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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 September 30, 2003
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
(Exact name of registrant as specified in its charter)
Massachusetts 04-3073045
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
One Beacon Street, Boston, Massachusetts 02108
(Address of principal executive offices) (Zip Code)
(617) 523-0066
(Registrant's telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if
changed since last report)
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 |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
SEC1296 (08-03) Potential persons who are to respond to the collection of
information contained in this form are not required to respond
unless the form displays a currently valid OMB control number.
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. When used in this Form 10-Q, the words "believes," "anticipates,"
"expects," "plans," "intends," "estimates," "continue," "may" or "will" (or the
negative of such words) and similar expressions are intended to identify
forward-looking statements. Such statements are subject to a number of risks and
uncertainties, including but not limited to the following: federal, state or
local regulations; adverse changes in general economic or local conditions;
pre-payments of mortgages; failure of borrowers to pay participation interests
due to poor operating results of properties underlying the mortgages; uninsured
losses and potential conflicts of interest between the Trust and its Affiliates,
including the Trustees. The Company's filings with the Securities and Exchange
Commission, including its Annual Report on Form 10-K for the year ended December
31, 2002, contain additional information concerning such risk factors. Actual
results in the future could differ materially from those described in any
forward-looking statements as a result of the risk factors set forth above, and
the risk factors described in the Annual Report.
-2-
KRUPP GOVERNMENT INCOME TRUST II
BALANCE SHEETS
-------------------
ASSETS
September 30, December 31,
2003 2002
------------ -----------
Participating Insured Mortgage Investments
("PIMIs")(Note 2):
Insured mortgages $37,874,529 $ 49,641,101
Additional Loans 6,880,000 11,754,000
Participating Insured Mortgages ("PIMs")(Note 2) 17,846,150 36,817,984
Mortgage-Backed Securities ("MBS")(Note 3) 4,601,541 11,521,401
----------- ------------
Total mortgage investments 67,202,220 109,734,486
Cash and cash equivalents 23,042,895 20,450,923
Interest receivable and other assets 414,803 893,646
Prepaid acquisition fees and expenses, net of
accumulated amortization of $3,252,409 and
$6,479,558, respectively 609,505 1,286,992
Prepaid participation servicing fees, net of
accumulated amortization of $1,012,513 and
$1,991,606, respectively 274,792 494,352
----------- ------------
Total assets $91,544,215 $132,860,399
=========== ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities $ 38,178 $ 47,848
----------- ------------
Shareholders' equity (Note 4):
Common stock, no par value; 25,000,000
Shares authorized; 18,371,477 Shares
issued and outstanding 91,264,433 132,302,504
Accumulated comprehensive income 241,604 510,047
----------- ------------
Total Shareholders' equity 91,506,037 132,812,551
----------- ------------
Total liabilities and Shareholders' equity $91,544,215 $132,860,399
=========== ============
The accompanying notes are an integral
part of the financial statements.
-3-
KRUPP GOVERNMENT INCOME TRUST II
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
---------------------
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2003 2002 2003 2002
----------- ---------- ----------- ------------
Revenues:
Interest income - PIMs and PIMIs:
Basic interest $ 1,044,398 $1,649,343 $ 3,350,255 $ 5,279,308
Additional Loan interest 165,619 185,511 443,426 2,684,116
Participation interest 2,969,564 611,856 5,280,582 3,285,429
Interest income - MBS 198,062 213,122 691,592 662,263
Interest income - cash and cash equivalents 18,408 20,919 185,168 96,557
----------- ---------- ----------- ------------
Total revenues 4,396,051 2,680,751 9,951,023 12,007,673
----------- ---------- ----------- ------------
Expenses:
Asset management fee to an affiliate 152,303 230,305 490,066 723,605
Expense reimbursements to affiliates 65,220 62,406 239,150 156,787
Amortization of prepaid fees and expenses 364,373 278,555 897,047 1,842,519
General and administrative 105,231 149,567 310,986 349,630
Reduction of provision for impaired
additional loan -- -- -- (500,000)
----------- ---------- ----------- ------------
Total expenses 687,127 720,833 1,937,249 2,572,541
----------- ---------- ----------- ------------
Net income 3,708,924 1,959,918 8,013,774 9,435,132
Other comprehensive income:
Net change in unrealized gain on MBS (42,432) 87,736 (268,443) 195,102
----------- ---------- ----------- ------------
Total comprehensive income $ 3,666,492 $2,047,654 $ 7,745,331 $ 9,630,234
=========== ========== =========== ============
Basic earnings per share $ .21 $ .10 $ .44 $ .51
=========== ========== =========== ============
Weighted average Shares outstanding 18,371,477 18,371,477
========== ==========
The accompanying notes are an integral
part of the financial statements.
