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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, 2019

 

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 333-224557

 

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)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class   Trading Symbol(s)   Name of Each Exchange on Which Registered
None   None   None

 

Securities registered pursuant to Section 12(g) of the Act: None

 

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 every Interactive Data File required to be submitted 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 such files). Yes [X] No [  ]

 

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

 

Large accelerated filer [  ]   Accelerated filer [  ]
Non-accelerated filer [X]   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. [X]

 

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

 

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 12
Item 1B. Unresolved Staff Comments 26
Item 2. Properties 26
Item 3. Legal Proceedings 26
Item 4. Mine Safety Disclosures 26
PART II.  
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 27
Item 6. Selected Financial Data 28
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 52
Item 8. Financial Statements and Supplementary Data 52
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 52
Item 9A. Controls and Procedures 53
Item 9B. Other Information 53
PART III.  
Item 10. Directors, Executive Officers and Corporate Governance 53
Item 11. Executive Compensation 55
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 58
Item 13. Certain Relationships and Related Transactions, and Director Independence 59
Item 14. Principal Accounting Fees and Services 61
PART IV.  
Item 15. Exhibits, Financial Statement Schedules 63
Item 16. Form 10-K Summary 63
SIGNATURES 67

 

 2 
 

 


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.

 

 3 
 

 


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. We have an Internet website at www.shepherdsfinance.com. We are not incorporating by reference into this report any material from our website. The reference to our website is an inactive textual reference to the uniform resource locator (URL) and is for your reference only.

 

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 lots and 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 12 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, our Executive Vice President of Operations has 14 years of experience in this type of lending. Our Acting Chief Financial Officer (“CFO”), who served as our CFO from January 2018 to May 2019 and was appointed Acting CFO in July 2019, has 14 years of public accounting experience. Our Executive Vice President of Sales has been in the housing industry for over 35 years years, including holding executive level positions for the majority of that time.

 

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 now getting back to historical norms as of December 31, 2019), 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 2019, while more small banks returned to the construction lending market, the demand for our loan products has remained relatively constant. We attribute this to our sales staff, and an increase in the number of small home builders in the market.

 

 4 
 

 

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 December 31, 2019, we have retained 19 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 and have more stable demand than our new construction program.

 

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 for some of 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.

 

 5 
 

 

The following table contains items that we believe 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 offered 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 13% as of December 31, 2019. 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 21 states as of December 31, 2019.   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.

 

(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.

 

 6 
 

 

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.

 

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 the homebuilder 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, as of December 31, 2019, about 78% of our construction loans have been spec homes and 22% have been contracts.

 

In a typical rehab transaction, we fund all of the purchase price, and then all or a portion 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 this differentiates us from 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 fixed rate subordinated 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; and/or
     
  in most cases, personal guarantees of the principals of the borrower entity.

 

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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 is $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.

 

Rate Cost of Funds (“COF”) plus 3%, 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.

 

 8 
 

 

The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2019:

 

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

 

State 

Number

of
Borrowers

  

Number

of
Loans

   Value of
Collateral (1)
   Commitment
Amount
  

Gross

Amount
Outstanding

  

Loan to
Value

Ratio (2)

   Loan Fee 
Colorado   1    1   $630   $425   $424    67%   5%
Connecticut   1    1    340    224    55    66%   5%
Florida   17    112    32,259    24,031    16,826    74%   5%
Georgia   3    4    2,085    1,343    917    64%   5%
Idaho   1    1    310    217    173    70%   5%
Indiana   2    3    1,687    1,083    383    64%   5%
Michigan   4    11    3,696    2,566    1,820    69%   5%
New Jersey   3    6    1,925    1,471    1,396    76%   5%
New York   2    3    1,370    940    743    69%   5%
North Carolina   6    20    5,790    4,009    2,471    69%   5%
Ohio   3    9    4,117    2,664    2,153    65%   5%
Oregon   1    2    1,137    796    739    70%   5%
Pennsylvania   3    24    20,791    13,322    11,772    64%   5%
South Carolina   11    25    8,809    6,419    4,786    73%   5%
Tennessee   3    4    1,367    1,069    503    78%   5%
Texas   3    4    1,984    1,270    843    64%   5%
Utah   2    4    1,862    1,389    1,000    75%   5%
Virginia   1    3    1,245    815    734    65%   5%
Washington   1    2    1,040    728    445    70%   5%
Wisconsin   1    1    539    332    285    62%   5%
Wyoming   1    1    228    160    143    70%   5%
Total   70    241   $93,211   $65,273   $48,611    70%(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.

