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EX-32.1 - Shepherd's Finance, LLCex32-1.htm
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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, 2016

 

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 333-203707

 

SHEPHERD’S FINANCE, LLC

(Exact name of registrant as specified on its charter)

 

DELAWARE   36-4608739
(State or other jurisdiction of   (I.R.S. Employer
Incorporation or organization)   Identification No.)

 

12627 San Jose Blvd., Suite 203, Jacksonville, FL 32223

(Address of principal executive offices)

 

302-752-2688

(Registrant’s telephone number including area code)

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [  ]

 

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer [  ] Accelerated filer [  ]
Non-accelerated filer [  ] Smaller reporting company [X]

 

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

 

 

 

   
 

 

FORM 10-Q

SHEPHERD’S FINANCE, LLC

TABLE OF CONTENTS

 

 Page
Cautionary Note Regarding Forward-Looking Statements3
PART I. FINANCIAL INFORMATION4
Item 1. Financial Statements4
Interim Condensed Consolidated Balance Sheets as of September 30, 2016 (Unaudited) and December 31, 20154
Interim Condensed Consolidated Statements of Operations (Unaudited) for the Three and Nine Months Ended September 30, 2016 and 20155
Interim Condensed Consolidated Statement of Changes in Members’ Capital (Unaudited) for the Nine Months Ended September 30, 20166
Interim Condensed Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2016 and 20157
Notes to Interim Condensed Consolidated Financial Statements (Unaudited)8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations29
Item 3. Quantitative and Qualitative Disclosure About Market Risk49
Item 4. Controls and Procedures49
PART II. OTHER INFORMATION50
Item 1. Legal Proceedings 50
Item 1A. Risk Factors 50
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 50
Item 3. Defaults upon Senior Securities 50
Item 4. Mine Safety Disclosures 50
Item 5. Other Information 50
Item 6. Exhibits 50

 

2
 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Certain statements contained in this Form 10-Q of Shepherd’s Finance, LLC, other than historical facts, may be considered forward-looking statements within the meaning of the federal securities laws. Words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “continue,” “predict,” or other similar words identify forward-looking statements. Forward-looking statements appear in a number of places in this report, including without limitation, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and include statements regarding our intent, belief or current expectation about, among other things, trends affecting the markets in which we operate, our business, financial condition and growth strategies. Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those predicted in the forward-looking statements as a result of various factors, including but not limited to those set forth in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2015, as filed with the Securities and Exchange Commission. If any of the events described in “Risk Factors” occur, they could have an adverse effect on our business, consolidated financial condition, results of operations and cash flows.

 

When considering forward-looking statements, you should keep these risk factors, as well as the other cautionary statements in this report and in our 2015 Form 10-K in mind. You should not place undue reliance on any forward-looking statement. We are not obligated to update forward-looking statements.

 

3
 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

Shepherd’s Finance, LLC

Interim Condensed Consolidated Balance Sheets

 

   As of 
(in thousands of dollars)  September 30, 2016   December 31, 2015 
   (Unaudited)     
Assets          
Cash and cash equivalents  $561   $1,341 
Accrued interest on loans   208    146 
Loans receivable, net   17,915    14,060 
Foreclosed assets   3,237    965 
Other assets   89    14 
Total assets  $22,010   $16,526 
Liabilities and Members’ Capital          
Customer interest escrow  $639   $498 
Accounts payable and accrued expenses   1,165    539 
Notes payable secured   5,822    3,683 
Notes payable unsecured, net of deferred financing costs   10,941    8,497 
Due to preferred equity member   27    25 
Total liabilities   18,594    13,242 
           
Commitments and Contingencies (Notes 4 and 8)          
           
Series B preferred equity   1,100    1,010 
Class A common equity   2,316    2,274 
Members’ capital   3,416    3,284 
           
Total liabilities and members’ capital  $22,010   $16,526 

 

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

 

4
 

 

Shepherd’s Finance, LLC

Interim Condensed Consolidated Statements of Operations – Unaudited

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(in thousands of dollars)  2016   2015   2016   2015 
Interest Income                    
Interest and fee income on loans  $909   $450   $2,656   $1,236 
Interest expense   463    221    1,261    580 
                     
Net interest income   446    229    1,395    656 
Less: Loan loss provision   4    19    10    42 
                     
Net interest income after loan loss provision   442    210    1,385    614 
                     
Non-Interest Income                    
Gain from foreclosure of assets           44     
                     
Income   442    210    1,429    614 
                     
Non-Interest Expense                    
Selling, general and administrative   297    115    952    384 
                     
Total non-interest expense   297    115    952    384 
                     
Net Income  $145   $95   $477   $230 
                     
Earned distribution to preferred equity holder   27    25    79    75 
                     
Net income attributable to common equity holder  $118   $70   $398   $155 

 

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

 

5
 

 

Shepherd’s Finance, LLC

Interim Condensed Consolidated Statement of Changes in Members’ Capital – Unaudited

 

   Nine Months 
   Ended 
(in thousands of dollars)  September 30, 2016 
Members’ capital, as of December 31, 2015  $3,284 
Net income   477 
Additional capital (preferred)   90 
Earned distributions to preferred equity holder   (79)
Distributions to common equity holders   (356)
      
Members’ capital, as of September 30, 2016  $3,416 

 

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

 

6
 

 

Shepherd’s Finance, LLC

Interim Condensed Consolidated Statements of Cash Flows – Unaudited

 

   Nine Months Ended 
   September 30, 
(in thousands of dollars)  2016   2015 
         
Cash flows from operations          
Net income  $477   $230 
Adjustments to reconcile net income to net cash provided by (used in) operating activities          
Amortization of deferred financing costs   204    164 
Provision for loan losses   10    42 
Net loan origination fees deferred (earned)   (133)   (9)
Change in deferred origination expense   (30)    
Gain on foreclosed assets   (44)    
Net change in operating assets and liabilities          
Other assets   (75)   (17)
Accrued interest on loans   (192)   (41)
Customer interest escrow   (109)   150 
Accounts payable and accrued expenses   626    224 
           
Net cash provided by (used in) operating activities   734    743 
           
Cash flows from investing activities          
Loan originations and principal collections, net   (5,091)   (2,363)
Investment in foreclosed assets   (459)    
           
Net cash provided by (used in) investing activities   (5,550)   (2,363)
           
Cash flows from financing activities          
Contributions from members   90     
Distributions to members   (433)   (183)
Proceeds from secured note payable   6,544    1,951 
Repayments of secured note payable   (4,405)   (1,026)
Proceeds from unsecured notes payable   3,629    2,970 
Redemptions of unsecured notes payable   (1,336)   (644)
Repayment of unsecured note payable   ––    (375)
Deferred financing costs paid   (53)   (157)
           
Net cash provided by (used in) financing activities   4,036    2,536 
           
Net increase (decrease) in cash and cash equivalents   (780)   916 
           
Cash and cash equivalents          
Beginning of period   1,341    558 
           
End of period  $561   $1,474 
           
Supplemental disclosure of cash flow information          
Cash paid for interest  $671   $207 
Non-cash investing and financing activities          
Earned but not paid distribution to preferred equity holder  $27   $25 
Foreclosure of assets  $1,813   $93 
Accrued interest reduction due to foreclosure  $130   $ 
Net loan origination fees (earned) due to foreclosure  $(55)  $ 

 

The accompanying notes are an integral part of these interim condensed consolidated financial statements.

 

7
 

 

Shepherd’s Finance, LLC

Notes to Interim Condensed Consolidated Financial Statements (unaudited)

 

Information presented throughout these notes to the interim condensed consolidated financial statements (Unaudited) is in thousands of dollars.

 

1. Description of Business and Basis of Presentation

 

Description of Business

 

Description of Business

 

Shepherd’s Finance, LLC and subsidiaries (the “Company”, “we” or “our”) is a finance company that engages in commercial lending to residential homebuilders, financing construction of single family homes and residential development. The loans are extended to residential homebuilders and, as such, are commercial loans. We primarily fund our lending and operations by continued extension of Notes to the general public, which Notes are unsecured subordinated debt. We currently have six sources of capital:

 

   September 30, 2016   December 31, 2015 
Capital Source          
Purchase and sale agreements  $5,822   $3,683 
Secured line of credit from affiliates        
Unsecured Notes through our Notes offer, net of deferred costs   10,241    7,897 
Other unsecured debt   700    600 
Preferred equity   1,100    1,010 
Common equity   2,316    2,274 
           
Total  $20,179   $15,464 

 

Certain features of the purchase and sale agreements have added liquidity and flexibility, which have lessened the need for the lines of credit from affiliates. Eventually, the Company intends to permanently replace the lines of credit from affiliates with a secured line of credit from a bank or through other liquidity.

 

Basis of Presentation

 

The accompanying (a) condensed consolidated balance sheet as of December 31, 2015, which has been derived from audited consolidated financial statements, and (b) unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. While certain information and disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), management believes that the disclosures herein are adequate to make the unaudited interim condensed consolidated information presented not misleading. In the opinion of management, the unaudited interim condensed consolidated financial statements reflect all adjustments necessary for a fair presentation of the consolidated financial position, results of operations and cash flows for the periods presented. Such adjustments are of a normal, recurring nature. The results of operations for any interim period are not necessarily indicative of results expected for the fiscal year ending December 31, 2016. These unaudited interim condensed consolidated financial statements should be read in conjunction with the 2015 consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2015 (the “2015 Statements”). The accounting policies followed by the Company are set forth in Note 2 - Summary of Significant Accounting Policies of the notes to the 2015 Statements.