-4-
KRUPP GOVERNMENT INCOME TRUST II
STATEMENTS OF CASH FLOWS
---------------------
For the Nine Months
Ended September 30,
-------------------------------
2003 2002
------------ ------------
Operating activities:
Net income $ 8,013,774 $ 9,435,132
Adjustments to reconcile net income to net
cash provided by operating activities:
Amortization of net premium 55,740 59,824
Amortization of prepaid fees and expenses 897,047 1,842,519
Reduction of provision for impaired additional loan -- (500,000)
Changes in assets and liabilities:
Decrease in interest receivable and other assets 478,843 116,874
Decrease in deferred income on Additional Loans -- (1,242,282)
Decrease in liabilities (9,670) (6,309)
------------ ------------
Net cash provided by operating activities 9,435,734 9,705,758
------------ ------------
Investing activities:
Principal collections on MBS 17,794,608 3,272,036
Principal collections on Additional Loans 4,874,000 4,500,500
Principal collections on PIMs and Insured Mortgages 19,539,475 26,960,598
------------ ------------
Net cash provided by investing activities 42,208,083 34,733,134
------------ ------------
Financing activity:
Dividends (49,051,845) (45,377,549)
------------ ------------
Net increase (decrease) in cash and cash equivalents 2,591,972 (938,657)
Cash and cash equivalents, beginning of period 20,450,923 6,453,663
------------ ------------
Cash and cash equivalents, end of period $ 23,042,895 $ 5,515,006
============ ============
Supplemental disclosure of non-cash investing activities:
Reclassification of investment in a PIMI to a MBS $ 11,199,153 $ --
============ ============
Non cash activities:
Increase (decrease) in unrealized gain on MBS $ (268,443) $ 195,102
============ ============
The accompanying notes are an integral
part of the financial statements.
-5-
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 accounting principles
generally accepted in the United States of America 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"), which is
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. See Notes to Financial Statements in the Trust's
Form 10-K for the year ended December 31, 2002 for additional information
relevant to significant accounting policies followed by the Trust.
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 September 30, 2003, its results of operations for
the three and nine months ended September 30, 2003 and 2002 and its cash
flows for the nine months ended September 30, 2003 and 2002.
The results of operations for the three and nine months ended September
30, 2003 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 September 30, 2003, the Trust's PIMs and PIMIs, including Additional
Loans, had a fair value of $64,092,847 and gross unrealized gains of
$1,492,168. Fair value assumes that the insured first mortgage of the PIMs
and the Fannie Mae MBS portion of the PIMIs could be sold at prices equal
to the amounts being realized by MBS with similar interest rates. Fair
value includes the current carrying value of the Additional Loans. Fair
value does not include any value for the participation features. The PIMs
and PIMIs have maturities ranging from 2008 to 2036. At September 30,
2003, there were no PIMs or PIMIs within the Trust's portfolio that were
delinquent as to principal or interest.
On September 30, 2003, the Trust received a prepayment of the Crossings
Village Apartments Subordinated Promissory Note and the Crossings Village
Apartments Additional Loan. The Trust received $2,584,000 of Additional
Loan principal and $15,073 of Additional Loan interest. In addition, the
Trust received $2,454,048 of Preferred Interest and $38,646 of Shared
Appreciation Interest. On October 25, 2003, the Trust received $11,349,632
from the Fannie Mae MBS related to Crossings Village. During the fourth
quarter of 2003, the Trust will pay a special dividend of $0.90 per share
from the proceeds of the Crossings Village Apartments prepayment.
On September 18, 2003, the Trust received a prepayment of the Rivergreens
Apartments II PIM for $5,845,000. The Trust also received a prepayment
premium of $58,450 from this payoff. On September 30, 2003, the Trust paid
a special dividend of $0.33 per share from the proceeds of the Rivergreens
Apartments II PIM prepayment.
