10-K/A 1 pro10ka.txt DECEMBER 31, 2001 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A Annual Report Pursuant to Section 13 or 15(d) Of the Securities Exchange Act of 1934 For the Year Ended December 31, 2001 Commission File No. 0-16950 Prometheus Income Partners, a California limited partnership ------------------------------------------------------------ (Exact Name of Registrant as Specified in its Charter) California 77-0082138 -------------------------------------------- --------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 350 Bridge Parkway Redwood City, CA 94065-1517 -------------------------------------------- --------------------- (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (650) 596-5300 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Units of Limited Partnership Interest Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- No market for the Units of Limited Partnership Interest exists and therefore a market value for such Units cannot be determined. DOCUMENTS INCORPORATED BY REFERENCE Prospectus, dated February 12, 1987, and Supplement No. 1, dated September 18, 1987, incorporated into Registration Statement Form S-11 (Registration #33-9164), thereto filed pursuant to Section 424(b) under the Securities Act of 1933, and Solicitation/Recommendation Statement pursuant to Section 14(d)(4) of the Securities Exchange Act of 1934, Schedule 14D-9, dated November 4, 1996 and Schedules 14D-91A, Amendments 1, 2 and 3, dated November 15, 1996, December 12, 1996 and December 20, 1996, respectively are incorporated into Parts I, II, III and IV. Exhibit index located on page 23 Table of Contents Form 10-K/A Part I Page Item 1 Business......................................................... 3 Item 2 Properties........................................................4 Item 3 Legal Proceedings.................................................5 Item 4 Submission of Matters to Vote of Security Holders.................5 Part II Item 5 Market for Registrant's Units and Related Security Holder Matters..................................................6 Item 6 Selected Financial Data...........................................8 Item 7 Management's Discussion and Analysis of Financial Conditions and Results of Operations...........................10 Item 8 Financial Statements and Supplementary Data......................20 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............................20 Part III Item 10 Directors and Executive Officers of the Registrant...............21 Item 11 Executive Compensation...........................................21 Item 12 Security Ownership of Certain Beneficial Owners and Management...22 Item 13 Certain Relationships and Related Transactions...................22 Part IV Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K.........................................23-38 PART I ITEM 1. BUSINESS Prometheus Income Partners, a California limited partnership, (hereinafter referred to as "Partnership" or "Registrant") was formed on April 15, 1985, under the California Revised Limited Partnership Act. Prometheus Development Co., Inc., a California corporation, is the General Partner of the Partnership. The principal business of the Partnership is to invest in, construct, hold, operate, and ultimately sell two residential rental properties in Santa Clara, California, Alderwood Apartments ("Alderwood") and Timberleaf Apartments ("Timberleaf"), (collectively, the "Properties"). The principal investment objectives of the Partnership are to preserve and protect the Partnership's capital, to obtain capital appreciation from the sale of the Properties, and, beginning in 1987, to provide "tax sheltered" distributions of cash from operations due to the cost recovery and other non-cash tax deductions available to the Partnership. See Item 7, Liquidity and Capital Resources and Construction Defects discussions concerning deferment and resumption of distributions. For a further description of the Properties and the business of the Partnership; see Item 2 below, and the section entitled "Business of the Partnership" (pages 24-26) and "Properties" (pages 27-35) in the Prospectus. For financial information, see Item 8, below. Beginning in February 1987 through December 1987, the Partnership offered and sold 19,000 Units of Limited Partnership Interests ("Units") for $19,000,000. The net proceeds of this offering, together with the proceeds of the permanent financing, were used to satisfy construction loans with respect to Alderwood and Timberleaf and to exercise the purchase option for the Alderwood land site. The Partnership's investments in real property are affected by, and subject to, the general competitive conditions of the residential real estate rental market in the Santa Clara area. The Partnership's Properties are located in an area which contains numerous other competitive residential rental properties. The Partnership is engaged solely in the business of real estate investment. The business of the Partnership is not seasonal. The Partnership does not engage in foreign operations or derive revenues from foreign sources. The Partnership has no employees, officers or directors. The officers and employees of the General Partner and its Affiliates perform services for the Partnership. The income of the Properties may be affected by factors outside the Partnership's control. For example, changes in the supply of rental properties, population shifts, the availability of mortgage funds or changes in zoning laws could affect apartment rental rates. It is also possible that some form of rent control may be legislated at the state or local level. Expenses of operating the Properties, such as administrative and maintenance costs and real estate taxes, are subject to change due to inflation, supply factors or legislation. These increases in expenses may be offset by increases in rental rates, although such increases may be limited due to market conditions or other factors as discussed above. Certain expenses, such as debt service, are at fixed rates and are not affected by inflation. The General Partner is unable to predict the effect, if any, of such events on the future operations of the Partnership. There is no assurance there will be a ready market for the sale of the Properties or, if sold, such a sale would be made on favorable terms. 3 ITEM 2. PROPERTIES The Partnership has constructed two residential income-producing properties, Alderwood and Timberleaf, both in Santa Clara, California. The City of Santa Clara, with a population of approximately 104,000, is the third largest city in Santa Clara County, commonly referred to as Silicon Valley, is approximately 47 miles south of San Francisco, encompasses 1,300 square miles and has a population of approximately 1.7 million people, making it the most populous of the nine counties in the greater San Francisco Bay Area. The Alderwood luxury garden apartment complex is located at 900 Pepper Tree Lane in Santa Clara, California. Construction began in November 1985 and was completed by December 31, 1986. The complex contains 234 apartment units housed in 19 two-story buildings on a 9.4 acre site. Covered and uncovered parking for 468 cars is provided. See Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations, for a discussion of current operations. The Timberleaf luxury garden apartment complex is located at 2147 Newhall Street in Santa Clara, California. Construction began in November 1985 and was completed by December 31, 1986. The complex contains 124 apartment units housed in nine buildings of two or three stories on a five acre site. Covered and uncovered parking for 248 cars is provided. See Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations, for a discussion of current operations. Alderwood and Timberleaf are encumbered by first mortgage liens, which secure promissory notes payable in the amount of $16,488,000 and $9,060,000, respectively. The notes payable (collectively, the "Notes") bear interest at the rate of 6.99% per annum for Alderwood, and 7.09% per annum for Timberleaf, and mature in 2007. The Notes, if prepaid more than thirty (30) days from maturity, are subject to a prepayment penalty. 4 ITEM 3. LEGAL PROCEEDINGS See Item 7 for a discussion of construction defects. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the period covered by this report. 