 

8
 

 

2. Summary of Significant Accounting Policies

 

Segment Reporting

 

We report all ongoing operations in one segment, commercial lending.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with U.S. GAAP 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 interim condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. It is reasonably possible that market conditions could deteriorate, which could materially affect our consolidated financial position, results of operations, and cash flows. Among other effects, such changes could result in the need to increase the amount of our allowance for loan losses.

 

Revenue Recognition

 

Interest income generally is recognized on an accrual basis. The accrual of interest is generally discontinued on all loans past due 90 days or more. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income, unless management believes that the accrued interest is recoverable through liquidation of collateral. Interest received on nonaccrual loans is applied against principal. Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status.

 

Advertising

 

Advertising costs are expensed as incurred and are included in selling, general and administrative. Advertising expenses were $31 and $11 for the nine months ended September 30, 2016 and 2015, respectively.

 

Cash and Cash Equivalents

 

Management considers highly-liquid investments with original maturities of three months or less to be cash equivalents.

 

Fair Value Measurements

 

The Company follows the guidance of the Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic (ASC) 825, Financial Instruments, and ASC 820, Fair Value Measurements. ASC 825 permits entities to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. ASC 820 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Under this guidance, fair value measurements are not adjusted for transaction costs. This guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). See Note 3.

 

Loans Receivable

 

Loans are stated at the amount of unpaid principal, net of any allowances for loan losses, and adjusted for (1) the net unrecognized portion of direct costs and nonrefundable loan fees associated with lending, and (2) deposits made by the borrowers used as collateral for a loan and due back to the builder at or prior to loan payoff. The net amount of nonrefundable loan origination fees and direct costs associated with the lending process, including commitment fees, is deferred and accreted to interest income over the lives of the loans using a method that approximates the interest method.

 

9
 

 

A loan is classified as nonaccrual, and the accrual of interest on such loan is discontinued, when the contractual payment of principal or interest becomes 90 days past due. In addition, a loan may be placed on nonaccrual at any other time management has serious doubts about further collectability of principal or interest according to the contractual terms, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection or well-secured (i.e., the loan has sufficient collateral value). Loans are restored to accrual status when the obligation is brought current or has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is no longer in doubt.

 

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans, or portions thereof, are charged off when deemed uncollectible. Once a loan is 90 days past due, management begins a workout plan with the borrower or commences its foreclosure process on the collateral.

 

Allowance for Loan Losses

 

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio.

 

We establish a collective reserve for all loans which are not more than 60 days past due at the end of a quarter. This collective reserve takes into account both historical information and a qualitative analysis of housing and other economic factors that may impact our future realized losses. For loans to one borrower with committed balances less than 10% of our total committed balances on all loans extended to all customers, we individually analyze for impairment all loans which are more than 60 days past due at the end of a quarter. For loans to one borrower with committed balances equal to or greater than 10% of our total committed balances on all loans extended to all customers, we individually analyze all loans for potential impairment. The analysis of loans, if required, includes a comparison of estimated collateral value to the principal amount of the loan. For impaired loans, if the value determined is less than the principal amount due (less any builder deposit), then the difference is included in the allowance for loan loss. As values change, estimated loan losses may be provided for more or less than the previous period, and some loans may not need a loss provision based on payment history. For homes which are partially complete, we appraise on an as-is and completed basis, and use the one that more closely aligns with our planned method of disposal for the property.

 

For loans greater than 12 months in age that are individually evaluated for impairment, appraisals have been prepared within the last 13 months. For all loans individually evaluated for impairment, there is also a broker’s opinions of value (“BOV”) prepared, if the appraisal is more than six months old. The lower of any BOV prepared in the last six months, or the most recent appraisal, is used, unless we determine a BOV to be invalid based on the comparable sales used. If we determine a BOV to be invalid, we will use the appraised value. Appraised values are adjusted down for estimated costs associated with asset disposal. Broker’s opinion of selling price, currently valid sales contracts on the subject property, or representative recent actual closings by the builder on similar properties may be used in place of a BOV.

 

Impaired Loans

 

A loan is considered to be impaired when it is probable the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. The analysis of impaired loans includes a comparison of estimated collateral value to the principal amount of the loan. If the value determined is less than the principal amount due (less any builder deposit), then the difference is included in the allowance for loan loss. As values change, estimated loan losses may be provided for more or less than the previous period. For homes which are partially complete, we appraise on an as-is and completed basis, and use the one that more closely aligns with our planned method of disposal for the property.

 

Deferred Financing Costs, Net

 

We defer certain costs associated with financing activities related to the issuance of debt securities (deferred financing costs). These costs consist primarily of professional fees incurred related to the transactions. Deferred financing costs are amortized into interest expense over the life of the related debt. We make estimates for the average duration of future investments. If these estimates are determined to be incorrect in the future, the rate at which we are amortizing the deferred offering costs as interest expense would be adjusted and could have a material impact on the consolidated financial statements. The deferred financing costs are reflected as a reduction in the unsecured notes offering liability. The Company adopted the guidance on the presentation of debt issuance costs on January 1, 2016, as required. As a result, the Company retrospectively applied the guidance to the 2015 Consolidated Balance Sheet by reclassifying $599 of deferred financing costs previously classified in the assets section.

 

10
 

 

The following is a roll forward of deferred financing costs:

 

   Nine Months       Nine Months 
   Ended   Year Ended   Ended 
   September 30, 2016   December 31, 2015   September 30, 2015 
                
Deferred financing costs, beginning balance  $935   $737   $737 
Additions   53    198    157 
                
Deferred financing costs, ending balance  $988   $935   $894 
                
Less accumulated amortization   (540)   (336)   (271)
                
Deferred financing costs, net  $448   $599   $623 

 

The following is a roll forward of the accumulated amortization of deferred financing costs:

 

   Nine Months       Nine Months 
   Ended   Year Ended   Ended 
   September 30, 2016   December 31, 2015   September 30, 2015 
             
Accumulated amortization, beginning balance  $336   $107   $107 
Additions   204    229    164 
                
Accumulated amortization, ending balance  $540   $336   $271 

 

Income Taxes

 

The entities included in the consolidated financial statements are organized as pass-through entities under the Internal Revenue Code. As such, taxes are the responsibility of the members. Other significant taxes for which the Company is liable are recorded on an accrual basis.

 

The Company applies ASC Topic 740, Income Taxes. ASC 740 provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the consolidated financial statements and requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s consolidated financial statements to determine whether the tax positions are “more-likely-than-not” to be sustained by the applicable tax authority. Tax positions with respect to income tax at the LLC level not deemed to meet the “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the appropriate period. Management concluded that there are no uncertain tax positions that should be recognized in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations for years prior to 2013.

 

11
 

 

The Company’s policy is to record interest and penalties related to taxes in interest expense on the consolidated statements of operations. There have been no significant interest or penalties assessed or paid.

 

Risks and Uncertainties

 

The Company is subject to many of the risks common to the commercial lending and real estate industries, such as general economic conditions, decreases in home values, decreases in housing starts, and high unemployment. These risks, which could have a material and negative impact on the Company’s consolidated financial condition, results of operations, and cash flows include, but are not limited to, declines in housing starts, unfavorable changes in interest rates, and competition from other lenders. At September 30, 2016, our loans were significantly concentrated in a suburb of Pittsburgh, Pennsylvania, so the housing starts and prices in that area are more significant to our business than other areas until and if more loans are created in other markets.

 

Concentrations

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of loans receivable. As of September 30, 2016 and December 31, 2015, 39% and 37%, respectively, of our outstanding loan commitments consist of loans to one borrower, and the collateral is in one real estate market, Pittsburgh, Pennsylvania. Accordingly, the ultimate collectability of a significant portion of these loans is susceptible to changes in market conditions in that area. As of September 30, 2016, our next two largest customers make up 13% and 7% respectively of our loan commitments, with loans in Sarasota, Florida and Savannah, Georgia, respectively. As of December 31, 2015, our next two largest customers made up 22% and 6% respectively of our loan commitments, with loans in Sarasota, Florida and Columbia, South Carolina, respectively.

 

Recent Accounting Pronouncements

 

The FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 is effective for the Company on January 1, 2018. The Company is still evaluating the potential impact on the Company’s consolidated financial statements.

 

In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. The amendments in this ASU require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This guidance required retrospective application. The Company adopted the guidance on January 1, 2016, as required. See Note 1 - Deferred Financing Costs, Net for additional information regarding the adoption of the new guidance

 

On January 5, 2016, the FASB issued ASU 2016-01, Financial Instruments–Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. Changes to the current U.S. GAAP model primarily affect the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the FASB clarified guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. The accounting for other financial instruments, such as loans, investments in debt securities, and financial liabilities is largely unchanged. The ASU also eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The guidance is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and early application is permitted. The Company is currently evaluating the impact of this amendment on the consolidated financial statements.

