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INCOME OPPORTUNITY REALTY INVESTORS INC /TX/ - Quarter Report: 2005 June (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
     
þ   QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED JUNE 30, 2005
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM            TO           
Commission File Number 001-14784
 
INCOME OPPORTUNITY REALTY INVESTORS, INC.
(Exact Name of Registrant as Specified in Its Charter)
     
Nevada
(State or Other Jurisdiction of
Incorporation or Organization)
  75-2615944
(I.R.S. Employer
Identification No.)
     
1755 Wittington Place, Suite 340, Dallas, Texas
(Address of Principal Executive Office)
  75234
(Zip Code)
(214) 750-5800
(Registrant’s Telephone Number, Including Area Code)

 
     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 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 ¨.
APPLICABLE ONLY TO CORPORATE ISSUERS:
     Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date.
     
Common Stock, $.01 par value
(Class)
  4,168,035
(Outstanding at July 31, 2005)
 
 

 


TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF OPERATIONS
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES REGARDING MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 6. EXHIBITS
SIGNATURE PAGE
EXHIBITS TO QUARTERLY REPORT ON FORM 10-Q
Certification Pursuant to Rule 13a-14/15d-14
Certification Pursuant to 18 U.S.C. Section 1350


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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The accompanying Consolidated Financial Statements as of and for the three months ended June 30, 2005, have not been audited by independent certified public accountants, but in the opinion of the management of Income Opportunity Realty Investors, Inc. (“IORI”), all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of IORI’s consolidated financial position, consolidated results of operations and consolidated cash flows at the dates and for the periods indicated, have been included.
INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED BALANCE SHEETS
                 
    June 30,     December 31,  
    2005     2004  
            (Restated)  
    (dollars in thousands,  
    except per share)  
Assets
               
 
               
Real estate held for investment
  $ 35,068     $ 34,988  
Less—accumulated depreciation
    (3,969 )     (3,620 )
 
           
 
    31,099       31,368  
 
               
Related Party Notes and interest receivable
    55,627       54,911  
Investment in real estate partnerships
    577       604  
Cash and cash equivalents
    442       399  
Receivables from affiliates
    -0-       261  
Other assets
    3,016       3,905  
 
           
 
  $ 90,761     $ 90,638  
 
           
 
               
Liabilities and Stockholders’ Equity
               
 
               
Liabilities
               
Notes and interest payable
  $ 42,700     $ 44,571  
Payables to affiliates
    2,461       1,248  
Other liabilities
    1,001       1,529  
 
           
 
    46,162     $ 47,348  
 
               
Commitments and contingencies
               
 
               
Minority Interest
    475       -0-  
Stockholders’ Equity:
               
Common Stock, $.01 par value; authorized, 10,000,000 shares; issued and outstanding 4,168,035 shares in 2005 and 1,389,345 shares in 2004
    42       14  
Paid-in capital
    61,955       61,983  
Accumulated deficit
    (17,873 )     (18,707 )
 
           
 
    44,124       43,290  
 
           
 
  $ 90,761     $ 90,638  
 
           
These are the restated numbers which reflect corrections for the discontinued operations, the issuance of 3-for-1 stock dividends and the accounting error related to a deferral of operating income and/or expense. See “NOTE 1. BASIS OF PRESENTATION”.
The accompanying notes are an integral part of these Consolidated Financial Statements.

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INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
                                 
    For the Three Months     For the Six Months  
    Ended June 30,     Ended June 30,  
    (dollars in thousands, except per share)  
    2005     2004     2005     2004  
            (Restated)             (Restated)  
Property revenue:
                               
Rents
  $ 1,613     $ 1,022     $ 3,142     $ 2,917  
Property expense:
                               
Property operations (including $44 in 2005 and $78 in 2004 to affiliates and related parties)
    825       449       1,646       1,606  
 
                       
Operating income
    788       573       1,496       1,311  
 
                               
Other income (loss):
                               
Interest
    984       605       1,958       1,203  
Recovery of accounts receivable written off
                       
Equity in income (loss) of equity partnerships
    (19 )     11       (28 )     10  
 
                       
 
    965       616       1,930       1,213  
 
                               
Other expense:
                               
Interest
    562       750       1,498       1,802  
Depreciation
    173       116       350       386  
Advisory fee to affiliate
    170       201       337       393  
Net income fee to affiliate
    55       30       67       245  
General and administrative (including $36 in 2005 and $36 in 2004 to affiliates and related parties)
    199       179       341       446  
 
                       
 
    1,159       1,276       2,593       3,272  
 
                       
 
                               
Net income (loss) from continuing operations
    594       (87 )     833       (748 )
 
                               
Discontinued operations:
                               
Income/(loss) from discontinued operations
          4             (78 )
Gain on sale of operations
          417             3,674  
 
                       
 
          421             3,596  
 
                       
 