Rivergreens II was a participating insured mortgage that was not required
to simultaneously pay off the Subordinated Promissory Note with the first
mortgage. The release of the Subordinated Promissory Note and the amount
of participation income that the Trust is entitled to are currently being
negotiated. The Advisor has ordered a second appraisal of the property to
calculate participation interest and expects the valuation issue to be
resolved during the fourth quarter. Upon receipt of the participation
income, the Trust will distribute the proceeds through a special dividend.
On March 7, 2003, the Trust received a prepayment of the Oasis at
Springtree Additional Loan note. The Trust received $2,290,000 of
Additional Loan principal and $2,365,276 of Shared Appreciation Interest.
On May 8, 2003, the Trust paid a special dividend of $0.26 per share from
the proceeds of the Oasis at Springtree Additional Loan prepayment. As a
result of the prepayment, the insured first mortgage loan on Oasis at
Springtree was reclassified from a PIMI to a MBS as the only remaining
portion of the investment was a FNMA MBS. The Trust also reclassified this
investment as available-for-sale concurrent with the satisfaction of the
Continued
-6-
KRUPP GOVERNMENT INCOME TRUST II
NOTES TO FINANCIAL STATEMENTS, Continued
2. PIMs and PIMIs, continued
participation feature. The Trust continued to receive the scheduled
principal and interest payments on the first mortgage until it was paid in
full on September 25, 2003.
On December 30, 2002, the Trust received a prepayment of the Mequon Trails
PIM participation feature totaling $572,226. The payoff consisted of
$385,000 of Shared Appreciation Interest and $187,226 of Minimum
Additional Interest and Shared Income Interest. On January 27, 2003, the
Trust received $13,007,834 in proceeds from the Fannie Mae MBS related to
Mequon. On May 7, 2003, the Trust paid a special dividend of $0.74 per
share from the proceeds of the Mequon Trails PIM prepayment.
3. MBS
At September 30, 2003, the Trust's MBS portfolio had an amortized cost of
approximately $4,359,937 and gross unrealized gains of $241,604. The MBS
portfolio has maturities ranging from 2008 to 2031.
On September 25, 2003, the Trust received a payoff of the Oasis at
Springtree MBS for $11,116,057. On October 7, 2003, the Trust paid a
special dividend of $0.61 per share from the principal proceeds received.
On March 25, 2003, the Trust received a payoff of the Willows MBS for
$3,280,432. On May 9, 2003, the Trust paid a special dividend of $0.18 per
share from the principal proceeds received.
4. Changes in Shareholder's Equity
A summary of changes in Shareholders' equity for the nine months ended
September 30, 2003 is as follows:
Accumulated Total
Common Retained Comprehensive Shareholders'
Stock Earnings Income Equity
------------- ----------- ------------- -------------
Balance at December 31, 2002 $ 132,302,504 $ -- $ 510,047 $ 132,812,551
Net income -- 8,013,774 -- 8,013,774
Dividends (41,038,071) (8,013,774) -- (49,051,845)
Change in unrealized gain on MBS -- -- (268,443) (268,443)
------------- ----------- --------- -------------
Balance at September 30, 2003 $ 91,264,433 $ -- $ 241,604 $ 91,506,037
============= =========== ========= =============
-7-
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with the
financial statements and accompanying notes contained in the Trust's 2002 Annual
Report on Form 10-K and in this report on Form 10-Q.
Certain statements in this Management's Discussion and Analysis of Financial
Condition and Results of Operations and elsewhere in this report on Form 10-Q
constitute "forward-looking statements" within the meaning of the Federal
Private Securities Litigation Reform Act of 1995. These forward-looking
statements involve known and unknown risks, uncertainties and other factors
which may cause the Trust's actual results, performance or achievements to be
materially different from any future results, performance or achievements
expressed or implied by these forward-looking statements. These factors include,
among other things, federal, state or local regulations; adverse changes in
general economic or local conditions; the inability of the borrower to meet
financial obligations on Additional Loans; pre-payments of mortgages; failure of
borrowers to pay participation interests due to poor operating results at
properties underlying the mortgages; uninsured losses and potential conflicts of
interest between the Trust and its Affiliates, including the Advisor.
Liquidity and Capital Resources
At September 30, 2003, the Trust had liquidity consisting of cash and cash
equivalents of approximately $23.0 million, as well as the cash inflows provided
by PIMs, PIMIs, MBS and 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. As described more fully below, the Advisor has declared special
dividends related to the Crossing Village and Oasis at Springtree payoffs that
will result in the distribution of approximately $16.3 million of this cash in
the form of special dividends in the fourth quarter of 2003.
