AMERICAN REALTY INVESTORS INC - Annual Report: 2005 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2005

OR

Commission File Number 001-15663

American Realty Investors, Inc.

(Exact name of registrant as specified in its charter)

(469) 522-4200

Registrant’s Telephone Number, including area code

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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 (§229.405 of this chapter) 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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of “accelerated filer and large accelerated filer” in Rule 126-2 of the Exchange Act (check one).

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.    Yes  ¨    No  x

The aggregate market value of the shares of voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the closing price at which the common equity was last sold which was the sales price of the Common Stock on the New York Stock Exchange as of June 30, 2005 (the last business day of the Registrant’s most recently completed second fiscal quarter) was $16,375,845 based upon a total of 1,642,512 shares held as of June 30, 2005 by persons believed to be non-affiliates of the Registrant. The basis of the calculation does not constitute a determination by the Registrant as defined in Rule 405 of the Securities Act of 1933, as amended, such calculation, if made as of a date within sixty days of this filing, would yield a different value.

As of March 24, 2006, there were 10,895,972 shares of common stock outstanding, which includes 746,972 shares issued to and owned by Transcontinental Realty Investors, Inc.

Documents Incorporated By Reference:

Consolidated Financial Statements of Income Opportunity Realty Investors, Inc.; Commission File No. 001-14784

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ANNUAL REPORT ON FORM 10-K

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FORWARD-LOOKING STATEMENTS

Certain Statements in this Form 10-K are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. The words “estimate,” “plan,” “intend,” “expect,” “anticipate,” “believe,” and similar expressions are intended to identify forward-looking statements. The forward-looking statements are found at various places throughout this Report and in the documents incorporated herein by reference. The Company disclaims any intention or obligations to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Although we believe that our expectations are based upon reasonable assumptions, we can give no assurance that our goals will be achieved. Important factors that could cause our actual results to differ from estimates or projections contained in any forward-looking statements are described in Item 1A. “Risk Factors” beginning on page 7.

PART I

American Realty Investors, Inc., a Nevada corporation (“ARI” or the “Company” or “we” or “us”), was organized in 1999, and in August 2000, through mergers into wholly-owned subsidiaries of ARI, acquired American Realty Trust, Inc., a Georgia corporation (“ART”), and National Realty LP, a Delaware limited partnership (“NRLP”). ART was the successor to a District of Columbia business trust organized July 14, 1961, to provide investors with a professionally-managed, diversified portfolio of equity real estate and mortgage loan investments selected to provide opportunities for capital appreciation, as well as current income. The business trust merged into ART on June 24, 1988. NRLP was organized in 1987, and subsequently acquired all of the assets and assumed all of the liabilities of several public and private limited partnerships. NRLP also owned a portfolio of real estate and mortgage loan investments.

On December 31, 2005, ARI subsidiaries owned 82.2% of the outstanding shares of common stock of Transcontinental Realty Investors, Inc., a Nevada corporation (“TCI”), which has its common stock listed and traded on the New York Stock Exchange, Inc. (“NYSE”). The ownership of the TCI shares was achieved through a series of transactions, including a cash tender offer completed March 19, 2003, an exchange by certain ARI subsidiaries of securities with Basic Capital Management, Inc. (“BCM”) and a sale of a participating interest in a line of credit receivable from One Realco Corporation (“One Realco”) to BCM, as well as certain open market purchases of TCI shares in December 2003. See Note 1 to the Consolidated Financial Statements. ARI has consolidated TCI’s accounts and operations since March 31, 2003. At December 31, 2005, TCI owned 24.9% of Income Opportunity Realty Investors, Inc. (“IORI”) shares of common stock, and TCI owned 746,972 shares of common stock of ARI.

Effective July 1, 2003, Prime Asset Management, Inc. (“PAMI”) became the advisor to ARI and TCI. PAMI is owned by Realty Advisors, Inc. (80.0%) and Syntek West, Inc. (“Syntek West”) (20.0%), related parties. Syntek West is owned by Gene E. Phillips. Effective August 18, 2003, PAMI changed its name to Prime Income Asset Management, Inc. (“PIAMI”). On October 1, 2003, Prime Income Asset Management, LLC (“Prime”), which is 100% owned by PIAMI, replaced PIAMI as the advisor to ARI and TCI.