 

 9 
 

 

The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2018:

 

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

 

State 

Number

of
Borrowers

  

Number

of
Loans

   Value of
Collateral (1)
   Commitment
Amount
  

Gross

Amount
Outstanding

  

Loan to
Value

Ratio (2)

   Loan Fee 
Arizona   1    1   $1,140   $684   $214    60%   5%
Colorado   2    4    2,549    1,739    1,433    68%   5%
Florida   18    104    32,381    22,855    12,430    71%   5%
Georgia   5    6    5,868    3,744    2,861    64%   5%
Idaho   1    2    605    424    77    70%   5%
Indiana   2    5    1,567    1,097    790    70%   5%
Michigan   4    26    5,899    3,981    2,495    67%   5%
New Jersey   5    15    4,999    3,742    2,820    75%   5%
New York   2    4    1,555    1,089    738    70%   5%
North Carolina   5    12    3,748    2,580    1,712    69%   5%
North Dakota   1    1    375    263    227    70%   5%
Ohio   2    3    3,220    1,960    1,543    61%   5%
Pennsylvania   3    34    24,808    14,441    10,087    58%   5%
South Carolina   15    29    9,702    6,738    4,015    69%   5%
Tennessee   1    2    750    525    347    70%   5%
Texas   1    1    179    125    26    70%   5%
Utah   4    4    1,788    1,206    486    67%   5%
Virginia   3    6    1,675    1,172    806    70%   5%
Total   75    259   $102,808   $68,365   $43,107    67%(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.

 

2020 Outlook

 

In 2020, we anticipate using proceeds from the Notes Program, the loan 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. We anticipate that the rehab program will grow as a percentage of our origination volume.

 

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, 2019:

 

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

 

States 

Number

of Borrowers

  

Number

of

Loans

   Value of Collateral(1)   Commitment Amount(2)   Gross
Amount
Outstanding
  

Loan to

Value Ratio(3)

  

Interest

Spread

 
Pennsylvania     1    3   $10,191    7,000   $7,389    73%   7%
Florida   2    3    1,301    1,356    891    68%   7%
North Carolina   1    1    400    260    99    25%   7%
South Carolina   1    2    1,115    1,250    618    55%   7%
Total   5    9   $13,007   $9,866   $8,997    69%(4)   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 $1,470 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.

 

 10 
 

 

(2) The commitment amount does not include unfunded letters of credit.
   
(3) The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value calculated as described above.
   
(4) Represents the weighted average loan to value ratio of the loans.

 

The following is a summary of our loan portfolio to builders for land development as of December 31, 2018:

 

States 

Number

of Borrowers

  

Number

of

Loans

   Value of Collateral(1)   Commitment Amount(2)   Gross
Amount
Outstanding
  

Loan to

Value Ratio(3)

   Interest Spread 
Pennsylvania   1    3   $8,482   $5,000   $5,037    59%   7%
Florida   2    4    537    1,206    501    93%   7%
South Carolina   1    2    1,115    1,250    482    43%   7%
Total   4    9   $10,134   $7,456   $6,020    59%(4)   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 $1,320 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 commitment amount does not include unfunded letters of credit.
   
(3) The loan to value ratio is calculated by taking the outstanding amount and dividing by the appraised value calculated as described above.
   
(4) Represents the weighted average loan to value ratio of the loans.

 

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.

 

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;

 

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  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 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.

 

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.

 

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Risks Related to our Business

 

Our business is not industry-diversified. The United States economy is experiencing a slow recovery after the significant downturn in the homebuilding industry beginning in 2007, which was one of the worst credit and liquidity crises since the 1930s. 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.

 

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.

 

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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 has 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 $55,369,000 of loan assets as of December 31, 2019. A 35% reduction in total collateral value would reduce our earnings and net worth by $4,657,000. Larger reductions would result in lower earnings and lower net worth.

 

As of December 31, 2019, we had $55,369,000 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 $4,657,000 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 $8,997,000 of development loan assets as of December 31, 2019, 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 generally 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.

 

Currently, we are reliant on a single developer and homebuilder, the Hoskins Group, who is concentrated in the Pittsburgh, Pennsylvania market, for a significant portion of our revenues and a portion of our capital. Our second largest customer is in the Orlando, Florida market and is also a significant portion of our portfolio.

 

As of December 31, 2019, 25% 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 are referred to herein as the “Hoskins Group”). We refer to the loans to the Hoskins Group as the “Pennsylvania Loans.” 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. One of our independent managers, Gregory L. Sheldon, also serves an advisor to the Hoskins Group and, consequently, Mr. Sheldon may face conflicts of interest in the advice that he provides to us and the Hoskins Group, including if any such adverse condition were to materialize.

 

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Also, as of December 31, 2019, 15% of our outstanding loan commitments consisted of loans made to a customer in Orlando, Florida.

 

We have foreclosed assets as of December 31, 2019, which unlike our loans, are recorded on our balance sheet at the value of the collateral, net of estimated selling expenses.

 

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 (net of estimated selling expenses) would result in a $1,720,000 loss. 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. Immediately prior to 2007, 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 served 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 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.

 

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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 of our employees. If any of our key employees were to cease their affiliation with us, our consolidated operating results could 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 misconduct 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.

 

A failure in, or breach of, our operational or security systems or infrastructure, or those of our third-party vendors, including as a result of cyber-attacks, could disrupt our business, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs, and cause losses.

