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EX-32.2 - Shepherd's Finance, LLCex32-2.htm
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EX-31.1 - Shepherd's Finance, LLCex31-1.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-K

 

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Fiscal Year Ended December 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.)

 

13241 Bartram Park Blvd., Suite 2401, Jacksonville, Florida 32258

(Address of principal executive offices)

 

(302)-752-2688

(Registrant’s telephone number including area code)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [  ] No [X]

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [  ] No [X]

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K. [X]

 

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]
    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]

 

DOCUMENTS INCORPORATED BY REFERENCE:

None.

 

 

 

 
 

 

FORM 10-K

SHEPHERD’S FINANCE, LLC

 

TABLE OF CONTENTS

 

  Page
Cautionary Note Regarding Forward-Looking Statements 3
PART I.  
Item 1. Business 4
Item 1A. Risk Factors 11
Item 1B. Unresolved Staff Comments 22
Item 2. Properties 22
Item 3. Legal Proceedings 22
Item 4. Mine Safety Disclosures 22
PART II.  
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 22
Item 6. Selected Financial Data 25
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 26
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 47
Item 8. Financial Statements and Supplementary Data 47
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 47
Item 9A. Controls and Procedures 48
Item 9B. Other Information 48
PART III.  
Item 10. Directors, Executive Officers and Corporate Governance 49
Item 11. Executive Compensation 50
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 53
Item 13. Certain Relationships and Related Transactions, and Director Independence 53
Item 14. Principal Accounting Fees and Services 55
PART IV.  
Item 15. Exhibits, Financial Statement Schedules 56
SIGNATURES 62

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Certain statements contained in this Form 10-K 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 “Item 1A. Risk Factors.” 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, our risk factors, as well as the other cautionary statements in this report and in our Form S-1 Registration Statement, should be kept in mind. Do not place undue reliance on any forward-looking statement. We are not obligated to update forward-looking statements.

 

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PART I

 

ITEM 1. BUSINESS

 

Purpose and History

 

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 fully participating in the market. We were originally formed as a Pennsylvania limited liability company on May 10, 2007. To meet our business objectives, we changed our name to Shepherd’s Finance, LLC on December 2, 2011. We converted to a Delaware limited liability company on March 29, 2012. We are located in Jacksonville, Florida. As used in this report, “we,” “us,” “our,” and “Company” refer to Shepherd’s Finance, LLC.

 

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), and purchase defaulted secured debt from financial institutions at a discount.

 

Experience and Resources

 

Our Chief Executive Officer (“CEO”), Mr. Wallach, has been in the housing industry since 1985. He was the Chief Financial Officer 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 $2,000,000,000 in loans which generated interest spread of $50,000,000, 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 $300,000,000 at its peak. He also gained experience in securing defaulted unsecured debt.

 

In addition to our Executive Vice President of Operations has 12 years of experience in this type of lending. Our CEO and Executive Vice President of Operations have a combined 36 years of experience in this type of lending. Our Chief Financial Officer (“CFO”), who started with us in November 2017 as our Controller and was promoted to CFO in January 2018, has eleven years of public accounting experience.

 

Opportunity, Strategy, and Approach

 

Background and Strategy

 

Finance markets are highly fragmented, with numerous large, mid-size, and small lenders and investment companies, such as banks, savings and loan associations, credit unions, insurance companies, and institutional lenders, all competing for investment opportunities. Many of these market participants have experienced losses, as a result of the housing market (which started to decline in 2006, reached its bottom in 2008, and is not back to historical norms as of December 31, 2017), and their participation in lending in it. As a result of credit losses and restrictive government oversight, the financial institutions are not participating in this market to the extent they had before the credit crisis (as evidenced by the general lack of availability of construction financing and the higher cost of financing for the deals actually done). We believe that these lenders, while increasing their willingness and capacity to lend, will be unable to satisfy the current demand for residential construction financing, creating attractive opportunities for niche lenders such as us for many years to come. Our goal is not to be a customer’s only source of commercial lending, but an extra, more user-friendly piece of their financing. In 2017, while more small banks returned to the construction lending market, the demand for our loan products has increased. We attribute this to our sales staff, an increase in the number of small home builders in the market, and an improving housing market.

 

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Our loans are marketed by lending representatives who work for us and are driven to maintain long-term customer relationships. Compensation for loan originators is focused on the profitability of loans originated, not simply the volume of loans originated. As of January 1, 2018, we have retained 14 [full-time] employees (four of which are lending representatives) including our CEO. In his previous experience, our CEO had a nationwide staff of 20 lenders working in the field.

 

Our efforts are designed to create a loan portfolio that includes some or all of the following investment characteristics: (i) provides current income; (ii) is well-secured by residential real estate; (iii) is short term in nature; and (iv) provides high interest spreads.

 

Our investment policies may be amended or changed at any time by our board of managers. In the years ahead, we plan on continuing our expansion of lending, increasing our geographic diversity, growing our rehab lending program, and improving our financial performance. We will be adding systems and people to accomplish these goals.

 

As we continue to grow our business, we are focusing some of our efforts on our rehab program, which we believe in the long run will face less bank competition.

 

Risk and Mitigation

 

We believe that while creating speculative construction loans is a high-risk venture, the reduction in competition, the differences in our lending versus typical small bank lending, and our loss mitigation techniques will all help this to continue to be a profitable business.

 

We engage in various activities to try to mitigate the risks inherent in this type of lending by:

 

  Keeping the loan-to-value ratio (“LTV”), between 60% and 75% on a portfolio basis, however, individual loans may, from time to time, have a greater LTV;
     
  Generally using deposits from the builder on home construction loans to ensure the completion of the home. Lending losses on defaulted loans are usually a higher percentage when the home is not built, or is only partially built;
     
  Having a higher yield than other forms of secured real estate lending;
     
  Using interest escrows from our loans;
     
  Aggressively working with builders who are in default on their loan before and during foreclosure. This technique generally yields a reduced realized loss; and
     
  Market grading. We review all lending markets, analyzing their historic housing start cycles. Then, the current position of housing starts is examined in each market. Markets are classified into volatile, average, or stable, and then graded based on that classification and our opinion of where the market is in its housing cycle. This grading is then used to determine the builder deposit amount, LTV, and yield.

 

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We believe the following table contains items that differentiate us from our competitors:

 

Item   Our Methods   Comments
Lending Regulation   We follow various state and federal laws, but are not regulated and controlled by bank examiners from the government. We follow best practices we have learned through our experience, some of which are required of banks.   For instance, banks are not required to buy title insurance by law, but typically banks do purchase title insurance for the properties on which they lend. We generally do not, as it is very difficult to collect on title policies. Instead, we use title searches to protect our interests.
         
FDIC Insurance   We do not offer FDIC insurance to our unsecured notes investors.   Our yield to our customers, and our cost of funds is typically higher than that of most banks. We charge our borrowers higher interest rates than do most banks. We also save money by not paying for FDIC insurance.
         
Capital Structure   Typically, our unsecured notes offer through our notes program are due in one to four years, or when the Note matures.   This results in liquidity risk (i.e. funding borrowing requests or maturities of debt).
         
Community Reinvestment Act (CRA)1   We do not participate in the CRA.   Our sole purpose in making each individual loan is to maximize our returns while maintaining proper risk management.
         
Leverage   We try to maintain a 15% ratio of equity (including redeemable preferred equity) to loan assets.   Our equity to loan asset ratio was 16.2% as of December 31, 2017. The higher the ratio, the more potential losses the company can absorb without impacting debt holders.
         
Product Diversification   We generally make loans to builders to purchase lots and/or to construct or rehab homes.   We have extensive experience in our field.
         
Geographic Diversity   We lend in 16 states as of December 31, 2017.   We believe that this geographic diversity helps in down markets, as not all housing markets decrease at the same rate and time.
         
Governmental Bailouts   Most likely not eligible.   We are not likely to be eligible for bank bailouts, which have happened periodically. We maintain a better leverage ratio to counter this.
         
Underwriting   We focus on items that, in our experience, tend to predict risk.   These items include, using collateral, controlling LTVs, controlling the number of loans in one subdivision, underwriting appraisals, conducting property inspections, maintaining certain files and documents similar to those that a bank might maintain.

 

Lines of Business

 

Our efforts are designed to create a portfolio that includes some or all of the following investment characteristics: (i) provides current income; (ii) is well-secured by residential real estate; (iii) is short term in nature; and (iv) provides high interest spreads. While we primarily provide commercial construction loans to homebuilders (for residential real estate), we may also 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 investment policies may be amended or changed at any time by our board of managers.

 

 

1 The CRA subjects a bank who receives FDIC insurance to regulatory assessment to determine if the bank meets the credit needs of its entire community, and to consider that determination in its evaluation of any application made by the bank for, among other things, approval of the acquisition or establishment of a bank branch.

 

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Commercial Construction Loans to Homebuilders

 

We extend and service commercial loans to small-to-medium sized homebuilders for the purchase of lots and/or the construction of homes thereon. Our customers generally benefit from doing business with us not just because they are able to sell additional homes (which we finance), but because, as they build additional homes, they are able to increase sales of homes that are built as contracted homes, where the eventual home owner obtains the loan. Builders generally have more success selling homes when a model or spec home is available for customers to see. 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 lend money to purchase and rehabilitate older existing homes. Most of the loans are for “spec homes” or “spec lots,” meaning they are built or developed speculatively (with no specific end-user home owner in mind).

 

In a typical home construction transaction, a homebuilder obtains a loan to purchase a lot and build a home on that lot. In some cases, the builder has a contract with a customer to purchase the home upon its completion. In other cases, the home is built as a spec home, but the homebuilder believes it will sell before or shortly after completion, and therefore, building the home before it is under contract will increase the homebuilder’s sales and profitability. The builder may also believe that the construction of a spec home will increase the number of contract sales he will have in a given year, as it may be easier to sell contract homes when the customer can see the builder’s work in the spec home. In some cases, these speculatively built homes are constructed with the intention to keep them as a model for a period of time, to increase contract sales, and then be sold. These are called model homes. While we may lend to a homebuilder for any of these types of new construction homes, about 81% of our construction loans to date have been spec homes and 19% have been contracts.

 

In a typical rehab transaction, we fund all or a portion of the purchase price, and then all of the cost to complete the project. In some circumstances, we are unable to see the inside of the home prior to closing, so we assume that anything from drywall to completion needs to be redone, as well as what we can see from the outside. Because we are flexible in our need to see the inside of the home, and we only use experienced builders as customers for this type of lending, we believe that we are different than banks.

