- -------------------------------------------------------------------------------- U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------ FORM 10-QSB ------------------ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 ------------------ Commission file number 0-11973 CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP Organized pursuant to the Laws of the State of Maryland ------------------ Internal Revenue Service - Employer Identification No. 52-1321492 11200 Rockville Pike, Rockville, Maryland 20852 (301) 468-9200 ------------------ Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No | | - -------------------------------------------------------------------------------- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP INDEX TO FORM 10-QSB FOR THE QUARTER ENDED SEPTEMBER 30, 2004 Page Part I - FINANCIAL INFORMATION Item 1. Financial Statements Balance Sheets - September 30, 2004 and December 31, 2003................... 1 Statements of Operations and Accumulated Losses - for the three and nine months ended September 30, 2004 and 2003................................................... 2 Statements of Cash Flows - for the nine months ended September 30, 2004 and 2003...... 3 Notes to Financial Statements - September 30, 2004 and 2003................................. 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................... 10 Item 3. Controls and Procedures........................................ 14 Part II - OTHER INFORMATION Item 3. Defaults Upon Senior Securities................................ 14 Item 5. Other Information.............................................. 14 Item 6. xhibits........................................................ 16 Signature............................................................... 17 Part I. FINANCIAL INFORMATION Item 1. Financial Statements CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP BALANCE SHEETS ASSETS September 30, December 31, 2004 2003 ------------ ------------ (Unaudited) Investments in partnerships ....................................................... $ 954,086 $ 854,495 Investment in partnerships held for sale or transfer .............................. 551,106 508,229 Cash and cash equivalents ......................................................... 3,623,721 2,979,778 Acquisition fees, principally paid to related parties, net of accumulated amortization of $53,358 and $121,219, respectively ........... 23,091 57,667 Property purchase costs, net of accumulated amortization of $56,520 and $161,573, respectively ........... 26,229 82,098 Other assets ...................................................................... 133 40 ------------ ------------ Total assets ................................................................... $ 5,178,366 $ 4,482,307 ============ ============ LIABILITIES AND PARTNERS' CAPITAL Due on investments in partnerships ................................................ $ 1,400,000 $ 1,400,000 Accrued interest payable .......................................................... 2,720,762 2,626,262 Accounts payable and accrued expenses ............................................. 144,315 145,687 ------------ ------------ Total liabilities .............................................................. 4,265,077 4,171,949 ------------ ------------ Commitments and contingencies Partners' capital: Capital paid in: General Partners .............................................................. 2,000 2,000 Limited Partners .............................................................. 50,015,000 50,015,000 ------------ ------------ 50,017,000 50,017,000 Less: Accumulated distributions to partners ......................................... (15,293,973) (15,293,973) Offering costs ................................................................ (5,278,980) (5,278,980) Accumulated losses ............................................................ (28,530,758) (29,133,689) ------------ ------------ Total partners' capital ..................................................... 913,289 310,358 ------------ ------------ Total liabilities and partners' capital ..................................... $ 5,178,366 $ 4,482,307 ============ ============ The accompanying notes are an integral part of these financial statements. -1- Part I. FINANCIAL INFORMATION Item 1. Financial Statements CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP STATEMENTS OF OPERATIONS AND ACCUMULATED LOSSES (Unaudited) For the three months ended For the nine months ended September 30, September 30, ---------------------------- ---------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Share of income from partnerships ............... $ 159,852 $ 221,192 $ 1,228,378 $ 1,226,805 ------------ ------------ ------------ ------------ Other revenue and expenses: Revenue: Interest .................................... 9,080 6,336 17,816 22,493 Gain from extinguishment of debt ............ -- -- -- 670,099 ------------ ------------ ------------ ------------ 9,080 6,336 17,816 692,592 ------------ ------------ ------------ ------------ Expenses: Interest .................................... 31,500 31,500 94,500 94,500 General and administrative .................. 74,170 66,520 243,827 207,190 Management fee .............................. 62,499 62,499 187,497 187,497 Professional fees ........................... 35,625 23,250 106,875 79,750 Amortization of deferred costs .............. 