 

12
 

 

In February 2016, the FASB issued FASB ASU 2016-02, Leases (“ASU 2016-02”), which eliminates the current tests for lease classification under U.S. GAAP and requires lessees to recognize the right-to-use assets and related lease liabilities on the balance sheet. ASU 2016-02 is effective for annual and interim periods beginning after December 15, 2018 and early application is permitted. The new standard provides for a modified retrospective application for leases existing at, or entered into after, the earliest comparative period presented in the financial statements. The Company is currently evaluating the impact of this amendment on the consolidated financial statements.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (ASU 2016-13), which introduces the current expected credit losses methodology. Among other things, ASU 2016-13 requires the measurement of all expected credit losses for financial assets, including available-for-sale debt securities, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The new model will require institutions to calculate all probable and estimable losses that are expected to be incurred through the loan’s entire life. ASU 2016-13 also requires the allowance for credit losses for purchased financial assets with credit deterioration since origination to be determined in a manner similar to that of other financial assets measured at amortized cost; however, the initial allowance will be added to the purchase price rather than recorded as credit loss expense. The disclosure of credit quality indicators related to the amortized cost of financing receivables will be further disaggregated by year of origination (or vintage). Disaggregation by vintage will be optional for nonpublic business entities. Institutions are to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective. The amendments are effective for fiscal years beginning after December 15, 2020. Early application will be permitted for fiscal years beginning after December 15, 2018. The Company is currently evaluating the impact of these amendments on the consolidated financial statements.

 

On August 26, 2016, the FASB issued ASU 2016-15, which amends guidance in ASC 230 on the classification of certain cash receipts and payments in the statement of cash flows, in order to reduce inconsistent application. The amendments address eight cash flow issues including debt repayment and extinguishment costs, settlement of zero-coupon debt instruments, contingent consideration payments following a business combination, proceeds from the settlement of insurance claims and corporate-owned life insurance policies, distributions received from equity method investees, beneficial interests in securitization transactions and separately identifiable cash flows. ASU 2016-15 is effective for the Company for annual reporting periods beginning after December 15, 2017, including interim periods within those fiscal years. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. Adoption of ASU 2016-15 is not expected to have a material impact on the Company’s financial statements.

 

Subsequent Events

 

Management of the Company has evaluated subsequent events through November 3, 2016, the date these consolidated financial statements were issued. See Note 12.

 

3. Fair Value

 

Utilizing ASC 820, the Company has established a framework for measuring fair value under U.S. GAAP using a hierarchy, which requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs. Fair value measurements are an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Three levels of inputs are used to measure fair value, as follows:

 

  Level 1 – quoted prices in active markets for identical assets or liabilities;
     
  Level 2 – quoted prices in active markets for similar assets and liabilities and inputs that are observable for the asset or liability; or
     
  Level 3 – unobservable inputs, such as discounted cash flow models or valuations.

 

13
 

 

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

 

Fair Value Measurements of Financial Assets on a Recurring Basis

 

The Company has no financial and non-financial assets or liabilities measured at fair value on a recurring basis.

 

Fair Value Measurements of Financial Assets on a Non-recurring Basis

 

Certain assets are measured at fair value on a non-recurring basis when there is evidence of impairment. The fair values of impaired loans with specific allocations of the allowance for loan losses are generally based on recent real estate appraisals of the collateral less estimated cost to sell. Declines in the fair values of other real estate owned subsequent to their initial acquisitions are also based on recent real estate appraisals less selling costs.

 

Impaired Loans

 

Fair value estimates are determined using the methodology discussed in Note 2. The appraisals are on similar properties at similar times, however due to the differences in time and properties, the impaired loans are classified as Level 3. There were no impaired loan assets as of September 30, 2016 or December 31, 2015.

 

Foreclosed assets

 

Foreclosed assets (upon initial recognition or subsequent impairment) are non-financial assets measured at fair value on a non-recurring basis.

 

During both 2016 and 2015, certain foreclosed assets, upon initial recognition, were measured and reported at fair value. The excess of fair value measurements of foreclosed assets over the carrying value of the underlying loans result in a gain in non-interest income. The excess of the carrying value of the underlying loans over the fair value measurements of foreclosed assets are charged-off to the allowance for possible loan losses. These valuations are Level 3 valuations because the appraisal is comparing similar properties which sold at a similar date, but not the same. Foreclosed assets were $3,237 and $965 as of September 30, 2016 and December 31, 2015, respectively. In connection with the measurement and initial recognition of the foregoing foreclosed assets in 2016, the Company recognized a gain in non-interest income of approximately $44; during 2015, the Company recognized a gain of approximately $105 subsequent to September 30, 2015. During both 2016 and 2015, no foreclosed assets were remeasured at fair value subsequent to initial recognition.

 

Fair Value of Financial Instruments

 

ASC 825 requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

 

Cash and Cash Equivalents

 

The carrying amount approximates fair value because of the short maturity of these instruments.

 

Loans Receivable and Commitments to Extend Credit

 

For variable rate loans that reprice frequently with no significant change in credit risk, estimated fair values of collateral are based on carrying values at September 30, 2016 and December 31, 2015. The estimated fair values for other loans are calculated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and the same remaining maturities and approximate carrying values of these instruments at September 30, 2016 and December 31, 2015. Because the loans are demand loan and therefore have no known time horizon, there is no significant impact from fluctuating interest rates. For unfunded commitments to extend credit, because there would be no adjustment between fair value and carrying amount for the amount if actually loaned, there is no adjustment to the amount before it is loaned. The amount for commitments to extend credit is not listed in the tables below because there is no difference between carrying value and fair value, and the amount is not recorded on the consolidated balance sheets as a liability.

 

14
 

 

Interest Receivable

 

Although interest receivable from our customers does not yield additional interest to us, because interest is due roughly 10 days after it is billed, the impact is negligible and the fair value approximates the carrying value at both September 30, 2016 and December 31, 2015.

 

Customer Interest Escrow

 

The customer interest escrow does not yield interest to the customer, but because: 1) the customer loans are demand loans, 2) there is no way to estimate how long the escrow will be in place, and 3) the interest rate which could be used to discount this amount is negligible, the fair value approximates the carrying value at both September 30, 2016 and December 31, 2015.

 

Borrowings under Credit Facilities

 

The fair value of the Company’s borrowings under credit facilities is estimated based on the expected cash flows discounted using the current rates offered to the Company for debt of the same remaining maturities. As all of the borrowings under credit facilities or the Notes are either payable on demand or at similar rates to what the Company can borrow funds for today, the fair value of the borrowings is determined to approximate carrying value at September 30, 2016 and December 31, 2015. The interest on our Notes offering is paid to our Note holders either monthly or at the end of their investment, compounding on a monthly basis. For the same reasons as the determination for the principal balances on the Notes, the fair value approximates the carrying value for the interest as well. The interest payable makes up the bulk of our accounts payable and accrued expenses.

 

The table below is a summary of fair value estimates for financial instruments and the level of the fair value hierarchy (as discussed in Note 2) within which the fair value measurements are categorized at the periods indicated:

 

September 30, 2016

 

           Quoted Prices         
           in Active   Significant     
           Markets for   Other   Significant 
           Identical   Observable   Unobservable 
   Carrying   Estimated   Assets   Inputs   Inputs 
   Amount   Fair Value   Level 1   Level 2   Level 3 
Financial Assets                         
Cash and cash equivalents  $561   $561   $561   $   $ 
Loans receivable, net   17,915    17,915            17,915 
Accrued interest on loans   208    208            208 
Financial Liabilities                         
Customer interest escrow   639    639            639 
Notes payable secured   5,822    5,822            5,822 
Notes payable unsecured, net   10,941    10,941            10,941 
Accounts payable and accrued expenses   1,165    1,165            1,165 

 

15
 

 

December 31, 2015

 

           Quoted Prices         
           in Active   Significant     
           Markets for   Other   Significant 
           Identical   Observable   Unobservable 
   Carrying   Estimated   Assets   Inputs   Inputs 
   Amount   Fair Value   Level 1   Level 2   Level 3 
Financial Assets                         
Cash and cash equivalents  $1,341   $1,341   $1,341   $   $ 
Loans receivable, net   14,060    14,060            14,060 
Accrued interest on loans   146    146            146 
Financial Liabilities                         
Customer interest escrow   498    498            498 
Notes payable secured   3,683    3,683            3,683 
Notes payable unsecured, net   8,497    8,497            8,497 
Accounts payable and accrued expenses   539    539            539 

 

4. Financing Receivables

 

Financing receivables are comprised of the following as of September 30, 2016 and December 31, 2015:

 

   September 30, 2016   December 31, 2015 
         
Commercial loans, gross  $19,078   $15,247 
Less: Deferred loan fees   (440)   (628)
Less: Deposits   (705)   (521)
Plus: Deferred origination expense   30     
Less: Allowance for loan losses   (48)   (38)
           
Commercial loans, net  $17,915   $14,060 

 

Roll forward of commercial loans:

 

  

Nine Months

Ended
September 30, 2016

  

Year

Ended
December 31, 2015

  

Nine Months

Ended
September 30, 2015

 
             
Beginning balance  $14,060   $8,097   $8,097 
Additions   15,264    13,760    7,004 
Payoffs/Sales   (9,739)   (6,436)   (4,589)
Moved to foreclosed assets   (1,639)   (767)   (129)
Change in deferred origination expense   30         
Change in builder deposit   (184)   (387)   (53)
Change in loan loss provision   (10)   (17)   (5)
New loan fees   (792)   (897)   (452)
Earned loan fees   925    707    461 
                
Ending balance  $17,915   $14,060   $10,334 

 

16
 

 

Commercial Construction and Development Loans

 

Pennsylvania Loans

 

On December 30, 2011, pursuant to a credit agreement (as amended, the “Credit Agreement”) by and between us, Benjamin Marcus Homes, LLC (“BMH”), Investor’s Mark Acquisitions, LLC (“IMA”), and Mark L. Hoskins (“Hoskins”) (collectively, the “Hoskins Group”), we originated two new loan assets, one to BMH as borrower (the “BMH Loan”) and one to IMA as borrower (the “New IMA Loan”). Pursuant to the Credit Agreement and simultaneously with the origination of the BMH Loan and the New IMA Loan, we also assumed the position of lender on an existing loan to IMA (the “Existing IMA Loan”) and assumed the position of borrower on another existing loan in which IMA serves as the lender (the “SF Loan”). Throughout this report, we refer to the BMH Loan, the New IMA Loan, and the Existing IMA Loan collectively as the “Pennsylvania Loans.”

