**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

| **(Mark One)** |                                                                                                                                                                                  |
|----------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**          | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                  |
| ** **     | **For the fiscal year ended December 31, 2005**                                                                                                                                  |
| ** **     | **OR**                                                                                                                                                                                |
| **o**          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                              |
| ** **     | **For the transition period from                         to** |
| ** **     | **Commission file number: 0-17189**                                                                                                                                                   |

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

**(Exact name of registrant as specifiedin its charter)**

| **Delaware**                              | **02-0426634**       |
|-------------------------------------------|----------------------|
| (State or other  jurisdiction of          | (I.R.S. Employer     |
| incorporation or organization)            | Identification  No.) |
| **6 Executive Circle, Suite 250**    | **92614**            |
| **Irvine,  California**                   | (Zip Code)           |
| (Address of principal  executive offices) | ** **           |

 

Registrant’s telephone number, including area code:**(949) 250-7700**

Securities registered pursuant to Section 12(b) ofthe Act: **NONE**

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, par value $.05 per share**(Title of Class)

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. YES o  NO x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. YES o  NO x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES x  NO o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  YES x  NO o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

| **Large accelerated filer  ****o** |   | **Accelerated  filer ****x** |   | **Non-accelerated  filer ****o** |
|-----------------------------------------|--------|-----------------------------------|--------|---------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). YES o  NO x

The aggregate market value of the voting stock held bynon-affiliates of the registrant as of March 6, 2006 was$193,739,251.

The number of shares of Common Stock outstanding as of March 6,2006 was 10,160,212.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portions of the registrant’sProxy Statement for the 2006 Annual Meeting of Stockholders are incorporated byreference into Part III of this Annual Report on Form 10-K.

 

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**CALIFORNIA COASTAL COMMUNITIES, INC.FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2005INDEX**

|            | ** ** | ** **                                                                                                         | ** ** | **Page No.** |
|------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| ** ** |       | **PART I**                                                                                                    |       |              |
| Item 1.    |       | Business                                                                                                           |       | 2                 |
| Item 1A.   |       | Risk Factors                                                                                                       |       | 13                |
| Item 1B.   |       | Unresolved Staff Comments                                                                                          |       | 19                |
| Item 2.    |       | Properties                                                                                                         |       | 19                |
| Item 3.    |       | Legal Proceedings                                                                                                  |       | 19                |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                |       | 20                |
| ** ** | ** ** | **PART II**                                                                                                   | ** ** | ** **        |
| Item 5.    |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 21                |
| Item 6.    |       | Selected  Financial Data                                                                                           |       | 21                |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       | 21                |
| Item 7A.   |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       | 21                |
| Item 8.    |       | Financial Statements and Supplementary Data                                                                        |       | 21                |
| Item 9.    |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       | 21                |
| Item 9A.   |       | Controls and Procedures                                                                                            |       | 22                |
| Item 9B.   |       | Other  Information                                                                                                 |       | 26                |
| ** ** | ** ** | **PART III**                                                                                                  | ** ** | ** **        |
| Item 10.   |       | Directors and Executive Officers of the Registrant                                                                 |       | 26                |
| Item 11.   |       | Executive Compensation                                                                                             |       | 26                |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |       | 26                |
| Item 13.   |       | Certain Relationships and Related Transactions                                                                     |       | 26                |
| Item 14.   |       | Principal Accounting Fees and Services                                                                             |       | 26                |
| ** ** | ** ** | **PART IV**                                                                                                   | ** ** | ** **        |
| Item 15.   |       | Exhibits, Financial Statement Schedules                                                                            |       | 27                |

 

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**PART I**

**Item 1.**                        Business

**Overviewof California Coastal Communities, Inc.**

We are aresidential land development and homebuilding company with properties owned orcontrolled in six Southern California counties (Los Angeles, Orange, Riverside,San Bernardino, San Diego and Ventura). Our principal activities include:

·       obtainingzoning and other entitlements for land we own or control through purchaseoptions or joint ventures;

·       improvingthe land for residential development; and

·       designing,constructing and selling single-family homes in Southern California.

Once ourresidential land is entitled, we may build homes, sell unimproved land to otherdevelopers or homebuilders, sell improved land to homebuilders, or participatein joint ventures with other developers, investors or homebuilders to financeand construct infrastructure and homes. The majority of these homes aredesigned to appeal to move-up homebuyers and are generally offered for sale inadvance of their construction. During 2006, we will focus our primary effortsto:

·       begingrading and building model homes for our Brightwater project located on theupper bench of the Bolsa Chica mesa in Orange County, California  in accordance with the Coastal DevelopmentPermit for 349 homes issued by the California Coastal Commission in December 2005;

·       completethe entitlement process for a 168-acre joint venture project near Oxnard,California; and

·       continueto expand our profitable homebuilding operations throughout SouthernCalifornia.

However, we may also consider other strategic andjoint venture opportunities; and there can be no assurance that we willaccomplish, in whole or in part, all or any of these strategic goals.

Our total revenues for the years ended December 31,2005, 2004, and 2003 were $129.5 million, $76.0 million, and $55.8 million,respectively. Our total assets as of December 31, 2005 and 2004 were$330.4 million and $250.8 million, respectively. For the years ended December 31,2005, 2004, and 2003, we delivered 113, 135, and 154 homes. Over the last tenyears, we have delivered over 1,800 homes to families throughout SouthernCalifornia.

We were formed in 1988 andour executive offices are located at 6 Executive Circle, Suite 250,Irvine, California 92614. Our telephone number is (949) 250-7700.

**Our Current and Future Homesites**

We currently haveon-going Southern California homebuilding projects in:

·       RiversideCounty near the cities of Corona, North Corona and Riverside, and in the Cityof Beaumont;

·       SanBernardino County in the City of Ontario;

·       NorthernLos Angeles County in the City of Lancaster; and

·       SanDiego County in the Rancho Santa Fe area.

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Weexpect to begin grading our Brightwater development project during the secondquarter of 2006 and plan to process permits for seven homes on adjacentparcels, which would bring the total unit count up to 356. The following chartdescribes our current projects, their location and our year-end lotinventories:

| **Project**         | ** ** | ** **                    | ** ** | ** ** | **Location** | ** ** | ** ** | **12/31/05  Lot  Inventory** |
|---------------------|------------|-------------------------------|------------|------------|--------------|------------|------------|------------------------------|
| Chandler Ranch      |       | North Corona                  |       | 83         |
| Jasper Ranch        |       | Riverside                     |       | 1          |
| Alisal at Ontario   |       | Ontario                       |       | 26         |
| Woodhaven           |       | Beaumont                      |       | 102        |
| Hearthside Lane     |       | Corona                        |       | 151        |
|                | * *   | *Subtotal—Inland Empire* |       | 363        |
| Alisal at Lancaster |       | Lancaster                     |       | 49         |
| Lancaster II        |       | Lancaster                     |       | 72         |
| Quartz Hill         |       | Lancaster                     |       | 77         |
|                | * *   | *Subtotal - Lancaster*        |       | 198        |
| Cancion             |       | Rancho Santa Fe               |       | 26         |
| Brightwater         |       | Bolsa Chica                   |       | 356        |
|                |       |                          |       | 943        |

 

These homebuildingprojects are currently expected to generate cash flows and gross operatingmargins through mid-2009. We will continue to pursue residential lot acquisitionopportunities throughout Southern California, including increasing our lotinventory in existing successful submarkets and expanding into additionalsubmarkets. Up to approximately 555 additional single-family lots would beavailable for homebuilding operations if we obtain entitlements for our Oxnardproject; however, the exact number of homes will be dependent upon the finaloutcome of the entitlement process.

*Brightwater atBolsa Chica*

The Bolsa Chica upper mesa is the largest property inour portfolio, representing 40% of our total assets as of December 31,2005. The Bolsa Chica upper mesa is one of the last large undeveloped coastalproperties in Southern California, and is located in Orange County,approximately 35 miles south of downtown Los Angeles. Bolsa Chica is borderedon the north and east by residential development in the City of HuntingtonBeach, to the south by open space and the Bolsa Chica wetlands, and to the westby open space, Pacific Coast Highway, Bolsa Chica State Beach, and the PacificOcean. Our holdings include 68 acres of developable land on the Bolsa Chicaupper mesa planned for a residential community known as Brightwater, 37 acresof open space and conservation area in the planned community, five acres in theCity of Huntington Beach which are currently zoned agricultural, andapproximately 104 non-developable acres on, or adjacent to, the HuntingtonMesa. We are analyzing development alternatives for the 5-acre HuntingtonBeach parcel and expect to submit a proposed site plan later this year.

On December 15,2005, we received a permit from the California Coastal Commission fordevelopment of the 349-home Brightwater residential community, which willoffer a broad mix of home choices averaging 2,800 square feet and ranging insize from 1,700 square feet to 4,100 square feet. We expect to:

·       begingrading during the second quarter of 2006,

·       beginbuilding model homes during the third quarter of 2006, and

·       startselling homes during the second quarter of 2007.

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However, there can be no assurance in that regard, oras to the absence of further delays.

Our Brightwater plan also includes 37 acres of openspace and conservation area. With 349 homes on 68 acres of the upper mesa, theresulting low-density plan equates to approximately five homes per acre,consistent and compatible with the neighboring Huntington Beach communities. Inaddition, we own land adjacent to the planned Brightwater development, forwhich we intend to process permits to build seven additional homes which wouldbe included in the Brightwater community. Approximately 51 acres of land on theHuntington Mesa have been offered for dedication to the County of Orange forinclusion in the Harriet M. Weider Linear Park in conjunction with thedevelopment of Brightwater.

On December 21, 2005, we completed the sale of a103-acre parcel on the lower portion of the Bolsa Chica mesa to the Stateof California’s Wildlife Conservation Board for $65 million. The sale wasapproved by our stockholders at the August 11, 2005 Annual Meeting. Wealso completed the sale of 43 acres in the Bolsa Chica lowlands to theCalifornia State Lands Commission in December 2005 for $1.7 million. Oursubsidiary received net proceeds of $923,000, after using $798,000 to reimbursethe State for remediation costs, which were previously accrued.

During the first quarter of 2005, following theCoastal Commission’s conditional approval of our permit to develop Brightwater,we concluded that it is more likely than not that we will utilize all of our deferredtax assets, including net operating losses, to offset future taxable income. Asa result, we recorded a $4.7 million reversal of valuation allowances onpost-reorganization net operating losses and other deferred tax assets and a$38.5 million reversal of valuation allowance on federal pre-reorganization netoperating losses. See Note 8 in our financial statements included in thisAnnual Report.

We used thefollowing facts and assumptions in evaluating the value that we expect toreceive from the Brightwater development project:

·       TheBrightwater development permit provides for 349 homes aggregating approximately980,000 square feet.

·       Weown land adjacent to Brightwater, for which we intend to process permits tobuild seven additional homes which would be included in the Brightwatercommunity.

·       Developmentat Brightwater is projected to take approximately six months for infrastructureand two to three years for home construction.

·       Weare currently planning to: (i) begin grading during the second quarter of2006, (ii) begin building model homes during the third quarter of 2006, (iii) startselling homes during the second quarter of 2007, and (iv) start deliveringhomes in the fourth quarter of 2007.

·       Asof January 2006, new home prices approximate $650 per square foot,including view and other premiums, in the local residential market (coastalHuntington Beach).

·       Thefinished lot component of home prices ranges from 60% to 65%.

·       Coststo improve the lots from their raw condition to finished lots, includingbuilding permits and city fees, approximate $140,000 per lot.

·       Homeprices in the coastal Huntington Beach area (as well as other Orange Countycoastal areas) appreciated approximately 20% during 2005. While demandcontinues to exceed the supply of housing, pressure for continued appreciationof home prices may be reduced by any significant increases in interest rates.

The estimation processinvolved in the determination of value is inherently uncertain because itrequires estimates as to future events and market conditions. This estimationprocess assumes our ability to complete development and disposition of our realestate properties in the ordinary course of business 

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based onmanagement’s present plans and intentions. Economic, market, and environmentalconditions may affect our development and marketing plans. In addition, theimplementation of such development and marketing plans could be affected by theavailability of future financing for development and construction activities.The development of the Bolsa Chica upper mesa project is dependent upon variouseconomic factors. Accordingly, the amount ultimately realized from theBrightwater project may differ materially from our current estimates and theproject’s carrying value.

*Oxnard Land Development—UnconsolidatedJoint Venture*

In February 2003, we entered into two optioncontracts to acquire land adjacent to the City of Oxnard in Ventura County,California aggregating approximately 168 acres. We are in the process ofdeveloping a land plan for the area, which also includes an additional 149acres owned by other landowners, with the intention of entitling the propertyfor residential development and annexing it into Oxnard. We currently expectthe residential development plan to include approximately 800 single-familydetached lots and approximately 750 attached family residential units(townhomes, condominiums, and apartments); however, these numbers are subjectto change during the course of the entitlement process. Approximately 555 ofthe single-family lots and 490 of the attached units would be developed on the168 acres of optioned land that we currently expect to purchase. The optioncontracts give us two years, plus up to three additional years through theexercise of extensions, to complete these entitlement activities beforepurchasing the land. We have the right to terminate these option agreements byforfeiting the cash deposits. We are striving to complete the entitlementprocess by the end of 2006; however, delays could be encountered. We exercisedsix-month extensions in January and July 2005, and in January 2006.

During October 2003,we entered into a limited liability company joint venture agreement with amajor financial partner to pursue the Oxnard development opportunity. We assignedthe land purchase option contracts to the Oxnard limited liability company.Hearthside Homes, Inc., our homebuilding subsidiary, is the managingmember of the Oxnard joint venture, and made an initial contribution of$500,000. The non-managing member also made an initial contribution of $500,000to the joint venture and, as of December 31, 2005, had made an aggregateof $4 million of first tier additional contributions. The members have agreedto provide a second tier of additional capital contributions of up to $3million, as necessary, to complete the business plan. For contributions inexcess of $5 million, the first $500,000 is to be contributed equally by us andour partner. At our discretion, we could continue to contribute equally to thenext $500,000. Thereafter, the next $2 million is to be contributed equallybetween us. During the fourth quarter of 2005, we each contributedapproximately $160,000 of the additional $3 million. We expect to makeadditional aggregate capital contributions of approximately $1.3 million to thejoint venture during 2006. After payment of a 10% preferred return on investedcapital to us and our partner, first tier profits are generally allocated 75%to our partner and 25% to us and second tier profits and losses over $5 millionare generally allocated on a 50/50 basis. The first $5 million of losses aregenerally allocated 80% to our partner and 20% to us. While we exert a largedegree of influence over the joint venture, our partner does have varioussubstantive participating rights such as approval rights with regard to themajority of business decisions, including approval of project budgets.

*Homebuilding*

We acquired 699 single-family residential lots during2004 and 2005, which increased inventory in our existing markets in Riversideand San Bernardino counties, expanded into northern Los Angeles County andreturned us to the San Diego County market. Although home prices in SouthernCalifornia have increased 20% to 30% annually over the last few years, we donot expect appreciation to continue at that rate, but rather expect modestincreases of less than 10% over the next year. The record rainfall during thefourth quarter of 2004 and the first quarter of 2005 negatively impacted ourconstruction schedule and contributed to our lower number of home deliveries in2005.

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Ourhomebuilding projects are described below:

| ** **            | ** ** | ** **             | ** ** | **Land**        | ** ** | **Commenced**    | ** ** | **Commenced** | ** ** | **Deliveries** | ** ** |
|-----------------------|------------|------------------------|------------|-----------------|------------|------------------|------------|---------------|------------|----------------|------------|
| ** **            | ** ** | **Location**           | ** ** | **Acquisition** | ** ** | **Construction** | ** ** | **Sales**     | ** ** | **2003**       | ** ** | **2004** | ** ** | **2005** | ** ** |
| *Completed  Projects* |       | Various                |       | n/a             |       |             | n/a        |          |       |           | n/a        |   |   |   | 154 |   |   |   | 135 |   |   |   | 52 | * * |   |
| *Active  Projects*    |       |                   |       |            |       |             |       |          |       |           |       |   |   |   |   |   |   |   |   |   |   |   |   | * * |   |
| Chandler Ranch        |       | North Corona      |       | 2004            |       |             | 2005       |          |       |           | 2005       |   |   |   | — |   |   |   | — |   |   |   | — | * * |   |
| Cancion               |       | Rancho   Santa Fe |       | 2003-2005       |       |             | 2005       |          |       |           | 2005       |   |   |   | — |   |   |   | — |   |   |   | 6 | * * |   |
| Alisal at  Lancaster  |       | Lancaster              |       | 2004            |       |             | 2004       |          |       |           | 2005       |   |   |   | — |   |   |   | — |   |   |   | 55 | * * |   |
| Alisal at Ontario     |       | Ontario                |       | 2005            |       |             | 2005       |          |       |           | 2006       | (a) |   |   | — |   |   |   | — |   |   |   | — | * * |   |
| Woodhaven             |       | Beaumont               |       | 2005            |       |             | 2005       |          |       |           | 2006       | (a) |   |   | — |   |   |   | — |   |   |   | — | * * |   |
| Hearthside Lane       |       | Corona                 |       | 2005            |       |             | 2005       |          |       |           | 2006       | (a) |   |   | — |   |   |   | — |   |   |   | — | * * |   |
| Quartz Hill           |       | Lancaster              |       | 2005            |       |             | 2006       | (a)           |       |           | 2006       | (a) |   |   | — |   |   |   | — |   |   |   | — | * * |   |
| Brightwater           |       | Bolsa Chica       |       | 1970            |       |             | 2006       | (a)           |       |           | 2007       | (a) |   |   | — |   |   |   | — |   |   |   | — | * * |   |
|                  |       |                   |       |            |       |             |       |          |       |           |       |   |   |   | 154 |   |   |   | 135 |   |   |   | 113 | * * |   |

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(a)           Pending

*Riverside.*   During2003 and 2004, we acquired 67 lots for a project known as “Jasper Ranch” nearthe City of Riverside, in the master-planned community known as “VictoriaGrove.”  We began construction of homesaveraging 3,673 square feet during the third quarter of 2003 and opened forsales on these homes during June 2003. We delivered the first phase offive homes during the fourth quarter of 2003 at an average price ofapproximately $468,000, and an additional 38 homes during 2004, at an averageprice of approximately $612,000. We delivered 23 homes during 2005 at anaverage price of $694,000, and the remaining home is in escrow as of February 28,2006.

*Chino.**  *In May 2003, through a consolidated jointventure, we acquired 77 finished lots in Chino, California in San BernardinoCounty. This infill site is part of a new community known as The Reserve, whichencompasses 244 homes. We began construction of homes averaging approximately3,320 square feet during the fourth quarter of 2003 and opened for home salesin February 2004.  During 2004, wedelivered 65 homes at an average price of $593,000, and delivered the remaining12 homes at an average price of $622,000 during 2005.

During January 2004, we acquired 17 additionalfinished lots in the City of Chino which are near, but not a part of TheReserve, and are not a part of the joint venture described above. We beganconstruction of homes averaging 2,990 square feet during the fourth quarter of2004. We opened for sales at this project during January 2005 anddelivered all 17 homes during 2005 at an average price of $568,000.

*RanchoSanta Fe.**  *In October 2003,we entered into an agreement to acquire 32 lots in a luxury golf communityknown as Crosby Estates in the Rancho Santa Fe area of San Diego County inCalifornia. We acquired eight of the lots during the fourth quarter of 2003, 18additional lots during 2004 and the final six lots during March 2005. During2005, two model homes averaging approximately 3,370 square feet were completedand six homes were delivered at an average price of $1,223,000. As of February 28,2006, 20 homes are in escrow at an average price of $1,340,000, and fouradditional homes are under construction and held for sale.

*Lancaster.**  *We acquired 104 lots in the City of Lancaster innorthern Los Angeles County during May 2004. We began construction ofmodel homes averaging approximately 2,800 square feet during the third quarterof 2004 and opened for home sales in January 2005. During 2005, wedelivered 55 homes at an average price of $406,000. As of February 28,2006, 25 homes are in escrow at an average price of $443,000, and eight homesare under construction and held for sale. In April 2005, we acquired anadditional 72 lots in Lancaster, which will be marketed through the existingmodel homes.

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In December 2005, we acquired 77 additional lotsin an area known as Quartz Hill in the City of Lancaster. The homes in thiscommunity will be on 10,000 square foot lots and are currently planned toaverage 3,605 square feet. We expect to begin construction of models during thefirst quarter of 2006 and open for sales during the second quarter of 2006.

*Corona.**  *We acquired 83 lots in North Corona in May 2004.Following construction of infrastructure, during April 2005, we beganconstruction of homes averaging 3,160 square feet. We opened for sales duringthe third quarter of 2005 and delivered 24 homes during January and February 2006at an average price of $583,000. As of February 28, 2006, 21 homes are inescrow at an average price of $607,000, and 11 additional homes are underconstruction and have been released for sale.

During April 2005, we acquired 151 lots in Corona.Following construction of infrastructure, construction of homes averaging 3,583square feet is expected to begin during the second quarter of 2006.

*Ontario.**  *During April 2005, we acquired 26 lots in theCity of Ontario in Riverside County, California. This small community of homes,planned to average 3,380 square feet, is an infill site situated very close toour projects in the City of Chino. Construction began during the fourth quarterof 2005, and sales are expected to begin during the first quarter of 2006.

*Beaumont.*   Weacquired 102 lots in the City of Beaumont during the third quarter of 2005.Following construction of infrastructure, construction of homes averaging 2,518square feet began during the first quarter of 2006, and sales are expected tocommence during the first quarter of 2006.

**Joint Ventures**

We conduct our operationsas either wholly-owned projects or through joint ventures in which the jointventure partner typically provides more than a majority of the capital and/orfinancing required for the project. We have utilized joint ventures in order toincrease access to sources of capital, financing and land. We expect tocontinue to utilize joint ventures in the future on a selective basis, takinginto account other available sources of financing, project risk and the potentialreturn to us. The use of joint ventures may vary in the future in order toenable us to control an adequate supply of lots while minimizing capitalcommitments. We typically are required to fund a small percentage of thecapital requirements of each joint venture, which amount is included in otherassets in our consolidated balance sheets.

**Land Acquisition**

We typically considernumerous factors when analyzing the suitability of land for acquisition anddevelopment including, but not limited to: proximity to existing developedareas, population growth patterns, availability of existing community services(i.e. utilities, schools and transportation), employment growth rates,anticipated absorption rates for new housing, and the estimated cost of development.We try to avoid speculative building by constraining project phase sizes, andentitlement risks by acquiring entitled land when practicable and acquiringlots through the use of options, development agreements and joint ventures withlot owners, when available on favorable terms. Additionally, by forming jointventures with various sources of capital, we have been able to obtain access toadditional capital and construction financing to expand the number of lots wecontrol and to spread project risk.

**Strategic Alternatives**

From time to time we haveconsidered the various strategic alternatives available to us with respect toour businesses, assets, operations and available cash. We have engagedinvestment bankers and other advisors for this purpose, with a view towardsassessing alternatives which would enhance the value of our current businesses,create additional business opportunities, or otherwise maximize the value ofour company for our stockholders. Included in this process has been anexploration of merger, acquisition and 

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dispositionpossibilities; analysis of equity and debt financings, open market and otherrepurchases of our stock; dividends to our stockholders; and combinations ofthese alternatives. At this time our board of directors has not made adetermination with respect to any of the forgoing, and we will continue toevaluate our strategy to position the company to maximize value to ourstockholders.

**Product Design**

We contract with a number of outside architects,designers, engineers, consultants and subcontractors. We believe that the useof third parties for the production of the final design, engineering andconstruction reduces our costs, increases design innovation and quality, andreduces risks. We have a number of plans which we have used in various projectswhich can be re-used in new projects with appropriate modifications asnecessary. We offer options and upgrades to provide our homebuyers withopportunities to customize their home to fit their lifestyle. The extent ofsuch options and upgrades varies depending upon the project. However,structural and other changes which impact the build time of the home aretypically limited.

