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INREIT REAL ESTATE INVESTMENT TRUST - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

May 14, 2014

Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

Certain statements contained in this section and elsewhere in this Form 10-Q constitute "forward-looking statements"within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, but are not limited to: (i) trends affecting our financial condition or results of operations; (ii) our business and growth strategies; (iii) the real estate industry; (iv) our financing plans; and other risks detailed in the Company's other periodic reports filed with the Securities and Exchange Commission. The words "believe", "expect", "anticipate", "may", "plan", "should", and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statements were made and are not guarantees of future performance.



Overview

We operate as an Umbrella Partnership Real Estate Investment Trust (UPREIT), which is a REIT that holds all or substantially all of its assets through a partnership which the REIT controls as general partner. Therefore, we hold all or substantially all of our assets through our operating partnership. We control the operating partnership as the sole general partner and own approximately 28.0% of the operating partnership as of March 31, 2014. For purposes of satisfying the asset and income tests for qualification as a REIT for tax purposes, our proportionate shares of the assets and income of our operating partnership are deemed to be assets and income of the trust. We use this UPREIT structure to facilitate acquisitions of commercial real estate properties. A sale of property directly to a REIT is generally a taxable transaction to the property seller. However, in an UPREIT structure, if a property seller exchanges the property with one of its operating partnerships in exchange for limited partnership units, the seller may defer taxation of gain in such exchange until the seller resells its limited partnership units or exchanges its limited partnership units for the REIT's common stock. By offering the ability to defer taxation, we may gain a competitive advantage in acquiring desired properties over other buyers who cannot offer this benefit. In addition, investing in our operating partnership, rather than directly in INREIT, may be more attractive to certain institutional or other investors due to their business or tax structure. If an investor is interested in making a substantial investment in our operating partnership, our structure provides us the flexibility to accommodate different terms for each investment, while applicable tax laws generally restrict a REIT from charging different fee rates among its shareholders. Finally, if our shares become publicly traded, the former property seller may be able to achieve liquidity for his investment in order to pay taxes.



Operating Partnership

Our operating partnership, INREIT Properties, LLLP, was formed as a North Dakota limited liability limited partnership on April 25, 2003 to acquire, own and operate properties on our behalf. The operating partnership holds a diversified portfolio of commercial and multi-family properties located principally in the upper and central Midwest United States. As of March 31, 2014, approximately 66.4% of the properties were apartment communities located primarily in North Dakota with others located in Minnesota and Nebraska. Most multi-family properties are leased to a variety of tenants under short-term leases. As of March 31, 2014, approximately 33.6% of the properties were comprised of office, retail, industrial and medical commercial property located primarily in North Dakota with others located in Arkansas, Colorado, Iowa, Louisiana, Michigan, Minnesota, Mississippi, Nebraska, Texas and Wisconsin. We have both single and multi-family tenant properties in the commercial portfolio, most of which are under long-term leases. Our real estate portfolio consisted of 127 properties containing approximately 6,089 apartments and 1,384 square feet of leasable commercial space as of March 31, 2014. The portfolio has a gross book value of approximately $409,028, which includes assets held for sale, and book equity, including noncontrolling interests, of approximately $145,192 as of March 31, 2014. 35



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Our Board of Trustees and Executive Officers

We operate under the direction of our Board of Trustees, the members of which are accountable and our shareholders as fiduciaries. In addition, the Board has a specific fiduciary duty to supervise our relationship with the Advisor, and evaluate the performance of and fees paid to the Advisor on an annual basis prior to renewing the Advisory Agreement with the Advisor. Our Board of Trustees has provided investment guidance for the Advisor to follow, and must approve each investment recommended by the Advisor. Currently, we have nine members on our board, seven of whom are independent of our Advisor. Our trustees are elected annually by our shareholders. Although we have executive officers, we do not have any paid employees. Our Advisor Our external Advisor is INREIT Management, LLC, a North Dakota limited liability company formed on November 14, 2002. Our Advisor, with offices in Fargo, North Dakota, is responsible for managing our day-to-day affairs and for identifying, acquiring and disposing investments on our behalf.



Critical Accounting Estimates

Preparation of our financial statements requires estimates and judgments to be made that affect the amounts of assets, liabilities, revenues and expenses reported. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. We evaluate these estimates based on assumptions we believe to be reasonable under the circumstances.



There have been no material changes in our Critical Accounting Policies as disclosed in Note 2 to our financial statements for the three month period ended March 31, 2014 included elsewhere in this report.

