10-Q 1 d60440_10-q.txt QUARTERLY REPORT -------------------------- OMB APPROVAL -------------------------- OMB Number: 3235-0070 Expires: March 31, 2006 Estimated average burden hours per response: 192.00 -------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 or |_| 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 0-19244 Krupp Government Income Trust (Exact name of registrant as specified in its charter) Massachusetts 04-3089272 (State or jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) One Beacon Street, Boston, Massachusetts 02108 (Address of principal executive offices) (Zip Code) (617) 523-0066 (Registrant's telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| SEC 1296 (01-04) Potential persons who are to respond to the collection of information contained in this form are not required to respond unless the form displays a currently valid OMB control number. -1- Part I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. When used in this Form 10-Q, the words "believes," "anticipates," "expects," "plans," "intends," "estimates," "continue," "may" or "will" (or the negative of such words) and similar expressions are intended to identify forward-looking statements. Such statements are subject to a number of risks and uncertainties, including but not limited to the following: federal, state or local regulations; adverse changes in general economic or local conditions; pre-payments of mortgages; failure of borrowers to pay participation interests due to poor operating results of properties underlying the mortgages; uninsured losses and potential conflicts of interest between the Trust and its Affiliates, including the Trustees. The Company's filings with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the year ended December 31, 2003, contain additional information concerning such risk factors. Actual results in the future could differ materially from those described in any forward-looking statements as a result of the risk factors set forth above, and the risk factors described in the Annual Report. -2- KRUPP GOVERNMENT INCOME TRUST BALANCE SHEETS ASSETS

The accompanying notes are an integral part of the financial statements. -3- KRUPP GOVERNMENT INCOME TRUST STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

The accompanying notes are an integral part of the financial statements. -4- KRUPP GOVERNMENT INCOME TRUST STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of the financial statements. -5- KRUPP GOVERNMENT INCOME TRUST NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in this report on Form 10-Q pursuant to the Rules and Regulations of the Securities and Exchange Commission. However, in the opinion of Berkshire Mortgage Advisors Limited Partnership (the "Advisor"), which is the advisor to Krupp Government Income Trust (the "Trust"), the disclosures contained in this report are adequate to make the information presented not misleading. See Notes to Financial Statements in the Trust's Form 10-K for the year ended December 31, 2003 for additional information relevant to significant accounting policies followed by the Trust. In the opinion of the Advisor of the Trust, the accompanying unaudited financial statements reflect all adjustments (consisting of only normal recurring accruals) necessary to present fairly the Trust's financial position as of June 30, 2004, its results of operations for the three and six months ended June 30, 2004 and 2003 and its cash flows for the six months ended June 30, 2004 and 2003. The results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of the results which may be expected for the full year. See Management's Discussion and Analysis of Financial Condition and Results of Operations included in this report. 2. PIMIs At June 30, 2004, the Trust's remaining PIMI had a fair value of $9,046,653. Fair value of the FHA insured first mortgage is based on MBS with similar interest rates or on expected payoff proceeds. Fair value includes the estimated collection value of the Additional Loan. Fair value does not include any value for the participation features. The remaining PIMI matures in 2034. At June 30, 2004, the remaining PIMI was not delinquent as to principal or interest. Mountain View has been adversely affected by the competitive rental housing market. Based on the Advisor's analysis of market conditions and property operations and their effect on the property's value, the Trust maintains a valuation allowance of $1,032,617 for Mountain View. Between the valuation allowance and the related deferred income on the Additional Loans liability account, the Mountain View additional loan has been effectively fully reserved. 3. MBS At June 30, 2004, the Trust's MBS portfolio had an amortized cost of $1,267,195 and unrealized gains of $124,370. The portfolio has maturities ranging from 2008 to 2023. 4. Operating Expense Limitation Per Article VI, Section 5 of the Declaration of Trust, the total annual operating expenses of the Trust may not exceed the greater of 2% of the average invested assets of the Trust or 25% of the Trust's net income. These tests are calculated each quarter by the Advisor based on the prior twelve months of activity. In order for the Trust to be in compliance with this requirement, the Advisor reduced the operating expenses for the twelve months ended June 30, 2004 by $414,276. -6- 5. Changes in Shareholders' Equity A summary of changes in shareholders' equity for six months ended June 30, 2004 is as follows:

-7- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the financial statements and accompanying notes contained in the Trust's 2003 Annual Report on Form 10-K and in this report on Form 10-Q. Certain statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report on Form 10-Q constitute "forward-looking statements" within the meaning of the Federal Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the Trust's actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. These factors include, among other things, federal, state or local regulations; adverse changes in general economic or local conditions; the inability of the borrower to meet financial obligations on additional loans; pre-payments of mortgages; failure of borrowers to pay participation interests due to poor operating results at properties underlying the mortgages; uninsured losses and potential conflicts of interest between the Trust and its Affiliates, including the Advisor. Liquidity and Capital Resources At June 30, 2004, the Trust had liquidity consisting of cash and cash equivalents of approximately $1.4 million as well as the cash inflows provided by the remaining PIMI, MBS and cash and cash equivalents. The Trust may also receive additional cash flow from the participation features of its remaining PIMI. The Trust anticipates that these sources will be adequate to provide the Trust with sufficient liquidity to meet its obligations, including providing dividends to its investors. The most significant demand on the Trust's liquidity is the quarterly dividend paid to investors of approximately $300,000, which represents the current dividend rate of $0.02 per Share. Funds for dividends come from interest income received on the remaining PIMI, MBS and cash and cash equivalents, net of operating expenses, and the principal collections received on the remaining PIMI and MBS. The portion of dividends funded from principal collections and cash reserves reduces the capital resources of the Trust. As the capital resources of the Trust decrease, the total cash flows to the Trust will also decrease, which may result in periodic adjustments to the dividends paid to the investors. The Advisor periodically reviews the dividend rate to determine whether an adjustment is necessary based on projected future cash flows. The current dividend rate is $0.02 per Share per quarter. The Trustees, based on the Advisor's recommendations, generally set a dividend rate that provides for level quarterly dividends. To the extent quarterly dividends do not fully utilize the cash available for distribution and cash balances increase, the Advisor may adjust the dividend rate or distribute such funds through a special dividend. In addition to providing guaranteed or insured monthly principal and interest payments from the insured first mortgage, the Trust's investment in the remaining PIMI also may provide additional income through the interest on the Additional Loan portion of the PIMI as well as participation interest based on operating cash flow and an increase in the value realized upon the sale or refinance of the underlying property. However, collection of the Additional Loan principal and interest from the participation feature is neither guaranteed nor insured and depends upon the successful operation of the underlying property. The remaining PIMI investment, Mountain View, operates under a workout agreement, its second workout with the Trust. The Mountain View agreement modified the borrower's obligation to make Additional Loan interest payments, regardless of whether the property generates sufficient revenues to do so, to an obligation to pay Additional Loan interest only if the property generates Surplus Cash, as defined by HUD. For the underlying property's fiscal year ending December 31, 2003, Mountain View did not generate any Surplus Cash. Mountain View has experienced problems due to competitive market conditions. In June 1999, the Trust approved a second workout of Mountain View. Under its terms, the Trust agreed to reduce the effective interest rate on the insured first mortgage by 1.25% retroactively for 1999 and each year thereafter until 2004, and to change the loan's participation terms. The workout eliminated the preferred return feature, forgave $288,580 of previous accruals of Additional Loan interest related to the first workout, and changed the Trust's participation in Surplus Cash generated by the property and its application towards Additional Loan interest. The Trust will receive 75% of the first $130,667 of Surplus Cash and 50% of any remaining Surplus Cash on an annual basis to pay Additional Loan interest. Unpaid Additional Loan interest related to the second workout will accrue and be payable if there are sufficient proceeds from a sale or refinancing of the property. In addition, the borrower repaid $153,600 of the Additional Loan and funded approximately $54,000 to a reserve for property improvements. The Mountain View Additional Loan was scheduled to mature in September 2003. When the Trust entered into the second workout agreement in the June 1999, it was the Trust's intention to extend the maturity date of the Additional Loan to coincide with the -8- expiration date of the interest rebate in December 2004. While reviewing the existing Additional Loan Agreement, the Advisor noted that the maturity date of the Additional Loan was not updated at the time of the second workout agreement. On September 8, 2003, the Advisor entered into a third modification with the borrower to extend the maturity date to December 31, 2004 to correct this oversight. Under the restructuring described above, management determined that the new interest rate level of the loan was at or above the then prevailing rate for similar instruments and therefore did not meet the criteria for a troubled debt restructuring. Accordingly, the