We create architecturalvariety within our projects by offering numerous models, floor plans, and exteriorstyles in an effort to enhance home values by creating diversified neighborhoodappearances within our projects. The majority of these homes are designed toappeal to move-up homebuyers and are generally offered for sale in advance oftheir construction. Generally, we select the exterior finishes of our homessubject to necessary architectural approvals. We offer homebuyers theopportunity to engage interior design consultants to personalize the interiorof their homes. These services are offered at an additional cost to buyersthrough third parties contracted with by us, or the services may be providedthrough the homebuyer’s own consultants.

**Construction and Development**

We act as the general contractor for the constructionof our projects. All of our construction work is performed by subcontractors.Our employees coordinate the construction of each project and the activities ofsubcontractors and suppliers, and subject their work to quality and costcontrols and compliance with zoning and building codes. Subcontractorstypically are retained on a phase-by-phase basis to complete construction at afixed price. Agreements with our subcontractors are generally entered intoafter competitive bidding on a project-by-project basis. We have establishedrelationships with a large number of subcontractors and we are not dependent toany material degree upon the services of any one subcontractor. Decreasingavailability of insurance coverage for subcontractors, as well as the effectsof increased worker’s compensation insurance rates, may have an adverse effecton the availability of qualified subcontractors.

We develop our residentialprojects in several phases generally averaging approximately six to 20 homesper phase. We determine the number of homes to be built in the first phase andthe appropriate price range. The first phase of home construction is typicallyrelatively small to reduce risk while we measure consumer demand. Constructiongenerally does not begin until some sales have occurred, except for constructionof model homes and in some cases the first few additional homes. Subsequentphases are generally not started until 90% to 100% of the homes in the previousphase have been sold. Sales prices in the second phase are then adjusted toreflect market demand as evidenced by sales experience in the first phase. Witheach subsequent phase, we continue to accumulate data which enables us to makedecisions on the pricing, timing and size of subsequent phases. Although thetime required to complete a phase varies from development to developmentdepending on the factors above and the build time, which in turn variesgenerally with the size and complexity of the home, we typically completeconstruction of a phase within one of our developments in approximately five toeight months. We are continuously developing and refining our productionpractices in order to reduce cycle time within the construction process.

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**Sales and Marketing**

We typically build, furnish and landscape model homesfor each residential project and maintain on-site sales offices, which areusually open seven days a week once a project fully opens. We generally sellall of our homes through our sales representatives working from the salesoffices located at the model homes used in each subdivision. When appropriate,we also use cooperative brokers to sell our homes. We conduct preliminaryresearch concerning the credit status of each potential homebuyer in order to “pre-qualify”the homebuyer. Once the prospective homebuyer has been “pre-qualified” andthere is a strong indication that the homebuyer will qualify for a mortgage(although final loan approval is still pending), the homebuyer must submit an “earnestmoney deposit” usually ranging from $4,000 to $30,000 and complete a purchasecontract for the purchase of their home. We attempt to keep our contractcancellation rate low by attempting to pre-qualify prospective homebuyers andby allowing homebuyers to customize their homes at an early point in thepurchase process. When home purchase contracts are canceled, we seek toidentify alternative homebuyers.

We make extensive use ofadvertising and promotional resources, including newspaper and magazineadvertisements, brochures, direct mail and the placement of strategicallylocated signs. Because our projects are often within a multi-builder community,we are able to participate in community-wide advertising that highlights all ofthe projects within the same community. We provide flooring and other amenitiesand upgrades to our homebuyers through the various vendors with which wecontract.

**Backlog**

Backlog represents the number of our homes that areunder sales contracts. All of the homes in backlog as of December 31, 2005are expected to be delivered during fiscal 2006. Sales of our homes are made pursuantto standard sales contracts, which require a customer deposit at the time ofexecution. We generally permit customers to cancel their obligations and obtainrefunds of all or a portion of their deposits if they are unable to close onthe sale of their existing home, fail to qualify for financing or under certainother circumstances. A home sale is placed in backlog status upon execution ofsuch a contract and receipt of an earnest money deposit and is removed whensuch contracts are canceled as described above, or the home purchase escrow isclosed. We do not recognize revenue on homes under sales contracts until thesales are closed and title passes to the new homeowners.

Our backlog at December 31,2005 reached 82 units, up 1,071% from the seven backlog units at year-end2004. The aggregate sales value of our backlog was $53.9 million at December 31,2005. Our backlog ratio was 48% for the fourth quarter of 2005 and 102% for thefourth quarter of 2004. Backlog ratio is defined as unit deliveries as apercentage of beginning backlog in the quarter. In addition, deliveries of newhomes typically increase from the first to the fourth quarter in any year.

**Competition**

The home building industry is highly competitive andfragmented. We do not have a significant market presence in any of thegeographic areas where we are currently building homes or where we expect tobuild homes in the future. Most of our competitors have substantially greaterfinancial resources than we do, and they have much larger staffs and marketingorganizations. However, we believe  wecompete effectively in our existing markets as a result of our product design,development expertise, and our reputation as a producer of quality homes. Wehave seen the financial resources of our competitors increase as a result ofthe industry consolidation experienced in the past few years. As we enter anduntil we develop a reputation in a new market area, we expect to face even moresignificant competitive pressures. We compete for homebuyers on the basis of anumber of interrelated factors including location, price, reputation, amenities,design, quality and financing. In addition to competition for homebuyers, wealso compete with other homebuilders for desirable properties, raw materialsand reliable, skilled labor.

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**Regulation**

The housing and land development industries aresubject to increasing environmental, building, zoning and real estate salesregulations by various federal, state and local authorities. Such regulationsaffect home building by specifying, among other things, the type and quality ofbuilding materials that must be used, certain aspects of land use and buildingdesign, as well as the manner in which we conduct sales activities andotherwise deal with our customers. Such regulations affect developmentactivities by directly affecting the viability and timing of projects.

We must obtain the approval of numerous governmentauthorities which regulate such matters as land use and level of density, theinstallation of utility services, such as water and waste disposal, and thededication of acreage for open space, parks, schools and other communitypurposes. If these authorities determine that existing utility services willnot adequately support proposed development (including possibly in ongoingprojects), building moratoria may be imposed. As a result, we devote anincreasing amount of time to evaluating the impact of governmental restrictionsimposed upon a new residential development. Furthermore, as local circumstancesor applicable laws change, we may be required to obtain additional approvals ormodifications of approvals previously obtained or even stop all work. Theseincreasing regulations may result in a significant increase in time (andrelated carrying costs) between our initial acquisition of land and thecommencement and completion of our developments. In addition, the extent towhich we participate in land development activities subjects us to greaterexposure to regulatory risks.

The residentialhomebuilding industry is also subject to a variety of local, state, and federalstatutes, ordinances, rules, and regulations concerning the protection ofhealth and the environment. These environmental laws include such areas asstorm water and surface water management, soil, groundwater and wetlands protection,subsurface conditions and air quality protection and enhancement. Environmentallaws and existing conditions may result in delays, may cause us to incursubstantial compliance and other costs and may prohibit or severely restricthomebuilding activity in environmentally sensitive regions or areas.

**Raw Materials**

Typically all the rawmaterials and most of the components used in our business are readily availablein the United States. Most are standard items carried by major suppliers.However, a rapid increase in the number of homes started could cause shortagesin the availability of such materials or in the price of services, therebyleading to delays in the delivery of homes under construction. In addition,increases in the price of lumber and other materials have a negative impact onmargins. In the last 12 months, we have experienced some delays, shortages andprice increases for many raw materials components. Notably, lumber, concrete,plastic and drywall products have been significantly affected in both price andavailability, in part due to the ongoing rebuilding efforts in the areasaffected by Hurricane Katrina in 2005. We have minimized the delays based onour long-term relationships with subcontractors and suppliers.

**Homeowner Warranty**

We provide homeowners witha limited warranty for the items listed in the homeowner warranty manual, whichdoes not include items that are covered by manufacturers’ warranties (such asappliances and air conditioning) or items that are not installed by our employeesor contractors (such as flooring installed by an outside contractor employed bythe homeowner). Statutory requirements in California may grant homebuyersrights in addition to those that we provide.

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**Mortgage Company Services**

We offer mortgage brokerservices to our homebuyers through an unconsolidated joint venture with anaffiliate of Wells Fargo Home Mortgage. We are not a lender under thisarrangement, as we merely provide access to Wells Fargo as a source of homefinancing. The sales of our homes are not conditioned on using thisarrangement.

**Environmentaland Regulatory Matters**

Before we can develop a property, we must obtain avariety of discretionary approvals from local and state governments, as well asthe federal government in certain circumstances, with respect to such mattersas zoning, subdivision, grading, architecture and environmental matters. Theentitlement approval process is often a lengthy and complex procedurerequiring, among other things, the submission of development plans and reportsand presentations at public hearings. Because of the provisional nature ofthese approvals and the concerns of various environmental and public interestgroups, the approval process can be delayed by withdrawals or modifications ofpreliminary approvals and by litigation and appeals challenging developmentrights. Accordingly, our ability to develop properties and realize income fromsuch projects could be delayed or prevented due to litigation challengingpreviously obtained governmental approvals. We may also be subject to periodicdelays or may be precluded entirely from developing in certain communities dueto building moratoriums or “slow-growth” or “no-growth” initiatives that couldbe implemented in the future.

In December 2005, we received our permit to buildthe 349-home Brightwater community on the upper mesa of Bolsa Chica nextto Huntington Beach, California, from the Coastal Commission. We currentlyexpect to obtain a grading permit from the County of Orange and begin gradingduring the second quarter of 2006; however, there can be no assurance thatdelays will not be encountered.

We have expended and willcontinue to expend significant financial and managerial resources forcompliance with environmental regulations and local permitting requirements.Although we believe  our operations aregenerally in compliance with applicable environmental regulations, certainrisks of unknown costs and liabilities are inherent in developing and owningreal estate. We do not believe that such costs will have a material adverseeffect on our business, financial condition or results of operations. Thecurrently identifiable risks and uncertainties regarding other matters arediscussed below in “Item 3. Legal Proceedings” and in “Note 7—Other Liabilities”to the financial statements included in this Annual Report.

**Corporate Indemnification Matters**

We, and our predecessorand affiliated companies, have disposed of numerous assets and businesses since1986. Most of these dispositions have involved businesses that are unrelated toour current operations. By operation of law or contractual indemnityprovisions, we may have retained liabilities relating to certain of theseassets and businesses. There is generally no maximum obligation or amount ofindemnity provided for these liabilities. A portion of these liabilities issupported by insurance or by indemnities from certain of our previouslyaffiliated companies. We believe our balance sheet reflects adequate reservesfor these matters. More information on our contingent indemnity andenvironmental obligations is contained in “Item 3. Legal Proceedings” and “Note7—Other Liabilities”  in the financialstatements included in this Annual Report.

**Employees**

As of February 28,2006 we and our subsidiary companies had 64 employees. We believe that ourrelations with our employees are good. No employees are represented by acollective bargaining agreement.

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**Seasonality**

The rate of orders for newhomes is highly dependent on the number of active communities and the timing ofnew community openings. We have typically delivered a greater percentage ofhomes in the second half of the fiscal year compared with the first half. Inrecent years, this has been due in part to the timing of land acquisitions andthe ensuing course of development and construction required prior to deliveringhomes. During 2003 through 2005, the majority of lot acquisitions werecompleted during the second quarter and were followed by off-site and on-siteinfrastructure and construction of models prior to the start of production ofhomes. In addition, the number of homes sold during the spring and summermonths is typically greater than other periods during the year and new homedeliveries trail orders for new homes by up to six months. In the years ended December 31,2005, 2004, and 2003, 88%, 85%, and 73% of homes delivered during therespective year were delivered in the last two quarters of the year. As aresult, our revenues and operating earnings from sales of homes have beensignificantly higher in the second half of our fiscal year.

**Available Information**

We file annual, quarterly and special reports, proxystatements and other information with the Securities and Exchange Commission.Our SEC filings are available to the public over the Internet at the SEC’swebsite at http://www.sec.gov. The public may also read and copy any documentwe file at the SEC’s public reference room located at 100 F Street, N.E.,Washington D.C. 20549. Please call the SEC at 1-800-SEC-0330for further information on the operation of the public reference room.

We encourage the public to read our periodic andcurrent reports. We think these reports provide additional information whichprudent investors will find important. A copy of these filings as well as anyfuture filings may be obtained, at no cost, by writing to our investorrelations representative: Shareholder Services, 225 West Station Drive, Suite 545,Pittsburgh, PA 15219. Information about our homebuilding subsidiary and limitedinformation about us can also be found at http://www.hearthside-homes.com.

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**Item 1A.**                RiskFactors

In addition to the risks previously mentioned, thefollowing important risk factors could adversely impact our business. Theserisk factors could cause our actual results to differ materially from theforward-looking and other statements that we make in periodic reports and otherfilings with the SEC, and that we make from time to time in our news releases,annual reports and other written communications, as well as other statementsmade from time to time by our representatives. If any of the following risksdevelop into actual events, our business, financial condition, results ofoperations, cash flows, strategies and prospects could be materially adverselyaffected:

***Factors may affect our futureresults (Cautionary Statements Under the Private Securities Litigation ReformAct of 1995).***

Certain informationincluded in this report or in other materials we have filed or will file withthe SEC (as well as information included in oral statements or other writtenstatements made or to be made by us) contains or may contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended. You can identify these statements by the fact that they donot relate strictly to historical or current facts. They contain words such as “anticipate,”“estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “may,” “can,” “could,”“might” and other words or phrases of similar meaning in connection with anydiscussion of future operating or financial performance. These forward-lookingstatements include, but are not limited to:

·       statementsabout our strategies, plans, objectives, goals, expectations and intentions;

·       informationrelating to anticipated operating results, financial resources, changes inrevenues, changes in profitability, interest expense, growth and expansion,anticipated income to be realized from our investments in unconsolidatedentities;

·       theimpact of demographic trends and supply constraints on the demand for andsupply of housing;

·       housingmarket conditions in the geographic markets in which we operate;

·       thenumber and types of homes and number of acres of land that we may develop andsell;

·       theability to deliver homes from backlog;

·       thetiming and outcomes of regulatory approval processes or administrativeproceedings, which may result in delays in the land entitlement, development,construction, or the opening of new communities (including, but not limited toongoing administrative proceedings related to our joint venture near Oxnard, California);

·       theability to secure materials and subcontractors;

·       theability to produce the liquidity and capital necessary to expand and takeadvantage of opportunities in the future;

·       ourability to realize the value of our net operating loss carry forwards;

·       ourability to continue relationships with current or future partners;

·       theeffectiveness and adequacy of our disclosure and internal controls;

·       theimpact of recent accounting pronouncements; and

·       stockmarket valuations.

Any or all of the forward-looking statements includedin this report and in any other reports or public statements made by us mayturn out to be inaccurate. This can occur as a result of incorrect assumptionsor 

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as a consequence of knownor unknown risks and uncertainties. Many factors mentioned in this report or inother reports or public statements made by us, such as government regulationand the competitive environment, will be important in determining our futureperformance. Consequently, actual results may differ materially from those thatmight be anticipated from our forward-looking statements. You should not placeundue reliance on any of these forward-looking statements because they arebased on current expectations or beliefs regarding future events orcircumstances,  which involve known andunknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from any futureresults, performances or achievements expressed or implied by these forward-lookingstatements.

Although we believe that our strategies, plans,objectives, goals, expectations and intentions reflected in, or suggested bythese forward-looking statements are reasonable given current informationavailable to us, we can give no assurance that any of them will be achieved.

We undertake no obligationto publicly update any forward-looking statements, whether as a result of newinformation, future events or otherwise. However, any further disclosures madeon related subjects in our subsequent reports on Forms 10-K, 10-Qand 8-K should be consulted. The following cautionary discussion ofrisks, uncertainties and possible inaccurate assumptions relevant to ourbusiness includes factors we believe could cause our actual results to differmaterially from expected and historical results. Other factors beyond thoselisted below, including factors unknown to us and factors known to us which wehave not determined to be material, could also adversely affect us. Thisdiscussion is provided as permitted by the Private Securities Litigation ReformAct of 1995, and all of our forward-looking statements are expressly qualifiedin their entirety by the cautionary statements contained or referenced in thissection.

***Our homebuilding operations lack geographicdiversification.***

Our residential landdevelopment and homebuilding operations are limited to the following sixSouthern California counties: Los Angeles, Orange, Riverside, San Bernardino,San Diego and Ventura. Therefore, economic and other events that adverselyimpact this comparatively narrow geographic region will have a direct negativeimpact on our business and operations. Because we do not have more diversifiedgeographic operations, the following risk factors should be considered withextreme care given the potential material adverse effect on our limitedoperations that could occur if any of these risks become a reality.

***Our business is cyclical and downward changes ineconomic conditions generally or in the market regions where we operate coulddecrease demand and pricing for new homes in these areas.***

The residential homebuilding industry is sensitive tochanges in economic conditions such as those which are listed below. Adversechanges in any of these conditions generally, or in the market regions where weoperate, could decrease demand and pricing for new homes in these areas orresult in customer cancellations of pending contracts, which could adverselyaffect the number of home deliveries we make or reduce the prices we can chargefor homes, either of which could result in a decrease in our revenues andearnings.

Our business issubstantially affected by changes in national and general economic factorsoutside of our control, such as: 

·       shortand long term interest rates;

·       theavailability of financing for homebuyers;

·       consumerconfidence (which can be substantially affected by external conditions,including international hostilities involving the United States);

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·       consumerincome;

·       federalmortgage financing programs; and

·       federalincome tax provisions.

The cyclicality ofour business is also highly sensitive to changes in economic conditions thatcan occur on a local or regional basis, such as changes in: 

·       housingdemand;

·       populationgrowth;

·       employmentlevels and job growth; and

·       propertytaxes.

The factors described above can cause demand andprices for our homes to diminish or cause us to take longer and incur morecosts to build our homes. We may not be able to recover these increased costsby raising prices because the price of each home is usually set several monthsbefore the home is delivered, as our customers typically sign their homepurchase contracts before construction has even begun on their homes. Inaddition, some of the factors described above could cause some homebuyers tocancel their home purchase contracts altogether.

***Supply shortages and other risks related to the demandfor skilled labor and building materials could increase costs and delaydeliveries.***

Fluctuating lumber prices and shortages, as well asshortages or price fluctuations in other important building materials, can havean adverse effect on our homebuilding business. Similarly, labor shortages orunrest among key trades, such as carpenters, roofers, electricians andplumbers, can delay the delivery of our homes and increase our costs.Rebuilding efforts underway in the gulf coast region of the United Statesfollowing the destruction caused by the two devastating hurricanes there in thesummer of 2005 may cause or exacerbate shortages of labor and/or certainmaterials.

***Inflation may result in increased costs that we maynot be able to recoup if demand declines.***

Inflation can have a long-term impact on us becauseincreasing costs of land, materials and labor may require us to increase thesales price of homes in order to maintain satisfactory margins. However,inflation is often accompanied by higher interest rates, which can have anegative impact on housing demand, in which case we may not be able to raisehome prices sufficiently to keep up with the rate of inflation and our marginscould decrease.

***Tax law changes could make home ownership moreexpensive or less attractive.***

Significant expenses of owning a home, includingmortgage interest expense and real estate taxes, generally are deductibleexpenses for an individual’s federal, and in some cases state, income taxes,subject to various limitations under current tax law and policy. If the federalgovernment or a state government changes income tax laws, as has been discussedrecently, to eliminate or substantially modify these income tax deductions,then the after-tax cost of owning a new home would increase substantially. Thiscould adversely impact demand for, and/or sales prices of, new homes.

***Severe weather conditions and natural disasters coulddelay deliveries, increase costs and decrease demand for new homes in affected areas.***

Weather conditions and natural disasters such asearthquakes, landslides, floods, droughts, fires, extended periods of rain andother environmental conditions can harm our homebuilding business on a local orregional basis. Civil unrest can also have an adverse effect on ourhomebuilding business.

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***The homebuilding industry has not experienced aneconomic downturn in many years, which may have resulted in land and new homes beingovervalued.***

Although the homebuilding business historically hasbeen cyclical, it has not experienced a downturn in many years. During 2005,land and home prices rose significantly in several of our markets. Some havespeculated that the prices of land and new homes, and the stock prices ofcompanies like ours that build new homes, are inflated and may decline if thedemand for new homes weakens. A decline in the prices for new homes would havean adverse effect on our homebuilding business, in particular on our revenuesand margins. A decline in our stock price could also make financing or raisingcapital more difficult and expensive.

***When mortgage-financing costs are high, or as creditquality declines, customers may be unwilling or unable to purchase our homes.***

The majority of our homebuyers finance their purchasesthrough our joint venture with Wells Fargo or third-party lenders. In general,housing demand is adversely affected by increases in interest rates and bydecreases in the availability of mortgage financing as a result of decliningcustomer credit quality or other issues. If mortgage interest rates increaseand the ability or willingness of prospective buyers to finance home purchasesis adversely affected, our operating results may be adversely affected.

***Some homebuyers may cancel their home purchasesbecause the required deposits are small and generally refundable, if new homeprices decline, interest rates increase or there is a downturn in the economy.***

Our backlog numbers reflect the number of homes forwhich we have entered into a sales contract with a customer but not yetdelivered. Those sales contracts typically require only a small deposit and thedeposit is generally refundable if customers are unable to close on the sale oftheir existing home, fail to qualify for financing or under certain othercircumstances. If the prices for new homes begin to decline, interest ratesincrease or there is a downturn in local or regional economies or the nationaleconomy, homebuyers may have financial incentive to terminate their existingsales contracts in order to negotiate for a lower price or to explore otheroptions. Such a result could have an adverse effect on our homebuildingbusiness and our results of operations.

***Competition for homebuyers, labor and materials couldreduce our deliveries or decrease our profitability.***

The homebuilding industry is highly competitive forskilled labor, materials and suitable land, as well as homebuyers. We competein each of our markets with numerous national, regional and local homebuildersmany of whom have substantially greater resources than we do. In addition,smaller regional and local builders can have an advantage in local marketsbecause of long-standing relationships they may have with local labor or landsellers. This competition with other homebuilders could reduce the number ofhomes we deliver, or cause us to accept reduced margins in order to maintainsales volume.

We also compete withresales of existing used or foreclosed homes, housing speculators and availablerental housing. Increased competitive conditions in the residential resale orrental market in the regions where we operate could decrease demand for newhomes and increase cancellations of sales contracts in backlog.

***Slow or no growth initiatives have been or may beadopted in regions where we operate, which could adversely affect our abilityto build or timely build in these areas.***

Some municipalities where we operate have approved,and others where we operate may approve, various slow growth or no growthhomebuilding initiatives and other ballot measures that could negatively impactthe availability of land and building opportunities within those localities.Approval of slow growth, no growth or similar initiatives (including the effectof these initiatives on existing entitlements and zoning) could adverselyaffect our ability to build or timely build and sell homes in the affectedmarkets and or 

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create additionaladministrative and regulatory requirements and costs, which, in turn, couldhave an adverse effect on our future revenues and earnings.

***We may not be able to acquire land suitable forresidential homebuilding at reasonable prices, which could increase our costsand reduce our revenues, earnings and margins.***

The availability of finished and partially developedlots and undeveloped land for purchase that meet our internal criteria dependson a number of factors outside our control, including land availability ingeneral, competition with other homebuilders and land buyers for desirableproperty, inflation in land prices, and zoning, allowable housing density andother regulatory requirements. Our long-term ability to build homes dependsupon our acquiring land suitable for residential building at reasonable pricesin locations where we want to build. As competition for suitable landincreases, and as available land is developed, the cost of acquiring suitableremaining land could rise, and the availability of suitable land at acceptableprices may decline. Over the past few years, we have experienced an increase incompetition for suitable land as a result of land constraints in many of ourmarkets. Any land shortages or any decrease in the supply of suitable land atreasonable prices could limit our ability to develop new communities or resultin increased land costs. We may not be able to pass through to our customersany increased land costs, which could adversely impact our revenues, earningsand margins.

