10QSB 1 ddre2.txt DDRE2 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-QSB (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 [ ] 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 0-14483 Davidson Diversified Real Estate II, L.P. (Exact name of registrant as specified in its charter) Delaware 62-1207077 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 55 Beattie Place, P.O. Box 1089 Greenville, South Carolina 29602 (Address of principal executive offices) (864) 239-1000 (Issuer's telephone number) PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Davidson Diversified Real Estate II, L.P. CONSOLIDATED BALANCE SHEET (Unaudited) (in thousands, except unit data) September 30, 2003
Assets Cash and cash equivalents $ 572 Receivables and deposits 236 Restricted escrows 85 Other assets 431 Investment properties: Land $ 1,953 Buildings and related personal property 48,168 50,121 Less accumulated depreciation (21,718) 28,403 $ 29,727 Liabilities and Partners' Deficit Liabilities Accounts payable $ 1,131 Tenant security deposit liabilities 159 Accrued property taxes 606 Other liabilities 479 Due to affiliates 9,610 Mortgage notes payable 19,964 Partners' Deficit General partners $ (162) Limited partners (1,224.25 units issued and outstanding) (2,060) (2,222) $ 29,727 See Accompanying Notes to Consolidated Financial Statements
Davidson Diversified Real Estate II, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per unit data)
Three Months Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 Revenues: (Restated) (Restated) Rental income $ 1,405 $ 1,254 $ 4,008 $ 3,621 Other income 127 119 412 357 Casualty gain (Note D) -- 92 8 92 Total revenues 1,532 1,465 4,428 4,070 Expenses: Operating 824 445 1,990 1,752 General and administrative 71 86 227 261 Depreciation 330 363 1,085 1,104 Interest 258 224 636 766 Property taxes 157 93 440 277 Loss on early extinguishment of debt (Note E) -- 17 -- 17 Total expenses 1,640 1,228 4,378 4,177 (Loss) income from continuing operations (108) 237 50 (107) Loss from discontinued operations (6) (16) (208) (141) Gain on sale of discontinued operations (Note C) 2 -- 5,545 -- Net (loss) income $ (112) $ 221 $ 5,387 $ (248) Net (loss) income allocated to general partners $ (2) $ 4 $ 425 $ (5) Net (loss) income allocated to limited partners (110) 217 4,962 (243) $ (112) $ 221 $ 5,387 $ (248) Per limited partnership unit: (Loss) income from continuing operations $ (86.60) $ 189.50 $ 40.03 $ (85.77) Loss from discontinued operations (4.90) (12.25) (166.63) (112.72) Gain on sale of discontinued operations 1.63 -- 4,179.70 -- Net (loss) income $ (89.87) $ 177.25 $4,053.10 $ (198.49) See Accompanying Notes to Consolidated Financial Statements
Davidson Diversified Real Estate II, L.P. CONSOLIDATED STATEMENT OF CHANGES IN PARTNERS' DEFICIT (Unaudited) (in thousands, except unit data)
Limited Partnership General Limited Units Partners Partners Total Original capital contributions 1,224.25 $ 1 $24,485 $24,486 Partners' deficit at December 31, 2002 1,224.25 $ (587) $(7,022) $(7,609) Net income for the nine months ended September 30, 2003 -- 425 4,962 5,387 Partners' deficit at September 30, 2003 1,224.25 $ (162) $(2,060) $(2,222) See Accompanying Notes to Consolidated Financial Statements
Davidson Diversified Real Estate II, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)
Nine Months Ended September 30, 2003 2002 Cash flows from operating activities: Net income (loss) $ 5,387 $ (248) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 1,129 1,490 Casualty gain (8) (92) Gain on sale of discontinued operations (5,545) -- Loss on early extinguishment of debt 68 17 Amortization of debt discounts and loan costs 208 233 Change in accounts: Receivables and deposits 245 (468) Other assets (106) (54) Accounts payable (102) (273) Tenant security deposit liabilities 2 15 Accrued property taxes 78 99 Other liabilities (25) 225 Due to affiliate 223 266 Net cash provided by operating activities 1,554 1,210 Cash flows from investing activities: Property improvements and replacements (5,860) (5,291) Net proceeds from sale of investment property 2,547 -- Insurance proceeds received 13 -- Net withdrawals from restricted escrows -- 145 Net cash used in investing activities (3,300) (5,146) Cash flows from financing activities: Advances from affiliates 5,190 2,781 Payments on advances from affiliates (2,936) (77) Payments on mortgage notes payable (517) (386) Proceeds from mortgage note payable -- 7,462 Repayment on mortgage notes payable -- (4,097) Loan costs paid (10) (172) Net cash provided by financing activities 1,727 5,511 Net (decrease) increase in cash and cash equivalents (19) 1,575 Cash and cash equivalents at beginning of period 591 743 Cash and cash equivalents at end of period $ 572 $ 2,318 Supplemental disclosure of cash flow information: Cash paid for interest $ 729 $ 1,208 Supplemental disclosure of non-cash activity: Property improvements and replacements in accounts payable $ 1,057 $ -- Mortgage assumed by buyer on sale of investment property $ 6,899 $ -- Insurance proceeds in receivables and deposits $ -- $ 132 At December 31, 2002 and 2001, approximately $527,000 and $850,000 of property improvements and replacements were included in accounts payable and are included in property improvements and replacements at September 30, 2003 and 2002, respectively. See Accompanying Notes to Consolidated Financial Statements
Davidson Diversified Real Estate II, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note A - Basis of Presentation The accompanying unaudited consolidated financial statements of Davidson Diversified Real Estate II, L.P. (the "Partnership" or "Registrant") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-QSB and Item 310(b) of Regulation S-B. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of Davidson Diversified Properties, Inc. (the "Managing General Partner"), all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2003. For further information, refer to the consolidated financial statements and footnotes thereto included in the Partnership's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2002. The Managing General Partner is a subsidiary of Apartment Investment and Management Company ("AIMCO"), a publicly traded real estate investment trust. Effective January 1, 2002, the Partnership adopted Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" which established standards for the way that public business enterprises report information about long-lived assets that are either being held for sale or have already been disposed of by sale or other means. The standard requires that results of operations for a long-lived asset that is being held for sale or has already been disposed of be reported as a discontinued operation on the statement of operations. As a result, the accompanying consolidated statement of operations for the period ended September 30, 2002 has been restated as of January 1, 2002 to reflect the operations of LaFontenay I and II Apartments, which was sold January 2003 (see Note C), as loss from discontinued operations. Note B - Transactions with Affiliated Parties The Partnership has no employees and is dependent on the Managing General Partner and its affiliates for the management and administration of all Partnership activities. The Partnership Agreement provides for (i) payments to affiliates for services and (ii) reimbursement of certain expenses incurred by affiliates on behalf of the Partnership. Affiliates of the Managing General Partner are entitled to receive 5% of gross receipts from all of the Partnership's properties as compensation for providing property management services. The Partnership paid to such affiliates approximately $233,000 and $272,000 for the nine months ended September 30, 2003 and 2002, respectively, which is included in operating expenses and loss from discontinued operations. An affiliate of the Managing General Partner received reimbursement of accountable administrative expenses amounting to approximately $174,000 and $772,000 for the nine months ended September 30, 2003 and 2002, respectively, which is included in general and administrative expenses and investment properties. Included in these amounts are fees related to construction management services provided by an affiliate of the Managing General Partner of approximately $3,000 and $567,000 for the nine months ended September 30, 2003 and 2002, respectively. The fees are calculated based on a percentage of current year additions to investment properties. In accordance with the Partnership Agreement, the Managing General Partner has loaned the Partnership funds to cover operational expenses and to assist in the closing of the refinancing required at Reflections Apartments. At September 30, 2003, the amount of the outstanding loans and accrued interest to cover operational expenses and the required refinancing at Reflections Apartments was approximately $9,610,000. These amounts are included in due to affiliates on the accompanying consolidated balance sheet. Interest is charged at prime plus 1% or 5.00% at September 30, 2003. Interest expense was approximately $297,000 and $304,000 for the nine months ended September 30, 2003 and 2002, respectively. The Managing General Partner is considering the remedies it can pursue including accelerating repayment of the outstanding loans it has made to the Partnership to cover operational expenses and to assist in the refinancing of Reflections Apartments. Proceeds from the sale of LaFontenay I and II Apartments and funds received from the operating cash flow of Big Walnut and The Trails Apartments were used to make payments of approximately $2,936,000 on the outstanding loans to the Managing General Partner during the nine months ended September 30, 2003. The Partnership accrued a real estate commission of $48,000 upon the sale of Shoppes at River Rock due to the Managing General Partner during the year ended December 31, 1999. Approximately $18,000 is accrued at September 30, 2003 and is included in other liabilities in the accompanying consolidated balance sheet. Payment of the remaining accrued commission is subordinate to the limited partners receiving their original invested capital plus a cumulative non-compounded annual return of 8% on their adjusted invested capital. The Partnership insures most of its properties up to certain limits through coverage provided by AIMCO which is generally self-insured for a portion of losses and liabilities related to workers compensation, property casualty and vehicle liability. The Partnership insures its properties above the AIMCO limits through insurance policies obtained by AIMCO from insurers unaffiliated with the Managing General Partner. During the nine months ended September 30, 2003 and 2002, the Partnership was charged by AIMCO and its affiliates approximately $54,000 and $155,000, respectively, for insurance coverage and fees associated with policy claims administration. During 2003, the Partnership obtained insurance coverage for Reflections Apartments from an unaffiliated insurance company. On January 30, 2003, the Partnership sold LaFontenay I and II Apartments to an unaffiliated third party for $9,700,000. After payment of closing costs of approximately $254,000, and the assumption of the mortgage debt of approximately $6,899,000 by the purchaser, the net proceeds received by the Partnership were approximately $2,547,000. The sale of the property resulted in a gain on the sale of discontinued operations of approximately $5,545,000 for the nine months ended September 30, 2003. In addition, the Partnership recorded a loss on early extinguishment of debt of approximately $68,000 as a result of the write off of unamortized loan costs. The loss on early extinguishment of debt is included in the loss from discontinued operations in the accompanying consolidated financial statements. The Partnership used the proceeds received from the sale to make payments on the loan balances due to the Managing General Partner (see "Note B"). In accordance with Statement of Financial Accounting Standards No. 144, the operations of the property have been shown as loss from discontinued operations for the three and nine months ended September 30, 2003 and 2002. The property's operations, a loss of approximately $208,000 and $141,000 for the nine months ended September 30, 2003 and 2002, respectively, are included in loss from discontinued operations on the accompanying consolidated statements of operations and include revenues of approximately $179,000 and $1,377,000, respectively. Note D - Casualty Gains During the nine months ended September 30, 2003 a net casualty gain of approximately $8,000 was recorded at Big Walnut Apartments. The casualty gain related to a fire that occurred at Big Walnut Apartments that damaged two apartments in March 2003. The gain was the result of insurance proceeds received of approximately $13,000 less the net book value of the damaged property of approximately $ 5,000. During the three and nine months ended September 30, 2002, a net casualty gain of approximately $92,000 was recorded at Reflections Apartments. The casualty gain related to a fire that occurred at Reflections Apartments in October 2001. The gain was the result of insurance proceeds of approximately $132,000 less the net book value of the damaged property of approximately $40,000. Note E - Refinancing Mortgage Payable On September 