Results of Operations for the Three Months Ended March 31, 2014 and 2013

Specific Achievements

Increased revenues from rental operations by $2,445 or 16.7% for the

three months ended March 31, 2014, compared to same three month period in 2013.



Acquired four (4) properties totaling 142 residential apartment units

for a total of $7,024 during the three months ended March 31, 2014. Declared and paid dividends totaling $0.2250 per common share for first quarter of 2014. 36



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Three Months Ended March 31, 2014 Three Months Ended March 31, 2013 Residential Commercial Total Residential Commercial Total (unaudited) (unaudited) (in thousands) (in thousands) Real Estate Revenues $ 12,616$ 4,467$ 17,083$ 9,929$ 4,709$ 14,638 Real Estate Expenses Real Estate Taxes 1,054 261 1,315 949 651 1,600 Property Management Fees 1,482 76 1,558 1,110 71 1,181 Utilities 1,469 238 1,707 986 209 1,195 Repairs and Maintenance 2,124 227 2,351 1,186 200 1,386 Insurance 384 14 398 229 14 243 Total Real Estate Expenses 6,513 816 7,329 4,460 1,145 5,605 Net Operating Income $ 6,103$ 3,651$ 9,754$ 5,469$ 3,564$ 9,033 Interest 3,064 2,692 Depreciation and amortization 3,354 2,839 Administration of REIT 1,044 1,499 Other (income)/expense (575 ) (178 ) Income from continuing operations 2,867 2,181 Discontinued operations - 249 Net Income $ 2,867$ 2,430 Net Income Attributed to: Noncontrolling Interest $ 2,068$ 1,684 INREIT Real Estate Investment Trust $ 799$ 746 Dividends per share (1) $ 0.2250 $ 0.2100 Earnings per share $ 0.15$ 0.14



(1) Does not take into consideration the amounts distributed by the operating

partnership to limited partners.

Revenues

Property revenues of approximately $17,083 increased approximately $2,445 or 16.7% for the three months ended March 31, 2014 in comparison to the same period in 2013. Residential property revenues increased approximately $2,687 while commercial property revenues decreased approximately $242. The following table illustrates quarterly changes in occupancy for the periods indicated: March 31, 2014 March 31, 2013 Residential occupancy 97.2 % 98.9 % Commercial occupancy 99.5 % 99.4 % Residential revenues for the three month period ended March 31, 2014 increased $2,687 in comparison to the same period for 2013. Approximately $2,420 of the increase was due to residential properties acquired since January 1, 2013. Rental income from residential properties owned for more than one year increased approximately $267 in comparison to the same period in 2013. Residential revenues comprised 73.9% of total revenues for the three month period ended March 31, 2014 compared to 67.8% of total revenues for the three month period ended March 31, 2013. For the three month period ended March 31, 2014 commercial revenues decreased $242 in comparison to the same period for 2013. The decrease is despite an increase in revenues of approximately $166 from commercial properties acquired since January 1, 2013. Rental income from commercial properties owned for more than one year decreased approximately $408 in comparison to the same period in 2013 primarily due to decreased CAM income (common area maintenance). Commercial revenues comprised 26.1% of the total revenues for the three month period ended March 31, 2014 compared to 32.2% of total revenues for the three month period ended March 31, 2013. Expenses Residential expenses from operations of $6,513 during the three month period ended March 31, 2014 increased $2,053 or 46.0% in comparison to the same period in 2013. This increase was primarily attributed to the increase in number of residential properties owned during the three month period ended March 31, 2014 versus the same period in 2013. 37



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Commercial expenses from operations of $816 during the three month period ended March 31, 2014 decreased $329 or 28.7% in comparison to the same period in 2013. This decrease was in part attributed to real estate tax relief in North Dakota. In addition, the decrease was in part attributed to decreases in real estate tax expense which corresponds to the decrease in commercial CAM income. Interest expense of $3,064 during the three month period ended March 31, 2014 increased $372 in comparison to the same period in 2013. Interest expense was approximately 17.9% and 18.4% of rental income for three month periods ended March 31, 2014 and 2013, respectively. The decrease of interest expense as a percentage of rental income during the three month period ended March 31, 2014 was a result of lower interest rates for mortgage notes payable during this period in 2014 compared to the same period in 2013 and increased rental revenues from acquired properties unencumbered by mortgages. Depreciation and amortization expense increased 18.1% from $2,839 for the three months ended March 31, 2013 to approximately $3,354 for the three months ended March 31, 2014. The $515 increase was primarily a result of depreciation and amortization for the 17 properties added to our portfolio since March 31, 2013. Depreciation and amortization expense as a percentage of rental income for the three month periods ended March 31, 2014 and 2013 was relatively consistent at 19.6% and 19.4%, respectively. REIT administration expenses decreased from $1,499 for the three months ended March 31, 2013 to $1,044 for the three month periods ended March 31, 2014 due to a decrease in acquisition expenses related to less acquisition activity during the first quarter of 2014 in comparison to the same period in 2013.