 

We rely heavily on communications and information systems to conduct our business. Information security risks for our business have generally increased in recent years in part because of the proliferation of new technologies; the use of the Internet and telecommunications technologies to process, transmit, and store electronic information, including the management and support of a variety of business processes, including financial transactions and records, personally identifiable information, and customer and investor data; and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As customer, public, and regulatory expectations regarding operational and information security have increased, our operating systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Certain of our software and technology systems have been developed internally and may be vulnerable to unauthorized access or disclosure. Our business, financial, accounting, and data processing systems, or other operating systems and facilities, may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunication outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and, as described below, cyber-attacks.

 

Our business relies on its digital technologies, computer and email systems, software, and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems, and networks and, because the nature of our business involves the receipt and retention of personal information about our customers, our customers’ personal accounts may become the target of cyber-attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of our customers’, or other third parties’ confidential information. Third parties with whom we do business or who facilitate our business activities, including intermediaries or vendors that provide service or security solutions for our operations, and other third parties, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. In addition, hardware, software, or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information security.

 

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While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, there can be no assurance that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. Our risk and exposure to these matters remain heightened because of the evolving nature of these threats. As a result, cyber security and the continued development and enhancement of our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage, or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our business and customers, or cyber-attacks or security breaches of the networks or systems, could result in regulatory fines, penalties or intervention, reputation damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could have a material effect on our results of operations or financial condition. Furthermore, if such attacks are not detected immediately, their effect could be compounded.

 

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 and therefore typically are not required to be audited on a regular basis, 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. Customer fraud can come in other forms, including but not limited to fraudulent invoices for work done, appraisal fraud, and fraud related to inspections done by third parties.

 

We have entered into loan purchase and sale agreements with third parties to sell them portions of some of our loans. This increases 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 loan 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.

 

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 loans 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.

 

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Our systems and procedures might be inadequate to handle our potential growth. Failure to successfully improve our systems and procedures would adversely affect our ability to repay the Notes.

 

We may experience growth that could place a significant strain upon our operational systems and procedures. Initially, all of our computer systems used electronic spreadsheets and we utilized other methods that a small company would use. Over time, we added a loan document system which many banks use to produce closing documents for loans. During March 2018, we replaced our previous electronic spreadsheet system for Notes investors with a proprietary system. In addition, during July 2019, we replaced our loan asset tracking system with a new proprietary system. We may fail to implement these systems effectively. Additionally, our efforts to make these improvements may divert the focus of our personnel. If any of these systems fail, we could have a material adverse effect on our business, financial condition, results of operations, and, ultimately, our ability to repay principal and interest on the Notes.

 

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 of 2002, 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, including on the Notes.

 

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.

 

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 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 nine 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 Notes Program faster than most banks want to grow their CD base, our Notes offer significantly higher rates than bank CDs. Our cost of funds is higher than banks’ cost of funds due to, among other factors, the higher rate that we pay on our Notes and other sources of financing. 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.

 

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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 will not be 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.

 

We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act, or 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.

 

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 $1.07 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. However, we have elected to “opt out” of such extended transition period, and will therefore comply with new or revised accounting standards on the applicable dates on which the adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of such extended transition period for compliance with new or revised accounting standards is irrevocable.

 

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We are required to devote resources to comply with various provisions of the Sarbanes-Oxley Act, including Section 404 relating to internal controls testing, and this may reduce the resources we have available to focus on our core business.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act and the related rules adopted by the SEC and the Public Company Accounting Oversight Board, or PCAOB, our management is required to report on the effectiveness of our internal controls over financial reporting. We may encounter problems or delays in completing any changes necessary to our internal controls over financial reporting. Among other things, we may not be able to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404. Any failure to comply with the various requirements of the Sarbanes-Oxley Act may require significant management time and expenses and divert attention or resources away from our core business. In addition, we may encounter problems or delays in completing the implementation of any requested improvements provided by our independent registered public accounting firm.

 

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.

 

Our underwriting standards and procedures are more lenient than conventional lenders.

 

We invest in loans with borrowers who will not be required to meet the credit standards of conventional mortgage lenders, which is riskier than investing in loans made to borrowers who are required to meet those higher credit standards. Because we generally approve loans more quickly than some other lenders or providers of capital, there may be a risk that the due diligence we perform as part of our underwriting procedures will not reveal the need for additional precautions. If so, the interest rate that we charge and the collateral that we require may not adequately protect us or generate adequate returns for the risk undertaken.

 

The collateral securing our real estate loans may not be sufficient to pay back the principal amount in the event of a default by the borrowers.

 

In the event of default, our real estate loan investments are generally dependent entirely on the loan collateral to recover our investment. Our loan collateral consists primarily of a mortgage on the underlying property. In the event of a default, we may not be able to recover the premises promptly and the proceeds we receive upon sale of the property may be adversely affected by risks generally related to interests in real property, including changes in general or local economic conditions and/or specific industry segments, declines in real estate values, increases in interest rates, real estate tax rates and other operating expenses including energy costs, changes in governmental rules, regulations and fiscal policies (including environmental legislation), acts of God, and other factors which are beyond our or our borrowers’ control. Current market conditions may reduce the proceeds we are able to receive in the event of a foreclosure on our collateral. Our remedies with respect to the loan collateral may not provide us with a recovery adequate to recover our investment.