***We are subject to substantial legal and regulatoryrequirements regarding the development of land, the homebuilding process andprotection of the environment, and compliance with federal, state and localregulations related to our business could have substantial costs both in timeand money, and some regulations could prohibit or restrict some homebuildingprojects.***

Our homebuilding businessis heavily regulated and subject to increasing local, state and federalstatutes, ordinances, rules and regulations concerning zoning, resourceprotection, other environmental impacts, building design, construction andsimilar matters. These regulations often provide broad discretion togovernmental authorities that regulate these matters, which can result inunanticipated delays or increases in the cost of a specified project or anumber of projects in particular markets. We may also experience periodicdelays in homebuilding projects due to building moratoria in any of the areasin which we operate.

Our business is conducted in California, which is oneof the most highly regulated and litigious states in the country. Therefore,our potential exposure to losses and expenses due to new laws, regulations orlitigation may be greater than other homebuilders with a less significantCalifornia presence.

We are subject to extensive and complex laws andregulations that affect the land development and homebuilding process,including laws and regulations related to zoning, permitted land uses, levelsof density, building design, elevation of properties, water and waste disposaland use of open spaces. In addition, we are subject to laws and regulationsrelated to workers’ health and safety. We generally are required to obtainpermits, entitlements and approvals from local authorities to commence andcomplete residential development or home construction. Such permits,entitlements and approvals may, from time-to-time, be opposed or challenged bylocal governments, neighboring property owners or other interested parties,adding delays, costs and risks of non-approval to the process. Our obligationto comply with the laws and regulations under which we operate, and ourobligation to ensure that our employees, subcontractors and other agents complywith these laws and regulations, could result in delays in construction andland development, cause us to incur substantial costs and prohibit or restrictland development and homebuilding activity in certain areas in which weoperate.

We are also subject to a variety of local, state andfederal statutes, ordinances, rules and regulations concerning theenvironment. These laws and regulations may cause delays in construction anddelivery of new homes, may cause us to incur substantial compliance and othercosts, and can prohibit or severely restrict homebuilding activity in certainenvironmentally sensitive regions or areas. In addition, 

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environmental laws mayimpose liability for the costs of removal or remediation of hazardous or toxicsubstances whether or not the developer or owner of the property knew of, orwas responsible for, the presence of those substances. The presence of thosesubstances on our properties may prevent us from selling our homes and we mayalso be liable, under applicable laws and regulations or lawsuits brought byprivate parties, for hazardous or toxic substances on properties and lots thatwe have sold in the past.

***Changing market conditions may adversely impact ourability to sell homes at expected prices, which could reduce our margins.***

There is often a significant amount of time betweenwhen we initially acquire land and when we can make homes on that landavailable for sale. The market value of a proposed home can vary significantlyduring this time due to changing market conditions. In the past, we havebenefited from increases in the value of homes over time, but if marketconditions were to reverse, we may need to sell homes at lower prices than weanticipate. We may also need to take write-downs of our home inventories andland holdings if market values decline.

***Home prices and sales activity in the particularmarkets and regions in which we do business impact our results of operationsbecause our business is concentrated in these markets.***

Home prices and sales activity in some of our keymarkets have declined from time to time for market-specific reasons, includingadverse weather or economic contraction due to, among other things, the failureor decline of key industries and employers. If home prices or sales activitydecline in one or more of the key markets in which we operate, our costs maynot decline at all or at the same rate and, as a result, our overall results ofoperations may be adversely impacted.

***Product liability litigation and warranty claims thatarise in the ordinary course of business may be costly, which could adverselyaffect our business.***

As a homebuilder, we are subject to constructiondefect and home warranty claims arising in the ordinary course of business.These claims are common in the homebuilding industry and can be costly. Inaddition, the costs of insuring against construction defect and productliability claims are high, and the amount of coverage offered by insurancecompanies is currently limited. There can be no assurance that this coveragewill not be further restricted and become more costly. If we are not able toobtain adequate insurance against these claims, we may experience losses thatcould hurt our financial results.

***We could be hurt by the loss of key managementpersonnel.***

Our future success depends, to a significant degree,on the efforts of our senior management. Our operations could be adverselyaffected if key members of senior management cease to be active in our company.

***Future terrorist attacks against the United States orincreased domestic or international instability could have an adverse effect onour operations.***

Adverse developments in the war on terrorism, futureterrorist attacks against the United States, or increased domestic orinternational instability could adversely affect our business.

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**Item 1B.**               UnresolvedStaff Comments

None.

**Item 2.**                        Properties

We lease our principalexecutive offices, which are located in Irvine, California. We believe that ourproperties are generally well maintained, in good condition and adequate fortheir present and proposed uses. The inability to renew any short-termreal property lease would not be expected to have a material adverse effect onour results of operations. We own land, lots, and homes that are held asinventory in the ordinary course of our homebuilding business. These propertiesare discussed in “Item 1—Business” of this Annual Report.

**Item 3.**                        LegalProceedings

In December 2005, we resolved an environmentalproperty matter with the State of California that began in 1999 when PCBs werediscovered on a 43-acre property we acquired in the Bolsa Chica lowlandsin 1997. We acquired this land with the intent of selling it to the State inconnection with the State’s planned restoration of 1,000 acres of the adjacentwetlands. In anticipation of entering into a purchase agreement, the Stateperformed limited soils sampling on this property and notified us in 1999 thatit had discovered contamination from a group of chemicals called PCBs. In 2002,the State’s Department of Toxic Substances Control  became the regulatory agency responsible foroverseeing our efforts to clean up the contamination on this property and oursubsidiary entered into a consent order regarding the clean up. Our subsidiaryprepared a Remedial Investigation Workplan, which was approved by the State in August 2003.A Remedial Action Workplan was approved by the State in December 2004, andthe removal of the contaminated soil was completed during September 2005.In July 2005, our subsidiary entered into an agreement with the StateLands Commission to sell this property to the State for $1.7 million, with upto $1 million of such funds to be utilized for accrued remediation costs. Followingthe State’s acceptance of the remediation work in December 2005, wecompleted the sale of this property, for which our subsidiary received netproceeds of $923,000, after using $798,000 to reimburse the State for actualremediation costs. As of December 31, 2005, our subsidiary had noadditional amounts accrued for environmental testing and clean up of thisproperty since the remediation has been completed to the State’s satisfaction.

In May 2004,our subsidiary received an invoice from the State for $793,000 for itsoversight and clean up costs incurred with respect to PCBs found on neighboringresidential properties. Since receiving the original invoice, our subsidiaryhas received invoices for an additional $131,000. However, our subsidiarycontends, based upon advice of counsel, that it is not responsible for thesecosts because:

·       wedid not develop or build the neighboring residential properties,

·       wedid not generate the contamination,

·       thecontamination did not emanate from our property and the 43-acre siteshould not be part of the same site as the residential properties, and

·       theState did not submit these bills in accordance with the requirements of theapplicable law.

Therefore, our subsidiary intends to vigorously defenditself in this matter and, given our belief that we will prevail in thismatter, we have not accrued for any of the State’s $924,000 of claims relatedto the clean up of these residential properties.

Our consolidated balance sheet includes reserves forcontingent indemnity obligations for certain businesses disposed of by ourformer affiliated companies whose business was unrelated to our currenthomebuilding operations. On April 6, 2005, we and RESCO Holdings, Inc.,a former affiliate, settled 

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litigation with DresserIndustries, Inc., and we paid $1.33 million as our share of thesettlement, which was the amount of our litigation accrual at December 31,2004.

The case was filed in 2002 as “Dresser Industries, Inc.vs. California Coastal Communities, Inc. and RESCO.,” in the 58th Judicial District Court of Jefferson County,Texas. Dresser sought a declaratory judgment regarding the rights andobligations of the parties under a 1988 purchase agreement. Under theagreement, Dresser acquired an engineering and construction business from TheM.W. Kellogg Company. RESCO and Kellogg are former affiliates of ours. Kelloggand its parent company, Wheelabrator Technologies, Inc., agreed toindemnify Dresser against certain pre-sale claims. In a later transaction,Wheelabrator assigned to us certain assets and liabilities relating to the 1988agreement. Dresser also sought unspecified damages for breach of the 1988agreement, along with attorney’s fees and costs. Dresser’s indemnity claimsrelated to several hundred lawsuits encompassing approximately 5,900 contestedasbestos claims made by third parties in connection with work in facilities inwhich the Dresser-acquired engineering and construction business was allegedlyconnected.

Neither we nor RESCOadmitted any fault or liability with respect to Dresser’s claims and, while webelieve we had numerous defenses to Dresser’s claims, we decided to settle thematter in order to avoid the continued cost and uncertainty of litigation. Asof December 31, 2005, we have no additional amounts accrued for thislitigation since it was settled in April 2005.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

During the fourth quarter of the fiscal year ended December 31,2005, no matters were submitted to a vote of security holders.

20

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

Thefollowing tables set forth information with respect to bid quotations for ourcommon stock  for the periods indicatedas reported on the Nasdaq National Market. These quotations are interdealerprices without retail markup, markdown or commission and may not necessarilyrepresent actual transactions.

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 26.40      |    | $          | 23.80 |   |
| Second Quarter |       | $        | 34.39      |    | $          | 25.20 |   |
| Third Quarter  |       | $        | 37.15      |    | $          | 32.25 |   |
| Fourth Quarter |       | $        | 40.10      |    | $          | 33.47 |   |
| **2004**       |       |     |       |    |       |
| First Quarter  |       | $        | 18.70      |    | $          | 10.50 |   |
| Second Quarter |       | $        | 20.55      |    | $          | 14.00 |   |
| Third Quarter  |       | $        | 22.85      |    | $          | 17.50 |   |
| Fourth Quarter |       | $        | 24.50      |    | $          | 18.01 |   |

 

The number of beneficialholders of our common stock as of March 6, 2006 was approximately 1,700. Wehave not paid any cash dividends on our common stock to date, nor do wecurrently intend to pay regular cash dividends on our common stock.

**Item 6.**                        SelectedFinancial Data

Our Selected FinancialData is set forth on page 31 of this Annual Report.

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

Management’s Discussionand Analysis of Financial Condition and Results of Operations is set forthbeginning on page 31 of this Annual Report.

**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk

We utilize project debtfinancing for acquisition, development and construction of homes. The interestrates on our project debt approximate the current rates available for securedreal estate financing with similar terms and maturities, and as a result, theircarrying amounts approximate fair value. While changes in interest ratesgenerally do not impact the fair market value of the debt instrument, they doaffect our earnings and cash flows. Holding our variable rate debt balanceconstant as of December 31, 2005, each one point percentage increase ininterest rates would result in an increase in variable rate interest incurred forthe coming year of approximately $600,000.

**Item 8.**                        FinancialStatements and Supplementary Data

Our consolidated financialstatements, schedules and supplementary data and that of our subsidiaries arelisted under Item 15, and are submitted as a separate section of this AnnualReport, beginning on page F-2.

**Item 9.**                        Changesin and Disagreements With Accountants on Accounting and Financial Disclosure

None.

21

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**Item 9A.**                Controlsand Procedures

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

No matter how well acontrol system is conceived and operated, it can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Inaddition, the design of a control system must reflect the fact that there areresource constraints and the benefits of controls must be considered relativeto costs. Therefore, no cost-effective control systems and no evaluation ofcontrols can provide absolute assurance that all control issues and instances ofmisstatements due to error or fraud, if any, within our company have beendetected.

*Evaluation ofDisclosure Controls and Procedures*

Our chief executiveofficer and chief financial officer, with the assistance of management,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended) as of the end of the periodcovered by this report (the “Evaluation Date”). Based on that evaluation, ourchief executive officer and chief financial officer concluded that, as of theEvaluation Date, our disclosure controls and procedures were effective toensure that information required to be disclosed in our reports under theExchange Act, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

*Changes in InternalControls*

There have been no significant changes in our internalcontrol over financial reporting during the three months ended December 31,2005 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

22

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**MANAGEMENT’S REPORT ONINTERNAL CONTROL OVER FINANCIAL REPORTING**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting as such term isdefined in the Securities Exchange Act Rule 13a-15(f). Internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. Internal control over financial reportingincludes those policies and procedures that (i) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of our assets; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that our receipts and expenditures are being made only inaccordance with authorizations of our management and directors; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of our assets that could have a materialeffect on our financial statements. Because of its inherent limitations,internal control over financial reporting may not prevent or detectmisstatements. In addition, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequate becauseof changes in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

Under the supervision and with the participation ofour management, including our principal executive officer and our principalfinancial officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting based on the framework in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on this evaluation under theframework in Internal Control—Integrated Framework, our management concludedthat our internal control over financial reporting was effective as of December 31,2005.

Ourmanagement’s assessment of the effectiveness of internal control over financialreporting as of December 31, 2005 has been audited by Deloitte &Touche LLP, our independent registered public accounting firm, as stated intheir report, which appears below.
| /s/ RAYMOND  J. PACINI                               |   |
|------------------------------------------------------|--------|
| Raymond J. Pacini                                    |   |
| *President and Chief Executive Officer*              |   |
| /s/ SANDRA G. SCIUTTO                                |   |
| Sandra G. Sciutto                                    |   |
| *Senior  Vice President and Chief Financial Officer* |   |

 

23

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders ofCalifornia Coastal Communities, Inc.

We have audited management’s assessment, included inthe accompanying *Management’s Report on Internal Control overFinancial Reporting*appearing in Item 9A, that California CoastalCommunities, Inc. and subsidiaries (the “Company”) maintained effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission. The Company’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use or disposition of the company’sassets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on the criteriaestablished in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission. Also in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on the criteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.

24

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We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements as of and for the yearended December 31, 2005 of the Company and our report dated March 14, 2006expressed an unqualified opinion on those financial statements.

DELOITTE & TOUCHE LLP

Costa Mesa, CaliforniaMarch 14, 2006

25

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**Item 9B.**               OtherInformation

None.

**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

Information appearing under the captions “OurManagement” in the Proxy Statement for our 2006 Annual Meeting of ourStockholders is for the limited purpose of providing the information necessaryto comply with this Item 10, incorporated herein by this reference.

We have adopted a Code ofEthics and Business Conduct applicable to our directors and all of ouremployees, including our Chief Executive Officer, Chief Financial Officer, andany other principal executive, senior financial or principal accountingofficer. The full text of the Code of Business Conduct and Ethics is availablein print to any stockholder who requests a printed copy by writing to: CaliforniaCoastal Communities, Inc., Attn: Investor Relations, 6 Executive Circle, Suite 250,Irvine, California 92614.

**Item 11.**                 ExecutiveCompensation

Information appearingunder the caption “Compensation of Directors and Executive Officers” in theProxy Statement for our 2006 Annual Meeting of Stockholders and is for thelimited purpose of providing the information necessary to comply with this Item11, incorporated herein by this reference.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Information appearingunder the captions “Our Management” and “Compensation of Directors andExecutive Officers” in the Proxy Statement for our 2006 Annual Meeting ofStockholders, and is for the limited purpose of providing the informationnecessary to comply with this Item 12, incorporated herein by this reference.

**Item 13.**                 CertainRelationships and Related Transactions

Information appearingunder the captions “Certain Relationships and Related Transactions” and “Compensationof Directors and Executive Officers” in the Proxy Statement for our 2006 AnnualMeeting of Stockholders, and is for the limited purpose of providing theinformation necessary to comply with this Item 13, incorporated herein by thisreference.

**Item 14.**                 PrincipalAccounting Fees and Services

Information in answer to this Item appears under thecaption “Independent Registered Public Accounting Firm” in the Proxy Statementfor our 2006 Annual Meeting of Stockholders and is, for the limited purpose ofproviding the information necessary to comply with this Item 14, incorporatedherein by this reference.

26

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules

(a)(1) ConsolidatedFinancial Statements:

Our following consolidatedfinancial statements and supplementary data is included in a separate sectionof this Annual Report commencing on the page numbers specified below: 

|                                                                                                                            | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                   |       |     | F-1        |   |   |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                                         |       |     | F-2        |   |   |
| Consolidated Statements of Operations and Comprehensive  Income for the Years  Ended December 31, 2005, 2004 and 2003 |       |     | F-3        |   |   |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2005, 2004 and 2003                           |       |     | F-4        |   |   |
| Consolidated Statements of Changes in Stockholders’  Equity for the Years Ended December 31, 2005, 2004 and 2003 |       |     | F-5        |   |   |
| Notes to Consolidated Financial Statements                                                                                 |       |     | F-6        |   |   |

 

(2)   Consolidated Financial Statement Schedules:

Allschedules have been omitted since they are not applicable, not required, or theinformation is included in the consolidated financial statements or notesthereto.

(3)   Listing of Exhibits: 

| 3.01(a) |   | Amended and Restated Certificate of Incorporation of  the Registrant, incorporated by reference to Form 8-K filed October 14,  1999.                                                                                             |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.01(b) |   | Certificate of Amendment  to Amended and Restated Certificate of Incorporation, incorporated by  reference to Exhibit 3.01(b) to the Registrant’s Annual Report on Form 10-K  for 2004.                                |
| 3.02    |   | Amended By-Laws of  the Registrant, incorporated by reference to Exhibit 4.03 to the  Registrant’s Post-Effective Amendment No. 4 to Form S-4,  Registration Statement No. 333-29883, filed August 28, 1997. |
| 4.01(a) |   | Amended and Restated  Certificate of Incorporation of the Registrant, incorporated by reference to Form 8-K  filed October 14, 1999.                                                                                             |
| 4.01(b) |   | Certificate of Amendment  to Amended and Restated Certificate of Incorporation, incorporated by  reference to item 3.01 (b).                                                                                                               |
| 4.02    |   | Amended By-Laws of  the Registrant, incorporated by reference to Exhibit 4.03 to the  Registrant’s Post-Effective Amendment No. 4 to Form S-4,  Registration Statement No. 333-29883, filed August 28, 1997. |
| 10.01   |   | Amended and Restated  1993 Stock Option/Stock Issuance Plan, incorporated by reference to Exhibit 10.01  to the Registrant’s Annual Report on Form 10-K for 2004.                                                           |
| 10.02   |   | Deferred Compensation  Plan for Non-Employee Directors of the Registrant, incorporated by  reference to Exhibit 10.14 to the Registrant’s Registration Statement on  Form 10.                                               |
| 10.03   |   | Retirement Plan for Non-Employee  Directors of the Registrant, incorporated by reference to Exhibit 10.15  to the Registrant’s Registration Statement on Form 10.                                                           |

27

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| 10.04  |   | Retirement Plan of the  Registrant, incorporated by reference to Exhibit 10.16 to Amendment No. 3  on Form 8 to the Registrant’s Registration Statement on Form 10.                                                                                                     |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.04A |   | Amendment to Retirement  Plan of the Registrant dated December 8, 1993, incorporated by reference  to Exhibit 10.07A to the Registrant’s Annual Report on Form 10-K  for 1993.                                                                                               |
| 10.04B |   | Amendment to Retirement Plan of the Registrant dated  effective January 1, 2000, incorporated by reference to Exhibit 10.08B  to Registrant’s Annual Report on Form 10-K for 1999.                                                                                           |
| 10.04C |   | Amendment to Retirement  Plan of the Registrant dated December 19, 2001, incorporated by  reference to Exhibit 10.08C to Registrant’s Annual Report on Form 10-K  for 2001.                                                                                                  |
| 10.04D |   | Amendment to Retirement  Plan of the Registrant dated December 30, 2002, incorporated by  reference to Exhibit 10.04D to Registrant’s Annual Report on Form 10-K  for 2002.                                                                                                  |
| 10.05  |   | California Coastal  Communities, Inc. 401(k) Plan and Trust Agreement dated effective January 1,  2000, incorporated by reference to Exhibit 10.10 to Registrant’s Annual  Report on Form 10-K for 1999.                                                           |
| 10.06  |   | Employment Agreement between  the Registrant and Mr. Raymond J. Pacini, dated as of May 1, 1998,  incorporated by reference to Exhibit 10.1 to Registrant’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 1998.                                   |
| 10.06A |   | Extension and  Modification of Employment Agreement between the Registrant and Raymond J.  Pacini, dated as of December 7, 1999, incorporated by reference to Exhibit 10.11A  to Registrant’s Annual Report on Form 10-K for 1999.                                           |
| 10.06B |   | Extension and  Modification of Employment Agreement between the Registrant and Mr. Raymond  J. Pacini, dated as of April 30, 2001, incorporated by reference to Exhibit 10.2  to Registrant’s Quarterly Report on Form 10-Q for the quarter  ended March 31, 2001. |
| 10.06C |   | Extension and  Modification of Employment Agreement between the Registrant and Mr. Raymond  J. Pacini, dated as of March 17, 2003, incorporated by reference to Exhibit 10.1  to Registrant’s Quarterly Report on Form 10-Q for the quarter  ended March 31, 2003. |
| 10.06D |   | Extension and  Modification of Employment Agreement between the Registrant and Mr. Raymond  J. Pacini, dated as of March 14, 2005, incorporated by reference to Exhibit 10.08  to Registrant’s original Annual Report on Form 10-K for 2004.                            |
| 10.07  |   | Employment Agreement  between the Registrant and Ms. Sandra G. Sciutto, dated as of May 1,  1998, incorporated by reference to Exhibit 10.2 to Registrant’s  Quarterly Report on Form 10-Q for the quarter ended March 31,  1998.                                  |
| 10.07A |   | Extension and  Modification of Employment Agreement between the Registrant and Sandra G.  Sciutto, dated as of December 7, 1999, incorporated by reference to Exhibit 10.12A  to Registrant’s Annual Report on Form 10-K for 1999.                                           |
| 10.07B |   | Extension and  Modification of Employment Agreement between the Registrant and Ms. Sandra  G. Sciutto, dated as of April 30, 2001, incorporated by reference to Exhibit 10.3  to Registrant’s Quarterly Report on Form 10-Q for the quarter  ended March 31, 2001. |

28

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| 10.07C  |   | Extension and  Modification of Employment Agreement between the Registrant and Ms. Sandra  G. Sciutto, dated as of March 17, 2003, incorporated by reference to Exhibit 10.2  to Registrant’s Quarterly Report on Form 10-Q for the quarter  ended March 31, 2003.                |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.07D  |   | Extension and  Modification of Employment Agreement between the Registrant and Ms. Sandra  G. Sciutto, dated as of March 14, 2005, incorporated by reference to Exhibit 10.08  to Registrant’s original Annual Report on Form 10-K for 2004.                                           |
| 10.08   |   | Employment Contract  between Hearthside Homes, Inc., a subsidiary of the Registrant and Mr. Michael  J. Rafferty, dated as of August 8, 2005, incorporated by reference to Exhibit 10.1  to Registrant’s Quarterly Report on Form 10-Q for the quarter  ended June 30, 2005. |
| 10.09   |   | Employment Contract  between Hearthside Homes, Inc., a subsidiary of the Registrant, and Mr. John  W. Marshall, dated as of August 8, 2005, incorporated by reference to Exhibit 10.2  to Registrant’s Quarterly Report on Form 10- Q for the quarter  ended June 30, 2005.  |
| 10.10*  |   | Employment Contract  between Hearthside Homes, Inc., a subsidiary of the Registrant, and Mr. Ed  Mountford, dated as of May 1, 1998.                                                                                                                                                             |
| 10.10A* |   | Modification of  Employment Agreement between Hearthside Homes, Inc., a subsidiary of the  Registrant, and Mr. Ed Mountford, dated as of November 12, 2003.                                                                                                                                      |
| 10.10B* |   | Extension and  Modification Agreement between Hearthside Homes, Inc., a subsidiary of  the Registrant, and Mr. Ed Mountford, dated as of July 20, 2005.                                                                                                                                          |
| 10.11   |   | Audit Committee Policy  for Pre-Approval of Auditor Services of the Registrant, incorporated by  reference to Exhibit 10.08 to Registrant’s original Annual Report on Form 10-K  for 2004.                                                                                                       |
| 21.01*  |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                |
| 31.1*   |   | Section 302  Certificate of Raymond J. Pacini, Chief Executive Officer of California  Coastal Communities, Inc.                                                                                                                                                                                       |
| 31.2*   |   | Section 302  Certificate of Sandra G. Sciutto, Chief Financial Officer of California  Coastal Communities, Inc.                                                                                                                                                                                       |
| 32.1*   |   | Section 906 Certificate  of Raymond J. Pacini, Chief Executive Officer and Sandra G. Sciutto, Chief  Financial Officer of California Coastal Communities, Inc.**                                                                                                                                                |

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*                    Filedherewith.