 

As a result of amendments to the Credit Agreement, we converted $1,000 of the SF Loan from debt to preferred equity. The new preferred equity serves as collateral for the Pennsylvania Loans. There is no liquid market for the preferred equity instrument, so we can give no assurance as to our ability to generate any amount of proceeds from that collateral. We also reduced the balance of the SF Loan by $125, which was added to the interest escrow, and repaid the remaining $375 with cash. The interest rate on the Existing IMA Loan was raised to match the New IMA Loan. Beginning in December 2015, the Hoskins Group invests in our preferred equity in an amount equal to $10 per closing of a lot payoff in the Hamlets or Tuscany subdivisions.

 

Also as a result of amendments to the Credit Agreement, we funded an additional $750 of interest escrow, we issued several letters of credit relating to BMH Loan which totaled $90 and $68 at September 30, 2016 and December 31, 2015, respectively (the “Letter of Credit”), and we issued cash bonds for development with $257 outstanding at both September 30, 2016 and December 31, 2015. The terms and conditions of the Pennsylvania Loans are set forth in further detail below.

 

BMH Loan

 

The BMH Loan is a revolving demand loan in the original principal amount of up to $4,164, of which $3,568 was funded at closing. We collected a fee of $750 upon closing of the BMH Loan, which was funded from proceeds of the loan. Additionally, $450 of the loan proceeds was allocated to an interest escrow account (the “Interest Escrow”). Interest on the BMH Loan accrues annually at 2.0% (7.0% starting August 1, 2016) plus the greater of (i) 5.0% or (ii) the weighted average price paid by us on or in connection with all of our borrowed funds (such weighted average price includes interest rates, loan fees, legal fees and any and all other costs paid by us on our borrowed funds, and, in the case of funds borrowed by us from our affiliates, the weighted average price paid by such affiliate on or in connection with such borrowed funds) (“COF”).

 

The BMH Loan is secured by a first priority mortgage in residential property consisting of 13 building lots and a parcel of land of approximately 10 acres which is currently under development, all located in the subdivision commonly known as the Hamlets of Springdale in Peters Township, Pennsylvania, a suburb of Pittsburgh, as well as the Interest Escrow. The seller of the property securing the BMH Loan retained a second mortgage in the amount of $400, with a balance of approximately $100 and $157 as of September 30, 2016 and December 31, 2015, respectively.

 

New IMA Loan

 

The New IMA Loan is a demand loan in the original principal amount of up to $2,225, of which $250 was funded at closing. We collected a fee of $250 upon closing of the New IMA Loan, which was funded from proceeds of the loan. Interest on the New IMA Loan accrues annually at 2.0% (7.0% starting August 1, 2016) plus the greater of (i) 5.0% or (ii) the weighted average price paid by us on or in connection with all of our borrowed funds (such weighted average price includes interest rates, loan fees, legal fees and any and all other costs paid by us on our borrowed funds, and, in the case of funds borrowed by us from our affiliates, the weighted average price paid by such affiliate on or in connection with such borrowed funds).

 

17
 

 

The New IMA Loan is secured by a mortgage in residential property originally consisting of 18 lots (5 and 8 lots remained as of September 30, 2016 and December 31, 2015, respectively) located in the subdivision commonly known as the Tuscany Subdivision in Peters Township, Pennsylvania, a suburb of Pittsburgh. Construction of the improvements for the Tuscany Subdivision began in December 2012, with $113 remaining to be completed as of September 30, 2016.

 

Existing IMA Loan

 

The Existing IMA Loan is a demand loan in the original principal amount of $1,687, of which $1,687 was outstanding as of both September 30, 2016 and December 31, 2015. Interest on the Existing IMA Loan accrued annually at a rate of 7.0% through December 30, 2014. Beginning December 31, 2014, the interest rate was the same as the New IMA Loan. Pursuant to the Credit Agreement, interest payments on the Existing IMA Loan are funded from the Interest Escrow, with any shortfall funded by IMA.

 

The Existing IMA Loan is secured by a mortgage in the residential property that also secures the New IMA Loan.

 

SF Loan

 

Concurrent with the execution of the loans above, we entered into the SF Loan with the Hoskins Group, under which we were the borrower. The SF Loan is described in Note 6.

 

Interest Escrow

 

The Pennsylvania Loans called for a funded Interest Escrow account which was funded with proceeds from the Pennsylvania Loans. The initial funding on that Interest Escrow was $450. The balance as of September 30, 2016 and December 31, 2015 was $365 and $267, respectively. To the extent the balance is available in the Interest Escrow, interest due on certain loans is deducted from the Interest Escrow on the date due. The Interest Escrow is increased by 20% of lot payoffs on the same loans, and by interest and/or distributions on the SF Loan and Hoskins Group preferred equity. All of these transactions are noncash to the extent that the total escrow amount does not need additional funding. The Interest Escrow is also used to contribute to the reduction of the $400 subordinated mortgage upon certain lot sales of the collateral of the BMH Loan.

 

18
 

 

A detail of the financing receivables for the Pennsylvania Loans at September 30, 2016 is as follows:

 

Item  Term    Interest Rate   Funded to
borrower
   Estimated
collateral values
 
                      
BMH Loan   Demand(1)    COF +2%
(7% Floor)
           
Land for phase 5 (10 acres)             $   $1,079 
Lots              569    2,126(7)
Interest Escrow              950    365 
Cash Bond              257(5)   257 
Loan Fee              750     
                      
Total BMH Loan              2,526    3,827 
IMA Loans                     
New IMA Loan (loan fee)   Demand(1)    COF +2%
(7% Floor)
    250     
New IMA Loan (advances)   Demand(1)    COF +2%
(7% Floor)
    505     
Interest Escrow              250     
Existing IMA Loan   Demand(2)    COF +2%
(7% Floor)
    1,687    1,774(3)
                      
Total IMA Loans              2,692    1,774 
                      
Unearned Loan Fee                   
SF Preferred Equity                  1,100(8)
                      
Total             $5,218   $6,701 

 

A detail of the financing receivables for the Pennsylvania Loans at December 31, 2015 is as follows:

 

Item  Term    Interest Rate   Funded to
borrower
   Estimated
collateral values
 
                  
BMH Loan   Demand(1)    COF +2%
(7% Floor)
           
Land for phase 5 (10 acres)             $   $1,079 
Lots              974    2,338(4)
Interest Escrow              950    267 
Cash Bond              257(5)   257 
Loan Fee              750     
                      
Total BMH Loan              2,931    3,941 
IMA Loans                     
New IMA Loan (loan fee)   Demand(1)    COF +2%
(7% Floor)
    250     
New IMA Loan (advances)   Demand(1)    COF +2%
(7% Floor)
    1,251     
Existing IMA Loan   Demand(2)    COF +2%
(7% Floor)
    1,687    2,951(6)
                      
Total IMA Loans              3,188    2,951 
                      
Unearned Loan Fee              (115)    
SF Preferred Equity                  1,010(8)
                      
Total             $6,004   $7,902 

 

19
 

 

(1) These are the stated terms; however, in practice, principal will be repaid upon the sale of each developed lot.

 

(2) These are the stated terms; however, in practice, principal will be repaid upon the sale of each developed lot after the BMH loan and the New IMA loan are satisfied.

 

(3) Estimated collateral value is equal to the appraised value of the remaining lots of $1,887, net of the net estimated costs to finish the development of $113.

 

(4) Estimated collateral value is equal to the appraised value of the remaining lots of $3,600, net of the net estimated costs to finish the development of $531 and the first mortgage amount of $731.

 

(5) The cash bond is in place to guarantee to the township that work will be completed on this project. We will fund this work and expect to cancel the bond upon completion of the work.

 

(6) Estimated collateral value is equal to the appraised value of $3,101, net of estimated costs to finish the development of $150.

 

(7) Estimated collateral value is equal to the lots’ appraised value of $2,556 minus remaining improvements of $430.

 

(8) In the event of a foreclosure on the property securing certain of our loans, a portion of our collateral is preferred equity in our Company, which might be difficult to sell, which could impact our ability to eliminate the loan balance. The loans are collectively cross-collateralized and, therefore, treated as one loan for the purpose of calculating the effective interest rate and for available remedies upon an instance of default. As lots are released, a specific release price is repaid by the borrower, with 10% of that amount being used to fund the Interest Escrow (except for the construction funding for homes). The customer will make cash interest payments only when the Interest Escrow is fully depleted, except for construction funding for homes, where the customer makes interest payments monthly.

 

The Pennsylvania Loans created in 2011 had a $1,000 loan fee. The expenses incurred related to issuing the loan were approximately $76, which were netted against the loan amount. The remaining $924, which was netted against the gross loan amount, was recognized over the expected life of the loans using the straight-line method in accordance with ASC 310-20, Nonrefundable Fees and Other Costs. The loan has lasted beyond its expected life.

 

The Company has a credit agreement with its largest borrower which includes a maximum exposure on all three loans, as described in the chart below. This limit does not include construction loans.