5 PART II ITEM 5. MARKET FOR THE REGISTRANT'S UNITS AND RELATED SECURITY HOLDER MATTERS A) No public trading market exists or is expected to be established for the Registrant's Units. The Units were issued by the Partnership for $1,000 per Unit. The General Partner established a Limited Liquidity Plan which commenced in 1989 and provides Limited Partners with the option, subject to certain conditions, to have their Units repurchased by the Partnership (or a person designated by the Partnership). A further description of the repurchase terms can be found in the section entitled "Business of the Partnership-Limited Liquidity Plan" (pages 24-25) in the Prospectus. B) At December 31, 2001, the 18,995 outstanding Units were held by 979 investors. C) Tender Offers To Purchase Units During 1996, competing tender offers were made for limited partner interests ("Units") in the Partnership. One tender offer from Prom Investment Partners, LLC ("Prom"), an unrelated third party, commenced in December 1996. The second tender offer from PIP Partners - General, LLC ("PIP Partners"), an affiliate of the General Partner, commenced in January 1997. An aggregate 2,750.5 Units were tendered and purchased by these bidders -- 1,430 to PIP Partners and 1,320.5 to Prom, or 7.5283% and 6.9518% of the total outstanding Units, respectively. Under the terms of the Partnership Agreement, the transfers were effective as of April 1, 1997. All Units were purchased for $495 per unit. During 1998, Bond Purchase, LLC, an unrelated third party, made an unsuccessful offer to purchase Units. The offer was for less than 5% of outstanding Units and nominal legal costs were incurred by the Partnership. On October 16, 1998, Bond Purchase, LLC cancelled its transfer request and no Units were acquired by it. On June 27, 2000, Everest Management, LLC ("Everest"), an unrelated third party, made a tender offer for up to 2% of the units, or 379 units, for $650 per unit. This tender expired by its terms on July 31, 2000. Under the terms of the Partnership Agreement, Everest was admitted as a limited partner on October 1, 2000 and January 1, 2001 with respect to 289 and 15 Units, respectively, that were tendered pursuant to this tender offer, for a total 1.600% of the outstanding Units. On March 5, 2001, Everest made another tender offer for up to 1.6% of the units, or 300 units, for $800 per unit. This tender originally was set to expire by its terms on March 30, 2001 but subsequently was extended by Everest to April 20, 2001. Under the terms of the Partnership Agreement, Everest Properties II, LLC was admitted as a limited partner on July 1, 2001 as to an additional 639.5 Units tendered pursuant to this tender offer, for a total 3.367% of the outstanding Units. Everest and its affiliates own a combined total of 943.5 Units or 4.9671% of the outstanding Units. On September 4, 2001, Equity Resource Lexington Fund, L.P., ("Equity Resource"), an unrelated third party, by letter to the limited partners, made a tender offer to purchase an unspecified number of units at a price of $700 per unit. By its terms, this offer was set to expire on October 4, 2001. By letter to the limited 6 partners dated October 29, 2001 from Equity Resource, the expiration of this tender offer was purportedly extended to November 29, 2001. Under the terms of the Partnership Agreement, Equity Resource was admitted as a limited partner with an effective date of January 1, 2002 with respect to 492 Units that were tendered pursuant to this tender offer, for a total of 2.5902% of the outstanding Units. D) Distributions to Limited Partners began with the quarter ending September 30, 1987. Cash distributions were suspended in 1996. See Item 7, Liquidity and Capital Resources and Construction Defects for discussions concerning the deferment and resumption of distributions. No distributions were made for 1997, 1998, 1999, 2000, and 2001. 7 ITEM 6. SELECTED FINANCIAL DATA The following represent selected financial data for the Partnership for the years ended December 31, 2001, 2000, 1999, 1998, and 1997. The data should be read in conjunction with the financial statements and related notes included elsewhere in this Form 10-K/A. The selected financial data presented below are unaudited. Refer also to Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations. For the Years Ended December 31, ------------------------------------------------------ 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- (Restated) (In Thousands, Except for Unit Data) Rental revenues $7,387 $6,695 $5,674 $5,578 $5,256 Net income $2,589 $2,409 $1,431 896 $477 Net income per $1,000 limited partnership unit $135 $126 $75 $47 $25 Cash and cash equivalents per $1,000 limited partnership unit $210 $186 $101 $62 $34 Number of units used in computation 18,995 18,995 18,995 18,995 18,995 Total assets $44,127 $31,088 $28,873 $27,830 $27,016 Notes payable $25,548 $25,879 $26,188 $26,476 $26,723 8 ITEM 6a. SELECTED FINANCIAL DATA The following represent selected financial data for the Partnership for the quarters ended March 31, June 30, September 30, and December 31, 2001 and 2000. The data should be read in conjunction with the financial statements and related notes included elsewhere in this Form 10-K/A. The selected financial data presented below are unaudited. Refer also to Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations.
For The Three Months Ended ----------------------------------------------------------------------------------- Dec 31, Sept. 30, June 30, Mar 31, Dec 31, Sept. 30, June 30, Mar 31, 2001 2001 2001 2001 2000 2000 2000 2000 ---- ---- ---- ---- ---- ---- ---- ---- (Restated) (In Thousands, Except For Unit Data) Rental revenues $1,747 $1,776 $1,935 $1,929 $1,856 $1,724 $1,595 $1,520 Net income $692 $599 $512 $786 $921 $602 $427 $459 Net income per $1,000 limited partnership unit $36 $31 $27 $41 $49 $31 $22 $24 Cash and cash equivalents per $1,000 limited partnership unit $210 $205 $208 $205 $186 $147 $115 $105 Number of units used in computation 18,995 18,995 18,995 18,995 18,995 18,995 18,995 18,995 Total assets $44,127 $32,845 $32,128 $31,769 $31,088 $30,176 $29,554 $29,296 Notes payable $25,548 $25,633 $25,716 $25,799 $25,879 $25,958 $26,036 $26,113
9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS The following discussion is based on the financial statements of the Partnership as of and for the years ended December 31, 2001, 2000 and 1999. This information should be read in conjunction with the accompanying financial statements and notes thereto, included in Item 14. Introduction ------------ The Partnership was organized in April 1985. Construction of Alderwood and Timberleaf commenced in November 1985 and was completed by December 1986. Lease-up activities began in November 1986 and continued through the third quarter of 1987. The Partnership Registration Statement was declared effective on February 12, 1987 and completed in December 1987. This Item should be read in conjunction with the financial statements, footnotes and other Items contained elsewhere in this report. Liquidity and Capital Resources ------------------------------- The primary sources of funding for the Partnership's activities through 1987 were capital contributions of its Limited Partners, construction financing and permanent financing. The Partnership obtained $15,800,000 in permanent financing in November 1987. These proceeds, together with the Limited Partners' capital contributions, were applied towards the various construction costs and offering expenses as outlined in the Prospectus. In addition, proceeds from the loan were used to purchase the previously leased Alderwood land site. Once lease-up began in 1986, operating expenses, debt service and Limited Partner distributions were funded from apartment rental receipts and cash reserves. Quarterly distributions have been suspended in order to continue building reserves for the potential cost of dealing with the construction defect problems. See Construction Defects below for a more comprehensive discussion of this matter. Each property has a non-recourse note payable (collectively the "Notes"), secured by a first deed of trust. These Notes bear fixed interest of 6.99% for Alderwood, and 7.09% for Timberleaf. The terms of the Notes and the Security Agreement, Disbursement Agreement and Assignment of Agreements (collectively the "Agreements") require that each property maintain a hardboard siding security account. These security accounts are additional collateral for the lender. Cash held in these security accounts was $3,384,000 and $2,486,000 for Alderwood and Timberleaf, respectively, as of December 31, 2001. Until the Completion Date, as defined in the Agreements, annually the Partnership is obligated to contribute an additional 10%, as defined in the Agreements, or monthly cash flow, whichever is less, and shall be deposited into each security account. Should the hardboard siding repairs not be completed by December 2002, or every two years thereafter, and insufficient cash has been accumulated to cure the defects based upon the lender's determination of the cost, then all cash flow shall be deposited into each applicable security account, as necessary, to fully fund the cost of construction. If the projected cash flow is insufficient to satisfy this deficiency contribution, then the Partnership has 60 days to fund the shortage over the projected cash flow. No withdrawals are permitted from the security accounts except to cure the siding defects. The lender shall have the right to hire its own consultants to review, approve and inspect the construction. All such reasonable fees and expenses incurred by the lender shall be paid by the Partnership. Should construction not be completed by the Completion Date due to an act of force majeure, the Completion Date can be further extended to complete the construction work. 10 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) The Partnership was involved in litigation involving construction defects at its Properties (see "Construction Defects" for a more comprehensive discussion of the matter). The Defendants have settled both the Alderwood and Timberleaf litigation. The $4,533,000 of Timberleaf net settlement proceeds were received by the Partnership in 2001, and are segregated in a reserve bank account and are designated as restricted cash in the balance sheet. Timberleaf's settlement proceeds, including accumulated interest income, total approximately $4,585,000 as of December 31, 2001. The Alderwood net settlement proceeds of $6,299,000 were received on March 5, 2002. A receivable for those net settlement proceeds was recorded in the balance sheet as of December 31, 2001. All the settlement proceeds, including accumulated interest income, is reserved for use to pay all siding related design and construction repair expenditures. Cash and cash equivalents not being held by the lender or from settlement proceeds are comprised of cash invested in market rate, checking and investment accounts. Cash balances were approximately $4,036,000, $3,568,000, and $1,942,000, at December 31, 2001, 2000 and 1999, respectively. Cash distributions will only resume when a determination has been made that the Partnership has adequate cash reserves (including restricted cash) to complete repairs of the construction defects in the Partnership's Properties. This determination can only be made when the costs to repair construction defects to the Partnership's Properties have been determined with a high degree of certainty. Therefore, it is uncertain when cash distributions will resume. As of the date of this report, the Partnership anticipates that following the receipt by the Partnership of all settlement proceeds in respect of the construction defects litigation, the Partnership will have sufficient reserves to enable it to begin distributions to limited partners during 2002. However, there can be no assurances given as to when distributions will actually resume and the level at which any such distributions will be made. The hardboard siding security accounts must be maintained until such time as the Partnership's lender has determined the repair work has been completed. In addition, if repairs of the Properties are not completed by December 2002, the Partnership's lender has the right to require the Partnership to retain additional cash collateral reserves, which could require further suspension of distributions to Limited Partners. Construction Defects -------------------- In June 1996, the General Partner became aware of defects in the hardboard siding used in both of the Partnership's Properties. On September 23, 1996, the Partnership filed two lawsuits (since settled) seeking recovery of costs to repair those defects from the manufacturer of the hardboard siding, as well as the general contractor, the subcontractors, and the architects involved in the original construction of the two Properties. Since June 1996, the General Partner has determined that the defects did not reduce the assets' value to an amount below their net book value, based on a comparison of future cash flows to the carrying amount of the Properties at the end of subsequent reporting periods. This continues to be the case at December 31, 2001. The General Partner has also determined that, although the construction defects may be substantial in nature, the Properties will continue to function as safe, inhabitable, income-generating Properties without a full repair of the defects for an indeterminate amount of time. As such, the Partnership has been under no obligation to undertake a major repair project to remedy the construction defects at either of the Properties. The Partnership has made certain emergency repairs to the Properties since June 1996, and has expensed those repair costs as incurred with no consideration of potential recoveries from the ongoing litigation or potential settlement thereof. As of December 31, 2001, the cost of emergency repairs charged to expense since June 1996 totaled approximately $3,457,000. This amount is not included in the Partnership's current estimates. 11 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) Construction Defects (Continued) --------------------- to repair construction defects. In 2001, the Partnership's litigation against the responsible parties was settled. In total, from all Alderwood and Timberleaf settlements, defendants agreed to pay the Partnership an aggregate of $14,600,000. The Partnership received net proceeds (after payment of attorney's fees, litigation costs and a litigation management fee of 3% of the gross settlement amount to an affiliate of the Partnership's General Partner) of $10,832,000. The net proceeds related to the Timberleaf property of $4,533,000 were received by the Partnership in 2001. The Alderwood litigation was settled on October 3, 2001 and net settlement proceeds of $6,299,000 were received by the Partnership on March 5, 2002. As such, a receivable for the Alderwood net settlement proceeds was recorded as of December 31, 2001. The General Partner believes that these settlements were, in substance, payment for non-operating costs to be incurred by the Partnership to repair the defects at both Properties. In 2001, upon learning that the defendants in the litigation were willing to resolve the lawsuits in return for a substantial settlement to the Partnership, the General Partner made the decision to utilize the proceeds of the settlement to undertake a major repair project related to the construction defects. The General Partner is currently engaged in the process of developing an updated repair plan, and anticipates that the repairs will occur during 2002 and 2003. In light of the settlement recovery, the General Partner is hopeful, that under prevailing circumstances and market conditions, it can develop a plan to repair the construction defects, including all costs associated with the repairs, (including rent concessions and lost rents) for approximately $12,500,000 to $14,000,000, an amount that exceeds the net settlement proceeds received by the Partnership. This preliminary projection of the cost to repair the construction defects is an estimate, and as such it could change in the near term due to certain factors that could be encountered in either the design engineering phase, and / or actual construction phase due to hidden defects that are not evident until the current siding is removed and the underlying wall and flooring structures are exposed and examined. As such, the cost to repair could change, and the change could be material to this preliminary projection. The Partnership has recorded a construction defects reserve liability of $10,832,000 in the accompanying Balance Sheet at December 31, 2001 equal to the net settlement proceeds. All construction repair expenditures up to $10,832,000 will be charged to the reserve liability and amounts in excess of $10,832,000, if any, will be expensed as incurred. None of the expenditures made to repair the construction defects will be capitalized, due to the fact that the repairs are not considered a betterment that will extend the life of the Partnership's assets. The construction defects repairs are intended to restore the assets to their original condition as though the defects had never existed. The expenditures for the repair costs will be made from cash reserves that the Partnership possesses at December 31, 2001, along with the cash from the net settlement proceeds received by the Partnership on March 5, 2002, including accumulated interest on all cash reserves. The terms of the Notes require each Property maintain a Hardboard Siding security account to cover potential liabilities with respect to defects in the Properties' hardboard siding, to the extent that the Partnership was unable to make sufficient recoveries from the responsible parties. These security accounts serve as additional collateral for the lender and, as of December 31, 2001, the Partnership has provided $5,852,000 toward these accounts. These security accounts must be maintained until such time as the Partnership's lender has determined that these accounts contain sufficient cash to complete the repairs of the Partnership's Properties. Additionally, the settlement proceeds of $4,585,000 related to the Timberleaf property, included accumulated interest income, have been segregated by the Partnership in a reserve bank account. The sum of these two amounts, or 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) Construction Defects (Continued) --------------------- $10,437,000, is reflected as restricted cash in the accompanying balance sheet as of December 31, 2001, as it will be utilized to fund the repair costs. The Securities and Exchange Commission encourages companies to disclose forward-looking information so that investors can better understand a company's future prospects and make informed investment decisions. This Annual Report on Form 10-K/A contains such forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "anticipate," "estimate," "expects," "projects," "intends," "plans," "believes" and words of similar substance used in connection with any discussion of future operations or financial performance identify forward-looking statements. In particular, statements relating to working capital, liquidity and the cost to repair construction defects are forward-looking statements. These forward-looking disclosures are found at various places throughout this document. Wherever they occur in this document, forward-looking disclosures are necessarily estimates reflecting judgments based on currently available information. However, these disclosures still involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking disclosures. These forward-looking disclosures should, therefore, be considered in light of various important factors, including those set forth in the preceding paragraphs. The limited