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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 March 31, 2017

 

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, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [  ]

 

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 Statements   3
       
PART I. FINANCIAL INFORMATION    
     
  Item 1. Financial Statements   4
       
    Interim Condensed Consolidated Balance Sheets as of March 31, 2017 (Unaudited) and December 31, 2016   4
       
    Interim Condensed Consolidated Statements of Operations (Unaudited) for the Three Months Ended March 31, 2017 and 2016   5
       
    Interim Condensed Consolidated Statement of Changes in Members’ Capital (Unaudited) for the Three Months Ended March 31, 2017   6
       
    Interim Condensed Consolidated Statements of Cash Flows (Unaudited) for the Three Months Ended March 31, 2017 and 2016   7
       
    Notes to Interim Condensed Consolidated Financial Statements (Unaudited)   8
       
  Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   22
       
  Item 3. Quantitative and Qualitative Disclosure About Market Risk   41
       
  Item 4. Controls and Procedures   41
       
PART II. OTHER INFORMATION    
     
  Item 1. Legal Proceedings   42
       
  Item 1A. Risk Factors   42
       
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   42
       
  Item 3. Defaults upon Senior Securities   43
       
  Item 4. Mine Safety Disclosures   43
       
  Item 5. Other Information   43
       
  Item 6. Exhibits   43

 

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, 2016, 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 2016 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)  March 31, 2017   December 31, 2016 
    (Unaudited)      
Assets          
Cash and cash equivalents  $586   $1,566 
Accrued interest on loans   320    280 
Loans receivable, net   24,167    20,091 
Foreclosed assets   1,081    2,798 
Property, plant and equipment   625     
Other assets   67    151 
           
Total assets  $26,846   $24,886 
           
Liabilities, Redeemable Preferred Equity and Members’ Capital          
           
Liabilities          
           
Customer interest escrow  $1,021   $812 
Accounts payable and accrued expenses   1,482    1,363 
Notes payable secured   6,728    7,322 
Notes payable unsecured, net of deferred financing costs   13,587    11,962 
Due to preferred equity member   31    28 
           
Total liabilities   22,849    21,487 
           
Commitments and Contingencies (Notes 3 and 10)          
           
Redeemable Preferred Equity          
           
Series C preferred equity   440     
           
Members’ Capital          
           
Series B preferred equity   1,160    1,150 
Class A common equity   2,397    2,249 
Members’ capital   3,557    3,399 
           
Total liabilities, redeemable preferred equity and members’ capital  $26,846   $24,886 

 

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

For the Three Months ended March 31, 2017 and 2016

 

(in thousands of dollars)  2017   2016 
           
Net Interest Income          
Interest and fee income on loans  $1,174   $849 
Interest expense:          
Interest related to secured borrowings   179    117 
Interest related to unsecured borrowings   367    245 
Interest expense   546    362 
           
Net interest income   628    487 
Less: Loan loss provision   11    8 
           
Net interest income after loan loss provision   617    479 
           
Non-Interest Income          
Gain from sale of foreclosed assets   77     
           
Income   694    479 
           
Non-Interest Expense          
Selling, general and administrative   454    350 
Impairment loss on foreclosed assets   49     
           
Total non-interest expense   503    350 
           
Net income  $191   $129 
           
Earned distribution to preferred equity holders   31    26 
           
Net income attributable to common equity holders  $160   $103 

 

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

 

5
 

 

Shepherd’s Finance, LLC

Interim Condensed Consolidated Statements of Changes In Members’ Capital - Unaudited

For the Three Months Ended March 31, 2017

 

(in thousands of dollars)  2017 
      
Members’ capital, beginning balance  $3,399 
Net income   191 
Contributions from members (preferred)   10 
Earned distributions to preferred equity holder   (31)
Distributions to common equity holders   (12)
      
Members’ capital, ending balance  $3,557 

 

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

For the Three Months Ended March 31, 2017 and 2016

 

(in thousands of dollars)   2017     2016  
             
Cash flows from operations                
Net income   $ 191     $ 129  
Adjustments to reconcile net income to net cash provided by (used in) operating activities                
Amortization of deferred financing costs     64       67  
Provision for loan losses     11       8  
Net loan origination fees deferred (earned)     198       (49 )
Change in deferred origination expense     (64 )     (10 )
Impairment of foreclosed assets     49        
Gain from sale of foreclosed assets     (77 )      
Net change in operating assets and liabilities                
Other assets     15        
Accrued interest on loans     (40 )     (103 )
Customer interest escrow     209       (35 )
Accounts payable and accrued expenses     119       269  
                 
Net cash provided by (used in) operating activities     675       276  
                 
Cash flows from investing activities                
Loan originations and principal collections, net     (4,221 )     (3,404 )
Investment in foreclosed assets     (145 )     (213 )
Proceeds from sale of foreclosed assets     1,890        
Property plant and equipment additions     (556 )      
                 
Net cash provided by (used in) investing activities     (3,032 )     (3,617 )
                 
