**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

(Mark One)

x                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

 

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

 

**Forthe transition period from                          to**

**Commissionfile number: 0-17189**

**CALIFORNIACOASTAL COMMUNITIES, INC.**

(Exact name of registrantas specified in its charter)

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

 

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

**Securities registered pursuant to Section 12(b) ofthe Act:**
|                                         | **Title of Each Class** | ** ** | ** ** | **Name of Each Exchange on Which Registered** | ** ** |
|-----------------------------------------|-------------------------|------------|------------|-----------------------------------------------|------------|
| Common Stock, par  value $.05 per share | NASDAQ Global  Market   |

 

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

**None**

**Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities 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 statements incorporatedby reference in Part III of this Form 10-K or any amendment tothis Form 10-K. YES **x*   *NO o

**Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):**

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

 

**Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). YES **o NO x

**Theaggregate market value of the voting stock held by non-affiliates of theregistrant as of March 8, 2007 was $160,309,874.**

**Thenumber of shares of Common Stock outstanding as of March 8, 2007 was10,855,963.**

**DOCUMENTS INCORPORATED BY REFERENCE**

**Portionsof the registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholdersare incorporated by reference into Part III of this Annual Report on Form 10-K.**

 

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**CALIFORNIA COASTALCOMMUNITIES, INC.**

**FORM 10-K**

**FOR THE YEAR ENDEDDECEMBER 31, 2006**

**INDEX**
|                   | ** ** | ** **                                                                                                                      | ** ** | Page No. | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|
| **PART I**   |       |
| Item 1.           |       | Business                                                                                                                        |       |          | 3          |   |
| Item  1A.         |       | Risk  Factors                                                                                                                   |       |          | 15         |   |
| Item 1B.          |       | Unresolved Staff Comments                                                                                                       |       |          | 23         |   |
| Item 2.           |       | Properties                                                                                                                      |       |          | 23         |   |
| Item  3.          |       | Legal  Proceedings                                                                                                              |       |          | 23         |   |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                             |       |          | 24         |   |
| **PART II**  |       |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities              |       |          | 25         |   |
| Item  6.          |       | Selected  Financial Data                                                                                                        |       |          | 26         |   |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       |          | 26         |   |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       |          | 26         |   |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                                     |       |          | 27         |   |
| Item 9.           |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                  |       |          | 27         |   |
| Item 9A.          |       | Controls and Procedures                                                                                                         |       |          | 27         |   |
| Item  9B.         |       | Other  Information                                                                                                              |       |          | 31         |   |
| **PART III** |       |
| Item 10.          |       | Directors, Executive Officers and Corporate Governance                                                                          |       |          | 31         |   |
| Item 11.          |       | Executive Compensation                                                                                                          |       |          | 31         |   |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                  |       |          | 31         |   |
| Item 13.          |       | Certain Relationships and Related Transactions, and Director  Independence                                                      |       |          | 31         |   |
| Item 14.          |       | Principal Accountant Fees and Services                                                                                          |       |          | 31         |   |
| **PART IV**  |       |
| Item 15.          |       | Exhibits, Financial Statement Schedules                                                                                         |       |          | 32         |   |

 

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**PART I**

**Item 1.**                        Business

**Overview ofCalifornia 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 our homes are designedto appeal to move-up homebuyers and are generally offered for sale in advanceof their construction. During the next 12 months, we will focus our primaryefforts to:

·       completeinfrastructure and model home construction, and begin selling production homesat the 356-home Brightwater project located on the Bolsa Chica mesa inOrange County, California;

·       completethe entitlement process for a 168-acre joint venture project near Oxnard,California currently being planned for 554 single-family detached homes and 500attached homes (townhomes, condominiums and apartments); and

·       maximizedeliveries, revenues and profitability of our homebuilding operationsthroughout Southern California.

However, we may also consider other strategicopportunities as discussed below; and there can be no assurance that we willaccomplish, in whole or in part, all or any of our strategic goals.

Our total revenues for the years ended December 31,2006, 2005, and 2004 were $95.7 million, $129.5 million, and $76.0 million,respectively. For the years ended December 31, 2006, 2005, and 2004, wedelivered 147, 113, and 135 homes. Our total assets as of December 31,2006 and 2005 were $332.3 million and $330.4 million, respectively. Ourhomebuilding subsidiary, Hearthside Homes, Inc., has delivered over 2,000homes to families throughout Southern California since its formation in 1994.

Prior to obtaining the Coastal Development Permit forour Brightwater project in December 2005, we historically maintained aminimal amount of leverage. In September 2006, we obtained $225 million ofdebt financing as described in Notes 5 and 6 to the Consolidated FinancialStatements, which provided $125 million to fund the special dividend to ourstockholders that is described in Note 13 to the Consolidated FinancialStatements. As of December 31, 2006, we had $188.2 million of debt against$123.5 million of book equity and a $232.8 million equity marketcapitalization.

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 and ourwebsite address is http://www.californiacoastalcommunities.com. We expect tomake available through our website by March 30, 2007 our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to these reports filed or furnished pursuant to Section 13(d) or15(d) of the Exchange Act as soon as reasonably practicable after they arefiled with, or furnished to, the SEC. Copies of our Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to these reports are available free of charge upon request. Inaddition, at our website we expect to post 

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currentversions of our code of ethics, audit committee charter and nominatingcommittee charter by March 30, 2007.

**Our Current andFuture Homesites**

We currently haveon-going Southern California homebuilding projects in:

·       OrangeCounty in the Huntington Beach area;

·       RiversideCounty near the cities of Corona and North Corona, and in the City of 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.

Wecompleted grading our Brightwater development project in Orange County during October 2006and plan to process permits for seven homes on adjacent parcels in the City ofHuntington Beach, which would bring the total unit count up to 356. Thefollowing chart describes our current projects, their location and our year-endlot inventories:

| **Project**                 | ** ** | ** **                    | ** ** | **Location** | ** ** | **12/31/06 Lot  Inventory** | ** ** |
|-----------------------------|------------|-------------------------------|------------|--------------|------------|----------------------------------|------------|
| Orange County:              |       |                          |       |         |       |                             |       |
| Brightwater                 |       | Bolsa  Chica                  |       |         | 356        |                             |       |
| Inland Empire:              |       |                          |       |         |       |                             |       |
| Chandler Ranch              |       | North  Corona                 |       |         | 25         |                             |       |
| Alisal at Ontario           |       | Ontario                       |       |         | 17         |                             |       |
| Woodhaven                   |       | Beaumont                      |       |         | 87         |                             |       |
| Hearthside Lane             |       | Corona                        |       |         | 151        |                             |       |
|                        | * *   | *Subtotal—Inland Empire* |       |         | 280        |                             |       |
| Lancaster:                  |       |                          |       |         |       |                             |       |
| Alisal at  Lancaster        |       | Lancaster                     |       |         | 8          |                             |       |
| Lancaster II                |       | Lancaster                     |       |         | 73         |                             |       |
| Las Colinas at Quartz  Hill |       | Lancaster                     |       |         | 74         |                             |       |
|                        | * *   | *Subtotal—Lancaster*     |       |         | 155        |                             |       |
| San Diego County:           |       |                          |       |         |       |                             |       |
| Cancion                     |       | Rancho  Santa Fe              |       |         | 6          |                             |       |
|                        | * *   | *Total—All  Projects*    |       |         | 797        |                             |       |

 

These homebuildingprojects are currently expected to generate cash flows and gross operatingmargins through mid-2010. Up to approximately 554 additionalsingle-family lots could be available for homebuilding operations if we obtainentitlements for our Oxnard project; however, the exact number of homes willdepend on the final outcome of the entitlement process.

*Brightwater atBolsa Chica*

The 110-acre Bolsa Chica upper mesa is thelargest property in our portfolio, representing approximately 47% of our totalassets as of December 31, 2006. The Bolsa Chica upper mesa is one of thelast large undeveloped coastal properties in Southern California, and islocated in Orange County, approximately 35 miles south of downtown Los Angeles.Bolsa Chica is bordered on the north and east by 

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residential development inthe City of Huntington Beach and Huntington Harbor, to the south by open spaceand the 1,200-acre Bolsa Chica wetlands, and to the west by 120 acres ofpublicly-owned space on the lower bench of the Bolsa Chica mesa, Pacific CoastHighway, Bolsa Chica State Beach, and the Pacific Ocean. Our holdings on theBolsa Chica mesa include 68 acres of developable land on the upper mesa plannedfor a residential community known as Brightwater, 37 acres of open space andconservation area in the planned community, and five acres in the City ofHuntington Beach which are currently zoned agricultural. We are analyzingdevelopment alternatives for this 5-acre parcel and expect to submit aproposed site plan to the City of Huntington Beach during 2007.

We also own approximately 104 non-developable acreson, or adjacent to, the Huntington Mesa. 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 and an additional 51 acres are subject to aconservation easement.

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 2,860 square feet and ranging insize from 1,720 square feet to 4,140 square feet. The smaller homes arecurrently expected to be offered at prices starting in the low to mid $1millions and the larger homes are currently expected to start in excess of $2million. In addition, we own land adjacent to the planned Brightwaterdevelopment in the City of Huntington Beach, for which we intend to processpermits to build seven additional homes which would be included in theBrightwater community. With 356 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. Todate, over 2,400 people have registered on our website requesting informationabout purchasing a home at Brightwater. We completed grading the Brightwaterdevelopment during October 2006, started building eight of the 17 modelhomes in December 2006, and currently expect to:

·       completeconstruction of the first eight model homes, which range from 1,710 to 2,160square feet, during the summer of 2007,

·       startselling production homes from the first eight model homes during the summer of2007,

·       completeconstruction of nine additional model homes, which will range from 2,720 to4,140 square feet, during the early fall of 2007,

·       startselling production homes from the nine additional model homes during the earlyfall of 2007, and

·       begindelivering homes for the first eight models by the end of 2007.

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

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

·       TheBrightwater coastal development permit provides for 349 homes aggregatingapproximately 995,000 square feet.

·       Weown land adjacent to Brightwater in the City of Huntington Beach, for which weintend to process permits to build seven additional homes which would beincluded in the Brightwater community.

·       Modelhomes for the first two products at Brightwater are projected to be completedduring the summer of 2007 and build-out of production homes is expected to takeapproximately three years.

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·       Weare currently planning to: (i) begin selling homes during the summer of2007, and (ii) begin delivering homes by the end of 2007.

·       Wecurrently expect to deliver the majority of the Brightwater homes in 2008 and2009.

·       Asof January 2006, new home prices approximated $650 per square foot,including view and other premiums, in the local residential market (coastalHuntington Beach). We expect to conduct an updated market survey during thesecond quarter of 2007 as we prepare to open for sale during the summer of2007.

·       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.

·       Thedirect costs (excluding indirect costs such as supervision, overhead, sales andmarketing, warranty, insurance, etc.) of building homes at Brightwater arecurrently expected to range from approximately $120 to $150 per square foot.

·       Brightwateris currently expected to generate gross margins that are approximately two tothree times our 2006 homebuilding margins due to our low book basis inBrightwater.

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 inventories in the ordinary course of business based on management’spresent plans and intentions. Economic, market, and environmental conditions mayaffect our development and marketing plans. The development of Brightwaterdepends upon various factors. Accordingly, the amount ultimately realized fromthe Brightwater project may differ materially from our current estimates andthe project’s carrying value.

*Oxnard LandDevelopment - Unconsolidated Joint 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 developing a land planfor the area, which also includes an additional 149 acres owned by otherlandowners, with the intention of entitling the property for residentialdevelopment and annexing it into Oxnard. During October 2003, we enteredinto a joint venture agreement with a major financial partner to pursue theOxnard development opportunity. We assigned the land purchase option contractsto the Oxnard joint venture. Hearthside Homes, Inc., our homebuildingsubsidiary, is the manager of the Oxnard joint venture.

We currently expect the residential development planto include approximately 760 single-family detached lots and approximately 630attached residential units (townhomes, condominiums and apartments); however,these numbers are subject to change during the course of the entitlementprocess. Approximately 554 of the single-family lots and approximately 500 ofthe attached units would be developed on the 168 acres of optioned land that wecurrently expect the Oxnard joint venture to purchase. The single-family detachedproduct is currently expected to range from approximately 1,880 square feet to3,850 square feet and the attached units are currently expected to range fromapproximately 1,030 square feet to 1,850 square feet. An independent marketstudy as of August 2006 estimated average home prices for the project ofapproximately $665,800, or an average of $311 per square foot.

The option contracts give the Oxnard joint venture twoyears, plus up to three additional years through the exercise of extensions, tocomplete entitlement activities before purchasing the land. The Oxnard jointventure has the right to terminate these option agreements by forfeiting thecash deposits. The Oxnard joint venture is striving to obtain approval of itsplan from the Oxnard City Council in the second half of 2007 and approval ofannexation into the City of Oxnard from the Local Agency Formation 

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Commission in the first quarterof 2008; however, delays could be encountered. If the Oxnard joint venturecompletes the entitlement process in the time frame set forth above, anddecides to build homes (rather than sell lots), most of the homes would bedelivered between 2010 and 2012, based on current expectations and assumptions.The Oxnard joint venture has exercised five six-month extensions, extending thecurrent closing date for the option contracts to August 2007, and there isone remaining six-month extension through February 2008.

The Oxnard joint venture is funded by both of itsmembers. Hearthside Homes, Inc. made an initial contribution of $500,000.The non-managing member also made an initial contribution of $500,000 to thejoint venture and, as of December 31, 2005, had made an aggregate of $4million of first tier additional contributions. The members have provided asecond tier of additional capital contributions of $1 million each, asoriginally provided in the joint venture agreement. In addition, the membershave agreed to provide an additional $325,000 each of temporary advances, asnecessary, to complete the business plan. During the fourth quarter of 2005,and fiscal year 2006, the members each contributed approximately $160,000 and$1.0 million, respectively.

In addition to the land purchase options for theproject property, the Oxnard joint venture holds a land purchase option whichcontrols property which was expected to provide fill dirt for the projectproperty. During February 2007, the Oxnard joint venture agreed to sellthe non-project land purchase option since the fill dirt is no longer requiredfor the project. The sale for $1.8 million is contingent upon various closingconditions including feasibility studies, and is scheduled to close during thethird quarter of 2007. The Oxnard joint venture expects to receive proceeds ofapproximately $1.5 million for this transaction after paying commissions andclosing costs, and plans to utilize the proceeds to fund ongoing developmentcosts.

Our total investment in the venture as of December 31,2006 is $1.7 million. We expect to make additional aggregate capitalcontributions of approximately $100,000 to the joint venture during 2007,bringing our total expected investment in the venture to $1.8 million. Theamount of contributions could be substantially increased if the sale of thenon-project land option is not completed as discussed above.

After payment of a 10% preferred return on investedcapital to us and our partner, the first $8 million of profits are allocated75% to our partner and 25% to us, and profits over $8 million and losses over$5 million are generally allocated on a 50/50 basis in accordance with theoperating agreement. The first $5 million of losses are generally allocated 80%to our partner and 20% to us. Given current market conditions, we presentlyestimate that cash flow to our homebuilding subsidiary, after preferred returnsto our joint venture partner and payment of incentive compensation to ouremployees, would approximate $26 million (including returns of our capital andour related preferred returns) if: (i) entitlements for the SouthShoreproject in Oxnard had been completed as of December 31, 2006, (ii) the168 acres controlled by our Oxnard joint venture were purchased by the ventureunder the existing option agreements upon completion of the entitlements,and  (iii) the 168 acres wereimmediately sold as paper lots for approximately $750,000 per acre (whichincludes a discount to reflect current market conditions). In view of theever-present uncertainties of the entitlement process and the currentvolatility in the homebuilding industry, there can be no assurances that theOxnard joint venture will be able to obtain the entitlements, or sell the paperlots at the estimated price.

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 delivered 147 homes during 2006, compared to 113deliveries in 2005. We acquired no single-family residential lots during 2006.After several years of dramatic home price appreciation in Southern 

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California, we saw pricedepreciation during 2006 in the Inland Empire (Corona, Ontario and Beaumont),Lancaster and San Diego markets. We have reduced sales prices and offeredincentives for a number of our homes which are not yet in escrow in response toour competition and to reflect current market pricing.

Our homebuilding projectsare described below:

| ** **          | ** ** | ** **                  | ** ** | **Land**        | ** ** | **Commenced**    | ** ** | **Commenced** | ** ** | **Deliveries** | ** **               |
|---------------------|------------|-----------------------------|------------|-----------------|------------|------------------|------------|---------------|------------|----------------|--------------------------|
| ** **          | ** ** | **Location**                | ** ** | **Acquisition** | ** ** | **Construction** | ** ** | **Sales**     | ** ** | **2004**       | ** **               | **2005** | ** ** | **2006** | ** ** |   |
| Completed Projects  |       | Various                     |       |            | n/a        |             |       |          | n/a        |           |                     |   | n/a |   |   |   | 135 |   |   |   | 52 |   |   |   | 1 |   |   |   |
| Active Projects     |       |                        |       |            |       |             |       |          |       |           |                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Brightwater         |       | Bolsa  Chica                |       |            | 1970       |             |       |          | 2006       |           |                     |   | 2007 | (a) |   |   | — |   |   |   | — |   |   |   | — |   |   |   |
| Cancion             |       | Rancho   Santa Fe |       |            | 2003-2005  |             |       |          | 2005       |           |                     |   | 2005 |   |   |   | — |   |   |   | 6 |   |   |   | 20 |   |   |   |
| Chandler Ranch      |       | North  Corona               |       |            | 2004       |             |       |          | 2005       |           |                     |   | 2005 |   |   |   | — |   |   |   | — |   |   |   | 58 |   |   |   |
| Alisal at Ontario   |       | Ontario                     |       |            | 2005       |             |       |          | 2005       |           |                     |   | 2006 |   |   |   | — |   |   |   | — |   |   |   | 9 |   |   |   |
| Woodhaven           |       | Beaumont                    |       |            | 2005       |             |       |          | 2005       |           |                     |   | 2006 |   |   |   | — |   |   |   | — |   |   |   | 15 |   |   |   |
| Hearthside Lane     |       | Corona                      |       |            | 2005       |             |       |          | 2005       |           |                     |   | 2007 | (a) |   |   | — |   |   |   | — |   |   |   | — |   |   |   |
| Alisal at Lancaster |       | Lancaster                   |       |            | 2004       |             |       |          | 2004       |           |                     |   | 2005 |   |   |   | — |   |   |   | 55 |   |   |   | 41 |   |   |   |
| Quartz Hill         |       | Lancaster                   |       |            | 2005       |             |       |          | 2006       |           |                     |   | 2006 |   |   |   | — |   |   |   | — |   |   |   | 3 |   |   |   |
| Lancaster II        |       | Lancaster                   |       |            | 2005       |             |       |          | 2008       | (a)            |                     |   | 2008 | (a) |   |   | — |   |   |   | — |   |   |   | — |   |   |   |
|                |       |                        |       |            |       |             |       |          |       |           | *Total  Deliveries* |   | 135 |   |   |   | 113 |   |   |   | 147 |   |   |   |

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(a)           Planned

*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 the lots during the period from October 2003 to March 2005.During 2005, two model homes averaging approximately 3,370 square feet werecompleted and six homes were delivered at an average price of $1.2 million. Wedelivered 20 homes during 2006 at an average price of $1.4 million. During January andFebruary 2007, two additional homes were delivered at an average price of$1.3 million. As of February 28, 2007, the final four homes are in escrow atan average price of $1.2 million.

*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 58 homes during 2006 at an averageprice of $600,000. During January and February 2007, two additionalhomes were delivered at an average price of $597,000. As of February 28,2007, three homes are in escrow at an average price of $592,000, and 16additional homes are completed and have been released for sale.

During April 2005, we acquired 151 additionallots in Corona. Following construction of infrastructure, construction of fivemodel homes averaging 3,600 square feet on lots of approximately 7,200 squarefeet began during the fourth quarter of 2006. These models are expected to becompleted during the second quarter of 2007, at which time production phasehomes will be offered for sale.

*Ontario.**  *During April 2005, we acquired 26 lots in theCity of Ontario in Riverside County, California. This small community of homes,averaging 3,380 square feet, is an infill site situated very close to theprojects we completed in the City of Chino in 2005. Construction of the firstphase of 13 homes began during the fourth quarter of 2005, and we opened forsales during March 2006. We delivered nine homes during 2006 at an averageprice of $675,000. During February 2007, one additional home was deliveredat a price of $695,000. As of February 28, 2007, four homes are in escrowat an average price of $666,000. During February 2007, we released sixadditional homes for sale for which construction is expected to start in March 2007.