3,521 6,138 10,564 18,733 ------------ ------------ ------------ ------------ 207,315 189,907 643,263 587,670 ------------ ------------ ------------ ------------ Total other revenue and expenses .......... (198,235) (183,571) (625,447) 104,922 ------------ ------------ ------------ ------------ Net (loss) income ............................... (38,383) 37,621 602,931 1,331,727 Accumulated losses, beginning of period ......... (28,492,375) (28,827,195) (29,133,689) (30,121,301) ------------ ------------ ------------ ------------ Accumulated losses, end of period ............... $(28,530,758) $(28,789,574) $(28,530,758) $(28,789,574) ============ ============ ============ ============ Net (loss) income allocated to General Partners (1.51%) ................... $ (580) $ 568 $ 9,104 $ 20,109 ============ ============ ============ ============ Net (loss) income allocated to Initial and Special Limited Partners (1.49%) $ (572) $ 561 $ 8,984 $ 19,843 ============ ============ ============ ============ Net (loss) income allocated to Additional Limited Partners (97%) .......... $ (37,231) $ 36,492 $ 584,843 $ 1,291,775 ============ ============ ============ ============ Net (loss) income per unit of Additional Limited Partner Interest, based on 49,910 units outstanding ................................... $ (0.75) $ 0.73 $ 11.72 $ 25.88 ============ ============ ============ ============ The accompanying notes are an integral part of these financial statements. -2- Part I. FINANCIAL INFORMATION Item 1. Financial Statements CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP STATEMENTS OF CASH FLOWS (Unaudited) For the nine months ended September 30, -------------------------- 2004 2003 ----------- ----------- Cash flows from operating activities: Net income .................................................................. $ 602,931 $ 1,331,727 Adjustments to reconcile net income to net cash used in operating activities: Share of income from partnerships ......................................... (1,228,378) (1,226,805) Gain from extinguishment of debt .......................................... -- (670,099) Amortization of deferred costs ............................................ 10,564 18,733 Changes in assets and liabilities: (Increase) decrease in other assets ..................................... (93) 335,778 Increase in accrued interest payable .................................... 94,500 94,500 (Decrease) increase in accounts payable and accrued expenses ............ (1,372) 2,724 ----------- ----------- Net cash used in operating activities ................................. (521,848) (113,442) ----------- ----------- Cash flows from investing activities: Receipt of distributions from partnerships .................................. 1,165,200 1,200,394 Additional proceeds from disposition of investment in partnership ........... 591 1,043 ----------- ----------- Net cash provided by investing activities ............................. 1,165,791 1,201,437 ----------- ----------- Net increase in cash and cash equivalents ..................................... 643,943 1,087,995 Cash and cash equivalents, beginning of period ................................ 2,979,778 3,420,489 ----------- ----------- Cash and cash equivalents, end of period ...................................... $ 3,623,721 $ 4,508,484 =========== =========== The accompanying notes are an integral part of these financial statements. -3- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 1. BASIS OF PRESENTATION In the opinion of C.R.I., Inc. (CRI), the Managing General Partner, the accompanying unaudited financial statements reflect all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the financial position of Capital Realty Investors-II Limited Partnership (the Partnership) as of September 30, 2004, and the results of its operations for the three and nine month periods ended September 30, 2004 and 2003, and its cash flows for the nine month periods ended September 30, 2004 and 2003. The results of operations for the interim periods ended September 30, 2004, are not necessarily indicative of the results to be expected for the full year. The accompanying unaudited financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and with the instructions to Form 10-QSB. Certain information and accounting policies and footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such instructions. These condensed financial statements should be read in conjunction with the financial statements and notes thereto included in the Partnership's annual report on Form 10-KSB at December 31, 2003. In December 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (revised December 2003) (FIN 46-R), Consolidation of Variable Interest Entities. FIN 46-R clarifies the application of Accounting Research Bulletin 51, Consolidated Financial Statements, for certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest ("variable interest entities"). Variable interest entities within the scope of FIN 46-R will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity's expected losses, receives a majority of its expected returns, or both. The Managing General Partner has evaluated the Partnership's investments in partnerships and has determined that they are not variable interest entities subject to consolidation by the Partnership under the provisions of FIN 46-R. 2. PLAN OF LIQUIDATION AND DISSOLUTION On February 4, 2004, the Partnership filed a Definitive Proxy Statement, pursuant to Section 14(a) of the Securities Exchange Act of 1934, to solicit consent for, among other things, the sale of all of the Partnership's assets and the dissolution of the Partnership pursuant to a Plan of Liquidation and Dissolution. As of the voting deadline, March 22, 2004, the holders of 28,699 units of limited partner interest (57.5%) voted "for" such sale and dissolution, and the Managing General Partner began to proceed accordingly. -4- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 2. PLAN OF LIQUIDATION AND DISSOLUTION - Continued The Partnership received an offer from Equity Resource Investments, LLC (ERI) to purchase the Partnership's limited partner interests in all 12 Local Partnerships, and to purchase the general partner interests in the Local Partnerships held by affiliates of the Managing General Partner (CRI). On July 1, 2004, ERI, the Partnership and CRI signed a non-binding Letter of Intent, in which ERI agreed in principle that it and/or its affiliated entities or assignees would purchase all of the ownership interests of the Partnership in the Local Partnerships for approximately $21,000,000, and all of the