990, affiliates of BCM have provided property management services. Currently, Triad provides such property management services for a fee of 5% or less of the monthly gross rents collected on residential properties and 3% or less of the monthly gross rents collected on commercial properties under its management. Triad subcontracts with other entities for the provision of the property-level management services to IORI at various rates. The general partner of Triad is BCM. The limited partner of Triad is Highland Realty Services, Inc. ("Highland"), a related party. Triad subcontracted the property-level management and leasing of 5 of IORI's commercial properties to Regis, a related party, which is a company owned by Highland, until December 2002. Regis was entitled to receive property and construction management fees and leasing commissions in accordance with its property-level management agreement with Triad, until December 2002. Beginning January 1, 2003, Regis Realty I, LLC ("Regis I") provides these services. The sole member of Regis I is Highland.
Real Estate Brokerage
Regis also provided real estate brokerage services to IORI (on a non-exclusive basis), until December 2002. Regis was entitled to receive a real estate commission for property purchases and sales in accordance with the following sliding scale of total fees to be paid: (1) maximum fee of 4.5% on the first $2.0 million of any purchase
or sale transaction of which no more than 3.5% would be paid to Regis or affiliates; (2) maximum fee of 3.5% on transaction amounts between $2.0 million-$5.0 million of which no more than 3% would be paid to Regis or affiliates; (3) maximum fee of 2.5% on transaction amounts between $5.0 million-$10.0 million of which no more than 2% would be paid to Regis or affiliates; and (4) maximum fee of 2% on transaction amounts in excess of $10.0 million of which no more than 1.5% would be paid to Regis or affiliates. Beginning January 1, 2003, Regis I provides these services. The sole member of Regis I is Highland.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
IORI has no employees, payroll or benefit plans and pays no compensation to its executive officers. The executive officers of IORI, who are also officers or employees of BCM, IORI's advisor, are compensated by BCM. Such executive officers perform a variety of services for BCM and the amount of their compensation is determined solely by BCM. BCM does not allocate the cash compensation of its officers among the various entities for which it serves as advisor. See ITEM 10. "DIRECTORS, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT--The Advisor" for a more detailed discussion of the compensation payable to BCM.
The only remuneration paid by IORI is to the Directors who are not officers or directors of BCM or its affiliated companies. The Independent Directors (1) review the business plan of IORI to determine that it is in the best interest of the stockholders, (2) review the advisory contract, (3) supervise the performance of IORI's advisor and review the reasonableness of the compensation paid to the advisor in terms of the nature and quality of services performed, (4) reviews the reasonableness of the total fees and expenses of IORI and (5) select, when necessary, a qualified independent real estate appraiser to appraise properties acquired.
Each Independent Director receives compensation in the amount of $15,000 per year, plus reimbursement for expenses. The Chairman of the Board receives an additional fee of $1,500 per year. The members of the Audit Committee receive a fee of $250 for each committee meeting attended. In addition, each Independent Director receives an additional fee of $1,000 per day for any special services rendered by him to IORI outside of his ordinary duties as Director, plus reimbursement of expenses.
During 2002, $43,557 was paid to the Independent Directors in total Directors' fees for all services including the annual fee for service during the period January 1, 2002, through December 31, 2002, and 2002 special service fees as follows: Earl D. Cecil, $12,057; Ted P. Stokely, $16,500; and Martin L. White, $15,000.
Performance Graph
The following performance graph compares the cumulative total stockholder return on IORI's shares of Common Stock with the Dow Jones US Total Market Index ("DJ Total Market Index") and the Dow Jones Real Estate Investment Index ("DJ Real Estate Index"). The comparison assumes that $100 was invested on December 31, 1997, in IORI's shares of Common Stock and in each of the indices and further assumes the reinvestment of all distributions. Past performance is not necessarily an indicator of future performance. [CHART]
IORI DJ Total Market Index DJ Real Estate Index ---- --------------------- -------------------- 1997 100.00 100.00 100.00 1998 58.11 124.90 78.88 1999 55.37 153.28 74.69 2000 88.29 139.07 95.24 2001 197.12 122.50 106.49 2002 204.24 95.45 110.35
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Security Ownership of Certain Beneficial Owners. The following table sets forth the ownership of IORI's shares of Common Stock, both beneficially and of record, both individually and in the aggregate for those persons or entities known by IORI to be beneficial owners of more than 5% of its shares of Common Stock as of the close of business on March 19, 2003.
* Update for post tender offer
- -------- (1) Percentages are based upon 1,438,945 shares of Common Stock outstanding at March 19, 2003. (2) EQK Holdings, Inc. ("EQK") is a wholly-owned subsidiary of ART which is a wholly-owned subsidiary of ARI.