Business Plan and Investment Policy

ARI’s primary business is investing in equity interests in real estate (including equity securities of real estate-related entities), leases, joint venture development projects, and partnerships and, to a lesser extent, financing real estate and real estate activities through investments in mortgage loans, including first, wraparound and junior mortgage loans. Information regarding the real estate and mortgage notes receivable portfolios of ARI is set forth in ITEM 2. “PROPERTIES,” NOTE 3. “NOTES AND INTEREST RECEIVABLE” and in

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Schedules III and IV to the Consolidated Financial Statements included in ITEM 8. “CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.” ARI has six operating segments: apartments, commercial properties, hotels, land ownership, quick-service restaurants, and notes receivable. For additional information, see NOTE 18 to the Consolidated Financial Statements.

ARI’s business objective is to maximize long-term value for its stockholders by investing in commercial real estate through the ownership, management, development, and acquisition of apartments, commercial properties, hotels, and land. ARI intends to achieve this objective through acquiring and developing properties in multiple markets and operating as an industry-leading landlord. ARI believes this objective will provide the benefits of enhanced investment opportunities, economies of scale, risk diversification, both in terms of geographic market and real estate product type, and continuing access to both debt and equity capital. In pursuing its business objective, ARI seeks to achieve a combination of internal and external growth, maintain a strong balance sheet, and pursue a strategy of financial flexibility. ARI maximizes the value of its apartments and commercial properties by maintaining high occupancy levels while charging competitive rental rates, controlling costs, and focusing on tenant retention.

ARI generates increased operating cash flow through annual contractual increases in rental rates under existing leases. ARI also seeks to identify best practices across operating platforms in order to enhance cost savings and other efficiencies. ARI and its subsidiaries employ capital improvement and preventive maintenance programs designed to reduce operating costs and to increase the long-term value of its real estate investments.

ARI also pursues attractive development opportunities, focusing primarily on new construction or development, either directly or in concert with unaffiliated parties or affiliates. A summary of the properties under construction is set forth under ITEM 2. “PROPERTIES” below.

ARI also seeks to acquire properties consistent with its business objectives and strategies. ARI executes its acquisition strategy by purchasing properties which management believes will create stockholder value over the long-term. ARI will also sell properties when management believes value has been maximized or when a property is no longer considered an investment to be held long-term. During the year ended December 31, 2005, ARI, through its subsidiaries, acquired 37 properties and sold 42 properties.

ARI is continuously in various stages of discussions and negotiations with respect to development, acquisition, and disposition projects. The consummation of any current or future development, acquisition, or disposition, if any, and the pace at which any may be completed cannot be assured or predicted.

Substantially all properties are owned by subsidiaries of ARI, many of which are single-asset entities. This ownership structure permits greater access to financing for individual properties and permits flexibility in the type of transaction available for future disposition of each property by permitting a sale of either the asset or the equity ownership in the entity owning the asset. From time-to-time, subsidiaries have invested in joint ventures with others, creating the possibility of risks that do not exist with properties solely owned by an ARI subsidiary. In those instances where other investors are involved, those other investors may have business, economic, or other objectives that are inconsistent with ARI’s objectives, which may in turn require ARI to make investment decisions different than it might if ARI was the sole investor.

Real estate generally cannot be sold quickly. ARI and its subsidiaries may not be able to promptly dispose of properties in response to economic or other conditions. To offset this challenge, selective dispositions have been a part of ARI’s strategy to create an efficient portfolio and to provide additional sources of capital for future use. See the discussion under “LIQUIDITY AND CAPITAL RESOURCES” in Management’s Discussion and Analysis of Financial Condition and Results of Operations for information concerning sales of properties during the past year. ARI and its subsidiaries finance acquisitions through non-recourse mortgages, internally generated funds, and, to a lesser extent, property sales. Those sources provide the bulk of funds for future acquisitions. ARI, from time-to-time, acquires properties subject to existing indebtedness by a subsidiary assuming such

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indebtedness. When properties are acquired in such a manner, ARI and its subsidiaries customarily seek to refinance the asset in order to properly leverage the asset for future operation.

ARI, through its interest in Milano Restaurants International Corporation (“Milano”), operates and franchises several quick-service restaurant concepts including pizzerias featuring pizza delivery, carryout, and dine-in under the trademarks “Me-N-Ed’s Pizzerias,” “Me-N-Ed’s Slices,” and “Angelo & Vito’s Pizzerias (collectively “the Pizzerias”).” The first Me-N-Ed’s Pizzeria opened in 1958. At December 31, 2005, there were 59 restaurants in operation, consisting of 41 owned and 18 franchised. Two of the restaurants were located in Texas and the remainder were in California. In addition to the Pizzerias, Milano has developed two new concepts: Pizzeria del Pane, a bakery/café concept and Me-N-Ed’s Pizza Pastaria, a quick-service Italian restaurant. The initial locations for each of the concepts opened in 2004.

