10KSB 1 ddre2.txt DDRE2 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 Form 10-KSB (Mark One) [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004 [ ] TRANSITION REPORT UNDER 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. (Name of small business issuer in its charter) Delaware 62-1207077 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 55 Beattie Place, PO Box 1089 Greenville, South Carolina 29602 (Address of principal executive offices) (864) 239-1000 Issuer's telephone number Securities registered under Section 12(b) of the Exchange Act: None Securities registered under Section 12(g) of the Exchange Act: Units of Limited Partnership (Title of class) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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___ Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [X] State issuer's revenues for its most recent fiscal year. $6,736,000 State the aggregate market value of the voting partnership interests held by non-affiliates computed by reference to the price at which the partnership interests were sold, or the average bid and asked prices of such partnership interests as of December 31, 2004. No market exists for the limited partnership interests of the Registrant, and, therefore, no aggregate market value can be determined. DOCUMENTS INCORPORATED BY REFERENCE None 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. PART I Item 1. Description of Business Davidson Diversified Real Estate II, L.P. (the "Partnership" or "Registrant") is a Delaware limited partnership organized in June 1984. The general partners of the Partnership are Davidson Diversified Properties, Inc., a Tennessee corporation ("Managing General Partner"); Davidson Equities, Limited, ("Associate General Partner"); and David W. Talley ("Individual General Partner") (collectively, the "General Partners"). Prior to February 25, 1998, the Managing General Partner was a wholly-owned subsidiary of MAE GP Corporation ("MAE GP"). Effective February 25, 1998, MAE GP was merged into Insignia Properties Trust ("IPT"), which was merged into Apartment Investment and Management Company ("AIMCO") effective February 26, 1999. Thus, the Managing General Partner is now a wholly-owned subsidiary of AIMCO, a publicly traded real estate investment trust. The Partnership Agreement provides that the Partnership is to terminate on December 31, 2008, unless terminated prior to such date. The offering of the Partnership's limited partnership units (the "Units") commenced on October 16, 1984, and terminated on October 15, 1985. The Partnership received gross proceeds from the offering of $24,485,000 and net proceeds of $21,760,500. Upon termination of the offering, the Partnership had accepted subscriptions for 1,224.25 Units. Since its initial offering, the Partnership has not received, nor are limited partners required to make, additional capital contributions. The Partnership is engaged in the business of operating and holding real estate properties for investment. In 1984 and 1985, during its acquisition phase, the Partnership acquired eight existing multifamily residential and commercial properties of which three have been sold and two have been foreclosed upon by the mortgage holder. The last commercial shopping center was sold on December 30, 1999. As of December 31, 2004, the Partnership owned and operated three multifamily residential properties. The Partnership has no employees. Management and administrative services are provided by the Managing General Partner. These services were provided by affiliates of the Managing General Partner for the years ended December 31, 2004 and 2003. Risk Factors The real estate business in which the Partnership is engaged is highly competitive. There are other residential properties within the market area of the Partnership's properties. The number and quality of competitive properties, including those which may be managed by an affiliate of the Managing General Partner in such market area could have a material effect on the rental market for the apartments at the Partnership's properties and the rents that may be charged for such apartments. While the Managing General Partner and its affiliates own and/or control a significant number of apartment units in the United States, such units represent an insignificant percentage of total apartment units in the United States and competition for the apartments is local. Laws benefiting disabled persons may result in the Partnership's incurrence of unanticipated expenses. Under the Americans with Disabilities Act of 1990, or ADA, all places intended to be used by the public are required to meet certain Federal requirements related to access and use by disabled persons. Likewise, the Fair Housing Amendments Act of 1988, or FHAA, requires apartment properties first occupied after March 13, 1990 to be accessible to the handicapped. These and other Federal, state and local laws may require modifications to the Partnership's properties, or restrict renovations of the properties. Noncompliance with these laws could result in the imposition of fines or an award of damages to private litigants and also could result in an order to correct any non-complying feature, which could result in substantial capital expenditures. Although the Managing General Partner believes that the Partnership's properties are substantially in compliance with the present requirements, the Partnership may incur unanticipated expenses to comply with the ADA and the FHAA. Both the income and expenses of operating the properties owned by the Partnership are subject to factors outside of the Partnership's control, such as changes in the supply and demand for similar properties resulting from various market conditions, increases/decreases in unemployment or population shifts, changes in the availability of permanent mortgage financing, changes in zoning laws, or changes in patterns or needs of users. In addition, there are risks inherent in owning and operating residential properties because such properties are susceptible to the impact of economic and other conditions outside of the control of the Partnership. From time to time, the Federal Bureau of Investigation, or FBI, and the United States Department of Homeland Security issue alerts regarding potential terrorist threats involving apartment buildings. Threats of future terrorist attacks, such as those announced by the FBI and the Department of Homeland Security, could have a negative effect on rent and occupancy levels at the Partnership's properties. The effect that future terrorist activities or threats of such activities could have on the Partnership's operations is uncertain and unpredictable. If the Partnership were to incur a loss at a property as a result of an act of terrorism, the Partnership could lose all or a portion of the capital invested in the property, as well as the future revenue from the property. In this regard, the Partnership has purchased insurance to cover acts of terrorism. The Managing General Partner does not anticipate that these costs will have a negative effect on the Partnership's consolidated financial condition or results of operations. There have been, and it is possible there may be other, Federal, state and local legislation and regulations enacted relating to the protection of the environment. The Partnership is unable to predict the extent, if any, to which such new legislation or regulations might occur and the degree to which such existing or new legislation or regulations might adversely affect the properties owned by the Partnership. The Partnership monitors its properties for evidence of pollutants, toxins and other dangerous substances, including the presence of asbestos. In certain cases environmental testing has been performed which resulted in no material adverse conditions or liabilities. In no case has the Partnership received notice that it is a potentially responsible party with respect to an environmental clean up site. A further description of the Partnership's business is included in "Management's Discussion and Analysis or Plan of Operation" included in "Item 6." of this Form 10-KSB. Item 2. Description of Properties The following table sets forth the Partnership's investments in properties as of December 31, 2004:
Date of Property Purchase Type of Ownership Use Big Walnut Apartments 03/28/85 Fee ownership subject to Apartment - Columbus, Ohio first mortgage (1) 251 units The Trails Apartments 08/30/85 Fee ownership subject to Apartment - Nashville, Tennessee first mortgage (1) 248 units Reflections Apartments 09/30/85 Fee ownership subject to Apartment - Indianapolis, Indiana first mortgage (2) 582 units
(1) The property is held by a Limited Partnership in which the Partnership owns a 99.90% interest. (2) The property is held by a Limited Partnership wholly owned by the Partnership. 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 year ended December 31, 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. Schedule of Properties Set forth below for each of the Partnership's properties is the gross carrying value, accumulated depreciation, depreciable life, method of depreciation and Federal tax basis.
Gross Carrying Accumulated Depreciable Federal Property Value Depreciation Life Method Tax Basis (in thousands) (in thousands) Big Walnut Apartments $10,730 $ 7,099 5-25 yrs S/L $ 2,353 The Trails Apartments 9,959 6,830 5-25 yrs S/L 1,431 Reflections Apartments 30,159 11,207 5-25 yrs S/L 18,689 $50,848 $25,136 $22,473
See "Note A" to the consolidated financial statements included in "Item 7 - Financial Statements" for a description of the Partnership's capitalization and depreciation policies. Schedule of Property Indebtedness The following table sets forth certain information relating to the loans encumbering the Partnership's properties.
