1
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
( X ) QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarter ended: June 30, 1996
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File number: 0-17656
VANGUARD REAL ESTATE FUND II
A SALES-COMMISSION-FREE INCOME PROPERTIES FUND
(Exact name of Registrant as specified in its charter)
Massachusetts 23-2482429
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
Vanguard Financial Center
Malvern, PA 19355
(Address of principal executive (Zip Code)
offices)
Registrant's telephone number (610) 669-1000
Indicate by checkmark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities and 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 _____
6,432,626 shares of beneficial interest outstanding as of July 31, 1996.
2
INDEX
ITEM Page
No. No.
Cover Page . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
PART I FINANCIAL INFORMATION
ITEM 1. Financial Statements
--------------------
Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Income Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-4
Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-6
Statements of Changes in Shareholders' Equity . . . . . . . . . . . . . . . . . . . . . . . . . 6
Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-8
ITEM 2. Management's Discussion and Analysis of Financial
-------------------------------------------------
Condition and Results of Operations . . . . . . . .. . . . . . . . . . . . . . . . . . . 9-14
-----------------------------------
PART II OTHER INFORMATION
ITEM 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
-----------------
ITEM 2. Changes in Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
---------------------
ITEM 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . . . . . . . . 15
-------------------------------
ITEM 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . 15
---------------------------------------------------
ITEM 5. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
-----------------
ITEM 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . . . . . . 15
--------------------------------
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1
3
BALANCE SHEETS
(unaudited)
June 30, 1996 December 31, 1995
($ in 000's) ($ in 000's)
---------- -----------
ASSETS
Investments in Real Estate:
Direct Ownership Investments:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,900 $ 6,000
Buildings and Improvements . . . . . . . . . . . . . . . . . . . . . . 5,200 8,192
-------- --------
7,100 14,192
Less -- Accumulated Depreciation . . . . . . . . . . . . . . . . . . . -- 1,255
-------- --------
7,100 12,937
Mortgage Loans Receivable . . . . . . . . . . . . . . . . . . . . . . . . -- 8,290
Less -- Allowance for Possible Losses . . . . . . . . . . . . . . . . . -- 800
-------- --------
Net Investment Portfolio . . . . . . . . . . . . . . . . . . . . . . . . 7,100 20,427
Marketable Securities - REMICs . . . . . . . . . . . . . . . . . . . . . . . -- 1,194
Short-Term Investments:
Vanguard Money Market Reserves - Prime Portfolio
(333,495 and 959,453 shares, respectively) . . . . . . . . . . . . . . 333 959
Temporary Cash Investments . . . . . . . . . . . . . . . . . . . . . . . 799 4,995
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465 789
-------- --------
TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,697 $ 28,364
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Mortgage Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- $ 6,115
Deferred Revenue -- Mountain View . . . . . . . . . . . . . . . . . . . . . . $ 1,864 1,856
Due to Affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 142
Other Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 506
-------- --------
TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,969 8,619
-------- --------
Shares of Beneficial Interest, without par value, unlimited shares authorized 14,315 31,361
Accumulated Taxable Distributions in Excess
of Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,587) (11,616)
-------- --------
TOTAL SHAREHOLDERS' EQUITY . . . . . . . . . . . . . . . . . . . . . . . . . 6,728 19,745
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY . . . . . . . . . . . . . . . . . $ 8,697 $ 28,364
======== ========
The accompanying notes are an integral part of these statements.
2
4
INCOME STATEMENTS
(unaudited)
Three Months Ended June 30,
1996 1995
(000) (000)
--------- ---------
REAL ESTATE INCOME
Rental Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 317 $ 1,296
Mortgage Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 205
--------- ---------
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 1,501
--------- ---------
REAL ESTATE EXPENSES
Mortgage Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- 341
Real Estate Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 190
Property Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 271
Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . -- 237
Provision for Possible Losses . . . . . . . . . . . . . . . . . . . . . . . . . . 400 --
--------- ---------
510 1,039
--------- ---------
(LOSS) INCOME FROM REAL ESTATE . . . . . . . . . . . . . . . . . . . . . . . . . (193) 462
INVESTMENT INCOME FROM SHORT-TERM
INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 103
--------- ---------
(96) 565
--------- ---------
ADMINISTRATIVE EXPENSES
Investment Advisory Fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 56
Administrative Fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 47
Other Administrative Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 84 59
--------- ---------
108 162
--------- ---------
(LOSS) INCOME BEFORE NET GAIN ON SALE OF INVESTMENTS . . . . . . . . . . . . . . (204) 403
Net Gain on Sale of Investments . . . . . . . . . . . . . . . . . . . . . . . . . -- 185
--------- ---------
NET (LOSS) INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (204) $ 588
========= =========
Weighted Average Number of Shares Outstanding . . . . . . . . . . . . . . . . . . 6,432,626 6,432,626
========= =========
Net (Loss) Income Per Share:
(Loss) Income Before Net Gain on Sale of Investments . . . . . . . . . . . . . $ (.03) $ .06
Net Gain on Sale of Investments . . . . . . . . . . . . . . . . . . . . . . . -- .03
--------- ---------
Net (Loss) Income Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (.03) $ .09
========= =========
The accompanying notes are an integral part of these statements.