Security Ownership of Management. The following table sets forth the ownership of IORI's shares of Common Stock, both beneficially and of record, both individually and in the aggregate, for the Directors and executive officers of IORI as of the close of business on March 19, 2003.
- -------- (1) Percentage is based upon 1,438,945 shares of Common Stock outstanding at March 19, 2003. (2) Includes 345,728 shares owned by TCI of which the Directors and executive officers of IORI may be deemed to be beneficial owners by virtue of their positions as directors and executive officers of TCI. (3) Includes 416,501 shares owned by EQK, of which the executive officers of IORI may be deemed to be beneficial owners by virtue of their positions as executive officers of ARI, and of which Messrs. Cecil, and Stokely may be deemed to be beneficial owners by virtue of their positions as directors of ARI, the parent company of EQK. The Directors and executive officers disclaim beneficial ownership of such shares. (4) Includes 106,802 shares owned by BCM of which the executive officers of IORI may be deemed to be beneficial owners by virtue of their positions as executive officers of BCM.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Certain Business Relationships
In February 1989, the Board of Directors voted to retain BCM as IORI's advisor. See ITEM 10. "DIRECTORS, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT--The Advisor." BCM is a company of which Messrs. Branigan, Corna and Kimbrough serve as executive officers. BCM is indirectly owned by a trust for the children of Gene E. Phillips. Mr. Phillips is not an officer or director of BCM, but serves as a representative of trust, is indirectly involved in daily consultation with the officers of BCM and has significant influence over the conduct of BCM's business, including the rendering of advisory services and the making of investment decisions for itself and for IORI.
Since February 1, 1991, affiliates of BCM have provided property management services to IORI. Currently, Triad provides such property management services. The general partner of Triad is BCM. The limited partner of Triad is Highland, a related party. Triad subcontracted the property-level management and leasing of five of IORI's commercial properties to Regis, a related party, which is a company owned by Highland, until December 2002. Since January 1, 2003, Regis I provided this service.
Regis also provides real estate brokerage services for IORI, on a non-exclusive basis, and receives brokerage commissions in accordance with the brokerage agreement, until December 2002. Since January 1, 2003, Regis I provided this service.
The Directors and officers of IORI also serve as directors and officers of TCI. The Directors owe fiduciary duties to TCI as well as to IORI under applicable law. TCI has the same relationship with BCM as IORI. BCM also serves as advisor to ARI. Messrs. Cecil and Stokely also serve as Directors of ARI. Messrs. Branigan, Corna and Kimbrough serve as executive officers of ARI.
Related Party Transactions
Historically, IORI has engaged in and may continue to engage in business transactions, including real estate partnerships, with related parties. Management believes that all of the related party transactions represented the best investments available at the time and were at least as advantageous to IORI as could have been obtained from unrelated third parties.
In January 2002, IORI purchased 100% of the outstanding common shares of Rosedale Corporation ("Rosedale"), a wholly-owned subsidiary of American Realty Investors, Inc. ("ARI"), a related party, for $5.1 million cash. Rosedale owned the 83,331 sq. ft. Rosedale Towers Office Building in Roseville, Minnesota. ARI guaranteed that the asset would produce at least a 12% return annually of the purchase price for a period of three years from the purchase date. If the asset failed to produce the 12% return, ARI shall pay IORI any shortfall. Management has classified this related party transaction as a note receivable from ARI. In the first quarter of 2002, after reviewing the property's fair value after costs to sell, even though ARI has guaranteed the 12% return, IORI recognized a provision for loss on the note receivable of $767,000. In December 2002, the Rosedale Towers Office Building was sold for $7.2 million. IORI received $3.5 million of the proceeds after the payment of the first lien debt and various closing costs. IORI recognized an additional loss of $801,000 on its note.
In February 2002, IORI funded a $2.0 million mortgage loan as a participation agreement with Transcontinental Realty Investors, Inc. ("TCI"), a related party. The loan was secured by a second lien on a retail center in Montgomery County, Texas. The note receivable bore interest at 16.0% per annum, required monthly interest only payments of $47,000 and matured in February 2002. In February 2002, the loan was extended until April 2002. In April 2002, IORI extended the loan until July 2002, receiving $8,500 as an extension fee. In July 2002, the loan was extended until September 2002, with IORI receiving $8,500 as an extension fee. Also in July 2002, IORI received a $500,000 principal paydown on the note. In August 2002, the note was paid off including accrued but unpaid interest.
As more fully described in ITEM 2. "PROPERTIES--Real Estate," IORI is a partner with TCI in Nakash Income Associates and TCI Eton Square, L.P.