16, 2002, the Partnership refinanced the mortgages encumbering Big Walnut Apartments. The refinancing replaced a first mortgage of approximately $3,930,000 and a second mortgage of approximately $167,000 with a new mortgage of $5,720,000. Total capitalized loan costs were approximately $155,000 during the year ended December 31, 2002 and an additional $10,000 was capitalized during the nine months ended September 30, 2003. The Partnership recognized a loss on the early extinguishment of debt of approximately $17,000 due to the write-off of unamortized loan costs during the three and nine months ended September 30, 2002. Big Walnut Apartments was initially refinanced under an interim credit facility ("Interim Credit Facility") which had a term of six months. The Interim Credit Facility included properties in other partnerships that are affiliated with the Partnership. However, the Interim Credit Facility created separate loans for each property that were not cross-collateralized or cross-defaulted with the other property loans. During the six month term of the Interim Credit Facility, the properties were required to make interest-only payments. The first month's interest, which was paid at the date of the refinancing, was calculated at LIBOR plus 70 basis points. Interest for the following two months was calculated at LIBOR plus 150 points and was due monthly. During December 2002, the Interim Credit Facility encumbering Big Walnut Apartments was sold to Fannie Mae under a permanent credit facility ("Permanent Credit Facility"). The Permanent Credit Facility has a maturity of five years, with one five-year extension option. This Permanent Credit Facility also creates separate loans for each property that are not cross-collateralized or cross-defaulted with the other property loans. Each note under this Permanent Credit Facility will begin as a variable rate loan with the option of converting to a fixed rate loan after three years. The interest rate on the variable rate loan is the Fannie Mae discounted mortgage-backed security index plus 85 basis points. The rate was 1.9% at September 30, 2003 and will reset monthly. Each loan will automatically renew at the end of each month. In addition, monthly principal payments are required based on a 30-year amortization schedule, using the interest rate in effect during the first month that any property is on the Permanent Credit Facility. The loans are prepayable without penalty. Note F - Legal Proceedings In March 1998, several putative unit holders of limited partnership units of the Partnership commenced an action entitled Rosalie Nuanes, et al. v. Insignia Financial Group, Inc., et al. (the "Nuanes action") in the Superior Court of the State of California for the County of San Mateo. The plaintiffs named as defendants, among others, the Partnership, its Managing General Partner and several of their affiliated partnerships and corporate entities. The action purported to assert claims on behalf of a class of limited partners and derivatively on behalf of a number of limited partnerships (including the Partnership) that are named as nominal defendants, challenging, among other things, the acquisition of interests in certain Managing General Partner entities by Insignia Financial Group, Inc. ("Insignia") and entities that were, at one time, affiliates of Insignia; past tender offers by the Insignia affiliates to acquire limited partnership units; management of the partnerships by the Insignia affiliates; and the series of transactions which closed on October 1, 1998 and February 26, 1999 whereby Insignia and Insignia Properties Trust, respectively, were merged into AIMCO. The plaintiffs sought monetary damages and equitable relief, including judicial dissolution of the Partnership. In addition, during the third quarter of 2001, a complaint (the "Heller action") was filed against the same defendants that are named in the Nuanes action, captioned Heller v. Insignia Financial Group. On or about August 6, 2001, plaintiffs filed a first amended complaint. The Heller action was brought as a purported derivative action, and asserted claims for, among other things, breach of fiduciary duty, unfair competition, conversion, unjust enrichment, and judicial dissolution. On January 8, 2003, the parties filed a Stipulation of Settlement in proposed settlement of the Nuanes action and the Heller action. In general terms, the proposed settlement provides for certification for settlement purposes of a settlement class consisting of all limited partners in this Partnership and others (the "Partnerships") as of December 20, 2002, the dismissal with prejudice and release of claims in the Nuanes and Heller litigation, payment by AIMCO of $9.9 million (which shall be distributed to settlement class members after deduction of attorney fees and costs of class counsel and certain costs of settlement) and up to $1 million toward the cost of independent appraisals of the Partnerships' properties by a Court appointed appraiser. An affiliate of the Managing General Partner has also agreed to make at least one round of tender offers to purchase all of the partnership interests in the Partnerships within one year of final approval, if it is granted, and to provide partners with the independent appraisals at the time of these tenders. The proposed settlement also provided for the limitation of the allowable costs which the Managing General Partner or its affiliates will charge the Partnerships in connection with this litigation and imposes limits on the class counsel fees and costs in this litigation. On April 11, 2003, notice was distributed to limited partners providing the details of the proposed settlement. On June 13, 2003, the Court granted final approval of the settlement and entered judgment in both the Nuanes and Heller actions. On August 12, 2003, an objector filed an appeal seeking to vacate and/or reverse the order approving the settlement and entering judgment thereto. The Managing General Partner intends to file a respondent's brief in support of the order approving settlement and entering judgment thereto. The Managing General Partner does not anticipate that any costs to the Partnership, whether legal or settlement costs, associated with these cases will be material to the Partnership's overall operations. On August 8, 2003 AIMCO Properties L.P., an affiliate of the Managing General Partner, was served with a Complaint in the United States District Court, District of Columbia alleging that AIMCO Properties L.P. willfully violated the Fair Labor Standards Act (FLSA) by failing to pay maintenance workers overtime for all hours worked in excess of forty per week. The Complaint is styled as a Collective Action