<PAGE> 1
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
( X ) QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934. For the quarter ended: March 31, 1996
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File number: 0-17656
VANGUARD REAL ESTATE FUND II
A SALES-COMMISSION-FREE INCOME PROPERTIES FUND
(Exact name of Registrant as specified in its charter)
<TABLE>
<S> <C>
Massachusetts 23-2482429
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
Vanguard Financial Center
Malvern, PA 19355
(Address of principal executive (Zip Code)
offices)
</TABLE>
Registrant's telephone number (610) 669-1000
Indicate by checkmark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities and 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
----- -----
6,432,626 shares of beneficial interest outstanding as of April 30, 1996.
<PAGE> 2
INDEX
<TABLE>
<CAPTION>
Item Page
No. No.
<S> <C>
Cover Page . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
PART I FINANCIAL INFORMATION
ITEM 1. Financial Statements
Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Income Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Statement of Changes in Shareholders' Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-8
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations. . . . . . . . . . . . . . . . . . . . . . 9-13
PART II OTHER INFORMATION
ITEM 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
ITEM 2. Changes in Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
ITEM 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . . . . . . . . . 14
ITEM 4. Submission of Matters to a Vote of Security Holders. . . . . . . . . . . . . . . 14
ITEM 5. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
ITEM 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . . . . . . 14
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
</TABLE>
<PAGE> 3
BALANCE SHEETS
<TABLE>
<CAPTION>
March 31, 1996
($ in 000's) December 31, 1995
ASSETS (unaudited) ($ in 000's)
------------- -------------
<S> <C> <C>
Investments in Real Estate:
Direct Ownership Investments:
Land . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000 $ 6,000
Building and Improvements . . . . . . . . . . . . . . . 5,500 8,192
------- -------
7,500 14,192
Less--Accumulated Depreciation . . . . . . . . . . . . -- 1,255
------- -------
7,500 12,937
Mortgage Loan Receivable . . . . . . . . . . . . . . . . -- 8,290
Less--Allowance for Possible Losses . . . . . . . . . . -- 800
------- -------
Net Investment Portfolio . . . . . . . . . . . . . . . . 7,500 20,427
Marketable Securities--REMICs . . . . . . . . . . . . . . . . -- 1,194
Short-Term Investments:
Vanguard Money Market Reserves-Prime Portfolio
(813,668 and 959,453 shares, respectively) . . . . . . 814 959
Temporary Cash Investments . . . . . . . . . . . . . . 17,499 4,995
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . 446 789
------- -------
TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . . . . $26,259 $28,364
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Mortgage Loans . . . . . . . . . . . . . . . . . . . . . . . -- $ 6,115
Deferred Revenue--Mountain View . . . . . . . . . . . . . . . $ 1,859 1,856
Due to Affiliates . . . . . . . . . . . . . . . . . . . . . 283 142
Dividend Payable . . . . . . . . . . . . . . . . . . . . . . 17,046 --
Other Liabilities . . . . . . . . . . . . . . . . . . . . . 139 506
------- -------
TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . 19,327 8,619
------- -------
Shares of Beneficial Interest, without par value, unlimited
shares authorized . . . . . . . . . . . . . . . . . . . . 14,315 31,361
Accumulated Taxable Distributions in Excess of Net Income . (7,383) (11,616)
------- -------
TOTAL SHAREHOLDERS' EQUITY . . . . . . . . . . . . . . . . . 6,932 19,745
------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY . . . . . . . . . $26,259 $28,364
======= =======
</TABLE>
The accompanying notes are an integral part of these statements.