Cash flows from financing activities                
Contributions from redeemable preferred equity     440        
Contributions from members (preferred)     10       40  
Distributions to members     (40 )     (190 )
Proceeds from secured note payable     2,001       3,892  
Repayments of secured note payable     (2,595 )     (1,578 )
Proceeds from unsecured notes payable     4,144       633  
Redemptions/repayments of unsecured notes payable     (2,573 )     (10 )
Deferred financing costs paid     (10 )     (19 )
                 
Net cash provided by (used in) financing activities     1,377       2,768  
                 
Net increase (decrease) in cash and cash equivalents     (980 )     (573 )
                 
Cash and cash equivalents                
Beginning of period     1,566       1,341  
                 
End of period   $ 586     $ 768  
                 
Supplemental disclosure of cash flow information                
Cash paid for interest   $ 488     $ 152  
                 
Non-cash investing and financing activities                
Earned but not paid distribution of preferred equity holders   $ 31     $ 1  

 

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 subsidiary (the “Company”, “we” or “our”) was originally formed as a Pennsylvania limited liability company on May 10, 2007. We are the sole member of a consolidating subsidiary, 84 REPA, LLC. The Company operated pursuant to an operating agreement by and among Daniel M. Wallach and the members of the Company from its inception through March 29, 2012, at which time it adopted an amended and restated operating agreement.

 

The Company lends money to residential homebuilders to construct single family homes, to develop undeveloped land into residential building lots, and to purchase and improve for sale older homes. The loans are extended to residential homebuilders and, as such, are commercial loans. We lend in 16 states as of March 31, 2017.

 

Basis of Presentation

 

The accompanying (a) condensed consolidated balance sheet as of December 31, 2016, 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 consolidated results of operations for any interim period are not necessarily indicative of results expected for the fiscal year ending December 31, 2017. These unaudited interim condensed consolidated financial statements should be read in conjunction with the 2016 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, 2016 (the “2016 Statements”). The accounting policies followed by the Company are set forth in Note 2 - Summary of Significant Accounting Policies, (“Note 2”) of the notes to the 2016 Statements.

 

2. Fair Value

 

Utilizing Financial Accounting Standards Board Accounting Standards Codification (“FASB 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.

 

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.

 

8
 

 

Fair Value Measurements of Non-financial Instruments on a Recurring Basis

 

The Company has no non-financial instruments measured at fair value on a recurring basis.

 

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

 

Foreclosed Assets

 

Foreclosed assets consist of properties obtained through foreclosure or in satisfaction of loans and is recorded at the fair value of the property, less estimated costs to sell. Estimates of fair value are generally based on third-party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes discounted based on management’s knowledge of the property and/or changes in market conditions from the date of the most recent appraisal. Such discounts are typically significant unobservable inputs for determining fari value.

 

The following tables presents the balances of non-financial instruments measured at fair value on a non-recurring basis as of March 31, 2017 and December 31, 2016.

 

March 31, 2017

 

           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 
                          
Foreclosed assets  $1,081   $1,081   $   $   $1,081 

 

December 31, 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 
                          
Foreclosed assets  $2,798   $2,798   $   $   $2,798 

 

9
 

 

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 both March 31, 2017 and December 31, 2016. Because the loans are demand loans 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.

 

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 March 31, 2017 and December 31, 2016.

 

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 March 31, 2017 and December 31, 2016.

 

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 both March 31, 2017 and December 31, 2016. The interest on our Notes offering is paid to our Note holders either monthly or at the end of their investment, compounded 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:

 

10
 

 

March 31, 2017

 

           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  $586   $586   $586   $   $ 
Loans receivable, net   24,167    24,167            24,167 
Accrued interest on loans   320    320            320 
Financial Liabilities                         
Customer interest escrow   1,021    1,021            1,021 
Notes payable secured   6,728    6,728            6,728 
Notes payable unsecured, net   13,587    13,587            13,587 
Accrued interest payable   998    998            998 

 

December 31, 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  $1,566   $1,566   $1,566   $   $ 
Loans receivable, net   20,091    20,091            20,091 
Accrued interest on loans   280    280            280 
Financial Liabilities                         
Customer interest escrow   812    812            812 
Notes payable secured   7,322    7,322            7,322 
Notes payable unsecured, net   11,962    11,962            11,962 
Accrued interest payable   993    993            993 

 

3. Financing Receivables

 

Financing receivables are comprised of the following as of March 31, 2017 and December 31, 2016:

 

   March 31, 2017   December 31, 2016 
           
Commercial loans, gross  $26,121   $21,569 
Less: Deferred loan fees   (816)   (618)
Less: Deposits   (1,192)   (861)
Plus: Deferred origination expense   119    55 
Less: Allowance for loan losses   (65)   (54)
           
Commercial loans, net  $24,167   $20,091 

 

11
 

 

Roll forward of commercial loans:

 

  

Three Months

Ended
March 31, 2017

  

Year

Ended
December 31, 2016

  

Three Months

Ended
March 31, 2016

 
                
