UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
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: 0-30507
Primecore Mortgage Trust, Inc.
(Exact name of registrant as specified in its charter)
Maryland 94-3324992
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
99 El Camino Real
Menlo Park, CA 94025
(Address of principal offices) (zip code)
(650) 328-3060
(Registrant's telephone number, including area code)
Not Applicable
(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 Act).
Yes [ ] No [X]
The number of shares of convertible preferred stock outstanding as of
October 31, 2003 was 22,381,473. The number of shares of common stock
outstanding as of October 31, 2003 was 100.
18
Table of Contents
Part I. Financial Information
Item 1. Financial Statements ............................................. 2
Consolidated Balance Sheets as of September 30, 2003 (unaudited)
and December 31, 2002............................................. 3
Consolidated Statements of Operations for the Three and Nine Months
Ended September 30, 2003 and 2002 (unaudited)..................... 4
Consolidated Statement of Shareholders' Equity for the Nine Months
Ended September 30, 2003 and 2002 (unaudited)..................... 5
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2003 and 2002 (unaudited)........................... 6
Notes to the Consolidated Financial Statements (unaudited)........ 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 14
Item 3. Quantitative and Qualitative Disclosures about Market Risk....... 24
Item 4. Controls and Procedures.......................................... 24
Part II. Other Information
Item 1. Legal Proceedings................................................ 25
Item 2. Changes in Securities and Use of Proceeds........................ 25
Item 3. Defaults Upon Senior Securities.................................. 25
Item 4. Submission of Matters to a Vote of Security Holders.............. 25
Item 5. Other Information................................................ 25
Item 6. Exhibits and Reports on Form 8-K................................. 25
Signatures....................................................... 27
1
Part I. Financial Information
Item 1. Financial Statements
Attached are the following financial statements of Primecore Mortgage
Trust, Inc. (the "Company"):
(1) Consolidated Balance Sheets as of September 30, 2003 (unaudited), and
December 31, 2002
(2) Consolidated Statements of Operations for the Three and Nine Months
ended September 30, 2003 and 2002 (unaudited)
(3) Consolidated Statement of Shareholders' Equity for the Nine Months
ended September 30, 2003 (unaudited)
(4) Consolidated Statements of Cash Flows for the Nine Months ended
September 30, 2003 and 2002 (unaudited)
(5) Notes to the Consolidated Financial Statements (unaudited)
The financial statements referred to above should be read in
conjunction with the Company's audited financial statements for the year ended
December 31, 2002 as filed with the Securities and Exchange Commission in our
Annual Report on Form 10-K filed March 31, 2003.
2
PRIMECORE MORTGAGE TRUST, INC.
CONSOLIDATED BALANCE SHEETS
September 30, 2003
(unaudited) December 31, 2002
--------------------- --------------------
ASSETS:
Investments in real estate under development............................ $ 65,608,390 $ 101,141,515
Investments in real estate held for sale................................ 36,059,497 44,510,168
Loans Receivable........................................................ -- 4,695,000
Cash and cash equivalents............................................... 784,942 4,394,107
Other assets, net....................................................... 335,646 326,245
--------------------- --------------------
Total assets.................................................... $ 102,788,475 $ 155,067,035
===================== ====================
LIABILITIES AND SHAREHOLDERS' EQUITY:
Unsecured notes payable (including $280,000 to a director at September
30, 2003 and $150,000 December 31, 2002)............................. $ 6,147,143 $ 14,276,929
Secured notes payable................................................... 3,185,000 7,693,000
Secured line of credit.................................................. -- 14,431,132
Accrued expenses and other.............................................. 252,076 256,059
Preferred stock dividends payable....................................... -- 1,312,417
Payable to manager...................................................... 313,298 669,480
--------------------- --------------------
Total liabilities............................................... 9,897,517 38,639,017
--------------------- --------------------
SHAREHOLDERS' EQUITY:
Preferred stock: par value $0.01, 40,000,000 shares authorized;
22,381,473 and 22,496,804 shares issued and outstanding at
September 30, 2003, and December 31, 2002, respectively.............. 225,640,549 226,079,882
Common stock: par value $0.01, 10,000,000 shares authorized; 100
shares issued and outstanding at September 30, 2003, and December
31, 2002, respectively............................................... 1 1
Accumulated dividends and distributions................................. (90,621,455) (80,132,217)
Accumulated deficit..................................................... (42,128,137) (29,519,648)
--------------------- --------------------
Total shareholders' equity...................................... 92,890,958 116,428,018
--------------------- --------------------
Total liabilities and shareholders' equity...................... $ 102,788,475 $ 155,067,035
===================== ====================
The accompanying notes are an integral part of these statements
3
PRIMECORE MORTGAGE TRUST, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
September September September September
30, 2003 30, 2002 30, 2003 30, 2002
------------------- ---------------------------------------------------------
REVENUES:
Income from completed real estate
development............................... $ 3,984,006 $ 2,787,906 $ 8,218,106 $ 9,526,432
Income from Manager obligation............... 27,958 -- 27,958 --
Other........................................ 95 141 16,359 62,098
------------------- ---------------- ------------------- ----------------
Total revenues.......................... 4,012,059 2,788,047 8,262,423 9,588,530
------------------- ---------------- ------------------- ----------------
EXPENSES:
Management fees ............................. 896,095 2,438,338 3,120,171 7,546,893
Provision for impairment of investments in
real estate............................... 2,208,575 7,992,171 16,577,672 9,465,487
General, administrative and other............ 529,883 117,001 1,173,069 285,358
------------------- ---------------- ------------------- ----------------
Total expenses.......................... 3,634,553 10,547,510 20,870,912 17,297,738
------------------- ---------------- ------------------- ----------------
Net income (loss)......................... 377,506 (7,759,463) (12,608,489) (7,709,208)
Preferred stock dividends and
distributions......................... (2,623,555) (5,871,995) (10,489,238) (17,369,556)
------------------- ---------------- ------------------- ----------------
Net loss allocable to common.............. $ (2,246,049) $ (13,631,458) $ (23,097,727) $ (25,078,764)
=================== ================ =================== ================
Basic and diluted net loss per common
share..................................... $ (22,460) $ (136,315) $ (230,977) $ (250,788)
=================== ================ =================== ================
Basic and diluted weighted-average shares
outstanding............................... 100 100 100 100
=================== ================ =================== ================
The accompanying notes are an integral part of these statements
4
PRIMECORE MORTGAGE TRUST, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
For the six months ended June 30, 2003
(unaudited)
Preferred Stock Common Stock
----------------------------- -----------------
Accumulated
Dividends
and Accumulated
Shares Amount Shares Amount Distributions Deficit Total
------------- --------------- -------- -------- ---------------- --------------- ---------------
Shareholders' equity at December
31, 2002......................... 22,496,804 $226,079,882 100 $ 1 $ (80,132,217) $ (29,519,648) $116,428,018
Reinvested dividends................ 235 1,499 -- -- -- -- 1,499
Adjustment for dividend
reinvestment..................... (9,433) (94,330) -- -- -- -- (94,330)
Stock redemption.................... (106,133) (346,502) -- -- -- -- (346,502)
Dividends and distributions to
preferred shareholders........... -- -- -- -- (10,489,238) -- (10,489,238)
Net loss............................ -- -- -- -- -- (12,608,489) (12,608,489)
------------------------------------------------------------------------------------------------
Shareholders' equity at September
30, 2003......................... 22,381,473 $ 225,640,549 100 $ 1 $ (90,621,455) $ (42,128,137) $ 92,890,958
================================================================================================
The accompanying notes are an integral part of these statements
5
PRIMECORE MORTGAGE TRUST, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Nine Months
Ended Ended
September September
30, 2003 30, 2002
---------------------- --------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.................................................................. $ (12,608,489) $ (7,709,208)
Adjustments to reconcile net (loss) to net cash provided by (used in)
operations;
Provision for impairment of investments in real estate................. 16,577,672 9,465,487
Decrease in accrued expenses and other................................ (3,983) (990,862)
(Decrease) increase in payable to manager............................. (356,182) 110,126
(Increase) decrease in other assets, net.............................. (9,401) 168,543
---------------------- -------------------
Net cash provided by operating activities........................ 3,599,617 1,044,086
---------------------- -------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Investments in real estate under development and property held
for sale............................................................. (19,382,070) (26,853,379)
