UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-20164 Krupp Government Income Trust II Massachusetts 04-3073045 (State or other jurisdiction of (IRS employer incorporation or organization) identification no.) 470 Atlantic Avenue, Boston, Massachusetts 02210 (Address of principal executive offices) (Zip Code) (617) 423-2233 (Registrant's telephone number, including area code) 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. FINANCIAL STATEMENTS This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, including those identified herein. KRUPP GOVERNMENT INCOME TRUST II BALANCE SHEETS ASSETS June 30, December 31, 1998 1997 Participating Insured Mortgage Investments ("PIMIs")(Note 2): Insured mortgages $144,807,366 $145,537,234 Additional loans 29,152,351 29,152,351 Participating Insured Mortgages ("PIMs")(Note 2) 38,490,431 37,645,082 Mortgage-Backed Securities and multi-family insured mortgage loan (AMBS")(Note 3) 47,187,093 51,171,301 Total mortgage investments 259,637,241 263,505,968 Cash and cash equivalents 14,871,996 13,520,091 Prepaid acquisition fees and expenses, net of accumulated amortization of $6,893,351 and $6,099,180, respectively 9,590,291 10,384,462 Prepaid participation servicing fees, net of accumulated amortization of $2,115,663 and $1,858,497, respectively 3,378,884 3,636,050 Interest receivable and other assets 1,935,229 2,111,153 Total assets $289,413,641 $293,157,724 LIABILITIES AND SHAREHOLDERS' EQUITY Deferred income on Additional Loans (Note 5) $ 2,541,374 $ 2,755,705 Other liabilities 24,070 30,949 Total liabilities 2,565,444 2,786,654 Commitments (Note 2) Shareholders' equity (Note 4): Common stock, no par value; 25,000,000 Shares authorized; 18,371,477 Shares issued and outstanding 286,334,599 289,864,327 Unrealized gain on MBS 513,598 506,743 Total Shareholders' equity 286,848,197 290,371,070 Total liabilities and Shareholders' equity $289,413,641 $293,157,724 The accompanying notes are an integral part of the financial statements. KRUPP GOVERNMENT INCOME TRUST II STATEMENTS OF INCOME For the Three Months For the Six Months Ended June 30, Ended June 30, 1998 1997 1998 1997 Revenues: Interest income - PIMs and PIMIs: Base interest $3,206,385 $3,636,543 $6,343,372 $6,990,634 Additional loan interest 373,763 417,443 885,750 1,028,911 Participation interest 138,559 161,0008 32,913 652,525 Interest income - MBS 821,250 706,558 1,779,542 1,435,740 Interest income - other 237,848 135,766 426,753 256,478 Total revenues 4,777,805 5,057,310 10,268,330 10,364,288 Expenses: Asset management fee to an affiliate 485,653 496,278 970,604 1,000,721 Expense reimbursements to affiliates (35,643) 108,482 72,840 229,392 Amortization of prepaid expenses and fees 525,669 523,078 1,051,337 1,057,825 General and administrative 136,455 107,007 221,077 241,269 Total expenses 1,112,134 1,234,845 2,315,858 2,529,207 Net income $3,665,671 $3,822,465 $7,952,472 $7,835,081 Earnings per share $ .20 $ .21 $ .43 $ .43 Weighted average shares outstanding 18,371,477 18,371,477 The accompanying notes are an integral part of the financial statements. KRUPP GOVERNMENT INCOME TRUST II STATEMENTS OF CASH FLOWS For the Six Months Ended June 30, 1998 1997 Operating activities: Net income $ 7,952,472 $ 7,835,081 Adjustments to reconcile net income to net cash provided by operating activities: Premium amortization 80,747 49,087 Amortization of prepaid expenses and fees 1,051,337 1,057,825 Changes in assets and liabilities: Decrease in interest receivable and other assets 175,924 299,149 Decrease in other liabilities (6,879) (11,045) Net cash provided by operating activities 9,253,601 9,230,097 Investing activities: Investment in PIMs and Insured Mortgages (1,003,677) - Investment in Additional Loans - (465,000) Principal collections on MBS 3,910,316 2,213,065 Principal collections on PIMs 888,196 888,676 Increase (decrease) in deferred income on Additional Loans (214,331) 116,765 Net cash provided by investing activities 3,580,504 2,753,506 Financing activity: Dividends (11,482,200) (11,482,200) Net increase in cash and cash equivalents 1,351,905 501,403 Cash and cash equivalents, beginning of period 13,520,091 9,214,592 Cash and cash equivalents, end of period $ 14,871,996 $ 9,715,995 The accompanying notes are an integral part of the financial statements. KRUPP GOVERNMENT INCOME TRUST II NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in this report on Form 10-Q pursuant to the Rules and Regulations of the Securities and Exchange Commission. However, in the opinion of Berkshire Mortgage Advisors Limited Partnership (the "Advisor"), the Advisor to Krupp Government Income Trust II (the "Trust"), the disclosures contained in this report are adequate to make the information presented not misleading. In the opinion of the Advisor of the Trust, the accompanying unaudited financial statements reflect all adjustments (consisting primarily of normal recurring accruals) necessary to present fairly the Trust's financial position as of June 30, 1998, the results of its operations for the three and six months ended June 30, 1998 and 1997 and its cash flows for the six months ended June 30, 1998 and 1997. The results of operations for the three and six months ended June 30, 1998 are not necessarily indicative of the results which may be expected for the full year. See Management's Discussion and Analysis of Financial Condition and Results of Operations included in this report. 