 

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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 lines of credit made to us, which could result in actions that are not in the best interests of our Note holders.

 

We have two lines of credit from Daniel M. Wallach (our CEO and chairman of the board of managers) and his affiliates. The first line of credit has a maximum principal borrowing amount of $1,250,000 and is payable to Mr. Wallach and his wife, Joyce S. Wallach, as tenants by the entirety (the “Wallach LOC”). The second line of credit has a maximum principal borrowing amount of $250,000 and is payable to the 2007 Daniel M. Wallach Legacy Trust (the “Wallach Trust LOC,” and together with the Wallach LOC, the “Wallach Affiliate LOCs”). As of December 31, 2019, we borrowed $0 on the Wallach Trust LOC, with availability on that line of credit of $250,000, and $44,000 on the Wallach LOC, with remaining availability on that line of credit of $1,206,000. The interest rates on the Wallach Affiliate LOCs generally equal the prime rate plus 3% and were 7.75% as of December 31, 2019. The Wallach Affiliate LOCs are collateralized by a lien against all of our assets. The Notes are subordinated in right of payment to all secured debt, including these Wallach Affiliate LOCs. Pursuant to the promissory note for each Wallach Affiliate LOC, the lenders 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 Wallach Affiliate LOCs. 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.

 

Some of our employees and managers may face conflicts of interest as a result of their and their relatives’ investment in the Notes, which could result in actions that are not in your best interests.

 

Employees, managers, members, and relatives of managers and members have invested in the Notes, with $3,849,000 outstanding as of December 31, 2019. While investment in the Notes by our affiliates may align their interests with those of other Note holders, it could also create conflicts of interest by influencing those employees’ or managers’ actions during times of financial difficulties. For example, the fact that certain of our managers hold Notes, and the value of Notes they hold, could influence their decision to redeem Notes at a time or times when it would be prudent to use our cash resources to build capital, pay down other outstanding obligations, or grow our business. There may be other situations not presently foreseeable in which the ownership of Notes by related persons may create conflicts of interest. These conflicts of interest could result in action or inaction by management that is adverse to other holders of the Notes.

 

As a result of his large equity ownership in the Company, our CEO will face a conflict of interest in deciding the amount of distributions to equity owners, which could result in actions that are not in the best interests of Note holders.

 

As of December 31, 2019, our CEO (who is also on the board of managers) beneficially owned 80.7% of the common equity of the Company. He and his wife also own 48% the Series C cumulative preferred units outstanding as of December 31, 2019. 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.

 

We have three 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, 2019, we had $189,000 of secured debt outstanding on our senior debt lines of credit from affiliates of $2,500,000 and the capacity to sell portions of many loans under the terms of our loan purchase and sale agreements. The affiliate loans are collateralized by a lien against all of our assets. The loan purchase and sale agreements and other secured debt are with third-parties and are collateralized by loans. 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.

 

 21 
 

 

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 loan purchase and sale agreements and our lines of credit from affiliates 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 loan purchase and sale agreements with third parties have added liquidity and flexibility, which have lessened the need for the lines of credit from affiliates. If we fail to maintain liquidity through our loan 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 and we fail to obtain or renew a line of credit, or we default on any of our lines of credit, then 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), 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, 2019. 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 loan 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, 2019, we have $16,662,000 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, loan purchase and sale agreements, 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.

 

We have a secured line of credit which expires in 2020, and the unsecured portion of a line of credit which also expires in 2020. Failure of those lines to renew could strain our ability to pay other obligations.

 

We have a $1,325,000 line of credit due in July 2020 (the “Shuman LOC”). The Shuman LOC was fully borrowed as of December 31, 2019. We do not know whether the Shuman LOC will be renewed. We also have a $7,000,000 line of credit, a portion of which is unsecured (the “Unsecured Swanson LOC”). The balance on the Unsecured Swanson LOC as of December 31, 2019 was $1,176,000, $1,000,000 of which is due in June 2020 with the remainder due in November 2020. We do not know whether the Unsecured Swanson LOC will be renewed. If we are unable to renegotiate or extend these lines of credit, then we may default on one or both of those lines of credit. Therefore, we could default on repayment obligations to some of our debt holders, including our Note holders.

 

 22 
 

 

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, Note 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 and our Executive Vice President of Sales. 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.

 

Our loan purchase and sale agreements and secured lines of credit with third-parties also function as senior debt. The balance on those loan purchase and sale agreements and other secured debt, net of deferred financing costs was $26,991,000 on December 31, 2019, and is expected to grow in the future. We also have senior subordinated notes which are senior to the Notes of $1,407,000 as of December 31, 2019. In addition, 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.

 

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.