2
<PAGE> 4
INCOME STATEMENTS
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended March 31,
1996 1995
REAL ESTATE INCOME (000) (000)
------------- -------------
<S> <C> <C>
Rental Income . . . . . . . . . . . . . . . . . . . . . . . . $ 471 $1,294
Mortgage Interest Income . . . . . . . . . . . . . . . . . . . 107 216
------------- -------------
578 1,510
REAL ESTATE EXPENSES
Mortgage Interest Expense . . . . . . . . . . . . . . . . . . 78 340
Real Estate Taxes . . . . . . . . . . . . . . . . . . . . . . 92 149
Property Operating Expenses . . . . . . . . . . . . . . . . . 159 278
Depreciation and Amortization . . . . . . . . . . . . . . . . -- 221
------------- -------------
329 988
------------- -------------
INCOME FROM REAL ESTATE 249 522
INVESTMENT INCOME FROM SHORT-TERM
INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . . 122 91
------------- -------------
371 613
------------- -------------
ADMINISTRATIVE EXPENSES
Investment Advisory Fee . . . . . . . . . . . . . . . . . . . 34 50
Administrative Fee . . . . . . . . . . . . . . . . . . . . . . 22 47
Other Administrative Expenses . . . . . . . . . . . . . . . . 70 82
------------- -------------
126 179
------------- -------------
INCOME BEFORE NET GAIN ON SALES
OF INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . 245 434
Net Gain on Sale of Investments . . . . . . . . . . . . . . . 3,988 --
------------- -------------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . $4,233 $ 434
============== ==============
Net Income Per Share:
Income Before Net Gain on Sale of Investments . . . . . . . $.04 $.07
Net Gain on Sale of Investments . . . . . . . . . . . . . . .62 --
------------- -------------
Net Income Per Share $.66 $.07
------------- -------------
_____________ _____________
Weighted Average Number of Shares Outstanding . . . . . . . . 6,432,626 6,432,626
============== ==============
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE> 5
STATEMENTS OF CASH FLOWS
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended March 31,
1996 1995
CASH FLOWS FROM OPERATING ACTIVITIES (000) (000)
------------- -------------
<S> <C> <C>
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,233 $ 434
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and Amortization . . . . . . . . . . . . . . -- 221
Distribution from Joint Venture--Operating . . . . . . . 3 1
Net Gain on Sale of Investments . . . . . . . . . . . . . (3,988) --
Changes in Other Assets and Liabilities . . . . . . . . . (387) 126
------------- -------------
Net Cash (Used In) Provided by Operating Activities . . (139) 782
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Investments in Real Estate:
Building Improvements . . . . . . . . . . . . . . . . . . . -- (298)
Proceeds from Sale of Investment--Arapahoe . . . . . . . . 17,489 --
Marketable Securities Sold . . . . . . . . . . . . . . . . . 1,194 --
Transaction Fees . . . . . . . . . . . . . . . . . . . . . . (70) --
Principal Repayments on Marketable Securities--REMICs . . . -- 73
------------- -------------
Net Cash Provided by (Used In) Investing Activities . . 18,613 (225)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Mortgage Principal Payments . . . . . . . . . . . . . . . . (17) (23)
Payment of Mortgage Loan--Arapahoe . . . . . . . . . . . . . (6,098) --
------------- -------------
Net Cash Used In Financing Activities . . . . . . . . . (6,115) (23)
------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS . . . . . . . . . . 12,359 534
CASH AND CASH EQUIVALENTS--Beginning of Period . . . . . . . . 5,954 6,293
------------- -------------
CASH AND CASH EQUIVALENTS--End of Period . . . . . . . . . . . $18,313 $6,827
============== ==============
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE> 6
STATEMENT OF CHANGES IN
SHAREHOLDERS' EQUITY
(unaudited)
<TABLE>
<CAPTION>
Accumulated Taxable
Shares of Distributions
Beneficial Interest In Excess of Total Shareholders'
Number Amount Net Income Equity
(000) (000) (000)
--------------------------------------------------------------------------
<S> <C>
Balance: January 1, 1996 . . 6,432,626) $ 31,361) $(11,616) $ 19,745
Net Income for the Period . 4,233 4,233
Liquidating Distributions . (17,046) (17,046)
--------------------------------------------------------------------------
Balance: March 31, 1996 6,432,626 $ 14,315 $ (7,383) $ 6,932
==========================================================================
</TABLE>
The accompanying notes are an integral part of these statements.
5
<PAGE> 7
NOTES TO FINANCIAL STATEMENTS
1. These financial statements should be read in conjunction with the
financial statements and notes thereto contained in the Fund's Annual Report to
Shareholders for the year ended December 31, 1995. The results of operations
for the three months ended March 31, 1996 are not necessarily indicative of the
results for the entire year ending December 31, 1996.