Principal Principal Balance At Stated Balance December 31, Interest Period Maturity Due At Property 2004 Rate Amortized Date Maturity (in thousands) (in thousands) Big Walnut Apartments $ 5,442 (1) 360 months 09/15/07 $ 5,042 The Trails Apartments 4,455 (2) 240 months 12/01/09 3,010 Reflections Apartments 13,213 4.17% (3) 300 months 01/01/29 -- Totals 23,110 $ 8,052 Less unamortized discounts (657) Total $22,453
(1) Adjustable interest rate is based on the Fannie Mae discounted mortgage-backed security index plus 85 basis points. The rate at December 31, 2004 was 3.07%. (2) Adjustable rate based on 75% of the interest rate on new-issue long-term A-rated utility bonds as determined on the first day of each calendar quarter. The rate at December 31, 2004 was 4.23%. (3) Fixed rate mortgage. See "Item 7. Financial Statements - Note B" for information with respect to the Partnership's ability to prepay the loans and other specific details about the loans. The mortgage discount is reflected as a reduction of the mortgage notes payable and increases the effective rate of the debt to 6.34% for The Trails Apartments. The Multifamily Housing Revenue Bonds and Note Agreement collateralized by The Trails Apartments were called and, therefore, payable in full on February 1, 1997 in accordance with the terms of the agreements. On June 30, 1997, the Partnership entered into a Modification of Bond Documents with the issuer. Pursuant to the modification, the call notice was rescinded. The modification converted the monthly payments from interest only to principal and interest payments with an amortization period of twenty years. The note and bond mature on December 1, 2009 with a balloon payment of approximately $3,010,000 due at maturity. On December 11, 2003, the Partnership refinanced the construction loan mortgage encumbering Reflections Apartments. The refinancing replaced mortgage indebtedness of approximately $10,379,000 with a new mortgage of approximately $13,500,000. The new mortgage carries a stated interest rate of 4.17% compared to a variable interest rate on the prior mortgage. Payments of principal and interest of approximately $73,000 are due on the first day of each month commencing in February 2004 until January 2029 at which time the mortgage is scheduled to be fully amortized. However, the lender can exercise a call option on the mortgage on February 1, 2009 and every fifth anniversary thereafter until maturity on January 1, 2029. If the lender exercises the call option, the outstanding principal balance and any related interest expense is due and payable on the call date. Capitalized loan costs, which are included in other assets, incurred with the refinancing were approximately $119,000, and are being amortized over the life of the mortgage note payable. The Partnership wrote off unamortized loan costs of approximately $17,000 resulting in a loss on early extinguishment of debt. The Partnership refinanced the mortgage encumbering Big Walnut Apartments during 2002. During the year ended December 31, 2003, the Partnership capitalized an additional $10,000 in loan costs related to the refinancing. Rental Rates and Occupancy Average annual rental rates and occupancy for 2004 and 2003 for each property: Average Annual Average Rental Rates Occupancy (per unit) Property 2004 2003 2004 2003 Big Walnut Apartments (1) $6,592 $6,725 80% 92% The Trails Apartments 6,810 6,729 95% 96% Reflections Apartments (2) 6,424 6,225 89% 67% (1) The Managing General Partner attributes the decrease in occupancy at Big Walnut Apartments to a slow economy in the Columbus, Ohio area combined with lower rates for home mortgages. (2) The Managing General Partner attributes the increase in occupancy at Reflections Apartments to the completion of a major renovation project during 2003. The project enhanced the appearance of the property to attract desirable tenants. As noted under "Item 1. Description of Business", the real estate industry is highly competitive. All of the properties are subject to competition from other residential apartment complexes in the area. The Managing General Partner believes that all of the properties are adequately insured. Each property is an apartment complex which leases units for terms of one year or less. As of December 31, 2004, no residential tenant leases 10% or more of the available rental space. All of the properties are in good condition subject to normal depreciation and deterioration as is typical for assets of this type and age. Schedule of Real Estate Taxes and Rates Real estate taxes and rates in 2004 for each property were: 2004 2004 Taxes Rates (in thousands) Big Walnut Apartments $ 137 6.00% The Trails Apartments 126 3.84% Reflections Apartments 161 1.65% Capital Improvements Big Walnut Apartments: During the year ended December 31, 2004, the Partnership completed approximately $643,000 of capital expenditures at Big Walnut Apartments consisting primarily of floor covering and appliance replacements, parking lot improvements, major landscaping and gutter installation. These improvements were funded from operating cash flow and advances from the Managing General Partner. The Partnership regularly evaluates the capital improvement needs of the property. While the Partnership has no material commitments for property improvements and replacements, certain routine capital expenditures are anticipated during 2005. Such capital expenditures will depend on the physical condition of the property as well replacement reserves and anticipated cash flow generated by the property. The Trails: During the year ended December 31, 2004, the Partnership completed approximately $100,000 of capital expenditures at The Trails Apartments consisting primarily of appliance and floor covering replacements, major landscaping, and structural improvements. These improvements were funded from operating cash flow. The Partnership regularly evaluates the capital improvement needs of the property. While the Partnership has no material commitments for property improvements and replacements, certain routine capital expenditures are anticipated during 2005. Such capital expenditures will depend on the physical condition of the property and anticipated cash flow generated by the property. Reflections: During the year ended December 31, 2004, the Partnership completed approximately $82,000 in capital expenditures at Reflections Apartments consisting primarily of office computers and floor covering replacements. These improvements were funded from operating cash flow. The Partnership regularly evaluates the capital improvement needs of the property. While the Partnership has no material commitments for property improvements and replacements, certain routine capital expenditures are anticipated during 2005. Such capital expenditures will depend on the physical condition of the property and anticipated cash flow generated by the property. Capital expenditures will be incurred only if cash is available from operations or from Partnership reserves. To the extent that capital improvements are completed, the Partnership's distributable cash flow, if any, may be adversely affected at least in the short term. Item 3. 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 captioned Heller v. Insignia Financial Group (the "Heller action") was filed against the same defendants that are named in the Nuanes action. 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 ("Objector") filed an appeal (the "Appeal") seeking to vacate and/or reverse the order approving the settlement and entering judgment thereto. On November 24, 2003, the Objector filed an application requesting the court order AIMCO to withdraw settlement tender offers it had commenced, refrain from making further offers pending the appeal and auction any units tendered to third parties, contending that the offers did not conform with the terms of the settlement. Counsel for the Objector (on behalf of another investor) had alternatively requested the court take certain action purportedly to enforce the terms of the settlement agreement. On December 18, 2003, the court heard oral argument on the motions and denied them both in their entirety. The Objector filed a second appeal challenging the court's use of a referee and its order requiring Objector to pay those fees. On January 28, 2004, the Objector filed his opening brief in the Appeal. On April 23, 2004, the Managing General Partner and its affiliates filed a response brief in support of the settlement and the judgment thereto. The plaintiffs have also filed a brief in support of the settlement. On June 4, 2004, Objector filed a reply to the briefs submitted by the Managing General Partner and Plaintiffs. In addition both the Objector and plaintiffs filed briefs in connection with the second appeal. On March 21, 2005, the Court of Appeals issued opinions in both pending appeals. With regard to the settlement and judgment entered thereto, the Court of Appeals vacated the trial court's order and remanded to the trial court for further findings on the basis that the "state of the record is insufficient to permit meaningful appellate review". With regard to the second appeal, the Court of Appeals reversed the order requiring the Objector to pay referee fees. 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. As previously disclosed, AIMCO Properties L.P. and NHP Management Company, both affiliates of the Managing General Partner, are defendants in an action in the United States District Court, District of Columbia. The plaintiffs have styled their complaint as a collective action under the Fair Labor Standards Act ("FLSA") and seek 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, plaintiffs allege 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 defendants have filed an answer to the amended complaint denying the substantive allegations. Discovery relating to the certification of the collective action has concluded and briefing on the matter is underway. Although the outcome of any litigation is uncertain, AIMCO Properties, L.P. does not believe that the ultimate outcome will have a material adverse effect on its financial condition or results of operations. Similarly, the Managing General Partner does not believe that the ultimate outcome will have a material adverse effect on the Partnership's consolidated financial condition or results of operations. Item 4. Submission of Matters to a Vote of Security Holders During the quarter ended December 31, 2004, no matters were submitted to a vote of Unit holders through the solicitation of proxies or otherwise. PART II Item 5. Market for the Partnership Equity and Related Partner Matters The Partnership, a publicly-held limited partnership, offered and sold 1,224.25 Limited Partnership Units ("Units") aggregating $24,485,000. As of December 31, 2004 there were 738 holders of record owning an aggregate of 1,224.25 Units. Affiliates of the Managing General Partner owned 656.50 units or 53.62% of the outstanding Units at December 31, 2004. There is no established market for the Units and it is not anticipated that any will develop in the future. No cash distributions were made to the partners during 2004 or 2003. Future cash distributions will depend on the levels of net cash generated from operations, the timing of debt maturities, property sales and/or refinancings. The Partnership's cash available for distribution is reviewed on a monthly basis. In light of the recently completed rehabilitation project at Reflections Apartments and the significant amount due to the Managing General Partner at December 31, 2004, it is not anticipated that the Partnership will make any distributions in the foreseeable future. See "Item 2. Description of Properties - Capital Improvements" for information relating to anticipated capital expenditures at the properties. In addition to its indirect ownership of the managing and associate general partner interest in the Partnership, AIMCO and its affiliates owned 656.50 limited partnership units ("Units") in the Partnership representing 53.62% of the outstanding Units at December 31, 2004. 