SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q Quarterly Report Under Section 13 or 15(d) Of the Securities Exchange Act of 1934 For Quarter Ended June 30, 1998 Commission File No. 000-16950 Prometheus Income Partners, a California Limited Partnership (Exact name of registrant as specified in its charter) California 77-0082138 (State or other jurisdiction of (IRS Employer ID Number) incorporation or organization) 350 Bridge Parkway Redwood City, California 94065-1517 (Address of principal (zip code) executive offices) Registrant's telephone number, including area code: (650) 596-5300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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 [ ] PART I: FINANCIAL INFORMATION Item 1. Condensed Financial Statements The accompanying unaudited financial statements should be read in conjunction with the Form 10-K filed by the Partnership for the year ended December 31, 1997. These statements have been prepared in accordance with the instructions of the Securities and Exchange Commission Form 10-Q and do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The financial information does not include any adjustments for the capitalization of any improvements which are done only in conjunction with the year-end financial statements. While the financial information is unaudited, in the opinion of the Partnership, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the six months ended June 30, 1998 are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. PROMETHEUS INCOME PARTNERS a California Limited Partnership BALANCE SHEETS JUNE 30, 1998 AND DECEMBER 31, 1997 (In Thousands, Except for Unit Data) June 30, December 31, 1998 1997 (Unaudited) (Audited) ----------- --------- ASSETS Real Estate: Land, buildings and improvements $ 29,614 $ 29,614 Accumulated depreciation (7,316) (7,041) -------- -------- 22,298 22,573 Cash and cash equivalents 894 638 Restricted cash 3,752 3,503 Deferred expenses, net 283 283 Accounts receivable and other assets 64 19 -------- -------- Total assets $ 27,291 $ 27,016 ======== ======== LIABILITIES AND PARTNERS' CAPITAL Notes payable $ 26,613 $ 26,723 Payables and accrued liabilities 174 259 -------- -------- Total liabilities 26,787 26,982 -------- -------- General partner deficit (396) (401) Limited partners' capital 18,995 limited partnership units issued and outstanding 900 435 -------- -------- Total partners' capital 504 34 -------- -------- Total liabilities and partners' capital $ 27,291 $ 27,016 ======== ======== The accompanying notes are an integral part of these financial statements. PROMETHEUS INCOME PARTNERS a California Limited Partnership STATEMENTS OF INCOME FOR THE THREE MONTHS ENDED JUNE 30, 1998 AND 1997 (In Thousands, Except for Unit Data) 1998 1997 (Unaudited) (Unaudited) ----------- ----------- REVENUES Rental (including revenue from Affiliates of $0 and $120, respectively) $ 1,397 $ 1,332 Other income 47 38 Interest income 59 39 ------- ------- Total revenues 1,503 1,409 ------- ------- EXPENSES Interest and amortization 476 690 Operating 688 494 Depreciation 137 134 Administrative 14 12 Payments to general partner and affiliates: Management fees 76 68 Operating and administrative 132 114 ------- ------- Total expenses 1,523 1,512 ------- ------- NET LOSS $ (20) $ (103) ======= ======= Net loss per $1,000 limited partnership unit $ (1) $ (5) ======= ======= Number of limited partnership units used in computation 18,995 18,995 ======= ======= The accompanying notes are an integral part of these financial statements. PROMETHEUS INCOME PARTNERS a California Limited Partnership STATEMENTS OF INCOME FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (In Thousands, Except for Unit Data) 1998 1997 (Unaudited) (Unaudited) ----------- ----------- REVENUES Rental (including revenue from Affiliates of $0 and $260, respectively) $ 2,782 $ 2,607 Other income 88 77 Interest income 115 69 ------- ------- Total revenues 2,985 2,753 ------- ------- EXPENSES Interest and amortization 869 1,370 Operating 959 758 Depreciation 275 268 Administrative 28 23 Payments to general partner and affiliates: Management fees 148 135 Operating and administrative 236 208 ------- ------- Total expenses 2,515 2,762 ------- ------- NET INCOME (LOSS) $ 470 $ (9) ======= ======= Net income (loss) per $1,000 limited partnership unit $ 25 $ (.5) ======= ======= Number of limited partnership units used in computation 18,995 18,995 ======= ======= The accompanying notes are an integral part of these financial statements. PROMETHEUS INCOME PARTNERS a California Limited Partnership STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (In Thousands) 1998 1997 (Unaudited) (Unaudited) ----------- ----------- CASH FLOW FROM OPERATING ACTIVITIES Net income (loss) $ 470 $ (9) Adjustments to reconcile net income to cash provided by operating activities: Depreciation 275 268 Amortization 15 43 Decrease in accounts receivable and other assets (45) (38) Deferral of mortgage interest 0 833 Decrease in payables and accrued liabilities (85) (182) ------- ------- Net cash provided by operating activities 630 915 ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Increase in restricted cash (249) 0 Principal reductions on notes payable (110) (46) Increase in deferred loan fees (15) 0 ------- ------- Net cash used for financing activities (374) (46) ------- ------- Net increase in cash and cash equivalents 256 869 Cash and cash equivalents at beginning of year 638 2,227 ------- ------- Cash and cash equivalents at end of period $ 894 $ 3,096 ======= ======= The accompanying notes are an integral part of these financial statements. PROMETHEUS INCOME PARTNERS a California Limited Partnership NOTES TO FINANCIAL STATEMENTS 1. THE PARTNERSHIP Prometheus Income Partners, a California Limited Partnership (the "Partnership"), was formed to construct, invest