In July 2003, ARI sold its interest in Milano to Gruppa Florentina, LLC (“Gruppa”), for $18.5 million, receiving $7.4 million in cash after debt assumption and providing purchase money financing of $2.3 million (see NOTE 3. “NOTES RECEIVABLE”). ARI owns 20.0% of Gruppa, thereby retaining a 20.0% interest in Milano. ARI remains as the guarantor of $8.7 million of assumed debt and is one of the guarantors of $7.5 million in new debt obtained by Gruppa. Due to the debt guarantees and ARI’s continuing ownership interest in Milano, management determined that the sale should be accounted for as a financing transaction. In September 2003, ARI sold the note to Syntek West for $2.3 million, plus accrued and unpaid interest, to reduce affiliate debt.

ARI’s businesses are not generally seasonal with regard to real estate investments. ARI’s investment strategy seeks both current income and capital appreciation. ARI’s plan of operation is to continue, to the extent its liquidity permits, to make equity investments in income-producing real estate such as hotels, apartments, and commercial properties, including equity securities of real estate-related entities. ARI also intends to continue to pursue higher risk, higher reward investments, such as improved and unimproved land where it can obtain financing of substantially all of a property’s purchase price. ARI intends to seek selected dispositions of certain of its assets, including in particular selected income producing properties in stabilized markets and certain of its land holdings where the prices obtainable for such assets justify their disposition. ARI has determined that it will no longer actively seek to fund or purchase mortgage loans. However, it may, in selected instances, originate mortgage loans or it may provide purchase money financing in conjunction with a property sale. See ITEM 2. “PROPERTIES,” NOTE 3. “NOTES AND INTEREST RECEIVABLE” and Schedules III and IV to the Consolidated Financial Statements included in ITEM 8. “CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.”

ARI’s Board of Directors has broad authority under ARI’s governing documents to make all types of investments, and may devote available assets to particular investments or types of investments, without restriction on the amount or percentage of assets that may be allocated to a single investment or to any particular type of investment, and without limit on the percentage of securities of any one issuer that may be acquired. Investment objectives and policies may be changed at any time by the Board without stockholder approval.

The specific composition from time-to-time of ARI’s real estate portfolio owned through subsidiaries depends largely on the judgment of management to changing investment opportunities and the level of risk associated with specific investments or types of investments. Management intends to attempt to maintain a real estate portfolio diversified by location and type of property.

In addition to its equity investments in real estate, ARI and/or its subsidiaries have also invested in private and open market purchases of the equity securities of IORI and TCI, both affiliates of ARI. See ITEM 2. “PROPERTIES—Investments in Real Estate Companies and Real Estate Partnerships.”

Management of the Company

Although the Board of Directors is directly responsible for managing the affairs of ARI and for setting the policies which guide it, its day-to-day operations are performed by Prime, a contractual advisor under the

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supervision of the Board. The duties of Prime include, among other things, locating, investigating, evaluating, and recommending real estate and mortgage note investments and sales opportunities, as well as financing and refinancing sources. Prime also serves as a consultant in connection with ARI’s business plan and investment policy decisions made by the Board. Prime is a single-member limited liability company, the sole member of which is PIAMI, which is owned 80% by Realty Advisors, Inc. and 20% by Syntek West, Inc. Realty Advisors, Inc. is owned 100% by a trust for the benefit of the children of Gene E. Phillips. Syntek West, Inc. is owned 100% by Gene E. Phillips. Mr. Phillips is not an officer or director of Prime but serves as a representative of the Trust, is involved in daily consultation with the officers of Prime and has significant influence over the conduct of Prime’s business, including the rendering of advisory services and the investment decisions for Prime and for ARI. As of March 24, 2006, PIAMI, Prime’s parent, owned 1,437,208 shares of ARI’s common stock, approximately 13.2% of the shares then outstanding. Prime is more fully described in ITEM 10. “DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT—The Advisor.”