2. PIMs and PIMIs At June 30, 1998, the Trust's PIMs and PIMIs have a fair value of $208,866,480 and gross unrealized losses of $3,583,668, respectively. The PIMs and PIMIs have maturities ranging from 2008 to 2036. At June 30, 1998 there are no insured mortgage loans within the Trust=s portfolio that are delinquent of principal or interest. During the second quarter of 1998, the Trust completed the funding of its commitment on the Fountains PIM. Windmill Lakes has been adversely affected by a competitive housing market in its South Florida area. As a result, at March 31, 1998 the borrower of the Windmill Lakes Additional Loan is in technical default on its Additional Loan for not making the full required base interest payments due on the Additional Loan. The Advisor is currently assessing the feasibility of extending debt service relief to the borrower until the market stabilizes. 3. MBS At June 30, 1998, the Trust's MBS portfolio has an amortized cost of approximately $46,673,495 and gross unrealized gains and losses of approximately $520,704 and $7,106, respectively. The MBS portfolio has maturities ranging from 2008 to 2023. In June 1997, Statement of Financial Accounting Standards No. 130, 'Reporting Comprehensive Income' (FASB 130), was issued establishing standards for reporting and displaying comprehensive income and its components effective January 1, 1998. FASB 130 requires comprehensive income and its components, as recognized under accounting standards, to be displayed in a financial statement with the same prominence as other financial statements, if material. FASB 130 had no material effect on the Trust's financial position or results of operations. Continued KRUPP GOVERNMENT INCOME TRUST II NOTES TO FINANCIAL STATEMENTS, Continued 4. Changes in Shareholder's Equity A summary of changes in Shareholders' equity for the six months ended June 30, 1998 is as follows: Total Common Retained Unrealized Shareholders' Stock Earnings Gain Equity Balance at December 31, 1997 $289,864,327 $ - $ 506,743 $290,371,070 Net income - 7,952,472 - 7,952,472 Dividends (3,529,728) (7,952,472) - (11,482,200) Change in unrealized gain on MBS - - 6,855 6,855 Balance at $286,334,599 $ - $ 513,598 $286,848,197 June 30, 1998 5. Related Party Transactions During the three months ended June 30, 1998 and June 30, 1997 the Trust received $0 and $56,471 of interest income on Additional Loans from an affiliate of the Advisor. During the six months ended June 30, 1998 and 1997, the Trust received $221,641 and $254,732 of interest income on Additional Loans from an affiliate of the Advisor. In addition, the Trust received $68,456 and $0 related to participation interest income for the six months ended June 30, 1998 and 1997. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements including those concerning Management's expectations regarding future financial performance and future events. These forward-looking statements involve significant risk and uncertainties, including those described herein. Actual results may differ materially from those anticipated by such forward-looking statements. Liquidity and Capital Resources At June 30, 1998 the Trust has significant liquidity consisting of cash and cash equivalents, of approximately $14.9 million as well as the cash inflows provided by PIMs, PIMIs, MBS, cash and cash equivalents. The Trust may also receive additional cash flow from the participation features of its PIMs and PIMIs. The Trust anticipates that these sources will be adequate to provide the Trust with sufficient liquidity to meet its obligations, including providing dividends to its investors. The most significant demand on the Trust's liquidity is quarterly dividends paid to investors of approximately $5.7 million. Funds for dividends come from interest income received on PIMs, PIMIs, MBS and cash and cash equivalents net of operating expenses, and the principal collections received on PIMs, PIMIs and MBS. The portion of dividends funded from principal collections reduces the capital resources of the Trust. As the capital resources of