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*Beaumont.*   Weacquired 102 lots in the City of Beaumont during the third quarter of 2005.Following construction of infrastructure, construction of homes averaging 2,500square feet began during the first quarter of 2006, and sales commenced during March 2006.We delivered 15 homes during 2006 at an average price of $387,000. As of February 28,2007, two homes are in escrow at an average price of $422,000 and 23 additionalhomes are completed or under construction and have been released 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 2,850 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. We delivered 41 homesduring 2006 at an average price of $448,000, and delivered one additional homeat a price of $425,000 during February 2007. As of February 28, 2007,four homes are in escrow at an average price of $462,000, and two homes arecompleted or are under construction and held for sale. In April 2005, weacquired an additional 73 unentitled lots in Lancaster. The entitlement processis near completion; however, we have determined that the construction start forthe 73-unit project, which has no recorded loan, will be deferred untilsales activity in the market has improved.

In December 2005, weacquired 77 additional lots in an area known as Quartz Hill in the City ofLancaster. The homes in this community are on 10,000 square foot lots and willaverage 3,640 square feet. Construction of models began in May 2006 and weopened for sales during July 2006. During 2006, we delivered three homesat an average price of $537,000, and one additional home during February 2007at a price of $549,000. As of February 28, 2007, two homes are in escrowat an average price of $572,000 and seven additional production homes arecompleted and have been released for sale.

**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 thepotential return to us. The use of joint ventures may vary in the future inorder to enable us to control an adequate supply of lots while minimizingcapital commitments. We typically are required to fund a small percentage ofthe capital requirements of each joint venture, and the amount is included inother assets in our consolidated balance sheets.

**Land Acquisition**

We typically consider numerous factors when analyzingthe suitability of land for acquisition and development including, but notlimited to: proximity to existing developed areas, population growth patterns,availability of existing community services (i.e. utilities, schools andtransportation), employment growth rates, anticipated absorption rates for newhousing, and the estimated cost of development. We try to avoid speculativebuilding by constraining project phase sizes, and entitlement risks byacquiring entitled land when practicable and acquiring lots through the use ofoptions, development agreements and joint ventures with lot owners, whenavailable on favorable terms. Additionally, by forming joint ventures withvarious sources of capital, we have been able to obtain access to additionalcapital and construction financing to expand the number of lots we control andto spread project risk.

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**StrategicAlternatives**

Our Board of Directors and management have always beenand continue to be committed to enhancing value for all stockholders. From timeto time, we have considered the various strategic alternatives available to uswith respect to our businesses, assets, operations and available cash. We haveengaged investment bankers and other advisors for this purpose, with a viewtowards assessing alternatives which would enhance the value of our currentbusinesses, create additional business opportunities, or otherwise maximize thevalue of our company for our stockholders. Included in this process has been anexploration of merger, acquisition and disposition possibilities; analysis ofequity and debt financings; open market and other repurchases of our stock;dividends and other distributions to our stockholders; and combinations ofthese alternatives. In September 2006, we paid a special dividend of$12.50 per share to all of our stockholders, which represented a return ofcapital to the extent of each stockholder’s basis in our stock.

As we continue to developBrightwater, we will also continue to evaluate any other available strategicalternatives that will maximize value to our stockholders.

**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, andexterior styles in an effort to enhance home values by creating diversifiedneighborhood appearances within our projects. The majority of these homes aredesigned to appeal to move-up homebuyers and are generally offered for sale inadvance of their construction. Generally, we select the exterior finishes ofour homes subject 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 andDevelopment**

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 ranging from 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 

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measureconsumer demand. Construction generally does not begin until some sales haveoccurred, except for construction of model homes and in some cases the firstfew production homes. Subsequent phases are generally not started until 90% to100% of the homes in the previous phase have been sold. Sales prices in thesecond phase are then adjusted to reflect market demand as evidenced by salesexperience in the first phase. With each subsequent phase, we continue toaccumulate data which enables us to make decisions on the pricing, timing andsize of subsequent phases. Although the time required to complete a phasevaries from development to development depending on the factors above and thebuild time, which in turn varies generally with the size and complexity of thehome, we typically complete construction of a phase within one of ourdevelopments in approximately five to eight months. We are continuouslydeveloping and refining our production practices in order to reduce cycle timewithin the construction process.

**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 the purchaseprocess in exchange for additional deposits. We provide flooring and otheramenities and upgrades to our homebuyers through the various vendors with whichwe contract. When home purchase contracts are canceled, we retain the depositsof non-contingent buyers and seek to identify 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.

**Backlog**

Backlog represents the number of our homes that areunder sales contracts. Sales of our homes are made pursuant to standard salescontracts, which require a customer deposit at the time of execution. Wegenerally permit customers to cancel their obligations and obtain refunds ofall or a portion of their deposits if they are unable to close on the sale oftheir existing home, fail to qualify for financing or under certain othercircumstances. A home sale enters backlog status upon execution of such acontract and receipt of an earnest money deposit and is removed when suchcontracts 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 31,2006 was 17 homes compared with 83 homes in backlog at year-end 2005,reflecting a slowdown in sales contracts and higher cancellation rates during2006 as a result of an overall softening of the housing market and anincreasing supply of homes available for sale in our markets. The aggregatesales value of our backlog was $10.9 million at December 31, 2006. Ourbacklog ratio was 109.7% for the fourth quarter of 2006 and 48% for the fourthquarter of 2005. Backlog ratio is defined as unit deliveries as a percentage ofbeginning backlog for the quarter. Approximately 23% of our deliveries in 2006occurred in the fourth quarter, compared to 48% during the comparable period in2005. 

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As of February 28,2007, five of the homes in backlog at December 31, 2006 have beendelivered and an additional 10 of the homes are expected to be delivered duringthe first half of fiscal 2007.

**Competition**

The homebuilding industryis highly competitive and fragmented. We do not have a significant marketpresence in any of the geographic areas where we are currently building homesor where we expect to build homes in the future. Most of our competitors havesubstantially greater financial resources than we do, and they have much largerstaffs and marketing organizations. However, we believe we compete effectivelyin our existing markets as a result of our product design, developmentexpertise, and our reputation as a producer of quality homes. We have seen thefinancial resources of our competitors increase as a result of the industryconsolidation experienced in the past several years. As we enter and until wedevelop 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 forhomebuyers, we also compete with other homebuilders for desirable properties,raw materials and reliable, skilled labor.

**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 wetlandsprotection, subsurface conditions and air quality protection and enhancement.Environmental laws and existing conditions may result in delays, may cause usto incur substantial compliance and other costs and may prohibit or severelyrestrict homebuilding 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 

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services,thereby leading to delays in the delivery of homes under construction. Inaddition, high prices of lumber and other materials have a negative impact onmargins. In the last six months, we have negotiated with our suppliers forprice reductions on materials and labor, based on the general slowdown in themarket. We have experienced and anticipate some substantial price reductionsand are continuing to monitor the supply markets to achieve the best pricesavailable.

**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 ouremployees or contractors (such as flooring installed by an outside contractoremployed by the homeowner). Statutory requirements in California may granthomebuyers rights in addition to those that we provide.

**Mortgage CompanyServices**

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.

**Environmental andRegulatory 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 procedure requiring,among other things, the submission of development plans and reports andpresentations at public hearings. Because of the provisional nature of theseapprovals and the concerns of various environmental and public interest groups,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.

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 are generally in compliance with applicableenvironmental regulations, certain risks of unknown costs and liabilities areinherent in developing and owning real estate. We do not believe that suchcosts will have a material adverse effect on our business, financial conditionor results of operations. The currently identifiable risks and uncertaintiesregarding other matters are discussed below in “Item 3. Legal Proceedings” andin “Note 8 - Other Liabilities” to the financial statements included in thisAnnual Report.

**CorporateIndemnification 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 is supportedby insurance or by 

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indemnitiesfrom certain of our previously affiliated companies. We believe our balancesheet reflects adequate reserves for these matters. More information on ourcontingent indemnity and environmental obligations is contained in “Item 3.Legal Proceedings” and “Note 8 - Other Liabilities” in the financial statementsincluded in this Annual Report.

**Employees**

As of February 28,2007 we and our subsidiary companies had 59 employees. We believe that ourrelations with our employees are good. No employees are represented by acollective bargaining agreement.

**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 due inpart to the timing of land acquisitions and the ensuing course of developmentand construction required prior to delivering homes. Historically, the numberof homes sold during the spring and summer months is typically greater thanother periods during the year, and new home deliveries trail orders for newhomes by up to six months. As a result, our revenues and operating earningsfrom sales of homes have been significantly higher in the second half of ourfiscal year in prior years. However, during 2006, approximately 47% of thehomes delivered during the year were delivered during the second half of theyear, compared with 88% and 85% for the years ended December 31, 2005 and2004, respectively. This departure from historical trends reflects our muchhigher backlog at the beginning of 2006, along with a decrease in net neworders during 2006 as a result of the industry-wide slowdown and highercancellation rates.

**AvailableInformation**

We file annual, quarterly and special reports, proxystatements and other information with the Securities and Exchange Commission.You may read and copy any materials we file with the Securities and ExchangeCommission at its Public Reference Room at 450 Fifth Street, NW.,Washington, DC 20549. You also may obtain information on the operation of thePublic Reference Room by calling the SEC at 1-800-SEC-0330.Our Securities and Exchange Commission filings are available to the public atthe SEC’s website at http://www.sec.gov. 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 and other information about us which will be available at ourwebsite: http://www.californiacoastalcommunities.com by March 30, 2007. Wethink these reports provide additional information which prudent investors willfind important. A copy of these filings as well as any future filings may be obtained,at no cost, by writing to our investor relations representative: ShareholderServices, 225 West Station Drive, Suite 545, Pittsburgh, PA 15219.

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**Item 1A.**                RiskFactors

In addition to the riskspreviously mentioned, the following important risk factors could adverselyimpact our business. These risk factors could cause our actual results todiffer materially from the forward-looking and other statements that we make inperiodic reports and other filings with the SEC, and that we make from time totime in our news releases, annual reports and other written communications, aswell as other statements made from time to time by our representatives. If anyof the following risks develop into actual events, our business, financialcondition, results of operations, cash flows, strategies and prospects could bematerially adversely affected:

***Factors may affectour future results (Cautionary Statements Under the Private SecuritiesLitigation Reform Act of 1995).***

This Annual Report on Form 10-K containsforward-looking statements within the meaning of Section 27A of theSecurities Exchange Act of 1933 and Section 21E of the Securities ExchangeAct of 1934 that relate to future events or our future financial performance.In addition, other statements we may make from time to time, such as pressreleases, oral statements made by our officials and other reports that we filewith the Securities and Exchange Commission may also contain suchforward-looking statements. Undue reliance should not be placed on thesestatements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. In some cases, you canidentify forward-looking statements by terminology such as “may”, “will”, “should”,“expects”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”,“continue”, or the negative of such terms or other comparable terminology.

Theseforward-looking statements 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;

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·       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 as a consequence of known or unknown risks and uncertainties. These risksand uncertainties include the competitive environment in which we operate;local, regional and national economic conditions; the demand for homes;fluctuations in interest rates and the availability of mortgage financing;changes in home prices; the availability and cost of land for future growth;the availability of capital; uncertainties and fluctuations in capital andsecurities markets; changes in tax laws and their interpretation; legalproceedings; the ability of customers to finance the purchase of homes or sellexisting homes; the availability and cost of labor and materials; the amount ofour debt and the impact of restrictive covenants in our loan agreements;adverse weather conditions; domestic and international political events;uncertainties created by terrorist attacks; the effects of governmentalregulation, including regulations concerning development of land, the homebuilding industry, sales and customer financing processes, and the environment;and other risks discussed in our filings with the Securities and ExchangeCommission. Many factors mentioned in this report or in other reports or publicstatements made by us, such as government regulation and the competitiveenvironment, will be important in determining our future performance.Consequently, actual results may differ materially from those that might beanticipated from our forward-looking statements. You should not place unduereliance on any of these forward-looking statements because they are based oncurrent expectations or beliefs regarding future events or circumstances, whichinvolve known and unknown risks, uncertainties and other factors which maycause our actual results, performance or achievements to be materiallydifferent from any future results, performances or achievements expressed orimplied by these forward-looking statements.

Although we believe that our strategies, plans, objectives,goals, expectations and intentions reflected in, or suggested by theseforward-looking statements are reasonable given current information availableto us, we can give no assurance that any of them will be achieved.Forward-looking statements speak only as of the date they are made. Weundertake no obligation to publicly update any forward-looking statements,whether as a result of new information, future events or otherwise. However,any further disclosures made on related subjects in our subsequent reports onForms 10-K, 10-Q and 8-K should be consulted.

These forward-looking statements should be consideredin light of the information included in this report and our other filings withthe Securities and Exchange Commission, including, without limitation, the “RiskFactors” set forth below, as well as the description of trends and otherfactors in “Management’s Discussion and Analysis of Financial Condition andResults of Operations”, set forth in this Form 10-K. You should alsoread the following “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” in conjunction with the consolidated financialstatements and the related notes that appear elsewhere in this report.

The following cautionarydiscussion of risks, uncertainties and possible inaccurate assumptions relevantto our business includes factors we believe could cause our actual results todiffer materially from expected and historical results. Other factors beyondthose listed below, including factors unknown to us and factors known to uswhich we have not determined to be material, could also adversely affect us.This discussion is provided as permitted by the Private Securities LitigationReform Act of 1995, and all of our forward-looking statements are expresslyqualified in their entirety by the cautionary statements contained orreferenced in this section.

***Our homebuildingoperations lack geographic diversification.***

Our residential landdevelopment and homebuilding operations are limited to the following sixSouthern California counties: Los Angeles, Orange, Riverside, San Bernardino,San Diego and Ventura. 

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Therefore,economic and other events that adversely impact this comparatively narrowgeographic region will have a direct negative impact on our business andoperations. Because we do not have more diversified geographic operations, thefollowing risk factors should be considered with extreme care given thepotential material adverse effect on our limited operations that could occur ifany of these risks become a reality.

***Our business iscyclical*** anddownward changes in economic conditions generally or in the market regionswhere we operate could decrease demand and pricing for new homes in theseareas.

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, includinginternational hostilities involving the United States);

·       consumerincome;

·       federalmortgage financing programs; and

·       federaland state income tax provisions, including provisions for the deduction ofmortgage interest payments.

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 describedabove can cause demand and prices for our homes to diminish or cause us to takelonger and incur more costs to build our homes. We may not be able to recoverthese increased costs by raising prices because the price of each home isusually set several months before the home is delivered, as our customerstypically sign their home purchase contracts before construction has even begunon their homes. In addition, some of the factors described above could causesome homebuyers to cancel their home purchase contracts altogether.

***Supply shortagesand other risks related to the demand for skilled labor and building materialscould increase costs and delay deliveries.***

Fluctuating lumber pricesand potential shortages, as well as shortages or price fluctuations in otherimportant building materials, can have an adverse effect on our homebuildingbusiness. Similarly, labor 

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shortagesor unrest among key trades, such as carpenters, roofers, electricians andplumbers, can delay the delivery of our homes and increase our costs.

***Inflation mayresult in increased costs that we may not be able to recoup if demand declines.***

Inflation can have along-term impact on us because increasing costs of land, materials and labormay require us to increase the sales price of homes in order to maintainsatisfactory margins. However, inflation is often accompanied by higherinterest rates, which can have a negative impact on housing demand, in whichcase we may not be able to raise home prices sufficiently to keep up with therate of inflation and our margins could decrease.

***We have recentlyincurred a significant amount of debt, and we may incur significant additionaldebt, which could prevent us from fulfilling our obligations and harm ourfinancial health.***

As of December 31, 2006, our total consolidatedliabilities were approximately $209 million. In addition, subject to therestrictions in our credit facilities, we may incur significant additionalindebtedness. There is no guarantee that this amount of additional borrowings,or any amounts, would be available to us. In addition, as these and otherfactors change, the amount of additional senior borrowing we could incur underthese restrictions could increase or decrease significantly.

Our business may not generate sufficient cash flowfrom operations and borrowings may not be available to us under our creditfacilities in an amount sufficient to enable us to pay our debt serviceobligations or to fund our other liquidity needs. We may need to refinance allor a portion of our debt on or before maturity, which we may not be able to doon favorable terms or at all.

The amount of ourindebtedness could also have the following important consequences:

·       makingus more vulnerable to a downturn in our business or in general economicconditions;

·       requiringus to dedicate a substantial portion of our cash flows from operations topayments on our debt and reducing our ability to use our cash flow for otherpurposes;

·       limitingour flexibility to engage in certain transactions or to plan for, or react to,changes in our business and the homebuilding industry;

·       limitingour ability to obtain future financing for working capital, capitalexpenditures, acquisitions, debt obligations and other general corporaterequirements; and

·       placingus at a disadvantage compared to competitors who have less debt than we do.

Our credit facilitiesimpose restrictions on our operations and activities and require us to complywith certain financial covenants, including restrictions on debt incurrence,sales of assets and cash distributions by us. If we fail to comply with theserestrictions or covenants, our debt could become due and payable prior tomaturity.

***Tax law changescould make home ownership more expensive or less attractive.***

Significant expenses ofowning a home, including mortgage interest expense and real estate taxes,generally are deductible expenses for an individual’s federal, and in somecases state, income taxes, subject to various limitations under current tax lawand policy. If the federal government or a state government changes income taxlaws, as has been discussed recently, to eliminate or substantially modifythese income tax deductions, then the after-tax cost of owning a new home wouldincrease substantially. This could adversely impact demand for, and/or salesprices of, new homes.

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***Severe weatherconditions and natural disasters could delay deliveries, increase costs anddecrease demand for new homes in affected areas.***

Weather conditions andnatural disasters such as earthquakes, landslides, floods, droughts, fires,extended periods of rain and other environmental conditions can harm ourhomebuilding business on a local or regional basis. Civil unrest can also havean adverse effect on our homebuilding business.

***The homebuildingindustry is in a significant downturn that could adversely affect our businessand results of operations for an indefinite period.***

In 2006, the homebuilding industry experienced asignificant and sustained decrease in demand for new homes and an oversupply ofnew and existing homes available for sale. In many markets, a rapid increase innew and existing home prices over the past several years reduced housingaffordability and tempered buyer demand. In addition, investors and speculatorsreduced their purchasing activity and instead stepped up their efforts to sellthe residential property they had earlier acquired. These trends resulted infewer home sales overall, greater cancellations of home purchase agreements bybuyers, higher inventories of unsold homes and the increased use byhomebuilders, speculators, investors and others of discounts, incentives andprice concessions compared with the past several years.

As a result, we, like many other homebuilders,experienced a large drop in net new orders, slower price appreciation for newhomes sold and a reduction in our margins. We can provide no assurances thatthe homebuilding market will improve in the near future, and it may weakenfurther. Continued weakness in the homebuilding market would have an adverseeffect on our business and our results of operations as compared to those ofprior periods.

Despite some adjustmentsduring 2006, some have speculated that the prices of land and new homes, andthe stock prices of companies like ours that build new homes, may still beinflated and may decline further if the demand for new homes continues toweaken. A decline in the prices for new homes has had and would continue tohave an adverse effect on our homebuilding business, in particular on ourrevenues and margins. A decline in our stock price could also make financing orraising capital more difficult and expensive.

***Whenmortgage-financing costs are high, or as credit quality declines, customers maybe unwilling or unable to purchase our homes.***

The majority of ourhomebuyers finance their purchases through our joint venture with Wells Fargoor third-party lenders. In general, housing demand is adversely affected byincreases in interest rates and by decreases in the availability of mortgagefinancing as a result of declining customer credit quality, tightening ofmortgage loan underwriting standards, or other issues. Our operating resultsmay be adversely affected if mortgage interest rates increase or mortgage loansbecome more difficult to obtain, or the ability or willingness of prospectivebuyers to finance home purchases is adversely affected.

***Some homebuyers maycancel their home purchases because the required deposits are small andgenerally refundable, if new home prices decline, interest rates increase orthere is a downturn in the economy.***

Our backlog numbersreflect the number of homes for which we have entered into a sales contractwith a customer but not yet delivered. Those sales contracts typically requireonly a small deposit and the deposit is generally refundable if customers areunable to close on the sale of their existing home, fail to qualify forfinancing or under certain other circumstances. If the prices for new homesbegin to decline, interest rates increase or there is a downturn in local orregional economies or the national economy, homebuyers may have financialincentive to terminate their existing sales contracts in order to negotiate fora lower price or to explore other options. Such a result could have an adverseeffect on our homebuilding business, financial condition, and our results ofoperations.

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***Competition forhomebuyers, labor and materials could reduce our deliveries or decrease ourprofitability.***

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. Thiscompetition with other homebuilders could reduce the number of homes wedeliver, or cause us to accept reduced margins in order to maintain salesvolume.

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 new homesand increase cancellations of sales contracts in backlog.