Prime has been providing advisory services to ARI since October 1, 2003. Prime also serves as advisor to TCI. The officers of ARI are also officers of IORI, TCI, and Prime. The directors of ARI also serve as directors of TCI. The Chairman of the Board of Directors of ARI also serves as the Chairman of the Board of Directors of TCI and IORI. One other director of ARI also serves as a director of TCI and IORI. Affiliates of Prime have provided property management services to ARI. Currently, Triad Realty Services, Ltd. (“Triad”), an affiliate, and Carmel Realty, Inc. (“Carmel”) provide such property management services. Triad and Carmel subcontract with other entities for property-level management services. The general partner of Triad is PIAMI. The limited partner of Triad is Highland Realty Services, Inc. (“Highland”). Triad subcontracts the property-level management and leasing of 29 of ARI’s commercial properties (shopping centers, office buildings, and industrial warehouses) to Regis Realty I, LLC (“Regis I”) which is owned by Highland. Regis I receives property and construction management fees and leasing commissions in accordance with the terms of its property-level management agreement with Triad. Regis Hotel I, LLC, manages ARI’s 11 hotels. The sole member of Regis I and Regis Hotel I, LLC is Highland. Carmel is owned by Regis I.

Regis I is also entitled to receive real estate brokerage commissions in accordance with the terms of the Advisory Agreement as discussed in ITEM 10. “DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT—The Advisor.”

ARI has no employees itself, but Milano has 895 employees. Under the terms of the Advisory Agreement, employees of Prime render services to ARI.

Competition

Real Estate.    The real estate business is highly competitive and ARI competes with numerous entities engaged in real estate activities (including certain entities described in ITEM 13. “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS—Related Party Transactions”), some of which have greater financial resources than ARI. Management believes that success against such competition is dependent upon the geographic location of the property, the performance of property-level managers in areas such as leasing and marketing, collections and control of operating expenses, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors include ease of access to the property, the adequacy of related facilities, such as parking and other amenities, and sensitivity to market conditions in determining rent levels. With respect to apartments, competition is also based upon the design and mix of the units and the ability to provide a community atmosphere for the residents. With respect to hotels, competition is also based upon the market served, i.e., transient, commercial, or group users. Management believes that beyond general economic circumstances and trends, the degree to which properties are renovated or new properties are developed in the competing submarket are also competitive factors. See also ITEM 1A. “RISK FACTORS.”

To the extent that ARI seeks to sell any of its properties, the sales prices for the properties may be affected by competition from other real estate entities and financial institutions, also attempting to sell properties in areas where ARI’s properties are located, as well as aggressive buyers attempting to dominate or penetrate a particular market.

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As described above and in ITEM 13. “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS—Related Party Transactions,” the officers and directors of ARI also serve as officers and directors of TCI and the officers of ARI also serve as the officers of IORI and two directors of ARI are also directors of IORI. Both TCI and IORI have business objectives similar to ARI’s. ARI’s officers and directors owe fiduciary duties to both IORI and TCI as well as to ARI under applicable law. In determining whether a particular investment opportunity will be allocated to ARI, IORI, or TCI, management considers the respective investment objectives of each Company and the appropriateness of a particular investment in light of each Company’s existing real estate and mortgage notes receivable portfolio. To the extent that any particular investment opportunity is appropriate to more than one of the entities, the investment opportunity may be allocated to the entity which has had funds available for investment for the longest period of time, or, if appropriate, the investment may be shared among all three or two of the entities.

In addition, also as described in ITEM 13. “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,” ARI competes with affiliates of Prime having similar investment objectives, in the purchasing, selling, leasing, and financing of real estate and real estate-related investments. In resolving any potential conflicts of interest which may arise, Prime has informed ARI that it intends to exercise its best judgment as to what is fair and reasonable under the circumstances in accordance with applicable law.

ARI is subject to all the risks incident to ownership and financing of real estate and interests therein, many of which relate to the general illiquidity of real estate investments. These risks include, but are not limited to, changes in general or local economic conditions, changes in interest rates and availability of permanent mortgage financing which may render the purchase, sale, or refinancing of a property difficult or unattractive, and which may make debt service overly burdensome, changes in real estate and zoning laws, increases in real estate taxes, federal or local economic or rent controls, floods, earthquakes, hurricanes and other acts of God and other factors beyond the control of management or the advisor. The illiquidity of real estate investments may also impair the ability of management to respond promptly to changing circumstances. Management believes that such risks are partially mitigated by the diversification by geographic region and property type of ARI’s real estate and mortgage notes receivable portfolios. However, to the extent that property sales, new property investments, in particular improved and unimproved land, or mortgage lending are concentrated in any particular region, the advantages of geographic diversification are mitigated.

Virtually all of ARI’s real estate, equity security holdings in TCI, and its portfolio of equity securities are held subject to secured indebtedness. Such borrowings increase the risk of loss because they represent a prior claim on ARI’s assets and require fixed payments regardless of profitability. In the event of default, the lender may foreclose on the assets securing such indebtedness, and ARI could lose its investment in the pledged assets.