2. On December 8, 1995, the Fund's Board of Trustees approved a Plan of
Liquidation and Termination (the "Liquidation Plan"). The Fund's Declaration of
Trust initially contemplated the liquidation of all of the Fund's investments
after a period of approximately seven to twelve years following completion of
its initial public offering. The Liquidation Plan provides that the Fund will
dispose of all of its assets, wind up its affairs, pay or adequately provide
for the payment of all of its liabilities and distribute for the benefit of its
shareholders all of the Fund's assets over 24 months in complete cancellation
and redemption of all issued and outstanding shares of beneficial interest. The
Liquidation Plan provides that the Fund's assets may be sold, conveyed,
transferred or otherwise disposed of when and on such terms and conditions as
are deemed by the Trustees to be in the best interests of the Fund and the
shareholders.
The Fund is currently in the process of liquidating its real estate
investments with the intention of distributing the net proceeds to its
shareholders in accordance with the Liquidation Plan. At March 31, 1996, the
Fund held an investment in an income-producing shopping center and also held a
limited partnership interest in a limited partnership that owns an
income-producing office building. It is contemplated that the Fund will be
completely liquidated and dissolved by December 8, 1997. To the extent that the
Fund has not disposed of all of its assets or made provision for all of its
liabilities on December 8, 1997, the Fund intends to form a liquidating trust,
the beneficiaries of which will be the shareholders of the Fund. All assets and
liabilities not disposed of and discharged will be transferred to the
liquidating trust. Shares of the Fund would no longer be traded and the
beneficial interests in the liquidating trust would not be readily
transferable.
The Fund intends to continue to qualify as a REIT under the Internal
Revenue Code during the Fund's liquidation period.
3. The Fund's financial statements have been prepared on the basis of a
going concern using historical cost. As of June 30, 1995, the Fund considered
all of its remaining investments as held for sale and reduced the carrying
value of such investments to the extent that each investment's then-current
carrying value exceeded its estimated net realizable value, defined as
estimated fair market value less selling costs. Upon obtaining binding
agreements of sale for all of its remaining real estate investments, the Fund
will account for such investments on a liquidation basis and will at that time
recognize estimated net gains, if any, on such investments. Prior to June 30,
1995, depreciation on real estate owned was computed using the straight-line
method over 40 years for buildings and costs incurred in conjunction with the
acquisition of real estate investments were deferred and amortized on a
straight-line basis over the life of the loan for mortgage loan investments and
the life of the property for equity investments. After June 30, 1995, no
depreciation or amortization expense related to the Fund's owned real estate
and acquisition costs is recognized, since the Fund's real estate investments
are considered to be held-for-sale assets.
4. On March 7, 1996, the Fund sold its Arapahoe Village Investment
("Arapahoe") in Boulder, Colorado for a gross contract price of $17,550,000.
The Fund reported in November 1995 that it had then been recently advised by
its adviser, Aldrich, Eastman, and Waltch, L.P. ("AEW"), that soil and
groundwater samples
6
<PAGE> 8
NOTES TO FINANCIAL STATEMENTS (continued)
extracted from the site revealed the presence of constituents of gasoline and
dry-cleaning fluid in the soil and groundwater. The samples were taken as part
of an environmental assessment undertaken at the request of a contract
purchaser in connection with a contemplated sale of the property. AEW
subsequently engaged on the Fund's behalf attorneys and environmental
consultants in an effort to further assess the scope and magnitude of the
possible contamination. Pursuant to the terms of an amended sale agreement, the
Fund completed the sale of Arapahoe to the same contract purchaser. The Fund
recorded a net gain on the sale of Arapahoe of $3,988,000, after payment by the
Fund of applicable transaction costs, including a disposition fee payable to
AEW in the amount of $232,000.
5. On February 29, 1996, the Fund took title to the Bayside Business Center
("Bayside") in lieu of foreclosure on the former senior and junior mortgage
loans receivable secured by Bayside. Under the original loans' terms, upon
repayment of the Bayside junior loan, the Fund was entitled to receive an
amount equal to the greater of (i) an amount sufficient to generate a 12.4%
internal rate of return (as defined in the loan documents) on the junior loan
or (ii) 50% of Bayside's fair market value in excess of $9 million. In
anticipation of the Fund exercising its call option in early 1995, at December
31, 1994, the Fund management reduced the loans' carrying value (remaining loan
balance plus the deferred interest receivable pursuant to the
shared-appreciation feature of the mortgage) to the estimated fair value of the
collateral less estimated selling costs. This determination to reduce the
carrying value was based on: (i) an evaluation of the borrower's remaining
equity in the Bayside property securing the mortgage loan and; (ii) the
economic prospects of the borrower and Bayside property over its expected
remaining holding period. On April 13, 1995, the Fund exercised its call right
on the loan and the entire balance of the loan became due and payable on
October 18, 1995.