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 53.62% 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. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF PLAN OF OPERATION This item should be read in conjunction with the consolidated financial statements and other items contained elsewhere in this report. The Partnership's financial results depend on a number of factors including the ability to attract and maintain tenants at the investment properties, interest rates on mortgage loans, costs incurred to operate the investment properties, general economic conditions and weather. As part of the ongoing business plan of the Partnership, the Managing General Partner monitors the rental market environment of its investment properties to assess the feasibility of increasing rents, maintaining or increasing occupancy levels and protecting the Partnership from increases in expenses. 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. Further, a number of factors that are outside the control of the Partnership such as the local economic climate and weather can adversely or positively affect the Partnership's financial results. Results of Operations The Partnership's net loss was approximately $1,218,000 for the year ended December 31, 2004 compared to net income of approximately $4,029,000 for the year ended December 31, 2003. The decrease in net income for the year ended December 31, 2004 was primarily due to the recognition of a gain on the sale of LaFontenay I and II Apartments in 2003. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the operations of LaFontenay I and II Apartments for the years ended December 31, 2004 and 2003 have been shown as loss from discontinued operations due to the sale of the property in 2003. 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 year ended December 31, 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 loss from discontinued operations on the accompanying consolidated statement of operations. The Partnership used the proceeds received from the sale to make payments on the loan balances due to an affiliate of the Managing General Partner. The property's operations, a loss of approximately $208,000 for the year ended December 31, 2003, includes revenues of approximately $179,000. Included in discontinued operations for the year ended December 31, 2004 is approximately $47,000 of city income taxes related to the sale of LaFontenay I and II Apartments. Excluding the gain on sale of discontinued operations and loss from discontinued operations, the Partnership's loss from continuing operations was approximately $1,171,000 and $1,308,000 for the years ended December 31, 2004 and 2003, respectively. The decrease in loss from continuing operations was due to an increase in total revenues partially offset by an increase in total expenses. Total revenues increased due to an increase in rental income. Rental income increased due to an increase in occupancy at Reflections Apartments and a decrease in bad debt expense at Reflections and Big Walnut Apartments, partially offset by a decrease in occupancy at Big Walnut Apartments. During the year ended December 31, 2003 a net casualty gain of approximately $8,000 was recorded at Big Walnut Apartments. The casualty gain related to a fire at the property in March 2003 that damaged two apartment units. 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 year ended December 31, 2004, the Partnership received additional proceeds of approximately $9,000, which were recognized as a casualty gain. Total expenses increased due to increases in operating and depreciation expense, partially offset by decreases in general and administrative, interest, and property tax expenses. Operating expenses increased due to increases in advertising, property and maintenance expenses. Advertising expense increased due to increased marketing efforts at Reflections Apartments after completion of the renovation project. Property expense increased due to increased payroll and related benefits and utilities at Big Walnut Apartments. Maintenance expense increased due to increases in contract labor at Big Walnut and Reflections Apartments. Depreciation expense increased due to fixed assets being placed into service during the fourth quarter of 2003 at Reflections Apartments as a result of the renovation project. Interest expense decreased due to a decrease in loan amortization costs at Reflections Apartments partially offset by an increase in the amortization of the debt discount at The Trails. Property tax expense decreased due to a decrease in the estimated tax accrual for Reflections Apartments, as discussed below. During 2003, the state of Indiana implemented a reassessment of property tax values. The Partnership appealed the reassessed property tax value of Reflections Apartments. In the state of Indiana property tax bills are paid one year in arrears. Thus, the 2003 property tax bills are received and paid in 2004. Due to the Partnership's appeal of the reassessed property value, the property tax accrual for 2004 and 2003 was based on the property tax value as estimated by a third party property tax specialist. During September 2004, the Partnership was successful in its appeal and the assessed value of Reflections Apartments was reduced for tax years 2002, 2003 and 2004. During the year ended December 31, 2004 the Partnership recorded a receivable of approximately $141,000 for a refund related to 2002 taxes paid in 2003, recorded a reduction of tax expense of approximately $81,000 for 2003 taxes paid in 2004 and reduced the accrual for estimated 2004 taxes to be paid in 2005 by approximately $41,000. General and administrative expense decreased due to a decrease in management reimbursements to the Managing General Partner as allowed under the Partnership Agreement and a decrease in the cost of the annual audit. Also included in general and administrative expenses for both December 31, 2004 and 2003 are costs associated with the quarterly and annual communications with investors and regulatory agencies. Liquidity and Capital Resources At December 31, 2004, the Partnership had cash and cash equivalents of approximately $696,000 compared to approximately $746,000 at December 31, 2003. Cash and cash equivalents decreased approximately $50,000 since December 31, 2003 due to approximately $773,000 of cash used in investing activities and approximately $834,000 of cash used in financing activities partially offset by approximately $1,557,000 of cash provided by operating activities. Cash used in investing activities consisted of property improvements and replacements and net deposits to restricted escrows partially offset by insurance proceeds received at Big Walnut Apartments. Cash used in financing activities consisted of principal payments on the mortgages encumbering the investment properties and payments on advances from an affiliate of the Managing General Partner partially offset by advances received from an affiliate of the Managing General Partner. The Partnership invests its working capital reserves in interest bearing accounts. In accordance with the Partnership Agreement, an affiliate of the Managing General Partner advanced the Partnership funds to cover operational expenses, real estate taxes and to assist in the closing of the refinancing required at Reflections Apartments of approximately $545,000 and $7,243,000 during the years ended December 31, 2004 and 2003, respectively. The Partnership repaid approximately $682,000 and $5,577,000 during the same periods. At December 31, 2004, the amount of the outstanding loans and accrued interest was approximately $8,632,000 and is shown as due to affiliate on the accompanying consolidated balance sheet. Interest on advances is charged at prime plus 1% or 6.25% at December 31, 2004. Interest expense was approximately $452,000 and $436,000 for the years ended December 31, 2004 and 2003, respectively. The Partnership paid approximately $316,000 and $599,000 in interest during the years ended December 31, 2004 and 2003, 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. On December 11, 2003, the Partnership refinanced the construction loan mortgage encumbering Reflections Apartments. The refinancing replaced mortgage indebtedness of approximately $10,379,000 with a new mortgage of approximately $13,500,000. The new mortgage carries a stated interest rate of 4.17% compared to a variable interest rate of the prior mortgage. Payments of principal and interest of approximately $73,000 are due on the first day of each month commencing in February 2004 until January 2029 at which time the mortgage is scheduled to be fully amortized. However, the lender can exercise a call option on the mortgage on February 1, 2009 and every fifth anniversary thereafter until maturity on January 1, 2029. If the lender exercises the call option, the outstanding principal balance and any related interest expense is due and payable on the call date. Capitalized loan costs, which are included in other assets, incurred with the refinancing were approximately $119,000, and are bring amortized over the life of the mortgage note payable. The Partnership wrote off unamortized loan costs of approximately $17,000 resulting in a loss on early extinguishment of debt. The Partnership refinanced the mortgage encumbering Big Walnut Apartments during 2002. During the year ended December 31, 2003, the Partnership capitalized an additional $10,000 in loan costs related to the refinancing. 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. For example, 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. The Partnership regularly evaluates the capital improvement needs of the properties. While the Partnership has no material commitments for property improvements and replacements, certain routine capital expenditures are anticipated during 2005. Such capital expenditures will depend on the physical condition of the property as well as reserves and anticipated cash flow generated by the property. 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 Reflections Apartments of approximately $13,213,000 matures in January 2029 at which time the loan is scheduled to be fully amortized. The mortgage indebtedness encumbering Big Walnut Apartments of approximately $5,442,000 matures in September 2007 at which time a balloon payment of approximately $5,042,000 is required. The Managing General Partner has the option to extend the maturity on the Big Walnut Apartments loan for another five years. The mortgage indebtedness encumbering The Trails Apartments of approximately $4,455,000 matures in December 2009 at which time a balloon payment of approximately $3,010,000 is required. 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 to the partners during 2004 or 2003. Future cash distributions will depend on the levels of net cash generated from operations, the timing of debt maturities, property sales and/or refinancings. The Partnership's cash available for distribution is reviewed on a monthly basis. In light of the recently completed rehabilitation project at Reflections Apartments and the significant amount due to the Managing General Partner at December 31, 2004, it is not anticipated that the Partnership will make any 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 656.50 limited partnership units ("Units") in the Partnership representing 53.62% of the outstanding Units at December 31, 2004. 