**             Thesecertifications are being furnished solely to accompany this report pursuant to18 U.S.C. Section 1350, and are not being filed for purposes of Section 18of the Securities Exchange Act of 1934, as amended, and are not to beincorporated by reference into any filing of the Company, whether made beforeor after the date hereof, regardless of any general incorporation language insuch filing.

29

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
| Date:  March 15, 2006 | CALIFORNIA COASTAL COMMUNITIES, INC. |
|----------------------------|--------------------------------------|
|                       | By:                                  | /s/ SANDRA G. SCIUTTO |
|                       |                                 | Sandra G. Sciutto |
|                       |                                 | *Senior Vice President and* |
|                       |                                 | *Chief Financial Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the date indicated.
|                              | **Signature** | ** **                                       | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|------------------------------|---------------|--------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/ GEOFFREY W. ARENS        |          | Director                                         |       | March 15, 2006 |
| (Geoffrey W. Arens)          |          |                                             |       |                |
| /s/ PHILLIP R. BURNAMAN II   |          | Director                                         |       | March 15, 2006 |
| (Phillip R. Burnaman II)     |          |                                             |       |                |
| /s/ RAYMOND J. PACINI        |          | President, Chief  Executive Officer and Director |       | March 15, 2006 |
| (Raymond J. Pacini)          |          |                                             |       |                |
| /s/ THOMAS W. SABIN, JR.     |          | Director and  Chairman of the Board              |       | March 15, 2006 |
| (Thomas W.  Sabin, Jr.) |          |                                             |       |                |
| /s/ SANDRA G. SCIUTTO        |          | Senior Vice  President and                       |       | March 15, 2006 |
| (Sandra G. Sciutto)          |          | Chief Financial Officer                          |       |                |

 

 

30

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**Item 6.**                        SelectedFinancial Data

Setforth below is selected financial data about us and our consolidatedsubsidiaries. The following information should be read in conjunction with theConsolidated Financial Statements beginning on page F-2 of thisAnnual Report on Form 10-K and Management’s Discussion and Analysis.

| ** **                                                      | ** ** | **Years Ended December 31,**                          | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                                                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                      | ** ** | **(in millions, except per share amounts)** | ** ** |
| **Balance sheet data at period  end:**                          |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Unrestricted cash, cash equivalents and short-term  investments |       | $                                                                    | 38.0       |   | $ | 9.0 |   | $ | 14.7 |   | $ | 9.2 |   | $ | 16.2 |   |
| Total assets                                                    |       | 330.4                                                                |       | 250.8 |   | 198.1 |   | 187.6 |   | 180.2 |   |
| Project debt                                                    |       | 57.9                                                                 |       | 22.6 |   | 10.4 |   | 9.8 |   | 3.1 |   |
| Total stockholders’ equity                                 |       | $                                                                    | 246.9      |   | $ | 178.9 |   | $ | 164.6 |   | $ | 159.9 |   | $ | 159.0 |   |
| Shares outstanding at end of period                             |       | 10.2                                                                 |       | 10.1 |   | 10.1 |   | 10.1 |   | 10.1 |   |
| Stockholders’ equity per common share(a)                   |       | $                                                                    | 24.21      |   | $ | 17.71 |   | $ | 16.30 |   | $ | 15.83 |   | $ | 15.74 |   |
| **Statement of operations data:**                               |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Homebuilding                                                    |       | $                                                                    | 62.7       |   | $ | 75.9 |   | $ | 54.7 |   | $ | 32.8 |   | $ | 39.0 |   |
| Non-residential land                                            |       | 66.8                                                                 |       | .1 |   | 1.1 |   | — |   | — |   |
| Total revenues                                                  |       | $                                                                    | 129.5      |   | $ | 76.0 |   | $ | 55.8 |   | $ | 32.8 |   | $ | 39.0 |   |
| Net income(b)                                                   |       | 28.4                                                                 |       | 4.8 |   | 2.9 |   | 1.7 |   | 11.1 |   |
| **Per common share—basic:**                                |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Earnings                                                        |       | $                                                                    | 2.78       |   | $ | .48 |   | $ | .29 |   | $ | .17 |   | $ | 1.10 |   |
| **Per common share—diluted:**                              |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Earnings                                                        |       | $                                                                    | 2.70       |   | $ | .44 |   | $ | .27 |   | $ | .16 |   | $ | 1.10 |   |
| **Weighted-average  shares outstanding—basic**             |       | 10.2                                                                 |       | 10.1 |   | 10.1 |   | 10.1 |   | 10.1 |   |
| **Weighted-average shares  outstanding—diluted(c)**        |       | 10.5                                                                 |       | 10.8 |   | 10.8 |   | 10.8 |   | 10.1 |   |

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(a)           We believe thatstockholders’ equity per common share, which is computed by dividingstockholders’ equity by common shares outstanding at the end of each period, isa useful supplemental measure of the strength of our balance sheet and anindicator of the historical carrying basis of our net assets.

(b)          In addition tohomebuilding operations, net income for the year ended December 31, 2005reflects income from the sale of non-residential land at Bolsa Chica, in OrangeCounty, California. In addition to homebuilding operations, net income for theyear ended December 31, 2001 reflects other income from receipt ofsecurities as demutualization proceeds from an insurance company in which wewere a policy holder, and the settlement or resolution of certain tax and otherliabilities.

(c)           Beginningthe year ended December 31, 2002, the increase in weighted-average sharesoutstanding—diluted reflects outstanding options with an exercise price belowthe average market price of our common stock.

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The following discussionshould be read together with our Consolidated Financial Statements and Noteswhich are set forth below commencing on page F-2 of this AnnualReport.

31

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**Overview**

We are aresidential land development and homebuilding company with properties owned orcontrolled in six Southern California counties (Los Angeles, Orange, Riverside,San Bernardino, San Diego and Ventura). Our principal activities include:

·       obtainingzoning and other entitlements for land we own or control through purchaseoptions or joint ventures;

·       improvingthe land for residential development; and

·       designing,constructing and selling single-family homes in Southern California.

Once ourresidential land is entitled, we may build homes, sell unimproved land to otherdevelopers or homebuilders, sell improved land to homebuilders, or participatein joint ventures with other developers, investors or homebuilders to financeand construct infrastructure and homes. The majority of our homes are designedto appeal to move-up homebuyers and are generally offered for sale in advanceof their construction. During 2006, we will focus our primary efforts on:

·       begingrading and building model homes for our Brightwater project located on the upperbench of the Bolsa Chica mesa in Orange County, California  in accordance with the Coastal DevelopmentPermit for 349 homes issued by the California Coastal Commission in December 2005;

·       completethe entitlement process for a 168-acre joint venture project near Oxnard,California; and

·       continueto expand our profitable homebuilding operations throughout SouthernCalifornia.

However, we may also consider other strategic andjoint venture opportunities; and there can be no assurance that we will accomplish,in whole or in part, all or any of these strategic goals.

From time to time we have considered the variousstrategic alternatives available to us with respect to our businesses, assets,operations and available cash. We have engaged investment bankers and otheradvisors for this purpose, with a view towards assessing alternatives whichwould enhance the value of our current businesses, create additional businessopportunities, or otherwise maximize the value of our company for ourstockholders. Included in this process has been an exploration of merger,acquisition and disposition possibilities; analysis of equity and debtfinancings, open market and other repurchases of our stock; dividends to ourstockholders; and combinations of these alternatives. At this time our board ofdirectors has not made a determination with respect to any of the forgoing, andwe will continue to evaluate our strategy to position the company to maximizevalue to our stockholders.

We currently have on-going Southern Californiaprojects in Riverside County near the cities of Beaumont, Corona, North Coronaand Riverside, in the City of Ontario in San Bernardino County, in the City ofLancaster in northern Los Angeles County, and in the Rancho Santa Fe area inSan Diego County. With the December 15, 2005 Coastal Commission issuanceof the permit for development of our 349-home Brightwater project, ourinventory of entitled land available for homebuilding projects representsapproximately a 3.5 year (2006-2009) supply at levels well above recentyears. These homebuilding projects are currently expected to generate cashflows and gross operating margins through mid-2009. We will continue topursue residential lot acquisition opportunities throughout SouthernCalifornia, including increasing our lot inventory in existing successfulsubmarkets and expanding into additional submarkets. Up to approximately 555additional single-family lots would be available for homebuilding operations ifwe obtain entitlements for our Oxnard project; however, the exact number ofhomes will be dependent upon the final outcome of the entitlement process.

Bolsa Chica is our largest asset, representing 40% oftotal assets at December 31, 2005. It has required and continues torequire significant investments for entitlement and land developmentactivities. On October 5, 2005, the County of Orange approvedmodifications to our site plan and on October 18, 2005 

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approved the tentativetract map for 349 homes. These approvals were necessary to comply with theCoastal Commission’s conditions of approval for our permit, which we receivedin December 2005.

The Brightwater planned community will offer a broadmix of home choices averaging 2,800 square feet and ranging in size from 1,700square feet to 4,100 square feet. The plan also includes 37 acres of open spaceand conservation area. With only 349 homes on 68 acres, the resultinglow-density plan equates to approximately five homes per acre, consistent andcompatible with the neighboring Huntington Beach communities. We also plan toprocess a tentative tract map for seven additional homes in the City ofHuntington Beach. In addition, we have offered approximately 51 acres of landon the Huntington Mesa for dedication to the County of Orange to complete theHarriett M. Wieder Linear Park.

On December 21, 2005,we completed the sale of a 103-acre parcel on the lower bench of theBolsa Chica mesa  to the State ofCalifornia’s Wildlife Conservation Board for $65 million. The sale was approvedby our stockholders at the August 11, 2005 Annual Meeting.

Bolsa Chica is carried at fair value as of September 2,1997, following adoption of Fresh-Start Reporting as discussed in Note 1 to theConsolidated Financial Statements, as adjusted by subsequent activity. Our realestate properties are subject to a number of uncertainties which can affect thevalues of those assets. These uncertainties include availability of adequatecapital, financing and cash flow. In addition, future values may be adverselyaffected by increases in property taxes, increases in the costs of labor andmaterials and other development risks, changes in general economic conditions,including higher mortgage interest rates, and other real estate risks such asthe general demand for housing and the supply of competitive products. Realestate properties do not constitute liquid assets and, at any given time, itmay be difficult to sell a particular property for an appropriate price.

**Impactof Inflation; Changing Prices and Economic Conditions**

Real estate and residential housing prices areaffected by inflation, which can cause increases in the price of land, rawmaterials and subcontracted labor. Unless these increased costs are recoveredthrough higher sales prices, gross margin from home sales would decrease. If interestrates increase, construction and financing costs would also increase, which canalso result in lower gross margin from home sales. The volatility of interestrates could have an adverse effect on our future operations and liquidity.Among other things, these conditions may affect adversely the demand forhousing and the availability of mortgage financing and may reduce the creditfacilities we offer.

In general, while these price increases have beengreater than the general rate of inflation in our housing markets, they havenot had a significant adverse effect on the sale of our homes. A significantrisk faced by the housing industry generally is that rising home costs,including land and interest costs, will substantially outpace increases in the incomeof potential purchasers. In recent years, in the price ranges in which ourhomes sell, we have not found this risk to be a significant problem. Inflationhas a lesser short-term effect on us because we generally negotiate fixed-pricecontracts with our subcontractors and material suppliers for the constructionof our homes. These prices are generally applicable for a specified number ofhomes.

There can be no assurance regarding the continuedhealth of the Southern California residential real estate market. Inparticular, (i) the significant increases in home prices over the last sixyears and the related decline in the affordability of new homes in SouthernCalifornia, (ii)  the state of the national economy, continued increasesin interest rates by the Federal Reserve Board and the possibility of arecession in the future, and (iii) the volatility in the stock market,collectively may exert recessionary pressures on the California economy and mayhave a negative impact on the Southern California housing market.

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While low mortgage rates have sustained housing demandto date, interest rates have been rising and any significant future increase inmortgage rates or significant loss of jobs in Southern California would mostlikely slow demand for new homes. Increases in home mortgage interest ratesmake it more difficult for our customers to qualify for home mortgage loans,potentially decreasing home sales volume and prices. The tight supply ofavailable homes in Southern California has resulted in significant home priceincreases over the last six years. As a result, the affordability of new homeshas been declining and could jeopardize future demand. The percentage of homebuyers utilizing variable-rate and/or interest only mortgages to affordSouthern California new home prices has been increasing. These buyers may bemore sensitive to increases in interest rates and may encounter difficulty inmaking increased mortgage payments on their homes in the future. This couldhave negative consequences on the demand for new homes if it results in reducedbuyer confidence and an increase in secondary market homes available for sale,competing with sales of new homes.

Approximately 38% (based on number of lots) of ouractive homebuilding projects are located in the “Inland Empire” area ofSouthern California, which includes Riverside and San Bernardino counties;however, in 2006 we will also be actively developing our 349-homeBrightwater community adjacent to Huntington Beach, California. None of ourprojects experienced any direct impact from the Southern California landslidesin early 2005. The Inland Empire has experienced significant population and jobgrowth in the past decade. While continued population growth and demand for newhomes are expected to continue, partially due to the limited supply ofaffordably priced housing in coastal areas such as Orange County, there can beno assurance that economic, demographic or other factors will not slow,diminish or cause such growth to diminish or cease. We are continuing to pursueland development and lot acquisition opportunities throughout SouthernCalifornia.

During 2005, the homebuilding environment remainedstrong due to a positive supply/demand relationship in Southern California, aswell as relatively low interest rates. As a result of this favorableenvironment and growth in the number of our active communities, our net neworders increased by 54% in 2005. Although the homebuilding businesshistorically has been cyclical, it has not undergone an economic down cycle ina number of years. Further, during 2005, home prices rose significantly in allof our markets. This has led some people to assert that the prices of land, newhomes and the stock prices of homebuilding companies may be inflated and maydecline if the demand for new homes weakens. A decline in the prices for newhomes could adversely affect both our revenues and margins. A decline in ourstock price could make raising capital through stock issuances more difficultand expensive.

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**CriticalAccounting Policies and Estimates**

In the preparation of theConsolidated Financial Statements, we applied accounting principles generallyaccepted in the United States of America. The application of generally acceptedaccounting principles may require management to make estimates and assumptionsthat affect the amounts reported in the financial statements and accompanyingresults. Listed below are those policies and estimates that we believe arecritical and require the use of complex judgment in their application. Inparticular, our critical accounting policies and estimates include theevaluation of the impairment of long-lived assets and the evaluation of theprobability of being able to realize the future benefits indicated by oursignificant federal tax net operating losses, as discussed further in Note 2 tothe Consolidated Financial Statements.

*Impairment ofLong-Lived Assets*

We assess the impairment of land held for futuredevelopment or sale, real estate inventories, and other long-lived assets inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” whichrequires that an impaired asset, for which costs cannot be recovered fromestimated undiscounted future cash flows, be written down to fair value.Long-lived assets are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. As provided by SFAS No. 144, impairment is evaluated bycomparing an asset’s carrying value to the undiscounted estimated cash flowsexpected from the asset’s operations and eventual disposition. If the sum ofthe undiscounted estimated future cash flows is less than the carrying value ofthe asset, an impairment loss is recognized based on the fair value of theasset. If impairment occurs, the fair value of an asset for purposes of SFAS No. 144is deemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction. These assets are carried at cost, unless thecarrying amount of the parcel or subdivision is determined not to be fullyrecoverable, in which case the impaired real estate is written down to fairvalue. Given the significance of the carrying value of land held for futuredevelopment or sale and real estate inventories, the application of SFAS No. 144in evaluating any potential impairment is critical to our consolidatedfinancial statements, as discussed further in Note 2 to the ConsolidatedFinancial Statements.

The Bolsa Chica property is our largest asset. Priorto the December 2005 receipt of our Brightwater permit, the property wasincluded in land held for future development or sale. In December 2005, wesold approximately 146 acres of the property to the State. Beginning in December 2005,the remaining portion consisting of approximately 214 acres is included in realestate inventories.

In accordance with SFAS No. 144, in developingestimated future cash flows for impairment testing, we incorporated our ownmarket assumptions including those regarding home prices, infrastructure,home-building costs, and financing costs regarding both land held for futuredevelopment or sale and real estate inventories. Additionally, as appropriate,we identify alternative courses of action to recover the carrying value of ourlong-lived assets and evaluate all likely alternatives under aprobability-weighted approach as described in SFAS No. 144.

The estimation processinvolved in the determination of value is inherently uncertain because itrequires estimates as to future events and market conditions. Such estimationprocess assumes our ability to complete development and disposition of our realestate properties in the ordinary course of business based on management’spresent plans and intentions. Economic, market, environmental and politicalconditions may affect management’s development and marketing plans. Inaddition, the implementation of such development and marketing plans could beaffected by the availability of future financing for development andconstruction activities. The development of our Brightwater project isdependent upon various economic factors. Accordingly, the amount ultimatelyrealized from such project may differ materially from current estimates and theproject’s carrying value.

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*Basis ofConsolidation*

Certain of ourwholly-owned subsidiaries are members in joint ventures involved in thedevelopment and sale of residential projects and residential loan production.Our consolidated statements include  ouraccounts and all of our majority-owned and controlled subsidiaries and jointventures. The financial statements of joint ventures in which we generally havea controlling or majority economic interest (and thus are controlled by us) areconsolidated with our financial statements. Minority interest represents theequity interest of our joint venture partner for one consolidated venture andis further described in Note 9 to the Consolidated Financial Statements. Ourinvestments in unconsolidated joint ventures are accounted for using the equitymethod when we do not have voting or economic control of the ventureoperations, as further discussed in Note 5 to the Consolidated FinancialStatements.

*Income Taxes*

We account for income taxes on the liability method.Deferred income taxes are determined based on the difference between thefinancial statement and tax bases of assets and liabilities. The liabilitymethod requires an evaluation of the probability of being able to realize thefuture benefits indicated by deferred tax assets, such as tax net operatinglosses. A valuation allowance related to the deferred tax asset is recordedwhen it is more likely than not that some portion or all of the deferred taxasset will not be realized. Given the significance of our historical federaltax net operating losses, as discussed in Note 8 to the Consolidated FinancialStatements, the application of our policy in evaluating the expected futurebenefit of net operating losses is critical. In applying those policies,estimates and judgments affect the amounts at which certain assets andliabilities are recorded. We apply our accounting policies on a consistentbasis. As circumstances change, they are considered in our estimates andjudgments, and future changes in circumstances could result in changes inamounts at which assets and liabilities are recorded.

We remain subject to thegeneral rules of Section 382, which limit the availability of netoperating losses if an ownership change occurs. If we were to experienceanother ownership change, the amount of net operating losses available wouldgenerally be limited to an annual amount equal to (i) the value of ourequity immediately before the ownership change, multiplied by the long-termtax-exempt rate (4.61% as of February 2006) plus (ii) recognizedbuilt-in-gains, defined as those gains recognized within five years of theownership change subject to an overall limitation of the net unrealizedbuilt-in gains existing as of the ownership change date. We believe we have netunrealized built-in gains sufficient to allow utilization of the entire netoperating loss, assuming that we are able to recognize these gains within thefive-year time limitation. We estimate that as of February 28, 2006, wehave experienced a three-year cumulative ownership shift of approximately 40%,as computed in accordance with Section 382.

*HomebuildingRevenues and Cost of Sales*

Our homebuilding operationgenerates revenues from the sale of homes to homebuyers. The majority of thesehomes are designed to appeal to move-up homebuyers and the homes are generallyoffered for sale in advance of their construction. Sales contracts are usuallysubject to certain contingencies such as the buyer’s ability to qualify forfinancing. Revenue from the sale of homes is recognized at closing when titlepasses to the buyer, and the earnings process is complete. As a result, ourrevenue recognition process does not involve significant judgments orestimates. However, we do rely on certain projections and estimates todetermine the related construction costs and resulting gross margins associatedwith revenues recognized. The cost of sales is recorded based upon totalestimated costs within a subdivision and allocated using the relative salesvalue method. Our construction costs are comprised of direct and allocatedcosts, including estimated costs for future warranties and indemnities. Ourestimates are based on historical results, adjusted for current factors.

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*Litigation Reserves*

We and certain of oursubsidiaries have been named as defendants in various cases arising in thenormal course of business and regarding assets and businesses disposed of by usor our former affiliates. See Notes 7 and 10 in our financial statementsincluded in this Annual Report. We have reserved for costs expected to beincurred with respect to these cases based upon information provided by ourlegal counsel. There can be no assurance that total litigation costs actuallyincurred will not exceed the amount of such reserve.

**New Accounting Pronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS 123(R)”). This Statement replaces SFAS 123, “Accounting forStock-Based Compensation” and supersedes Accounting Principles Board (“APB”)Opinion No. 25. “Accounting for Stock Issued to Employees.”  SFAS 123(R) addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices in exchange for (a) equity instruments of the enterprise or (b) liabilitiesthat are based on the fair value of the enterprise’s equity instruments or thatmay be settled by the issuance of such equity instruments. SFAS 123(R) eliminatesthe ability to account for share-based compensation transactions using theintrinsic value method under APB No. 25, and generally would requireinstead that such transactions be accounted for using a fair-value-based method.In the first quarter of 2006, we will adopt SFAS 123(R) using the modifiedprospective method, which requires that compensation is recognized on or afterthe required effective date for the portion of outstanding awards for which therequisite service has not yet been rendered, based on the grant-date fair valueof those awards calculated under SFAS 123 for either recognition or pro formadisclosures. As discussed further in Note 13—Stock Plans, we adopted the fairvalue recognition provisions of SFAS 123 in 2003. The adoption of SFAS 123(R) willnot have a material impact on our consolidated financial position, results ofoperations, or cash flows.

In December 2004, the FASB issued SFAS No. 153,“Exchanges of Nonmonetary Assets—An amendment of APB 29, Accounting forNonmonetary Transactions” (“SFAS 153”). This statement amends APB 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance. A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. This statement is effectivebeginning in our first quarter of 2006. We have evaluated the impact ofadopting SFAS 153 and have determined that it will not have a material impacton our consolidated financial position, results of operations, or cash flows.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections” (“SFAS 154”). This statement replaces APBOpinion No. 20, “Accounting Changes” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS 154 requires retrospective application of changes in accountingprinciple to prior periods’ financial statements unless it is impracticable todetermine the period-specific effects or the cumulative effect of the change.This statement is effective beginning in our first quarter of 2006. We haveevaluated the impact of adopting SFAS 154 and have determined that it will nothave a material impact on our consolidated financial position, results ofoperations, or cash flows.