 

We fund the loans that we originate using available cash resources that are generated primarily from borrowings, our purchase and sale agreements, proceeds from the Notes (“Notes”) offered pursuant to our public offering (“Notes Program”), equity, and net operating cash flow. We intend to continue funding loans we originate using the same sources.

 

There is a seasonal aspect to home construction, and this affects our monthly cash flow. In general, since the home construction loans we create will last less than a year on average, and since we are geographically diverse, the seasonality impact is somewhat mitigated.

 

Generally, our real estate loans are secured by one or more of the following:

 

  the parcels of land to be developed;
     
  finished lots;
     
  new or rehabbed single-family homes;
     
  in most cases, personal guarantees of the principals of the borrower entity.

 

Most of our lending is based on the following general policies:

 

Customer Type Small-to-Medium Size Homebuilders
Loan Type Commercial
Loan Purpose Construction/Rehabilitation of Homes or Development of Lots
Security Homes, Lots, and/or Land
Priority Generally, our loans are secured by a first priority mortgage lien; however, we may make loans secured by a second or other lower priority mortgage lien.
Loan-to-Value Averages 60-75%
Loan Amounts Average home construction loan $300,000, development loans vary greatly
Term Demand, however most home construction loans typically payoff in under one year, and development loans are typically three to five-year projects.

 

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Rate Cost of Funds (“COF”) plus 2%, minimum rate of 7%
Origination Fee 5% for home construction loans, development loans on a case by case basis
Title Insurance Only on high risk loans and rehabs
Hazard Insurance Always
General Liability Insurance Always
Credit Builder should have significant building experience in the market, be building in the market currently, be able to make payments of interest, be able to make the required deposit, have acceptable personal credit, and have open lines of credit (unsecured) with suppliers reasonably within terms. Required deposits may be able to be avoided if we do not fund the purchase of land. We generally do not advertise to find customers, but use our loan representatives. We believe this approach will allow us to focus our efforts on builders that meet our acceptable risk profile.
Third Party Guarantor None, however the loans are generally guaranteed by the owners of the borrower

 

We may change these policies at any time based on then-existing market conditions or otherwise, at the discretion of our CEO and board of managers.

 

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

 

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

 

State  Number of
Borrowers
  Number of
Loans
  Value of
Collateral (1)
   Commitment
Amount
   Amount
Outstanding
   Loan to
Value Ratio(2)
   Loan
Fee
 
Colorado  3  6  $3,224   $2,196   $925    68%   5%
Delaware  1  1   244    171    147    70%   5%
Florida  15  54   25,368    16,555    10,673    65%   5%
Georgia  7  13   8,932    5,415    3,535    61%   5%
Indiana  2  2   895    566    356    63%   5%
Michigan  4  25   7,570    4,717    2,611    62%   5%
New Jersey  2  11   3,635    2,471    1,227    68%   5%
New York  1  5   1,756    929    863    53%   5%
North Carolina  3  6   1,650    1,155    567    70%   5%
Ohio  1  1   711    498    316    70%   5%
Oregon  1  1   607    425    76    70%   5%
Pennsylvania  2  20   15,023    7,649    5,834    51%   5%
South Carolina  7  18   4,501    3,058    1,445    68%   5%
Tennessee  1  2   690    494    494    72%   5%
Utah  1  2   790    553    344    70%   5%
Virginia  1  1   335    235    150    70%   5%
Total  52(4) 168  $75,931   $47,087   $29,563    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.
     
  (4) We have one builder in two states.

 

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2018 Outlook

 

In 2018, we anticipate using proceeds from the Notes Program, the purchase and sale agreements, and other sources to generate additional loans (mostly spec home construction loans), increase loan balances, and increase our customer and geographic diversity.

 

Commercial Loans – Real Estate Development Loan Portfolio Summary

 

In a typical development transaction, a homebuilder/developer purchases a specific parcel or parcels of land. Developers must secure financing in order to pay the purchase price for the land as well as to pay expenses incurred while developing the lots. This is the financing we provide. Once financing has been secured, the lot developers create individual lots. Developers secure permits allowing the property to be developed and then design and build roads and utility systems for water, sewer, gas, and electricity to service the property. The individual lots are then sold before a home is built on them; paid off, built on and then sold; or built on, then sold and paid off (in these cases, we may subordinate our loan to the home construction loan).

 

The following is a summary of our loan portfolio to builders for land development as of December 31, 2017 which we refer to throughout this report as the (“Pennsylvania Loans”):

 

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

 

State  Number of
Borrowers
   Number of
Loans
   Value of
Collateral(1)
   Commitment Amount(3)   Amount
Outstanding
   Loan to
Value
Ratio(2)
   Loan Fee   Interest
Rate
Pennsylvania   1    3   $4,997   $4,600  $2,811    56%  $1,000   COF plus 7%
                                       

 

  (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 $1,240 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 $4,600 commitment amount.

 

Credit Quality Information

 

See the notes to our financial statements for credit quality information.

 

Competition

 

Historically, our industry has been highly competitive. We compete for opportunities with numerous public and private investment vehicles, including financial institutions, specialty finance companies, mortgage banks, pension funds, opportunity funds, hedge funds, REITs, and other institutional investors, as well as individuals. Many competitors are significantly larger than us, have well-established operating histories and may have greater access to capital, resources and other advantages over us. These competitors may be willing to accept lower returns on their investments or to modify underwriting standards and, as a result, our origination volume and profit margins could be adversely affected.

 

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We believe that this is a good time to extend commercial loans to builders in the residential real estate market because, currently, this market appears underserved, home values are average, and  many of our competitors have sustained losses due to declines in home values in the second half of the previous decade and, therefore, are reluctant to lend in this space at this time. We expect our loans to be different than other lenders in the markets in which we are active. Typically, the differences are:

 

  our loans may have a higher fee;
     
  our loans typically require a small deposit which is refundable, versus a large upfront payment for the lot which is not refundable; and
     
  some of our loans may have lower costs as a result of not requiring title insurance.

 

Regulatory Matters

 

Financial Regulation

 

Our operations are not subject to the stringent regulatory requirements imposed upon the operations of commercial banks, savings banks, and thrift institutions. We are not subject to periodic compliance examinations by federal or state banking regulators. Further, our Notes are not certificates of deposit or similar obligations or guaranteed by any depository institution and are not insured by the FDIC or any governmental or private insurance fund, or any other entity.

 

The Investment Company Act of 1940

 

An investment company is defined under the Investment Company Act of 1940, as amended (the “Investment Company Act”), to include any issuer engaged primarily in the business of investing, reinvesting, or trading in securities. Absent an exemption, investment companies are required to register as such with the SEC and to comply with various governance and operational requirements. If we were considered an “investment company” within the meaning of the Investment Company Act, we would be subject to numerous requirements and restrictions relating to our structure and operation. If we were required to register as an investment company under the Investment Company Act and to comply with these requirements and restrictions, we may have to make significant changes in our proposed structure and operations to comply with exemption from registration, which could adversely affect our business. Such changes may include, for example, limiting the range of assets in which we may invest. We intend to conduct our operations so as to fit within an exemption from registration under the Investment Company Act for purchasing or otherwise acquiring mortgages and other liens on and interest in real estate. In order to satisfy the requirements of such exemption, we may need to restrict the scope of our operations.

 

Environmental Compliance

 

We do not believe that compliance with federal, state, or local laws relating to the protection of the environment will have a material effect on our business in the foreseeable future. However, loans we extend or purchase are secured by real property. In the course of our business, we may own or foreclose and take title to real estate that could be subject to environmental liabilities with respect to these properties. We (or our loan customers) may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation, and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical release at a property. The costs associated with the investigation or remediation activities could be substantial. In addition, if we become the owner of or discover that we were formerly the owner of a contaminated site, we may be subject to common law claims by third-parties based on damages and costs resulting from environmental contamination emanating from the property. To date, we have not incurred any significant costs related to environmental compliance and we do not anticipate incurring any significant costs for environmental compliance in the future. Generally, when we are lending on property which is being developed into single family building lots, an environmental assessment is done by the builder for the various governmental agencies. When we lend for new construction on newly developed lots, the lots have generally been reviewed while they were being developed. We also perform our own physical inspection of the lot, which includes assessing potential environmental issues. Before we take possession of a property through foreclosure, we again assess the property for possible environmental concerns, which, if deemed to be a significant risk compared to the value of the property, could cause us to forego foreclosure on the property and to seek other avenues for collection.

 

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ITEM 1A. RISK FACTORS 

 

Below are risks and uncertainties that could adversely affect our operations that we believe are material to investors. Other risks and uncertainties may exist that we do not consider material based on the information currently available to us at this time.

 

Risks Related to our Business

 

Our business is not industry-diversified and the homebuilding industry has undergone a significant downturn. Further deterioration in industry or economic conditions could further decrease demand and pricing for new homes and residential home lots. A decline in housing values similar to the recent national downturn in the real estate market would have a negative impact on our business. Smaller value declines will also have a negative impact on our business. These factors may decrease the likelihood we will be able to generate enough cash to repay the Notes.

 

Developers and homebuilders to whom we may make loans use the proceeds of our loans to develop raw land into residential home lots and construct homes. The developers obtain the money to repay our development loans by selling the residential home lots to homebuilders or individuals who will build single-family residences on the lots, or by obtaining replacement financing from other lenders. A developer’s ability to repay our loans is based primarily on the amount of money generated by the developer’s sale of its inventory of single-family residential lots. Homebuilders obtain the money to repay our loans by selling the homes they construct or by obtaining replacement financing from other lenders, and thus, the homebuilders’ ability to repay our loans is based primarily on the amount of money generated by the sale of such homes.

 

The homebuilding industry is cyclical and is significantly affected by changes in industry conditions, as well as in general and local economic conditions, such as:

 

  employment level and job growth;
     
  demographic trends, including population increases and decreases and household formation;
     
  availability of financing for homebuyers;
     
  interest rates;
     
  affordability of homes;
     
  consumer confidence;
     
  levels of new and existing homes for sale, including foreclosed homes and homes held by investors and speculators; and
     
  housing demand generally.

 

These conditions may occur on a national scale or may affect some of the regions or markets in which we operate more than others.