The Fund and the borrower reached agreement to satisfy in full the
obligations due under the loan balance by means of a discounted payoff of
$7,600,000. The Fund also agreed to provide the borrower 120 days to obtain
financing to make the payoff in exchange for a commitment to transfer title to
the Fund in lieu of foreclosure if the borrower could not make the discounted
payoff. The borrower was unable to secure the necessary financing and,
accordingly, the Fund took title to Bayside in late February 1996. The former
borrower remained current on all interest payments due on the loan. Since both
the net proceeds expected to be received from the possible discounted payoff of
the loan and the estimated net realizable value of the collateral approximated
the investment's carrying value, no provision for possible losses was required
related to Bayside during the year ended 1995 or for the quarter ended March
31, 1996.
6. On January 12, 1996, the Fund sold its investment in marketable
securities (REMIC) for net proceeds of $1,194,000. Since such securities are
carried at fair market value, no gain or loss on the sale was recognized.
7. The Fund holds a Limited Partnership interest in Plymouth Street, L.P.
(the "Partnership"), which investment is accounted for under the equity method.
The Partnership owns an office property located in Mountain View, California
("Mountain View"). In 1992, the Partnership entered into a Loan Agreement and
Option and Put Agreement with an unrelated party. The Loan Agreement provides
for scheduled advances totaling $17.5 million over five years, such advances
secured by a non-recourse mortgage on the property bearing interest at 10% per
annum. The net proceeds of such advances are to be immediately distributed to
the Partners under the terms of the Partnership Agreement. Prior to these
agreements, there was no debt outstanding on the property. The Fund received
aggregate net cash proceeds of $14,299,000 from scheduled advances
7
<PAGE> 9
through 1994, which in the aggregate exceeded the carrying value of the
investment. Additionally, the Fund expects to receive an additional
distribution of $75,000 from the advance scheduled for July 1, 1997. A deferred
credit representing the excess of distributions received over the Fund's
carrying value is reflected in the balance sheets as Deferred Revenue--Mountain
View. The remaining proceeds are to be distributed to the general partner in
accordance with the scheduled advances under the Loan Agreement and terms of
the Partnership Agreement.
Under the terms of the Option and Put Agreement, the Partnership has the
right to require the lender to purchase the property during the period December
7, 1997 to February 28, 1998, and the lender has the exclusive right to
purchase the property during the period March 1, 1998 to May 30, 1998, for
$19,000,000. Upon exercise of the option or put, the Fund will receive 50% of
the proceeds in excess of the aggregate advances received to date and those yet
to be received under the Loan Agreement. The Partnership also has the right to
repurchase the lender's purchase option for an amount of at least $3,000,000
between July 1, 1996, and December 31, 1996.
As a result of the Loan Agreement executed during the fourth quarter of
1992 described above, and the resultant interest thereon, the Partnership has
since generated net losses. Such losses were allocated entirely to the general
partner in accordance with the terms of the Partnership Agreement. Since the
Fund has received distributions in excess of the carrying value of its
investment in the Partnership, if any future losses are allocated to the Fund,
such allocated losses will be recognized only to the extent of previously
allocated net income.
8
<PAGE> 10
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Vanguard Real Estate Fund II, A Sales-Commission-Free Income
Properties Fund (the "Fund"), was organized on September 24, 1987 as a
Massachusetts business trust and is a qualified finite-life real estate
investment trust ("REIT") under the Internal Revenue Code of 1986, as amended.
The Fund has no employees. The Fund's Declaration of Trust precludes the Fund
from reinvesting net proceeds from the sale or repayment of its real estate
investments after December 31, 1994 and contemplates the liquidation of all the
Fund's investments after a period of approximately seven to twelve years
following the completion of its initial public offering, or between 1995 and
2000, respectively.