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 53.62% 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 A summary of the Partnership's significant accounting policies is included in "Note A - Organization and Summary of Significant Accounting Policies" which is included in the consolidated financial statements in "Item 7. Financial Statements". The Managing General Partner believes that the consistent application of these policies enables the Partnership to provide readers of the consolidated financial statements with useful and reliable information about the Partnership's operating results and financial condition. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires the Partnership to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Judgments and assessments of uncertainties are required in applying the Partnership's accounting policies in many areas. 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 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 an impairment of the Partnership's assets. Revenue Recognition The Partnership generally leases apartment units for twelve-month terms or less. The Partnership will offer rental concessions during particularly slow months or in response to heavy competition from other similar complexes in the area. Rental income attributable to leases, net of any concessions, is recognized on a straight-line basis over the term of the lease. The Partnership evaluates all accounts receivable from residents and establishes an allowance, after the application of security deposits, for accounts greater than 30 days past due on current tenants and all receivables due from former tenants. Item 7. Financial Statements DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. LIST OF FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm Consolidated Balance Sheet - December 31, 2004 Consolidated Statements of Operations - Years ended December 31, 2004 and 2003 Consolidated Statements of Changes in Partners' Deficit - Years ended December 31, 2004 and 2003 Consolidated Statements of Cash Flows - Years ended December 31, 2004 and 2003 Notes to Consolidated Financial Statements Report of Independent Registered Public Accounting Firm The Partners Davidson Diversified Real Estate II, L.P. We have audited the accompanying consolidated balance sheet of Davidson Diversified Real Estate II, L.P. as of December 31, 2004, and the related consolidated statements of operations, changes in partners' deficit, and cash flows for each of the two years in the period ended December 31, 2004. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Partnership's internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Davidson Diversified Real Estate II, L.P. at December 31, 2004, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States. /s/ERNST & YOUNG LLP Greenville, South Carolina March 21, 2005 DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. CONSOLIDATED BALANCE SHEET (in thousands, except unit data) December 31, 2004
Assets Cash and cash equivalents $ 696 Receivables and deposits 439 Restricted escrows 86 Other assets 445 Investment properties (Notes B,E & F): Land $ 1,953 Buildings and related personal property 48,895 50,848 Less accumulated depreciation (25,136) 25,712 $ 27,378 Liabilities and Partners' Deficit Liabilities Accounts payable 146 Tenant security deposit payable 140 Accrued property taxes 428 Other liabilities 324 Due to affiliates (Note D) 8,685 Mortgage notes payable (Note B) 22,453 Partners' Deficit General partners $ (213) Limited partners (1,224.25 units issued and outstanding) (4,585) (4,798) $ 27,378 See Accompanying Notes to Consolidated Financial Statements
DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per unit data)
Years Ended December 31, 2004 2003 Revenues: Rental income $ 6,115 $ 5,422 Other income 612 584 Casualty gains (Note G) 9 8 Total revenues 6,736 6,014 Expenses: Operating 3,338 2,882 General and administrative 271 288 Depreciation 2,468 2,037 Interest 1,560 1,610 Property taxes 270 488 Loss on early extinguishment of debt (Note B) -- 17 Total expenses 7,907 7,322 Loss from continuing operations (1,171) (1,308) Loss from discontinued operations (47) (208) Gain on sale of discontinued operations (Note E) -- 5,545 Net (loss) income (Note C) $ (1,218) $ 4,029 Net (loss) income allocated to general partners $ (24) $ 398 Net (loss) income allocated to limited partners (1,194) 3,631 $ (1,218) $ 4,029 Per limited partnership unit: Loss from continuing operations $ (937.72) $(1,047.17) Loss from discontinued operations (37.57) (166.63) Gain on sale of discontinued operations -- 4,179.70 Net (loss) income $ (975.29) $ 2,965.90 See Accompanying Notes to Consolidated Financial Statements
DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS' DEFICIT (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 year ended December 31, 2003 -- 398 3,631 4,029 Partners' deficit at December 31, 2003 1,224.25 (189) (3,391) (3,580) Net loss for the year ended December 31, 2004 -- (24) (1,194) (1,218) Partners' deficit at December 31, 2004 1,224.25 $ (213) $(4,585) $(4,798) See Accompanying Notes to Consolidated Financial Statements
DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
Years Ended December 31, 2004 2003 Cash flows from operating activities: Net (loss) income $(1,218) $4,029 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation 2,468 2,080 Amortization of discounts and loan costs 228 278 Loss on early extinguishment of debt -- 85 Gain on sale of discontinued operations -- (5,545) Casualty gain (9) (8) Change in accounts: Receivables and deposits 121 (79) Other assets (36) (102) Accounts payable (57) (18) Tenant security deposit liabilities (27) 10 Accrued property taxes (89) (11) Other liabilities (13) (31) Due to affiliate 189 (166) Net cash provided by operating activities 1,557 522 Cash flows from investing activities: Property improvements and replacements (781) (6,819) Net proceeds from sale of investment property -- 2,547 Insurance proceeds received 9 13 Net deposits to restricted escrows (1) -- Net cash used in investing activities (773) (4,259) Cash flows from financing activities: Advances from affiliates 545 7,243 Payments on advances from affiliates (682) (5,577) Payments on mortgage notes payable (697) (630) Proceeds from debt refinancing -- 13,500 Repayment of mortgage notes payable -- (10,379) Fees related to debt refinancing -- (136) Loan costs paid -- (129) Net cash (used in) provided by financing activities (834) 3,892 Net (decrease) increase in cash and cash equivalents (50) 155 Cash and cash equivalents at beginning of year 746 591 Cash and cash equivalents at end of year $ 696 $ 746 Supplemental disclosure of cash flow information: Cash paid for interest $ 1,148 $ 1,493 Supplemental disclosure of non-cash activity: Property improvements and replacements in accounts payable $ 44 $ -- Mortgage assumed by buyers on sale of investment property $ -- $ 6,899 See Accompanying Notes to Consolidated Financial Statements
DAVIDSON DIVERSIFIED REAL ESTATE II, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 Note A - Organization and Summary of Significant Accounting Policies Organization Davidson Diversified Real Estate II, L.P. (the "Partnership" or "Registrant") is a Delaware limited partnership organized in June 1984 to acquire and operate residential and commercial real estate properties. The Partnership's managing general partner is Davidson Diversified Properties, Inc (the "Managing General Partner"). Prior to February 25, 1998, the Managing General Partner was a wholly-owned subsidiary of MAE GP Corporation ("MAE GP"). Effective February 25, 1998, MAE GP merged into Insignia Properties Trust ("IPT"), which was merged into Apartment Investment and Management Company ("AIMCO") effective February 26, 1999. Thus the Managing General Partner is now a wholly-owned subsidiary of AIMCO, a publicly traded real estate investment trust. The Partnership commenced operations on October 16, 1984, and completed its acquisition of investment properties prior to December 31, 1985. The Partnership Agreement provides that the Partnership is to terminate on December 31, 2008, unless terminated prior to such date. As of December 31, 2004, the Partnership operates three apartment properties located in or near major urban areas in the United States. Basis of Presentation In accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the operations of LaFontenay I and II Apartments for the years ended December 31, 2004 and 2003 have been shown as loss from discontinued operations due to the sale of the property in 2003. Principles of Consolidation The Partnership's financial statements include all the accounts of the Partnership and its two 99.9% owned partnerships and one wholly owned Partnership. The general partner of these partnerships is Davidson Diversified Properties, Inc. Davidson Diversified Properties, Inc. may be removed as the general partner of these partnerships by the Partnership; therefore, the consolidated partnerships are controlled and consolidated by the Partnership. All significant interpartnership balances have been eliminated. Allocations of Profits, Gains & Losses Net income, other than that arising from the occurrence of a sale or refinancing, and net loss shall be allocated 2% to the general partners and 98% to the limited partners. Allocation of Cash Distributions Cash distributions by the Partnership are allocated between general and limited partners in accordance with the Partnership Agreement. The Partnership Agreement provides that 98% of distributions of adjusted cash from operations are allocated to the limited partners and 2% to the general partners. Cash from operations is defined as the excess of cash received from operations less operating expenses paid, adjusted for certain specified items which primarily include mortgage payments on debt, property improvements and replacements not previously reserved, and the effects of other adjustments to reserves including reserve amounts deemed necessary by the Managing General Partner. Distributions made from reserves no longer considered necessary by the general partners are considered to be additional adjusted cash from operations for allocation purposes. No cash distributions to the partners were made during the years ended December 31, 2004 or 2003. Cash from sales or refinancings (as defined in the Partnership Agreement) shall be distributed to the limited partners until each limited partner has received his original invested capital plus an amount equal to a cumulative 8% per annum of the average of the limited partners' adjusted invested capital, less any prior distributions. The general partners are then entitled to receive 3% of the selling price of properties sold where they acted as a broker. The limited partners will then be allocated 85% of any remaining distributions and the general partners will receive 15%. Restricted Escrow At the time of the refinancing of Big Walnut Apartments in 2002, the Partnership was required to establish a repair escrow of approximately $85,000 to be used to complete required repairs. The balance in this account at December 31, 2004 was approximately $86,000. Investment Properties Investment properties consist of three apartment complexes and are stated at cost. Acquisition fees are capitalized as a cost of real estate. The Partnership capitalizes all expenditures in excess of $250 that clearly relate to the acquisition and installation of real and personal property components. These expenditures include costs incurred to replace existing property components, costs incurred to add a material new feature to a property, and costs that increase the useful life or service potential of a property component. These capitalized costs are depreciated over the useful life of the asset. Expenditures for ordinary repairs, maintenance and apartment turnover costs are expensed as incurred. The Partnership capitalized