Quick-Service Restaurants.    The pizza parlor business is highly competitive and is affected by changes in consumer tastes and eating habits, as well as national, regional, and local economic conditions, and demographic trends. The performance of an individual pizza parlor can be affected by changes in traffic patterns, demographics, and the type, number and location of competing restaurants.

The quick-service restaurant industry is extremely competitive with respect to price, service, location, and food quality. Milano and its franchisees compete with a variety of other restaurants in the quick-service restaurant industry; including those that offer dine-in, carryout and delivery services. These competitors include national and regional chains, franchisees of other restaurant chains and local owner-operated restaurants. Some of these competitors have been in existence longer and have an established market presence in certain geographic regions, and some have substantially greater financial, marketing, and other resources than Milano and its franchisees. Milano competes for qualified franchisees with many other restaurant concepts, including national and regional restaurant chains.

Milano’s success is largely dependent upon the efforts of its management and other key personnel. The loss of the service of one or more members of management could have an adverse effect on Milano’s operations.

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Significant transitions in management involve important risks, including potential loss of key personnel, difficulties in implementing changes to operational strategies and maintaining relationships with franchisees.

At December 31, 2005, Milano owned and operated 41 and franchised 18 pizza parlors. The results achieved by Milano’s relatively small pizza parlor base may not be indicative of the results of a larger number of pizza parlors in a more geographically dispersed area. Because of Milano’s relatively small pizza parlor base, an unsuccessful pizza parlor has a more significant effect on Milano’s results of operations than would be the case in a company owning more pizza parlors.

Milano’s existing pizza parlors, both owned and franchised, are located predominately in California. At December 31, 2005, there were 55 pizza parlors in California and two in Texas. Accordingly, Milano’s results of operations may be affected by economic or other conditions in those regions. Given Milano’s present geographic concentration, publicity relating to Milano’s pizza parlors could have a more pronounced effect on Milano’s overall sales than might be the case if Milano’s pizza parlors were more geographically dispersed.

All of Milano’s owned pizza parlors are operated on premises leased from third parties. Most of the pizza parlor leases provide for a minimum annual rent. There can be no assurance that Milano will be able to renew leases upon expiration or that the lease terms on renewal will be as favorable as the current lease terms. In 2005, Milano purchased one franchise store and sold one company-owned store as a franchise. Milano also closed one company-owned store and converted two stores into a Me-N-Ed’s Pizza Pastaria. Milano opened one new franchise with two franchises leaving the system.

Available Information

ARI maintains an Internet site at http://www.amrealtytrust.com. Available through the website, free of charge, are Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, reports filed pursuant to Section 16, and amendments to those reports, as soon as reasonably practicable after they are electronically filed or furnished to the Securities and Exchange Commission. In addition, ARI has posted the charters for the Audit Committee, Compensation Committee, and Governance and Nominating Committee, as well as the Code of Business Conduct and Ethics, Corporate Governance Guidelines on Director Independence, and other information on the website. These charters and principles are not incorporated in this report by reference. ARI will also provide a copy of these documents free of charge to stockholders upon written request. ARI issues Annual Reports containing audited financial statements to its common stockholders.

ITEM 1A.    RISK FACTORS

An investment in our securities involves various risks. All investors should carefully consider the following risk factors in conjunction with the other information in this report before trading our securities.

Risk Factors Related to ARI’s Business

Adverse events concerning existing tenants, or negative market conditions that may affect existing tenants could have an adverse impact on ARI’s ability to attract new tenants, relet space, collect rent or renew leases, and thus could adversely affect cash flow from operations and inhibit growth.    Cash flow from operations depends in part on the ability to lease space to tenants on economically favorable terms. ARI could be adversely affected by various facts and events over which the Company has limited or no control, such as:

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At any time, any tenant may experience a downturn in its business that may weaken its financial condition. As a result, a tenant may delay a lease commencement, fail to make rental payments when due, decline to extend a lease upon its expiration, become insolvent or declare bankruptcy. Any tenant bankruptcy or insolvency, leasing delay or failure to make rental payments when due could result in the termination of the tenant’s lease and material losses to the Company.

If tenants do not renew their leases as they expire, ARI may not be able to rent the space. Furthermore, leases that are renewed, and some new leases for space that is relet, may have terms that are less economically favorable than expiring lease terms, or may require ARI to incur significant costs, such as renovations, tenant improvements, or lease transaction costs.

Any of these events could adversely affect cash flow from operations and ARI’s ability to make distributions to shareholders and service indebtedness.