the Trust decrease, the total cash flows to the Trust will also decrease which may result in periodic adjustments to the dividends paid to the investors. The Advisor of the Trust periodically reviews the dividend rate to determine whether an adjustment is necessary based on projected future cash flows. Based on current projections, the Advisor believes the Trust can maintain the current dividend rate for the foreseeable future. In general, the Advisor tries to set a dividend rate that provides for level quarterly distributions. To the extent quarterly dividends do not fully utilize the cash available for distribution and cash balances increase, the Advisor may reinvest the available proceeds, adjust the dividend rate or distribute such funds through a special distribution. The borrower on the St. Germain PIMI is expected to prepay the first mortgage loan and the Additional Loan on July 31, 1998 as a result of a refinancing of the property. In addition, to the principal repayments, the Trust will receive the full, preferred return earned on its investment through the date of the prepayment as well as its share of the increase in the property's value. Most of the other properties in the Trust's portfolio generate sufficient operating revenues to adequately maintain the property, service the debt and pay participating interest to the Trust. However the operating performance of two properties located in South Florida, Oasis at Springtree and Windmill Lakes, continue to be adversely affected by highly competitive housing markets. Low interest rates and available building sites have encouraged aggressive development of both single-family homes and new apartment product. The borrower on the Windmill Lakes PIMI is currently delinquent in his obligation on the Additional Loan. Although he is trying to sell the property, he has been unable to secure a purchase offer that will cover the property's outstanding liabilities. The Advisor is currently assessing the feasibility of extending debt service relief on Windmill Lakes until that market stabilizes. The borrower on the Lakes at Vinings and Martins Landing PIMIs sold the property during July 1998, and the purchaser assumed both the guaranteed first mortgage loans and the Additional Loans on both properties. However, the purchaser has requested the Trust to allow it to prepay the Additional Loans. The Advisor is currently assessing the request. The borrower on the Windsor Lake PIMI has approached the Trust with a request to either allow a prepayment of the PIMI at a discount or enter into a workout agreement that would provide debt service relief. There are significant repair and replacement issues with Windsor Lake that have begun to have an effect on the leasing at the property. The Advisor is currently assessing the borrower's request and expects to respond prior to year-end. For the first five years of the PIMs and PIMIs the borrowers are prohibited from prepaying. For the second five years, the borrowers can prepay the loans incurring a prepayment penalty for PIMs or paying all amounts due under the PIMIs and satisfying the required preferred return. The Trust has the option of calling certain PIMs and all the PIMIs by accelerating their maturity if the loans are not prepaid by the tenth year after permanent funding. The Trust will determine the merits of exercising the call option for each PIM or PIMI as economic conditions warrant. Such factors as the condition of the asset, local market conditions, interest rates and available financing will have an impact on this decision. Assessment of Credit Risk The Partnership's investments in mortgages are guaranteed or insured by the FannieMae, the Federal Home Loan Mortgage Corporation (AFHLMC@), and the United States Department of Housing and Urban Development (AHUD@) and therefore the certainty of their cash flows and the risk of material loss of the amounts invested depends on the creditworthiness of these entities. FannieMae is a federally chartered private corporation that guarantees obligations originated under its programs. However, obligations of FannieMae are not backed by the U.S. Government. FannieMae is one of the largest corporations in the United States and the Secretary of the Treasury of the United States has discretionary authority to lend up to $2.25 billion to FannieMae at any time. FHLMC is a federally chartered corporation that guarantees obligations originated under its programs and is wholly owned by the twelve Federal Home Loan Banks. These obligations are not guaranteed by the U.S. Government or the Federal Home Loan Bank Board. HUD, an agency of the U.S. Government, insures the obligations originated under its programs, which are backed by the full faith and credit of the U.S. Government. The