The most significant demands on the Trust's liquidity are quarterly dividends
paid to investors of approximately $2.6 million and special dividends. Dividends
are funded by 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 periodically reviews the dividend rate to determine whether an
adjustment is necessary based on projected future cash flows. The current
dividend rate is $0.14 per share per quarter. The Trustees, based on the
Advisor's recommendations, generally 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 Trustees may
adjust the dividend rate or distribute such funds through a special dividend.
The Advisor made a recommendation to the Trustees at the November Board Meeting
to reduce the dividend rate from $0.14 per share to $0.05 per share effective
with the May 2004 dividend. The Trustees approved the recommendation to reduce
the dividend rate.
In addition to providing guaranteed or insured monthly principal and interest
payments from the insured first mortgage or Fannie Mae MBS portion of a PIM or
PIMI, the Trust's investments in the PIMs and PIMIs also may provide additional
income through the interest on the Additional Loan portion of the PIMIs as well
as participation interest based on operating cash flow and increase in the value
realized upon the sale or refinance of the underlying properties. However, these
payments and collection of the Additional Loan principal are neither guaranteed
nor insured and depend on the successful operations of the underlying
properties.
Through the nine months ended September 30, 2003, the Trust received both
installments of Additional Loan interest due in 2003 from its remaining PIMI
investments.
The Trust received participation interest based on cash flow generated by
property operations from three of its investments during the nine months ended
September 30, 2003. Mill Pond II paid $19,309, Martins Landing paid $138,603 and
the Lakes paid $260,508. In addition, the Trust received and recognized
participation interest related to the Oasis at Springtree Additional Loan payoff
and the Crossings Village Additional Loan payoff (see below).
During the first quarter of 2003, the Trust refunded $54,258 of participation
interest received in 2000 and 2001 to the borrower on the Fountains PIM. The
refund was due to an overpayment of participation interest by the borrower as a
result of an error the borrower made in their initial surplus cash calculations
for 2000 and 2001. Upon reexamination, the borrower determined that certain
proceeds were incorrectly included in those calculations. The borrower then
submitted
-8-
revised surplus cash calculations to the Advisor and, upon review, the Advisor
determined that a refund was due to the borrower.
On September 30, 2003, the Trust received a prepayment of the Crossings Village
Subordinated Promissory Note and the Crossings Village Additional Loan. The
Trust received $2,584,000 of Additional Loan principal and $15,073 of Additional
Loan interest. In addition, the Trust received $2,454,048 of Preferred Interest
and $38,646 of Shared Appreciation Interest. On October 25, 2003, the Trust
received $11,349,632 from the Fannie Mae MBS related to Crossings Village.
During the fourth quarter of, 2003, the Trust will pay a special dividend of
$0.90 per share from the proceeds of the Crossings Village Apartments
prepayment.
On September 25, 2003, the Trust received a payoff of the Oasis at Springtree
MBS for $11,116,057. On October 7, 2003, the Trust paid a special dividend of
$0.61 per share from the principal proceeds received.
On September 18, 2003, the Trust received a prepayment of the Rivergreens
Apartments II PIM for $5,845,000. The Trust also received a prepayment premium
of $58,450 from this payoff. On September 30, 2003, the Trust paid a special
dividend of $0.33 per share from the proceeds of the Rivergreens Apartments II
PIM prepayment.
Rivergreens II was a participating insured mortgage that was not required to
simultaneously pay off the Subordinated Promissory Note with the first mortgage.
The release of the Subordinated Promissory Note and the amount of participation
income that the Trust is entitled to are currently being negotiated. The Advisor
has ordered a second appraisal of the property to calculate participation
interest and expects the valuation issue to be resolved during the fourth
quarter. Upon receipt of the participation income, the Trust will distribute the
proceeds through a special dividend.
On May 5, 2003, the Trust paid a special dividend of $0.74 per share from the
proceeds received in 2002 from the Sunset Summit PIMI payoff.
On March 25, 2003, the Trust received a payoff of the Willows MBS for
$3,280,432. On May 9, 2003, the Trust paid a special dividend of $0.18 per share
from the principal proceeds.
