AMERICAN REALTY INVESTORS INC 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and related notes in Part II, Item 8 of this Report. Our results of operations for the year ended December 31, 2022 were affected by a acquisitions and disposition, refinancing activity, development activity as discussed below. Management's Overview We are an externally advised and managed real estate investment company that owns a diverse portfolio of income-producing properties and land held for development throughout the Southern United States. Our portfolio of income-producing properties generally includes multifamily residential properties, office buildings and other commercial properties. Our investment strategy includes acquiring existing income-producing properties as well as developing new properties on land already owned or acquired for a specific development project. Our operations are managed by Pillar in accordance with an Advisory Agreement. Pillar’s duties include, but are not limited to, locating, evaluating and recommending real estate and real estate-related investment opportunities. Pillar also arranges our debt and equity financing with third party lenders and investors. We rely upon the employees of Pillar render services to us in accordance with the terms of the Advisory Agreement. Pillar is considered to be a related party due to its ownership by RAI. 17 The following is a summary of our recent acquisition, disposition, financing and development activities: Acquisitions and Dispositions • On March 30, 2021, we sold a 50% ownership interest in Overlook at Allensville Phase II, a 144 unit multifamily property in Sevierville, Tennessee to Macquarie, for $2.6 million resulting in a gain on sale of $1.4 million. Concurrent with the sale, we each contributed our 50% ownership interests in Overlook at Allensville Phase II into VAA. • On August 26, 2021, we sold 600 Las Colinas, a 512,173 square foot office building in Irving, Texas for $74.8 million, resulting in a gain on sale of $27.3 million. We used the proceeds to pay off the mortgage note payable on the property (See "Financing Activities") and for general corporate purposes. • During the year ended December 31, 2021, we sold a total of 134.7 acres of land from our holdings in Windmill Farms for $20.2 million in aggregate, resulting in gains on sale of $10.3 million . In addition, we sold 14.1 acres of land from our holdings in Mercer Crossing for $9.0 million , resulting in a gain on sale of $6.4 million . • On January 14, 2022, we sold Toulon, a 240 unit multifamily property in Gautier, Mississippi for $26.8 million, resulting in a gain on sale of $9.4 million. We used the proceeds to pay off the $14.7 million mortgage note payable on the property and for general corporate purposes. • On May 17, 2022 , we sold Fruitland Park, a 6,722 square foot commercial building in Fruitland Park, Florida for $0.8 million , resulting in a gain on sale of $0.7 million . We used the proceeds for general corporate purposes. • On September 16, 2022, we sold Sugar Mill Phase III, a 72 unit multifamily property in Baton Rouge , Louisiana for $11.8 million in connection with a sale of properties by VAA (See "Other Developments"), resulting in a gain on sale of $1.9 million. We used the proceeds to pay off the $9.6 million mortgage note payable on the property and for general corporate purposes. • On November 1, 2022, we acquired seven multifamily properties from VAA (See "Other Developments") with a fair value of $219.5 million . • During the year ended December 31, 2022 , we sold a total of 26.9 acres of land from our holdings in Windmill Farms for $5.1 million in aggregate, resulting in gains on sale of $4.2 million. In addition, we sold 14.09 acres of land from our holdings in Mercer Crossing for $9.0 million, resulting in a gain on sale of $6.4 million. Financing Activities • On March 2, 2021 , we extended our $1.2 million loan on Athens to August 28, 2022 . • On March 4, 2021 , we extended the maturity of our $6.4 million loan on Windmill Farms until February 28, 2023 at a reduced interest rate of 5%. • On August 25, 2021, we replaced the existing loan on Villas at Bon Secour with a new $20.0 million loan that bears interest at 3.08% and matures on September 1, 2031. • On August 26, 2021, we paid off the $35.9 million loan on 600 Las Colinas in connection with the sale of the underlying property (See "Acquisitions and Dispositions"). • On January 14, 2022, the $14.7 million loan on Toulon was paid off in connection with the sale of the underlying property (See "Acquisitions and Dispositions"). • On March 3, 2022 , we extended the loan on Stanford Center to February 26, 2023 . • On September 1, 2022 , we extended our $1.2 million loan on Athens to August 28, 2023. • On September 16, 2022 , we paid off the $9.6 million loan on Sugar Mill Phase III in connection with the sale of the underlying property (See "Acquisitions and Dispositions"). • On October 21, 2022, we paid off the $38.5 million loan on Stanford Center from the cash generated from sale of the VAA Sale Portfolio . • On November 1, 2022, we assumed the $70.3 million mortgage notes payable on the VAA Holdback Portfolio in connection with the distribution of the underlying properties from VAA (See "Other Developments"). • On January 31, 2023 , we paid off our $66.5 million Series C bonds. 