 

Commercial Loans – Real Estate Development Loan Portfolio Summary

 

The following is a summary of our loan portfolio to builders for land development as of September 30, 2016. The Pennsylvania loans below are included as part of the Pennsylvania Loans discussed above.

 

State   Number
of
Borrowers
   Number
of
Loans
   Value of
Collateral
(1)
   Commitment
Amount
   Gross Amount
Outstanding
   Loan to
Value Ratio
(2)
   Loan Fee 
Pennsylvania    1    3   $6,701   $6,479(3)  $5,218    78%  $1,000 
Total    1    3   $6,701   $6,479   $5,218    78%  $1,000 

 

(1) The value is determined by the appraised value adjusted for remaining costs to be paid and third party mortgage balances. Part of this collateral is $1,100 of preferred equity in our Company. In the event of a foreclosure on the property securing certain of our loans, a portion of our collateral is preferred equity in our Company, which might be difficult to sell, which could impact our ability to eliminate the loan balance.
   
(2) The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value.
   
(3) The commitment amount includes letters of credit and cash bonds.

 

20
 

 

The following is a summary of our loan portfolio to builders for land development as of December 31, 2015. The Pennsylvania loans below are included as part of the Pennsylvania Loans discussed above.

 

State   Number
of
Borrowers
   Number
of
Loans
   Value of
Collateral
(1)
   Commitment
Amount
   Gross Amount
Outstanding
   Loan to
Value Ratio
(2)
   Loan Fee 
Pennsylvania    1    3   $7,902   $6,456(3)  $6,119    77%  $1,000 
Total    1    3   $7,902   $6,456   $6,119    77%  $1,000 

 

(1) The value is determined by the appraised value adjusted for remaining costs to be paid and third party mortgage balances. Part of this collateral is $1,010 of preferred equity in our Company. In the event of a foreclosure on the property securing certain of our loans, a portion of our collateral is preferred equity in our Company, which might be difficult to sell, which could impact our ability to eliminate the loan balance.
   
(2) The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value.
   
(3) The commitment amount includes letters of credit and cash bonds.

 

Commercial Loans – Construction Loan Portfolio Summary

 

The following is a summary of our loan portfolio to builders for home construction loans as of September 30, 2016.

 

State  Number of
Borrowers
   Number of
Loans
   Value of
Collateral
(1)
   Commitment
Amount
   Gross Amount
Outstanding
   Loan to
Value Ratio
(2)
   Loan
Fee
 
Colorado   1    4   $2,095   $1,467   $857    70%   5%
Connecticut   1    1    715    500    435    70%   5%
Delaware   1    2    1,544    671    540    43%   5%
Florida   4    8    9,198    5,522    3,990    60%   5%
Georgia   3    5    4,390    2,610    1,643    59%   5%
Idaho   1    1    319    215    204    67%   5%
Michigan   1    1    210    126    47    60%   5%
New Jersey   3    3    978    719    432    74%   5%
New York   1    2    1,170    452    452    39%   5%
North Carolina   2    3    1,260    805    204    64%   5%
Ohio   1    1    1,405    843    444    60%   5%
Pennsylvania   2    8    8,583    4,556    3,403    53%   5%
South Carolina   4    8    1,987    1,391    429    70%   5%
Tennessee   1    3    1,080    767    395    71%   5%
Utah   1    2    730    511    385    70%   5%
Total   27    52   $35,664   $21,155   $13,860    59%(3)   5%

 

(1) The value is determined by the appraised value.
   
(2) The loan to value ratio is calculated by taking the commitment amount and dividing by the appraised value.
   
(3) Represents the weighted average loan to value ratio of the loans.

 

21
 

 

The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2015.

 

State  Number of
Borrowers
   Number of
Loans
   Value of
Collateral (1)
   Commitment
Amount
   Gross Amount
Outstanding
   Loan to
Value Ratio(2)
   Loan
Fee
 
Colorado   1    4   $2,160   $1,519   $830    70%   5%
Connecticut   1    1    715    500    251    70%   5%
Delaware   1    2    1,074    671    105    63%   5%
Florida   3    10    10,683    6,440    4,378    60%   5%
Georgia   2    3    3,916    2,278    712    58%   5%
New Jersey   1    2    510    357    268    70%   5%
North Carolina   1    2    385    270    172    70%   5%
Pennsylvania   2    6    4,107    2,391    1,275    58%   5%
South Carolina   2    16    2,395    1,699    1,136    71%   5%
Total   14    46   $25,945   $16,125   $9,127    62%(3)   5%

 

(1) The value is determined by the appraised value.
   
(2) The loan to value ratio is calculated by taking the commitment amount and dividing by the appraised value.
   
(3) Represents the weighted average loan to value ratio of the loans.

 

Credit Quality Information

 

The following table presents credit-related information at the “class” level in accordance with ASC 310-10-50, Disclosures about the Credit Quality of Finance Receivables and the Allowance for Credit Losses. A class is generally a disaggregation of a portfolio segment. In determining the classes, the Company considered the finance receivable characteristics and methods it applies in monitoring and assessing credit risk and performance.

 

The following table summarizes finance receivables by the risk ratings that regulatory agencies utilize to classify credit exposure and which are consistent with indicators the Company monitors. Risk ratings are reviewed on a regular basis and are adjusted as necessary for updated information affecting the borrowers’ ability to fulfill their obligations.

 

The definitions of these ratings are as follows:

 

    Pass – finance receivables in this category do not meet the criteria for classification in one of the categories below.
     
  Special mention – a special mention asset exhibits potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects.
     
  Classified – a classified asset ranges from: 1) assets that are inadequately protected by the current sound worth and paying capacity of the borrower, and are characterized by the distinct possibility that some loss will be sustained if the deficiencies are not corrected to 2) assets with weaknesses that make collection or liquidation in full unlikely on the basis of current facts, conditions, and values. Assets in this classification can be accruing or on non-accrual depending on the evaluation of these factors.

 

22
 

 

Finance Receivables – By risk rating:

 

   September 30, 2016   December 31, 2015 
         
Pass  $15,517   $14,060 
Special mention   2,398     
Classified – accruing        
Classified – nonaccrual        
           
Total  $17,915   $14,060 

 

Finance Receivables – Method of impairment calculation:

 

   September 30, 2016   December 31, 2015 
         
Performing loans evaluated individually  $10,654   $9,971 
Performing loans evaluated collectively   7,261    4,089 
Non-performing loans without a specific reserve      
Non-performing loans with a specific reserve        
           
Total evaluated collectively for loan losses  $17,915   $14,060 

 

At September 30, 2016 and December 31, 2015, there were no loans acquired with deteriorated credit quality, loans past due 90 or more days, impaired loans, or loans on nonaccrual status.

 

5. Foreclosed Assets

 

Roll forward of Foreclosed Assets:

 

  

Nine Months

Ended
September 30, 2016

  

Year

Ended
December 31, 2015

  

Nine Months

Ended
September 30, 2015

 
             
Beginning balance  $965   $   $ 
Additions from loans   1,813    880    93 
Additions for construction/development   459    85     
                
Ending balance  $3,237   $965   $93 

 

We foreclosed on five properties during 2015, of which four were acquired at the foreclosure sale and one was acquired via a deed in lieu of foreclosure. Three of the properties were lots in Georgia. We have an agreement with a builder to build a house on one of the lots (which is complete as of September 30, 2016) and will likely start construction on a second home once the first has a sales agreement. Two of the properties were partially completed homes in Louisiana, one has been finished and work is proceeding to complete the second of these homes. We acquired one property via a deed in lieu of foreclosure during 2016. This property is a beach lot in Sarasota, Florida. We have executed the seller’s part of an option to purchase the property which expires in December 2016. If that sale is executed, we will record a small gain on the sale.

 

23
 

 

6. Borrowings

 

The following table displays our borrowings:

 

   September 30, 2016   December 31, 2015 
Borrowing Source          
Purchase and sale agreements  $5,822   $3,683 
Secured line of credit from affiliates        
Unsecured Notes through our Notes offer, net of deferred costs   10,241    7,897 
Other unsecured debt   700    600 
           
Total  $16,763   $12,180 

 

Purchase and Sale Agreements

 

In December 2014, the Company entered into a purchase and sale agreement with 1st Financial Bank USA whereby the purchaser may buy loans offered to it by us, and we may be obligated to offer certain loans to purchaser. Purchaser is buying senior positions in the loans they purchase, originally 50%, 60% on new loans as of January 2016, of each loan. Purchaser generally receives the interest rate we charge the borrower (with a floor of 10%) on their portion of the loan balance, and we receive the rest of the interest and all of the loan fee. We service the loans. There is an unlimited right for us to call any loan sold, however in any case of such call, a minimum of 4% of the commitment amount of purchaser must have been received by purchaser in interest, or we must make up the difference. Also, the purchaser has a put option, which is limited to 10% of the funding provided by purchaser under all loans purchased in the trailing 12 months.