general partner interests held by affiliates of CRI for approximately $800,000, subject to the terms and conditions of one or more definitive acquisition agreements to be negotiated and entered into among the parties. Closing would then be scheduled after successful completion of an inspection period, receipt of all necessary third party and governmental and regulatory approvals, and the satisfaction of all other respective conditions to closing. On July 2, 2004, ERI filed a Schedule 13D with the Securities and Exchange Commission (SEC) regarding the offer. On September 15, 2004, four definitive acquisition agreements were signed in which ERI agreed to purchase the Partnership's limited partner interests in Arrowhead Apartments Associates (Arrowhead), Blackburn Limited Partnership (Country Place I), Second Blackburn Limited Partnership (Country Place II) and Moorings Apartment Associates (Moorings) on or about December 1, 2004, for a total of approximately $13,750,000, and all of the general partner interests held by affiliates of CRI for approximately $797,000. Each sale is conditioned on the closing of the other three sales of the Partnership's limited partner interests. There can be no assurance that a sale of the Partnership's limited partner interests will occur. Due to the impending sale of the Partnership's limited partner interests in Arrowhead, Country Place I, Country Place II, and Moorings, the Partnership's basis in each of these four Local Partnerships, along with the net unamortized amount of acquisition fees and property purchase costs, which totaled $25,461, $21,994, $11,885 and $25,220, respectively, at September 30, 2004, has been reclassified to investments in partnerships held for sale or transfer in the accompanying balance sheet at that date. On October 29, 2004, the Partnership and ERI agreed that they could not come to terms for the sale of the Partnership's interests in the remaining eight Local Partnerships, so they formally terminated the Letter of Intent as to those interests. 3. INVESTMENTS IN PARTNERSHIPS a. Due on investments in partnerships and accrued interest payable --------------------------------------------------------------- Westgate -------- The Partnership defaulted on its one remaining purchase money note, related to Westgate Limited Dividend Housing Association (Westgate), on September 1, 2003, when the note (as extended) matured and was not paid. The default amount included principal and accrued interest of $1,400,000 and $2,584,492, respectively. As of November 11, 2004, principal and accrued interest of $1,400,000 and $2,732,585, respectively, were due. In September 2003, the Managing General Partner offered to tender the Partnership's interest in Westgate to the purchase money noteholders, in full satisfaction of the principal and accrued interest balances due on the purchase money note. In the fall of 2003, the trustee for the noteholders acknowledged receipt of the Managing General Partner's offer, but indicated that it might take several months to obtain a response from the numerous noteholders. No response has been received as of November 11, 2004. There is no assurance that the noteholders will accept the offer, or what other course of action the noteholders might choose to pursue. -5- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 3. INVESTMENTS IN PARTNERSHIPS - Continued The Partnership's inability to pay the Westgate purchase money note principal and accrued interest balance when due, and the resulting uncertainty regarding the Partnership's continued ownership interest in Westgate, does not adversely impact the Partnership's financial condition because the purchase money note is nonrecourse and secured solely by the Partnership's interest in Westgate. Therefore, even though the Partnership's investment in Westgate has not produced sufficient value to satisfy the related purchase money note, the Partnership's exposure to loss is limited because the amount of the nonrecourse indebtedness of the matured purchase money note exceeds the carrying amount of the investment in Westgate. Thus, even a complete loss of the Partnership's interest in Westgate would not have a material adverse impact on the financial condition of the Partnership. In the event of a foreclosure or other transfer of the Partnership's interest, the excess of the nonrecourse indebtedness over the carrying amount of the Partnership's investment in Westgate will result in a taxable gain. This gain will be taxable to Limited Partners at a federal tax rate of up to 25.0%, as it will reflect recapture of depreciation deductions claimed in prior years. Additionally, the Partnership would lose its investment in Westgate and, likewise, its share of any future cash distributed by Westgate from rental operations, mortgage debt refinancings, or the sale of the real estate. Interest expense on the Partnership's Westgate purchase money note was $31,500 for each of the three month periods ended September 30, 2004 and 2003, and $94,500 for each of the nine month periods ended September 30, 2004 and 2003. The accrued interest payable on the purchase money note of $2,720,762 and $2,626,262 as of September 30, 2004 and December 31, 2003, respectively, is in default. Due to the possible transfer of the Partnership's interest in Westgate to the noteholders, the Partnership's basis in the Local Partnership, along with the net unamortized amount of acquisition fees and property purchase costs, which totaled $466,546 and $508,229 as of September 30, 2004 and December 31, 2003, respectively, has been reclassified to investment in partnerships held for sale or transfer in the accompanying balance sheets. b. Summarized financial information -------------------------------- Combined statements of operations for the 12 Local Partnerships in which the Partnership was invested as of September 30, 2004 and 2003, follow. The combined statements have been compiled from information supplied by the management agents of the properties and are unaudited. The