Investments in real estate under development by affiliates............. -- (8,187,884)
Repayments of investments in real estate under development and
property held for sale............................................... 46,841,782 34,307,360
Repayments of investments in real estate under development by
affiliates........................................................... -- 8,711,083
Cash received from loan repayments..................................... 4,695,000 --
---------------------- -------------------
Net cash provided by investing activities........................ 32,154,712 7,977,180
---------------------- -------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sales of preferred stock, net of offering costs.......... -- 12,549,640
Capital contributions by Manager....................................... -- 1,220,484
Redemptions of preferred stock......................................... (346,502) (7,381,650)
Adjustments for dividend reinvestment.................................. (94,330) --
Borrowings under notes payable......................................... 476,679 3,967,061
Payments under unsecured notes payable................................. (8,660,053) (6,809,010)
Payments under secured notes payable................................... (4,508,000) --
Payments on secured line of credit, net................................ (14,431,132) --
Payment of preferred stock dividends and distributions................. (11,800,156) (14,235,731)
---------------------- -------------------
Net cash used in financing activities............................. (39,363,494) (10,689,206)
---------------------- -------------------
Net decrease in cash and cash equivalents....................... (3,609,165) (1,667,940)
Beginning cash and cash equivalents............................. 4,394,107 2,706,204
---------------------- -------------------
Ending cash and cash equivalents................................ $ 784,942 $ 1,038,264
====================== ===================
Cash paid for interest, net of amounts capitalized of $1,595,332 and
$1,974,285, for the nine months ended September 30, 2003 and 2002,
respectively........................................................... $ -- $ --
====================== ===================
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING
AND FINANCING ACTIVITIES:
Reinvested Preferred Stock dividends..................................... $ 1,499 $ 3,068,200
Interest accrued on unsecured notes payable............................... $ 53,588 $ 356,872
The accompanying notes are an integral part of these statements
6
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. ORGANIZATION AND BUSINESS:
Organization
Primecore Mortgage Trust, Inc., a Maryland corporation, was formed on March 18,
1999 and commenced operations effective May 1, 1999 as a real estate investment
trust (REIT). We are engaged in the business of funding and holding land
acquisition, development and construction mortgage loans secured by residential
real property, as well as secured by undeveloped real property, located in the
greater San Francisco Bay Area. We have only one operating segment. Primecore
Mortgage Trust, Inc. is also the sole member of 99 Investors, LLC a California
limited liability company. 99 Investors, LLC owns certain real property in which
we have invested. We are managed by Primecore Funding Group, Inc., (the
"Manager") an affiliated California corporation located in Menlo Park,
California.
On October 7, 2003 our Board of Directors voted to withdraw our REIT election
effective for the tax year beginning January 1, 2004. We do not anticipate this
action having a material effect on the Company's financial statements.
Risk Factors
General Economic Conditions in Lending Areas. Properties securing repayment of
the mortgage loans are located in the San Francisco Bay Area, with the majority
in the counties of Santa Clara and San Mateo. Since the properties secured by
the mortgage loans are located in a limited geographical region, these mortgage
loans may be subject to a greater risk of delinquency or default if the
industries concentrated there suffer adverse economic or business developments.
Realization of Assets. The Company's liquidity and ability to meet its
obligations as they become due are subject to, among other things, its ability
to obtain timely repayments of its loans and sales of its investment in real
estate held for sale. In the event that repayments are not sufficient to timely
meet our commitments and unsecured notes cannot be extended , we may be forced
to reduce prices on properties we control in order to expedite their repayment.
In such cases, the amount of proceeds received could be substantially less than
what we would have expected if we allowed a proper marketing period for the
property. This would have a negative impact on the estimated net realizable
value of our assets and would force the Company to adopt an alternative strategy
that may include actions such as seeking additional capital or further
downsizing of the Company. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
Other. In addition, we are subject to other significant business and financial
risks, including but not limited to liquidity, the prevailing market for
high-end residential real estate, interest rates, dependence on our manager,
timely completion of projects, lack of borrower diversification, and potential
environmental matters relating to properties on which we have made loans. For
additional information see Risk Factors in our Annual Report on Form 10-K for
the year ending December 31, 2002 filed March 31, 2003.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Presentation
The accompanying unaudited financial statements present the financial position
of the Company as of September 30, 2003 (unaudited), and December 31, 2002, and
the results of operations and cash flows of the Company for the three months and
nine months ended September 30, 2003 and 2002. In the opinion of management, the
accompanying unaudited financial statements contain all adjustments (consisting
of only normal accruals) necessary to present fairly the financial position and
results of operations of the Company as of September 30, 2003 and for the
periods then ended.
7
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Use of Estimates
These financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation
of financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company's significant estimates include the valuation of
investments in real estate. Actual results could differ from those estimates.
Investments in Real Estate under Development
We have originated loans to acquire, develop and construct residential real
estate ("ADC loans"). Our loans contain many of the following characteristics
which are identified with ADC loans:
1. The lender has agreed to provide all or substantially all necessary funds
to acquire, develop or construct the property. The borrower has title to
but little or no cash equity in the project;
2. The lender funds substantially all the interest and fees during the term of
the loan by adding them to the loan balance; 3. Typically, the lender's
only security is the project itself, the lender has no recourse to other
assets of the borrower, and
the borrower does not guarantee the debt;
4. In order for the lender to recover its investment in the project, the
property must be sold to independent third parties or the borrower must
obtain refinancing from another source.
Therefore, our ADC loans are classified for financial reporting purposes as
investments in real estate under development (Note 3). Revenue from interest and
points is recognized as cash is received from the sale or refinancing of such
properties. If our ADC loans qualified as loans under US GAAP, interest and
points would be recognized in income as earned instead of at the time of sale of
the underlying property.
Such investments are stated at the lower of cost or fair value. Management
conducts a review for impairment on an investment-by-investment basis whenever
events or changes in circumstances indicate that the carrying amount of an
investment may not be recoverable. Impairment is recognized when estimated
expected future cash flows (undiscounted and without interest charges),
typically from the sale of a completed property, are less than the carrying
amount of the investment, which does not include accrued interest and points.
The estimation of expected future net cash flows is inherently uncertain and
relies to a considerable extent on assumptions regarding current and future
economic and market conditions. If, in future periods, there are changes in the
estimates or assumptions incorporated into the impairment review analysis, the
changes could result in an adjustment to the carrying amount of the investments.
To the extent impairment has occurred, the excess of the carrying amount of the
investment over its estimated fair value, less estimated selling costs, will be
charged to operations.
Investments in Real Estate Held for Sale
We may take title to property through foreclosure or by deed in lieu of
foreclosure when a borrower defaults on our ADC loan. Such arrangements are
accounted for in a manner similar to our investments in real estate under
development.
Cash and Cash Equivalents
Cash and cash equivalents include cash held in financial institutions and other
highly liquid short-term investments with original maturities of three months or
less.
Income from Completed Real Estate Development
Our investment objective is to make ADC loans on projects we believe are likely
to ultimately sell for an amount sufficient to repay the principal plus accrued
8
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
interest at the contracted interest rate and points on those ADC loans. We
recognize income from our ADC loans and investments in real estate held for sale
as costs are recovered, generally upon the sale or refinancing of the underlying
completed real estate to or by a third party. No interest income or points are
recognized until the financed property is sold or refinanced. We compute income
as the difference between cash received from the sale or refinancing of the
property and the carrying value of the investments at the date of repayment.