Net Operating Income

We measure the performance of our segments based on net operating income ("NOI"), which we define as total revenue from rental operations less expenses from rental operations and real estate taxes (excluding depreciation and amortization related to real estate investments and impairment of real estate investments). We believe that NOI is an important supplemental measure of operating performance for a REIT because it provides a measure of core operations unaffected by depreciation, amortization, financing, and administration expense. NOI does not represent cash generated by operating activities in accordance with GAAP and should not be considered an alternative to net income, net income available for non-controlling interests and shareholders of the Trust or cash flow from operating activities as a measure of financial performance. Residential NOI increased $634 or 11.6% for the three month period ended March 31, 2014 in comparison to the same three month period in 2013 due primarily to acquisition activity in the residential segment. Commercial NOI increased $87 or 2.4% for the three month period ended March 31, 2014 in comparison to the same three month period in 2013 due primarily to acquisition activity in the commercial segment.



Property Acquisitions and Dispositions

Property Acquisitions and Dispositions during the three month period ended March 31, 2014

We acquired four properties for a total of $7,024 during the first three months of 2014. Total consideration for the acquisitions was the issuance of approximately $5,352 in limited partnership units of the operating partnership and cash of $1,672.



During the first quarter of 2014, there were no dispositions.

Property Acquisitions and Dispositions during the three month period ended March 31, 2013

We acquired nine properties for a total of $16,331 during the first three months of 2013. Total consideration for the acquisitions was the issuance of approximately $13,559 in limited partnership units of the operating partnership, new loans of $2,511 and cash of $261.



During the first quarter of 2013, there were no dispositions.

See Notes 19 and 20 to the Consolidated Financial Statements included above for more information regarding our acquisitions and dispositions during the three month periods ended March 31, 2014 and 2013. 38



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Funds From Operations and Modified Funds From Operations (FFO and MFFO)

Funds From Operations (FFO) applicable to common shares and limited partnership units means net income (computed in accordance with GAAP), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis. Historical cost accounting for real estate assets implicitly assumes the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies use historical cost accounting to be insufficient by themselves. The term Funds From Operations (FFO) was created to address this problem. It was intended to be a standard supplemental measure of REIT operating performance that excluded historical cost depreciation from - or "added it back" to - GAAP net income. Our management believes this non-GAAP measure is useful to investors because it provides supplemental information that facilitates comparisons to prior periods and for the evaluation of financial results. Management uses this non-GAAP measure to evaluate our financial results, develop budgets and manage expenditures. The method used to produce non-GAAP results is not computed according to GAAP, is likely to differ from the methods used by other companies and should not be regarded as a replacement for corresponding GAAP measures. Management encourages the review of the reconciliation of this non- GAAP financial measure to the comparable GAAP results. Since the introduction of the definition of FFO, the term has come to be widely used by REITs. In the view of National Association of Real Estate Investment Trusts ("NAREIT"), the use of the definition of FFO (combined with the primary GAAP presentations required by the Securities and Exchange Commission) has been fundamentally beneficial, improving the understanding of operating results of REITs among the investing public and making it easier than before to compare the results of one REIT with another. In addition to FFO, management also uses Modified Funds From Operations ("MFFO") as a non-GAAP supplemental performance measure. MFFO as defined by us excludes from FFO acquisition related costs which are required to be expensed in accordance with GAAP. Our definition of MFFO also excludes disposition costs related to sales of investment properties. Acquisition and disposition related expenses include those paid to our Advisor and third parties. Management believes that excluding acquisition and disposition related costs from MFFO provides useful supplemental performance information that is comparable over the long-term and this is consistent with management's analysis of the operating performance of the REIT. While FFO and MFFO applicable to common shares and limited partnership units are widely used by REITs as performance metrics, all REITs do not use the same definition of FFO and MFFO or calculate FFO and MFFO in the same way. The FFO and MFFO reconciliation presented here is not necessarily comparable to FFO and MFFO presented by other real estate investment trusts. FFO and MFFO should also not be considered as an alternative to net income as determined in accordance with GAAP as a measure of a real estate investment trust's performance, but rather should be considered as an additional, supplemental measure, and should be viewed in conjunction with net income as presented in the consolidated financial statements included in this report. FFO and MFFO applicable to common shares and limited partnership units does not represent cash generated from operating activities in accordance with GAAP, and is not necessarily indicative of sufficient cash flow to fund a real estate investment trust's needs or its ability to service indebtedness or to pay dividends to shareholders. 39