information for each of the periods is presented separately for those Local Partnerships which have positive investment basis (equity method), and for those Local Partnerships which have cumulative losses in excess of the amount of the Partnership's investments in those Local Partnerships (equity method suspended). Certain reclassifications have been made to the 2003 amounts to conform them to the 2004 presentation. Appended after the combined statements is information concerning the Partnership's share of income from partnerships related to cash distributions recorded as income, and related to the Partnership's share of income from Local Partnerships. -6- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 3. INVESTMENTS IN PARTNERSHIPS - Continued COMBINED STATEMENTS OF OPERATIONS (Unaudited) For the three months ended September 30, ----------------------------------------------------------- 2004 2003 ----------------------------------------------------------- Equity Equity Method Suspended Method Suspended ---------- ---------- ---------- ---------- Number of Local Partnerships 4 8 4 8 = = = = Revenue: Rental $1,525,216 $2,512,053 $1,451,382 $2,482,867 Other 58,648 72,673 78,796 102,719 ---------- ---------- ---------- ---------- Total revenue 1,583,864 2,584,726 1,530,178 2,585,586 ---------- ---------- ---------- ---------- Expenses: Operating 675,334 1,532,367 732,006 1,534,178 Interest 213,732 943,914 216,195 942,108 Depreciation and amortization 205,573 447,683 200,136 439,376 ---------- ---------- ---------- ---------- Total expenses 1,094,639 2,923,964 1,148,337 2,915,662 ---------- ---------- ---------- ---------- Net income (loss) $ 489,225 $ (339,238) $ 381,841 $ (330,076) ========== ========== ========== ========== Cash distributions $ -- $ -- $ 199,980 $ 57,980 ========== ========== ========== ========== Cash distributions recorded as reduction of investments in partnerships $ -- $ -- $ 199,980 $ -- ========== ========== ========== ========== Cash distributions recorded as income $ -- $ -- $ -- $ 57,980 Partnership's share of Local Partnership net income 159,440 -- 163,212 -- Miscellaneous -- 412 -- -- ----------------------------------------------------------- Share of income from partnerships $159,852 $221,192 ======== ======== -7- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 3. INVESTMENTS IN PARTNERSHIPS - Continued COMBINED STATEMENTS OF OPERATIONS (Unaudited) For the nine months ended September 30, --------------------------------------------------------- 2004 2003 ------------------------ ------------------------ Equity Equity Method Suspended Method Suspended ---------- ---------- ---------- ---------- Number of Local Partnerships 4 8 4 8 = = = = Revenue: Rental $4,481,492 $ 7,536,164 $4,355,191 $7,438,406 Other 124,031 218,019 146,335 308,027 ---------- ----------- ---------- ---------- Total revenue 4,605,523 7,754,183 4,501,526 7,746,433 ---------- ----------- ---------- ---------- Expenses: Operating 2,321,255 4,597,103 2,348,065 4,555,718 Interest 641,192 2,831,746 648,586 2,826,323 Depreciation and amortization 616,722 1,343,056 600,414 1,318,134 ---------- ----------- ---------- ---------- Total expenses 3,579,169 8,771,905 3,597,065 8,700,175 ---------- ----------- ---------- ---------- Net income (loss) $1,026,354 $(1,017,722) $ 904,461 $ (953,742) ========== =========== ========== ========== Cash distributions $ 986,287 $ 178,913 $ 880,481 $ 319,913 ========== =========== ========== ========== Cash distributions recorded as reduction of investments in partnerships $ 957,414 $ -- $ 874,039 $ -- ========== =========== ========== ========== Cash distributions recorded as income $ 28,873 $ 178,913 $ 6,442 $ 319,913 Partnership's share of Local Partnership net income 1,020,001 -- 899,407 -- Miscellaneous -- 591 -- 1,043 ------------------------- ------------------------- Share of income from partnerships $1,228,378 $1,226,805 ========== ========== Cash distributions received from Local Partnerships which have investment basis (equity method) are recorded as a reduction of investments in partnerships and as cash receipts on the respective balance sheets. Cash distributions received from Local Partnerships which have cumulative losses in excess of the amount of the Partnership's investments in those Local Partnerships (equity method suspended) are recorded as share of income from partnerships on the respective statements of operations and as cash receipts on the respective balance sheets. As of September 30, 2004 and 2003, the Partnership's share of cumulative losses to date for eight of the 12 Local Partnerships exceeded the amount of the Partnership's investments in those Local Partnerships by $21,236,242 and $19,844,126, respectively. As the Partnership has no further obligation to advance funds or provide financing to these Local Partnerships, the excess losses have not been reflected in the accompanying financial statements. -8- CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) 4. RELATED PARTY TRANSACTIONS In accordance with the terms of the Partnership Agreement, the Partnership is obligated to reimburse the Managing General Partner for its direct expenses in connection with managing the Partnership. The Partnership paid $55,584 and $176,440 for the three and nine month periods ended September 30, 2004, respectively, and $54,397 and $173,550 for the three and nine month periods ended September 30, 2003, respectively, to the Managing General Partner as direct reimbursement of expenses incurred on behalf of the Partnership. Such expenses are included in general and administrative expenses in the accompanying statements of operations. In accordance with the terms of the Partnership Agreement, the Partnership is obligated to pay the Managing General Partner an annual incentive management fee (Management Fee) after all other expenses of the Partnership are paid. The Partnership paid the Managing General Partner a Management Fee of $62,499 for each of the three month periods ended September 30, 2004 and 2003, and $187,497 for each of the nine month periods ended September 30, 2004 and 2003. In accordance with the terms of a Definitive Proxy Statement for the Liquidation and Dissolution of the Partnership, which was approved on March 22, 2004, by holders of a majority of the Units of Limited Partner Interest, the Managing General Partner may receive property disposition fees from the Partnership on the same basis as such fees may currently be paid to Local General Partners, real estate brokers or other third party intermediaries employed to sell Partnership properties, to the extent that CRI markets and sells the Partnership's properties instead of such persons. In addition, the Managing General Partner may receive a partnership liquidation fee in the amount of $500,000, payable only if the Managing General Partner is successful in liquidating all of the Partnership's investments within 36 months from the date the liquidation is approved, in recognition that one or more of the properties in which the Partnership holds an interest might not be saleable to parties not affiliated with the respective Local Partnership due to the amount and/or terms of their current indebtedness. See Note 2 above for additional information concerning an unsolicited offer to purchase the Partnership's interests in four Local Partnerships. # # # -9- Part I. FINANCIAL INFORMATION Item 2. Management's Discussion Analysis of Financial Condition and Results of Operations Capital Realty Investors-II Limited Partnership's (the Partnership) Management's Discussion and Analysis of Financial Condition and Results of Operations section is based on the financial statements, and contains information that may be considered forward looking, including statements regarding the effect of governmental regulations. Actual results may differ materially from those described in the forward looking statements and will be affected by a variety of factors including national and local economic conditions, the general level of interest rates, governmental regulations affecting the Partnership and interpretations of those regulations, the competitive environment in which the Partnership operates, and the availability of working capital. Critical Accounting Policies ---------------------------- The Partnership has disclosed its selection and application of significant accounting policies in Note 1 of the notes to financial statements included in the Partnership's annual report on Form 10-KSB at December 31, 2003. The Partnership accounts for its investments in partnerships (Local Partnerships) by the equity method because the Partnership is a limited partner in the Local Partnerships. As such the Partnership has no control over the selection and application of accounting policies, or the use of estimates, by the Local Partnerships. Environmental and operational trends, events and uncertainties that might affect the properties owned by the Local Partnerships would not necessarily have a significant impact on the Partnership's application of the equity method of accounting, since the equity method has been suspended for eight Local Partnerships which have cumulative losses in excess of the amount of the Partnership's investments in those Local Partnerships. New Accounting Pronouncement ---------------------------- In December 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (revised December 2003) (FIN 46-R), Consolidation of Variable Interest Entities. FIN 46-R clarifies the application of Accounting Research Bulletin 51, Consolidated Financial Statements, for certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest ("variable interest entities"). Variable interest entities within the scope of FIN 46-R will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity's expected losses, receives a majority of its expected returns, or both. The Managing General Partner has evaluated the Partnership's investments in partnerships and has determined that they are not variable interest entities subject to consolidation by the Partnership under the provisions of FIN 46-R. Plan of Liquidation and Dissolution ----------------------------------- On February 4, 2004, the Partnership filed a Definitive Proxy Statement, pursuant to Section 14(a) of the Securities Exchange Act of 1934, to solicit consent for, among other things, the sale of all of the Partnership's assets and the dissolution of the Partnership pursuant to a Plan of Liquidation and Dissolution. As of the voting deadline, March 22, 2004, the holders of 28,699 units of limited partner interest (57.5%) voted "for" such sale and dissolution. See Notes 2 and 4 of the notes to financial statements contained in Part I, Item 1, hereof, for additional information concerning an offer to purchase the Partnership's limited partner interests in four Local Partnerships. There can be no assurance that the sale of the Partnership's limited partner interests in four Local Partnerships will occur. -10- Part I. FINANCIAL INFORMATION Item 2. Management's Discussion Analysis of Financial Condition and Results of Operations - Continued General ------- Some of the rental properties owned by the Local Partnerships are financed by state housing agencies. The Managing General Partner has sold or refinanced, and will continue to sell or refinance, certain properties pursuant to programs developed by these agencies. These programs may include opportunities to sell a property to a qualifying purchaser who would agree to maintain the property as low to moderate income housing, or to refinance a property, or to obtain supplemental financing. The Managing General Partner continues to monitor certain state housing agency programs, and/or programs provided by certain lenders, to ascertain whether the properties would qualify within the parameters of a given program and whether these programs would provide an appropriate economic benefit to the Limited Partners of the Partnership. Some of the rental properties owned by the Local Partnerships are dependent on the receipt of project-based Section 8 