In 2002, IORI paid BCM and its affiliates and related parties $714,000 in advisory fees $169,000 in net income fees, $262,000 in mortgage brokerage and equity refinancing fees, $397,000 in real estate brokerage fees and $262,000 in property and construction management fees and leasing commissions, net of property management fees paid to subcontractors other than Regis. In addition, from time-to-time, IORI has made advances to BCM which generally have not had specific repayment terms and have been reflected in IORI's financial statements as other assets or other liabilities from affiliates. At December 31, 2002, IORI had advanced BCM, ARI and TCI, $1.7 million, $3.5 million and $5.3 million, respectively.
Restrictions on Related Party Transactions
Article FOURTEENTH of IORI's Articles of Incorporation provides that IORI shall not, directly or indirectly, contract or engage in any transaction with (1) any director, officer or employee of IORI, (2) any director, officer or employee of the advisor, (3) the advisor or (4) any affiliate or associate (as such terms are defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended) of any of the aforementioned persons, unless (a) the material facts as to the relationship among or financial interest of the relevant individuals or persons and as to the contract or transaction are disclosed to or are known by IORI's Board of Directors or the appropriate committee thereof and (b) IORI's Board of Directors or committee thereof determines that such contract or transaction is fair to IORI and simultaneously authorizes or ratifies such contract or transaction by the affirmative vote of a majority of independent directors of IORI entitled to vote thereon.
Article FOURTEENTH defines an "Independent Director" as one who is neither an officer or employee of IORI, nor a director, officer or employee of IORI's advisor.
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PART IV
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
(a) Within the 90 days prior to the date of this report, IORI carried out an evaluation, under the supervision and with the participation of IORI's management, including IORI's Acting Principal Executive Officer and principal accounting officer, of the effectiveness of the design and operation of IORI's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon the evaluation, IORI's Acting Principal Executive Officer and principal accounting officer concluded that IORI's disclosure controls and procedures are effective in timely alerting him to material information relating to IORI (including its consolidated subsidiaries) required to be included in IORI's periodic SEC filings.
(b) There have been no significant changes in IORI's internal controls or in other factors that could significantly affect IORI's internal controls subsequent to the date IORI carried out this evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Report:
1. Consolidated Financial Statements
Report of Independent Certified Public Accountants
Consolidated Balance Sheets--December 31, 2002 and 2001
Consolidated Statements of Operations--Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Stockholders' Equity--Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows--Years Ended December 31, 2002, 2001 and 2000
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule III--Real Estate and Accumulated Depreciation
All other schedules are omitted because they are not applicable or because the required information is shown in the Financial Statements or the Notes thereto.
3. Exhibits
The following documents are filed as Exhibits to this Report:
(b) Reports on Form 8-K:
None.
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.
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 date indicated.
Signature Title Date --------- ----- ----
/s/ TED P. STOKELY Chairman of the Board and March 31, 2003 - ----------------------------- Director Ted P. Stokely
/s/ HENRY A. BUTLER Director March 31, 2003 - ----------------------------- Henry A. Butler
/s/ EARL D. CECIL Director March 31, 2003 - ----------------------------- Earl D. Cecil
/s/ MARTIN L. WHITE Director March 31, 2003 - ----------------------------- Martin L. White
/s/ RONALD E. KIMBROUGH Executive Vice President and March 31, 2003 - ----------------------------- Chief Financial Officer Ronald E. Kimbrough (Principal Financial and Accounting Officer and Acting Principal Executive Officer)
CERTIFICATION
I, Ronald E. Kimbrough, Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and Acting Principal Executive Officer) of Income Opportunity Realty Investors, Inc. ("IORI"), certify that:
1. I have reviewed this annual report on Form 10-K of IORI;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. I am responsible for establishing and maintaining internal controls and procedures and have:
a. designed such internal controls to insure that material information relating to IORI and its consolidated subsidiaries is made known to me by others within those entities, particularly for the periods presented in this annual report;
b. evaluated the effectiveness of IORI's internal controls as of a date within 90 days prior to the filing date of this annual report; and
c. presented in this annual report my conclusions about the effectiveness of the disclosure controls and procedures based on a date within 90 days prior to the filing date of this annual report;
5. I have disclosed to IORI's auditors and Audit Committee of the Board of Directors (or persons fulfilling the equivalent function):
a. all significant deficiencies in the design or operation of internal controls which could adversely affect IORI's ability to record, process, summarize, and report financial data and have identified for IORI's auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management or other employees who have a significant role in IORI's internal controls; and
6. I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of my most recent evaluation, including corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 31, 2003 /s/ RONALD E. KIMBROUGH ------------------------- Ronald E. Kimbrough Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and Acting Principal Executive Officer)
ANNUAL REPORT ON FORM 10-K
EXHIBIT INDEX
For the Year Ended December 31, 2002
Exhibit Page Number Description Number - -------- ------------------------------------------------------------ --------
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.