Income Taxes
Our taxable income differs from income measured in accordance with generally
accepted accounting principles in the United States of America due to timing
differences in the recognition of income from our ADC loans. For tax purposes,
interest and points are accrued as income according to the terms of our loan
contracts, but not recognized under generally accepted accounting principles in
the United States of America until the contract has been paid through sale or
refinancing of the secured property. We have, in the past, distributed Preferred
Stock dividends monthly at a level sufficient to satisfy specified return
targets for our investors. As a result, dividends paid were, in some years, in
excess of taxable income. On July 17, 2003 our Board of Directors voted to
suspend payment of dividends effective after payment of our August declaration.
On October 7, 2003 our Board of Directors voted to withdraw our REIT election
effective with the tax year beginning January 1, 2004. The withdrawal of this
election results in a loss of our ability to deduct the payment of dividends
from our taxable income. However, because we will generate a large net operating
loss from the disposition of assets in our portfolio, we can carry this net
operating loss forward against future taxable income. Because of this net
operating loss, we do not expect to be subject to federal corporate level tax
during the next five years.
Net Loss Per Share of Common Stock
Per share amounts for our common stock are computed using the weighted average
common shares outstanding during the period. Net loss used in the calculation is
increased by declared dividends owed to preferred shareholders. There are
currently no stock options or other dilutive common stock equivalents, and as a
result, the basic and diluted weighted average common shares outstanding for the
three and nine month period ended September 30, 2003 and 2002, are the same and
are 100 shares.
Consolidation Policy
The consolidated financial statements include the accounts of Primecore Mortgage
Trust and its wholly owned subsidiary, 99 Investors LLC. All intercompany
accounts and transactions have been eliminated in consolidation.
Reclassifications
Certain prior period amounts have been reclassified to conform to current period
presentation.
New Accounting Pronouncements
SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities
In April 2003, the FASB issued SFAS No. 149 (FAS 149), "Amendment of Statement
133 on Derivative Instruments and Hedging Activities" (FAS149). FAS 149 amends
and clarifies the accounting guidance on (1) derivative instruments (including
certain derivative instruments embedded in other contracts) and (2) hedging
activities that fall within the scope of FASB Statement No. 133 (FAS 133),
Accounting for Derivative Instruments and Hedging Activities. FAS 149 is
effective (1) for contracts entered into or modified after June 30, 2003, with
certain exceptions, and (2) for hedging relationships designated after June 30,
2003. The adoption of FAS 149 did not have a material impact on our financial
condition and results of operations.
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics
of both Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150 (FAS 150), "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
9
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
statement requires that (1) financial instruments issued in the form of
mandatorily redeemable shares, (2) financial instruments that, at inception,
represents an obligation to repurchase the issuer's shares or is an obligation
indexed to the price of the company's shares, and (3) financial instruments that
embody an unconditional obligation, or a conditional obligation for an
instrument other than an outstanding share, that the issuer must or may settle
by issuing a variable number of equity shares, be classified as liabilities if
at inception the monetary value is based on (1) a fixed amount, (2) variations
in something other than the fair value of the issuer's shares or (3) variations
inversely related to the fair value of the issuer's shares. We adopted the
required provisions of FAS 150 on July 1, 2003 and the adoption did not
materially impact our financial statements.
3. INVESTMENTS IN REAL ESTATE UNDER DEVELOPMENT:
We make ADC loans with maturity dates generally up to 18 months. The term of an
ADC loan may be extended, when management deems it appropriate to do so. For
financial reporting purposes, we account for our ADC loans as investments in
real estate under development. Investments in real estate under development
represent funds advanced in cash plus capitalized interest on arrangements in
effect at any particular time. Since real estate under development generates no
operating income, we do not accrue any income for financial reporting purposes
until the sale to a third party or refinancing of a property by another lender.
The income (interest and points) that we ultimately realize is based upon the
value of the financed property and terms of the ADC loan. During the three
months ended September 30, 2003 fixed contractual interest rates on ADC loans
outstanding ranged from 11 percent to 17 percent. In the case of ADC loans on
which the borrower defaulted under the terms of our lending contract, the
interest rate charged during the period of default was an additional 5 percent
over the note rate. In addition, we charged points on most ADC loans, which were
typically 4 percent of the borrowed amount.
The following table summarizes our portfolio of ADC loans at September 30, 2003:
Maturity Commitment Carrying
Location - County Number Dates Amount Amount
- --------------------- --------- -------------- ---------------- ---------------
Alameda 2 12/02-04/03 $ 3,954,000 $ 1,281,949
Marin 7 08/01-12/03 39,425,000 17,558,492
Monterey 3 12/02-12/03 25,025,000 15,784,808
San Francisco 2 03/02-06/03 12,950,000 4,109,517
San Mateo 9 04/02-08/05 51,359,485 20,682,386
Santa Clara 4 09/01-06/03 10,925,000 6,191,238
--------- ----------------- ---------------
27 $ 143,638,485 $ 65,608,390
========= ================= ===============
During the three months and nine months ended September 30, 2003, we capitalized
$226,354 and $1,123,480 of interest costs to investments in real estate under
development compared with $503,557 and $1,552,936 during the three months and
nine months ended September 30, 2002.
We expect to fund commitments on existing ADC loans from the repayment of other
ADC loans, proceeds from sales of REO properties or issuance of unsecured notes
payable. As of September 30, 2003 our unfunded commitment was $19,089,414,
exclusive of interest and points compared with $23,835,015 at December 31, 2002.
We believe we will have adequate sources of capital to fund these commitments
when and as they become due.
As of September 30, 2003, we had loans with a carrying amount of $3,513,053,
which had not been paid by their stated maturity dates and which we do not
intend to extend compared with $10,293,731 at December 31, 2002. These ADC loans
accrue interest at the default rate, which is 500 basis points above the note
rate. We may choose not to extend these contracts for a variety of reasons.
10
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Additionally, at September 30, 2003, we had recorded notices of default on loans
with a carrying amount of $27,157,790 compared with $18,886,100 at December 31,
2002. Recording a notice of default begins the process of foreclosure. All ADC
loans for which a notice of default has been recorded are charged interest at
the default rate which interest will be collected upon repayment of the ADC loan
assuming there are sufficient proceeds. Recording a Notice of Default is our
last resort and usually is done only in cases where we believe that the builder
cannot or will not perform its obligations.
During the three months and nine months ended September 30, 2003, we charged
$1,770,336 and $9,227,547 to operations for ADC loans we believe are impaired
compared with $550,984 and $1,945,042 during the three months and nine months
ended September 30, 2002, respectively.
4. INVESTMENT IN REAL ESTATE HELD FOR SALE:
As of September 30, 2003, we held title to 14 properties received through
foreclosure or by deed in lieu of foreclosure.
The following table summarizes investments in real estate held for sale at
September 30, 2003:
Carrying
County Number Amount
- ------------------------------------------------------- ------------------
Alameda 1 $ 210,127
Marin 2 3,658,671
San Francisco 3 3,382,877
San Mateo 2 7,263,590
Santa Clara 6 21,544,232
----------- ------------------
Total 14 $ 36,059,497
=========== ==================
We report these properties at the lower of their existing carrying amount or net
realizable value and they are in various stages of construction. The properties
will be sold in the manner which we believe maximizes their value to us. During
the three months and nine months ended September 30, 2003, we capitalized
$96,559 and $330,674 of interest costs to investments in real estate held for
sale that were still under construction compared with $108,665 and $207,404
during the three months and nine months ended September 30, 2002.
Additional funds will be required to complete certain investments in real estate
held for sale. We will fund these costs from the repayment of other ADC loans,
proceeds from the sale of REO properties or issuance of unsecured notes payable.
As of September 30, 2003, our estimated costs to complete these investments was
$8,809,783 compared with $15,320,528 at December 31, 2002.
During the three months and nine months ended September 30, 2003, we charged
$438,239 and $6,911,886 to operations for impairments on Investments in Real
Estate Held For Sale compared with none during the three months and nine months
ended September 30, 2002.
5. UNSECURED NOTES PAYABLE:
We had unsecured borrowings of $6,071,404 at September 30, 2003 on notes issued
to accredited investors through private placements compared with $14,095,017 at
December 31, 2002. These notes have varying maturities of up to two years from
the date of issuance and bear interest at fixed rates between 8.50 and 12.00
percent with interest payable monthly in arrears. We may repay these notes,
without penalty, at our option before their stated maturity.