Rental Housing Assistance Payments (HAP) provided by the U.S. Department of Housing and Urban Development (HUD) pursuant to Section 8 HAP contracts. Current legislation allows all expired Section 8 HAP contracts with rents at less than 100% of fair market rents to be renewed for up to one year. Expiring Section 8 HAP contracts with rents that exceed 100% of fair market rents could be renewed for up to one year, but at rents reduced to 100% of fair market rents (Mark-to-Market). All expiring Section 8 HAP contracts with rents exceeding comparable market rents, and properties with mortgage loans insured by the Federal Housing Administration (FHA), became subject to the Mark-to-Market legislation. Mark-to-Market (M2M) implementation will reduce rental income at properties that are currently subsidized at higher-than-market rental rates, and will therefore lower cash flow available to meet mortgage payments and operating expenses. In some instances, a property will be able to meet its existing debt service payments after the reduction in rental income. In this case, the property may enter the M2M "Lite" program, which would not require a debt restructuring. In the remaining instances, the affected property may undergo debt restructuring according to terms determined by an individual property and operations evaluation. This would involve reducing the first mortgage loan balance to an amount supportable by the property's operations, taking into account the property's operating expenses and reduced income. The balance of the amount written down from the first mortgage loan would be converted to a non-performing but accruing (soft) second mortgage loan. When the existing first mortgage loan is bifurcated into a first and second mortgage loan, the newly created second mortgage loan will accrue interest at a below-market rate. The Internal Revenue Service issued a ruling in July 1998, that concluded that the below-market rate of interest would not generate additional ordinary income. Each property subject to M2M will be affected in a different manner, and it is difficult to predict the exact form of restructuring, or potential tax liabilities to the Limited Partners. All properties, upon entering the M2M program (excluding M2M Lite), are required to enter into an agreement restricting the property's use to affordable housing for 30 years. Finally, under HUD's "Mark-up-to-Market" program, properties with expiring Section 8 HAP contracts that are located in high-rent areas as defined by HUD are eligible for rent increases which would be necessary to bring Section 8 HAP contract rents in line with market rate rents. For properties that enter the program and have interest rate subsidized FHA loans, the rents are adjusted to take into account the benefits the property is already receiving from the below-market interest rate by means of a HUD-determined adjustment factor. The purpose of this program is to provide incentives to owners of properties with expiring Section 8 HAP contracts not to convert these properties to market rate housing. -11- Part I. FINANCIAL INFORMATION Item 2. Management's Discussion Analysis of Financial Condition and Results of Operations - Continued In return for receiving market rate rents under Mark-up-to-Market, the property owner must enter into a five year conditional Section 8 HAP contract with HUD, subject to the annual availability of funding by Congress. In addition, property owners who enter into the Mark-up-to- Market program may receive increased cash flow as the limited dividend will be increased in an amount equal to the increase in gross rental revenues. Mercy Terrace Associates (Mercy Terrace) had a Section 8 HAP contract covering 100% of its apartment units which expired in November 2003. The Local Managing General Partner entered Mercy Terrace into the Mark-up-to-Market program at that time. The Section 8 HAP contract will be renewed annually. Four Winds West Company Ltd. (Four Winds) has a Section 8 HAP contract covering 100% of its apartment units which expires in October 2005. Four Winds anticipates a one- year renewal of its Section 8 HAP contract at expiration. Posada Associates Limited Partnership (Posada Vallarta) has a Section 8 HAP contract covering 21% of its apartment units which expires in February 2005. Posada Vallarta anticipates a one-year renewal of its Section 8 HAP contract at expiration. Chevy Chase Park, Ltd. (Chevy Chase) has a Section 8 HAP contract covering 100% of its apartment units which expires in September 2005. Chevy Chase anticipates a one-year renewal of its Section 8 HAP contract at expiration. As of September 30, 2004, the carrying amount of the Partnership's investments in two Local Partnerships with Section 8 HAP contracts expiring in the next 12 months was $953,855. The Managing General Partner continues to seek strategies to deal with affordable housing policy. While the Managing General Partner cannot predict the outcome for any particular property at this time, the Managing General Partner will continue to work with the Local Partnerships to develop strategies that maximize the benefits to investors. Financial Condition/Liquidity ----------------------------- The Partnership's liquidity, with unrestricted cash resources of $3,623,721 as of September 30, 2004, along with anticipated future cash distributions from the Local Partnerships, is expected to be adequate to meet its current and anticipated operating cash needs. As of November 11, 2004, there were no material commitments for capital expenditures. The Managing General Partner currently intends to retain all of the Partnership's remaining undistributed cash pending resolution of the Partnership's remaining purchase money note and related accrued interest, for its Plan of Liquidation and Dissolution, and for operating cash reserves. The Partnership's remaining obligation with respect to its investment in Local Partnerships, in the form of a nonrecourse purchase money note having a principal balance of $1,400,000 plus accrued interest