On December 8, 1995, the Fund's Board of Trustees adopted a Plan of
Liquidation and Termination (the "Liquidation Plan"). The Trustee's decision
to adopt the Liquidation Plan at this point in the Fund's initially
contemplated liquidation period was driven by several factors, including real
estate market conditions affecting each investment in the Fund's portfolio and
tax considerations affecting real estate investment trusts. The Liquidation
Plan provides that the Fund will dispose of all of its assets, wind up its
affairs, pay or adequately provide for the payment of all of its liabilities
and distribute for the benefit of its shareholders all of the Fund's assets
over 24 months, in complete cancellation and redemption of all issued and
outstanding shares of beneficial interest. Under the Liquidation Plan, the
Fund's Adviser, Aldrich, Eastman and Waltch, L.P. ("AEW"), Trustees and
officers are authorized and directed to take any and all actions as may be
necessary or convenient to market the assets of the Fund and convert them into
a form that may be distributed to shareholders. The Liquidation Plan provides
that the Fund's assets may be sold, conveyed, transferred or otherwise disposed
of when and on such terms and conditions as are deemed by the Trustees to be in
the best interests of the Fund and the shareholders.
The Fund is currently in the process of liquidating its real estate
investments with the intention of distributing the net proceeds to its
shareholders in accordance with the Liquidation Plan. At March 31, 1996, the
Fund held investments in two income-producing properties, consisting of an
industrial park and a limited partnership interest in a limited partnership
that owns an income producing office building. It is contemplated that the
Fund will be completely liquidated and dissolved by December 8, 1997. To the
extent that the Fund has not disposed of all of its assets or made provision
for all of its liabilities on December 8, 1997, the Fund intends to form a
liquidating trust, the beneficiaries of which will be the shareholders of the
Fund. All assets and liabilities of the Fund not previously disposed of and
discharged will be transferred to the liquidating trust. Shares of the Fund
would no longer be traded and the beneficial interests in the liquidating trust
would not be readily transferable.
Pending disposition of the Fund's real estate investments pursuant to
the Liquidation Plan, the Fund's real estate investments will continue to be
subject to competition from existing commercial, industrial, and residential
properties and will be subject to competition from properties that are
developed in the future. The REIT provisions of the Internal Revenue Code of
1986 ("the Code") impose certain financial, investment and operational
restrictions that are not applicable to competing entities that are not REITs.
On February 29, 1996, the Fund took title to the Bayside Business
Center ("Bayside") in lieu of foreclosure on the former senior and junior
mortgage loans receivable secured by Bayside. On April 13, 1995, the Fund
exercised its call rights on the loans and the entire balance of the loans
became due and payable on October 18, 1995. The Fund and the borrower reached
agreement to satisfy in full the obligations due under the loan balance by
means of a discounted payoff of $7,600,000. The Fund also agreed to provide
the borrower 120 days to obtain financing to make the payoff in exchange for a
commitment to transfer title to the Fund in lieu of foreclosure if the borrower
could not make the discounted payoff. The borrower was unable to secure the
necessary financing and, accordingly, the
9
<PAGE> 11
Fund took title to Bayside in late February 1996. The former borrower remained
current on all interest payments due on the loan.
On March 7, 1996, the Fund sold its Arapahoe Village Investment
("Arapahoe") in Boulder, Colorado for a gross contract price of $17,550,000.
The Fund reported in November 1995 that it had then been recently advised by
AEW that soil and groundwater samples extracted from the site revealed the
presence of constituents of gasoline and dry-cleaning fluid in the soil and
groundwater. The samples were taken as part of an environmental assessment
undertaken at the request of a contract purchaser in connection with a
contemplated sale of the property. AEW subsequently engaged on the Fund's
behalf attorneys and environmental consultants in an effort to further assess
the scope and magnitude of the possible contamination. Pursuant to the terms
of an amended sale agreement, the Fund completed the sale of Arapahoe to the
same contract purchaser. The Fund recorded a net gain on the sale of Arapahoe
of $3,988,000, after payment by the Fund of applicable transaction costs,
including a disposition fee payable to AEW in the amount of $232,000.