partners are cautioned not to place undue reliance on these forward-looking disclosures, which speak only as of the date hereof. The Partnership disclaims any intent or obligation to update forward-looking disclosures, except as required by law. Moreover, the Partnership, through its General Partner, may from time to time make forward-looking disclosures about the matters described in this document or other matters concerning the Partnership. While the General Partner believes the estimated cost to repair the construction defects and estimate of the costs associated with the repairs and assumptions are reasonable, there can be no assurance that these estimates will prove to be accurate, and actual results may vary materially from those shown. These estimates were based upon a variety of estimates and assumptions. It is expected that there will be differences between the actual and estimated cost to repair the construction defects and all costs associated with the repairs may be materially higher or lower than those estimated. Inclusion of these estimates should not be regarded as an indication that the General Partner considers it an accurate prediction of future events. In light of the uncertainties inherent in forward-looking information of any kind, the inclusion of this projection in this document should not be regarded as a representation by the Partnership or its General Partner that the anticipated cost to repair the construction defects and all costs associated with the repairs will be achieved and limited partners are cautioned not to place undue reliance on this information. The Partnership is under no obligation, and expressly disclaims any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. All forward-looking statements contained herein are qualified in their entirety by the foregoing cautionary statements. 13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) Results of Operations --------------------- COMPARISON OF THE YEAR ENDED DECEMBER 31, 2001 TO THE YEAR ENDED DECEMBER 31, 2000. Following is a table, for comparative purposes, presenting the results of operations for the years ended December 31, 2001 and 2000. For the years ended December 31, 2001 2000 -------- -------- (Restated) (In Thousands) REVENUES Rental and other resident revenue $7,456 $6,783 Interest 415 464 -------- ------- Total revenues 7,871 7,247 -------- -------- EXPENSES Interest and amortization 1,837 1,860 Operating and administrative 2,763 2,360 Depreciation 682 618 ---------- --------- Total expenses 5,282 4,838 ---------- --------- NET INCOME $2,589 $2,409 ========== ========= For the years ended December 31, 2001 and 2000, the average occupied rent obtained from leased units, and the average occupancy percentages were as follows: Average Occupied Rental Rates ----------------------------- 2001 2000 ---- ---- One Bedroom Units $1,575 $1,641 Two Bedroom Units $1,931 $2,115 Average Occupancy ----------------- 2001 2000 ---- ---- Alderwood 96% 98% Timberleaf 95% 99% 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) RENTAL AND OTHER RESIDENT REVENUE: Both Properties are located in Santa Clara County, in an area commonly referred to as Silicon Valley. With the decline in the economy, and specifically in the high tech industry, the primary employer in the Silicon Valley, job growth no longer continued to climb as in prior years, and actually decreased by 45,000 jobs between December 31, 2000 and 2001. The fourth quarter ending December 31, 2001 saw unemployment rise to 6.1% from 1.5% at December 31, 2000. Commencing in the later half of 2000 and continuing into 2001, unemployment rose, new job growth was non-existent with jobs decreasing This decline in jobs, coupled with new housing units (both single family and multi-family) coming on line has resulted in a softening of the rental market. As a result, average rental rates obtained from leased units decreased 28.79% from 2000 to 2001. Concessions were utilized to increase occupancy, and to remain competitive in the Santa Clara market. At the same time, rental revenue as presented in the Statements of Income in Item 14 continues to appear strong, increasing 10% between years, due to residents whose leases had not yet reached the end of their term. As with newly leased units, upon lease expiration those current residents who did renew their leases, renewed at significantly reduced market rental rates. Rental revenues are recognized when contractually due based on the terms of signed lease agreements, which range in duration from month-to-month to one year. Average quarterly occupancy went from a high of 99% for Alderwood and Timberleaf, respectively as of the quarter ending December 31, 2000 to a low in the third quarter 2001 of 94% and 93%, respectively. Given the sharp decrease in employment, many residents terminated their leases early, while remaining contractually and economically bound to the terms of their lease agreement until their respective units were either re-leased or their lease expired. For those former residents whose units were leased before their lease expiration date, they remained obligated for the short fall in the rental rates through the end of their lease term. INTEREST INCOME: While more cash, including the Timberleaf net settlement proceeds, were placed in interest bearing accounts in 2001 as compared to 2000, less interest income was earned due to declining interest rates. OPERATING AND ADMINISTRATIVE EXPENSES: These expenses include on-site management, maintenance, utilities, marketing and other expenses related to earning rental revenues. Some of the operating expenses vary as occupancy changes throughout the year. Others, such as property taxes, do not fluctuate in response to changing occupancy levels. Operating expenses increased 17% or $403,000 between 2001 and 2000. The significant increase in expenses from 2000 to 2001 reflected the following. The softening residential rental market resulted in an increase in expenditures of $125,000 in (1) additional personnel for leasing and unit turnover maintenance; (2) turnover costs for unit cleaning, painting and minor refurbishment supplies, and labor in those instances where the work could not be accomplished by the resident staff; and (3) media advertising costs. Additionally, rising energy costs due to the California energy crisis added $33,000 in utility costs over 2000. Insurance premiums for liability and property coverage increased $21,000 year-to-year. Professional services increased $126,000 year-to-year, principally due to a change in accounting firms, and to the retention of an independent financial advisor to evaluate the fairness from a financial point of view of the consideration proposed to be paid by an affiliate of the General Partner to acquire limited partnership units in the Partnership held by limited partners unaffiliated with the General Partner. Management fees increased $59,000 due to the revenue stream (as noted in the Rental and Other Resident Revenue section above) and for management supervision fees on contracted major non-recurring maintenance and improvement projects. 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) INTEREST AND AMORTIZATION: Interest expense on the Notes, which both commenced in December 1997, is at a fixed rate of 6.99% per annum for Alderwood, and 7.09% per annum for Timberleaf and decreased $23,000 year-to-year. Monthly principal and interest payments under these Notes are $114,659 and $63,587, respectively. Amortization of financing costs remained constant between years at $30,000 per year. DEPRECIATION: Depreciation expense was $682,000 and $618,000 in 2001 and 2000, respectively, primarily due to the acquisition of assets. NET INCOME: Net income increased between years to $2,589,000 in 2001 from $2,409,000 in 2000. While newly leased rental rates and occupancy decreased between years rental revenue reported a net increase due to continuing rental revenue earned from leases executed before the rental market softened. Offsetting the revenue increase, were increased levels of expenditures associated with the softening residential rental market and for professional services. COMPARISON OF THE YEAR ENDED DECEMBER 31, 2000 TO THE YEAR ENDED DECEMBER 31, 1999. Following is a table, for comparative purposes, presenting the results of operations for the years ended December 31, 2000 and 1999. For the years ended December 31, 2000 1999 ---- ---- (In Thousands) REVENUES Rental $6,783 $5,856 Interest 464 250 ------- -------- Total revenues 7,247 6,106 ------- -------- EXPENSES Interest and amortization 1,860 1,881 Operating 2,360 2,221 Depreciation 618 573 ------- -------- Total expenses 4,838 4,675 ------- -------- NET INCOME $2,409 $1,431 ======= ======== 16 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) For the years ended December 31, 2000 and 1999, the average occupied rent obtained from leased units, and the average occupancy percentages were as follows: Average Occupied Rental Rates ----------------------------- 2000 1999 ---- ---- One Bedroom Units $1,641 $1,285 Two Bedroom Units $2,115 $1,567 Average Occupancy ----------------- 2000 1999 ---- ---- Alderwood 98% 97% Timberleaf 99% 97% RENTAL AND OTHER RESIDENT REVENUE: The Silicon Valley saw continued job growth and low unemployment between 1999 and 2000. The unemployment rate for the fourth quarter 2000 decreased to 1.5% from 2.3% in the fourth quarter of 1999. During 2000, 