 

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We generally lend a percentage of the values of the homes and lots. These values are determined shortly prior to the lending. If the values of homes and lots in markets in which we lend drop fast enough to cause the builders losses that are greater than their equity in the property, we will be forced to liquidate the loan in a fashion which will cause us to lose money. If these losses when combined and added to our other expenses are greater than our revenue from interest charged to our customers, we will lose money overall, which will hurt our ability to pay interest and principal on the Notes. Values are typically affected by demand for homes, which can change due to many factors, including but not limited to, demographics, interest rates, overall economy, cost of building materials and labor, availability of financing for end-users, inventory of homes available and governmental action or inaction. The tightening credit markets have made it more difficult for potential homeowners to obtain financing to purchase homes. If housing prices decline or sales in the housing market decline, our customers may have a hard time selling their homes at a profit. This could cause the amount of defaulted loans that we will own to increase. An increase in defaulted loans would reduce our revenue and could lead to losses on our loans. A decline in housing prices will further increase our losses on defaulted loans. If the amount of defaulted loans or the loss per defaulted loan is large enough, we will operate at a loss, which will decrease our equity. This could cause us to become insolvent, and we will not be able to pay back Note holders’ principal and interest on the Notes.

 

The homebuilding industry could experience adverse conditions, and the industry’s implementation of strategies in response to such conditions may not be successful.

 

The United States homebuilding industry experienced a significant downturn beginning in 2007. During the course of the downturn, many homebuilders focused on generating positive operating cash flow, resizing and reshaping their product for a more price-conscious consumer and adjusting finished new home inventories to meet demand, and did so in many cases by significantly reducing the new home prices and increasing the level of sales incentives. Notwithstanding these strategies, homebuilders continued to experience an elevated rate of sales contract cancelations, as many of the factors that affect new sales and cancelation rates are beyond the control of the homebuilding industry. Although the homebuilding industry recently experienced positive gains, there can be no assurance that these gains will continue. The homebuilding industry could suffer similar, or worse, adverse conditions in the future. Continued decreases in new home sales would increase the likelihood of defaults on our loans and, consequently, reduce our ability to repay Note holders’ principal and interest on the Notes.

 

We have $30,043,000 of loan assets as of December 31, 2017. A 35% reduction in total collateral value would reduce our earnings and net worth by $1,145,000. Larger reductions would result in lower earnings and lower net worth.

 

As of December 31, 2017, we had $30,043,000 of loan assets on our books. These assets are recorded on our balance sheet at the lower of the loan amount or the value of the collateral after deduction for expected selling expenses. A reduction in the value of the underlying collateral could result in significant losses. A 35% reduction, for instance, would result in a $1,145,000 loss. Accordingly, our business is subject to risk of a loss of a portion of our Note holders’ investments if such a reduction were to occur.

 

We have $2,811,000 of development loan assets as of December 31, 2017, which unlike our construction loans, are long term loans. This longer duration as well as the nature of collateral (raw ground and lots) creates more risk for that portion of our portfolio.

 

Development loans are riskier than construction loans for two reasons: the duration of the loan and the nature of the collateral. The duration (being three to five years as compared to less than one year on construction loans) allows for a greater period of time over which the collateral value could decrease. Also, the collateral value of development loans is more likely to change in greater percentages than that of built homes. For example, during a 70% reduction in housing starts, newly completed homes still have value, but lots may be worthless. This added risk to this portion of our portfolio adds risk to our investors as our net worth would be significantly impacted by losses.

 

12
 

 

Currently, we are reliant on a single developer and homebuilder, the Hoskins Group, who is concentrated in the Pittsburgh, Pennsylvania market, for a material portion of our revenues and a portion of our capital.

 

As of December 31, 2017, 22% of our outstanding loan commitments consisted of loans made to Benjamin Marcus Homes, LLC and Investor’s Mark Acquisitions, LLC, both of which are owned by Mark Hoskins (collectively all three parties referred to herein as the “Hoskins Group”). The Hoskins Group is concentrated in the Pittsburgh, Pennsylvania market. The Hoskins Group also has a preferred equity interest in us. Therefore, currently, we are reliant upon a single developer and homebuilder who is concentrated in a single city, for a significant portion of our revenues and a portion of our capital. Any event of bankruptcy, insolvency, or general downturn in the business of this developer and homebuilder or in the Pittsburgh housing market generally will have a substantial adverse financial impact on our business and our ability to pay back Note holders’ investments in the Notes in the long term. Adverse conditions affecting the local housing market could include, but are not limited to, declines in new housing starts, declines in new home prices, declines in new home sales, increases in the supply of available building lots or built homes available for sale, increases in unemployment, and unfavorable demographic changes.

 

We have foreclosed assets as of December 31, 2017, which unlike our loans, are generally recorded on our balance sheet at the value of the collateral.

 

A reduction in the value of the underlying collateral of our foreclosed assets could result in significant losses. For example, a 35% reduction in the value of the underlying collateral would result in a $363,000 loss. While we are not carrying large balances of foreclosed assets, our business is subject to increased risk of not being able to repay timely our Note holders’ investments if such a reduction were to occur.

 

Increases in interest rates, reductions in mortgage availability, or increases in other costs of home ownership could prevent potential customers from buying new homes and adversely affect our business and financial results.

 

Most new home purchasers finance their home purchases through lenders providing mortgage financing. Prior to the recent volatility in the financial markets, interest rates were at historically low levels and a variety of mortgage products were available. As a result, home ownership became more accessible. The mortgage products available included features that allowed buyers to obtain financing for a significant portion or all of the purchase price of the home, had very limited underwriting requirements or provided for lower initial monthly payments. Accordingly, more people were qualified for mortgage financing.

 

Since 2007, the mortgage lending industry has experienced significant instability, beginning with increased defaults on subprime loans and other nonconforming loans and compounded by expectations of increasing interest payment requirements and further defaults. This, in turn, resulted in a decline in the market value of many mortgage loans and related securities. Lenders, regulators and others questioned the adequacy of lending standards and other credit requirements for several loan products and programs offered in recent years. Credit requirements tightened, and investor demand for mortgage loans and mortgage-backed securities declined. In general, fewer loan products, tighter loan qualifications, and a reduced willingness of lenders to make loans make it more difficult for many buyers to finance the purchase of homes. These factors serve to reduce the pool of qualified homebuyers and made it more difficult to sell to first-time and move-up buyers.

 

Mortgage rates may rise significantly in over the next several years. The benefit of recent trends loosening credit to potential end users of homes may be outweighed by the rise of interest rates for those borrowers, which might lower demand for new homes.

 

A reduction in the demand for new homes may reduce the amount and price of the residential home lots sold by the developers and homebuilders to which we loan money and/or increase the amount of time such developers and homebuilders must hold the home lots in inventory. These factors increase the likelihood of defaults on our loans, which would adversely affect our business and consolidated financial results.

 

Most of our assets are commercial construction loans to homebuilders and/or developers which are a higher than average credit risk, and therefore could expose us to higher rates of loan defaults, which could impact our ability to repay amounts owed to Note holders.

 

Our primary business is extending commercial construction loans to homebuilders, along with some loans for land development. These loans are considered higher risk because the ability to repay depends on the homebuilder’s ability to sell a newly built home. These homes typically are not sold by the homebuilder prior to commencement of construction. Therefore, we may have a higher risk of loan default among our customers than other commercial lending companies. If we suffer increased loan defaults, in any given period, our operations could be materially adversely affected, and we may have difficulty making our principal and interest payments on the Notes.

 

13
 

 

If we lose or are unable to hire or retain competent personnel, we may be delayed or unable to implement our business plan, which would adversely affect our ability to repay the Notes.

 

We do not have an employment agreement with any of our employees and cannot guarantee that they will remain affiliated with us. We do not have key man insurance on any key employees as well. If any of our key employees were to cease their affiliation with us, our consolidated operating results would suffer. We believe that our future success depends, in part, upon our ability to hire and retain additional personnel. We cannot assure Note holders that we will be successful in attracting and retaining such personnel, which could hinder our ability to implement our business plan.

 

Employee misconducts could harm us by subjecting us to monetary loss, significant legal liability, regulatory scrutiny, and reputational harm.

 

Our reputation is critical to maintaining and developing relationships with our existing and potential customers and third parties with whom we do business. There is a risk that our employees could engage in misconduct that adversely affects our business. For example, if an employee were to engage-or be accused of engaging-in illegal or suspicious activities including fraud or theft, we could suffer direct losses from the activity, and in addition we could be subject to regulatory sanctions and suffer serious harm to our reputation, financial condition, customer relationships, and ability to attract future customers or employees. Employee misconduct could prompt regulators to allege or to determine based upon such misconduct that we have not established adequate supervisory systems and procedures to inform employees of applicable rules or to detect and deter violations of such rules. It is not always possible to deter employee misconduct, and the precautions we take to detect and prevent misconduct may not be effective in all cases. Misconduct by our employees, or even unsubstantiated allegations of misconduct, could result in a material adverse effect on our reputation and our business.

 

We are susceptible to customer fraud, which could cause us to suffer losses on our loan portfolio.

 

Because most of our customers do not publicly report their financial condition, we are susceptible to a customer’s fraud, which could cause us to suffer losses on our loan portfolio. The failure of a customer to accurately report its financial position, compliance with loan covenants, or eligibility for additional borrowings could result in our providing loans that do not meet our underwriting criteria, defaults in loan payments, and the loss of some or all of the principal of a particular loan or loans.

 

We have entered into purchase and sale agreements with third parties to sell them portions of some of our loans. This will increase our leverage. While the agreements are intended to increase our profitability, large loan losses and/or idle cash, could actually reduce our profitability, which could impair our ability to pay principal and/or interest on the Notes.

 

The purchase and sale agreements we entered into have allowed us to increase our loan assets and debt. If loans that we create have significant losses, the benefit of larger balances can be outweighed by the additional loan losses. Also, while these transactions are booked as secured financing, they are not lines of credit. Accordingly, we will have increased our loan balances without increasing our lines of credit, which can cause a decrease in liquidity. One solution to this liquidity problem is having idle cash for liquidity, which then could reduce our profitability. If either of these problems is persistent and/or significant, our ability to pay interest and principal on our Notes may be impaired.

 

14
 

 

Management has broad discretion over the use of proceeds from this offering, and it is possible that the funds will not be used effectively to generate enough cash for payment of principal and interest on the Notes.

 

We expect to use the proceeds from this offering for purposes detailed in our prospectus under the “Questions and Answers” and “Use of Proceeds” sections. Because no specific allocation of the proceeds is required in the indenture, our management will have broad discretion in determining how the proceeds of the offering will be used.

 

Additional competition may decrease our profitability, which would adversely affect our ability to repay the Notes.

 

We may experience increased competition for business from other companies and financial institutions that are willing to extend the same types of loans that we extend at lower interest rates and/or fees. These competitors also may have substantially greater resources, lower cost of funds, and a better-established market presence. If these companies increase their marketing efforts to our market niche of borrowers, or if additional competitors enter our markets, we may be forced to reduce our interest rates and fees in order to maintain or expand our market share. Any reduction in our interest rates, interest income, or fees could have an adverse impact on our profitability and our ability to repay the Notes.