under the FLSA and seeks to certify state subclasses in California, Maryland, and the District of Columbia. Specifically, the plaintiffs contend that AIMCO Properties L.P. failed to compensate maintenance workers for time that they were required to be "on-call". Additionally, the Complaint alleges AIMCO Properties L.P. failed to comply with the FLSA in compensating maintenance workers for time that they worked in responding to a call while "on-call". The Complaint also attempts to certify a subclass for salaried service directors who are challenging their classification as exempt from the overtime provisions of the FLSA. AIMCO Properties L.P. has filed an answer to the Complaint denying the substantive allegations. Although the outcome of any litigation is uncertain, in the opinion of the Managing General Partner the claims will not result in any material liability to the Partnership. The Partnership is unaware of any other pending or outstanding litigation matters involving it or its investment properties that are not of a routine nature arising in the ordinary course of business. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION The matters discussed in this report contain certain forward-looking statements, including, without limitation, statements regarding future financial performance and the effect of government regulations. Actual results may differ materially from those described in the forward-looking statements and will be affected by a variety of risks and factors including, without limitation: national and local economic conditions; the terms of governmental regulations that affect the Registrant and interpretations of those regulations; the competitive environment in which the Registrant operates; financing risks, including the risk that cash flows from operations may be insufficient to meet required payments of principal and interest; real estate risks, including variations of real estate values and the general economic climate in local markets and competition for tenants in such markets; litigation, including costs associated with prosecuting and defending claims and any adverse outcomes, and possible environmental liabilities. Readers should carefully review the Registrant's financial statements and the notes thereto, as well as the risk factors described in the documents the Registrant files from time to time with the Securities and Exchange Commission. The Partnership's investment properties consist of three apartment complexes. The following table sets forth the average occupancy of the properties for the nine months ended September 30, 2003 and 2002: Average Occupancy 2003 2002 Big Walnut Apartments Columbus, Ohio (1) 92% 96% The Trails Apartments Nashville, Tennessee 95% 94% Reflections Apartments Indianapolis, Indiana (2) 62% 43% (1) The Managing General Partner attributes the decrease in occupancy at Big Walnut Apartments to a slow economy in the Columbus, Ohio area and lower mortgage rates. (2) The low occupancy at Reflections Apartments is due to rehabilitation at the property. The property has completed a major renovation project to enhance the appearance of the property to attract desirable tenants. The increase in occupancy over the prior year is due to the completion of the rehabilitated apartment units. Results of Operations The Partnership's net income for the nine months ended September 30, 2003 was approximately $5,387,000 as compared to a net loss of approximately $248,000 for the nine months ended September 30, 2002. The Partnership had a net loss of approximately $112,000 for the three months ended September 30, 2003 as compared to net income of approximately $221,000 for the three months ended September 30, 2002. The increase in net income for the nine months ended September 30, 2003 was primarily due to a gain on the sale of LaFontenay I and II Apartments. Effective January 1, 2002, the Partnership adopted Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" which established standards for the way that public business enterprises report information about long-lived assets that are either being held for sale or have already been disposed of by sale or other means. The standard requires that results of operations for a long-lived asset that is being held for sale or has already been disposed of be reported as a discontinued operation on the statement of operations. As a result, the accompanying consolidated statement of operations for the period ended September 30, 2002 has been restated as of January 1, 2002 to reflect the operations of LaFontenay I and II Apartments as loss from discontinued operations. On January 30, 2003, the Partnership sold LaFontenay I and II Apartments to an unaffiliated third party for $9,700,000. After payment of closing costs of approximately $254,000, and the assumption of the mortgage debt of approximately $6,899,000 by the purchaser, the net proceeds received by the Partnership were approximately $2,547,000. The sale of the property resulted in a gain on the sale of discontinued operations of approximately $5,545,000 for the nine months ended September 30, 2003. In addition, the Partnership recorded a loss on early extinguishment of debt of approximately $68,000 as a result of the write off of unamortized loan costs. The loss on early extinguishment of debt is included in the loss from discontinued operations in the accompanying consolidated financial statements. The property's operations, a loss of approximately $208,000 and $141,000 for the nine months ended September 30, 2003 and 2002, respectively, are included in loss from discontinued operations on the accompanying consolidated statements of operations. The Partnership used the proceeds received from the sale to make payments on the loan balances due to the Managing General Partner. The income from continuing operations for the nine months ended September 30, 2003 was approximately $50,000 compared to a loss of approximately $107,000 for the nine months ended September 30, 2002. The loss from continuing operations for the three months ended September 30, 2003 was approximately $108,000 compared to income from continuing operations of approximately $237,000 for the three months ended September 30, 2002. The increase in income from continuing operations for the nine months ended September 30, 2003 was due to an increase in total revenues partially offset by an increase in total expenses. The increase in loss from continuing operations for the three months ended September 30, 2003 was due to an increase in total expenses partially offset by an increase in total revenues. Total revenues increased for the three and nine months ended September 30, 2003 due to an increase in rental income and other income