of $2,720,762 as of September 30, 2004, matured on September 1, 2003, and was not paid. The purchase money note, which is nonrecourse to the Partnership, is secured solely by the Partnership's interest in the related Local Partnership, Westgate Tower Limited Dividend Housing Association (Westgate). Since the Partnership's investment in Westgate has not produced sufficient value to satisfy the purchase money note, the Managing General Partner offered to tender the Partnership's interest in Westgate to the purchase money noteholders. See the notes to financial statements for additional information concerning this purchase money note. The Partnership's inability to pay the Westgate purchase money note principal and accrued interest balance when due, and the resulting uncertainty regarding the Partnership's continued ownership interest in Westgate, does not adversely impact the Partnership's financial condition because the purchase money note is nonrecourse and secured solely by the Partnership's interest in Westgate. Therefore, even though the Partnership's investment in Westgate has not produced sufficient value to satisfy the related purchase money note, the Partnership's exposure to loss is limited because the amount of the nonrecourse indebtedness of the matured purchase money note exceeds the carrying amount of the investment in Westgate. Thus, even a complete loss of the -12- Part I. FINANCIAL INFORMATION Item 2. Management's Discussion Analysis of Financial Condition and Results of Operations - Continued Partnership's interest in Westgate would not have a material adverse impact on the financial condition of the Partnership. In the event of a foreclosure or other transfer of the Partnership's interest, the excess of the nonrecourse indebtedness over the carrying amount of the Partnership's investment in Westgate will result in a taxable gain. This gain will be taxable to Limited Partners at a federal tax rate of up to 25.0%, as it will reflect recapture of depreciation deductions claimed in prior years. Additionally, the Partnership would lose its investment in Westgate and, likewise, its share of any future cash distributed by Westgate from rental operations, mortgage debt refinancings, or the sale of the real estate. The Partnership received no cash distributions from Westgate during 2003 and through November 11, 2004; thus in the event of a foreclosure or other transfer of the Partnership's interest, there would be no material adverse impact on the cash liquidity of the Partnership. The Managing General Partner has received consent from a majority in interest of the Limited Partners for the liquidation of the Partnership. It is anticipated that the Partnership's obligation, discussed above, would be retired in conjunction with such liquidation. There can be no assurance that the liquidation will be completed pursuant to the Plan of Liquidation and Dissolution. The Partnership closely monitors its cash flow and liquidity position in an effort to ensure that sufficient cash is available for operating requirements. For the nine month period ended September 30, 2004, the receipt of distributions from Local Partnerships was adequate to support operating cash requirements. Cash and cash equivalents increased $643,943 during the nine month period ended September 30, 2004, primarily as a result of the receipt of distributions from partnerships exceeding cash used in operating activities. The primary use of cash in operating activities was to pay management and professional fees, and general and administrative expenses. Results of Operations --------------------- The Partnership recognized net loss of $38,383 for the three month period ended September 30, 2004, compared to net income of $37,621 for the corresponding period in 2003, primarily due to a decrease in share of income from partnerships, and also due to increases in professional legal fees and general and administrative expenses, partially offset by a nominal increase in interest revenue and a nominal decrease in amortization of deferred costs. The Partnership's net income for the nine month period ended September 30, 2004, decreased $728,796 from the corresponding period in 2003, primarily due to gain from extinguishment of debt related to the transfer of one Local Partnership in 2003, and also due to an increase in general and administrative expenses related to the Partnership's Definitive Proxy Statement and higher reimbursed payroll costs, an increase in professional legal fees and a nominal decrease in interest revenue. Partially offsetting the decrease in net income was a nominal increase in share of income from partnerships and a decrease in amortization of deferred costs. For financial reporting purposes, the Partnership, as a limited partner in the Local Partnerships, does not record losses from the Local Partnerships in excess of its investment to the extent that the Partnership has no further obligation to advance funds or provide financing to the Local Partnerships. As a result, the Partnership's share of income from partnerships for the three and nine month periods ended September 30, 2004 did not include losses of $332,129 and $996,393, respectively, compared to excluded losses of $332,684 and $962,344 for the three and nine month periods ended September 30, 2003, respectively. Distributions of $0 and $178,913, received from zero and five Local Partnerships during the three and nine month periods ended September 30, 2004, respectively, and which have cumulative losses in excess of the Partnership's investments in the Local Partnerships (equity method suspended), were recorded as increases in the Partnership's share of income from partnerships when received, compared to distributions of $57,980 and $319,913, received from six Local Partnerships during the three and nine month periods ended September 30, 2003, respectively. -13- Part I. FINANCIAL INFORMATION Item 2. Management's Discussion Analysis of Financial Condition and Results of Operations - Continued No other significant changes