 

Our real estate loans are illiquid, which could restrict our ability to respond rapidly to changes in economic conditions.

 

The real estate loans we currently hold and intend to extend are illiquid. As a result, our ability to sell under-performing loan in our portfolio or respond to changes in economic, financial, investment, and other conditions may be very limited. We cannot predict whether we will be able to sell any real estate loan for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a loan. The relative illiquidity of our loan assets may impair our ability to generate sufficient cash to make required interest and principal payments on the Notes.

 

We need to improve our systems and procedures as we grow. Failure to do so would adversely affect our ability to repay the Notes.

 

Initially all of our computer systems used excel spread sheets and other methods a small company would use. Over time, we added a loan document system which many banks use to produce closing documents for loans. We are replacing our excel spread sheet system for investors in 2018 with a proprietary system that we have been developing. We also plan on replacing our loan asset tracking system in 2018 or 2019 with another proprietary system. If either of these systems fail, or we do not replace our loan asset tracking system soon, we may be unable to function properly as a business.

 

If we do not meet the requirements to maintain effective internal controls over financial reporting, our ability to raise new capital will be harmed.

 

If we do not maintain effective internal controls over our financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act, then it could result in delaying future SEC filings or future offerings. If future SEC filings or future offerings are delayed, it could have an extreme negative impact on our cash flow causing us to default on our obligations.

 

We are subject to risk of significant losses on our loans because we do not require our borrowers to insure the title of their collateral for our loans.

 

It is customary for lenders extending loans secured by real estate to require the borrower to provide title insurance with minimum coverage amounts set by the lender. We do not require most of our homebuilders to provide title insurance on their collateral for our loans to them. This represents an additional risk to us as the lender. The homebuilder may have a title problem which normally would be covered by insurance, but may result in a loss on the loan because insurance proceeds are not available.

 

15
 

 

If a large number of our current and prospective borrowers are unable to repay their loans within a normal average number of months, we will experience a significant reduction in our income and/or liquidity, and may not be able to repay the Notes as they become due.

 

Construction loans that we extend are expected to be repaid in a normal average number of months, typically eight months, depending on the size of the loan. Development loans are expected to last for many years. We have interest paid on a monthly basis, but also charge a fee which will be earned over the life of the loan. If these loans are repaid over a longer period of time, the amount of income that we receive on these loans expressed as a percentage of the outstanding loan amount will be reduced, and fewer loans with new fees will be able to be made, since the cash will not be available. This will reduce our income as a percentage of the Notes, and if this percentage is significantly reduced it could impair our ability to pay principal and interest on the Notes.

 

Our cost of funds is substantially higher than that of banks.

 

Because we do not offer FDIC insurance, and because we want to grow our Note program faster than most banks want to grow their CD base, our Notes offer significantly higher rates than bank CDs. This may make it more difficult for us to compete against banks when they rejoin our niche lending market in large numbers. This could result in losses which could impair or eliminate our ability to pay interest and principal on our outstanding Notes.

 

We are subject to the general market risks associated with real estate construction and development.

 

Our financial performance depends on the successful construction and/or development and sale of the homes and real estate parcels that serve as security for the loans we make to homebuilders and developers. As a result, we are subject to the general market risks of real estate construction and development, including weather conditions, the price and availability of materials used in construction of homes and development of lots, environmental liabilities and zoning laws, and numerous other factors that may materially and adversely affect the success of the projects.

 

Our operations are not subject to the stringent banking regulatory requirements designed to protect investors, so repayment of Note holders’ investments is completely dependent upon our successful operation of our business.

 

Our operations are not subject to the stringent regulatory requirements imposed upon the operations of commercial banks, savings banks, and thrift institutions, and are not subject to periodic compliance examinations by federal or state banking regulators. For example, we are not well diversified in our product risk, and we cannot benefit from government programs designed to protect regulated financial institutions. Therefore, an investment in our Notes does not have the regulatory protections that the holder of a demand account or a certificate of deposit at a bank does. The return on any Notes purchased by a Note holder is completely dependent upon our successful operations of our business. To the extent that we do not successfully operate our business, our ability to pay interest and principal on the Notes will be impaired.

 

We are an “emerging growth company” under the federal securities laws and are subject to reduced public company reporting requirements.

 

In April 2012, President Obama signed into law the Jumpstart Our Business Startups Act, or the JOBS Act. We are an “emerging growth company,” as defined in the JOBS Act, and are eligible to take advantage of certain exemptions from, or reduced disclosure obligations relating to, various reporting requirements that are normally applicable to public companies.

 

16
 

 

We will remain an “emerging growth company” until the earliest of (1) the last day of the first fiscal year in which we have total annual gross revenues of $1 billion or more, (2) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement, (3) the date on which we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act (which would occur if the market value of our common equity held by non-affiliates exceeds $700 million, measured as of the last business day of our most recently completed second fiscal quarter, and we have been publicly reporting for at least 12 months) or (4) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three-year period. Under the JOBS Act, emerging growth companies are not required to (1) 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, (2) comply with new requirements adopted by the Public Company Accounting Oversight Board, or the PCAOB, which require mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor must provide additional information about the audit and the issuer’s financial statements, (3) comply with new audit rules adopted by the PCAOB after April 5, 2012 (unless the SEC determines otherwise), (4) provide certain disclosures relating to executive compensation generally required for larger public companies or (5) hold shareholder advisory votes on executive compensation.

 

Additionally, the JOBS Act provides that an “emerging growth company” may take advantage of an extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies. This means an “emerging growth company” can delay adopting certain accounting standards until such standards are otherwise applicable to private companies. 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 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.

 

We are exposed to risk of environmental liabilities with respect to properties of which we take title. Any resulting environmental remediation expense may reduce our ability to repay the Notes.

 

In the course of our business, we may foreclose and take title to real estate that could be subject to environmental liabilities. We may be held liable to a governmental entity or to third-parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical release at any property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third-parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity, and results of operations could be materially and adversely affected.

 

Risks Related to Conflicts of Interest

 

Our CEO (who is also on our board of managers) will face conflicts of interest as a result of the secured affiliated loans made to us, which could result in actions that are not in the best interests of our Note holders.

 

As of December 31, 2017, we had borrowed $0 from the 2007 Daniel M. Wallach Legacy Trust, with availability on that line of credit of $250,000, and $0 from Daniel M. Wallach, our CEO (who is also on our Board of managers), and his wife, Joyce Wallach, with availability on that line of credit of $1,250,000. These affiliate loans are collateralized by a lien against all of our assets. The Notes are subordinated in right of payment to all secured debt, including these affiliate loans. Pursuant to each promissory note, the affiliates have the option of funding any amount up to the face amount of the note, in the lender’s sole and absolute discretion. Therefore, Mr. Wallach will face conflicts of interest in deciding whether and when to exercise any rights pursuant to the promissory notes and pledge agreement. If these Wallach affiliates exercise their rights to collect on their collateral upon a default by us, we could lose some or all of our assets, which could have a negative effect on our ability to repay the Notes.

 

Our CEO will face conflicts of interest as a result of his equity ownership in the Company, which could result in actions that are not in Note holders’ best interests.

 

As of December 31, 2017, our CEO beneficially owned 96% of the common equity of the Company. As of January 1, 2018, our CEO beneficially owns 92% of the common equity of the Company. Since the Company is taxed as a partnership for federal income tax purposes, all profits and losses flow through to the equity owners. Therefore, Mr. Wallach and his affiliated equity owners of the Company will be motivated to distribute profits to the equity owners on an annual basis, rather than retain earnings in the Company for Company purposes. There is currently no limit in the indenture or otherwise on the amount of funds that may be distributed by the Company to its equity owners. If substantial funds are distributed to the equity owners, the liquidity and capital resources of the Company will be reduced and our ability to repay the Notes may be negatively impacted.

 

17
 

 

We have two lines of credit from affiliates which allow us to incur a significant amount of secured debt. These lines are collateralized by a lien against all of our assets. Our purchase and sale agreements function as secured debt as well. We expect to incur a significant amount of additional debt in the future, including issuance of the Notes, which will subject us to increased risk of loss.

 

As of December 31, 2017, we had $0 of secured debt outstanding on our senior debt lines of credit to affiliates of $1,500,000, with availability of $1,500,000 and the capacity to sell portions of many loans under the terms of our purchase and sale agreements. The lines of credit are from affiliates. The affiliate loans are collateralized by a lien against all of our assets. The purchase and sale agreements and other secured debt are with third-parties and are collateralized by loans. We have a senior subordinated note for $279,000 and a line of credit from a bank with a maximum outstanding balance of $500,000 which is senior unsecured. In addition, we expect to incur a significant amount of additional debt in the future, including issuance of the Notes, borrowing under credit facilities and other arrangements. The Notes will be subordinated in right of payment to all secured debt, including the affiliate loans. Therefore, in the event of a default on the secured debt, affiliates of our Company, including Mr. Wallach, have the right to receive payment ahead of Note holders, as do other secured debt holders, such as the loan purchasers under the purchase and sale agreements. Accordingly, our business is subject to increased risk of a total loss of our Note holders’ investments if we are unable to repay all of our secured debt.

 

Risks Related to Liquidity

 

We depend on the availability of significant sources of credit to meet our liquidity needs and our failure to maintain these sources of credit could materially and adversely affect our liquidity in the future.

 

We plan to maintain our purchase and sale agreements and our lines of credit so that we may draw funds when necessary to meet our obligation to redeem maturing Notes, pay interest on the Notes, meet our commitments to lend money to our customers, and for other general corporate purposes. Certain features of the purchase and sale agreements with third parties have added liquidity and flexibility, which have lessened the need for the lines of credit from affiliates; however, we do plan to replace our line of credit from affiliates with a line of credit from a financial institution. If we fail to maintain liquidity through our purchase and sale agreements and lines of credit, we will be more dependent on the proceeds from the Notes for our continued liquidity. If the sale of the Notes is significantly reduced or delayed for any reason we fail to obtain or renew a line of credit; or we default on our line of credit, our ability to meet our obligations, including our Note obligations, could be materially adversely affected, and we may not have enough cash to pay back Note holders’ investments. Also, the failure to maintain an active line of credit (and therefore using cash for liquidity instead of a borrowing line), even though we have liquidity from the Notes, will reduce our earnings, because we will be paying interest on the Notes, while we are holding cash instead of reducing our borrowings.

 

We have unfunded commitments to builders as of December 31, 2017. If every builder borrowed every amount allowed (which would mean all of their homes were complete) and no builders paid us back, we would need to fund that amount. While some of that amount would automatically come from our purchase and sale agreements, the rest would have to come from our Notes program and/or our lines of credit. Therefore, we may not have the ability to fund our commitments to builders.