***Slow or no growthinitiatives have been or may be adopted in regions where we operate, whichcould adversely affect our ability to build or timely build in these areas.***

Some municipalities wherewe operate have approved, and others where we operate may approve, various slowgrowth or no growth homebuilding initiatives and other ballot measures thatcould negatively impact the availability of land and building opportunitieswithin those localities. Approval of slow growth, no growth or similarinitiatives (including the effect of these initiatives on existing entitlementsand zoning) could adversely affect our ability to build or timely build andsell homes in the affected markets and or create additional administrative andregulatory requirements and costs, which, in turn, could have an adverse effecton our future revenues and earnings.

***We may not be ableto acquire land suitable for residential homebuilding at reasonable prices,which could increase our costs and reduce our revenues, earnings and margins.***

The availability offinished and partially developed lots and undeveloped land for purchase thatmeet our internal criteria depends on a number of factors outside our control,including land availability in general, competition with other homebuilders andland buyers for desirable property, inflation in land prices, and zoning,allowable housing density and other regulatory requirements. Our long-termability to build homes depends upon our acquiring land suitable for residentialbuilding at reasonable prices in locations where we want to build. Ascompetition for suitable land increases, and as available land is developed,the cost of acquiring suitable remaining land could rise, and the availabilityof suitable land at acceptable prices may decline. Over the past few years, wehave experienced an increase in competition for suitable land as a result ofland constraints in many of our markets. Any land shortages or any decrease inthe supply of suitable land at reasonable prices could limit our ability todevelop new communities or result in increased land costs. We may not be ableto pass through to our customers any increased land costs, which couldadversely impact our revenues, earnings and margins.

***We are subject tosubstantial legal and regulatory requirements regarding the development ofland, the homebuilding process and protection of the environment, andcompliance with federal, state and local regulations related to our businesscould have substantial costs both in time and money, and some regulations couldprohibit or restrict some homebuilding projects.***

Our homebuilding business is heavily regulated andsubject to increasing local, state and federal statutes, ordinances, rules andregulations concerning zoning, resource protection, other environmentalimpacts, building design, construction and similar matters. These regulationsoften provide broad discretion to governmental authorities that regulate thesematters, which can result in unanticipated delays or increases in the cost of aspecified project or a number of projects in particular markets. We may also 

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experience periodic delaysin homebuilding projects due to building moratoria in any of the areas in whichwe 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 avariety of local, state and federal statutes, ordinances, rules andregulations concerning the environment. These laws and regulations may causedelays in construction and delivery of new homes, may cause us to incursubstantial compliance and other costs, and can prohibit or severely restricthomebuilding activity in certain environmentally sensitive regions or areas. Inaddition, environmental laws may impose liability for the costs of removal orremediation of hazardous or toxic substances whether or not the developer orowner of the property knew of, or was responsible for, the presence of thosesubstances. The presence of those substances on our properties may prevent usfrom selling our homes and we may also be liable, under applicable laws andregulations or lawsuits brought by private parties, for hazardous or toxicsubstances on properties and lots that we have sold in the past.

***Changing marketconditions may adversely impact our ability to sell homes at expected prices,which could reduce our margins.***

There is often a significantamount of time between when we initially acquire land and when we begin to sellhomes on that land. 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 as marketconditions reverse, we may need to sell homes at lower prices than weanticipate. We may also need to record write-downs of our home inventories andland holdings if market values continue to decline.

***Home prices andsales activity in the particular markets and regions in which we do businessimpact our results of operations because our business is concentrated in thesemarkets.***

Home prices and salesactivity in some of our key markets have declined from time to time formarket-specific reasons, including adverse weather or economic contraction dueto, among other things, the failure or decline of key industries and employers.If home prices or sales activity decline in one or more of the key markets in whichwe operate, our costs may not decline at all or at the same rate and, as aresult, our overall results of operations may be adversely impacted.

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***Product liabilitylitigation and warranty claims that arise in the ordinary course of businessmay be costly, which could adversely affect our business.***

As a homebuilder, we aresubject to construction defect and home warranty claims arising in the ordinarycourse of business. These claims are common in the homebuilding industry andcan be costly. In addition, the costs of insuring against construction defectand product liability claims are high, and the amount of coverage offered byinsurance companies is currently limited. There can be no assurance that thiscoverage will not be further restricted and become more costly. If we are notable to obtain adequate insurance against these claims, we may experiencelosses that could impact our financial results.

***We could be hurt bythe loss of key management personnel.***

Our future successdepends, to a significant degree, on the efforts of our senior management. Ouroperations could be adversely affected if key members of senior managementcease to be active in our company.

***Changes inaccounting principles, interpretations and practices may affect our reportedrevenues, earnings and results of operations.***

Generally acceptedaccounting principles and accounting pronouncements, implementation guidelines,interpretations and practices for certain aspects of our business are complexand may involve subjective judgments, such as, revenue recognition, inventoryvaluations and income taxes. Changes in these areas could significantly affectour reported revenues, earnings and operating results.

***Future terroristattacks against the United States or increased domestic or internationalinstability could have an adverse effect on our 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” ofthis Annual Report.

**Item 3.**                        LegalProceedings

We are involved inlitigation arising in the ordinary course of business, none of which isexpected to have a material adverse effect on our financial position or resultsof operations and we are subject to extensive and complex regulations thataffect the development and homebuilding processes, including zoning, density,building standards, mortgage financing and product liability. These regulationsoften provide broad discretion to the administering governmental authorities.This can delay or increase the cost of development or homebuilding.

*Golden State Water*

On December 14, 2006 Golden State Water Companyfiled a complaint in Orange County Superior Court against the City ofHuntington Beach and two of our subsidiaries seeking compensatory and punitivedamages from Huntington Beach and our subsidiaries. Golden State’s claimsrelate to alleged breaches of agreements between Golden State and the City, andalleged interference with such agreements by two of our subsidiaries.

Golden State also filed amotion for a preliminary injunction to stop the City of Huntington Beach fromproviding water to our Brightwater residential development project on the BolsaChica mesa. On January 22, 2007, the Court denied Golden State’s motionfor a preliminary injunction. The Court indicated that an injunction was notappropriate because monetary damages would be an adequate remedy if theplaintiff prevails on the merits of their case at trial. No trial date has beenset at this time, and we, on the advice of our legal counsel, believe thatthere are strong arguments against Golden State’s position.

*CaliforniaDepartment of Toxic Substances Control*

On October 13, 2006, the California Department ofToxic Substances Control (“DTSC”) filed a civil complaint against ourHearthside Residential Corp. subsidiary (“HRC”) in the Federal District Courtfor the Southern Division of the Central District of California. The DTSC’scomplaint requests that HRC pay approximately $1.0 million for costs incurredby the DTSC, together with interest on that amount, primarily in connectionwith the oversight and remediation of PCB contamination found on residentialproperties adjacent to a 43-acre site where HRC completed the removal ofPCB contaminated soil during September 2005. HRC’s remediation process wasapproved by the DTSC in December 2005 when it issued a final acceptance ofthe remediation work. The complaint also seeks an order for HRC to pay anyfuture costs that may be incurred in connection with further remediation,together with court costs and attorney’s fees.

Since May 2004, HRC has received invoices fromDTSC seeking reimbursement for these costs; however, HRC contends, based uponadvice of counsel, that it is not responsible for such costs because neitherHRC nor any affiliate ever developed or built the neighboring residentialproperties, neither HRC 

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nor any affiliategenerated the contamination, and the contamination did not emanate from the 43-acresite HRC remediated and, therefore, it should not be part of the same “site” asthe contaminated residential properties. Furthermore, HRC has also disputedsuch charges due to the fact that DTSC did not present its bill in accordancewith the requirements of the applicable law. Our subsidiary intends tovigorously defend itself in this matter. Therefore, we have not accrued for anyof DTSC’s approximately $1.0 million of claims related to these residentialproperties.

See Note 11 to the Consolidated Financial Statementsabove, and “Item 1 - Business - Corporate Indemnification Matters” in thisAnnual Report on Form 10-K.

Our consolidated balancesheet includes reserves for contingent indemnity obligations for certainbusinesses disposed of by our former affiliated companies whose business wasunrelated to our current homebuilding operations.

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

During the fourth quarter of the fiscal year ended December 31,2006, no matters were submitted to a vote of security holders.

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**PART II**

**Item5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

The following tables setforth information with respect to bid quotations for our common stock  for the periods indicated as reported on theNasdaq Global Market. These quotations are interdealer prices without retailmarkup, markdown or commission and may not necessarily represent actualtransactions.

| ** **     | ** ** | **High (1)** | ** ** | **Low(1)** | ** ** |
|----------------|------------|-------------------|------------|------------|------------|
| **2006**       |       |              |       |       |       |   |   |
| First Quarter  |       |              | $          | 27.02      |       |   | $ | 22.80 |   |
| Second Quarter |       |              | $          | 25.28      |       |   | $ | 16.50 |   |
| Third Quarter  |       |              | $          | 21.30      |       |   | $ | 14.99 |   |
| Fourth Quarter |       |              | $          | 22.00      |       |   | $ | 17.26 |   |
| **2005**       |       |              |       |       |       |   |   |
| First Quarter  |       |              | $          | 13.90      |       |   | $ | 11.30 |   |
| Second Quarter |       |              | $          | 21.89      |       |   | $ | 12.70 |   |
| Third Quarter  |       |              | $          | 24.65      |       |   | $ | 19.75 |   |
| Fourth Quarter |       |              | $          | 27.60      |       |   | $ | 20.97 |   |

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(1)**         **Amountsare adjusted for September 2006 special dividend of $12.50 per share.

The number of beneficialholders of our common stock as of March 1, 2007 was approximately 2,000. OnSeptember 28, 2006, we paid a special dividend of $12.50 per share toholders of record on September 25, 2006. While we did pay a specialdividend in September 2006, we do not currently intend to pay regular cashdividends on our common stock.

Thetax characterization of dividends depends upon the availability of a company’searnings and profits, as defined by the Internal Revenue Code, first for thecurrent year and then on an accumulated basis. If the distribution isdetermined to be out of earnings and profits, it is characterized as anordinary dividend. If current and accumulated earnings and profits arenegative, the distribution is characterized as a non-dividend distribution. Theresults of a detailed earnings and profits study indicated that we had negativeaccumulated earnings and profits prior to 2006, and we had no earnings andprofits for 2006 due to tax deductions related to the exercise of stock options.Therefore, the special dividend was characterized as a non-dividenddistribution when reported on IRS Form 1099. Stockholders should consulttheir tax advisors for details as to what impact the tax treatment of thisdistribution will have in their individual tax situations.

*Equity Compensation Plan*

The following tableprovides information as of December 31, 2006 with respect to the shares ofcommon stock that may be issued under our equity compensation plan.

| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average exercise  price of outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities listed  in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders(1)  |       |       | 17,500     |                                                                                                                                                      |       |                                                                                                                 | $          | 21.58                                                                                                                                                                                                              |       |   |   | 364,988 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                                                      |       |                                                                                                                 | —     |                                                                                                                                                                                                               |       |   | — |   |   |
| Total                                                       |       |       | 17,500     |                                                                                                                                                      |       |                                                                                                                 | $          | 21.58                                                                                                                                                                                                              |       |   |   | 364,988 |   |   |

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(1)          Consistsof options issued in accordance with the Director Fee Program of the Amendedand Restated 1993 Stock Option/Stock Issuance Plan.

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*Performance Graph*

The following graphillustrates the return during the past five years that would have been realizedon December 31 of each year (assuming reinvestment of dividends) by aninvestor who invested $100 on December 31, 2001 in each of (i) ourcommon stock, (ii) a peer group index (“Real Estate Index”), whichconsists of four real estate development and homebuilding companies, and (iii) theHemscott Composite Market Value Index.

Our peer group indexincludes the following companies: Brookfield Homes Corporation, Meritage HomesCorporation, Standard Pacific Corporation, and Tejon Ranch Company.

**COMPARE5-YEAR CUMULATIVE TOTAL RETURNAMONG CALIFORNIA COASTAL COMMUNITIES, INC.,HEMSCOTT INDEX AND PEER GROUP INDEX**

ASSUMES $100 INVESTED ON DEC. 31, 2001ASSUMES DIVIDEND REINVESTEDFISCAL YEAR ENDING DEC. 31, 2006

| ** **                                 | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| California  Coastal Communities, Inc. |       | 100.00   |       | 122.89   |       | 242.67   |       | 534.44   |       | 871.78   |       | 658.77   |       |
| Peer Group Index                           |       | 100.00   |       | 114.37   |       | 207.18   |       | 296.48   |       | 359.35   |       | 290.91   |       |
| Hemscott Index                             |       | 100.00   |       | 79.43    |       | 105.75   |       | 118.62   |       | 127.02   |       | 147.03   |       |

 

The above graph is basedupon common stock and index prices calculated as of year-end for each of thelast five calendar years. The stock price performance of our common stockdepicted in the graph above represents past performance only and is notnecessarily indicative of future performance.

**Item6.**                        SelectedFinancial Data

Our Selected Financial Data is set forth on page 36of this Annual Report.

**Item7.**                        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 37 of this Annual Report.

**Item7A.**                Quantitative andQualitative Disclosures About Market Risk

We utilize variable ratedebt financing for acquisition, development and construction of homes. Theinterest rates on our debt approximate the current rates available for securedreal estate financing with 

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similarterms and maturities, and as a result, their carrying amounts approximate fairvalue. While changes in interest rates generally do not impact the fair marketvalue of the debt instrument, they do affect our earnings and cash flows.Holding our variable rate debt balance constant as of December 31, 2006,each one point percentage increase in interest rates would result in anincrease in variable rate interest incurred for the next 12 months ofapproximately $1.3 million.

We are exposed to marketrisks related to fluctuations in interest rates on our outstanding variablerate debt. Other than an interest rate swap used to manage our exposure tochanges in interest rates on $62.5 million of our variable rate-based TermLoan, we did not utilize swaps, forward or option contracts on interest rates,or other types of derivative financial instruments as of or during the yearended December 31, 2006. We do not enter into or hold derivatives fortrading or speculative purposes.

Under the Term Loanagreement, we were required to enter into a swap agreement to hedge againstrisks associated with fluctuating interests rates related to $62.5 million offloating rate debt. On September 15, 2006 we entered into an interest rateswap transaction to effectively fix the interest rate on $62.5 million infloating rate debt at 8.015% per annum for two years. The swap transactionterminates in September 2008. Since we do not use derivative financialinstruments for trading purposes, the swap did not qualify for hedge accountingunder SFAS No. 133. The fair value of the interest rate swap agreementrepresents the spread between the interest rate we paid and the interest ratewe would receive over the remaining life of the agreement; however, this wasnot considered material at December 31, 2006. The change in fair value ofthe interest rate swap agreement during the year ended December 31, 2006was not material to us. The counterparties to the interest rate swap agreementare financial institutions.

You should be aware thatmany of the statements contained in this section are forward looking and shouldbe read in conjunction with our disclosures under the heading “Forward-LookingStatements.”

**Item8.**                        FinancialStatements and Supplementary Data

Our consolidated financialstatements are listed under Item 15 and are submitted as a separate section ofthis Annual Report, beginning on page F-2.

**Item9.**                        Changes inand Disagreements With Accountants on Accounting and Financial Disclosure

None.

**Item9A.**                Controls andProcedures

*Conclusion Regarding the Effectiveness of DisclosureControls 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.

However, no matter howwell a control system is conceived and operated, it can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. In addition, the design of a control system must reflect the fact thatthere are resource constraints and the benefits of controls must be consideredrelative to costs. Therefore, no cost-effective control system and noevaluation of controls can provide absolute assurance that all control issuesand instances of misstatements due to error or fraud, if any, within ourcompany have been detected.

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*Management’s Reporton Internal 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 31,2006.

Ourmanagement’s assessment of the effectiveness of internal control over financialreporting as of December 31, 2006 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* |   |

 

*Changes in InternalControls*

During the fourth quarter of 2006, we engaged athird-party public accounting firm to assist us in the preparation of ourincome tax calculations. We believe that engaging external tax advisorsstrengthens our internal control over financial reporting.

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*Report ofIndependent Registered Public Accounting Firm*

To the Board of Directors and Stockholders of California 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, 2006, 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 31,2006, 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 31,2006, based on the criteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.

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We have alsoaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated financial statements as ofand for the year ended December 31, 2006 of the Company and our reportdated March 9, 2007 expressed an unqualified opinion on those financialstatements.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, CaliforniaMarch 9, 2007

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**Item 9B.**               OtherInformation

None.

**PART III**

**Item 10.**                 Directors.Executive Officers and Corporate Governance

Information appearingunder the captions “Our Management,” “Corporate Governance” and “Our ExecutiveOfficers” in the Proxy Statement for our 2007 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. You may obtain a copy of our Code of Business Conduct and Ethics,without charge, by writing to: California Coastal Communities, Inc., Attn:Investor Relations, 6 Executive Circle, Suite 250, Irvine, California92614.

**Item 11.**                 ExecutiveCompensation

Information appearingunder the caption “Compensation of Executive Officers” in the Proxy Statementfor our 2007 Annual Meeting of Stockholders and is for the limited purpose ofproviding the information necessary to comply with this Item 11, incorporatedherein by this reference.

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

Information appearingunder the captions “Our Management,” “Corporate Governance” and “Compensationof Executive Officers” in the Proxy Statement for our 2007 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, and Director Independence

Information appearingunder the captions “Certain Relationships and Related Transactions,” “OurManagement,” “Corporate Governance” and “Compensation of Executive Officers” inthe Proxy Statement for our 2007 Annual Meeting of Stockholders, and is for thelimited purpose of providing the information necessary to comply with this Item13, incorporated herein by this reference.

**Item 14.**                 PrincipalAccountant Fees and Services

Information in answer to this Item appears under thecaption “Independent Registered Public Accounting Firm” in the Proxy Statementfor our 2007 Annual Meeting of Stockholders and is, for the limited purpose ofproviding the information necessary to comply with this Item 14, incorporatedherein by this reference.

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**PART IV**

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

(a)(1)                    ConsolidatedFinancial Statements:

Our following consolidated financial statements andsupplementary data is included in a separate section of this Annual Reportcommencing on the page numbers specified below:
|                                                                                                                                                    | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                           |       | F-1      |       |
| Consolidated Balance Sheets as of December 31,  2006 and 2005                                                                                 |       | F-2      |       |
| Consolidated Statements of Operations and  Comprehensive Income for the Years Ended December 31, 2006, 2005 and  2004                         |       | F-3      |       |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2006, 2005 and 2004                                                   |       | F-4      |       |
| Consolidated Statements of Changes in Stockholders’  Equity for the Years Ended December 31, 2006, 2005 and 2004     |       | F-5      |       |
| Notes to Consolidated Financial Statements                                                                                                         |       | F-6      |       |

 

(2)         Consolidated FinancialStatement Schedules:

All schedules havebeen omitted since they are not applicable, not required, or the information isincluded in the consolidated financial statements or notes thereto.