On March 7, 2003, the Trust received a prepayment of the Oasis at Springtree
Additional Loan note. The Trust received $2,290,000 of Additional Loan principal
and $2,365,276 of Shared Appreciation Interest. On May 8, 2003, the Trust paid a
special dividend of $0.26 per share from the proceeds of the Oasis at Springtree
Additional Loan prepayment. As a result of the prepayment, the insured first
mortgage loan on Oasis at Springtree was reclassified from a PIMI to a MBS, as
the only remaining portion of the investment was a FNMA MBS. The Trust also
reclassified this investment as available-for-sale concurrent with the
satisfaction of the participation feature. The Trust continued to receive the
scheduled principal and interest payments on the first mortgage until it was
paid in full on September 25, 2003.
On December 30, 2002, the Trust received a prepayment of the Mequon Trails PIM
participation feature totaling $572,226. The payoff consisted of $385,000 of
Shared Appreciation Interest and $187,226 of Minimum Additional Interest and
Shared Income Interest. On January 27, 2003, the Trust received $13,007,834 in
proceeds from the Fannie Mae MBS related to Mequon. On May 7, 2003, the Trust
paid a special dividend of $0.74 per share from the proceeds of the Mequon
Trails PIM prepayment.
Whether the operating performance of any of the remaining properties will
provide sufficient cash flow from operations to pay either the Additional Loan
interest or participation interest will depend on factors that the Trust has
minimal control over. Should the properties be unable to generate sufficient
cash flow to pay the Additional Loan interest, it would reduce the Trust's
distributable cash flow and could affect the value of the Additional Loan
collateral.
There are contractual restrictions on the prepayment of the PIMs and PIMIs.
During the first five years of the investment, borrowers are generally
prohibited from repayment. During the second five years, the PIM borrowers can
prepay the insured mortgage by paying the greater of a prepayment premium or the
participation interest due at the time of the prepayment. Similarly, the PIMI
borrowers can prepay the insured mortgage and the Additional Loan by satisfying
the Preferred Return obligation. The participation features and the Additional
Loans are neither insured nor guaranteed. If the prepayment of the PIM or PIMI
results from the foreclosure on the underlying property or an insurance claim,
the Trust generally would not receive any participation interest or any amounts
due under the Additional Loan.
The borrower on The Fountains PIM has contacted the Trust regarding a payoff.
The borrower has requested a reduction in the 9% prepayment premium to
approximately 2.25%. Due to declining property operations, the competitive
market, and significant repairs required at the property to replace
deteriorating exterior staircases, the Advisor agreed to the lower prepayment
premium to mitigate a potential default on the first mortgage. The Trust expects
that the loan will be paid off
-9-
during the fourth quarter of 2003. An appraisal of the property has determined
that the underlying property value has not increased sufficiently to meet the
criteria for the Trust to earn any participation interest.
The Trust has the option to call certain PIMs and all of the PIMIs by
accelerating their maturity. If the call feature were exercised for an entire
PIM or PIMI, then the insurance feature of that loan would be cancelled.
Therefore, the Advisor will determine the merits of exercising the call option
for each PIM and PIMI as economic conditions warrant. The Advisor also has the
ability to modify or waive the prepayment premiums. Such factors as the
condition of the asset, local market conditions, the interest rate environment
and available financing will have an impact on these decisions.
Critical Accounting Policies
The Trust's critical accounting policies relate to revenue recognition related
to the Trust's PIM and PIMI investments, impaired mortgage loans, amortization
of Prepaid Fees and Expenses and the carrying value of its MBS. The Trust's
policies are as follows:
The Trust accounts for its MBS portion of a PIM or PIMI investment in accordance
with the Financial Accounting Standards Board's Statement 115, "Accounting for
Certain Investments in Debt and Equity Securities" ("FAS 115"), under the
classification of held to maturity as these investments have a participation
feature. As a result, the Trust would not sell or otherwise dispose of the MBS.
Accordingly, the Trust has both the intention and ability to hold these
investments to expected maturity. The Trust carries these MBS at amortized cost.
The insured mortgage portion of the Federal Housing Administration ("FHA") PIM
or PIMI is carried at amortized cost. The Trust holds these mortgages at
amortized cost since they are fully insured by the FHA. The Additional Loans are
carried at amortized cost unless the Advisor believes there is an impairment in
value, in which case a valuation allowance is established in accordance with FAS
114 "Accounting by Creditors for Impairment of a Loan" and FAS 118 "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". The
Trust, in accordance with FAS 115, classifies its MBS portfolio as
available-for-sale. The Trust classifies its MBS portfolio as available-for-sale
as a portion of the MBS portfolio may remain after all of the PIMs and PIMIs
payoff and it will then be necessary to sell the remaining MBS portfolio in
order to close out the Trust. In addition, other situations such as liquidity
needs could arise which would necessitate the sale of a portion of the MBS
portfolio. The Trust carries its MBS at fair market value and reflects any
unrealized gains (losses) as a separate component of Shareholders' Equity. The
Trust amortizes purchase premiums or discounts over the life of the underlying
mortgages using the effective interest method.