A significant portion of the costs of owning property, such as real estate taxes, insurance costs, and debt service payments are not necessarily reduced when circumstances cause a decrease in rental income from the properties.

ARI may not be able to compete successfully with other entities that operate in our industry.    ARI experiences a great deal of competition in attracting tenants for its properties and in locating land to develop and properties to acquire.

In ARI’s effort to lease its properties, ARI competes for tenants with a broad spectrum of other landlords. These competitors include, among others, publicly-held REITs, privately-held entities, individual property owners and tenants who wish to sublease their space. Some of these competitors may be able to offer prospective tenants more attractive financial terms than ARI is able to offer.

If the availability of land or high quality properties in ARI’s markets diminishes, operating results could be adversely affected.

ARI may experience increased operating costs, which could adversely affect our financial results and the value of our properties.    ARI’s properties are subject to increases in operating expenses such as insurance, cleaning, electricity, heating, ventilation and air conditioning, administrative costs and other costs associated with security, landscaping, repairs, and maintenance of the properties. While some current tenants generally are obligated by their leases to reimburse ARI for a portion of these costs, there is no assurance that these tenants will make such payments or agree to pay these costs upon renewal or new tenants will agree to pay these costs. If operating expenses increase in ARI’s markets, ARI may not be able to increase rents or reimbursements in all of these markets to offset the increased expenses, without at the same time decreasing occupancy rates. If this occurs, ARI’s ability to make distributions to shareholders and service indebtedness could be adversely affected.

ARI’s ability to achieve growth in operating income depends in part on its ability to develop properties.    ARI intends to continue to develop properties where warranted by market conditions. ARI has a number of ongoing development and land projects being readied for commencement.

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Additionally, general construction and development activities include the following risks:

ARI faces risks associated with property acquisitions.    ARI acquires individual properties and various portfolios of properties and intends to continue to do so. Acquisition activities are subject to the following risks:

ARI may acquire properties subject to liabilities and without any recourse, or with limited recourse, with respect to unknown liabilities. However, if an unknown liability was later asserted against the acquired properties, ARI might be required to pay substantial sums to settle it, which could adversely affect cash flow.

Many of ARI’s properties are concentrated in our primary markets, and the Company may suffer economic harm as a result of adverse conditions in those markets.    ARI’s properties are located principally in specific geographic areas in the Southwestern, Southeastern, and Midwestern United States. The Company’s overall performance is largely dependent on economic conditions in those regions.

ARI is leveraged and we may not be able to meet our debt service obligations.    ARI had total indebtedness at December 31, 2005 of approximately $1.044 billion. Substantially all assets have been pledged to secure debt. These borrowings increase the risk of loss because they represent a prior claim on assets and most require fixed payments regardless of profitability. ARI’s leveraged position makes it vulnerable to declines in the general economy and may limit the Company’s ability to pursue other business opportunities in the future.

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The Company may not be able to access financial markets to obtain capital on a timely basis, or on acceptable terms.    ARI relies on proceeds from property dispositions and third party capital sources for a portion of its capital needs, including capital for acquisitions and development. The public debt and equity markets are among the sources upon which the Company relies. There is no guarantee ARI will be able to access these markets or any other source of capital. The ability to access the public debt and equity markets depends on a variety of factors, including:

ARI may suffer adverse effects as a result of terms and covenants relating to the Company’s indebtedness.    Required payments on ARI’s indebtedness generally are not reduced if the economic performance of the portfolio declines. If the economic performance declines, net income, cash flow from operations and cash available for distribution to stockholders may be reduced. If payments on debt cannot be made, ARI could sustain a loss or suffer judgments, or in the case of mortgages, suffer foreclosures by mortgagees. Further, some obligations contain cross-default and/or cross-acceleration provisions, which means that a default on one obligation may constitute a default on other obligations.

ARI anticipates only a small portion of the principal of its debt will be repaid prior to maturity. Therefore, ARI is likely to refinance a portion of its outstanding debt as it matures. There is a risk that ARI may not be able to refinance existing debt or the terms of any refinancing will not be as favorable as the terms of the maturing debt. If principal balances due at maturity cannot be refinanced, extended, or repaid with proceeds from other sources, such as the proceeds of sales of assets or new equity capital, cash flow may not be sufficient to repay all maturing debt in years when significant “balloon” payments come due.

ARI’s credit facilities and unsecured debt contain customary restrictions, requirements and other limitations on the ability to incur indebtedness, including total debt to asset ratios, secured debt to total asset ratios, debt service coverage ratios, and minimum ratios of unencumbered assets to unsecured debt, which ARI must maintain. ARI’s continued ability to borrow is subject to compliance with financial and other covenants. In addition, failure to comply with such covenants could cause a default under credit facilities, and ARI may then be required to repay such debt with capital from other sources. Under those circumstances, other sources of capital may not be available, or be available only on unattractive terms.