(3)         Listingof 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 | .01(a) |   | Amended and Restated  1993 Stock Option/Stock Issuance Plan, incorporated by reference to  Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2006.                        |   |
|   | 10 | .01A   |   | Amendment Dated  June 14, 2006 to Amended and Restated 1993 Stock Option/Stock Issuance  Plan, incorporated by reference to Form 8-K filed June 14,  2006.                                                                  |   |
|   | 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.                                               |   |

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|        | 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.                                                                                                                 |   |
|--------|----|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | 10 | .04   |   | Retirement Plan of the  Registrant, Amended and Restated through December 19, 2001, dated  December 21, 2001, incorporated by reference to Exhibit 10.2 to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2006.                   |   |
|   | 10 | .04A  |   | Amendment No. 1 to  Retirement Plan of the Registrant dated June 26, 2002, incorporated by  reference to Exhibit 10.3 to the Registrant’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2006.                                                      |   |
|   | 10 | .04B  |   | Amendment No. 2 to  Retirement Plan of the Registrant dated December 30, 2002, incorporated  by reference to Exhibit 10.04D to the Registrant’s Annual Report on  Form 10-K for the year ended December 31, 2002.                                                  |   |
|   | 10 | .04C* |   | Amendment No. 3 to  Retirement Plan of the Registrant dated December 19, 2006.                                                                                                                                                                                                         |   |
|   | 10 | .04D* |   | Amendment No. 4 to  Retirement Plan of the Registrant dated December 19, 2006.                                                                                                                                                                                                         |   |
|   | 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. |   |
|   | 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. |   |

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|        | 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, incorporated by  reference to Exhibit 10.10 to Registrant’s Annual Report on Form 10-K  for 2005.                                            |   |
|   | 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,  incorporated by reference to Exhibit 10.10A to Registrant’s Annual  Report on Form 10-K for 2005.                    |   |
|   | 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, incorporated  by reference to Exhibit 10.10B to Registrant’s Annual Report on  Form 10-K for 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.                                                                                                       |   |
|   | 10 | .12  |   | $125 Million Senior  Secured Term Loan Agreement among the Registrant, as Borrower, and KeyBank  National Association, as Lender and Agent, et. al., dated September 15,  2006, incorporated by reference to Exhibit 10.1 to Form 8-K  filed September 19, 2006.                            |   |
|   | 10 | .13  |   | $100 Million Senior  Secured Revolving Credit Agreement among the Registrant, as Borrower, and  KeyBank National Association, as Lender and Agent, et. al., dated  September 15, 2006, incorporated by reference to Exhibit 10.2 to  Form 8-K filed September 19, 2006.                     |   |
|   | 21 | .01* |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                |   |
|   | 23 | .1*  |   | Consent of Independent  Registered Public Accounting Firm—Deloitte & Touche LLP.                                                                                                                                                                                                                       |   |
|   | 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.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

| Date: March 9, 2007 | 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 9, 2007 |
| (Geoffrey W. Arens)          |          |                                             |       |               |
| /s/ PHILLIP R. BURNAMAN II   |          | Director                                         |       | March 9, 2007 |
| (Phillip R. Burnaman II)     |          |                                             |       |               |
| /s/ RAYMOND J. PACINI        |          | President, Chief  Executive Officer and Director |       | March 9, 2007 |
| (Raymond J. Pacini)          |          |                                             |       |               |
| /s/ THOMAS W. SABIN, JR.     |          | Director and  Chairman of the Board              |       | March 9, 2007 |
| (Thomas W.  Sabin, Jr.) |          |                                             |       |               |
| /s/ SANDRA G. SCIUTTO        |          | Senior Vice  President and                       |       | March 9, 2007 |
| (Sandra G. Sciutto)          |          | Chief Financial Officer                          |       |               |

 

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**Item 6.**                        SelectedFinancial Data

Set forth below is selected financial data about usand our consolidated subsidiaries. The following information should be read inconjunction with the Consolidated Financial Statements beginning on page F-2of this Annual Report on Form 10-K and Management’s Discussion andAnalysis of Financial Condition and Results of Operations.
|                                                                                         | ** ** | **Years Ended December 31,**                          | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                              | ** ** | **(in millions, except per share amounts)** | ** ** |
| **Statement of operations data:**                                                       |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Homebuilding                                                                            |       | $                                                                    | 95.7       |   | $ | 62.7 |   | $ | 75.9 |   | $ | 54.7 |   | $ | 32.8 |   |
| Non-residential  land                                                                   |       | —                                                               |       | 66.8 |   | .1 |   | 1.1 |   | — |   |
| Total revenues                                                                          |       | $                                                                    | 95.7       |   | $ | 129.5 |   | $ | 76.0 |   | $ | 55.8 |   | $ | 32.8 |   |
| Net income(a)                                                                           |       | 5.6                                                                  |       | 28.4 |   | 4.8 |   | 2.9 |   | 1.7 |   |
| Net earnings per common share:                                                          |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | $                                                                    | .54        |   | $ | 2.78 |   | $ | .48 |   | $ | .29 |   | $ | .17 |   |
| Diluted                                                                                 |       | $                                                                    | .53        |   | $ | 2.70 |   | $ | .44 |   | $ | .27 |   | $ | .16 |   |
| Weighted-average shares outstanding:                                                    |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                                   |       | 10.4                                                                 |       | 10.2 |   | 10.1 |   | 10.1 |   | 10.1 |   |
| Diluted(b)                                                                              |       | 10.6                                                                 |       | 10.5 |   | 10.8 |   | 10.8 |   | 10.8 |   |
| Special cash dividend  declared per common share                                        |       | $                                                                    | 12.50      |   | — |   | —- |   | — |   | — |   |
| **Balance sheet data at period  end:**                                                  |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Unrestricted  cash, cash equivalents and short-term investments     |       | $                                                                    | 11.1       |   | $ | 38.0 |   | $ | 9.0 |   | $ | 14.7 |   | $ | 9.2 |   |
| Total assets                                                                            |       | 332.3                                                                |       | 330.4 |   | 250.8 |   | 198.1 |   | 187.6 |   |
| Debt(c)                                                                                 |       | 188.2                                                                |       | 57.9 |   | 22.6 |   | 10.4 |   | 9.8 |   |
| Total  stockholders’ equity                                                        |       | $                                                                    | 123.5      |   | $ | 246.9 |   | $ | 178.9 |   | $ | 164.6 |   | $ | 159.9 |   |
| Shares  outstanding at end of period                                                    |       | 10.9                                                                 |       | 10.2 |   | 10.1 |   | 10.1 |   | 10.1 |   |
| Stockholders’  equity per common share(d)                                          |       | $                                                                    | 11.33      |   | $ | 24.21 |   | $ | 17.71 |   | $ | 16.30 |   | $ | 15.83 |   |

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(a)           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.

(b)          Beginning the year endedDecember 31, 2002, the increase in weighted-average shares outstanding—dilutedreflects outstanding options with an exercise price below the average marketprice of our common stock.

(c)           Beginning the yearended December 31, 2006, debt includes borrowings from the senior securedproject revolver, senior secured term loan, as well as other project debt.

(d)          Webelieve that stockholders’ equity per common share, which is computed bydividing stockholders’ equity by common shares outstanding at the end of eachperiod, is a useful supplemental measure of the strength of our balance sheetand an indicator of the historical carrying basis of our net assets. Thedecrease in the measure from 2005 to 2006 primarily reflects the specialdividend of $12.50 per share paid in September 2006.

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

Thefollowing discussion should be read together with our Consolidated FinancialStatements and Notes which are set forth below commencing on page F-2of this Annual Report.

**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 2007, we will focus our primary efforts on:

·       completinginfrastructure and model home construction, and beginning sales of productionhomes at the 356-home Brightwater project located on the Bolsa Chica mesain Orange County, California;

·       completingthe entitlement process for our 168-acre joint venture project near Oxnard,California being planned for 554 single-family detached homes and 500 attachedhomes (townhomes, condominiums and apartments); and

·       maximizingdeliveries, revenues and profitability of our homebuilding operationsthroughout Southern California.

However, we may also consider other strategicopportunities as discussed below; and there can be no assurance that we willaccomplish, 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 debt financings,open market and other repurchases of our stock; dividends and otherdistributions to our stockholders; and combinations of these alternatives. In September 2006,we paid a special dividend of $12.50 per share to all of our stockholders,which represented a return of capital to the extent of each stockholder’s basisin our stock. As we continue to develop Brightwater, we will also continue toevaluate any other available strategic alternatives that will maximize value toour 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. As of December 31, 2006, we have an inventory of 797lots available for homebuilding projects. These homebuilding projects arecurrently expected to generate cash flows and gross operating margins throughmid-2010. We may pursue residential lot acquisition opportunitiesthroughout Southern California, if we 

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are able to identify landin existing successful submarkets or additional submarkets which we believewill provide opportunities for enhancing shareholder value. Up to approximately554 additional single-family lots could be available for homebuildingoperations if we obtain entitlements for our Oxnard project; however, the exactnumber of homes will be dependent upon the final outcome of the entitlementprocess.

Brightwater at Bolsa Chica is our largest asset,representing 47% of total assets at December 31, 2006. The Brightwaterplanned community will offer a broad mix of home choices averaging 2,860 squarefeet and ranging in size from 1,720 square feet to 4,140 square feet. The planalso includes 37 acres of open space and conservation area. With 349 homespermitted on 68 acres of the Upper Mesa, the resulting low-density plan equatesto approximately five homes per acre, consistent and compatible with theneighboring Huntington Beach communities. In addition, we own land adjacent tothe planned Brightwater development, on which we intend to process permits tobuild seven additional homes which will be included in the Brightwatercommunity.

Bolsa Chica is carried atfair value as of September 2, 1997, following adoption of Fresh-StartReporting as discussed in Note 1 to the Consolidated Financial Statements, asadjusted by subsequent activity. Our real estate properties are subject to anumber of uncertainties which can affect the values of those assets. Theseuncertainties include availability of adequate capital, financing and cashflow. In addition, future values may be adversely affected by increases inproperty taxes, increases in the costs of labor and materials and otherdevelopment risks, changes in general economic conditions, including highermortgage interest rates, and other real estate risks such as the general demandfor housing and the supply of competitive products. Real estate properties donot constitute liquid assets and, at any given time, it may be difficult tosell a particular property for an appropriate price.

**Outlook**

The housing market in Southern California slowedconsiderably during 2006. During 2006, our net new orders decreased 56.4% to 82homes from 188 homes in 2005. The decrease in net new orders reflects theindustry-wide slowdown and is comparable to the 62.2% decrease in the firstnine months of 2006 (62 net new orders for the first nine months of 2006compared with 164 net new orders for the first nine months of 2005). At thesame time, backlog as of December 31, 2006 decreased to 17 homes comparedwith 83 homes as of December 31, 2005, while the value of homes in backlogdecreased 80.1% to $10.9 million from $54.9 million. Although the homebuildingbusiness historically has been cyclical, it has not undergone an economic downcycle in a number of years. Further declines in the prices for new homes couldadversely affect our results of operations, revenues, and margins.

This slowdown reflects an overall softening of demandfor new homes, as well as an oversupply of homes available for sale. Weattribute the reduction in demand to reduced affordability of new homes due torapid price increases between 2002 and 2005 and declines in consumer confidencerelated to concerns on the part of prospective home buyers about the futuredirection of home prices, and their ability to sell existing homes. Inaddition, speculators and investors are no longer helping to fuel demand. Wetry to avoid selling homes to speculators and start few homes without having asigned agreement of sale. However, as of December 31, 2006 we had aninventory of 46 completed unsold homes compared to no such inventory as of December 31,2005. As of February 28, 2007, our standing inventory was 39 homes.

In addition, based on the high cancellation ratesreported by other builders, and on the increased cancellation rates we haveexperienced, non-speculative buyer cancellations are also adding to the supplyof homes in the marketplace. We had 33 cancellations in 2006, compared with 32in 2005. Approximately 72% of the cancellations in 2005 occurred during thesecond half of the year compared with 42% and 58% during the first and secondhalves of the year, respectively, in 2006.

We have also been impacted by an overall increase inthe supply of homes available for sale in our markets as certain largehomebuilders continue to build product in excess of current demand and as 

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speculators attempt tosell the homes they previously purchased, or cancel contracts for homes underconstruction. At the same time, many of the large national homebuildersoperating in our markets are attempting to reduce their inventories by offeringincentives and/or lowering prices, leading to lower gross margins on home sales.We will continue to assess our owned land position to identify those assetsthat should be reduced or repositioned. Additionally, our strategy is to adjustour cost structure to today’s market conditions by rebidding subcontracts andmaterials in line with reduced demand, all in an effort to partially offset ourdeclining margins.

Despite this slowdown, we remain cautiously optimisticabout the future growth of our business. The long-term outlook for homebuildingin Southern California remains strong due to the continuing regulation-inducedconstraints on lot supplies. We have traditionally employed a conservativeapproach to managing our real estate inventories and believe we arewell-positioned to withstand the effects of the market downturn as it unfolds. Wedo not presently expect that current weaknesses in the homebuilding market willsignificantly impact our Brightwater project given the site’s superior coastallocation, the extremely limited supply of new homes on the coast of SouthernCalifornia and the absence of significant competition from other homebuildersin the Huntington Beach market.

There can be no assurance regarding the duration ofthe current slowdown of the Southern California residential real estate market.In particular, (i) the significant increases in home prices between 2002and 2005 and the related decline in the affordability of new homes in SouthernCalifornia, (ii) the decline in consumer confidence with respect to thehousing market, (iii)  the state of the national economy, increases ininterest rates by the Federal Reserve Board between mid-2004 and 2006 andthe possibility of a recession in the future, and (iv) the continuedthreat of inflation and potential for further increases in interest rates bythe Federal Reserve Board, collectively may exert recessionary pressures on theCalifornia economy and may have further negative impacts on the SouthernCalifornia housing market.

In response to slowersales, we are offering more incentives and some price reductions, and we havedetermined that the construction start for the 73-unit Lancaster IIproject, which has no recorded loan, will be deferred until sales activityimproves.

**Critical Accounting 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 the evaluationof the impairment of long-lived assets and the evaluation of the probability ofbeing able to realize the future benefits indicated by our significant federaltax net operating losses, as discussed further in Note 9 to the ConsolidatedFinancial Statements.

*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 financial statements include our accounts and all of ourmajority-owned and controlled subsidiaries and joint ventures. The financialstatements of joint ventures in which we generally have a controlling ormajority economic interest (and thus are controlled by us) are consolidatedwith our financial statements. Minority interest represents the equity interestof our joint venture partner for one consolidated venture and is furtherdescribed in Note 10 to the Consolidated Financial Statements. Our investmentsin unconsolidated joint ventures are accounted for using the equity method whenwe do not have voting or economic control of the venture operations, as furtherdiscussed in Note 4 to the Consolidated Financial Statements.

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*Impairment ofLong-Lived Assets*

We assess the impairment of real estate inventoriesand other long-lived assets in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” which requires that an impaired asset, forwhich costs cannot be recovered from estimated undiscounted future cash flows,be written down to fair value. Long-lived assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. As provided by SFAS No. 144, weevaluate impairment by comparing an asset’s carrying value to the undiscountedestimated cash flows expected from the asset’s operations and eventualdisposition. If the sum of the undiscounted estimated future cash flows is lessthan the carrying value of the asset, an impairment loss is recognized based onthe fair value of the asset. If impairment occurs, the fair value of an assetfor purposes of SFAS No. 144 is deemed to be the amount a willing buyerwould pay a willing seller for such asset in a current transaction.

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 real estate inventories. Additionally,as appropriate, we identify alternative courses of action to recover thecarrying value of our long-lived assets and evaluate all likely alternativesunder a probability-weighted approach as described in SFAS No. 144.

We have not recorded anyimpairment charges to date primarily because most of our lot acquisitions werenegotiated prior to 2005 (thus reflecting less expensive land prices andbenefiting from home price appreciation during 2005 that exceeded the declinein home prices during 2006). In addition, our carrying costs are lower thansome of our competitors due to our modest amount of leverage. However, asrequired by SFAS 144, should market conditions deteriorate in the future orother events occur that indicate the carrying amount of our real estateinventories may not be recoverable, we will reevaluate our expected cash flowsfrom each project to determine whether any impairment exists at that time.

*Income Taxe**s*

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 the futurebenefits indicated by deferred tax assets, such as tax net operating losses. Avaluation 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. Given the significance of our historical federal tax netoperating losses, as discussed in Note 9 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 of the Internal Revenue Code, whichlimit the availability of net operating losses if an ownership change occurs.If we were to experience another ownership change, the amount of net operatinglosses available would generally be limited to an annual amount equal to (i) thevalue of our equity immediately before the ownership change, multiplied by thelong-term tax-exempt rate (4.14% as of February 2007) 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, 2007, we 

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haveexperienced a three-year cumulative ownership shift of approximately 35%, ascomputed 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.

*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 8 and 11 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 employee servicesin 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.We adopted SFAS 123(R) in the first quarter of 2006 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 14—Stock Plans, we previously adoptedthe fair value recognition provisions of SFAS 123 in 2003. The adoption of SFAS123(R) did not have a material impact on our consolidated financialposition, 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, “Reporting AccountingChanges in Interim Financial Statements,” and changes the requirements for theaccounting for and reporting of a change in accounting principle. SFAS 154requires retrospective application of changes in accounting principle to priorperiods’ financial statements unless it is impracticable to determine theperiod-specific effects or the cumulative effect of the change. This 

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statement was effectivebeginning in our first quarter of 2006. The adoption of SFAS 154 did not have amaterial impact on our consolidated financial position, results of operations,or cash flows.

In June 2005, the Emerging Issues Task Force(“EITF”) reached a final consensus on Issue No. 04-5, “DeterminingWhether a General Partner, or the General Partners as a Group, Controls aLimited Partnership or Similar Entity When the Limited Partners Have CertainRights” (“EITF 04-5”). EITF 04-5 affects the consolidation ofentities in which a general partner or managing member is presumed to control apartnership or limited liability company. EITF 04-5 was effective for usbeginning in the first quarter of 2006. The adoption of EITF 04-5 did nothave a material impact on our consolidated financial position, results ofoperations, or cash flows upon initial adoption. EITF 04-5 may materiallyimpact our consolidated financial position, results of operations, or cashflows in future periods should we form new limited partnerships or modifyexisting limited partnerships such that we are deemed to control the limitedpartnership. Under those circumstances, we may be required by EITF 04-5to consolidate the limited partnership.

In July 2006, the FASB issued FASB InterpretationNo. 48  (“FIN 48”), Accounting for Uncertainty in Income Taxes, whichprescribes a recognition threshold and measurement process for recording in thefinancial statements uncertain tax positions taken or expected to be taken in atax return. Additionally, FIN 48 provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure requirements for uncertain tax positions. The accounting provisionsof FIN 48 are effective for reporting periods beginning after December 15,2006. We will adopt FIN 48 during the first quarter of 2007 and are currentlyevaluating the impact of such adoption by assessing the existence of anypotential liabilities for uncertain tax positions. If we are required to recorda reserve for any contingent liabilities under FIN 48, the amount would berecorded as an adjustment to beginning retained earnings as a cumulative effectof a change in accounting principle.

In September 2006, the FASB issued SFASNo. 157, “*Fair Value Measurements*”(“SFAS 157”), which defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. SFAS 157 is effective for financial statementsissued for fiscal periods beginning after November 15, 2007 (our fiscalyear beginning January 1, 2008), and interim periods within those fiscalyears. We are currently evaluating the impact of adopting SFAS 157 on ourconsolidated financial statements.

In September 2006, the FASB issued SFASNo. 158, “Employer’s Accounting for Defined Benefit Pension and OtherPostretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and132(R)” (“SFAS 158”). SFAS 158 requires an employer to recognize the overfundedor underfunded status of defined benefit and retiree medical plans as an assetor liability in its statement of financial position and to recognize throughcomprehensive income changes in the funded status in the year in which theyoccur. SFAS 158 is effective for financial statements issued for fiscal periodsending after December 15, 2006. We adopted SFAS 158 duringDecember 2006. The adoption of SFAS 158 did not have a material impact onour consolidated financial position, results of operations, or cash flows.

In September 2006, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, *“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”* (“SAB 108”). SAB108 provides guidance on the consideration of effects of the prior yearmisstatements in quantifying current year misstatements for the purpose of amateriality assessment. SAB 108 was effective for the first annual periodending after November 15, 2006. The adoption of SAB 108 during the fourthquarter of 2006 did not have a material impact on our consolidated financialposition, results of operations, or cash flows.

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**Liquidity andCapital Resources**

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

| ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents                       |       | $        | 10.6       |     | $          | 7.7      |       | $ | 9.0 |   |
| Short-term investments                           |       | .5       |       | 30.3     |       | —-  |       |
| Cash used in  operating activities               |       | (10.9    | )          | (4.6     | )          | (9.7     | )          |
| Cash provided by  (used in) investing activities |       | 16.5     |       | (31.6    | )          | (1.1     | )          |
| Cash (used in) provided  by financing activities |       | (2.7     | )          | 34.9     |       | 5.1      |       |
|                                                  |            |          |            |          |            |          |            |  |  |  |

 

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. On September 15, 2006 we obtained the$100 million Senior Secured Project Revolver as a construction facility tofinance infrastructure and homebuilding activities at Brightwater as furtherdescribed in Note 5 to the Consolidated Financial Statements. This loan isfunding the first $100 million of construction costs for the Brightwaterproject. Availability under the loan is subject to the applicable borrowingbase limitations and includes financial covenants which may limit the amountthat may be borrowed. The initial borrowing base value of the Brightwaterproject was determined by an independent third-party appraisal of the projecton an “as-is” basis, which was $302 million as of July 6, 2006. Thisappraisal reflects substantial value in excess of the book value of $142million as of June 30, 2006. Outstanding advances bear interest at ouroption at either (i) the Alternate Base rate (“Prime”) minus 25 basispoints or (ii) LIBOR plus 200 basis points. Our unrestricted cash and cashequivalents plus short-term investments as of December 31, 2006 aggregated$11.1 million. In 2006, we primarily utilized internally generated cash to fundnew construction at our homebuilding projects other than Brightwater in orderto reduce the negative arbitrage between interest costs on project debtcompared with interest income earned on short-term investments.

We have substantial borrowing capacity available. Asof December 31, 2006, based on construction in place, the immediatelyavailable borrowing capacity on our other project debt construction loanfacilities is approximately $17.0 million for projects other than Brightwater. Theadditional facility availability for future construction costs is $81.7 millionfor Brightwater and approximately $46.0 million for other projects. During December 2006,we extended the Corona-Hellman project facility to January 2009 andincreased our borrowing capacity by $13.4 million to $54.5 million. Loans onthe Rancho Santa Fe and Chandler projects were repaid in full in January andFebruary 2007. Our loan on the Ontario project which matures in April 2007has an automatic six-month extension available (see Note 7 to the ConsolidatedFinancial Statements).