 

In April 2015, the Company entered into a purchase and sale agreement with Seven Kings Holdings, Inc. (“7Kings”) as purchaser and the Company as seller, whereby 7Kings buys loans offered to it by us, providing that their portions of the loans always total less than $1,500. On or about May 7, 2015, 7Kings assigned its right and interest in the purchase and sale agreement to S.K. Funding, LLC (“S.K. Funding”), an affiliate of 7Kings. S.K. Funding may adjust the $1,500 with notice, but such change will not cause a buyback by us. S.K. Funding is buying pari-passu positions in the loans they purchase, generally 50% of each loan. S.K. Funding generally receives a 9% interest rate on its portion of the loan balance, and we receive the rest of the interest and all of the loan fees. We service the loans. There is an unlimited right for us to call any loan sold. This transaction is accounted for as a secured line of credit. In the fourth quarter of 2015, we entered into a modification of our agreement with S.K. Funding whereby S.K. Funding agreed to buy priority interests of $1,000 each in two large loans we originated. In the first quarter of 2016, after one of the $1,000 loans repaid, we entered into an additional modification whereby S.K. Funding agreed to buy priority interests totaling $2,000 in a total of three large loans we originated. The interest rate for the loans covered by these modifications is 9.5% to S.K. Funding. On June 30, 2016, one of those two loans was terminated with a deed in lieu of foreclosure. The property is owned by us, and we owe S.K. Funding $1,000 on that property (secured by mortgage) to be repaid upon the sale of the property. This amount is still covered by our purchase and sale agreement and is included in the totals in the chart below. On December 31, 2015, S.K. Funding purchased 4% of our common equity from the Wallach family.

 

The purchase and sale agreements are recorded as secured borrowings.

 

The purchase and sale agreements are detailed below:

 

   September 30, 2016   December 31, 2015 
   Book Value of   Due From   Book Value of   Due From 
   Loans which   Shepherd’s   Loans which   Shepherd’s 
   Served as   Finance to Loan   Served as   Finance to Loan 
   Collateral   Purchaser   Collateral   Purchaser 
Loan purchaser                    
1st Financial Bank, USA  $4,688   $2,070   $2,723   $1,061 
S.K. Funding, LLC   6,276    3,752    4,522    2,622 
                     
Total  $10,964   $5,822   $7,245   $3,683 

 

The $6,276 of loans which served as collateral for S.K. Funding, LLC does not include the book value of the foreclosed assets which also secure their position, which amount is $1,813.

 

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Affiliate Loans

 

In December 2011, the Company entered into two secured revolving lines of credit with affiliates, both of whom are members. These loans have an interest rate of the affiliates’ cost of funds, which was 4.18% and 4.20% as of September 30, 2016 and December 31, 2015, respectively. They are demand notes. The maximum that can be borrowed under these notes is $1,500, at the discretion of the lenders. The actual amount borrowed was $0 at both September 30, 2016 and December 31, 2015, leaving $1,500 in potential credit availability on those dates. There is no obligation of the affiliates to lend money up to the note amount. The security for the lines of credit includes all of the assets of the Company. The Company has not borrowed on these lines in either 2015 or 2016.

 

S.K. Funding owns 4% of our common equity. S.K. Funding is also a buyer in a purchase and sale agreement where we are the seller. 7Kings is an investor in our notes program for $500 and has a $500 unsecured note due from us.

 

Other Unsecured Loans

 

In August 2015, we entered into an unsecured note with 7Kings, under which we are the borrower. The note has a maximum amount outstanding of $500, of which $500 was outstanding as of September 30, 2016 and December 31, 2015. Interest on the 7Kings loan accrues annually at a rate of 7.5%. The note was due on February 19, 2016, was renewed several times and is now due February 18, 2017, and may be prepaid at any time without penalty. Interest is due at the end of each month and was $14 in 2015 and $28 in the first nine months of 2016. On December 31, 2015, S.K. Funding, an affiliate of 7Kings, purchased 4% of our common equity from the Wallach family.

 

In December 2015, we entered into an unsecured note with an unrelated third party, under which we are the borrower. The note has a maximum amount outstanding of $100, of which $100 was outstanding on both September 30, 2016 and December 31, 2015. Interest on this note accrues annually at a rate of 7.9%. The note is due on June 23, 2017 and may be prepaid at any time without penalty. Interest accrues and compounds monthly. In April 2016, we entered into an unsecured note with the same unrelated third party, under which we are the borrower. The note has a maximum amount outstanding of $100, of which $100 was outstanding on September 30, 2016. Interest on this note accrues annually at a rate of 10%. The note is due on April 15, 2020 and may be prepaid at any time without penalty. Interest accrues and compounds monthly.

 

SF Loan

 

The SF Loan, under which we were the borrower, was an unsecured loan in the original principal amount of $1,500. Interest on the SF Loan accrued annually at a rate of 5.0%. On December 31, 2014, the Company and the Hoskins Group entered into a series of agreements which, among other things, 1) converted $1,000 of the SF Loan from debt to preferred equity, 2) repaid $125 of the SF Loan and applied those proceeds to increase the interest escrow, and 3) required elimination of the remaining balance of the SF Loan with a cash payment upon the repayment of the construction loan on lot 5 of the Tuscany subdivision. This payment was made in the first quarter of 2015.

 

Notes Program

 

Borrowings through our public offerings were $10,689 and $8,496 at September 30, 2016 and December 31, 2015, respectively. The effective interest rate on the borrowings at September 30, 2016 and December 31, 2015 was 7.87% and 7.30%, respectively, not including the amortization of deferred financing costs. There are limited rights of early redemption. We generally offer four durations at any given time, ranging anywhere from 12 to 48 months. The following table shows the roll forward of our Notes program:

 

   Nine Months
Ended
September 30, 2016
   Year Ended
December 31, 2015
   Nine Months
Ended
September 30, 2015
 
             
Notes outstanding, beginning of period  $8,496   $5,427   $5,427 
Notes issued   3,529    3,737    2,470 
Note repayments / redemptions   (1,336)   (668)   (644)
                
Notes outstanding, end of period  $10,689   $8,496   $7,253 
                
Less deferred financing costs, net   448    599    623 
                
Notes outstanding, net   10,241    7,897    6,630 

 

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The following table shows the maturity of outstanding debt as of September 30, 2016.

 

Year Maturing   Total Amount
Maturing
   Public Offering   Other
Unsecured
   Purchase and Sale
Agreements
 
                  
2016   $6,733   $911   $   $5,822 
2017    3,516    2,916    600     
2018    2,289    2,289         
2019    2,577    2,577           
2020    2,096    1,996    100     
                      
Total   $17,211   $10,689   $700   $5,822 

 

Purchase and sale agreements are treated as secured lines of credit, where the collateral is demand loans, and therefore they are considered short term liabilities.

 

7. Members’ Capital

 

There are currently two classes of units (class A common units and series B cumulative preferred units).

 

The Class A common units are held by three members, all of whom have no personal liability. All Class A common members have voting rights in proportion to their capital account. There were 2,629 Class A common units outstanding at both September 30, 2016 and December 31, 2015. On December 31, 2015, an affiliate of 7Kings, S.K. Funding, purchased 4% of our common equity from the Wallach family.

 

The series B cumulative preferred units were issued to the Hoskins Group through a reduction in the SF Loan. They are redeemable only at the option of the Company or upon a change or control or liquidation. Ten units were issued for a total of $1,000. The series B units have a fixed value which is their purchase price, and preferred liquidation and distribution rights. Yearly distributions of 10% of the units’ value (providing profits are available) are made quarterly. The Hoskins Group series B cumulative preferred units are also used as collateral for that group’s loans to the Company. There is no liquid market for the preferred equity instrument, so we can give no assurance as to our ability to generate any amount of proceeds from that collateral. In December of 2015, the Hoskins Group agreed to purchase 0.1 unit for $10 at each closing of a lot to a third party in the Hamlets and Tuscany subdivisions.

 

There are two additional authorized unit classes: class A preferred units and class B profit units. Once class B profit units are issued, the existing class A common units will become class A preferred units. Class A preferred units will receive preferred treatment in terms of distributions and liquidation proceeds.

 

The members’ capital balances by class are as follows:

 

Class  September 30, 2016   December 31, 2015 
B Preferred Units  $1,100   $1,010 
A Common Units   2,316    2,274 
           
Members’ Capital  $3,416   $3,284 

 

26
 

 

8. Related Party Transactions

 

Notes and Accounts Payable to Affiliates

 

The Company has a loan agreement with two of our affiliates, as more fully described in Note 6 – Affiliate Loans.

 

The Company had loan agreements with the Hoskins Group, as more fully described in Note 6 – SF Loan and Note 4 – Pennsylvania Loans.

 

The Hoskins Group has a preferred equity interest in the Company, as more fully described in Note 7.

 

S.K. Funding, an affiliate of 7Kings, owns 4% of our common equity. S.K. Funding is also a buyer in a purchase and sale agreement where we are the seller. 7Kings is an investor in our notes program for $500 and has a $500 unsecured note due from us.

 

The Company has accepted new investments under the Notes program from employees, managers, members and relatives of managers and members, with $2,624 outstanding at September 30, 2016. The larger of these investments are detailed below:

 

   Relationship
to
      Weighted
average
interest
   Interest earned
during the six
months ended
 
   Shepherd’s  Amount invested as of   rate as of   September 30, 
Investor  Finance  September 30, 2016   December 31, 2015   September 30, 2016   2016   2015 
Bill Myrick  Independent Manager  $288   $268    7.76%  $17   $9 
                             
R. Scott Summers  Son of Independent Manager   225    475    7.26%   26    8 
                             
Wallach Family Irrevocable Educational Trust  Trustee is Member   200    200    7.00%   12    11 
                             
David and Carole Wallach  Parents of Member   111    111    8.00%   7    7 
                             
Eric Rauscher  Independent Manager   600    600    7.13%   34    27 
                             
Joseph Rauscher  Parents of Independent Manager   186    186    8.00%   12    12 
                             
Schultz Family Revocable Living Trust  Parents of Member   111    96    8.21    7    5 
                             
Seven Kings Holdings, Inc.  Member   500    500    9.00%   26    50 

 

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9. Commitments and Contingencies

 

In the normal course of business there may be outstanding commitments to extend credit that are not included in the consolidated financial statements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon and some of the funding may come from the earlier repayment of the same loan (in the case of revolving lines), the total commitment amounts do not necessarily represent future cash requirements. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of amounts recognized in the consolidated financial statements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. Unfunded commitments to extend credit, which have similar collateral, credit risk and market risk to our outstanding loans, were $8,556 and $7,332 at September 30, 2016 and December 31, 2015, respectively.