interest costs of approximately $155,000, tax and insurance expenses of approximately $84,000 and other construction period expenses of approximately $136,000 during the year ended December 31, 2003 with respect to the renovation project that was completed at Reflections Apartments. Total interest expense incurred before recognition of the capitalized amount was approximately $1,794,000 for the year ended December 31, 2003. During 2003, it was determined that overcapitalization of certain items occurred during 2003 and 2002. The overcapitalization was corrected in 2003 (see "Note I - Quarterly Adjustments"). In accordance with SFAS No. 144, the Partnership records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. No adjustments for impairment of value were recorded in the years ended December 31, 2004 or 2003. Depreciation Depreciation is provided by the straight-line method over the estimated lives of the apartment properties and related personal property. For Federal income tax purposes, the accelerated cost recovery method is used for real property over 19 years for additions after May 8, 1985, and before January 1, 1987. As a result of the Tax Reform Act of 1986, for additions after December 31, 1986, the modified accelerated cost recovery method is used for depreciation of (1) real property additions over 27 1/2 years, and (2) personal property additions over 5 years. Deferred Costs Loan costs of approximately $364,000, less accumulated amortization of approximately $134,000, are included in other assets. The loan costs are amortized over the terms of the related loan agreements. Amortization expense was approximately $64,000 and $226,000 for the years ended December 31, 2004 and 2003, respectively, and is included in interest expense and loss from discontinued operations on the accompanying consolidated statements of operations. Amortization expense is expected to be approximately $66,000 in 2005 and 2006, $58,000 in 2007 and $33,000 in 2008 and $7,000 in 2009. Leasing commissions and other direct costs incurred in connection with successful leasing efforts are deferred and amortized over the terms of the related leases. Amortization of these costs is included in operating expenses. Cash and Cash Equivalents Cash and equivalents include cash on hand and in banks. At certain times, the amount of cash deposited at a bank may exceed the limit on insured deposits. Cash balances include approximately $667,000 at December 31, 2004 that are maintained by an affiliated management company on behalf of affiliated entities in cash concentration accounts. Tenant Security Deposits The Partnership requires security deposits from lessees for the duration of the lease and such deposits are included in receivables and deposits. The security deposits are refunded when the tenant vacates, provided the tenant has not damaged their space and is current on rental payments. Leases The Partnership generally leases apartment units for twelve-month terms or less. The Partnership will offer rental concessions during particularly slow months or in response to heavy competition from other similar complexes in the area. Rental income attributable to leases, net of any concessions, is recognized on a straight-line basis over the term of the lease. The Partnership evaluates all accounts receivable from residents and establishes an allowance, after the application of security deposits, for accounts greater than 30 days past due on current tenants and all receivables due from former tenants. Advertising Costs The Partnership expenses the costs of advertising as incurred. Advertising expense, included in operating expenses and loss from discontinued operations, was approximately $330,000 and $229,000 for the years ended December 31, 2004 and 2003, respectively. Fair Value of Financial Instruments SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", as amended by SFAS No. 119, "Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments", requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate fair value. Fair value is defined in the SFAS as the amount at which the instruments could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes that the carrying amounts of its financial instruments (except for long term debt) approximates their fair value due to the short term maturity of these instruments. The Partnership estimates the fair value of its long term debt by discounting future cash flows using a discount rate commensurate with that currently believed to be available to the Partnership for similar term, fully amortizing long-term debt. The fair value of the Partnership's long term debt at the Partnership's incremental borrowing rate is approximately $20,720,000 at December 31, 2004. Segment Reporting SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information" established standards for the way public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. It also established standards for related disclosures about products and services, geographic areas, and major customers. As defined in SFAS No. 131, the Partnership has only one reportable segment. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Note B - Mortgage Notes Payable
Principal Monthly Principal Balance At Payment Stated Balance December 31, Including Interest Maturity Due At Property 2004 Interest Rate Date Maturity (in thousands) (in thousands) Big Walnut Apartments 1st mortgage $ 5,442 $ 26 (1) 9/15/07 $ 5,042 The Trails Apartments 1st mortgage 4,455 38 (2) 12/01/09 3,010 Reflections Apartments 1st mortgage 13,213 73 4.17% (3) 01/01/29 -- 23,110 $ 137 $ 8,052 Less unamortized discounts (657) Total $22,453
(1) Adjustable interest rate is based on the Fannie Mae discounted mortgage-backed security index plus 85 basis points. The rate at December 31, 2004 was 3.07%. (2) Adjustable rate based on 75% of the interest rate on new-issue long-term A-rated utility bonds as determined on the first day of each calendar quarter. The rate at December 31, 2004 was 4.23%. (3) Fixed rate mortgage. The mortgage discount is reflected as a reduction of the mortgage notes payable and increases the effective rate of the debt to 6.34% for The Trails Apartments. The mortgage notes payable are non-recourse and are secured by a pledge of the Partnership's rental properties and by a pledge of revenues from the respective rental properties. The mortgage note payable for Reflections Apartments includes a prepayment penalty if repaid prior to maturity. Further, the properties may not be sold subject to existing indebtedness. The mortgage for Big Walnut Apartments is financed 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 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 begins 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 loans is the Fannie Mae discounted mortgage-backed security index plus 85 basis points (3.07% at December 31, 2004) and resets monthly. Each loan automatically renews 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 in the Permanent Credit Facility. The loans are prepayable without penalty. The Multifamily Housing Revenue Bonds and Note Agreement collateralized by The Trails Apartments were called and, therefore, payable in full on February 1, 1997 in accordance with the terms of the agreements. On June 30, 1997, the Partnership entered into a Modification of Bond Documents with the issuer. Pursuant to the modification, the call notice was rescinded. The modification converted the monthly payments from interest only to principal and interest payments with an amortization period of twenty years. The note and bond mature on December 1, 2009 with a balloon payment of approximately $3,010,000 due at maturity. On December 11, 2003, the Partnership refinanced the construction loan mortgage encumbering Reflections Apartments. The refinancing replaced mortgage indebtedness of approximately $10,379,000 with a new mortgage of approximately $13,500,000. The new mortgage carries a stated interest rate of 4.17% compared to a variable interest rate on the prior mortgage. Payments of principal and interest of approximately $73,000 are due on the first day of each month commencing in February 2004 until January 2029 at which time the mortgage is scheduled to be fully amortized. However, the lender can exercise a call option on the mortgage on February 1, 2009 and every fifth anniversary thereafter until maturity on January 1, 2029. If the lender exercises the call option, the outstanding principal balance and any related interest expense is due and payable on the call date. Capitalized loan costs, which are included in other assets, incurred with the refinancing were approximately $119,000, and are being amortized over the life of the mortgage note payable. The Partnership wrote off unamortized loan costs of approximately $17,000 resulting in a loss on early extinguishment of debt. The Partnership refinanced the mortgage encumbering Big Walnut Apartments during 2002. During the year ended December 31, 2003, the Partnership capitalized an additional $10,000 in loan costs related to the refinancing. Scheduled principal payments of the mortgage notes payable subsequent to December 31, 2004, are as follows (in thousands): 2005 $ 740 2006 769 2007 5,803 2008 677 2009 3,680 Thereafter 11,441 $23,110 Note C- Income Taxes The Partnership received a ruling from the Internal Revenue Service that it is to be classified as a partnership for Federal income tax purposes. Accordingly, no provision for income taxes is made in the consolidated financial statements of the Partnership. Taxable income or loss of the Partnership is reported in the income tax returns of its partners. The following is a reconciliation of reported net (loss) income and Federal taxable (loss) income (in thousands, except per unit data): 2004 2003 Net (loss) income as reported $ (1,218) $ 4,029 Add (deduct) Gain on sale -- 1,552 Casualty (9) (74) Depreciation differences 709 581 Amortization of discounts 52 52 Unearned income (9) (17) Other (232) 731 Federal taxable (loss) income $ (707) $ 6,854 Federal taxable (loss) income per limited partnership unit $ (565.68) $4,065.09 The following is a reconciliation between the Partnership's reported amounts and Federal tax basis of net liabilities (in thousands): Net liabilities as reported $ (4,798) Land and buildings 2,427 Accumulated depreciation (5,666) Other 977 Net liabilities - Federal tax basis $ (7,060) Note D - Transactions with Affiliated Parties The Partnership has no employees and depends 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 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 $333,000 and $317,000 for the years ended December 31, 2004 and 2003, respectively, which is included in operating expenses and loss from discontinued operations. An affiliate of the Managing General Partner charged the Partnership reimbursement of accountable administrative expenses amounting to approximately $228,000 and $207,000 for the years ended December 31, 2004 and 2003, respectively, which is included in general and administrative expense and investment properties. The portion of these reimbursements included in investment properties for the years ended December 31, 2004 and 2003 are fees related to construction management services provided by an affiliate of the Managing General Partner of approximately $54,000 and $8,000, respectively. The fees are calculated based on a percentage of current year additions to investment properties. At December 31, 2004, the Partnership owed an affiliate of the Managing General Partner approximately $53,000 of accrued accountable administrative expenses, which is included in due to affiliates. In addition to reimbursement for services of affiliates, the Partnership paid an affiliate of the Managing General Partner approximately $10,000 for loan costs related to the refinancing