3
5
INCOME STATEMENTS
(unaudited)
Six Months Ended June 30,
1996 1995
(000) (000)
--------- ---------
REAL ESTATE INCOME
Rental Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $788 $2,590
Mortgage Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 421
--------- ---------
895 3,011
--------- ---------
REAL ESTATE EXPENSES
Mortgage Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 681
Real Estate Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 339
Property Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 549
Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . -- 458
Provision for Possible Losses . . . . . . . . . . . . . . . . . . . . . . . . . . 400 --
--------- ---------
839 2,027
--------- ---------
INCOME FROM REAL ESTATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 984
INVESTMENT INCOME FROM SHORT-TERM
INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 194
--------- ---------
275 1,178
--------- ---------
ADMINISTRATIVE EXPENSES
Investment Advisory Fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 106
Administrative Fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 94
Other Administrative Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 154 141
--------- ---------
234 341
--------- ---------
INCOME BEFORE NET GAIN ON SALE
OF INVESTMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 837
Net Gain on Sale of Investment . . . . . . . . . . . . . . . . . . . . . . . . . 3,988 185
--------- ---------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,029 $1,022
========= =========
Weighted Average Number of Shares Outstanding . . . . . . . . . . . . . . . . . . 6,432,626 6,432,626
========= =========
Net Income Per Share:
Income Before Net Gain on Sale of Investment . . . . . . . . . . . . . . . . . $.01 $.13
Net Gain on Sale of Investment . . . . . . . . . . . . . . . . . . . . . . . . .62 .03
--------- ---------
Net Income Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $.63 $.16
========= =========
The accompanying notes are an integral part of these statements.
4
6
STATEMENTS OF CASH FLOWS
(unaudited)
Three Months Ended June 30,
1996 1995
(000) (000)
-------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net (Loss) Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(204) $ 588
Adjustments to Reconcile Net (Loss) Income to
Net Cash Provided by Operating Activities:
Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . - 237
Provision for Possible Losses . . . . . . . . . . . . . . . . . . . . . . . 400 -
Distribution from Joint Venture -- Operating . . . . . . . . . . . . . . . . 5 9
Net Gain on Sale of Investments . . . . . . . . . . . . . . . . . . . . . . - (185)
Changes in Other Assets and Liabilities . . . . . . . . . . . . . . . . . . (104) (211)
------- ------
Net Cash Provided by Operating Activities . . . . . . . . . . . . . . . . 97 438
------- ------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in Real Estate:
Building Improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . - (17)
Proceeds from Sale of Investment -- Raleigh . . . . . . . . . . . . . . . . . - 1,153
Transaction Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (232) -
Principal Repayments on Marketable Securities -- REMICs . . . . . . . . . . . - 55
------- ------
Net Cash (Used In) Provided by Investing Activities . . . . . . . . . . . (232) 1,191
------- ------
CASH FLOWS FROM FINANCING ACTIVITIES
Mortgage Principal Payments . . . . . . . . . . . . . . . . . . . . . . . . . - (23)
Dividends Paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,046) (482)
------- ------
Net Cash Used In Financing Activities . . . . . . . . . . . . . . . . . . (17,046) (505)
------- ------
NET (DECREASE) INCREASE IN CASH AND
CASH EQUIVALENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,181) 1,124
CASH AND CASH EQUIVALENTS -- Beginning of Period . . . . . . . . . . . . . . 18,313 6,827
------- ------
CASH AND CASH EQUIVALENTS -- End of Period . . . . . . . . . . . . . . . . . $1,132 $7,951
======= ======
The accompanying notes are an integral part of these statements.
5
7
STATEMENTS OF CASH FLOWS
(unaudited)
Six Months Ended June 30,
1996 1995
(000) (000)
------- ------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,029 $1,022
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . -- 458
Provision for Possible Losses . . . . . . . . . . . . . . . . . . . . . . . 400 --
Distribution from Joint Venture -- Operating . . . . . . . . . . . . . . . . 8 10
Net Gain on Sale of Investments . . . . . . . . . . . . . . . . . . . . . . (3,988) (185)
Changes in Other Assets and Liabilities . . . . . . . . . . . . . . . . . . (491) (85)
------- ------
Net Cash (Used in) Provided by Operating Activities . . . . . . . . . . . (42) 1,220
------- ------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in Real Estate:
Building Improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . -- (315)
Proceeds from Sale of Investment -- Raleigh . . . . . . . . . . . . . . . . . -- 1,153
Proceeds from Sale of Investment -- Arapahoe . . . . . . . . . . . . . . . . . 17,489 --
Transaction Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (302) --
Marketable Securities Sold . . . . . . . . . . . . . . . . . . . . . . . . . . 1,194 --
Principal Repayments on Marketable Securities -- REMICs . . . . . . . . . . . -- 128
------- ------
Net Cash Provided by Investing Activities . . . . . . . . . . . . . . . . 18,381 966
------- ------
CASH FLOWS FROM FINANCING ACTIVITIES
Mortgage Principal Payments . . . . . . . . . . . . . . . . . . . . . . . . . (17) (46)
Payment of Mortgage Loan -- Arapahoe . . . . . . . . . . . . . . . . . . . . . (6,098)
Dividends Paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (17,046) (482)
------- ------
Net Cash Used In Financing Activities . . . . . . . . . . . . . . . . . . (23,161) (528)
------- ------
NET (DECREASE) INCREASE IN CASH AND
CASH EQUIVALENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,822) 1,658
CASH AND CASH EQUIVALENTS -- Beginning of Period . . . . . . . . . . . . . . 5,954 6,293
------- ------
CASH AND CASH EQUIVALENTS -- End of Period . . . . . . . . . . . . . . . . . $1,132 $7,951
======= ======
- --------------------------------------------------------------------------------
STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(unaudited)
Accumulated Taxable
Shares of Distributions
Beneficial Interest In Excess of Total Shareholders'
Number Amount Net Income Equity
(000) (000) (000)
------------------------------------------------------------------------
Balance: January 1, 1996 . . . . . . . . 6,432,626 $31,361 $(11,616) $19,745
Net Income for the Period . . . . . . . 4,029 4,029
Liquidating Distributions . . . . . . . (17,046) (17,046)
------------------------------------------------------------------------
Balance: June 30, 1996 . . . . . . . . . 6,432,626 $14,315 $ (7,587) $ 6,728
========================================================================
The accompanying notes are an integral part of these statements.