We are utilizing internally generated cash, and jointventure contributions, to fund the Oxnard land development project. Wecurrently expect to make aggregate additional capital contributions ofapproximately $100,000 to the Oxnard joint venture during the next 12 months,bringing our total expected investment in the project to $1.8 million (see Note4 to the Consolidated Financial Statements).

We believe that our cash and cash equivalents,short-term investments, future real estate sales proceeds, and funds availableunder our current and future credit agreements will be sufficient to meet anticipatedoperating and capital investment requirements and project development costs forhomebuilding projects, the Oxnard land development project, and general andadministrative expenses, for at least the next 12 months.

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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 purchase andoption agreements by forfeiting the cash deposit with no further financialresponsibility. As of December 31, 2006, we have one consolidated landoption deposit for $25,000 which is non-refundable. In addition, ourunconsolidated Oxnard joint venture has land deposits of $2.5 million.

We may enter into landdevelopment and homebuilding joint ventures from time to time as a means ofexpanding our market opportunities, establishing strategic alliances, managingour risk profile and leveraging our capital base. These joint ventures mayobtain secured acquisition, development and construction financing, whichminimize the use of funds from other corporate financing sources.

*2006 Compared with2005*

Cash used in homebuilding operations of $10.9 millionfor 2006 primarily reflects net real estate proceeds of $94.7 million fromdeliveries of 147 homes, offset by uses of cash for investments in real estateinventories and construction costs of $91.8 million, selling, general andadministrative expenses of $5.0 million, income tax payments of $4.6 millionand investments in the Oxnard joint venture of $1.0 million. The mostsignificant use of cash was for payment of the special dividend of $135.7million as described in Note 13 to the Consolidated Financial Statements. Theprimary sources of cash during the year were borrowings from our Senior SecuredTerm Loan  (“Term Loan”) of $125.0million (see Note 6 to the Consolidated Financial Statements) and SeniorSecured Project Revolver (“Revolver”) of $18.3 million (see Note 5), and netsales of short-term investments of $29.8 million. Other significant uses of cashinclude repayments of other project debt in excess of borrowings of $13.0million which we made in order to reduce the negative arbitrage betweeninterest costs on project debt compared with interest income earned onshort-term investments. These items, as well as other activity presented in theStatements of Cash Flows, resulted in a $2.9 million increase in cash and cashequivalents.

The $12.3 million increase in restricted cashprimarily reflects cash held in restricted bank and investment accounts asrequired by the terms of our Term Loan and Revolver agreements.

The $6.0 million increase in other assets primarilyreflects $3.3 million of deferred financing costs related to the Term Loan,Revolver, and other project debt, as well as approximately $1.0 million incontributions to the Oxnard joint venture and other receivables of $1.1 millionrelated to cancelled and replaced project insurance policies.

The $4.3 million decrease in accounts payable andaccrued liabilities reflects $4.6 million of income tax payments primarilyrelated to 2005 income.

On September 15, 2006, we entered into the $100million Revolver and the $125 million Term Loan with KeyBank NationalAssociation, as a lender and agent for several other lenders. These loans aredescribed in greater detail in Notes 5 and 6 to the Consolidated FinancialStatements.

The $123.4 milliondecrease in stockholders’ equity primarily reflects the special dividend of$135.7 million, offset by net income of $5.6 million and the issuance of commonstock upon exercise of stock options and related income tax benefits of $6.3million, as described in Notes 9 and 14 to the Consolidated FinancialStatements.

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*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 other 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 435 lots in 2005. Lots acquired werethroughout Southern California and include 151 in Corona, 150 in Lancaster, 102in Beaumont, 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 of approximately$5.3 million. These items, as well as other activity presented in theStatements 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 435 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$600,000 increase in warranty reserves. See Note 8 in our consolidatedfinancial statements included 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 operating lossesutilized 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.

**Off Balance SheetFinancing**

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, includinginterest and other carrying costs; and minimize land inventories. Under suchland option contracts, we will fund a specified option deposit or earnest moneydeposit in consideration for the right to purchase land in the future, usuallyat a predetermined price. Our liability is generally limited to forfeiture ofthe nonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of December 31, 2006, we have one consolidated land optiondeposit of $25,000 and no third party guarantees.

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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 strategicpartner. While we view the use of unconsolidated joint ventures as beneficialto our homebuilding activities, we do not view them as essential to thoseactivities.

Our investment in unconsolidated joint venturestotaled $1.7 million and $700,000 at December 31, 2006 and 2005,respectively. These joint ventures had total assets of $9.5 million and $5.8million as of December 31, 2006 and 2005, respectively, which includedland deposits of $2.5 million and $1.6 million, respectively. In certaininstances, we may provide varying levels of guarantees on debt ofunconsolidated joint ventures. As of December 31, 2006, we provide noguarantees 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), weanalyze our land option contracts and other contractual arrangements andconsider whether we should consolidate the fair value of certain VIEs fromwhich we are purchasing land under option contracts. As of December 31,2006, we had no deposits with VIEs.

**Results ofOperations**

*2006 Compared with2005*

We reported revenues of $95.7 million and grossoperating profit of $13.6 million for 2006, compared with $129.5 million inrevenues and gross operating profit of $48.0 million for 2005. Revenues for2006 reflect deliveries of 147 homes, including 58 at the Chandler Ranchproject in North Corona, 41 homes at the Alisal project in Lancaster, 20 homesat the Rancho Santa Fe project, 15 homes at the Woodhaven project in Beaumont,nine homes at the Alisal project in Ontario, three homes at the Las Colinasproject in Quartz Hill, and one home at the completed Jasper Ranch project inRiverside. The results for the prior year reflect the $65 million sale of thelower bench portion of the Bolsa Chica mesa, the $1.7 million sale of 43 acresin the Bolsa Chica lowlands, and deliveries of an aggregate of 113 homes at theLancaster, Chino, Riverside and Rancho Santa Fe projects. Homebuilding revenuesincreased $33.0 million, or 53%, primarily as a result of the 30%  increase in deliveries. The homebuildinggross margin for 2006 of 14.2% is lower than the prior year’s homebuildinggross margin of 19.9% due to the use of sales price reductions and incentivesin 2006 in response to slowing housing sales and increased competition for areduced supply of buyers. In addition, the lower profitability of the Ontarioand Beaumont homes delivered during 2006 as compared with the Chino andRiverside homes delivered during 2005 contributed to lower gross margins thisyear.

The $300,000 decrease in selling, general andadministrative expenses to $5.0 million in 2006 compared with $5.3 million in2005, primarily reflects a $1.4 million reduction in incentive-basedcompensation related to decreased profitability at our homebuilding subsidiaryafter internally-charged interest costs, partially offset by increases inemployer payroll taxes related to 2006 option exercises, professional servicesand selling expenses.

The $2.2 million increase in other income, net in 2006compared with 2005 primarily reflects increased interest income on short-terminvestments during the year.

The effective income taxrate for the year ended December 31, 2006 is 41.1%, as compared with aneffective income tax rate of 30.3% during 2005. The increase in the effectiverate is primarily due to a tax 

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benefitin 2005 of $4.7 million for the reversal of valuation allowances onpost-Reorganization state net operating losses which we recorded following theCalifornia Coastal Commission’s approval of the development plan for 349 homeson the Upper Mesa (see Note 9 to the Consolidated Financial Statements).

*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 and Chinoprojects. The homebuilding gross margin for 2005 of 19.9% is lower than theprior year’s homebuilding gross margin of 24.1% due to the lower profitabilityof the Lancaster homes delivered during 2005 as compared with the Riverside(Jasper Ranch) and Chino homes delivered during 2004. Home prices in theLancaster 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 in2004, primarily reflects an $800,000 decrease in accrued incentive compensationfor our 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 in 2004includes a $500,000 accrual for the Dresser litigation settlement. See Note 8in our consolidated 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.

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*Payments UnderContractual Obligations*

Wehave entered into certain contractual obligations to make future payments foritems such as loans, project debt, lease agreements and liability insurance. Asummary of the payments due under specified contractual obligations, aggregatedby category of contractual obligation, for specified time periods is presentedbelow as of December 31, 2006 (in millions):

| ** **                 | ** ** | **Payments due by period** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **Total**                                 | ** ** | **Less  than 1  year** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **More  than 5  years** | ** ** |
| Revolving loan             |       | $                                         | 18.3       |   | $ | — |   | $ | 18.3 |   | $ | — |   |   | $ | — |   |   |
| Term loan                  |       | 125.0                                     |       | — |   | 75.0 |   | 50.0 |   |   | — |   |   |
| Other project debt         |       | 44.9                                      |       | 24.0 |   | 20.9 |   | — |   |   | — |   |   |
| Operating leases           |       | 1.7                                       |       | .3 |   | .7 |   | .7 |   |   | — |   |   |
| Insurance premium  payable |       | 1.4                                       |       | 1.4 |   | — |   | — |   |   | — |   |   |
| Total                      |       | $                                         | 191.3      |   | $ | 25.7 |   | $ | 114.9 |   | $ | 50.7 |   |   | $ | — |   |   |

 

Our purchase contracts which are made in the normalcourse of our homebuilding business for land acquisition and constructionsubcontracts are generally cancelable at will. Other contractual obligationsincluding our tax liabilities, accrued benefit liability for a frozen retirementplan and other accrued pensions, home warranty reserves and contingentindemnity and environmental obligations are estimated based on various factors.Payments are not due as of a given date, but rather are dependent upon theincurrence of professional services, the lives of annuitants and other factors.The estimation process involved in the determination of carrying values ofthese obligations is inherently uncertain since it requires estimates as tofuture events and contingencies. We have provided additional disclosure in Item3. “Legal Proceedings” and in Note 11 to our Consolidated Financial Statementsin this Annual Report.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have audited the accompanying consolidated balancesheets of California Coastal Communities, Inc. and subsidiaries (the “Company”)as of December 31, 2006 and 2005 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, 2006.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, 2006and 2005 and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2006, 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, 2006, based on the criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated March 9, 2007 expressed an unqualified opinion on management’sassessment of the effectiveness of the Company’s internal control over financialreporting and an unqualified opinion on the effectiveness of the Company’sinternal control over financial reporting.

/s/ Deloitte & Touche LLP

Costa Mesa, CaliforniaMarch 9, 2007

F-1

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                              | ** ** | **December 31**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                              | ** ** | **2006**               | ** ** | **2005** | ** ** |
| ** **                                                                                                                              | ** ** | **(in millions)** | ** ** |
| **ASSETS**                                                                                                                              |       |                   |       |   |   |
| Cash and cash equivalents                                                                                                               |       | $                      | 10.6       |   | $ | 7.7 |   |
| Short-term  investments                                                                                                                 |       | .5                     |       | 30.3 |   |
| Restricted cash                                                                                                                         |       | 14.6                   |       | 2.3 |   |
| Real estate  inventories                                                                                                                |       | 264.8                  |       | 253.6 |   |
| Deferred tax  assets                                                                                                                    |       | 34.7                   |       | 35.4 |   |
| Other assets, net                                                                                                                       |       | 7.1                    |       | 1.1 |   |
|                                                                                                                                    |       | $332.3                 |       | $ | 330.4 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                           |       |                   |       |   |   |
| Liabilities:                                                                                                                            |       |                   |       |   |   |
| Accounts payable and accrued liabilities                                                                                                |       | $                      | 13.1       |   | $ | 17.4 |   |
| Senior secured project revolver                                                                                                         |       | 18.3                   |       | — |   |
| Senior secured term loan                                                                                                                |       | 125.0                  |       | — |   |
| Other project debt                                                                                                                      |       | 44.9                   |       | 57.9 |   |
| Other liabilities                                                                                                                       |       | 7.5                    |       | 7.9 |   |
| Total liabilities                                                                                                                       |       | 208.8                  |       | 83.2 |   |
| Minority interest                                                                                                                       |       | —                 |       | .3 |   |
| Commitments and  contingencies                                                                                                          |       |                   |       |   |   |
| Stockholders’  equity:                                                                                                             |       |                   |       |   |   |
| Common Stock—$.05  par value; 13,500,000 shares authorized; 10,852,708 and 10,160,212 shares  issued and outstanding, respectively |       | .5                     |       | .5 |   |
| Excess Stock—$.05  par value; 13,500,000 shares authorized; no shares outstanding                                                  |       | —                 |       | — |   |
| Additional  Paid-In Capital                                                                                                             |       | 62.3                   |       | 191.6 |   |
| Retained earnings                                                                                                                       |       | 62.2                   |       | 56.6 |   |
| Accumulated other  comprehensive loss                                                                                                   |       | (1.5                   | )          | (1.8 | ) |
| Total stockholders’ equity                                                                                                         |       | 123.5                  |       | 246.9 |   |
|                                                                                                                                    |       | $                      | 332.3      |   | $ | 330.4 |   |

 

See accompanying notes to consolidated financial statements.

F-2

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

**CONSOLIDATEDSTATEMENTS OF INCOMEAND COMPREHENSIVE INCOME**

| ** **                                                             | ** ** | **For the Years Ended  December 31,**            | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(in millions, except per share amounts)** | ** ** |
| Revenues:                                                              |       |                                                                 |       |   |   |   |   |
| Homebuilding                                                           |       | $                                                                    | 95.7       |   | $ | 62.7 |   | $ | 75.9 |   |
| Non-residential land                                                   |       | —                                                               |       | 66.8 |   | .1 |   |
|                                                                   |       | 95.7                                                                 |       | 129.5 |   | 76.0 |   |
| Cost of sales:                                                         |       |                                                                 |       |   |   |   |   |
| Homebuilding                                                           |       | 82.1                                                                 |       | 50.2 |   | 57.6 |   |
| Non-residential land                                                   |       | —                                                               |       | 31.3 |   | — |   |
|                                                                   |       | 82.1                                                                 |       | 81.5 |   | 57.6 |   |
| Gross operating profit                                                 |       | 13.6                                                                 |       | 48.0 |   | 18.4 |   |
| Selling, general  and administrative expenses                          |       | 5.0                                                                  |       | 5.3 |   | 5.8 |   |
| Interest expense                                                       |       | .1                                                                   |       | .1 |   | .2 |   |
| Income from unconsolidated joint ventures                              |       | (.2                                                                  | )          | (.1 | ) | (.4 | ) |
| Other (income)  expense, net                                           |       | (.8                                                                  | )          | 1.4 |   | 1.1 |   |
| Income before  income taxes                                            |       | 9.5                                                                  |       | 41.3 |   | 11.7 |   |
| Provision for income taxes                                             |       | 3.9                                                                  |       | 12.5 |   | 4.5 |   |
| Minority interest  in income of consolidated joint venture, net of tax |       | —                                                               |       | .4 |   | 2.4 |   |
| Net income                                                             |       | $                                                                    | 5.6        |   | $ | 28.4 |   | $ | 4.8 |   |
| Other  comprehensive income (loss), net of income taxes:               |       |                                                                 |       |   |   |   |   |
| Minimum pension liability adjustment                                   |       | .3                                                                   |       | .8 |   | (.2 | ) |
| Comprehensive income                                                   |       | $                                                                    | 5.9        |   | $ | 29.2 |   | $ | 4.6 |   |
| Net earnings per  common share:                                        |       |                                                                 |       |   |   |   |   |
| Basic                                                                  |       | $                                                                    | .54        |   | $ | 2.78 |   | $ | .48 |   |
| Diluted                                                                |       | $                                                                    | .53        |   | $ | 2.70 |   | $ | .44 |   |
| Common equivalent  shares:                                             |       |                                                                 |       |   |   |   |   |
| Basic                                                                  |       | 10.4                                                                 |       | 10.2 |   | 10.1 |   |
| Diluted                                                                |       | 10.6                                                                 |       | 10.5 |   | 10.8 |   |
| Special dividend  paid per common share outstanding                    |       | $                                                                    | 12.50      |   | $ | — |   | $ | — |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                                                                            | ** ** | **For the Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                            | ** ** | **(in millions)**                                    | ** ** |
| Cash flows from operating  activities:                                                                                                                                |       |                                                      |       |   |   |   |   |
| Net income                                                                                                                                                            |       | $                                                         | 5.6        |   | $ | 28.4 |   | $ | 4.8 |   |
| Adjustments  to reconcile net income to cash used in operating activities:                                                                                            |       |                                                      |       |   |   |   |   |
| Income from unconsolidated joint ventures                                                                                                                             |       | (.2                                                       | )          | (.1 | ) | (.4 | ) |
| Distributions from unconsolidated joint ventures                                                                                                                      |       | .2                                                        |       | .2 |   | .4 |   |
| Amortization of discount                                                                                                                                              |       | .1                                                        |       | .1 |   | .2 |   |
| Benefit from reversal of deferred tax asset allowance                                                                                                                 |       | —                                                    |       | (4.7 | ) | — |   |
| Stock-based compensation expense                                                                                                                                      |       | .1                                                        |       | — |   | .3 |   |
| Excess tax benefit from share-based payment  arrangements                                                                                                             |       | (3.1                                                      | )          | — |   | (.3 | ) |
| Deferred taxes                                                                                                                                                        |       | 3.6                                                       |       | 12.6 |   | — |   |
| Minority interest in income of consolidated joint  venture                                                                                                            |       | —                                                    |       | .4 |   | 2.4 |   |
| Gains on sales of real estate inventories                                                                                                                             |       | (13.6                                                     | )          | (48.0 | ) | (18.4 | ) |
| Proceeds from real estate sales, net                                                                                                                                  |       | 94.7                                                      |       | 62.4 |   | 75.6 |   |
| Proceeds from land sales, net                                                                                                                                         |       | —                                                    |       | 64.9 |   | .1 |   |
| Investments in real estate inventories                                                                                                                                |       | (91.8                                                     | )          | (122.9 | ) | (79.7 | ) |
| Changes  in assets and liabilities:                                                                                                                                   |       |                                                      |       |   |   |   |   |
| Investment in land held for future development                                                                                                                        |       | —                                                    |       | (3.7 | ) | (2.8 | ) |
| (Increase) decrease in other assets                                                                                                                                   |       | (1.7                                                      | )          | 5.0 |   | (.2 | ) |
| (Decrease) increase in accounts payable, accrued and other liabilities                                                                                                |       | (4.8                                                      | )          | .8 |   | 8.3 |   |
| Cash used in operating activities                                                                                                                                     |       | (10.9                                                     | )          | (4.6 | ) | (9.7 | ) |
| Cash flows from  investing activities:                                                                                                                                |       |                                                      |       |   |   |   |   |
| Sales of short-term investments                                                                                                                                       |       | 75.3                                                      |       | — |   | — |   |
| Purchases of short-term investments                                                                                                                                   |       | (45.5                                                     | )          | (30.3 | ) | — |   |
| Investments in unconsolidated joint ventures                                                                                                                          |       | (1.0                                                      | )          | (.1 | ) | — |   |
| Changes in restricted cash                                                                                                                                            |       | (12.3                                                     | )          | (1.2 | ) | (1.1 | ) |
| Cash provided by (used in) investing activities                                                                                                                       |       | 16.5                                                      |       | (31.6 | ) | (1.1 | ) |
| Cash flows from financing  activities:                                                                                                                                |       |                                                      |       |   |   |   |   |
| Borrowings of senior secured project revolver                                                                                                                         |       | 18.3                                                      |       | — |   | — |   |
| Borrowings of senior secured term loan                                                                                                                                |       | 125.0                                                     |       | — |   | — |   |
| Borrowings of other project debt                                                                                                                                      |       | 31.6                                                      |       | 109.7 |   | 49.3 |   |
| Repayments of other project debt                                                                                                                                      |       | (44.6                                                     | )          | (74.4 | ) | (37.1 | ) |
| Deferred financing costs                                                                                                                                              |       | (3.3                                                      | )          | — |   | — |   |
| Special dividend paid                                                                                                                                                 |       | (135.7                                                    | )          | — |   | — |   |
| Proceeds from exercise of stock options                                                                                                                               |       | 3.2                                                       |       | .3 |   | .2 |   |
| Excess tax benefit from share-based payment  arrangements                                                                                                             |       | 3.1                                                       |       | — |   | .3 |   |
| Minority interest distributions                                                                                                                                       |       | (.3                                                       | )          | (.7 | ) | (7.6 | ) |
| Cash (used in) provided by financing activities                                                                                                                       |       | (2.7                                                      | )          | 34.9 |   | 5.1 |   |
| Net increase (decrease) in cash and cash equivalents                                                                                                                  |       | 2.9                                                       |       | (1.3 | ) | (5.7 | ) |
| Cash and cash equivalents—beginning of year                                                                                                                      |       | 7.7                                                       |       | 9.0 |   | 14.7 |   |
| Cash and cash equivalents—end of year                                                                                                                            |       | $                                                         | 10.6       |   | $ | 7.7 |   | $ | 9.0 |   |
| Supplemental  disclosures of cash flow information:                                                                                                                   |       |                                                      |       |   |   |   |   |
| Cash paid during the period for income taxes, net of  refunds received                                                                                                |       | $                                                         | 4.6        |   | $ | .8 |   | $ | .5 |   |
| Supplemental  disclosures of non-cash investing and financing activities:                                                                                             |       |                                                      |       |   |   |   |   |
| Minimum pension  liability adjustment recorded as other comprehensive income (loss), net of  income tax expense (benefit) of $.2, $(.9), and $0 million, respectively |       | .3                                                        |       | .8 |   | (.2 | ) |

 

See accompanying notes to consolidated financial statements.