of Big Walnut Apartments during the year ended December 31, 2003. These costs were capitalized and are included in other assets on the consolidated balance sheet. In accordance with the Partnership Agreement, an affiliate of the Managing General Partner advanced the Partnership funds to cover operational expenses, real estate taxes and capital improvements and to assist in the closing of the refinancing required at Reflections Apartments of approximately $545,000 and $7,243,000 during the years ended December 31, 2004 and 2003, respectively. The Partnership repaid approximately $682,000 and $5,577,000 during the same periods. At December 31, 2004, the amount of the outstanding loans and accrued interest was approximately $8,632,000 and is shown as due to affiliate on the accompanying consolidated balance sheet. Interest on advances is charged at prime plus 1% or 6.25% at December 31, 2004. Interest expense was approximately $452,000 and $436,000 for the years ended December 31, 2004 and 2003, respectively. The Partnership paid approximately $316,000 and $599,000 in interest during the years ended December 31, 2004 and 2003, 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. The Partnership accrued a real estate commission due to the Managing General Partner of $48,000 upon the sale of Shoppes at River Rock during the year ended December 31, 1999. During 2002, the Partnership paid $30,000 of this amount to an unaffiliated third party as part of a settlement regarding brokerage services. Approximately $18,000 is accrued at December 31, 2004 and is included in other liabilities in the accompanying consolidated balance sheet. Payment of this 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 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 years ended December 31, 2004 and 2003, the Partnership was charged by AIMCO and its affiliates approximately $85,000 and $54,000, respectively, for insurance coverage and fees associated with policy claims administration. In addition to its indirect ownership of the managing and associate general partner interest in the Partnership, AIMCO and its affiliates owned 656.50 limited partnership units ("Units") in the Partnership representing 53.62% of the outstanding Units at December 31, 2004. 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 53.62% 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. Note E - Sale of Investment Property 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 year ended December 31, 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 loss from discontinued operations on the accompanying consolidated statement of operations. The Partnership used the proceeds received from the sale to make payments on the loan balances due to an affiliate of the Managing General Partner. The property's operations, a loss of approximately $208,000 for the year ended December 31, 2003 includes revenues of approximately $179,000. These amounts are included in loss from discontinued operations on the accompanying consolidated statements of operations. Included in discontinued operations for the year ended December 31, 2004 is approximately $47,000 of city income taxes related to the sale of the property. Note F - Investment Properties and Accumulated Depreciation Initial Cost To Partnership (in thousands)
Buildings Net Cost And Related Capitalized Personal Subsequent to Apartment Properties Encumbrances Land Property Acquisition (in thousands) (in thousands) Big Walnut Apartments $ 5,442 $ 520 $ 6,505 $ 3,705 The Trails Apartments 4,455 586 7,054 2,319 Reflections Apartments 13,213 847 9,684 19,628 23,110 Less unamortized discounts (657) Total $22,453 $ 1,953 $23,243 $25,652
Gross Amount At Which Carried At December 31, 2004 (in thousands)
Buildings And Related Personal Accumulated Date of Date Depreciable Description Land Property Total Depreciation Construction Acquired Life-Years Apartment Properties Big Walnut $ 520 $10,210 $10,730 $ 7,099 1971 03/28/85 5/25 The Trails 586 9,373 9,959 6,830 1984-1985 08/30/85 5/25 Reflections 847 29,312 30,159 11,207 1970-1975 09/30/85 5/25 Totals $1,953 $48,895 $50,848 $25,136
Reconciliation of "Investment Properties and Accumulated Depreciation" Years Ended December 31, 2004 2003 (in thousands) Investment Properties Balance at beginning of year $ 50,024 $ 54,265 Property improvements 825 6,292 Write-offs (1) (17) Sale of investment property -- (10,516) Balance at end of year $ 50,848 $ 50,024 Accumulated Depreciation Balance at beginning of year $ 22,669 $ 27,242 Additions charged to expense 2,468 2,080 Write-offs (1) (12) Sale of investment property -- (6,641) Balance at end of year $ 25,136 $ 22,669 The aggregate cost of the real estate for Federal income tax purposes at December 31, 2004 and 2003, is approximately $53,275,000 and $53,152,000 respectively. The accumulated depreciation taken for Federal income tax purposes at December 31, 2004 and 2003, is approximately $30,802,000 and $29,043,000, respectively. Note G - Casualty Events During the year ended December 31, 2003 a net casualty gain of approximately $8,000 was recorded at Big Walnut Apartments. The casualty gain related to a fire at the property in March 2003 that damaged two apartment units. 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 year ended December 31, 2004, the Partnership received additional proceeds of approximately $9,000, which were recognized as a casualty gain. Note H - Contingencies 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 captioned Heller v. Insignia Financial Group (the "Heller action") was filed against the same defendants that are named in the Nuanes action. 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 ("Objector") filed an appeal (the "Appeal") seeking to vacate and/or reverse the order approving the settlement and entering judgment thereto. On November 24, 2003, the Objector filed an application requesting the court order AIMCO to withdraw settlement tender offers it had commenced, refrain from making further offers pending the appeal and auction any units tendered to third parties, contending that the offers did not conform with the terms of the settlement. Counsel for the Objector (on behalf of another investor) had alternatively requested the court take certain action purportedly to enforce the terms of the settlement agreement. On December 18, 2003, the court heard oral argument on the motions and denied them both in their entirety. The Objector filed a second appeal challenging the court's use of a referee and its order requiring Objector to pay those fees. On January 28, 2004, the Objector filed his opening brief in the Appeal. On April 23, 2004, the Managing General Partner and its affiliates filed a response brief in support of the settlement and the judgment thereto. The plaintiffs have also filed a brief in support of the settlement. On June 4, 2004, Objector filed a reply to the briefs submitted by the Managing General Partner and Plaintiffs. In addition both the Objector and plaintiffs filed briefs in connection with the second appeal. On March 21, 2005, the Court of Appeals issued opinions in both pending appeals. With regard to the settlement and judgment entered thereto, the Court of Appeals vacated the trial court's order and remanded to the trial court for further findings on the basis that the "state of the record is insufficient to permit meaningful appellate review". With regard to the second appeal, the Court of Appeals reversed the order requiring the Objector to pay referee fees. 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. As previously disclosed, AIMCO Properties L.P. and NHP Management Company, both affiliates of the Managing General Partner, are defendants in an action in the United States District Court, District of Columbia. The plaintiffs have styled their complaint as a collective action under the Fair Labor Standards Act ("FLSA") and seek 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, plaintiffs allege 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 defendants have filed an answer to the amended complaint denying the substantive allegations. Discovery relating to the certification of the collective action has concluded and briefing on the matter is underway. Although the outcome of any litigation is uncertain, AIMCO Properties, L.P. does not believe that the ultimate outcome will have a material adverse effect on its financial condition or results of operations. Similarly, the Managing General Partner does not believe that the ultimate outcome will have a material adverse effect on the Partnership's consolidated financial condition or results of operations. 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. Environmental Various Federal, state and local laws subject property owners or operators to liability for management, and the costs of removal or remediation, of certain hazardous substances present on a property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release or presence of the hazardous substances. The presence of, or the failure to manage or remedy properly, hazardous substances may adversely affect occupancy at affected apartment communities and the ability to sell or finance affected properties. In addition to the costs associated with investigation and remediation actions brought by government agencies, the presence of hazardous substances on a property could result in claims by private plaintiffs for personal injury, disease, disability or other infirmities. Various laws also impose liability for the cost of removal, remediation or disposal of hazardous substances through a licensed disposal or treatment facility. Anyone who arranges for the disposal or treatment of hazardous substances is potentially liable under such laws. These laws often impose liability whether or not the person arranging for the disposal ever owned or operated the disposal facility. In connection with the ownership and operation of its properties, the Partnership could potentially be liable for environmental liabilities or costs associated with its properties. Mold The Partnership is aware of lawsuits against owners and managers of multifamily properties asserting claims of personal injury and property damage caused by the presence of mold, some of which have resulted in substantial monetary judgments or settlements. The Partnership has only limited insurance coverage for property damage loss claims arising from the presence of mold and for personal injury claims related to mold exposure. Affiliates of the Managing General Partner have implemented a national policy and procedures to prevent or eliminate mold from its properties and the Managing General Partner believes that these measures will eliminate, or at least minimize, the effects that mold could have on residents. To date, the Partnership has not incurred any material costs or liabilities relating to claims of mold exposure or to abate mold conditions. Because the law regarding mold is unsettled and subject to change the Managing General Partner can make no assurance that liabilities resulting from the presence of or exposure to mold will not have a material adverse effect on the Partnership's consolidated financial condition or results of operations. SEC Investigation As previously disclosed, the Central Regional Office of the United States Securities and Exchange Commission (the "SEC") is conducting a formal investigation relating to certain matters. Although the staff of the SEC is not limited in the areas that it may investigate, AIMCO believes the areas of investigation include AIMCO's miscalculated monthly net rental income figures in third quarter 2003, forecasted guidance, accounts payable, rent concessions, vendor rebates, capitalization of payroll and certain other costs, and tax credit transactions. AIMCO is cooperating fully. AIMCO is not able to predict when the matter will be resolved. AIMCO does not believe that the ultimate outcome will have a material adverse effect on its consolidated financial condition or results of operations. Similarly, the Managing General Partner does not believe that the ultimate outcome will have a material adverse effect on the Partnership's consolidated financial condition or results of operations. Note I - Quarterly Adjustments During September 2003, the three-year redevelopment project at Reflections Apartments was completed. During the redevelopment process, the Partnership overcapitalized interest expense and certain operating costs and understated depreciation expense for the years ended December 31, 2003 and 2002 in connection with the accounting for the redevelopment. The net impact of correcting the overcapitalization of interest expense and operating costs resulted in a restatement of the first three quarters of 2003 of approximately $276,000 as a net increase to expense and the recording of approximately $211,000 of 2002 capitalized costs as an increase to expense during the fourth quarter of 2003. In addition, depreciation expense for Reflections Apartments was understated by approximately $329,000 during the first three quarters of 2003. The effect of the correction of the understatement of depreciation expense and the overcapitalization of interest expense and operating costs for the 2003 quarters is as follows (in thousands):