Beginning balance  $20,091   $14,060   $14,060 
Additions   7,461    23,184    7,081 
Payoffs/sales   (2,909)   (15,168)   (3,620)
Moved to foreclosed assets       (1,639)    
Change in deferred origination expense   64    55    10 
Change in builder deposit   (331)   (340)   (57)
Change in loan loss provision   (11)   (16)   (8)
New loan fees   (593)   (1,270)   (332)
Earned loan fees   395    1,225    381 
                
Ending balance  $24,167   $20,091   $17,515 

 

Commercial Construction and Development Loans

 

Pennsylvania Loans

 

We have three development loans (the “Pennsylvania Loans”) covering two developments. The loans are to the same borrowing group (the “Hoskins Group”). They are cross-defaulted and cross-collateralized with each other. Our total commitment amount under the Pennsylvania Loans is approximately $5,231 as of March 31, 2017, as described in more detail below. As such, we are currently reliant on a single developer and homebuilder for a significant portion of our revenues. As part of our agreement with the Hoskins Group, they invest in our preferred equity in an amount equal to $10 per closing of a lot payoff in the two developments. We collected a fee of $1,000 upon closing of the loans in 2011, which was recognized through July 2016, the original expected life of the loan. Additionally, we created an interest escrow account (the “Interest Escrow”) which has been funded at various times by borrowings, and by a portion of each lot payoff. Interest on the Pennsylvania Loans accrues annually at 7% (2% prior to 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”). Pursuant to the credit agreement, interest payments on the loans are funded from the Interest Escrow, with any shortfall funded by the Hoskins Group. Loans may be prepaid in whole or in part at any time without penalty.

 

The loans are secured by several first priority mortgages in residential building lots located in the subdivisions commonly known as the Hamlets of Springdale and the Tuscany Subdivision, both in Peters Township, Pennsylvania, a suburb of Pittsburgh, as well as the Interest Escrow.

 

Commercial Loans – Real Estate Development Loan Portfolio Summary

 

The following is a summary of our loan portfolio to builders for land development as of March 31, 2017. The Pennsylvania loans below are 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   $6,333   $5,231(3)  $3,901    62%  $1,000 
Total   1    3   $6,333   $5,231   $3,901    62%  $1,000 

 

12
 

 

(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 $1,160 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 does not include letters of credit and cash bonds, as the sum of the total balance outstanding including the cash bonds plus the letters of credit and remaining to fund for construction is less than the $5,231 commitment amount.

 

The following is a summary of our loan portfolio to builders for land development as of December 31, 2016. The Pennsylvania loans below are 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   $6,586   $5,931(3)  $4,082    62%  $1,000 
Total   1    3   $6,586   $5,931   $4,082    62%  $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 $1,150 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 does not include letters of credit and cash bonds, as the sum of the total balance outstanding including the cash bonds plus the letters of credit and remaining to fund for construction is less than the $5,931 commitment amount.

 

Commercial Loans – Construction Loan Portfolio Summary

 

As of March 31, 2017, we have 43 other borrowers, all of whom, along with the Hoskins Group, borrow money for the purpose of building new homes.

 

The following is a summary of our loan portfolio to builders for home construction loans as of March 31, 2017.

 

State  Number of Borrowers   Number of Loans   Value of Collateral(1)   Commitment Amount  

Gross

Amount

Outstanding

  

Loan to Value

Ratio(2)

   Loan Fee 
Colorado   2    5   $2,314   $1,566   $694    68%   5%
Connecticut   1    1    715    500    500    70%   5%
Delaware   1    1    244    171    40    70%   5%
Florida   11    23    17,194    10,633    6,158    62%   5%
Georgia   7    17    11,455    6,728    3,744    59%   5%
Indiana   2    2    995    597    103    60%   5%
Michigan   3    7    1,609    1,047    614    65%   5%
New Jersey   3    8    2,023    1,451    996    72%   5%
New York   1    6    1,855    853    805    46%   5%
North Carolina   1    2    490    343    131    70%   5%
Ohio   1    1    1,405    843    505    60%   5%
Pennsylvania   2    16    13,170    6,887    5,758    52%   5%
South Carolina   8    15    4,106    2,709    999    66%   5%
Tennessee   1    3    1,080    767    606    71%   5%
Utah   1    3    1,133    793    472    70%   5%
Virginia   1    1    408    260    95    64%   5%
Total   45(4)   111   $60,196   $36,148   $22,221    60%(3)   5%

 

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(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.
     
(4)   One builder borrows in multiple states.