6
8
NOTES TO FINANCIAL STATEMENTS
1. These financial statements should be read in conjunction with the financial
statements and notes thereto contained in the Fund's Annual Report to
Shareholders for the year ended December 31, 1995. The results of operations
for the three and six months ended June 30, 1996 are not necessarily indicative
of the results for the entire year ending December 31, 1996.
2. On December 8, 1995, the Fund's Board of Trustees approved a Plan of
Liquidation and Termination (the "Liquidation Plan"). The Fund's Declaration of
Trust initially contemplated the liquidation of all of the Fund's investments
after a period of approximately seven to twelve years following completion of
its initial public offering. The Liquidation Plan provides that the Fund will
dispose of all of its assets, wind up its affairs, pay or adequately provide
for the payment of all of its liabilities and distribute for the benefit of its
shareholders all of the Fund's assets over 24 months in complete cancellation
and redemption of all issued and outstanding shares of beneficial interest. The
Liquidation Plan provides that the Fund's assets may be sold, conveyed,
transferred or otherwise disposed of when and on such terms and conditions as
are deemed by the Trustees to be in the best interests of the Fund and the
shareholders.
The Fund is currently in the process of liquidating its real estate
investments with the intention of distributing the net proceeds to its
shareholders in accordance with the Liquidation Plan. At June 30, 1996, the
Fund held an investment in an income-producing industrial park and also held a
limited partnership interest in a limited partnership that owns an
income-producing office building. It is contemplated that the Fund will be
completely liquidated and dissolved by December 8, 1997. To the extent that the
Fund has not disposed of all of its assets or made provision for all of its
liabilities on December 8, 1997, the Fund intends to form a liquidating trust,
the beneficiaries of which will be the shareholders of the Fund. All assets and
liabilities not disposed of and discharged will be transferred to the
liquidating trust. Shares of the Fund would no longer be traded and the
beneficial interests in the liquidating trust would not be readily
transferable.
The Fund intends to continue to qualify as a REIT under the Internal
Revenue Code during the Fund's liquidation period.
3. The Fund's financial statements have been prepared on the basis of a going
concern using historical cost. As of June 30, 1995, the Fund considered all of
its remaining investments as held for sale and reduced the carrying value of
such investments to the extent that each investment's then-current carrying
value exceeded its estimated net realizable value, defined as estimated fair
market value less selling costs. Upon obtaining binding agreements of sale for
all of its remaining real estate investments, the Fund will account for such
investments on a liquidation basis and will at that time recognize estimated
net gains, if any, on such investments. Prior to June 30, 1995, depreciation on
real estate owned was computed using the straight-line method over 40 years for
buildings, and costs incurred in conjunction with the acquisition of real
estate investments were deferred and amortized on a straight-line basis over
the life of the loan for mortgage loan investments and the life of the property
for equity investments. After June 30, 1995, no depreciation or amortization
expense related to the Fund's owned real estate and acquisition costs is
recognized, since the Fund's real estate investments are considered to be
held-for-sale assets.
4. On March 7, 1996, the Fund sold its Arapahoe Village Investment
("Arapahoe") in Boulder, Colorado for a gross contract price of $17,550,000.
The Fund reported in November 1995 that it had then been recently advised by
its adviser, Aldrich, Eastman, and Waltch, L.P. ("AEW"), that soil and
groundwater samples extracted from the site revealed the presence of
constituents of gasoline and dry-cleaning fluid in the soil and groundwater.
The samples were taken as part of an environmental assessment undertaken at the
request of a contract purchaser in connection with a contemplated sale of the
property. AEW subsequently engaged on the Fund's behalf attorneys and
environmental consultants in an effort to further assess the scope and
magnitude of the possible contamination. Pursuant to the terms of an amended
sale agreement, the Fund completed the sale of Arapahoe to the same contract
purchaser. The Fund recorded a net gain on the sale of Arapahoe of $3,988,000,
after payment by the Fund of applicable transaction costs, including a
disposition fee to AEW in the amount of $232,000.