 

The Company has several Letters of Credit relating to the BMH Loan. Refer to the chart in Note 4 – Commercial Loans – Real Estate Development Loan Portfolio Summary for further details describing this commitment.

 

10. Selected Quarterly Condensed Consolidated Financial Data (Unaudited)

 

Summarized unaudited quarterly condensed consolidated financial data for the four quarters of 2016 and 2015 are as follows (in thousands):

 

   Quarter
4
   Quarter
3
  

Quarter

2

   Quarter
1
   Quarter
4
   Quarter
3
   Quarter
2
   Quarter
1
 
   2016   2016   2016   2016   2015   2015   2015   2015 
                                 
Net Interest Income  $   $442   $464   $479   $326   $210   $212   $192 
Non-Interest Income           44        105             
SG&A expense       297    305    350    163    115    119    150 
Net Income  $   $145   $203   $129   $268   $95   $93   $42 

 

11. Non-Interest expense detail

 

The following table displays our SG&A expenses:

 

   For the Nine Months Ended
September 30,
 
   2016   2015 
Selling, general and administrative expenses          
Legal and Accounting  $139   $113 
Salaries and related expenses   593    124 
Board related expenses   84    76 
Advertising   31    11 
Rent and Utilities   15    15 
Printing   8    12 
Loan and foreclosed asset expenses   17    5 
Travel   26    10 
Other   39    18 
Total SG&A  $952   $384 

 

12. Subsequent Events

 

Management of the Company has evaluated subsequent events through November 3, 2016, the date these interim condensed consolidated financial statements were issued and there were none to disclose.

 

28
 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

(All dollar [$] amounts shown in thousands.)

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our interim condensed consolidated financial statements and the notes thereto contained elsewhere in this report. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should also be read in conjunction with our audited annual consolidated financial statements and related notes and other consolidated financial data included in the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2015. See also “Cautionary Note Regarding Forward-Looking Statements” preceding Part I.

 

Overview

 

We were organized in the Commonwealth of Pennsylvania in 2007 under the name 84 RE Partners, LLC and changed our name to Shepherd’s Finance, LLC on December 2, 2011. We converted to a Delaware limited liability company on March 29, 2012. Our business is focused on commercial lending to participants in the residential construction and development industry. We believe this market is underserved because of the lack of traditional lenders currently participating in the market. We are located in Jacksonville, Florida. Our operations are governed pursuant to our operating agreement.

 

From 2007 through the majority of 2011, we were the lessor in three commercial real estate leases with a then affiliate, 84 Lumber Company. Beginning in late 2011, we began commercial lending to residential homebuilders. Our current loan portfolio is described more fully in this section under the sub heading “Commercial Construction and Development Loans.” We have a limited operating history as a finance company. We currently have four paid employees, including our Executive Vice President of Operations. We currently use our Chief Executive Officer, Daniel M. Wallach, to originate most of our new loans, and augment that with several people to whom we pay consulting fees. Our Board of Managers is comprised of Mr. Wallach and three independent Managers – Bill Myrick, Eric Rauscher, and Kenneth R. Summers. Our officers are responsible for our day-to-day operations, while the Board of Managers is responsible for overseeing our business.

 

The commercial loans we extend are secured by mortgages on the underlying real estate. We extend and service commercial loans to small-to-medium sized homebuilders for the purchase of lots and/or the construction of homes thereon. In a few limited circumstances, we lend money to homebuilders for the purchase of existing homes to be rehabbed. We also extend and service loans for the purchase of undeveloped land and the development of that land into residential building lots. In addition, we may, depending on our cash position and the opportunities available to us, do none, any or all of the following: purchase defaulted unsecured debt from suppliers to homebuilders at a discount (and then secure that debt with real estate or other collateral), purchase defaulted secured debt from financial institutions at a discount, and purchase real estate in which we will operate our business.

 

Our CEO, Mr. Wallach, has been in the housing industry since 1985. He was the CFO of a multi-billion dollar supplier of building materials to home builders for 11 years. He also was responsible for that company’s lending business for 20 years. During those years, he was responsible for the creation and implementation of many secured lending programs to builders. Some of these were performed fully by that company, and some were performed in partnership with banks. In general, the creation of all loans, and the resolution of defaulted loans, was his responsibility, whether the loans were company loans or loans in partnership with banks. Through these programs, he was responsible for the creation of approximately $2,000,000 in loans which generated interest spread of $50,000, after deducting for loan losses. Through the years, he managed the development of systems for reducing and managing the risks and losses on defaulted loans. Mr. Wallach also was responsible for that company’s unsecured debt to builders, which reached over $300,000 at its peak. He also gained experience in securing defaulted unsecured debt.

 

29
 

 

We had $17,915 and $14,060 in loan assets as of September 30, 2016 and December 31, 2015, respectively. As of September 30, 2016, we have a limited number of construction loans in 15 states with 27 borrowers, and have three development loans in Pittsburgh, Pennsylvania. At the end of 2014 and again in April 2015, we entered into purchase and sale agreements for portions of our loans. The first loan portions sold under the program took place during the first quarter of 2015 and it has allowed us to increase our loan balances and commitments significantly in 2015 and 2016.

 

We currently have six sources of capital:

 

   September 30, 2016   December 31, 2015 
Capital Source          
Purchase and sale agreements  $5,822   $3,683 
Secured line of credit from affiliates        
Unsecured Notes through our Notes offer, net of deferred costs   10,241    7,897 
Other unsecured debt   700    600 
Preferred equity   1,100    1,010 
Common equity   2,316    2,274 
           
Total  $20,179   $15,464 

 

Certain features of the purchase and sale agreements have added liquidity and flexibility, which have lessened the need for the lines of credit from affiliates. Eventually, the Company intends to permanently replace the lines of credit from affiliates with a secured line of credit from a bank or through other liquidity.

 

Critical Accounting Estimates

 

To assist in evaluating our consolidated financial statements, we describe below the critical accounting estimates that we use. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used, would have a material impact on our consolidated financial condition or results of operations.

 

Loan Losses

 

Nature of estimates required

 

Loan losses, as applicable, are accounted for both on the consolidated balance sheets and the consolidated statements of operations. On the consolidated statements of operations, management estimates the amount of losses to capture during the current year. This current period amount incurred is referred to as the loan loss provision. The calculation of our allowance for loan losses, which appears on our consolidated balance sheets, requires us to compile relevant data for use in a systematic approach to assess and estimate the amount of probable losses inherent in our commercial lending operations and to reflect that estimated risk in our allowance calculations. We use the policy summarized as follows:

 

We establish a collective reserve for all loans which are not more than 60 days past due at the end of a quarter. This collective reserve takes into account both historical information and a qualitative analysis of housing and other economic factors that may impact our future realized losses. For loans to one borrower with committed balances less than 10% of our total committed balances on all loans extended to all customers, we individually analyze for impairment all loans which are more than 60 days past due at the end of a quarter. For loans to one borrower with committed balances equal to or greater than 10% of our total committed balances on all loans extended to all customers, we individually analyze all loans for potential impairment. The analysis of loans, if required, includes a comparison of estimated collateral value to the principal amount of the loan. For impaired loans, if the value determined is less than the principal amount due (less any builder deposit), then the difference is included in the allowance for loan loss. As values change, estimated loan losses may be provided for more or less than the previous period, and some loans may not need a loss provision based on payment history. For homes which are partially complete, we appraise on an as-is and completed basis, and use the one that more closely aligns with our planned method of disposal for the property.

 

30
 

 

For loans greater than 12 months in age that are individually evaluated for impairment, appraisals have been prepared within the last 13 months. For all loans individually evaluated for impairment, there is also a broker’s opinions of value (“BOV”) prepared, if the appraisal is more than six months old. The lower of any BOV prepared in the last six months, or the most recent appraisal, is used, unless we determine a BOV to be invalid based on the comparable sales used. If we determine a BOV to be invalid, we will use the appraised value. Appraised values are adjusted down for estimated costs associated with asset disposal. Broker’s opinion of selling price, currently valid sales contracts on the subject property, or representative recent actual closings by the builder on similar properties may be used in place of a broker’s opinion of value.

 

Appraisers are state certified, and are selected by first attempting to utilize the appraiser who completed the original appraisal report. If that appraiser is unavailable or not affordable, we use another appraiser who appraises routinely in that geographic area. BOVs are created by real estate agents. We try to first select an agent we have worked with, and then, if that fails, we select another agent who works in that geographic area.

 

Loan losses are also impacted when a loan asset is taken through foreclosure or similar means and changed from a loan to a foreclosed asset. The valuation for foreclosed assets does not include future value, as it does while the asset is a loan, and therefore the calculation can have a different result.