In completing its Liquidation Plan, the Fund is in competition with
other domestic institutional investors, including commercial banks and other
financial institutions, insurance companies, pensions and other retirement
funds, mortgage bankers, other real estate investment trusts, real estate
brokers, developers and various types of foreign investors who may be seeking
to dispose of real estate investments. The principal factors of competition
for the disposition of leased properties which the Fund owns or which underlie
Fund investments include how rental rates, lease terms, free rent concessions
and tenant improvement allowances compare with those in local markets.
Of the Fund's two remaining real estate investments, the Fund's
adviser is currently actively marketing the Bayside investment for sale and,
for the Mountain View investment, the adviser is discussing alternatives that
could accelerate the Fund's receipt of its remaining residual interest under
the financing agreement. Based on information provided by the adviser, it is
possible that both investments could be sold during 1996. However, there can
be no assurance that such sales can be completed during 1996. Upon sale of
these two remaining investments, the Fund's Trustees and management intend to
complete the Fund's Liquidation Plan as soon as practicable thereafter. In
addition to liquidating the Fund's assets, settling all of the Fund's
liabilities, making a final distribution(s) to shareholders and dissolving the
Fund, such activities are expected to include, but not necessarily be limited
to, (i) delisting the Fund's shares from trading on the American Stock
Exchange, (ii) deregistering the Fund's shares under the Securities Exchange
Act of 1934, (iii) making provision for contingent liabilities of the Fund, if
any, and (iv) obtaining any necessary insurance coverages.
On January 12, 1996, the Fund sold its investment in marketable
securities (REMIC) for net proceeds of $1,194,000. Since such securities were
carried at fair market value, no gain or loss on the sale was recognized.
The Fund has elected to be treated as a REIT under the Code. The Fund
intends to operate in a manner that will continue to maintain its qualification
as a REIT during its liquidation period.
10
<PAGE> 12
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 1996 VS. THREE MONTHS ENDED MARCH 31, 1995
The Fund had net income of $4,233,000, or $.66 per share, for the three months
ended March 31, 1996, as compared to a net income of $434,000, or $.07 per
share, for the same period of 1995. Included in net income in the 1996 period
was a $3,988,000 net gain on the March 7, 1996 sale of the Arapahoe investment.
Excluding the Arapahoe gain, net income decreased by $189,000 for the three
months ended March 31, 1996, as compared to net income in the same period in
1995. This decrease, as more fully described below, reflects a smaller real
estate asset base in 1996 and corresponding decreases in net rental income and
mortgage interest income, partially offset by an increase in investment income
and decreases in mortgage interest expense, administrative expenses and
depreciation and amortization expense, in each case as compared to such items
in 1995.
Net rental income (rental income less real estate taxes and property operating
expenses) decreased by $647,000, or 75%, from $867,000 for the three months
ended March 31, 1995 to $220,000 for the three months ended March 31, 1996.
This decrease was primarily due to 1995 and 1996 property dispositions. The
1995 property dispositions included: (i) the sale of the Raleigh Building on
June 16, 1995, (ii) the sale of the Sequoia Commerce Center on November 17,
1995, and (iii) the sale of the remaining Penn Warner Buildings, which sales
generated for the Fund net rental income of $33,000, $286,000, and $155,000,
respectively, for the three months ended March 31, 1995. On March 7, 1996, the
Fund sold the Arapahoe Village Shopping Center. Arapahoe provided the Fund
with net rental income during the three months ended March 31, 1995, of
$392,000, as compared to $167,000 for the period such investment was held in
the first quarter of 1996. Offsetting this decrease was an increase
of $65,000 in net rental income generated by the Bayside Business Center,
resulting from the Fund taking title to Bayside on February 29, 1996, as
discussed below.
Mortgage interest income decreased by $109,000, or 50%, from $216,000 for the
three months ended March 31, 1995, to $107,000 for the same period of 1996.