 

The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 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       3     $ 1,615     $ 1,131     $ 605       70 %     5 %
Connecticut     1       1       715       500       479       70 %     5 %
Delaware     1       2       244       171       40       70 %     5 %
Florida     7       15       14,014       8,548       4,672       61 %     5 %
Georgia     4       9       6,864       4,249       2,749       62 %     5 %
Idaho     1       1       319       215       205       67 %     5 %
Michigan     1       1       210       126       118       60 %     5 %
New Jersey     1       3       977       719       528       74 %     5 %
New York     1       4       1,745       737       685       42 %     5 %
North Carolina     2       2       1,015       633       216       62 %     5 %
Ohio     1       1       1,405       843       444       60 %     5 %
Pennsylvania     2       15       12,725       6,411       5,281       50 %     5 %
South Carolina     5       7       2,544       1,591       783       63 %     5 %
Tennessee     1       3       1,080       767       430       71 %     5 %
Utah     1       2       715       500       252       70 %     5 %
Total     30       69     $ 46,187     $ 27,141     $ 17,487       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.

 

Credit Quality Information

 

The following table presents credit-related information at the “class” level in accordance with FASB 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.

 

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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.

 

Finance Receivables – By risk rating:

 

  

March 31, 2017

   December 31, 2016 
         
Pass  $22,448   $18,275 
Special mention   3,673    3,294 
Classified – accruing        
Classified – nonaccrual        
Total  $26,121   $21,569 

 

Finance Receivables – Method of impairment calculation:

 

  

March 31, 2017

   December 31, 2016 
         
Performing loans evaluated individually  $9,555   $12,424 
Performing loans evaluated collectively   16,566    9,145 
Non-performing loans without a specific reserve      
Non-performing loans with a specific reserve        
Total  $26,121   $21,569 

 

At March 31, 2017 and December 31, 2016, there were no loans acquired with deteriorated credit quality, loans past due 90 or more days, impaired loans, or loans on nonaccrual status.

 

Concentrations

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of loans receivable. Our concentration risks for individual borrowers are summarized in the table below:

 

   March 31, 2017  December 31, 2016
      Percent of      Percent of 
   Borrower  Loan   Borrower  Loan 
   City  Commitments   City  Commitments 
                 
Highest concentration risk  Pittsburgh, PA   28%  Pittsburgh, PA   37%
Second highest concentration risk  Sarasota, FL   9%  Sarasota, FL   11%
Third highest concentration risk  Savannah, GA   5%  Savannah, GA   6%

 

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At March 31, 2017, 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.

 

4. Foreclosed Assets

 

Roll forward of Foreclosed Assets:

 

  

Three Months

Ended
March 31, 2017

  

Year

Ended
December 31, 2016

  

Three Months

Ended
March 31, 2016

 
             
Beginning balance  $2,798   $965   $965 
Additions from loans       1,813     
Additions for construction/development   145    566    213 
Sale proceeds   (1,890)   (463)    
Gain on sale   77    28     
Impairment loss on foreclosed assets   (49)   (111)    
Ending balance  $1,081   $2,798   $1,178 

 

5. Property, Plant and Equipment

 

We purchased a partially completed building in which we plan to operate for $625 in the first quarter of 2017. No depreciation has been recorded as the asset has not been placed in service.

 

6. Borrowings

 

The following table displays our borrowings and a ranking of priority:

 

   Priority Rank  

March 31, 2017

   December 31, 2016 
Borrowing Source               
Purchase and sale agreements   1   $6,728   $7,322 
Secured line of credit from affiliates   2         
Unsecured line of credit (senior)   3         
Other unsecured debt (senior subordinated)   4    279    279 
Unsecured Notes through our public offering   5    12,792    11,221 
Other unsecured debt (subordinated)   5    700    700 
Other unsecured debt (junior subordinated)   6    173    173 
Total       $20,672   $19,695 

 

The following table shows the maturity of outstanding debt as of March 31, 2017.

 

Year Maturing  Total Amount
Maturing
   Public Offering   Other Unsecured   Purchase and Sale
Agreements
 
                 
2017  $8,575   $1,247   $600   $6,728 
2018   3,091    3,091         
2019   3,563    3,563         
2020   2,578    2,578         
2021   2,865    2,313    552     
Total  $20,672   $12,792   $1,152   $6,728 

 

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Purchase and Sale Agreements

 

We have two current purchase and sale agreement relationships where we are the seller of portions of loans we create. The two purchasers are Builder Finance, Inc. and S.K. Funding, LLC. Generally, the purchasers buy between 50% and 70% of each loan sold. Builder Finance, Inc., a subsidiary of 1st Financial Bank, USA, began purchasing portions of loans effective as of August 1, 2016. Prior to August 1, 2016, 1st Financial Bank, USA had purchased these loans under a separate loan purchase and sale agreement.

 

The buyers receive interest rates ranging from our cost of funds to the note rate charged to the borrower (interest rates we paid were between 9% and 12% for both 2017 and 2016). The buyers generally receive none of the loan fees we charge. We have the right to call some of the loans sold, with some restrictions. Once sold, the buyer must fund their portion of the loans purchased. We service the loans. Also, there are limited put options in some cases, whereby the purchaser can cause us to repurchase a loan. The purchase and sale agreements are recorded as secured borrowings.