In June 2005, theEmerging Issues Task Force (“EITF”) reached a final consensus on Issue No. 04-5,“Determining Whether a General Partner, or the General Partners as a Group,Controls a Limited Partnership or Similar Entity When the Limited Partners HaveCertain Rights” (“EITF 04-5”). EITF 04-5 affects the consolidationof entities in which a general partner or managing member is presumed tocontrol a partnership or limited liability company. EITF 04-5 will beeffective for us beginning in the first quarter 

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of 2006.We have evaluated the impact of adopting EITF 04-5 and have determinedthat it will not have a material impact on our consolidated financial position,results of operations, or cash flows upon initial adoption. EITF 04-5 maymaterially impact our consolidated financial position, results of operations,or cash flows in future periods should we form new limited partnerships ormodify existing limited partnerships such that we are deemed to control thelimited partnership. Under those circumstances, we may be required by EITF 04-5to consolidate the limited partnership. 

**Liquidity and Capital Resources**

Year-over-yearchanges in the principal components of our liquidity and capital resources areas follows (in millions, except percentages):

| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents                       |       | $        | 7.7        |     | $          | 9.0      |       | $ | 14.7 |   |
| Short-term  investments                          |       | 30.3     |       | —   |       | —   |       |
| Cash (used in)  provided by operating activities |       | (4.6     | )          | (9.7     | )          | 0.9      |       |
| Cash used in  investing activities               |       | (31.6    | )          | (1.1     | )          | —   |       |
| Cash provided by  financing activities           |       | 34.9     |       | 5.1      |       | 4.6      |       |
|                                                  |            |          |            |          |            |          |            |  |  |  |

 

The principal assets in our portfolio are residentialland which must be held over an extended period of time in order to bedeveloped to a condition that, in management’s opinion, will ultimatelymaximize our return. Consequently, we require significant capital to financeour real estate development and homebuilding operations. Historically, sourcesof capital have included loan facilities secured by specific projects, assetsales and available internal funds. We are currently utilizing internallygenerated cash to fund our Brightwater land development project at Bolsa Chicaand, along with joint venture contributions, to fund the Oxnard landdevelopment project. We expect to obtain construction financing forinfrastructure and homebuilding activities at Brightwater. We expect to make anaggregate additional capital contribution of approximately $1.3 million to theOxnard joint venture during 2006. See Note 5 in our financial statementsincluded in this Annual Report. We are utilizing internally generated cash andproject debt to fund construction of our homebuilding projects. Our current andpending homebuilding projects, (excluding Brightwater) which are primarily inthe “Inland Empire” area of Southern California (Riverside and San Bernardinocounties) and Lancaster in northeastern Los Angeles County, are currentlyexpected to generate approximately $90 million of positive cash flows over thenext three years, based on present economic conditions and market assumptions.However, any adverse change in such conditions or assumptions would adverselyimpact the amount of our cash flows. Our unrestricted cash and cash equivalentsand short-term investments as of December 31, 2005 were $38 million. Webelieve that our cash and cash equivalents, short-term investments, future realestate sales proceeds, and funds available under our current and future creditagreements will be sufficient to meet anticipated operating and capitalinvestment requirements, primarily project development costs for homebuildingprojects, and the Oxnard and Brightwater land development projects, along withgeneral and administrative expenses, for at least the next 12 months.

We are subject to the usual obligations associatedwith entering into contracts for the purchase of land and improved homesites.The purchase of properties under these contracts is generally contingent uponsatisfaction of certain requirements by the sellers, including obtainingapplicable property entitlements. We also utilize option contracts withthird-party land sellers and financial entities as a method of acquiring landin staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Purchase and option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. We have the right atour discretion to terminate our obligations under these land 

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purchase and optionagreements by forfeiting the cash deposit with no further financialresponsibility. As of December 31, 2005, we have no consolidated landoption deposits. However, our unconsolidated Oxnard joint venture does haveland deposits.

We may enter into land developmentand homebuilding joint ventures from time to time as a means of expanding ourmarket opportunities, establishing strategic alliances, managing our riskprofile and leveraging our capital base. These joint ventures may obtainsecured acquisition, development and construction financing, which minimize theuse of funds from other corporate financing sources.

*2005 Compared with2004*

Cash flows from operations for 2005 primarily reflectsales proceeds of $62.7 million from deliveries of 113 homes and land salesproceeds of $66.8 million, primarily from the sale of the lower bench portionof the Bolsa Chica mesa. Approximately $30 million of the proceeds from thesale of the lower bench were used to repay project debt in December 2005,and an additional $30 million was invested in short-term auction ratesecurities, which are long-term municipal bonds and preferred stock withinterest rates that reset through an auction process every seven to 90 days.Cash flows from financing activities reflect net borrowing under project debtfinancing of $35.3 million. These sources of funds were used primarily forinvestments in real estate and construction costs of $122.9 million, includingthe acquisition of an aggregate of 434 lots in 2005. Lots acquired were throughoutSouthern California and include 151 in Corona, 149 in Lancaster, 102 inBeaumont, 26 in Ontario and 6 lots in the Rancho Santa Fe, California area.Other significant uses of cash include joint venture (minority interest)distributions for the Chino project of $600,000, approximately $3.7 million forinvestment in the Brightwater project, primarily for consultants engaged in theentitlement process, and selling, general and administrative expenses paid ofapproximately $5.3 million. These items, as well as other activity presented inthe Statements of Cash Flows, resulted in the $1.3 million decrease in cash andcash equivalents.

The $203.7 million increase in real estate inventoriesreflects (i) $131 million reflecting the inclusion of 110 acres of theBolsa Chica upper mesa that, prior to issuance of the permit for Brightwater inDecember 2005, was included in land held for development or sale, and (ii) thepurchase of 434 lots described above and project construction, partially offsetby reductions recorded upon sale of homes.

The $5.0 million decrease in other assets primarilyreflects a decrease in predevelopment costs, which primarily includes landoption deposits and related costs, as of December 31, 2005.

Accounts payable and accrued liabilities increased by$2.4 million, to a balance of $17.4 million as of December 31, 2005,primarily reflecting an increase in current taxes payable resulting from thesale of the lower bench of Bolsa Chica and an increased level of monthlyaccounts payable for project construction costs, partially offset by areduction in amounts due to land sellers for participation in homebuildingprofits from certain projects.

The $1.4 million decrease in other liabilitiesprimarily reflects reductions in contingent indemnity and environmentalobligations related to the Dresser litigation settled in April 2005 andthe lowland remediation completed in December 2005, partially offset by a$500,000 increase in warranty reserves. See Note 7 in our financial statementsincluded in this Annual Report.

The $38.8 million increasein capital in excess of par value primarily reflects the reversal of $38.5million of valuation reserves on pre-Reorganization federal net operatinglosses utilized during 2005 and anticipated to be utilized in the future. Anadditional increase of approximately $400,000 for issuance of common stockpursuant to option exercises and the related state tax effect are alsoreflected.

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*2004 Compared with2003*

Cash provided by (used in) operating activities was$(9.7) million in 2004 compared to $900,000 in 2003. This change is primarilydue to the use of $79.7 million to acquire 265 lots throughout SouthernCalifornia, compared with $47.9 million in 2003. During 2004, 104 lots werepurchased in Lancaster, 83 in Corona, 43 near Riverside, 17 in Chino and 18 inthe Rancho Santa Fe area. Cash outflows for the acquisition of lots were offsetby sales proceeds of $75.7 million in 2004 compared with $55.7 million in 2003.Cash flows from homebuilding operations for 2004 primarily reflect salesproceeds of $75.9 million from deliveries of 135 homes and cash flows fromfinancing activities reflect net borrowing under project debt financing of$12.2 million. Other significant uses of cash include joint venture (minorityinterest) distributions for the Chino project of $7.6 million, approximately$2.8 million for investment in the Brightwater project, primarily forconsultants engaged in the entitlement process, and selling, general andadministrative expenses paid of approximately $5.5 million. These items, aswell as other activity presented in the Statements of Cash Flows, resulted inthe $5.7 million decrease in cash and cash equivalents.

The $22.4 million increase in real estate inventoriesreflects the purchase of 265 lots described above and project construction,partially offset by reductions recorded upon sale of homes.

The $7.4 million increase in other assets primarilyreflects deposits for purchases of entitled land in Southern California and netdeferred tax assets, reflected as of December 31, 2003 as a net liability.

Accounts payable and accrued liabilities increased by$8.7 million, to a balance of $15.0 million as of December 31, 2004,primarily reflecting accruals of $6.3 million for estimated payments due toland sellers for participation in homebuilding profits from certain projects,an increased level of monthly accounts payable for project construction and anincreased accrual for incentive bonuses related to our homebuilding operation.

The $3.6 million decrease in other liabilitiesprimarily reflects the reversal of valuation reserves on pre-reorganization netoperating losses described below. The resulting net deferred tax balance isreflected as an asset as of December 31, 2004.

The $9.7 million increasein capital in excess of par value primarily reflects the reversal of $9.1million of valuation reserves on pre-Reorganization federal net operatinglosses utilized during 2004 and anticipated to be utilized in the future. Additionalincreases of approximately $300,000 for recognition of non-cash compensationexpense for stock options and $300,000 for issuance of common stock pursuant tooption exercises and the related state tax effect are also reflected.

**Off Balance Sheet Financing**

In the ordinary course of business, we enter into landoption contracts in order to procure land for the construction of homes. Theuse of such option agreements allows us to reduce the risks associated withland ownership and development; reduce our financial commitments, including interestand other carrying costs; and minimize land inventories. Under such land optioncontracts, we will fund a specified option deposit or earnest money deposit inconsideration for the right to purchase land in the future, usually at apredetermined price. Our liability is generally limited to forfeiture of thenonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of December 31, 2005, we have no consolidated land optiondeposits and no material third party guarantees.

We also acquire land and conduct residentialconstruction activities through participation in joint ventures in which wehold less than a controlling interest. Through joint ventures, we reduce andshare our risk and also reduce the amount invested in land, while increasingour access to potential future home sites. The use of joint ventures also, insome instances, enables us to acquire land which we might not otherwise obtainor access on as favorable terms, without the participation of a strategic partner.While we 

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view the use ofunconsolidated joint ventures as beneficial to our homebuilding activities, wedo not view them as essential to those activities.

Our investment in unconsolidated joint venturestotaled $700,000 at December 31, 2005 and 2004. These joint ventures hadtotal assets of $5.8 million and $5.4 million as of December 31, 2005 and2004, respectively, which included land deposits of $1.6 million and$1.1 million, respectively. In certain instances, we may provide varyinglevels of guarantees on debt of unconsolidated joint ventures. As of December 31,2005, we provide no guarantees on debt of unconsolidated joint ventures.

Under the requirements ofFASB Interpretation No. 46(R), “Consolidation of Variable InterestEntities” (“FASB Interpretation No. 46(R)”), certain of our land optioncontracts may create a variable interest for us, with the land seller beingidentified as a VIE. In compliance with FASB Interpretation No. 46(R), weanalyzed our land option contracts and other contractual arrangements and haveconsolidated the fair value of certain VIEs from which we are purchasing landunder option contracts.

**Results of Operations**

The nature of ourbusiness, including our limited inventory of buildable lots, is such that thestatus of each project often causes significant fluctuations in operatingresults from quarter-to-quarter and year-to-year.

*2005 Compared with2004*

We reported revenues of $129.5 million and grossoperating profit of $48.0 million for 2005, compared with $76.0 million inrevenues and gross operating profit of $18.4 million for 2004. Revenues for2005 reflect the $65 million sale of the lower bench portion of the Bolsa Chicamesa, the $1.7 million sale of 43 acres in the Bolsa Chica lowlands, anddeliveries of 113 homes, including 29 at the Chino projects, 23 homes at ourRiverside (Jasper Ranch) project, 55 homes at the Lancaster project, and 6homes at the Rancho Santa Fe project. The results for the prior year reflectdeliveries of an aggregate of 135 homes at the Riverside, North Corona andChino projects. The homebuilding gross margin for 2005 of 19.9% is lower thanthe prior year’s homebuilding gross margin of 24.1% due to the lowerprofitability of the Lancaster homes delivered during 2005 as compared with theRiverside (Jasper Ranch) and Chino homes delivered during 2004. Home prices inthe Lancaster area are generally lower than prices of comparable homes in theInland Empire region. This decrease is also due to increased raw materialscosts, as well as lower levels of price appreciation resulting from shorterholding periods for the land underlying the homes delivered during 2005.

The $500,000 decrease in selling, general andadministrative expenses to $5.3 million in 2005 compared with $5.8 million in 2004,primarily reflects an $800,000 decrease in accrued incentive compensation forour homebuilding business, and the decrease of $200,000 of non-cashcompensation expense as a result of the issuance and vesting of stock optionsin 2004. These decreases were partially offset by increased audit fees,primarily related to Sarbanes Oxley compliance.

The $1.4 million of other expense, net for 2005primarily reflects increases in warranty reserves, partially offset by adecrease in environmental accruals. The $1.1 million of other expense, net in2004 includes a $500,000 accrual for the Dresser litigation settlement. SeeNote 7 in our financial statements included in this Annual Report.

The effective income taxrate for the year ended December 31, 2005 is 30.3%, as compared with aneffective income tax rate of 38.5% during 2004. The decrease in the effectiverate primarily reflects a tax benefit of $4.7 million for the reversal ofvaluation allowances on post-Reorganization state net operating losses.

41

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*2004 Compared with2003*

We reported revenues of $76.0 million and grossoperating profit of $18.4 million for 2004, compared with $55.8 million inrevenues and gross operating profit of $10.3 million for 2003. Revenues for2004 reflect deliveries of 135 homes, including 65 at the Chino Reserveproject, 32 at the Providence Ranch project and 38 homes at our Riverside(Jasper Ranch) project and a $100,000 land sale. The results for the prior yearreflect deliveries of an aggregate of 154 homes at the Riverside, North Coronaand Yucaipa projects. The homebuilding gross margin for 2004 of 24.1% is higherthan the prior year’s homebuilding gross margin of 17.0% due to home priceappreciation experienced over the past year and higher profitability of theRiverside (Jasper Ranch), Chino and North Corona homes delivered during 2004 ascompared with the North Corona and Riverside (Harvest) homes delivered during2003.

The $1.4 million increase in selling, general andadministrative expenses to $5.8 million in 2004 compared with $4.4 million in2003, primarily reflects an increase in accrued incentive compensation for ourhomebuilding business of $1.0 million, and $300,000 for non-cash compensationexpense as a result of the issuance and vesting of stock options in 2004.

The $1.1 million of other expense, net for 2004primarily reflects increases in litigation and environmental accruals,including a $500,000 accrual for the Dresser litigation settlement. The $1.1million of other expense, net in 2003 includes accruals of approximately$700,000 for estimated environmental remediation costs for the 43-acreBolsa Chica lowland remediation and $300,000 for contingent indemnityobligations related to asbestos claims, partially offset by income ofapproximately $400,000 from recovery of the value of water rights certificates,related to a completed project, which had been reserved. See Note 7 in ourfinancial statements included in this Annual Report.

The effective income tax rate for the year ended December 31,2004 is 38.5%, as compared with an effective income tax rate of 43.1% during2003. The decrease in the effective rate primarily reflects a tax benefit of$400,000 for the reversal of valuation allowances on post-Reorganization statenet operating losses. In addition, during each of 2004 and 2003, we recorded atax benefit of approximately $100,000 in connection with the resolution ofoutstanding tax matters in two and eight states, respectively.

*Payments UnderContractual Obligations*

We have enteredinto certain contractual obligations to make future payments for items such asproject debt and lease agreements. A summary of the payments due underspecified contractual obligations, aggregated by category of contractualobligation, for specified time periods is presented below as of December 31,2005 (in millions):

| ** **       | ** ** | **Payments due by period** | ** ** |
|------------------|------------|-------------------------------------------|------------|
| ** **       | ** ** | **Total**                                 | ** ** | **Less  than 1  year** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **More  than 5  years** | ** ** |
| Project debt     |       | $                                         | 57.9       |   | $ | 28.4 |   | $ | 29.5 |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating leases |       | 0.2                                       |       | 0.2 |   | — |   |   | — |   |   |   | — |   |   |
| Total            |       | $                                         | 58.1       |   | $ | 28.6 |   | $ | 29.5 |   |   | $ | — |   |   |   | $ | — |   |   |

Ourpurchase contracts which are made in the normal course of our homebuildingbusiness for land acquisition and construction subcontracts are generallycancelable at will. Other contractual obligations including our taxliabilities, accrued benefit liability for a frozen retirement plan and otheraccrued pensions, home warranty reserves and contingent indemnity andenvironmental obligations are estimated based on various factors. Payments arenot due as of a given date, but rather are dependent upon the incurrence ofprofessional services, the lives of annuitants and other factors. Theestimation process involved in the determination of carrying values of theseobligations is inherently uncertain since it requires estimates as to futureevents and contingencies. We have provided additional disclosure in Item 3. “LegalProceedings” and in  Note 7 to ourConsolidated Financial Statements in this Annual Report.

42

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To The Board of Directors and Stockholdersof California Coastal Communities, Inc.:

We have audited the accompanying consolidated balancesheets of California Coastal Communities, Inc. and its subsidiaries (the “Company”)as of December 31, 2005 and 2004 and the related consolidated statementsof income and comprehensive income, cash flows, and changes in stockholders’equity for each of the three years in the period ended December 31, 2005.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of CaliforniaCoastal Communities, Inc. and its subsidiaries as of December 31, 2005and 2004 and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2005, in conformity withaccounting principles generally accepted in the United States of America.

We have also audited, in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates), the effectiveness of the Company’s internal control over financialreporting as of December 31, 2005, based on the criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated March 14, 2006 expressed an unqualified opinion on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.

**Deloitte &Touche LLP**

**CostaMesa, California**

March 14, 2006

F-1

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

| ** **                                                                                                                              | ** ** | **December 31**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                              | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                                                                                                              | ** ** | **(in millions)** | ** ** |
| **ASSETS**                                                                                                                              |       |                   |       |   |   |
| Cash and cash  equivalents                                                                                                              |       | $                      | 7.7        |   | $ | 9.0 |   |
| Short-term  investments                                                                                                                 |       | 30.3                   |       | — |   |
| Restricted cash                                                                                                                         |       | 2.3                    |       | 1.1 |   |
| Real estate  inventories                                                                                                                |       | 253.6                  |       | 49.9 |   |
| Consolidated real  estate to be held for current development—not owned                                                             |       | —                 |       | 24.7 |   |
| Land held for  future development or sale                                                                                               |       | —                 |       | 156.4 |   |
| Deferred tax  assets                                                                                                                    |       | 35.4                   |       | 3.6 |   |
| Other assets                                                                                                                            |       | 1.1                    |       | 6.1 |   |
|                                                                                                                                    |       | $                      | 330.4      |   | $ | 250.8 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                           |       |                   |       |   |   |
| Liabilities:                                                                                                                            |       |                   |       |   |   |
| Accounts payable and accrued liabilities                                                                                                |       | $                      | 17.4       |   | $ | 15.0 |   |
| Project debt                                                                                                                            |       | 57.9                   |       | 22.6 |   |
| Consolidated obligations related to real estate—not  owned                                                                         |       | —                 |       | 24.7 |   |
| Other liabilities                                                                                                                       |       | 7.9                    |       | 9.3 |   |
| Total liabilities                                                                                                                       |       | 83.2                   |       | 71.6 |   |
| Minority interest                                                                                                                       |       | .3                     |       | .3 |   |
| Commitments and contingencies                                                                                                           |       |                   |       |   |   |
| Stockholders’  equity:                                                                                                             |       |                   |       |   |   |
| Common Stock—$.05  par value; 13,500,000 shares authorized; 10,160,212 and 10,130,212 shares  issued and outstanding, respectively |       | .5                     |       | .5 |   |
| Excess Stock—$.05  par value; 13,500,000 shares authorized; no shares outstanding                                                  |       | —                 |       | — |   |
| Capital in excess  of par value                                                                                                         |       | 191.6                  |       | 152.8 |   |
| Retained earnings                                                                                                                       |       | 56.6                   |       | 28.2 |   |
| Accumulated other  comprehensive loss                                                                                                   |       | (1.8                   | )          | (2.6 | ) |
| Total stockholders’ equity                                                                                                         |       | 246.9                  |       | 178.9 |   |
|                                                                                                                                    |       | $                      | 330.4      |   | $ | 250.8 |   |

 

See accompanying notes to consolidated financial statements.

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

**AND COMPREHENSIVEINCOME**

| ** **                                                             | ** ** | **For the Years EndedDecember 31,**              | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                             | ** ** | **(in millions, except per share amounts)** | ** ** |
| Revenues:                                                              |       |                                                                 |       |   |   |   |   |
| Homebuilding                                                           |       | $                                                                    | 62.7       |   | $ | 75.9 |   | $ | 54.7 |   |
| Non-residential land                                                   |       | 66.8                                                                 |       | .1 |   | 1.1 |   |
|                                                                   |       | 129.5                                                                |       | 76.0 |   | 55.8 |   |
| Cost of sales:                                                         |       |                                                                 |       |   |   |   |   |
| Homebuilding                                                           |       | 50.2                                                                 |       | 57.6 |   | 45.4 |   |
| Non-residential land                                                   |       | 31.3                                                                 |       | — |   | .1 |   |
|                                                                   |       | 81.5                                                                 |       | 57.6 |   | 45.5 |   |
| Gross operating profit                                                 |       | 48.0                                                                 |       | 18.4 |   | 10.3 |   |
| Selling, general  and administrative expenses                          |       | 5.3                                                                  |       | 5.8 |   | 4.4 |   |
| Interest expense                                                       |       | .1                                                                   |       | .2 |   | .2 |   |
| Income from  unconsolidated joint ventures                             |       | (.1                                                                  | )          | (.4 | ) | (.5 | ) |
| Other expense,  net                                                    |       | 1.4                                                                  |       | 1.1 |   | 1.1 |   |
| Income before income taxes                                             |       | 41.3                                                                 |       | 11.7 |   | 5.1 |   |
| Provision for income taxes                                             |       | 12.5                                                                 |       | 4.5 |   | 2.2 |   |
| Minority interest  in income of consolidated joint venture, net of tax |       | .4                                                                   |       | 2.4 |   | — |   |
| Net income                                                             |       | $                                                                    | 28.4       |   | $ | 4.8 |   | $ | 2.9 |   |
| Other  comprehensive income (loss), net of income taxes:               |       |                                                                 |       |   |   |   |   |
| Minimum pension liability adjustment                                   |       | .8                                                                   |       | (.2 | ) | — |   |
| Comprehensive income                                                   |       | $                                                                    | 29.2       |   | $ | 4.6 |   | $ | 2.9 |   |
| Net earnings per  common share:                                        |       |                                                                 |       |   |   |   |   |
| Basic                                                                  |       | $                                                                    | 2.78       |   | $ | .48 |   | $ | .29 |   |
| Diluted                                                                |       | $                                                                    | 2.70       |   | $ | .44 |   | $ | .27 |   |
| Common equivalent  shares:                                             |       |                                                                 |       |   |   |   |   |
| Basic                                                                  |       | 10.2                                                                 |       | 10.1 |   | 10.1 |   |
| Diluted                                                                |       | 10.5                                                                 |       | 10.8 |   | 10.8 |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**CALIFORNIACOASTAL COMMUNITIES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