Trust's Additional Loans have similar risks as those associated with higher risk debt instruments, including: reliance on the owner's operating skills and ability to maintain occupancy levels, control operating expenses, maintain properties and obtain adequate insurance coverage; adverse changes in general economic conditions, adverse local conditions, and changes in governmental regulations, real estate zoning laws, or tax laws; and other circumstances over which the Trust may have little or no control. The Trust includes in cash and cash equivalents approximately $14 million of commercial paper, which is issued by entities with a credit rating equal to one of the top two rating categories of a nationally recognized statistical rating organization. Operations The following discussion relates to the operations of the Trust during the three and six months ended June 30, 1998 and 1997. The Trust's net income decreased $157,000 for the three months ended June 30, 1998 as compared to the same period of 1997 due to decreases in PIM and PIMI base interest of approximately $430,000 and an increase in general and administrative expenses of approximately $29,000. This was offset by increases in other interest income and interest income on MBS of approximately $102,000 and $115,000, respectively and a decrease in expense reimbursements of $144,000. The decrease in base interest on PIMs and PIMIs and the increase in interest income on MBS for the three months ended June 30, 1998 as compared to the same period of 1997 are primarily due to two transactions in 1997 involving the Willows Apartment PIMI and the Estates Apartment PIM. In each of these transactions the properties were sold and the Participating and Additional Loans were paid off. However, the buyer assumed the existing first mortgage and the Trust will continue to receive principal and interest on the portion of the financing but has now classified it as an MBS. Other interest income also increased due to the Trust having higher short-term investment balances during the three months ended June 30, 1998 as compared to the same period of 1997. During the second quarter of 1998, the Trust received a rebate for expense reimbursements related to 1997. The Trust's net income increased $117,000 for the six months ended June 30, 1998 as compared to the same period of 1997. The increase was due to an increase in interest income on MBS, participation interest and other interest income of approximately $344,000, $180,000 and $170,000, respectively, and a decline in expenses of approximately $213,000. This was offset by decreases in base interest income from PIM and PIMIs of approximately $647,000 and additional loan interest of approximately $143,000. The increase in participation income is due to the Trust recognizing the settlement related to The Estates of $232,000 that was received in 1998. The increase in interest income on MBS and decrease in the base interest income from PIM and PIMIs is due to the transactions involving the Willows Apartment PIMI and the Estates Apartment PIM as mentioned above. The decrease in Additional Loan interest is due to the prepayment of the Willows Additional Loan during the third quarter of 1997 and no Additional Loan interest payment from the borrower of the Windmill Lakes PIMI. Other interest income also increased due to the Trust having higher short-term investment balances during the six months ended June 30, 1998 when compared to the same period in 1997. The decrease in expenses is primarily due to lower expenses reimbursements, asset management fee and general and administrative expenses of approximately $157,000 $30,000 and $20,000, respectively, during the six months ended June 30, 1998 as compared to the same period in 1997. As principal collections reduce the Trust's investments in MBS, PIMs and PIMIs, interest income on MBS and base interest income on PIMs and PIMIs will decline. The Trust funds a portion of dividends with principal collections, which will continue to reduce the assets of the Trust thereby reducing the income, generated by the Trust in the future. KRUPP GOVERNMENT INCOME TRUST II PART II - OTHER INFORMATION Item 1. Legal Proceedings Response: None Item 2. Changes in Securities Response: None, Item 3. Defaults upon Senior Securities Response: None Item 4. Submission of Matters to a Vote of Security Holders Response: None Item 5. Other Information Response: None Item 6. Exhibits and Reports on Form 8-K Response: None SIGNATURE Pursuant to the requirements 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. Krupp Government Income Trust II (Registrant) BY: /s/Robert A. Barrows Robert A. Barrows Treasurer and Chief Accounting Officer of Krupp Government Income Trust II. DATE: July 31, 1998