 

 23 
 

 

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 and we would be obligated to fulfill such redemption request. Holders of a 36 month Note issued on or after February 4, 2020 may request redemption at any time and, subject to certain limitations, we would be obligated to fulfill such redemption request. 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 $2,500,000 with $189,000 borrowed as of December 31, 2019, our affiliates are not obligated to fund our borrowing requests. 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.

 

A portion of our collateral securing the Pennsylvania Loans is preferred equity in our Company. In the event of a foreclosure on the properties securing the Pennsylvania Loans, a portion of our collateral is preferred equity in our Company, it would be difficult to sell the preferred equity 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 $1,470,000 as of December 31, 2019. If the borrower defaults on any of the Pennsylvania Loans and we are forced to use collateral to repay any of the Pennsylvania Loans, we will need to sell this preferred interest in us to a third party. There is no liquid market for this instrument, so we 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.

 

 24 
 

 

The indenture and terms of our Notes do not restrict our use of leverage. A relatively small loss can cause over leveraged companies to suffer 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 13% and 12% of our loan assets in equity as of December 31, 2019 and 2018, 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 sale of Notes 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 lines 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 an additional line of credit when needed or retain one or more of our existing lines 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 on our outstanding Notes 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 may be forced to cease our operations.

 

If we default in our Note payment obligations, the indenture agreements provide 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 agreements with U.S. Bank National Association as trustee. Under the indentures, 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.

 

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 operations, investing and financing activities and other sources of financing for repayment, such as funds from sale of the Notes, 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 we have a large number of repayments on the Notes, whether because of maturity or redemption, we may be unable to make such repayments.

 

We are obligated to redeem a Note without any interest penalty (i) 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), and (ii) subject to certain limitations, upon request by an investor holding a 36 month Note issued on or after February 4, 2020. Such redemption requests are not subject to our consent but are subject to restrictions in the indenture. We may be faced with a large number of such redemption requests at one time. We are also required to repay all of the Notes upon their maturity. If the amounts of those repayments 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 repay the investments.

 

 25 
 

 

We have a significant amount of debt and 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. Our present and future senior debt may make it difficult to repay the Notes.

 

We have a significant amount of debt and expect to incur a significant amount of additional debt in the future. As of December 31, 2019, we have approximately $53,511,000 of debt. Our primary sources of debt include our lines of credit, loan purchase and sale agreements, and the Notes. As of December 31, 2019, we have a total outstanding balance of $10,216,000 on our lines of credit and $16,146,000 on our loan purchase and sale agreements. We also have the capacity to sell portions of many loans under the terms of our loan purchase and sale agreements. The loan purchase and sale agreements and other secured debt are with third parties and all but one of the lines of credit are collateralized by loans that we have issued to builders. 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. 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.

 

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 Wallach Affiliate LOCs, the loan purchase and sale agreements, the senior subordinated note discussed in the prior paragraph, and the line of credit discussed in the prior paragraph. 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 loan purchase and sale agreements. Accordingly, our business is subject to increased risk of a total loss of Note holders’ investment if we are unable to repay all of our secured debt.

 

Increases in interest rates would increase the amount of debt payments under the Wallach Affiliate LOCs which could impair our ability to repay the principal and interest on the Notes.

 

The interest rate under the Wallach Affiliate LOCs is generally equal to the prime rate plus three percent. Increases in interest rates will increase the applicable prime rate and therefore, the interest rate under the Wallach Affiliate LOCs will increase. An increase in the interest rate would increase the amount of debt payments under the Wallach Affiliate LOCs which would reduce our cash flows and could impair our ability to repay the principal and interest on the Notes.

 

We incurred indebtedness secured by our office property, which may result in foreclosure.

 

The debt incurred by us in connection with our office property is secured by a mortgage. If we default on our secured indebtedness, the lender may foreclose and the entire investment in the office property could be lost, which could adversely affect our ability to repay the principal and interest on the Notes.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

Not applicable.

 

ITEM 2. PROPERTIES

 

As of December 31, 2019, 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 a majority of the construction was completed. As of December 31, 2019, our mortgage payable balance was $634,000.

 

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.

 

 26 
 

 

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, 2019, we had 2,629 Class A common membership units (“Class A Common Units”) outstanding, held by our eight members. There is no established public trading market for our Class A Common Units. As of December 31, 2019, 80.7% 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.

 

Preferred Equity

 

Series B Preferred Units

 

We previously entered into an agreement with the Hoskins Group (consisting of Benjamin Marcus Homes, LLC, Investor’s Mark Acquisitions, LLC, and Mark L. Hoskins) pursuant to which we sell the Hoskins Group 0.1 Series B cumulative preferred units (“Series B Preferred Units”) upon the closing of certain lots. We issued 0.2 Series B Preferred Units to the Hoskins Group in December, 2019 for $20,000.

 

There is no established public trading market for our Series B Preferred Units. 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

 

As of December 31, 2019, we had 29.59 Series C cumulative preferred units (“Series C Preferred Units”) outstanding, held by nine investors. There is no established public trading market for our Series C Preferred Units. As of December 31, 2019, 48.1% of our outstanding Series C Preferred Units are beneficially owned by our CEO (who is also on our board of managers), Daniel M. Wallach, and his wife, Joyce S. Wallach.