restructuring and new rate was accounted for prospectively and not as a troubled debt restructuring. Operating results at Mountain View peaked in 2001, but have deteriorated since then. Occupancy has been affected by local economic conditions. These factors have made the rental market much more competitive for apartment owners, and the use of concessions to attract potential renters has increased throughout the market. Consequently, rental income decreased in 2002 and did not significantly improve in 2003. Additionally, both insurance costs and real estate taxes have increased significantly, which have further deteriorated operating results. As a result of the factors described above, the Trust maintains a valuation allowance for Mountain View of $1,032,617. Between the valuation allowance and the related deferred income on Additional Loans liability account, Mountain View Additional loan has been effectively fully reserved. Whether the operating performance of Mountain View provides sufficient cash flow from operations to pay either the Additional Loan principal and interest or participation income will depend on factors that the Trust has little or no control over. Should the property be unable to generate sufficient cash flow to pay the Additional Loan interest, it would reduce the Trust's distributable cash flow and continue to negatively affect the value of the Additional Loan collateral. The borrower has indicated that they are considering refinancing the property in 2004. There are no contractual restrictions on the repayment of the remaining PIMI. The participation feature and Additional Loan are neither insured nor guaranteed. If the prepayment of the PIMI results from the foreclosure on the underlying property or an insurance claim, the Trust would probably not receive any participation income or any amounts due under the Additional Loan. In the event that the Mountain View PIMI pays off, the Trust would then commence an orderly liquidation of the remaining assets of the Trust and subsequently pay a liquidating dividend. The invested assets of the Trust have declined significantly due to the number of prepayments of mortgage investments in 2002 and 2003. Net income has also declined over this period as a result of the prepayments. Per Article VI, Section 5 of the Declaration of Trust, the total annual operating expenses of the Trust may not exceed the greater of 2% of the average invested assets of the Trust or 25% of the Trust's net income. These tests are calculated each quarter by the Advisor based on the prior twelve months of activity. In order for the Trust to be in compliance with this requirement for the twelve months ended June 30, 2004, the Advisor reduced the operating expenses by $414,276. The application of these same tests in prospective quarters may, however, substantially change the amount of expenses to be recognized and the resulting amount due from affiliate. As a result, the timing and amount of the net payment received from the Advisor in 2004 could be determined by the timing of the potential Mountain View payoff. In the event that the remaining PIMI does not payoff as discussed above, the Trust does have the option to call this PIMI by accelerating the maturity. If the call feature is exercised, then the insurance feature of the loan would be canceled. Therefore, the Advisor will determine the merits of exercising the call option for the remaining PIMI as economic conditions warrant. Such factors as the condition of the asset, local market conditions, the interest rate environment and available financing will have an impact on these decisions. Critical Accounting Policies The Trust's critical accounting policies relate to revenue recognition related to the Trust's remaining PIMI investment, impaired mortgage loan, amortization of Prepaid Fees and Expenses and the carrying value of its MBS. The Trust's policies are as follows: The insured mortgage portion of the FHA PIMI is carried at amortized cost. The Trust holds these mortgages at amortized cost since they are fully insured by the FHA. The Additional Loan is carried at amortized cost unless the Advisor of the Trust believes there is an impairment in value, in which case a valuation allowance is established in accordance with the Financial Accounting Standards Board's Statement ("FAS") 114 "Accounting by Creditors for Impairment of a Loan" and FAS 118 "Accounting by Creditors for Impairment of a Loan- Income Recognition and Disclosures". The Trust, in accordance with FAS 115, "Accounting for Certain Investments in Debt and Equity Securities", classifies its MBS portfolio as available-for-sale. The Trust classifies its MBS portfolio as available-for-sale as a portion of the MBS portfolio may remain after the remaining PIMI pays off. It will be necessary to then sell the remaining MBS portfolio at that time in order to close out the Trust. In addition, other situations such as -9- liquidity needs could arise which would necessitate the sale of a portion of the MBS portfolio. As such, the Trust carries its MBS at fair market value and reflects any unrealized gains (losses) as a separate component of Shareholders' Equity. The Trust amortizes purchase premiums or discounts over the life of the underlying mortgages using the effective interest method. Basic interest is recognized based on the stated rate of the Department of Housing and Urban Development ("HUD") Insured Mortgage loan (less the servicer's fee) or the coupon rate of the Government National Mortgage Association ("GNMA") MBS. The Trust recognizes interest related to the participation features when the amount becomes fixed and the transaction