Basic interest is recognized based on the stated rate of the Department of
Housing and Urban Development ("HUD") Insured Mortgage loan (less the servicer's
fee) or the coupon rate of the Fannie Mae MBS. The Trust recognizes interest
related to the participation features when the amount becomes fixed and the
transaction that gives rise to such amount is finalized, cash is received and
all contingencies are resolved. This could be the sale or refinancing of the
underlying real estate, which results in a cash payment to the Trust or a cash
payment made to the Trust from surplus cash relative to the participation
feature. The Trust defers the recognition of Additional Loan interest payments
as income to the extent these interest payments are from escrows established
with the proceeds of the Additional Loan. When the properties underlying the
PIMIs generate sufficient cash flow to make the required Additional Loan
interest payments and the Additional Loan value is deemed collectible, the Trust
recognizes income as earned and commences amortizing deferred interest amounts
into income over the remaining estimated term of the Additional Loan. During
periods where mortgage loans are impaired the Trust suspends amortizing deferred
interest.
The Trust also fully reserves the portion of any Additional Loan interest
payment satisfied through the issuance of an operating loan and any associated
interest due on such operating loan. The Trust will recognize the income related
to the operating loan when the borrower repays amounts due under the operating
loan.
Impaired loans are those Additional Loans for which the Advisor believes the
collection of all amounts due in accordance with the contractual terms of the
loan agreement is not likely. Where necessary, impaired loans are measured based
on the fair value of the underlying collateral net of estimated selling costs.
The Trust measures impairment on these loans quarterly. Interest received on
impaired loans is generally applied against the loan principal.
Prepaid fees and expenses represent prepaid acquisition fees and expenses and
prepaid participation servicing fees paid for the acquisition and servicing of
PIMs and PIMIs. The Trust amortizes prepaid acquisition fees and expenses using
a method that approximates the effective interest method over a period of ten to
twelve years, which represents the estimated life of the underlying mortgage.
The prepaid participation servicing fees are amortized using a method that
approximates the effective interest method over a ten-year period, beginning at
final endorsement of the loan if a HUD-insured loan and at closing if a Fannie
Mae loan. Upon the repayment of a PIM or PIMI, any unamortized acquisition fees
and expenses and unamortized participation servicing fees related to such loan
are expensed.
-10-
Results of Operations
The Trust's net income increased in the three months ended September 30, 2003 as
compared to the three months ended September 30, 2002 primarily due to an
increase in participation interest. This increase was partially offset by a
decrease in basic interest on PIMs and PIMIs. Participation interest increased
primarily due to the participation interest collected from the payoff of the
Crossings Village Apartments Additional Loan. Basic interest on PIMs and PIMIs
decreased primarily due to the Mequon Trails payoff in January 2003 and the
Sunset Summit payoff in 2002. Basic interest on PIMs and PIMIs also decreased
due to the reclassification of the Oasis at Springtree PIMI to a MBS in March
2003.
The Trust's net income decreased in the nine months ended September 30, 2003 as
compared to the nine months ended September 30, 2002 primarily due to decreases
in basic interest on PIMs and PIMIs, Additional Loan interest and a reduction in
the provision for impaired mortgage loans in the first quarter of 2002. This
decrease was partially offset by an increase in participation interest and
decreases in amortization expense and asset management fees. Basic interest on
PIMs and PIMIs decreased primarily due to the Mequon Trails payoff in January
2003 and the Norumbega Pointe, Windmill Lakes and Sunset Summit payoffs in 2002.
Basic interest on PIMs and PIMIs also decreased due to the reclassification of
the Oasis at Springtree PIMI to a MBS in March 2003. Additional Loan interest
decreased primarily due to the recognition in 2002 of deferred income from the
Norumbega Pointe payoff, base interest recognized from the Windmill Lakes payoff
in 2002, the Sunset Summit payoff in 2002 and the Oasis at Springtree payoff in
March 2003. The reduction in the provision for impaired mortgage loans was due
to the reversal of the impairment provision for the Windmill Lakes PIMI as a
result of the Additional Loan payoff received in the first quarter of 2002.