 

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 the quarter ended December 31, 2019:

 

Recipient  Units Issued   Distribution Proceeds 
Daniel M. Wallach and Joyce S. Wallach   1.5995326   $159.95326 
Gregory L. Sheldon and Madeline M. Sheldon   0.2903015    29.03015 
BLDR Holdings, LLC   0.5174969    51.74969 
Jeffrey L. Eppinger   0.4866401    48.66401 
Fernando Ascencio and Lorraine Carol Ascencio   0.1400246    14.00246 
Schultz Family Revocable Living Trust   0.1287337    12.87337 
Total   3.1627294   $316.27294 

 

 27 
 

 

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 they were 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, 2019, we had issued a gross amount of $8,411 in Notes pursuant to our public offering. From March 23, 2019 through December 31, 2019, we incurred expenses of $359 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, 2019 were $8,052, and primarily used to increase loan balances.

 

  (c) None.

 

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, 2019 and 2018 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, 2017, 2016, and 2015 is derived from our audited consolidated financial statements not included in this document.

 

 28 
 

 

As of and for the years ended December 31,

 

   2019   2018   2017   2016   2015 
   (Audited)   (Audited)   (Audited)   (Audited)   (Audited) 
Operations Data                         
Net interest income                         
Interest and fee income on loans  $10,131   $7,764   $5,812   $3,640   $1,863 
Interest expense   5,780    4,296    2,707    1,748    864 
Provision for Loan losses   222    89    44    16    59 
Net interest income after loan loss provision   4,129    3,379    3,061    1,876    940 
Non-Interest Income                         
Gain on foreclosure of assets   203    19    77    72    105 
Non-Interest Expense                         
Selling, general and administrative expenses   2,486    2,112    2,090    1,319    547 
Loss on sale of foreclosed assets   274    103             
Impairment loss on foreclosed assets   558    515    266    111     
Net income  $1,014   $668   $782   $518   $498 
                          
Balance Sheet Data                         
Cash and cash equivalents  $1,883   $1,401   $3,478   $1,566   $1,341 
Accrued interest on loans   1,031    568    720    280    146 
Premises and equipment   936    1,051    1,020    69      
Other assets   202    327    58    82    14 
Loans receivable, net   55,369    46,490    30,043    20,091    14,060 
Foreclosed assets   4,916    5,973    1,036    2,798    965 
Total assets   64,337    55,810    36,355    24,886    16,526 
Customer interest escrow   643    939    935    812    498 
Accounts payable, accrued interest payable and other accrued expenses   2,999    2,864    2,058    1,363    539 
Notes payable unsecured, net of deferred financing costs   26,520    22,635    16,904    11,962    8,497 
Notes payable secured, net of deferred financing costs   26,991    23,258    11,644    7,322    3,683 
Due to preferred equity member   37    32    31    28    25 
Total liabilities   57,190    49,728    31,572    21,487    13,242 
Redeemable preferred equity   2,959    2,385    1,097         
Members’ capital   4,188    3,697    3,686    3,399    3,284 
Members’ contributions   150    80    90    140    10 
Members’ distributions   (357)   (737)   (585)   (543)   (281)

 

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 lots and 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.

 

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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, 2019 and 2018, 25% and 23% 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, 2019, our next two largest customers make up 15% and 3% of our loan commitments, with loans in Orlando, Florida and Cape Coral, Florida, respectively. As of December 31, 2018, our next two largest customers made up 13% and 4% 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 75% of its loan amount outstanding on average. That means that on average, about 25% of the commitment is not loaned, usually because the house is not complete. As of December 31, 2019, unfunded commitments totaled $16,662, 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.

 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, 2019, nonperforming assets were approximately $6,411 (defined as impaired loans and/or loans on nonaccrual plus foreclosed assets). However, we do have the ability to repay most of our debt without penalty, if we believe that is appropriate.

 

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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; and
     
  retaining a portion of earnings to grow the equity of the Company.

 

Critical Accounting Estimates

 

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

 

Loan Losses

 

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 as a reduction to Loans receivable, net and is detailed in the notes to our financial statements, 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 individually analyze for impairment all loans which are more than 60 days past are due at the end of each quarter. We also review for impairment all loans to one borrower with greater than or equal to 10% of our total committed balances. 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.

 

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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.

 

   December 31, 2019 
   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%**  $4,657 

 

* 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 $55,369, and the fair value of the real estate collateral on all outstanding loans was reduced by 35%.

 

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 the 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:

 

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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 estimated 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, we adjust the portion of the appraised value related to construction improvements for the percentage of the improvements which have not yet been made.

 

The fair value of real estate will impact our foreclosed asset value, which is recorded 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, 2019 
  

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%  $1,720 

 

* 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. However, the increase in fair value may be recognized up to the cost basis of the foreclosed asset which was determined at the foreclosure date.

 

Other Loss Contingencies

 

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

 

Accounting and Auditing Standards Applicable to “Emerging Growth Companies”

 

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

 

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.