partially offset by a decrease in casualty gain. Rental income increased due to increases in occupancy at Reflections and The Trails Apartments and average rental rates at Big Walnut Apartments partially offset by a decrease in occupancy and an increase in bad debt expense at Big Walnut Apartments and reduced rental rates at The Trails Apartments. Other income increased due to increases in utility reimbursements at Reflections Apartments and increased lease cancellation fees at Big Walnut Apartments and The Trails Apartments, partially offset by a decrease in lease cancellation fees at Reflections Apartments. During the nine months ended September 30, 2003 a net casualty gain of approximately $8,000 was recorded at Big Walnut Apartments. The casualty gain related to a fire that occurred at Big Walnut Apartments that damaged two apartments in March 2003. The gain was the result of insurance proceeds received of approximately $13,000 less the net book value of the damaged property of approximately $ 5,000. During the three and nine months ended September 30, 2002, a net casualty gain of approximately $92,000 was recorded at Reflections Apartments. The casualty gain related to a fire that occurred at Reflections Apartments in October 2001. The gain was the result of insurance proceeds of approximately $132,000 less the net book value of the damaged property of approximately $40,000. Total expenses for the nine months ended September 30, 2003 increased due to increases in operating and property tax expenses partially offset by decreases in interest and general and administrative expenses. Total expenses for the three months ended September 30, 2003 increased due to increases in operating and property tax expenses partially by a decrease in general and administrative expenses. Operating expenses increased primarily due to increases in insurance and maintenance expenses partially offset by decreases in advertising and property expenses. Insurance expense increased due to an increase in hazard insurance premiums at all of the Partnership's investment properties. Maintenance expense increased primarily due to a decrease in operating costs capitalized as part of the renovation project at Reflections Apartments due to units being completed and becoming available for tenants. Advertising expense decreased due to decreases in periodical advertising and referral fees at Reflections Apartments due to units being completed and becoming available for tenants. Property expense decreased primarily due to decreases in utilities, commissions and bonuses and payroll and related benefits expenses at Reflections Apartments. Property tax expense increased due to increases in the assessed value of Big Walnut Apartments and the tax rate at Reflections Apartments, which is located in Indianapolis, Indiana. During 2003, Indiana has adjusted its methodology for assessing property tax values and tax rates, which has resulted in a significant increase in property tax expense. Interest expense for the nine months ended September 30, 2003 decreased due to variable rate interest mortgages at all of the Partnership's properties whereby the interest rates were lower in 2003 compared to 2002. General and administrative expenses decreased due to a decrease in reimbursements to the Managing General Partner allowed under the Partnership Agreement. Also included in general and administrative expenses for the nine months ended September 30, 2003 and 2002 are the costs associated with the quarterly communications with investors and regulatory agencies and the annual audit required by the Partnership Agreement. As part of the ongoing business plan of the Partnership, the Managing General Partner monitors the rental market environment of the investment properties to assess the feasibility of increasing rents, maintaining or increasing occupancy levels and protecting the Partnership from increases in expense. As part of this plan, the Managing General Partner attempts to protect the Partnership from the burden of inflation-related increases in expenses by increasing rents and maintaining a high overall occupancy level. However, the Managing General Partner may use rental concessions and rental rate reductions to offset softening market conditions, accordingly, there is no guarantee that the Managing General Partner will be able to sustain such a plan. Liquidity and Capital Resources At September 30, 2003, the Partnership had cash and cash equivalents of approximately $572,000 as compared to approximately $2,318,000 at September 30, 2002. Cash and cash equivalents decreased approximately $19,000 since December 31, 2002 primarily due to approximately $3,300,000 of cash used in investing activities which was partially offset by approximately $1,554,000 of cash provided by operating activities and approximately $1,727,000 of cash provided by financing activities. Cash used in investing activities consisted of property improvements and replacements partially offset by proceeds from the sale of LaFontenay I and II Apartments and the receipt of insurance proceeds. Cash provided by financing activities consisted of advances from affiliates partially offset by payments on advances from affiliates, principal payments on the mortgage indebtedness encumbering the Partnership's properties and loan costs paid. The Partnership invests its working capital reserves in interest bearing accounts. The sufficiency of existing liquid assets to meet future liquidity and capital expenditure requirements is directly related to the level of capital expenditures required at the various properties to adequately maintain the physical assets and other operating needs of the Partnership and to comply with Federal, state, and local legal and regulatory requirements. The Managing General Partner monitors developments in the area of legal and regulatory compliance and is studying new federal laws, including the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 mandates or suggests additional compliance measures with regard to governance, disclosure, audit and other areas. In light of these changes, the Partnership expects that it will incur higher expenses related to compliance, including increased legal and audit fees. Capital improvements planned for each of the Partnership's properties are detailed below. Big Walnut Apartments During the nine months ended September 30, 2003, the Partnership completed approximately $137,000 of capital improvements at Big Walnut Apartments, consisting primarily of swimming pool improvements, floor covering and appliance replacements, heating upgrades and building repairs relating to the March 2003 casualty at Big Walnut Apartments. These improvements were funded from operating