Included in our unsecured notes payable is $280,000 owed to one of our directors
at September 30, 2003 compared with $150,000 at December 31, 2002. One note for
$150,000, bears interest at 10%, was issued for a two-year term and matures on
June 28, 2004. The second note for $130,000, bears interest at 8.50% was issued
for a three-year term and matures on May 29, 2006.
Additionally, at September 30, 2003, we had $75,739 due on notes payable to
financial institutions to finance the cost of our insurance policies compared
with $181,912 at December 31, 2002. The note bears interest at 8.77% and
requires monthly payments $11,138.
11
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
The following table summarizes the maturities of our notes payable at September
30, 2003:
December 31, Amount
-------------------- ----------------
2003 $ 2,835,890
2004 2,931,253
2005 250,000
2006 130,000
----------------
Total $ 6,147,143
================
6. SECURED NOTES PAYABLE:
At September 30, 2003 we owed $3,185,000 under a note payable, payable to a
financial institution secured by real property we own, compared with $7,993,000
at December 31, 2002. The note bears interst at 5.0%, requires monthly interest
only payments of $11,944 and matures May 1, 2030.
7. Secured Line of Credit
At September 30, 2003 we had retired our secured line of credit which balance
was $14,431,132 at December 31, 2002. The line was fully repaid on September 7,
2003
8. SHAREHOLDERS' EQUITY
We have authorized 50,000,000 shares of capital stock with a $0.01 par value;
40,000,000 shares are designated Class A Convertible Preferred (Preferred
Stock), and 10,000,000 shares are designated as common. At September 30, 2003,
there were 100 shares of common stock outstanding.
The 22,481,373 and 22,496,804 shares of Preferred Stock outstanding as of
September 30, 2003 and December 31, 2002, respectively, rank senior to our
common stock as to dividends and liquidation rights. The shares are convertible
into, and have voting rights equal to, the same number of shares of our common
stock. We will not pay any dividends to the holders of the common stock so long
as any Preferred Stock is outstanding.
Preferred Stock dividends and distributions were $0.12 and $0.47 per share
(based on weighted average preferred shares outstanding of 22,487,371) for the
three months and nine months ended September 30, 2003 compared with $0.26 and
$0.79 per share (based on weighted average preferred shares outstanding of
22,369,356 and 22,058,891) for the three months and nine months ended September
30, 2002. On July 16, our Board of Directors voted to suspend payment of return
of capital dividends after the payment of August dividends, which was made on
September 7, 2003.
Holders of our Preferred Stock do not have a right to redeem their shares. Our
Board of Directors has adopted a stock redemption policy for Preferred
shareholders who wish to sell their shares to us. The policy may be modified or
terminated at the Board's discretion at any time. Effective February 12, 2003,
the Board of Directors implemented a new redemption policy for shareholders who
wish to sell their shares to us. Under this policy we will repurchase shares, at
fair market value, as determined by our Board of Directors, utilizing 25% of
"free cash flow" for such purposes. "Free cash flow" means the total of all
proceeds from repayments of loans and all net proceeds from the sale of
real-estate-owned properties in the Company's portfolio during a Repurchase
Period, and then subtracting from such total amounts due during the same period
for (i) existing loan commitments, (ii) debt payments to third parties, (iii)
dividend or other distributions to shareholders, and (iv) operating expenses.
The periods between October 1 and March 31 of the following year, and April 1
and September 30 are each a "Repurchase Period" for the purposes of calculating
"free cash flow," except that the first Repurchase Period under the policy ran
12
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
from January 1, 2003 through March 31, 2003. Redemption of shares is always
subject to availability of funds for redemption purposes. All redemption
requests will be determined and acted upon in accordance with the best interests
of the Company. We will not sell or otherwise liquidate any portion of our
mortgage loan portfolio or other assets to fund a redemption request
We have sold stock through private placement, five of which have closed since
our inception, resulting in issuance of 26,161,438 shares at $10.00 per share.
We have used the proceeds from issuance of our Preferred Stock primarily to fund
additional ADC loans and also for working capital purposes. As of September 30,
2003 we did not have an active private placement.
9. TRANSACTIONS WITH AFFILIATES:
Management Fees
Our day-to-day business affairs are managed, pursuant to a written agreement by
Primecore Funding Group, Inc. The agreement generally provides that the fees our
manager earns will be based on three components: a base fee, determined monthly,
of 3.125% per annum of the total carrying amount of our investments in real
estate, determined according to US GAAP; a cash flow bonus, determined
quarterly, payable only upon achieving certain levels of loan repayments; and a
rate of return bonus, determined quarterly, which is payable only upon achieving
certain income per share returns for holders of Preferred Stock.
During the three and nine months ended September 30, 2003 our Manager earned a
cash flow bonus of $39,940. Of the amount earned, $27,958 was used to repay the
Manager's obligation under the Affilate Loan Agreement.
Payable to Manager
We owed $301,316 to our Manager at September 30, 2003 for fees earned in
September 2003 and reimbursable expenses compared with $669,480 payable December
31, 2002. The amounts payable to our Manager are typically paid during the
following month.
Real Estate Sales Commissions
We paid real estate sales commissions of $489,900 and $725,500 during the three
months and nine months ended September 30, 2003 to Primecore Properties, Inc.,
an affiliate, compared with $40,200 and $88,500 during the three months and nine
months ended September 30, 2002. The commissions were paid for services provided
by Primecore Properties under listing agreements to sell property acquired by us
through foreclosure or deed in lieu of foreclosure. Under the listing
agreements, Primecore Properties, Inc. has agreed to charge us a below-market
commission rate in connection with their services. Primecore Properties, Inc.
only provides services in those geographic areas where it normally practices; in
other areas, we list the sale of our real estate owned properties with
unaffiliated brokers.
10. COMMITMENTS AND CONTINGENCIES:
Litigation
We are involved in legal actions arising in the normal course of our business.
We are not presently subject to any material litigation nor, to our knowledge,
is any litigation threatened against us which collectively is expected to have a
material adverse effect on our cash flows, financial condition or results of
operations.
Construction Contracts
In connection with our development of investments in real estate held for sale,
we have entered into contracts with construction companies totaling $2,432,623
to complete these projects where necessary. We will make payments on these
contracts as construction progresses in much the same manner we do for our
investments in real estate and investments in real under development by
affiliates.
13
PRIMECORE MORTGAGE TRUST, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
General Uninsured Losses
We require that our borrowers carry comprehensive liability, fire, flood,
extended coverage, and rental loss insurance with policy specifications, limits,
and deductibles customarily carried for similar properties. We also carry
insurance to cover losses in case a borrower's policy lapses. There are,
however, certain types of extraordinary losses that may be either uninsurable or
not economically insurable. Further, all of our investments are located in areas
that are subject to earthquake activity. Should an investment sustain damage as
a result of an earthquake, we may incur losses due to insurance deductibles,
co-payments on insured losses, or uninsured losses. Should an uninsured loss
occur, we could lose our investment in, and anticipated profits and cash flows
from an investment.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
General
Our material financial transactions have been acquiring and holding a portfolio
of construction mortgage loans. Statements contained in this Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," and elsewhere in this Form 10-Q, which are not historical facts,
may be forward-looking statements. Such statements are subject to risks and
uncertainties that could cause actual results to differ materially from those
projected. Investors are cautioned not to attribute undue certainty to these
forward-looking statements, which speak only as of the date of this Form 10-Q.
We undertake no obligation to publicly release any revisions to these
forward-looking statements to reflect events or circumstances after the date of
this Form 10-Q or to reflect the occurrence of unanticipated events, other than
as required by law.
Overview
We are primarily engaged in the business of providing secured loans for the
development of residential real estate. The business has been active in its
current form since 1999 and related business activities that preceded the
formation of the corporation began in 1996. Officers and employees of the
Company and its Manager have substantial experience in real estate and real
estate lending matters.