                               
Net income
  $ 594     $ 334     $ 833     $ 2,848  
 
                       
 
                               
Earnings (loss) per share:
                               
Net income (loss) from continuing operations
  $ 0.14     $ (0.02 )   $ 0.20     $ (0.17 )
Discontinued operations
          0.10             0.83  
 
                       
Net income
  $ 0.14     $ 0.08     $ 0.20     $ 0.66  
 
                       
 
                               
Weighted average common shares used in computing earnings per share
    4,168,035       4,316,835       4,168,035       4,316,835  
 
                       
These are the restated numbers which reflect corrections for the discontinued operations, the issuance of 3-for-1 stock dividends and the accounting error related to a deferral of operating income and/or expense. See “NOTE 1. BASIS OF PRESENTATION”.
The accompanying notes are an integral part of these Consolidated Financial Statements.

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INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For the Six Months Ended June 30, 2005
                                         
    Common Stock     Paid-in     Accumulated     Stockholders'  
    Shares     Amount     Capital     Deficit     Equity  
    (dollars in thousands)  
 
                                       
Balance, January 1, 2005 (Restated)
    1,389,345     $ 14     $ 61,983     $ (18,707 )   $ 43,290  
 
                                       
Common Stock Dividends
    2,778,690       28       (28 )            
 
                                       
Net income
                      833       833  
 
                             
 
                                       
Balance, June 30, 2005
    4,168,035     $ 42     $ 61,955     $ (17,874 )   $ 44,123  
 
                             
The accompanying notes are an integral part of these Consolidated Financial Statements.

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INCOME OPPORTUNITY REALTY INVESTORS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
                 
    For the Six Months  
    Ended June 30,  
    2005     2004  
            (Restated)  
    (dollars in thousands)  
Cash Flows from Operating Activities
               
Net income/(loss)
  $ 833     $ 2,848  
Reconciliation of net income (loss) to net cash used by operating activities
               
Adjustments to reconcile net income (loss) to net cash used in operating activities
               
Depreciation and amortization
    482       636  
Gain on sale of real estate
          (3,674 )
Loss (gain) on equity partnerships
    28       (11 )
Increase in interest receivable
    (543 )     (317 )
Decrease (Increase) in other assets
    232       (1,876 )
Increase in interest payable
    45       15  
(Decrease) increase in other liabilities
    (553 )     231  
 
           
Net cash provided by (used in) operating activities
    524       (2,148 )
 
               
Cash Flows from Investing Activities
               
Proceeds from sale of real estate
          3,444  
Advances from (payments to) advisor and affiliates
    1,436       (2,057 )
 
           
 
               
Net cash provided by (used in) investing activities
    1,436       1,387  
 
               
Cash Flows from Financing Activities
               
Payments on notes payable
  $ (1,917 )   $ (462 )
Proceeds on notes payable
          1,193  
Deferred financing costs
          90  
 
           
Net cash (used in) provided by financing activities
    (1,917 )     821  
 
               
Net increase in cash and cash equivalents
  $ 43     $ 60  
Cash and cash equivalents, beginning of period
    399       58  
 
           
Cash and cash equivalents, end of period
  $ 442     $ 118  
 
           
 
               
Supplemental Disclosures of Cash Flow Information
               
Cash paid for interest
  $ 1,727     $ 2,232  
Note receivable from sale of real estate
          2,990  
The accompanying notes are an integral part of these Consolidated Financial Statements.

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INCOME OPPORTUNITY INVESTORS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF PRESENTATION
The accompanying Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. Operating results for the six-month period ended June 30, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the Consolidated Financial Statements and notes thereto included in IORI’s Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004 Form 10-K”). Dollar amounts in tables are in thousands, except per share amounts.
Certain balances for 2004 have been reclassified to conform to the 2005 presentation in order to properly account for the discontinued operations, the issuance of 3-for-1 stock dividends, and the correction of the accounting error in the financial statements related to formation of certain partnerships with Metra Capital LLC in April 2002, which error evolved in the establishment of the process relating to accounting for a deferral of operating income or expense from the properties in question until the sale of the applicable property; the error correction necessitates the changes described below:
    Decrease in interest expense by $15,000 for the three months ended June 30, 2004.
 
    Decrease in advisory fee by $1,000 for the three months ended June 30, 2004.
 
    Increase in interest expense by $125,000 for the six months ended June 30, 2004.
 
    Decrease in advisory fee by $2,000 for the six months ended June 30, 2004.
NOTE 2. REAL ESTATE
The following tables compare properties sold during the second quarter ended in 2005 and 2004.
For the second quarter ended June 30, 2005, IORI did not sell any properties.
For the second quarter ended June 30, 2004, IORI sold the following properties:
                                                 
                    Sales     Net Cash     Debt     Gain  
Property   Location     Units/Sq.Ft.     Price     Received     Discharged     on Sale  
 
                                               
Apartment Building
                                               
Treehouse (1)
  Irving, TX
  160 Units   $ 8,017       ($498 )   $ 5,018     $ - (2)
Commercial Building
                                               
Akard Plaza
  Dallas, TX
  42,258 Sq.Ft.   $ 3,900     $ 2,007     $ 1,849     $ 417  
 
(1)   Property sold to TCI, a related party, for assumption of debt and a note receivable, less $498,000 in cash paid.
 