18 Development Activities During 2022, we spent $6.0 million on our ongoing development of Windmill Farms . Our expenditure includes $1.2 million on the development of land lots for sale to single family home developers and $4.8 million on reimbursable infrastructure investments. We have investment in nine notes receivable that were issued to fund the development of multifamily properties. Each of these notes are convertible, at our option, into a 100% ownership interest in the underlying property. As of December 31, 2022, one of the projects was in construction, one was in lease-up and seven were stabilized. In 2022, we advanced $2.1 million on these development notes. Other Developments: During 2021, we recorded a loss of $29.6 million on the remeasurements of certain assets ("Earn Out Obligation") that were sold in connection with our initial investment in VAA . On June 17, 2022, we entered into an agreement to sell 45 properties (“VAA Sale Portfolio”) held by VAA and one property held by our SPC subsidiary. On September 15, 2022, we entered into a Distribution and Holdback Property Agreement (“Distribution Agreement”) with Macquarie, which provides the timing and ordering of the distribution of the net proceeds from the sale of the VAA Sale Portfolio, the repayment of the Mezzanine Loans, and the distribution of the remaining seven properties of VAA (“VAA Holdback Portfolio”). On September 16, 2022, VAA completed the sale of the VAA Sale Portfolio for $1.8 billion, resulting in gain on sale of $738.4 million to the joint venture. In connection with sale, we received an initial distribution of $182.8 million from VAA, which included the payment of the remaining balance of our Earn Out Obligation to Macquarie. On November 1, 2022, in connection with the sale of the VAA Sale Portfolio, we received an additional distribution from VAA, which included a cash payment of $204.0 million and the full operational control of the VAA Holdback Portfolio, which resulted a $73.2 million gain on the remeasurement of assets. We are in the process of negotiating the assumption of the mortgage notes payable on the VAA Holdback Portfolio. Our ownership interest in VAA is held by SPC, and is therefore our share of the proceeds from the sale of the VAA Sale Portfolio is subject to the debt covenants of the bonds issued by SPC. These provisions include restrictions on the distribution of cash from SPC. 19 Critical Accounting Policies The preparation of our consolidated financial statements in conformity with United States generally accepted accounting principles (“GAAP”) 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. Some of these estimates and assumptions include judgments on revenue recognition, estimates for common area maintenance and real estate tax accruals, provisions for uncollectible accounts, impairment of long-lived assets, the allocation of purchase price between tangible and intangible assets, capitalization of costs and fair value measurements. Our significant accounting policies are described in more detail in Note 2—Summary of Significant Accounting Policies in our notes to the consolidated financial statements. However, the following policies are deemed to be critical. Fair Value of Financial Instruments We apply the guidance in ASC Topic 820, “Fair Value Measurements and Disclosures,” to the valuation of real estate assets. These provisions define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date that is other than in a forced or liquidation sale, establish a hierarchy that prioritizes the information used in developing fair value estimates and require disclosure of fair value measurements by level within the fair value hierarchy. The hierarchy gives the highest priority to quoted prices in active markets (Level 1 measurements) and the lowest priority to unobservable data (Level 3 measurements), such as the reporting entity’s own data. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date and includes three levels defined as follows: Level 1—Unadjusted quoted prices for identical and unrestricted assets or liabilities in active markets. Level 2—Quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3—Unobservable inputs that are significant to the fair value measurement. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Related Parties We apply ASC Topic 805, “Business Combinations”, to evaluate business relationships. Related parties are persons or entities who have one or more of the following characteristics, which include entities for which investments in their equity securities would be required, trust for the benefit of persons including principal owners of the entities and members of their immediate families, management personnel of the entity and members of their immediate families and other parties with which the entity may deal if one party controls or can significantly influence the decision making of the other to an extent that one of the transacting parties might be prevented from fully pursuing our own separate interests, or affiliates of the entity. Environmental Matters Under various federal, state and local environmental laws, ordinances and regulations, we may be potentially liable for removal or remediation costs, as well as certain other potential costs, relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos-containing materials into the air, and third parties may seek recovery for personal injury associated with such materials. We are not aware of any environmental liability relating to the above matters that would have a material adverse effect on our business, assets or results of operations. 