On October 7, 2003 our Board of Directors voted to revoke our REIT status
effective with the tax year beginning January 1, 2004. In making this decision
the board considered the following factors: (1) We project that we will have a
net operating loss which can be used to offset taxable income in the future and
thereby avoid corporate level tax; (2) By revoking our REIT status we will be
free of restrictions that apply to our investments and which potentially limit
the rate of return we can achieve on them; (3) federal tax legislation adopted
in 2003 caps an individual's maximum taxable rate for corporate dividends at 15%
but does not apply to REIT dividends. Therefore, income dividends distributed by
us if we remained a REIT would be taxable at maximum personal income tax rates
rather than at the 15% rate paid by non-REIT corporations.
Our strategy targets the needs of small and medium-sized developers who are
actively building single-family and smaller multi-family housing units in high
demand residential areas. Several characteristics of this target customer base
and residential housing market have been vital to our business model:
1. These borrowers are generally not well served by institutional lenders such
as commercial banks. There are few lending institutions that are interested in
making construction loans to smaller developers. Traditional lending
institutions often lack the focused local residential real estate development
expertise to evaluate specific projects involving redevelopment of individual
home sites or smaller multifamily complexes. Thus these institutions are
generally slow to respond to developers needs and they propose difficult terms
and conditions on their loans. Developers have been pleased to deal with
Primecore due to its knowledge and responsiveness with respect to such projects.
Furthermore, the developers have been willing to pay interest rates and loan
fees above those charged by commercial banks on other classes of loans.
14
2. Residential real estate demand in certain well-established locations has
historically been strong throughout the various stages of economic cycles.
Except during exceptional economic downturns, this demand strength has supported
relatively strong and stable valuations for such residential real estate.
Similarly, this demand strength has typically led to high sales volumes of
dwelling units.
3. The greater San Francisco Bay Area and specifically the mid-peninsula region,
includes numerous cities, towns and neighborhoods that exhibit attractive
residential housing characteristics. This region has a large and diverse economy
developed in a geographically constrained area. Most residential housing
locations have been fully developed for decades and yet a chronic shortage of
housing perpetually exists in proximity to employment opportunities. New housing
built in this region on either the few remaining undeveloped lots or on lots
formerly occupied by older housing has historically, excluding exceptional
economic downturns, enjoyed strong demand and relatively stable high values.
Most of the loans we make are classified as Acquisition, Development and
Construction (ADC) loans because they contain most of the characteristics
peculiar to these types of loans. ADC loans have the following characteristics:
1. The lender has agreed to provide all or substantially all necessary funds
to acquire, develop or construct the property. The borrower has title to
but little or no cash equity in the project;
2. The lender funds substantially all the interest and fees during the term of
the loan by adding them to the loan balance;
3. Typically, the lender's only security is the project itself, the lender no
recourse to other assets of the borrower, and the borrower does not
guarantee the debt;
4. In order for the lender to recover its investment in the project, the
property must be sold to independent third parties or the borrower must
obtain refinancing from another source.
Our business model contemplates making ADC loans and mezzanine loans secured by
residential real estate as well as real estate equity investments. We have, in
the past, sought to accomplish a gross yield of approximately 16% on our loans.
However, the Bay Area economy has endured an unprecedented slowdown beginning
approximately 2001. This was driven first by a reversal of the rapid expansion
of the technology and telecommunications industries in which Silicon Valley
companies play a leading role. Then, the general economic slowdown, and the
slowdown in real estate activity, experienced in the United States and Europe
following terrorist attacks in the fall of 2001, the war in Iraq further
exacerbated this economic slowdown.
While some residential real estate in the region has generally continued to
enjoy strong demand despite the economic downturn, projects in the locations
and price ranges we funded were hard hit. In particular, housing with prices in
excess of $2.5 million experienced a significant slow down in sales volume and
unprecedented valuation declines. Prior to and during 2000, we made a
significant number of ADC loans for the development of such housing units. As
of January 1, 2003, 66% of the estimated collections from our investments were
invested in properties with estimated sale prices greater than $2.5 million per
unit. These properties have been selling slower than anticipated, and in a
number of cases have been sold at substantially lower prices than contemplated
when the ADC loans were made. During 2003 and 2004, additional non-performing
ADC loans and foreclosed properties that we now own ("REO") must be liquidated.
We expect continued lower than expected revenues during this liquidation period.
As non-performing investments are completed and sold, new investments will be
made with the intent to yield attractive rates of return.
Results of Operations
Income from Real Estate Investments
Our business model targets a 16% gross rate of return on these funds. Although
we charge our borrowers for the use of our money, we typically do not actually
collect principal, interest or fees until the financed property has sold or is
refinanced by a third party lender. We also do not generally have recourse to
other borrower assets, so we must usually rely on the value of the securing
property to support repayment of our loan plus accrued interest. We calculate
the gross internal rate of return for our closed investments based on the
discounted present value of the investment cash flows on an
15
investment-by-investment basis. Our target yield is 16%. The chart below depicts
the two-year average yield on our investments. We use a two-year average because
it fairly closely corresponds with the average term of our investments.
[GRAPHIC OMITTED]
The chart shows the effects the economic downturn has had on the yield of our
closed investments. The two-year average yield from our investments during the
three and nine months ended September 30, 2003 was 4.73% and 6.72% compared with
14.31% and 14.99% during the three and nine months ended September 30, 2002. The
decrease resulted mainly from our inability to collect the amounts we had
estimated on the loans we made in 1999 and 2000. As we continue to close ADC
loans and REO properties in our portfolio that were made in 1999 and 2000, we
expect the two-year average yield will continue to decrease. As we use the
proceeds from these investments to make new loans we anticipate the average
yield will begin to move toward our target yield, however, because the yield
reflects data from closed investments and our investment cycle is typically two
years, we do not expect to observe this upward trend until the end of the
investment cycle.
The following table sets forth our proforma results of operations for the three
and nine months ended September 30, 2003 if we recognized accrued income on our
performing ADC loans during the period the income was accrued and not when we
receive repayment of the ADC loan. This information is not required disclosure
and is not intended to present our results of operations in conformity with
Generally Accepted Accounting Principles in the United States of America.
Because our basis of presentation under US GAAP does not allow for recognition
of accrued interest and points from the ADC loans in our investment portfolio,
we are unable to reflect accrued interest and fees during the same period we
report expenses in our GAAP finanical statements. This proforma presentation
reports the estimated collectible revenues in the same period with the expenses
incurred to collect it. In this presentation we recognize income from our ADC
loans as it is accrued but only to the extent that we believe the value of the
underlying property supports collection. We include interest expense on our
obligations as an expense rather than capitalizing it to the ADC loans. We also
recognize charges to income for any changes in net realizable value that affect
the collectibility of our ADC loans.
16
Three months Nine months
ended ended
September 30, 2003 September 30,
2003
------------------- ------------------
Proforma income from real estate loans and ADC loans $ 616,017 $ 4,786,781
Proforma expenses
Management fee expense 896,095 3,120,171
Interest expense 322,913 1,454,155
General and administrative expense 529,883 1,173,069
------------------- ------------------
Total proforma expenses 1,748,891 5,747,395
------------------- ------------------
Proforma loss from operations (1,132,874) (960,614)
Proforma loss on ADC loans and REO properties (2,734,888) (32,348,706)
------------------- ------------------
Proforma net loss (3,867,762) (33,309,320)
------------------- ------------------
Proforma loss per share of preferred stock (based on
weighted average shares outstanding of 22,457,956
and 22,484,152 $ (0.17) $ (1.48)
=================== ==================
During the three and nine months ended September 30, 2003 we funded
approximately $2.7 millionin new investments. At September 30, 2003 we had
performing ADC loans totaling $20.4 million, including the $2.7 million in new
investments. We accrued interest of $616,017 and $4,786,781 on performing ADC
loans during the three and nine months ending September 30, 2003. Performing ADC
loans are ADC loans which accrue interest and have estimated net realizable
values which support collection of the ADC loan balance, including accrued
interest.
Our management fee expense, interest expense and general and administrative
expenses results are the same amounts shown in our US GAAP statement of
operations and the results are discussed below.