 

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Consolidated Results of Operations

 

Key financial and operating data for the years ended December 31, 2019 and 2018 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.

 

Below is a summary of our statement of operations for the years ended December 31, 2019 and 2018:

 

   2019   2018 
         
Net Interest Income          
Interest and fee income on loans  $10,131   $7,764 
Interest expense:          
Interest related to secured borrowings   2,948    2,114 
Interest related to unsecured borrowings   2,832    2,182 
Interest expense  $5,780   $4,296 
           
Net interest income   4,351    3,468 
           
Less: Loan loss expense   222    89 
Net interest income after loan loss expense   4,129    3,379 
           
Non-Interest Income          
Gain on foreclosure of assets  $203   $19 
Total non-interest income   203    19 
           
Income   4,332    3,398 
           
Non-Interest Expense          
Selling, general and administrative  $2,394   $2,030 
Depreciation and amortization   92    82 
Loss on the sale of foreclosed assets   274    103 
Impairment loss on foreclosed assets   558    515 
Total non-interest expense   3,318    2,730 
           
Net income  $1,014   $668 
           
Earned distribution to preferred equity holder   457    292 
           
Net income attributable to common equity holders  $557   $376 

 

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Net income for the year ended December 31, 2019 increased $346 when compared to the same period of 2018. The increase in net income was mainly due to an increase in net interest income of $883 to $4,351 for the year ended December 31, 2019 compared to the same period of 2018. Net interest income increased primarily due to the additional gross amount outstanding on our development loans of $2,977 which increased to $8,997 as of December 31, 2019 compared to the same period of 2019. Our development loans margin is fixed at 7%. In addition, the gross amount outstanding on our construction loans increased $5,504 to $48,611 as of December 31, 2019 compared to the same period of 2018. For construction loans, the margin is fixed at 3% which increased from 2% for loans originated after July 1, 2018. Our increase in interest income was offset by an increase in non-interest expense.

 

Non-interest expense increased as follows for the year ended December 31, 2019 compared to the same period of 2018:

 

  Selling, general and administrative expenses (“SG&A”) increased $364 when compared to the same period of 2018. The increase in SG&A was primarily due to increases in salaries and related expenses; and
  Loss on the sale of foreclosed assets increased $171 due to the sale of a certain foreclosed property during August 2019 for sale proceeds of $4,543.

 

In addition, we had $55,369 and $46,490 in loan assets, net as of December 31, 2019 and 2018, respectively. As of December 31, 2019, we had 241 construction loans in 21 states with 70 borrowers and nine development loans in four states with five borrowers.

 

Interest Spread

 

The following table displays a comparison of our interest income, expense, fees and spread for the years ended December 31, 2019 and 2018:

 

   2019   2018 
Interest Income        *         * 
Interest income on loans  $7,601    14%  $5,694    14%
Fee income on loans   2,530    5%   2,070    5%
Interest and fee income on loans   10,131    19%   7,764    19%
Interest expense – secured   2,948    6%   2,114    5%
Interest expense – unsecured   2,671    5%   1,998    4%
Offering costs expense   161    -%   184    1%
Interest expense   5,780    11%   4,296    10%
Net interest income (spread)   4,351    8%   3,468    9%
                     
Weighted average outstanding loan asset balance  $53,308        $41,341      

 

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

 

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

 

Difference between the interest rate received (on our loan assets) and the interest rate paid (on our borrowings). The loans we have originated have interest rates which are based on our cost of funds, with a minimum cost of funds of 7%. For most loans, the margin is fixed at 3%; however, for our development loans the margin is fixed at 7%. Loans originated prior to July 1, 2018 have a 2% margin. This component is also impacted by the lending of money with no interest cost (our equity). For the years ended December 31, 2019, the difference between interest income and interest expense was 3% compared to 4% as of the year ended December 31, 2018. The decrease relates to a 1% increase of interest in both our secured and unsecured borrowings which increased $7,618 to $53,511 which increased our average cost of funds to 10.81% for the year ended December 31, 2019 compared to 10.06% for the same period of 2018. In addition, during 2018 we had more loans paying default rate interest compared to 2019. Our average construction loan lasts for ten months, with a weighted average of twelve months. Those that go beyond twelve months pay a higher rate of interest, even though they are paying interest on time. The increase in secured and unsecured interest expense was offset by a 1% decrease in offering costs.

 

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Fee income. Our construction loans have a 5% fee on the amount that we commit to lend, which is amortized over the expected life of each of those loans; however, we do not recognize a loan fee on our development loans. When loans pay back quicker than their expected life, the remaining unrecognized fee is recognized upon the termination of the loan. Fee income was 5% for both 2019 and 2018, of the average outstanding balance on all loans. In the future, we anticipate that fee income will continue at the same historical rates.

 

Amount of nonperforming assets. Generally, we have two types of nonperforming assets that negatively affect interest spread which are loans not paying interest and foreclosed assets.

 

As of December 31, 2019, all loans were paying interest with the exception of four impaired loans which were classified as non-accruing compared to 23 impaired loans classified as non-accruing as of December 31, 2018.