20 Inflation The effects of inflation on our operations are not quantifiable. Revenues from property operations tend to fluctuate proportionately with inflationary increases and decreases in housing costs. Fluctuations in the rate of inflation also affect sales values of properties and the ultimate gain to be realized from property sales. To the extent that inflation affects interest rates, our earnings from short-term investments, the cost of new financings and the cost of variable interest rate debt will be affected. Results of Operations Many of the variations in the results of operations, discussed below, occurred because of the transactions affecting our properties described above, including those related to the Redevelopment Property, Acquisition Properties and the Disposition Properties (each as defined below). For purposes of the discussion below, we define "Same Properties" as all of our properties with the exception of those properties that have been recently constructed or leased-up (“Redevelopment Property”), properties that have recently been acquired ("Acquisition Properties") and properties that have been disposed ("Disposition Properties"). A developed property is considered leased-up, when it achieves occupancy of 80% or more. We move a property in and out of Same Properties based on whether the property is substantially leased-up and in operation for the entirety of both periods of the comparison. For the comparison of the year ended December 31, 2022 to the year ended December 31, 2021 , the Redevelopment Property is Landing Bayou. The Acquisition Properties are Blue Lake Villas, Blue Lake Villas Phase II, Northside on Travis, Parc at Denham Springs, Residences at Holland Lake, Villas of Park West I and Villas of Park West II. The Disposition Properties are 600 Las Colinas, Fruitland Park, Overlook at Allensville Phase II, Sugar Mill Phase III and Toulon. The following table provides a summary of the results of operations of 2022 and 2021: For the Years Ended December 31, 2022 2021 Variance Multifamily Segment Revenue $ 17,828 $ 14,495 $ 3,333 Operating expenses (9,524) (8,167) (1,357) 8,304 6,328 1,976 Commercial Segment Revenue 16,252 23,313 (7,061) Operating expenses (8,815) (12,693) 3,878 7,437 10,620 (3,183) Segment operating income 15,741 16,948 (1,207) Other non-segment items of income (expense) Depreciation and amortization (9,686) (11,870) 2,184 General, administrative and advisory (18,786) (29,927) 11,141 Interest, net 9,030 (5,659) 14,689 Loss on early extinguishment of debt (2,805) (1,451) (1,354) Gain (loss) on foreign currency transactions 20,067 (6,175) 26,242 Gain sale, remeasurement or write down of assets 87,132 24,647 62,485 Income from joint ventures 469,268 14,634 454,634 Other (expense) income (94,644) 5,298 (99,942) Net income $ 475,317 $ 6,445 $ 468,872 21 Comparison of the year ended December 31, 2022 to the year ended December 31, 2021: Our $468.9 million increase in net income in 2022 is primarily attributed to the following: • The $2.0 million increase in profit the multifamily is due to increases of $2.5 million from the Acquisition Properties and $0.4 million from the Same Properties offset in part a decrease of $0.6 million from the Disposition Properties and $0.3 million from the Redevelopment Property . • The $3.2 million decrease in profit from the commercial properties is due to a decreases of $2.6 million from the Disposition Properties and $0.6 million from the Same Properties . • The decrease in general, administrative and advisory expenses is primarily due to the decrease in legal costs from the arbitration settlement in 2021 (See " Other Developments" in Management's Overview) and a decrease in other administrative and advisory expenses . • The change in interest, net is due a $7.2 million increase in interest income and $4.8 million decrease in interest expense. The increase in interest income is due to an increase in interest from our convertible loans, an increase in interest rates and an increase in short term investments in 2022. The increase in short-term investments is due the $388.0 million in cash distributions received from VAA in 2022 (See " Other Developments" in Management's Overview ). The decrease in interest expense is primarily due to pay downs of our bonds payable and repayment of mortgage notes payable on properties sold in 2021 and 2022 (See " Acquisitions and Dispositions " in Management's Overview). • The increase in gain on foreign currency transactions is due to a favorable change in the U.S. Dollar and the New Israeli Shekel conversion rate. • Gain on sale, remeasurement or write down of assets increased $65.8 million from $23.4 million in 2021 to $89.2 million in 2022. The increase is due to the $73.2 million gain on remeasurement of the VAA Holdback Portfolio in 2022 and other transactions described in "Other Developments" and " Acquisitions and Dispositions " in Management's Overview. • The increase in income from joint ventures is primarily due our share of the gain on the sale of the VAA Sale Portfolio in 2022 (See "Other Developments" in Management's Overview). • The change in other (expense) income is primarily due to the $104.2 million increase in tax expense as a result of the sale of the VAA Sale Portfolio in 2022. Comparison of the year ended December 31, 2021 to the year ended December 31, 2020: See Item 7 of Part II in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC on March 29, 2022 for a discussion of our results of operations for the year ended December 31, 2021. Liquidity and Capital Resources Our principal sources of cash have been, and will continue to be, property operations; proceeds from land and income-producing property sales; collection of mortgage notes receivable; collections of receivables from related companies; refinancing of existing mortgage notes payable; and additional borrowings, including mortgage notes and bonds payable, and lines of credit. Our principal liquidity needs are to fund normal recurring expenses; meet debt service and principal repayment obligations including balloon payments on maturing debt; fund capital expenditures, including tenant improvements and leasing costs; fund development costs not covered under construction loans; and fund possible property acquisitions. We anticipates that our cash, cash equivalents and short-term investments as of December 31, 2022, along with cash that will be generated in 2023 from notes and interest receivables, will be sufficient to meet all of our cash requirements. We intends to selectively sell land and income-producing assets, refinance or extend real estate debt and seek additional borrowings secured by real estate to meet our liquidity requirements. Although history cannot predict the future, historically, we have been successful at refinancing and extending a portion of our current maturity obligations. 