5. On February 29, 1996, the Fund took title to the Bayside Business Center
("Bayside") in lieu of foreclosure on the former senior and junior mortgage
loans receivable secured by Bayside. Under the original loans' terms, upon
repayment of the Bayside junior loan, the Fund was entitled to receive an
amount equal to the greater of (i) an amount sufficient to generate a 12.4%
internal rate of return (as defined in the loan documents) on the junior loan
or (ii) 50% of Bayside's fair market value in excess of $9 million. In
anticipation of the Fund exercising its call option in early 1995, at December
31, 1994, the Fund management reduced the loans' carrying value (remaining loan
balance plus the deferred interest receivable pursuant to the
shared-appreciation feature of the mortgage) to the estimated fair value of the
collateral less estimated selling costs. This determination to reduce the
carrying value was based on: (i) an evaluation of the borrower's remaining
equity in the Bayside property securing the mortgage loan and; (ii) the
economic prospects of the borrower and
7
9
NOTES TO FINANCIAL STATEMENTS
Bayside property over its expected remaining holding period. On April 13, 1995,
the Fund exercised its call right on the loan and the entire balance of the
loan became due and payable on October 18, 1995.
The Fund and the borrower reached agreement to satisfy in full the
obligations due under the loan balance by means of a discounted payoff of
$7,600,000. The Fund also agreed to provide the borrower 120 days to obtain
financing to make the payoff in exchange for a commitment to transfer title to
the Fund in lieu of foreclosure if the borrower could not make the discounted
payoff. The borrower was unable to secure the necessary financing and,
accordingly, the Fund took title to Bayside in late February 1996. The former
borrower remained current on all interest payments due on the loan. Since both
the net proceeds expected to be received from the possible discounted payoff of
the loan and the estimated net realizable value of the collateral approximated
the investment's carrying value, no provision for possible losses was required
related to Bayside during the year ended December 31, 1995. Upon taking title,
the Fund's adviser immediately began to market the property for sale.
Subsequently, based on an evaluation of information gathered from potential
buyers contacted during the initial marketing process, the adviser reduced its
estimate of the property's fair market value during the second quarter of 1996.
Accordingly, during the quarter ended June 30, 1996, $400,000 was charged to
the provision for possible losses to write down the carrying value of Bayside
to its estimated fair market value less selling costs.
6. On January 12, 1996, the Fund sold its investment in marketable securities
(REMIC) for net proceeds of $1,194,000. Since such securities are carried at
fair market value, no gain or loss on the sale was recognized.
7. The Fund holds a Limited Partnership interest in Plymouth Street, L.P. (the
"Partnership"), which investment is accounted for under the equity method. The
Partnership owns an office property located in Mountain View, California
("Mountain View"). In 1992, the Partnership entered into a Loan Agreement and
Option and Put Agreement with an unrelated party. The Loan Agreement provides
for scheduled advances totaling $17.5 million over five years, such advances
secured by a non-recourse mortgage on the property bearing interest at 10% per
annum. The net proceeds of such advances are to be immediately distributed to
the Partners under the terms of the Partnership Agreement. Prior to these
agreements, there was no debt outstanding on the property. The Fund received
aggregate net cash proceeds of $14,299,000 from scheduled advances through
1994, which in the aggregate exceeded the carrying value of the investment.
Additionally, the Fund expects to receive an additional distribution of $75,000
from the advance scheduled for July 1, 1997. A deferred credit representing the
excess of distributions received over the Fund's carrying value is reflected in
the balance sheets as Deferred Revenue -- Mountain View. The remaining proceeds
are to be distributed to the general partner in accordance with the scheduled
advances under the Loan Agreement and terms of the Partnership Agreement.
Under the terms of the Option and Put Agreement, the Partnership has the
right to require the lender to purchase the property during the period December
7, 1997 to February 28, 1998, and the lender has the exclusive right to
purchase the property during the period March 1, 1998 to May 30, 1998, for
$19,000,000. Upon exercise of the option or put, the Fund will receive 50% of
the proceeds in excess of the aggregate advances received to date and those yet
to be received under the Loan Agreement. The Partnership also has the right to
repurchase the lender's purchase option for an amount of at least $3,000,000
between July 1, 1996, and December 31, 1996. In the event the lender purchases
the property pursuant to the Option and Put Agreement or the Fund sells its
remaining interest in the Partnership, the Fund would recognize a gain equal to
the then deferred revenue balance plus any additional amounts received as a
result of the sale of the property or the Fund's partnership equity interest.
As a result of the Loan Agreement executed during the fourth quarter of
1992 described above, and the resultant interest thereon, the Partnership has
since generated net losses. Such losses were allocated entirely to the general
partner in accordance with the terms of the Partnership Agreement. Since the
Fund has received distributions in excess of the carrying value of its
investment in the Partnership, if any future losses are allocated to the Fund,
such allocated losses will be recognized only to the extent of previously
allocated net income.