Proforma loss on investments result from adjustments to our estimates of net
realizable value or from actual results which were less than our net realizable
value estimates. We recognized a proforma loss on investments of $2,734,888 and
$32,348,706 for the three and nine months ended September 30, 2003.
Approximately $2.4 million of the $2.7 million proforma loss during the three
months ended September 30, 2003 resulted from changes in values we ascribed to
properties resulting from changes in our planned disposition of the properties.
Most of the approximately $32.3 million proforma loss recognized during the nine
months ended September 30, 2003 resulted from the revaluation of most of the
high end properties in our portfolio in June 2003. As we discussed in our June
30, 2003 10-Q the information we used to determine the net realizable values of
our investments prior June 2003 had been taken from the few sales of high-end
properties in the middle and later months of 2002. The prices received from
high-end properties in our portfolio were significantly lower than our
estimates.
Realizable Value of Investments
For financial statement purposes, we do not report as income the amount of
interest and points we charge to borrowers until we collect it. Because we have
a contractual right to receive it, the amount of interest and points we charge
borrowers is added to the balance due on our ADC loans. As the values of the
collateral supporting payment of our ADC loans have declined, the collectibility
of our accrued interest and points has, in many cases, become doubtful.
Management includes the amount of collectible interest and points we are
entitled to receive when it sets dividend rates and prices for selling and
redeeming our stock. The information presented below summarizes that analysis
and reconciles the differences between the carrying values under US GAAP and the
estimated realizable value (NRV) of our investments.
17
September 30,2003 December 31, 2002
------------------- -----------------
Investments in real estate under
construction $ 65,608,390 $ 101,141,515
Investments in real estate held for sale 36,059,497 44,510,168
------------------- -----------------
Total investments in real estate per US
GAAP 101,667,887 145,651,683
Add: GAAP impairments 23,692,658 18,753,706
Accrued interest and points 50,760,152 64,337,376
Less: Capitalized interest (5,816,309) (6,566,481)
------------------- -----------------
Balance owed on real estate investments 170,304,388 222,176,284
Amount estimated uncollectible (56,556,843) (43,875,448)
------------------- -----------------
Estimated realizable value of investments
in real estate (NRV) $ 113,747,545 $ 178,300,836
=================== ==================
NRV represents our current estimate of the amount of proceeds we expect to
receive once our investment is completed and ready for sale. The estimate relies
on a number of assumptions including the expected value of the investment once
completed, less applicable selling costs, the remaining costs required to
complete projects and the length of time required to complete the project. Many
factors, some outside our control, can cause changes in these estimates and
produce significantly different results.
Stock Redemption Price
Our Preferred Stock does not trade on any secondary market. Accordingly, we have
established a repurchase policy to provide liquidity to our shareholders. The
Board has determined that the repurchase price of the stock should be determined
with reference to the NRV of our assets.
The following calculation established the repurchase price of our stock at
September 30, 2003 and December 31, 2002 for purposes of our Redemption Policy
only:
September 30, 2003 December 31, 2002
------------------- ------------------
Cash $ 784,942 $ 4,394,107
NRV of investments in real estate 113,747,545 178,300,836
Loans secured by real estate -- 4,695,000
------------------- ------------------
Total realizable assets 114,532,487 187,389,943
Total liabilities (9,897,517) (38,639,018)
------------------- ------------------
Net realizable assets 104,634,970 148,750,925
Preferred shares outstanding 22,381,473 22,496,804
------------------- ------------------
Preferred Stock repurchase price $ 4.68 $ 6.61
=================== ==================
The Preferred Stock repurchase price is determined for the sole purpose of
satisfying the provisions of our Redemption Policy and is not meant to establish
the fair market value of our Preferred Stock. The fair market value of our stock
can only be determined through a free market of buyers and sellers. The
repurchase price is also not meant to represent the amount which would be
obtained for a share of Preferred Stock upon liquidation of the company. The
repurchase price uses estimates of future completed values which cannot be
18
assured; does not discount for the period it would take to complete our ADC
Loans and REO properties; and does not factor in administrative costs or
potential future revenues collectible.
The following table details the changes to our Preferred Stock repurchase price
for the nine months ended September 30, 2003:
Repurchase price at December 31, 2002 6.61
Proforma loss per share (1.48)
Preferred stock distributions (0.47)
Discount on redemption of Preferred Stock 0.02
-------------------
Repurchase price at September 30, 2003 4.68
===================
Management fees
During the three and nine months ended September 30, 2003 our management fee
expense was $856,155 and $3,080,231 compared with $2,438,338 and $7,546,893
during the three and nine months ended September 30, 2002. The decrease is due
to an amendment of the management agreement which became effective January 1,
2003. The agreement generally provides that the fees our manager earns will be
based on three components: a base fee, determined monthly, of 3.125% per annum
of the total carrying amount of our investments in real estate, determined
according to US GAAP; a cash flow bonus, determined quarterly, payable only upon
achieving certain levels of loan repayments; and a rate of return bonus,
determined quarterly, which is payable only upon achieving certain income per
share returns for holders of Preferred Stock. Prior to January 1, 2003, we paid
management fees based on the amount of loan commitments outstanding at the end
of each month.
During the three and nine months ended September 30, 2003 our Manager earned a
cash flow bonus of $39,940. Of the amount earned, $27,958 was used to repay the
Manager's obligation under the Affiliate Loan Agreement.
Interest costs
Since December 31, 1999, all interest costs have been capitalized as a cost of
our investments. Interest cost associated with our borrowings was $322,913 and
$1,454,155 during the three and nine months ended September 30, 2003, compared
with $616,988 and $1,949,086 during the three and nine months ended September
30, 2002. The decrease in interest costs for the three months ended September
30, 2003 compared to the three months ended September 30, 2002 was due to a
lower amount of debt on our balance sheet, an average of $14.7 million during
the three months ended September 30, 2003 compared to an average of $28.7
million for the three months ended September 30, 2002. The cost of our debt
increased slightly to an average of 9.14% from 8.40% during the same period as
we paid down our lower cost secured debt faster than our unsecured notes. Our
interest cost also decreased during the nine months ended September 30, 2003
compared with the nine months ended September 30, 2002 due to a combination of a
decrease in the average amount of debt outstanding, $23.6 million during the
nine months ended September 30, 2003 compared with $28.4 million during the nine
months ended September 30, 2002. The cost of our debt also decreased to 8.43%
from 9.32% during the same period as a result of the decrease the borrowing
costs associated with our secured debt tied to the prime rate and through
extensions and renegotiations of our unsecured notes. We expect to continue to
reduce debt as we receive payments from our ADC loans and REO properties. We
also paid off our secured line of credit in full on September 7, 2003.
General and administrative expenses
We have no employees, and our general and administrative and other expenses
consist primarily of professional fees, directors' fees and insurance costs.
General administrative and other expenses were $529,883 and $1,173,069 during
the three and nine months ended September 30, 2003, compared with $117,001 and
$285,358 during the three and nine months ended September 30, 2002. The
increased costs of approximately $413,000 during the three months ended
September 30, 2003 compared to the three months ended September 30, 2002
resulted from increased legal fees of approximately $113,000 associated with
protecting our security interests in our investments and costs of approximately
$300,000 associated with ownership and disposition or our REO properties. The
19
increased costs of approximately $888,000 during the nine months ended September
30, 2003 compared to the nine months ended September 30, 2002 resulted from
increased legal costs of approximately $129,000 associated with protecting our
security interests in our investments; increased insurance costs associated of
approximately $180,000 with our ownership of our REO properties; and increased
costs of approximately $450,000 associated with ownership and dispostition or
our REO properties. Additionally, the cost of our quarterly reviews and annual
audits increased by approximately $74,000 due to additional procedures performed
by our new auditors necessary to comply with new regulatory requirements.
Finally, we incurred additional expenses of approximately $54,000 for
professional services associated with appraisal of our investments and services
necessary to seek additional financing.