| ** **                                                                                                                                                  | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2005**                                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                  | ** ** | **(in millions)**                                    | ** ** |
| Cash flows from  operating activities:                                                                                                                      |       |                                                      |       |   |   |   |   |
| Net income                                                                                                                                                  |       | $                                                         | 28.4       |   | $ | 4.8 |   | $ | 2.9 |   |
| Adjustments to  reconcile net income to cash (used in) provided by operating activities:                                                                    |       |                                                      |       |   |   |   |   |
| Income from unconsolidated joint ventures                                                                                                                   |       | (.1                                                       | )          | (.4 | ) | (.5 | ) |
| Distributions from unconsolidated joint ventures                                                                                                            |       | .2                                                        |       | .4 |   | .5 |   |
| Amortization of discount                                                                                                                                    |       | .1                                                        |       | .2 |   | .2 |   |
| Benefit from reversal of deferred tax asset  allowance                                                                                                      |       | (4.7                                                      | )          | — |   | — |   |
| Stock-based compensation expense                                                                                                                            |       | —                                                    |       | .3 |   | — |   |
| Tax benefit from exercise of stock options                                                                                                                  |       | —                                                    |       | (.3 | ) | — |   |
| Deferred taxes                                                                                                                                              |       | 12.6                                                      |       | — |   | — |   |
| Minority interest in income of consolidated joint  venture                                                                                                  |       | .4                                                        |       | 2.4 |   | — |   |
| Gains on sales of real estate inventories                                                                                                                   |       | (48.0                                                     | )          | (18.4 | ) | (10.3 | ) |
| Proceeds from real estate sales, net                                                                                                                        |       | 62.4                                                      |       | 75.6 |   | 54.7 |   |
| Proceeds from land sales, net                                                                                                                               |       | 64.9                                                      |       | .1 |   | 1.0 |   |
| Investments in real estate inventories                                                                                                                      |       | (122.9                                                    | )          | (79.7 | ) | (47.9 | ) |
| Changes in assets  and liabilities:                                                                                                                         |       |                                                      |       |   |   |   |   |
| Investment in land held for future development                                                                                                              |       | (3.7                                                      | )          | (2.8 | ) | (1.7 | ) |
| Decrease (increase) in other assets                                                                                                                         |       | 5.0                                                       |       | (.2 | ) | (.8 | ) |
| Increase in accounts payable, accrued and other liabilities                                                                                                 |       | .8                                                        |       | 8.3 |   | 2.8 |   |
| Cash (used in) provided by operating activities                                                                                                             |       | (4.6                                                      | )          | (9.7 | ) | .9 |   |
| Cash flows from  investing activities:                                                                                                                      |       |                                                      |       |   |   |   |   |
| Purchases of short-term investments                                                                                                                         |       | (30.3                                                     | )          | — |   | — |   |
| Investments in unconsolidated joint ventures                                                                                                                |       | (.1                                                       | )          | — |   | — |   |
| Change in restricted cash                                                                                                                                   |       | (1.2                                                      | )          | (1.1 | ) | — |   |
| Cash used in investing activities                                                                                                                           |       | (31.6                                                     | )          | (1.1 | ) | — |   |
| Cash flows from  financing activities:                                                                                                                      |       |                                                      |       |   |   |   |   |
| Borrowings of project debt                                                                                                                                  |       | 109.7                                                     |       | 49.3 |   | 23.6 |   |
| Repayments of project debt                                                                                                                                  |       | (74.4                                                     | )          | (37.1 | ) | (23.0 | ) |
| Proceeds from exercise of warrants and stock options                                                                                                        |       | .3                                                        |       | .2 |   | .1 |   |
| Tax benefit from exercise of stock options                                                                                                                  |       | —                                                    |       | .3 |   | — |   |
| Minority interest (distributions) contributions                                                                                                             |       | (.7                                                       | )          | (7.6 | ) | 3.9 |   |
| Cash provided by financing activities                                                                                                                       |       | 34.9                                                      |       | 5.1 |   | 4.6 |   |
| Net (decrease) increase in cash and cash equivalents                                                                                                        |       | (1.3                                                      | )          | (5.7 | ) | 5.5 |   |
| Cash and cash  equivalents—beginning of year                                                                                                           |       | 9.0                                                       |       | 14.7 |   | 9.2 |   |
| Cash and cash  equivalents—end of year                                                                                                                 |       | $                                                         | 7.7        |   | $ | 9.0 |   | $ | 14.7 |   |
| Supplemental  disclosures of cash flow information:                                                                                                         |       |                                                      |       |   |   |   |   |
| Cash paid during the period for income taxes, net of  refunds received                                                                                      |       | $                                                         | .8         |   | $ | .5 |   | $ | .7 |   |
| Supplemental disclosures  of non-cash investing and financing activities:                                                                                   |       |                                                      |       |   |   |   |   |
| (Minimum pension  liability adjustment recorded as other comprehensive income loss), net of  income tax (benefit) of $(.9), $0 and $0 million, respectively |       | .8                                                        |       | (.2 | ) | — |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

| ** **                                                    | ** ** | **Common  Stock**      | ** ** | **Capital in  Excess of  Par Value** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------------------|------------|------------------------|------------|-----------------------------------------------------------|------------|-----------|------------|
| ** **                                                    | ** ** | **(in millions)** | ** ** |
| Balance at  January 1, 2003                              |       |                   | $          | .5                                                  |       |                   |       | $                                                         | 141.3      |      |       |   | $ | 20.5 |   |   |   | $ | (2.4 | ) |   | $ | 159.9 |   |
| Net income                                                    |       |                   | —     |                                                |       |                   | —     |                                                      |       |      | 2.9        |   |   |   | — |   |   | 2.9 |   |
| Exercise of warrants                                          |       |                   | —     |                                                |       |                   | .1         |                                                      |       |      | —     |   |   |   | — |   |   | .1 |   |
| Utilization of pre-reorganization net operating  losses  |       |                   | —     |                                                |       |                   | 1.7        |                                                      |       |      | —     |   |   |   | — |   |   | 1.7 |   |
| Balance at  December 31, 2003                            |       |                   | .5         |                                                |       |                   | 143.1      |                                                      |       |      | 23.4       |   |   |   | (2.4 | ) |   | 164.6 |   |
| Net income                                                    |       |                   | —     |                                                |       |                   | —     |                                                      |       |      | 4.8        |   |   |   | — |   |   | 4.8 |   |
| Other comprehensive loss, net of income taxes                 |       |                   | —     |                                                |       |                   | —     |                                                      |       |      | —     |   |   |   | (.2 | ) |   | (.2 | ) |
| Stock-based compensation expense—stock options           |       |                   | —     |                                                |       |                   | .3         |                                                      |       |      | —     |   |   |   | — |   |   | .3 |   |
| Exercise of stock options and related state taxes             |       |                   | —     |                                                |       |                   | .3         |                                                      |       |      | —     |   |   |   | — |   |   | .3 |   |
| Utilization of pre-reorganization net operating  losses  |       |                   | —     |                                                |       |                   | 9.1        |                                                      |       |      | —     |   |   |   | — |   |   | 9.1 |   |
| Balance at  December 31, 2004                            |       |                   | .5         |                                                |       |                   | 152.8      |                                                      |       |      | 28.2       |   |   |   | (2.6 | ) |   | 178.9 |   |
| Net income                                                    |       |                   | —     |                                                |       |                   | —     |                                                      |       |      | 28.4       |   |   |   | — |   |   | 28.4 |   |
| Other comprehensive income, net of income taxes               |       |                   | —     |                                                |       |                   | —     |                                                      |       |      | —     |   |   |   | .8 |   |   | .8 |   |
| Exercise of stock options and related taxes                   |       |                   | —     |                                                |       |                   | .3         |                                                      |       |      | —     |   |   |   | — |   |   | .3 |   |
| Utilization of pre-reorganization net operating  losses  |       |                   | —     |                                                |       |                   | 38.5       |                                                      |       |      | —     |   |   |   | — |   |   | 38.5 |   |
| Balance at  December 31, 2005                            |       |                   | $          | .5                                                  |       |                   |       | $                                                         | 191.6      |      |       |   | $ | 56.6 |   |   |   | $ | (1.8 | ) |   | $ | 246.9 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note1—Formation and Basis of Presentation**

California Coastal Communities, Inc. includingits consolidated subsidiaries (the “Company”) was formerly known as Koll RealEstate Group, Inc. (October 1993—April 1998), The Bolsa ChicaCompany (July 1992—September 1993), Henley Properties Inc. (December 1989—July 1992)and The Henley Group, Inc. (December 1988—December 1989). Theprincipal activities of the Company currently include: (i) obtainingzoning and other entitlements for land it owns or controls through purchaseoptions, (ii) improving the land for residential development, and (iii) designing,constructing and selling single-family residential homes in SouthernCalifornia. Once the residential land owned by the Company is entitled, theCompany may build homes; sell unimproved land to other developers orhomebuilders; sell improved land to homebuilders; or participate in jointventures with other developers, investors or homebuilders to finance andconstruct infrastructure and homes.

On December 31, 1989, The Henley Group, Inc.separated its business into two public companies through a distribution to itscommon stockholders of all of the common stock of a newly formed Delawarecorporation to which The Henley Group, Inc. had contributed its non-realestate development operations, certain assets and related and unrelatedliabilities. The new company was named The Henley Group, Inc. (“HenleyGroup”) immediately following the distribution. The remaining company wasrenamed Henley Properties Inc. (“Henley Properties”) and consisted of the realestate development business and assets of Henley Group, including its principalsubsidiary Signal Landmark.

On July 16, 1992, a subsidiary of HenleyProperties merged with and into Henley Group (the “Merger”) and Henley Groupbecame a wholly owned subsidiary of Henley Properties. In the Merger, HenleyProperties, through its Henley Group subsidiary, received net assets having a bookvalue as of July 16, 1992 of approximately $45.3 million. In connectionwith the Merger, Henley Properties was renamed The Bolsa Chica Company.

On September 30, 1993, a subsidiary of The BolsaChica Company acquired the domestic real estate development business andrelated assets of The Koll Company. In connection with this acquisition, TheBolsa Chica Company was renamed Koll Real Estate Group, Inc.

On September 2, 1997, the Company completed arecapitalization (“Recapitalization”). The Recapitalization, which waseffective pursuant to a prepackaged plan of reorganization that was confirmedby the U.S. Bankruptcy Court, resulted in the exchange of all the then existingDebentures, Series A Preferred Stock and Class A Common Stock intonew Common Stock. The prepackaged plan was filed by the Company, excluding allof its subsidiaries and affiliates, contemporaneously with a voluntary petitionfor relief under Chapter 11 of the bankruptcy code in July 1997. Upon theRecapitalization, the Company adopted the provisions of Statement of Position (“SOP”)No. 90-7, “Financial Reporting by Entities in Reorganization Underthe Bankruptcy Code” (“Fresh-Start Reporting”). Accordingly, all assets andliabilities were revalued to reflect their reorganization value, approximatingtheir fair value at the effective date of the Recapitalization. In addition,the accumulated deficit of the Company was eliminated and its capital structurerecast in conformity with the Recapitalization and, as such, the Company hasrecorded the effects of the Recapitalization and Fresh-Start Reporting as ofthe effective date.

On April 30, 1998, the Company sold itscommercial development business. Immediately following the sale, Koll RealEstate Group, Inc. was renamed California Coastal Communities, Inc.

The accompanyingconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America andinclude the accounts of the 

F-6

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Companyand its wholly-owned subsidiaries. Intercompany accounts and transactionshave been eliminated.

**Note2—Significant Accounting Policies**

*Use of Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportingperiod. On an ongoing basis, management reviews its estimates based uponcurrently available information. Actual results could differ from thoseestimates.

*Basis ofConsolidation*

The accompanyingconsolidated financial statements include the accounts of the Company and allmajority-owned and controlled subsidiaries, joint ventures, and other entitieswhich have been determined to be variable interest entities in which theCompany is deemed the primary beneficiary. Certain wholly-owned subsidiaries ofthe Company are members in joint ventures involved in the development and saleof residential projects and residential loan production. The financialstatements of joint ventures in which the Company generally has a controllingor majority economic interest (and thus are controlled by the Company) areconsolidated with the Company’s financial statements. The Company’s investmentsin unconsolidated joint ventures and variable interest entities in which theCompany is not the primary beneficiary are accounted for using the equitymethod, when the Company does not have voting or economic control of theventure operations, as further described in Note 5. Minority interestrepresents the equity interest of the Company’s joint venture partner for oneconsolidated venture and is further described in Note 9. All significantintercompany accounts and transactions have been eliminated in consolidation.

*Segment Information*

SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” establishes standardsfor the manner in which public enterprises report information about operatingsegments. The Company’s operations are managed as a single business ofhomebuilding with entitlement and land development activities employed asnecessary, only for the Company’s own homebuilding inventory. Therefore, forfinancial reporting purposes, the Company aggregates homebuilding and landdevelopment into a single reportable segment.

*Consolidation ofVariable Interest Entities*

A Variable Interest Entity (“VIE”) is created when (i) theequity investment at risk is not sufficient to permit the entity to finance itsactivities without additional subordinated financial support from other partiesor (ii) equity holders either (a) lack direct or indirect ability tomake decisions about the entity, (b) are not obligated to absorb expectedlosses of the entity or (c) do not have the right to receive expectedresidual returns of the entity if they occur. If an entity is deemed to be aVIE, pursuant to Financial Interpretation FIN No. 46, “Consolidation ofVariable Interest Entities—an interpretation of ARB No. 51” (“FIN 46”), anenterprise that has the majority of the variability in gains and losses of theVIE is considered to be the primary beneficiary and must consolidate the VIE. FIN46 was effective immediately for VIEs created after January 31, 2003.

Based on the provisions of FIN 46, the Company hasconcluded that whenever it options land or lots from an entity and pays anon-refundable deposit, a VIE may be created under conditions (ii)(b) and (c) of

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the previous paragraph. TheCompany may be deemed to have provided subordinated financial support, whichrefers to variable interests that will absorb some or all of an entity’sexpected theoretical losses if they occur. For each VIE created with asignificant nonrefundable option fee, the Company will compute expected losses and residual returns based onthe probability of future cash flows as outlined in FIN 46. If the Company isdeemed to be the primary beneficiary of the VIE, the VIE will be consolidatedon the Company’s balance sheet. The fair value of the VIE’s real estate will bereported as consolidated real estate to be held for current development—notowned and the related theoretical liability will be reported as consolidatedobligations related to real estate—not owned.

The Company’s exposure to loss as the result of apurchase contract with a VIE is limited to the amount of the non-refundableoption deposit, which is generally 5% to 15% of the purchase price, not totalassets on the balance sheet of the VIE. Therefore, the Company believes thatconsolidating the VIE does not reflect the economic realities or risks ofowning and developing land. The Company has no material third party guaranteesrelated to these contracts. Creditors of these VIEs, if any, have no recourseagainst the Company.

During November 2004,the Company entered into an agreement to purchase land from a third partyentity deemed to be a VIE, with the Company as the primary beneficiary of theentity. Because the Company does not have access to the financial informationof the VIE, the fair value of the optioned property less the cash deposit andconsolidated obligations related to consolidated real estate - not owned of$24.7 million is reflected on the Company’s balance sheet as of December 31,2004. During April 2005, the Company completed the acquisition of landwhich was the subject of the agreement, and as such the land is included inReal estate inventories as of December 31, 2005. As of December 31,2005, the Company has no deposits with VIEs. See Note 10—Real Estate Matters.

*Cash and CashEquivalents and Restricted Cash*

The Company considers allhighly liquid instruments with a maturity of three months or less whenpurchased to be cash equivalents. The Company’s restricted cash represents cashheld as security for standby letters of credit and bonds for homebuildingprojects under development.

*Short-TermInvestments*

Short-term investmentsconsist of auction rate securities. Auction rate securities are long-termmunicipal bonds and preferred stock with interest rates that reset periodicallythrough an auction process, which occurs in 7-, 28-, 35-, or90-day periods. There are no cumulative gross unrealized holding gains orlosses associated with these investments, and all income is recorded asinterest income.

*Real Estate*

Real estate inventories primarily consists of homesunder construction and lots under development and is carried at the lower ofcost or fair value less costs to sell. Land held for future development or saleis carried at cost, with write-downs to fair value only in the event that costscannot be recovered from estimated undiscounted future cash flows, as describedunder “Impairment of Long-Lived Assets.” The estimation process involved in thedetermination of fair value is inherently uncertain since it requires estimatesas to future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and dispose of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic, market, environmental and political conditionsmay affect management’s development and marketing plans. In addition, theimplementation of such development and marketing plans could be affected by theavailability of future financing for development and construction activities.Accordingly, the ultimate values of the Company’s real estate 

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properties are dependentupon future economic and market conditions, the availability of financing, andthe resolution of political, environmental and other related issues.

The cost of sales of multi-unitprojects is generally computed using the relative sales value method. Interestcost is capitalized to real estate projects during their development andconstruction period.

*Impairment ofLong-Lived Assets*

The Company assesses the impairment of land held forfuture development or sale and other long-lived assets in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, which requires thatan impaired asset, for which costs cannot be recovered from estimatedundiscounted future cash flows, be written down to fair value. Long-livedassets are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Asprovided by SFAS No. 144, impairment is evaluated by comparing an asset’scarrying value to the undiscounted estimated cash flows expected from the asset’soperations and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset for purposes of SFAS No. 144 is deemed tobe the amount a willing buyer would pay a willing seller for such asset in acurrent transaction.

In accordance with SFAS No. 144,in developing estimated future cash flows for impairment testing, the Companyhas incorporated its own assumptions regarding the entitlement prospects ofland held for future development or sale and its own market assumptionsincluding those regarding home prices, infrastructure and home-building costsregarding both land held for future development or sale and real estateinventories. Additionally, as appropriate, the Company identifies alternativecourses of action to recover the carrying value of its long-lived assets andevaluates all likely alternatives under a probability-weighted approach asdescribed in SFAS No. 144.

*Income Taxes*

The Company accounts forincome taxes on the liability method, in accordance with SFAS No. 109, “Accountingfor Income Taxes”. Deferred income taxes are determined based on the differencebetween the financial statement and tax bases of assets and liabilities, usingenacted tax rates in effect in the years in which these differences areexpected to reverse. The liability method requires an evaluation of the probabilityof being able to realize the future benefits indicated by deferred tax assets.A valuation allowance related to the deferred tax asset is recorded when it ismore likely than not that some portion or all of the deferred tax asset willnot be realized.

*HomebuildingRevenues and Cost of Sales*

The Company’s homebuildingoperation generates revenues from the sale of homes to homebuyers. The majorityof these homes are designed to appeal to move-up homebuyers and are generallyoffered for sale in advance of their construction. Sales contracts are usuallysubject to certain contingencies such as the buyer’s ability to qualify forfinancing. Revenue from the sale of homes is recognized at closing when titlepasses to the buyer and the earnings process is complete. As a result, theCompany’s revenue recognition process does not involve significant judgments orestimates. However, the Company does rely on certain estimates to determine therelated construction costs and resulting gross margins associated with revenuesrecognized. The cost of sales is recorded based upon total estimated costswithin a subdivision and allocated using the relative sales value method. TheCompany’s construction costs are comprised of direct and allocated costs,including estimated costs for future warranties and indemnities. The Company’sestimates are based on historical results, adjusted for current factors.

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*Home Warranty Costs*

Warranty reserves areestablished as homes close escrow in an amount estimated to be adequate tocover expected warranty-related costs for materials and outside labor to beincurred during the warranty period. Reserves are determined based uponhistorical data with respect to similar product types and geographical areas.

*Earnings Per CommonShare*

Earnings per common share is accounted for inaccordance with SFAS No. 128, “Earnings Per Share”. Basic earnings percommon share is computed using the weighted-average number of common sharesoutstanding for the period. The weighted-average number of common sharesoutstanding was 10.2 million, 10.1 million and 10.1 million for the years endedDecember 31, 2005, 2004 and 2003, respectively. The weighted averagenumber of common shares, assuming dilution, was 10.5 million, 10.8 million and 10.8 millionfor the years ended December 31, 2005, 2004 and 2003, respectively.Diluted earnings per common share is computed using the weighted-average numberof common shares outstanding and the dilutive effect of potential common sharesoutstanding. For the years ended December 31, 2005, 2004 and 2003, theaverage market price of the Company’s common stock exceeded the exercise priceof outstanding stock options. Therefore, diluted earnings per share includesthe dilutive effect of the weighted average number of common shares frompotential exercise of approximately 700,000 options. For the year ended December 31,2003, the average market price of the Company’s common stock exceeded theexercise price of the 48,000 outstanding warrants, which were exercised orexpired in December 2003. Therefore, the dilutive effect of outstandingwarrants is reflected in the weighted-average common shares assuming dilutionfor 2003.

Thetable below sets forth the reconciliation of the denominator of the earningsper share calculation (in millions):

| ** **                                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used in  computing basic earnings per common share   |       | 10.2     |       | 10.1     |       | 10.1     |       |
| Dilutive effect  of stock options                           |       | .3       |       | .7       |       | .7       |       |
| Shares used in computing  diluted earnings per common share |       | 10.5     |       | 10.8     |       | 10.8     |       |

 

*Stock-BasedCompensation*

The Company uses a fair value based method ofaccounting for share-based compensation provided to employees in accordancewith SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).Stock options are valued based upon an option-pricing model and the fair valueis recognized as an expense over the period in which the options vest. Duringthe second quarter of 2003, the Company adopted the fair value recognitionprovisions of SFAS 123. For this change in accounting, the Company selected the“modified prospective method” under the provisions of SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure—an Amendment of FASBStatement No. 123” (“SFAS 148”). Under this method, the change wasretroactive to January 1, 2003 and compensation cost recognized during2003 is zero, the same as that which would have been recognized had therecognition provisions of SFAS 123 been applied from its original effectivedate.

Until the second quarterof 2003, the Company applied Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB 25”), and relatedinterpretations in accounting for its plan. Accordingly, no compensationexpense was recognized through 2002 for its stock-based compensation plansother than for variable accounting for repriced stock options as describedabove.

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*Fair Value of Financial Instruments*

The carrying amounts ofthe Company’s financial instruments including cash and cash equivalents,short-term investments, accounts payable, accrued liabilities, and project debtapproximate their respective fair values because of the relatively short periodof time between origination of the instruments and their expected realization,or because they are carried at fair value.

*Other Comprehensive Income (Loss)*

Other comprehensive income(loss) items under SFAS No. 130, “Reporting Comprehensive Income”, aretransactions recorded in stockholders’ equity during the year, excluding netincome (loss) and transactions with stockholders. The components of othercomprehensive income (loss) are disclosed in the consolidated statements ofoperations net of tax.

*New Accounting Pronouncements*

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004), “Share-Based Payment” (“SFAS 123(R)”). This Statement replaces SFAS 123,“Accounting for Stock-Based Compensation” and supersedes Accounting PrinciplesBoard (“APB”) Opinion No. 25. “Accounting for Stock Issued to Employees.”  SFAS 123(R) addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices in exchange for (a) equity instruments of the enterprise or (b) liabilitiesthat are based on the fair value of the enterprise’s equity instruments or thatmay be settled by the issuance of such equity instruments. SFAS 123(R) eliminatesthe ability to account for share-based compensation transactions using theintrinsic value method under APB No. 25, and generally would requireinstead that such transactions be accounted for using a fair-value-based method.In the first quarter of 2006, the Company will adopt SFAS 123(R) using themodified prospective method, which requires that compensation is recognized onor after the required effective date for the portion of outstanding awards forwhich the requisite service has not yet been rendered, based on the grant-datefair value of those awards calculated under SFAS 123 for either recognition orpro forma disclosures. As discussed further in Note 13—Stock Plans, the Companyadopted the fair value recognition provisions of SFAS 123 in 2003. The adoptionof SFAS 123(R) will not have a material impact on the Company’sconsolidated financial position, results of operations, or cash flows.

In December 2004, theFASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—An amendment ofAPB 29, Accounting for Nonmonetary Transactions” (“SFAS 153”). This statementamends APB No. 29 to eliminate the exception for nonmonetary exchanges ofsimilar productive assets and replaces it with a general exception forexchanges of nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. Thisstatement is effective beginning in the Company’s first quarter of 2006. TheCompany has evaluated the impact of adopting SFAS 153 and has determined thatit will not have a material impact on the Company’s consolidated financialposition, results of operations, or cash flows.

