REGENCY AFFILIATES INC
10-K405, 1999-04-14
HEATING EQUIPMENT, EXCEPT ELECTRIC & WARM AIR FURNACES
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<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                    FORM 10-K

                 X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934


     FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 COMMISSION FILE NO. 1-7949
                               ------------ ----

                            REGENCY AFFILIATES, INC.
                           -------------------------
             (Exact name of registrant as specified in its charter)


           Delaware                                          72-0888772
           --------                                          ----------
 (State or other jurisdiction of                           (IRS Employer
 incorporation or organization)                         Identification Number)

729 South Federal Hwy., Suite 307, Stuart, Fl.                 34994
- ----------------------------------------------                 -----
 (Address of principal executive offices)                    (Zip Code)

10842 Old Mill Road, # 5B, Omaha, NE                           68154
- ------------------------------------                           -----
 (Address of administrative offices)                         (Zip Code)

<TABLE>
<CAPTION>

<S>                                                                      <C>  
Registrant's Telephone Number (executive office), including Area Code:      (561-220-7662)
                                                                            --------------

Registrant's Telephone Number (administrative office), including Area Code: (402-330-7460) 
                                                                            --------------
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           SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                                                         Name of Each Exchange
                                                         ---------------------
          Title of Each Class                             on Which Registered
          -------------------                             -------------------

      Common Stock, $0.40 Par Value                              None

           SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT.

       ______________________________ None ______________________________
                                (Title of Class)



<PAGE>   2


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
                               ---          ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

The aggregate market value of voting stock held by non affiliates of the
registrant was approximately $8,842,000 on February 28, 1999, computed on the
basis of $.70 per share of Common Stock, the mean of the bid and asked price as
reported on the over-the-counter market of the bulletin board on that date.

The number of shares outstanding of the registrant's $.40 Par Value Common
Stock, as of February 28, 1999, was 12,632,089.

Documents incorporated by reference (See Exhibit Listing).

This report on Form 10-K consists of 36 pages, including two cover pages.



            (The remainder of this page is intentionally left blank.)

                                       2

<PAGE>   3


                                    FORM 1O-K

                                     PART I

ITEM 1.  BUSINESS.

General development of business.

         Regency Affiliates, Inc. (the "Company" or "Regency" or the
"Registrant") formerly TransContinental Energy Corporation, was organized as a
Delaware corporation in 1980 to be the successor to Transcontinental Oil
Corporation which existed since 1947.

         Subsequent to a restructuring in 1992, the Company, on July 7, 1993,
acquired an 80% interest in National Resource Development Corporation ("NRDC")
(the "NRDC Transaction") by the issuance of 2,975,000 shares of the Company's
$0.40 p.v. Common Stock, 208,850 shares of the Company's cumulative $100 Series
C Preferred Stock and 20% of the outstanding shares of Transcontinental Drilling
Company ("Drilling"), a subsidiary of the Company to the Statesman Group, Inc.
("Statesman"), an international business corporation organized under the laws of
the Bahamas (see Item 12). NRDC's principal asset consists of previously
quarried and stockpiled aggregate inventory located at a mine site in Michigan.
The aggregate inventory was, and continues to be, pledged to secure repayment of
certain Zero Coupon bonds which have been issued by NRDC having a face value at
maturity of $542,000 on January 1, 2002.

         On July 7, 1993, Statesman designated eight (8) persons to fill
existing vacancies on the Board of Directors of the Company. The appointments
were made by the sole acting director to fill the vacancies until their
successors are duly elected and qualified.

         Statesman, in addition to owning the shares of the Company's Common
Stock received in the NRDC Transaction, through its right to designate the eight
persons to fill the existing vacancies on the Board of Directors until a
Shareholders' Meeting, effectively has current voting control of a total of
3,982,368 shares, or approximately 32% of the 12,632,089 outstanding shares as
of December 31, 1998, by virtue of irrevocable proxies over 855,991 shares given
to a proxy committee of the Board of Directors as part of the NRDC Transaction,
and the 3,126,377 shares currently held by Statesman.

         On November 18, 1994, the Company acquired a limited partnership
interest in Security Land and Development Company Limited Partnership for an
equity investment of $350,000. The Partnership owns an office building complex
in Woodlawn, Maryland, which is leased to the United States Social Security
Administration.

         On March 17, 1997, the Company, through Rustic Crafts International,
Inc., a wholly owned subsidiary, acquired the assets and assumed certain
liabilities of Rustic Crafts, Co., Inc., a manufacturer of wood and cast marble
decorative electric fireplaces and related accessories. Consideration for the
acquisition consisted of cash of $1,100,000, assumption of certain liabilities,


                                       3
<PAGE>   4


and 100,000 shares of the Company's Common Stock, which shares are restricted
under the federal securities laws.

Financial information about industry segments and foreign and domestic
operations.

         Reference is made to the Company's financial statements at page F-1 for
this information.

Narrative description of business.

            SECURITY LAND AND DEVELOPMENT COMPANY LIMITED PARTNERSHIP

         On November 18, 1994, Regency Affiliates, Inc. acquired a limited
partnership interest in Security Land And Development Company Limited
Partnership (the "Partnership") for an equity investment of $350,000, which
amount was used to pay brokerage fees related to Regency's purchase of its
interest in the Partnership. Regency has no obligation to make any further
capital contribution to the Partnership. The Partnership owns the 34.3 acre
Security West complex at 1500 Woodlawn Drive, Woodlawn, MD consisting of a
two-story office building and a connected six-story office tower occupied by the
United States Social Security Administration Office of Disability and
International Operations under a nine year lease expiring October 31, 2003 (the
"Lease"). The buildings have a net rentable area of approximately 717,000 square
feet. The construction of the Security West Buildings was completed in 1972 and
the building has been occupied by the Social Security Administration since 1972
under prior leases between the U.S. Government and the Partnership.

         During 1994, the Partnership completed the placement of a $56,450,000
non-recourse project note, due November 15, 2003, issued by the Partnership. The
placement of the project note was undertaken by the issuance of 7.90%
certificates of participation and was underwritten by Dillon Read & Co., Inc.
The net proceeds received from the sale of the certificates have or are being
used to refinance existing debt of the Partnership related to the project, to
finance certain alterations to the project by the Partnership, to fund certain
reserves and to pay costs of the project note issue. The project note is a
non-recourse obligation of the Partnership and is payable solely from the Lease
payments from the U.S. Government. Such rental payments under the Lease are not
subject to annual appropriation by the United States Congress and accordingly,
the obligations to make such payments are unconditional general obligations of
the government backed by the full faith and credit of the United States. The
payments under the Lease consist of base rent, maintenance rent, additional base
rent, additional maintenance rent and the government tax reimbursement amount.
The base rent, maintenance rent and additional base rent are fixed amounts and
are not subject to adjustment. The base rent and the additional base rent
together constitute the finance rent, which will be utilized to pay principal
and interest on the project note, certain real estate taxes and costs of
insurance and other reserves.

         The terms of the Security Land And Development Company Limited
Partnership Agreement (as amended) and the project note (which note will be
fully amortized over the term of the lease) call 


                                       4
<PAGE>   5

for Regency Affiliates, Inc. to be allocated 95% of the profits and losses of
the Partnership until October 31, 2003, and 50% thereafter. Regency is to
receive certain limited cash flow after debt service, and a contingent equity
build-up depending upon the value of the project upon termination of the Lease.

          The transaction with Security Land And Development Company Limited
Partnership provides for the Company to receive management fees of $100,000 per
year.



                        RUSTIC CRAFTS INTERNATIONAL, INC.

         Rustic Crafts International, Inc., a wholly owned subsidiary of the
Company, is a manufacturer of decorative wood and cast marble fireplaces,
mantels, shelves, fireplace accessories and other home furnishings.
Rustic Crafts employs approximately 50 persons.

         In 1998 and 1997 Rustic Crafts generated revenues of approximately
$3,698,000 and $2,873,000, respectively, which represented 98% and 99% of total
revenues of the Company, excluding income from its equity investment in the
Partnership. Its largest customer, J.C. Penney Co., Inc. represents 53% and 28%
of the consolidated revenues of Regency in 1998 and 1997, respectively.
Approximately 35% of the sales of Rustic Crafts occur in the fourth quarter of
the calendar year. As of December 31, 1998, Rustic Crafts had a backlog of
orders of approximately $1,110,000. Although orders are generally subject to
termination, the Company has historically experienced minimal cancellation of
orders.

         Rustic Crafts purchases the raw materials used in its manufacturing
process from several suppliers. The Company believes that there is minimal risk
from any cancellation of suppliers and that there are several suppliers who are
capable of supplying similar quality products at competitive prices.

         Rustic Crafts has a number of competitors for its products, and
management considers the business to be competitive.

                                      NRDC

         NRDC has as its sole asset approximately 75 million short tons of
previously quarried and stockpiled rock ("Aggregate") located at the site of the
Groveland Mine in Dickinson County, Michigan. During the year ended December 31,
1998, NRDC made only casual sales of Aggregate (less than $100,000).

                                       5

<PAGE>   6


         Aggregate is primarily sold for railroad ballast, road construction,
construction along shore lines and decorative uses. The market for aggregate
stone is highly competitive and, as shipping costs are high, the majority of
sales, if any, can be anticipated to be made locally. Other companies that
produce rock and aggregate products are located in the same region as the
Groveland Mine. Many of the competitors have greater financial and personnel
resources than the Company. As a consequence, there can be no assurance that
acting alone NRDC will be able to consummate sales of material amounts of its
Aggregate.

Employees

         As of December 31, 1998, Regency and its subsidiaries employed 54
people.



ITEM 2.  PROPERTIES

         Reference is made to Item 1, Business, page 3 of this report, for a
description of the Security West Building at 1500 Woodlawn Drive, Woodlawn, MD,
which property is owned by Security Land And Development Company Limited
Partnership.

         Rustic Crafts International, Inc. conducts its manufacturing operations
in a multistory leased facility located at 315 Cherry Street, Scranton,
Pennsylvania and in a second leased facility located at 305 Cherry Street,
Scranton, Pennsylvania. Both premises are occupied pursuant to a sublease which
terminates July 31, 2001, with Rustic Crafts Co., Inc., the seller of the assets
of the business. In March 1998, the Company purchased a 126,000 square foot
building located at 40 Poplar Street in Scranton, Pennsylvania. The Company has
renovated the building and will begin to occupy the space during 1999. Almost
all manufacturing operations will eventually be moved to this location.
Approximately 50,000 square feet in this building are leased to other tenants.

         As of December 31, 1998, NRDC owned approximately 75 million short tons
of Aggregate located at the site of the Groveland Mine in Dickinson County,
Michigan. The Groveland Mine is an iron ore mine that was shut down in 1981 by a
former owner and operator, M.A. Hanna Company. The mine was acquired by
International Aggregate Corporation in December, 1989. International Aggregate
Corporation subsequently transferred title to the Aggregate to National Resource
Development Corporation (Delaware), NRDC's predecessor.

         The 75 million short tons of Aggregate is commingled with other
aggregate not owned by NRDC and is rock that was separated from iron ore during
previous mining operations. The ownership of the Aggregate is subject to a
Royalty Agreement between North American Demolition Company (International
Aggregate Corporation's predecessor in title) and M.A. Hanna Company dated
December 22, 1989, as amended, which requires the payment of certain royalties
to M.A. Hanna Company upon sales of Aggregate.

                                       6
<PAGE>   7


         As of December 31, 1998 the Company owned a one-story commercial
building located on a one-eighth acre parcel of land located in Stuart, Florida
which was leased to a single tenant. The Company also owned a condominium in
Jensen Beach, Florida. These properties were sold in March 1999 at approximately
their original purchase price.


ITEM 3.  LEGAL PROCEEDINGS

         As of December 31, 1998 and the date of this report there were no legal
proceedings involving the Company or any of its subsidiaries.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         No matters were submitted to the vote of security holders during the
quarter ending December 31, 1998.



                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS' MATTERS

Market information.

         Regency's Common Stock is traded in the over-the-counter market on the
bulletin board. The following table sets forth the high and low bid prices for
each calendar quarter during the last two fiscal years of the Company. The bid
quotations represent interdealer prices and do not include retail markups,
mark-downs or commissions. The prices indicated may not reflect the actual
market for substantial quantities of the Company's Common Stock. As of December
31, 1998, there were approximately 3,200 common shareholders of record.

                 YEAR ENDED
               DECEMBER 31, 1997       HIGH ($)             LOW ($)
               -----------------       --------             -------

               First Quarter            .72                   .44
               Second Quarter           .69                   .50
               Third Quarter            .94                   .56
               Fourth Quarter           .69                   .48


                                       7
<PAGE>   8


                   YEAR ENDED
                DECEMBER 31, 1998       HIGH ($)            LOW ($)
                -----------------       --------            -------

                First Quarter            .63                   .44
                Second Quarter           .78                   .59
                Third Quarter            .85                   .50
                Fourth Quarter           .66                   .50


Dividend policy.

         The Company has not paid or declared cash dividends on its Common Stock
during the last two fiscal years. The Company has no present intention to pay
cash dividends on its Common Stock in the future.

         In early 1990, Continental Illinois National Bank & Trust of Chicago
("Continental") resigned as the Company's registrar and transfer agent because
of the Company's inability to pay Continental for services performed. The
records were forwarded to the Company and the Company has since assumed the
record keeping responsibility.

Issuance of securities.

         In 1998, the Company issued 187,000 shares of its Common Stock to
William R. Ponsoldt, Sr. as part of his compensation. Also, in 1998, the Company
issued 10,000 shares of its Common Stock to two employees of Rustic Crafts as
part of their compensation.

         In March 1997, the Company issued 100,000 shares of its Common Stock at
a value of $60,000 to Rustic Crafts Co., Inc., as part of the sale of that
corporation's business to Rustic Crafts International, Inc. The Company received
no cash consideration for the issuance of these shares and no underwriter was
involved. The Company claims an exemption from registration pursuant to Section
4 of the Securities Act of 1933.

         Effective June 3, 1997, the Company issued 466,667 shares of Common
Stock at a value of $233,333 and options to purchase an additional 6.1 million
shares of Common Stock to Statesman Group, Inc. as part of the consideration to
secure the release of Mr. William R. Ponsoldt, Sr. to serve as President and
Chief Executive Officer of the Company and in consideration of the agreement by
Statesman to provide loan guarantees not to exceed the sum of $300,000 upon the
request of the Company and a showing of reasonable need. Pursuant to the Amended
and Restated Agreement between the Company and Statesman, until their date of
expiration, the options are exercisable at any time in whole or in part at a
price equal to the lower of (a) the closing trading price of the shares as of
the most recent date on which at least 10,000 shares of such stock were traded,
or (b) the average closing trading price of the shares during the ninety day
period immediately preceding the date of exercise. The Company agreed to reserve
sufficient shares to meet the requirements of the options. 


                                       8
<PAGE>   9

The options are exercisable immediately and remain exercisable until April 15,
2007. At the option of Statesman, payment may be made by Statesman for exercise
of the options, in whole or in part, in the form of a promissory note executed
by Statesman, secured only by a pledge of the shares purchased, with interest
accruing for any quarter at the prime rate, and interest and principal payable
in a balloon payment five years after the date of the note, provided that if the
Company's Board of Directors reasonably determines that exercising the options
by delivery of a note would render the respective purchase of shares void or
voidable, then the Board may require, as a condition to exercise of the options,
that Statesman either (i) pay at least the par value of the shares in cash (with
the balance paid by delivery of a note), or (ii) provide acceptable collateral
other than the shares themselves to secure payment of the note. The Company has
determined that these options have no readily determinable fair value consistent
with the provisions of SFAS No. 123. Therefore, the Company has not recognized
any cost associated with the issuance of these options, and net earnings per
share for 1997 have not reflected any such costs.


Securities of the registrant.

         Voting $0.40 Par Value Common

         Regency Affiliates, Inc. has authorized 25,000,000 shares of its voting
$0.40 p.v. Common Stock. Holders of the Common Stock are entitled to one vote
per share on matters submitted to shareholders for approval or upon the election
of directors.

         Cumulative Contingent Convertible Preferred $10 Stated Value Series-B
         Stock - $0.10 Par Value

         By agreement and in settlement of the Senior Lenders' obligations as
part of the Company's 1992 Restructuring Plan, 212,747 shares of the Series-B
Preferred Stock were issued to Washington Square Capital and 158,000 shares to
Cargill Financial Services. Such shares (370,747 in the aggregate) represent
100% of the shares of Series-B authorized, issued and outstanding. Semi-annual
dividend periods commence on the 24th month from the consummation of an "Initial
Business Combination", as defined in the Certificate of Designation for the
Series-B Preferred Stock, and accrue for a period of 35 months without cash
payment. Dividends accrue at the rate of 6% per annum. The holders of the
Series-B Preferred Stock hold contingent rights to convert into Common Stock
exercisable on the earlier of the date that the Company (and its tax
consolidated subsidiaries) has accumulated consolidated taxable earnings of $55
Million, or the date that at least 80% in value of any convertible securities of
the Company, as adjusted in certain circumstances, issued in the Initial
Business Combination are retired or converted by the holders thereof. The
Series-B shares carry a preference upon liquidation. Except in limited
circumstances, the Series-B shares carry no voting rights. The Company has the
right to redeem the Series-B Preferred Stock at any time.

                                       9
<PAGE>   10

         Cumulative Senior Preferred $100 Stated Value Series-C Stock - $0.10
         Par Value

         On July 7, 1993, 208,850 shares of the Company's Cumulative Senior
Preferred $100 Series-C Stock were delivered to Statesman Group, Inc. as part of
the NRDC Transaction. Such shares represent 100% of the issued and outstanding
Series-C shares. 210,000 shares of the Series-C Preferred Stock are authorized.
Quarterly dividend periods commenced on September 30, 1993 and quarterly
dividends per share are equal to 20%, not to exceed $500,000, of the annual
after tax earnings of NRDC, divided by the number of shares outstanding. The
Series-C shares carry a preference upon liquidation. Except in limited
circumstances, the Series-C shares carry no voting rights. The Company has the
right to redeem the Series-C Preferred Stock at any time.

         Cumulative Contingent Convertible Junior Preferred $10 Stated Value
         Series-D Stock - $0.10 Par Value

         The Series-D junior preferred shares were issued in exchange for the
serial restructuring promissory notes issued as part of Company's 1992
Restructuring. The total issued was 25,694 shares and was required by the
Acquisition Agreement as a condition to closing. 26,000 shares of the Series-D
Preferred Stock are authorized. Annual dividend periods commenced on January 1,
1993. Dividends accrue at the rate of 7% per annum. The holders of the Series-D
Preferred Stock hold contingent rights to convert into Common Stock, but can not
convert without the consent of a majority of the holders of the Series-C
Preferred Stock. The Series-D shares carry a preference upon liquidation. Except
in limited circumstances, the Series-D shares carry no voting rights. The
Company has the right to redeem the Series-D Preferred Stock at any time.

         Series-E Cumulative Convertible Preferred Stock - $100 Stated Value -
         $0.10 Par Value

         Quarterly dividends on the Series-E Preferred Stock are cumulative from
the dates of original issue and are payable in cash or accrued at the option of
the Company. The Series-E Preferred Stock carries the right to receive an annual
dividend of $12.50 per share. Subject to certain conditions, the Series-E
Preferred Stock must be redeemed by the Company commencing on the fifth
anniversary from the date of issuance. At any time after the second anniversary
of the date of issuance, the Company may redeem the shares at their stated value
plus accrued and unpaid dividends. Holders of the Series-E Preferred Stock,
commencing on the second anniversary of the date of issuance, have the right to
convert their shares into a number of shares of Common Stock of the Company
determined by dividing $100, plus accrued and unpaid dividends, by a figure
equal to 88% of the average bid price for Common Stock for the 90 days previous
to the date the Series-E stock is surrendered for conversion. Redemption of the
Series-E shares by the Company will terminate the conversion rights. The
Series-E shares carry a preference upon liquidation. Except in limited
circumstances, the Series-E shares carry no voting rights. As of December 31,
1998, a total of 2,477 shares of the Series-E Preferred Stock have been
converted into 468,551 shares of the Company's Common Stock, leaving 2,567
shares of the Series-E Preferred Stock issued and outstanding at year end.


                                       10
<PAGE>   11

         RegTransco, Inc. Ownership

         RegTransco, Inc. (RTI) has two classes of outstanding common stock,
Class A and Class B. There are 20,000 shares of Class A common stock
outstanding, all of which are owned by Drilling (an 80% owned subsidiary of
Regency Affiliates, Inc.). Five thousand (5,000) shares of Class B common stock
were issued to the Original Investors who financed the Company's Chapter XI
filing in 1986 and 1987 and represented 20% of the voting power of RTI's
outstanding common stock. As part of the 1992 Restructuring, the holders of the
Class B stock returned their 20% interest as a group to RTI. RTI's Class A and
Class B common stock are equal to each other in all respects except dividend
preference. Holders of shares of Class A and Class B common stock are entitled
to one vote per share in the election of directors.

         TransContinental Drilling Company ("Drilling") Ownership

         As part of the NRDC Transaction, Drilling issued sufficient shares to
transfer 20% of the issued and outstanding stock of Drilling to Statesman. The
remainder (80%) is owned by Regency Affiliates, Inc.

         NRDC

         As part of the NRDC Transaction, Regency Affiliates, Inc. acquired 80%
of the issued and outstanding stock of NRDC. The remainder (20%) is owned by
Statesman.

         Rustic Crafts International, Inc.

         Regency Affiliates, Inc. is the owner of 100% of the issued and
outstanding common stock of Rustic Crafts International, Inc.


                                       11


<PAGE>   12


ITEM 6.           SELECTED FINANCIAL DATA.


<TABLE>
<CAPTION>

                                                                             
                                        1998           1997          1996         1995            1994   
                                        ----           ----          ----         ----            ----   
- ---------------------------------------------------------------------------------------------------------
<S>                              <C>           <C>               <C>           <C>           <C>   
REVENUES                             $3,789,839    $2,908,253        $6,102        $2,597        $5,125

INCOME FROM EQUITY INVESTMENT IN
PARTNERSHIP                           3,950,090     3,820,913     4,268,904     3,718,056       100,000

NET INCOME (LOSS)                     1,794,560     2,187,618     2,802,467     3,298,589     (102,541)

NET INCOME (LOSS) PER SHARE
(BASIC)                                    0.14          0.17          0.24          0.29        (0.01)

NET INCOME (LOSS) PER SHARE
(DILUTED)(1995 RESTATED)                   0.12          0.15          0.20          0.21        (0.01)

TOTAL ASSETS                         24,127,416    15,432,529    11,566,678     4,980,148     1,473,832

LONG-TERM DEBT (INCLUDING CURRENT
PORTION) & REDEEMABLE PREFERRED      11,795,480     5,175,400     4,600,994       691,254       557,954
STOCK
</TABLE>




ITEM 7.  MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS 
         OF OPERATIONS.


General.

         Regency Affiliates, Inc. (the "Company") is the parent company of
several subsidiary business operations. The Company is committed to develop
and/or monetize these business operations for the benefit of its shareholders
and continue to commit both financial and personnel resources to an active
merger and acquisition program in order to enhance common stockholders' values.
The Company's Stockholders' Equity at December 31, 1998 was $11,219,050 as
compared to $9,341,708 at December 31, 1997, an increase of $1,877,342 for the
year ended December 31, 1998.

                                       12

<PAGE>   13

Liquidity and Capital Resources.

         The investment in Security is estimated to provide the Company with
management fees of approximately $100,000 per annum until 2003. In the year
ending December 31, 1998, the Company's income from its equity investment in the
Partnership was $3,950,090. These funds, however, are presently committed for
the amortization of the outstanding principal balance on Security's real estate
mortgage and, while the Company's equity investment has increased to
$15,799,631, the partnership does not provide liquidity to the Company in excess
of the $100,000 annual management fee. The Company has, however, been successful
in obtaining financing with respect to this investment.

         On March 15, 1998, Rustic Crafts purchased a building of 126,000 square
feet located near the current facility in Scranton, Pennsylvania. The cost of
acquiring and equipping this facility of approximately $2 million is being
funded by new borrowings from PNC Bank in the form of a first mortgage in the
amount of $960,000, a construction line of credit of $410,000 and equipment
financing of $400,000. This new facility will significantly increase the
operating capacity and enable Rustic Crafts to more efficiently meet its current
order backlog and increase its customer base. Rustic Crafts has recently
employed a new President who has substantial industry background and plans to
increase its sales and distribution of both manufactured and imported products.
Management anticipates that Rustic Crafts will provide significant cash
distributions for use by the Company.

         On the date of acquisition of the new facility, a tenant was renting
23,000 square feet of this facility at a base rent of $17,400 per year plus an
allocable share of the real estate taxes. The Company intends to maintain this
tenant relationship on an ongoing basis. As of August 15, 1998, the Company
rented an additional 28,000 square feet at an annual minimum rent of $71,680 and
plans to occupy the remainder of this facility for operations.