in the Partnership's operations have taken place during the nine month period ended September 30, 2004. Item 3. Controls and Procedures In October 2004, representatives of the Managing General Partner of the Partnership carried out an evaluation of the effectiveness of the design and operation of the Partnership's disclosure controls and procedures, pursuant to Exchange Act Rules 13a-15 and 15d-15. The Managing General Partner does not expect that the Partnership's disclosure controls and procedures will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Based on the October 2004 evaluation, and subject to the foregoing, the Principal Executive Officer and Principal Financial Officer concluded that the Partnership's disclosure controls and procedures are effective as of the end of the period covered by this report to alert them in a timely manner to any material information relating to the Partnership that must be included in the Partnership's periodic SEC filings, and particularly during the period in which this report is being prepared. In addition, there have been no significant changes in the Partnership's internal control over financial reporting that occurred during the Partnership's most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Partnership's internal control over financial reporting. Part II. OTHER INFORMATION Item 3. Defaults Upon Senior Securities See Note 3.a. of the notes to financial statements contained in Part I, Item 1, hereof, for information concerning the Partnership's default on one purchase money note. Item 5. Other Information a. There is no established market for the purchase and sale of units of additional limited partner interest (Units) in the Partnership, although various informal secondary market services exist. Due to the limited markets, however, investors may be unable to sell or otherwise dispose of their Units. -14- Part II. OTHER INFORMATION Item 5. Other Information - Continued Registered Tender Offer ----------------------- On January 23, 2004, Equity Resource Fund XXII (Equity) initiated a registered tender offer to purchase up to 5,000 of the outstanding Units in the Partnership at a price of $175 per Unit; the offer, as extended, expired March 23, 2004. Equity is unaffiliated with the Partnership or the Managing General Partner. The price offered was determined solely at the discretion of Equity and does not necessarily represent the fair market value of each Unit. In response to the registered tender offer, on February 4, 2004, the Managing General Partner filed Schedule 14D-9. In that filing, the Managing General Partner recommended that Limited Partners reject the offer because it viewed the offer price as inadequate. Unregistered Tender Offers -------------------------- On January 26, 2004, Peachtree Partners (Peachtree) initiated an unregistered tender offer to purchase up to 4.9% (including 1,525 Units or 3.1%, already owned by affiliates) of the outstanding Units in the Partnership at a price of $175 per Unit less a transfer fee of $100 per investor; the offer expired March 23, 2004. On March 14, 2003, Peachtree initiated an unregistered tender offer to purchase an unspecified number of the outstanding Units in the Partnership at a price of $100 per Unit; the offer expired April 18, 2003. Peachtree is unaffiliated with the Partnership or the Managing General Partner. The prices offered were determined solely at the discretion of Peachtree and do not necessarily represent the fair market value of each Unit. The Managing General Partner did not express any opinion and remained neutral toward the 2003 unregistered tender offer for the purchase of Units described above, and in its Definitive Proxy Statement, dated February 4, 2004, recommended that Limited Partners reject the 2004 unregistered tender offer because it viewed the offer price as inadequate. b. On September 17, 2004, the Partnership filed a Current Report on Form 8-K, dated September 15, 2004, to report that, on September 15, 2004, the Partnership and two of its affiliates had entered into material definitive agreements not made in the ordinary course of business. The definitive agreements consisted of four Purchase and Sale Agreements with affiliates of Equity Resource Investments, LLC, to sell their partnership interests in four of the twelve partnerships in which the Partnership currently holds interests. The sales are in furtherance of the liquidation of the Partnership pursuant to a consent solicitation approved by a majority in interest of the Partnership's limited partners in March 2004. -15- Part II. OTHER INFORMATION Item 6. Exhibits Exhibit No. Description ---------- ----------- 10.1 Purchase and Sale Agreement, dated September 15, 2004, for the sale of 100% of the partnership interests in Arrowhead Apartments Associates. 10.2 Purchase and Sale Agreement, dated September 15, 2004, for the sale of 100% of the partnership interests in Blackburn Limited Partnership. 10.3 Purchase and Sale Agreement, dated September 15, 2004, for the sale of 100% of the partnership interests in Second Blackburn Limited Partnership. 10.4 Purchase and Sale Agreement, dated September 15, 2004, for the sale of 100% of the partnership interests in Moorings Apartments Associates. 31.1 Certification of Principal Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification of Principal Executive Officer and Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99 Schedule 13D, dated July 2, 2004. (Incorporated by reference thereto.) All other Items are not applicable. -16- SIGNATURE In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CAPITAL REALTY INVESTORS-II LIMITED PARTNERSHIP ---------------------------------------------- (Registrant) by: C.R.I., Inc. ----------------------------------------- Managing General Partner November 11, 2004 by: /s/ Michael J. Tuszka - ----------------- ------------------------------------ DATE Michael J. Tuszka Vice President and Chief Accounting Officer (Principal Financial Officer and Principal Accounting Officer) -17-