This decrease was due to the Fund taking title to the Bayside Business Center
in lieu of foreclosure on the senior and junior mortgage loans receivable
secured by Bayside on February 29, 1996. Under the original loan's terms, upon
repayment of the Bayside junior mortgage loan receivable the Fund was entitled
to receive an amount equal to the greater of (i) an amount sufficient to
generate a 12.4% internal rate of return (as defined in the loan documents) on
the junior loan or (ii) 50% of Bayside's fair market value in excess of $9
million. In anticipation of the Fund exercising its call option in early 1995,
at December 31, 1994, Fund management reduced the loan's carrying value
(remaining loan balance plus a deferred interest receivable pursuant to the
shared-appreciation feature of the mortgage) to the estimated fair value of the
collateral less estimated selling costs. This determination to reduce the
carrying value was based on (i) an evaluation of the borrower's remaining
equity in the Bayside property securing the mortgage loan and (ii) the economic
prospects of the borrower and Bayside property over its expected remaining
holding period. On April 13, 1995, the Fund exercised its call right on the
loans and the entire balance of the loans became due and payable on October 18,
1995.
The Fund and the borrower reached agreement to satisfy in full the obligations
due under the loan balance by means of a discounted payoff of $7,600,000. The
Fund also agreed to provide the borrower 120 days to obtain financing to make
the payoff in exchange for a commitment to transfer title to the Fund in lieu
of foreclosure if the borrower could not make the discounted payoff. The
borrower was unable to secure the necessary financing and, accordingly, the
Fund took title to Bayside in late February
11
<PAGE> 13
1996. The former borrower remained current on all interest payments due on the
loan. Since both the net proceeds expected to be received from the possible
discounted payoff of the loan and the estimated net realizable value of the
collateral approximated the investment's carrying value, no provision for
possible losses were required related to Bayside during 1995, or for the three
months ended March 31, 1996.
At March 31, 1996 and March 31, 1995, the overall occupancy rate of the Fund's
remaining direct real estate investment was 100% and 95%, respectively. Leases
for 4.5% of the rentable space of the property directly owned by the Fund are
scheduled to expire during the remainder of 1996. The Fund's Adviser is
currently working to renew leases and to identify new tenants for space covered
by leases that have expired or are expiring. However, there is no assurance
that the Fund will be able to maintain its current occupancy and level of
rental income.
Investment income from short-term investments increased by $31,000, or 34%,
from $91,000 for the three months ended March 31, 1995 to $122,000 for the same
period of 1996. Investment income increased in the 1996 period primarily due
to an increase in the average short-term investment balance, as a result of the
net proceeds generated from the sales of the remaining Penn Warner buildings in
December 1995, the sale of the mortgage backed securities in January 1996, and
the sale of Arapahoe on March 7, 1996. Such net proceeds were included in the
April 30, 1996 distribution to the Fund's shareholders.
Mortgage interest expense decreased by $262,000, from $340,000 for the three
months ended March 31, 1995, to $78,000 for the comparable period of 1996.
This decrease is primarily attributable to: (i) the satisfaction of the
mortgage loan secured by the Fund's Sequoia investment resulting from the sale
of Sequoia in November of 1995, and (ii) the satisfaction of the senior
mortgage loan secured by Arapahoe Village in connection with the sale of
Arapahoe on March 7, 1996.
Administrative expenses decreased $53,000, or 30%, from $179,000 for the three
months ended March 31, 1995 to $126,000 for the comparable period of 1996.
This decrease was primarily due to lower advisory and administrative fees
payable in 1996 period, which fees are based on average invested real estate
assets. Such fees decreased as a result of the 1995 sales of the Sequoia
Commerce Center, Raleigh Office Building and the remaining Penn Warner
buildings.
Depreciation and amortization expense decreased by $221,000, or 100%. This
decrease resulted from management's decision to consider, as of June 30, 1995,
all of the Fund's remaining investments to be held for sale. After June 30,
1995, no depreciation or amortization expense related to the Fund's owned real
estate and acquisition costs was recognized. Prior to June 30, 1995,
depreciation on real estate owned was computed using the straight-line method
over 40 years for buildings and costs incurred in conjunction with the
acquisition of real estate investments were deferred and amortized on a
straight-line basis over the life of the loan for mortgage loan investments and
the life of the property for equity investments.
On March 20, 1996, the Fund's Board of Trustees declared a liquidating
distribution of $2.65 per share to shareholders of record on March 29, 1996.