(2)   Excludes a $56,000 deferred gain from a related party sale.
NOTE 3. NOTES AND INTEREST RECEIVABLE
Junior Mortgage Loans. Junior mortgage loans are loans secured by mortgages that are subordinate to one or more prior liens either on the fee or a leasehold interest in real estate. Recourse on the loans ordinarily includes the real estate which secures the loan, other collateral and personal guarantees of the borrower.

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NOTE 4. RECEIVABLE FROM AND PAYABLE TO AFFILIATES
Related Party. On September 19, 2002, IORI’s Board of Directors authorized the Chief Financial Officer of the Company to advance funds either to or from the Company, through the advisor without interest, in an amount up to $5.0 million on the condition that such advances shall be repaid in cash or transfers of assets within 90 days. From time-to-time, IORI and its affiliates and related parties have made unsecured advances to each other to fund their respective operations, which generally have not had specific repayment terms and have been reflected in IORI’s financial statements as other assets. IORI had payables of $2.4 million and $1.3 million to Syntek West, Inc. (“SWI”), $22,000 and $-0- to Prime Income Asset Management, Inc. (“Prime”), and receivables of $-0- and $261,000 from Transcontinental Realty Investors, Inc. (“TCI”) at June 30, 2005 and December 31, 2004, respectively. See also NOTE 6. “RELATED PARTY TRANSACTIONS”.
NOTE 5. NOTES AND INTEREST PAYABLE
In April 2002, the Company transferred all of its residential properties to partnerships formed with Metra Capital LLC (“Metra”). The properties included the 60-unit Brighton Court, the 92-unit Del Mar, the 68-unit Enclave, the 280-unit Meridian, the 57-unit Signature, and the 114-unit Sinclair, all located in Midland, Texas, and the 106-unit Treehouse located in San Antonio, Texas. Innovo Realty, Inc., a subsidiary of Innovo Group, Inc. (“Innovo”) is a limited partner in the partnerships that purchased the properties. A former director of American Realty Investors, Inc. (“ARI”), a related party, controlled approximately 11.67% of the outstanding common stock of Innovo. The transfer constituted 23% of the total assets of the Company as of December 31, 2001. The transfer price for the properties totaled $26.2 million, of which the Company received $5.3 million in cash after the payment of $15.9 million in debt and various closing costs. Management determined to account for the transaction as a refinancing transaction (rather than a sale) in accordance with SFAS 66 “Accounting for Sales of Real Estate.” At the time of the transaction in April 2002, ARI was a related party to the Company by virtue of ARI’s subsidiaries’ ownership of approximately 28.5% of the then outstanding common stock of the Company, and the fact that ARI and the Company had the same persons as executive officers. The compensation price for the properties transferred totaled $26.2 million and possible additional contingent consideration depending upon the sale price of the properties by the Metra partnerships. The Company also received $5.2 million in value of 8% non-recourse, non-convertible preferred stock of Innovo. Based upon the prospect of additional consideration, ultimate continued involvement through the preferred stock and the related-party nature of the former ARI director’s involvement, as well as the Company retaining a right to approve the price of any ultimate sale by a Metra partnership of the properties, and a process by which the Company effectively guaranteed a preferential return to the Metra investors, management determined that the transaction must be classified as a financing transaction and not a sale. The Company continued to be able to exert control over the Metra partnerships, and no sale was recorded. The Treehouse property was subsequently sold to a non-related party in February 2004, and all of its debts have been repaid to the lenders at the time of the sale. During August 2004, certain entities, including the Company, instituted an action in a Texas state court against Innovo and Metra and others over the process, as well as distribution questions. During April 2005, a resolution of the litigation occurred settling all liabilities remaining from the original partnership arrangements which included a return of the Metra investor equity, prepayment of prospective asset management fees and miscellaneous fees and transaction costs from the Company and the other plaintiffs as a payment of the Preferential Return along with the delegation of management to another entity. Of the payment made, the Company has recognized expense of $56,000 and a reduction of $1,476,000 in liabilities during the second quarter of 2005.
NOTE 6. RELATED PARTY TRANSACTIONS
Prior to the time of settlement with Metra in April 2005 as mentioned in “NOTE 5. NOTES AND INTEREST PAYABLE,” IORI had been under a contractual agreement to pay a management fee, a cumulative annual amount of .5% of the average outstanding balance of the mortgage indebtedness secured by the properties, each to Metra and Innovo. Per the settlement, IORI’s obligation to pay the management fee to Metra has been delegated to Prime. ARI, TCI, and IORI acquired Innovo whose name was changed to Midland Odessa Properties, Inc. (“MOPI”). ARI paid $475,000 to acquire from IORI an additional 9.05% ownership of MOPI, which reduced IORI’s ownership interest in MOPI to 19.9%.