cash flow and insurance proceeds. The Partnership evaluates the capital improvement needs of the property during the year and currently expects to complete an additional $20,000 in capital improvements during the remainder of 2003. The additional capital improvements will consist primarily of floor covering and air conditioning unit replacements. Additional capital improvements may be considered and will depend on the physical condition of the property as well as the anticipated cash flow generated by the property. The Trails Apartments During the nine months ended September 30, 2003, the Partnership completed approximately $76,000 of capital improvements at The Trails Apartments, consisting primarily of appliance and floor covering replacements, water and sewer line improvements and structural improvements. These improvements were funded from operating cash flow. The Partnership evaluates the capital improvement needs of the property during the year and currently expects to complete an additional $21,000 in capital improvements during the remainder of 2003. The additional capital improvements will consist primarily of floor covering, appliance and air conditioning unit replacements. Additional capital improvements may be considered and will depend on the physical condition of the property as well as the anticipated cash flow generated by the property. Reflections Apartments This property has been undergoing a major rehabilitation project. All units were completed and available for rent at September 30, 2003. During the nine months ended September 30, 2003, the Partnership completed approximately $6,153,000 of capital improvements at Reflections Apartments, consisting primarily of building construction, furniture and fixtures, and floor covering replacements. These expenditures included capitalized construction period interest of approximately $436,000, tax and insurance expenses of approximately $84,000 and other construction period expenses of approximately $132,000. These improvements were funded from loans from the Managing General Partner and operating cash flow. The Partnership evaluates the capital improvement needs of the property during the year and currently expects to complete an additional $1,191,000 in capital improvements during the remainder of 2003. The additional capital improvements will consist primarily of floor covering and roofing replacements and remaining costs related to the reconstruction project. Additional capital improvements may be considered and will depend on the physical condition of the property as well as the anticipated cash flow generated by the property and further refinancing proceeds. LaFontenay I and II Apartments During the nine months ended September 30, 2003, the Partnership completed approximately $24,000 of capital improvements at LaFontenay I and II Apartments consisting primarily of floor covering replacements. These improvements were funded from operating cash flow. The property was sold January 30, 2003. The additional capital expenditures will be incurred only if cash is available from operations, Partnership reserves or further refinancing proceeds. To the extent that such budgeted capital improvements are completed, the Registrant's distributable cash flow, if any, may be adversely affected at least in the short term. On September 16, 2002, the Partnership refinanced the mortgages encumbering Big Walnut Apartments. The refinancing replaced a first mortgage of approximately $3,930,000 and a second mortgage of approximately $167,000 with a new mortgage of $5,720,000. Total capitalized loan costs were approximately $155,000 during the year ended December 31, 2002 and an additional $10,000 was capitalized during the nine months ended September 30, 2003. The Partnership recognized a loss on the early extinguishment of debt of approximately $17,000 due to the write-off of unamortized loan costs during the three and nine months ended September 30, 2002. Big Walnut Apartments was initially refinanced under an interim credit facility ("Interim Credit Facility") which had a term of six months. The Interim Credit Facility included properties in other partnerships that are affiliated with the Partnership. However, the Interim Credit Facility created separate loans for each property that were not cross-collateralized or cross-defaulted with the other property loans. During the six month term of the Interim Credit Facility, the properties were required to make interest-only payments. The first month's interest, which was paid at the date of the refinancing, was calculated at LIBOR plus 70 basis points. Interest for the following two months was calculated at LIBOR plus 150 points and was due monthly. During December 2002, the Interim Credit Facility encumbering Big Walnut Apartments was sold to Fannie Mae under a permanent credit facility ("Permanent Credit Facility"). The Permanent Credit Facility has a maturity of five years, with one five-year extension option. This Permanent Credit Facility also creates separate loans for each property that are not cross-collateralized or cross-defaulted with the other property loans. Each note under this Permanent Credit Facility will begin as a variable rate loan with the option of converting to a fixed rate loan after three years. The interest rate on the variable rate loan is the Fannie Mae discounted mortgage-backed security index plus 85 basis points. The rate was 1.9% at September 30, 2003 and will reset monthly. Each loan will automatically renew at the end of each month. In addition, monthly principal payments are required based on a 30-year amortization schedule, using the interest rate in effect during the first month that any property is on the Permanent Credit Facility. The loans are prepayable without penalty. The Partnership's assets are thought to be sufficient for any near-term needs (exclusive of capital improvements) of the Partnership. The mortgage indebtedness encumbering the Partnership's investment properties of approximately $19,964,000, net of discount, is amortized over varying periods with required balloon payments ranging from January 2004 to December 2009. The Managing General Partner will attempt to refinance and/or sell the properties prior to such maturity dates. If the properties cannot be refinanced or sold for a sufficient amount, the Partnership may risk losing such properties through foreclosure. Pursuant to the Partnership Agreement, the term of the Partnership is scheduled to expire on December 31, 2008. Accordingly, prior to such date the Partnership will need to either sell the investment properties or extend the term of the Partnership. No cash distributions were made during the nine months ended September 30, 2003 