 

The purchase and sale agreements are detailed below:

 

    March 31, 2017     December 31, 2016  
    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/Builder Finance, Inc.   $ 5,706     $ 3,025     $ 5,779     $ 2,517  
S.K. Funding, LLC     8,182       3,703       7,770       4,805  
                                 
Total   $ 13,888     $ 6,728     $ 13,549     $ 7,322  

 

At December 31, 2016, the $7,770 of loans which served as collateral for S.K. Funding does not include the book value of the foreclosed assets which also secured their position, which amount was $1,813. There were no foreclosed assets securing S.K. Funding, LLC’s position as of March 31, 2017.

 

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 4.19% as of both March 31, 2017 and December 31, 2016, respectively. They are demand notes. The maximum that can be borrowed under these notes is $1,500, at the discretion of the lenders. 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 2017 or 2016.

 

Other Unsecured Loans

 

In August 2015, we entered into an unsecured note with Seven Kings Holdings, Inc. (“7Kings”), under which we are the borrower. The note has a maximum amount outstanding of $500, of which $500 was outstanding as of both March 31, 2017 and December 31, 2016. Interest on the 7Kings loan accrues annually at a rate of 7.5%. The note was due on February 19, 2016 and was renewed several times. The maturity date is now August 18, 2017 and may be prepaid at any time without penalty. Interest is due at the end of each month and was $9 for both of the three month periods ended March 31, 2017 and 2016.

 

We have four other unsecured notes, which are listed in the first two tables of this Note 6. The interest rates and priorities vary. We recorded $15 and $2 in interest related to these four notes for the three months ended March 31, 2017 and 2016, respectively.

 

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Unsecured Notes through the Public Offering (Notes Program)

 

The effective interest rate on the unsecured subordinated notes (the “Notes”) offered pursuant to our public offering at March 31, 2017 and December 31, 2016 was 8.58% and 8.26%, 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:

 

   Three Months Ended
March 31, 2017
   Year Ended
December 31, 2016
   Three Months Ended
March 31, 2016
 
             
Gross notes outstanding, beginning of period  $11,221   $8,496   $8,496 
Notes issued   4,144    4,972    633 
Note repayments / redemptions   (2,573)   (2,247)   (10)
                
Gross notes outstanding, end of period  $12,792   $11,221   $9,119 
                
Less deferred financing costs, net   357    411    551 
                
Notes outstanding, net  $12,435   $10,810   $8,568 

 

The following is a roll forward of deferred financing costs:

 

   Three Months       Three Months 
   Ended   Year Ended   Ended 
   March 31, 2017   December 31, 2016   March 31, 2016 
             
Deferred financing costs, beginning balance  $1,014   $935   $935 
Additions   10    79    19 
Deferred financing costs, ending balance  $1,024   $1,014   $954 
Less accumulated amortization   (667)   (603)   (403)
Deferred financing costs, net  $357   $411   $551 

 

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

 

   Three Months       Three Months 
   Ended   Year Ended   Ended 
   March 31, 2017   December 31, 2016   March 31, 2016 
             
Accumulated amortization, beginning balance  $603   $336   $336 
Additions   64    267    67 
Accumulated amortization, ending balance  $667   $603   $403 

 

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7. Redeemable Preferred Equity

 

The Series C cumulative preferred units were issued to Margaret Rauscher IRA LLC (Margaret Rauscher is the wife of our manager Eric Rauscher). They are redeemable by the Company at any time, upon a change of control or liquidation, or by the investor any time after 6 years from the initial date of purchase. The Series C units have a fixed value which is their purchase price, and preferred liquidation and distribution rights. Yearly distributions of 12% of the Series C units’ value (provided profits are available) will be made quarterly. This rate can increase if our interest rates on our Note Program rise above 12%. Dividends can be reinvested monthly into additional Series C units.

 

Roll forward of redeemable preferred equity:

 

  

Three Months

Ended
March 31, 2017

  

Year

Ended
December 31, 2016

  

Three Months

Ended
March 31, 2016

 
             
Beginning balance  $   $   $ 
Additions from new investment   440         
                
Ending balance  $440   $   $ 

 

The following table shows the earliest redemption options for investors in Series C units as of March 31, 2017.

 

Year Maturing   Total Amount
Redeemable
   
         
2023   $ 440    
           
Total   $ 440    

 

8. Members’ Capital

 

There are currently three classes of units: Class A common units, Series B cumulative preferred units, and Series C cumulative preferred units.

 

The Class A common units are held by eight 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 March 31, 2017 and December 31, 2016. On December 31, 2015, an affiliate of 7Kings, S.K. Funding, LLC, purchased 4% of our common equity from the Wallach family. In March 2017, S.K. Funding, LLC sold its 4% interest in our common equity in equal 1% portions to each of our three independent managers and our Executive Vice President of Operations.