         The Company experimented during 1997 for a one month period by
installing aggregate crushing and marketing operations at the Groveland Mine in
an informal joint venture with another company. The Company marketed
approximately 60,000 tons of aggregate rock and had revenue from all sources of
approximately $92,000,000 during the year ended December 31, 1998. Based on this
experiment, the Company is attempting to establish a permanent infrastructure to
commercialize the inventory of previously quarried and stockpiled aggregate at
the Groveland Mine in conjunction with an experienced aggregate supply company.
At this time there is no assurance that such 


                                       13
<PAGE>   14

commercialization will occur. The Company is also exploring opportunities to
monetize this asset for the benefit of the Company's shareholders and has thus
entered in an Agreement and Plan of Merger with Cotton Valley with respect to
this property (see Subsequent Events).

         The Company is continuing to explore opportunities for the acquisition
of companies with operations that will provide additional liquidity and cash
flow (see Subsequent Events with respect to GuildMaster). The Company
anticipates that such acquisitions would be financed by borrowings secured by
the assets acquired and by the proceeds of its recent Loan Agreement, or other
loans. There can be no assurance that any such acquisition or transaction will
come to fruition. On August 17, 1998, the Company engaged Cruttenden Roth, Inc.
a California based Investment Banking firm, to assist the Company with its
acquisition program. The Company has agreed to pay Cruttenden Roth a fee of
$25,000 payable over 12 months and a success fee if the Company acquires a
business within the next two years. The Company is analyzing the acquisition
prospects introduced by Cruttenden Roth.

Results of Operations.

         The operations of Regency Affiliates, Inc. and its subsidiaries during
the year ended December 31, 1998, included the casual sales of aggregate,
limited rental income and the sale of wood and cast marble decorative
fireplaces, heater logs, and related accessories, as well as an active merger
and acquisition program with a view to enhance future company value.

         1998 Compared to 1997

         Net sales increased $881,586 in 1998 over 1997 reflecting twelve months
of sales of Rustic Crafts in 1998 compared to ten months in 1997. Sales for the
ten-month period ended December 31, 1998 increased 14% or $396,000 over the
comparable period in 1997. As a result of increased volumes, Rustic Crafts
purchased an additional facility in order to meet the increased demand for its
products. Rustic Crafts also hired a new president to oversee the manufacturing
operations which has slightly increased its administrative costs.

         Gross margins increased $188,714 as a result of the increase in sales
described above. However, the percentage of gross margin to sales declined from
33.7% in 1997 to 30.8% in 1998, primarily as a result of higher direct labor
costs at Rustic Crafts.

         General and administrative expenses increased $255,221 or 14.3% in 1998
over 1997, largely as a result of increased corporate expenses, particularly
executive salaries and bonuses and a transition of management at Rustic Crafts.

                                       14
<PAGE>   15

         Income from equity in partnership increased $129,177 over 1997 due to
higher rental income from renovated space partially offset by higher net
interest expense, depreciation and other operating costs.

         Other income increased $95,920 in 1998 primarily as a result of rental
income from the building purchased by Rustic Craft in early 1998, and interest
income from short-term investments purchased with the proceeds of long-term
debt.

         Interest expense increased $512,754 in 1998 over 1997. This reflects
the higher principal of the KBC loan and the payment of a penalty to pay off the
SIPI loan before maturity. The effective interest rate was reduced from almost
20% on the SIPI loan to less than 9% on the KBC loan.

         Net income decreased $393,058 in 1998. Although gross margins increased
$188,714, the increase was offset by increases in general and administrative
expenses and interest expense.

         1997 Compared to 1996

         1997 included ten months of operations of Rustic Crafts which reflect
net sales of $2,872,865, cost of sales of $1,912,413 and general and
administrative expenses of $610,714 exclusive of the allocation of general and
administrative expenses of $230,000 from Regency. There were no operations of
Rustic Crafts included in 1996.

         Income from the Company's equity investment in Security Land and
Development decreased $447,991 in 1997 as compared to 1996. This decrease was
the result of lower interest income as escrow funds were invested in
renovations, and higher depreciation expense due to capitalized improvements,
offset by reductions in interest expense and increases in other income.

         Interest expense increased $396,759 primarily due to interest on the
SIPI loan for twelve months in 1997 compared to six months in 1996.

         Income tax expense decreased $152,723 in 1997. Income taxes in 1996
included provisions for years prior to 1996.

         Net income attributable to common shareholders decreased $586,980 in
1997 compared to 1996. The decrease is the result of operating income from
Rustic Crafts and lower income taxes offset by increases in administrative
expenses, lower equity earnings from investment in Security Land and Development
and increased interest expense.

Subsequent Events

         On March 1, 1999, the Company and Cotton Valley Resources Corporation
("Cotton Valley") entered into an Agreement and Plan of Merger (the "Merger
Agreement") which was subsequently approved by each company's Board of
Directors. The Merger Agreement provides that Cotton 

                                       15
<PAGE>   16

Valley will exchange 15 million of its common shares for the Company's interest
in NRDC and 10 million of its common shares for Statesman's interest in NRDC and
Statesman's interest in International Aggregate Company. The Merger Agreement is
contingent upon the vote of the Cotton Valley shareholders which is scheduled
for May 21, 1999, Cotton Valley maintaining its American Stock Exchange listing,
and other matters. While the Company expects that these contingencies will be
satisfied, there can be no assurance that these expectations will be met and the
transaction will be consummated.

         In March 1999, the Company reached an agreement in principle to acquire
the assets and assume certain liabilities of GuildMaster, Inc. ("GuildMaster").
The agreement provides that the Company will acquire the assets of GuildMaster
in exchange for $500,000 in cash, $1,800,000 of face value convertible preferred
shares with terms and conditions to be designated by the Board of Directors, the
assumption of certain liabilities and other consideration based on the future
performance of GuildMaster. GuildMaster manufactures innovative and
fashion-forward decorative accessories for the home. Revenues for 1998 are
estimated to be $4,500,000. While the Company believes that this transaction
will be consummated, there can be no assurance that the transaction will be
completed or that, if completed, it will be on the same or similar economic
terms.

Year 2000 Issues.

         The Company has determined that there will be no material effect on the
Company's business, results of operations or financial condition as a
consequence of its Year 2000 issues, considering the Company's efforts to avoid
any such consequences.

Statements of Financial Accounting Standards.

         The Financial Accounting Standards Board issued "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of "
("SFAS 121"). SFAS 121 requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. SFAS 121 has not had a material effect on the Company's
financial position or results of operation.

         Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation," establishes accounting and reporting standards for
stock-based compensation plans. This standard encourages the adoption of the
fair value-based method of accounting for employee stock options or similar
equity instruments, but continues to allow the Company to measure compensation
cost for those equity instruments using the intrinsic value-based method of
accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees." Under the fair value-based method, compensation
cost is measured at the grant date based on the value of the award. Under the
intrinsic value-based method, compensation cost is the excess, if any, of the
quoted market price of the stock at the grant date or other measurement date
over the amount the employee must pay to acquire the stock. The Company uses the
intrinsic value-

                                       16
<PAGE>   17

based method for stock-based compensation to employees. As a result, this
standard does not have any effect to the Company's financial statements other
than to require disclosure of the pro forma effect on net income of using the
fair value-based method of accounting. Management believes this effect to
currently be immaterial.


Forward-Looking Statements.

         This Report contains forward-looking statements which are made pursuant
to the safe harbor provisions of the Securities Litigation Reform Act of 1995.
Statements as to what the Company "believes," "intends," "expects," or
"anticipates", and other similarly anticipatory expressions, are generally
forward-looking and are made only as of the date of this Report. Readers of this
Report are cautioned not to place undue reliance on such forward-looking
statements, as they are subject to risks and uncertainties which could cause
actual results to differ materially from those discussed in the forward-looking
statements and from historical results of operations. The Company is subject to
numerous contingencies, risks and uncertainties including, but not limited to,
the following that could have a severe impact on the Company;


          (i)     The Company currently does not generate positive cash flow
                  and, historically, the Company has had limited operating
                  activities and substantially all of its efforts have been
                  devoted to acquiring or developing profitable operations. The
                  Company's ability to continue in existence is partly dependent
                  upon its ability to attain satisfactory levels of operating
                  cash flows.

         (ii)     The Company currently lacks the necessary infrastructure at
                  the site of the Groveland Mine to permit the Company to make
                  more than casual sales of the Aggregate.

         (iii)    As of December 31, 1998, the Company was dependent upon its
                  investment in Security Land And Development Company Limited
                  Partnership, the operations of Rustic Crafts International,
                  Inc. and its interest income for a material portion of its
                  cash flow and for a material portion of its reportable income.

         (iv)     The investment activities of the Company do not, in and of
                  themselves, generate sufficient cash flow to cover its
                  corporate operating expenses and thus the Company must rely on
                  its cash reserves to fund these expenses.

         (v)      An unsecured default in the Lease or sudden catastrophe to the
                  Security West Building from uninsured acts of God or war could
                  have a materially adverse impact upon the Company's investment
                  in Security Land And Development Company Limited Partnership
                  and therefore its financial position and results of
                  operations.

         (vi)     The failure of the Social Security Administration to renew its
                  lease of the Security West Buildings upon its expiration on
                  October 31, 2003 could have a materially adverse impact upon
                  the Company's investment in Security Land And Development
                  Company Limited Partnership.

         (vii)    The Company has significant tax loss and credit carryforwards
                  and no assurance can be provided that the Internal Revenue
                  Service would not attempt to limit or disallow altogether the
                  Company's use, retroactively and/or prospectively, of such
                  carryforwards, due to ownership changes or any other reason.
                  The disallowance of the utilization of the Company's net
                  operating loss would severely impact the Company's financial
                  position and results of operations due to the significant
                  amounts of taxable income (generated by the Company's
                  investment in Security) that has in the past been, and is
                  expected in the future to be, offset by the Company's net
                  operating loss carryforwards.

                                       17

<PAGE>   18

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

         The Financial Statements and supplementary data required by Item 8 of
Part II of Form 10-K for the year ending December 31, 1998, are included as
follows:

<TABLE>
<CAPTION>

                                                                                       Page
                                                                                       ----

<S>                                                                                <C>
         Independent Auditors' Report                                                   F-3

         Consolidated Balance Sheets as of December 31, 1998 and 1997                   F-4


         Consolidated Statements of Operations for the years ended December 31,
         1998, 1997 and 1996                                                            F-6

         Consolidated Statements of Shareholders' Equity for the years ended
         December 31, 1998, 1997 and 1996                                               F-7

         Consolidated Statements of Cash Flows for the years ended December 31,
         1998, 1997 and 1996                                                            F-8
 
</TABLE>
                                      18
<PAGE>   19



                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                       1998 CONSOLIDATED FINANCIAL REPORT

                                       F-1

<PAGE>   20





                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                                    CONTENTS



- ------------------------------------------------------------------------------

                                                                         Page
                                                                         ----


AUDITORS' REPORT                                                         F-3

FINANCIAL STATEMENTS
    Consolidated balance sheets                                    F-4 - F-5 
    Consolidated statements of operations                                F-6 
    Consolidated statements of shareholders' equity                      F-7 
    Consolidated statements of cash flows                          F-8 - F-9 
    Notes to consolidated financial statements                   F-10 - F-29


                                       F-2

<PAGE>   21


                          Independent Auditors' Report
                          ----------------------------

Shareholders and Board of Directors
Regency Affiliates, Inc.
Stuart, Florida


         We have audited the accompanying consolidated balance sheets of Regency
Affiliates, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

         We did not audit the 1998, 1997 and 1996 financial statements of
Security Land and Development Company Limited Partnership, the investment in
which is reflected in the accompanying financial statements using the equity
method of accounting. The investment in this partnership represents 65% and 77%
of consolidated total assets as of December 31, 1998 and 1997, respectively, and
100% of the income from equity investment in partnership for the years ended
December 31, 1998, 1997 and 1996. Those financial statements were audited by
other auditors whose reports have been furnished to us, and our opinion, insofar
as it relates to the 1998, 1997 and 1996 amounts included for Security Land and
Development Company Limited Partnership, is based solely on the reports of such
other auditors.

         We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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, based on our audits and the report of the other
auditors, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Regency Affiliates,
Inc. and subsidiaries as of December 31, 1998 and 1997, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998 in conformity with generally accepted
accounting principles.

         As more fully discussed in Note 1.L. to the financial statements, the
Company has adopted various Statements of Financial Accounting Standards and
other professional standards as required. The disclosure requirements of
Statement of Position 94-6 (SOP 94-6), "Disclosure of Certain Risks and
Uncertainties" are included throughout the notes to the Company's financial
statements with an emphasis in Notes 1 and 12.

                                     HAUSSER + TAYLOR LLP

Cleveland, Ohio
March 31, 1999

                                       F-3


<PAGE>   22
                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

                          December 31, 1998 and 1997
- --------------------------------------------------------------------------------

                                                  1998            1997
                                                  ----            ----
      ASSETS
      ------

  CURRENT ASSETS
   Cash and cash equivalents                  $ 2,168,541   $   252,354
   Accounts receivable                            752,861       581,585
   Inventory                                      806,006       536,150
   Other current assets                           130,375       120,891
                                              -----------   -----------
       Total current assets                     3,857,783     1,490,980

  PROPERTY, PLANT AND EQUIPMENT, NET            1,980,063       140,182

  INVESTMENTS
   Investment in partnership                   15,799,631    11,951,819
   Rental property, net                           108,512       113,217
                                              -----------   -----------
       Total investments                       15,908,143    12,065,036

  OTHER ASSETS
   Aggregate inventory                            843,049       848,937
   Goodwill, net of amortization                  631,788       677,248
   Debt issuance costs, net of amortization       869,643       128,253
   Other                                           36,947        81,893
                                              -----------   -----------
       Total other assets                       2,381,427     1,736,331




                                              -----------   -----------
                                              $24,127,416   $15,432,529
                                              ===========   ===========

   The accompanying notes are an integral part of these financial statements.

                                      F-4
<PAGE>   23
                         REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                                CONSOLIDATED BALANCE SHEETS

                                 December 31, 1998 and 1997
- --------------------------------------------------------------------------------

<TABLE>
<CAPTION>

                                                                   1998            1997
                                                                   ----            ----
           LIABILITIES AND SHAREHOLDERS' EQUITY
           ------------------------------------

<S>                                                         <C>            <C>
CURRENT LIABILITIES
 Current portion of long-term debt                             $    38,300     $   925,040
 Current portion of serial preferred stock subject to
  mandatory redemption                                             163,600               -
 Note payable                                                      464,200         140,000
 Accounts payable                                                  282,945         256,465
 Accrued expenses                                                  276,165         424,401
                                                               -----------     -----------
     Total current liabilities                                   1,225,210       1,745,906

LONG-TERM DEBT, net of current portion                          11,519,930       4,031,060

COMMITMENTS AND CONTINGENCIES                                            -               -

MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES                      89,576          94,555

SERIAL PREFERRED STOCK SUBJECT TO MANDATORY
 REDEMPTION (liquidation preference and redemption
 value, $256,700 in 1998 and 1997), net of current portion          73,650         219,300

SHAREHOLDERS' EQUITY
 Serial preferred stock not subject to mandatory redemption
  (maximum liquidation preference, $24,957,326 and
  $24,939,340 in 1998 and 1997, respectively)                    1,052,988       1,052,988
 Common stock, par value $.40, authorized 25,000,000 shares
  issued and outstanding 12,632,089 and 12,435,089 shares
  in 1998 and 1997, respectively (net of 12,460 and
  22,460 treasury shares, respectively)                          5,047,129       4,963,729
 Additional paid-in capital                                        270,510         221,600
 Readjustment resulting from quasi-reorganization at
  December 31, 1987                                             (1,670,596)     (1,670,596)
 Retained earnings                                               6,519,019       4,773,987
                                                               -----------     -----------
     Total shareholders' equity                                 11,219,050       9,341,708
                                                               -----------     -----------

                                                               $24,127,416     $15,432,529
                                                               ===========     ===========
</TABLE>

   The accompanying notes are an integral part of these financial statements.

                                      F-5
<PAGE>   24


                      REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                        CONSOLIDATED STATEMENTS OF OPERATIONS

                     Years Ended December 31, 1998, 1997 and 1996
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>


                                                                 1998           1997           1996
                                                                 ----           ----           ----

<S>                                                      <C>            <C>            <C>        
NET SALES                                                    $ 3,789,839    $ 2,908,253    $     6,102

COSTS AND EXPENSES
 Cost of goods sold                                            2,621,363      1,928,491              -
 General and administrative expenses                           2,042,871      1,787,650        920,789
                                                             -----------    -----------    -----------
                                                               4,664,234      3,716,141        920,789
                                                             -----------    -----------    -----------

LOSS FROM OPERATIONS                                            (874,395)      (807,888)      (914,687)

INCOME FROM EQUITY INVESTMENT IN PARTNERSHIP                   3,950,090      3,820,913      4,268,904

OTHER INCOME, NET                                                141,220         45,300         74,137

INTEREST EXPENSE                                              (1,314,351)      (801,597)      (404,838)
                                                             -----------    -----------    -----------

INCOME BEFORE INCOME TAX EXPENSE AND
  MINORITY INTEREST                                            1,902,564      2,256,728      3,023,516

INCOME TAX EXPENSE                                               (98,583)       (73,665)      (226,388)

MINORITY INTEREST                                                 (9,421)         4,555          5,339
                                                             -----------    -----------    -----------

NET INCOME                                                   $ 1,794,560    $ 2,187,618    $ 2,802,467
                                                             ===========    ===========    ===========

NET INCOME ATTRIBUTABLE TO COMMON
 SHAREHOLDERS
 [after paid or accrued preferred stock dividends of $49,564,
 $65,475 and $81,144 in 1998, 1997 and 1996, respectively,
 and preferred stock accretion of $17,950, $20,600 and
 $32,800 in 1998, 1997 and 1996, respectively]               $ 1,727,046    $ 2,101,543    $ 2,688,523
                                                             ===========    ===========    ===========

NET INCOME PER COMMON SHARE:
 BASIC                                                       $      0.14    $      0.17    $      0.24
                                                             ===========    ===========    ===========

 DILUTED                                                     $      0.12    $      0.15    $      0.20
                                                             ===========    ===========    ===========

</TABLE>

   The accompanying notes are an integral part of these financial statements.

                                      F-6

<PAGE>   25




                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

                  Years Ended December 31, 1998, 1997 and 1996
- --------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                         
                                                                                         
                                              Preferred Stock*          Common Stock**    
                                            -----------------       -------------------  
                                            Shares     Amount       Shares       Amount  
                                            ------     ------       ------       ------  

<S>                                     <C>        <C>            <C>          <C>       
BALANCE - JANUARY 1, 1996                  605,291   $1,052,988   11,166,537   $4,456,308
 Issuance of common stock                        -            -      233,334       93,334
 Net income                                      -            -            -            -    
 Accretion of Series E preferred stock           -            -            -            -    
 Payment of dividend on Series E
  preferred stock                                -            -            -            -    
                                           -------   ----------   ----------   ----------
BALANCE - DECEMBER 31, 1996                605,291    1,052,988   11,399,871    4,549,642

 Issuance of common stock                        -            -      566,667      226,667
 Conversion of Series E preferred stock          -            -      468,551      187,420
 Accretion of Series E preferred stock           -            -            -            -    
 Payment of dividend on Series E
  preferred stock                                -            -            -            -    
 Net income                                      -            -            -            -    
                                           -------   ----------   ----------   ----------
BALANCE - DECEMBER 31, 1997                605,291    1,052,988   12,435,089    4,963,729

 Issuance of common stock                        -            -      197,000       83,400
 Accretion of Series E preferred stock           -            -            -            -    
 Payment of dividend on Series E
  preferred stock                                -            -            -            -    
 Net income                                      -            -            -            -    
                                           -------   ----------   ----------   ----------
BALANCE - DECEMBER 31, 1998                605,291   $1,052,988   12,632,089   $5,047,129
                                           =======   ==========   ==========   ==========

</TABLE>


<TABLE>
<CAPTION>
                                                                                                                  
                                                     Readjustment
                                         Additional   Resulting        Retained         Total
                                           Paid-in    from Quasi-      Earnings     Shareholders'
                                           Capital   Reorganization    (Deficit)       Equity
                                           -------   --------------    ---------       ------

<S>                                          <C>            <C>             <C>             <C>         
BALANCE - JANUARY 1, 1996                  $140,000   $(1,670,596)   $  (52,051)   $ 3,926,649
 Issuance of common stock                         -             -             -         93,334
 Net income                                       -             -     2,802,467      2,802,467
 Accretion of Series E preferred stock            -             -       (32,800)       (32,800)
 Payment of dividend on Series E
  preferred stock                                 -             -       (63,158)       (63,158)
                                           --------   -----------    ----------    -----------
BALANCE - DECEMBER 31, 1996                 140,000    (1,670,596)    2,654,458      6,726,492

 Issuance of common stock                    66,666             -             -        293,333
 Conversion of Series E preferred stock      14,934             -             -        202,354
 Accretion of Series E preferred stock            -             -       (20,600)       (20,600)
 Payment of dividend on Series E
  preferred stock                                 -             -       (47,489)       (47,489)
 Net income                                       -             -     2,187,618      2,187,618
                                           --------   -----------    ----------    -----------
BALANCE - DECEMBER 31, 1997                 221,600    (1,670,596)    4,773,987      9,341,708

 Issuance of common stock                    48,910             -             -        132,310
 Accretion of Series E preferred stock            -             -       (17,950)       (17,950)
 Payment of dividend on Series E
  preferred stock                                 -             -       (31,578)       (31,578)
 Net income                                       -             -     1,794,560      1,794,560
                                           --------   -----------    ----------    -----------
BALANCE - DECEMBER 31, 1998                $270,510   $(1,670,596)   $6,519,019    $11,219,050
                                           ========   ===========    ==========    ===========
</TABLE>


*  Preferred stock does not include Series E preferred stock which is subject to
   mandatory redemption
** Common stock is net of 12,460 treasury shares at December 31, 1998 and 22,460
   treasury shares at December 31, 1997 and 1996

   The accompanying notes are an integral part of these financial statements.

                                      F-7

<PAGE>   26
                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                  Years Ended December 31, 1998, 1997 and 1996
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>

                                                                1998            1997            1996
                                                                ----            ----            ----
<S>                                                       <C>            <C>             <C>   
CASH FLOWS FROM OPERATING ACTIVITIES
 Net income                                                  $1,794,560      $2,187,618      $2,802,467
 Adjustments to reconcile net income to net cash
  used by operating activities:
   Minority interest                                              9,421          (4,555)         (5,339)
   Income from equity investment in partnership              (3,950,090)     (3,820,913)     (4,268,904)
   Distribution of equity earnings from partnership             102,278         102,825         103,229
   Interest amortization on long-term debt                      612,855         756,160         376,940
   Depreciation and amortization                                124,959          91,573           7,401
   Issuance of common stock in lieu of cash compensation        132,310         233,333          93,334
   Changes in operating assets and liabilities:
    Accounts receivable                                        (171,276)       (327,259)              -
    Inventory                                                  (269,856)        (49,137)              -
    Other current assets                                         (9,484)        (96,156)         (1,724)
    Other assets                                                 46,644        (135,813)         13,113
    Accounts payable                                             26,480          26,335         (16,074)
    Accrued expenses                                           (148,236)        102,671         (21,640)
                                                             ----------       ---------      ----------
     Net cash used by operating activities                   (1,699,435)       (933,318)       (917,197)

CASH FLOWS FROM INVESTING ACTIVITIES
 Acquisition of business, net of cash of $13,535                 -           (1,086,465)              -
 Expenditures for property and equipment                     (1,910,484)       (122,029)        (50,884)
                                                             ----------       ---------      ----------
     Net cash used by investing activities                   (1,910,484)     (1,208,494)        (50,884)

CASH FLOWS FROM FINANCING ACTIVITIES
 Proceeds from long-term debt                                10,805,307               -       3,500,000
 Payment of long-term debt                                   (4,607,750)              -               -
 Debt issuance costs                                           (949,673)              -        (124,795)
 Net short-term proceeds (payments)                             324,200         140,000         (80,000)
 Dividends paid                                                 (31,578)        (47,489)        (63,158)
 Dividends paid to minority interest                            (14,400)         (2,000)              -
                                                             ----------       ---------      ----------
     Net cash provided by financing activities                5,526,106          90,511       3,232,047
                                                             ----------       ---------      ----------

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS              1,916,187      (2,051,301)      2,263,966

CASH AND CASH EQUIVALENTS - BEGINNING                           252,354       2,303,655          39,689
                                                             ----------       ---------      ----------

CASH AND CASH EQUIVALENTS - ENDING                           $2,168,541       $ 252,354      $2,303,655
                                                             ==========       =========      ==========

</TABLE>

   The accompanying notes are an integral part of these financial statements.