or 2002. The Partnership's cash available for distribution is reviewed on a monthly basis. Future cash distributions will depend on the levels of net cash generated from operations, the availability of cash reserves, and the timing of debt maturities, refinancings and/or property sales. In light of the rehabilitation project at Reflections Apartments and the significant amounts due to the Managing General Partner at September 30, 2003, it is not anticipated that the Partnership will make distributions in the foreseeable future. Other In addition to its indirect ownership of the managing and associate general partner interest in the Partnership, AIMCO and its affiliates owned 620.25 limited partnership units ("Units") in the Partnership representing 50.66% of the outstanding units at September 30, 2003. A number of these Units were acquired pursuant to tender offers made by AIMCO or its affiliates. It is possible that AIMCO or its affiliates will acquire additional Units in exchange for cash or a combination of cash and units in AIMCO Properties, L.P., the operating partnership of AIMCO, either through private purchases or tender offers. Pursuant to the Partnership Agreement, unitholders holding a majority of the Units are entitled to take action with respect to a variety of matters that include, but are not limited to, voting on certain amendments to the Partnership Agreement and voting to remove the Managing General Partner. As a result of its ownership of 50.66% of the outstanding Units, AIMCO and its affiliates are in a position to control all such voting decisions with respect to the Partnership. Although the Managing General Partner owes fiduciary duties to the limited partners of the Partnership, the Managing General Partner also owes fiduciary duties to AIMCO as its sole stockholder. As a result, the duties of the Managing General Partner, as managing general partner, to the Partnership and its limited partners may come into conflict with the duties of the Managing General Partner to AIMCO, as its sole stockholder. Critical Accounting Policies and Estimates The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States which require the Partnership to make estimates and assumptions. The Partnership believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity. Impairment of Long-Lived Assets Investment properties are recorded at cost, less accumulated depreciation, unless considered impaired. If events or circumstances indicate that the carrying amount of a property may be impaired, the Partnership will make an assessment of its recoverability by estimating the undiscounted future cash flows, excluding interest charges, of the property. If the carrying amount exceeds the aggregate future cash flows, the Partnership would recognize an impairment loss to the extent the carrying amount exceeds the fair value of the property. Real property investments are subject to varying degrees of risk. Several factors may adversely affect the economic performance and value of the Partnership's investment properties. These factors include, but are not limited to, changes in the national, regional and local economic climate; local conditions, such as an oversupply of multifamily properties; competition from other available multifamily property owners and changes in market rental rates. Any adverse changes in these factors could cause impairment of the Partnership's assets. Revenue Recognition The Partnership generally leases apartment units for twelve-month terms or less. Rental income attributable to leases is recognized monthly as it is earned and the Partnership fully reserves all balances outstanding over thirty days. The Partnership will offer rental concessions during particularly slow months or in response to heavy competition from other similar complexes in the area. Any concessions given at the inception of the lease are amortized over the life of the lease. ITEM 3. CONTROLS AND PROCEDURES (a) Disclosure Controls and Procedures. The Partnership's management, with the participation of the principal executive officer and principal financial officer of the Managing General Partner, who are the equivalent of the Partnership's principal executive officer and principal financial officer, respectively, has evaluated the effectiveness of the Partnership's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the principal executive officer and principal financial officer of the Managing General Partner, who are the equivalent of the Partnership's principal executive officer and principal financial officer, respectively, have concluded that, as of the end of such period, the Partnership's disclosure controls and procedures are effective. (b) Internal Control Over Financial Reporting. There have not been any changes in the Partnership's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Partnership's internal control over financial reporting. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In March 1998, several putative unit holders of limited partnership units of the Partnership commenced an action entitled Rosalie Nuanes, et al. v. Insignia Financial Group, Inc., et al. (the "Nuanes action") in the Superior Court of the State of California for the County of San Mateo. The plaintiffs named as defendants, among others, the Partnership, its Managing General Partner and several of their affiliated partnerships and corporate entities. The action purported to assert claims on behalf of a class of limited partners and derivatively on behalf of a number of limited partnerships (including the Partnership) that are named as nominal defendants, challenging, among other things, the acquisition of interests in certain Managing General Partner entities by Insignia Financial Group, Inc. ("Insignia") and entities that were, at one time, affiliates of Insignia; past tender offers by the Insignia affiliates to acquire limited partnership units; management of the partnerships by the Insignia affiliates; and the series of transactions which closed on October 1, 1998 and February 26, 1999 whereby Insignia and Insignia Properties Trust, respectively, were merged into AIMCO. The plaintiffs sought monetary damages and equitable relief, including judicial dissolution of the Partnership. In addition, during the third quarter of 2001, a complaint (the "Heller action") was filed against the same defendants that are named in the Nuanes action, captioned Heller v. Insignia Financial Group. On or about August 6, 2001, plaintiffs filed a first amended complaint. The Heller action was brought as a purported derivative action, and asserted claims for, among other things, breach of fiduciary duty, unfair competition, conversion, unjust enrichment, and judicial dissolution. On