in, operate and ultimately sell two multi-family apartment projects, Alderwood Apartments ("Alderwood") and Timberleaf Apartments ("Timberleaf"), located in Santa Clara, California. The General Partner is Prometheus Development Co., Inc., a California corporation. The financial information does not include any adjustments for the capitalization of any improvements which are done only in conjunction with the year end financial statements. The financial information included herein at June 30, 1998 and for the three and six months ended June 30, 1998 and 1997 is unaudited and, in the opinion of the Partnership, reflects all adjustments (which include only normal recurring accruals) necessary for a fair presentation of the financial position as of those dates and the results of operations for those periods. Management fees and payments to the General Partner and Affiliates represent compensation for services provided and certain expense reimbursements, at cost, in accordance with the Partnership Agreement. The information in the Balance Sheets at December 31, 1997 was derived from the Partnership's audited annual report for 1997. Partnership profits, losses and distributions are allocated among the partners based on the provisions of the Partnership Agreement which generally provide for allocations to begin when the partners are admitted to the Partnership. 2. INCOME TAXES In accordance with federal and California income tax regulations, no income taxes are levied on the Partnership; rather, such taxes are levied on the individual partners. Consequently, no provision or liability for federal or California income tax has been reflected in the accompanying financial statements. 3. HARDBOARD SIDING The General Partner has learned that the type of hardboard siding which was used at Alderwood and Timberleaf is failing to perform as expected in a number of projects in various parts of the United States. The wood technologist retained by the General Partner to test the performance of the hardboard siding confirms that the physical characteristics of the hardboard at both properties has deteriorated. A construction consultant retained by the General Partner to investigate the failure of the hardboard siding, along with the defendants in the case, has completed his destructive investigation phase and is currently performing temporary repairs to maintain the integrity of the buildings. To date, there is no conclusion regarding the extent of damage nor, the ultimate cost to repair. The General Partner has filed litigation on behalf of the Partnership as a result of this problem. Several unrelated property owners are litigating the matter against the hardboard siding manufacturer. One such case has concluded the trial phase. In that case, the owner reached various settlements with the contractor and various subcontractors and vendors before the trial, then prevailed in a jury verdict against the manufacturer which had not settled. The extent of the recovery from the trial has not yet been finally determined, as the court has yet to decide on the allocation of liabilities among settling and non-settling defendants for all the damages that were suffered. Also, the manufacturer has the right to appeal. It is not possible to predict whether any appeal will be filed, and if filed, the outcome thereof. While each case is different and the extent of the hardboard siding damage at each property is different, the General Partner is closely following the aforementioned case and its potential impact to the Partnership's case. Lastly, one defendant named in the Partnership's complaint has filed a cross-complaint against the Partnership. The amount of damages being sought is unspecified at this time. 4. REAL ESTATE Statement of Financial Accounting Standards 121 ("FASB 121"), Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of, requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In connection with the hardboard siding matter, the General Partner reviewed the projected cash flows of both properties to ensure an adjustment of the book value was not required in accordance with FASB 121. Further, although the full extent of the damage to the hardboard siding for these two properties is unknown, management believes that the fair market value of each property still remains greater than their respective book values. ITEM 2: Management's Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION Alderwood and Timberleaf, which are located in Santa Clara, California, are apartment complexes with 234 units and 124 units, respectively. The properties commenced operations at completion of construction in December 1986. LIQUIDITY AND CAPITAL RESOURCES Cash generated by operations during the first six months of 1998 was used to pay current operating expenses and debt service, including payments to the hardboard siding security account. Quarterly distributions have been suspended in order to accumulate working capital reserves until the degree of damage to the hardboard siding and determination of liability are known. See Note 3 to Financial Statements, Hardboard Siding, for a more comprehensive discussion of this matter. Each property has a non-recourse note payable, secured by a first deed of trust. These notes bear fixed interest of 6.99% for Alderwood and 7.09% for Timberleaf. The terms of the notes payable require that each property maintain a hardboard siding security account. These security accounts are additional collateral for the lender. Cash held in these security accounts was $2,103,000 and $1,643,000 for Alderwood and Timberleaf, respectively, as of June 30, 1998. The Alderwood trust deed requires that the security account be increased to $2,200,000 by December 1998. Thereafter, until the Completion Date, as defined, an additional 10%, as defined, or monthly cash flow, whichever is less, shall be deposited into