                                      F-8

<PAGE>   27

                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

                  Years Ended December 31, 1998, 1997 and 1996
- --------------------------------------------------------------------------------

<TABLE>
<CAPTION>



                                                                                  1998             1997             1996
                                                                                  ----             ----             ----
<S>                                                                        <C>            <C>               <C> 
Supplemental disclosures of cash flow information:
 Cash paid during the year for:
  Interest (includes prepayment penalty of $216,702 in 1998)                  $ 746,413       $   27,187         $ 23,890
  Income taxes                                                                   82,350           60,750          257,838

Supplemental disclosures of noncash investing and financing activities:

 In 1998, the Company issued 187,000 shares of common
 stock as compensation to Mr. William R. Ponsoldt, Sr., the
 Company's President.

 In 1998, the Company issued 10,000 shares of common
 stock held in treasury to two of its employees as
 additional compensation.

 In 1997, the Company issued 468,551 shares of common
 stock in exchange for 2,477 shares of Series E mandatorily
 redeemable preferred stock.

 In 1997, the Company issued 100,000 shares of its common
 stock and paid $1,100,000 in cash for all of the assets of
 Rustic Crafts, Inc. (see Note 2).  In connection therewith, the
 Company acquired assets and assumed certain liabilities as
 follows:

        Fair value of assets acquired including goodwill                                      $1,573,778
        Cash paid                                                                             (1,100,000)
        Common stock issued                                                                      (60,000)
                                                                                              ----------
        Liabilities assumed                                                                   $  413,778
                                                                                              ==========
</TABLE>


   The accompanying notes are an integral part of these financial statements.

                                      F-9

<PAGE>   28


                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

               A.   Principles of Consolidation and Nature of Business - The
                    consolidated financial statements include the accounts of
                    Regency Affiliates, Inc. (the "Company"), its wholly owned
                    subsidiary, Rustic Crafts International, Inc. ("Rustic
                    Crafts") and its 80% owned subsidiaries, National Resource
                    Development Corporation ("NRDC"), Transcontinental Drilling
                    Company ("Drilling") and RegTransco, Inc. ("RTI"). All
                    significant intercompany balances and transactions have been
                    eliminated in consolidation. Substantially all net sales in
                    1998 and 1997 were generated through Rustic Crafts, which
                    manufactures wood and cast marble decorative fireplaces,
                    heater logs and related accessories. Rustic Crafts extends
                    credit to its customers who primarily are mass merchants,
                    fireplace specialty distributors and furniture stores. One
                    customer accounted for approximately 53% and 28% of
                    consolidated sales for 1998 and 1997, respectively. The loss
                    of this customer could have a significant effect on Rustic
                    Crafts' results of operations.

                    Regency Affiliates, Inc.'s (Registrant's) share of
                    consolidated net assets at December 31, 1998 and 1997
                    consists principally of cash and cash equivalents of
                    approximately $2,105,000 and $248,000, respectively,
                    investment in partnership of approximately $15,800,000 and
                    $11,952,000, respectively, property, plant and equipment
                    (including rental property) of approximately $128,000 and
                    $133,000, respectively, and liabilities of approximately
                    $9,965,000 and $5,070,000, respectively.

                    On July 7, 1993, the Company entered into an Acquisition
                    Agreement with National Resource Development Corporation and
                    Statesman Group, Inc. ("Statesman"), an international
                    business corporation organized under the laws of the
                    Bahamas, which provided for the acquisition of an 80%
                    interest in National Resource Development Corporation, which
                    was wholly owned by Statesman, in exchange for 2,975,000
                    shares of the Company's common stock, 208,850 shares of the
                    Company's Series C preferred stock and 20% of the
                    outstanding shares of Transcontinental Drilling Co. (the
                    "Transaction"). Statesman has the right to transfer some or
                    all of these shares to its nominees. Through its right to
                    designate eight individuals to fill vacancies on the Board
                    of Directors, Statesman also controls 855,991 common shares
                    by virtue of irrevocable proxies given to a proxy committee
                    of the Board of Directors.

               B.   Earnings Per Share - Basic earnings per share are computed
                    by dividing net income attributable to common shareholders
                    (net income less preferred stock dividend requirements and
                    periodic accretion) by the weighted average number of common
                    shares outstanding during the year. Diluted earnings per
                    share computations assume the conversion of Series E, Series
                    B, and Junior Series D preferred stock during the period
                    that the preferred stock issues were outstanding. If the
                    result of these assumed conversions is dilutive, the
                    dividend requirements and periodic accretion for the
                    preferred stock issues are reduced (See Note 7).


                                      F-10
<PAGE>   29

                    REGENCY AFFILIATES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

               B.   Earnings Per Share (Continued)

                    The weighted average number of shares used in basic earnings
                    per share computations for 1998, 1997 and 1996 was
                    approximately 12,546,000, 12,038,000 and 11,400,000,
                    respectively. The weighted average number of shares used in
                    the computation of diluted earnings per share for 1998, 1997
                    and 1996 was approximately 14,892,000, 14,231,000 and
                    14,252,000, respectively. The Company's stock is thinly
                    traded in the over-the-counter market on the bulletin board
                    section. In 1998, 1997 and 1996, market prices of $.547 per
                    share, $.616 per share and $.525 per share, respectively,
                    were utilized in the conversion formulas for the computation
                    of diluted earnings per share. In 1998, 1997 and 1996, if
                    market prices of $.437 per share, $.437 per share and $.25
                    per share, respectively, the lowest bid price of the
                    Company's common shares during the year, were used in the
                    conversion formulas, the weighted average number of shares
                    utilized in the computation of diluted earnings per share
                    would amount to approximately 15,169,000, 14,631,000 and
                    16,164,000, respectively, yielding diluted earnings per
                    share of $.12, $.15, and $.17, respectively.

               C.   Fair Value of Financial Instruments - The fair values of
                    cash, accounts receivable, accounts payable and other
                    short-term obligations approximate their carrying values
                    because of the short maturity of these financial
                    instruments. The carrying values of the Company's long-term
                    obligations approximate their fair value. In accordance with
                    Statement of Financial Accounting Standards No. 107,
                    "Disclosure About Fair Value of Financial Instruments,"
                    rates available at balance sheet dates to the Company are
                    used to estimate the fair value of existing debt.

               D.   Cash and Cash Equivalents - Cash and cash equivalents
                    represent cash and short-term highly liquid investments with
                    original maturities of three months or less. The Company
                    places its cash and cash equivalents with high credit
                    quality financial institutions which may exceed federally
                    insured amounts at times.

               E.   Inventory - Inventories are stated at the lower of cost or
                    market using the first-in, first-out (FIFO) method.
                    Inventory is comprised of the following at December 31, 1998
                    and 1997:

                                                           1998          1997
                                                           ----          ----

                        Finished products               $ 379,672     $ 294,564
                        Work-in-process                   120,416        56,049
                        Raw materials and supplies        305,918       185,537
                                                        ---------     ---------

                                                        $ 806,006     $ 536,150
                                                        =========     =========



                                      F-11


<PAGE>   30


                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 1.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

               F.   Property, Plant and Equipment/Rental Property - Property,
                    plant and equipment and rental property are carried at cost.
                    Depreciation is provided over the estimated useful lives of
                    the assets by the use of the straight-line and declining
                    balance methods. These items consist of the following at
                    December 31, 1998 and 1997:

<TABLE>
<CAPTION>

                                                        Property, Plant
                                                         and Equipment                  Rental Property
                                                     --------------------            --------------------
                                                     1998            1997            1998            1997
                                                     ----            ----            ----            ----

                  <S>                          <C>             <C>             <C>             <C>      
                    Real property                 $1,836,526      $       -       $ 118,877       $ 118,877
                    Leasehold improvements            73,200         73,200               -               -
                    Machinery and equipment          173,347         99,389               -               -
                                                  ----------      ---------       ---------       ---------
                                                   2,083,073        172,589         118,877         118,877
                    Accumulated depreciation         103,010         32,407          10,365           5,660
                                                  ----------      ---------       ---------       ---------
                                                  $1,980,063      $ 140,182       $ 108,512       $ 113,217
                                                  ==========      =========       =========       =========
</TABLE>


                    Depreciation expense for the years ended December 31, 1998,
                    1997 and 1996 was $81,056, $36,194 and $-0-, respectively.

               G.   Aggregate Inventory - Inventory, which consists of 75
                    million short tons of previously quarried and stockpiled
                    aggregate rock located at the site of the Groveland Mine in
                    Dickinson County, Michigan, is stated at lower of cost or
                    market. Liens have been attached to the aggregate inventory
                    by the holders of the zero coupon bonds. The Company is also
                    subject to a royalty agreement which requires the payment of
                    certain royalties to a previous owner of the aggregate
                    inventory upon sales of the aggregate.

                    During the years ended December 31, 1998, 1997 and 1996, the
                    Company made only casual sales of aggregate. Aggregate is
                    primarily sold for railroad ballast, road construction,
                    construction along shore lines and decorative uses. The
                    market for aggregate stone is highly competitive and, as
                    shipping costs are high, the majority of sales, if any, can
                    be anticipated to be made locally. Other companies that
                    produce rock and aggregate products are located in the same
                    region as the Groveland Mine. Many of these competitors will
                    have greater financial and personnel resources than the
                    Company. Therefore, the Company is actively pursuing various
                    ventures to process and market the aggregate. While the
                    Company is hopeful that such a venture can be formed, there
                    can be no assurance that such a transaction will come to
                    fruition. Moreover, the success of such a venture will be
                    dependent upon the market for aggregate in the State of
                    Michigan. As a consequence, there can be no assurance that
                    the Company will be able to consummate sales of material
                    amounts of its aggregate (See Note 12).

               H.   Goodwill - Goodwill resulted from the acquisition of Rustic
                    Crafts in 1997. The goodwill is being amortized
                    straight-line over a period of 15 years. Accumulated
                    amortization was $83,344 and $37,884 at December 31, 1998
                    and 1997, respectively.

               I.   Debt Issuance Costs - Debt issuance costs are recorded at
                    cost and are being amortized over 66 months, the life of the
                    related loan using the effective interest method.
                    Accumulated amortization was $80,029 and $25,042 at December
                    31, 1998 and 1997, respectively.

                                      F-12

<PAGE>   31

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 1.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

               J.   Income Taxes - The Company utilizes Statement of Financial
                    Accounting Standards No. 109 ("SFAS 109"), "Accounting for
                    Income Taxes," which requires an asset and liability
                    approach to financial accounting and reporting for income
                    taxes. The difference between the financial statement and
                    tax basis of assets and liabilities is determined annually.
                    Deferred income tax assets and liabilities are computed for
                    those temporary differences that have future tax
                    consequences using the current enacted tax laws and rates
                    that apply to the periods in which they are expected to
                    affect taxable income. In some situations SFAS 109 permits
                    the recognition of expected benefits of utilizing net
                    operating loss and tax credit carryforwards. Valuation
                    allowances are established based upon management's estimate,
                    if necessary. Income tax expense is the current tax payable
                    or refundable for the period plus or minus the net change in
                    the deferred tax assets and liabilities.

               K.   Use of Estimates - The preparation of financial statements
                    in conformity with generally accepted accounting principles
                    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.

               L.   New Authoritative Pronouncements - In March 1995, the
                    Financial Accounting Standards Board issued a new standard,
                    Statement of Financial Accounting Standards No. 121,
                    "Accounting for the Impairment of Long-Lived Assets and for
                    Long-Lived Assets to be Disposed Of" (SFAS 121). SFAS 121
                    requires that long-lived assets and certain identifiable
                    intangibles to be held and used by an entity be reviewed for
                    impairment whenever events or changes in circumstances
                    indicate that the carrying amount of an asset may not be
                    recoverable. SFAS 121 is effective for financial statements
                    for fiscal years beginning after December 15, 1995. The
                    Company adopted SFAS 121 in the first quarter of 1996. The
                    Company's primary long-lived assets are property, plant and
                    equipment (as described in Note 1.F.), the aggregate
                    inventory (as described in Note 1.G.), the investment in
                    partnership (as described in Note 3), the Company's net
                    operating loss carryforward (as described in Note 9), and
                    goodwill (as described in Note 1.H.). The adoption did not
                    have a material effect on the Company's financial position
                    or results of operations.

                    In October 1995, Statement of Financial Accounting Standards
                    No. 123, "Accounting for Stock-Based Compensation," was
                    issued which establishes accounting and reporting standards
                    for stock-based compensation plans. This standard encourages
                    the adoption of the fair value-based method of accounting
                    for employee stock options or similar equity instruments,
                    but continues to allow the Company to measure compensation
                    cost for those equity instruments using the intrinsic
                    value-based method of accounting prescribed by Accounting
                    Principles Board Opinion No. 25, "Accounting for Stock
                    Issued to Employees." Under the fair value-based method,
                    compensation cost is measured at the grant date based on the
                    value of the award. Under the intrinsic value-based method,
                    compensation cost is the excess, if any, of the quoted
                    market price of the stock at the grant date or other
                    measurement date over the amount the employee must pay to
                    acquire the stock. The Company uses the intrinsic
                    value-based method for stock-based compensation to
                    employees. As a result, this standard does not have any
                    effect to the Company's financial statement other than to
                    require disclosure of the pro forma effect on net income of
                    using the fair value-based method of accounting. Management
                    believes this effect to currently be immaterial.

                                      F-13

<PAGE>   32

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 1.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

               L.   New Authoritative Pronouncements (Continued)

                    In June 1997, Statement of Financial Accounting Standards
                    No. 130, "Reporting Comprehensive Income" (SFAS 130), was
                    issued. SFAS 130 establishes new standards for reporting
                    comprehensive income and its components and is effective for
                    periods beginning after December 15, 1997. The adoption did
                    not have a material effect on the Company's financial
                    statements or notes thereto.

                    In June 1997, Statement of Financial Accounting Standards
                    No. 131, "Disclosures About Segments of an Enterprise and
                    Related Information" (SFAS 131), was issued. SFAS No. 131
                    changes the standards for reporting financial results by
                    operating segments, related products and services,
                    geographic areas and major customers and is effective for
                    periods beginning after December 15, 1997. Segment
                    information is included in Note 14.

                    In February 1998, Statement of Financial Accounting
                    Standards No. 132, "Employers' Disclosures About Pensions
                    and Other Postretirement Benefits" (SFAS 132), was issued.
                    SFAS 132 standardizes the disclosure requirements for
                    pension and other postretirement benefit plans but does not
                    change the measurement or recognition of those plans. SFAS
                    132 is effective for fiscal years beginning after December
                    15, 1997. The adoption did not have a material effect on the
                    Company's financial statements or notes thereto.

                    In June 1998, Statement of Financial Accounting Standards
                    No. 133, "Accounting for Derivative Instruments and Hedging
                    Activities" (SFAS 133), was issued. SFAS 133 establishes
                    accounting and reporting standards for derivative
                    instruments and hedging activities. SFAS 133 is effective
                    for fiscal years beginning after June 15, 1999. Management
                    believes this pronouncement will have no effect on the
                    financial statements.

               M.   Year 2000 - The Company is aware of the implications and
                    issues associated with certain computer-based systems which
                    are dependent upon date routines that may cause errors in
                    computer processing in connection with the year 2000. The
                    Company is evaluating and responding to the potential impact
                    of the year 2000 issue on its computer and other operating
                    systems. The Company is in contact with certain key third
                    parties, including financial institutions, customers and
                    suppliers with which the Company does business
                    electronically to address the compatibility of systems. To
                    the extent that these key third parties are impacted by
                    their failure to address the year 2000 problem, such
                    disruption could have a direct and material impact on the
                    Company. The Company does not anticipate that the total cost
                    of being in compliance with year 2000 needs will have a
                    material effect on the Company's financial position or
                    results of operations.

               N.   Reclassifications - Certain reclassifications were made to
                    prior period financial statement presentations to conform
                    with current period presentations.

                                      F-14

<PAGE>   33

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 2.        ACQUISITION OF RUSTIC CRAFTS INTERNATIONAL, INC.

               In March 1997, the Company, through its newly formed subsidiary,
               Rustic Crafts, acquired all of the operating assets, including
               cash, accounts receivable, inventory, property and equipment and
               intangibles, of Rustic Crafts Co., Inc. Rustic Crafts is involved
               in the manufacture of wood and cast marble decorative fireplaces,
               heater logs and related accessories. The Company paid $1,100,000
               in cash and issued 100,000 shares of common stock and assumed
               trade accounts payable, bank debt and certain other accrued
               liabilities of $413,778. The transaction was accounted for using
               the purchase method and resulted in goodwill and intangibles of
               $715,000. Such goodwill is being amortized on a straight-line
               basis over a fifteen year period.

               The cash purchase price was provided by funds obtained under the
               Agreement (see Note 5). The Company advanced $201,000 to retire
               the bank debt of Rustic Crafts, subsequent to the purchase.


NOTE 3.        INVESTMENT IN PARTNERSHIP

               In November 1994, the Company invested $350,000 for a limited
               partnership interest in Security Land and Development Company
               Limited Partnership ("Security"), which owns and operates an
               office complex. The Company has limited voting rights and is
               entitled to be allocated 95% of the profit and loss of the
               Partnership until October 31, 2003 (the lease termination date of
               the sole tenant of the office complex) and 50% thereafter. The
               Company is entitled to 95% of operating cash flow distributions,
               as defined, until October 31, 2003, which are expected to be
               limited in amount, and 50% thereafter. Further, the partners are
               entitled to the net cash flow generated from the sale or
               refinancing of the property in the proportion of their individual
               positive capital account balance to the total positive capital
               account balances of all the partners. The Company can force the
               sale of the property after December 31, 2004.

               Security was organized to own and operate two buildings
               containing approximately 717,000 net rentable square feet
               consisting of a two-story office building and a connected
               six-story office tower. The building was purchased by Security in
               1986 and is located on approximately 34.3 acres of land which is
               also owned by Security. The building has been occupied by the
               United States Social Security Administration's Office of
               Disability and International Operations for approximately 24
               years under leases between the United States of America, acting
               by and through the General Services Administration ("GSA").
               Effective November 1, 1994, Security and the GSA entered into a
               nine-year lease (the "Lease") for 100% of the building. The
               Lease, among other provisions, requires substantial renovations
               and improvements to the building, which were completed in 1998.
               Security has received an opinion of the Assistant General Counsel
               to the GSA that lease payments are not subject to annual
               appropriation by the United States Congress and the obligations
               to make such payments are unconditional general obligations of
               the United States Government.

                                      F-15

<PAGE>   34

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 3.        INVESTMENT IN PARTNERSHIP (CONTINUED)

               The Company accounts for the investment in partnership on the
               equity method, whereby the carrying value of the investment is
               increased or decreased by the Company's allocable share of income
               or loss. The investment in partnership included in the
               Consolidated Balance Sheets at December 31, 1998 and 1997 was
               $15,799,631 and $11,951,819, respectively. The income from the
               Company's equity investment in the Partnership for the years
               ended December 31, 1998, 1997 and 1996 was $3,950,090, $3,820,913
               and $4,268,904, respectively. The undistributed earnings from the
               Company's equity investment in the Partnership as of December 31,
               1998 and 1997 amounted to $15,449,631 and $11,601,819,
               respectively.

               Summarized financial information for Security is as follows:

<TABLE>
<CAPTION>
                                                                         1998                 1997
                                                                         ----                 ----
                BALANCE SHEET DATA
                ------------------

             <S>                                                <C>                   <C>        
                 Cash and receivables                                $ 1,234,122           $ 1,304,814
                 Restricted cash                                       3,658,402             4,113,938
                 Real estate                                          50,507,072            52,999,775
                 Other assets                                          1,181,135             1,537,967
                                                                     -----------           -----------

                   Total assets                                      $56,580,731           $59,956,494
                                                                     ===========           ===========

                 Accounts payable and accrued expenses               $   611,411           $ 1,625,287
                 Project note payable                                 35,871,949            41,467,993
                 Other liabilities                                     4,444,625             5,261,112
                                                                     -----------           -----------

                   Total liabilities                                  40,927,985            48,354,392

                 Partners' capital:
                  Regency Affiliates, Inc.                            15,799,631            11,951,819
                  Other partners                                        (146,885)             (349,717)
                                                                     -----------           -----------
                   Total partners' capital                            15,652,746            11,602,102
                                                                     -----------           -----------

                   Total liabilities and partners' capital           $56,580,731           $59,956,494
                                                                     ===========           ===========
</TABLE>


                STATEMENT OF OPERATIONS DATA
                ----------------------------
<TABLE>
<CAPTION>

                                                  1998                  1997                 1996
                                                  ----                  ----                 ----
             <S>                            <C>                  <C>                   <C>        
                 Revenues                      $13,207,758          $11,865,721           $11,760,267

                 Expenses                        6,074,879            5,673,776             5,080,768
                                               -----------          -----------           -----------
                 Net operating income            7,132,879            6,191,945             6,679,499

                 Other expenses                 (2,974,574)          (2,169,931)           (2,185,911)
                                               -----------          -----------           -----------
                 Net income                    $ 4,158,305          $ 4,022,014           $ 4,493,588
                                               ===========          ===========           ===========

</TABLE>

                                                                                
See Note 12. Contingencies, Risks and Uncertainties related to the Company's
investment in Security.


                                      F-16

<PAGE>   35
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 4.        NOTE PAYABLE

               The Company's subsidiary, Rustic Crafts, has established a
               $1,000,000 line of credit with PNC Bank. The line of credit
               expires on May 18, 1999 and bears interest at the Bank's prime
               rate minus one-half percent (7.25% at December 31, 1998).

               The accounts receivable, inventory and other assets, such as
               property and equipment, of Rustic Crafts have been pledged as
               collateral to secure the line of credit. Rustic Crafts has agreed
               to maintain certain net worth, current ratio and debt service
               coverage and is in compliance with these requirements at December
               31, 1998. The line of credit is guaranteed by the Company.

               At December 31, 1998 and 1997, the amounts outstanding under the
               line of credit were $464,200 and $140,000, respectively.


NOTE 5.        LONG-TERM DEBT

               KBC Bank Loan - On June 24, 1998, the Company refinanced the
               long-term debt previously outstanding with Southern Indiana
               Properties, Inc. ("SIPI") and entered into a Loan Agreement (the
               "Loan") with KBC Bank N.V. ("KBC"). Under the terms of the Loan
               Agreement, KBC advanced $9,383,320. The due date of the Loan is
               November 30, 2003 with interest at the rate of 7.5% compounded
               semi-annually on each June 1 and December 1, commencing December
               1, 1998. The interest may be paid by the Company in cash on these
               semi-annual dates or the Company may elect to add the interest to
               the principal of the Loan then outstanding. As of December 31,
               1998, the amount outstanding under the Loan is $9,756,698,
               including $373,378 of interest, through December 31, 1998.

               The Loan is secured by all of the Company's interest in Security,
               including the Company's interest in all profits and
               distributions, other than the payment of management fees of
               $100,000 annually, and all of the Company's rights, powers, and
               remedies under the Security Land and Development Company Limited
               Partnership Agreement as amended and restated. The security
               agreement requires the Company to maintain a certain ratio of
               debt to equity. At any time, the Company may prepay the entire
               principal balance of the Loan, plus accrued and unpaid interest,
               plus a make-whole premium as defined in the Loan Agreement, if
               any.

               To facilitate the loan from KBC, the Company purchased a residual
               value insurance policy through R.V.I. American Insurance Company
               ("RVI") which secures the repayment of the outstanding principal
               and interest when due with a maximum liability of $14 million.
               Should RVI pay a claim under this policy they will be entitled to
               certain of the Company's rights with respect to the property of
               Security, including but not limited to the right to solicit bona
               fide, third party offers for the property and to accept such
               offers and bind the Partnership in order to recoup the amount
               paid. The costs related to this insurance in the amount of
               $745,000 along with legal fees and other costs associated with
               obtaining the Loan in the amount of $205,000 for a total of
               $950,000 have been capitalized and are shown as Debt Issuance
               Costs. These Debt Issuance Costs will be amortized over the life
               of the Loan using the effective interest method.

                                      F-17
<PAGE>   36

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 5.        LONG-TERM DEBT (CONTINUED)

               Credit Agreement - In June 1996, the Company entered into a
               Credit Agreement (the "Agreement") with Southern Indiana
               Properties, Inc. (the "Lender") for the purpose of obtaining
               loans secured by the Company's investment in Security. Under
               terms of the Agreement, the Lender advanced to the Company
               $2,750,000 under Loan A and $750,000 under Loan B. Both Loan A
               and Loan B had stated interest at the rate of 14% per annum ("the
               Regular Interest Rate"). The Company elected, as permitted by the
               Agreement, to add the Regular Interest to the principal of the
               loan then outstanding.