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ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
BUSINESS
Vanguard Real Estate Fund II, A Sales-Commission-Free Income Properties Fund
(the "Fund"), was organized on September 24, 1987 as a Massachusetts business
trust and is a qualified finite-life real estate investment trust ("REIT")
under the Internal Revenue Code of 1986, as amended. The Fund has no
employees. The Fund's Declaration of Trust precludes the Fund from reinvesting
net proceeds from the sale or repayment of its real estate investments after
December 31, 1994 and contemplates the liquidation of all the Fund's
investments after a period of approximately seven to twelve years following the
completion of its initial public offering, or between 1995 and 2000,
respectively.
On December 8, 1995, the Fund's Board of Trustees adopted a Plan of Liquidation
and Termination (the "Liquidation Plan"). The Trustee's decision to adopt the
Liquidation Plan at this point in the Fund's initially contemplated liquidation
period was driven by several factors, including real estate market conditions
affecting each investment in the Fund's portfolio and tax considerations
affecting real estate investment trusts. The Liquidation Plan provides that
the Fund will dispose of all of its assets, wind up its affairs, pay or
adequately provide for the payment of all of its liabilities and distribute for
the benefit of its shareholders all of the Fund's assets over 24 months, in
complete cancellation and redemption of all issued and outstanding shares of
beneficial interest. Under the Liquidation Plan, the Fund's Adviser, Aldrich,
Eastman and Waltch, L.P. ("AEW"), Trustees and officers are authorized and
directed to take any and all actions as may be necessary or convenient to
market the assets of the Fund and convert them into a form that may be
distributed to shareholders. The Liquidation Plan provides that the Fund's
assets may be sold, conveyed, transferred or otherwise disposed of when and on
such terms and conditions as are deemed by the Trustees to be in the best
interests of the Fund and the shareholders.
The Fund is currently in the process of liquidating its real estate investments
with the intention of distributing the net proceeds to its shareholders in
accordance with the Liquidation Plan. At June 30, 1996, the Fund held
investments in two income-producing properties, consisting of an industrial
park and a limited partnership interest in a limited partnership that owns an
income producing office building. It is contemplated that the Fund will be
completely liquidated and dissolved by December 8, 1997. To the extent that
the Fund has not disposed of all of its assets or made provision for all of its
liabilities on December 8, 1997, the Fund intends to form a liquidating trust,
the beneficiaries of which will be the shareholders of the Fund. All assets
and liabilities of the Fund not previously disposed of and discharged will be
transferred to the liquidating trust. Shares of the Fund would no longer be
traded and the beneficial interests in the liquidating trust would not be
readily transferable.
Pending disposition of the Fund's real estate investments pursuant to the
Liquidation Plan, the Fund's real estate investments will continue to be
subject to competition from existing commercial, industrial, and residential
properties and will be subject to competition from properties that are
developed in the future. The REIT provisions of the Internal Revenue Code of
1986 ("the Code") impose certain financial, investment and operational
restrictions that are not applicable to competing entities that are not REITs.
During the six months ended June 30, 1996, the Fund took title to the Bayside
Business Center ("Bayside") in lieu of foreclosure on the former senior and
junior mortgage loans receivable secured by Bayside. Previously, on April 13,
1995, the Fund exercised its call rights on the loans and the entire balance of
the loans became due and payable on October 18, 1995. The Fund and the
borrower reached agreement to satisfy in full the obligations due under the
loan balance by means of a discounted payoff of $7,600,000. The Fund also
agreed to provide the borrower 120 days to obtain financing to make the payoff
in exchange for a commitment to transfer title to the Fund in lieu of
foreclosure if the borrower could not make the discounted payoff. The borrower
was unable to secure the necessary financing and, accordingly, the Fund took
title to
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Bayside in late February 1996. The former borrower remained current on all
interest payments due on the loan.
On March 7, 1996, the Fund sold its Arapahoe Village Investment ("Arapahoe") in
Boulder, Colorado for a gross contract price of $17,550,000. The Fund reported
in November 1995 that it had then been recently advised by AEW that soil and
groundwater samples extracted from the site revealed the presence of
constituents of gasoline and dry-cleaning fluid in the soil and groundwater.
The samples were taken as part of an environmental assessment undertaken at the
request of a contract purchaser in connection with a contemplated sale of the
property. AEW subsequently engaged, on the Fund's behalf, attorneys and
environmental consultants to further assess the issue and conduct additional
testing at the site, and appropriate State of Colorado environmental officials
were notified of the contamination as required by law. In December 1995, the
tests were completed and subsequently the State of Colorado issued "no further
action" letters. Pursuant to the terms of an amended sale agreement, the Fund
completed the sale to the same contract purchaser. The Fund recorded a net
gain on the sale of Arapahoe of $3,988,000, after payment by the Fund of
applicable transaction costs, including a disposition fee payable to AEW in the
amount of $232,000.
In completing its Liquidation Plan, the Fund is in competition with other
domestic institutional investors, including commercial banks and other
financial institutions, insurance companies, pensions and other retirement
funds, mortgage bankers, other real estate investment trusts, real estate
brokers, developers and various types of foreign investors who may be seeking
to dispose of real estate investments. The principal factors of competition
for the disposition of leased properties which the Fund owns or which underlie
Fund investments include how rental rates, lease terms, free rent concessions
and tenant improvement allowances compare with those in local markets.