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

| ** **                                                                               | ** ** | **Common Stock**  | ** ** | **Additional  Paid-In** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|------------|------------|
| ** **                                                                               | ** ** | **Shares**             | ** ** | **Stock**               | ** ** | **Capital**  | ** ** | **Earnings**                          | ** ** | **Loss**   | ** ** | **Total** | ** ** |
| ** **                                                                               | ** ** | **(in millions)** | ** ** |
| Balance at January 1, 2004                                                          |       |                   | 10.2       |                    |       |         | $          | .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 |   |
| Issuance of common stock upon exercise of stock  options and related income tax benefits |       |                   |       |                    |       |         | —     |                                  |       |       | .3         |   |   |   | — |   |   |   | — |   |   | .3 |   |
| Utilization of pre-reorganization net operating  losses                                  |       |                   | —     |                    |       |         | —     |                                  |       |       | —     |   |   |   | 9.1 |   |   |   | — |   |   | — |   |
| Balance at December 31, 2004                                                        |       |                   | 10.2       |                    |       |         | .5         |                                  |       |       | 152.8      |   |   |   | 28.2 |   |   |   | (2.6 | ) |   | 178.9 |   |
| Net income                                                                               |       |                   |       |                    |       |         | —     |                                  |       |       | —     |   |   |   | 28.4 |   |   |   | — |   |   | 28.4 |   |
| Other comprehensive income, net of income taxes                                          |       |                   |       |                    |       |         | —     |                                  |       |       | —     |   |   |   | —- |   |   |   | .8 |   |   | .8 |   |
| Issuance of common stock upon exercise of stock options  and related income tax benefits |       |                   |       |                    |       |         | —     |                                  |       |       | .3         |   |   |   | — |   |   |   | — |   |   | .3 |   |
| Utilization of pre-reorganization net operating  losses                                  |       |                   | —     |                    |       |         | —     |                                  |       |       | 38.5       |   |   |   | — |   |   |   | — |   |   | 38.5 |   |
| Balance at December 31, 2005                                                        |       |                   | 10.2       |                    |       |         | .5         |                                  |       |       | 191.6      |   |   |   | 56.6 |   |   |   | (1.8 | ) |   | 246.9 |   |
| Net income                                                                               |       |                   |       |                    |       |         | —     |                                  |       |       | —     |   |   |   | 5.6 |   |   |   | — |   |   | 5.6 |   |
| Other comprehensive income, net of income taxes                                          |       |                   |       |                    |       |         | —     |                                  |       |       | —     |   |   |   | — |   |   |   | .3 |   |   | .3 |   |
| Cash dividends paid                                                                      |       |                   |       |                    |       |         | —     |                                  |       |       | (135.7     | ) |   |   | — |   |   |   | — |   |   | (135.7 | ) |
| Stock-based compensation expense—stock options                                      |       |                   |       |                    |       |         | —     |                                  |       |       | .1         |   |   |   | — |   |   |   | — |   |   | .1 |   |
| Issuance of common stock upon exercise of stock  options and related income tax benefits |       |                   | .7         |                    |       |         | —     |                                  |       |       | 6.3        |   |   |   | — |   |   |   | — |   |   | 6.3 |   |
| Balance at  December 31, 2006                                                       |       |                   | 10.9       |                    |       |         | $          | .5                                    |       |       |       | $ | 62.3 |   |   |   | $ | 62.2 |   |   |   | $ | (1.5 | ) |   | $ | 123.5 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**CALIFORNIA COASTAL COMMUNITIES, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—Formationand 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.

**Note 2—SignificantAccounting 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 4. Minority interestrepresents the equity interest of the Company’s joint venture partner for oneconsolidated venture and is further described in Note 10. 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(R), “Consolidation ofVariable Interest Entities—an interpretation of ARB No. 51” (“FIN 46(R)”),an enterprise that has the majority of the variability in gains and losses ofthe VIE is considered to be the primary beneficiary and must consolidate theVIE. FIN 46(R) was effective immediately for VIEs created after January 31,2003.

Based on the provisions of FIN 46(R), 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 

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(c) of the previousparagraph. The Company may be deemed to have provided subordinated financialsupport, which refers to variable interests that will absorb some or all of anentity’s expected 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(R). If the Companyis deemed to be the primary beneficiary of the VIE, the VIE will beconsolidated on the Company’s balance sheet.

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.

As of December 31,2006, the Company has no deposits with VIEs. See Note 11—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 and cash equivalents. The Company’s restricted cashrepresents cash held as security for the Company’s senior secured projectrevolver, senior secured term loan, standby letters of credit, and bonds forhomebuilding projects 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 are carried at the lower ofcost or fair value less costs to sell. 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, and environmental conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Accordingly,the ultimate values of the Company’s real estate properties depend upon futureeconomic and market conditions, and the availability of financing.

The cost of sales of multi-unitprojects is generally computed using the relative sales value method. Interestand other carrying costs are capitalized to real estate projects during theirdevelopment and construction period.

*Impairment ofLong-Lived Assets*

The Company assesses the impairment of real estateinventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets”, (“SFAS 144”) whichrequires that an impaired asset, for 

F-8

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which costs cannot berecovered from estimated undiscounted future cash flows, be written down tofair value. Long-lived assets are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. As provided by SFAS 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 ofSFAS 144 is deemed to be the amount a willing buyer would pay a willingseller for such asset in a current transaction.

In accordance with SFAS 144, in developingestimated future cash flows for impairment testing, the Company hasincorporated its own market assumptions including those regarding home prices,infrastructure and home-building costs and financing costs regarding realestate inventories. Additionally, as appropriate, the Company identifiesalternative courses of action to recover the carrying value of its long-livedassets and evaluates all likely alternatives under a probability-weightedapproach as described in SFAS 144.

The Company has notrecorded any impairment charges to date primarily because most of its lotacquisitions were negotiated prior to 2005 (thus reflecting less expensive landprices and benefiting from home price appreciation during 2005 that exceededthe decline in home prices during 2006). However, as required by SFAS 144,should market conditions deteriorate in the future or other events occur thatindicate the carrying amount of the Company’s real estate inventories may notbe recoverable, the Company will reevaluate the expected cash flows from eachproject to determine whether any impairment exists at that time.

*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 theprobability of being able to realize the future benefits indicated by deferredtax assets. 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.

*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 for financing.Revenue from the sale of homes is recognized at the close of escrow 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.

*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 

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period.Reserves are determined based upon historical data with respect to similarproduct 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. Diluted earnings per common share is computed usingthe weighted-average number of common shares outstanding and the dilutiveeffect of potential common shares outstanding. For the years ended December 31,2005 and 2004, the average market price of the Company’s common stock exceededthe exercise price of approximately 700,000 outstanding stock options. Therefore,diluted earnings per share includes the dilutive effect of the weighted averagenumber of common shares from potential exercise of approximately 700,000options. During the second and third quarters of 2006, approximately 700,000options were exercised, which reduced the dilutive effect of stock options in 2006compared with 2005 and 2004.

The table below sets forth the reconciliation of thedenominator of the earnings per share calculation (in millions):

| ** **                                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Shares used in  computing basic earnings per common share   |       | 10.4     |       | 10.2     |       | 10.1     |       |
| Dilutive effect  of stock options                           |       | .2       |       | .3       |       | .7       |       |
| Shares used in computing  diluted earnings per common share |       | 10.6     |       | 10.5     |       | 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 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). Stockoptions are valued using a fair-value-based option-pricing model and the fairvalue is recognized as an expense over the period in which the options vest. Duringthe first quarter of 2006, the Company adopted SFAS 123(R) using themodified prospective method. The Company previously adopted the fair valuerecognition provisions of SFAS 123 in 2003. For this change in accounting, theCompany selected the “modified prospective method” under the provisions of SFASNo. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure—an Amendment of FASB Statement No. 123” (“SFAS 148”). Underthis method, the change was retroactive to January 1, 2003 and compensationcost recognized during 2003 is zero, the same as that which would have beenrecognized had the recognition provisions of SFAS 123 been applied from itsoriginal effective date.

SFAS 123(R) also requires a calculation toestablish the beginning pool of excess tax benefits, or the additional paid-incapital pool (“APIC pool”), available to absorb any tax deficiencies recognizedafter the adoption of SFAS 123(R). The Company has elected the alternativetransition method, which includes a simplified calculation method, set forth inFASB Staff Position No. FAS 123(R)-3, *“TransitionElection Related to Accounting for the Tax Effects of Share-Based PaymentAwards” *to calculate itsbeginning APIC pool.

Until the second quarter of 2003, the Company appliedAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”), and related interpretations in accounting forits plan. Accordingly, no compensation expense was recognized through 2002 forits stock-based compensation plans other than for variable accounting forrepriced stock options as described above.

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*Fair Value ofFinancial Instruments*

The carrying amounts ofthe Company’s financial instruments including cash and cash equivalents,restricted cash, short-term investments, accounts payable, accrued and otherliabilities, and debt approximate their respective fair values because of therelatively short period of time between origination of the instruments andtheir expected realization, or because they are carried at fair value.

*Other ComprehensiveIncome (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 loss are disclosed in the consolidated statements of income netof tax.

*New AccountingPronouncements*

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-basedmethod. The Company adopted SFAS 123(R) in the first quarter of 2006 usingthe modified prospective method, which requires that compensation is recognizedon or after the required effective date for the portion of outstanding awardsfor which the requisite service has not yet been rendered, based on thegrant-date fair value of those awards calculated under SFAS 123 for eitherrecognition or pro forma disclosures. The Company previously adopted the fairvalue recognition provisions of SFAS 123 in 2003. The adoption of SFAS 123(R)did not have a material impact on the Company’s consolidated financialposition, 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 was effective beginning in the Company’s first quarter of 2006.The adoption of SFAS 154 did not have a material impact on the Company’sconsolidated financial position, results of operations, or cash flows.

In June 2005, the Emerging Issues Task Force (“EITF”)reached a final consensus on Issue No. 04-5, “Determining Whether a GeneralPartner, or the General Partners as a Group, Controls a Limited Partnership orSimilar 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 was effective for the Company beginning inthe first quarter of 2006. The adoption of EITF 04-5 did not have amaterial impact on the Company’s consolidated financial position, results ofoperations, or cash flows upon initial adoption. EITF 04-5 may materiallyimpact the Company’s consolidated financial position, results of operations, orcash flows in future periods should the Company form new limited partnershipsor modify existing limited partnerships such that the 

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Company is deemed tocontrol the limited partnership. Under those circumstances, the Company may berequired by EITF 04-5 to consolidate the limited partnership. 

In July 2006, the FASB issued FASB InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes”, (“FIN 48”), whichprescribes a recognition threshold and measurement process for recording in thefinancial statements uncertain tax positions taken or expected to be taken in atax return. Additionally, FIN 48 provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure requirements for uncertain tax positions. The accounting provisionsof FIN 48 are effective for reporting periods beginning after December 15,2006. The Company will adopt FIN 48 during the first quarter of 2007 and theCompany is currently evaluating the impact of such adoption by assessing theexistence of any potential liabilities for uncertain tax positions. If theCompany is required to record a reserve for any contingent liabilities underFIN 48, the amount would be recorded as an adjustment to opening retainedearnings as a cumulative effect of a change in accounting principle.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal periods beginning after November 15,2007 (the Company’s fiscal year beginning January 1, 2008), and interimperiods within those fiscal years. The Company is currently evaluating theimpact of adopting SFAS No. 157 on the consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158,“Employer’s Accounting for Defined Benefit Pension and Other PostretirementPlans—an amendment of FASB Statements No. 87, 88, 106 and 132(R)”  (“SFAS 158”). SFAS 158 requires an employerto recognize the overfunded or underfunded status of defined benefit andretiree medical plans as an asset or liability in its statement of financialposition and to recognize through comprehensive income changes in the fundedstatus in the year in which they occur. SFAS 158 is effective for financialstatements issued for fiscal periods ending after December 15, 2006. TheCompany adopted SFAS 158 during December 2006. The adoption of SFAS 158did not have a material impact on the Company’s consolidated financialposition, results of operations, or cash flows.

In September 2006,the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin(“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”).SAB No. 108 provides guidance on the consideration of effects of the prioryear misstatements in quantifying current year misstatements for the purpose ofa materiality assessment. SAB No. 108 was effective for the first annualperiod ending after November 15, 2006. The adoption of SAB 108 did nothave a material impact on the Company’s consolidated financial position,results of operations, or cash flows.

**Note 3—Real EstateInventories**

Real estate inventoriesprimarily consist of homes under construction and lots under development atBrightwater and eight additional communities in five Southern Californiacounties. At December 31, 2006, real estate inventories aggregated 797lots and homes, including 46 homes completed and unsold, and 14 homes completedand in escrow. Real estate inventories at December 31, 2006 includes$155.8 million recorded for the Brightwater community which is located on a 105-acreparcel on a mesa north of the Bolsa Chica wetlands (“Upper Mesa”) Brightwateris planned for 356 homes as discussed below. In addition, real estateinventories includes approximately 51 acres nearby which have been offered fordedication to the County of Orange for inclusion in the Harriet M. Weider LinearPark in conjunction with the development of Brightwater, and 51 additionalacres which are subject to a conservation easement. The carrying value of thesetwo properties is zero. The Company capitalizes direct carrying costs including

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interestand property taxes, as well as direct construction costs, to real estateinventories during the development and construction period.

The Brightwater plannedcommunity will offer a broad mix of home choices, averaging 2,860 square feetand ranging in size from 1,720 square feet to 4,140 square feet. The plan alsoincludes 37 acres of open space and conservation area. With 349 homes permittedon 68 acres of the Upper Mesa, the resulting low-density plan equates toapproximately five homes per acre, consistent and compatible with theneighboring Huntington Beach communities. In addition, the Company owns landadjacent to the planned Brightwater development, on which it intends to processpermits to build seven additional homes which will be included in the Brightwatercommunity. The Company completed grading during October 2006, and iscurrently constructing infrastructure (sewer, water, storm drain, streets,utilities, etc.) Model home construction began in December 2006 for two ofthe four home products and in February 2007 for the additional twoproducts. The Company expects to start selling homes during the summer of 2007and begin delivering homes by the end of 2007. However, there can be no assurancein that regard, or as to the absence of further development or constructiondelay.

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 dispositionof its real estate properties in the ordinary course of business based onmanagement’s present plans and intentions. Economic and market conditions mayaffect 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 amount ultimately realized from such project may differmaterially from current estimates and the project’s carrying value.

Capitalized interest isallocated to real estate inventories when incurred and charged to cost of saleswhen the related property is delivered. Certain information regarding interestfollows (in millions):

| ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Capitalized  interest, beginning of period |       | $        | 6.1        |     | $          | 1.3 |   |
| Interest incurred  and capitalized         |       | 8.1      |       | 6.7      |       |
| Charged to cost  of sales                  |       | (4.0     | )          | (1.9     | )          |
| Capitalized interest,  end of period       |       | $        | 10.2       |     | $          | 6.1 |   |

 

**Note 4—Investments in Unconsolidated Joint Ventures**

The Company’s investmentsin unconsolidated joint ventures are 50% or less owned, not substantiallycontrolled by the Company, and accordingly, are accounted for using the equitymethod and are not consolidated with the Company’s consolidated financialstatements. Investments are included in the Company’s balance sheet in otherassets. Condensed combined financial information regarding the Company’sinvestments in: (i) the Oxnard land development joint venture (describedbelow), (ii) a residential loan production partnership with a majorcommercial bank and (iii) the completed San Diego area homebuilding jointventure are summarized as follows (in millions):

| ** **                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance Sheet Data:            |       |     |       |     |       |     |       |
| Total assets                   |       | $        | 9.5        |     | $          | 5.8      |       | $ | 5.4 |   |
| Total liabilities              |       | (2.2     | )          | (.5      | )          | (1.5     | )          |
| Venturers’  capital       |       | $        | 7.3        |     | $          | 5.3      |       | $ | 3.9 |   |
| Statement of  Operations Data: |       |     |       |     |       |     |       |
| Revenues                       |       | $        | .8         |     | $          | .7       |       | $ | 1.4 |   |
| Expenses                       |       | (.5      | )          | (.5      | )          | (.7      | )          |
| Net income                     |       | $        | .3         |     | $          | .2       |       | $ | .7 |   |

 

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During 2006, 2005 and2004, the Company received $200,000, $200,000, and $400,000, respectively, inaggregate cash distributions from the residential loan production partnershipand $100,000 in 2004, from the completed San Diego area homebuilding joint venture.

*Oxnard LandDevelopment Joint Venture*

In February 2003, the Company entered into twooption contracts to acquire land adjacent to the City of Oxnard in VenturaCounty, California aggregating approximately 168 acres. The Company isdeveloping 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. During October 2003,the Company entered into a limited liability company joint venture agreementwith a major financial partner to pursue the Oxnard development opportunity.The Company assigned the land purchase option contracts to the Oxnard limitedliability company (“Oxnard LLC”). Hearthside Homes, Inc., the Company’shomebuilding subsidiary, is the managing member of the Oxnard LLC.

The Company currently expects the residentialdevelopment plan to include approximately 760 single-family detached lots andapproximately 630 attached residential units (townhomes, condominiums andapartments); however, these numbers are subject to change during the course ofthe entitlement process. Approximately 554 of the single-family lots andapproximately 500 of the attached units could be developed on the 168 acres ofoptioned land that the Company currently expects the Oxnard LLC to purchase.The single-family detached product is currently expected to range fromapproximately 1,880 square feet to 3,850 square feet and the attached units arecurrently expected to range from approximately 1,030 square feet to 1,850square feet. An independent market study as of August 2006 estimatedaverage home prices for the project of approximately $665,800, or an average of$311 per square foot.

The option contracts give the Oxnard LLC two years, plusup to three additional years through the exercise of extensions, to completeentitlement activities before purchasing the land. The Oxnard LLC has the rightto terminate these option agreements by forfeiting the cash deposits. TheOxnard LLC is striving to obtain approval of its plan from the Oxnard CityCouncil in the second half of 2007 and approval of annexation into the City ofOxnard from the Local Agency Formation Commission in the first quarter of 2008;however, delays could be encountered. If the Oxnard LLC completes theentitlement process in the time frame set forth above, and decides to buildhomes (rather than sell lots), most of the homes would be delivered between2010 and 2012, based on current expectations and assumptions. The Oxnard LLChas exercised five six-month option extensions, extending the current closingdate for the option contracts to August 2007, and there is one remainingsix-month extension through February 2008.

The Oxnard LLC is funded by both of its members.Hearthside Homes, Inc. made an initial contribution of $500,000. Thenon-managing member also made an initial contribution of $500,000 to the jointventure and, as of December 31, 2005, had made an aggregate of $4 millionof first tier additional contributions. The members have provided a second tierof additional capital contributions of $1 million each, as originally providedin the venture agreement. In addition, the members have agreed to provide anadditional $325,000 each of temporary advances, as necessary, to complete thebusiness plan. During the fourth quarter of 2005 and the year ended December 31,2006, the members each contributed approximately $160,000 and $1.0 million,respectively.

In addition to the land purchase options for the projectproperty, the Oxnard LLC holds a land purchase option which controls propertywhich was expected to provide fill dirt for the project property. During February 2007,the Oxnard LLC agreed to sell the non-project land purchase option since thefill dirt is no longer required for the project. The sale for $1.8 million iscontingent upon various closing conditions including feasibility studies, andis scheduled to close during the third quarter of 2007. Oxnard LLC expects toreceive proceeds of approximately $1.5 million for this transaction afterpaying commissions and closing costs, and plans to utilize the proceeds to fundongoing development costs.