 

The Series B cumulative preferred units were issued to the Hoskins Group through a reduction in a loan issued by the Hoskins Group to the Company. The Series B preferred units are redeemable only at the option of the Company or upon a change or control or liquidation. Ten Series B preferred units were initially issued for a total of $1,000. The Series B preferred units have a fixed value which is their purchase price, and preferred liquidation and distribution rights. Yearly distributions of 10% of the Series B preferred units’ value (provided profits are available) will be made quarterly. The Hoskins Group’s Series B preferred units are also used as collateral for that group’s loans to the Company. There is no liquid market for the Series B preferred units, so we can give no assurance as to our ability to generate any amount of proceeds from that collateral. In December 2015, the Hoskins Group agreed to purchase 0.1 units of Series B preferred units for $10 at each closing of a lot to a third party in the Hamlets and Tuscany subdivision. As of March 31, 2017, the Hoskins Group owns a total of 11.6 Series B preferred units, which were issued for a total of $1,160.

 

There are two additional authorized unit classes, of which no units are outstanding: 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.

 

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The members’ capital balances by class are as follows:

 

Class 

March 31, 2017

   December 31, 2016 
B Preferred Units  $1,160   $1,150 
A Common Units  2,397   2,249 
           
Members’ Capital  $3,557   $3,399 

 

9. Related Party Transactions

 

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

 

The Company has loan agreements with the Hoskins Group, as more fully described in Note 3.

 

The Hoskins Group has a preferred equity interest in the Company, as more fully described in Note 8.

 

Each of our three independent managers on our board of managers and our Executive Vice President of Operations own 1% of our Class A common units.

 

The Company has accepted new investments under the Notes program from employees, managers, members and relatives of managers and members, with $2,355 and $2,197 outstanding at March 31, 2017 and December 31, 2016, respectively. The larger of these investments are detailed below:

 

         Weighted
average interest
   Interest earned during the
three months ended
 
   Relationship to  Amount invested as of   rate as of   March 31, 
Investor 

Shepherd’s Finance

 

March 31, 2017

  

March 31, 2016

  

March 31, 2017

   2017   2016 
William Myrick  Independent Manager  $260   $288    8.94%  $7   $6 
                             
R. Scott Summers  Son of Independent Manager   275    375    8.00%   3    6 
                             
Wallach Family Irrevocable Educational Trust  Trustee is Member   200    200    9.00%   5    4 
                             
Eric Rauscher  Independent Manager   475    600    10.00%   9    11 
                             
Joseph Rauscher  Parents of Independent Manager   195    186    9.33%   4    4 
                             
Seven Kings Holdings, Inc.(1)  Affiliate of Member   500    500    9.00%   11    9 

 

(1) S.K. Funding, LLC, an affiliate of Seven Kings Holdings, Inc., is no longer a member of the Company as of March 2017.

 

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10. 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. The Company has several Letters of Credit relating to development loans which are part of the unfunded commitment amount. Unfunded commitments to extend credit, which have similar collateral, credit risk and market risk to our outstanding loans, were $15,257 and $11,503 at March 31, 2017 and December 31, 2016, respectively.

 

11. Selected Quarterly Condensed Consolidated Financial Data (Unaudited)

 

Summarized unaudited quarterly condensed consolidated financial data for the four quarters of 2017 and 2016 are as follows (in thousands):

 

   Quarter 4   Quarter 3  

Quarter 2

   Quarter 1   Quarter 4   Quarter 3   Quarter 2   Quarter 1 
   2017   2017   2017   2017   2016   2016   2016   2016 
                                 
Net Interest Income after Loan Loss Provision  $   $   $   $617   $491   $442   $464   $479 
Non-Interest Income               77    28        44     
SG&A expense               454    367    297    305    350 
Impairment loss on foreclosed assets               49    111             
Net Income  $   $   $   $191   $41   $145   $203   $129 

 

12. Non-Interest expense detail

 

The following table displays our SG&A expenses:

 

   For the Three Months Ended
March 31,
 
   2017   2016 
Selling, general and administrative expenses          
Legal and accounting  $96   $86 
Salaries and related expenses   254    180 
Board related expenses   29    29 
Advertising   17    18 
Rent and utilities   5    5 
Printing   6    4 
Loan and foreclosed asset expenses   7    4 
Travel   15    9 
Software   8     
Other   17    15 
Total SG&A  $454   $350 

 

13. Subsequent Events

 

Management of the Company has evaluated subsequent events through April 27, 2017, the date these consolidated financial statements were issued.

 

On April 14, 2017, the Company sold 5.637 Series C Cumulative Preferred Units (the “Preferred Units”) for the total price of $564 to William Myrick, one of the Company’s independent managers, through his individual retirement account (such transaction, the “Preferred Units Sale Transaction”). The Preferred Units Sale Transaction was effected in a private transaction exempt from the registration requirements of the Securities Act of 1933 (the “Securities Act”) under Section 4(a)(2) of the Securities Act. The Preferred Units Sale Transaction did not involve any public offering, was made without general solicitation or advertising, and the buyer represented to the Company that it is an “accredited investor” as defined under the Securities Act, with access to all relevant information necessary to evaluate the investment in the Preferred Units.