At present, the Fund's adviser is in active negotiations to dispose of the
Fund's two remaining real estate investments. Regarding Bayside Business
Center, the Fund's adviser has executed a purchase and sale agreement with a
prospective investor contemplating its sale. Subject to the satisfactory
completion of due diligence by the potential buyer, such sale is expected to
occur by the end of August, 1996. With respect to the Mountain View
investment, the adviser has tentatively reached an agreement in principle with
the Plymouth Street, L.P. ("the Partnership") general partner regarding an
assignment of the Fund's limited partnership interest to the general partner.
Such assignment would result in an immediate cash payment to the Fund in
exchange for the Fund's right to receive any remaining distributions from
proceeds paid to the Partnership pursuant to the Loan and Option and Put
Agreements described in Note 5 to the accompanying financial statements.
Subject to negotiation of a definitive written modification of the
Partnership agreement satisfactory to both the Fund and the general partner,
such payment could occur by late August 1996. Such a modification would result
in the Fund's immediate recognition of a gain on the sale of its remaining
interest in the Partnership equal to: (i) a deferred credit representing the
excess of aggregate distributions received over the Fund's carrying value of
the investment (reflected as "Deferred Revenue - Mountain View" in the amount
of $1,864,000 in the balance sheets of the accompanying June 30, 1996 financial
statements) plus (ii) the payment, net of all associated fees and expenses,
received upon execution of the modification agreement. Based on the agreement
in principle, such net payment is currently estimated to be approximately
$200,000 to $250,000. Based on information provided by the adviser, it is
possible that both investments could be sold during 1996. However, there can
be no assurance that such sales can be completed during 1996. Upon sale of
these two remaining investments, the Fund's Trustees and management intend to
complete the Fund's Liquidation Plan as soon as practicable thereafter. In
addition to liquidating the Fund's assets, settling or making a provision for
all of the Fund's liabilities, making a final distribution(s) to shareholders
and dissolving the Fund, such activities are expected to include, but not
necessarily be limited to, (i) delisting the Fund's shares from trading on the
American Stock Exchange, (ii) deregistering the Fund's shares under the
Securities Exchange Act of 1934, (iii) making provision for contingent
liabilities of the Fund, if any, and (iv) obtaining any necessary insurance
coverages.
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12
On January 12, 1996, the Fund sold its investment in marketable securities
(REMIC) for net proceeds of $1,194,000. Since such securities were carried at
fair market value, no gain or loss on the sale was recognized.
The Fund has elected to be treated as a REIT under the Code. The Fund intends
to operate in a manner that will continue to maintain its qualification as a
REIT during its liquidation period.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1996 VS. SIX MONTHS ENDED JUNE 30, 1995
The Fund had net income of $4,029,000, or $.63 per share, for the six months
ended June 30, 1996, as compared to net income of $1,022,000, or $.16 per
share, for the same period of 1995. Included in net income in 1996 and 1995
periods were net gains realized on the sale of investments of $3,988,000 and
$185,000 resulting from the sales of the Arapahoe and the Raleigh investments,
respectively. Excluding net gains on property sales, net income decreased by
$796,000 for the six months ended June 30, 1996, as compared to net income in
the same period in 1995. This decrease, as more fully described below,
reflects a smaller real estate asset base in 1996, and corresponding decreases
in net rental income and mortgage interest income, and a provision for possible
losses of $400,000 recorded in the second quarter of 1996. This decrease was
primarily offset by an increase in investment income and decreases in mortgage
interest expense, administrative expenses and depreciation and amortization
expense, in each case as compared to such items in 1995.
Net rental income (rental income less real estate taxes and property operating
expenses) decreased by $1,275,000, or 75%, from $1,702,000 for the six-month
period ended June 30, 1995 to $427,000 for the six-month period ended June 30,
1996. This decrease was primarily due to 1995 and 1996 property dispositions.
The 1995 property dispositions included: (i) the sale of the Raleigh Building
on June 16, 1995, (ii) the sale of the Sequoia Commerce Center on November 17,
1995 and (iii) the sale of the remaining Penn Warner Buildings, which sales
generated for the Fund net rental income of $56,000, $559,000, and $297,000,
respectively, for the six months ended June 30, 1995. On March 7, 1996, the
Fund sold the Arapahoe investment, which provided the Fund with net rental
income during the six months ended June 30, 1995, of $793,000, as compared to
$172,000 for the period such investment was held in the first half of 1996.
Offsetting this decrease was an increase of $255,000 in net rental income
generated by the Bayside Business Center, resulting from the Fund taking title
to Bayside on February 29, 1996, as discussed below.
Mortgage interest income decreased by $314,000, or 75%, from $421,000 for the
six months ended June 30, 1995, to $107,000 for the same period of 1996. This
decrease was due to the Fund taking title to the Bayside Business Center in
lieu of foreclosure on the senior and junior mortgage loans receivable secured
by Bayside on February 29, 1996. Under the original loan's terms, upon
repayment of the Bayside junior mortgage loan receivable the Fund was entitled
to receive an amount equal to the greater of (i) an amount sufficient to
generate a 12.4% internal rate of return (as defined in the loan documents) on
the junior loan or (ii) 50% of Bayside's fair market value in excess of $9
million. In anticipation of the Fund exercising its call option in early 1995,
at December 31, 1994, Fund management reduced the loan's carrying value
(remaining loan balance plus a deferred interest receivable pursuant to the
shared-appreciation feature of the mortgage) to the estimated fair value of the
collateral less estimated selling costs. This determination to reduce the
carrying value was based on (i) an evaluation of the borrower's remaining
equity in the Bayside property securing the mortgage loan and (ii) the economic
prospects of the borrower and Bayside property over its expected remaining
holding period. On April 13, 1995, the Fund exercised its call right on the
loans and the entire balance of the loans became due and payable on October 18,
1995.