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”).This statement replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3,“Reporting Accounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS 154 requires retrospective application of changes in accountingprinciple to prior periods’ financial statements unless it is impracticable todetermine the period-specific effects or the cumulative effect of the change.This statement is effective beginning in the Company’s first quarter of 2006.The Company has evaluated the impact of adopting SFAS 154 and has determinedthat it will not have a material impact on the Company’s consolidated financialposition, results of operations, or cash flows.

In June 2005, theEmerging Issues Task Force (“EITF”) reached a final consensus on Issue No. 04-5,“Determining Whether a General Partner, or the General Partners as a Group,Controls a Limited 

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Partnershipor Similar Entity When the Limited Partners Have Certain Rights” (“EITF 04-5”).EITF 04-5 affects the consolidation of entities in which a generalpartner or managing member is presumed to control a partnership or limitedliability company. EITF 04-5 will be effective for the Company beginningin the first quarter of 2006. The Company has evaluated the impact of adoptingEITF 04-5 and has determined that it will not have a material impact onthe Company’s consolidated financial position, results of operations, or cashflows upon initial adoption. EITF 04-5 may materially impact the Company’sconsolidated financial position, results of operations, or cash flows in futureperiods should the Company form new limited partnerships or modify existinglimited partnerships such that the Company is deemed to control the limitedpartnership. Under those circumstances, the Company may be required by EITF 04-5to consolidate the limited partnership. 

*Reclassifications*

Certain prior year amountsin the consolidated financial statements have been reclassified to conform withthe 2005 presentation. The Company reclassified changes in restricted cash of$1.1 million from financing activities to investing activities for the yearended December 31, 2004 to conform with the 2005 presentation. Thisreclassification had no impact on reported net income.

**Note3—Real Estate Inventories**

Real estate inventoriesprimarily consist of homes under construction and lots under development incommunities in five Southern California counties. At December 31, 2005,real estate inventories include 942 lots and homes under construction, and onecompleted home. In addition, the balance includes the value of theapproximately 105-acre parcel of land on the upper bench of a mesa north of theBolsa Chica wetlands (“Upper Mesa”), approximately 51 acres nearby which havebeen offered for dedication to the County of Orange for inclusion in theHarriet M. Weider Linear Park in conjunction with the development of the UpperMesa, and 51 additional acres which are subject to a conservation easement (seeNote 4—Land Held for Future Development or Sale). The Company capitalizesdirect carrying costs including interest and property taxes, as well as directconstruction costs, to real estate inventories.

The planned community onthe Upper Mesa, known as “Brightwater,” will offer a broad mix of home choices,averaging 2,800 square feet and ranging in size from 1,700 square feet to 4,100square feet. The plan also includes 37 acres of open space and conservationarea. With 349 homes on 68 acres of the Upper Mesa, the resulting low-densityplan equates to approximately five homes per acre, consistent and compatiblewith the neighboring Huntington Beach communities. In addition, the Companyowns land adjacent to the planned Brightwater development, on which it intendsto process permits to build seven additional homes which will be included inthe Brightwater community. The Company expects to (i) begin grading duringthe second quarter of 2006, (ii) begin building model homes during thethird quarter of 2006, (iii) start selling homes during the second quarterof 2007, and (iv) begin delivering homes during the fourth quarter of 2007.However, there can be no assurance in that regard, or as to the absence offurther administrative or construction delay.

The estimation processinvolved in the determination of value is inherently uncertain since itrequires estimates as to future events and market conditions. Such estimationprocess assumes the Company’s ability to complete development and disposition ofits real estate properties in the ordinary course of business based onmanagement’s present plans and intentions. Economic, market, environmental andpolitical conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. The development of the Company’s Upper Mesa project isdependent upon market conditions and economic factors. Accordingly, the amountultimately realized from such project may differ materially from currentestimates and the project’s carrying value.

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Capitalizedinterest is allocated to real estate inventories when incurred and charged tocost of sales when the related property is delivered. Certain informationregarding interest follows (in millions):

| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Capitalized  interest, beginning of period |       | $        | 1.3        |     | $          | .6 |   |
| Interest incurred  and capitalized         |       | 6.7      |       | 2.1      |       |
| Charged to cost  of sales                  |       | (1.9     | )          | (1.4     | )          |
| Capitalized interest,  end of period       |       | $        | 6.1        |     | $          | 1.3 |   |

 

**Note4—Land Held for Future Development or Sale**

At December 31, 2004,land held for future development or sale included approximately 360 acreslocated in Orange County, California overlooking the Pacific Ocean and theBolsa Chica wetlands (which were sold by the Company to the State of Californiain 1997), surrounded by the City of Huntington Beach and approximately 35 milessouth of downtown Los Angeles. Land held for future development or sale included214 acres on a mesa north of the Bolsa Chica wetlands (“Bolsa Chica Mesa”) andapproximately 104 acres on, or adjacent to, the Huntington Beach mesa (“HuntingtonMesa”) and 43 acres of lowlands which were acquired by the Company in September 1997.

On April 14, 2005,the Company obtained approval from the California Coastal Commission for aCoastal Development Permit (“CDP”) to build 349 homes on 68 acres of itsapproximately 105-acre upper bench of the Bolsa Chica Upper Mesa, subjectto satisfying the Coastal Commission’s permit conditions. On October 5,2005, the County of Orange approved modifications to the Company’s site planand on October 18, 2005 approved the tentative tract map for 349 homes.This approval was necessary to comply with the California Coastal Commission’sconditions of approval for a CDP. In December 2005, the Company satisfiedthe remaining conditions for issuance of the CDP and the Coastal Commissionissued a CDP to the Company for development of 349 homes on the Upper Mesa on December 15,2005.

On December 21, 2005,the Company completed the sale of a 103-acre parcel of the Bolsa ChicaMesa known as the “Lower Bench” to the State of California’s WildlifeConservation Board for $65 million. The sale was approved by the Company’s stockholdersat the August 11, 2005 Annual Meeting. The Company also completed the saleof 43 acres in the Bolsa Chica lowlands to the California State LandsCommission (“SLC”) in December 2005. The Company’s subsidiary received netproceeds of $923,000, after using $798,000 to reimburse SLC for remediationcosts, which were previously accrued.

At December 31, 2005,the remaining 214 acres of the Bolsa Chica property is classified as realestate inventories, following the issuance of the CDP. The Company’s holdingsinclude 110 acres on the Bolsa Chica Mesa (including the five-acre parcel inthe City) and 104 acres on or adjacent to the Huntington Mesa.

On September 2, 1997,the Company completed a recapitalization pursuant to court confirmation of aPrepackaged Plan of Reorganization (the “Recapitalization”), and the Companyapplied the principles required by the American Institute of Certified PublicAccountant’s Statement of Position (“SOP”) 90-7, “Financial Reporting byEntities in Reorganization Under the Bankruptcy Code” (“Fresh-Start Reporting”),and the carrying value of land held for development (Bolsa Chica) was adjustedto fair value. The fair value was determined in 1997 using discounted estimatedcash flows expected from the asset’s operations and eventual disposition. TheCompany updated its analysis at each year-end since 1997, and noted noindicators of impairment.

**Note5—Investments in Unconsolidated Joint Ventures**

TheCompany’s investments in unconsolidated joint ventures are 50% or less owned,not substantially controlled by the Company, and accordingly, are accounted forusing the equity method and are not consolidated with the Company’sconsolidated financial statements. Investments are included in the 

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Company’s balance sheet in other assets. Condensedcombined financial information regarding the Company’s investments in: (i) theOxnard land development joint venture (described below), (ii) aresidential loan production partnership with a major commercial bank and (iii) thecompleted San Diego area homebuilding joint venture are summarized as follows(in millions):

| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance Sheet  Data:          |       |     |       |     |       |     |       |
| Total assets                  |       | $        | 5.8        |     | $          | 5.4      |       |   |   |
| Total liabilities             |       | (.5      | )          | (1.5     | )          |     |       |
| Venturers’  capital      |       | $        | 5.3        |     | $          | 3.9      |       |   |   |
| Statement of Operations Data: |       |     |       |     |       |     |       |
| Revenues                      |       | $        | .7         |     | $          | 1.4      |       | $ | 1.6 |   |
| Expenses                      |       | (.5      | )          | (.7      | )          | (.4      | )          |
| Net income                    |       | $        | .2         |     | $          | .7       |       | $ | 1.2 |   |

 

During 2005, 2004 and2003, the Company received $200,000, $400,000, and $300,000, respectively, inaggregate cash distributions from the residential loan production partnershipand $100,000 and $200,000 in 2004 and 2003, respectively, from the completedSan Diego area homebuilding joint venture.

*Oxnard Land Development Joint Venture*

In February 2003, theCompany entered into two option contracts to acquire land adjacent to the Cityof Oxnard in Ventura County, California aggregating approximately 168 acres. TheCompany is in the process of developing a land plan for the area, which alsoincludes an additional 149 acres owned by other landowners, with the intentionof entitling the property for residential development and annexing it to theCity of Oxnard. The Company currently expects that the residential developmentplan will include approximately 800 single-family detached lots andapproximately 750 attached family residential units (townhomes, condominiums,and apartments); however, these numbers are subject to change during the courseof the entitlement process. Approximately 555 of the single family lots and 490of the attached units would be developed on the 168 acres of optioned landexpected to be purchased by the Company. The option contracts allow the Companytwo years, plus up to three additional years through the exercise ofextensions, in order to complete these entitlement activities beforeconsummating the purchase transactions. The option-holder has the right in itssole discretion to terminate the obligations under these option agreements byforfeiting the cash deposits with no further financial responsibility. TheCompany is striving to complete the entitlement process during the fourthquarter of 2006; however, delays could be encountered. The first threesix-month option extensions were exercised during January and July 2005and January 2006.

During October 2003,the Company entered into a limited liability company (“Oxnard LLC”) jointventure agreement with a major financial partner to pursue the Oxnarddevelopment opportunity. The Company assigned the land purchase optioncontracts to the Oxnard LLC. Hearthside Homes, Inc. (the Company’shomebuilding subsidiary) is the managing member of the Oxnard LLC, and made aninitial contribution of $500,000 to the venture. The non-managing member alsomade an initial contribution of $500,000 to the venture and as of December 31,2005, had made an aggregate of $4 million of first tier additionalcontributions. Under the Oxnard LLC operating agreement (as amended in November 2005),the members have agreed to provide a second tier of additional capital contributionsof up to $3 million, as necessary, to complete the business plan. Forcontributions in excess of $5 million, the first $500,000 is to be contributedequally by the members. The Company’s subsidiary, at its discretion, couldcontinue to contribute equally to the next $500,000. Thereafter, the next $2million is to be contributed equally by the members.  During the fourth quarter of 2005, each of themembers contributed approximately $160,000 of the additional $3 million. TheCompany’s subsidiary expects to make additional aggregate capital 

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contributionsof approximately $1.3 million to the Oxnard LLC during 2006. After payment of a10% preferred return on invested capital to each member, first tier profits aregenerally allocated 75% to the non-managing member and 25% to the managingmember and second tier profits and losses over $5 million are generallyallocated 50% to each member. The first $5 million of losses are generallyallocated 80% to the non-managing member and 20% to the managing member. Whilethe Company exerts a large degree of influence over the venture, thenon-managing member does have various participating rights such as approvalrights with regard to the majority of business decisions, including approval ofproject budgets.

**Note 6—Project Debt**

Inconjunction with the acquisition of single-family residential lots, the Company’shomebuilding subsidiary, Hearthside Homes, Inc. and its subsidiaries,enter into construction loan agreements with commercial banks. These loanfacilities finance a portion of the land acquisition and the majority of theconstruction of infrastructure and homes. Each loan facility requires aguaranty of project completion and an environmental indemnity. The loanssecured by first trust deeds bear an interest rate of prime plus three-fourthspercent (8% at December 31, 2005), and some of these loan facilities havea minimum interest rate ranging from 5.75% to 7.5%. During the year ended December 31,2005, Hearthside Homes, Inc. entered into 12 new first trust deed loanfacilities aggregating $153.9 million in conjunction with the acquisitions anddevelopment of a total of 389 single family residential lots, including 27acquired during 2004. In addition, a subsidiary of Hearthside Homes, Inc.entered into two loan facilities aggregating $14.5 million and secured bysecond trust deeds which bear interest at 17%. During December 2005, theloans secured by the second trust deed balances were repaid in full. Thefollowing amounts were available and outstanding under these loan facilities asof December 31, 2005 and 2004 ($ in millions):

| ** **          | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | **Outstanding at**    | ** ** |
|---------------------|------------|-----------------|------------|-------------|------------|--------------|------------|-----------------------|------------|
| ** **          | ** ** | **Amount**      | ** ** | **Number**  | ** ** | **Maturity** | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **of Facility** | ** ** | **of Lots** | ** ** | **Date**     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| *First Trust Deeds* |       |            |       |        |       |         |       |                  |       |   |   |
| Riverside           |       | $2.3            |       | 13          |       | 5/10/05      |       | $—               |       | $2.3 |   |
| Chino               |       | 9.6             |       | 11          |       | 7/29/05      |       | —                |       | .5 |   |
| Chino II            |       | 6.3             |       | 17          |       | 8/11/05      |       | —                |       | 1.7 |   |
| Rancho Santa Fe     |       | 5.2             |       | 8           |       | 11/19/05     |       | —                |       | 1.6 |   |
| Lancaster           |       | 10.7            |       | 104         |       | 11/23/05     |       | —                |       | 4.0 |   |
| Corona              |       | 21.1            |       | 83          |       | 11/24/05     |       | —                |       | 11.4 |   |
| Rancho Santa Fe     |       | 3.9             |       | 6           |       | 12/13/05     |       | —                |       | 1.1 |   |
| Rancho Santa Fe     |       | 15.4            |       | 18          |       | 3/27/06      |       | 8.5                   |       | — |   |
| Ontario             |       | 11.7            |       | 26          |       | 4/19/06      |       | 4.6                   |       | — |   |
| Lancaster           |       | 9.5             |       | 10          |       | 5/10/06      |       | .2                    |       | — |   |
| Rancho Santa Fe     |       | 1.8             |       | 2           |       | 9/13/06      |       | 1.7                   |       | — |   |
| Corona              |       | 1.9             |       | 4           |       | 10/26/06     |       | 1.8                   |       | — |   |
| Corona              |       | 14.8            |       | 36          |       | 10/26/06     |       | 7.0                   |       | — |   |
| Lancaster           |       | 1.0             |       | 3           |       | 11/17/06     |       | 1.0                   |       | — |   |
| Lancaster           |       | 10.5            |       | 36          |       | 11/17/06     |       | 3.6                   |       | — |   |
| Corona              |       | 41.1            |       | 151         |       | 1/7/07       |       | 18.8                  |       | — |   |
| Beaumont            |       | 20.7            |       | 102         |       | 2/17/07      |       | 7.6                   |       | — |   |
| Lancaster           |       | 17.7            |       | 77          |       | 7/1/07       |       | 3.1                   |       | — |   |
|                |       |            |       |        |       |         |       | $57.9                 |       | $22.6 |   |

 

F-15

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**Note 7—Other Liabilities**

Otherliabilities were comprised of the following as of December 31 (inmillions):

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| Accrued pensions  and benefits                      |       | $        | 4.8        |     | $          | 4.9 |   |
| Home warranty  reserves                             |       | 2.1      |       | 1.6      |       |
| Contingent  indemnity and environmental obligations |       | 1.5      |       | 3.5      |       |
| Unamortized  discount                               |       | (.5      | )          | (.7      | )          |
|                                                |       | $        | 7.9        |     | $          | 9.3 |   |

 

Contingent indemnity andenvironmental obligations primarily reflect reserves before related discount(recorded pursuant to Fresh-Start Reporting) for contingent indemnityobligations for businesses disposed of by former affiliates and unrelated tothe Company’s current operations. At December 31, 2004, other liabilitiesalso includes a $1.33 million accrual for the Dresser litigation settlementdescribed below and an accrual of $800,000 for the contingent liability of asubsidiary of the Company for PCB contamination on a 43-acre Bolsa Chicalowlands property as further described below.

*Dresser Litigation*

In May 2002, DresserIndustries, Inc. (“Dresser”) filed litigation, captioned Dresser Industries, Inc.vs. California Coastal Communities, Inc. and RESCO Holdings, Inc. (“RESCO”,a former affiliate), in the 58th Judicial District Court of Jefferson County,Texas. Dresser sought a declaratory judgment regarding the rights andobligations of the parties under a January 1988 purchase agreement.Dresser’s indemnity claims related to several hundred lawsuits encompassingapproximately 5,900 contested asbestos claims made by third parties inconnection with work in facilities in which the Dresser-acquired engineeringand construction business was allegedly connected. The Company denied Dresser’sallegations and vigorously defended itself in this case and related matters. OnApril 6, 2005, RESCO and the Company settled this litigation with Dresserand the Company paid $1.33 million, its share of the settlement, which is theamount of the Company’s litigation accrual as of December 31, 2004. TheCompany and RESCO did not admit fault or liability with respect to Dresser’sclaims, but settled the matter in order to avoid the continued cost anduncertainty of litigation.

*Lowland  Remediation*

In September 1997, the Company acquired 43 acresin the Bolsa Chica lowlands with the intent of selling it to the State ofCalifornia in connection with their planned restoration of 1,000 acres ofadjacent wetlands. In anticipation of entering into a purchase agreement, theState performed limited soils sampling on this property and notified theCompany in 1999 that it had discovered contamination from a group of chemicalscalled PCBs. In 2002, the State’s Department of Toxic Substances Control (“DTSC”)became the regulatory agency responsible for overseeing the Company’s effortsto remediate the contamination on this property and a subsidiary of the Companyentered into a consent order with DTSC regarding remediation. The Company’ssubsidiary prepared a Remedial Investigation (“RI”) Workplan, which wasapproved by DTSC in August 2003. During late 2003, the subsidiaryperformed soil sampling at the site according to the RI Workplan to determinethe nature and extent of contamination, and submitted an RI Report to DTSC in February 2004.A Remedial Action Workplan (“RAW”) was approved by DTSC in December 2004. Theremoval of contaminated soil was completed during September 2005 and in December 2005,the DTSC issued a final acceptance of the remediation work.

In July 2005, the Company’s subsidiary enteredinto an agreement with the SLC to sell this property to the SLC for $1.7million, with up to $1 million of such funds to be utilized for remediationcosts. Following DTSC’s acceptance of the remediation, SLC completed theiracquisition of this property from the 

F-16

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Company’s subsidiary. TheCompany’s subsidiary received net proceeds of $923,000,  after using $798,000 to reimburse SLC forremediation costs, which were previously accrued. As of December 31, 2005,the subsidiary has no additional amounts accrued for environmental testing andremediation of this property since the remediation has been completed to DTSC’ssatisfaction.

In May 2004, theCompany’s subsidiary received an invoice from DTSC seeking reimbursement for$793,000 of oversight and remediation costs incurred by DTSC with respect toPCBs found on neighboring residential properties. Since receiving the originalinvoice, the Company’s subsidiary has received six similar invoices for anaggregate additional $131,000 including accrued interest. However, the Company’ssubsidiary contends, based upon advice of counsel, that it is not responsiblefor such costs because the Company did not develop or build the neighboringresidential properties, the Company did not generate the contamination, thecontamination did not emanate from the Company’s property and the 43-acresite should not be part of the same “site” as the residential properties.Furthermore, the Company’s subsidiary has also disputed such charges due to thefact that DTSC did not bill the Company’s subsidiary in accordance with therequirements of the applicable law. The Company’s subsidiary intends tovigorously defend itself in this matter. Therefore, the Company has not accruedfor any of DTSC’s $924,000 of claims related to these residential properties.

*Home WarrantyReserve*

TheCompany provides a home warranty reserve to reflect its contingent obligationfor product liability. The Company generally records a provision as homes aredelivered, based upon historical and industry experience, for the items listedin the homeowner warranty manual, which does not include items that are coveredby manufacturers’ warranties or items that are not installed by the Company’semployees or contractors. The home warranty reserve activity is presented belowfor the years ended December 31 (in millions):

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Balance at  beginning of period |       | $        | 1.6        |     | $          | 1.2 |   |
| Provision                       |       | 1.0      |       | .6       |       |
| Payments                        |       | (.5      | )          | (.2      | )          |
| Balance at end of period        |       | $        | 2.1        |     | $          | 1.6 |   |

 

**Note 8—Income Taxes**

Upon completion of the 1997 Recapitalization, theCompany experienced an “ownership change” under Section 382 of theInternal Revenue Code (the “Code”) as a result of the increase in thepercentage of the Company’s stock by value held by certain persons (includingcreditors who exchanged debt for stock) of more than 50 percentage points atany time during a three-year period. Subsequent to an ownership change, theCompany’s annual use of its net operating losses (“NOLs”) is generally limitedto the value of the Company’s equity immediately before the ownership changemultiplied by the long-term tax-exempt rate. However, Section 382(l)(5) ofthe Code, the “bankruptcy exception,” provides that if the ownership changeoccurs through a bankruptcy, such as the Company’s Recapitalization whichutilized a prepackaged plan, and if the continuing shareholders and “qualifyingcreditors” before the ownership change own at least 50% of the Company’s stockafter the ownership change, the general limitations of Section 382 willnot apply. “Qualifying creditors” generally must have held their debt at least18 months before the prepackaged plan was filed on July 14, 1997, or thedebt must have arisen in the ordinary course of the Company’s business.

The Company believes that it qualifies for the “bankruptcyexception” of Section 382(l)(5). Under this exception, the Company wasrequired to reduce its NOLs by (i) the amount of interest accrued on anydebt exchanged for stock in the bankruptcy proceeding during the year of theproceeding and the three prior 

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taxable years and (ii) anadditional amount required to make the total reduction equal to the amount ofcancellation of indebtedness income realized. Accordingly, the Company’s NOLsof approximately $271 million as of September 2, 1997 were reduced byapproximately $79 million. As reduced, the Company’s NOL carryovers are fullydeductible against post-reorganization income, subject to the general rules regardingchange of ownership as discussed below, and expiration of NOLs. The federalNOLs available as of December 31, 2005 are approximately $125 million. Theamount of NOLs which expire if not utilized is zero for 2006, 2007, and 2008and $9 million, $49 million and $67 million for 2009, 2010 and thereafter,respectively.

The Company remains subject to the general rules ofSection 382, which limit the availability of NOLs if an ownership changeoccurs. If the Company was to experience another ownership change, the amountof NOLs available would generally be limited. The Company estimates that as of February 28,2006, it has experienced a three-year cumulative ownership shift ofapproximately 40%, as computed in accordance with Section 382.

In October 1999, in response to an unsolicitedwritten consent from a majority of its stockholders, the Company amended itscertificate of incorporation in order to preserve the ability of the Company toutilize federal NOLs. Since the Company’s use of its NOLs may be severelyrestricted if it experiences an ownership change of more than 50%, the Company’smajority stockholders requested that the Board of Directors enact theamendments, which have been determined to be in the best interest of theCompany and its stockholders. The amendments prohibit future purchases of theCompany’s common stock by persons who would become new 5% holders, and alsoprohibit current holders of over 5% from increasing their positions, except incertain permissible circumstances which would not jeopardize the Company’sability to use its NOLs. While these amendments reduced the Company’s risk ofan ownership change occurring due to the acquisition of shares by 5%stockholders, the risk remains that an ownership change could result from thesale of shares by existing 5% stockholders. The Company’s Board of Directorsevaluates requests to purchase any amounts in excess of 5% of the Company’scommon stock and authorizes such transactions which are not expected tojeopardize the Company’s ability to use its NOLs.