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The following table reconciles the beginning and ending balances of Accounts Receivable from Affiliates as of June 30, 2005.
                                 
    SWI     Prime     ARI     TCI  
 
                               
Balance, December 31, 2004
  $ (1,248 )   $     $     $ 261  
Cash transfers
    5,112             475        
Cash repayments
    (5,863 )                 (261 )
Other additions
                       
Other repayments
    (440 )     (22 )     (475 )      
 
                       
Balance, June 30, 2005
  $ (2,439 )   $ (22 )   $     $  
 
                       

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NOTE 7. OPERATING SEGMENTS
Significant differences among the accounting policies of the operating segments as compared to the Consolidated Financial Statements principally involve the calculation and allocation of general and administrative expenses. Management evaluates the performance of the operating segments and allocates resources to each of them based on their operating income and cash flow. Items of income that are not reflected in the segments are interest and equity in partnerships totaling $965,000 and $1.9 million for the three and six months ended June 30, 2005, and $616,000 and $1.2 million for the three and six months ended June 30, 2004. Expenses that are not reflected in the segments are general and administrative expenses, advisory fees, and net income fees totaling $404,000 and $725,000 for the three and six months ended June 30, 2005, and $411,000 and $1.1 million for the three and six months ended June 30, 2004. Excluded from operating segment assets are assets of $59.7 million at June 30, 2005 and $57.4 million at June 30, 2004, which are not identifiable with an operating segment. There are no intersegment revenues and expenses and all business is conducted in the United States.
Presented below is the operating income and assets of each operating segment.
                         
Three Months Ended   Commercial              
June 30, 2005   Properties     Apartments     Total  
                         
 
                       
Rents
  $ 374     $ 1,239     $ 1,613  
Property operating expenses
    215       610       825  
 
                 
Operating income (loss)
  $ 159     $ 629     $ 788  
 
                 
 
                       
Depreciation
  $ 112     $ 61     $ 173  
Interest
    143       190       562  
Real estate improvements
    36             36  
Assets
    12,952       18,147       31,099  
 
                       
Six Months Ended
                       
June 30, 2005
                       
 
                       
Rents
  $ 696     $ 2,446     $ 3,142  
Property operating expenses
    426       1,220       1,646  
 
                 
Operating income (loss)
  $ 270     $ 1,226     $ 1,496  
 
                 
 
                       
Depreciation
  $ 127     $ 223     $ 350  
Interest
    469       579       1,498  
Real estate improvements
                 
Assets
    12,952       18,147       31,099  

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Three Months Ended                          
June 30, 2004           Commercial              
(Restated)   Land     Properties     Apartments     Total  
                                 
 
                               
Rents
  $     $ 126 *   $ 896     $ 1,022 *
Property operating expenses
          -- *     449       449 *
 
                       
Operating income (loss)
  $     $ 126 *   $ 447     $ 573 *
 
                       
 
                               
Depreciation
  $     $ 47 *   $ 69     $ 116 *
Interest
    244       173 *     333 *     750 *
Real estate improvements
                       
Assets
    44       18,458       18,592       37,094  
 
                               
Six Months Ended                                
June 30, 2004                                
(Restated)                                
 
                               
 
                               
Rents
  $     $ 607 *   $ 2,310     $ 2,917 *
Property operating expenses
          334 *     1,272       1,606 *
 
                       
Operating income (loss)
  $     $ 273 *   $ 1,038     $ 1,311 *
 
                         
 
                               
Depreciation
  $     $ 163 *   $ 223     $ 386 *
Interest
    569       431 *     802 *     1,802 *
Real estate improvements
                       
Assets
    44       18,458       18,592       37,094  
 
*   These are the restated numbers which reflect corrections for the discontinued operations, the issuance of 3-for-1 stock dividends and the accounting error related to a deferral of operating income and/or expense. See “NOTE 1. BASIS OF PRESENTATION”.
NOTE 8. ADVISORY FEES, PROPERTY MANAGEMENT, ETC.
Revenue, fees and cost reimbursements to its advisors and affiliates for the six months ended:
                 
    For the Six Months  
    Ended June 30,  
    2005     2004  
            (Restated)  
 
               
Fees
               
Advisory
  $ 337     $ 393  
Net income
    67       245  
Property and construction management and leasing commission
    44       78  
 
           
 
  $ 448     $ 716  
 
           
 
               
Cost reimbursements
  $ 36     $ 36  
 
           

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NOTE 9. DISCONTINUED OPERATIONS
Effective January 1, 2002, IORI adopted Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which established a single accounting model for the impairment or disposal of long-lived assets including discontinued operations. This statement requires that the operations related to properties that have been sold, or properties that are intended to be sold, be presented as discontinued operations in the statement of operations for all periods presented, and the properties intended to be sold are to be designated as “held for sale” on the balance sheet. In the event of a future asset sale, IORI is required to reclassify portions of previously reported operations to discontinued operations within the Statements of Operations. No property was sold during the six months ended June 30, 2005. The following table summarizes revenue and expense information for the properties sold.
                                 