               In addition to the Regular Interest Rate, the Agreement provided
               for additional consideration ("the Contingent Interest") as
               necessary to enable the Lender to achieve an Internal Rate of
               Return on each loan of twenty percent (20%) per annum on a
               cumulative basis over the term of such loan. However, no
               Contingent Interest or prepayment penalties were due on Loan B if
               such loan was repaid prior to December 21, 1998. The Company had
               recorded the Contingent Interest on Loan A. However, the Company
               had intended to and did prepay Loan B prior to December 21, 1998
               and, therefore, had not recorded Contingent Interest on such
               loan. As a result of the intention to prepay Loan B in 1998, the
               balance of Loan B at December 31, 1997 of $925,040 was presented
               as a current liability. The total of the amounts outstanding
               under the Agreement at December 31, 1997 was $4,572,600.

               On June 24, 1998, the Agreement was refinanced by proceeds
               advanced from KBC Bank N.V. under terms and conditions described
               above. Principal, Regular Interest, Contingent Interest and
               Prepayment Penalty in the amount of $5,213,810 was paid to
               Southern Indiana Properties, Inc. The prepayment of the Credit
               Agreement resulted in additional charges of $335,684 in the year
               ended December 31, 1998, resulting from the write-off of
               unamortized debt issuance costs and payment of prepayment
               penalties. Such amount is included as interest expense in the
               Consolidated Statement of Operations.

               Mortgage Loans - On March 25, 1998, Rustic Crafts purchased a
               building of 126,000 square feet located near the current facility
               in Scranton, Pennsylvania. The purchase and the cost of equipping
               this facility were funded in part by a first mortgage term loan
               in the amount of $960,000 and a convertible line of credit in the
               amount of $410,000 from PNC Bank. At December 31, 1998, the
               amounts outstanding on these loans were $1,369,901.

               The first mortgage term loan is payable in consecutive monthly
               installments over 10 years with a 20 year amortization. The
               convertible line of credit is available for 80% of the cost of
               construction improvements on the building for a 2 year period,
               ending in March 2000, at which time the convertible line of
               credit becomes payable in consecutive monthly installments over
               10 years with a 20 year amortization. The interest rate on the
               first mortgage term loan and the convertible line of credit are
               at the PNC Bank prime rate minus one-half percent (7.25% at
               December 31, 1998).

               Rustic Crafts' real and personal property, equipment, accounts
               receivable, inventory and other general intangibles are pledged
               as security for the loans. The loans are also guaranteed by
               Regency Affiliates, Inc., the parent company. The security
               agreement requires Rustic Crafts to maintain certain financial
               ratios. Rustic Crafts was in compliance with such ratios at
               December 31, 1998.

               Vehicle Note - Rustic Crafts has outstanding a vehicle note in
               the amount of $16,931 at December 31, 1998.

                                      F-18

<PAGE>   37

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 5.        LONG-TERM DEBT (CONTINUED)

               Zero Coupon Bonds - The zero coupon non-recourse secured bonds,
               due January 1, 2002, have a face value of $542,000 and a carrying
               value of $414,700 and $383,500 at December 31, 1998 and 1997,
               respectively. The bonds were issued by NRDC and the difference
               (discount) between the face value and carrying value is being
               amortized utilizing the interest method at 9%. Interest expense
               related to the bonds for 1998, 1997 and 1996 was $31,200, $31,200
               and $29,300, respectively. The bonds are redeemable at any time
               at the option of the Company at an amount that approximates the
               carrying value. As of December 31, 1998, a sinking fund has not
               been established to fund the payment of the zero coupon
               non-recourse secured bonds upon maturity. The Collateral Trust
               Indenture ("Indenture"), dated as of April 1, 1991, states that
               the Company is prohibited from selling all or any of the pledged
               aggregate inventory unless the Company makes a payment to the
               bond trustee for deposit into the sinking fund. The Indenture
               grants the trustee, to secure the bonds, a first priority
               mortgage lien and security interest in the aggregate and
               establishes a "mandatory sinking fund payment per short ton sold"
               of pledged aggregate inventory until the maturity of the bonds.
               The minimum payment for sales during calendar years 1995 through
               2002 ranges from $0.60 to $1.00 per short ton. The Indenture
               provides that the Company will have no personal liability for the
               payment of the debts evidenced by the Indenture or any bond or
               for the performance of the covenants, representations and
               warranties of the Company in the Indenture or any bond, and that
               the rights of the trustee and the bondholders shall be limited to
               the foreclosure on the lien, with certain exceptions.

               Required annual principal payments (based on the current carrying
               value of debt securities) on long-term debt at December 31, 1998
               are:


                           1999                           $    38,300
                           2000                                37,200
                           2001                                40,300
                           2002                               456,800
                           2003                             9,798,300
                           Thereafter                       1,187,330
                                                          -----------

                                                          $11,558,230
                                                          ===========

               Subsequent to year end, Rustic Crafts obtained additional
               financing from PNC Bank to fund equipment purchases. Maximum
               borrowings under this facility is $400,000.

NOTE 6.        MINORITY INTEREST

               Statesman Group, Inc. has a 20% minority interest in the
               Company's three 80% owned subsidiaries. In addition, Statesman
               holds a significant common stock interest and holds significant
               options (see Note 8) in the Company.


NOTE 7.        SERIAL PREFERRED STOCK

               At December 31, 1998 and 1997, the Company had 5,000,000
               authorized shares of $.10 par value serial preferred stock.
               Serial preferred stock at December 31, 1998 and 1997, all of
               which is convertible (other than Series C) and cumulative,
               consists of:

                                      F-19

<PAGE>   38

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 7.        SERIAL PREFERRED STOCK (CONTINUED)

               Mandatory Redeemable Shares - Series E, $100 stated value, 12.5%
               ----------------------------------------------------------------
               cumulative
               ----------

<TABLE>
<CAPTION>

                                                          Shares                        Value
                                                -------------------------      -------------------------
                                                Designated    Outstanding      Carrying      Liquidation
                                                ----------    -----------      --------      -----------
            <S>                             <C>              <C>             <C>           <C>     
               Balance, January 1, 1996          566,400         5,044         $368,254       $504,400

               Accretion                               -             -           32,800              -
                                                 -------        ------         --------       --------

               Balance, December 31, 1996        566,400         5,044          401,054        504,400

               Converted to common shares              -        (2,477)        (202,354)      (247,700)

               Accretion                               -             -           20,600              -
                                                 -------        ------         --------       --------

               Balance, December 31, 1997        566,400         2,567          219,300        256,700

               Accretion                               -             -           17,950              -
                                                 -------        ------         --------       --------

               Balance, December 31, 1998        566,400         2,567         $237,250       $256,700
                                                 =======        ======         ========       ========
</TABLE>



               Certain Series E holders elected to convert 2,477 shares of
               Series E preferred stock into 468,551 shares of common stock
               during 1997.

               Redeemable Shares at Company's Option
               -------------------------------------
<TABLE>
<CAPTION>

                                                          Shares                                           Value
                                                 ----------------------------  -----------------------------------------------------
                                                                                                      1998                1997
                                                 Designated     Outstanding        Carrying       Liquidation          Liquidation
                                                 ----------     -----------        --------       -----------          ----------- 
            <S>                                 <C>             <C>           <C>             <C>                 <C>
               Series C, $100 stated
               value, cumulative                   210,000         208,850      $   229,136     $ 20,885,000 (a)    $ 20,885,000 (a)
 
               Series B, $10 stated
               value, 6% cumulative                370,747         370,747          566,912        3,707,470           3,707,470
 
               Junior Series, D, $10 stated
               value, 7% cumulative                 26,000          25,694          256,940          364,856 (b)         346,870 (b)
                                                   -------         -------      -----------     ------------        ------------    
 
                                                   606,747         605,291      $ 1,052,988     $ 24,957,326        $ 24,939,340
                                                   =======         =======      ===========     ============        ============
</TABLE>


               (a) This represents the estimated maximum possible liquidation
                   value of the Series C preferred shares, which is defined as
                   the lesser of: 1) net proceeds of the assets of NRDC or 2)
                   the redemption value (defined below). In the event of
                   liquidation, the Series C shares are senior to all other
                   shares of the Company's stock, with the exception of the
                   Series E shares.

              (b)  The liquidation value of the Junior Series D shares includes
                   accrued and unpaid dividends of $107,916 and $89,930 at
                   December 31, 1998 and 1997, respectively.

                                      F-20
<PAGE>   39
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 7.        SERIAL PREFERRED STOCK (CONTINUED)

               SERIES E - The Series E shares must be redeemed by the Company at
               the stated value plus accrued and unpaid dividends on the fifth
               anniversary from the date of issuance (mandatory redemptions from
               November 1999 through April 2000). The Company, at its option,
               may redeem the shares beginning on the second anniversary of the
               date of issuance. The carrying value of the Series E stock was
               recorded at its issue price (net of issue costs). Beginning in
               1995, the carrying value is being increased by periodic accretion
               to the Company's retained earnings (deficit), for the difference
               between the initial carrying value and the redemption value.
               Accretion, utilizing the interest method, for 1998, 1997 and 1996
               was $17,950, $20,600 and $32,800, respectively. Dividends of
               $31,578, $47,489 and $63,158 on the Series E stock were paid or
               accrued in 1998, 1997 and 1996, respectively. Holders of Series E
               stock may convert their shares to common stock based on the
               stated value divided by 88% of the average bid price for the 90
               days preceding the conversion date of the Company's common shares
               beginning on the second anniversary from the date of issuance of
               the Series E shares. In 1997, certain holders of Series E stock
               elected to convert 2,477 Series E shares into 468,551 shares of
               common stock.

               SERIES C - The Series C shares were issued on July 7, 1993 as
               part of the transaction to acquire an 80% interest in NRDC. The
               cumulative dividend right is equal to 20% (not to exceed
               $500,000) of annual after tax earnings of NRDC. At the Company's
               option, the Series C may be redeemed at the lesser of (a) the
               stated value plus accrued and unpaid dividends or (b) the fair
               market value of the common stock interest acquired by the Company
               in NRDC.

               SERIES B - The Series B shares were issued in 1991 as part of a
               restructuring plan limited to senior lenders and was issued in
               exchange for all obligations and any claims or causes of action
               relating to the Company's obligations and guarantees. Such
               preferred stock includes, among other provisions and preferences,
               the following:

                      a)     A 6% cumulative dividend right commencing on the
                             24th month from the consummation of a defined
                             "initial business combination transaction" (which
                             occurred with the acquisition of Rustic Crafts in
                             1997 (see Note 2)) and if the Company has reached a
                             defined ratio of earnings to fixed charges. In
                             addition, dividends accrue for a period of 35
                             additional months without cash payment.

                      b)     At the Company's option, the shares may be
                             redeemed, subject to certain limitations, by cash
                             payment or by exchanging shares of its common stock
                             at 77% of its stated value divided by the quoted
                             market value of its common stock.

                      c)     A contingent conversion provision which conversion
                             right, and the Company common shares to be issued
                             in connection with the conversion, would be based
                             on the stated value divided by the average bid and
                             asked price for the 90 days preceding the
                             conversion date of the Company's common shares. In
                             addition, the number of the Company's common shares
                             to be received upon conversion is subject to
                             certain limitations.

                                      F-21

<PAGE>   40
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 7.        SERIAL PREFERRED STOCK (CONTINUED)

               JUNIOR SERIES D - The junior preferred stock was issued in 1992
               in exchange for the Company's Restructuring Serial Promissory
               Notes. This preferred stock is redeemable, at the Company's
               option, at the stated value plus accrued and unpaid dividends and
               is contingently convertible into common at the fair market value
               of the common as determined by the average of the bid and asked
               price for the thirty (30) day period preceding the conversion
               date.

               Generally, no dividends can be paid on the Company's common stock
               until all cumulative dividends on the serial preferred stock have
               been paid. Additionally, no dividends on the Company's common
               shares can be paid if the Company is in default or in arrears
               with respect to any sinking or analogous fund or any call or
               tenders or other agreement for the purchase, redemption or other
               retirement of shares of preferred stock. No provision for
               dividends has been made for the Company's Series B and C
               "increasing rate preferred stock," as defined in Staff Accounting
               Bulletin Topic 5Q, due to the contingent nature of dividends on
               such shares.

               Generally the preferred shares have limited voting rights.
               However, in the event dividends payable on the Series C and E
               shares, respectively, are accumulated and unpaid for seven
               quarterly dividends (whether or not declared and whether or not
               consecutive), the holders of record of the Series C and E shares,
               respectively, shall thereafter have the right to elect two
               directors (each) until all arrears in required cash dividends
               (whether or not declared) on such shares have been paid. Its
               bylaws provide for eight members on its Board of Directors. At
               December 31, 1998, the Company had no accumulated and unpaid
               dividends on Series C and E preferred shares.


NOTE 8.        STOCK OPTIONS/STOCK OPTION PLANS

               Effective June 3, 1997, the Company issued options to purchase
               6.1 million shares of common stock to Statesman Group, Inc. as
               part of the consideration to secure the release of Mr. William R.
               Ponsoldt, Sr. to serve as President and Chief Executive Officer
               of the Company and Statesman agreed to provide loan guarantees
               not to exceed the sum of $300,000 upon the request of the Company
               and the showing of reasonable need. Pursuant to the Amended and
               Restated Agreement between the Company and Statesman, until their
               date of expiration, the options shall be exercisable at any time
               in whole or in part at a price equal to the lower of (a) the
               closing trading price as of the most recent date on which at
               least 10,000 shares of such stock were traded or (b) the average
               closing trading price of the shares during the ninety day period
               immediately preceding the date of exercise. The Company agreed to
               reserve sufficient shares to meet the requirements of the
               options. The options became exercisable immediately and remain
               exercisable until April 15, 2007. At the option of Statesman,
               payment may be made by Statesman for exercise of the options, in
               whole or in part, in the form of a promissory note executed by
               Statesman, secured only by a pledge of the shares purchased,
               which promissory note will accrue interest for any quarter at the
               prime rate in effect on the last day of the quarter at Chase
               Manhattan Bank, with interest and principal payable in a balloon
               payment five

                                      F-22
<PAGE>   41

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8.        STOCK OPTIONS/STOCK OPTION PLANS (CONTINUED)

               years after the date of execution of the note, provided that if
               the Company's Board of Directors reasonably determines that
               exercising the options by delivery of a note would render the
               respective purchase of shares void or voidable, then the Board
               may require, as a condition to exercise of the options, that
               Statesman either (i) pay at least the par value of the shares in
               cash (with the balance paid by delivery of a note) or (ii)
               provide acceptable collateral other than the shares themselves to
               secure payment of the note. The Company has determined that these
               options have no readily determinable fair value consistent with
               the provisions of SFAS No. 123. Therefore, the Company has not
               recognized any cost associated with the issuance of these options
               and net earnings per share for 1997 have not reflected any such
               costs.

               The Company has reserved 125,000 shares of its common stock for
               issuance upon exercise of incentive stock options under the 1984
               Incentive Stock Option Plan. The plan provides that options must
               be granted within ten years after February 8, 1984, the effective
               date of the plan, must have not more than a ten year term and, in
               general, must be exercised during the optionee's employment. The
               exercise price must be equal to the fair market value of the
               common stock on the date of the grant. Subject to the limitations
               in the plan, an Employee Incentive Stock Option Plan committee of
               the Board of Directors determines the optionee, the number of
               shares covered by each option and the duration of each option. As
               of December 31, 1997 and 1996, options aggregating 50,000 shares
               had been granted, exercisable at prices of $1.31 to $1.75 per
               share. These options expired in 1998 without being exercised.

               In addition, the Company has reserved 500,000 shares of common
               stock for issuance upon exercise of incentive stock options under
               the 1988 Incentive Stock Option Plan. The plan provides that no
               option is exercisable less than six months nor more than ten
               years from the grant date and, in general, must be exercised
               during the optionee's employment. The exercise price must be at
               least equal to the fair market value of the common stock on the
               date of the grant. Subject to limitations in the plan, a
               Personnel and Compensation Committee of the Board of Directors
               determines the optionee, the number of shares to be granted to
               each employee and the restrictions to be imposed upon each grant.
               During 1998, 1997 and 1996, no options to purchase stock under
               this plan were issued or outstanding. The Employment Agreement
               described in Note 10 provides for the issuance of options. Such
               options have not been issued by the Company.


NOTE 9.        INCOME TAXES

               As referred to in Note 1, the Company accounts for income taxes
               under SFAS 109, "Accounting for Income Taxes." The deferred taxes
               are the result of long-term temporary differences between
               financial reporting and tax reporting for earnings from the
               Company's partnership investment in Security Land and Development
               Company Limited Partnership related to depreciation and
               amortization and the recognition of income tax carryforward
               items.

                                      F-23

<PAGE>   42

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 9.        INCOME TAXES (CONTINUED)

               At December 31, 1998 and 1997, the Company's net deferred tax
               asset, utilizing a 34% effective tax rate, consists of:
<TABLE>
<CAPTION>

                                                                             1998                 1997
                                                                             ----                 ----
            <S>                                                        <C>                 <C> 
               Deferred tax assets:
                Investment partnership earnings                          $ 2,384,000          $ 1,921,000
                Net operating loss carryforwards                          11,068,000           12,197,000
                Alternative minimum tax credits                              394,000              321,000
                                                                         -----------          ----------- 

               Total deferred tax assets before valuation allowance       13,846,000           14,439,000

               Valuation allowance                                       (13,846,000)         (14,439,000)
                                                                         -----------          ----------- 

                 Net deferred tax assets                                 $         -          $         -
                                                                         ===========          ===========

</TABLE>

               The valuation allowance was established to reduce the net
               deferred tax asset to the amount that will more likely than not
               be realized. This reduction is necessary due to uncertainty of
               the Company's ability to utilize the net operating loss and tax
               credit carryforwards before they expire.

               For regular federal income tax purposes, the Company has
               remaining net operating loss carryforwards of approximately
               $32,500,000. These losses can be carried forward to offset future
               taxable income and, if not utilized, will expire in varying
               amounts beginning in the year 2001. The Company's tax returns
               have not recently been examined by the Internal Revenue Service
               ("Service") and there is no assurance that the Service would not
               attempt to limit the Company's use of its net operating loss and
               tax credit carryforwards.

               For the years ended December 31, 1998, 1997 and 1996, the tax
               effect of net operating loss carryforwards reduced the current
               provision for regular federal income taxes by approximately
               $583,000, $708,000 and $1,030,000, respectively. At December 31,
               1998, 1997 and 1996, the Company has provided $98,583, $73,665
               and $226,388, respectively, for taxes, which relate to
               alternative minimum tax liabilities (See Note 12) and state
               income taxes.

                                      F-24

<PAGE>   43
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 10.       EMPLOYMENT AGREEMENTS

               On June 3, 1997, Regency entered into an Employment Agreement
               with William R. Ponsoldt, Sr. pursuant to which he became the
               President and CEO of the Company. The Agreement provides for Mr.
               Ponsoldt to continue in these duties until his attainment of
               retirement age, provided that he may resign upon the provision of
               30 days notice to the Company and further provided that Mr.
               Ponsoldt may be removed from office upon death or disability or
               for just cause. The Agreement provides for a base salary in
               annual installments, in advance, of $250,000 each, which salary
               is to be adjusted on January 1 of every year by any increase
               since the previous January 1 in the Consumer Price Index ("CPI")
               for All Urban Consumers, U.S. city average, as published by the
               U.S. Department of Labor Bureau of Labor Statistics. At December
               31, 1998 and 1997, approximately $43,000 and $104,000,
               respectively, of advance salary is included in other current
               assets in the consolidated balance sheets. As additional
               compensation, Mr. Ponsoldt is to receive an amount equal to 20%
               of the Company's increase in quarterly common stock net worth,
               which is defined to be the difference between (i) total
               shareholders' equity and (ii) any shareholders' equity accounts
               relating to preferred stock. At December 31, 1998 and 1997,
               approximately $136,600 and $292,000, respectively, of additional
               compensation is included in accrued expenses in the consolidated
               balance sheets. The Company may elect to pay up to 50% of the
               additional compensation by the issuance of warrants to purchase
               the Company's common stock at a price equal to 50% of the average
               bid price for the Company's common stock for the calendar quarter
               for which the increased compensation is payable. The Agreement
               further provides for Mr. Ponsoldt to receive health and
               disability insurance ($100,000/year in the event of long term
               disability), an automobile allowance of $600/month (to be
               adjusted by increases in the CPI), and reimbursement of expenses.
               The Agreement provides that Mr. Ponsoldt will not compete with
               the Company for a two year period following the termination of
               his employment and provides for indemnification under certain
               circumstances. Any disputes between the Company and Mr. Ponsoldt
               under the Agreement are to be resolved through arbitration.

               On February 1, 1996, the Company entered into a written agreement
               ("Employment Agreement") with Gary K. Nuttall pursuant to which
               Mr. Nuttall was employed as the Company's President and Chief
               Executive Officer, in which capacities he served, until his
               removal on August 26, 1996. Mr. Nuttall's Employment Agreement
               provided for him to receive 233,334 shares of the Company's
               common stock. Mr. Nuttall also received a bonus in the amount of
               $350,000 in connection with the consummation of the $3.5 million
               loan the Company secured from Southern Indiana Properties, Inc.
               Mr. Nuttall's Employment Agreement with the Company provided for
               him to receive options to purchase 450,000 shares of the
               Company's common stock pursuant to the terms of the Company's
               1988 Incentive Stock Option Plan, as described in Note 8, which
               options have not been issued by the Company, nor does the Company
               intend to issue such options in the future due to Mr. Nuttall's
               removal.

                                      F-25


<PAGE>   44
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 11.       RELATED PARTY TRANSACTIONS

               L. J. Horbach and Associates, of which L. J. Horbach, a director
               of the Company, is the sole owner, was compensated for services
               rendered in the amount of $36,000 in each of the years ended
               December 31, 1998, 1997 and 1996, under an agreement to provide
               certain administrative services to the Company.

               In 1996, Pamlyn Kelly, Ph.D., former Interim President and a
               director of the Company, was paid $16,899 as a consultant for
               testing administered to candidates for the presidency of the
               Company.

NOTE 12.       CONTINGENCIES, RISKS AND UNCERTAINTIES

               The Company is subject to numerous contingencies, risks and
               uncertainties including, but not limited to, the following that
               could have a severe impact on the Company:

               (i)    The Company currently does not generate positive cash flow
                      and, historically, the Company has had limited operating
                      activities and substantially all of its efforts have been
                      devoted to acquiring or developing profitable operations.
                      The Company's ability to continue in existence is partly
                      dependent upon its ability to attain satisfactory levels
                      of operating cash flows, including its ability to develop
                      positive cash flow and profitable operations in NRDC to
                      meet its obligations.

               (ii)   The Company currently lacks the necessary infrastructure
                      at the site of the Groveland Mine in order to permit the
                      Company to make more than casual sales of the aggregate
                      (See Note 1.G.).

               (iii)  As of December 31, 1998, the Company was dependent upon
                      the investment in Security Land and Development Company
                      Limited Partnership and the operations of Rustic Crafts
                      International, Inc. for a material portion of its cash
                      flow and for a material portion of its reportable income.

               (iv)   The investment activities of the Company do not, in and of
                      themselves, generate sufficient cash flow to cover its
                      corporate operating expenses.

               (v)    An unsecured default in the Lease or sudden catastrophe to
                      the Security office complex from uninsured acts of God or
                      war could have a materially adverse impact upon the
                      Company's investment in Security Land and Development
                      Company Limited Partnership and, therefore, its financial
                      position and results of operations (See Note 3).

               (vi)   The failure of the Social Security Administration to renew
                      its lease of the Security West Buildings upon its
                      expiration on October 31, 2003 could have a materially
                      adverse impact upon the Company's investment in Security
                      Land and Development Company Limited Partnership.

               (vii)  The Company has significant tax loss and credit
                      carryforwards and no assurance can be provided that the
                      Internal Revenue Service would not attempt to limit or
                      disallow altogether the Company's use, retroactively
                      and/or prospectively, of such carryforwards, due to
                      ownership changes or any other reason. The disallowance of
                      the utilization of the Company's net operating loss would
                      severely impact the Company's financial position and
                      results of operations due to the significant amounts of
                      taxable income (generated by the Company's investment in
                      Security) that has in the past been, and is expected in
                      the future to be, offset by the Company's net operating
                      loss carryforwards (See Note 9).

                                      F-26
<PAGE>   45
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 13.       LEASE COMMITMENTS

               The Company, through Rustic Crafts, leases a manufacturing
               facility through March 15, 2000. Base annual lease payments are
               approximately $55,200. The Company also leases office space
               through July 2002. Base annual lease payments are approximately
               $34,000.

               Future minimum lease payments under operating leases that have
               initial or remaining noncancelable lease terms in excess of one
               year are as follows:

                           1999                        $ 92,600
                           2000                          48,900
                           2001                          37,400
                           2002                          21,800
                                                      ---------

                                                      $ 200,700
                                                      =========




NOTE 14.       SEGMENT INFORMATION

               The Company's operating structure includes operating segments for
               Home Furnishing Accessories (the operations of Rustic Crafts,
               which commenced upon its acquisition in March 1997 (Note 2)),
               Investment in Partnership (the investment in Security Land and
               Development Limited Partnership (Note 3)), and Corporate and
               Other. The Company operates and its revenue is generated
               primarily in the United States. One Home Furnishing Accessories
               customer accounted for approximately 53% and 28% of consolidated
               sales for 1998 and 1997, respectively.