 

Foreclosed assets do not provide a monthly interest return. During the year ended December 31, 2019 and December 31, 2018, we recorded $3,352 and $4,494, respectively, from loans receivables, net to foreclosed assets on the balance sheet which resulted in a negative impact on our interest spread.

 

Loan Loss Provision

 

We recorded $222 and $89 in the years ended December 31, 2019 and 2018, respectively. The provision was comprised of approximately $219 and $75 related to loans without specific reserves for the years ended December 31, 2019 and 2018, respectively. We anticipate that the collective and specific reserves will increase as our loan balances rise throughout 2020.

 

Non-Interest Income

 

We recognized foreclosed gains of $203 and $19 in the years ended December 31, 2019 and 2018, 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.

 

SG&A Expenses

 

The following table displays our SG&A expenses for the years ended December 31, 2019 and 2018:

 

   2019   2018 
Selling, general and administrative expenses          
Legal and accounting  $240   $340 
Salaries and related expenses   1,387    1,090 
Board related expenses   91    70 
Advertising   128    87 
Rent and utilities   57    37 
Loan and foreclosed asset expenses   211    150 
Travel   138    102 
Other   142    154 
Total SG&A  $2,394   $2,030 

 

Loss on the Sale of Foreclosed Assets

 

We recorded a loss on the sale of foreclosed assets of $274 and $103 for the years ended December 31, 2019 and 2018, respectively. During August 2019, we sold one of our foreclosed assets for sale proceeds of $4,543. During 2018, we sold two of our foreclosed assets located in Louisiana which resulted in the loss for that year.

 

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Impairment Loss on Foreclosed Assets

 

We recorded $558 and $515 for the years ended December 31, 2019 and 2018, respectively, in impairment losses of our foreclosed assets (real estate taken in foreclosure). These losses are primarily due to decreases in value or cost overruns in completion. We may incur additional impairment in 2020 either on our existing or acquired foreclosed assets.

 

Consolidated Financial Position

 

Cash and Cash Equivalents

 

We try to avoid borrowing on our lines 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, 2019 and 2018, we had $1,883 and $1,401, respectively, in cash. See our Liquidity and Capital Resources section for more information.

 

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, 2019:

 

State 

Number

of
Borrowers

  

Number

of
Loans

   Value of
Collateral(1)
   Commitment
Amount
  

Gross

Amount
Outstanding

  

Loan to
Value

Ratio(2)

   Loan Fee 
Colorado   1    1   $630   $425   $424    67%   5%
Connecticut   1    1    340    224    55    66%   5%
Florida   17    112    32,259    24,031    16,826    74%   5%
Georgia   3    4    2,085    1,343    917    64%   5%
Idaho   1    1    310    217    173    70%   5%
Indiana   2    3    1,687    1,083    383    64%   5%
Michigan   4    11    3,696    2,566    1,820    69%   5%
New Jersey   3    6    1,925    1,471    1,396    76%   5%
New York   2    3    1,370    940    743    69%   5%
North Carolina   6    20    5,790    4,009    2,471    69%   5%
Ohio   3    9    4,117    2,664    2,153    65%   5%
Oregon   1    2    1,137    796    739    70%   5%
Pennsylvania   3    24    20,791    13,322    11,772    64%   5%
South Carolina   11    25    8,809    6,419    4,786    73%   5%
Tennessee   3    4    1,367    1,069    503    78%   5%
Texas   3    4    1,984    1,270    843    64%   5%
Utah   2    4    1,862    1,389    1,000    75%   5%
Virginia   1    3    1,245    815    734    65%   5%
Washington   1    2    1,040    728    445    70%   5%
Wisconsin   1    1    539    332    285    62%   5%
Wyoming   1    1    228    160    143    70%   5%
Total   70    241   $93,211   $65,273   $48,611    70%(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.

 

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The following is a summary of our loan portfolio to builders for home construction loans as of December 31, 2018:

 

State 

Number

of
Borrowers

  

Number

of
Loans

   Value of
Collateral(1)
   Commitment
Amount
  

Gross

Amount
Outstanding

  

Loan to
Value

Ratio(2)

   Loan Fee 
Arizona   1    1   $1,140   $684   $214    60%   5%
Colorado   2    4    2,549    1,739    1,433    68%   5%
Florida   18    104    32,381    22,855    12,430    71%   5%
Georgia   5    6    5,868    3,744    2,861    64%   5%
Idaho   1    2    605    424    77    70%   5%
Indiana   2    5    1,567    1,097    790    70%   5%
Michigan   4    26    5,899    3,981    2,495    67%   5%
New Jersey   5    15    4,999    3,742    2,820    75%   5%
New York   2    4    1,555    1,089    738    70%   5%
North Carolina   5    12    3,748    2,580    1,712    69%   5%
North Dakota   1    1    375    263    227    70%   5%
Ohio   2    3    3,220    1,960    1,543    61%   5%
Pennsylvania   3    34    24,808    14,441    10,087