    For the Three Months     For the Six Months  
    Ended June 30,     Ended June 30,  
Revenue   2005     2004     2005     2004  
 
                               
Rental
  $     $ 1,076     $     $ 1,485  
Property Operations
          639             865  
 
                       
Operating income
          437             620  
 
                               
Expense
                               
Interest
          262             447  
Depreciation
          174             251  
 
                       
Total expenses
          436             698  
 
                               
Net gain from discontinued operations before gains on sale of operations
          1             (78 )
 
                               
Gain on sale of operations
          417             3,674  
 
                       
 
                               
Net income/(loss) from discontinued operations
  $     $ 418     $     $ 3,596  
 
                       
Discontinued operations have not been segregated in the consolidated statement of cash flows. Therefore, amounts for certain captions will not agree with respective consolidated statements of operations.
NOTE 10. COMMITMENTS AND CONTINGENCIES
Liquidity. Management anticipates that IORI will generate excess cash from operations in 2005 due to increased rental rates and occupancy at its properties, however, such excess may not be sufficient to discharge all of IORI’s debt obligations as they mature. Management may selectively sell income producing assets, refinance real estate and/or incur additional borrowings against real estate to meet its cash requirements.
Other Litigation. IORI is also involved in various other lawsuits arising in the ordinary course of business. Management is of the opinion that the outcome of these lawsuits will have no material impact on the Company’s financial condition, results of operations or liquidity.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
IORI invests in equity interests in real estate through acquisitions, leases and partnerships and also invests in mortgage loans. IORI is the successor to a California business trust organized on December 14, 1984, which commenced operations on April 10, 1985.
Critical Accounting Policies
Critical accounting policies are those that are both important to the presentation of IORI’s financial condition and results of operations and require management’s most difficult, complex or subjective judgments. IORI’s critical accounting policies relate to the evaluation of impairment of long-lived assets and the evaluation of the collectibility of accounts and notes receivable.
If events or changes in circumstances indicate that the carrying value of a rental property to be held and used or land held for development may be impaired, management performs a recoverability analysis based on estimated undiscounted cash flows to be generated from the property in the future. If the analysis indicates that the carrying value is not recoverable from future cash flows, the property is written down to estimated fair value and an impairment loss is recognized. If management decides to sell rental properties or land held for development, management evaluates the recoverability of the carrying amounts of the assets. If the evaluation indicates that the carrying value is not recoverable from estimated net sales proceeds, the property is written down to estimated fair value less costs to sell and an impairment loss is recognized within income from continuing operations. IORI’s estimates of cash flow and fair values of the properties are based on current market conditions and consider matters such as rental rates and occupancies for comparable properties, recent sales data for comparable properties and, where applicable, contracts or the results of negotiations with purchasers or prospective purchasers. IORI’s estimates are subject to revision as market conditions and IORI’s assessments of them change.
IORI’s allowance for doubtful accounts receivable and notes receivable is established based on analysis of the risk of loss on specific accounts. The analysis places particular emphasis on past due accounts. Management considers such information as the nature and age of the receivable, the payment history of the tenant or other debtor, the financial condition of the tenant or other debtor and IORI’s assessment of its ability to meet its lease or interest obligations. IORI’s estimate of the required allowance, which is reviewed on a quarterly basis, is subject to revision as these factors change and is sensitive to the effects of economic and market conditions. Typically, IORI’s notes receivable are collateralized by income producing real estate. IORI had notes receivable of $55.6 million at June 30, 2005 and $54.9 million at December 31, 2004.
Liquidity and Capital Resources
Cash and cash equivalents at June 30, 2005 were $442,000, compared with $399,000 at December 31, 2004. IORI’s principal sources of cash have been and will continue to be property operations, proceeds from asset sales, interest earned on notes receivable, financings and refinancings and partnership distributions. Management anticipates that IORI will generate excess cash from operations in 2005 due to increased rental receipts at its properties; however, such excess may not be sufficient to discharge all of IORI’s debt obligations as they mature. Management may selectively sell income producing assets, refinance real estate and/or incur additional borrowings against real estate to meet its cash requirements.
The Company reported net income of $833,000 for the six months ended June 30, 2005, which included the following changes: depreciation and amortization of $482,000, decreases in other assets of $232,000, increases in interest receivable of $543,000, increases in interest payable of $45,000, loss on equity partnership of $28,000, and decreases in other liabilities of $553,000. Net cash provided by operating activities amounted to $524,000 for the six months ended June 30, 2005. During the six months ended June 30, 2005, the decrease in other liabilities was primarily due to a decrease in accrued property taxes and the decrease in other assets was primarily due to a decrease in deposits, deferred borrowing costs, and accounts receivable. Net cash provided by investing activities of $1.2 million was the advances from SWI and the repayments from TCI. Net cash used in financing activities of $1.9 million was the payments on notes payable.
Management reviews the carrying values of IORI’s properties at least annually and whenever events or a change in circumstances indicate that impairment may exist. Impairment is considered to exist if, in the case of a property, the future cash flow from the property (undiscounted and without interest) is less than the carrying amount of the property.