               Information about the Company's operations by segment follows:

<TABLE>
<CAPTION>

                                                               Home          Investment
                                                            Furnishing           in            Corporate
                                                            Accessories      Partnership       and Other       Consolidated
                                                         ---------------- ----------------- ---------------- ----------------
 <S>                                                       <C>               <C>               <C>             <C>
   1998
   ----
   Net sales                                                 $ 3,697,648                        $    92,191      $ 3,789,839
   Income (loss) from operations                                 186,993                         (1,061,388)        (874,395)
   Interest income                                                   250                             76,001           76,251
   Interest expense                                               67,785                          1,246,566        1,314,351
   Income from equity investment in partnership                                $ 3,950,090                         3,950,090
   Identifiable operating assets                               4,242,019                          3,977,254        8,219,273
   Investments                                                                  15,799,631          108,512       15,908,143
   Capital expenditures                                        1,904,321                              6,163        1,910,484
   Depreciation and amortization                                 108,997                             15,962          124,959
   Income before income tax expense and
     minority interest                                           144,985         3,950,090       (2,192,511)       1,902,564

</TABLE>

                                      F-27

<PAGE>   46
                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 14.       SEGMENT INFORMATION (CONTINUED)

<TABLE>
<CAPTION>

                                                               Home          Investment
                                                            Furnishing           in             Corporate
                                                            Accessories      Partnership        and Other       Consolidated
                                                         ---------------- ----------------- ---------------- ----------------
 <S>                                                       <C>                <C>              <C>             <C>
   1997
   ----
   Net sales                                                 $ 2,872,865                           $ 35,388      $ 2,908,253
   Income (loss) from operations                                 119,738                           (927,626)        (807,888)
   Interest income                                                                                   53,324           53,324
   Interest expense                                               27,670                            773,927          801,597
   Income from equity investment in partnership                                $ 3,820,913                         3,820,913
   Identifiable operating assets                               1,955,219                          1,412,274        3,367,493
   Investments                                                                  11,951,819          113,217       12,065,036
   Capital expenditures (excluding
     acquisition of Rustic Crafts)                                29,942                             92,087          122,029
   Depreciation and amortization                                  64,556                             27,017           91,573
   Income before income tax expense and
     minority interest                                            84,040         3,820,913       (1,648,225)       2,256,728



   1996
   ----
   Net sales                                                                                          6,102            6,102
   Income (loss) from operations                                                                   (914,687)        (914,687)
   Interest income                                                                                   74,137           74,137
   Interest expense                                                                                 404,838          404,838
   Income from equity investment in partnership                                  4,268,904                         4,268,904
   Identifiable operating assets                                                                  3,282,063        3,282,063
   Investments                                                                   8,233,731           50,884        8,284,615
   Capital expenditures                                                                              50,884           50,884
   Depreciation and amortization                                                                      7,401            7,401
   Income before income tax expense and
     minority interest                                                           4,268,904       (1,245,388)       3,023,516

</TABLE>

NOTE 15.       SUBSEQUENT EVENTS

               In March 1999, the Company and Cotton Valley Resources
               Corporation ("Cotton Valley") entered into an Agreement and Plan
               of Merger (the "Merger Agreement") which was subsequently
               approved by each company's Board of Directors. The Merger
               Agreement provides that Cotton Valley will exchange 15 million of
               its common shares for the Company's interest in NRDC and 10
               million of its common shares for Stateman's interest in NRDC and
               Stateman's interest in International Aggregate Company. The
               Merger Agreement is contingent upon the vote of the Cotton Valley
               shareholders which is scheduled for May 21, 1999, Cotton Valley
               maintaining its American Stock Exchange listing and other
               matters. While the Company expects that these contingencies will
               be satisfied, there can be no assurance that these expectations
               will be met and the transaction will be consummated.

                                      F-28

<PAGE>   47

                   REGENCY AFFILIATES, INC. AND SUBSIDIARIES

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 15.       SUBSEQUENT EVENTS (CONTINUED)

               In March 1999, the Company reached an agreement in principle to
               acquire the assets and assume certain liabilities of GuildMaster,
               Inc. ("GuildMaster"). The agreement provides that the Company
               will acquire the assets of GuildMaster in exchange for $500,000
               in cash, $1,800,000 of face value convertible preferred shares
               with terms and conditions to be designated by the Board of
               Directors, the assumption of certain liabilities and other
               consideration based on the future performance of GuildMaster.
               GuildMaster manufacturers innovative and fashion-forward
               decorative accessories for the home. Revenues for 1998 are
               estimated to be $4,500,000. While the Company believes that this
               transaction will be consummated there can be no assurance that
               the transaction will be completed or that, if completed, will be
               on the same or similar economic terms.

                                      F-29


<PAGE>   48

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
         FINANCIAL DISCLOSURE.

         There has not been and do not presently exist any disagreements between
the Company and its accountants concerning accounting principles, auditing
procedures or financial disclosure.





                                    PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS OF THE REGISTRANT.

Identification of directors and officers.

         There has not been an annual meeting of the stockholders since August
of 1988, and, accordingly, the sitting Directors have appointed persons to fill
existing vacancies on the Board. Executive officers are elected annually by the
Board of Directors or until their successors are duly elected and qualified. In
connection with the NRDC Transaction, new directors were designated to fill
eight vacant director positions to serve until elected at the next annual
meeting of stockholders. Following is a list of the names and addresses, ages,
positions with the Company, principal occupation and periods of service of the
directors and executive officers.

<TABLE>
<CAPTION>
             

                                                   POSITIONS AND OFFICES HELD AND PRINCIPAL OCCUPATIONS 
NAME, ADDRESS (AGE)                                OR EMPLOYMENT DURING PAST FIVE YEARS
===================================================================================================================

<S>                                             <C>                                     
William R. Ponsoldt, Sr. (57)                      Director since June, 1996. Chairman of the Board of Directors
729 South Federal Hwy., Suite 307,                 since August, 1996. President and CEO since June, 1997. During
Stuart, Florida 34994                              the past five years, Mr. Ponsoldt has served as the portfolio
                                                   manager for several hedge funds. Mr. Ponsoldt is the father of
                                                   William R. Ponsoldt, Jr., a director of the Company.

Stephanie Carey (48)                               Director since July 1993. Ms. Carey is a principal and the
West Bay Street                                    Investment Manager for Managed Companies with Bradley Management
P.O. Box CB 10985                                  (Bahamas) Limited. She is also a director of Regal Bahamas
Nassau, Bahamas                                    International Airways Limited.

Martin J. Craffey (61)                             Director since July 1993. From January 1988 until December 31,
58 Mainsail Drive                                  1993, Mr. Craffey was a real estate and business broker and
Patchogue, New York  11772                         contract vendee with Prudential Realty of Long Island, N.Y. Mr.
                                                   Craffey is presently employed in seeking financing for and
                                                   reorganizing real estate projects.

Larry J. Horbach (57)                              Director from 1987 to 1990, from 1992 to February 15, 1994
and 1869 South 120th Street                        since November 16, 1994. Interim Secretary and Treasurer from 
Omaha, Nebraska 68144                              July 1993 until his resignation effective February 15, 1994.
                                                   Mr.  Horbach has been  
</TABLE>

                                                   19
<PAGE>   49


<TABLE>
<CAPTION>

<S>                                             <C>                                     
                                                   Chairman of the Board, and has had other executive positions
                                                   with Gateway Energy Corporation since June 1990. In addition,
                                                   during the past five years, Mr. Horbach has been associated
                                                   with L.J. Horbach & Associates.

Pamlyn Kelly, Ph.D. (55)                           Director since July 1993. Dr. Kelly is principal and Chief
10 Winged Foot Drive                               Executive Officer of Human Resource Concepts, Novato, CA, a
Novato, California  94949                          registered minority owned management consulting firm, and she
                                                   has a private practice.

William R. Ponsoldt, Jr. (33)                      Director since July 1993. Mr. Ponsoldt is an attorney engaged in
770 S.W. Lighthouse Dr.,                           the private practice of law in Florida with the law firm of
Palm City, Florida 34990                           Warner, Fox, Seeley, Dungey & Sweet. Formerly, he was with Kohl,
                                                   Metzter, Spotts, Ponsoldt & Tapper, P.A. Mr. Ponsoldt is the
                                                   son of William R. Ponsoldt, Sr., a director of the Company.

Fredric R. Lowe (55)                               Director since October, 1997. Mr. Lowe has been employed as a 
1345 Avenue of the Americas                        retail stock broker during the past five years. For the past 
21st Floor                                         four years he has been employed by Smith Barney and prior to 
New York, New York 10105                           that he was employed by its predecessor, Lehman Brothers.


Douglas F. Long (54)                               Chief Financial Officer of the Company since March, 1998 and
13377 S. Indian River Drive                        previously an employee. During the past five years Mr. Long was
Jensen Beach, FL  34957                            involved in business and real estate development matters.


Eunice M. Antosh (49)                              Secretary of the Company since February 25, 1994. Since
802 County Road "N"                                October, 1993, Mrs. Antosh has also been employed by Gateway
Yutan, Nebraska 68073                              Energy Corporation.

</TABLE>

         Each of Messrs. Ponsoldt, Jr. and Craffey, Dr. Kelly and Ms. Carey were
appointed directors of the Company by Statesman as part of the closing of the
NRDC Transaction on July 7, 1993. Each had an understanding with Statesman
and/or the Company that as an inducement to accept their positions as directors
he or she would receive certain consideration from Statesman and/or the
Company. Dr. Kelly and Ms. Carey each received 100,000 shares of the
Company's Common Stock from Statesman while Messrs. Ponsoldt, Jr., Craffey,
and Dr. Kelly received options to purchase shares of the Company's Cumulative
Senior Preferred $100 Series-C Stock as set forth on page 27 of this report.

                                       20
<PAGE>   50

         Mr. Horbach was a Director of the Company from 1987 to 1990 and again
from 1992 to February 15, 1994. He rejoined the Board on November 16, 1994. Mr.
Horbach served as the interim President of the Registrant on a part time basis
until the closing of the 1993 Transaction. On February 7, 1995, Regency
Affiliates, Inc. entered into an agreement with L.J. Horbach & Associates, Inc.
pursuant to which L.J. Horbach & Associates, Inc. will provide certain
administrative services to the Company for a monthly fee of $3,000, including
but not limited to accounting and stock transfer record keeping. L.J. Horbach &
Associates, Inc. is wholly owned by Larry J. Horbach.


Item 405 Disclosure.

         None.


ITEM 11.  EXECUTIVE COMPENSATION.

Summary Compensation Table.

         The following table sets forth the annual and long-term compensation
during the last three years of William R. Ponsoldt, Sr., Douglas F. Long and
Eunice M. Antosh, the only officers who received compensation during 1998.

                                       21

<PAGE>   51

<TABLE>
<CAPTION>


                                            SUMMARY COMPENSATION TABLE
- ------------------------------------------------------------------------------------------------------------------------
                                  ANNUAL COMPENSATION                        LONG TERM COMPENSATION
                                                                       -----------------------------------
                                                                       AWARDS                      PAYOUTS 
                                  --------------------------------------------------------------------------------------
   (A)         (B)            (C)            (D)          (E)           (F)             (G)           (H)         (I)
- ------------------------------------------------------------------------------------------------------------------------      
                                                         Other         Restricted    Securities
Name and                                                 Annual Com-   Stock         Underlying                  All
Principal                    Salary         Bonus        pensa-        Award(s)      Options/        LTIP        Other 
Position      Year           ($)            ($)          tion ($)      ($)           SARs (#)        Payouts     Compen-
                                                                                                     ($)         sation
- ------------------------------------------------------------------------------------------------------------------------
<S>        <C>           <C>            <C>            <C>             <C>             <C>            <C>         <C>
William R.    1998          252,333(1)     373,022(2)     7,200          -0-(3)          -0-            -0-         -0-
Ponsoldt,Sr.  1997          250,000(1)     292,500(2)     5,700          -0-(3)          -0-            -0-         -0-
Chairman      1996            -0-            -0-           -0-           -0-             -0-            -0-         -0-
Pres/CEO
- ------------------------------------------------------------------------------------------------------------------------
Douglas F.    1998           52,800          -0-          2,400          -0-             -0-            -0-         -0-
Long, CFO     1997           25,600          -0-           -0-           -0-             -0-            -0-         -0-
              1996            -0-            -0-           -0-           -0-             -0-            -0-         -0-
- ------------------------------------------------------------------------------------------------------------------------
Eunice M.     1998           12,000          -0-           -0-           -0-             -0-            -0-         -0-
Antosh,       1997           12,000          -0-           -0-           -0-             -0-            -0-         -0-
Secretary     1996           12,000          -0-           -0-           -0-             -0-            -0-         -0-
- ------------------------------------------------------------------------------------------------------------------------

</TABLE>

    ---------------------

        1        Mr. Ponsoldt's salary is to be adjusted on January 1 of every 
      year by any increase since the previous January 1 in the Consumer Price
      Index ("CPI") for All Urban Consumers, U.S. city average, as published by
      the U.S. Department of Labor Bureau of Labor Statistics.

        2        Under the terms of Mr. Ponsoldt's Employment Agreement dated 
      June 3, 1997, he is entitled to receive as additional compensation an
      amount equal to 20% of the Company's increase in quarterly common stock
      net worth, which is defined to be the difference between (i) total
      shareholders' equity and (ii) any shareholders' equity accounts relating
      to preferred stock.

        3        Pursuant to an Agreement dated June 3, 1997 between the Company
      and Statesman Group, Inc., which agreement provided for the release of Mr.
      Ponsoldt to assume the offices of President and CEO of the Company,
      466,667 shares of the Company's $0.40 p.v. Common Stock were issued to
      Statesman at a value of $233,333.

                                       22
<PAGE>   52


Stock Options.

         The Option/SAR Grants Table is omitted as there were no individual
grants of stock options (whether or not in tandem with SARs) nor freestanding
SARs made during the last completed fiscal year to any of the named executive
officers.

         The Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End
Option/SAR Values table is omitted as there were no exercise of stock options
(nor tandem SARs) nor freestanding SARs during the last completed fiscal year by
any of the named executive officers.

         Stock Options Granted to Statesman Group, Inc.

         Pursuant to an Agreement dated June 3, 1997, as amended and restated on
March 24, 1998, Statesman Group, Inc. was granted options to purchase 6.1
million shares of Common Stock. Statesman owned approximately 25% of the
Company's outstanding common stock prior to the issuance of these options. The
options were issued to Statesman in order to secure the release of Mr. William  
R. Ponsoldt, Sr. to serve as President and Chief Executive Officer of the
Company and pursuant to the Amended and Restated Agreement between the Company
and Statesman, until their date of expiration, the options shall be exercisable
at any time in whole or in part at a price equal to the lower of (a) the
closing trading price as of the most recent date on which at least 10,000
shares of such stock were traded, or (b) the average closing trading price of
the shares during the ninety day period immediately preceding the date of
exercise. The Company agreed to reserve sufficient shares to meet the
requirements of the options. The options became exercisable immediately and
remain exercisable until April 15, 2007. At the option of Statesman, payment
may be made by Statesman for exercise of the options, in whole or in part, in
the form of a promissory note executed by Statesman, secured only by a pledge
of the shares purchased, which promissory note will accrue interest for any
quarter at the prime rate in effect on the last day of the quarter at Chase
Manhattan Bank, with interest and principal payable in a balloon payment five
years after the date of execution of the note, provided that if the Company's
Board of Directors reasonably determines that exercising the options by
delivery of a note would render the respective purchase of shares void or
voidable, then the Board may require, as a condition to exercise of the
options, that Statesman either (i) pay at least the par value of the shares in
cash (with the balance paid by delivery of a note), or (ii) provide acceptable
collateral other than the shares themselves to secure payment of the note. The
Company received no cash consideration with respect to the issuance of the
securities to Statesman, no commissions were paid, and no underwriter was
involved. The options granted to Statesman have no readily determinable value
and, therefore, the Company has not recognized any costs associated with the
issuance of these options.

         Incentive Stock Option Plans.

         The Company has reserved 500,000 shares of its Common Stock for
issuance under the 1988 Incentive Stock Plan.

                                       23

<PAGE>   53


Other.

         LTIP Awards.

         There have been no awards under any Long-Term Incentive Plan during the
last completed fiscal year.

         Defined Benefit Plans.

         The Company has no defined benefit or actuarial plans.

         Compensation of Directors.

         Standard Arrangements.

         The members of the Board of Directors of Regency Affiliates, Inc. each
receive the sum of $500 for their attendance at directors' meetings.

         At a meeting of the Board of Directors of Regency held on October 10,
1997, the Board approved, subject to its adoption by the shareholders of the
Company, a compensation plan for directors providing for (i) an annual retainer
for independent directors of $10,000, payable one-half in cash and one-half in
the Common Stock of the Company, (ii) a fee of $125/hour, with a two hour
minimum, for attendance at each meeting of the Board or committee thereof, and
(iii) an award of an option to each independent director for the purchase of
10,000 shares of the Company's Common Stock. As of the date of this report, this
compensation plan had not been submitted to the shareholders of the Company and
had not been implemented.

         Other Arrangements.

          There were no other arrangements pursuant to which any director of
Regency Affiliates, Inc. was compensated during the Company's last completed
fiscal year for services provided as a director. Martin J. Craffey was paid
$4,750 for consulting primarily with respect to the operations of Rustic Crafts
International, Inc.

         Employment Contracts, Termination of Employment and Change in Control
         Arrangements.

         On June 3, 1997, Regency entered into an Employment Agreement with
William R. Ponsoldt, Sr. pursuant to which he became the President and CEO of
the Company. The Agreement provides for Mr. Ponsoldt to continue in these duties
until his attainment of retirement age, provided that he may resign upon 30 days
notice to the Company and further provided that Mr. Ponsoldt may be removed from
office upon death or disability or for just cause. The Agreement provides for a
base salary in annual installments, in advance, of $250,000 each, which salary
is to be adjusted on January 1 of every year by any increase since the previous
January 1 in the Consumer Price Index ("CPI") for 


                                       24
<PAGE>   54

All Urban Consumers, U.S. city average, as published by the U.S. Department of
Labor, Bureau of Labor Statistics. As additional compensation, Mr. Ponsoldt is
to receive an amount equal to 20% of the Company's increase in quarterly common
stock net worth, which is defined to be the difference between (i) total
shareholders' equity and (ii) any shareholders' equity accounts relating to
preferred stock. The Company may elect to pay up to 50% of the additional
compensation by the issuance of warrants to purchase the Company's Common Stock
at a price equal to 50% of the average bid price for the Company's Common Stock
for the calendar quarter for which the increased compensation is payable. The
Agreement further provides for Mr. Ponsoldt to receive health and disability
insurance (with a benefit of $100,000/year payable in the event of long term
disability), an automobile allowance of $600/month (to be adjusted by increases
in the CPI), and reimbursement of expenses. The Agreement provides that Mr.
Ponsoldt will not compete with the Company for a two year period following the
termination of his employment and provides for indemnification under certain
circumstances. Any disputes between the Company and Mr. Ponsoldt under the
Agreement are to be resolved through arbitration.

         Compensation Committee Report on Executive Compensation.

         This item is omitted as Regency Affiliates, Inc. qualifies as a "small
business issuer" under Rule 405 and Regulation S-B.

         Performance Graph.

         This item is omitted as Regency Affiliates, Inc. qualifies as a "small
business issuer" under Rule 405 and Regulation S-B.

         Compensation Committee Interlocks and Insider Participation in
         Compensation Decisions.

         This item is omitted as Regency Affiliates, Inc. qualifies as a "small
business issuer" under Rule 405 and Regulation S-B.



                                       25
<PAGE>   55


ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

Security ownership of certain beneficial owners.

         To the best of the Company's knowledge, the only beneficial owners of
more than five percent of Regency's voting securities as of February 28, 1999
are listed below:

<TABLE>
<CAPTION>

                                                        AMOUNT AND NATURE
                                                        -----------------
                             NAME AND ADDRESS OF          OF BENEFICIAL       PERCENT OF
                             -------------------          -------------       ----------
     TITLE OF CLASS           BENEFICIAL OWNER              OWNERSHIP            CLASS
     --------------           ----------------              ---------            -----

<S>                     <C>                             <C>                   <C>  
Regency Affiliates,        Statesman Group, Inc.           3,126,377 (1)          24.7%
Inc. $0.40 p.v.            King & George Streets
Common Stock                 Nassau, Bahamas

Regency Affiliates,        Edward E. Gatz                  1,135,750               9.0%
Inc. $0.40 p.v.            10029 Frederick St.
Common Stock               Omaha, NE  68124
</TABLE>


- --------------

         (1) The nature of beneficial ownership is sole investment power and
             sole voting power as to all shares listed.



         Statesman Group, Inc. is an international business corporation
organized under the laws of the Bahamas. Statesman's principal business is the
making of investments in the United States and elsewhere. Both its principal    
business and principal office are located at King & George Streets, Nassau,
Bahamas. The Statesman Irrevocable Trust dated April 15, 1991 is the controlling
person of Statesman. The Statesman Trust is an irrevocable trust for the benefit
of William R. Ponsoldt, Jr., a director of the Company, Tracey A. Ponsoldt, now
married and sometimes known as Tracey A. Powers, and Christopher J. Ponsoldt,
all children of William R. Ponsoldt, Sr. The acting trustees of The Statesman
Trust dated April 15, 1991, have the sole right to control the disposition of
and vote the Regency securities acquired by Statesman and, through the
designation of eight members of the Board of Directors to fill the existing
vacancies on the Board of Directors, the right to vote the irrevocable proxies
over Regency Common Stock delivered to a proxy committee of the Board of
Directors pursuant to the terms of the NRDC Transaction.

Security ownership of management.

         The following table sets forth as of December 31, 1998 the number of
shares of Regency's $0.40 p.v. Common Stock beneficially owned by each director
and by all executive officers and directors of Regency as a group as of such
date. Unless otherwise indicated, each person has sole voting and investment
powers with respect to the shares indicated.

                                       26


<PAGE>   56

<TABLE>
<CAPTION>

                                 NAME OF                 AMOUNT AND NATURE OF
                                 -------                 --------------------
TITLE OF CLASS               BENEFICIAL OWNER            BENEFICIAL OWNERSHIP         PERCENT OF CLASS
- --------------               ----------------            --------------------         ----------------

<S>                        <C>                            <C>                              <C>
Regency Affiliates, Inc.     Larry J. Horbach                  363,397(1)                     2.9%
$0.40 p.v. Common
Stock

Regency Affiliates Inc.      Pamlyn Kelly                      100,000                         .8%
$0.40 p.v. Common
Stock

Regency Affiliates, Inc.     Eunice M. Antosh                   62,345                         .5%
$0.40 p.v. Common 
Stock

Regency Affiliates, Inc.     All officers and                  525,742                        4.2%
$0.40 p.v. Common            directors as a group (8
Stock                        individuals)


</TABLE>

- ------------------
   (1) An irrevocable proxy with respect to these shares, so long as the shares
are held by Mr. Horbach, was given to a proxy committee of the Board of
Directors as part of the NRDC transaction.

Cumulative Senior Preferred $100 Series-C Stock

         As of December 31, 1998 certain members of the Board of Directors of
Regency Affiliates, Inc. held warrants to purchase Cumulative Senior Preferred
$100 Series-C Stock from Statesman Group, Inc., as follows: William R. Ponsoldt,
Jr. (warrants to purchase 1,000 shares); Pamlyn Kelly, Ph.D. (warrants to
purchase 1,000 shares); and Martin J. Craffey (warrants to purchase 1,000
shares).


Series-D Junior Preferred Stock - $10 Stated Value

         Larry J. Horbach holds 1,238 shares of the Series-D Junior Preferred
Stock - $10 Stated Value over which he has sole voting power and sole investment
power.

                                       27
<PAGE>   57

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

Transactions with management and others.

         Reference is made to Part III, Item 10, page 21 of this report for a
description of certain transactions with L.J. Horbach & Associates, Inc.

Certain business relationships.

         Not applicable.

Indebtedness of Management.

         Not applicable.




                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K.

a)        Documents filed as part of the report.

          1)       See Item 8.

          2)       Certain schedules are omitted because of the condition under
                   which they are required or because the required information 
                   is included in the financial statements or notes thereof.

          3)       See Index to Exhibits.

b)        Reports on Form 8-K - None.



                                       28

<PAGE>   58




                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) 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.


                            REGENCY AFFILIATES, INC.
                    ----------------------------------------
                                  (Registrant)




April   13, 1999                       By: /s/William R. Ponsoldt Sr., President
- ----------------                          --------------------------------------
Date                                       William R. Ponsoldt, President


                                       By: /s/ Douglas F. Long
                                          --------------------------------------
                                           Douglas F. Long, CFO


         Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.