 

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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, 2016. 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.” Since 2011, we have originated approximately 225 construction loans totaling $66,000. We currently have 10 paid employees, including our Executive Vice President of Operations. We currently use three employees to originate most of our new loans. Our office staff processes, underwrites, documents, and funds our loans. Our office staff also manages our investor relations and relationships with other debt holders. Our board of managers is comprised of Daniel M. Wallach and three independent managers — William Myrick, Eric A. 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 some circumstances, the lot is purchased with an older home on the lot which is then either removed or rehabilitated. If the home is rehabilitated, the loan is referred to as a “rehab” loan. 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. In February 2017, we purchased a building in which we intend to operate once renovation has been completed. We anticipate that renovation will be completed in the summer of 2017.

 

Our Chief Executive Officer, 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.

 

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We had $24,167 and $20,091 in loan assets as of March 31, 2017 and December 31, 2016, respectively. As of March 31, 2017, we have 111 construction loans in 16 states with 45 borrowers, and have three development loans in Pittsburgh, Pennsylvania. We have entered into two purchase and sale agreement relationships with third-parties to sell portions of our loans. The first loan portions sold under the program took place during the first quarter of 2015. These agreements have allowed us to increase our loan balances and commitments significantly. In January 2017, we entered into a line of credit agreement with a bank for $500, which we used at times during the first three months of 2017. In March 2017, we added a third class of equity, Series C cumulative preferred units. These Series C preferred units have a redemption feature after six years, and therefore show as mezzanine equity on our financial statements.

 

We currently have eight sources of capital:

 

   March 31, 2017   December 31, 2016 
Capital Source          
Purchase and sale agreements (1)  $6,728   $7,322 
Secured line of credit from affiliates        
Unsecured senior line of credit from a bank        
Unsecured Notes through our public offering   12,792    11,221 
Other unsecured debt   1,152    1,152 
Preferred equity, Series B units   1,160    1,150 
Preferred equity, Series C units (2)   440     
Common equity   2,397    2,249 
           
Total  $24,669   $23,094 

 

(1) We have two current purchase and sale agreement relationships where we are the seller of portions of loans we create. The two purchasers are Builder Finance, Inc. and S.K. Funding, LLC. Generally, the purchasers buy between 50% and 70% of each loan sold. Builder Finance, Inc., a subsidiary of 1st Financial Bank, USA, began purchasing portions of loans effective as of August 1, 2016. Prior to August 1, 2016, 1st Financial Bank, USA had purchased these loans under a separate loan purchase and sale agreement.
   
(2) The first Series C preferred units were issued in March 2017.

 

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

 

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:

 

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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 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 unreasonably expensive, 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.

 

Fair value of collateral has the potential to impact the calculation of the loan loss provision. Specifically relevant to the allowance for loan loss reserve is the fair value of the underlying collateral supporting the outstanding loan balances. 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.

 

   March 31, 2017 
   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 $24,167, 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.

 

Foreclosed Assets

 

Foreclosed assets, as applicable, are accounted for both on the consolidated balance sheets and the interim condensed consolidated statements of operations. On the interim condensed consolidated statements of operations, management estimates the amount of impairment to capture when a loan is converted to a foreclosed asset, the impairment when the value of an asset drops below its carrying amount, and any gain or loss upon final disposition of the asset. The calculation of the impairment, which appears on our interim condensed consolidated balance sheets as a reduction in the asset, requires us to compile relevant data for use in a systematic approach to assess and estimate the value of the asset and therefore any required impairment thereof. We use the policy summarized as follows:

 

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For properties which exist in the condition in which we intend to sell them, we obtain an appraisal of the asset’s current value. We reduce the appraised value by 10% to account for selling costs. This amount is used to initially record the asset. Typically, prior to the initial booking of the foreclosed asset, the loan has already been reserved to this level. If during ownership, the value of the foreclosed asset drops, an additional impairment is recorded. For assets that need to be improved prior to sale, the above calculation is performed at the time of the booking of the foreclosed asset (an appraisal “as-is”), but subsequent to that, we look at the to be completed value minus 10% and subtract off the estimated cost of remaining work to be done. If this results in additional impairment, it is booked in non-interest expense. For assets which are going to be improved, while the asset is a loan (before it becomes a foreclosed asset) the calculation of the specific loan loss reserve is done based on the to be completed value as compared to the book value plus estimated completion costs. This can result in an impairment at the initial booking of the foreclosed asset.

 

The fair value of real estate will impact 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.

 

   March 31, 2017 
   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%  $(324)

 

* 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.

 

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 34 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.

 

Change in Anticipated Average Duration  Resulting adjustment needed to Interest Expense during the next 12 months
Higher/(Lower)
 
Decreasing the average duration to 5 months for all remaining months of origination  $15 
Increasing the average duration to 5 months for all remaining months of origination  $(11)

 

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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.

 

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, offsetting assets and liabilities, 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 2016 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 months ended March 31, 2017 and 2016 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.