ARI’s leverage could affect the Company’s ability to obtain additional financing for working capital, capital expenditures, acquisitions, development, or other general corporate purposes. The degree of leverage could also make ARI more vulnerable to a downturn in business or the economy or could affect the market price of the Company’s common stock.

An increase in interest rates would increase interest costs on variable rate debt and could adversely impact the Company’s ability to refinance existing debt.    ARI currently has, and may incur more, indebtedness that bears interest at variable rates. Accordingly, if interest rates increase, so will the interest costs, which would adversely affect cash flow and the ability to pay principal and interest on ARI’s debt and the ability to make distributions to shareholders. Further, rising interest rates could limit ARI’s ability to refinance existing debt when it matures.

Unbudgeted capital expenditures or cost overruns could adversely affect business operations and cash flow.    If capital expenditures for ongoing or planned development projects or renovations exceed expectations, the additional cost of these expenditures could have an adverse effect on business operations and cash flow. In addition, ARI might not have access to funds on a timely basis to pay the unexpected expenditures.

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Construction costs are funded in large part through construction financing, which the Company may guarantee and the Company’s obligation to pay interest on this financing continues until the rental project is completed, leased up, and permanent financing is obtained, or the for sale project is sold or the construction loan is otherwise paid. Unexpected delays in completion of one or more ongoing projects could also have a significant adverse impact on business operations and cash flow.

ARI may need to sell properties from time-to-time for cash flow purposes.    Because of the lack of liquidity of real estate investments generally, ARI’s ability to respond to changing circumstances may be limited. Real estate investments generally cannot be sold quickly. In the event that ARI must sell assets to generate cash flow, ARI cannot predict whether there will be a market for those assets in the time period desired, or whether ARI will be able to sell the assets at a price that will allow the Company to fully recoup its investment. ARI may not be able to realize the full potential value of the assets and may incur costs related to the early pay-off of the debt secured by such assets.

The Company intends to devote resources to the development of new projects.    ARI plans to continue developing new projects as opportunities arise in the future. Development and construction activities entail a number of risks, including but not limited to the following:

The overall business is subject to all of the risks associated with the real estate industry.    ARI is subject to all risks incident to investment in real estate, many of which relate to the general lack of liquidity of real estate investments, including, but not limited to:

Risks Related to the Real Estate Industry

Real estate investments are illiquid, and the Company may not be able to sell properties if and when it is appropriate to do so.    Real estate generally cannot be sold quickly. ARI may not be able to dispose of properties promptly in response to economic or other conditions. In addition, provisions of the Internal Revenue Code may

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limit ARI’s ability to sell properties (without incurring significant tax costs) in some situations when it may be otherwise economically advantageous to do so, thereby adversely affecting returns to stockholders and adversely impacting ARI’s ability to meet it’s obligations.

ITEM 1B.    UNRESOLVED STAFF COMMENTS

None.

ARI’s principal offices are located at 1800 Valley View Lane, Suite 300, Dallas, Texas 75234 and are, in the opinion of management, suitable and adequate for ARI’s present operations.

Details of ARI’s and its subsidiaries’ real estate and mortgage notes receivable portfolios at December 31, 2005, are set forth in SCHEDULES III and IV, respectively, to the Consolidated Financial Statements included in ITEM 8. “CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.” The discussions set forth below under the headings “Real Estate” and “Mortgage Loans” provide certain summary information concerning ARI’s real estate and mortgage notes receivable portfolios.

At December 31, 2005, no single asset accounted for 10.0% or more of total assets. At December 31, 2005, 82.7% of ARI’s assets consisted of real estate, and 6.1% consisted of notes and interest receivable. The remaining 11.2% of ARI’s assets were cash, cash equivalents, marketable equity securities, restaurant equipment, investments in equity investees, goodwill and other intangibles, and other assets. The percentage of assets invested in any one category is subject to change and no assurance can be given that the composition of ARI’s assets in the future will approximate the percentages listed above.

ARI’s real estate is geographically diverse with concentrations in the Southwest, Southeast, and Midwest regions. At December 31, 2005, ARI’s real estate was located in all geographic regions of the continental United States, other than the Northeast region, as shown more specifically in the table under “Real Estate” below. ARI also holds mortgage notes receivable secured by real estate located in the Southwest, Pacific, and Midwest regions of the continental United States. See SCHEDULE IV to the Consolidated Financial Statements included in ITEM 8. “CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for a detailed description of ARI’s notes receivable portfolio.