DATE                                          SIGNATURE AND TITLE
- ----                                          -------------------

April  13, 1999                         By: /s/ William R. Ponsoldt
- ---------------                             ------------------------------------
Date                                        William R. Ponsoldt, President
                                            and Director


April  13, 1999                             /s/ Stephanie Carey
- ---------------                             ------------------------------------
Date                                        Stephanie Carey,
                                            Director


April  13, 1999                             /s/ Martin J. Craffey
- ---------------                             ---------------------
Date                                        Martin J. Craffey,
                                            Director

                                       29
<PAGE>   59




April   13, 1999                            /s/ Larry J. Horbach
- ---------------                             ------------------------------------
Date                                        Larry J. Horbach,
                                            Director


April   13, 1999                            /s/ Pamlyn Kelly, Ph.D.
- ---------------                             ------------------------------------
Date                                        Pamlyn Kelly, Ph.D.,
                                            Director


April   13, 1999                            /s/ William R. Ponsoldt, Jr.
- ----------------                            -----------------------------
Date                                        William R. Ponsoldt, Jr.,
                                            Director


April   13, 1999                            /s/ Fredric R. Lowe
- ---------------                             ------------------------------------
Date                                        Fredric R. Lowe,
                                            Director


                                       30


<PAGE>   60


                               INDEX TO EXHIBITS

Exhibit No.                Description of Document
- -----------                -----------------------

     1(a)                 Agreement For Acquisition among Regency Affiliates,
                          Inc., Statesman Group, Inc., and National Resource
                          Development Corporation, as amended, and incorporated
                          herein by reference

     1(b)                 Irrevocable Proxies over 855,991 shares of Regency's
                          $0.40 par value Common Stock, and incorporated herein
                          by reference

     1(c)                 National Resource Development Corporation Assignment
                          and Assumption Agreement, and incorporated herein by
                          reference

     1(d)                 Security Land And Development Company Limited
                          Partnership Agreement, as amended, filed as Exhibit
                          1(a) to Registrant's Annual Report on Form 10-K for
                          the year ended December 31, 1994, and incorporated
                          herein by reference

     1(e)                 Letter Agreement dated November 17, 1994 between TCG
                          Management Corporation and Regency Affiliates, Inc.,,
                          filed as Exhibit 1(b) to Registrant's Annual Report on
                          Form 10-K for the year ended December 31, 1994, and
                          incorporated herein by reference

     1(f)                 Security Land And Development Company Limited
                          Partnership Irrevocable Written Instruction Concerning
                          Payments From Escrow Fund, filed as Exhibit 1(c) to
                          Registrant's Annual Report on Form 10-K for the year
                          ended December 31, 1994, and incorporated herein by
                          reference

     1(g)                 Audited financial statement for Security Land And
                          Development Company Limited Partnership, filed as
                          Exhibit 1(d) to Registrant's Annual Report on Form
                          10-K for the year ended December 31, 1994, and
                          incorporated herein by reference

     3(a)                 Certificate of Incorporation of Registrant filed at
                          Exhibit 6.1 to Registrant's Registration Statement on
                          Form S-14, Registration No. 2-66923 1 (a), page E-1
                          Agreement For Acquisition among Regency Affiliates,
                          Inc., Statesman Group, Inc., and National Resource
                          Development Corporation, as amended, and incorporated
                          herein by reference

                                       31

<PAGE>   61


     3(b)                 Certificate of Amendment of Certificate of
                          Incorporation of Registrant filed at Exhibit 3.2 to
                          Registrant's Annual Report on Form 10-K, and
                          incorporated herein by reference

     3(c)                 Certificate of Amendment of Certificate of
                          Incorporation filed February 15, 1988, and
                          incorporated herein by reference

     3(d)                 By-laws of Registrant filed at Exhibit 3.4 to
                          Registrant's Registration Statement on Form S-1,
                          Registration No. 2-86906, and incorporated herein by
                          reference

     4                    Certificate of Designation - Series A Cumulative $10
                          Convertible Preferred Stock, $.10 par value, filed as
                          Exhibit to Form 8-K dated June 19, 1989, and
                          incorporated herein by reference

     4(a)                 Restated Certificate of Designation Series A $10
                          Convertible Preferred Stock, $.10 par value filed as
                          Exhibit to Form 10-K dated June 7, 1993 and
                          incorporated herein by reference

     4(b)                 Certificate of Designation - Series B Preferred Stock,
                          $10 Stated Value, $.10 Par Value filed as Exhibit to
                          Form 10-K dated June 7, 1993 and incorporated herein
                          by reference

     4(c)                 Certificate of Designation - Series C Preferred Stock,
                          $100 Stated Value, $.10 Par Value filed as Exhibit to
                          Form 10-K dated June 7, 1993 and incorporated herein
                          by reference

     4(d)                 Certificate of Designation - Series D Junior Preferred
                          Stock, $10 Stated Value, $.10 Par Value filed as
                          Exhibit to Form 10-K dated June 7, 1993 and
                          incorporated herein by reference

     4(e)                 Certificate of Designation, Preferences and Rights of
                          Cumulative Senior Preferred Stock $100, Series C and
                          incorporated herein by reference

     4(f)                 Specimen of Certificate representing Cumulative Senior
                          Preferred Stock $100, Series C and incorporated herein
                          by reference

     4(g)                 Specimen of Certificate representing Warrants and
                          incorporated herein by reference

                                       32

<PAGE>   62


     4(h)                 Restated Certificate of Designation of Preferences and
                          Rights of Cumulative Senior Preferred $100, Series-C
                          Stock, filed as Exhibit 4(a) to Registrant's Annual
                          Report on Form 10-K for the year ended December 31,
                          1994, and incorporated herein by reference

     4(I)                 Certificate of Designation of Preferences and Rights
                          of Cumulative Contingent Convertible Senior Preferred
                          $100, Series-E Stock, filed as Exhibit 4(b) to
                          Registrant's Annual Report on Form 10-K for the year
                          ended December 31, 1994, and incorporated herein by
                          reference

     4(j)                 Specimen Certificate for Cumulative Contingent
                          Convertible Senior Preferred $100, Series-E Stock,
                          filed as Exhibit 4(c) to Registrant's Annual Report on
                          Form 10-K for the year ended December 31, 1994, and
                          incorporated herein by reference

     4(k)                 Certificate of Designation - Series C Preferred Stock,
                          $100 Stated Value, $.10 Par Value filed as Exhibit 4.1
                          to Registrant's Annual Report on Form 10-K for the
                          year ended December 31, 1995 at page E-1, and
                          incorporated herein by reference

     9                    Letter dated November 30, 1994 from R.L. Quint & Co.
                          to Regency Affiliates, Inc., filed as Exhibit 4(c) to
                          Registrant's Annual Report on Form 10-K for the year
                          ended December 31, 1994

    10                    1984 Incentive Stock Option filed as exhibit to
                          Registrants' 1984 Proxy Statement, and incorporated
                          herein by reference

    10(a)                 Agreement For Acquisition among Regency Affiliates,
                          Inc., Statesman Group, Inc., and National Resource
                          Development Corporation filed as Exhibit to Form 10-K
                          dated June 7, 1993 and incorporated herein by
                          reference

    10(b)                 Agreement between Regency Affiliates, Inc. and Edward
                          G. Harshfield, as amended and incorporated herein by
                          reference

    10(c)                 Agreement dated July 25, 1994 between Edward G.
                          Harshfield and Regency Affiliates, Inc., filed as
                          Exhibit 10(a) to Registrant's Annual Report on Form
                          10-K for the year ended December 31, 1994

    10(d)                 Agreement dated July 21, 1994 between Gary F. Spahn
                          and Regency Affiliates, Inc., filed as Exhibit 10(b)
                          to Registrant's Annual Report on Form 10-K for the
                          year ended December 31, 1994


                                       33

<PAGE>   63
    10(e)                 Letter Agreement dated February 7, 1995 between L.J.
                          Horbach & Associates, Inc., filed as Exhibit 10(c) to
                          Registrant's Annual Report on Form 10-K for the year
                          ended December 31, 1994

    10(f)                 Agreement executed February 1, 1996 between Gary K.
                          Nuttall and Regency Affiliates, Inc. filed as Exhibit
                          10.1 to Registrant's Annual Report on Form 10-K for
                          the year ended December 31, 1995 at page E-12, and
                          incorporated herein by reference

    10(g)                 Credit Agreement and Collateral Assignment, Pledge and
                          Security Agreement dated June 21, 1996 between the
                          Company and Southern Indiana Properties, Inc. filed as
                          Exhibit Exhibits 10(a) and 10(b) to the Registrant's
                          Quarterly Report on Form 10-Q for the quarter ended
                          June 30, 1996 at page E-1, and incorporated herein by
                          reference.

    10(h)                 Employment Agreement dated June 3, 1997, between
                          Regency Affiliates, Inc. and William R. Ponsoldt, Sr.,
                          and Agreement dated June 3, 1997, between Regency
                          Affiliates, Inc. and Statesman Group, Inc. filed as
                          Exhibits 10(a) and (b) to the Registrant's report on
                          Form 8-K dated June 13, 1997, and incorporated herein
                          by reference.

    10(i)                 Asset Purchase and Sale Agreement dated February 27,
                          1997, between Rustic Crafts Co., Inc. and certain
                          individuals, as Sellers, and Regency Affiliates, Inc.,
                          as Purchaser, and Assignment and Assumption of
                          Purchase Agreement dated March 17, 1997, between
                          Regency Affiliates, Inc., and Rustic Crafts
                          International, Inc., filed as Exhibit 10.1 to
                          Registrant's Annual Report on Form 10-K for the year
                          ended December 31, 1997 at page E-1, and incorporated
                          herein by reference.

    10(j)                 Amended and Restated Agreement Between Regency
                          Affiliates, Inc. and the Statesman Group dated March
                          24, 1998 filed as Exhibit 10.2 to Registrant's Annual
                          Report on Form 10-K for the year ended December 31,
                          1997, at page E-36, and incorporated herein by
                          reference.

    10(k)                 Loan Agreement and Pledge and Security Agreement with
                          KBC Bank N.V. dated June 24, 1998, filed as Exhibits
                          10.1 and 10.2 to the registrant's report on Form 10-Q
                          for the quarter ended June 30, 1998, and incorporated
                          herein by reference.

                                       34
<PAGE>   64


     10(l)                7th Amendment to Partnership Agreement of Security
                          Land and Development Company Limited Partnership dated
                          June 24, 1998, filed as Exhibit 10.3 to the
                          Registrant's report on Form 10-Q for the quarter ended
                          June 30, 1998, and incorporated herein by reference.

     28                   Private Placement Offering Memorandum dated June 3,
                          1991 offering $400,000 of Regency Restructuring Serial
                          Promissory Notes filed as Exhibit to Form 10-K dated
                          June 7, 1993 and incorporated herein by reference

                                       35

<PAGE>   65




                            EXHIBITS FILED HEREWITH:


EXHIBIT NO.                          DESCRIPTION OF DOCUMENT
- -----------                          -----------------------


21,  page E-37                       Schedule of Registrant's Subsidiaries

27,  page E-38                       Financial Data Schedule

99,  page E-39                       Audited financial statement for
                                     Security Land And Development Company
                                     Limited Partnership, for three years ended
                                     December 31, 1998, December 31, 1997 and
                                     December 31, 1996.


                                       36




<PAGE>   1

                                   EXHIBIT 21



                            REGENCY AFFILIATES, INC.

                            SCHEDULE OF SUBSIDIARIES

<TABLE>
<CAPTION>

         Name of Subsidiary          Percent Owned   State of Incorporation    Other Names Used
- -----------------------------------------------------------------------------------------------
<S>                                      <C>               <C>                <C>   
National Resource Development            80%                 Nevada                 None
Corp.

TransContinental Drilling Co.            80%                 Delaware               None
("Drilling")

RegTransco, Inc.                         80%1                Delaware               None

Rustic Crafts International, Inc.        100%                Delaware               None
</TABLE>




- --------------------

1    RegTransco, Inc. is wholly owned by Drilling, which is itself an 80% owned
     subsidiary of the Registrant.


<TABLE> <S> <C>

<ARTICLE> 5
       
<S>                             <C>
<PERIOD-TYPE>                   YEAR
<FISCAL-YEAR-END>                                  DEC-31-1998
<PERIOD-START>                                     JAN-01-1998
<PERIOD-END>                                       DEC-31-1998
<CASH>                                               2,168,541
<SECURITIES>                                                 0
<RECEIVABLES>                                          752,861
<ALLOWANCES>                                                 0
<INVENTORY>                                            806,006
<CURRENT-ASSETS>                                     3,857,783
<PP&E>                                               2,083,073
<DEPRECIATION>                                         103,010
<TOTAL-ASSETS>                                      24,127,416
<CURRENT-LIABILITIES>                                1,225,210
<BONDS>                                             11,519,930
                                  237,250
                                          1,052,988
<COMMON>                                             5,047,129
<OTHER-SE>                                           5,118,933
<TOTAL-LIABILITY-AND-EQUITY>                        24,127,416
<SALES>                                              3,789,839
<TOTAL-REVENUES>                                     3,789,839
<CGS>                                                2,621,363
<TOTAL-COSTS>                                        2,621,363
<OTHER-EXPENSES>                                     2,042,871
<LOSS-PROVISION>                                             0
<INTEREST-EXPENSE>                                   1,314,351
<INCOME-PRETAX>                                      1,893,143
<INCOME-TAX>                                            98,583
<INCOME-CONTINUING>                                  1,794,560
<DISCONTINUED>                                               0
<EXTRAORDINARY>                                              0
<CHANGES>                                                    0
<NET-INCOME>                                         1,794,560
<EPS-PRIMARY>                                              .14
<EPS-DILUTED>                                              .12
        


</TABLE>

<PAGE>   1
                                                                   EXHIBIT 99(a)











                            FINANCIAL STATEMENTS AND
                          INDEPENDENT AUDITORS' REPORT

                     SECURITY LAND AND DEVELOPMENT COMPANY
                              LIMITED PARTNERSHIP

                               DECEMBER 31, 1998



<PAGE>   2

           Security Land and Development Company Limited Partnership

                               TABLE OF CONTENTS

                                                                          PAGE

INDEPENDENT AUDITORS' REPORT                                                3

FINANCIAL STATEMENTS

         BALANCE SHEET                                                      4

         STATEMENT OF OPERATIONS                                            5

         STATEMENT OF CHANGES IN PARTNERS' CAPITAL                          6

         STATEMENT OF CASH FLOWS                                            7

         NOTES TO FINANCIAL STATEMENTS                                      8


<PAGE>   3
                         [LOGO-COMPANY LETTERHEAD-RF&S]

                           Reznick Fedder & Silverman
            Certified Public Accountants A Professional Corporation
              4520 East West Highway Suite 300 Bethesda, Maryland
               20814-3319 Phone (301) 652-9100 Fax (301) 652-1848



                          INDEPENDENT AUDITORS' REPORT

To the Partners
Security Land and Development Company Limited Partnership


         We have audited the accompanying balance sheet of Security Land and
Development Company Limited Partnership as of December 31, 1998, and the related
statements of operations, changes in partners' capital and cash flows for the
year then ended. 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 generally accepted auditing
standards. 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 financial position of Security Land and
Development Company Limited Partnership as of December 31, 1998, and the results
of its operations, changes in partners' capital and cash flows for the year then
ended in conformity with generally accepted accounting principles.




                                                /s/ Reznick Fedder & Silverman
                                                -------------------------------
Bethesda, Maryland
February 10, 1999





                                      -3-
<PAGE>   4

<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                                 BALANCE SHEET

                               December 31, 1998

<S>                                                          <C>        
Investment in real estate, net of accumulated depreciation   $50,507,072

Cash and cash equivalents                                        202,649

Restricted escrow                                              3,658,402

Tenant accounts receivable                                     1,031,473

Prepaid expenses and other receivables                           361,623

Accrued interest income                                           12,682

Deferred charges, net of accumulated 
  amortization of $ 1,821,897                                    806,830
                                                             -----------
  Total assets                                               $56,580,731
                                                             ===========

Note payable, net of discount                                $35,871,949

Accounts payable and accrued expenses                            246,571

Accrued interest payable                                         364,840

Deferred rental income                                         3,944,625

Deferred interest income                                         500,000
                                                             -----------
                                                              40,927,985
Partners' capital                                             15,652,746
                                                             -----------
  Total liabilities and partners' capital                    $56,580,731
                                                             ===========
</TABLE>





                       See notes to financial statements

                                      -4-
<PAGE>   5

<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                            STATEMENT OF OPERATIONS

                          Year ended December 31, 1998


<S>                                                                  <C>        
REVENUE
  Rental income                                                      $13,143,041
  Interest income                                                        254,402
  Tenant reimbursements and other income                                  64,717
                                                                     -----------
    Total revenue                                                     13,462,160
                                                                     -----------


Administrative
  Management fees                                                        270,600
  Professional fees                                                      102,803
  Payroll expenses                                                       502,817
  Office expenses                                                         59.918
                                                                     -----------
                                                                         936.138
                                                                     -----------
Operating
  Janitorial                                                           1,087,735
  Maintenance contracts                                                   88,596
  Repairs and maintenance                                                184,510
  Maintenance supplies                                                   248,329
                                                                     -----------
                                                                       1,609,170
                                                                     -----------
Interest, taxes and insurance
  Interest                                                             3,228,976
  Real estate taxes                                                      601,560
  Insurance                                                               86,150
                                                                     -----------
                                                                       3,916,686
                                                                     -----------
Depreciation and amortization
  Depreciation                                                         2,524,223
  Amortization                                                           317,638
                                                                     -----------
                                                                       2,841,861
                                                                     -----------
    Total expenses                                                     9,303,855
                                                                     -----------
    NET INCOME                                                       $ 4,158,305
                                                                     ===========
</TABLE>

                  See notes to financial statements

                                       -5-


<PAGE>   6

           Security Land and Development Company Limited Partnership

                   STATEMENT OF CHANGES IN PARTNERS' CAPITAL

                          Year ended December 31, 1998

<TABLE>
<CAPTION>

                                                                                Special
                                              General           Limited         limited
                             Total            partner           partner         partner
                          ------------      -----------     ------------      -----------
<S>                       <C>               <C>             <C>               <C>        
Balance, beginning        $ 11,602,102      $ 1,032,917     $ (1,382,639)     $11,951,824

Net income                   4,158,305          167,996           39,920        3,950,389

Distributions                 (107,661)          (4,351)          (1,032)        (102,278)
                          ------------      -----------     ------------      -----------
Balance, end              $ 15,652,746      $ 1,196,562     $ (1,343,751)      15,799,935
                          ============      ===========     ============      ===========
</TABLE>





                       See notes to financial statements

                                      -6-


<PAGE>   7

<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                            STATEMENT OF CASH FLOWS

                          Year ended December 31, 1998


<S>                                                                 <C>        
Cash flows from operating activities
  Net income                                                        $ 4,158,305
  Adjustments to reconcile net income to
  net cash provided by operating activities
    Depreciation                                                      2,524,223
    Amortization                                                        317,638
    Deferred rental income                                             (816,487)
    Amortization of debt discount                                        94,024
    Increase in tenant accounts receivable                                 (734)
    Decrease in prepaid expenses and other receivables                   35,582
    Decrease in accrued interest income                                   3,612
    Decrease in accounts payable and accrued
     expenses - operating                                               (22,393)
    Decrease in accrued interest payable                                (57.121)
                                                                    -----------
  Net cash provided by operating activities                           6,236,649
                                                                    -----------

Cash flows from investing activities
  Withdrawals from restricted escrow                                    455,536
  Investment in real estate                                            (965,882)
                                                                    -----------
      Net cash used in investing activities                            (510,346)
                                                                    -----------

Cash flows from financing activities
  Payments on note payable                                           (5,690,068)
  Distributions                                                        (107,661)
                                                                    -----------
      Net cash used in financing activities                          (5,797,729)
                                                                    -----------

         NET DECREASE IN CASH                                           (71,426)

Cash and cash equivalents, beginning                                    274,075
                                                                    -----------
Cash and cash equivalents, end                                      $   202,649
                                                                    ===========
Cash paid for interest during the year                              $ 3,192,073
                                                                    ===========
</TABLE>


                        See notes to financial statements

                                      -7-
<PAGE>   8


           Security Land and Development Company Limited Partnership

                         NOTES TO FINANCIAL STATEMENTS


                               December 31, 1998


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



     Security Land and Development Company Limited Partnership (the
     "partnership") was formed under the laws of the State of Maryland. The
     partnership was organized to own and operate, for investment purposes, the
     project (the "project") which consists of a building known as the Security
     West Building (the "building").

     The building is an approximately 717,000 square foot, two-phase office
     building, consisting of a two-story office building and a connected
     six-story office tower, located at 1500 Woodlawn Drive, Woodlawn, Maryland.
     The building was purchased by the partnership in 1986 and is located on
     land which is approximately 34.3 acres, also owned by the partnership. The
     building has been occupied by the United States Social Security
     Administration's Office of Disability and International Operations (the
     "tenant") for approximately 24 years under leases between the United States
     of America, acting by and through the General Services Administration
     ("GSA"). Effective November 1, 1994, the partnership and GSA entered into a
     nine-year lease (the "lease") for the Building. The terms of the lease
     agreement call for substantial alterations to the building. The partnership
     has executed a contract in the original amount of approximately $24,000,000
     to complete the alterations. The alterations were completed during the year
     ended December, 31, 1998.

     The general partner of the partnership is 1500 Woodlawn Limited Partnership
     (the "general partner"), a Delaware limited partnership with an 80.8
     percent general partner interest. Three limited partners ("limited
     partners"), own the remaining 19.2 percent limited partnership interest.
     The limited partners and the general partner are herein referred to as
     Class A partners.

     Regency Affiliates, Inc. (the "special limited partner") is a special
     limited partner with no stated voting interest in the partnership.

     Profits, losses and cash available for distribution to partners as
     defined by the partnership agreement, as amended, are allocated as
     follows:

<TABLE>
<CAPTION>
                                                    Before             After
                                                   11/1/2003         10/31/2003
                                                   ---------         ----------
<S>                                              <C>               <C>   
         General partner                              4.04 %            40.4 %
         Special limited partner                     95.00              50.0
         Limited partners                              .96               9.6
                                                    ------             ----- 
                                                    100.00%            100.0%
                                                    ======             ===== 
</TABLE>

                                      -8-

<PAGE>   9


           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING 
         POLICIES (Continued)

     Notwithstanding these allocation percentages, the partnership has made
     arrangements so that to the extent that 95% of cash available for
     distribution is less than $100,000, funds which would otherwise be used to
     pay management fees to TCG Management (see note G) up to the $100,000 will
     be made available for distribution. For financial reporting purposes,
     income or loss is allocated among the partners based upon their stated
     interests in cash available for distribution.

     Taxable gains recognized upon sale, exchange or liquidation of the
     partnership are allocated: first, to bring negative capital accounts to
     zero; second, to bring the capital accounts of the Class A partners as a
     group equal to the capital account of the special limited partner; third,
     $1,000,000 to the Class A partners as a group; and then 50% to the Class A
     partners as a group and 50% to the special limited partner. Taxable losses
     recognized upon sale, exchange or liquidation of the partnership are
     generally allocated: first, to bring the capital account of the special
     limited partner to not less than zero and to bring the capital accounts of
     the Class A partners as a group to not less than a $1,000,000 deficit;
     second, in accordance with each partner's risk of loss, as called for by
     the partnership agreement; and third, in accordance with partnership
     interests.

     The terms of the partnership agreement call for the proceeds from
     liquidation, sale of any assets or refinancing to be used first in
     settlement of partnership liabilities and for the establishment of reserves
     (as deemed necessary by the general partner) and then to the partners in
     proportion to their positive capital account balances.

     USE OF ESTIMATES

     The preparation of financial statements in conformity with generally
     accepted accounting principles 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 revenue and expenses
     during the reporting period. Actual results could differ from those
     estimates.

     REAL ESTATE

     Real estate is carried at cost. Depreciation is provided for in amounts
     sufficient to relate the cost of depreciable assets to operations over
     their estimated service lives by use of the straight-line method for
     financial reporting purposes.

                                      -9-



<PAGE>   10

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED


                               December 31, 1998


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
         (Continued)

     DEFERRED CHARGES

     Deferred charges consist of permanent loan closing costs which are being
     amortized over the term of the related note payable using the effective
     interest method.


     DEFERRED RENTAL INCOME

     Rents of $2,785,769 received upon signing the lease agreement are being
     amortized on a straight-line basis over the life of the lease. Rental
     income received for phases under construction was deferred until
     construction was complete and is being amortized over the remaining term of
     the lease.

     DEFERRED INTEREST INCOME

     Interest earned on the Project Account in excess of the estimated cost of
     alterations was deferred because such funds, if not expended, must be paid
     to the tenant (see note D). Deferred amounts are recognized as income when
     it is determined that the funds will be used for the cost of alterations.