 

As of December 31, 2017, we have $19,312,000 of unfunded commitments to builders. If every builder borrowed every amount allowed and no builders repaid us then we would need to fund that amount. Lines of credit, payoffs from builders, and immediate investments in our Notes may not be enough to fund our commitments to builders as they become payable. If we default on these obligations, then we may face any one or more of the following: a higher default rate, lawsuits brought by customers, an eventual lack of business from borrowers, missed principal and interest payments to Note holders and holders of other debt, and a lack of desire for investors to invest in our Notes Program. Therefore, we could default on our repayment obligations to our Note holders.

 

18
 

 

We have two secured lines of credit, one of which expires in 2018 and the other in 2019. Failure of those lines to renew could strain our ability to pay other obligations.

 

Our $1,325,000 line of credit due in July 2018 is funded by a group of companies, the majority of which were owned by an individual who died after the line was created. We do not know whether this line will be renewed. Our $4,000,000 secured line is due in January 2019. It is too early to tell what the renewal risk is for this line. If we are unable to renegotiate or extend our lines of credit, then we may default. Therefore, we could default on repayment obligations to some of our debt holders, which could include our Note holders.

 

If the proceeds from the issuance of the Notes exceed the cash flow needed to fund the desirable business opportunities that are identified, we may not be able to invest all of the funds in a manner that generates sufficient income to pay the interest and principal on the Notes.

 

Our ability to pay interest on our debt, including the Notes, pay our expenses, and cover loan losses is dependent upon interest and fee income we receive from loans extended to our customers. If we are not able to lend to a sufficient number of customers at high enough interest rates, we may not have enough interest and fee income to meet our obligations, which could impair our ability to pay interest and principal on the Notes. If money brought in from new Notes and from repayments of loans from our customers exceeds our short-term obligations such as expenses, Notes interest and redemptions, and line of credit principal and interest, then it is likely to be held as cash, which will have a lower return than the interest rate we are paying on the Notes. This will lower earnings and may cause losses which could impair our ability to repay the principal and interest on the Notes.

 

The indenture does not contain the type of covenants restricting our actions, such as restrictions on creating senior debt, paying distributions to our owners, merging, recapitalizing, and/or entering into highly leveraged transactions. The indenture does not contain provisions requiring early payment of Notes in the event we suffer a material adverse change in our business or fail to meet certain financial standards. Therefore, the indenture provides very little protection of Note holders’ investments.

 

The Notes do not have the benefit of extensive covenants. The covenants in the indenture are not designed to protect Note holders’ investments if there is a material adverse change in our consolidated financial condition, results of operations, or cash flows. For example, the indenture does not contain any restrictions on our ability to create or incur senior debt or other debt to pay distributions to our equity holders, including our Chief Executive Officer. It also does not contain any financial covenants (such as a fixed charge coverage or a minimum amount of equity) to help ensure our ability to pay interest and principal on the Notes. The indenture does not contain provisions that permit Note holders to require that we redeem the Notes if there is a takeover, recapitalization or similar restructuring. In addition, the indenture does not contain covenants specifically designed to protect Note holders if we engage in a highly leveraged transaction. Therefore, the indenture provides very little protection of Note holders’ investments.

 

Payment on the Notes is subordinate to the payment of our outstanding present and future senior debt, if any. Since there is no limit to the amount of senior debt we may incur, our present and future senior debt may make it difficult to repay the Notes.

 

As of December 31, 2017, we had $0 of senior debt outstanding on our senior debt lines of credit of $1,500,000, with availability of $1,500,000. Our purchase and sale agreements and secured lines of credit with third-parties also function as senior debt. The balance on those purchase and sale agreements was $11,644,000 on December 31, 2017, and is expected to grow in the future. We also have senior subordinated notes which are senior to the Notes of $279,000 as of December 31, 2017. In January 2017, we entered into a line of credit agreement which is senior unsecured, with a maximum outstanding balance of $500,000. The Notes are subordinate and junior in priority to any and all of our senior debt and senior subordinated debt, and equal to any and all non-senior debt, including other Notes. The Notes are senior to junior subordinated notes. There are no restrictions in the indenture regarding the amount of senior debt or other indebtedness that we may incur. Upon the maturity of our senior debt, by lapse of time, acceleration or otherwise, the holders of our senior debt have first right to receive payment, in full, prior to any payments being made to a Note holder or to other non-senior debt. Therefore, upon such maturity of our senior debt Note holders would only be repaid in full if the senior debt is satisfied first and, following satisfaction of the senior debt, if there is an amount sufficient to fully satisfy all amounts owed under the Notes and any other non-senior debt.

 

19
 

 

Additional competition for investment dollars may decrease our liquidity, which would adversely affect our ability to repay the Notes.

 

We could experience increased competition for investment dollars from other companies and financial institutions that are willing to offer higher interest rates. We may be forced to increase our interest rates in order to maintain or increase the issuance of Notes. Any increase in our interest rates could have an adverse impact on our liquidity and our ability to meet a debt covenant under any future lines of credit obtained and/or to repay the Notes.

 

If we are unable to meet our Note maturity and redemption obligations, and we are unable to obtain additional financing or other sources of capital, we may be forced to sell off our operating assets or we might be forced to cease our operations, and Note holders could lose some or all of their investment.

 

Our Notes have maturities ranging from one year to four years. In addition, holders of our Notes may request redemption upon death. We intend to pay our Note maturity and redemption obligations using our normal cash sources, such as collections on our loans to customers, as well as proceeds from the Notes Program. We may experience periods in which our Note maturity and redemption obligations are high. Since our loans are generally repaid when our borrower sells a real estate asset, our operations and other sources of funds may not provide sufficient available cash flow to meet our continued Note maturity and redemption obligations. While we have secured lines of credit from affiliates of up to $1,500,000 with no borrowings as of December 31, 2017, our affiliates are not obligated to fund our borrowing requests. Our secured line of credit with an outside party is only $500,000 (which was undrawn on December 31, 2017.) For all of these reasons we may be substantially reliant upon the net offering proceeds we receive from the Notes Program to pay these obligations. If we are unable to repay or redeem the principal amount of the Notes when due, and we are unable to obtain additional financing or other sources of capital, we may be forced to sell off our operating assets or we might be forced to cease our operations, and Note holders could lose some or all of their investment.

 

There is no “early warning” on the Notes if we perform poorly. Only interest and principal payment defaults on the Notes can trigger a default on the Notes prior to a bankruptcy.

 

There are a limited number of performance covenants to be maintained under the Notes and/or the indenture. Therefore, no “early warning” of a possible default by us exists. Under the indenture, only (i) the non-payment of interest and/or principal on the Notes by us when payments are due, (ii) our bankruptcy or insolvency, or (iii) a failure to comply with provisions of the Notes or the indenture (if such failure is not cured or waived within 60 days after receipt of a specific notice) could cause a default to occur.

 

Note holders do not have the opportunity to evaluate our investments before they are made.

 

We intend to use the net offering proceeds in accordance with the “Use of Proceeds” section of our prospectus, including investment in secured real estate loans for the acquisition and development of parcels of real property as single-family residential lots and/or the construction of single-family homes. Since we have not identified any investments that we will make with the net proceeds of this offering, we are generally unable to provide Note holders with information to evaluate the potential investments we may make with the net offering proceeds before purchasing the Notes. Note holders must rely on our management to evaluate our investment opportunities, and we are subject to the risk that our management may not be able to achieve our objectives, may make unwise decisions or may make decisions that are not in our best interest.

 

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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 in order to reduce the loan balance.

 

Some of the collateral securing the Pennsylvania Loans is preferred equity in our Company, which has a book value of $1,240,000 as of December 31, 2017. If the borrower defaults on the loan and we are forced to use collateral to repay the loan, we will need to sell this preferred interest in us to a third-party. There is no liquid market for this instrument, so we then can give no assurance as to our ability to generate any amount of proceeds from that collateral.

 

Because we require a substantial amount of cash to service our debt, we may not be able to pay our obligations under the Notes.

 

To service our total indebtedness, we require a significant amount of cash. Our ability to generate cash depends on many factors, including our successful financial and operating performance. We cannot assure Note holders that our business plans will succeed or that we will achieve our anticipated financial results, which may prevent us from being able to pay our obligations under the Notes.

 

The indenture and terms of our Notes do not restrict our use of leverage. A relatively small loss can cause over leveraged companies a material adverse change in their financial position. If this happened to us, it may make it difficult to repay the Notes.

 

Financial institutions which are federally insured typically have 8-12% of their total assets in equity. A reduction in their loan assets due to losses of 2% reduces their equity by roughly 20%. Our company had 16% and 17% of our loan assets in equity as of December 31, 2017 and 2016, respectively. If we allow our assets to increase without increasing our equity, we could have a much lower equity as a percentage of assets than we have today, which would increase our risk of nonpayment on the Notes. Note holders have no structural mechanism to protect them from this action, and rely solely on us to keep equity at a satisfactory ratio.

 

We expect to be substantially reliant upon the net offering proceeds we receive from the sale of our Notes to meet principal and interest obligations on previously issued Notes.

 

We intend to use the net offering proceeds from the Notes Program to, among other things, make payments on other borrowings, fund redemption obligations, make interest payments on the Notes, and to run our business to the extent that other sources of liquidity from our operations (e.g., repayment of loans we have previously extended to our customers) and our credit line are inadequate. However, these other sources of liquidity are subject to risks. Our operations alone may not produce a sufficient return on investment to repay interest and principal on our outstanding Notes. We may not be able to obtain or retain a line of credit. We may not be able to attract new investors, have sufficient loan repayments, or have sufficient borrowing capacity when we need additional funds to repay principal and interest or redeem our outstanding Notes. If any of these things occur, our liquidity and capital needs may be severely affected, and we may be forced to sell off our loan receivables and other operating assets, or we might be forced to cease our operations.

 

If we default in our Note payment obligations, the indenture agreement provides that the trustee could accelerate all payments due under the Notes, which would further negatively affect our consolidated financial position and cash flows.

 

Our obligations with respect to the Notes are governed by the terms of indenture agreement with U.S. Bank as trustee. Under the indenture, in addition to other possible events of default, if we fail to make a payment of principal or interest under any Note and this failure is not cured within 30 days, then we will be deemed in default. Upon such a default, the trustee or holders of 25% in principal of the outstanding Notes could declare all principal and accrued interest immediately due and payable. If our total assets do not cover these payment obligations, then we would most likely be unable to make all payments under the Notes when due, and we might be forced to cease our operations.