 

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   Three Months Ended March 31, 
   2017   2016 
         
Net Interest Income          
Interest and fee income on loans  $1,174   $849 
Interest expense:          
Interest related to secured borrowings   179    117 
Interest related to unsecured borrowings   367    245 
Interest expense   546    362 
           
Net interest income   628    487 
Less: Loan loss provision   11    8 
           
Net interest income after loan loss provision   617    479 
           
Non-Interest Income          
Gain from sale of foreclosed assets   77     
           
Income   694    479 
           
Non-Interest Expense          
Selling, general and administrative   454    350 
Impairment loss on foreclosed assets   49     
           
Total non-interest expense   503    350 
           
Net income  $191   $129 
           
Earned distribution to preferred equity holders   31    26 
           
Net income attributable to common equity holders  $160   $103 

 

Interest Spread

 

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

 

   For the Three Months Ended March 31, 
   2017   2016 
Interest Income         *         * 
Interest income on loans  $780    13%  $505    12%
Fee income on loans   394    7%   344    8%
Interest and fee income on loans   1,174    20%   849    20%
Interest expense – secured   179    3%   117    3%
Interest expense – unsecured   303    5%   178    4%
Amortization of offering costs   64    1%   67    2%
Interest expense   546    9%   362    9%
Net interest income (spread)   628    11%   487    11%
                     
Weighted average outstanding loan asset balance  $23,756        $17,131      

 

*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%. For most loans, 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 the first three months of 2017 as compared to 2016 by 1%. This increase was due to an increase in the rate we are charging on our development loans. Our interest expense for unsecured borrowings increased in 2017 as compared to 2016 due to an increase in what we are paying our Note holders, but this was offset by a decrease in the percentage cost of our offering costs, which decreased due to an increase in borrowings without an increase in cost. We anticipate the difference between interest income and interest expense to be between 3% and 4% during 2017.

 

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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. 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. Our fee income decreased as a percentage of our loan balance because the recognition of our loan fee on our development loans was completed in 2016. We anticipate that our fee percentage in 2017 compared to 2016 will be lower in the first seven months due to the development loan fee income, and higher in the last five months due to an increase in construction loans as a percentage of our total balance.

 

Amount of nonperforming assets. Generally we can have three types of nonperforming assets. Loans not paying interest can impact our interest spread. We had no such loans in the first three months of both 2017 and 2016. Foreclosed assets do not have a monthly interest return. While we had fewer foreclosed assets as of March 31, 2017 as compared to March 31, 2016, our average balance of foreclosed assets during the three month period ended March 31, 2017 was higher than the same period of 2016.

 

Loan Loss Provision

 

We recorded $11 and $8 in the three months ended March 31, 2017 and 2016, respectively, in loss reserve provision related to our collective reserve (loans not individually impaired). These increases were due to increases in loan balances. We did not reserve any amount in those same periods in our specific reserve (for loans individually impaired). We anticipate that the collective reserve will increase as our balances rise throughout 2017.

 

Non-Interest Income

 

We sold a foreclosed asset in 2017 and recognized a gain of $77.

 

SG&A Expenses

 

The following table displays our SG&A expenses:

 

   For the Three Months Ended
March 31,
 
   2017   2016 
Selling, general and administrative expenses          
Legal and Accounting  $96   $86 
Salaries and related expenses   254    180 
Board related expenses   29    29 
Advertising   17    18 
Rent and Utilities   5    5 
Printing   6    4 
Loan and foreclosed asset expenses   7    4 
Travel   15    9 
Software   8     
Other   17    15 
Total SG&A  $454   $350 

 

We had twice as many employees during the three month period ended March 31, 2017 as we did during the same period in 2016, which increased our payroll and travel costs. We anticipate adding more staff in 2017. We will also have expenses related to operating from our new office in the second half of 2017. We added a loan document software package in the second half of 2016. We may also expend funds to improve our back office computer systems in 2017.

 

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Consolidated Financial Position

 

Cash and Cash Equivalents

 

We try to avoid borrowing on our line of credit from affiliates. To accomplish this, we must carry some cash for liquidity. At March 31, 2017 and December 31, 2016, we had $586 and $1,566, respectively, in cash. When we create new loans, they typically do not have significant outstanding loan balances for several months. In January 2017, we executed a line of credit with a bank with a maximum outstanding of $500, which should lessen somewhat the amount of cash we carry on our books.

 

Deferred Financing Costs, Net

 

Our deferred financing costs are related to our public offering of unsecured Notes. The deferred financing costs are reflected as a reduction in the unsecured Notes offering liability. The first offering which was effective from October 2012 through September 2015 cost more to create than our second offering, which has been effective since September 2015. As the amortization from the first offering is being wrapped up and the second offering’s amortization is increasing, the effect of this is a small decrease in total amortization during the three months ended March 31, 2017 as compared to the same period of 2016. As the amortization is much more than the amount we are spending on the offerings during these same periods, the net deferred financing costs have been decreasing.

 

The following is a roll forward of deferred financing costs:

 

   Three Months   Year Ended   Three Months Ended 
   March 31, 2017   December 31, 2016   March 31, 2016 
Deferred financing costs, beginning balance  $1,014   $935   $935 
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