1st Quarter 2nd Quarter 3rd Quarter Interest and operating expense $ (116) $ (79) $ (81) Depreciation expense (62) (86) (181) $ (178) $ (165) $ (262) Net income (loss) previously reported $5,398 $ 101 $ (112) Net income (loss) as adjusted $5,220 $ (64) $ (374)
During 2003, the state of Indiana implemented a reassessment of property tax values. The Partnership appealed the reassessed property tax value of Reflections Apartments. In the state of Indiana property tax bills are paid one year in arrears. Thus, the 2003 property tax bills are received and paid in 2004. Due to the Partnership's appeal of the reassessed property value, the property tax accrual for 2004 and 2003 was based on the property tax value as estimated by a third party property tax specialist. During the fourth quarter of 2003, the Partnership recorded an adjustment to reflect the property value estimated by the specialist and reduced the accrued property taxes and tax expense by approximately $73,000. During September 2004, the Partnership was successful in its appeal and the assessed value of Reflections Apartments was reduced for tax years 2002, 2003 and 2004. During the year ended December 31, 2004 the Partnership recorded a receivable of approximately $141,000 for a refund related to 2002 taxes paid in 2003, recorded a reduction of tax expense of approximately $81,000 for 2003 taxes paid in 2004 and reduced the accrual for estimated 2004 taxes to be paid in 2005 by approximately $41,000. As a result of the settlement, the Partnership reduced previously capitalized property tax expenses by approximately $74,000. Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures None. Item 8a. 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 fourth quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Partnership's internal control over financial reporting. Item 8b. Other Information None. PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act Davidson Diversified Real Estate II, L.P. (the "Registrant" - or the "Partnership") does not have any directors or officers. The Managing General Partner of the Partnership is Davidson Diversified Properties, Inc. The names and ages of, as well as the position and offices held by the present directors and officers of the Managing General Partner are set forth below. There are no family relationships between or among any directors and officers. Martha L. Long 45 Director and Senior Vice President Harry G. Alcock 42 Director and Executive Vice President Miles Cortez 61 Executive Vice President, General Counsel and Secretary Patti K. Fielding 41 Executive Vice President Paul J. McAuliffe 48 Executive Vice President and Chief Financial Officer Thomas M. Herzog 42 Senior Vice President and Chief Accounting Officer Stephen B. Waters 43 Vice President Martha L. Long has been a Director and Senior Vice President of the Managing General Partner since February 2004. Ms. Long has been with AIMCO since October 1998 and has served in various capacities. From 1998 to 2001, Ms. Long served as Senior Vice President and Controller of AIMCO and the Managing General Partner. During 2002 and 2003, Ms. Long served as Senior Vice President of Continuous Improvement for AIMCO. Harry G. Alcock was appointed as a Director of the Managing General Partner in October 2004 and was appointed Executive Vice President of the Managing General Partner in February 2004 and has been Executive Vice President and Chief Investment Officer of AIMCO since October 1999. Prior to October 1999 Mr. Alcock served as a Vice President of AIMCO from July 1996 to October 1997, when he was promoted to Senior Vice President-Acquisitions where he served until October 1999. Mr. Alcock has had responsibility for acquisition and financing activities of AIMCO since July 1994. Miles Cortez was appointed Executive Vice President, General Counsel and Secretary of the Managing General Partner in February 2004 and of AIMCO in August 2001. Prior to joining AIMCO, Mr. Cortez was the senior partner of Cortez Macaulay Bernhardt & Schuetze LLC, a Denver law firm, from December 1997 through September 2001. Patti K. Fielding was appointed Executive Vice President - Securities and Debt of the Managing General Partner in February 2004 and of AIMCO in February 2003. Ms. Fielding was appointed Treasurer of AIMCO in January 2005. Ms. Fielding is responsible for debt financing and the treasury department. Ms. Fielding previously served as Senior Vice President - Securities and Debt of AIMCO from January 2000 to February 2003. Ms. Fielding joined AIMCO in February 1997 as a Vice President. Paul J. McAuliffe has been Executive Vice President and Chief Financial Officer of the Managing General Partner since April 2002. Mr. McAuliffe has served as Executive Vice President of AIMCO since February 1999 and was appointed Chief Financial Officer of AIMCO in October 1999. From May 1996 until he joined AIMCO, Mr. McAuliffe was Senior Managing Director of Secured Capital Corp. Thomas M. Herzog was appointed Senior Vice President and Chief Accounting Officer of the Managing General Partner in February 2004 and of AIMCO in January 2004. Prior to joining AIMCO in January 2004, Mr. Herzog was at GE Real Estate, serving as Chief Accounting Officer & Global Controller from April 2002 to January 2004 and as Chief Technical Advisor from March 2000 to April 2002. Prior to joining GE Real Estate, Mr. Herzog was at Deloitte & Touche LLP from 1990 until 2000. Stephen B. Waters was appointed Vice President of the Managing General Partner in April 2004. Mr. Waters previously served as a Director of Real Estate Accounting since joining AIMCO in September 1999. Mr. Waters has responsibilities for real estate and partnership accounting with AIMCO. One or more of the above persons are also directors and/or officers of a general partner (or general partner of a general partner) of limited partnerships which either have a class of securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934, or are subject to the reporting requirements of Section 15(d) of such Act: Further, one or more of the above persons are also directors and/or officers of Apartment Investment and Management Company and the general partner of AIMCO Properties, L.P., entities that have a class of securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934, or are subject to the reporting requirements of Section 15 (d) of such Act. The board of directors of the Managing General Partner does not have a separate audit committee. As such, the board of directors of the Managing General Partner fulfills the functions of an audit committee. The board of directors has determined that Martha L. Long meets the requirement of an "audit committee financial expert". The directors and officers of the Managing General Partner with authority over the Partnership are all employees of subsidiaries of AIMCO. AIMCO has adopted a code of ethics that applies to such directors and officers that is posted on AIMCO's website (www.AIMCO.com). AIMCO's website is not incorporated by reference to this filing. Item 10. Executive Compensation None of the directors and officers of the Managing General Partner received any remuneration from the Partnership. Item 11. Security Ownership of Certain Beneficial Owners and Management Except as noted below, no person or entity was known by the Partnership to be the beneficial owner of more than 5% of the Limited Partnership Units of the Partnership as of December 31, 2004. Entity Number of Units Percentage Cooper River Properties, LLC 122.75 10.03% (an affiliate of AIMCO) AIMCO IPLP, L.P. 35.75 2.92% (an affiliate of AIMCO) Davidson Diversified Properties, Inc. 0.25 0.02% (an affiliate of AIMCO) AIMCO Properties, L.P. 497.75 40.65% (an affiliate of AIMCO) Cooper River Properties, LLC, AIMCO IPLP, L.P. and Davidson Diversified Properties, Inc., are indirectly ultimately owned by AIMCO. Their business address is 55 Beattie Place, Greenville, SC 29602. AIMCO Properties, L.P. is indirectly ultimately controlled by AIMCO. Its business address is 4582 S. Ulster St. Parkway, Suite 1100, Denver, Colorado 80237. No director or officer of the Managing General Partner owns any Units. Item 12. Certain Relationships and Related Transactions The Partnership has no employees and depends 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 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 $333,000 and $317,000 for the years ended December 31, 2004 and 2003, respectively, which is included in operating expenses and loss from discontinued operations. An affiliate of the Managing General Partner charged the Partnership reimbursement of accountable administrative expenses amounting to approximately $228,000 and $207,000 for the years ended December 31, 2004 and 2003, respectively, which is included in general and administrative expense and investment properties. The portion of these reimbursements included in investment properties for the years ended December 31, 2004 and 2003 are fees related to construction management services provided by an affiliate of the Managing General Partner of approximately $54,000 and $8,000, respectively. The fees are calculated based on a percentage of current year additions to investment properties. At December 31, 2004, the Partnership owed an affiliate of the Managing General Partner approximately $53,000 of accrued accountable administrative expenses, which is included in due to affiliates. In addition to reimbursement for services of affiliates, the Partnership paid an affiliate of the Managing General Partner approximately $10,000 for loan costs related to the refinancing of Big Walnut Apartments during the year ended December 31, 2003. These costs were capitalized and are included in other assets on the consolidated balance sheet. In accordance with the Partnership Agreement, an affiliate of the Managing General Partner advanced the Partnership funds to cover operational expenses, real estate taxes and capital improvements and to assist in the closing of the refinancing required at Reflections Apartments of approximately $545,000 and $7,243,000 during the years ended December 31, 2004 and 2003, respectively. The Partnership repaid approximately $682,000 and $5,577,000 during the same periods. At December 31, 2004, the amount of the outstanding loans and accrued interest was approximately $8,632,000 and is shown as due to affiliate on the accompanying consolidated balance sheet. Interest on advances is charged at prime plus 1% or 6.25% at December 31, 2004. Interest expense was approximately $452,000 and $436,000 for the years ended December 31, 2004 and 2003, respectively. The Partnership paid approximately $316,000 and $599,000 in interest during the years ended December 31, 2004 and 2003, 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. The Partnership accrued a real estate commission due to the Managing General Partner of $48,000 upon the sale of Shoppes at River Rock during the year ended December 31, 1999. During 2002, the Partnership paid $30,000 of this amount to an unaffiliated third party as part of a settlement regarding brokerage services. Approximately $18,000 is accrued at December 31, 2004 and is included in other liabilities in the accompanying consolidated balance sheet. Payment of this 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 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 years ended December 31, 2004 and 2003, the Partnership was charged by AIMCO and its affiliates approximately $85,000 and $54,000, respectively, for insurance coverage and fees associated with policy claims administration. In addition to its indirect ownership of the managing and associate general partner interest in the Partnership, AIMCO and its affiliates owned 656.50 limited partnership units ("Units") in the Partnership representing 53.62% of the outstanding Units at December 31, 2004. 