 

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There is no sinking fund to ensure repayment of the Notes at maturity, so Note holders are totally reliant upon our ability to generate adequate cash flows.

 

We do not contribute funds to a separate account, commonly known as a sinking fund, to repay the Notes upon maturity. Because funds are not set aside periodically for the repayment of the Notes over their respective terms, Note holders must rely on our consolidated cash flows from operating, investing and financing activities and other sources of financing for repayment, such as funds from the Notes Program, loan repayments, and other borrowings. To the extent cash flows from operations and other sources are not sufficient to repay the Notes, Note holders may lose all or part of their investment.

 

If a large number of our Note holders die, we may be unable to repay their investments.

 

Upon the death of an investor, if requested by the executor or administrator of the investor’s estate (or if the Note is held jointly, by the surviving joint investor), we are obligated to redeem his or her Notes without any interest penalty. Such redemption requests are not subject to our consent but may be subject to restrictions in the indenture. If a large number of our investors, or a single investor holding a significant portion of the Notes, die within a short period of time, we could be faced with a large number of redemption requests. If the amounts of those redemptions are too high, and we cannot offset them with loan repayments, secure new financing, or issue additional Notes, we may not have the liquidity to redeem the investments.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

Not applicable.

 

ITEM 2. PROPERTIES

 

As of December 31, 2017, we operate an office in Jacksonville, Florida, which we own. We entered into a mortgage on our office building for $660,000 in January 2018 after construction was completed.

 

ITEM 3. LEGAL PROCEEDINGS

 

  (a) As of the date of this filing, we are not aware that we or our members are a party to any pending or threatened legal proceeding or proceeding by a governmental authority that would have a material adverse effect on our business.
     
  (b) None.

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not applicable.

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCK HOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

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

 

  (a) Common Equity

 

As of December 31, 2017, we had 2,629 Class A common membership units (“Class A Common Units”) outstanding, held by our eight members. There is no established trading market for our Class A Common Units. As of December 31, 2017, 96% of our outstanding Class A Common Units are beneficially owned by our CEO (who is also on our board of managers), Daniel M. Wallach, and his wife, Joyce S. Wallach.

 

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In March 2017, our Executive Vice President of Operations and each of our three independent board members acquired the remaining 4% of Class A Common Units outstanding. For the fiscal years ended December 31, 2017 and 2016, we declared and paid total distributions to the holders of our Class A Common Units of $373 and $436, respectively, which distributions were declared and paid on a quarterly basis.

 

In January 2018, our Executive Vice President of Operations and CFO acquired 1% and 2% of our Class A Common Units, respectively, by purchasing such Class A Common Units from Mr. and Mrs. Wallach. In addition, in March 2018, William Myrick, a former member of our board of managers, acquired 14.3% of our Class A Common Units by purchasing those Class A Common Units from Mr. and Mrs. Wallach for $1,000. Mr. Myrick resigned his position on the board of managers effective March 2018 and now serves as our Executive Vice President of Sales.

 

Preferred Equity

 

Series B Preferred Units

 

As of December 31, 2017, the Hoskins Group (consisting of Benjamin Marcus Homes, LLC, Investor’s Mark Acquisitions, LLC, and Mark L. Hoskins) owns a total of 12.4 Series B cumulative preferred units (“Series B Preferred Units”), which were issued for a total of $1,240. Of that total, 0.9 and 1.4 Series B Preferred Units were issued to the Hoskins Group during 2017 and 2016, respectively, pursuant to an agreement whereby the Hoskins Group agreed to purchase 0.1 Series B Preferred Units upon each closing of a lot sale in the subdivisions in which we lend the Hoskins Group development funds. The Series B Preferred Units are redeemable by the Company at any time. 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 (providing 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.

 

The transactions in Series B Preferred Units described above were effected in private transactions exempt from the registration requirements of the Securities Act under Section 4(a)(2) of the Securities Act. The transactions described above did not involve any public offering, were made without general solicitation or advertising, and the buyer represented to us that it is an “accredited investor’’ within the meaning of Rule 501 of Regulation D promulgated under the Securities Act, with access to all relevant information necessary to evaluate the investment in the Series B Preferred Units.

 

Series C Preferred Units

 

Series C cumulative preferred units (“Series C Preferred Units”) were issued to Margaret Rauscher IRA LLC (Margaret Rauscher is the wife of one of our independent managers, Eric A. Rauscher) in March 2017 and to an IRA owned by William Myrick, a former independent manager, in April 2017. The Series C Preferred Units 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 Preferred Units have a fixed value which is their purchase price and preferred liquidation and distribution rights. Yearly distributions of 12% of the Series C Preferred Units’ value (provided profits are available) will be made quarterly. This rate may increase if our Notes Program interest rates rise above 12%. Dividends may be reinvested monthly into additional Series C Preferred Units.

 

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Investors in the Series C Preferred Units may elect to reinvest their distributions in additional Series C Preferred Units (the “Series C Reinvestment Program”). Pursuant to the Series C Reinvestment Program, we issued the following Series C Preferred Units during 2017:

 

Date  Recipient  Series C Preferred Units Issued   Distribution Proceeds 
March 31, 2017  Margaret Rauscher IRA LLC   0.0212903   $2.12903 
   William Myrick (IRA)   -    - 
              
April 30, 2017  Margaret Rauscher IRA LLC   0.0442129   4.42129 
   William Myrick (IRA)   0.0300670   3.00670 
              
May 31, 2017  Margaret Rauscher IRA LLC   0.0446550   4.46550 
   William Myrick (IRA)   0.0566763   5.66763 
              
June 30, 2017  Margaret Rauscher IRA LLC   0.0451016   4.51016 
   William Myrick (IRA)   0.0572431   5.72431 
              
July 31, 2017  Margaret Rauscher IRA LLC   0.0455526   4.55526 
   William Myrick (IRA)   0.0578155   5.78155 
              
August 31, 2017  Margaret Rauscher IRA LLC   0.0460081   4.60081 
   William Myrick (IRA)   0.0583936   5.83936 
              
September 30, 2017  Margaret Rauscher IRA LLC   0.0464682   4.64682 
   William Myrick (IRA)   0.0589776   5.89776 
              
October 31, 2017  Margaret Rauscher IRA LLC   0.0469329   4.69329 
   William Myrick (IRA)   0.0595674   5.95674 
              
November 30, 2017  Margaret Rauscher IRA LLC   0.0474022   4.74022 
   William Myrick (IRA)   0.0601630   6.01630 
              
December 31, 2017  Margaret Rauscher IRA LLC   0.0478762   4.78762 
   William Myrick (IRA)   0.0607647   6.07647 
              
Total      0.9351681   $93.51682 

 

The proceeds received from the sales of the Series C Preferred Units discussed above were used for the funding of construction loans. The transactions in Series C Preferred Units described above were effected in private transactions exempt from the registration requirements of the Securities Act under Section 4(a)(2) of the Securities Act. The transactions described above did not involve any public offering, were made without general solicitation or advertising, and the buyer represented to us that it is an “accredited investor’’ within the meaning of Rule 501 of Regulation D promulgated under the Securities Act, with access to all relevant information necessary to evaluate the investment in the Series C Preferred Units.

 

  (b) Notes Program

 

We registered up to $70,000 in Fixed Rate Subordinated Notes in our public offering (SEC File No. 333-203707, effective September 29, 2015). As of December 31, 2017, we had issued a gross amount of $14,614 in Notes pursuant to our public offering. From September 29, 2015 through December 31, 2017, we incurred expenses of $193 in connection with the issuance and distribution of the Notes, which were paid to third parties. These expenses were not for underwriters or discounts, but were for advertising, printing, and professional services. Net offering proceeds as of December 31, 2017 were $14,421, 100% of which was used to increase loan balances.

 

  (c) None.

 

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ITEM 6. SELECTED FINANCIAL DATA

 

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

 

The following selected consolidated financial data should be read together with our consolidated financial statements and accompanying notes and “Management Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this document. The selected consolidated financial data in this section is not intended to replace our consolidated financial statements and the accompanying notes. Our historical results and information are not necessarily indicative of our future results.

 

The summary consolidated financial data as of and for the fiscal years ended December 31, 2017 and 2016 is derived from our audited consolidated financial statements included elsewhere in this document. The summary consolidated financial data as of and for the fiscal years ended December 31, 2015, 2014, and 2013 is derived from our audited consolidated financial statements not included in this document.

 

As of, and for, the years ended December 31,

 

   2017   2016   2015   2014   2013 
   (Audited)   (Audited)   (Audited)   (Audited)   (Audited) 
Operations Data                         
Net interest income                         
Interest income  $5,812   $3,640   $1,863   $1,138   $596 
Interest expense   2,707    1,748    864    433    157 
Provision for Loan losses   44    16    59    22     
Net interest income after loan loss provision   3,061    1,876    940    683    439 
Non-Interest Income                         
Gain from foreclosure of assets   77    72    105         
Non-Interest Expense                         
Selling, general and administrative expenses   2,090    1,319    547    390    415 
Impairment loss on foreclosed assets   266    111             
Net income  $782   $518   $498   $293   $24 
                          
Balance Sheet Data                         
Cash and cash equivalents  $3,478   $1,566   $1,341   $558   $722 
Accrued interest on loans   720    280    146    78    27 
Property, plant and equipment   910    69              
Other assets   168    82    14    13    14 
Loans receivable, net   30,043    20,091    14,060    8,097    4,045 
Foreclosed assets   1,036    2,798    965         
Total assets   36,355    24,886    16,526    8,746    4,808 
Customer interest escrow   935    812    498    318    255 
Accounts payable, accrued interest payable and other accrued expenses   2,058    1,363    539    199    59 
Notes payable unsecured, net of deferred financing costs   16,904    11,962    8,497    5,172    2,590 
Notes payable secured   11,644    7,322    3,683         
Notes payable related parties                    
Due to preferred equity member   31    28    25         
Total liabilities   31,572    21,487    13,242    5,689    2,904 
Redeemable preferred equity   1,097                 
Members’ capital   3,686    3,399    3,284    3,057    1,904 
Members’ contributions   90    140    10    1,000     
Members’ distributions   (585)   (543)   (281)   (140)   (22)

 

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ITEM 7. 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 consolidated financial statements and the notes thereto contained elsewhere in this report. 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.

 

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.