Real Estate

At December 31, 2005, 83.7% of ARI’s assets were invested in real estate and the equity securities of IORI and other equity investees. ARI invests in real estate located throughout the continental United States, either on a leveraged or non-leveraged basis. ARI’s real estate portfolio consists of properties held for investment, properties held for sale, investments in partnerships, and investments in equity investees.

Types of Real Estate Investments.    ARI’s real estate consists of apartments, commercial properties (office buildings, industrial warehouses, shopping centers, and a merchandise mart), hotels, and improved and unimproved land. In selecting real estate for investment, the location, age, and type of property, gross rents, lease terms, financial and business standing of tenants, operating expenses, fixed charges, land values, and physical condition are among the factors considered. Properties may be purchased subject to debt, or existing debt may be assumed and properties may be mortgaged, pledged or otherwise collateralized to obtain financing. The Board of Directors may alter the types of and criteria for selecting new real estate investments and for obtaining financing without a vote of stockholders.

Although ARI has typically invested in developed real estate, it may also invest in new construction or development either directly or in partnership with unaffiliated parties or affiliates (subject to approval by the

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Board of Directors). To the extent that it invests in construction and development projects, such as the apartments described below, ARI is subject to business risks, which include cost overruns and construction delays, associated with higher risk projects.

At December 31, 2005, ARI had the following properties under construction.

In 2005, ARI completed the 70 unit Blue Lake Villas II in Waxahachie, Texas, the 272 unit Bluffs at Vista Ridge in Lewisville, Texas, the 232 unit Bridges on Kinsey in Tyler, Texas, the 208 unit Dakota Arms in Lubbock, Texas, the 240 unit Lake Forest in Houston, Texas, the 220 unit Wildflower Villas in Temple, Texas, the 398 unit Kingsland Ranch Apartments in Houston, Texas, the 240 unit Stonebridge at City Park Apartments in Houston, Texas, and the 240 unit Vistas of Vance Jackson in San Antonio, Texas.

In the opinion of management, the properties owned by ARI are adequately covered by insurance.

The Company’s three office buildings in downtown New Orleans suffered extensive damage from Hurricane Katrina. Management is presently working with the Company’s insurance carriers to finalize all related claims. Most of the necessary repairs to the Amoco and 1010 Common Buildings have either been made or scheduled. At year-end, the Company had received approximately $8.7 million from its insurance carriers principally as partial reimbursement for Katrina-related lost rents. At the same time, the Company had spent $1.7 million to stabilize and initiate repairs to the buildings. At December 31, 2005, the Amoco Building and the 1010 Common Building were open for business on a limited-access basis. The 225 Baronne Building, however, is closed until the assessment of damages can be fully completed. We believe our insurance coverage is adequate to fully cover the cost of repairs and lost rents, less our normal property and wind deductibles.

Two of our apartment communities (Island Bay and Marina Landing) in Galveston, Texas and one property (Harper’s Ferry) in Lafayette, Louisiana suffered damage from Hurricane Rita. Most of the repairs have either been completed or scheduled. Our insurance policies will cover the costs of the required repairs, excluding normal property and wind deductibles.

The following table sets forth the percentages, by property type and geographic region, of owned real estate (excluding 92 parcels of improved and unimproved land, a hotel in Wroclaw, Poland, and a single-family residence, described below) at December 31, 2005.

The foregoing table is based solely on the number of apartment units, amount of commercial square footage, and number of hotel rooms owned, and does not reflect the value of ARI’s investment in each region. See

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SCHEDULE III to the Consolidated Financial Statements included in ITEM 8. “CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” for a detailed description of owned real estate.

Excluded from the table above are a 165 room hotel in Wroclaw, Poland, a single family residence in Dallas, Texas, and 92 parcels of improved and unimproved land. See “Land Properties” table below for a listing of properties, locations, and acres.

A summary of the activity in the owned real estate portfolio during 2005 is as follows:

Operating Properties.    Set forth below are ARI’s operating properties and the monthly rental rate for apartments, the average annual rental rate for commercial properties, the average daily room rate and room revenue divided by total available rooms for hotels, and occupancy at December 31, 2005, 2004, and 2003 for apartments and commercial properties and average occupancy during 2005, 2004, and 2003 for hotels.

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Occupancy presented above and throughout this ITEM 2. is without reference to whether leases in effect are at, below, or above market rates.

In 2005, ARI purchased the following properties:

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