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If impairment is found to exist, a provision for loss is recorded by a charge against earnings. The property review generally includes selective property inspections, discussions with the manager of the property, visits to selected properties in the area and a review of the following: (1) the property’s current rents compared to market rents, (2) the property’s expenses, (3) the property’s maintenance requirements and (4) the property’s cash flows.
Results of Operations
IORI had net income of $594,000 for the three months ended June 30 2005, and net income of $833,000 for the six months ended June 30, 2005, as compared to net income of $334,000 and $2.8 million for the corresponding periods in 2004. The net income in 2004 included gains on sale of real estate totaling $3.7 million whereas no property was sold in 2005. Fluctuations in components of revenue and expense between the 2005 and 2004 periods are discussed below.
Rents in the three and six months ended June 30, 2005 were $1.6 million and $3.1 million versus $1.0 million and $2.9 million in the corresponding periods in 2004. Rental income during the remaining periods of 2005 is expected to increase if IORI purchases more properties.
Property operations expense in the three and six months ended June 30, 2005 were $825,000 and $1.6 million versus $449,000 and $1.6 million in the corresponding periods in 2004. The decreases in 2005 were primarily due to the sale of three properties in 2004. Property operations expense is expected to increase during the remaining quarters of 2005 if IORI purchases more properties.
Interest income in the three and six months ended June 30, 2005 was $984,000 and $2.0 million versus $605,000 and $1.2 million in the corresponding periods in 2004. The increase in 2005 from 2004 was due to additional interest earned from the additional notes receivable obtained from affiliates of IORI. Interest income is expected to exceed the previous year in the remaining quarters of 2005 due to the increase in notes receivable during 2004.
Interest expense in the three and six months ended June 30, 2005 was $562,000 and $1.5 million versus $750,000 and $1.8 million in the corresponding periods in 2004. The decrease in 2005 from 2004 was primarily due to the retirement of four notes payable from sale of properties during 2004.
Depreciation expense in the three and six months ended June 30, 2005 was $173,000 and $350,000 versus $116,000 and $386,000 in the corresponding periods in 2004. The decrease in 2005 from 2004 was due to sale of properties and fully depreciated tenant improvements in 2004.
Advisory fee to affiliate in the three and six months ended June 30, 2005 was $170,000 and $337,000 versus $201,000 and $393,000 in the corresponding periods in 2004. The decrease in 2005 from 2004 was due to changes in gross assets, the basis of the fee. See NOTE 8. “ADVISORY FEES.”
Net income fee to affiliate was $67,000 for the six months ended June 30, 2005. Net income fee is based on 7.5% of IORI’s net income.
General and administrative expense in the three and six months ended June 30, 2005 was $199,000 and $341,000 versus $179,000 and $446,000 in the corresponding periods in 2004. The decrease in 2005 from 2004 was primarily due to a decrease in property insurance and rental expense.
Related Party Transactions
Historically, IORI, ARI, Regis Realty I, LLC (“Regis I”), and TCI have each engaged in and may continue to engage in business transactions, including real estate partnerships with related parties. Management believes that all of the related party transactions represented the best investments available at the time and were at least as advantageous to IORI, ARI, Regis I, and TCI as could have been obtained from unrelated third parties.
Taxes
For the tax years prior to 2003, IORI elected and qualified to be treated as a Real Estate Investment Trust (“REIT”), as defined in Sections 856 and 860 of the Internal Revenue Code of 1986, as amended (the “Code”), and as such was not taxed for federal income tax purposes on that portion of its taxable income which is distributed to stockholders.