 

We had $30,043 and $20,091 in loan assets as of December 31, 2017 and 2016, respectively. As of December 31, 2017, and 2016, respectively, we had 168 and 69 construction loans in 16 and 15 states with 52 and 30 borrowers. As of December 31, 2017, and 2016 we had three development loans in Pittsburgh, Pennsylvania. We have various sources of funding, detailed below:

 

   December 31, 2017   December 31, 2016 
Capital Source          
Purchase and sale agreements and other secured borrowings  $11,644   $7,322 
Secured line of credit from affiliates        
Unsecured senior line of credit from a bank        
Unsecured Notes through our Notes Program   14,121    11,221 
Other unsecured debt   3,069    1,152 
Preferred equity Series B units   1,240    1,150 
Preferred equity Series C units   1,097     
Common equity   2,446    2,249 
           
Total  $33,617   $23,094 

 

In 2017 and continuing into 2018, we worked on expanding our loan portfolio, while increasing capital and adding people and infrastructure to accommodate our expansion.

 

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Economic and Industry Dynamics

 

We found a niche in the home construction financing industry, to become the lender of choice or secondary lender to residential homebuilders during the absence of sufficient lending at the homebuilder’s local financial institution or community bank. Our customers increase their sales and profits by borrowing from us and, in return we generate positive returns on secured loans we make to them.

 

Perceived Challenges and Anticipated Responses

 

The following is not intended to represent a comprehensive list or description of the risks or challenges facing the Company. Currently, our management is most focused on the following challenges along with the corresponding actions to address those challenges:

 

Perceived Challenges and Risks     Anticipated Management Actions/Response
Potential loan value-to-collateral value issues (i.e., being underwater on particular loans)     We manage this challenge by risk-rating both the geographic region and the builder, and then adjusting the loan-to-value (i.e., the loan amount versus the value of the collateral) based on risk assessments. Additionally, we collect a deposit up-front for construction loans. Despite these efforts, if values in a particular area of the country drop by 60%, we will have loaned more than the value of the collateral. We have found that the best solution to this risk is a speedy resolution of the loan, and helping the builder finish the home rapidly rather than foreclosing on the partially built home. Our experience in this area will help us limit, but not eliminate, the negative effects in the event of another economic downturn.
Concentration of loan portfolio (i.e., how many of the loans are of or with any particular type, customer, or geography)     As of December 31, 2017, and 2016, 22% and 37%, 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 December 31, 2017, our next two largest customers make up 7% and 5% of our loan commitments, with loans in Sarasota, Florida and Orlando, Florida, respectively. As of December 31, 2016, our next two largest customers made up 11% and 6% of our loan commitments, with loans in Sarasota, Florida and Savannah, Georgia, respectively. In the upcoming years, we plan on continuing to increase our geographic and builder diversity while continuing to focus on our residential homebuilder customers.
Not having funds available to us to service the commitments we have    

The typical construction loan has about 60% of its loan amount outstanding on average. That means that on average, about 40% of the commitment is not loaned, usually because the house is not complete. As of December 31, 2017, unfunded commitments totaled $19,312, which we will fund along with our purchase and sale agreement participants. However, if we are short on cash, we could do the following:

 

●   raise interest rates on the Notes we offer to our investors to attract new Note investments;

 

●    sell more secured interest on our loans; or

 

●    draw down on our lines of credit from our affiliates.

 

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Nonpayment of interest by our customers     Most of our customers pay interest on a monthly basis, and these funds are used to, among other things, pay interest on our debt monthly. While we have the liquidity to withstand some nonpayment of interest, if a high percentage of our customers were not paying interest, it will impede our ability to pay our debts on time.
Nonperforming assets     As of December 31, 2017, we had $3,478 in cash and $1,036 in foreclosed assets. These items do not have a return. However, we do have the ability to repay most of our debt without penalty, if we believe that is appropriate.

 

Opportunities

 

Although we can give no assurance as to our success, in the future, our management will focus its efforts on the following opportunities:

 

  receiving money from the Notes and other sources of capital, sufficient to operate our business and allow for growth and diversification in our loan portfolio;
     
  growing loan assets, staffing, and infrastructure to handle it. We hire office staff as loan volume grows, and hire the origination staff, which is field-based, as our liquidity allows for new loan originations. The goal for the field staff is to have a geographic coverage that eventually covers most of the continental U.S.;
     
  obtaining lines of credit from financial institutions. We would like the maximum amount (the credit limit) to be 20% of our asset size, and our outstanding amounts to average 10% of our asset size. We added an unsecured line of credit in January 2017, but want more capacity in this area; and
     
  retaining a portion of earnings to grow the equity of the Company.

 

Understanding and Evaluating Our Operating Results

 

Our results of operations are driven by three major factors - interest spread, loan losses, and selling, general and administrative (SG&A) expenses.

 

Interest Spread

 

Interest spread is generally made up of the following three components:

 

Difference between the interest rate received (on our loan assets) and the interest rate paid (on our borrowings).

 

Fee income. This fee is generally recognized over the life of the loan, based on the maximum allowed loan balance over the expected life of the loan. The amount of interest spread on these loans will depend on the life of the loans, as well as the fee percentage. As more competition comes into the residential construction lending market, we expect this portion of spread income to decrease as a percentage of assets.

 

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Amount of nonperforming assets. Since we are paying interest on all money we borrow, any asset created or funded with borrowed funds that does not have an interest return costs us money. There is an interest expense for us, with no interest income to offset it. Generally, there are two types of nonperforming assets. The first is nonperforming loans and related foreclosed assets held, which do not generate interest income unless actually received in cash. The second nonperforming asset type is money borrowed which is not invested in loans. To mitigate the negative spread on unused borrowed funds (idle cash), we can use our lines of credit to handle daily liquidity. We would like to maintain a secured line of credit with a credit limit of 20% of our loan assets, and generally carry a balance of 10% of our loan assets on that line. This way, as money comes in from Notes or loan payoffs, it can be used to pay down the line, and as money goes out for Note redemptions and new loans created, money can be drawn on the line. This will help reduce any negative spread on idle cash. In January 2017, we obtained an unsecured line of credit, with a maximum borrowing limit of $500, which is 2% of our loan assets as of December 31, 2017. We have additional lines of credit which are secured lines. Those lines are typically fully borrowed (with the exception of our lines of credit to affiliates), and have not yet been used to handle daily liquidity.

 

We calculate interest spread by taking the difference between interest income and expense, and, when we express it as a percentage, by dividing it by our weighted average outstanding loan balance.

 

Loan Losses

 

The second major factor in determining our profitability is loan losses. Losses on loans occur with nonperforming loans (i.e., when customers are unable to repay their interest and/or principal). Normally, the loss in this situation is the difference between the collateral value and the loan value, less any costs of disposal. Homes which were constructed in the mid 2000’s created significant losses because many homes were worth less when completed than the appraised value at the time the loan was created. Losses also occur in loans when homes are partly built at the point of default, or never built. Generally, a declining real estate market will be the primary driver for loan losses. We believe that while current values may fall in some real estate markets, in general, values are average and represent an average risk, and that over the last several years in general, values have been rising. Another type of loss relating to loans is the loss which occurs when the loan becomes a foreclosed asset. At the initial conversion from loan to foreclosed asset, there is a calculation of current value of the real estate vs. the loan amount. If this amount is a loss and has not been provided for previously through our allowance for loan losses, there will be a loss in our consolidated financial statements, typically in the loan loss provision. If there is a gain it will show up in non-interest income. If during the ownership of the asset there is a reason to further write the item down, this loss shows as a non-interest expense. If upon sale there is a gain or loss, those items show up as non-interest gains or losses. Even though these items don’t impact interest spread, they are important pieces of our consolidated financial statements.

 

SG&A Expenses

 

SG&A expenses include costs that are not interest and loan/foreclosed asset losses. In 2017, we increased SG&A as compared to 2016 mostly due to increases in the number of employees. We anticipate SG&A expenses increasing as our loan balance increases in 2018; however, this SG&A increase will be partially offset by a reduction in our CEO compensation.

 

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.

 

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Loan Losses

 

Future losses on current loans are estimated in our financial statements. This estimate is important because it is on our largest asset (loans receivable). It is impossible to know what these losses will be, as the condition of the market cannot be determined, and specific situations with each loan are unpredictable and change constantly. 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 each quarter. This collective reserve includes both a quantitative and qualitative analysis. In addition to historical loss information, the analysis incorporates collateral value, decisions made by management and staff, percentage of aging spec loans, policies, procedures, and economic conditions. We analyze the following:

 

  Loans to one borrower with less than 10% of our total committed balances; and
  Loans to one borrower with greater than or equal to 10% of our total committed balances.

 

We individually analyze for impairment all loans which more than 60 days past are due at the end of each quarter. If required, the analysis 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.

 

Currently, 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.

 

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   December 31, 2017 
   Loan Loss 
   Provision 
Change in Fair Value Assumption  Higher/(Lower) 
Increasing fair value of the real estate collateral by 35%*  $ 
Decreasing fair value of the real estate collateral by 35%**  $1,145 

 

* 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 $30,043, and the fair value of the real estate collateral on all outstanding loans was reduced by 35%, an addition to the loan loss provision of $1,145 would be required.

 

Foreclosed Assets

 

Foreclosed assets, 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 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 loss or gain upon final disposition of the asset. The calculation of the impairment, which appears on our 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:

 

For properties which exist in the condition in which we intend to sell them, we obtain an appraisal of the assets current value. We reduce the appraised value by 10% to account for selling costs. This amount is used to initially book 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.

 

   December 31, 2017 
   Foreclosed 
   Assets 
Change in Fair Value Assumption  Higher/(Lower) 
Increasing fair value of the foreclosed asset by 35%*  $ 
Decreasing fair value of the foreclosed asset by 35%  $(363)

 

* 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.

 

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.

 

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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 Note 2 of 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 years ended December 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.

 

Accounting principles generally accepted in the United States of America (U.S. GAAP) require that we report financial and descriptive information about reportable segments and how these segments were determined. Our management determines the allocation and performance of resources based on operating income, net income and operating cash flows. Segments are identified and aggregated based on the products sold or services provided and the market(s) they serve. Based on these factors, management has determined that our ongoing operations are in one segment, commercial lending.