Participation interest decreased due primarily to the participation interest
collected from the Oasis at Springtree and Crossings Village payoffs in 2003
exceeding the participation interest collected from the Norumbega Pointe payoff
in 2002. Amortization expense increased as a result of the full amortization of
the remaining prepaid fees and expenses on the PIMI prepayments in 2002. Asset
management fees decreased due to the decrease in the Trust's investments as a
result of principal collection and payoffs.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Assessment of Credit Risk
The Trust's investments in insured mortgages and MBS are guaranteed and/or
insured by Fannie Mae, FHLMC, the Government National Mortgage Association
("GNMA") and HUD, 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.
Fannie Mae is a federally chartered private corporation that guarantees
obligations originated under its programs. FHLMC is a federally chartered
corporation that guarantees obligations originated under its programs. These
obligations are not guaranteed by the U.S. Government or the Federal Home Loan
Bank Board. However, Fannie Mae and FHLMC are two of the largest corporations in
the United States, and both have significant experience in mortgage
securitizations. In addition, their MBS carry the highest credit rating given to
financial instruments. GNMA guarantees the full and timely payment of principal
and basic interest on the securities it issues, which represents interest in
pooled mortgages insured by HUD. Obligations insured by HUD, an agency of the
U.S. Government, are backed by the full faith and credit of the U.S. Government.
Collection of the principal and interest of the Additional Loans and interest on
the participation features have risks similar to those associated with higher
risk debt instruments, including: reliance on the owner's operating skills,
ability to maintain occupancy levels, control operating expenses, ability to
maintain the properties and obtain adequate insurance coverage. Operations also
may be affected by adverse changes in general economic conditions, 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's investments also include cash and cash equivalents of approximately
$17.8 million of Agency paper, which is issued by Government Sponsored
Enterprises with a credit rating equal to the top rating category of a
nationally recognized statistical rating organization.
Interest Rate Risk
The Trust's primary market risk exposure is to interest rate risk, which can be
defined as the exposure of the Trust's net income, comprehensive income or
financial condition to adverse movements in interest rates. At September 30,
2003, the Trust's PIMs, PIMIs and MBS comprise the majority of the Trust's
assets. Decreases in interest rates may accelerate the prepayment of the Trust's
investments. Increases in interest rates may decrease the proceeds from a sale
of the MBS. The Trust does not utilize any derivatives or other instruments to
manage this risk as the Trust plans to hold all of its PIM
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and PIMI investments to expected maturity while it is expected that
substantially all of the MBS will prepay over the same time period thereby
mitigating any potential interest rate risk to the disposition value of any
remaining MBS.
The Trust monitors prepayments and considers prepayment trends, as well as
dividend requirements of the Trust, when setting regular dividend policy. For
MBS, the fund forecasts prepayments based on trends in similar securities as
reported by statistical reporting entities such as Bloomberg. For PIMs and
PIMIs, the Trust incorporates prepayment assumptions into planning as individual
properties notify the Trust of the intent to prepay or as they are scheduled to
mature.
Item 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
Within the 90 days prior to the date of this Quarterly Report on Form 10-Q, the
Chief Executive Officer and Chief Accounting Officer carried out an evaluation
of the effectiveness of the design and operation of the Trust's disclosure
controls and procedures. Based upon that evaluation, the Chief Executive Officer
and the Chief Accounting Officer concluded that the Trust's disclosure controls
and procedures were effective as of the date of their evaluation in timely
alerting them to material information relating to the Trust required to be
included in this Quarterly Report on Form 10-Q.
(b) Changes in Internal Controls
There were no significant changes in the Trust's internal controls or in other
factors that could significantly affect such internal controls subsequent to the
date of the evaluation described in paragraph (a) above.
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KRUPP GOVERNMENT INCOME TRUST II
PART II - OTHER INFORMATION
---------------------
Item 1. Legal Proceedings
None
Item 2. Changes in Securities and Use of Proceeds
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
(a) Exhibits
(31.1) Chief Executive Officer Certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
(31.2) Chief Accounting Officer Certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
(32.1) Chief Executive Officer Certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(32.2) Chief Accounting Officer Certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
None
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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/ Alan Reese
--------------------------------
Alan Reese
Treasurer and Chief Accounting Officer of
Krupp Government Income Trust II.
DATE: October 30, 2003
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