The distribution was paid on April 30, 1996 and included net proceeds from the
sales of the Penn Warner buildings in December 1995 and Arapahoe Village in
March 1996. Given the Fund's reduced asset base, the Fund expects to make two
further distributions, other than quarterly distributions from operations; one
following the sale of Bayside and a final, residual payment upon final
dissolution of the Fund.
12
<PAGE> 14
LIQUIDITY AND CAPITAL RESOURCES
During the Fund's remaining liquidation period, its ability to make quarterly
distributions will be dependent upon its financial condition, earnings and cash
flow, and cash position and future working capital requirements. As a result
of 1995 property sales, and the subsequent year-end liquidating distribution of
the proceeds from such sales, the book value of the Fund's shares has been
significantly reduced. The amount of future income the Fund may be expected to
generate has also been reduced. Further, the Fund's remaining investments are
being held for sale, rather than the production of income, and, accordingly,
income from real estate operations can be expected to decline throughout the
Fund's liquidation period. Future liquidating distributions to shareholders,
excluding any amounts distributed from net proceeds from property sales, will
be largely dependent upon the amount of funds from operations generated by the
Fund during its liquidation period. Funds from operations are generated from
the ongoing operations of the Fund's direct real estate investments and
interest income on short-term investments. Accordingly, unfavorable economic
conditions, vacancies, environmental requirements, reductions in prevailing
short-term interest rates or increases in major expenses such as energy,
insurance, and real estate taxes during the liquidation period could have an
adverse impact upon the Fund's ability to generate future funds from operations
and to make distributions to shareholders.
The exact amount of quarterly distributions to shareholders will be determined
by the Trustees based on the Fund's actual results of operations and cash
position. The timing and amount of distributions of net proceeds from property
sales to shareholders will be determined by the Trustees as such amounts are
realized and based on relevant considerations such as the Fund's then current
results of operations, cash position, and future working capital requirements.
During the fourth quarter of 1990, the Fund instituted a share repurchase
program. Under the program, the Fund is authorized to repurchase in the open
market from time to time up to 300,000 of the Fund's outstanding shares. As of
March 31, 1996, an aggregate of 233,200 shares have been repurchased at an
aggregate cost of $1,586,000. No shares have been repurchased since October
1993 and the Fund's management, in consideration of the Liquidation Plan, does
not expect the Fund to repurchase any additional shares.
The Fund intends to continue to qualify as a real estate investment trust under
the Internal Revenue Code and distribute all of its taxable income. The Fund's
management considers the Fund's liquidity, as well as its ability to generate
cash, as adequate to meet its presently foreseeable operating and shareholder
distribution requirements and to fund its capital improvements.
13
<PAGE> 15
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
None
Item 2. Changes in Securities.
None
Item 3. Defaults Upon Senior Securities.
None
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable
Item 5. Other Information.
None
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
27. Financial Data Schedule
A Financial Data Schedule for the three months ended March
31, 1996, was submitted in electronic format only.
(b) Reports on Form 8-K
The Fund filed no reports on Form 8-K during the first quarter
ended March 31, 1996.
14
<PAGE> 16
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Vanguard Real Estate Fund II,
A Sales-Commission-Free Income Properties Fund
DATE May 15, 1996 /s/ John J. Brennan
------------ ---------------
John J. Brennan
President & Chief Executive Officer
DATE May 15, 1996 /s/ Ralph K. Packard
------------ ----------------
Ralph K. Packard
Vice President
15
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
REGISTRANT'S MARCH 31, 1996 UNAUDITED FINANCIAL STATEMENTS AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> MAR-31-1996
<CASH> 18,313
<SECURITIES> 0
<RECEIVABLES> 285
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 18,759
<PP&E> 7,500
<DEPRECIATION> 0
<TOTAL-ASSETS> 26,259
<CURRENT-LIABILITIES> 17,469
<BONDS> 0
0
0
<COMMON> 14,315
<OTHER-SE> (7,383)
<TOTAL-LIABILITY-AND-EQUITY> 26,259
<SALES> 0
<TOTAL-REVENUES> 578
<CGS> 0
<TOTAL-COSTS> 251
<OTHER-EXPENSES> 126
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 78
<INCOME-PRETAX> 4,233
<INCOME-TAX> 0
<INCOME-CONTINUING> 4,233
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,233
<EPS-PRIMARY> .66
<EPS-DILUTED> .66
</TABLE>