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 53.62% 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. Item 13. Exhibits See attached Exhibit Index. Item 14. Principal Accountant Fees and Services The Managing General Partner has reappointed Ernst & Young LLP as independent auditors to audit the financial statements of the Partnership for 2005. The aggregate fees billed for services rendered by Ernst & Young LLP for 2004 and 2003 are described below. Audit Fees. Fees for audit services totaled approximately $43,000 and $56,000 for 2004 and 2003, respectively. Fees for audit services also include fees for the reviews of the Partnership's Quarterly Reports on Form 10-QSB. Tax Fees. Fees for tax services totaled approximately $19,000 and $27,000, for 2004 and 2003, respectively. 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/Martha L. Long Martha L. Long Senior Vice President /s/Stephen B. Waters By: Stephen B. Waters Vice President Date: March 31, 2005 In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. /s/Harry G. Alcock Director and Executive Date: March 31, 2005 Harry G. Alcock Vice President /s/Martha L. Long Director and Senior Vice Date: March 31, 2005 Martha L. Long President /s/Stephen B. Waters Vice President Date: March 31, 2005 Stephen B. Waters DAVIDSON DIVERSIFIED REAL ESTATE II, LP EXHIBIT INDEX Exhibit Number Description of Exhibit 3 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. 3B 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. 4 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. 4A Certificate of Amendment to 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. 4B 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. 10I Contract for Sale of Real Estate for Big Walnut Apartments dated December 6, 1984 between Community Development Company, an Ohio limited partnership and Tennessee Trust Company, as Trustee is incorporated by reference to Exhibit 10(b) to the Registrant's Current Report on Form 8-K dated March 28, 1985. 10J Assignment of Contract for Sale of Real Estate dated March 22, 1985 between Tennessee Trust Company, Trustee, and the Registrant, relating to assignment of Purchase Agreement for Big Walnut Apartments is incorporated by reference to Exhibit 10(a) to the Registrant's Current Report on Form 8-K dated March 28, 1985. 10K Contract for Sale of Real Estate for The Trails Apartments dated July 31, 1985 between Trails of Nashville Associates, Ltd., a Tennessee limited partnership by reference to Exhibit 10(b) to the Registrant's Current Report on Form 8-K dated August 30, 1985. 10L Assignment of Contract for Sale of Real Estate dated August 28, 1985 between Tennessee Trust Company, as Trustee and the Registrant, relating to assignment of Contract for Sale of Real Estate for The Trails Apartments is incorporated by reference to Exhibit 10(a) to the Registrant's Current Report on Form 8-K dated August 30, 1985. 10M Contract for Sale of Real Estate for Greensprings Manor Apartments dated July 15, 1985 between Greensprings Apartments Associates, an Indiana limited partnership and Tennessee Trust Company, as Trustee, is incorporated by reference to Exhibit 20(d) to the Registrant's Current Report on Form 8-K dated August 30, 1985. 10N Assignment of Contract for Sale of Real Estate dated August 28, 1985 between Tennessee Trust Company, as Trustee and the Registrant, relating to assignment of Contract for Sale of Real Estate for Greensprings Manor Apartments is incorporated by reference to Exhibit 10(c) to the Registrant's Current Report on Form 8-K dated August 30, 1985. 10W Deed of Trust and Security Agreement dated December 1, 1984 between Trails of Nashville Associates, Ltd., and Capital Holding Corporation relating to The Trails Apartments is incorporated by reference to Exhibit 10QQ to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10X Note dated December 28, 1984 executed by Trails of Nashville Associates, Ltd., payable to The Industrial Development Board of the Metropolitan Government of Nashville and Davidson County relating to The Trails Apartments is incorporated by reference to Exhibit 10RR to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10GG Assignment of Limited Partnership Interest of Freeman Equities, Limited, dated December 31, 1991 between Davidson Diversified Properties, Inc. and Insignia Jacques-Miller, L.P. is incorporated by reference to Exhibit 10KKK to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10HH Assignment of General Partner Interests of Freeman Equities, Limited, dated December 31, 1991 between Davidson Diversified Properties, Inc. and MAE GP Corporation is incorporated by reference to Exhibit 10LLL to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10II Stock certificate, dated December 31, 1991 showing ownership of 1,000 shares of Davidson Diversified Properties, Inc. by MAE GP Corporation is incorporated by reference to Exhibit 10MMM to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10OO Multifamily Note secured by a Mortgage or Deed of Trust dated September 16, 2002, between Big Walnut, L.P. and GMAC Commercial Mortgage Corporation, a California Corporation, related to Big Walnut Apartments is incorporated by reference to the exhibit filed with the Form 10-QSB dated September 30, 2002. 10.4 Purchase and Sale Contract between Registrant and Connor & Murphy, Ltd., an Ohio limited liability company, effective November 26, 2002, for the sale of Lafontenay I & II Apartments incorporated by reference to the Registrant's Current Report on Form 8-K dated January 30, 2003. 10.5 Assignment and Assumption of Sale Contract between Connor & Murphy, Ltd., an Ohio limited liability company, and Lafontenay Apartments, LLC, an Ohio limited liability company, dated January 22, 2003 incorporated by reference to the Registrant's Current Report on Form 8-K dated January 30, 2003. 10.6 Promissory Note dated December 11, 2003 between AIMCO Greenspring L.P., a Delaware limited partnership, and Golden American Life Insurance Company, a Delaware corporation incorporated by reference to the Registrant's Current Report on Form 8-K dated December 11, 2003. 10.7 Mortgage, Security Agreement, Financing Statement and Fixture Filing dated December 11, 2003 between AIMCO Greenspring L.P., a Delaware limited partnership, and Golden American Life Insurance Company, a Delaware corporation incorporated by reference to the Registrant's Current Report on Form 8-K dated December 11, 2003. 10.8 Assignment of Rents and Leases dated December 11, 2003 between AIMCO Greenspring L.P., a Delaware limited partnership, and Golden American Life Insurance Company, a Delaware corporation incorporated by reference to the Registrant's Current Report on Form 8-K dated December 11, 2003. 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. 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. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99A Agreement of Limited Partnership for Big Walnut, L.P. between Davidson Diversified Properties, Inc. and Davidson Diversified Real Estate II, L.P. entered into on August 23, 1991 is incorporated by reference to Exhibit 99A to the Registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1992. Exhibit 31.1 CERTIFICATION I, Martha L. Long, certify that: 1. I have reviewed this annual report on Form 10-KSB 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 small business issuer as of, and for, the periods presented in this report; 4. The small business issuer'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 small business issuer 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 small business issuer, 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 small business issuer'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 small business issuer's internal control over financial reporting that occurred during the small business issuer's most recent fiscal quarter (the small business issuer's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuer's internal control over financial reporting; and 5. The small business issuer's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuer's auditors and the audit committee of the small business issuer'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 small business issuer'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 small business issuer's internal control over financial reporting. Date: March 31, 2005 /s/Martha L. Long Martha L. Long Senior Vice President of Davidson Diversified Properties, Inc., equivalent of the chief executive officer of the Partnership Exhibit 31.2 CERTIFICATION I, Stephen B. Waters, certify that: 1. I have reviewed this annual report on Form 10-KSB 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 small business issuer as of, and for, the periods presented in this report; 4. The small business issuer'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 small business issuer 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 small business issuer, 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 small business issuer'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 small business issuer's internal control over financial reporting that occurred during the small business issuer's most recent fiscal quarter (the small business issuer's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuer's internal control over financial reporting; and 5. The small business issuer's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuer's auditors and the audit committee of the small business issuer'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 small business issuer'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 small business issuer's internal control over financial reporting. Date: March 31, 2005 /s/Stephen B. Waters Stephen B. Waters Vice President 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 Annual Report on Form 10-KSB of Davidson Diversified Real Estate II, L.P. (the "Partnership"), for the year ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Martha L. Long, as the equivalent of the chief executive officer of the Partnership, and Stephen B. Waters, 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/Martha L. Long Name: Martha L. Long Date: March 31, 2005 /s/Stephen B. Waters Name: Stephen B. Waters Date: March 31, 2005 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.