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The following tables include calculations of FFO and MFFO, and the reconciliations to net income, for the three months ended March 31, 2014 and 2013, respectively. We believe these calculations are the most comparable GAAP financial measure (in thousands):



Reconciliation of Net Income Attributable to INREIT to FFO and MFFO Applicable to Common Shares and Limited Partnership Units

Three Month Period Ending March 31, Three Month Period Ending March 31, 2014 2013 Per Per Share Share Weighted Avg and Weighted Avg and Amount Shares and Units(1) Unit(2) Amount Shares and Units(1) Unit(2) (unaudited) (in thousands, except per share data) Net Income attributable to INREIT Real Estate Investment Trust $ 799 5,439 $ 0.15$ 746 5,316 $ 0.14 Add back: Noncontrolling Interest-OPU 2,061 13,901 1,676 11,828 Depreciation & Amortization from continuing operations 3,354 2,838 Depreciation & Amortization from discontinued operations - 181 Pro rata share of unconsolidated affiliate depreciation & amortization 121 102 Loss on depreciable asset sales - - Loss on impairment of property - -



Subtract:

(Gains) loss on land and depreciable asset sales - - Funds from operations applicable to common shares and limited partnership units 6,335 19,340 $ 0.33 5,543 17,144 $ 0.32 Add back: Acquisition and disposition expenses 361 888 Modified Funds from Operations (MFFO) $ 6,696 19,340 $ 0.35$ 6,431 17,144 $ 0.38



(1) Please see Note 11 to the consolidated financial statements included above

for more information.

(2) Net Income is calculated on a per share basis. FFO is calculated on a per

share and unit basis.

Liquidity and Capital Resources

Our principal demands for funds will be for the (i) acquisition of real estate and real estate-related investments, (ii) payment of acquisition related expenses and operating expenses, (iii) payment of dividends/distributions and repurchases, and (iv) payment of principal and interest on current and any future outstanding indebtedness. Generally, we expect to meet cash needs for the payment of operating expenses and interest on outstanding indebtedness from cash flow from operations. We expect to pay dividends/distributions and any repurchase requests to our shareholders and the unit holders of our operating partnership from cash flow from operations; however, we may use other sources to fund dividends/distributions and repurchases, as necessary. We expect to meet cash needs for acquisitions and other real-estate investments from cash flow from operations, net proceeds of share offerings and debt proceeds.



Evaluation of Liquidity

We continually evaluate our liquidity and ability to fund future operations, debt obligations and any repurchase requests. As part of our analysis, we consider among other items, credit quality of tenants and lease expirations.

Credit Quality of Tenants

We are exposed to credit risk within our tenant portfolio, which can reduce our results of operations and cash flow from operations if our tenants are unable to pay their rent. Tenants experiencing financial difficulties may become delinquent on their rent or default on their leases and, if they file for bankruptcy protection, may reject our lease in bankruptcy court, resulting in reduced cash flow. This may negatively impact net asset values and require us to incur impairment charges. Even if a default has not occurred and a tenant is continuing to make the required lease payments, we may restructure or renew leases on less favorable terms, or the tenant's credit profile may deteriorate, which could affect the value of the leased asset and could in turn require us to incur impairment charges. 40



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Historically, the geographic location of our properties and credit-worthiness of our tenants have resulted in minimal to no property impairments or write-offs on uncollectible rental revenues. We currently anticipate the trend to continue. It is possible, however, that tenants may file for bankruptcy or default on their leases in the future and that economic conditions may deteriorate. To mitigate credit risk on commercial properties, we have historically looked to invest in assets that we believe are critically important to our tenant's operations and have attempted to diversify our portfolio by tenant, tenant industry and geography. We also monitor all of our properties performance through review of rent delinquencies as a precursor to a potential default, meetings with tenant management and review of tenants' financial statements and compliance with financial covenants. When necessary, our asset management process includes restructuring transactions to meet the evolving needs of tenants, refinancing debt and selling properties, as well as protecting our rights when tenants default or enter into bankruptcy.