The Fund and the borrower reached agreement to satisfy in full the obligations
due under the loan balance by means of a discounted payoff of $7,600,000. The
Fund also agreed to provide the borrower 120 days to
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13
obtain financing to make the payoff in exchange for a commitment to transfer
title to the Fund in lieu of foreclosure if the borrower could not make the
discounted payoff. The borrower was unable to secure the necessary financing
and, accordingly, the Fund took title to Bayside in late February 1996. The
former borrower remained current on all interest payments due on the loan.
Since both the net proceeds expected to be received from the possible
discounted payoff of the loan and the estimated net realizable value of the
collateral approximated the investment's carrying value, no provision for
possible losses was required relating to Bayside during the year ended December
31, 1995. Upon taking title, the Fund's adviser immediately began to market
the property for sale. Subsequently, based on an evaluation of information
gathered from potential buyers contacted during the initial marketing process,
the adviser reduced its estimate of the property's fair market value during the
second quarter of 1996. Accordingly, during the quarter ended June 30, 1996,
$400,000 was charged to the provision for possible losses to write down the
carrying value of Bayside to its estimated fair market value less selling
costs.
At June 30, 1996 and June 30, 1995, the overall occupancy rate of the Fund's
remaining two direct real estate investments was 100% and 91%, respectively.
The overall occupancy of the Bayside Business Center was 100% at both June 30,
1996 and 1995. Leases for 4.5% of the rentable space of the properties
directly owned by the Fund are scheduled to expire during the remainder of
1996. The Fund's Adviser is currently working to renew leases and to identify
new tenants for space covered by leases that have expired or are expiring.
However, there is no assurance that the Fund will be able to maintain its
current occupancy and level of rental income.
Investment income from short-term investments increased by $25,000, from
$194,000 for the six months ended June 30, 1995 to $219,000 for the same period
of 1996. Investment income increased in the 1996 period primarily due to an
increase in the average short-term investment balance, as a result of the net
proceeds generated from the sales of the remaining Penn Warner buildings in
December 1995, the sale of the mortgage backed securities in January 1996, and
the sale of Arapahoe on March 7, 1996. Such net proceeds were included in the
April 30, 1996 distribution to the Fund's shareholders.
Mortgage interest expense decreased by $603,000, or 89%, from $681,000 for the
six months ended June 30, 1995, to $78,000 for the comparable period of 1996.
This decrease is primarily attributable to: (i) the satisfaction of the
mortgage loan secured by the Fund's Sequoia investment resulting from the sale
of Sequoia in November of 1995, and (ii) the satisfaction of the senior
mortgage loan secured by Arapahoe Village in connection with the sale of
Arapahoe on March 7, 1996.
Administrative expenses decreased by $107,000, or 31%, from $341,000 for the
six months ended June 30, 1995 to $234,000 for the comparable period in 1996.
This decrease was primarily due to lower advisory and administrative fees
payable in 1996 period, which fees are based on average invested real estate
assets. Such fees decreased as a result of: (i) the 1995 sales of the Sequoia
Commerce Center, Raleigh Office Building and the remaining Penn Warner
buildings and, (ii) the 1996 sale of the Arapahoe Village Shopping Center.
Depreciation and amortization expense decreased by $458,000, or 100%. This
decrease resulted from management's decision to consider, as of June 30, 1995,
all of the Fund's remaining investments to be held for sale. After June 30,
1995, no depreciation or amortization expense related to the Fund's owned real
estate and acquisition costs was recognized. Prior to June 30, 1995,
depreciation on real estate owned was computed using the straight-line method
over 40 years for buildings and costs incurred in conjunction with the
acquisition of real estate investments were deferred and amortized on a
straight-line basis over the life of the loan for mortgage loan investments and
the life of the property for equity investments.
On March 20, 1996, the Fund's Board of Trustees declared a liquidating
distribution of $2.65 per share to shareholders of record on March 29, 1996.
The distribution was paid on April 30, 1996 and included net proceeds from the
sales of the Penn Warner buildings in December 1995, the Mortgage Backed
Securities in
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January 1996, and Arapahoe Village in March 1996. Given the Fund's reduced
asset base, the Fund expects to make only two further distributions; one
following the sale of Bayside and a final, residual payment upon final
dissolution of the Fund.
THREE MONTHS ENDED JUNE 30, 1996 VS. THREE MONTHS ENDED JUNE 30, 1995
The Fund incurred a net loss of ($204,000), or ($.03) per share, for the three
months ended June 30, 1996, as compared to net income of $588,000, or $.09 per
share, for the same period of 1995. Included in net income in 1995 is a net
gain on sale of investments of $185,000 realized on the sale of the Raleigh
Office Building. Excluding the Raleigh gain, net income decreased $607,000 for
the three months ended June 30, 1996 as compared to the same period in 1995.