24,100 jobs were created, an increase of 2.4% over 1999. The low unemployment rate coupled with a robust job market in turn created a housing shortage driving up the value of housing prices -- both home prices and apartment rents. The strong residential rental market conditions allowed the maintenance of high occupancy without the need to offer concessions. Additionally, no new housing units permitted continued market rate growth in rental rates, as evidenced by average occupied rental rates increasing 27.48% from 1999 to 2000. While average occupied rent obtained from leased units increased 27.48% during 2000, the Statements of Income in Item 14, reflect rental revenues increasing 18%. The lower increase in rental revenue as compared to the average occupied rental rates from leased units is attributable to current residents whose leases had not yet reached the end of their term. As with newly leased units, upon lease expiration those current residents who renewed their leases, renewed at significantly higher market rental rates. Rental revenues are recognized when contractually due based on the terms of signed lease agreements, which range in duration from month-to-month to one year. INTEREST INCOME: Cash flow increased to $1,626,000 in 2000 as compared to $759,000 in 1999. This increase in cash invested in interest bearing accounts accounted for the more than doubling the interest earned in 2000 as compared to 1999. OPERATING AND ADMINISTRATIVE EXPENSES: These expenses include on-site management, maintenance, utilities, marketing and other expenses related to earning rental revenues. Some of the operating expenses vary as occupancy changes throughout the year. Others, such as property taxes, do not fluctuate in response to changing occupancy levels. Operating expenses increased 6% or $139,000 between 2000 and 1999. The significant increase in expenses from 1999 to 2000 reflected the following. Payroll increased $67,000 due principally to higher rental commissions and incentive bonuses related to the stronger market forcing units to turnover as residents either purchased homes or moved to other apartments; higher salaries as the shortage of high tech industry applicants increased salaries for all businesses in the rental market, and increases in benefits. Insurance premiums for liability and property coverage increased $12,000 year-to-year. Management fees increased $72,000 due to the revenue stream (as noted in the Rental and Other Resident Revenue section above) and 17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) for management supervision fees on contracted major non-recurring maintenance and improvement projects. INTEREST EXPENSE AND AMORTIZATION: Interest expense on the Notes, which both commenced in December 1997, is at a fixed rate of 6.99% per annum for Alderwood, and 7.09% per annum for Timberleaf. Monthly principal and interest payments under these notes are $114,659 and $63,587, respectively. Amortization of financing costs remained constant between years at $30,000 per year. DEPRECIATION: Depreciation expense was $618,000 and $573,000 in 2000 and 1999, respectively, primarily due to the acquisition of assets. NET INCOME: Net income increased $978,000 between years to $2,409,000 in 2000 from $1,431,000 in 1999, due principally to the strength of the rental market which contributed $927,000; interest income contributed $214,000, as reduced by an increase in expenses of $163,000, principally for expenditures relating to residential rental market conditions. Economic Environment -------------------- Both the national and California economy and specifically the economy of Santa Clara County in which the Partnership owns and manages its two Properties have been and continue to be in a recession. This has resulted in reduced occupancy rates, and reductions in market rental rates. The Partnership's property type and geographic location provide some degree of risk moderation but are not immune to a prolonged down cycle in the real estate market in which the Partnership operates. Although the Partnership believes it is well positioned to meet the challenges ahead, it is possible that further reductions in occupancy and market rental rates will result in reduction of rental revenues, operating income, cash flows. Inflation --------- Inflationary increases would likely have a negative effect on property operating results and such increases may be at a greater rate of increases than property rental rates in a period of recession. However, the ability to affect increases in rental rates may be impacted by market conditions such as the supply of rental housing or local economic conditions. Certain expenses, such as property taxes and debt service, may not be impacted by inflation. Property taxes are affected primarily by limits placed by legislation. Debt financing is at a fixed rate. The Partnership believes it effectively manages its Properties and other expenses but understands that a return to higher annual rates of inflation would result in increases to operating expenses. Critical Accounting Polices --------------------------- The Partnership's most significant accounting policies are described in the notes to the Financial Statements. The most critical policies relate to the categories of Related Party Transactions (Note 3), Debt and Debt Covenants (Notes 2, 4 and 6), and Real Estate (Notes 1, 4 and 5). All of these policies are mandatory under accounting principles generally accepted in the United States and the regulations of the Securities and Exchange Commission. Each of these policies has a material effect on the timing of revenue and expense recognition for significant Partnership operations. 18 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (Continued) Recent Accounting Pronouncement ------------------------------- In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. The Partnership expects to adopt SFAS 144 as of January 1, 2002 and has not yet determined the impact, if any, that the adoption of the SFAS 144 will have on the Partnership's financial position and results of operations. 19 ITEM 7a. QUALITATIVE AND QUANTITATIVE INFORMATION ABOUT MARKET RISK The Company has no debt subject to variable rates of interest and does not invest in derivatives or similar types of instruments. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this item is submitted as a separate section of this Form 10-K. See Item 14. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 20 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnership has no directors or executive officers. For informational purposes only, the following are the names and additional information relating to controlling persons, directors, executives and senior management of Prometheus Development Co., Inc., the General Partner of the Registrant. Sanford N. Diller. Age 73. President, Secretary and sole Director. Mr. Diller supervises the acquisition, disposition and financial structuring of properties. Mr. Diller founded the General Partner, and effectively controls all of its outstanding stock. Mr. Diller received his undergraduate education at the University of California at Berkeley and his Doctor of Jurisprudence from the University of San Francisco. He has been an attorney since 1953. Since the mid 1960's, he has been involved in the development and/or acquisition of more than 70 properties, totaling more than 13,000 residential units and over 2,000,000 square feet of office space. Vicki R. Mullins. Age 42. Vice President. Ms. Mullins' responsibilities include supervising all property operations, information systems and finance, as well as manages the disposition and financial structuring of properties. Ms. Mullins came to Prometheus Development Co. from The Irvine Company where she spent seven years as Vice President of Finance and Accounting, and Director of Internal Controls. Prior to the Irvine Company, she spent six years with Ernst & Young as an audit manager. Ms. Mullins is a Certified Public Accountant and holds a B.S. degree in Accounting with honors from the University of Illinois. John J. Murphy. Age 40. Vice President. Mr. Murphy's responsibilities include managing all financial, accounting and reporting activities, and insurance. Mr. Murphy came to Prometheus Development Co. from KPMG Peat Marwick where he spent seven years and was a Senior Manager. He is a Certified Public Accountant and holds a B.S. degree in Accounting with honors from the University of San Francisco. ITEM 11. EXECUTIVE COMPENSATION The Partnership does not pay or employ directly any officers or directors. Compensation to executives and employees of the General Partner is not based on the operations of the Partnership. The General Partner and its affiliates receive a management fee as compensation for services rendered and reimbursement of certain Partnership expenses. See Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations (Critical Accounting Policies), and Item 13, Certain Relationships and Related Transactions. 