 

Fair Value

 

Nature of estimates required

 

Currently, fair value of collateral has the potential to impact the calculation of the loan loss provision most heavily. Specifically relevant to the allowance for loan loss reserve is the fair value of the underlying collateral supporting the outstanding loan balances. Also the fair value of real estate will affect our foreclosed asset value (which is booked at 100% of fair value, after selling costs are deducted). Fair value measurements are an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Due to a rapidly changing economic market, an erratic housing market, the various methods that could be used to develop fair value estimates, and the various assumptions that could be used, determining the collateral’s fair value requires significant judgment.

 

Sensitivity analysis

 

   September 30, 2016 
   Loan Loss 
   Provision 
Change in Fair Value Assumption  Higher/(Lower) 
Increasing fair value of the real estate collateral by 30%*  $ 
Decreasing fair value of the real estate collateral by 30%**  $46 

 

* Increases in the fair value of the real estate collateral do not impact the loan loss provision, as the value generally is not “written up.”

 

**If the loans were nonperforming, assuming a book amount of the loans outstanding of $17,915 and the fair value of the real estate collateral on all outstanding loans was reduced by 30%, an addition to the loan loss provision of $46 would be required.

 

31
 

 

   September 30, 2016 
   Foreclosed 
   Assets 
Change in Fair Value Assumption  Higher/(Lower) 
Increasing fair value of the foreclosed asset by 30%*  $ 
Decreasing fair value of the foreclosed asset by 30%**  $(971)

 

* Increases in the fair value of the foreclosed assets do not impact the carrying value, as the value generally is not “written up.” Those gains would be recognized at the sale of the asset.

 

**This decrease would result in a recognition of loss in non-interest income.

 

Amortization of Deferred Financing Costs

 

We amortize our deferred financing costs based on the effective interest method. As such, we make estimates for the duration of the future investment proceeds we anticipate receiving from our Notes offering. If this estimate is determined to be incorrect in the future, the rate at which we are amortizing the deferred financing costs as interest expense would be adjusted.

 

Currently we anticipate a consistent average duration of 38 months for the Notes in our current offering. An increasing average duration over the remaining anticipated length of the Notes offering would decrease the amount of amortization reflected in interest in the next 12 months, and a decreasing average duration of investments over the remaining anticipated length would increase the amount reflected in the next 12 months.

 

Sensitivity analysis for average duration

 

Change in Anticipated Average Duration  Resulting
adjustment
needed to Interest
Expense during
the next 12
months
Higher/(Lower)
 
Decreasing the average duration by 5 months for all remaining months of origination  $10 
Increasing the average duration by 5 months for all remaining months of origination  $(8)

 

Other Loss Contingencies

 

Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Disclosure is required when there is a reasonable possibility that the ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as courts, arbitrators, juries, or regulators.

 

Accounting and Auditing Standards Applicable to “Emerging Growth Companies”

 

We are an “emerging growth company” under the recently enacted JOBS Act. For as long as we are an “emerging growth company,” we are not required to: (1) comply with any new or revised financial accounting standards that have different effective dates for public and private companies until those standards would otherwise apply to private companies, (2) provide an auditor’s attestation report on management’s assessment of the effectiveness of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (3) comply with any new requirements adopted by the Public Company Accounting Oversight Board, or the PCAOB, requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer or (4) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. We intend to take advantage of such extended transition period. Since we will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, our consolidated financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If we were to subsequently elect to instead comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.

 

32
 

 

Other Significant Accounting Policies

 

Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the consolidated financial statements. Policies related to credit quality information, fair value measurements, related party transactions and revenue recognition require difficult judgments on complex matters that are often subject to multiple and recent changes in the authoritative guidance. Certain of these matters are among topics currently under reexamination or have recently been addressed by accounting standard setters and regulators. Specific conclusions have not been reached by these standard setters, and outcomes cannot be predicted with confidence. Also, see Notes 1 and 2 to our consolidated financial statements, as they discuss accounting policies that we have selected from acceptable alternatives.

 

Consolidated Results of Operations

 

Key financial and operating data for the three and six months ended September 30, 2016 and 2015 are set forth below. For a more complete understanding of our industry, the drivers of our business, and our current period results, this discussion should be read in conjunction with our consolidated financial statements, including the related notes and the other information contained in this document.

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(in thousands of dollars)  2016   2015   2016   2015 
Interest Income                    
Interest and fee income on loans  $909   $450   $2,656   $1,236 
Interest expense   463    221    1,261    580 
                     
Net interest income   446    229    1,395    656 
Less: Loan loss provision   4    19    10    42 
                     
Net interest income after loan loss provision   442    210    1,385    614 
                     
Non-Interest Income                    
Gain from foreclosure of assets           44     
                     
Income   442    210    1,429    614 
                     
Non-Interest Expense                    
Selling, general and administrative   297    115    952    384 
                     
Total non-interest expense   297    115    952    384 
                     
Net Income  $145   $95   $477   $230 
                     
Earned distribution to preferred equity holder   27    25    79    75 
                     
Net income attributable to common equity holder  $118   $70   $398   $155 

 

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Interest Spread

 

The following table displays a comparison of our interest income, expense, fees and spread:

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(in thousands of dollars)  2016   2015   2016   2015 
Interest Income        *          *          *          *  
Interest income on loans  $623    13%  $286    11%  $1,737    13%  $779    11%
Fee income on loans   286    6%   164    6%   919    6%   457    7%
Interest and fee income on loans   909    19%   450    17%   2,656    19%   1,236    18%
Interest expense related parties                                
Interest expense unsecured   246    5%   135    5%   648    5%   351    5%
Interest expense secured   147    3%   27    1%   409    3%   65    1%
Amortization offering costs   70    2%   59    2%   204    1%   164    2%
Interest expense   463    10%   221    8%   1,261    9%   580    8%
Net interest income   446    9%   229    9%   1,395    10%   656    10%
                                         
Weighted average outstanding loan asset balance  $18,620        $10,260        $17,875        $9,253      

 

*annualized amount as percentage of weighted average outstanding gross loan balance

 

There are three main components that can impact our interest spread:

 

Difference between the interest rate received (on our loan assets) and the interest rate paid (on our borrowings). The loans we have originated have interest rates which are based on our cost of funds, with a minimum cost of funds of 5%. The margin is fixed at 2%. Future loans are anticipated to be originated at approximately the same 2% margin. This component is also impacted by the lending of money with no interest cost (our equity). Our interest income on loans was higher in both the three and nine month periods ended September 30, 2016 as compared to the same periods in 2015. This increase was due to: 1) default interest charged to a borrower in 2016; 2) a higher interest rate charged to all of our borrowers (caused by an increase in our borrowing costs); 3) not recognizing interest in 2015 for a borrower we were foreclosing on; and 4) an increase in the rate we are charging on our development loans. Our interest expense increased in 2016 as we sought to increase our loan balances and found that we were able to do so by raising the interest rates we paid to our lenders, including the Notes program. Also we were using capital raised from debt to carry foreclosed assets, and while that raised our interest cost, it did not increase our weighted average outstanding loan balance.

 

The difference (spread) between the interest income and interest expense was 3% in the three month period ended September 30, 2016, and 4% for the nine month period ended the same date. The spread was 3% for the three and nine month periods ended September 30, 2015. This increase is due to charging default interest to one of our borrowers during 2016, and not charging interest during default of a borrower during 2015.

 

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Fee income. Fee income is displayed in the table above. The two loans originated in December 2011 had a net origination fee of $924. This fee was recognized over the life of the loans, and has been fully recognized as of August, 2016. In both 2016 and 2015, this fee was 4% of the average outstanding balance on those loans. All of our construction loans have a 5% fee on the amount we commit to lend, which is amortized over the expected life of each of those loans. When loans pay back quicker than their expected life, the remaining unrecognized fee is recognized upon the termination of the loan. In the nine months ended September 30, 2016 and 2015, this fee was 6% and 7%, respectively, of the average outstanding balance on those loans. This decrease was due to a longer weighted average duration of our loan portfolio in the 2016. In the future, we anticipate creating loans with fees ranging between 4 and 5% of the maximum loan amount, and we anticipate that our fee percentage in 2016 vs. 2015 will be slightly higher due to construction loans being a higher portion of our balances in 2016, and slightly lower due to the 2011 loans only having fee income through July 2016. After July 2016, the interest rate on those loans increases to offset the decrease in fee income, but that amount will be reflected in the difference between the interest rate received and the interest rate paid amounts described in the previous paragraph. Fee income for both the three months periods ended September 30, 2016 and 2015 was 6%.

 

Amount of nonperforming assets. In 2015 we had loan assets we were foreclosing on which were not paying interest, and in 2016 we had no such loan assets. Our real estate assets we owned (after we foreclosed on loans and took possession of the property serving as collateral) do not have an interest return either, and the balance of those has risen over the last four quarters. On September 30, 2016 and December 31, 2015, we carried cash balances of $561 and $1,341, respectively, which also do not have a material return.

 

Loan Loss Provision

 

We recorded $4 in both of the three month periods ended September 30, 2016 and 2015, respectively, in loss reserve related to our collective reserve (loans not individually impaired). We recorded $10 and $6 in the nine month periods ended September 30, 2016 and 2015, respectively, in loss reserve related to our collective reserve. In addition, we reserved $15 and $36 in the three and nine month periods ended September 30, 2015 in our specific reserve (for loans individually impaired) specifically related to loans we were foreclosing on in 2015. We anticipate that the collective reserve will increase as our balances rise throughout 2016.

 

SG&A Expenses

 

The following table displays our SG&A expenses:

 

   Three Months   Nine Months 
   Ended September 30,   Ended September 30, 
   2016   2015   2016   2015 
Selling, general and administrative expenses                    
Legal and accounting  $27   $25