This decrease, as more fully described below, reflects a smaller real estate
asset base on 1996, and corresponding decreases in net rental income and
mortgage interest income and an increase in the provision for possible losses,
partially offset by decreases in mortgage interest expense, depreciation and
amortization expense, and administrative expenses, in each case as compared to
such items in 1995.
Net rental income decreased by $628,000, or 75%, from $835,000 for the three
months ended June 30, 1995 to $207,000 for the three months ended June 30,
1996. This decrease was primarily due to the effect of 1995 and 1996 property
dispositions. Properties either sold during or subsequent to the quarter ended
June 30, 1995 provided the Fund with an aggregate net rental income of $434,000
for the three months ended June 30, 1995. The Arapahoe Village Shopping
Center, sold on March 7, 1996, provided the Fund with net rental income during
the three months ended June 30, 1995, of $401,000. Offsetting this decrease
was an increase of $207,000 in net rental income generated by the Bayside
Business Center, resulting from the Fund taking title to Bayside on February
29, 1996.
Mortgage interest expense decreased by $341,000, or 100%. No such interest was
incurred during the quarter ended June 30, 1996 as a result of the satisfaction
of outstanding mortgage loans prior to April 1, 1996 as discussed above.
Depreciation and amortization expense decreased by $237,000, or 100%. As
discussed above, after June 30, 1995, no depreciation or amortization expense
related to the Fund's owned real estate and acquisition costs is recognized,
since the Fund's real estate investments are considered to be held-for-sale
assets.
Administrative expenses decreased by $54,000, or 33%, from $162,000 for the
three months ended June 30, 1995 to $108,000 for the comparable period in 1996.
This decrease was primarily due to a decrease in average assets invested in
real estate as a result of the 1995 and the 1996 property sales as discussed
above.
LIQUIDITY AND CAPITAL RESOURCES
During the Fund's remaining liquidation period, its ability to make quarterly
distributions will be dependent upon its financial condition, earnings and cash
flow, and cash position and future working capital requirements. As a result
of 1995 and 1996 property sales, and the subsequent year-end liquidating
distribution of the proceeds from such sales, the book value of the Fund's
shares has been significantly reduced. The amount of future income the Fund
may be expected to generate has also been reduced. Further, the Fund's
remaining investments are being held for sale, rather than the production of
income, and, accordingly, income from real estate operations can be expected to
decline throughout the Fund's liquidation period. Future liquidating
distributions to shareholders, excluding any amounts distributed from net
proceeds from property sales, will be largely dependent upon the amount of
funds from operations generated by the Fund during its liquidation period.
Funds from operations are generated from the ongoing operations of the Fund's
direct real estate investments and interest income on short-term investments.
Accordingly, unfavorable economic conditions, vacancies, environmental
requirements, reductions in prevailing short-term interest rates or increases
in major expenses such as energy, insurance, and real estate
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taxes during the liquidation period could have an adverse impact upon the
Fund's ability to generate future funds from operations.
Given the size of the Fund's remaining asset base, the present level of funds
from operations ($.03 per share for the three months ended June 30, 1996) and
the foregoing factors impacting funds from operations, the Fund's Board of
Trustees has decided to make only two further liquidating distributions - one
following the disposition of Bayside and a final, residual payment upon the
final dissolution of the Fund. The timing and amount of distributions of net
proceeds from property sales to shareholders will be determined by the Trustees
as such amounts are realized and based on relevant considerations such as the
Fund's then current results of operations, cash position, and future working
capital requirements.
During the fourth quarter of 1990, the Fund instituted a share repurchase
program. Under the program, the Fund is authorized to repurchase in the open
market from time to time up to 300,000 of the Fund's outstanding shares. As of
June 30, 1996, an aggregate of 233,200 shares have been repurchased at an
aggregate cost of $1,586,000. No shares have been repurchased since October
1993 and the Fund's management, in consideration of the Liquidation Plan, does
not expect the Fund to repurchase any additional shares.
The Fund intends to continue to qualify as a real estate investment trust under
the Internal Revenue Code and distribute all of its taxable income. The Fund's
management considers the Fund's liquidity, as well as its ability to generate
cash, as adequate to meet its presently foreseeable operating and shareholder
distribution requirements and to fund its capital improvements.
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PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
None
Item 2. Changes in Securities.
None
Item 3. Defaults Upon Senior Securities.
None
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable
Item 5. Other Information.
None
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
27. Financial Data Schedule A Financial Data Schedule for the
six months ended June 30, 1996, was submitted in electronic
format only.
(b) Reports on Form 8-K
The Fund filed no reports on Form 8-K during the second quarter
ended June 30, 1996.
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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.
Vanguard Real Estate Fund II,
A Sales-Commission-Free Income Properties Fund
DATE August 14, 1996 /s/ John J. Brennan
------------------------ -----------------------------------
John J. Brennan
President & Chief Executive Officer
DATE August 14, 1996 /s/ Ralph K. Packard
------------------------ -----------------------------------
Ralph K. Packard
Vice President
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