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Due to the completion of a tender offer by ARI, an affiliate, and the resulting concentration of ownership, IORI no longer met the requirements for tax treatment as a REIT under the Code as of January 1, 2003, and is prohibited for re-qualifying for REIT status for at least five years.
Financial statement income varies from taxable income principally due to the accounting for income and losses of investees, gains and losses from asset sales, depreciation on owned properties, amortization of discounts on notes receivable and payable and the difference in the allowance for estimated losses. IORI had a loss for federal income tax purposes in the second quarter of 2005 and a loss for federal income tax purposes after the use of net operating loss carryforwards in the second quarter of 2004; therefore, it recorded no provision for income taxes.
At June 30, 2005, IORI had a net deferred tax asset of approximately $1.8 million due to tax deductions available to it in future years. However, as management cannot determine that it is more likely than not that IORI will realize the benefit of the deferred tax asset, a 100% valuation allowance has been established.
Inflation
The effects of inflation on IORI’s operations are not quantifiable. Revenues from apartment operations tend to fluctuate proportionately with inflationary increases and decreases in housing costs. Fluctuations in the rate of inflation also affect the sales value of properties and the ultimate gain to be realized from property sales. To the extent that inflation affects interest rates, earnings from short-term investments and the cost of new financings, as well as the cost of variable interest rate debt, will be affected.
Environmental Matters
Under various federal, state and local environmental laws, ordinances and regulations, IORI may be potentially liable for removal or remediation costs, as well as certain other potential costs, relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos-containing materials into the air and third parties may seek recovery for personal injury associated with such materials.
Management is not aware of any environmental liability relating to the above matters that would have a material adverse effect on IORI’s business, assets or results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES REGARDING MARKET RISK
At June 30, 2005, IORI’s exposure to a change in interest rates on its debt is as follows:
                         
            Weighted     Effect of 1%  
            Average     Increase In  
    Balance     Interest Rate     Base Rates  
Wholly-owned debt:
                       
Variable rate
  $ 9,425       8.23 %   $ 94  
 
                   
 
                       
Total decrease in IORI’s annual
                       
Net income
                  $ 94  
 
                     
 
                       
Per share
                  $ 0.02  
 
                     

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ITEM 4. CONTROLS AND PROCEDURES
Based upon their most recent evaluation, which was completed as of the end of the period covered by this Report, the Acting Principal Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at June 30, 2005, to ensure that information required to be disclosed in reports that the Company files or submits under the Securities Exchange Act of 1934, is recorded, processed, summarized and reported within the time period specified in Securities and Exchange Commission rules and forms. There were no changes in the Company’s internal controls over financial reporting during the quarter ended June 30, 2005, except as described in the following paragraph that have materially affected or are reasonably likely to materially affect the Company’s internal controls over financial reporting.
However, the Company and its accountants identified a control deficiency in its internal controls over financial reporting as of April 2002 which continued undetected through March 2005, which constituted a “material weakness” within the meaning of the Public Company Accounting Oversight Board Auditing Standard No. 2. A “material weakness” is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of annual or interim financial statements will not be prevented or detected. The material weakness related to the Company’s accounting for the “Metra” transaction in April 2002, which included a deferral of operating income and/or expense until the time of ultimate sale of a property to an independent third party purchaser. As a result, an error was discovered that affected the consolidated balance sheet, consolidated statement of operations, consolidated statements of stockholders’ equity, and consolidated statements of cash flows for 2002 and subsequent periods. The amounts for 2002 were not material, but the amounts for 2003 were material which causes the need for correction of the 2003 financial statements. Management undertook exhaustive efforts to obtain relevant financial records to support the correction of error as of June 30, 2005 and concluded that the financial statements were improperly stated for such periods. In response to the material weakness, Management
     (i) is continuing to re-evaluate its control procedures with the assistance of an outside consulting firm that specializes in internal control procedures,
     (ii) has concluded that at a minimum, Management will, beginning August 1, 2005, review all material historical transactions and supporting documents that could have a continuing impact upon any current reporting periods,
     (iii) will review quarterly on a sampling basis non-material historical transactions that are included in financial statements for any current reporting period,
     (iv) will continue the process of reviewing all current transactions included in current reporting period financial statements, and
     (v) believes that the transaction involving the error was uniquely complex and is not likely to be repeated, but Management is working with its outside consultant for guidance about other possible control procedures to ensure that in the future, errors will be detected and material misstatement of annual or interim financial statements will be prevented.
WARNING CONCERNING FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q and IORI’s 2004 Form 10-K, referred to herein, contain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and federal securities laws. These statements concern the intent, belief or expectations of IORI’s officers with respect to IORI’s ability to lease its properties, tenant’s ability to pay rents, purchase of additional properties, ability to pay interest and debt principal and make distributions, policies and plans regarding investments and financings, and other matters. Also, words such as “believe”, “expect”, “anticipate”, “intend”, “plan”, “estimate”, or similar expressions identify forward looking statements. Actual results may differ materially from those contained in or implied by the forward looking statements as a result of various factors. Such factors include, without limitation, the impact of changes in the economy and the capital markets on IORI and its tenants, competition within the real estate industry or those industries in which its tenants operate, and changes in federal, state and local legislation. For example: Some of IORI’s tenants may not renew expiring leases and IORI may be unable to locate new tenants to maintain the historical occupancy rates of the properties; rents which IORI can achieve at its properties may decline; tenants may experience losses and become unable to pay rents; and IORI may be unable to identify or to negotiate

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acceptable purchase prices for new properties. These results could occur due to many different circumstances, some of which, such as changes in IORI’s tenants’ financial conditions or needs for leased space, or changes in the capital markets or the economy, generally, are beyond IORI’s control. Forward looking statements are only expressions of IORI’s present expectations and intentions. Forward looking statements are not guaranteed to occur, and they may not occur. You should not place undue reliance upon forward looking statements.