22 Cash Flow Summary The following summary discussion of our cash flows is based on the consolidated statements of cash flows in Part II, Item 8. “Consolidated Financial Statements and Supplementary Data” and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below (dollars in thousands): Year Ended December 31, 2022 2021 Variance Net cash used in operating activities $ (45,386) $ (11,523) $ (33,863) Net cash provided by investing activities $ 307,357 $ 100,822 $ 206,535 Net cash used in financing activities $ (112,377) $ (103,585) $ (8,792) The increase in cash used in operating activities is primarily due to payments of taxes related to our share of the gain on the sale of VAA Sale Portfolio in 2022. The increase in cash provided by investing activities is primarily due the $376.9 million increase in distribution from joint venture and the $175.3 million redemption of short term investments in 2022 offset in part by the $261.6 million purchase of short term investments in 2022, the $61.0 million decrease in proceeds from the sale of real estate and the $15.1 million decrease in collection of notes receivable. The increase in distribution from joint venture is due to the sale of the VAA Sale Portfolio in 2022 (See "Other Developments" in Management's Overview). The increase in cash used in financing activities is primarily due to the $20.0 million proceeds from mortgages, notes and bonds payable in 2021 offset in part by a $7.9 million decrease in payments of mortgages, notes and bonds payable. 23 Funds From Operations ("FFO") We use FFO in addition to net income to report our operating and financial results and considers FFO and FFO-diluted as supplemental measures for the real estate industry and a supplement to GAAP measures. The National Association of Real Estate Investment Trusts ("Nareit") defines FFO as net income (loss) (computed in accordance with GAAP), excluding gains (or losses) from sales of properties, plus real estate related depreciation and amortization, impairment write-downs of real estate and write-downs of investments in an affiliate where the write-downs have been driven by a decrease in the value of real estate held by the affiliate and after adjustments for unconsolidated joint ventures. Adjustments for unconsolidated joint ventures are calculated to reflect FFO on the same basis. We also presents FFO excluding the impact of the effects of foreign currency translation. FFO and FFO on a diluted basis are useful to investors in comparing operating and financial results between periods. This is especially true since FFO excludes real estate depreciation and amortization, as we believe real estate values fluctuate based on market conditions rather than depreciating in value ratably on a straight-line basis over time. We believe that such a presentation also provides investors with a meaningful measure of our operating results in comparison to the operating results of other real estate companies. In addition, we believe that FFO excluding gain (loss) from foreign currency transactions provide useful supplemental information regarding our performance as they show a more meaningful and consistent comparison of our operating performance and allows investors to more easily compare our results. We believe that FFO does not represent cash flow from operations as defined by GAAP, should not be considered as an alternative to net income as defined by GAAP, and is not indicative of cash available to fund all cash flow needs. We also caution that FFO, as presented, may not be comparable to similarly titled measures reported by other real estate companies. We compensate for the limitations of FFO by providing investors with financial statements prepared according to GAAP, along with this detailed discussion of FFO and a reconciliation of net income to FFO and FFO-diluted. We believe that to further understand our performance, FFO should be compared with our reported net income and considered in addition to cash flows in accordance with GAAP, as presented in our consolidated financial statements. The following reconciles our net income attributable to FFO and FFO-basic and diluted, excluding loss from foreign currency transactions and loss on extinguishment of debt for the years ended December 31, 2022, 2021 and 2020 (dollars and shares in thousands): For the Year Ended December 31, 2022 2021 2020 Net income attributable to the Company $ 373,349 $ 3,347 $ 9,030 Depreciation and amortization on consolidated assets 9,686 11,870 14,755 Gain on sale, remeasurement or write down of assets (87,132) (24,647) (36,895) Gain on sale of land 4,752 16,645 25,171 Gain on sale of assets from unconsolidated joint venture at our pro rata share less noncontrolling interest (265,804) — — Depreciation and amortization on unconsolidated joint ventures at pro rata share 8,424 11,604 11,295 FFO-Basic and Diluted 43,275 18,819 23,356 Loss on early extinguishment of debt 2,805 1,451 — Loss on early extinguishment of debt from unconsolidated joint venture at our pro rata share 15,254 — — (Gain) loss on foreign currency transactions (20,067) 6,175 13,378 FFO-adjusted $ 41,267 $ 26,445 $ 36,734