that gives rise to such amount is finalized, cash is received and all contingencies are resolved. This could be the sale or refinancing of the underlying real estate, which results in a cash payment to the Trust or a cash payment made to the Trust from surplus cash relative to the participation feature. The Trust defers the recognition of Additional Loan interest payments as income to the extent these interest payments were from escrows established with the proceeds of the Additional Loan. When the properties underlying the PIMI's generate sufficient cash flow to make the required Additional Loan interest payments and the Additional Loan value is deemed collectible, the Trust recognizes income as earned and commences amortization of the deferred interest amounts into income over the remaining estimated term of the Additional Loan. During periods where mortgage loans are impaired the Trust suspends amortizing deferred interest. The Trust also fully reserves the portion of any Additional Loan interest payment satisfied through the issuance of an operating loan and any associated interest due on such operating loan. The Trust will recognize the income related to the operating loan when the borrower repays amounts due under the operating loan. Impaired loans are those Additional Loans which the Advisor believes that the collection of all amounts due in accordance with the contractual terms of the loan agreement are not likely. Impaired loans are measured based on the fair value of the underlying collateral net of estimated selling costs. The Trust measures impairment on these loans quarterly using the most current operating information available. Interest received on the impaired loans is applied against the loan principal. Prepaid fees and expenses represented prepaid acquisition fees and expenses and prepaid participation servicing fees paid for the acquisition and servicing of the PIMs and PIMIs. The Trust amortized prepaid acquisition fees and expenses using a method that approximated the effective interest method over a period of ten to twelve years, which represented the estimated life of the underlying mortgage. The Trust amortized prepaid participation servicing fees using a method that approximated the effective interest method over a ten-year period beginning at final endorsement of the loan if a HUD-insured mortgage loan or a GNMA MBS. Upon the repayment of a PIM or PIMI any unamortized acquisition fees and expenses and unamortized participation servicing fees related to such loan were expensed. Results of Operations Net income of the Trust decreased for the three months ending June 30, 2004 as compared to the same period ending June 30, 2003 primarily due to decreases in participation income, additional loan interest and basic interest income on PIM's and PIMI's. This is partially offset by the operating expense limitation adjustment and decreases in expense reimbursement to affiliates, asset management fees and amortization expense. Participation income was greater in 2003 due to the collection of Shared Appreciation Interest from the Windward Lakes PIMI payoff in May of 2003. Additional loan interest was greater in 2003 due to the recognition of deferred revenue and the collection of accrued interest from the Windward Lakes PIMI. Basic interest income on PIM's and PIMI's decreased due to the payoff of the Windward Lakes PIMI mentioned above. In the second quarter of 2004, the operating expenses of the Trust were decreased in order for the Trust to be in compliance with the annual operating expenses limitation test as defined in the Declaration of Trust. Expense reimbursement to affiliates decreased in 2004 due to the Advisor decreasing its expense reimbursement in anticipation of the Trust's operating expenses exceeding the annual operating expense limitation. Asset management fees decreased due to principal collections and prepayments. Amortization expense decreased due to the full recognition of prepaid fees and expenses from the Mountain View PIMI in August 2003. Net income of the Trust decreased for the six months ending June 30, 2004 as compared to the same period ending June 30, 2003 primarily due to decreases in participation income, additional loan interest and basic interest income on PIM's and PIMI's. This is partially offset by the operating expenses limitation adjustment and decreases in expense reimbursement to affiliates, asset management fees and amortization expense. Participation income was greater in 2003 due to the collection of participation income received in 2003 from the payoffs of the Rivergreens PIM and the Windward Lakes and Lifestyles PIMIs. Additional loan interest was greater in 2003 due to the recognition of deferred revenue and the collection of accrued interest from the Windward Lakes PIMI and the recognition of deferred revenue from the Lifestyles PIMI payoff in March of 2003. Basic interest income on PIM's and PIMI's decreased due to the payoffs of the Rivergreens PIM and the Lifestyles PIMI in March of 2003 and the Windward Lakes PIMI in June of 2003. In the second quarter of 2004, the operating expenses of the Trust were decreased in order for the Trust to be in compliance with the annual operating expenses limitation test as defined in the Declaration of Trust. Expense reimbursement to affiliates decreased in 2004 due to the Advisor decreasing its expense reimbursement in anticipation of the Trust's operating -10- expenses exceeding the annual operating expense limitation. Asset management fees decreased due to principal collections and prepayments. Asset management fees decreased due to principal collections and prepayments. Amortization expense decreased due to the full recognition of prepaid fees and expenses from the Mountain View PIMI in August 2003, the Rivergreens PIM in March of 2003 and the Mill Pond I PIM in January of 2003. Off Balance Sheet Arrangements The Trust has no off balance sheet arrangements as described in Item 303(a)(4)(ii) of Regulation S-K and did not have any such arrangements during the period covered by this report on Form 10-Q. Contractual Obligations The Trust has no contractual obligations as contemplated by Item 303(a)(5) of Regulation S-K and did not have any such arrangements either during the period covered by this report on Form 10-Q or during the Trust's most recent completed fiscal year. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Assessment of Credit Risk The Trust's investments in its remaining insured mortgage and MBS are guaranteed and/or insured by Fannie Mae, the Federal Home Loan Mortgage Corporation ("FHLMC"), GNMA and HUD and therefore the certainty of their cash flows and the risk of material loss of the amounts invested depends on the creditworthiness of these entities. Fannie Mae is a federally chartered private corporation that guarantees obligations originated under its programs. FHLMC is a federally chartered corporation that guarantees obligations originated under its programs. These obligations are not guaranteed by the U.S. Government or the Federal Home Loan Bank Board. However, Fannie Mae and FHLMC are two of the largest corporations in the United States and both have significant experience in mortgage securitizations. In addition, their MBS carry the highest credit rating given to financial instruments. GNMA guarantees the full and timely payment of principal and basic interest on the securities it issues, which represents interest in pooled mortgages insured by HUD. Obligations insured by HUD, an agency of the U.S. Government, are backed by the full faith and credit of the U.S. Government. Collection of the principal and interest of the Additional Loan and interest on the participation features have risks similar to those associated with higher risk debt instruments, including: reliance on the owner's operating skills, ability to maintain occupancy levels, control operating expenses, ability to maintain the properties and obtain adequate insurance coverage. Operations also may be affected by adverse changes in general economic conditions, local conditions, and changes in governmental regulations, real estate zoning laws, or tax laws, and other circumstances over which the Trust may have little or no control. At June 30, 2004, the Trust's investments also include cash and cash equivalents of approximately $1.1 million of Agency paper, which is issued by Government Sponsored Enterprises with a credit rating equal to the top rating category of a nationally recognized statistical rating organization. Interest Rate Risk The Trust's primary market risk exposure is to interest rate risk, which can be defined as the exposure of the Trust's net income, comprehensive income or financial condition to adverse movements in interest rates. At June 30, 2004, the Trust's remaining PIMI and MBS comprise the majority of the Trust's assets. Decreases in interest rates may accelerate the prepayment of the Trust's investments. Increases in interest rates may decrease the proceeds from a sale of the MBS. The Trust does not utilize any derivatives or other instruments to manage this risk as the Trust plans to hold its remaining PIMI investment to expected maturity. It is expected that substantially all of the MBS will prepay over the same period, mitigating any potential interest rate risk to the disposition value of any remaining MBS. The Trust monitors prepayments and considers prepayment trends, as well as dividend requirements of the Trust, when setting regular dividend policy. For MBS, the fund forecasts prepayments based on trends in similar securities as reported by statistical reporting entities such as Bloomberg. For its remaining PIMI investment, the Trust incorporates prepayment assumptions into planning as the property notifies the Trust of the intent to prepay or as it matures. -11- Item 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures As of June 30, 2004, the Chief Executive Officer and Chief Accounting Officer carried out an evaluation of the effectiveness of the design and operation of the Trust's disclosure controls and procedures. The Chief Executive Officer and the Chief Accounting Officer concluded that the Trust's disclosure controls and procedures were effective as of the date of their evaluation, in timely alerting them to material information relating to the Trust required to be included in this Quarterly Report on Form 10-Q. (b) Changes in Internal Controls There were no significant changes in the Trust's internal controls or in other factors that could significantly affect such internal controls subsequent to the date of the evaluation described in paragraph (a) above. -12- KRUPP GOVERNMENT INCOME TRUST PART II - OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits (31.1) Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (31.2) Chief Accounting Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (32.1) Chief Executive Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (32.2) Chief Accounting Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K None -13- SIGNATURE 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. Krupp Government Income Trust (Registrant) BY: /s/ Alan Reese ------------------ Alan Reese Treasurer and Chief Accounting Officer of Krupp Government Income Trust Date: August 13, 2004 -14-

KRUPP GOVERNMENT INCOME TRUST 10-Q