21 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Other than PIP Partners - General, LLC ("PIP Partners"), an affiliate of the General Partner, which owns 18.1679%, of the outstanding limited partner Units, no person of record owns or is known by the Registrant to own beneficially more than 5% of the outstanding Units. (b) The General Partner owns no Units. However, the General Partner, pursuant to the Partnership Agreement, has discretionary control over most of the decisions made for the Partnership. The executive officers of the General Partner, as a group, own no Units. PIP Partners, acquired 7.5283% of outstanding Limited Partner Units in the Partnership during 1997. (See Item 5 for further discussion.) During 1998, 1999, and 2000, PIP Partners acquired .716%, 1.2371% and 8.6865% of outstanding Limited Partner Units, respectively. No Units were acquired in 2001. As of December 31, 2001 PIP Partners owns 18.1679% of the outstanding Units. (c) Not applicable. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Partnership pays or has paid fees to the General Partner and its Affiliates. See Footnote 4 - Related Party Transactions of the financial statements found in Item 14 and the Prospectus (pages 14-16 and 46-48) filed pursuant to Rule 424(b) under the Securities Act of 1934, which is incorporated by reference herein. 22 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Page ---- Report of Ernst & Young LLP, Independent Auditors...................25 Report of Arthur Andersen LLP, Independent Auditors.................26 Financial Statements: Balance Sheets as of December 31, 2001 and 2000.....................27 Statements of Income for the years ended December 31, 2001, 2000 and 1999..................................28 Statements of Partners' Capital (Deficit) for the years ended December 31, 2001, 2000 and 1999......................29 Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999..................................30 Notes to Financial Statements.......................................31 2. FINANCIAL STATEMENT SCHEDULES: Schedule III - Real Estate and Accumulated Depreciation .........37-38 All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto. (b) The following reports on Form 8-K's were filed during the period covered by this report. The company filed Form 8-K on November 27, 2000, with respect to matters not required to be disclosed in a Form 10-K filing. The company filed Form 8-K on March 5, 2001, with respect to the notification of the change in accounting firms for the fiscal year ended December 31, 2000. The company filed Form 8-K on March 12, 2001 with respect to matters not required to be disclosed in a Form 10-K filing. The company filed Form 8-K on April 2, 2001, with respect to the notification of the settlement reached with selected defendants in the Timberleaf litigation. The company filed Form 8-K on May 24, 2001, with respect to the notification of the settlement reached with the remaining defendants in the Timberleaf litigation. 23 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (CONTINUED) (b) The following reports on Form 8-K's were filed during the period covered by this report, (Continued). The company filed Form 8-K on October 11, 2001, with respect to the notification of the settlement reached with the defendants in the Alderwood litigation. The company filed Form 8-K on March 5, 2002, with respect to the notification of the Limited Partners summarizing the settlements reached with the defendants in the Alderwood and Timberleaf litigations and the impacts on cash flow and future distributions. (c) No additional exhibits are required pursuant to Item 601(b) of Regulation S-K. 24 Report of Ernst & Young LLP, Independent Auditors To the Partners Prometheus Income Partners, A California limited partnership: We have audited the accompanying balance sheets of Prometheus Income Partners, a California limited partnership, as of December 31, 2001 and 2000, and the related statements of income, partners' capital (deficit), and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as 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 financial position of Prometheus Income Partners, a California limited partnership, at December 31, 2001 and 2000, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules when considered in relation to the basic financial statements as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 7, the accompanying financial statements have been restated to reflect the reversal of an accrual previously made in error. /s/ Ernst & Young LLP San Francisco, California March 1, 2002, except for Notes 1, 5 and 7, as to which the date is May 10, 2002. 25 REPORT OF ARTHUR ANDERSEN LLP, INDEPENDENT AUDITORS To the Partners of Prometheus Income Partners, a California limited partnership: We have audited the accompanying statements of income, partners' capital (deficit) and cash flows for each of the two years in the period ended December 31, 1999 of Prometheus Income Partners, a California limited partnership. 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 audit. We conducted our audit in accordance with auditing standards generally accepted in the 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the results of income and cash flows of Prometheus Income Partners, a California limited partnership, for the year ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP San Francisco, California March 28, 2000 26 PROMETHEUS INCOME PARTNERS a California limited partnership BALANCE SHEETS As of December 31, 2001 and 2000 (In Thousands, Except for Unit Data) 2001 2000 ---------- ---------- (Restated) ASSETS Real Estate Land, buildings and improvements $31,881 $30,778 Construction in progress 776 44 Accumulated depreciation (9,483) (8,801) -------- -------- 23,174 22,021 Cash and cash equivalents 4,036 3,568 Restricted cash 10,437 5,256 Deferred financing costs, net of accumulated amortization of $120 and $90 179 209 Accounts receivable and other assets 2 34 Receivable from settlement of construction defects litigation 6,299 -- -------- -------- Total assets $44,127 $31,088 ======== ======== LIABILITIES AND PARTNERS' CAPITAL (DEFICIT) Notes payable $25,548 $25,879 Accounts payable and accrued liabilities 388 439 Construction defects reserve 10,832 -- -------- -------- Total liabilities 36,768 26,318 -------- -------- Commitments and contingencies (see Notes 4 5, and 6) Partners' Capital (Deficit) General partner deficit (328) (354) Limited partners' capital, 18,995 limited partnership units issued and outstanding 7,687 5,124 -------- -------- Total partners' capital (deficit) 7,359 4,770 -------- -------- Total liabilities and partners' capital (deficit) $44,127 $31,088 ======== ======== See accompanying notes. 27 PROMETHEUS INCOME PARTNERS a California limited partnership STATEMENTS OF INCOME For the years ended December 31, 2001, 2000 and 1999 (In Thousands, Except for Unit Data) 2001 2000 1999 -------- -------- -------- (Restated) REVENUES Rental $7,387 $6,695 $5,674 Interest 415 464 250 Other 69 88 182 -------- -------- -------- Total revenues 7,871 7,247 6,106 -------- -------- -------- EXPENSES Interest and amortization 1,837 1,860 1,881 Operating 1,731 1,421 1,400 Depreciation 682 618 573 Administrative 44 40 40 Payments to general partner and affiliates: Management fees 431 372 300 Operating and administrative 557 527 481 -------- -------- -------- Total expenses 5,282 4,838 4,675 -------- -------- -------- NET INCOME $2,589 $2,409 $1,431 ======== ======== ======== Net income per $1,000 limited partnership unit $135 $126 $75 ======== ======== ======== Number of limited partnership units used in computation 18,995 18,995 18,995 ======== ======== ======== See accompanying notes. 28 PROMETHEUS INCOME PARTNERS a California limited partnership STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) For the years ended December 31, 2001, 2000 and 1999 (In Thousands) General Limited Partner Partners Total ------- --------- ----- Balance as of December 31, 1998 $(392) $1,322 $930 Net Income 14 1,417 1,431 ------- --------- ------- Balance as of December 31, 1999 (378) 2,739 2,361 Net Income 24 2,385 2,409 ------- --------- ------- Balance as of December 31, 2000 (354) 5,124 4,770 Net Income (Restated) 26 2,563 2,589 ------- --------- ------- Balance as of December 31, 2001 (Restated) $(328) $7,687 $7,359 ======= ========= ======= See accompanying notes. 29 PROMETHEUS INCOME PARTNERS a California limited partnership STATEMENTS OF CASH FLOWS For the years ended December 31, 2001, 2000 and 1999 (In Thousands) 2001 2000 1999 -------- -------- -------- (Restated) CASH FLOWS FROM OPERATING ACTIVITIES Net income $2,589 $2,409 $1,431 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation 682 618 573 Amortization 30 30 30 Increase in restricted cash (5,181) (698) (568) Decrease (increase) in accounts receivable and other assets 32 (5) 32 (Decrease) increase in payables and accrued liabilities (51) 115 (101) -------- ------- ------- Net cash (used in) provided by operating activities (1,899) 2,469 1,397 -------- ------- ------- CASH FLOWS USED IN INVESTING ACTIVITIES Additions to buildings and improvements (1,103) (490) (350) Construction in progress (732) (44) -- -------- ------- ------- Cash used in investing activities (1,835) (534) (350) -------- ------- ------- CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES Principal reductions on notes payable (331) (309) (288) Proceeds from settlement of construction defects litigation, net of direct costs incurred 4,533 -- -- -------- ------- ------- Net cash provided by (used in) financing activities 4,202 (309) (288) -------- ------- ------- Net increase in cash and cash equivalents 468 1,626 759 Cash and cash equivalents at beginning of year 3,568 1, 942 1,183 -------- ------- ------- Cash and cash equivalents at end of year $4,036 $3,568 $ 1,942 ======== ======= ======= SUPPLEMENTAL DISCLOSURE OF NON-CASH OPERATING ACTIVITY Receivable from settlement of construction defects litigation $6,299 $ -- $ -- ======== ======= ======= See accompanying notes. 