each security account. Should the hardboard siding repairs not be completed by December 2002, or every two years thereafter, and insufficient cash has been accumulated to cure the defects based upon the lender's determination of the cost, then all cash flow shall be deposited into each applicable security account, as necessary, to fully fund the cost of construction. If the projected cash flow is insufficient to satisfy this deficiency contribution, then the Partnership has 60 days to fund the shortage over the projected cash flow. No withdrawals are permitted from the account except to cure the siding defects. The lender shall have the right to hire its own consultants to review, approve and inspect the construction. All such reasonable fees and expenses incurred by the lender shall be paid by the Partnership. Should the litigation not be settled by December 2002, and the Partnership has met all its obligations under the notes payable, then the Completion Date shall be extended 18 months from the earlier of the pending settlement date or the last day for filing an appeal. Should construction not be completed by the Completion Date due to an act of force majeure, the Completion Date can be further extended to complete the construction work. RESULTS OF OPERATIONS During the past year, Santa Clara County has continued to experience growth in the creation of new jobs. This continued job growth has helped offset the impact of the new housing developed. Since the second quarter of 1997, approximately 2,000 new apartments have been developed in the Santa Clara County market and an additional 900 units are due to come on line this summer. The new supply of apartments in the market has stabilized market rent growth. In the second quarter of 1998, the properties marketed available units at rents that averaged $1,260 for one bedroom units and $1,556 for two bedroom units. Average occupied rent per unit for the quarter was $1,348 and average occupancy during the quarter was 97% for both Alderwood and Timberleaf. As of June 30, 1998, Alderwood was 97% occupied and Timberleaf was 98% occupied. In the second quarter of 1997, the properties marketed available units at rents which averaged $1,247 for one bedroom units and $1,514 for two bedroom units. Average occupied rent per unit for the quarter was $1,231 and average occupancy during the quarter was 96% for Alderwood and 94% for Timberleaf. As of June 30, 1997, Alderwood was 97% occupied and Timberleaf was 92% occupied. Excluding expenditures relating to quantification of the extent of damage to the hardboard siding and associated litigation costs, operating expenses increased 3%. The following second quarter operating expenses increased between years: payroll, due to an addition of an assistant manager; management fees due to an increase in revenues; repairs and maintenance associated with exercise equipment and fire alarms, purchase of glass and screen supplies, and the first installment on the carport replacement contract. These increases were offset by the decrease in costs associated with the elimination of the corporate housing program which was discontinued in the second quarter 1997. Operating expenses inclusive of hardboard siding related costs increased 32%. Overall, net operating income decreased 22% during the three months ending June 30, 1998 when compared to 1997. IMPACT OF THE YEAR 2000 The year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in similar normal business activities. The General Partner believes that it will not be required to modify or replace significant portions of its software and that the year 2000 issue will not pose significant operational problems for its computer systems. Ultimately, the potential impact of the year 2000 issue, will depend not only on the corrective measures the General Partner undertakes, but also on the way in which the year 2000 issue is addressed by businesses and other entities whose financial condition or operational capability is important to the Partnership. Therefore, the General Partner is communicating with the parties to ensure they are aware of the year 2000 issue, to learn how they are addressing it, and to evaluate any likely impact on the Partnership. PART II: OTHER INFORMATION Item 1. Legal Proceedings. Fisher Friedman, the project architects, have filed a cross complaint against the Partnership. The cross complaint seeks a determination of the proportionate share of responsibility of the various defendants for the damage to the property arising from the defective hardboard siding, but does not specify any basis for making such an apportionment. The cross complaint further claims that if negligence is found, that Fisher Friedman's negligence be found to be secondary (rather than primary) in nature, thereby obligating the primarily liable defendants to indemnify Fisher Friedman for its liability. Again, the cross complaint fails to state any basis for which the Partnership has primary liability for the defective hardboarding siding. Also see Note 3 to Financial Statements, Hardboard Siding, for a more comprehensive discussion of this matter. Item 2. Changes in Securities. None. Item 3. Defaults Upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. None Item 6. Exhibits and 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. PROMETHEUS INCOME PARTNERS, a California Limited Partnership By: PROMETHEUS DEVELOPMENT CO., INC., a California corporation, It's General Partner Date: August 12, 1998 By: /s/ Vicki R. Mullins Vicki R. Mullins Executive Vice President and Chief Financial Officer Date: August 12, 1998 By: /s/ John J. Murphy John J. Murphy Vice President of Finance and Accounting EXHIBIT INDEX ------------- EXHIBIT NO. DESCRIPTION - ------- ----------- 27 Financial Data Schedule, which is submitted electronically to the Securities and Exchange Commission for information