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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Innovo Realty, Inc. On August 10, 2004, three entities, including the Income Opportunity Realty Investors, Inc. (the “Company”), instituted an action in Texas State District Court as Cause No. 2004-60231-393 styled American Realty Investors, Inc., Transcontinental Realty Investors, Inc. and Income Opportunity Realty Investors, Inc., Plaintiffs v. Innovo Realty, Inc. and Innovo Group, Inc., Involuntary Plaintiffs v. Innovo Realty, Inc., Metra Capital LLC, Innovo Group, Inc., Joseph Mizrachi, Simon Mizrachi, Herbert Guez, Third Millennium Partners LLC, Third Millennium Partners, Inc., Third Millennium Group LLC and Sunridge Management, Inc., Defendants. The Plaintiffs’ complaint alleges that a former director of American Realty Investors, Inc. (“ARI”), and others, offered a plan to the Plaintiffs to create one or more joint venture arrangements with one or more of the Plaintiffs to pursue alternative forms of financing or refinancing portions of Plaintiffs’ real estate portfolios, which entailed the creation of 22 separate limited partnerships to acquire 28 separate apartment complexes in three states (Texas, Florida and Louisiana), the general partners of which are affiliates of, or are controlled by, the former director of ARI. During April 2005, a resolution of the litigation occurred, settling all liabilities remaining from the original partnership arrangements, which included a return of investor equity, prospective asset management fees and miscellaneous fees and transaction costs from the Company and the other Plaintiffs as payment of a Preferred Return, along with the delegation of management to another entity. Of the payment, the Company has recognized a settlement expense of $56,000, and a reduction of $1,476,000 in liabilities during the second quarter of 2005.
There have been no material developments in other previously reported items of litigation during the quarter ended June 30, 2005. The ownership of property and provision of services to the public as tenants entails an inherent risk of liability, although the Company and its subsidiaries are involved in various items of litigation incidental to and in the ordinary course of its business, in the opinion of management, the outcome of such litigation will not have a material adverse impact upon the Company’s financial condition, results of operation or liquidity.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(c) During the period of time covered by this Report, the Company did not repurchase any of its equity securities. The following table sets forth a summary by month for the quarter indicating no repurchases were made, and that at the end of the period covered by this Report, a specified number of shares may yet be purchased under the program specified below:
                                 
                    Total Number of        
                    Shares     Maximum Number  
                    Purchased as     of Shares that May  
    Total Number of     Average Price     Part of Publicly     Yet be Purchased  
    Shares     Paid per     Announced     Under the  
Period   Purchased     Share     Program     Program(1)  
April 1-30, 2005
    ¯     $ ¯       ¯       ¯  
May 1-31, 2005
    ¯       ¯       ¯       ¯  
June 1-30, 2005
    ¯       ¯       ¯       ¯  
 
                       
Total
    ¯     $ ¯       ¯       31,596  
 
                       
 
(1)   On September 23, 2000, the IORI Board of Directors approved a share repurchase program for up to 300,000 shares of our common stock. This repurchase program has no termination date.

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ITEM 6. EXHIBITS
     The following exhibits are filed herewith or incorporated by reference as indicated below:
     
Exhibit No.   Exhibit Designation
3.0
  Articles of Incorporation of Income Opportunity Realty Investors, Inc. (incorporated by reference to Appendix C to the Registrant’s Registration Statement on Form S-4 dated February 12, 1996).
3.1
  Bylaws of Income Opportunity Realty Investors, Inc. (incorporated by reference to Appendix D to the Registrant’s Registration Statement on Form S-4 dated February 12, 1996).
31.1*
  Certification pursuant to Rule 13a-14 and 15d-14 under the Securities Exchange Act of 1934
32.1*
  Certification pursuant to 18 U.S.C. 1350.
 
    *Filed herewith.

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SIGNATURE PAGE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  INCOME OPPORTUNITY REALTY INVESTORS, INC.
 
Date: August 15, 2005  By:   /s/ Robert N. Crouch II    
    Robert N. Crouch II   
    Executive Vice President, Chief Financial Officer, and Acting Principal Executive Officer   
 

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INCOME OPPORTUNITY REALTY INVESTORS, INC.
EXHIBITS TO
QUARTERLY REPORT ON FORM 10-Q
For the Quarter ended June 30, 2005
         
Exhibit       Page
Number   Description   Number
 
       
31.1
  Certification Pursuant to Rules 13a-14 and 15d-14 Under the Securities Exchange Act of 1934.    
 
       
32.1
  Certification Pursuant to 18 U.S.C. Section 1350.