Thetax effects of items that gave rise to significant portions of the deferred taxaccounts for the years ended December 31 (in millions) are as follows:

| ** **                                                                                                                                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                                                                                                                                                                |       |     |       |     |       |
| Accruals/reserves not deductible until paid                                                                                                                                          |       | $        | 3.7        |     | $          | 4.7 |   |
| Accrued seller participation not deductible until  paid                                                                                                                              |       | .3       |       | 2.2      |       |
| Net operating loss and alternative minimum tax  credit carryforwards                                                                                                                 |       | 45.1     |       | 57.9     |       |
| State income tax provisions deductible when paid for  federal tax purposes                                                                                                           |       | 2.1      |       | 1.0      |       |
| Valuation allowance                                                                                                                                                                  |       | —   |       | (43.2    | )          |
| Deferred tax liabilities:                                                                                                                                                            |       | 51.2     |       | 22.6     |       |
| Land held for future development/real estate  inventories (principally due to accounting for a prior business combination,  partially offset by asset revaluations in 1995 and 1997) |       | 15.8     |       | 19.0     |       |
| Net deferred tax assets                                                                                                                                                              |       | $        | 35.4       |     | $          | 3.6 |   |

 

The net deferred tax balance at December 31, 2005and 2004 is primarily composed of federal NOL. As of December 31, 2004,the Company had established a valuation allowance related to the potentialutilization of its deferred tax assets due to uncertainties that precluded itfrom determining that it was “more likely than not” that the Company would beable to generate sufficient taxable income to realize such assets. Suchuncertainties included the availability of real estate for development ateconomically viable prices, government approvals, results of litigation andeconomic factors affecting the Company’s 

F-18

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operations. The Companymonitors these, as well as other positive and negative factors that may arisein the future, as it assesses the need for a valuation allowance against itsdeferred tax assets. As a result of the California Coastal Commission’sapproval of the Company’s development plan for the Upper Mesa on April 14,2005, the Company concluded that it is more likely than not that it willutilize all of its deferred tax assets, including NOLs, to offset futuretaxable income. Therefore, during the three months ended March 31, 2005,the Company recorded a reversal of valuation allowances on post-reorganizationNOLs and other deferred tax assets of approximately $4.7 million, which isreflected in the 2005 tax benefit. Pursuant to Fresh Start Reporting, alsoduring the three months ended March 31, 2005, a reversal of valuationallowance on federal Pre-reorganization NOLs of approximately $38.5 million wasreflected by increasing the Company’s capital in excess of par value.

Thefollowing is a summary of the income tax provision (benefit) applicable toincome before income taxes for the years ended December 31 (in millions):

| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current taxes                                            |       | $        | 4.6        |     | $          | 1.5      |       | $ | .5 |   |
| Deferred taxes                                           |       | 12.6     |       | 3.1      |       | 1.8      |       |
| Reversal of  valuation allowances on deferred tax assets |       | (4.7     | )          | —   |       | —   |       |
| Reduction in contingent  tax liabilities                 |       | —   |       | (.1      | )          | (.1      | )          |
|                                                     |       | $        | 12.5       |     | $          | 4.5      |       | $ | 2.2 |   |

 

Theprincipal items accounting for the difference in taxes on income computed atthe statutory rate and as recorded, are as follows for the years ended December 31(in millions):

| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Provision for  income taxes at statutory rate            |       | $        | 14.5       |     | $          | 4.1      |       | $ | 1.8 |   |
| State income  taxes, net                                 |       | 2.4      |       | .4       |       | .4       |       |
| Reduction in  contingent tax liabilities                 |       | —   |       | (.1      | )          | (.1      | )          |
| Reversal of  valuation allowances on deferred tax assets |       | (4.7     | )          | —   |       | —   |       |
| All other items,  net                                    |       | .3       |       | .1       |       | .1       |       |
|                                                     |       | $        | 12.5       |     | $          | 4.5      |       | $ | 2.2 |   |

 

The tax provision for theyear ended December 31, 2004 reflects a $400,000 benefit for a reductionin valuation allowance on post-Reorganization state NOLs. During the yearsended 2005, 2004 and 2003, reductions in valuation allowance on federalpre-Reorganization NOLs, of $38.5 million, $9.1 million and $1.7 million,respectively, were recorded, as the Company determined that the utilization ofthese NOLs is “more likely than not” based on forecasted earnings. Pursuant toFresh-Start Reporting, the reductions in valuation allowance related topre-Reorganization NOLs were reflected by increasing the Company’s capital inexcess of par value.

*Tax ComplianceMatters*

In 1998, the Company andthe IRS settled a significant dispute with respect to the tax returns of theCompany and its consolidated subsidiaries, including formerly affiliatedentities, for the years ended December 31, 1989, 1990 and 1991. All of thestate jurisdictions in which the Company filed amended returns for these yearshave accepted such returns, thereby eliminating the Company’s exposure topotential claims. In conjunction with periodic reviews of the adequacy ofreserves for estimated state income tax exposure related to the 1998 IRS taxsettlement, the Company reduced its reserves by approximately $100,000 in eachof 2004 and 2003. Each reduction in contingent tax liabilities is reflected asa benefit in the income tax provision.

F-19

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**Note 9—Minority Interest**

In April 2003, theCompany entered into a Limited Liability Company (“Chino LLC”) joint ventureagreement for the purpose of designing, constructing and selling 77 homes inChino, California. The Chino LLC acquired the 77 lots in May 2003 andbegan construction during the fourth quarter of 2003. The Company delivered 65homes during 2004 and the remaining 12 homes during 2005. Hearthside Homes, Inc.(one of the Company’s principal subsidiaries) is the managing member of theChino LLC, manages its operations and contributed capital of approximately$400,000 (approximately 10%) to the venture. Minority interest represents thenon-managing member’s equity interest in the venture including a capitalcontribution of approximately $4.0 million (approximately 90%), net ofdistributions and as adjusted for the member’s allocation of profits andlosses. Profits and losses are generally allocated 50% to each member, after a10% preferred return on invested capital. During the year ended December 31,2004, capital distributions of approximately $7.6 million were made to thenon-managing member, repaying all of its initial capital contribution, plus all$600,000 of accumulated preferred return and $3.1 million in profitdistributions, in conjunction with the delivery of the first 65 homes. Duringthe year ended December 31, 2005, additional distributions of $675,000were made to the non-managing member and the Company recorded minority interestin income of consolidated joint venture of $400,000, net of income tax benefitof $200,000.

**Note10—Commitments and Contingencies**

*Real Estate Matters*

The Company is subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhomesites. The purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers, includingobtaining applicable property entitlements. The Company also utilizes optioncontracts with third-party land sellers and financial entities as a method ofacquiring land in staged takedowns and minimizing the use of funds from othercorporate financing sources. These option contracts also help to manage thefinancial and market risk associated with land holdings. Option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. The Company has theright at its discretion to terminate its obligations under these land purchaseand option agreements by forfeiting the cash deposit with no further financialresponsibility. As of December 31, 2005, the Company has no land optiondeposits.

The Company hadoutstanding performance and surety bonds, for the benefit of city and countyjurisdictions, related principally to its obligations for site improvements atvarious projects at December 31, 2005. The Company does not believe thatdraws upon these bonds, if any, will have a material effect on the Company’sfinancial position, results of operations or cash flows.

*Legal Proceedings*

There are various lawsuits and claims pending againstthe Company and certain subsidiaries. In the opinion of the Company’smanagement, ultimate liability, if any, will not have a material adverse effecton the Company’s financial condition or results of operations.

See Note 7 for a discussion of other contingencies.

F-20

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*Lease Obligations*

For the years ended December 31,2005, 2004 and 2003, the Company incurred rents for corporate facilities ofapproximately $219,000, $166,000 and $131,000, respectively. Future minimumnoncancelable operating lease payments for the year ending December 31,2006 are approximately $229,000. Thereafter such amounts are zero.

*CorporateIndemnification Matters*

The Company and its formeraffiliates have, through a variety of transactions effected since 1986,disposed of several assets and businesses, many of which are unrelated to theCompany’s current operations. By operation of law or contractual indemnityprovisions, the Company may have retained liabilities relating to certain ofthese assets and businesses. There is generally no maximum obligation or amountof indemnity provided for such liabilities. A portion of such liabilities issupported by insurance or by indemnities from certain of the Company’spreviously affiliated companies. The Company believes its consolidated balancesheet reflects adequate reserves for these matters.

**Note 11—Retirement Plans**

The Company adopted a retirement savings planeffective January 1, 2000 pursuant to Section 401(k) of theCode, and participants may contribute a portion of their compensation to theirrespective retirement accounts, in an amount not to exceed the maximum allowedunder the Code. Prior to January 1, 2000, the Company participated in asimilar plan sponsored by a former affiliate. All participants in the previousplan were allowed to transfer their balances to the Company-sponsored planeffective January 1, 2000. The new plan provides for certain matchingcontributions paid in cash by the Company to non-highly compensated employees,as defined in the Internal Revenue Code. Plan participants are immediatelyvested in their own contributions, while Company contributions vest over a 6-yearperiod.

TheCompany has a noncontributory defined benefit retirement plan which coveredsubstantially all employees of the Company prior to September 30, 1993 whohad completed one year of continuous employment. The benefit accrual for allparticipants was terminated on December 31, 1993. Net periodic pensioncost was as follows for the years ended December 31 (in millions):

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                   |       | $        | —     |     | $          | —   |       | $ | — |   |
| Interest cost                  |       | .4       |       | .4       |       | .3       |       |
| Expected return  on assets     |       | (.4      | )          | (.3      | )          | (.2      | )          |
| Net amortization  and deferral |       | .1       |       | .1       |       | .1       |       |
| Net periodic pension  expense  |       | $        | .1         |     | $          | .2       |       | $ | .2 |   |

 

Thedevelopment of the projected benefit obligation for the plan at December 31,2005 and 2004 is based on the following assumptions:

| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Measurement date                   |       | 12/31/05 |       | 12/31/04 |       |
| Discount rate                      |       | 5.5%     |       | 5.5%     |       |
| Expected long-term rate  of return |       | 8.0%     |       | 8.0%     |       |

 

During 2005, theassumption regarding long-term return on plan assets was 8%, unchanged from theprior year. The Company considers both historical and expected long-term ratesto determine its assumption. The historical rate of returns over the past 10years and five years were approximately 10% 

F-21

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and 4%,respectively. The currently expected long-term rates of return on bonds andequities are approximately 10% and 6%, respectively.

**Plan asset information:**

| ** **        | ** ** | **Target**     | ** ** | ** **     | ** ** | ** **     | ** ** |
|-------------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **        | ** ** | **Allocation** | ** ** | **Allocation** | ** ** | **Allocation** | ** ** |
| ** **        | ** ** | **2006**       | ** ** | **2005**       | ** ** | **2004**       | ** ** |
| Equity securities |       |           | 100        | %              |       |           | 100        | % |   |   | 84 | % |   |
| Debt securities   |       |           | 0          | %              |       |           | 0          | % |   |   | 16 | % |   |
| Cash              |       |           | 0          | %              |       |           | 0          | % |   |   | 0 | % |   |

 

Thefunded status and accrued pension cost at December 31, 2005 and 2004 forthe defined benefit retirement plan were as follows (in millions):

| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| **Benefit  obligation:**                        |       |     |       |     |       |
| Benefit  obligation at beginning of year        |       | $        | 6.7        |     | $          | 6.4 |   |
| Service cost                                    |       | —   |       | —   |       |
| Interest cost                                   |       | .3       |       | .4       |       |
| Actuarial loss                                  |       | .1       |       | .5       |       |
| Change in  assumptions                          |       | —   |       | —   |       |
| Benefits paid                                   |       | (.5      | )          | (.5      | )          |
| Administrative  expenses paid                   |       | (.1      | )          | (.1      | )          |
| Benefit  obligation at end of year              |       | $        | 6.5        |     | $          | 6.7 |   |
| **Plan assets:**                                |       |     |       |     |       |
| Fair value of  plan assets at end of prior year |       | $        | 4.5        |     | $          | 4.4 |   |
| Net return on  plan assets                      |       | .2       |       | .5       |       |
| Assets  contributed to plan                     |       | .2       |       | .2       |       |
| Benefits paid                                   |       | (.5      | )          | (.5      | )          |
| Administrative  expenses paid                   |       | (.1      | )          | (.1      | )          |
| Fair value of  plan assets at end of year       |       | $        | 4.3        |     | $          | 4.5 |   |
| Funded status                                   |       | $        | (2.2       | )        | $          | (2.2 | ) |
| Unrecognized net  actuarial loss                |       | 3.0      |       | 2.9      |       |
| Prepaid benefit  cost                           |       | .8       |       | .7       |       |
| Additional  minimum liability charged to other  |       |     |       |     |       |
| comprehensive loss                              |       | (3.0     | )          | (2.9     | )          |
| Accrued benefit  liability                      |       | $        | (2.2       | )        | $          | (2.2 | ) |

 

The Company estimates that benefit payments will beapproximately $500,000 for each of the next five years, and an aggregate of$2.6 million for the five fiscal years thereafter.

The $1.8 million and $2.6million balance of accumulated other comprehensive loss as of December 31,2005 and 2004, respectively, reflects the additional minimum liability of $3.0million and $2.9 million, respectively. The related tax benefit as of December 31,2004 reflects a reserve corresponding to the reserve on the Company’s federaltax NOLs. The $900,000 reserve was reversed during 2005 and reflected in othercomprehensive income. The amount of the accrued benefit liability is reflectedin other liabilities.

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**Note 12—Capital Stock**

*Common Stock*

During October 1999, pursuant to an unsolicitedwritten consent from a majority of the Company’s stockholders, the Companyadopted certain amendments to its certificate of incorporation. The amendmentsauthorized 18,000,000 shares of a second class of stock, (“Excess Stock”) to beissued under certain circumstances. The effect of the amendments is to prohibitthe acquisition of the Company’s Common Stock by anyone who would become a 5%stockholder or by existing 5% stockholders, except in certain permissiblecircumstances which would not significantly increase the risk of an OwnershipChange (as defined by the Internal Revenue Code of 1986, as amended) and wouldnot, therefore, jeopardize the Company’s ability to use its $125 million ofNOLs (see Note 8). While these amendments reduced the Company’s risk of anOwnership Change occurring due to the acquisition of shares by 5% stockholders,the risk remains that an Ownership Change could result from the sale of sharesby existing 5% stockholders. The Company’s Board of Directors evaluatesrequests to purchase any amounts in excess of 5% of the Company’s common stockand authorizes such transactions which are not expected to jeopardize theCompany’s ability to use its NOLs.

At the May 2000Annual Meeting, the Company’s shareholders approved a reduction in authorizedshares of both Common Stock and Excess Stock from 18,000,000 shares to11,000,000 shares. At the May 2004 Annual Meeting, the Company’sshareholders approved an increase in authorized shares of both Common andExcess Stock from 11,000,000 shares to 13,500,000 shares.

*Warrants*

During December 2003,the Company issued 18,000 common shares upon the exercise of a warrantpreviously issued to a consultant in partial compensation for its services in1999. The warrant was issued with its exercise price at a then current marketprice of $7.00 per share, and vested after one year. The Company received$126,000 in cash in connection with the exercise of this warrant. As of December 31,2005 and 2004, there are no warrants outstanding.

**Note 13—Stock Plans**

*1993 StockOption/Stock Issuance Plan*

The 1993 Stock Option/Stock Issuance Plan (“1993 Plan”)was approved at the 1994 Annual Meeting of Stockholders, reserving 7.5 millionshares each of Series A Preferred Stock and Class A Common Stock forissuance to officers, key employees and consultants of the Company and itssubsidiaries and the non-employee members of the Board of Directors (the “Board”).On April 28, 1997, in connection withthe Recapitalization, the Compensation Committee of the Board authorized thegrant of stock options for 759,984 shares, equivalent at that time to 6% of theCompany’s fully diluted equity, for certain directors and officers. At the May 2004stockholder meeting, the stockholders of the Company authorized an additional150,000 stock options for the 1993 Plan.

In 1998, options for 569,988 shares were terminated inconnection with the Company’s sale of its commercial development business andnew options for 295,000 shares were granted. During 1999, options aggregating270,000 shares were issued to certain officers and directors of the Company andits subsidiaries. These options have a term of 10 years and vested 50% afterone year and the remaining 50% after two years. During 2004, options for 20,000shares were issued to a Director at an exercise price of $10.90 and vesting wasaccelerated to make the options currently exercisable. During the year endedDecember 31, 2005, the Company granted 10,000 options with a fair value of$104,000 that vest 50% after one year and 100% after two years, and have a termof 10 years. Pursuant to SFAS 123, the Company 

F-23

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recorded $36,000 and$271,000 of compensation expense during the years ended December 31, 2005and 2004, respectively, which is reflected in capital in excess of par value.

Asummary of the status of the Company’s stock option plan for the years ended December 31,2005 and 2004 follows (there was no activity in the plan from January 1,2002 to December 31, 2003):

| ** **                                        | ** ** | **2005**                    | ** ** | **2004**                                | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|
| ** **                                        | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining Life** | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average**

**Remaining Life** | ** ** |
| Outstanding,  beginning of period                 |       |                        | 719,996    |                                    |       |   | $ | 4.68 |   |   |   |   |   |   |   | 754,996 |   |   |   | $ | 4.50 |   |   |   |   |   |   |
| Granted                                           |       |                        | 10,000     |                                    |       |   | $ | 31.92 |   |   |   |   |   |   |   | 20,000 |   |   |   | $ | 10.90 |   |   |   |   |   |   |
| Exercised                                         |       |                        | (30,000    | )                                       |       |   | $ | 8.77 |   |   |   |   |   |   |   | (55,000 | ) |   |   | $ | 4.50 |   |   |   |   |   |   |
| Outstanding,  December 31               |       |                        | 699,996    |                                    |       |   | $ | 4.89 |   |   |   | 2.7 years |   |   |   | 719,996 |   |   |   | $ | 4.68 |   |   |   | 3.5 years |   |   |
| Fully vested and  exercisable at December 31 |       |                        | 689,996    |                                    |       |   | $ | 4.50 |   |   |   | 2.6 years |   |   |   | 719,996 |   |   |   | $ | 4.68 |   |   |   | 3.5 years |   |   |
| Available for future  grants at December 31  |       |                        | 124,988    |                                    |       |   |   |   |   |   |   |   |   |   | 134,988 |   |   |   |   |   |   |   |   |   |   |

 

As of December 31, 2005, there were 699,996options outstanding with a weighted-average exercise price of $4.89 (rangingfrom $4.50 to $37.07) and a weighted-average remaining life of 2.70 years. In February 2005,options for 20,000 shares at $10.90 per share and options for 10,000 shares at$4.50 per share were exercised.

Until the second quarter of 2003, the Companyaccounted for its stock-based employee compensation plan using the recognitionand measurement principles (intrinsic value method) of Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,”and the related Financial Accounting Standards Board (“FASB”) Interpretation No. 44,“Accounting for Certain Transactions Involving Stock Compensation” (“FIN 44”).Accordingly, no compensation expense was recognized through 2002 for itsstock-based compensation plans other than for variable accounting for repricedstock options. During the second quarter of 2003, the Company adopted the fairvalue recognition provisions of SFAS 123. Stock options are valued using theBlack-Scholes option-pricing model and this fair value is recognized as anexpense over the period in which the options vest. For this change inaccounting, the Company selected the “modified prospective method” under theprovisions of SFAS 148. Under this method, the change was retroactive to January 1,2003 and compensation cost recognized during 2003 was zero, the same as thatwhich would have been recognized had the recognition provisions of SFAS 123been applied from its original effective date. In accordance with SFAS 148,results for prior years have not been restated. SFAS 123 states that theadoption of the fair value based method is a change to a preferable method ofaccounting. Management believes that use of the fair value based method torecord employee stock-based compensation expense is consistent with theaccounting for all other forms of compensation.

Theweighted-average assumptions used for stock option grants in December 31,2005 and 2004 were as follows (no stock options were granted in 2003):

| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Risk-free  interest rate  |       | 4.1%     |       | 3.6%     |       |
| Expected life (in  years) |       | 4        |       | 4        |       |
| Expected  volatility      |       | 35.0%    |       | 40.0%    |       |
| Expected dividends        |       | None     |       | None     |       |

 

F-24

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**Note14—Unaudited Quarterly Financial Information**

Thefollowing is a summary of quarterly financial information for 2005 and 2004 (inmillions, except per share amounts):

| ** **                                   | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Full  Year** | ** ** |
|----------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|----------------|------------|
| **2005**                                     |       |      |       |       |       |      |       |       |       |           |       |   |   |   |   |
| Revenues (a)                                 |       | $         | 6.5        |       |       | $         | 3.1        |       |       | $              | 24.4       |   |   | $ | 95.5 |   |   | $ | 129.5 |   |
| Cost of sales                                |       | 4.8       |       |       | 2.2        |      |       | 19.5       |       |           | 55.0       |   |   | 81.5 |   |
| Gross operating  profit                      |       | 1.7       |       |       | .9         |      |       | 4.9        |       |           | 40.5       |   |   | 48.0 |   |
| Net income                                   |       | 4.7       |       |       | —     |      |       | 1.7        |       |           | 22.0       |   |   | 28.4 |   |
| Other  comprehensive income (loss)           |       | .9        |       |       | —     |      |       | —     |       |           | (.1        | ) |   | .8 |   |
| Earnings per  common share—basic        |       | $         | .46        |       |       | $         | —     |       |       | $              | .17        |   |   | $ | 2.15 |   |   | $ | 2.78 |   |
| Earnings per  common share—diluted      |       | $         | .43        |       |       | $         | —     |       |       | $              | .16        |   |   | $ | 2.11 |   |   | $ | 2.70 |   |
| Weighted-average common  shares outstanding: |       |      |       |       |       |      |       |       |       |           |       |   |   |   |   |
| Basic                                        |       | 10.2      |       |       | 10.2       |      |       | 10.2       |       |           | 10.2       |   |   | 10.2 |   |
| Diluted                                      |       | 10.9      |       |       | 10.9       |      |       | 10.5       |       |           | 10.5       |   |   | 10.5 |   |

 

| ** **                                   | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Full  Year** | ** ** |
|----------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|----------------|------------|
| **2004**                                     |       |      |       |       |       |      |       |       |       |           |       |   |   |   |   |
| Revenues (a)                                 |       | $         | 5.6        |       |       | $         | 3.2        |       |       | $              | 28.4       |   |   | $ | 38.8 |   |   | $ | 76.0 |   |
| Cost of sales                                |       | 4.3       |       |       | 2.1        |      |       | 22.4       |       |           | 28.8       |   |   | 57.6 |   |
| Gross operating  profit                      |       | 1.3       |       |       | 1.1        |      |       | 6.0        |       |           | 10.0       |   |   | 18.4 |   |
| Net income                                   |       | .3        |       |       | .2         |      |       | 1.3        |       |           | 3.0        |   |   | 4.8 |   |
| Other  comprehensive loss (b)                |       | —    |       |       | —     |      |       | —     |       |           | (.2        | ) |   | (.2 | ) |
| Earnings per  common share—basic        |       | $         | .03        |       |       | $         | .02        |       |       | $              | .13        |   |   | $ | .30 |   |   | $ | .48 |   |
| Earnings per  common share—diluted      |       | $         | .03        |       |       | $         | .02        |       |       | $              | .12        |   |   | $ | .27 |   |   | $ | .44 |   |
| Weighted-average common  shares outstanding: |       |      |       |       |       |      |       |       |       |           |       |   |   |   |   |
| Basic                                        |       | 10.1      |       |       | 10.1       |      |       | 10.1       |       |           | 10.1       |   |   | 10.1 |   |
| Diluted                                      |       | 10.8      |       |       | 10.8       |      |       | 10.9       |       |           | 10.9       |   |   | 10.8 |   |

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(a)           The Company recordedrevenues from the delivery of 113 and 135 homes, respectively, in 2005 and 2004and $66.8 million in revenues from non-residential land sales at Bolsa Chica inthe fourth quarter of 2005.

(b)          Other comprehensive lossreflects a minimum pension liability adjustment of $200,000 reflected in thefourth quarter of 2004 and reversal of tax benefit of $900,000 in 2005.

F-25

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