     CASH AND CASH EQUIVALENTS

     For purposes of the statement of cash flow, cash and cash equivalents
     include the partnership's operating money market accounts, excluding
     restricted escrow held by the escrow agent.

     RESTRICTED ESCROW

     The partnership has a portfolio of investments in money market accounts
     which are held in trust by State Street Bank and Trust Company (see note
     D).

     INCOME TAXES

     No provision or benefit for income taxes has been included in these
     financial statements since taxable income or loss passes through to, and is
     reportable by, the partners individually.


                                     - 10 -
<PAGE>   11



           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE B - INVESTMENT IN REAL ESTATE

     Investment in real estate is carried at cost and consists of the following:

<TABLE>
<CAPTION>
                                                       Estimated
                                                       useful life
                                                       ------------
<S>                                                   <C>            <C>         
         Land                                                   -       $  2,151,154
         Building                                        40 years         28,436,133
         Improvements - building                         40 years         23,246,353
         Improvements - tenant                          7-9 years          7,455,934
         Improvements - land                             10 years          1,610,778
         Furniture and equipment                          7 years            839,513
                                                                        ------------
                                                                          63,739,865
         Less accumulated depreciation                                    13,232,793
                                                                        ------------
                                                                        $ 50,507,072
                                                                        ============
</TABLE>



     For income tax reporting purposes, depreciation has been computed in
     accordance with the Internal Revenue Code, generally using shorter lives
     and accelerated methods.

NOTE C - NOTE PAYABLE

     The partnership has a note payable to State Street Bank and Trust Company,
     as Trustee (Trustee), dated November 17, 1994 and maturing in 2003. The
     note is in the principal amount of $56,450,000, and is effectively secured
     by substantially all the assets of the partnership and rights to future
     lease payments. In addition, the partnership has agreed to various
     covenants including those that require the partnership to conduct its
     affairs as a separate entity and prohibit it from selling all or
     substantially all of its assets; conducting business other than related to
     the project; conducting business other than arms' length; commingling
     assets with other entities; acting as creditor or pledging its assets for
     the benefit of another entity; and incurring certain types of indebtedness.

     The debt proceeds were obtained by the trustee through the sale of
     Certificates of Participation (COPs) representing interests in a trust
     established pursuant to a trust agreement between the partnership and the
     Trustee. The net proceeds received from the sale of the COPs were used to
     repay the then existing debt of the partnership, to fund certain reserves,
     and to pay costs of issuance.


                                      -11-

<PAGE>   12

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE C - NOTE PAYABLE (Continued)

     The COPs were issued at a discount of $705,625 which is being amortized
     over the life of the note on the effective interest method. Unamortized
     discount at December 31, 1998 was $238,937. Amortized discount for the year
     ending December 31, 1998 was $94,024, and is included in interest expense
     on the accompanying statement of operations.

     The note requires semiannual payments of principal and interest in
     accordance with the terms of the COPs. Those terms require payments of
     interest at a rate of 7.9% and two principal payments per year (May 15 and
     November 15) aggregating to:

<TABLE>
<S>      <C>                  <C>               
         1999                 $        6,148,461
         2000                          6,643,763
         2001                          7,179,009
         2002                          7,757,350
         Thereafter                    8,382,303
                                    ------------

         Total                        36,110,886
         Less: unamortized discount      238,937
                                    ------------
         Total                      $ 35,871,949
                                    ============
</TABLE>

     Interest incurred during the year ended December 31, 1998 was $3,134,916
     excluding discount amortization of $94,060.

NOTE D - RESTRICTED ESCROW

     The partnership is required to setup and maintain escrow accounts with
     State Street Bank and Trust Company as the escrow agent. Amounts on deposit
     are classified as restricted escrow in the accompanying balance sheet. The
     required accounts and funded balance at December 31, 1998 are as follows:



                                      -12-
<PAGE>   13

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE D - RESTRICTED ESCROW (Continued)

<TABLE>
<CAPTION>
                                                    Description                            Amount
                                            -------------------------------------       ------------
<S>                                         <C>                                       <C>       
         Project account                    To be used for alterations                   $  496,205
         Note payment accounts              To repay Certificates of Participation          993,120
         Liquidity account                  To be used for debt liquidity                   740,178
         Replacement reserve account        To be used for capital improvements             546,255
         Tax account                        To pay real estate taxes                        339,216
         Insurance account                  To pay insurance expense                         69,870
         Operations account                 To pay operating expenses                       100,000
         Partnership account                To pay partnership expenses                     146,466
         Supplemental retention account     To be used as additional
                                               funds to repay COPs                          226,431
         Lease payment account              To be used for collection of monthly
                                               rent payments                                    661
                                                                                         ----------
                                                                                         $3,658,402
                                                                                         ==========
</TABLE>

     All of the restricted escrows are invested in money market funds.


     Any amounts remaining in the project account after the alterations have
     been completed revert back to the tenant either in a lump sum payment or to
     be applied against rental income. (Accordingly, earnings on funds deposited
     in the project account in excess of the estimated cost of alterations have
     been deferred.) If any changes to the budgeted alterations require the use
     of the amounts earned, the income will be recognized at that time. Total
     earnings deferred at December 31, 1998, are $500,000.

     The partnership deposited with the escrow agent a letter of credit to
     satisfy the requirements for the Supplemental Disbursement Account. At
     December 31, 1998, $450,000 was outstanding.

NOTE E - RENTAL OPERATIONS

     On November 17, 1994, the partnership and the tenant entered into a lease
     agreement for 100% of the building with a term of nine years expiring on
     October 31, 2003. The lease agreement provides for minimum annual lease
     payments of $ 12,154,632 payable monthly in arrears, plus provisions for
     escalations in the event of increased operating costs and real estate
     taxes.

                                     - 13-
<PAGE>   14

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE E - RENTAL OPERATIONS (Continued) 

     Future minimum rentals are as follows:

<TABLE>
<S>                                         <C>         
         December 31, 1999                  $ 12,154,632
                      2000                    12,154,632
                      2001                    12,154,632
                      2002                    12,154,632
                Thereafter                    10,128,860
                                            ------------
                                            $ 58,747,388
                                            ============
</TABLE>


     The partnership has received an opinion of Assistant General Council to the
     General Services Administration that lease payments are not subject to
     annual appropriation by the United States Congress and the obligations to
     make such payments are unconditional general obligations of the United
     States Government.

     The Lease requires the partnership to maintain and repair the building and
     land in accordance with specific standards, to maintain certain insurance
     coverages and to use amounts in the Project Account plus interest accrued
     to make certain alterations (the "Alterations").

     The partnership assigned its right to receive payments under the lease with
     GSA to the Escrow Agent. Payments received or distributions made by the
     Escrow Agent and transfers between individual accounts are governed by an
     escrow agreement for the ultimate benefit of the partnership.

NOTE F - CONCENTRATION OF CREDIT RISK

     The partnership maintains a cash account insured by the Federal Deposit
     Insurance Corporation (FDIC) up to $100,000. At December 31, 1998 the
     balance was $201,649. The uninsured balance at December 31, 1997 was
     $101,649.



                                     - 14 -
<PAGE>   15

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1998


NOTE G - RELATED PARTY TRANSACTIONS

     JANITORIAL SERVICES

     The partnership entered into an agreement with Woodlawn Service
     Corporation, an affiliate of the general partner, to provide janitorial
     services for the building. The agreement provides for a fee for services
     provided and for a reimbursement for expenses incurred, not to exceed
     $1,905,770 per annum, from which Woodlawn Service Corporation is to provide
     the cost of materials, salaries and other costs of providing such services.
     The agreement extends to the year 2003 with options to renew annually
     thereafter. Total janitorial fees for the year ended December 31, 1998
     were $1,087,735 with $123,724 remaining unpaid at year end.

     MANAGEMENT SERVICES

     The partnership entered into an agreement with TCG Management Corporation,
     an affiliate of the general partner, to provide management services. The
     original agreement provides for a fee of $250,000 per annum. In March of
     1998, the fee was increased to $269,700 per annum. The agreement is for a
     term of one year with automatic renewals through the year 2003. Total
     management fees for the year ended December 31, 1997 were $270,600 with
     $22,925 remaining unpaid at year end.

     CONSTRUCTION MANAGEMENT SERVICES

     The partnership entered into an agreement with TCG Construction Corporation
     to provide construction management services relating to the building and
     tenant alterations. The agreement provides for a management construction
     fee of 10% of total costs incurred in connection with the alterations. In
     addition, TCG Construction shall receive 100% of any cost savings payments
     received by the partnership related to the alterations. The agreement is
     for a term of one year with automatic renewals through the year 2003. Total
     fees incurred at December 31, 1998 are $3,029,213 and have been capitalized
     to the cost of improvements.

                                     - 15 -


<PAGE>   1
                                                                   EXHIBIT 99(b)
                                                                   -------------


                            FINANCIAL STATEMENTS AND
                          INDEPENDENT AUDITORS' REPORT

                     SECURITY LAND AND DEVELOPMENT COMPANY
                              LIMITED PARTNERSHIP

                               DECEMBER 31, 1997

<PAGE>   2

           Security Land and Development Company Limited Partnership

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                    PAGE

<S>                                                 <C>
INDEPENDENT AUDITORS' REPORT                         3

FINANCIAL STATEMENTS
         BALANCE SHEET                               4
         STATEMENT OF OPERATIONS                     5
         STATEMENT OF CHANGES IN PARTNERS' CAPITAL   6
         STATEMENT OF CASH FLOWS                     7
         NOTES TO FINANCIAL STATEMENTS               8
</TABLE>
<PAGE>   3

                     [REZNICK FEDDER & SILVERMAN LETTERHEAD]

                          INDEPENDENT AUDITORS' REPORT

To the Partners
Security Land and Development Company Limited Partnership


         We have audited the accompanying balance sheet of Security Land and
Development Company Limited Partnership as of December 31, 1997, and the related
statements of operations, changes in partners' capital and cash flows for the
year then ended. 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 generally accepted auditing
standards. 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 financial position of Security Land and
Development Company Limited Partnership as of December 31, 1997, and the results
of its operations, changes in partners' capital and cash flows for the year then
ended in conformity with generally accepted accounting principles.


                                        /s/ Reznick Fedder & Silverman 


Bethesda, Maryland
February 17, 1998

                                      -3-


<PAGE>   4

           Security Land and Development Company Limited Partnership

                                 BALANCE SHEET

                               December 31, 1997
<TABLE>
<S>                                                               <C>        
Investment in real estate, net of accumulated depreciation        $52,999,775

Cash and cash equivalents                                             274,075

Restricted escrow                                                   4,113,938

Tenant accounts receivable                                          1,030,739

Prepaid expenses and other receivables                                397,205

Accrued interest income                                                16,294

Deferred charges, net of accumulated amortization of $1,504,259     1,124,468
                                                                  -----------
  Total assets                                                    $59,956,494
                                                                  ===========

Note payable, net of discount                                     $41,467,993

Accounts payable and accrued expenses                               1,203,326

Accrued interest payable                                              421,961

Deferred rental income                                              4,761,112

Deferred interest income                                              500,000
                                                                  -----------

                                                                   48,354,392

Partners' capital                                                  11,602,102
                                                                  -----------

         Total liabilities and partners' capital                  $59,956,494
                                                                  ===========
</TABLE>

                       See notes to financial statements

                                      -4-

<PAGE>   5

           Security Land and Development Company Limited Partnership

                            STATEMENT OF OPERATIONS

                          Year ended December 31, 1997

<TABLE>
<S>                                               <C>        
Revenue
         Rental income                            $11,765,563
         Interest income                              909,628
         Tenant reimbursements and other income       100,158
                                                  -----------

               Total revenue                       12,775,349
                                                  -----------

Administrative
         Management fees                              250,000
         Professional fees                             53,073
         Payroll expenses                             506,352
         Office expenses                               38,626
                                                  -----------

                                                      848,051
                                                  -----------

Operating
         Janitorial                                 1,075,388
         Maintenance contracts                         86,959
         Repairs and maintenance                      184,359
         Maintenance supplies                         209,181
                                                  -----------

                                                    1,555,887
                                                  -----------

Interest, taxes and insurance
         Interest                                   3,079,559
         Real estate taxes                            600,000
         Insurance                                     90,202
                                                  -----------

                                                    3,769,761
                                                  -----------

Depreciation and amortization
         Depreciation                               2,223,792
         Amortization                                 355,844
                                                  -----------

                                                    2,579,636
                                                  -----------

               Total expenses                       8,753,335
                                                  -----------

               Net income                         $ 4,022,014
                                                  ===========
</TABLE>


                       See notes to financial statements

                                      -5-
<PAGE>   6


           Security Land and Development Company Limited Partnership

                   STATEMENT OF CHANGES IN PARTNERS' CAPITAL

                          Year ended December 31, 1997

<TABLE>
<CAPTION>
                                                                        Special
                                        General         Limited         limited
                        Total           partner         partner         partner
                     ------------    ------------    ------------    ------------
<S>                  <C>             <C>             <C>             <C>         
Balance, beginning   $  7,688,325    $    874,802    $ (1,420,213)   $  8,233,736
Net income              4,022,014         162,489          38,612       3,820,913
Distributions            (108,237)         (4,374)         (1,038)       (102,825)
                     ------------    ------------    ------------    ------------
Balance, end         $ 11,602,102    $  1,032,917    $ (1,382,639)   $ 11,951,824
                     ============    ============    ============    ============
</TABLE>

                       See notes to financial statements

                                      -6-
<PAGE>   7

           Security Land and Development Company Limited Partnership

                            STATEMENT OF CASH FLOWS

                          Year ended December 31, 1997

<TABLE>
<S>                                                                        <C>        
Cash flows from operating activities
         Net income                                                        $ 4,022,014
         Adjustments to reconcile net income to net cash provided by
         operating activities
           Depreciation                                                      2,223,792
           Amortization                                                        355,844
           Deferred rental income                                              517,210
           Amortization of debt discount                                       107,255
           Increase in tenant accounts receivable                               (2,325)
           Decrease in prepaid expenses and other receivables                   21,432
           Decrease in accrued interest income                                 109,397
           Decrease in accounts payable and accrued expenses - operating       (25,191)
           Decrease in accrued interest payable                                (53,155)
                                                                           -----------

              Net cash provided by operating activities                      7,276,273
                                                                           -----------

Cash flows from investing activities
         Withdrawals from restricted escrow                                  4,101,150
         Investment in real estate                                          (5,959,522)
                                                                           -----------

              Net cash used in investing activities                         (1,858,372)
                                                                           -----------

Cash flows from financing activities
         Payments on note payable                                           (5,265,851)
         Distributions                                                        (108,237)
                                                                           -----------

              Net cash used in financing activities                         (5,374,088)
                                                                           -----------
              NET INCREASE IN CASH                                              43,813

Cash and cash equivalents, beginning                                           230,262
                                                                           -----------

Cash and cash equivalents, end                                             $   274,075
                                                                           ===========
Cash paid for interest during the year, net of amount capitalized          $ 3,025,459
                                                                           ===========
</TABLE>

Significant noncash investing and financing activities 
Accounts payable and accrued expenses of $934,362 have been capitalized to the 
real estate.

                       See notes to financial statements

                                      -7-

<PAGE>   8

           Security Land and Development Company Limited Partnership

                         NOTES TO FINANCIAL STATEMENTS

                               December 31, 1997


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Security Land and Development Company Limited Partnership (the "partnership")
was formed under the laws of the State of Maryland. The partnership was
organized to own and operate, for investment purposes, the project (the
"project") which consists of a building known as the Security West Building (the
"building").

The building is an approximately 717,000 square foot, two-phase office building,
consisting of a two-story office building and a connected six-story office
tower, located at 1500 Woodlawn Drive, Woodlawn, Maryland. The building was
purchased by the partnership in 1986 and is located on land which is
approximately 34.3 acres, also owned by the partnership. The building has been
occupied by the United States Social Security Administration's Office of
Disability and International Operations (the "tenant") for approximately 23
years under leases between the United States of America, acting by and through
the General Services Administration ("GSA"). Effective November 1, 1994, the
partnership and GSA entered into a nine-year lease (the "lease") for the
Building. The terms of the lease agreement call for substantial alterations to
the building. The partnership has executed a contract in the original amount of
approximately $24,000,000 to complete the alterations.

The general partner of the partnership is 1500 Woodlawn Limited Partnership (the
"general partner"), a Delaware limited partnership with an 80.8 percent general
partner interest. Three limited partners ("limited partners"), own the remaining
19.2 percent limited partnership interest. The limited partners and the general
partner are herein referred to as Class A partners.

Regency Affiliates, Inc. (the "special limited partner") is a special limited
partner with no stated voting interest in the partnership.

Profits, losses and cash available for distribution to partners as defined by
the partnership agreement, as amended, is allocated as follows:

<TABLE>
<CAPTION>
                                 Before       After
                               11/1/2003   10/31/2003
                               ---------   ----------
<S>                            <C>         <C>
General partner                     4.04%        40.4%
Special limited partner            95.00         50.0
Limited partners                     .96          9.6
                                  ------        -----
                                  100.00%       100.0%
                                  ======        =====
</TABLE>

                                      -8-
<PAGE>   9

           Security Land and Development Company Limited Partnership

                    NOTE TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
         POLICIES (Continued)

     Notwithstanding these allocation percentages, the partnership has made
     arrangements so that to the extent that 95% of cash available for
     distribution is less than $100,000, funds which would otherwise be used to
     pay management fees to TCG Management (see note G) up to the $100,000 will
     be made available for distribution. For financial reporting purposes,
     income or loss is allocated among the partners based upon their stated
     interests in cash available for distribution.

     Taxable gains recognized upon sale, exchange or liquidation of the
     partnership are allocated: first, to bring negative capital accounts to
     zero; second, to bring the capital accounts of the Class A partners as a
     group equal to the capital account of the special limited partner; third,
     $1,000,000 to the Class A partners as a group; and then 50% to the Class A
     partners as a group and 50% to the special limited partner. Taxable losses
     recognized upon sale, exchange or liquidation of the partnership are
     generally allocated: first, to bring the capital account of the special
     limited partner to not less than zero and to bring the capital accounts of
     the Class A partners as a group to not less than a $1,000,000 deficit;
     second, in accordance with each partner's risk of loss, as called for by
     the partnership agreement; and third, in accordance with partnership
     interests.

     The terms of the partnership agreement call for the proceeds from
     liquidation, sale of any assets or refinancing to be used first in
     settlement of partnership liabilities and for the establishment of reserves
     (as deemed necessary by the general partner) and then to the partners in
     proportion to their positive capital account balances.

     Use of Estimates 
     ----------------

     The preparation of financial statements in conformity with generally
     accepted accounting principles 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 revenue and expenses
     during the reporting period. Actual results could differ from those
     estimates.

     Real Estate
     -----------

     Real estate is carried at cost. Depreciation is provided for in amounts
     sufficient to relate the cost of depreciable assets to operations over
     their estimated service lives by use of the straight-line method for
     financial reporting purposes.

                                      -9-

<PAGE>   10

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
         (Continued)

     Deferred Charges
     ----------------

     Deferred charges consist of permanent loan closing costs which are being
     amortized over the term of the related note payable using the effective
     interest method.

     Deferred Rental Income
     ----------------------

     Rents of $2,785,769 received upon signing the lease agreement are being
     amortized on a straight-line basis over the life of the lease. Rental
     income received for phases under construction has been deferred until
     construction is complete and is then amortized over the remaining term of
     the lease.

     Deferred Interest Income
     ------------------------

     Interest earned on the Project Account in excess of the estimated cost of
     alterations was deferred because such funds, if not expended, must be paid
     to the tenant (see note D). Deferred amounts are recognized as income when
     it is determined that the funds will be used for the cost of alterations.

     Cash and Cash Equivalents
     -------------------------

     For purposes of the statement of cash flow, cash and cash equivalents
     include the partnership's operating money market accounts, excluding
     restricted escrow held by the escrow agent.

     Restricted Escrow
     -----------------

     The partnership has a portfolio of investments in money market accounts
     which are held in trust by State Street Bank and Trust Company (see note
     D).

     Income Taxes
     ------------

     No provision or benefit for income taxes has been included in these
     financial statements since taxable income or loss passes through to, and is
     reportable by, the partners individually.


                                      -10-
<PAGE>   11

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE B - INVESTMENT IN REAL ESTATE

     Investment in real estate is carried at cost and consist of the following:

<TABLE>
<CAPTION>
                                                    Estimated
                                                   useful life
                                                 --------------
<S>                                              <C>                  <C>
         Land                                               -         $ 2,151,154
         Building                                    40 years          28,436,133
         Improvements - building                     40 years          23,231,609
         Improvements - tenant                        9 years           7,455,934
         Improvements - land                         10 years           1,610,778
         Furniture and equipment                      7 years             822,737
                                                                      -----------
                                                                       63,708,345
         Less accumulated depreciation                                 10,708,570
                                                                      -----------

                                                                      $52,999,775
                                                                      ===========
</TABLE>

     For income tax reporting purposes, depreciation has been computed in
     accordance with the Internal Revenue Code, generally using shorter lives
     and accelerated methods.

NOTE C - NOTE PAYABLE

     The partnership has a note payable to State Street Bank and Trust Company,
     as Trustee (Trustee), dated November 17, 1994 and maturing in 2003. The
     note is in the principal amount of $56,450,000, and is effectively secured
     by substantially all the assets of the partnership and rights to future
     lease payments. In addition, the partnership has agreed to various
     covenants including those that require the partnership to conduct its
     affairs as a separate entity and prohibit it from selling all or
     substantially all of its assets; conducting business other than related to
     the project; conducting business other than arms length; commingling assets
     with other entities; acting as creditor or pledging its assets for the
     benefit of another entity; and incurring certain types of indebtedness.

     The debt proceeds were obtained by the trustee through the sale of
     Certificates of Participation (COPs) representing interests in a trust
     established pursuant to a trust agreement between the partnership and the
     Trustee. The net proceeds received from the sale of the COPs were used to
     repay the then existing debt of the partnership, to fund certain reserves,
     and to pay costs of issuance.

                                      -11-


<PAGE>   12

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE C - NOTE PAYABLE (Continued)

     The COPs were issued at a discount of $705,625 which is being amortized
     over the life of the note on the effective interest method. Unamortized
     discount at December 31, 1997 was $332,961. Amortized discount for the year
     ending December 31, 1997 was $107,255, and is included in interest expense
     on the accompanying statement of operations.

     The note requires semiannual payments of principal and interest in
     accordance with the terms of the COPs. Those terms require payments of
     interest at a rate of 7.9% and two principal payments per year (May 15 and
     November 15) aggregating to:

<TABLE>
<S>                                     <C>
         1998                           $ 5,690,068
         1999                             6,148,461
         2000                             6,643,763
         2001                             7,179,009
         2002                             7,757,350
         Thereafter                       8,382,303
                                        -----------

         Total                           41,800,954
         Less: unamortized discount         332,961
                                        -----------

         Total                          $41,467,993
                                        ===========
</TABLE>

     Interest incurred during the year ended December 31, 1997 was $3,563,135
     excluding discount amortization of $107,255. $590,831 of interest relating
     to construction has been capitalized to the cost improvements.

NOTE D - RESTRICTED ESCROW

     The partnership is required to setup and maintain escrow accounts with
     State Street Bank and Trust Company as the escrow agent. Amounts on deposit
     are classified as restricted escrow in the accompanying balance sheet. The
     required accounts and funded balance at December 31, 1997 are as follows:

                                      -12-
<PAGE>   13


           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE D - RESTRICTED ESCROW (Continued)

<TABLE>
<CAPTION>
                                                  Description                             Amount
                                            --------------------------------------    ------------
<S>                                         <C>                                       <C>
         Project account                    To be used for alterations                $  1,346,923
         Note payment accounts              To repay Certificates of Participation         930,273
         Liquidity account                  To be used for debt liquidity                  740,178
         Replacement reserve account        To be used for capital improvements            380,221
         Tax account                        To pay real estate taxes                       322,924
         Insurance account                  To pay insurance expense                        49,085
         Operations account                 To pay operating expenses                      100,000
         Partnership account                To pay partnership expenses                     74,568
         Supplemental retention account     To be used as additional funds to repay
                                              COPs                                         169,630
         Lease payment account              To be used for collection of monthly
                                              rent payments                                    136
                                                                                      ------------
                                                                                      $  4,113,938
                                                                                      ============
</TABLE>

     All of the restricted escrows are invested in money market funds.


     Any amounts remaining in the project account after the alterations have
     been completed revert back to the tenant either in a lump sum payment or to
     be applied against rental income. (Accordingly, earnings on funds deposited
     in the project account in excess of the estimated cost of alterations have
     been deferred.) If any changes to the budgeted alterations require the use
     of the amounts earned, the income will be recognized at that time. Total
     earnings deferred at December 31, 1997, are $500,000.

     The partnership deposited with the escrow agent a letter of credit to
     satisfy the requirements for the Supplemental Disbursement Account. At
     December 31, 1997, $450,000 was outstanding.