 

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Below is a summary of our income statement for the years ended December 31, 2017 and 2016:

 

   2017   2016 
         
Net Interest Income          
Interest and fee income on loans  $5,812   $3,640 
Interest expense:          
Interest related to secured borrowings   1,047    570 
Interest related to unsecured borrowings   1,660    1,178 
Interest expense  $2,707   $1,748 
           
Net interest income   3,105    1,892 
           
Less: Loan loss provision   44    16 
Net interest income after loan loss provision   3,061    1,876 
           
Non-Interest Income          
Gain on foreclosure of assets   77    44 
Gain on sale of foreclosed assets       28 
Total non-interest income   77    72 
           
Income   3,138    1,948 
           
Non-Interest Expense          
Selling, general and administrative   2,090    1,319 
Impairment loss on foreclosed assets   266    111 
Total non-interest expense   2,356    1,430 
           
Net income  $782   $518 
           
Earned distribution to preferred equity holder   212    107 
           
Net income attributable to common equity holders  $570   $411 

 

Interest Spread

 

The following table displays a comparison of our interest income, expense, fees and spread for the years ended December 31, 2017 and 2016:

 

   2017   2016 
Interest Income         *         * 
Interest income on loans  $3,914    14%  $2,413    13%
Fee income on loans   1,898    7%   1,227    7%
Interest and fee income on loans   5,812    21%   3,640    20%
Interest expense – secured   1,047    4%   570    3%
Interest expense – unsecured   1,447    5%   911    5%
Amortization of offering costs   213    1%   267    2%
Interest expense   2,707    10%   1,748    10%
Net interest income (spread)   3,105    11%   1,892    10%
                     
Weighted average outstanding loan asset balance  $27,269        $18,249      

 

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

 

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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 2017 vs. 2016 by 1%. This increase was due to: 1) an increase in the rate we are charging on our development loans, and 2) an increase in the rate charged to builders beyond our standard rates (typically due to the age of the loan). While our average construction loan lasts for eight months, those that go beyond twelve months pay a higher rate of interest, even though they are paying interest on time. Our interest expense in 2017 was the same percentage cost as 2016 (10%).

 

The difference between the interest income and interest expense was 4% and 3% for 2017 and 2016, respectively. This was due to the interest income increasing, as discussed in the previous paragraph. We anticipate similar numbers in 2018 to the past two years, with some of the same reasons impacting the difference (the percentage of development loans compared to total loans, and the percentage of outstanding dollars on construction loans paying higher than standard rates).

 

Fee income. The Pennsylvania Loans originated in December 2011 had a net origination fee of $924. This fee was recognized over the life of the loans, and was 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. For both 2017 and 2016, fee income was 7% of the average outstanding balance on all loans. The decrease in fee income from the development loans in the later part of 2016 and all of 2017 was offset by a higher percentage of our loans being construction loans. In the future, we anticipate creating loans with fees ranging between 4% and 5% of the collateral loan amount, and we anticipate that our fee percentage in 2018 will be similar.

 

Amount of nonperforming assets. Generally, we have three types of nonperforming assets that negatively affect interest spread: loans not paying interest, foreclosed assets, and cash. We had two nonperforming loans in the first half of 2017, which terminated in the second half of 2017. Our foreclosed asset balance decreased to $1,036 at December 31, 2017, compared to $2,798 at December 31, 2016. The amount of nonperforming assets is expected to rise over the next twelve months, both due to work expected on the two lots we currently own and due to idle cash increases which are anticipated due to large borrowing inflows.

 

Loan Loss Provision

 

We recorded $44 and $16 in the years ended December 31, 2017 and 2016, respectively, in loss reserve related to our collective reserve (loans not individually impaired) and $0 in both years for our specific reserve (for loans individually impaired). We anticipate that the collective and specific reserves will increase as our loan balances rise throughout 2018.

 

Non-Interest Income

 

We recognized foreclosed gains of $0 and $44 in the years ended December 31, 2017 and 2016, respectively, from the initial foreclosure of assets. This represents the difference between our loan book value and the appraised value, net of selling costs, of the real estate. We also sold a foreclosed asset in both 2017 and 2016 and recognized gains of $77 and $28, respectively. We do not anticipate revenue in this area in 2018.

 

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SG&A Expenses

 

The following table displays our SG&A expenses for the years ended December 31, 2017 and 2016:

 

   2017   2016 
Selling, general and administrative expenses          
Legal and accounting  $196   $167 
Salaries and related expenses   1,435    798 
Board related expenses   108    112 
Advertising   59    46 
Rent and utilities   33    19 
Loan and foreclosed asset expenses   57    62 
Travel   78    35 
Other   124    80 
Total SG&A  $2,090   $1,319 

 

Our payroll cost was significantly higher in 2017 as our staff grew. We anticipate continuing to grow our staff in 2018, however we also anticipate that our CEO will receive significantly less pay in 2018, which may partially offset some of these increases.

 

Impairment Loss on Foreclosed Assets

 

We recorded $266 and $111 in the years ended December 31, 2017 and 2016, respectively, in impairment losses of our foreclosed assets (real estate taken in foreclosure). These losses are generally due to either decreases in value or cost overruns in completion. We may have more impairment in 2018 either on our existing or acquired foreclosed assets.

 

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. This amount generally grows as our Company grows. At December 31, 2017 and 2016, we had $3,478 and $1,566, respectively, in cash. See our Liquidity and Capital Resources section for more information.

 

Deferred Financing Costs, Net

 

We expect that the gross deferred financing amount will continue to increase over time as the anticipated financing costs are deferred when paid, and expensed over the life of the debt associated with the financing using the effective interest method. We also expect that the amortization expense and the accumulated amortization will increase in 2018 as compared to 2017. The deferred financing costs are reflected as a reduction in the unsecured Notes Program.

 

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The following is a roll forward of deferred financing costs:

 

   December 31, 2017   December 31, 2016 
         
Deferred financing costs, beginning balance  $1,014   $935 
Additions   88    79 
Deferred financing costs, ending balance  $1,102   $1,014 
Less accumulated amortization   (816)   (603)
Deferred financing costs, net  $286   $411 

 

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

 

   December 31, 2017   December 31, 2016 
         
Accumulated amortization, beginning balance  $603   $336 
Additions   213    267 
Accumulated amortization, ending balance  $816   $603 

 

Loans Receivable

 

Commercial Loans – Construction Loan Portfolio Summary

 

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

 

State  Number of
Borrowers
  Number of
Loans
  Value of
Collateral (1)
   Commitment
Amount
   Amount
Outstanding
   Loan to
Value Ratio(2)
   Loan Fee 
Colorado  3  6  $3,224   $2,196   $925    68%   5%
Delaware  1  1   244    171    147    70%   5%
Florida  15  54   25,368    16,555    10,673    65%   5%
Georgia  7  13   8,932    5,415    3,535    61%   5%
Indiana  2  2   895    566    356    63%   5%
Michigan  4  25   7,570    4,717    2,611    62%   5%
New Jersey  2  11   3,635    2,471    1,227    68%   5%
New York  1  5   1,756    929    863    53%   5%
North Carolina  3  6   1,650    1,155    567    70%   5%
Ohio  1  1   711    498    316    70%   5%
Oregon  1  1   607    425    76    70%   5%
Pennsylvania  2  20   15,023    7,649    5,834    51%   5%
South Carolina  7  18   4,501    3,058    1,445    68%   5%
Tennessee  1  2   690    494    494    72%   5%
Utah  1  2   790    553    344    70%   5%
Virginia  1  1   335    235    150    70%   5%
Total  52(4) 168  $75,931   $47,087   $29,563    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.
     
  (4) We have one builder in two states.

 

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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
   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%

 

Commercial Loans – Real Estate Development Loan Portfolio Summary

 

The following is a summary of our loan portfolio to builders for land development as of December 31, 2017 and December 31, 2016:

 

Year  State  Number of Borrowers  Number of Loans  Value of Collateral(1)   Commitment Amount(3)   Gross
Amount
Outstanding
   Loan to Value
Ratio(2)
   Loan
Fee
 
2017  Pennsylvania  1  3  $4,997   $4,600  $2,811    56%  $1,000 
2016  Pennsylvania  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 $1,240 in 2017 and $1,150 in 2016 of preferred equity in our Company. In the event of a foreclosure on the property securing these loans, the portion of our collateral that is preferred equity in our Company 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 calculated as described above.
   
(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 $4,600 commitment amount.

 

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Financing receivables are comprised of the following:

 

   December 31, 2017   December 31, 2016 
         
Loans receivable, gross  $32,375   $21,569 
Less: Deferred loan fees   (847)   (618)
Less: Deposits   (1,497)   (861)
Plus: Deferred origination expense   109    55 
Less: Allowance for loan losses   (97)   (54)
           
Loans receivable, net  $30,043   $20,091 

 

In 2018, we anticipate continued growth in our loans receivable, net, and all of the items that comprise it (seen in the chart above).

 

Roll forward of commercial loans:

 

   December 31, 2017   December 31, 2016 
         
Beginning balance  $20,091   $14,060 
Additions   33,451    23,184 
Payoffs/sales   (22,645)   (15,168)
Moved to foreclosed assets       (1,639)
Change in deferred origination expense   55    55 
Change in builder deposit   (636)   (340)
Change in loan loss provision   (44)   (16)
New loan fees   (2,127)   (1,270)
Earned loan fees   1,898    1,225 
           
Ending balance  $30,043   $20,091 

 

Credit Quality Information

 

Finance Receivables – By risk rating:

 

   December 31, 2017   December 31, 2016 
         
Pass  $25,656   $18,275 
Special mention   6,719    3,294 
Classified – accruing        
Classified – nonaccrual        
           
Total  $32,375   $21,569 

 

Please see our notes to consolidated financial statements for more information about the ratings in the table above.

 

Finance Receivables – Method of impairment calculation:

 

   December 31, 2017   December 31, 2016 
         
Performing loans evaluated individually  $14,992   $12,424 
Performing loans evaluated collectively   17,383    9,145 
Non-performing loans without a specific reserve      
Non-performing loans with a specific reserve        
           
Total evaluated collectively for loan losses  $32,375   $21,569 

 

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Below is an aging schedule of loans receivable as of December 31, 2017, on a recency basis:

 

   No.
Accts.
   Unpaid
Balances
   % 
Current loans (current accounts and accounts on which more than 50% of an original contract payment was made in the last 59 days)   153   $26,421    82%
60-89 days   18    5,954    18%
90-179 days           0%
180-269 days           0%
                
Subtotal   171   $32,375    100%
                
Interest only accounts (Accounts on which interest, deferment, extension and/or default charges were received in the last 60 days)      $    -%
                
Partial Payment accounts (Accounts on which the total received in the last 60 days was less than 50% of the original contractual monthly payment. “Total received” to include interest on simple interest accounts, as well as late charges on deferment charges on pre-computed accounts.)      $    -%
                
Total   171   $32,375    100%

 

Below is an aging schedule of loans receivable as of December 31, 2016, on a recency basis:

 

   No.
Accts.
   Unpaid
Balances
   % 
Current loans (current accounts and accounts on which more than 50% of an original contract payment was made in the last 59 days)   71   $18,617    86%
60-89 days   1    2,952    14%
90-179 days           %
180-269 days           %
                
Subtotal   72   $21,569