January 8, 2003, the parties filed a Stipulation of Settlement in proposed settlement of the Nuanes action and the Heller action. In general terms, the proposed settlement provides for certification for settlement purposes of a settlement class consisting of all limited partners in this Partnership and others (the "Partnerships") as of December 20, 2002, the dismissal with prejudice and release of claims in the Nuanes and Heller litigation, payment by AIMCO of $9.9 million (which shall be distributed to settlement class members after deduction of attorney fees and costs of class counsel and certain costs of settlement) and up to $1 million toward the cost of independent appraisals of the Partnerships' properties by a Court appointed appraiser. An affiliate of the Managing General Partner has also agreed to make at least one round of tender offers to purchase all of the partnership interests in the Partnerships within one year of final approval, if it is granted, and to provide partners with the independent appraisals at the time of these tenders. The proposed settlement also provided for the limitation of the allowable costs which the Managing General Partner or its affiliates will charge the Partnerships in connection with this litigation and imposes limits on the class counsel fees and costs in this litigation. On April 11, 2003, notice was distributed to limited partners providing the details of the proposed settlement. On June 13, 2003, the Court granted final approval of the settlement and entered judgment in both the Nuanes and Heller actions. On August 12, 2003, an objector filed an appeal seeking to vacate and/or reverse the order approving the settlement and entering judgment thereto. The Managing General Partner intends to file a respondent's brief in support of the order approving settlement and entering judgment thereto. The Managing General Partner does not anticipate that any costs to the Partnership, whether legal or settlement costs, associated with these cases will be material to the Partnership's overall operations. On August 8, 2003 AIMCO Properties L.P., an affiliate of the Managing General Partner, was served with a Complaint in the United States District Court, District of Columbia alleging that AIMCO Properties L.P. willfully violated the Fair Labor Standards Act (FLSA) by failing to pay maintenance workers overtime for all hours worked in excess of forty per week. The Complaint is styled as a Collective Action under the FLSA and seeks to certify state subclasses in California, Maryland, and the District of Columbia. Specifically, the plaintiffs contend that AIMCO Properties L.P. failed to compensate maintenance workers for time that they were required to be "on-call". Additionally, the Complaint alleges AIMCO Properties L.P. failed to comply with the FLSA in compensating maintenance workers for time that they worked in responding to a call while "on-call". The Complaint also attempts to certify a subclass for salaried service directors who are challenging their classification as exempt from the overtime provisions of the FLSA. AIMCO Properties L.P. has filed an answer to the Complaint denying the substantive allegations. Although the outcome of any litigation is uncertain, in the opinion of the Managing General Partner the claims will not result in any material liability to the Partnership. The Partnership is unaware of any other pending or outstanding litigation matters involving it or its investment properties that are not of a routine nature arising in the ordinary course of business. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a) Exhibits Exhibit 3.1, Partnership Agreement dated June 11, 1984, as amended is incorporated by reference to Exhibit A to the Prospectus of the Registrant dated October 16, 1984 as filed with the Commission pursuant to Rule 424(b) under the Act. Exhibit 3.2, Amendment No. 1 to the Partnership Agreement dated August 1, 1985 is incorporated by reference to Exhibit 3B to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. Exhibit 4.1, Certificate of Limited Partnership dated June 11, 1984 is incorporated by reference to Exhibit 4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. Exhibit 4.2, Certificate of Amendment of Limited Partnership dated July 17, 1984 is incorporated by reference to Exhibit 4A to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. Exhibit 4.3, Restated Certificate of Limited Partnership dated October 5, 1984 is incorporated by reference to Exhibit 4B to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. Exhibit 31.1, Certification of equivalent of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 31.2, Certification of equivalent of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 32.1, 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 filed during the quarter ended September 30, 2003. SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. By: Davidson Diversified Properties, Inc. Managing General Partner By: /s/Patrick J. Foye Patrick J. Foye Executive Vice President By: /s/Paul J. McAuliffe Paul J. McAuliffe Executive Vice President and Chief Financial Officer Date: November 13, 2003 Exhibit 31.1 CERTIFICATION I, Patrick J. Foye, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Davidson Diversified Real Estate II, L.P.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2003 /s/Patrick J. Foye Patrick J. Foye Executive Vice President of Davidson Diversified Properties, Inc., equivalent of the chief executive officer of the Partnership Exhibit 31.2 CERTIFICATION I, Paul J. McAuliffe, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Davidson Diversified Real Estate II, L.P.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2003 /s/Paul J. McAuliffe Paul J. McAuliffe Executive Vice President and Chief Financial Officer of Davidson Diversified Properties, Inc., equivalent of the chief financial officer of the Partnership Exhibit 32.1 Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Quarterly Report on Form 10-QSB of Davidson Diversified Real Estate II, L.P. (the "Partnership"), for the quarterly period ended September 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Patrick J. Foye, as the equivalent of the chief executive officer of the Partnership, and Paul J. McAuliffe, as the equivalent of the chief financial officer of the Partnership, each hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Partnership. /s/Patrick J. Foye Name: Patrick J. Foye Date: November 13, 2003 /s/Paul J. McAuliffe Name: Paul J. McAuliffe Date: November 13, 2003 This certification is furnished with this Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by the Partnership for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.