NOTE E - RENTAL OPERATIONS

     On November 17, 1994, the partnership and the tenant entered into a lease
     agreement for 100% of the building with a term of nine years expiring on
     October 31, 2003. The lease agreement provides for minimum annual lease
     payments of $12,154,632 payable monthly in arrears, plus provisions for
     earnings escalations in the event of increased operating costs and real
     estate taxes.


                                      -13-

<PAGE>   14

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE E - RENTAL OPERATIONS (Continued) 

     Future minimum rentals are as follows:

<TABLE>
<S>                              <C>        
December 31, 1998                $12,154,632
             1999                 12,154,632
             2000                 12,154,632
             2001                 12,154,632
             2002                 12,154,632
       Thereafter                 10,128,860
                                 -----------

                                 $70,902,020
                                 ===========
</TABLE>

     The partnership has received an opinion of Assistant General Council to the
     General Services Administration that lease payments are not subject to
     annual appropriation by the United States Congress and the obligations to
     make such payments are unconditional general obligations of the United
     States Government.

     The Lease requires the partnership to maintain and repair the building and
     land in accordance with specific standards, to maintain certain insurance
     coverages and to use amounts in the Project Account plus interest accrued
     to make certain alterations (the "Alterations").

     The partnership assigned its right to receive payments under the lease with
     GSA to the Escrow Agent. Payments received or distributions made by the
     Escrow Agent and transfers between individual accounts are governed by an
     escrow agreement for the ultimate benefit of the partnership.

NOTE F - CONCENTRATION OF CREDIT RISK

     The partnership maintains a cash account insured by the Federal Deposit
     Insurance Corporation (FDIC) up to $100,000. At December 31, 1997 the
     balance was $273,075. The uninsured balance at December 31, 1997 was
     $173,075.


                                      -14-
<PAGE>   15


           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1997


NOTE G - RELATED PARTY TRANSACTIONS

     Janitorial Services
     -------------------

     The partnership entered into an agreement with Woodlawn Service
     Corporation, an affiliate of the general partner, to provide janitorial
     services for the building. The agreement provides for a fee for services
     provided and for a reimbursement for expenses incurred, not to exceed
     $1,905,770 per annum from which Woodlawn Service Corporation is to provide
     the cost of materials, salaries and other costs of providing such services.
     The agreement extends to the year 2003 with options to renew annually
     thereafter. Total janitorial fees for the year ended December 31, 1997 were
     $1,075,388 with $117,302 remaining unpaid at year end.

     Management Services
     -------------------

     The partnership entered into an agreement with TCG Management Corporation,
     an affiliate of the general partner, to provide management services. The
     agreement provides for a fee of $250,000 per annum. The agreement is for a
     term of one year with automatic renewals through the year 2003. Total
     management fees for the year ended December 31, 1997 were $250,000 with
     $20,833 remaining unpaid at year end.

     Construction Management Services
     --------------------------------

     The partnership entered into an agreement with TCG Construction Corporation
     to provide construction management services relating to the building and
     tenant alterations. The agreement provides for a management construction
     fee of 10% of total costs incurred in connection with the alterations. In
     addition, TCG Construction shall receive 100% of any cost savings payments
     received by the partnership related to the alterations. The agreement is
     for a term of one year with automatic renewals through the year 2003. Total
     fees incurred at December 31, 1997 are $3,008,215 and have been capitalized
     to the cost of improvements.


                                      -15-


<PAGE>   1
                                                                   EXHIBIT 99(c)











                            FINANCIAL STATEMENTS AND
                          INDEPENDENT AUDITORS' REPORT

                     SECURITY LAND AND DEVELOPMENT COMPANY
                              LIMITED PARTNERSHIP

                               DECEMBER 31, 1996

<PAGE>   2

           Security Land and Development Company Limited Partnership

                               TABLE OF CONTENTS

                                                                          PAGE
INDEPENDENT AUDITORS' REPORT                                               3

FINANCIAL STATEMENTS

  BALANCE SHEET                                                            4

  STATEMENT OF OPERATIONS                                                  5

  STATEMENT OF CHANGES IN PARTNERS' CAPITAL                                6

  STATEMENT OF CASH FLOWS                                                  7

  NOTES TO FINANCIAL STATEMENTS                                            8
<PAGE>   3


                           --------------------------
                           Reznick Fedder & Silverman
               Certified Public Accountants Business Consultants
                           A Professional Corporation

        4520 East-West Highway Suite 300. Bethesda, MD 20814-3319. (301)
                          652-9100. Fax (301) 652-1848



                         INDEPENDENT AUDITORS' REPORT





To the Partners
Security Land and Development Company Limited Partnership


         We have audited the accompanying balance sheet of Security Land and
Development Company Limited Partnership as of December 31, 1996, and the related
statements of operations, changes in partners' capital and cash flows for the
year then ended. 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 generally accepted auditing
standards. 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 financial position of Security Land and
Development Company Limited Partnership as of December 31, 1996, and the results
of its operations, changes in partners' capital and cash flows for the year then
ended in conformity with generally accepted accounting principles.




                                             /s/ REZNICK FEDDER & SILVERMAN

Bethesda, Maryland
February 4, 1997







                                      -3-


<PAGE>   4


<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                                 BALANCE SHEET

                               December 31, 1996

<S>                                                                  <C>        
Investment in real estate, net of
  accumulated depreciation                                           $49,644,320
Cash and cash equivalents                                                230,262
Restricted escrow                                                      8,215,088
Tenant accounts receivable                                             1,028,414
Prepaid expenses and other receivables                                   418,637
Accrued interest income                                                  125,691
Deferred charges, net of accumulated
         amortization of $1,148,415                                    1,480,312
                                                                     -----------
     Total Assets                                                    $61,142,724
                                                                     ===========

Note payable, net of discount                                        $46,626,589
Accounts payable and accrued expenses                                  1,608,792
Accrued interest payable                                                 475,116
Deferred rental income                                                 4,243,902
Deferred interest income                                                 500,000
                                                                     -----------
                                                                      53,454,399
Partners' capital                                                      7,688,325
                                                                     -----------
                                                                     $61,142,724
                                                                     ===========
</TABLE>


                       See notes to financial statements


                                      -4-

<PAGE>   5
<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                            STATEMENT OF OPERATIONS

                          Year ended December 31, 1996

<S>                                                                  <C>        
Revenue
  Rental income                                                      $11,748,346
  Interest income                                                      1,538,085
  Tenant reimbursements and other income                                  11,921
                                                                     -----------
        Total revenue                                                 13,298,352
                                                                     -----------

Administrative
  Management fees                                                        250,000
  Professional fees                                                       55,768
  Payroll expenses                                                       418,531
  Office expenses                                                         39,615
                                                                     -----------
                                                                         763,914
                                                                     -----------

Operating
  Janitorial                                                           1,020,180
  Maintenance contracts                                                   92,946
  Repairs and maintenance                                                281,576
  Maintenance supplies                                                   208,947
                                                                     -----------
                                                                       1,603,649
                                                                     -----------

Interest, taxes and insurance
  Interest                                                             3,723,996
  Real estate taxes                                                      595,213
  Insurance                                                               93,662
                                                                     -----------
                                                                       4,412,871

Depreciation and amortization
   Depreciation                                                        1,629,493
   Amortization                                                          394,837
                                                                     -----------
                                                                       2,024,330
                                                                     -----------
        Total expenses                                                 8,804,764
                                                                     -----------
        Net income                                                   $ 4,493,588
                                                                     ===========
</TABLE>


                       See notes to financial statements

                                       -5-


<PAGE>   6

           Security Land and Development Company Limited Partnership

                   STATEMENT OF CHANGES IN PARTNERS' CAPITAL

                          Year ended December 31, 1996
<TABLE>
<CAPTION>

                                                                                   Special
                                                     General          Limited      Limited
                                   Total             Partner          Partner      Partner
<S>                           <C>               <C>               <C>             <C>        
Balance, beginning            $3,303,399        $    697,652      $ (1,462,309)   $ 4,068,056
Net income                     4,493,588             181,540            43,139      4,268,909
Distributions                   (108,662)             (4,390)           (1,043)      (103,229)
                              ----------        ------------      ------------    -----------
Balance, ending               $7,688,325        $    874,802      $ (1,420,213)   $ 8,233,736
                              ==========        ============      ============    ===========
</TABLE>













                       See notes to financial statements


                                      -6-

<PAGE>   7
<TABLE>
<CAPTION>
           Security Land and Development Company Limited Partnership

                             STATEMENT OF CASH FLOW

                          Year ended December 31, 1996

Cash flows from operating activities
<S>                                                                <C>         
  Net income                                                       $  4,493,588
  Adjustments to reconcile net income to net
   cash provided by operating activities
    Depreciation                                                      1,629,493
    Amortization                                                        394,837
    Deferred rental income                                              480,719
    Amortization of debt discount                                       119,251
    Increase in tenant accounts receivable                              (15,528)
    Increase in prepaid expenses and other receivables                  (41,562)
    Increase in accrued interest income                                (125,691)
    Increase in accounts payable and accrued expenses -
     operating                                                           48,261
    Decrease in accrued interest payable                                (37,938)
    Decrease in deferred interest payable                              (359,988)
                                                                   ------------
         Net cash provided by operating activities                    6,585,442
                                                                   ------------

Cash flows from investing activities
  Withdrawals from restricted escrow                                 10,299,485
  Investment in real estate                                         (12,003,908)
                                                                   ------------
         Net cash used in investing activities                       (1,704,423)
                                                                   ------------

Cash flows from financing activities
  Payments on notes payable                                          (4,873,258)
  Distributions                                                        (108,662)
                                                                   ------------
         Net cash used for financing activities                      (4,981,920)
                                                                   ------------
         NET DECREASE IN CASH                                          (100,901)


Cash and cash equivalents, beginning                                    331,163
                                                                   ------------

Cash and cash equivalents, end                                     $    230,262
                                                                   ============

Cash paid for interest during the year, net of amount
 capitalized                                                       $  3,642,683
                                                                   ============
</TABLE>

Significant non-cash investing activities:
  Accounts payable and accrued expenses of $1,314,637 have been
  capitalized to the real estate.

                                       -7-


<PAGE>   8

          Security Land and Development Company Limited Partnership
                                      
                        NOTES TO FINANCIAL STATEMENTS
                                      
                              December 31, 1996
                                      

NOTE  A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Security Land and Development Company Limited Partnership (the
     "partnership") was formed under the laws of the State of Maryland. The
     partnership was organized to own and operate, for investment purposes, the
     project (the "project") which consists of a building known as the Security
     West Building (the "building").

     The building is approximately 717,000 square foot, two-phase office
     building, consisting of a two-story office building and a connected
     six-story office tower, located at 1500 Woodlawn Drive, Woodlawn, Maryland.
     The building was purchased by the partnership in 1986 and is located on
     land which is approximately 34.3 acres, also owned by the partnership. The
     building has been occupied by the United States Social Security
     Administration's Office of Disability and International Operations (the
     "tenant") for approximately 23 years under leases between the United States
     of America, acting by and through the General Services Administration
     ("GSA"). Effective November 1, 1994, the partnership and GSA entered into a
     nine-year lease (the "lease") for the Building. The terms of the lease
     agreement call for substantial alterations to the building. The partnership
     has executed a contract in the original amount of approximately $24,000,000
     to complete the alterations.

     The general partner of the partnership is 1500 Woodlawn Limited Partnership
     (the "general partner"), a Delaware limited partnership with an 80.8
     percent general partner interest. Three limited partners ("limited
     partners"), own the remaining 19.2 percent limited partnership interest.
     The limited partners and the general partner are herein referred to as
     Class A partners.

     Regency Affiliates, Inc. (the "special limited partner") is a special
     limited partner with no stated voting interest in the partnership.

     Profits, losses and cash available for distribution to partners as defined
     by the partnership agreement, as amended, is allocated as follows:


                                       -8-



<PAGE>   9

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996


NOTE A -   ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
           POLICIES (Continued)

<TABLE>
<CAPTION>
                                                   Before           After
                                                 11/1/2003        1013112003
<S>                                                 <C>              <C>  
         General partner                            4.04%            40.4%
         Special limited partner                   95.00             50.0
         Limited partners                           0.96              9.6
                                                  ------            ----- 
                                                  100.00%           100.0%
                                                  ======            ===== 
</TABLE>

     Notwithstanding these allocation percentages, the partnership has made
     arrangements so that to the extent that 95% of cash available for
     distribution is less than $100,000, funds which would otherwise be used to
     pay management fees to TCG Management (see note F) up to the $100,000 will
     be made available for distribution. For financial reporting purposes,
     income or loss is allocated among the partners based upon their stated
     interests in cash available for distribution.

     Taxable gains recognized upon sale, exchange or liquidation of the
     partnership are allocated: first, to bring negative capital accounts to
     zero; second, to bring the capital accounts of the -Class A partners as a
     group equal to the capital account of the special limited partner; third,
     $1,000,000 to the Class A partners as a group; and then 50% to the Class A
     partners as a group and 50% to the special limited partner. Taxable losses
     recognized upon sale, exchange or liquidation of the partnership are
     generally allocated: first, to bring the capital account of the special
     limited partner to not less than zero and to bring the capital accounts of
     the Class A partners as a group to not less than a $1,000,000 deficit;
     second, in accordance with each partner's risk of loss, as called for by
     the partnership agreement; and third, in accordance with partnership
     interests.

     The terms of the partnership agreement call for the proceeds from
     liquidation, sale of any assets or refinancing to be used first in
     settlement of partnership liabilities and for the establishment of reserves
     (as deemed necessary by the general partner) and then to the partners in
     proportion to their positive capital account balances.


                                      -9-


<PAGE>   10

            Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996

NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING

                  POLICIES (Continued)

     USE OF ESTIMATES

     The preparation of financial statements in conformity with generally
     accepted accounting principles 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 revenue and expenses
     during the reporting period. Actual results could differ from those
     estimates.


     REAL ESTATE

     Real estate is carried at cost. Depreciation is provided for in amounts
     sufficient to relate the cost of depreciable assets to operations over
     their estimated service lives by use of the straight-line method for
     financial reporting purposes.

     DEFERRED CHARGES

     Deferred charges consist of permanent loan closing costs which are being
     amortized over the term of the related note payable using the effective
     interest method.

     DEFERRED RENTAL INCOME

     Rents of $2,785,769 received upon signing the lease agreement are being
     amortized on a straight-line basis over the life of the lease. Rental
     income received for phases under construction is deferred until
     construction is complete and is then amortized over the remaining term of
     the lease.


     DEFERRED INTEREST INCOME

     Interest earned on the Project Account in excess of the estimated cost of
     alterations was deferred because such funds, if not expended, must be paid
     to the tenant (see note D). Deferred amounts are recognized as income when
     it is determined that the funds will be used for the cost of alterations.


                                     - 10 -
<PAGE>   11

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                                December 31, 1996

NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
         POLICIES (Continued)

     CASH AND CASH EQUIVALENTS

     For purposes of the statement of cash flow, cash and cash equivalents
     include the partnership's operating money market accounts, excluding
     restricted escrow held by the escrow agent (see note C).

     RESTRICTED ESCROW

     The partnership has a portfolio of investments in money market accounts,
     repurchase agreements, and debt securities, which are held in trust by
     Fleet National Bank (see note D). Management determines the appropriate
     classification of the debt securities at the time they are acquired and
     evaluates the appropriateness of such classifications at each balance sheet
     date. As of December 31, 1996, the company has classified all investments
     in debt securities as held-to-maturity. Held-to-maturity securities consist
     solely of debt securities which the company has the positive intent and
     ability to hold to maturity and are stated at amortized cost.

     INCOME TAXES

     No provision or benefit for income taxes has been included in these
     financial statements since taxable income or loss passes through to, and is
     reportable by, the partners individually.

NOTE B - INVESTMENT IN REAL ESTATE

     Investment in real estate is carried at cost and consist of the following:
<TABLE>
<CAPTION>
                                                   Estimated
                                                   Useful Life
                                                   -----------
<S>                                                 <C>               <C>       
         Land                                             -          $ 2,151,154
         Building                                   40 years          28,436,133
         Improvements - Building                    40 years          15,210,064
         Improvements - Tenant                       9 years           4,615,264
         Improvements - Land                        10 years           1,610,778
         Furniture and equipment                     7 years             810,752
         Construction in progress                         -            5,294,953
                                                                     -----------
                                                                      58,129,098

         Less accumulated depreciation                                 8,484,778
                                                                     -----------
                                                                     $49,644,320
                                                                     ===========
</TABLE>


                                      -11-

<PAGE>   12


           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996


NOTE B - INVESTMENT IN REAL ESTATE (Continued)

     For income tax reporting purposes, depreciation has been computed in
     accordance with the Internal Revenue Code, generally using shorter lives
     and accelerated methods.


NOTE C - NOTE PAYABLE

     The partnership has a note payable to Fleet National Bank, as Trustee
     (Trustee), dated November 17, 1994. The note is in the principal amount of
     $56,450,000, and is effectively secured by substantially all the assets of
     the partnership and rights to future lease payments. In addition, the
     partnership has agreed to various covenants including those that require
     the partnership to conduct its affairs as a separate entity and prohibit it
     from selling all or substantially all of its assets; conducting business
     other than related to the project; conducting business other than arms
     length; commingling assets with other entities; acting as creditor or
     pledging its assets for the benefit of another entity; and incurring
     certain types of indebtedness.

     The debt proceeds were obtained by the trustee through the sale of
     Certificates of Participation (COPs) representing interests in a trust
     established pursuant to a trust agreement between the partnership and the
     Trustee. The net proceeds received from the sale of the COPs were used to
     repay the then existing debt of the partnership, to fund certain reserves,
     and to pay costs of issuance.

     The COPs were issued at a discount of $705,625 which is being amortized
     over the life of the note on the effective interest method. Unamortized
     discount at December 31, 1996 was $440,216. Amortized discount for the year
     ending December 31, 1996 was $1 19,251, and is included in interest expense
     on the accompanying statement of operations.



                                      -12-

<PAGE>   13

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996

NOTE C - NOTE PAYABLE (Continued)

          The note requires semiannual payments of principal and interest in
          accordance with the terms of the COPs. Those terms require payments of
          interest at a rate of 7.9% and two principal payments per year (May 15
          and November 15) aggregating to:

                       1997                   $ 5,265,850
                       1998                     5,690,068
                       1999                     6,148,461
                       2000                     6,643,763
                       2001                     7,179,009
                       Thereafter              16,139,654
                                              -----------
                       Total                   47,066,805
                       Less: Unamortized
                       Discount                   440,216
                                              -----------
                       Total                  $46,626,589
                                              ===========

Interest incurred during the year ending December 31, 1996 was
$3,970,941 excluding
discount amortization of $119,251. $366,196 of interest relating
to construction has been
capitalized to the cost improvements.

NOTE D - RESTRICTED ESCROW

The partnership is required to setup and maintain escrow accounts with Shawmut
Bank, NA as the escrow agent. Amounts on deposit are classified as restricted
escrow in the accompanying balance sheet. The required accounts and funded
balance at December 31, 1996 are as follows:

<TABLE>
<CAPTION>
                                             Description                       Amount
                                      --------------------------             -----------
<S>                                 <C>                                    <C>       
        Project Account             To be used for alterations               $5,550,889
         Note Payment               To repay Certificates of
         Accounts                    Participation                              904,105
         Liquidity Account          To be used for debt liquidity               740,178
         Replacement                To be used for capital
          Reserve Account            improvements                               377,442
         Tax Account                To pay real estate taxes                    304,323
         Insurance Account          To pay insurance expense                     53,954
         Operations Account         To pay operating expenses                   107,767
         Partnership Account        To pay partnership distributions             94,234
         Supplemental retention     To be used as additional funds
          account                    to repay COPs                               82,196
                                                                             ----------
                                                                             $8,215,088
                                                                             ==========
</TABLE>

                                      -13-
<PAGE>   14

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996


NOTE D - RESTRICTED ESCROW (Continued)

          Restricted escrow is invested in money market funds of $2,952,413 and
          a repurchase agreement of $400,000, which approximate fair value. The
          remaining funds are invested in debt securities and at December 31,
          1996 are as follows:


<TABLE>
<CAPTION>
                                                   Held-to-Maturity
                                 ------------------------------------------------------
                                                     Gross         Gross
                                   Amortized        Unrealized    Unrealized     Fair
                                     Cost            Gains         Losses        Value
                                     ----            -----         ------        -----
<S>                             <C>              <C>              <C>         <C>       
        U.S. Government
        Debt Securities             $4,862,675       $620,165      $  --      $5,482,840

</TABLE>


          The amortized cost and fair value of debt securities classified as
          held-to-maturity, by contractual maturity, as of December 31, 1996 are
          as follows:

<TABLE>
<CAPTION>
                                             Amortized         Fair
                                                Cost           Value
                                            ----------      ----------
<S>                                         <C>             <C>       
         Due within one year                $4,862,675      $5,482,840
                                            ==========      ==========
</TABLE>

          Any amounts remaining in the project account after the alterations
          have been completed revert back to the tenant either in a lump sum
          payment or to be applied against rental income. (Accordingly, earnings
          on funds deposited in the project account in excess of the estimated
          cost of alterations have been deferred.) If any changes to the
          budgeted alterations require the use of the amounts earned, the income
          will be recognized at that time. Total earnings deferred at December
          31, 1996, is $500,000.

          The partnership deposited with the escrow agent a letter of credit to
          satisfy the requirements for the Supplemental Disbursement Account. At
          December 31, 1996, $450,000 was outstanding.


                                     - 14-
<PAGE>   15

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996

NOTE E - RENTAL OPERATIONS

          On November 17, 1994, the partnership and the tenant entered into a
          lease agreement for 100% of the building with a term of nine years
          expiring on October 31, 2003. The lease agreement provides for minimum
          annual lease payments of $12,154,632 payable monthly in arrears, plus
          provisions for escalations in the event of increased operating costs
          and real estate taxes.

Future minimum rentals are as follows:

<TABLE>
<S>               <C>                       <C>        
         December 31, 1997                  $12,154,632
                      1998                   12,154,632
                      1999                   12,154,632
                      2000                   12,154,632
                      2001                   12,154,632
                      Thereafter             22,283,492
                                            -----------
                                            $83,056,652
                                            ===========
</TABLE>

          The partnership has received an opinion of Assistant General Council
          to the General Services Administration that lease payments are not
          subject to annual appropriation by the United States Congress and the
          obligations to make such payments are unconditional general
          obligations of the United States Government.

          The Lease requires the partnership to maintain and repair the building
          and land in accordance with specific standards, to maintain certain
          insurance coverages and to use amounts in the Project Account plus
          interest accrued to make certain alterations (the "Alterations").

          The partnership assigned its right to receive payments under the lease
          with GSA to the Escrow Agent. Payments received or distributions made
          by the Escrow Agent and transfers between individual accounts are
          governed by an escrow agreement for the ultimate benefit of the
          partnership.







                                      -15-
<PAGE>   16

           Security Land and Development Company Limited Partnership

                   NOTES TO FINANCIAL STATEMENTS - CONTINUED

                               December 31, 1996


NOTE F - CONCENTRATION OF CREDIT RISK

          The partnership maintains a cash account insured by the Federal
          Deposit Insurance Corporation (FDIC) up to $100,000. At December 31,
          1996 the balance was $229,262. The uninsured balance at December 31,
          1996 was $129,262.

NOTE G - RELATED PARTY TRANSACTIONS

          JANITORIAL SERVICES

          The partnership entered into an agreement with Woodlawn Service
          Corporation, an affiliate of the general partner, to provide
          janitorial services for the building. The agreement provides for a fee
          for services provided and for a reimbursement for expenses incurred,
          not to exceed $1,905,770 per annum from which Woodlawn Service
          Corporation is to provide the cost of materials, salaries and other
          costs of providing such services. The agreement extends to the year
          2003 with options to renew annually thereafter. Total janitorial fees
          for the year ending December31, 1996 were $1,020,180 with $114,646
          remaining unpaid at year end.

          MANAGEMENT SERVICES

          The partnership entered into an agreement with TCG Management
          Corporation, an affiliate of the general partner, to provide
          management services. The agreement provides for a fee of $250,000 per
          annum. The agreement is for a term of one year with automatic renewals
          through the year 2003. Total management fees for the year ending
          December 31, 1996 were $250,000, with $20,833 remaining unpaid at year
          end.

          CONSTRUCTION MANAGEMENT SERVICES

          The partnership entered into an agreement with TCG Construction
          Corporation to provide construction management services relating to
          the building and tenant alterations. The agreement provides for a
          management construction fee of 10% of total costs incurred in
          connection with the alterations. In addition, TCG Construction shall
          receive 100% of any cost savings payments received by the partnership
          related to the alterations. The agreement is for a term of one year
          with automatic renewals through the year 2003. Total fees incurred at
          December 31, 1996 are $2,360,604 and have been capitalized to the cost
          of improvements.

                                     - 16-



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