Liquidity and Capital Resources
Liquidity means the need for, access to and uses of cash. Our principal demands
for liquidity are cash for operations, funds that are required to satisfy
obligations under existing loan commitments, management fees, interest expense
associated with our indebtedness and debt repayments. In the near term, our
principal sources of liquidity are the repayments of our real estate investments
and funds received from issuance of unsecured notes payable.
Sources of cash
Investment repayments
Our largest source of liquidity is the repayment of our investments in real
estate. In most cases, we must rely on the sale of the project before we can
collect our investment, which means that our repayment is largely dependent on
the state of the real estate market. As discussed above in Results of
Operations, at December 31, 2002 approximately 66% of the estimated proceeds
from our investments were invested in properties expected to sell at prices over
$2.5 million.
Sales of properties in the $2.5 million and over sector were very slow during
the first five months of 2003 during which we received no payments from our high
end investments. However, from June through September 2003 we received repayment
of approximately $25.6 from six investments which sold at prices over $2.5
million. During the nine months ended September 30, 2003, we received loan
repayments, including income, of approximately $59.6 million. Of the total
payments received, approximately $25.6 represented proceeds from properties
which sold at prices at $2.5 million or more. As a result, the weighting of
investments in our portfolio expected to sell at prices of $2.5 million and over
increased to approximately 72% at September 30, 2003.
The chart below depicts the amount of proceeds we expect to collect from our
existing investments once they have sold or refinanced. The bars of the graph
categorize the proceeds by the price sector of the underlying property.
20
[GRAPHIC OMITTED]
The chart shows that we estimate we will collect approximately $35 million in
proceeds from ADC loans and REO properties which were complete and on the market
as of September 30, 2003. Of that approximately $16 million represented ADC
loans and REO properties valued at less than $2.5 million per unit. We expect an
additional $3 million in estimated proceeds from ADC loans and REO properties
valued at less than $2.5 million to complete construction within the next three
months. We expect properties with offer prices under $2.5 million to sell in
three to six months if the property is well priced, based on existing market
conditions. Sales of properties in this price sector have remained fairly stable
and the cash flow we expect from them has been fairly reliable.
At September 30, 2003 we had approximately $19 million in estimated proceeds
from ADC loans and REO properties valued at $2.5 million or more, which were
complete and on the market. We expect an additional $19 million in estimated
proceeds from ADC loans and REO properties valued at $2.5 million or more to be
completed within the next three months. For properties with offer prices
exceeding $2.5 million, we expect six months to one year for the property to
sell if it is well priced. These properties have been the most difficult to sell
or refinance during the last 18 months and we currently expect that to continue.
Because a single loan repayment can have a large impact on our repayment
projections, it is difficult to predict repayments with precision, especially as
construction and sales can be delayed due to factors beyond our control, such as
weather, borrower delays, and lengthy foreclosure or borrower bankruptcy
proceedings Currently, we believe we will have sufficient funds from the
repayment of our ADC Loans and REO properties to meet our obligations over the
next twelve month period.
Stock sales
In the past, our liquidity has been enhanced through sales of our Preferred
Stock which was sold through private placements. We currently do not have an
active private placement and do not expect to open a new one until we have
liquidated a substantial part of our existing investment portfolio and
reinvested the proceeds in new projects.
Issuance of unsecured notes payable
We issue a limited amount of short-term notes payable as an investment
alternative to our Preferred Stock. During the three and nine months ended
September 30, 2003 we issued $0 and $380,000 in unsecured notes payable compared
21
with approximately $3.1 million and $4.0 million issued during the three and
nine months ended September 30, 2002.
Uses of Cash
The following table sets forth the projected timing and amount of our
obligations:
2005
Total 2003 2004 and beyond
------------- ----------- ------------ ------------
Investment fundings 31,668,000 7,000,000 24,668,000 --
Secured note payable 3,185,000 -- -- 3,185,000
Unsecured notes payable 6,147,143 2,835,890 2,931,253 380,000
Investment fundings
Investment fundings are the largest use of our cash. At September 30, 2003 we
estimated costs to complete our investments were $31.7 million. These amounts
will be funded as construction progresses on our investments. The exact timing
of the investment fundings is dependent on several factors including weather,
governmental regulation and developer related issues, so the timing of
investment fundings in the above table is an estimate based on information
available to us at this time. Additionally, we expect the amount of actual
investment fundings to be higher than our obligation existing at September 30,
2003 as we continue to make and fund new loan commitments in 2003 and beyond.
Secured notes payable
Our secured note payable is secured by a first deed of trust on a property we
own. Monthly interest payments of $11,944 are required and the note matures in
2030. The note contains a due on sale provision and will be repaid once the
property is completed and sold.
Unsecured notes payable
At September 30, 2003 we had approximately $6.1 million in unsecured notes
payable, approximately $2.8 million of which will mature in 2003.
Stock repurchases
Effective February 12, 2003, the Board of Directors implemented a new redemption
policy for shareholders who wish to sell their shares to us. The policy may be
modified or terminated at the Board's discretion at any time. Currently, we will
repurchase shares, at fair market value, as determined by our Board of
Directors, utilizing 25% of "free cash flow" for such purposes. "Free cash flow"
means the total of all proceeds from repayments of loans and all net proceeds
from the sale of real-estate-owned properties in the Company's portfolio during
a Repurchase Period, and then subtracting from such total amounts due during the
same period for (i) existing loan commitments, (ii) debt payments to third
parties, (iii) dividend or other distributions to shareholders, and (iv)
operating expenses. The periods between October 1 and March 31 of the following
year, and April 1 and September 30 are each a "Repurchase Period" for the
purposes of calculating "free cash flow," except that the first Repurchase
Period under the policy ran from January 1, 2003 through March 31, 2003.
Redemption of shares is always subject to availability of funds for redemption
purposes, and all redemption requests are acted upon in accordance with the best
interests of the Company.
During the nine months ended September 30, 2003 we made payments to shareholders
totaling $346,442 for repurchase of shares. Based on current cash flow
projections, we believe that the unpaid balance allocated for stock repurchases
at March 31, 2003 will be paid during the three months ended December 31, 2003.
The following table sets forth the determination and allocation of Free Cash
Flow to be made available for repurchase of stock on November 30, 2003 in
accordance with our Redemption Policy:
22
Six months
Ended
September 30, 2003
-------------------
Cash flow from operations $ 2,014,408
Cash flow from investing activities 24,681,827
Repayments of unsecured notes payable (5,889,683)
Repayments of secured notes payable (4,508,000)
Repayments of secured line of credit (7,595,559)
Dividends and distributions (7,869,111)
-------------------
Total "free cash flow" 833,882
Repurchase percentage 25%
-------------------
Funds allocated for stock repurchase $ 208,471
===================
We currently believe that there will be sufficient cash available to repurchase
shares with the allocated funds on November 30, 2003.
Critical Accounting Policies and Estimates
Management's Discussion and Analysis of Financial Condition and Results of
Operations covers our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. On an on-going basis, management evaluates its
estimates and judgments, including those related to the valuation of our assets
and liabilities. Management bases its estimates and judgments on historical
experience and on various other factors that are believed to be reasonable under
the circumstances, the results of which form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions. Management believes the following
critical accounting policies, among others, affect the more significant
judgments and estimates used in the preparation of its consolidated financial
statements.
Valuation and Realizability of Investments. All of our ADC loans are classified
for financial reporting purposes as investments in real estate under development
or investments in real estate under development by affiliates (see Notes 3 and 4
to the financial statements). We have foreclosed on some ADC loans that are
classified as investments in real estate held for sale (Note 5). Such
investments include capitalized interest and are stated at the lower of cost or
fair value. Management conducts a review for impairment on an
investment-by-investment basis whenever events or changes in circumstances
indicate that the carrying amount of an investment may not be recoverable.