30 PROMETHEUS INCOME PARTNERS a California limited partnership NOTES TO FINANCIAL STATEMENTS December 31, 2001 and 2000 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Prometheus Income Partners, a California limited partnership (the "Partnership"), was formed to invest in, construct, hold, operate and ultimately sell two multi-family apartment projects, Alderwood Apartments ("Alderwood") and Timberleaf Apartments ("Timberleaf"), located in Santa Clara, California (collectively, the "Properties"). The General Partner is Prometheus Development Co., Inc., ("Prometheus") a California corporation. The Partnership operates in one segment, residential real estate. In accordance with the terms of the Partnership Agreement, income or loss is allocated 1% to the General Partner and 99% to the Limited Partners. Net income or loss per limited partner unit is computed by dividing the net income or loss allocable to the Limited Partners by the number of units outstanding during the period in which the income or losses are allocated. 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Real estate, which includes development costs, construction costs, property taxes and interest incurred during the construction period, is valued at cost unless circumstances indicate that cost cannot be recovered, in which case the carrying value is reduced to estimated fair value. At December 31, 2001, the Partnership's management believes that the carrying value of the Partnership's real estate does not exceed its estimated fair value. None of the expenditures to repair the hardboard siding construction defects will be capitalized inasmuch as the repairs are not considered a betterment that will extend the life of the Partnership's assets, but are considered a correction of a past deficiency in the assets. The construction defects repairs will restore the assets to their original condition by maintaining the existing condition of the Properties. Maintenance and repair expenses are charged to operations as incurred. Buildings, asset replacements and improvements are capitalized and are depreciated using the straight-line method over their estimated useful lives, which range from 5 to 40 years, as follows. Buildings 40 years Land Improvements 30 years Structural Improvements 30 years Personal property 5 years Loan fees, incurred in conjunction with the notes payable have been deferred and are amortized, using the straight-line method which approximates the effective interest method, over the terms of the related notes payable. 31 NOTES TO FINANCIAL STATEMENTS (Continued) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) All leases are classified as operating leases. Rental revenues are recognized when contractually due based on the terms of signed lease agreements, which range in duration from month-to-month to one year. No income taxes are levied on the Partnership; rather, such taxes are levied on the individual partners. Consequently, no provision or liability for federal or California income taxes has been reflected in the accompanying financial statements. The net income or loss for financial reporting purposes differs from the net income or loss for income tax reporting purposes principally due to differences in useful lives and depreciation methods for buildings and improvements, amortization of construction period interest and taxes. Reconciliations of net income per the federal tax return to net income as reported in the accompanying financial statements for the years ended December 31, 2001, 2000 and 1999 follows (unaudited): 2001 2000 1999 ---------- ---------- --------- (Restated) (In Thousands) Net income per federal tax return $ 2,557 $ 2,348 $ 1,318 Prepaid rental receipts 3 (7) 24 Depreciation 29 68 89 ---------- ---------- --------- Net income per accompanying Statement of Income $ 2,589 $ 2,409 $ 1,431 ========== ========== ========= Syndication costs incurred in raising Limited Partners' capital are not charged to Limited Partners' capital for tax reporting purposes. The carrying amount of certain of the Partnership's financial instruments, including accounts receivable, accounts payable, and accrued liabilities, approximates fair value due to the relatively short maturity of such instruments. The fair value of the notes payable approximates the carrying value as of December 31, 2001 based on current rates available to the Partnership for debt with similar terms. Cash and cash equivalents consist of amounts held in market rate, checking and investment accounts with maturities of three months or less. The Partnership maintains its cash and cash equivalents in high credit-quality depository institutions. 32 NOTES TO FINANCIAL STATEMENTS (Continued) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Restricted cash, designated as lender's cash collateral, is invested in a government fund with original maturities of three months or less. (See Note 6 for further discussion.) The Timberleaf settlement proceeds are maintained in an investment account with a maturity of three months or less, and are also designated as restricted cash. Recent Accounting Pronouncement ------------------------------- In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of Accounting Principal Board Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. The Partnership expects to adopt SFAS 144 as of January 1, 2002 and has not yet determined the impact, if any, that the adoption of the SFAS 144 will have on the Partnership's financial position and results of operations. 2. NOTES PAYABLE The Partnership had the following notes payable (the "Notes") at December 31, 2001 and 2000: 2001 2000 ---- ---- (In Thousands) Non recourse note payable, secured by a first deed of trust on Alderwood; interest is payable monthly at a rate of 6.99% per annum; the balance is payable at maturity, December 2007. $ 16,488 $ 16,703 Non recourse note payable, secured by a first deed of trust on Timberleaf; interest is payable monthly at a rate of 7.09% per annum; the balance is payable at maturity, December 2007. 9,060 9,176 -------- -------- $ 25,548 $ 25,879 ======== ======== One of the terms of the Notes requires that cash be set aside in a hardboard siding security account, as additional collateral. See Note 6 for further discussion. Cash paid for interest in each of the years ended 2001, 2000 and 1999 was approximately $1,807,000, $1,830,000, and $1,851,000, respectively. 33 NOTES TO FINANCIAL STATEMENTS (Continued) 2. NOTES PAYABLE (Continued) As of December 31, 2001, maturities on the Notes (In Thousands) are as follows: 2002 $ 355 2003 381 2004 409 2005 439 2006 470 Thereafter 23,494 ---------- $25,548 The Notes, if prepaid more than thirty (30) days from maturity, are subject to a prepayment penalty. 3. RELATED PARTY TRANSACTIONS Prometheus Real Estate Group, Inc. ("Prometheus"), an affiliate of the General Partner, manages the Properties. Management fees and payments to the General Partner and affiliates represent compensation for services provided and certain expense reimbursements in accordance with the Partnership Agreement, which specifically provides for: o The actual cost to the General Partner or its affiliates of goods and materials used for or by the Partnership and obtained from entities which are not affiliated with the General Partner; o Expenses for specified administrative services; o Other administrative services, provided that these services are necessary to the prudent operation of the Partnership; and o Funds advanced to the Partnership by the General Partner or its affiliates pursuant to the management agreement. However no reimbursement for the administrative services is permitted for services for which the General Partner or its affiliates receive a separate fee, and the amount of these expenses may not exceed the lesser of: o The actual cost of these services; and o 90% of the amount which the Partnership would be required to pay to independent third parties for comparable services. For 2001, 2000 and 1999 the General Partner or its affiliates, other than Prometheus (which was entitled to additional reimbursements under the Partnership's management agreement), did not receive any reimbursement for direct or other administrative and out-of-pocket expenses. 34 NOTES TO FINANCIAL STATEMENTS (Continued) 4. COMMITMENTS Commencing on January 1, 1989, under the terms of the Limited Liquidity Plan ("Plan"), the Partnership may repurchase up to 5% in aggregate of the outstanding units from the Limited Partners, at the Limited Partners' option, in accordance with the Partnership Agreement. The General Partner may allocate up to 10% of the distributable cash from operations in the current year for the purpose of making such repurchases. The price of any units repurchased by the Partnership will be determined in accordance with the Partnership Agreement. The Partnership made no repurchases under the Plan during the years ended December 31, 2001, 2000 and 1999. 