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The Company’s total investment in the venture as of December 31,2006 is $1.7 million. The Company expects to make additional aggregate capitalcontributions of approximately $100,000 to the joint venture during 2007,bringing the Company’s total expected investment in the venture to $1.8million. The amount of contributions could be substantially increased if the saleof the non-project land option is not completed as discussed above. Afterpayment of a 10% preferred return on invested capital to the members, the first$8 million of profits are allocated 75% to the Company’s partner and 25% to theCompany, and profits over $8 million and losses over $5 million are generallyallocated on a 50/50 basis in accordance with the joint venture agreement. Thefirst $5 million of losses are generally allocated 80% to the Company’s partnerand 20% to the Company.

While the Company exerts alarge degree of influence over the venture, the Company’s partner does havevarious substantive participating rights such as approval rights with regard tothe majority of business decisions, including approval of project budgets.

**Note 5—SeniorSecured Project Revolver**

On September 15, 2006, the Company entered into athree-year, $100 Million Senior Secured Revolving Credit Agreement with KeyBankNational Association, as a lender and agent for several other lenders (the “RevolvingLoan”). The Revolving Loan is secured by a first trust deed on the Brightwaterproject, and stock pledges of the Company’s material subsidiaries. TheRevolving Loan will fund the first $100 million of construction costs for theproject. At the end of the second year of the term of this facility and eachsubsequent quarter, the commitment amount will decrease by $25 million untilthe commitment under the Revolving Loan is reduced to zero by the finalmaturity date, September 15, 2009. The Revolving Loan is also subject toearlier commitment reductions based on 40% of the $600,000 release price on thefirst 50 units closed at the Brightwater project, and 40% of the $1 millionrelease price per unit thereafter.

Availability under the $100 million Revolving Loan issubject to the applicable borrowing base limitations. The borrowing base limitslender advances to 50% of asset value. The borrowing base value is theappraised value of the Brightwater project, increased for costs incurredsubsequent to the most recent lender appraisal and reduced by 72% of the salesvalue of homes sold. The initial borrowing base value of the Brightwaterproject was determined by an independent third-party appraisal of the projecton an “as-is” basis as of July 6, 2006. Certain subsidiaries of theCompany provided full unconditional guarantees. The Revolving Loan includesfinancial covenants which may limit the amount that may be borrowed.Outstanding advances bear interest at the Company’s option at either (i) theAlternate Base rate (“Prime”) minus 25 basis points or (ii) LIBOR plus 200basis points.

As of December 31, 2006, $18.3 million wasoutstanding under the Revolving Loan. The undrawn availability was$81.7 million, as limited by the borrowing base formulas. Interest on thefacility is calculated on the average, outstanding daily balance and is paidmonthly. Interest incurred on the Revolving Loan for the year ended December 31,2006 was $217,000, at a weighted-average interest rate of 7.3%, which reflectsthe Company’s elected rate of LIBOR plus 2%.

Initial loan fees and closing costs of approximately$800,000 incurred for the Revolving Loan on September 15, 2006 aredeferred and included in other assets and amortized over the life of the loan.Amortization of these costs is included in the capitalization of interestallocated to real estate inventories when incurred, and charged to cost ofsales when the related homes are delivered. As of December 31, 2006,approximately $734,000 of deferred loan fees and closing costs related to theRevolving Loan are included in other assets.

Under the Revolving Loan,the Company is required to comply with a number of covenants, including aleverage covenant and a minimum consolidated tangible net worth covenant. TheCompany is in compliance with these covenants as of December 31, 2006.

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**Note 6—SeniorSecured Term Loan**

On September 15, 2006, the Company entered into afive-year, $125 Million Senior Secured Term Loan Agreement with KeyBankNational Association, as a lender and agent for several other lenders (the “TermLoan”), and on September 15, 2006, the Company borrowed the maximum loanamount of $125 million. The proceeds were used to fund a “special dividend” of$12.50 per share, totaling $135.7 million, to common stockholders paid on September 28,2006. At the end of the second, third and fourth years of the term of thisagreement, the commitment amount will decrease by $15 million, $25 million, and$35 million, respectively. Thereafter, for each subsequent quarter, the TermLoan commitment amount will decrease in four equal installments, until thecommitment under the agreement is reduced to zero by the final maturity date, September 15,2011. The Term Loan is also subject to mandatory repayments based on 60% of the$600,000 release price on the first 50 units closed at the Brightwater project,and 60% of the $1 million release price per unit thereafter.

Availability under the Term Loan is subject to theapplicable borrowing base loan to value limitations. The loan to value limitstotal lender advances under the Term Loan and the Revolving Loan to 65% ofasset value. This is based upon the initial appraised value of the Brightwaterproject, increased for costs incurred subsequent to the most recent lenderappraisal and reduced by 72% of the sales value of homes sold. The Term Loan issecured by a second trust deed on the Brightwater project, and a general pledgeand assignment of the Company’s ownership interests in all materialsubsidiaries. All existing material subsidiaries of the Company have providedfull unconditional guarantees. The Term Loan includes financial covenants whichmay limit the amount that may be outstanding. The outstanding balance bearsinterest at the Company’s option at either (i) the prime interest rateplus 25 basis points, or (ii) LIBOR plus 275 basis points.

As of December 31, 2006, $125 million wasoutstanding under the Term Loan. Interest on the Term Loan is calculated on theaverage, outstanding daily balance and is paid monthly. Interest incurred onthe Term Loan for the year ended December 31, 2006 was $3.1 million, at aweighted-average interest rate of 8.0%, which reflects the Company’s electedrate of LIBOR plus 2.75%.

Initial loan fees and closing costs of $2.3 millionincurred for the Term Loan on September 15, 2006 are deferred and includedin other assets and amortized over the life of the loan. Amortization of thesecosts is included in the capitalization of interest allocated to real estateinventories when incurred, and charged to cost of sales when the related homesare delivered. As of December 31, 2006, approximately $2.2 million ofdeferred loan fees and closing costs related to the Term Loan are included inother assets.

Under the Term Loan, the Company is required to complywith a number of covenants, including covenants related to  leverage, a minimum ratio of EBITDA tointerest, and a minimum consolidated tangible net worth. The Company is incompliance with these covenants as of and for the year ending December 31,2006.

Under the Term Loanagreement, the Company was required to enter into a swap agreement to hedgeagainst risks associated with fluctuating interests rates related to $62.5million of floating rate debt. On September 15, 2006 the Company enteredinto an interest rate swap transaction to effectively fix the interest rate on$62.5 million in floating rate debt at 8.015% per annum. The swap transactionterminates in September 2008. Since the Company does not use derivativefinancial instruments for trading purposes, the swap did not qualify for hedgeaccounting under SFAS No. 133, *“Accounting for DerivativeInstruments and Hedging Activities”*. The fair value of the interestrate swap agreement represents the spread between the interest rate the Companypaid and the interest rate the Company would receive over the remaining life ofthe agreement, however, this was insignificant at December 31, 2006. Thechange in fair value of the interest rate swap agreement during the year ended December 31,2006 was not material. The counterparties to the interest rate swap agreementare financial institutions.

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**Note 7—OtherProject Debt**

In conjunction with the acquisition of single-familyresidential lots, the Company’s homebuilding subsidiary, Hearthside Homes, Inc.and its subsidiaries, enter into construction loan agreements with commercialbanks. These loan facilities finance a portion of the land acquisition and themajority of the construction of infrastructure and homes. Each loan facilityrequires a guaranty of project completion and an environmental indemnity. Theloans secured by first trust deeds bear an interest rate of prime plusthree-fourths percent (9% at December 31, 2006),  except for two new loan facilities created inSeptember and December 2006 for the Rancho Santa Fe andCorona-Hellman projects, respectively, which bear interest at a rate of primeplus one-half percent (8.75% at December 31, 2006). Some of these loanfacilities have a minimum interest rate ranging from 5.75% to 8.5%. During theyear ended December 31, 2006, Hearthside Homes, Inc. entered into twonew first trust deed loan facilities aggregating $23.8 million in conjunctionwith the acquisition and development of a total of 163 single familyresidential lots. The following amounts were available and outstanding underthese loan facilities as of December 31, 2006 and 2005 ($ in millions):

| ** **        | ** ** | **Amount**           | ** ** | **Number**       | ** ** | **Maturity** | ** ** | **Outstanding at  December 31,** | ** ** |
|-------------------|------------|----------------------|------------|------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **        | ** ** | **of Facility** | ** ** | **of Lots** | ** ** | **Date**     | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| First Trust Deeds |       |                 |       |             |       |         |       |                                       |       |   |   |   |   |   |   |   |   |
| Rancho Santa Fe   |       |                 | $          | 15.4             |       |         |       | —                                     |       |   |   | — |   |   | $ | — |   | $ | 8.5 |   |
| Lancaster         |       |                 | 9.5        |             |       |         | —     |                                       |       |   | — |   |   | — |   | .2 |   |
| Lancaster         |       |                 | 1.0        |             |       |         | —     |                                       |       |   | — |   |   | — |   | 1.0 |   |
| Lancaster         |       |                 | 10.5       |             |       |         | —     |                                       |       |   | — |   |   | — |   | 3.6 |   |
| Rancho Santa Fe   |       |                 | 1.8        |             |       |         | —     |                                       |       |   | — |   |   | — |   | 1.7 |   |
| Rancho Santa Fe   |       |                 | 10.4       |             |       |         | 6          |                                       |       |   | 2/13/07 |   |   | 3.8 |   | — |   |
| Ontario           |       |                 | 11.7       |             |       |         | 17         |                                       |       |   | 4/19/07 |   |   | 4.6 |   | 4.6 |   |
| Corona-Chandler   |       |                 | 14.8       |             |       |         | 21         |                                       |       |   | 4/26/07 |   |   | .8 |   | 7.0 |   |
| Corona-Chandler   |       |                 | 1.9        |             |       |         | 4          |                                       |       |   | 4/26/07 |   |   | 1.9 |   | 1.8 |   |
| Lancaster         |       |                 | 17.7       |             |       |         | 74         |                                       |       |   | 7/1/07 |   |   | 2.2 |   | 3.1 |   |
| Beaumont          |       |                 | 20.7       |             |       |         | 87         |                                       |       |   | 8/17/07 |   |   | 10.7 |   | 7.6 |   |
| Corona-Hellman    |       |                 | 54.5       |             |       |         | 151        |                                       |       |   | 1/7/09 |   |   | 20.9 |   | 18.8 |   |
|              |       |                 |       |             |       |         |       |                                       |       |   |   |   |   | $44.9 |   | $ | 57.9 |   |
|                   |            |                      |            |                  |            |              |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

During January and February 2007,the Rancho Santa Fe and both Corona-Chandler loans were repaid in full. TheOntario project debt which matures in April 2007 has an automaticsix-month extension available.

**Note 8—OtherLiabilities**

Other liabilities were comprised of the following asof December 31 (in millions):

| ** **                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| Accrued pensions  and benefits                      |       | $        | 4.1        |     | $          | 4.8 |   |
| Home warranty  reserves                             |       | 2.4      |       | 2.1      |       |
| Contingent  indemnity and environmental obligations |       | 1.4      |       | 1.5      |       |
| Unamortized  discount                               |       | (.4      | )          | (.5      | )          |
|                                                |       | $        | 7.5        |     | $          | 7.9 |   |

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.

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*Home WarrantyReserve*

The Company provides a home warranty reserve toreflect its contingent obligation for product liability. The Company generallyrecords a provision as homes are delivered, based upon historical and industryexperience, for the items listed in the homeowner warranty manual, which doesnot include items that are covered by manufacturers’ warranties or items thatare not installed by the Company’s employees or contractors. The home warrantyreserve activity is presented below for the years ended December 31 (inmillions):

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Balance at  beginning of period |       | $        | 2.1        |     | $          | 1.6 |   |
| Provision                       |       | .6       |       | 1.0      |       |
| Payments                        | ** ** | (.3      | )          | (.5      | )          |
| Balance at end of period        |       | $        | 2.4        |     | $          | 2.1 |   |

 

**Note 9—Income Taxes**

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

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current taxes                                            |       | $        | .3         |     | $          | 4.6      |       | $ | 1.5 |   |
| Deferred taxes                                           |       | 3.6      |       | 12.6     |       | 3.1      |       |
| Reversal of  valuation allowances on deferred tax assets |       | —   |       | (4.7     | )          | —   |       |
| Reduction in  contingent tax liabilities                 |       | —   |       | —   |       | (.1      | )          |
|                                                     |       | $        | 3.9        |     | $          | 12.5     |       | $ | 4.5 |   |

 

The principal items accounting for the difference intaxes on income computed at the statutory rate and as recorded, are as followsfor the years ended December 31 (in millions):

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Provision for  income taxes at statutory rate            |       | $        | 3.3        |     | $          | 14.5     |       | $ | 4.1 |   |
| State income  taxes, net                                 |       | .6       |       | 2.4      |       | .4       |       |
| Reduction in  contingent tax liabilities                 |       | —   |       | —   |       | (.1      | )          |
| Reversal of  valuation allowances on deferred tax assets |       | —   |       | (4.7     | )          | —   |       |
| All other items,  net                                    |       | —   |       | .3       |       | .1       |       |
|                                                     |       | $        | 3.9        |     | $          | 12.5     |       | $ | 4.5 |   |

 

The tax provision for the year ended December 31,2004 reflects a $400,000 benefit for a reduction in valuation allowance onpost-Reorganization state net operating losses (“NOLs”). During the years ended2005 and 2004, reductions in valuation allowance on federal pre-ReorganizationNOLs of $38.5 million and $9.1 million, respectively, were recorded, as theCompany determined that the utilization of these NOLs is “more likely than not”based on forecasted earnings. Pursuant to Fresh-Start Reporting, the reductionsin valuation allowance related to pre-Reorganization NOLs were reflected byincreasing the Company’s additional paid-in capital.

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The tax effects of items that gave rise to significantportions of the deferred tax accounts for the years ended December 31 (inmillions) are as follows:

| ** **                                                                                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                                                                                                                |       |     |       |     |       |
| Accruals/reserves not deductible until paid                                                                                                         |       | $        | 3.7        |     | $          | 3.7 |   |
| Accrued seller participation not deductible until  paid                                                                                             |       | .8       |       | .3       |       |
| Net operating loss and alternative minimum tax  credit carryforwards                                                                                |       | 45.1     |       | 45.1     |       |
| State income tax provisions deductible when paid for  federal tax purposes                                                                          |       | .9       |       | 2.1      |       |
|                                                                                                                                                |       | 50.5     |       | 51.2     |       |
| Deferred tax  liabilities:                                                                                                                          |       |     |       |     |       |
| Real estate inventories (principally due to accounting  for a prior business combination, partially offset by asset revaluations in  1995 and 1997) |       | 15.8     |       | 15.8     |       |
| Net deferred tax assets                                                                                                                             |       | $        | 34.7       |     | $          | 35.4 |   |

 

The net deferred tax balance at December 31, 2006and 2005 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 and economicfactors affecting the Company’s operations. The Company monitors these, as wellas other positive and negative factors that may arise in the future, as itassesses the need for a valuation allowance against its deferred tax assets. Asa result of the California Coastal Commission’s approval of the Company’sdevelopment plan for Brightwater on April 14, 2005, the Company concludedthat it is more likely than not that it will utilize all of its deferred taxassets, including NOLs, to offset future taxable income. Therefore, during thethree months ended March 31, 2005, the Company recorded a reversal ofvaluation allowances on post-reorganization NOLs and other deferred tax assetsof approximately $4.7 million, which is reflected in the 2005 tax benefit. Pursuantto Fresh Start Reporting, also during the three months ended March 31,2005, a reversal of valuation allowance on federal Pre-reorganization NOLs ofapproximately $38.5 million was reflected by increasing the Company’sadditional paid-in capital.

Pursuant to SFAS 123(R), the Company has elected torecognize stock option deductions on the tax law ordering method, whichmaximizes the realization of the stock option deductions in the current year.While the Company realized the majority of its current year stock optiondeductions, approximately $400,000 of unrealized tax benefits related to stockoption deductions are not reflected in the consolidated financial statements.Upon realization of the tax benefits, the Company will increase its additionalpaid-in capital.

The federal NOLs available as of December 31,2006 are approximately $127 million. The amount of NOLs which expire if notutilized is zero for 2007 and 2008 and $9 million, $49 million, $42 million and$27 million for 2009, 2010, 2011 and thereafter, respectively.

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 NOLs is generally limited to the value of theCompany’s equity immediately before the ownership change multiplied by thelong-term tax-exempt rate. However, Section 382(l)(5) of the Code,the “bankruptcy exception,” provides that if the ownership change occursthrough a bankruptcy, such as the Company’s Recapitalization which utilized aprepackaged plan, and if the continuing shareholders and “qualifying creditors”before the ownership change own at least 

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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 taxable years and (ii) an additional amountrequired to make the total reduction equal to the amount of cancellation ofindebtedness income realized. Accordingly, the Company’s NOLs of approximately$271 million as of September 2, 1997 were reduced by approximately $79million. As reduced, the Company’s NOL carryovers are fully deductible againstpost-reorganization income, subject to the general rules regarding changeof ownership as discussed below, and expiration of NOLs.

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. The Code generally limits theavailability of NOLs if an ownership change occurs within any three-year periodunder Section 382. If the Company were to experience an ownership changeof more than 50%, the use of all remaining NOLs would generally be subject toan annual limitation equal to the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate. The Companyestimates that after giving effect to various transactions by stockholders whohold a 5% or greater interest in the Company, it has experienced a three-yearcumulative ownership shift of approximately 35% as of February 28, 2007,as computed in accordance with Section 382.

On September 18,2006, the Company’s Board of Directors suspended enforcement of the Company’scharter documents that restrict stockholders from acquiring more than 5% of theoutstanding shares of Common Stock. The Board determined that such restrictionswere not currently required to preserve the tax benefits of the Company’s $127million of NOLs. While the Company remains subject to the Internal Revenue Code’ssection 382, which limits the availability of NOLs in the event of an ownershipchange, the Company would have five years from the date of any such ownershipchange to recognize its built in gains and utilize its NOLs. With the recentcommencement of construction at Brightwater, and the related built-in-gain ofthe project,  the Company believes itwill fully utilize its NOLs within the next five years if an ownership changedoes occur; however, the Board may reinstitute the 5% ownership limitation ifcurrently unanticipated events so require.

*Uncertain Tax Positions*

In July 2006, theFASB issued FASB Interpretation No. 48, ”Accounting for Uncertainty inIncome Taxes”, (“FIN 48”), which prescribes a recognition threshold andmeasurement process for recording in the financial statements uncertain taxpositions taken or expected to be taken in a tax return. Additionally, FIN 48provides guidance on derecognition, classification, interest and penalties,accounting in interim 

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periodsand disclosure requirements for uncertain tax positions. The accountingprovisions of FIN 48 are effective for reporting periods beginning after December 15,2006. The Company will adopt FIN 48 during the first quarter of 2007 and iscurrently evaluating the impact of such adoption by assessing the existence ofany potential liabilities for uncertain tax positions. If the Company isrequired to record a reserve for any contingent liabilities under FIN 48, theamount would be recorded as an adjustment to beginning retained earnings as acumulative effect of a change in accounting principle.

**Note 10—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 anddelivered 65 homes during 2004 and the remaining 12 homes during 2005.Hearthside Homes, Inc. (one of the Company’s principal subsidiaries) isthe managing member of the Chino LLC, manages its operations and contributedcapital of approximately $400,000 (approximately 10%) to the venture. Minorityinterest represents the non-managing member’s equity interest in the ventureincluding a capital contribution of approximately $4.0 million (approximately90%), net of distributions and as adjusted for the member’s allocation ofprofits and losses. Profits and losses are generally allocated 50% to eachmember, after a 10% preferred return on invested capital. During the year endedDecember 31, 2004, capital distributions of approximately $7.6 millionwere made to the non-managing member, repaying all of its initial capitalcontribution, plus all $600,000 of accumulated preferred return and $3.1million in profit distributions, in conjunction with the delivery of the first65 homes. During the year ended December 31, 2005, additionaldistributions of $675,000 were made to the non-managing member and the Companyrecorded minority interest in income of consolidated joint venture of $400,000,net of income tax benefit of $200,000. During the year ended December 31,2006, distributions of $250,000 were made to the non-managing member.

**Note 11—Commitments and Contingencies**

*Real Estate Matters*

The Company is subject tothe usual obligations associated with entering into contracts for the purchaseof land and improved homesites. The purchase of properties under thesecontracts is generally contingent upon satisfaction of certain requirements bythe sellers, including obtaining applicable property entitlements. The Companyalso utilizes option contracts with third-party land sellers and financialentities as a method of acquiring land in staged takedowns and minimizing theuse of funds from other corporate financing sources. These option contractsalso help to manage the financial and market risk associated with landholdings. Option contracts generally require the payment of a non-refundablecash deposit of 5% to 15% of the purchase price for the right to acquire lotsover a specified period of time (usually one to two years) at predeterminedprices. The Company has the right at its discretion to terminate itsobligations under these land purchase and option agreements by forfeiting thecash deposit with no further financial responsibility. As of December 31,2006, the Company has one consolidated $25,000 land option deposit.