Impairment is recognized when estimated expected future cash flows (undiscounted
and without interest charges), typically from the sale of a completed property,
are less than the carrying amount of the investment, plus estimated costs to
complete. The estimation of expected future net cash flows is inherently
uncertain and relies to a considerable extent on assumptions regarding current
and future economics and market conditions. If, in future periods, there are
changes in the estimates or assumptions incorporated into the impairment review
analysis, the changes could result in an adjustment to the carrying amount of
the investments. To the extent an impairment has occurred, the excess of the
carrying amount of the investment over its estimated fair value, less estimated
selling costs, will be charged to income. In accordance with this policy, we
recorded a provision for impairment of Investments in Real Estate Under
Development and Investments in Real Estate Held For Sale totaling $2,208,575 and
$16,577,672 during the three and nine months ended September 30, 2003 compared
with $7,992,171 and $9,465,487 during the three and nine months ended September
30, 2002, respectively. We believe that all of our investments are carried at
the lower of cost or fair value, however conditions may change and cause our ADC
loans and REO properties to decline in value in a future period.
23
Loan Accounting. We have applied the guidance of AICPA Practice Bulletin 1,
Purpose and Scope of AcSEC Practice Bulletins and Procedures for Their Issuance,
Exhibit I in accounting for our investment loans as real estate acquisition,
development, or construction (ADC) arrangements. In accordance with the ADC
accounting rules, we do not accrue income for interest and points on our ADC
loans until the sale or refinancing of a property. Revenue from interest and
points is recognized as cash is received from the sale or refinancing of such
properties. ADC loans are classified as investments in real estate under
development and investments in real estate held for sale (see Notes 3, 4 and 5
to the financial statements) and include amounts funded under the loan
agreements and capitalized interest expense. If our ADC loans qualified as loans
under GAAP, interest and points would be recognized as income in periods prior
to the sale of the underlying property.
REIT status and taxation. As a REIT, we generally will not be subject to
corporate-level federal income tax on net income that we distribute to our
shareholders. As such, no provision for federal income taxes is included in our
financial statements. On October 7, 2003 our Board of Directors voted to
withdraw our REIT election effective with the tax year beginning January 1,
2004. In making this decision the board considered the following factors: (1) We
project that we will have a net operating loss which can be used to offset
taxable income in the future and thereby avoid corporate level tax; (2) By
revoking our REIT status we will be free of restrictions that apply to our
investments and which potentially limit the rate of return we can achieve on
them; (3) federal tax legislation passed in 2003 caps the taxable rate for
corporate dividends at 15% but does not apply to REIT dividends. Therefore, any
income dividends distributed by us as a REIT would be taxable at maximum
personal rates rather than at the 15% rate paid by non-REIT corporations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
An investment in our stock involves a high degree of risk. Among other things,
some of the principal risks are: the real estate lending business may be
adversely affected by periods of economic slowdown, which may be accompanied by
declining real estate values on properties securing repayment of loans;
construction mortgage loans involve greater risks of repayment than loans
secured by property that has already been improved since completion market
valuation of a given project can be highly speculative and subject to
unanticipated conditions; there is no public market for our securities, and
liquidity is not assured; under our business model, loan commitments will
generally exceed immediately available cash resources, and failure to obtain
repayment of loans in our portfolio, or a failure to maintain sufficient equity
would affect our ability to fund commitments; since we have no employees, if our
manager refused or became unable to continue to serve us, and a proper
replacement were not found, this would materially impact our business.
We make loans at fixed rates of interest. To the extent that prevailing market
interest rates change during the holding period, the value of our loans may be
either adversely or positively affected. When a loan matures, generally within a
12 to 18 month period, it is subject to a new interest rate, determined by us,
based upon current conditions. Since we intend to hold all loans until they are
repaid, we do not believe that changes in market interest rates have a material
impact on the value of the Company.
ITEM 4. CONTROLS AND PROCEDURES.
We carried out an evaluation, under the supervision of the Company's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
Company's disclosure controls and procedures as of the end of the period covered
by this report. These disclosure controls and procedures are those controls and
procedures which are designed to ensure that all the information required to be
disclosed by the Company in all its periodic reports filed with the Securities
and Exchange Commission is recorded, processed, summarized and reported within
the time periods specified by the Commission and that the information is
communicated to the Chief Executive Officer, the Chief Financial Officer and the
Board of Directors on a timely basis. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer have each concluded that those
controls and procedures were effective in making known to them, on a timely
basis, the material information needed for the preparation of this Report on
Form 10-Q. There were no significant changes in the Company's internal controls
or in other factors that could significantly affect those internal controls nor
did we find any significant deficiencies and material weaknesses that would have
required corrective actions to be taken with respect to those controls.
24
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are not presently subject to any material litigation nor, to our knowledge,
is any litigation threatened against us which collectively is expected to have a
material adverse effect on our cash flows, financial condition or results of
operations.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
(a) Not Applicable.
(b) Not Applicable.
(c) Sales of Equity Securities.
Between January 1, 2003 and September 30, 2003, we sold 235 shares of our
Class A Convertible Preferred stock for $1,499.
Purchasers of our Class A Convertible Preferred stock are accredited
investors as defined in Regulation D, Rule 501 (a) (4), (5) or (6) under
the 1933 Securities Act. Each investor signed a subscription agreement
which included representations that the investor had sufficient knowledge
and experience in financial and business matters to be capable of
evaluating the merits and risks of investments generally, and of the
investment in our stock and the investor was able to bear the economic risk
of the investment. Each investor further acknowledged the investor
understood the entire investment could be lost.
The sales of stock were exempt from the registration requirements of the
Securities Act of 1933 pursuant to Regulation D, Rule 506. Appropriate
legends were placed on each stock certificate. No underwriters were
involved and no underwriting commissions were paid in any of the
transactions.
The terms of conversion of the stock have been previously reported.
(d) Not Applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
ITEM 5. OTHER INFORMATION.
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
Exhibits included with this Form 10-Q following the signature page, or those
incorporated by reference to other filings are:
3i.1 Articles of Incorporation of the Company are hereby incorporated herein
by reference from Exhibit 3(i) to the Company's Registration Statement on
Form 10-12G, filed on April 28, 2000
3i.2 Articles Supplementary of the Company are hereby incorporated herein by
reference from Exhibit 99.1 to the Company's Registration Statement on
Form 10-12G, filed on April 28, 2000
3ii.1 Bylaws, Amended March 21, 2000 are hereby incorporated herein by
reference from Exhibit 3(ii) to the Company's Registration Statement on
Form 10-12G, filed on April 28, 2000
25
3ii.2 Bylaws, Amended March 1, 2001 are hereby incorporated herein by reference
from Exhibit 3ii.2 to the Company's Annual Report on Form 10-K, filed on
March 30, 2001
4.1 Specimen Stock Certificate is hereby incorporated herein by reference
from Exhibit 99.2 to the Company's Registration Statement on Form 10-12G
filed on April 28, 2000
4.2 Registration Rights Agreement is hereby incorporated herein by reference
from Exhibit 4.1 to the Company's Registration Statement on Form 10-12G,
filed on April 28, 2000
4.3 Founder's Registration Rights Agreement is hereby incorporated herein by
reference from Exhibit 4.2 to the Company's Registration Statement on
Form 10-12G, filed on April 28, 2000
10.1 Management Agreement dated March 30, 1999 is hereby incorporated herein
by reference from Exhibit 10 to the Company's Registration Statement on
Form 10-12G, filed on April 28, 2000
10.2 Management Agreement dated October 1, 2000 is hereby incorporated herein
by reference from Exhibit 10.2 to the Company's Annual Report on Form
10-K, filed on March 30, 2001
11.1 Statement regarding computation of per share earnings
31.1 Rule 13a-14(a)/15d-14(a) Certification
31.2 Rule 13a-14(a)/15d-14(a) Certification
32.1 Section 1350 Certification
32.2 Section 1350 Certification
(b) Reports on Form 8-K
The Company filed a report on form 8-K July 21, disclosing the text of the
Company's new policy to suspend the payment of return of capital dividends.
26
SIGNATURES
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.
Dated: November 14, 2003 /s/ SUSAN FOX
-------------
Susan Fox, President
Dated: November 14, 2003 /s/ MICHAEL RIDER
-----------------
Michael Rider, Chief Financial Officer
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