Lease Expirations and Occupancy

No significant leases are scheduled to expire or renew in the next twelve months. The Advisor, with the assistance of our property managers, actively manages our real estate portfolio and begins discussing options with tenants in advance of scheduled lease expirations. In certain cases, we may obtain lease renewals from our tenants; however, tenants may elect to move out at the end of their term. In the cases where tenants elect not to renew, we may seek replacement tenants or try to sell the property.



Cash Flow Analysis

Our objectives are to generate sufficient cash flow over time to provide shareholders with increasing dividends and to seek investments with potential for strong returns and capital appreciation throughout varying economic cycles. We have funded 100% of the dividends from operating cash flows. In setting a dividend rate, we focus primarily on expected returns from investments we have already made to assess the sustainability of a particular dividend rate over time. For the three months ended March 31, 2014 2013 (in thousands) Net cash flows provided by operating activities $ 1,451 $ 6,003



Net cash flows used in investing activities $ (3,413 )

$ (3,894 ) Net cash flows used in financing activities $ (4,936 ) $ (4,040 ) Operating Activities Our real estate properties generate cash flow in the form of rental revenues, which is reduced by interest payments, direct leases costs and property-level operating expenses. Property-level operating expenses consist primarily of property management fees including salaries and wages of property management personnel, utilities, cleaning, repairs, insurance, security and building maintenance costs, and real estate taxes. Additionally, we incur general and administrative expenses, advisory fees, acquisition and disposition expenses, and financing and development fees. Net cash provided by operating activities was $1,451 and $6,003 for the three months ended March 31, 2014 and 2013, respectively, which consists primarily of net income from property operations and adjusted non-cash depreciation and amortization. The funds generated for the three months ended March 31, 2014 and 2013 were primarily from property operations of our real estate portfolio. In addition during the three months ended March 31, 2014, we invested $5,000 in marketable securities. Investing Activities Our investing activities generally consist of real estate-related transactions (purchases and sales of properties) and payments of capitalized property-related costs such as intangible assets and real estate tax and insurance escrows. 41



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Net cash used in investing activities was $3,413 and $3,894 for the three months ended March 31, 2014 and 2013, respectively (this does not include the value of UPREIT units issued in connection with investing activities). For the three months ended March 31, 2014 and 2013, cash flows used in investing activities related primarily to the acquisition of properties and capital expenditures was $2,727 and $3,092, respectively, and the change in restricted cash for real estate tax, insurance and replacement reserve escrows was $1,113 and $983, respectively.



Financing Activities

Our financing activities generally consist of funding property purchases by raising proceeds and securing mortgage notes payable as well as paying dividends, paying syndication costs and making principal payments on mortgage notes payable.

Net cash used in financing activities was $4,936 and $4,040 for the three months ended March 31, 2014 and 2013, respectively. During this period in 2014, we paid approximately $3,247 in dividends and distributions, repurchased $2,490 of shares and units, received proceeds of $2,339 from short-term notes, and made mortgage principal payments of approximately $1,908. For the three months ended March 31, 2013, we paid approximately $2,801 in dividends and distributions, repurchased $1,138 of shares and units, received proceeds from new mortgage notes payable of approximately $4,864, and $3,711 in short-term notes, and made mortgage principal payments of approximately $8,654.



Dividends

Common Stock

We declared cash dividends to our shareholders during the period from January 1, 2014 to March 31, 2014 totaling $1,216 or $0.2250 per share, including amounts reinvested through the dividend reinvestment plan. During the three months ended March 31, 2014, we paid cash dividends of $399 and dividends of $817 were reinvested under the dividend reinvestment plan. The cash dividends were paid with the $6,451 from our cash flows from operations and $334 provided by distributions from unconsolidated affiliates. We declared cash dividends to our shareholders during the period from January 1, 2013 to March 31, 2013 totaling $1,112 or $0.2100 per share, including amounts reinvested through the dividend reinvestment plan. During the three months ended March 31, 2013, we paid cash dividends of $452 and dividends of $660 were reinvested under the dividend reinvestment plan. The cash dividends were paid with the $6,003 from our cash flows from operations and $271 provided by distributions from unconsolidated affiliates. We continue to provide cash dividends to our shareholders from cash generated by our operations. The following chart summarizes the sources of our cash used to pay dividends. Our primary source of cash is cash flow provided by operating activities from our investments as presented in our cash flow statement. We also include distributions from unconsolidated affiliates to the extent that the underlying real estate operations in these entities generate these cash flows and the gain on sale of properties relates to net profits from the sale of certain properties. Our presentation is not intended to be an alternative to our consolidated statement of cash flows and does not present all sources and uses of our cash.



The following table presents certain information regarding our dividend coverage (in thousands):


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Source: Edgar Glimpses