The Company’s homebuildingsubsidiary, Hearthside Homes, Inc., is the managing member of a jointventure to develop land in the City of Oxnard in Ventura County, California.Hearthside Homes, Inc., and the non-managing member have provided firstand second tier contributions and temporary advances to fund the business plan.The Company expects to make additional net aggregate temporary advances ofapproximately $100,000 to the joint venture during the next 12 months, bringingthe Company’s total expected investment in the venture to $1.8 million. SeeNote 4 for additional discussion of the terms of the joint venture agreement.

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 

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December 31,2006. The Company does not believe that draws upon these bonds, if any, willhave a material effect on the Company’s financial position, results ofoperations or cash flows.

*Legal Proceedings*

There are various lawsuitsand claims pending against the Company and certain subsidiaries. In the opinionof the Company’s management, ultimate liability, if any, will not have amaterial adverse effect on the Company’s financial condition or results ofoperations.

*Golden State Water*

On December 14, 2006Golden State Water Company filed a complaint in Orange County Superior Court(the “Court”) against the City of Huntington Beach (the “City”) and two of theCompany’s subsidiaries seeking compensatory and punitive damages fromHuntington Beach and the Company’s subsidiaries. Golden State’s claims relateto alleged breaches of agreements between Golden State and the City, andalleged interference with such agreements by two of the Company’s subsidiaries.

Golden State also filed amotion for a preliminary injunction to stop the City of Huntington Beach fromproviding water to the Company’s Brightwater residential development project onthe Bolsa Chica mesa. On January 22, 2007, the Court denied Golden State’smotion for a preliminary injunction. The Court indicated that an injunction wasnot appropriate because monetary damages would be an adequate remedy if theplaintiff prevails on the merits of their case at trial. No trial date has beenset at this time, and the Company, on the advice of legal counsel, believe thatthere are strong arguments against Golden State’s position.

*California Department of Toxic Substances Control*

On October 13, 2006,the California Department of Toxic Substances Control (“DTSC”) filed a civilcomplaint against our Hearthside Residential Corp. subsidiary (“HRC”) in theFederal District Court for the Southern Division of the Central District ofCalifornia. The DTSC’s complaint requests that HRC pay for approximately $1.0million of costs incurred by the DTSC, together with interest on that amount,primarily in connection with the oversight and remediation of PCB contaminationfound on residential properties adjacent to a 43-acre site where HRCcompleted the removal of PCB contaminated soil during September 2005. HRC’sremediation process was approved by the DTSC in December 2005 when itissued a final acceptance of the remediation work. The complaint also seeks anorder for HRC to pay any future costs which may be incurred in connection withfurther remediation, together with court costs and attorney’s fees.

Since May 2004, HRChas received invoices from DTSC seeking reimbursement for these costs; however,HRC contends, based upon advice of counsel, that it is not responsible for suchcosts because neither HRC nor any affiliate ever developed or built the neighboringresidential properties, neither HRC nor any affiliate generated thecontamination, and the contamination did not emanate from the 43-acresite HRC remediated and, therefore, it should not be part of the same “site” asthe contaminated residential properties. Furthermore, HRC has also disputedsuch charges due to the fact that DTSC did not present its bill in accordancewith the requirements of the applicable law. The Company’s subsidiary intendsto vigorously defend itself in this matter. Therefore, the Company has notaccrued for any of DTSC’s approximately $1.0 million of claims related to theseresidential properties.

See Note 8 for adiscussion of other contingencies.

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*Lease Obligations*

**For theyears ended December 31, 2006, 2005 and 2004, the Company incurred rents forcorporate facilities of approximately $243,000, $219,000 and $166,000,respectively. Future minimum noncancelable operating lease payments for theyears ending December 31, 2007, 2008, 2009, 2010, and 2011 are approximately$312,000, $326,000, $340,000, $353,000, and $367,000, respectively. Thereaftersuch amounts are zero.**

*CorporateIndemnification Matters*

**TheCompany and its former affiliates have, through a variety of transactionseffected since 1986, disposed of several assets and businesses, many of whichare unrelated to the Company's current operations. By operation of law orcontractual indemnity provisions, the Company may have retained liabilitiesrelating to certain of these assets and businesses. There is generally nomaximum obligation or amount of indemnity provided for such liabilities. Aportion of such liabilities is supported by insurance or by indemnities fromcertain of the Company's previously affiliated companies. The Company believesits consolidated balance sheet reflects adequate reserves for these matters.**

**Note 12—RetirementPlans**

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 Code. Plan participants are immediately vested in their owncontributions, while Company contributions vest over a 6-year period. Forthe years ended December 31, 2006, 2005, and 2004, the Company’scontributions to the 401(k) plan were not material.

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):

| ** **                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                   |       | $        | —     |     | $          | —   |       | $ | — |   |
| Interest cost                  |       | .3       |       | .4       |       | .4       |       |
| Expected return  on assets     |       | (.3      | )          | (.4      | )          | (.3      | )          |
| Net amortization  and deferral |       | .1       |       | .1       |       | .1       |       |
| Net periodic pension  expense  |       | $        | .1         |     | $          | .1       |       | $ | .2 |   |

 

The Company estimates that net periodic pension costfor 2007 will approximate the amounts for 2006.

Thedevelopment of the projected benefit obligation for the plan at December 31,2006 and 2005 is based on the following assumptions:

| ** **                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Measurement date                   |       | 12/31/06 |       | 12/31/05 |       |
| Discount rate                      |       | 5.75     | %          | 5.50     | %          |
| Expected long-term rate  of return |       | 8.00     | %          | 8.00     | %          |

 

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During 2006, the assumption regarding long-term returnon plan assets was 8%, unchanged from the prior year. The Company considersboth historical and expected long-term rates to determine its assumption. Thehistorical rate of returns over the past 10 years and five years wereapproximately 9.9% and 8.1%, respectively. The currently expected long-termrates of return on bonds and equities are approximately 8.1% and 7.6%,respectively.

**Plan asset information:**

| ** **        | ** ** | **Target  Allocation  2007** | ** ** | **Allocation  2006** | ** ** | **Allocation  2005** | ** ** |
|-------------------|------------|------------------------------|------------|----------------------|------------|----------------------|------------|
| Equity securities |       |                         | 100        | %                    |       |                 | 100        | % |   |   | 100 | % |   |
| Debt securities   |       |                         | 0          | %                    |       |                 | 0          | % |   |   | 0 | % |   |
| Cash              |       |                         | 0          | %                    |       |                 | 0          | % |   |   | 0 | % |   |

 

Thefunded status and accrued pension cost at December 31, 2006 and 2005 forthe defined benefit retirement plan were as follows (in millions):

| ** **                                                        | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Benefit  obligation:**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Benefit  obligation at beginning of year                          |       | $          | 6.5        |       | $          | 6.7 |   |
| Service cost                                                      |       | —     |       | —     |       |
| Interest cost                                                     |       | .3         |       | .3         |       |
| Actuarial loss                                                    |       | —     |       | .1         |       |
| Change in  assumptions                                            |       | —     |       | —     |       |
| Benefits paid                                                     |       | (.5        | )          | (.5        | )          |
| Administrative  expenses paid                                     |       | (.1        | )          | (.1        | )          |
| Benefit  obligation at end of year                                |       | $          | 6.2        |       | $          | 6.5 |   |
| **Plan assets:**                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of  plan assets at end of prior year                   |       | $          | 4.3        |       | $          | 4.5 |   |
| Net return on  plan assets                                        |       | .7         |       | .2         |       |
| Assets  contributed to plan                                       |       | .2         |       | .2         |       |
| Benefits paid                                                     |       | (.5        | )          | (.5        | )          |
| Administrative  expenses paid                                     |       | (.1        | )          | (.1        | )          |
| Fair value of  plan assets at end of year                         |       | $          | 4.6        |       | $          | 4.3 |   |
| Funded status                                                     |       | $          | (1.7       | )          | $          | (2.2 | ) |
| Unrecognized net  actuarial loss                                  |       | 2.5        |       | 3.0        |       |
| Prepaid benefit  cost                                             |       | .8         |       | .8         |       |
| Additional  minimum liability charged to other comprehensive loss |       | (2.5       | )          | (3.0       | )          |
| Accrued benefit  liability                                        |       | $          | (1.7       | )          | $          | (2.2 | ) |

 

The Company estimates that benefit payments will beapproximately $500,000 for each of the next five years, and an aggregate of$2.5 million for the five fiscal years thereafter. The Company estimates thatit will contribute approximately $200,000 to the plan in 2007.

The $1.5 million and $1.8million balance of accumulated other comprehensive loss as of December 31,2006 and 2005, respectively, reflects the additional minimum liability of $2.5million and $3.0 million, respectively, net of prepaid pension costs. Theamount of the accrued benefit liability is reflected in other liabilities.

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**Note 13—Stockholders’Equity**

*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 $127 million ofNOLs (see Note 9). 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.

On September 18, 2006, the Company’s Board ofDirectors suspended enforcement of the Company’s charter documents thatrestrict stockholders from acquiring more than 5% of the outstanding shares ofCommon Stock. The Board determined that such restrictions were not currentlyrequired to preserve the tax benefits of the Company’s $127 million of NOLs.While the Company remains subject to the Internal Revenue Code’s section 382,which limits the availability of NOLs in the event of an ownership change, theCompany would have five years from the date of any such ownership change torecognize its built in gains and utilize its NOLs. With the recent commencementof construction at Brightwater, and the related built-in-gain of theproject,  the Company believes it willfully utilize its NOLs within the next five years if an ownership change doesoccur; however, the Board may reinstitute the 5% ownership limitation ifcurrently unanticipated events so require.

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

During the year ended December 31, 2006, certaindirectors, officers and employees exercised options to purchase 689,996 sharesof the Company’s common stock at a price of $4.50 per share in accordance withthe Company’s 1993 Stock Option/Stock Issuance Plan (“1993 Plan”). In addition,during the year ended December 31, 2006, a director exercised options topurchase 2,500 shares of the Company’s common stock at an average price of$27.57 per share in accordance with the Company’s 1993 Plan. These stock optionexercises increased cash and additional paid-in capital by $3.2 million.Stockholders equity also reflects an income tax benefit of $3.1 million (whichwas credited to additional paid-in capital) related to the issuance of commonstock upon exercise of stock options during the year ended December 31,2006.

A special dividend of$12.50 per share, totaling $135.7 million, was paid to the holders of theCompany’s common stock on September 28, 2006. This special dividendreduced additional paid-in capital by $135.7 million and was funded primarilyby borrowings under the $125 million Senior Secured Term Loan described in Note6.

**Note 14—Stock Plan**

*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 

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for issuance to officers,key employees and consultants of the Company and its subsidiaries and the non-employeemembers of the Board of Directors (the “Board”). On April 28, 1997, in connection with the Recapitalization, a newclass of Common Stock replaced the Series A Preferred Stock and Class ACommon Stock, and the Compensation Committee of the Board authorized the grantof 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 2004and June 2006 stockholder meetings, the stockholders of the Companyauthorized an additional 150,000 and 250,000 stock options, respectively, forthe 1993 Plan, resulting in total authorized grants of 1,159,984.

During 2004, options for 20,000 shares were issued toa Director at an exercise price of $10.90 and vesting was accelerated to makethe options currently exercisable. The Company granted 10,000 options in eachof the years ended December 31, 2006 and 2005, with a fair value of$90,000 and $104,000, respectively. Each grant vests 50% after one year and100% after two years, and the options have a term of 10 years. The Companyrecognizes compensation expense for stock options with graded vesting on astraight-line basis over the requisite service period for each portion of thestock option grant. Pursuant to SFAS 123 and SFAS 123(R), the Company recorded$75,000, $36,000 and $271,000 of compensation expense during the years ended December 31,2006, 2005 and 2004, respectively, which is reflected in additional paid-incapital.

Asummary of the status of the Company’s stock option plan for the years ended December 31,2006, 2005 and 2004 follows:

| ** **                                       | ** ** | **2006**                    | ** ** | **2005**                                | ** ** | **2004**                                | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Life** | ** ** | **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                 |       |                        | 699,996    |                                    |       |                                    | $          | 4.89 |   |   |   |   |   |   |   | 719,996 |   |   |   | $ | 4.68 |   |   |   |   |   |   |   | 754,996 |   |   |   | $ | 4.50 |   |   |   |   |   |   |
| Granted                                          |       |                        | 10,000     |                                    |       |                                    | $          | 34.62 |   |   |   |   |   |   |   | 10,000 |   |   |   | $ | 31.92 |   |   |   |   |   |   |   | 20,000 |   |   |   | $ | 10.90 |   |   |   |   |   |   |
| Exercised                                        |       |                        | (692,496   | )                                       |       |                                    | $          | 4.58 |   |   |   |   |   |   |   | (30,000 | ) |   |   | $ | 8.77 |   |   |   |   |   |   |   | (55,000 | ) |   |   | $ | 4.50 |   |   |   |   |   |   |
| Outstanding, December 31                    |       |                        | 17,500     |                                    |       |                                    | $          | 21.58 | (a) |   |   | 9.1  years |   |   |   | 699,996 |   |   |   | $ | 4.89 |   |   |   | 2.7  years |   |   |   | 719,996 |   |   |   | $ | 4.68 |   |   |   | 3.5  years |   |   |
| Fully vested and exercisable at December 31 |       |                        | 2,500      |                                    |       |                                    | $          | 24.57 | (a) |   |   | 8.6 years |   |   |   | 689,996 |   |   |   | $ | 4.50 |   |   |   | 2.6 years |   |   |   | 719,996 |   |   |   | $ | 4.68 |   |   |   | 3.5 years |   |   |
| Available for  future grants at December 31 |       |                        | 364,988    |                                    |       |                                    |       |   |   |   |   |   |   |   | 124,988 |   |   |   |   |   |   |   |   |   |   |   | 134,988 |   |   |   |   |   |   |   |   |   |   |

----

(a)           Adjusted for specialdividend of $12.50

 

As of December 31, 2006, there were 17,500options outstanding with a weighted-average exercise price of $21.58 (rangingfrom $13.35 to $25.99) and a weighted-average remaining life of 9.1 years. Alloutstanding unvested stock options are expected to vest. The aggregateintrinsic value of all outstanding, fully-vested and exercisable stock optionsat December 31, 2006 was insignificant.

The Company adopted SFAS 123(R) in the firstquarter of 2006 using the modified prospective method. Similar to SFAS 123,which the Company adopted in 2003, SFAS 123(R) requires the cost of allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair valuesmeasured at the grant date, or the date of later modification, over therequisite service period. For tax purposes, the Company expects to be entitledto a tax deduction, subject to certain limitations, based on the fair value ofcertain equity awards when stock options are 

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exercised. SFAS****123(R) requires that compensationcost be recognized in the financial statements based on the fair value measuredat the grant date, or the date of later modification, over the requisiteservice period. The cumulative compensation cost recognized for equity awardspursuant to SFAS 123(R) and amounts that ultimately will be deductible fortax purposes are temporary differences as prescribed by SFAS 109,***“****Accounting for Income Taxes”*. The tax effect of compensationdeductions for tax purposes in excess of compensation cost recognized in thefinancial statements, if any, will be recorded as an increase to additionalpaid-in capital when realized. A deferred tax asset recorded for compensationcost recognized in the financial statements that exceeds the amount that isultimately realized on the tax return, if any, will be charged to income taxexpense when the restrictions lapse or stock options are exercised or expireunless the Company has an available additional paid-in capital pool (“APIC Pool”),as defined pursuant to SFAS 123(R). The Company is required to assess whetherthere is an available APIC Pool when the stock options are exercised or expire.

SFAS 123(R) also amends SFAS 95, *“Statement of Cash Flows”*, to require companies to changethe classification in the statement of cash flows of any tax benefits realizedupon the exercise of stock options or issuance of nonvested share unit awardsin excess of that which is associated with the expense recognized for financialreporting purposes. These amounts are required to be reported as a financingcash inflow rather than as a reduction of income taxes paid in operating cashflows.

In addition, SFAS 123(R) requires a calculationto establish the beginning pool of excess tax benefits, or the additionalpaid-in capital pool (“APIC pool”), available to absorb any tax deficienciesrecognized after the adoption of SFAS 123(R). The Company has elected thealternative transition method, which includes a simplified calculation method,set forth in FASB Staff Position No. FAS 123(R)-3, *“Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards”* to calculate its beginning APIC pool.

The Company estimates the fair value of its stockoptions using the Black-Scholes option pricing model (the “Option Model”). TheOption Model requires the use of subjective and complex assumptions, includingthe option’s expected term and the estimated future price volatility of theunderlying stock, which determine the fair value of the share-based awards. TheCompany’s estimate of expected term in 2006 was determined based on theweighted-average period of time that options granted are expected to beoutstanding considering current vesting schedules and the historical exercisepatterns of the existing option plan. The expected volatility assumption usedin the Option Model is based on historical volatility on traded options on theCompany’s stock in accordance with guidance provided in SFAS 123(R) andSAB 107. The risk-free interest rate used in the Option Model is based on theyield of U.S. Treasuries with a maturity closest to the expected term of theCompany’s stock options.

Theweighted-average assumptions used for stock option grants in December 31,2006, 2005 and 2004 were as follows:

| ** **                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate  |       | 5.0      | %          | 4.1      | %          | 3.6      | %          |
| Expected life (in  years) |       | 4        |       | 4        |       | 4        |       |
| Expected  volatility      |       | 28.0     | %          | 35.0     | %          | 40.0     | %          |
| Expected dividends        |       | None     |       | None     |       | None     |       |

 

F-27

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**Note 15—UnauditedQuarterly Financial Information**

Thefollowing is a summary of quarterly financial information for 2006 and 2005 (inmillions, except per share amounts):

| ** **                                   | ** ** | **First**  | ** ** | **Second** | ** ** | **Third**  | ** ** | **Fourth** | ** ** | **Full  Year** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------|------------|
| **2006**                                     | ** ** | ** ** | ** ** |       | ** ** | ** ** |       | ** ** | ** ** |           | ** ** | ** ** |   | ** ** | ** ** |
| Revenues                                     |       | $          | 27.9       |       |       | $          | 18.8       | ** ** |       | $              | 24.8       |   |   | $ | 24.2 | ** ** |   | $ | 95.7 |   |
| Cost of sales                                |       | 23.2       |       |       | 15.6       | ** ** |       | 21.4       |       |           | 21.9       | ** ** |   | 82.1 |   |
| Gross operating  profit                      |       | 4.7        |       |       | 3.2        | ** ** |       | 3.4        |       |           | 2.3        | ** ** |   | 13.6 |   |
| Net income                                   |       | 1.9        |       |       | 1.2        | ** ** |       | 1.3        |       |           | 1.2        | ** ** |   | 5.6 |   |
| Other  comprehensive income (loss)           |       | —     |       |       | —     | ** ** |       | —     |       |           | .3         | ** ** |   | .3 |   |
| Earnings per  common share—basic        |       | $          | .19        |       |       | $          | .12        | ** ** |       | $              | .12        |   |   | $ | .11 | ** ** |   | $ | .54 |   |
| Earnings per  common share—diluted      |       | $          | .18        |       |       | $          | .11        | ** ** |       | $              | .12        |   |   | $ | .11 | ** ** |   | $ | .53 |   |
| Weighted-average common  shares outstanding: |       |       |       |       |       | ** ** |       |       |       |           |       | ** ** |   |   |   |
| Basic                                        |       | 10.2       |       |       | 10.2       | ** ** |       | 10.5       |       |           | 10.9       | ** ** |   | 10.4 |   |
| Diluted                                      |       | 10.5       |       |       | 10.5       | ** ** |       | 10.7       |       |           | 10.9       | ** ** |   | 10.6 |   |

 

| ** **                                   | ** ** | **First**  | ** ** | **Second** | ** ** | **Third**  | ** ** | **Fourth** | ** ** | **Full  Year** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------|------------|
| **2005**                                     | ** ** | ** ** | ** ** |       | ** ** | ** ** |       | ** ** | ** ** |           | ** ** | ** ** |   | ** ** | ** ** |
| Revenues                                     |       | $          | 6.5        |       |       | $          | 3.1        | ** ** |       | $              | 24.4       |   |   | $ | 95.5 | (a) |   | $ | 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        | (b)        |       | —     | ** ** |       | 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 |   |

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(a)           The Company recordedrevenues of $66.8 million from non-residential land sales at Bolsa Chica in thefourth quarter of 2005.

(b)          Net income for the firstquarter of 2005 reflects a tax benefit of $4.7 million for the reversal ofvaluation allowances on post reorganization NOLs described in Note 9.

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