5. LITIGATION SETTLEMENT - CONSTRUCTION DEFECTS In June 1996, the General Partner became aware of defects in the hardboard siding used in both of the Partnership's properties. At that time, the General Partner began seeking recovery of costs to repair those defects from the manufacturer of the hardboard siding, as well as the general contractor, the subcontractors, and the architects involved in the original construction of the two properties. Since June 1996, the General Partner has determined that the defects did not reduce the assets' value to an amount below their net book value, based on a comparison of future cash flows to the carrying amount of the properties at the end of subsequent reporting periods. This continues to be the case at December 31, 2001. The General Partner has also determined that, although the construction defects may be substantial in nature, the properties will continue to function as safe, inhabitable, income-generating properties without a full repair of the defects for an indeterminate amount of time. As such, the Partnership has been under no obligation to undertake a major repair project to remedy the construction defects at either of the properties. The Partnership has made certain emergency repairs to the properties since June 1996, and has expensed those repair costs as incurred with no consideration of potential recoveries from the ongoing litigation or potential settlement thereof. As of December 31, 2001, the cost of emergency repairs charged to expense since June 1996 totaled approximately $3,457,000. In 2001, the Partnership's litigation against the responsible parties was settled with net proceeds (after legal costs) to the Partnership of $10,832,000. The net proceeds related to the Timberleaf property of $4,533,000 were received by the Partnership in 2001. The Alderwood litigation was settled on October 3, 2001 and net settlement proceeds of $6,299,000 were received by the Partnership on March 5, 2002. As such, a receivable for the Alderwood net settlement proceeds was recorded as of December 31, 2001. The General Partner believes that these settlements were, in substance, payment for non-operating costs to be incurred by the Partnership to repair the defects at both properties. In 2001, upon learning that the defendants in the litigation were willing to resolve the lawsuits in return for a substantial settlement to the Partnership, the General Partner made the decision to utilize the proceeds of the settlement to undertake a major repair project related to the construction defects. The General Partner is currently engaged in the process of developing an updated repair plan, and anticipates that the repairs will occur during 2002 and 2003. In light of the settlement recovery, the General Partner is hopeful, that under prevailing circumstances and market conditions, it can develop a plan to repair the construction defects, including all costs associated with the repairs, (including rent concessions and lost rents) for approximately $12,500,000 to $14,000,000, an amount that exceeds the net settlement proceeds received by the Partnership. This preliminary projection of the cost to repair the construction defects is an estimate, and as such the estimate could change in the near term due to certain factors that could be encountered in either the design engineering phase, 35 NOTES TO FINANCIAL STATEMENTS (Continued) 5. LITIGATION SETTLEMENT - CONSTRUCTION DEFECTS (Continued) and / or actual construction phase due to hidden defects that are not evident until the current siding is removed and the underlying wall and flooring structures are exposed and examined. As such, the cost to repair could change, and the change could be material to this preliminary projection. The Partnership has recorded a construction defects reserve liability of $10,832,000 in the accompanying Balance Sheet at December 31, 2001 equal to the net settlement proceeds. All construction repair expenditures up to $10,832,000 will be charged to the reserve liability and amounts in excess of $10,832,000, if any, will be expensed as incurred. None of the expenditures made to repair the construction defects will be capitalized, due to the fact that the repairs are not considered a betterment that will extend the life of the Partnership's assets. The construction defects repairs are intended to restore the assets to their original condition as though the defects had never existed. 6. RESTRICTED CASH - CASH COLLATERAL The terms of the Notes and the Security Agreement, Disbursements Agreement and Assignment of Agreements (collectively the "Agreements") (See Note 2 for further discussion) require that each Property maintain a hardboard siding security account. These security accounts are additional collateral for the lender. Cash held in these security accounts was $3,384,000 and $2,468,000 for Alderwood and Timberleaf, respectively, at December 31, 2001. Until the Completion Date, as defined in the Agreements, the Partnership is obligated to contribute annually, an additional 10%, as defined in the Agreements, or monthly cash flow, whichever is less and, shall be deposited into each security account. Should the hardboard siding repairs not be completed by December 2002, or every two years thereafter, and insufficient cash has been accumulated to cure the defects based upon the lender's determination of the cost, then all cash flow shall be deposited into each applicable security account, as necessary, to fully fund the cost of construction. If the projected cash flow is insufficient to satisfy this deficiency contribution, then the Partnership has 60 days to fund the shortage over the projected cash flow. No withdrawals are permitted from the security accounts except to cure the siding defects. The lender shall have the right to hire its own consultants to review, approve and inspect the construction. All such reasonable fees and expenses incurred by the lender shall be paid by the Partnership. Should construction not be completed by the Completion Date due to an act of force majeure, the Completion Date can be further extended to complete the construction work. The security accounts are to be invested in either a treasury or government fund. 7. SUBSEQUENT EVENT The defendants in the Alderwood construction defect litigation settled the litigation on October 3, 2001. The defendants agreed to pay the Partnership $8,500,000. Of this amount, the Partnership received on March 5, 2002, after payment of litigation expenses including legal fees, $6,299,000. Restatement: Subsequent to year end, the Partnership reevaluated its initial accounting for the Alderwood and Timberleaf litigation settlements and concluded that $1,667,000, representing estimated repair costs in excess of actual net settlement proceeds, was a disclosable commitment and not a probable liability as of December 31, 2001. Accordingly, the financial statements and certain information in Notes 1 and 5 have been revised to reflect the effects of reversing the accrual. The reversal resulted in an increase in net income and Partner's capital of $1,667,000 and a reduction in the construction defects reserve and total liabilities of $1,667,000. 36 SCHEDULE III PROMETHEUS INCOME PARTNERS a California limited partnership REAL ESTATE AND ACCUMULATED DEPRECIATION As of December 31, 2001 (In Thousands)
Cost Capitalized Gross Amount at Which Subsequent Carried To Acquisition at Close of Period(1) --------------------------- --------------------- Build- Build- Accumu- Cost to ings and Carry- ings and lated De- Date of Date Encum- the Partner- Improve- Improve- ing Improve- Total preciation Construc- Acquired Description brances ship Land ments ments Costs Land ments (3) (4) tion (2) ----------- ---------------------- --------------------------- --------------------- --------------------- -------- Alderwood Apts. Santa Clara, California $16,488 $5,931 $ -- $12,950 $441 $5,931 $14,472 $20,403 $6,066 11/86 12/87(5) Timberleaf Apts. Santa Clara, California 9,060 3,145 -- 6,961 510 3,145 8,333 11,478 3,417 11/86 11/86 Total $25,548 $9,076 $ -- $19,911 $951 $9,076 $22,805 $31,881 $9,483 ======= ====== ===== ======= ==== ====== ======= ======= ======
37 SCHEDULE III PROMETHEUS INCOME PARTNERS a California limited partnership REAL ESTATE AND ACCUMULATED DEPRECIATION (Continued) As of December 31, 2001 (In Thousands) NOTES: (1) The aggregate cost for federal income tax purposes is $29,849. (2) Depreciation is computed on lives ranging from 5 to 40 years. (3) Balance, December 31, 1998 $29,938 Additions 350 ------- Balance, December 31, 1999 30,288 Additions 1,103 Balance, December 31, 2000 30,778 Additions 490 ------- Balance December 31, 2001 $31,881 ======= (4) Balance, December 31, 1998 $ 7,610 Provision charged to expense 573 ------- Balance, December 31, 1999 8,183 Provision charged to expense 618 ------- Balance, December 31, 2000 8,801 Provision charged to expense 682 ------- Balance, December 31, 2001 $ 9,483 (5) The Land site was leased through November 1987 and acquired in December 1987. 38 SIGNATURES Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the date indicated. PROMETHEUS INCOME PARTNERS, a California limited partnership By PROMETHEUS DEVELOPMENT CO., INC., a California corporation, Its General Partner Date: May 14, 2002 By /s/ Vicki R. Mullins ------------ -------------------------------- Vicki R. Mullins, Vice President Date: May 14, 2002 By /s/ John J. Murphy ------------ -------------------------------- John J. Murphy, Vice President Supplemental Information to be furnished with Report, filed pursuant to Section 15(d) of the Act by Registrants, which have not registered Securities pursuant to Section 12 of the Act: None 39